The American economist's vice

Mark Thoma points us to an excellent review by Angus Deaton of the controversy surrounding the Stern climate report. Much of the discussion on the report has revolved around Stern's use of a very small discount rate, on the ethical assumption that we have no reason to value the wellbeing of a future generation less than we value our own.  American critics have objected on the ground that people do not really behave like this, and that the discount rates implicit in market outcomes suggest a much higher discount rate.

Deaton frames this as a conflict between British and American economists, with the former more at ease with making ethical assumptions and the latter preferring to defer to markets.  Deaton leaves no doubt which he thinks preferable--he is definitely not on the side of the country he lives in.

Whatever it is that is generating market behaviour, it is not the outcome of an infinitely lived and infinitely far-sighted representative agent whose market and moral behaviours are perfectly aligned, and who we can use as some sort of infallible guide to our own decisions and policies. The optimal savings and growth models that used to be taught in development courses as tools of central planning, along with careful explanations of why their solutions cannot not be decentralized by the market —remember the transversality conditions? — are now routinely taught in macroeconomics courses as descriptively accurate accounts of the economy. According to some stories, the government does better, correcting our collective missteps, but is it really possible to seriously imagine that an administration that dismissed global warming without economic analysis is nevertheless making optimal provision for future generations? Zero pure time preference, if it is a vice, is surely a minor one. Relying on markets to teach us ethics is very much worse.

I like especially the bit about old-style development economics. Can there be a bigger insult to modern macroeconomics than to say that it is falling into the same kind of trap that traditional development economics found itself in?

Comments

[David]

I actually think it is a very bad review of the reviewers of the Stern review (gee, this is really getting fun!).

First, after reading Deaton's piece one gets the impression that Nordhaus, Weitzman, Arrow and co are of the opinion that nothing should be done about climate change, because they disagree with Stern's ethical assumptions. This is simply wrong. They think Stern's work is bad, but all three of them (as far as I know), are in favour of greenhouse gas mitigation. I think Weitzman coined the term "right for the wrong reason": They believe that the analysis is just badly done by Stern, but conclude that after a proper analysis Climate Change still stands as a serious threat.

Second, I think the main quarrel with Stern's is not that he makes ethics explicit. The problem is the particular ethical position he picks. I don't even think most of these guys mind the pure rate of time preference 0% that much, as long as your overall discount rate is not just crazy, as Stern's is. I think the best way to look at this goes like this: Look at the preference preference ordering that underlies any of these analysis, as expressed in the social welfare function used, like the one of Stern, and ask yourself what else follows from it, other than in the Climate Change arena. If you pick Stern's welfare function and look at what it would mean in terms of money transfers between countries, between generations etc and still believe that it is a reasonable basis for discussing climate change policy, let me know.

[per]

Deaton's comment on Arrow is rather inaccurate. He's firmly in the "British" camp on discounting (see, for example, his chapter in Portney & Weyant eds. 'Discounting and Intergenerational Equity', RFF, 199)

Re the previous comment: the pure rate of time preference cannot be divorced from the discount rate. If you accept 0 rate of pure time preference you're going to need a very high elasticity of substitution for consumption at a given growth rate. That would put you in the camp of Dasgupta, but he's a rather lone voice.

[Per Kurowski]

Yes but both Americans and English bank regulators, ignoring that the markets already prices risks its own way, through their minimum capital requirements based solely on the risks as measured by their outsourced governmental risk surveyors the credit rating agencies, decided they just had to impose an additional cost on the risk of defaults to avoid bank crisis.

Why for instance would it not have been better for reducing the long term risk to all to impose minimum capital requirements for the banks based on environmental risks?

Why is never the possibility considered that a boom-bust cycle produces more net that just a cycle programmed to avoid the risks they have identified as risky. Where are those on either side of the ocean that dare to tell their regulators that the most expensive risk might be the risk avoided.

