GW: Discounting the Stern Report
People prefer to have money today rather than tomorrow. This concept is called the “time value of money” and is the reason why public policy analysis uses a discount rate to convert future cash flows into a net present value.
To understand this, consider a simple hypothetical situation. You have a choice between $100 now or $100 in one year. If you take the $100 now you can invest it and have $110 next year. Obviously, you take the money now. This shows a time value of money = 10%. However, now that you have the money you may decide to spend it. By spending the money you are showing that you get more value from $100 now than you would from $110 in the future, so the correct time value of money is actually > 10%.
There are various reasons why we prefer consumption today rather than tomorrow — today might be the “right” time for the spending, something may stop you having the money, you might not be alive in a year etc. All of these issues mean that the time value of money is higher than simply the return on investment.
There is no universally agreed time value of money so economists often use a range. By convention that range is typically between 5% and 15%. Sometimes a time-limit is added to account for the inherent uncertainty of future outcomes. In his report on the economics of global warming Nick Stern used a discount rate of 0.5% and his timeline extends forever. That’s just silly.
As John Quiggin recently pointed out, Stern also discounts for the the decreasing marginal utility of money (the more money you have, the less important $1 is). However that is a separate issue and should not be confused with the time value of money.
The reason that Stern uses such a low discount rate is that he wants us to give more weight to future generations and consider the welfare of the un-born. But this argument doesn’t hold up to closer scrutiny. While it may seem reasonable to ensure we don’t leave the world worse than we found it, Stern is actually claiming that we are obliged to maximise future utility.
The logical conclusion from Stern’s future-utility-maximising approach is that the current generation should forgo consumption (Nordhaus estimates a 14% decrease, or US$6 trillion) and instead put our money into research and capital accumulation so our kids can be richer. And the next generation should do the same. And the next generation should do the same. The Stern approach would approve of massive costs today to prevent a possible minor growth change in 400 years*. Obviously, no country (and no serious economist) would accept such a framework for evaluating public policy.
There is no moral basis for the idea that we should maximise the utility of non-existent people. Of course people care about their children and grandchildren — but that compassion means that future generations are already factored into the utility maximising decisions of the current population. To use a variation on the previous discounting example, consider if you had a choice between having $100 now and your great-grandchild having $100 in 100 years**. If you want your decendent to have the money you would still take the money today and invest it for 100 years and leave it to them. If people don’t care about future generations we wouldn’t be having this debate. If people do care then they will act accordingly and we don’t need the debate.
There is no case for maximising future utility, but what about the more sensible concern of intergenerational equity? Many people insist that we have a moral obligation to future generations to leave them a world at least as good as ours. However, that will occur irrespective of our action or inaction on global warming. By any reasonable measure (including Stern & IPCC projections) future generations will be far better off than the current generation even if they suffer the worst costs (economic & environmental) of global warming. For example, according to Stern’s growth projections we will have left our decendents are far richer world, with per capital consumption increasing from US$7600 to $94,000 by 2200***. No more poverty.
Using a near-zero discount rate for the time value of money has no moral justification, goes against economic convention and leads to ridiculous and unacceptable conclusions. This significant mistake undermines the conclusions and therefore the recomendations of the report.
* Nordhaus shows that if we use the Stern approach then we should sacrifice 2% of world GDP now to prevent a 10% chance of a 0.01% decrease in income starting after the year 2400.
** Of course it is not necessarily money that we are talking about. Money is simply the convenient unit of value that we measure everything in. It might be that we leave future generations better technology, infrastructure, institutions, health-systems, food, culture, environment or anything else. But we have to use a single unit of value and US$ is easier to use than movies, tractors or hospital beds.
*** As Jerry Tayler (CATO) points out in the US context: ”If global warming cuts GDP by even 10%, then GDP per capita will be $289,515 in 2106 rather than $321,684. Would anyone, let alone liberals, ever propose a 1% tax on those who make $44,000 to create benefits for those who make $289,000?”. Answer: No.
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