Social Discount Rate in an Era of Low Interest Rates and Weak Private Investment Nikitas Pittis University of Piraeus, ICRE8 Third SDSN Mediterranean Conference September 7-8, 2017 Athens Greece

Time of Project Evaluation Discounting: At which Rate? Τhe larger the discount rate, the smaller the present value of a future amount Benefit - Cost Benefit - Cost Benefit - Cost $1 $2 $3 t = 0 t = 1 t = 2 t = 3 time Discounting: convert costs and benefits that occur in the future into the equivalent values they would have if realized today today. Discounting Discounting Discounting: At which Rate? Discounting

Social Discount Rate: Main Issues SDR Not Analyzed Here How Should it be Related to Market Rates? Constant or Declining Over Time? Market Rates are at Historically Low Levels Globally A Big Disconnect between Investors’ Willingness to Assume Financial over Economic Risk Compressed Financial Risk Premia Combined with Weak Private Investments

SDR: Two Competing Interpretations Two Discount Rates Social Opportunity Cost Social Rate of Time Preference Determinants? Risk Premium Savers’ willingness to substitute present for future consumption Account for Investment Risk SRTP ≤ SDR ≤ SOC

Empirical Measures of SRTP (For example, Current guidance from the Office of Management and Budget - last revised in 2003, Circular A4): SRTP ~ Long-term (10-Year) Real Government Bond Yield 1973-2003: Average Nominal 10Y Yield = 8.1% 1973-2003: Average Inflation Rate = 5% Hence, Real Rate = 8.1%-5% = 3.1%

Empirical Measures of SOC SOC = SRTP + Risk Premium Risk Premium is the Extra (Excess) Return that An Investor Requires – over and above Risk Free Rate – as a Compensation for the Risk of the Investment Risk Premium is Unobservable Estimates Vary Widely OMB’s Estimate (2003) = 4%

The New Era: A Structural Shift Global Interest Rates are at Historically Low Levels Low for Long? Current US Real 10Y Yield: 2.07% - 1.7% = 0.37% Current GE Real 10y Yield: 0.35% - 1.8% = -1.45%

The Private Investment Paradox: Personal Consumption: Annual Rate of Change Business Investment: Annual Rate of Change Despite the Extremely Lowe Rates, Business Investment has been Persistently Weak REASONS? Structural Cyclical

Interest Rates: Low for Long? Excess Savings from Emerging Markets – China: Global Savings Glut Decline in Potential Growth: Low Productivity Declining Labor Force growth Reasons for Historically Low Rates Ultra Accommodative Monetary Policy: QE Unfavorable Demographics: Ageing Population Most of these Causes are Here to Stay Anemic Demand for Business Investment: Low Productivity Growth Elevated Uncertainty Disruptive Capacity of new Technologies – New Business Models? Decrease in Competition within Industries QE: Financial vs. Economic Risk

Risk Premia: Massively Compressed SDR = Market Rate + Risk Premium Risk Premia The Risk that Investors are Willing to Assume to “Buy” one Unit of Expected Return has Surged

Implications for Government Projects Supply of Funds is Far Greater than the Demand for Funds Private Sector Seems to be Unwilling to Fully Utilize the Available Funds Hence, Public Investments Do not Displace Private Ones (No Crowding Out) Government Projects - especially those that relate to global climate change – May be Used as Instruments for Fiscal Expansion Hopefully, they May Pave the Way for Private Investments related to Climate Change

Potential Impediment: Sovereign Debt Germany is Better Positioned than US for Fiscal Expansion