Monday, August 8, 2011

A Random Smattering of Shifting Baselines

Here is Russ Roberts on a Keynesian Theory of Aging:
Of course he is right. So the puzzle is why do I look older than when I first arrived at GMU? And the answer is that if it weren’t working at GMU, I’d look even older than I do.
Roberts refers to this idea of a shifting baseline as a "Keynesian" theory of aging. This is somewhat unfair to the logical construct as Keynesians are not the only ones who resort to the shifting baseline argument. It crops up everywhere in economics (and outside of economics). In fact, a quick search of Wikipedia results in another common shifting baseline in economics: inflation.
A conceptual metaphor for a shifting baseline is the price of coffee. A cup of coffee may have only cost a $0.05 in the 1950's, but in the 1980's the cost shifted to $1.00 (ignoring inflation). The current (21st century) coffee prices are based on the 1980s model, rather than the 1950s model. The point of reference moved.
That's not usually the way we describe inflation (and the language is a little odd: "1980s model"), but the logic is right. When comparing grandpa's 5 cent candy bar to my $1 candy bar (note: I shifted from coffee to candy bars), the baseline -- or the level of the prices -- is different.

Another topic where shifting baselines comes up is discounting future costs and benefits. As I have discussed on this blog before, not every cost-benefit analysis does this even though discounting should be common practice.
Suppose we also know the following facts with certainty:
  • In 2059, there will certainly be an environmental catastrophe that costs one billion dollars (in today's dollars) to clean up after the fact.
  • A savings account gets three percent real return per year for every year between now and 2059.
If we set aside $228 million dollars today [$1 billion / (1.03^50)] , the account will mature in 2059 with one billion dollars -- enough to cover the expense of the catastrophe. This means that $228 million is the real cost of a billion dollar expense 50 years into the future.
If you want to be really conservative (and report a large estimate of future costs), let's use a smaller interest rate: the 2011 interest rate (Electric Orange checking from ING Direct yields 1.10 percent APY on deposits greater than $50,000). Using a 1 percent rate, $608,038,825 deposited today leads to $1 billion in 2061, but that $400 million difference ($1 billion - $600 million) is still nothing to sneeze at.

All this discussion reminds me of a wonderful series of Greg Mankiw updates on unemployment and the stimulus. Here was the first post:
What does this mean? One interpretation is that the fiscal stimulus has failed to achieve what Team Obama thought it would. Another interpretation is that the baseline was worse than they believed at the time. I am confident the report authors would adopt the second interpretation. If so, that fact is consistent with what I said in a previous post: In light of the shifting baseline, it is impossible to hold the administration accountable for whether its policies are achieving their intended effects.
He updated it for a long time after the original post. Here is the graph from February 2010 (produced by innocentbystanders.net):


A final point: Mankiw is a Keynesian (technically, New Keynesian).

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