Wednesday, August 15, 2012

Paul Ryan and the Net Present Value of Human Misery

Mitt Romney's selection of Paul Ryan as his running mate has at least temporarily shifted the debate out of the gutter and into the classroom, notwithstanding the best efforts of President Obama and Vice President Biden to shift it back.

In the long run, possibly Ryan's most significant contribution to public discourse is not the willingness to address "third rail" issues like Medicare but the implicit introduction of the concept of net present value.

For non-financial types, net present value is a very basic financial concept. In the simplest terms, it is the way to answer the question, if I have a dollar coming to me in the future, what is that future dollar worth today? Typically, a promised dollar in the future is worth less than a dollar today - think of the old saying, "a bird in the hand is worth two in the bush." There are two main reasons for this. Reason one is that inflation generally means that a dollar will have less buying power in the future than it does today. Reason two is that while someone may promise you a dollar in the future, that someone may not keep their promise; they may not have the dollar to give you, or they may just decide not to keep their promise. So with net present value we estimate how much the buying power of a future dollar will decline, and how likely the promise of a future dollar is to be kept, and thereby arrive at an estimate of how much that future promise is worth right now.

Think of it this way: which would you rather have, a check for $100 from Warren Buffett, or a check for $1,000,000 from Dennis Rodman?  You would rather have a million dollars than a hundred dollars, sure, but since Warren Buffett is among the world's wealthiest men his check will surely clear, whereas Dennis Rodman is broke and his check would likely bounce. So the $100 check from Warren Buffett is likely to yield $100, whereas the $1,000,000 check from Dennis Rodman, while nominally larger, is likely to yield nothing, except maybe a returned item fee from your bank. The smaller promised payment, by virtue of being far more likely to actually go through, has a higher net present value than the larger payment. The rational person would prefer the more modest promise that can actually be kept.

Conceptually, what Paul Ryan has been doing is applying the concept of net present value not to dollars but to human misery.

Every dollar spent to alleviate human misery today, be it in the form of Medicare, Medicaid, TANF or any other program you care to name reduces the amount of money available to alleviate human misery tomorrow by more than one dollar. This is because whether raised by current taxation, or borrowed (against future taxation), the money spent on those programs in raised by taxes that generally reduce the marginal returns to work, and thus tend to reduce level of wealth that would otherwise be available to finance future efforts to address suffering.

In light of which, the attacks on Ryan as some sort of cruel beast devoid of empathy are simply perverse. The actual choice confronting us is not one between gradually starting to limit the scope of Medicare, or fulfilling its current promises to all future retirees. It is between gradually starting to limit the scope of Medicare, or waiting until we actually run out of money to sharply and suddenly reduce the scope of medicare.

By reducing marginal tax rates (which will tend to improve long term economic growth), and by reducing the growth in Medicare expenses, Ryan's budget proposals substantially increase the probability that we will be able to afford to make good on the promises embedded in programs like Medicare.

I can think of no more humane course.

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