Arnold Kling  

The Stern Swindle

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Concerning the discount rate assumptions used in the Stern climate review, Partha Dasgupta writes,


suppose, following the Review, we set delta [the rate of subjective time preference] equal to 0.1% per year and eta [the elasticity of marginal utility with respect to consumption] equal to 1 [so utility is logarithmic] in a deterministic economy where the social rate of return on investment is, say, 4% a year. It is an easy calculation to show that the current generation in that model economy ought to save a full 97.5% of its GDP for the future!

Thanks to Greg Mankiw for the pointer. What Dasgupta is saying is that the approach Stern uses to evaluate intertemporal trade-offs would, if applied generally, suggest that our consumption should drop from over 80 percent of GDP to 2.5 percent, in order to leave the target legacy to our children.

What Dasgupta's comment does is crystallize for me the magnitude of the intellectual swindle that Stern is attempting to pull off. Any time you assign a far-from-plausible interest rate to a long-term intertemporal problem, you get distorted results.

In the Social Security privatization debate, pro-privatization fanatics like Peter Ferrara were using far-from-market interest rates to make privatization sound like a free lunch.

Or consider the swindle of biweekly mortgages, which promise to save you "thousands of dollars of interest." In fact, those savings assumed a zero interest rate. Once you discount at the mortgage rate (or even at a lower short-term rate), and take into account the fees charged by those offering to do biweekly mortgage conversion, you actually come out behind Ed Lathrop's article concludes, "So you think my calling biweekly mortgage plans, "a scam", is being a little harsh? I don't think so, in fact, I think they are out and out robbery!." I used to have an even more biting article about the biweekly mortgage on homefair.com, but it's no longer available. The closest thing I can find is a Google cache of a highly sanitized version that I was forced to put up when we got some threatening correspondence from one of the biweekly-conversion scam artists.

The Stern Review is arguably the policy equivalent of biweekly mortgage conversion. I hope that is not true for the anti-global-warming crusade as a whole.


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COMMENTS (4 to date)
dearieme writes:

Stern was presumably appointed to his task by Blair. Nuff said.

Or perhaps one more thing. In Britain we have an Inheritance Tax rate of 40%. I trust he made a 40% reduction in the environmental "target legacy to our children"?

Bill Drissel writes:

Dr Kling:
I’m an engineer, not an economist. Could you steer me to a text that would enable me to follow Dasgupta? His single sentence dismissal of Stern is important:

“It is an easy calculation to show that the current generation in that model economy ought to save a full 97.5% of its GDP for the future!”

because I have never heard of anyone ever forgoing any consumption for his children’s legacy. Any model that postulates a society that changes from consuming 80% of current production to 2.5% for a doubtful, politically-contaminated, environmental goal is simply preposterous.

I’ve often thought logarithms would make ideal utility functions:
1. Derivative is positive (more is better).
2. Second derivation is non-positive, (diminishing returns)
3, Tractable (continuous, derivatives of all orders)

Regards,
Bill Drissel
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Valuethinker writes:

Bill

In conventional economics, what society invests is deferred for 'its children's future' ie for future time periods.

This would be about 18% of US GDP at the moment, and about 50% of China's GDP.

*however* there are a lot of unmeasurables:

- investment in education, healthcare etc. is an investment in future children. There is a huge correlation between you health and nutrition in childhood, and your level of education, and your life outcome.

For example in the UK I can tell from your postal code at age 15 whether you will go to university, with 90% success. (postal codes take you down to the side of the street)

- investment in cleaner environment is an investment in our children's future (deferred consumption now, for more consumption in the future)

There is a phenomenon called the 'Kuznets Curve' which basically says that once societies reach a certain level of income, they start to *improve* the environment. It's not valid in all places and all cases.

As to your core (excellent) question, I don't have a good reference on Partha's model

http://www.econ.yale.edu/~nordhaus/homepage/SternReviewD2.pdf

is a good plain English summary of the discount rate critique.

I don't find it entirely helpful, though. It seems to me the main concern about Global Warming is the possibility of a 'right tail' event, such as massive methane release, which makes civilisation impossible as we know it.

ie a set of events which *cannot* be adapted to.

If we take that 'right tail' as being a temperature increase of more than 5 degrees centigrade (where Stern says 'no one has tried to quantify the costs') and the percentage chance of that occurring as 20% (the IPCC forecast, which was deliberately conservative) then it seems to me that, prima facie, we have the case for dramatic intervention.

Because this isn't just about valuing Bangladesh, or moving the Dutch to higher ground, this is about our very ability to live on the surface of this planet. James Lovelock has talked about a couple of hundred million of us surviving in a nuclear powered society on the shores of a Mediterranean-like Arctic ocean.

You don't have to go that far to sketch scenarios of billions of people losing their lives, mass destruction, starvation, chaos and war.

Indeed we may already be seeing the first signs of this: Australia is experiencing the 'one in a thousand year drought' which may, in fact, be permanent climate change. In which case, much of Australian agriculture will shut down. The Sahel is in its 7th year of drought. Central China (Chengdu Province) is subsisting on rice rations, having had the worst drought ever recorded. And of course there was Katrina.

Any one of these events could be the natural cycle of the earth's weather, but taken together they paint a picture, along with the highest recorded temperatures ever, of a permanent change in the planet.

One of the things which is ignored in critiques of the Stern Review is its relatively optimistic focus on what can be done, and the range of costs to achieve it. They estimate we can address the excess release of CO2 for a cost of minus 1 to plus 5 (yes, minus 1 would increase the size of the economy) % of GDP in the year 2050. So 2 years of economic growth sacrificed between now and 2050.

*that* seems to me to be an insurance premium worth paying.

http://www.hm-treasury.gov.uk/media/8AC/F7/Executive_Summary.pdf

p13 gives a figure of 1% of world GDP for stabilisation at 550ppm.

Note that the world will be a very much warmer place at 550ppm than it is now. In essence, you could summarise the Stern Review as saying 'primarily we must adapt to Global Warming, but we ought to do something to mitigate it as well'.

http://www.hm-treasury.gov.uk/media/8A3/7A/Chapter_2_Economics,_Ethics_and_Climate_Change.pdf

Valuethinker writes:
What Dasgupta actually says :

I have little problem with the figure of 0.1% a year the authors have chosen for the rate of pure time/risk discount….(p. 6)

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