Discount rates and inequality

The other day I commented about the importance and ambiguity of discount rates when estimating the social cost of CO2 emissions.

One key issue that it seems resource/environmental economists have largely ignored is the link between inequality and discount rates.

First, some more background.  To focus cleanly on tradeoffs over time, nearly all the work in this area uses a representative-agent model that imagines society as a mythical aggregated individual deciding how much to consume today versus tomorrow. Within these models, equilibrium interest rates (i.e., discount rates) are intimately tied to consumption growth, which we imagine to be roughly equal to growth in GDP per capita.  Since historically that growth has been steady, leaders in environmental economics, including luminaries like William Nordhaus and Robert Pindyck, prefer the use of higher discount rates because they presume our ancestors descendents will be so much richer than we are.  Even Weitzman, who prefers very low discount rates, uses the representative agent model.

There are many ways in which these representative agent models oversimplify the world.  That simplification is feature, not a bug---it's necessary for getting our collective heads around tough problems.

But here's a particular rub with the representative agent model: while GDP growth generally has a steady upward trajectory (recent experience exempted), median consumption, income and wealth seems to have flatlined in the U.S. since the 1970s.  Extrapolating from that, it's hard to imagine most of our ancestors descendents necessarily being much better off than we are.

Now, it's true that interest rates are more reasonably tied to growth in the mean or the aggregate sum than to growth in the median.  But I think the fact that growth has not been and is unlikely to be anywhere near equal over the next 30 to 100 years should give us some pause.

We need more careful work connecting inequality with long-run discount rates, especially when thinking about the right price for greenhouse gas emissions.

Comments

  1. I think you mean "descendants" in the places you wrote "ancestors"

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  2. Thanks Bill. I don't know where head was.

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