Friday, March 16, 2012

What's the difference between Keurig Coffee and Nashville city government?

In order to persuade coffee drinkers to switch from normal drip coffee makers to Keurig's unique K-cup coffee system, Keurig has to keep the initial system price low by essentially giving away their coffee makers. Whatever Keurig loses on the machines, it more than gains on future sales of K-cups.

Similarly, Nashville discounts its future pension liabilities at the unreasonably high rate of 8.25%. This allows the city government to save less--and spend more--than they should.

Both Keurig and Nashville are taking advantage of people's irrational over-weighting of the present relative to the future, which is so common that economists have given it a name, hyperbolic discounting.

The difference is that Keurig will make up for the initial loss with profit from future sales whereas Nashville has no such plan. In the meantime, the size of our unfunded debt keeps growing. Someone else--presumably our kids--will wind up with the bill.

As strange as it may sound, we could learn something from California. Just yesterday, Calpers took the unusual step of lowering its discount rate to 7.5% (the actuary had recommended 7.25%). It is unusual because the the policy alleviates future problems, but causes pain today, exactly the opposite of what hyperbolic discounting tells them they should do.

By lowering the so-called discount rate, Calpers could ask the state to eventually contribute an additional $300 million annually. The pension board asked the staff to come up with a plan to phase in the increased contributions from state and other government agencies over the next two years to help soften the financial blow.

That such a small change in the discount rate (0.25%) can have such big effects illustrates the power of discounting. Imagine what would happen if they had to lower their discount rate to a much more realistic number, say 6.5%? (Derivation here).

See also Stossel on city pensions; and how the Swedes solved their pension mess.

And as if this weren't scary enough, the pension problems are dwarfed by the unfunded medical benefits:
while most public pension plans are 75 percent funded, the figure for health-care plans is only 4 percent nationwide. So unlike pensions, governments are setting aside little money in advance to pay for their future obligations.

HT: Instapundit


  1. If both sides of lending are hyperbolically discounting then what is the optimal choice?

  2. I recently saw on of these Keurig coffee machines being demonstrated by the folks over at and a very nice coffee maker, i think I'm sure to buy one of these espresso machines.