An interesting story by David Leonhardt in the New York Times, “Amid Ivy, a Battle About the Climate,” on a bit of dueling among economists about the Stern Report.
By way of background, the Stern Report was prepared by Sir Nicholas Stern for the UK government, and was the first attempt by an economist to assess the economic consequences of global warming. He concluded that failing to take corrective measures would lead to a reduction in world GDP of 5% to 20% (this is not one time, but ongoing) while taking action now would cost 1% of GDP.
Seems like a no-brainer, right? The problem is that to reach his conclusion, Stern used what most finance types would consider to be an absurdly low discount rate (0.1%, a truly unheard of figure). The reason he did that (there was a whole philosophical gloss in the paper) was that if you used a more typical discount rate (say the 30 year Treasury bond rate, which is about 5%), anything that happens more than 50 out is just plain irrelevant. It’s worth spending only $87 to avoid a $1000 cost in 50 years. If you use a 7.5% interest rate, you’d only spend $27 today to avoid that $1000 future cost. If you extend the time frame to 100 years, you’d spend only $8 if you assumed a 5% discount rate and 72 cents with 7.5%. And it’s not hard to make a case for higher discount rates.
In effect, Stern changed the prevailing approach to make the fact that our actions now could put an end to advanced civilization show up in his calculus.
As we reported earlier, Samuel Brittan of the Financial Times jiggered with Stern’s assumptions and used a higher (but still pretty low in conventional terms) discount rate and concluded that it still made sense to invest now to combat climate change.
The group at Yale that dissected Stern’s paper included famous names such as William Nordhaus and Jeffrey Sachs. They clearly took a dim view of Stern’s procedure, but after a great deal of hemming and hawing, didn’t dispute his conclusion. Even if you can’t make a compelling case quantitatively, the downside scenarios of global warming are so awful that even economics luminaries agree that it’s best to forestall it.
But the way the discussion was framed is revealing:
….once in a while there is an academic fight that really matters. The economics profession is engaged in one of those right now and, as luck would have it, it’s even more entertaining than most.
Last week, Sir Nicholas Stern, a top adviser to the British government, came to the United States to talk about climate change. In October, a commission he led released a 700-page report calling for “urgent action” against global warming to prevent economic damage that could rival that of the world wars and the Great Depression. Given its source and its tone, the Stern Review has nudged people to talk more seriously about climate change.
In the minds of a lot of American economists, however, the review is a badly flawed piece of work. These economists don’t doubt that earth is getting hotter, that human activity is the cause and that the results could be bad. But they think that Sir Nicholas may have exaggerated the likely speed of warming, among other things, and overstated the case for big, quick action.
The epicenter of the opposition has been here at Yale, and so last week, after stopping in Washington to testify before Congress, Sir Nicholas came to New Haven for a public debate with his critics….
The Stern Review’s most influential critic has probably been William Nordhaus, a 65-year-old Yale professor who is as mainstream as economists come….Mr. Nordhaus wondered if carbon emissions and temperatures would rise as quickly as the report suggests, and Mr. Mendelsohn predicted that people would learn to adapt to climate change, reducing its ultimate cost.
But their main objection revolved around something called the discount rate. The Stern Review assumed that a dollar of economic damage prevented a century from now (adjusted for inflation) is roughly as valuable as a dollar spent reducing emissions today. In effect, the report argues for spending the money to cut emissions because future generations have as much claim on resources as current generations. “I’ve still not heard a decent ethical argument” for believing otherwise, Sir Nicholas said at the debate….
But a dollar today truly is more valuable than a dollar a century from now…. So spending a dollar on carbon reduction today to avoid a dollar’s worth of economic damage in 2107 doesn’t make sense. We would be better off putting the money toward something likely to have a higher return than alternative energy, like education.
Technically, then, Sir Nicholas’s opponents win the debate. But in practical terms, their argument has a weak link. They are assuming that the economic gains from, say, education will make future generations rich enough to make up for any damage caused by climate change. Sea walls will be able to protect cities; technology can allow crops to grow in new ways; better medicines can stop the spread of disease.
No one knows whether this is true, let alone desirable, because no one knows what life will be like on a planet that is five degrees hotter. “If ever there was an example where there was uncertainty, this is it,” said Martin L. Weitzman, a Harvard economist who attended the debate.
While sitting there, I was reminded of the speeches that Alan Greenspan gave a few years ago about the risks of deflation. It wasn’t the most likely outcome, he said, but the consequences of it could be so bad that policy makers had to take steps to prevent it. Focusing attention on this point — the catastrophic risks of climate change — is Sir Nicholas’s biggest accomplishment, whatever you think of his math.
