Monday, February 05, 2007

Discount rates 

A question that arises whenever you teach cost-benefit analysis is "what is the right discount rate to use?" for treating the flows of future costs and future benefits. Over at their blog, Richard Posner and Gary Becker debate the point considering global warming and the new report from the IPCC. (John Hinderaker and Brian Ward discussed global warming on NARN Volume I on Saturday. It's worth a listen.)

The debate about discount rates has been around for some time. Becker explains:
Suppose the utility damages from global warming to generations 50 years from now are equivalent to about $2 trillion of their welfare. At a 3 percent discount rate, this major damage would be valued today at about $500 billion, while any spending today that reduces the harm to future generations would be valued dollar for dollar. Then with a 3 percent discount rate it would not pay to eliminate these very harmful effects on future generations if the cost were $800 billion (or more generally at least $500 billion) to largely eliminate the future harm from greenhouse gas emissions through steep taxes on emission, carbon sequestration, and other methods. To be sure, benefits would exceed the present value of costs of greenhouse warming if damages were discounted only at 0 percent, 1 percent, or as high as almost 2 percent discount rate. When analyzing effects much further into the future, such as 150 years into the future, the discount rate used is even more crucial.
A social discount rate permits one to account for the effect of current actions on future generations; these are usually not figured into private market analyses of benefits and costs, and thus we would have private market rates greater than the social rate you would use. But some analyses, including those of the IPCC, are using very low discount rates.

Discount rates reflect two parts of human behavior: impatience and diminishing marginal utility. We need to be induced to delay consumption, so we receive an interest payment to forgo consumption today. When Wimpy tries to borrow money for a cheeseburger today in return for a cheeseburger Tuesday, Popeye declines because he has no inducement to forgo the possibility of today's cheeseburger. Likewise, Wimpy isn't as willing to pay a premium for second cheeseburger today as he is for the first cheeseburger, because some of his hunger has been satisfied by the first.

In the case of global warming, one issue Becker and Posner discuss is whether we are more willing to pay for reducing greenhouse gases later, when we are wealthier than we are now.

The argument against this is that we cannot bargain on behalf of our children; when we discount, we are speaking on behalf of their utility without their permission. There is therefore a missing market for the utility of future generations, and the enlightened, noble elites say they will speak on the behalf of the generations yet to come. In particular, the part of the market's discount rate that reflects impatience should be removed, the argument goes, because we cannot assume that our impatience will be theirs.

But why should we trust the elites to make these arguments? If you are going to use an argument like that in the previous paragraph, you should also then account in any cost-benefit analysis the cost of government in raising a dollar of public spending. There are costs of collection and of compliance. There are costs of resource misallocation as the government monkeys around with free-market prices (what we call "deadweight losses.") Will these be included in the IPCC report? Not hardly.

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