Wednesday, November 4, 2009

On Discount Rates

RFF has published an article by Cameron Hepburn who confuses pure rate of time preference with consumption discount rate. It's troubling that this confusion still keeps popping up among academics. Hepburn says:
In contrast to Stern’s prescriptive approach, previous research tended to be “descriptive” in assumptions about discounting, focusing on what we actually do, rather than what we ought to do from an ethical point of view. The focus was on market interest rates, which reflect the sum of many individual choices. Historic market interest rates (ignoring past and present financial crises) have averaged around 6 percent, so most previous research applied consumption discount rates at roughly this level.
In finance, pure rate of time preference can be calculated from historical real market returns, or if you will, estimated by using the capital asset pricing model for future flows. However, in economics you have (1) the pure rate of time preference (PRTP), and (2) the consumption discount rate, which is PRTP plus the elasticity of marginal utility of consumption multiplied by the growth rate of consumption. In economics, it's not whether PRTP should or could be about ethics; it is about ethics. It's about the value of future, not the value of a future cash flow to you. It's about intergenerational justice, and if future generations were treated equally to us, PRTP should be zero.

Hepburn continues:
Also, if our ancestors had adopted Stern’s perspective, they would have had to devote more resources (by way of savings and investment) for our benefit, reducing their own consumption, and hence also their welfare. This seems unfair given that our ancestors were significantly poorer than we are today.
If our ancestors had known how rich we'd be, they certainly would've not saved more than they did. The reason why Stern chose a lower growth rate than historically, is because there's uncertainty whether that growth can be maintained. In a GHG world, growth is a random variable, and the left tail of probability distribution is thickened by possible impacts of climate change.

Lastly, Hepburn says:
by assuming the probabilities are themselves uncertain, further bridges the divide between the discount rate of the Stern Review and higher market interest rates. Also, it may be consistent to apply high discount rates for aggregate consumption, and low discount rates for (increasingly scarce) natural capital
And there is no connection between the two? For example, would you expect aggregate consumption to go up, if climate change wiped out a significant portion of all arable land? The consumption discount rate can be positive, zero or, in extreme case, negative.

According to Paul Krugman, Prescott had once boasted that Keynes was never mentioned in their graduate programs. I'm afraid that both Cameron Hepburn and William Nordhaus may have been asleep when Frank Ramsey was mentioned in theirs.

Monday, November 2, 2009

Self-fulfilling Prophecies

Angela Merkel on Friday:
It is realistic to say that in Copenhagen we will not be able to conclude a treaty
Guardian, yesterday:
"Nobody thinks we will get a full treaty," said a spokesman for the Department of Energy and Climate Change (UK)


Lars L√łkke Rasmussen, prime minister of Denmark, said: "We do not think it will be possible to decide all the finer details for a legally binding regime."

Hanne Bjurstroem, Norwegian cabinet minister and chief climate negotiator, told Reuters: "I don't believe we will get a full, ratifiable, legally binding agreement from Copenhagen."

Our climate negotiators desperately need psychology 101 before heading to Copenhagen.