But they tell you “Ah we have to save the tax payer from having to pay for a bank crisis” and I just ask “Whoever told you that?... it might in fact be that the tax payer ends up paying fortunes just because you did not dare to have him paying taxes for a bank crisis”

[alex]

The problem with both the Stern report and its economist critics is that they quibble over points like discount rate as though they weren't swamped by uncertainties in both both the cost of reducing GHG emissions and the costs of not doing so.

The former is (or at least can be) largely a matter of technological development, with its myriad uncertainties. I say this as someone who's basically a technology optimist.

The latter depends heavily on factors that realistic climatologists don't claim to be able to predict. Yes, the IPCC has authoritative estimates of the range of future global warming, but predicting regional effects is far harder. Will the American Midwest become too arid to grow grain? Will hurricane intensity grow due to higher sea surface temperatures, or will that be counteracted by changes in El Nino patterns?

While you can justify yourself by claiming to have evaluated the range of probabilities, the bottom line is still a WAG (wild ass guess).

I believe that we should limit GHG emissions. The best way to develop new technology is to light a fire under people's butts and watch them move. Until you've done that you don't really know what's possible.

[terence]

"Can there be a bigger insult to modern macroeconomics than to say that it is falling into the same kind of trap that traditional development economics found itself in?"

That they are near Marxian in there determinism and materialism?????

[Barkley Rosser]

Regarding the discount rate issue, the problem is not assuming zero for the pure rate of time preference, it is not putting in an assumed positive future growth rate of the economy, which Arrow has always advocated, along with attempting to account for the marginal utility of income (a trickier matter).

What is sort of funny is that in his main presentation in New Orleans (which I actually managed to see), Stern did plug this into the discussion. But, as near as I can tell, in the actual report they are using a final net discount rate of just above zero, meaning they do not plug that in.

So, one can go ahead an be all British and Ramseyian and assume an ethically pure zero time preference rate. But if one does not want a well-off (arguably "spoiled") future exploiting the present, one should plug in some accounting for their "being better off." That justifies putting in an assumed growth rate, which ought to get one up to a 2-3% discount rate or so.

Of course there is the Chichilnisky et al argument about the "green golden rule" that one should use higher rates for the shorter time horizons and lower rates for longer time horizons, so the future does not exploit the present, but the present does not exploit the future, although this involves time inconsistency and can become somewhat arbitrary. Nevertheless, this seems reasonably to me, and I have heard it claimed, if not verified, that the UK Treasury currently does this for their internal cost-benefit analyses, starting with a 3% rate for the near term and having it eventually decline to a 1%, still above the Sternian level.

[terence]

Thanks Barkley,

The conflation of those two arguments has always confused me. So, instead of, 'what value do we put on future generations?' the question is more 'how much more wealthy will we be in the future? and , in turn, to what extent will that wealth enable us to mitigate the problems we will confront?'

My bet is that economists are reasonably good at answering the first part of this question and terrible at the second.

[Aaron]

Dear sir,

I am a phd student at UCSC in my second year of the program. I just wanted to say that I am one of your biggest fans.

[francois]

as a macro person, I think the ramsey growth model works pretty well, if you take TFP as given. (e.g., think of the effect of a disaster or a war on a country.)
the model does not explain differences in TFP and thus is a poor model of development.
QED

[David]

Ok, just to sort this out: Stern does of course assume a positive growth rate and his discount rate is the combination of the per capita growth rate and the pure rate of time preference, as we all know it from the Ramsey equation.

The growth rate Stern assumes is fairly low (I believe lower than 2%, not 100% sure), and the pure rate of time preference he uses is 0.1%. Finally he assumes 1 as the marginal elasticity of utility of consumption, so that he ends up with an overal discount rate just barely (0.1%) above the assumed per capita growth rate.

I believe the major objection is to the overal discount rate he gets is too low. Whether you reach something higher by using a higher pure rate of time preference or assuming higher growth rates or assuming a higher elasticity of marginal utility, I think one can have long debates about. But the objection of the field seems to be that the particular combination of parameters he picked gives a too low discount rate.

