Once upon a time, canals were the latest thing in infrastructure investment. During the early years of the Industrial Revolution, they made it possible to move heavy goods, like coal, from mines to factories, using a fraction of the energy required by road transport. Delicate goods, like pottery, could be shipped with little breakage. Enterprising engineers and industrialists built canals in all sorts of unlikely places. There is even a canal system that crosses from England into the Welsh mountains, complete with the towering Pontcysyllte Aqueduct, which allows canal boats to traverse the Dee valley.
I visited Pontycysyllte this summer. When I showed Nick Rowe my holiday pictures and told him about the canal, his first reaction was “this is an argument for discounting future returns”
Why? The Pontcysyllte Aqueduct opened in 1805. Within 40 years, it was becoming obsolete, as railways began to supersede canals. Pontcysyllte exemplifies the fact that investment is an uncertain business. Any kind of technological or other kind of shock can cause the returns to infrastructure investment to evaporate.
For example, suppose I build a canal, expecting to generate, if current economic trends continue, a return of $5 million per year indefinitely. What if, every year, there is a one percent chance that a technological revolution will cause the canal's future profits to fall from $5 million per year to zero? The amount that the investor can expect to receive from the canal in year t then becomes 0.99t*$5 million - the compounded effects of there being, in every year, only a 99 percent chance that the canal will continue to be useful. In a picture:
The expected returns shown in the picture above are not the result of a traditional net-present-value calculation. Even a person who is indifferent between receiving $1 now and $1 in the future must realize that the future is uncertain, and factor that uncertainty into his or her investment calculations - not by discounting the future, but rather by recognizing uncertainty when estimating the future benefits and costs of their investments.
My reaction to the Pontcysyllte Aqueduct was very different from Nick’s. I thought: “this is an argument against discounting.” Why? Today, the Pontcysyllte Aqueduct is a lynchpin of the local economy. The tourists it attracts are one reason why the nearby town of Llangollen is thriving. The benefits that Pontcysyllte is generating now, more than 200 years after it opened, matter.
Discounting means that far distant costs and benefits are ignored in cost-benefit analyses. For example, using an 8 percent real discount rate – the rate cautiously suggested by the Treasury Board here - a $100 benefit received 200 years in the future is not worth one penny today. Yet when I stood on Pontcysyllte Aqueduct this summer the experience didn’t feel worthless – it meant something to me. What possible justification can there be for ignoring the long-run impacts of our actions? Future lives matter too.
One argument for discounting the happiness of future generations is that they will be so much richer than us that the future costs and benefits of our actions today will not matter to them. Perhaps a real return of $5 million will mean nothing in 200 years’ time. Yet it is also possible that future generations will be poorer than us, and $5 million will mean more to them than it does to us. Indeed, if climate change, resource depletion and population growth have serious negative consequences in the medium to long term, there is a case for using a negative discount rate. That is, if our grandchildren will be significantly worse off than we are now, it's worth sacrificing $100 today to generate benefits of $90 for our grandchildren.
Another argument in favour of discounting is “pure time preference” – the idea that having jam today is preferable than having jam tomorrow. (Until tomorrow comes and you’re hungry and wish you had some jam.)
For understanding individual decision making, the assumption of time preference makes a certain amount of sense. Empirical evidence suggests most people save little of their income for future consumption. Yet from a moral or ethical stand point, it is not clear why the happiness of future generations is of less worth than the happiness of people alive today.
The Stern Review on the Economics of Climate Change made this point quite forcefully:
Thus, while we do allow, for example, for the possibility that, say, a meteorite might obliterate the world, and for the possibility that future generations might be richer (or poorer), we treat the welfare of future generations on a par with our own. It is, of course, possible that people actually do place less value on the welfare of future generations, simply on the grounds that they are more distant in time. But it is hard to see any ethical justification for this. It raises logical difficulties, too. The discussion of the issue of pure time preference has a long and distinguished history in economics, particularly among those economists with a strong interest and involvement in philosophy. It has produced some powerful assertions. Ramsey (1928, p.543) described pure time discounting as ‘ethically indefensible and [arising] merely from the weakness of the imagination’. Pigou (1932, pp 24-25) referred to it as implying that ‘our telescopic faculty is defective’. Harrod (1948, pp 37-40) described it as a ‘human infirmity’ and ‘a polite expression for rapacity and the conquest of reason by passion’.
The Stern Review’s argument, in a picture:
The final justification for discounting the future returns from investment is the opportunity cost of capital. The funds required to build, say, an aqueduct must come either from foreign or from domestic savings. Any domestic savings used to finance an aqueduct represents money that could have been used for something else, either consumption, or other domestic investment. The opportunity cost of building an aqueduct is the returns the money could have earned elsewhere – and if the aqueduct does not generate returns at least as great as those available elsewhere in the economy, it is not worth building.
Jenkins and Kuo set out the opportunity cost argument for discounting here. Using data on the real returns to Canadian domestic investment from 1966 to 2005, as well as estimates of individuals' rates of time preference and the cost of foreign borrowing, they conclude, “The results suggest that estimates of the economic discount rate can range from 7.78 percent to 8.39 percent real”. Drawing in part from Jenkins and Kuo’s work, the Canadian Treasury Board Secretariat's 2007 Guidelines for Cost Benefit Analysis suggested the use of an 8 percent real discount rate. While this might seem high given current yields, it was actually significantly lower than the ten percent real rate of discount recommended by the Treasury Board in 1998.
The valuation of future benefits and costs is critical in any kind of long-term decision making, especially for deciding how much to invest to prevent or ameliorate the impacts of climate change. Consider, for example, an investment in preventing climate change that is expected to have some kind of payoff in 50 years’ time. With an 8 percent real discount rate, a $10 investment in a 50-year-time-horizon-project must have an expected payoff of at least $469 ($10*1.08^50) to be worthwhile. I would expect few projects to pass that kind of a test.
Recent government reports which have advocated taking action on climate change have done so on the basis of much lower real discount rates than the ones the Treasury Board recommended back in 2007. For example, a March 2016 Technical Update to Environment and Climate Change Canada's Social Cost of Greenhouse Gas Estimates had this to say on the choice of discount rate:
….there is no consensus position in the literature on the “correct” discount rate to use. Some advocate discount rates based on observed market rates of return. Others argue that it is unethical to value costs to future generations less than those to current generations.
The U.S. Group selected three different discount rates to reflect varying views in the economic literature (2.5%, 3% and 5%). The central rate at 3% is recommended by the U.S. Office of Management and Budget when a regulation primarily affects private consumption.
The Canadian Group considered how best to adapt the U.S. SCC work for Canada over the course of 2011. While alternative parameters, such as declining discount rates, were discussed, it was ultimately determined that it was more practical to adopt the U.S. results (emphasis added).
For some more background on how those US numbers were calculated, and the thinking behind the choice of discount rate, see here.
The most fundamental public policy choices we face involve trade-offs between current and future consumption: the desirability of tax cuts and deficit finance; the value of reducing greenhouse gas emissions; the advisability of investing in infrastructure. If you want to know an economist’s views on things that matter, forget about minimum wages or free trade. The most important question of all is “what is the social discount rate”? The moral argument for discounting the well-being of future generations has always been dubious. The opportunity cost argument might have seemed convincing during the heady days of the tech boom. But now that negative interest rates are a serious possibility, even the opportunity cost of capital argument for discounting seems questionable.