Discounting and “Libertarian” Paternalism

Richard Thaler is a leading proponent of “libertarian” (or “soft”) paternalism. But there is nothing “libertarian” or “soft” about paternalism, no matter what it’s called. (See this, for example.)

Thaler’s embrace of paternalism springs from arrogance — the presumption that he knows how others should lead their lives. A sign of that arrogance, and one that finds its way into Thaler’s rationale for paternalism, is the identification of well-being with wealth-maximization.

The surest route to wealth-maximization — for the Thalers of this world — is to evaluate alternative courses of action by discounting projected streams of revenues (income) or costs (expenses). Consider the following passage from an old paper of Thaler’s:

A discount rate is simply a shorthand way of defining a firm’s, organization’s, or person’s time value of money. This rate is always determined by opportunity costs. Opportunity costs, in turn, depend on circumstances. Consider the following example: An organization must choose between two projects which yield equal effectiveness (or profits in the case of a firm). Project A will cost $200 this year and nothing thereafter. Project B will cost $205 next year and nothing before or after. Notice that if project B is selected the organization will have an extra $200 to use for a year. Whether project B is preferred simply depends on whether it is worth $5 to the organization to have those $200 to use for a year. That, in turn, depends on what the organization would do with the money. If the money would just sit around for the year, its time value is zero and project A should be chosen. However, if the money were put in a 5 percent savings account, it would earn $10 in the year and thus the organization would gain $5 by selecting project B. (Center for Naval Analyses,  “Discounting and Fiscal Constraints: Why Discounting is Always Right,” Professional Paper 257, August 1979, pp. 1-2)

More generally, the preferred alternative — among alternatives conferring equal benefits (effectiveness, output, utility, satisfaction) — is the one whose cost stream has the lowest present value:

the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk.

It is my view that economists seize on discounting as a way of evaluating options because it is a trivial exercise to compute the present value of a stream of outlays (or receipts). I should say that discounting seems like a trivial exercise because the difficult tasks — choosing a time horizon, choosing a discount rate, and translating outlays into future benefits — are assumed away.

Consider the choices facing a government decision-maker. In Thaler’s simplified version of reality, a government decision-maker (manager) faces a choice between two projects that (ostensibly) would deliver equal benefits (effectiveness, output), even though their costs would be incurred at different times. Specifically, the manager must choose between project A, at a cost of $200 in year 1, and equally-effective project B, at a cost of $205 in year 2. Thaler claims that the manager can choose between the two projects by discounting their costs:

A [government] manager . . . cannot earn bank interest on funds withheld for a year. . . .  However, there will generally exist other ways for the manager to “invest” funds which are available. Examples include cost-saving expenditures, conservation measures, and preventive maintenance. These kinds of expenditures, if they have positive rates of return, permit a manager to invest money just as if he were putting the money in a savings account.

. . . Suppose a thorough analysis of cost-saving alternatives reveals that [in year 2] a maintenance project will be required at a cost of $215. Call this project D. Alternatively the project can be done [in year 1] (at the same level of effectiveness) for only $200. Call this project C. All of the options are displayed in table 1.

Discounting in the public sector_table 1

(op. cit, pp. 3-4)

Thaler believes that his example clinches the argument for discounting because the choice of project B (an expenditure of $205 in year 2) enables the manager to undertake project C in year 1, and thereby to “save” $10 in year 2. But Thaler’s “proof” is deeply flawed:

  • If a maintenance project is undertaken in year 1, it will pay off sooner than if it is undertaken in year 2 but, by the same token, its benefits will diminish sooner than if it is undertaken in year 2.
  • More generally, different projects cannot, by definition be equally effective. Projects A and B may be about equally effective by a particular measure of effectiveness, but because they are different things they will differ in other respects, and those differences could be crucial in choosing between A and B.
  • Specifically, projects A and B might be equally effective when compared quantitatively in the context of an abstract scenario, but A might be more effective in an unquantifiable but crucial respect. For example, the earlier expenditure on A might be viewed by a potential enemy as a more compelling deterrent than the later expenditure on B because it would demonstrate more clearly the government’s willingness and ability to mount a strong defense against the potential enemy.
  • The “correct” discount rate depends on the options available to a particular manager of a particular government activity. Yet Thaler insists on the application of a uniform discount rate by all government managers (op. cit., p. 6). By Thaler’s own example, such a practice could lead a manager to choose the wrong option.
  • For a decision to rest on the use of a particular discount rate, there must be great certainty about the future costs and benefits of alternative courses of action. But there seldom is. The practice of discounting therefore promotes an illusion of certainty — a potentially dangerous illusion, in the case of national defense.

The fundamental problem is that Thaler presumes to place himself in the position of the decision-maker. But every decision-maker — from a senior government executive to a young person starting his first job — has a unique set of objectives, options, uncertainties, and risk preferences. Because Thaler cannot locate himself in a decision-maker’s unique situation, he can exercise his penchant for arrogance only by insisting that each and every decision-maker adhere to a simplistic rule of thumb — one that obtains results favored by Thaler.

In the context of personal decision-making — which is the focal point of “libertarian” paternalism — the act of discounting serves wealth-maximization (a favored paternalistic objective). But, as I have said,

[t]here is simply a lot more to maximizing satisfaction than maximizing wealth. That’s why some people choose to have a lot of children, when doing so obviously reduces the amount they can save. That’s why some choose to retire early rather than stay in stressful jobs. Rationality and wealth maximization are two very different things, but a lot of laypersons and too many economists are guilty of equating them.

The 34-year-old Richard Thaler of 1979 was arrogantly wrong about government decision-making. The 65-year old Thaler of 2010 is — and has been — arrogantly wrong about personal decision-making.

I will have more to say about Thaler’s wrong-headedness. In the meantime, read this post and follow the links therein.