Fun With Discount Rates
Cass Sunstein wasn’t entirely pleased with a previous post I did on his paper with David Weisbach about discount rates and climate change and with some justice. So I’ll try to give a clearer and more accurate account of the contours of the dispute.
One thing people often do when engaged in cost-benefit analysis is some discounting of future costs. In other words, we regard bearing $100 in costs today as worse than bearing $102 in (inflation adjusted) costs ten years from now. This kind of issue is relevant to the climate change debate. The costs of reducing carbon emissions in 2009 will be borne in 2009. But the main benefits of reducing carbon emissions in 2009 will be accrued in the future. Consequently, insofar as you use a lower discount rate the case for more dramatic near-term action looks more compelling. As a consequence of that, different economists using the same assumptions about the costs of climate change and the costs of mitigation measures come to different conclusions about policy prescriptions based entirely on the discount rate with some saying we should discount in much the way we would if making ordinary investment decisions and others saying that there’s no ethical justification for discounting the well-being of future people in this way.
Sunstein & Weisbach agree that you shouldn’t discount future people in that way. We should, in other words, adhere to a principle of intergenerational equity. But they say that this isn’t relevant to the issue of the appropriate discount rate to use for cost-benefit analysis. Rather, the right way to think about it is that all proposals to help future people should be subjected to cost-benefit analysis using standard discount rates and then we should do the thing that’s most helpful. Now of course all that still leaves the question of what the appropriate discount rate is to use, which is tied up with various other issues and I’m pretty sure that trying to give an adequate discussion to them would take more space than is appropriate for a blog and I’m probably not the best person to ask anyway. But check out this Brad DeLong post if you want to see some equations.
30 Responses to “Fun With Discount Rates”
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August 26th, 2008 at 10:10 am
For reference, here is Matt’s original post.
August 26th, 2008 at 10:36 am
Yeah, discount rates are a huge fudge factor.
There’s also the question of how much Americans themselves care about future generations. Do people really care much about their great-grandkids? And if they don’t, should we try to make them care?
August 26th, 2008 at 10:40 am
I am concerned that economists are building the concept of inflation into all of our public policy proposals. We’re making decisions not on the cost of things, but on the cost of things projected into the future using equations with questionable assumptions. This has a very large impact on the advertised cost of large projects like public transportation. And, when one agency builds in inflation and another does not it can artificially make one proposal cost more than another.
I feel that inflation becomes a self fulfilling prophecy. A major construction project will factor in a percentage increase in contracting costs for each year of the project. The contractors adjust their prices to match the cost increases. Whether actual costs are going up or not, the inflation has already been factored in.
August 26th, 2008 at 10:48 am
This ties in strongly with the weak sustainability versus strong sustainability debate.
One of the tacit premises of that cost benefit comparison is that all factors are supposed to be translated into comparable values and summed together.
However, that implies a form of general substitutability that is not, in fact, a characteristic of complex natural systems.
Under weak sustainability, if a declining state has a superior cost benefit trade off to a steady state outcome at an acceptable discount rate, then it is superior, with the idea that in some sense the benefits provide sufficient means to acquire substitutes to the make good the losses.
But it is not generally warranted to assume that losses can be made good when talking about, for example, the ecosystem upon with we depend for life support at a level more fundamental than the economy.
Under strong sustainability, the generational equity rule applies first, before any discounted cost-benefit analysis is performed on those proposals that make the cut. If in fact it is possible to make good losses from benefits, that process had to be part of the proposal, rather than causality-free hand waving about the discounted present value of this benefit over here compensating for the discounted present value of that cost over there.
August 26th, 2008 at 10:56 am
you mean “benefits will accrue”.
not “be accrued”.
that would be accrued error to make, even for someone who types homophones.
August 26th, 2008 at 11:01 am
test
August 26th, 2008 at 11:04 am
One of the things that bugs me about the current Climate Change CBA debate is that we’re so caught up in absolute numbers (kind of like the GDP discussion) that we seem to forget about the other factors. Even if addressing climate change will cost us some growth and productivity, HOW ABOUT THE EQUITY BENEFITS? Alternative energy provides more jobs than traditional energy; we’ll be able to get out of the Middle East if we’re energy independent; kids in the innercity won’t suffer so much from asthma; the poor will benefit from increased public transportation. I know that solar panels cost a lot (oh noes! fewer flat screen TVs!), but doesn’t a vision of the future where we address this problem just look a hell of a lot better?
Who exactly are going to be the losers due to addressing climate change? The average American or the billionaires getting fat off of oil money? Personally, think that it hurt those at the top a bit, but that the ultimate effect of raising the lower economic class up. Even if a CBA comes up a bit on the negative side, this sounds like a good thing (if you care about equity, which so many people seem not to care about).
August 26th, 2008 at 11:08 am
“But it is not generally warranted to assume that losses can be made good when talking about, for example, the ecosystem upon with we depend for life support at a level more fundamental than the economy.”
wurd…
I’m just waiting for us to come up with the technology to effectively replace the productivity of the Amazon or ocean eco-systems (yay ocean acidification!). I’m sure we’ll figure somthing out. LOL
August 26th, 2008 at 11:59 am
I’m skeptical about these discussions simply because it seems like a way of economists working to fudge enough numbers to justify a less-than-effective approach. Which, considering the potentially catastrophic effects, strikes me as either naive or, well, evil.
(How do you discount “dead”?)
August 26th, 2008 at 1:12 pm
I’m not so familiar with the literature on conservation investment, but all other areas of finance and economics that I’ve worked with use one thing to assign discount rates: risk of the final outcome. In other words, the more speculative a conservation project is, the higher the necessary discount rate on its expected benefits. So for things like solar, wind and nuclear energy, which are pretty proven concepts that will almost certainly provide a strong payoff even if they need some further improvement, we could use a bond-like discount rate of 1-3% in real terms (solar probably being at the higher end of that range). Same with consumption reduction projects that have almost assured payoffs.
Speculative new sources of power, undeveloped new technologies such as advanced carbon sequestration, those sorts of things would probably need a more equity-like discount rate in the 6-10% range. But it also needs to be noted that even the equity premium seems to be reducing these days, and in fact future relevant real discount rates may shrink to a mere 4-5% for normal equities.
August 26th, 2008 at 1:29 pm
That falls under amortization.
August 26th, 2008 at 3:02 pm
And you people still think economics is some kind of science?
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