Friday, November 16, 2012

Discount rates and market failures: some original content

In grappling with climate change, we face a number of demanding decisions to make about land use, economic growth, and even basic justice. We must invest wisely, and our choices will have a dramatic impact on future generations. The stakes couldn't be higher.

In making these choices, policymakers assess the costs and benefits of a given measure over the life of a project, which in climate terms can be several generations, or even centuries. Because of the time frame, policymakers must gauge the present value of these costs and benefits. In other words, they use what's known as a social discount rate.  This measure looks like an interest rate, or the hurdle rates that corporations rely on when deciding to make business investments.

Many economists are drawn to the view that the social discount rate should track average market rates of return. A proper investment has a discount rate of five or six percent or more.   So the economically minded look for a six percent return on any climate change investments. 

A shaky assumption lies hidden in this point of view.  First of all, it means that the well-being of later generations matters less than economic growth right now.  The justification for this is the faith that later generations will benefit of years of economic development, to which investments like ours will make a strong contribution.

The social discount rate you choose is not a trivial decision. It can dramatically change the assessment of a given project, whether it's restoring wetlands or building flood barriers.

At five or six percent, a centuries-long issue like climate change is not worth much investment at all.  Positive discount rates have a magical effect on the costs of climate change -- they are minimized over short time periods, and they all but disappear over a century or two. Economic growth will take care of the problem.  Besides, an investor could make more money by buying a company and stripping its assets rather than investing in climate-friendly projects. 

Economists who study climate change disagree sharply about the social discount rate to use, with William Nordhaus arguing for a 5.5 percent rate, and Nicholas Stern insisting that a rate larger than 1.4 percent is, in fact, immoral. Stern even suggests that for ethical reasons, we should use a zero discount rate.

I side with Stern. When economists discuss the issue, the ethical dimensions are a major blind spot.   Climate change is also an ethical issue, not merely an economic one. The ethical reason for a zero discount rate -- otherwise we are reducing the standing and value of future generations.  In a moral discussion, all the participants should be on an equal or at least comparable footing.  Generations to come have a very strong stake in what we do today and ethically they must be taken into account.

Even more significant, climate change results from a broad, systemic market failure.  Without strong regulatory intervention, markets have no incentive of addressing externalities like pollution, greenhouse gas emissions, and the like.  We have little reason to believe that markets alone are going to solve the problems that unfettered markets have created.

Most economists are all too eager to minimize or eliminate the ethical dimensions to any discussion of climate change.  In doing so, they rely a psychological blind spot called hyperbolic discounting, which results when we dramatically overvalue present rewards over future rewards. It leads to short-term thinking run amok and unwillingness to plan for the long term.  Future generations get no say at all and have no standing when hyperbolic discounting is in force.

Since economists are inveterate hyperbolic discounters and often heedless of market failures, we should weigh their advice without much enthusiam.

Brooklyn Bridge with Freedom Tower and 8 Spruce Street in the background, New York, United States. A great shot by Kadellar, Wikimedia Commons, under the Creative Commons Attribution-Share Alike 3.0 Unported license

No comments: