Public investments should cover borrowing costs, not risk of default.
This paper provides a review of the modern finance literature examining how liquidity affects the private sector demand for real assets and financial securities. This literature shows that when firms evaluate risky investments they distinguish fundamental earnings risk and liquidity risks, and choose discount rates that link the discount rates they use to the liquidity and structure of their balance sheets. The government can mimic their behaviour by adopting a procedure that (i) ranks projects by discounting their expected costs and benefits by a low ‘fundamental earnings’ discount rate, perhaps 4 – 5 percent; and (ii) imposes a second ‘liquidity’ discount based on the government’s balance sheet structure and debt objectives that simultaneously determines the quantity of investments. By more closely copying private sector practice, this approach will directly link the quantity of investments that a government makes to the discount rates it uses. It will also enable the New Zealand government to reduce the discount rates it uses to evaluate long horizon investments without compromising its aim of ensuring the public and private sectors adopt a common method of evaluating investment projects.