Discounting the Future: Economics 1 – AGW 0

How can we evaluate future costs against present ones? Could it be right to apply a discount factor, so that $1 of today is equivalent to, say, $37 in the year 2100 (rate=4%), and to base on that, for example, climate change policy ?

The answer (“yes it may well be right!“) is buried deep among the dozens of comments to RealClimate’s quick rebuttal of Freeman Dyson’s ideas on global warming. And it is written in clear and concise explanations by a “card-carrying economist” signing as “Bob Murphy” (and no, I don’t think he considers himself as an “AGW skeptic”).

I report Murphy’s comments below (for my own convenience, mostly). Nothing against RealClimate here: there are plenty of blogs with hundreds and hundreds of replies by readers, and who knows how much truly insightful stuff is simply lost in the crowd.

One thing to note is that the reactions to Murphy’s perfectly reasonable remarks clearly show what the political and ethical slants of the RealClimate scientists are. Gavin’s conclusion is that “ethics are not discountable [so] there is no reason to think that [we should use] the same discounting rate that applies to today’s monetary investment decisions“. I am sure those are not the last words on this subject.

Bob Murphy Says:
25 May 2008 at 3:04 PM

Like Lou above, I also am a card-carrying economist, so you may want to discount what I say (ha ha)…

For the people who think economists have nothing to contribute to this issue, I guess all I can do is remind them that the various solutions being proposed to tackle climate change involve things economic. E.g., a tax on carbon or a cap-and-trade program. The hard sciences alone don’t tell us how many dollars per ton a carbon tax should be, just as it would be ridiculous for an economist to try to calculate that figure without asking help from the climatologists.

As far as discounting for future generations: You need to use a discount rate to make sure you’re helping them as much as possible. It seems that some posters here are objecting not to the discounting per se, but to the conversion of everything to dollars and cents. I have no problem with that objection.

However, if we’re going to quantify future damages from climate change into dollar terms, then we need to discount those numbers to sensibly determine how much it’s worth spending today to try to mitigate those damages. The reason is simple: We could take the money and invest it, giving a larger inheritance to future generations. Discounting makes sense even if the recipient isn’t alive yet. Presumably our grandkids would rather get something worth more than something worth less. And so that’s why it would be silly, say, to spend $900 today to avert $1000 in damages in the year 2100. It would make more sense to take that $900 and buy T-bills, and keep rolling them over for our descendants.

Again, if that talk sounds crazy to you, because “you can’t put a number on climate damage!” OK fair enough. But your problem isn’t with the discounting per se.

[Response: My problem is with discounting over long time frames, longer than a human lifetime. What if the ancient Greeks two thousand years ago had come up fossil energy, allowing them to thrive for a couple of hundred years? Would we thank them for leaving us a degraded world? Or do you think there would be some bank account somewhere where we could get all the invested money back, with interest, in compensation? David]

Bob Murphy Says:
25 May 2008 at 8:47 PM
David wrote:

My problem is with discounting over long time frames, longer than a human lifetime. What if the ancient Greeks two thousand years ago had come up fossil energy, allowing them to thrive for a couple of hundred years? Would we thank them for leaving us a degraded world? Or do you think there would be some bank account somewhere where we could get all the invested money back, with interest, in compensation?

If the ancient Greeks had attained our current level of technology, then right now I think we would all be thousands of times wealthier than we currently are. If the Earth were a bit warmer than it is right now, that would definitely be worth the extra wealth; everyone would turn up the AC in his or her hovercraft on the way to his or her 10-hour-per-week job.

Yes this is a fanciful scenario, but only because you gave me a fanciful assumption and asked about its implications.

There are billions of people who right now lack basic utilities like clean drinking water and dependable electricity. If they are encouraged (forced?) to try to leapfrog over fossil fuels and go right to solar or whatever, their development will be hindered. And hence their grandchildren will be much poorer than under the business-as-usual case.

I used the T-bill example just to make the point, but it doesn’t rely on direct lineage. E.g. you and I benefit right now from the capital accumulation of earlier generations. When people work with tools and equipment, their labor is much more productive than if we all had to start from scratch with just nature and our bare hands.