As Mr. Weitzman puts it, the Stern Review is “right for the wrong reasons.”….
In other words, it’s time for a tax on carbon emissions.
I’m as fond of math as the next person, but economics as a discipline has migrated over the years such that any really serious, top level work has to be stated in mathematical terms. It may help in terms of apparent rigor, but one can readily find well argued papers that run afoul of common sense. Here at least the critique of the work did not lose sight of what’s at stake.
But don’t be surprised when you see the various criticisms of the Stern Report picked up on the Wall Street Journal editorial pages, sans the acknowledgment that the conclusions are still likely to be valid.
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Yves,
Came across this a while ago but my proxy at work does not allow me to launch blogger comments. Wanted to correct this one thing though, seeing as it appears you are interested in this subject. Stern is not employing a .1% money discount rate. .1% refers to a parameter in the Ramsey formulation of interest rates known as the Pure Rate of Time Preference (and the applicable version in this case would be the Pure Rate of Social Time Preference). This parameter discounts utility not money/goods. The other parameter of Ramsey discounting is risk aversion. Taken together with his estimate of per capita income growth, Stern uses an effective discount rate of 1.4%. Keep in mind, this is a real, not nominal discount rate. That means for comparison purposes, you’d be comparing with real yields, and certain economists would argue for various reasons that the appropriate yield is the government bond yield. The long term data on that is not very far off Stern’s assumption, (though it is higher), and hence the numbers are not so outrageous (1.4% real vs. .1% nominal is a pretty large difference).
Saying all that, many economists criticize this assumption as being Philosopher King-esque, and indeed Stern alludes to moralist language in the Review to sustain to some degree these parameter choices. The intriguing thing with the PRTP is that if you set it very high, you are effectively saying that the welfare of a few generations hence is meaningless to people here and now (to society). Societal preferences are not like individual preferences- they require less than perfect assumptions to back out from individual behavior. There simply aren’t a lot of immortals running around out there whose revealed preferences tell us about pure rates of time preferences but that is precisely what society is. Even if people had settled on a particular ordained societal PRTP, it’s an highly simplified construct in the first place, and not necessarily a good one given that Ramsey discounting can’t even remotely explain why the risk free rate or the equity risk premium are what they are in the first place. In practice however, there are very good arguments to be made for very low or zero social PRTPs, and there are good arguments to be made for asymptotically declining discount rates applied to social projects.
Be that as it may, Stern is not off the hook. Some have pointed out, fairly, that The Review chose contradictory parameters for modeling in the IAM, (and, of lesser importance, high end estimates for damages), in particular with cross-sectional and intertemporal risk aversion, and based on these choices, many have accused him of reverse engineering a result. Something characterized like this isn’t likely to hold up to policy scrutiny. Weitzman as you point out is one of these who criticizes the review, but has gleaned some salient points from it, which can be summarized (roughly from the review)~ Averaging across probabilities conceals risks. That is an allusion to the impact of uncertainty and it is something Weitzman explores analytically, I think, to great effect (and no surprise this type of approach would more clearly argue for action). As a non-economist who has interacted with known climate change economists in the blogosphere, I can say that I have generally been highly unimpressed as to the way in which many of the estimates of damages from climate change have been estimated. The more you find out, the more scary the picture (one told me blithely that heat stress has no impact on drinking water- apparently he’s never been to the American Southwest or any of the major Asian nations that rely on Himalayan snow melt). In any case, you attention to this subject is welcome, and more broadly, your blog is superb. I would only warn you to beware the source, especially if it’s ever the WSJ editorial page!
Majorajam,
Thanks for taking the trouble to write such a lengthy and helpful comment. I do feel remiss in that I too often comment on things like the Stern Report and simply don’t have time to read the underlying documents. I’ve seen when I do read them that they are frequently mischaracterized, often not in bad faith, simply that a an article has to tell a story and journalist can’t be very nuanced in a short space.
The point you make about societal vs. individual preferences is very important, and unfortunately, most of the lay users of DCF approaches (finance and corporate types) don’t even consider the fact that there ought to be a distinction.
And a real discount rate of 1.4% is credible. I will try to put an addendum on subsequent posts on the Stern report to clear this matter up, since I didn’t have it right.
And thanks for your kind words! They are particularly welcome today, since I had a go with a couple of change deniers earlier.