‘Only pessimism will save us’
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The Office Budget Responsibility’s inclusion of the rising costs of climate change in its own forecasts for the path of the UK government’s debt was a positive step forward. As an aside, the then shadow chancellor John McDonnell announced this would be Labour policy in autumn 2017.
These costs nonetheless remain grossly underpriced, as Nick Stern has recently noted, focusing on the use of an excessively high “discount rate” in conventional economic modelling.
The discount rate is intended to capture the price of future events – typically expressed in cash flow terms – in terms of money available today.
Cost-benefit
You can think about it as something like the price of the future: the higher the value of this discount rate, the more the future is ‘discounted’ relative to the present; the lower the value, the more valuable the future will appear to be to us today.
This crops up in formal cost-benefit analysis, including cost-benefit analysis of climate change policy, as a way to try and systematically present potential future costs and benefits.
In an idealised capitalist economy of “perfect capital markets” the discount rate would take the same value as the interest rate for borrowing.
However, we don’t live in that idealised economy and aren’t ever going to, so the value of the discount rate has to be calculated: no capital markets exist for a whole load of future outcomes we might be interested in – it’s not possible to borrow today against the value of a marine species not being extinct in 15 years’ time, for instance.
This is where the arguments kick in. The review of the economics of climate change, led by Stern – and published 15 years ago – has a very clear walk-through of the case for believing that the discount rate we use in trying to price the future should be low – pretty close to zero.
Consume
Stern’s argument is that since there are no ethical grounds for deciding that future humans are less deserving of consumption than those alive today, therefore the part of the discount rate which reflects our inherent valuation of the future – the ‘rate of social time preference’ – must be close to zero.
He said: “The only sound ethical basis for placing less value on the utility – as opposed to consumption – of future generations was the uncertainty over whether or not the world will exist, or whether those generations will all be present.”
The question of how to value the future is fundamentally an ethical one. John’s Roemer’s paper, responding to the Stern Review, has further discussion of this point.
I’m going to come back to the problem of extinction, since what we’re dealing with today is likely to be not the relatively near-term loss of all human life, so much as things merely becoming more and more horrible forever.
For now, note that Stern doesn’t think the discount rate should simply be zero since the Review also argues that consumption growth will continue into the future as the economy grows, and that we will continue to value having more stuff to consume.
Wealth
This is the “Ramsey model” of discounting and, if we accept the premise that consumption growth will continue and that at the margin we always value more consumption, it makes sense.
If we further accept the methodological assumptions that a marginal utility for a “representative agent” can be aggregated to society, that individuals optimise, and that optimisation over time occurs around a given growth path: the usual neoclassical premises.
The discount rate Stern arrives at is 1.4 percent. To put this in context, the UK Treasury’s Green Book guidance for project appraisals by the UK Govenrment suggests that projects looking for investment should usually be evaluated with a discount rate of 3.5 percent.
The difference between the figures amounts to the Treasury saying that – relative to opinion of the Stern Review – those born recently and those who will be born in the future have standards of living that are worth less than those born further into the past.
A flipside of this, incidentally, is that the accumulated wealth of generations past but still alive is also worth significantly more in making evaluations than the potential wealth of future generations. You can draw your own conclusions about how closely this might fit the preferences of the current government.
Consequence
But there’s another factor at work here. If we accept Stern’s argument that “there is no serious ethical argument in favour of pure-time discounting” – i.e. we should treat future generations’ consumption as valuable as we treat our own – we are left with a discount rate that is based almost entirely on the expected rate of growth, and our estimate for how valuable we think new growth will be to those alive in the future – their ‘marginal utility’ of additional consumption.
The faster the rate of growth in the future, the higher the discount rate, since the assumption at work here is that the marginal utility of extra consumption declines as the economy grows – once we have lots of stuff already, we don’t care so much about having more, is the assumption.
That means that if the rate of growth is high, we will be richer in the future than otherwise, and so any additional consumption taking place in the future will be worth less to us than consumption taking place today, when we are poorer.
We are assuming in other words that we will all be richer in the future, anyway, so in terms of today’s consumption, we don’t care so much about consumption that takes place in the future. Again, the reverse applies: faster future growth also means the results of past growth appears to be worth more.
But this has the fairly direct consequence that if the expected rate of growth falls, the discount rate also falls since people in the future will be less well off than we were expecting them to be.
Damaging
Shocks that produce permanent losses in growth increase the value of taking action today, since future consumption will become worth more by comparison to today – there will be less of it than we expected, so we value it more by comparison, and losses to that consumption in the future from, e.g., catastrophic climate change, will appear more serious to us today.
We are, of course, still living through exactly such a negative growth shock, in the form of Covid-19: even if we accept the Office for Budget Responsibility’s seriously over-optimistic calculations of those permanent impacts, growth in the future will still be reduced as a result.
Throw in the rising costs of extreme weather, food shortages, future disease outbreaks and so on and, over time, the discounting model tells you that the costs of inaction now rise as growth falls away. So far, so sensible.
But note the flipside of this: excessive optimism about future growth reduces the case for taking action right now. Our conventional economic modelling is still trying to act as if two percent growth was the inevitable trend over the long term, a claim supported by the OBR. Indeed, the OBR has stated: “We expect growth in output per hour to rise steadily towards two percent over the long term…”
This being the case, we will consistently underprice the future and underdeliver on necessary action on the climate. It’s not just that optimism about the future is likely to be proved wrong. It’s that it is actively damaging today. Only pessimism will save us.
This Author
Dr James Meadway is an economist and a former advisor to the UK shadow chancellor.
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