Unit 9 Lenders and borrowers and differences in wealth

When economists disagree The discounting dilemma: How should we account for future costs and benefits?

When considering policies, economists seek to compare the benefits and costs of alternative approaches, often in cases where some people bear the costs and others enjoy the benefits. Doing this presents especially great challenges when the policy problem is climate change. The reason is that costs will be borne by the present generation but most of the benefits of a successful policy to limit CO₂ emissions, for example, will be enjoyed by people in the future, many of whom are not yet alive.

Put yourself in the shoes of an impartial policymaker and ask yourself: Are there any reasons why, in summing up the benefits and costs of such a policy, I should value the benefits expected to be received by future generations any less than the benefits and costs that will be borne by people today? Two reasons come to mind:

• Technological progress and diminishing marginal utility: People in the future may have lesser unmet needs than we do today. For example, as a result of continuing improvements in technology, they may be richer (either in goods or free time) than we are today, so it might seem fair that we should not value the benefits they will receive from our policies as highly as we value the costs that we will bear as a result.
• Extinction of the human species: There is a small possibility that future generations will not exist because humanity becomes extinct.

These are good reasons why we might discount the benefits received by future generations. Neither of these reasons for discounting is related to intrinsic impatience.

This was the approach adopted in the 2006 Stern Review on the Economics of Climate Change (read the executive summary on the UK National Archives website). Nicholas Stern, an economist, selected a discount rate to take account of the likelihood that people in the future would be richer. Based on an estimate of future productivity increases, Stern discounted the benefits to future generations by 1.3% per annum. To this he added a 0.1% per annum discount rate to account for the risk that in any future year there might no longer be surviving generations. Based on this assessment, Stern advocated an urgent and fundamental shift in the policies of governments and businesses to ensure substantial investments to limit CO₂ emissions today in order to protect the environment of the future.

Several economists, including William Nordhaus, criticized the Stern Review for its low discount rate. Nordhaus wrote that Stern’s choice of discount rate ‘magnifies impacts in the distant future’. He concluded that, with a higher discount rate, ‘the Review’s dramatic results [Stern’s policy conclusions above] disappear’.¹

Nordhaus advocated the use of a discount rate of 4.3%, which gave vastly different implications. Discounting at this rate means that a $100 benefit occurring 100 years from now is worth only $1.48 today, while under Stern’s 1.4% rate it would be worth $24.90. This means a policymaker using Nordhaus’s discount rate would approve of a project that would save future generations $100 in environmental damages only if it cost less than $1.48 today. A policymaker using Stern’s 1.4% would approve the project only if it cost less than $24.90.

Not surprisingly, then, Nordhaus’s recommendations for climate change abatement were far less extensive and less costly than those that Stern proposed. For example, Nordhaus proposed a carbon price of $35 per ton in 2015 to deter the use of fossil fuels, whereas Stern recommended a price of $360.

Why did the two economists differ so much? They agreed on the need to discount for the likelihood that future generations would be better off. But Nordhaus had an additional reason to discount future benefits: intrinsic impatience.

Reasoning as we did in Julia’s choice of consumption now or later, Nordhaus used estimates based on market interest rates (the slope of the feasible set) as measures of how people today value their own future versus present consumption. Using this method, he came up with a discount rate of 3% to measure the way people discount future benefits and costs that they themselves may experience. Nordhaus included this in his discount rate, which is why Nordhaus’s discount rate (4.3%) is so much higher than Stern’s (1.4%).

Critics of Nordhaus pointed out that a psychological fact like our own impatience—how much more we value our own consumption now versus later—is not a reason to discount the needs and aspirations of other people in future generations.

Stern’s approach counts all generations as equally worthy of our concern for their wellbeing. Nordhaus, in contrast, takes the current generation’s point of view and counts future generations as less worthy of our concern than the current generation, much in the way that, for reasons of intrinsic impatience, we typically value current consumption more highly than our own future consumption.

Is the debate resolved? The discounting question ultimately requires adjudicating between the competing claims of different individuals at different points of time. This involves questions of ethics on which economists will continue to disagree.²