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.

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* 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.

19 thoughts on “GW: Discounting the Stern Report

  1. 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.

    In a purely libertarian world there would be no fiat currencies. In such a case we would in all likely hood use commodities for money with gold being an obvious example. However such currencies have a storage cost. In the study of money this cost is known as demurrage.

    http://en.wikipedia.org/wiki/Demurrage#Currency

    So negative discount rates are certainly possible. And arguing that there is a moral problem with a zero discount rate is a little bit of a specious argument.

  2. Terje — your wierd (and mostly wrong) money fixation makes no difference on the issue of the time value of money.

    As I explained, you could invest your resources and have more in the future. That would mean (1) no storage cost; and (2) more resources. If you store your money you are showing that you value storing it more than you value investing it at the market rate of return. That means your discount rate is above the market rate of return. Certainly not zero.

    Despite your subtle semantic trick (I never said it was immoral to use a 0 discount rate — just wrong), it is strill true that there is no moral basis for conducting public policy on a future-utility-maximising approach. Ignoring this issue or misrepresenting my argument doesn’t make you right.

  3. At last, an economic debate. Economists arguing about scientists is tedious.

    with per capital consumption increasing from US$7600 to $94,000 by 2200***. No more poverty.

    Is that in current dollars?? Anyway, they’ll just redefine poverty to mean an inability to purchase a personal helicopter or something.

  4. John

    Don’t understand why Stern didn’t use an appropriate discount rate? Do you? I would have thought it would have helped him in a sense by creating the oprincal illusion that we needed less money to act on him advice. PVing Fv means a smaller number.

  5. As I explained, you could invest your resources and have more in the future.

    You could. However under a demurrage based currency you would be passing on the storage cost to others so they would give you a correspondingly smaller return on your investment.

    Go open an e-gold account and you will get a negative return on your investment (about -1% per annum). And yet people do have e-gold accounts. You could have 100gg now or 99gg in a years time. What does it tell you when people choose the latter? It tells you that obviously not everybody will take the money now.

    The whole basis of benchmarking returns is based on the idea that there is such a thing as a risk free rate of return. Which there isn’t. Government bonds may seem like a risk free return but even governments can default on their debts.

    In any case I’m not arguing with your basic point about public policy. I’m just picking at your assumptions about timeframes and what people obviously prefer. The nature of the monetary system is not neutral.

  6. “As Jerry Tayler (CATO) points out in the US context: ”

    I mentioned a little while ago that Stern is actually robbing the poor to hand over a gift to the rich. We are poor by the standards people will be living in 100 years from now. Stern wants to hand these rich people a gift.

  7. “And yet people do have e-gold accounts. You could have 100gg now or 99gg in a years time. What does it tell you when people choose the latter? It tells you that obviously not everybody will take the money now.”

    Central banks lend their gold at a lease rate. People holding E gold are simply getting ripped. I would bet the E bank is lending it out on the lease market if it is physical gold.

    I think you are using an example of retail pricing and saying that is the going rate . it isn’t.

  8. JC — regarding the present value cost of combatting GW — Stern assumes that these will fall steadily and disappear by 2050 as renewable energy becomes more efficient. Therefore, he doesn’t count any costs for after 2050.

    His approach to this is wrong also and I may tackle him on this issue in more detail later. In short, he only counted the higher energy prices as a cost and didn’t consider the consequences of higher energy prices such as lower GDP and potentially lower growth rates. Once these things are considered then there are of course significant costs from action going indefinitely into the future. This is another very significant error and another reason why the Stern report has been attacked by mainstream economists.

  9. Terje — your weird money fixation is derailing this discussion. If you want to debate the evils of fiat start a new discussion.

    It doesn’t matter that somebody has storage costs and may give you a lower return on your investment because of that. What matters is that your return is positive therefore the time value of money is positive. End of story.

    I’m not claiming there is a risk-free asset, but there is a fairly good way to work out what the risk-free rate of return is by using accounting identities. And the relevant point for the time value of money is the expected return anyway.

  10. “Therefore, he doesn’t count any costs for after 2050.”

    Really?????

    “In short, he only counted the higher energy prices as a cost and didn’t consider the consequences of higher energy prices such as lower GDP and potentially lower growth rates.”

    So in a world becoming more energy dependent by the hour he doesn’t think say a cost doubling would have any noticable effects on well being??? This is supposed to be a worthwile report????

    “Once these things are considered then there are of course significant costs from action going indefinitely into the future.”

    So Stern neglected opportunity cost as a relevant issue. Didn’t we learn about opportunity cost in 12 grade?

    In any event you would have to take the effect of the cost in all sorts of ways. The lower growth trajectory being one major issue I would think.

    What’s your Real Cost estimate up to 2100? Have you seen one?

  11. Now now Terje. Don’t jump out of the sandpit. It’s just time to play with some different toys instead of going back to your broken chunk of gold all the time. There’s lots of other fun toys to play with… :)

  12. Terje

    Wanniski was a quack. If we had followed his advice we would have had a massive inflation in the 90’s

    But this is not such a thread so I won’t say any more.

  13. JH, the only people that think you can logically apply nice simple discount rates like (1 – discount rate)^n to things like large scale extinction of species etc. are economists. This is why HC was arguing with you about the cost of a nice sunset.

  14. I agree that most people don’t understand public policy analysis, but that isn’t exactly a good thing. Sunsets and species are nice — but lots of things are nice and at the end of the day you have to use a single measure to be able to offer comparisons. The most convenient single measure is money. Check my second footnote.

    The alternative is that we go on the “vibe” or some sort of religious inspiration. That approach is probably more popular that the economists approach, but it’s not better. And Stern was attempting to write an economics paper, so it’s fair to offer an economists critique.

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