[Per Kurowski]

Allow me as a perhaps not sufficiently humble MBA to pose some questions on this subject to the PhDs.

Should future growth be discounted at the same rate by a country that has $40.000 GDP per capita than one with $1.000 GDP per capita?

Developed countries should probably use a lower discounts rate to find the present value of their perhaps lower future environmental pains while the developing countries should get their present value of future pains by discounting their perhaps higher future pains at their higher discount rates.

Considering the above, does it then makes economic sense to give poor developing countries more leeway in fighting climate change, sort of like giving them carbon indulgencies for free, even though admittedly they will suffer the most from the climate change?

[Barkley Rosser]

David,

Just for the record I have double-checked. Stern used 1.4%, assuming a 1.3% long term real growth per capita, and a unitary elasticity of consumption, which Nordhaus in particular criticizes, along with the 0.1% pure rate of time preference.

Personally I agree with Weitzman that the precautionary principle with the dangerous tail argument is more convincing.

[Mikael]

I am all for looking at markets and reveled preferences. However, in the case of picking a discount rate for the next 100 years, the market is irrelevant. We have no idea what the preferences of individuals in 100 years will be. Hence, what relevance does current market interest rates have on environmental investments with a 100-year time-frame or so?

Second, I think it's very strange to see economists argue for having a positive discount rate due to economic growth. What you're saying is that future generations marginal utility of income will be lower, given their (probably) higher income. What you argue for is then to use weighted-cost-benefit analysis (and I would like to see the same economists argue for wcba in short-term public investments as well then!). Hence, if we argue that we should take economig growth (and decreasing marginal utility) into consideration, this is not an argument for positive discount rates, it is an argument for weighted cba.

[Seth Edenbaum]

"...although this involves time inconsistency and can become somewhat arbitrary."

As opposed to what else under discussion here?

All this makes me think of listening to a group of engineers trying to discuss the molecular structure of cement... in a world where electrons switch polarity.
Tendencies are not laws and the relation between what the world "is" and "should be" changes as we move in time and on the landscape. The past is not the present; Sweden is not the US.

The impartial observation of the lowest common denominators of human behavior, the passive the greedy and the intellectually lazy, by the neutral and high-minded; put forth in numbers and graphs. Talk about teaching to the test!

"History is like foreign travel. It broadens the mind, but it does not deepen it." Descartes

Our mistakes begin there

[rolex watches]

People usually say :"Seeing is believing." http://www.tt88times.com
Each attempt has a corresponding gain, in part or obvious, or vague. At least we have the kind of satisfaction After I bought this watch ,in a sense,it means a great deal to me. http://www.fashionhairfu.com

[my travel]

But the follow-through selling that pushed stocks of some highly regarded companies into tailspins exacerbated concerns that regulators can quickly lose control of the http://www.52travelworld.com markets in a world of algorithmic trading.

[jordan shoes]

I am happy to find this post very useful for me, as it contains lot of information. I always prefer to read the quality content and this thing I found in you post. Thanks for sharing.

[Account Deleted]

raf

Thanks for article. Good.

[Account Deleted]

The new conventional wisdom on globalization emphasizes that reaping the benefits of trade and financial integration is not automatic, and requires better domestic institutions, essentially improved safety nets in rich countries and improved governance in the poor countries.

Property Investment USA
Property Management Firms

[Account Deleted]

Raf
raf

Thanks to you ...

[Account Deleted]

Raf
raf

Good Job ...

[Account Deleted]

Many places and centers offer business and trade promotions to both buyers and supplier.What about the differences in skill intensities across industries? The job losses in the relatively unskilled-labor intensive battery industry should have little effect on the relatively skilled-labor intensive machinery
sexshop
sexyshop
sexshop online

[SellHouseNash]

Good read!

SELL YOUR HOUSE NASHVILLE