Obviously, if you think that business-as-usual will lead to catastrophic damages, then a rational response would be to limit GHG emissions in the present, notwithstanding the high cost. But I’m just saying, the way to handle this in economic terms is to realize that the future damages are so high (measured in $$) that, even with discounting, they are still higher than the present costs of mitigation.

One other point: I want to second the statement of a previous poster, that yes Stern actually does discount future climate damages. This is because of the small probability that those generations won’t exist to enjoy the fruits of our current, costly mitigation efforts. E.g. there could be nuclear war, an asteroid could blow up the world in 2025, etc.

But Stern does not allow a “pure” discount rate, where the utility of future generations is discounted simply because of its futurity. So that’s why his overall discount rate is lower than Nordhaus’, who bases his on the market’s observed discount rate.

Bob Murphy Says:
25 May 2008 at 8:53 PM
David Benson wrote:

Lamont (48 ) wrote “Why can’t mitigating climate change and GHGs produce economic stimulus, rather than be a drag on the economy?” It can. I opine that it largely will be, due to ingenuity and innovation.

I agree that human ingenuity will always find ways to make a given situation better. But the point is, requiring a reduction in CO2 emissions takes away our range of options. Other things equal, it necessarily makes us poorer.

Now of course, most posters here would say other things aren’t equal. They would say the costs of mitigation are outweighed by the avoided damages of further global warming.

I’m not arguing that point right now. I’m merely saying that it’s not correct to, say, count up the “green jobs” as a benefit of a carbon tax or cap-and-trade program. This is because you would have to then include all the jobs that were destroyed (in SUV manufacturing, coal-fired power plants, etc.) by those measures.

If the government passed a law forbidding the production of anything that was yellow, that could only make us poorer. By the same token, if the government says industry has to reduce its carbon emissions by x% next year, in and of itself that makes us poorer.

Bob Murphy Says:
26 May 2008 at 9:26 AM

The real problem with doing nothing now will be the cost in lives not air conditioning later. That means you, your kids and the rest.

But this is also the “real problem” with severe restrictions on the use of fossil fuels. As I said earlier, there are billions of people who don’t have what we consider to be necessities of life. They really are dying every day in ways directly traceable to this lack.

So if your criterion is, “Minimize the number of premature deaths over the next 200 years” or something like that, it doesn’t automatically follow that a massive carbon tax now is the answer. It could be the answer, but it is an empirical question. Many posters here are acting as if altruism for others necessarily implies support for radical curbs on carbon emissions, when it doesn’t. You would have to (a) care about future generations, and (b) agree with some of the more catastrophic predictions, in order to support radical measures today.

On the issue of discounting, I agree that on the face of it, it sounds crazy to even ask, “How many future people are worth one person today?” But as I tried to get across (obviously not very persuasively) in earlier posts, the fact is that the price of current purchasing power is higher than (right now) the price of purchasing power in the year 2100. So there needs to be some discount rate (and people can argue about how high it should be) to make sure present mitigation efforts are as effective as they can be.

One final note: I am not saying that the psychological motivation of most “deniers” is concern for people dying of dysentery in Africa today. Of course not. But even so, it is a fact that there are people we know are dying today from poverty. Their efforts to climb out of poverty will be hampered by mitigation proposals. So it’s not simply a matter of, “Do you value human lives?” It’s an empirical an ethical issue of, “Is allowing x more people to die for sure over the next 20 years, counterbalanced by models that lead us to believe we will thus save x+y people over the next 200 years?”

Incidentally I am not being sarcastic in writing the above. The answer may very well be “yes, it is worth it.” I’m only trying to show that it is a question of balance, to quote Nordhaus. It’s not simply, “Do I value my SUV more than 80 kids 100 years from now?”

Bob Murphy Says:
26 May 2008 at 1:25 PM
In response to post #70, raypierre wrote:

The two points you make have been quite thoroughly addressed, but you weren’t paying attention….Besides [Nordhaus’ dubious model], there’s the highly questionable issue of the discount rate assumed by Nordhaus and many other economists. David addressed that specifically in his post.

