Yves here. This short post makes a point that can’t be stated strongly enough: the way that economic concepts and methodologies are applied to situations where they are inappropriate, producing garbage-in, garbage out results.
Sandwichman discusses the use of the finance concept, the time value of money, to climate change. The basic idea of the time value of money is that someone who has money expects to get a return if they give the money to another party with a promise to get it back in the future. That line of thinking undergrids financial analysis and capital budgeting.
Michael Hudson has described how unworkable this becomes when indebtedness becomes significant on a societal level. The interest payments eat into productive activity, which in ancient times led to periodic debt jubilees. The modern solution was bankruptcy, where the debt is written down to some level the borrower can pay (or forgiven if the borrower has nothing left, such as in Chapter 7 bankruptcies).
However, no one goes into a cost of capital analysis when their teen daughter gets pregnant, wants an abortion, and needs the Bank of Parents to pay for it, or when someone had a heart attack and needs a bypass to survive. Nor do we do cost of capital analyses when giving time and money to community and charitable activities.
Let me excerpt a 2007 post at some length to demonstrate this problem:
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:
….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…
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.
By Sandwichman. Originally published at Angry Bear
Peter Dorman calls attention to a NYT Upshot column by Neil Irwin about the cost of climate change. For Irwin, the question can be framed as a matter of discounting, “A dollar today is worth more than a dollar tomorrow and a lot more than a dollar in 100 years. But what discount rate you set determines how much more.”
As Irwin admits, the discount rate is a “business concept.” His conclusion, then, follows exclusively from a business concept of “how, as a society, we count the value of time.” Why are we compelled, as a society, to count the value of time in accordance with the business concept of discounting? Because there is no other concept of time? No, there are other concepts of time. More specifically, there is a concept of time directly opposed to and critical of the business concept of time. Labor time.
What discounting is to the business concept of time, alienation is to the labor concept of time. Alienation refers not to “feelings” of alienation but to the sale of one’s own time — and consequently autonomy — to another.
For every human being — as for the wage worker — there are 24 hours in a day, 168 hours in a week, 8760 or 8784 hours in a year. These are fixed amounts. You can’t put it in a bank and get it back in 20 years with interest. You can’t take it with you and you can’t convey it to your heirs in a will. Today is here today and gone tomorrow.
The discount rate concept has nothing to do with the qualitative experience of time by humans and everything to do with the quantitative accumulation of money by property owners. Framing the cost of climate change as a contest between different discount rates is totalitarian. We live in a totalitarian society in which the non-business concept of time is invisible. Neil Irwin sounds like a thoughtful person. It simply didn’t occur to him that there was any other relevant concept of time than the business concept.
That is why the climate is changing. And that is why not enough will be done about it. Because it all depends on how capital values time.