William D. Nordhaus, A Review of the Stern Review on the Economics of Climate Change, Journal of Economic Literature, 45(3):686-702, September 2007
How much and how fast should we react to the threat of global warming? The Stern Review argues that the damages from climate change are large, and that nations should undertake sharp and immediate reductions in greenhouse gas emissions. An examination of the Review's radical revision of the economics of climate change finds, however, that it depends decisively on the assumption of a near-zero time discount rate combined with a specific utility function. The Review's unambiguous conclusions about the need for extreme immediate action will not survive the substitution of assumptions that are consistent with today's marketplace real interest rates and savings rates.
My review of the review of the review, by John Whitehead
Rising like a phoenix from an office most known for ignorance, confusion and sloth, a little known blogger (i.e., web-logger) came to almost the same conclusions about the Stern Review as Nordhaus in the most recent issue of the prestigious Journal of Economic Literature. Said web-logger noted two key issues in the Stern Review that were fishy. One, a discount rate of 0.1% makes costs 200 years from now appear quite large. Second, huge costs will happen "now and forever."
Nordhaus, having read the Stern Review more closely and with more heft, notes this about the "now and forever" rhetoric:
When the [Stern] Review says that there are substantial losses "now," it does not mean "today."
I'm left to wonder what other sort of meaning "now" might take. Whenever I'm left wondering I usually end up at the Urban Dictionary (I always skip over the vulgarity and misogyny). Here is a good definition that might fit the Stern Review's use of the word "now":
Now - A never ending series of crappy music. I think we're up to Now 57...I'm serious do a google search for Now 57 cd.
So, when the Stern Review says that the big costs of climate change will occur now and forever, it means that it might occur like a never ending series of crappy music. That's scary indeed.
More importantly, Nordhaus employs the Ramsey Equation to illustrate the inconsistency of the 0.1% discount rate. Note, this is an inconsistency, not an ethical issue.
To this web-logger's untrained understanding the Ramsey equation is something like this:
- r = i + ag, where
- r = real return on capital
- i = intergenerational discount rate - the Stern Review uses 0.1
- a = consumption elasticity - "a parameter that reflects social choices about consumption inequality across generations" - the Stern Review assumes it equal to 1
- g = economic growth - the Stern Review uses 1.3
Nordhaus plugs the Stern Review numbers into the Ramsey equation and finds r = 1.4 which doesn't match the historical performance of the economy:
If we adopt the Stern consumption elasticity of 1, then we need a time discount rate [i] of 2.7 percent per year to match observed [real] rates of return.
In other words, the model used in the Stern Review is not calibrated to the historical pattern of the real economy. In conclusion:
The [Stern] Review's radical revision of the economics of climate change does not arise from any new economics, science, or modeling. Rather, it depends decisively on the assumption of a rear-zero time discount rate combined with a specific utility function. The Review's unambiguous conclusions about the need for extreme immediate action will not survive the substitution of assumptions that are more consistent with today's marketplace real interest rates and savings rates. Hence, the central questions about global-warming policy -- how much, how fast, and how costly -- remain open. The Review informs but does not answer these fundamental questions.
In addition, Nordhaus hits hard, saying the analysis was done hurriedly (without sensitivity tests) and as a piece of advocacy. Ouch.