Hang on a second. The following is David’s addressing of the issue of discount rates:

I personally can get my head around the concept of discounting if the time span is short enough that it’s the same person on either end of the transaction, but when the time scales start to reach hundreds and thousands of years, the people who pay in the future are not the same as the ones who benefit now.

There’s no polite way I can say this, but the above is honestly analogous to me (an economist) criticizing the IPCC at a website like WeHateGore.org and saying, “Personally, I don’t see why we should put any faith in these models. They can’t even tell me if it’s going to rain next week, so when the time scale goes to hundreds or thousands of years…!”

So whatever your thoughts on discounting, David’s expression of personal confusion over the practice of economists hardly counts as a thorough disposal of the practice.

And yes, some people pointed to Weitzman’s work, and the RFF paper. Again, this is analogous to me pointing to Lindzen and saying, “Look, even an MIT expert on this stuff agrees with me! These models are bunk!”

It’s hard to keep the different objections separate on this thread. As I keep pointing out, a lot of people here don’t like the idea of using dollar measurements in the first place, in which case the discussion of discounting is superfluous.

But if you are prepared to accept that a cost/benefit test of proposed mitigation measures isn’t absurd, then the next step is to ask whether future costs and benefits should be given equal weight to present ones.

And I’m saying the answer is no, because whether we agree with it or not, the market right now undervalues future dollars. So we can achieve our aims more cheaply by recognizing this basic fact, rather than declaring it immoral.

I’ll try one more analogy to get the point across. Suppose there is a homeowner trying to decide whether to spend $1000 renovating the insulation in his house, in order to save $100 on utility bills per year. Should he do it or not?

If David is right, then before we can answer that question, we need to know how old the homeowner is. After all, if he’s going to die in two years, then clearly the expenditure isn’t worth it, right?

(The standard answer of course is no, the age of the homeowner is irrelevant, assuming he wants to pass on as much wealth as possible to his heirs. They will reap the benefits of the efficient purchase of insulation. They would rather get the insulated home, and $800 less in cash, than the non-insulated home, and $800 more in cash. [The $200 comes from the two years of life left in the homeowner, in which he lowers his utility bills from the new insulation.])

[Response: There is a real difference between assessing a discount rate for dollar investments for which clear alternatives are available (i.e. why bother to invest in something special if the bank interest rate is higher than the expected return), and assessing the worth of non-economic goods (’the social discount rate’). Confusing the two concepts is at the heart of most of the noise surrounding this issue. To give an extreme example for clarity, if someone uses a bomb to blow up someone today, that is surely just as heinous as if they bury the bomb and set it to blow up tomorrow (or next week or next year). It is equally unethical to set the timer for a day in the future as for a hundred years, yet any substantial social discounting would downgrade the crime to a misdemeanor given a long enough lead time. There is a difference and pretending that only the economically illiterate think so, is not constructive. It is however an ethical decision, and can’t be proven one way or another using economics alone. – gavin]

Bob Murphy Says:
26 May 2008 at 1:28 PM
One final comment, and then I think I should quit while I’m ahead (or not too far behind): Nordhaus is actually on “your” side in this. He has been one of the most vocal economists on the importance of climate change.

If you think he is unduly activist, it might be because, as a professional economist, he sees costs of your personally favored policies that you aren’t considering.

Bob Murphy Says:
26 May 2008 at 1:52 PM
Whoops–typo: I meant above to say that if you think Nordhaus’ isn’t activist enough, then it might be because he is worrying about drawbacks to mitigation policies that you aren’t taking seriously. I.e. there seems to be a sense here that because he’s skeptical of some approaches, he must not care about the environment as much as Gore (or Stern) does. And I don’t think that’s it at all. Believe me, I have been a critic of Nordhaus on this very issue, so it’s odd that I’m defending him here.

