Blast from the past


Incidentally, I wrote about the problem of trying to do intergenerational cost-benefit analysis earlier this year:

The biggest problem is the easiest one to state: what is a cost and what is a benefit? How do you value the changes?

As I read it, Stern sort of punts when faced with these impossible calculations. Instead, it relies on status quo bias; now is good, so we should bequeath a world to our descendants that looks as much as possible like the one we live in today. Obviously, there are huge problems with status quo bias, most notably that none of us would like it at all if our ancestors had been at all successful in applying it. On the other hand, "better the devil you known than the devil you don't" is not an entirely awful heuristic. At any rate, that seems to be the underlying assumption of the report. The quickest way to produce that result financially is to set the pure rate of time preference to effectively nothing, and (says William Nordhaus) to rely on the more pessimistic forecasts.

Now, I actually find the moral intuition behind a zero rate of intergenerational time preference pretty compelling, but the practical implications are rather daunting. (A John Quiggin post responds that

"Strange as it may seem to Economist writers, there are phenomena in the world that aren’t particularly illuminated by applying economic concepts. Attitudes towards abortion have nothing at all to do with discounting rates."

Which doesn't strike me as illuminating, because the question at the heart of the Stern Report's choice of discount rates is no more a matter of economic concepts than abortion is. It's a moral philosophy problem: are we, or are we not, entitled to privilege our own interests over the interests of those who are not yet born, but probably will be? Otherwise, the low social discount rate is just a pseudomathematical attempt to dress up your preferences as science.)

Can one reject a compelling moral precept just because it's nearly impossible to live by? That's a question that devout Christians wrestle with every day. I am still thinking through this question. But my instinct to reject the precept simply because it would require me to overthrow half of my policy positions is not, at first glance, an admirable one.

But even if you accept a zero rate of intergenerational pure time preference, you can't just smack the pure time discount rate to zero and leave it. Discounting covers a multitude of financial sins by literally making them disappear. For example, if you have a very low rate of discounting, you run into a problem with future generations: there are too damn many of them. Because there are so many of them, even trivial income streams have extremely high net present values.

This is easy to illustrate with a basic equation, such as a discounted cash flow. Let's say that in year one, we have $100 in income, growing at 3% a year. In year 1,000, this will have turned into an annual income of $687 trillion, give or take a few trillion. If, just to keep things fair, we discount this by the rate of growth, we will find that the net present value of income over the next 1,000 years is $100 x 999 or $99,900.

A 0.1% increase in future income over the next thousand years thus has a discounted present value of about a dime a year, which sums to $99. Using these sorts of discount rates, a cost benefit analysis indicates that we should be willing to surrender up to $89.99 in order to produce this small increase in future cash flows, a patently ridiculous result. Discounting takes care of this problem, because even with a low discount rate, the present value of constant income streams quickly declines to nothing. If you don't use discounting, you have to account for this in some other way, by selecting a utility threshold or something. And measuring utility is a rather tricky business.

Another problem is wealth disparities between generations. As I read it, the Stern Report basically assumes that there are low diminishing returns to income (it sets the elasticity of marginal utility of consumption, or η, to 1). It strikes me as odd to see the left half of the blogosphere supporting this proposition; I'm fairly sure that John Quiggin, who is a social democrat, thinks it is higher than that. (Or at least I hope he does). Heck, I think it is higher than that; this is why I support a progressive, indeed negative, income tax, rather than a flat tax. (Yes, yes, I know: I'm not a real libertarian. You may have my card and my secret decoder ring back.) Discounting takes care of this problem by getting rid of very rich future generations; having done away with it, we are now stuck with them, the lucky bastards. I don't even know how you value marginal utility of even large income streams when incomes are $6 trillion, but it has to be pretty trivial. (Or maybe that's what our ancestors thought about incomes of $30K.) Anyway, I'm unhappy with Stern's approach. I'm not sure that you can reconcile owing anything to that thousand year generation with even moderate utilitiarianism, unless you keep ratcheting up the price of Cape Cod views.

Then there's uncertainty. There's still an awful lot of it, and I am not picking up the banner of the global warming sceptic here--when Ron Bailey has switched sides, I think it's safe to say that this particular debate is over. But we are still left with all kinds of uncertainties about what exactly will happen, and about what the world will look like, economically, technologically, and so forth. Climate stabilisers may kick in; they may make everything worse; in fifty years we may have batteries that let us use solar and nuclear energy for basically everything, meaning global warming will go away. We could find other ways to abate climate change. We could be preventing the recurrance of a new ice age--don't laugh, from what I understand, we're about due. At the risk of sounding like a broken record, normal discounting takes care of this problem, because things become more uncertain the farther they are in the future. Discounting progressively lowers the weight placed on future income streams, until they rapidly vanish.

A fourth problem was pointed out by an economist of my acquaintance: if you do away with time preference, you can't just apply this to the environment; you have to apply it to everything. Perhaps our descendants would prefer flying cars to Bangladesh. If you deliberately apply these low discount rates selectively, that's not a serious intellectual effort; it is at best cargo cult science, at worst intellectual fraud. I, too, have a strong intuitive preference for leaving the planet to our descendants in as good as, or preferably better, condition than we found it. But I recognize that there are strong practical and moral challenges to this desire, and the costs of advancing my preferences by random application of high discount rates outweigh the benefits. Let me make it clear that I am not accusing Mr Stern or anyone else of acting in bad faith. I am just saying that I think committing to the discount rate also entails committing to its use in a range of other applications, or justifying your environmental preferences on other grounds. I presume that Mr Stern and all of his supporters are prepared to do so, or to convince me that I am wrong and that ultra low pure time discount rates are uniquely applicable to the environment.

Which of course raises the fifth, and possibly the biggest problem with Stern: who the heck knows what our descendants want? Again, discounting takes care of this problem by essentially saying, "to hell with those young whippersnappers!" But if you don't do this, you have to attempt to grapple with changing preferences, a task at which, if Fifties SF is anything to go by, you will almost certainly fail.

This is not support for the "do nothing" crowd; like Megan, I think we should do rather a lot, starting with (in America) really whopping gas and carbon taxes. I am against subsidies for alternative fuels as a policy matter; I want to use a cap-and-trade system on greenhouse emissions with declining annual quotas that includes gasoline. (Yes, yes, I'll never use the secret handshake again, either.) But having endorsed these methods, I don't know how much we need to shoot for--and given the crudeness of the Stern Report's methodology, after reading it I still don't know.
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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