Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [104]
THE PROBLEM OF DISCOUNTING THE DISTANT FUTURE
Consider the Stern Review on climate change, written under the direction of British economist Sir Nicolas Stern, former chief economist of the World Bank. Most criticisms of the Stern Review are related to the discount rate, which was fixed at 1.4 percent per year in the Review. It asserts that most of the consequences of global warming will not appear before the year 2100. Thus, it isn’t the current generation but future ones who will bear the costs stemming from global warming. A crucial issue, then, is to determine how much the current generation should be ready to pay to reduce these future costs. We all agree that one dollar obtained immediately is better than one dollar obtained next year, given the positive return we can get by investing this dollar. This argument implies that costs and benefits occurring in the future should be discounted at a rate equal to the rate of return of capital over the corresponding period.
Because it is hard to predict the rate of return of capital for several centuries, one should instead select the discount rate, which, in turn, entails careful evaluation of the welfare effect of the environmental policy under consideration for each future generation. Because one compares consumption paths in which costs are redistributed across generations, it is important to make explicit the ethical and economic assumptions underlying these comparisons. Most environmental policies will generate winners and losers, but economists evaluate the welfare gain by defining an intergenerational welfare function that is a (discounted) sum of the welfare of each generation.
The welfare approach to discounting is based on the additional assumption that future generations will be wealthier than us. Suppose that the real growth rate of the world GDP per capita will be 2 percent per year over the next 200 years (as was the case over the last two centuries in the Western world), which implies that people will enjoy a real GDP per capita 50 times larger in 2200 than it is today. Suppose also that, as in the Stern Review in which the representative agent has a logarithmic utility function, doubling the GDP per capita halves the marginal utility of wealth. Combining these two assumptions implies that one more unit of consumption now has a marginal impact on social welfare that is 50 times larger than the same increment of consumption in 2200. This wealth effect corresponds to a discount rate of 2 percent per year.1 But is the future a simple mirror of the past?
In my view, it is absolute nonsense to justify discounting the future based on this argument without taking into account the enormous uncertainty affecting the long-term growth of the world economy. Estimating the growth rate for the coming year is already a difficult task. No doubt, any estimation of growth for the next century/millennium is subject to potentially enormous errors. The history of the Western world before the industrial revolution is rife with important economic slumps (as a consequence of the invasion of the Roman Empire, of the Black Death, of worldwide wars, etc.). Some experts argue that the effects of the improvements in information technology have yet to be realized, and that the world faces a period of more rapid growth. But others insist that natural resource scarcities will result in lower growth rates in the future. Still others posit a negative growth of GNP per capita in the future, due to deterioration of the environment, population growth, and decreasing productivity. These disparate views cast doubt on the relevance