Bob Murphy Says:
26 May 2008 at 2:54 PM
Well shoot, I said I was done pestering you guys, but then Gavin goes and makes a great analogy that I hope will really clarify our different positions on this. So if you’ll forgive me for one more attempt:

There is a real difference between assessing a discount rate for dollar investments for which clear alternatives are available (i.e. why bother to invest in something special if the bank interest rate is higher than the expected return), and assessing the worth of non-economic goods (’the social discount rate’). Confusing the two concepts is at the heart of most of the noise surrounding this issue. To give an extreme example for clarity, if someone uses a bomb to blow up someone today, that is surely just as heinous as if they bury the bomb and set it to blow up tomorrow (or next week or next year). It is equally unethical to set the timer for a day in the future as for a hundred years, yet any substantial social discounting would downgrade the crime to a misdemeanor given a long enough lead time.

OK thanks, as I said this really crystallized our differences on this. Note that we’re actually closer to agreement than you seem to think; all along I have said, “If you don’t want to put a dollar value on lives or the environment, that’s fine. But if you do then you need to discount.” I think we’re both agreed, then, that the basic problem with Nordhaus is his attempt to monetize everything, rather than his application of a discount rate to those monetary values.

But anyway, back to your example: First of all, under the law you will get a lighter sentence (today) for planting a bomb set to go off in one year, than if you planted one that went off two minutes ago. And the difference of course is that you haven’t actually killed anybody with the first bomb. This is relevant to the climate discussion, because those future harms might not actually occur. And I don’t even mean, maybe carbon-munching trees will be developed. As I said, Stern discounts the future because of the possibility that those people won’t exist (asteroid, nuclear war, etc.).

(Now in fairness, you could say, “OK, if the bomb is set to go off in one week, versus one year.” I don’t know what the legal treatment of these cases would be, but in either case you would not be charged with murder, because no one is yet dead.)

But now let’s make your bomb scenario a little closer to the climate change one, and hopefully you’ll see why I keep insisting that discounting is important. Suppose that instead of just an outright government crackdown on bomb-planting, the government capitulates to the bomb lobbyists and only imposes a $35 tax on every bomb planted. (Maybe most citizens view bomb planting as essential to their way of life.)

Now in that case, it really would be crazy to not discount the fine based on the timer setting, because otherwise the same crime would be penalized at different levels. E.g. someone today plants a bomb set to go off in one year, and he gets fined $35. Then next year, someone plants a bomb to go off in 24 hours, and he also gets fined $35.

Both bombers killed one person in the year 2009. But the first bomber paid a higher fine, because he had to pay $35 in 2008, while the second guy had to pay it in 2009. During his trial, the first guy in 2008 could have said, “Hang on a second! Don’t make me pay it now, make me pay the $35 when it actually kills someone.” And naturally he would prefer that outcome, because he could set aside less than $35 today (in 2008 when he’s convicted), and let it roll over to $35 in 2009 when his bomb actually causes damage.

So that’s one way of seeing why, if you’re going to bring monetary incentives into it, which plenty of environmentalists want to do, then it matters that “current money” is more expensive than “future money.”

To insist that monetary fees (carbon taxes, prices for cap-and-trade permits, etc.) reflect the prevailing exchange rate between present and future dollars, is no crazier than saying a carbon tax expressed in Japanese yen has to be higher per ton than a carbon tax expressed in US dollars.

To push the bomb analogy even further, yes it certainly would be better if the bomb planters could be persuaded to set their timers farther into the future, even if we’re solely concerned about minimizing the damages from their actions. This is because we have more time to adapt to the bombs. People in the vicinity can move away, they can buy armor for their cars, etc.

Obviously I’ve carried the analogy a bit far, but I’m just trying to show that the closer you make it to the actual situation of carbon emissions causing future damages, and especially where the government’s response is to inflict monetary fines on the parties doing the damaging, then you need to use discounting. Otherwise you end up with an outcome that is inferior from everyone’s viewpoint, to what would be achievable if discounting were used.

[Response: My point was only that ethics are not discountable. It is equally unethical to plant the bomb with a one day setting as with a century setting. Your extension to my analogy is really a stretch to make an ethical point into an economic point – I don’t see that any of your additional assumptions are necessarily valid. But nonetheless, there are clear uncertainties with future actions that mean that something that is almost certain to happen if I plan it for a day ahead, is less certain if I plan for a century ahead. Fine – some kind of allowance needs to be made for that (as Stern does). But there is no reason to think that it should be the same discounting rate that applies to today’s monetary investment decisions. – gavin]