tag:theconversation.com,2011:/us/topics/discount-rate-11793/articlesdiscount rate – The Conversation2018-02-25T19:18:18Ztag:theconversation.com,2011:article/922652018-02-25T19:18:18Z2018-02-25T19:18:18ZSmart money: a better way for Australia to select big transport infrastructure projects<p>Australia needs to change the way it assesses potential infrastructure projects, to ensure that governments can better understand which road and rail projects are worth building. </p>
<p>One way would be to make long-overdue changes to how we value the impact of infrastructure on future generations. This is done through the choice of a “<a href="https://www.investopedia.com/terms/d/discountrate.asp">discount rate</a>” – the mechanism used to compare costs and benefits of projects that occur at different points in time. </p>
<p>Australian governments have chosen to keep their central discount rate at 7% since at least 1989. This is despite one of the key components of the discount rate, the real borrowing rate, varying from as high as 8% to below 1% in this time.</p>
<p>The <a href="https://grattan.edu.au/report/unfreezing-discount-rates-transport-infrastructure-for-tomorrow/">latest report</a> released by the Grattan Institute recommends that governments adopt discount rates that change when the world changes, and that reflect the riskiness of a project. </p>
<p>While the concept might seem arcane, using an artificially high discount rate muffles the signal that tells governments what projects are worth building and which ones aren’t. Using the wrong discount rate probably means we build the wrong infrastructure. </p>
<h2>Costs and benefits</h2>
<p>A future benefit or cost needs to be converted into today’s dollars because future dollars have a different value to today’s dollars. This is because, even ignoring the effects of inflation, people value a dollar today more than one at some future date. </p>
<p>When a transport project’s benefits mostly come about in the distant future, a high discount rate treats those benefits more sceptically than a low discount rate would. </p>
<p>The Melbourne Metro rail project provides a good example of the discount rate’s importance. If we use a 7% discount rate, as recommended by Infrastructure Australia, the estimated benefits are only a tiny <a href="http://infrastructureaustralia.gov.au/projects/files/Melbourne_Metro_Project_Evaluation_v2.pdf">10% larger than the costs</a>. </p>
<p>But using a 4% discount rate, the project will deliver benefits that are <a href="http://metrotunnel.vic.gov.au/__data/assets/pdf_file/0006/40677/MM-Business-Case-Feb-2016-WEB.pdf">almost two-and-a-half</a> times greater than the project’s A$9 billion cost. </p>
<p>On one reading, then, the project is expected to be a major economic success. On another its value is marginal. Changing the discount rate has huge implications for the cost-benefit analysis of new projects. </p>
<p>The discount rate is also an important determinant of the mix of projects that governments consider. As you can see in the chart below, changing the discount rate changes the rankings of different projects. </p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=308&fit=crop&dpr=1 600w, https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=308&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=308&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=387&fit=crop&dpr=1 754w, https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=387&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/207620/original/file-20180223-108150-1xh6vfh.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=387&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption"></span>
<span class="attribution"><span class="license">Author provided</span></span>
</figcaption>
</figure>
<h2>Re-examining the basis for Australia’s discount rates</h2>
<p>Discount rates are part of the appraisal and ranking of potential infrastructure projects. The discount rate is designed to reflect the next-best use of the resources for that project, and with the same level of risk. </p>
<p>The next-best project could be another project in the transport portfolio, in another portfolio, or even a financial investment overseas with the same level of risk. </p>
<p>Our report challenges the way Australian governments apply this framework. Instead of being frozen at 7%, discount rates should vary when there is material variation in the cost of money. In addition, discount rates should differentiate between projects that are more risky and those that are less risky. If we are comparing a low-risk project with a riskier one, then we’re comparing apples with oranges.</p>
<p>The cost of money is usually inferred from government borrowing costs, signalled by the 10-year Commonwealth bond rate. Back in 1989, when the 7% discount rate was established in Australia, the government borrowing rate <a href="https://tradingeconomics.com/australia/government-bond-yield">was 6.8% in real terms</a> (adjusted for inflation); in 2017, it was 0.8%. </p>
<p>Discount rates should reflect such a dramatic change in the cost of money. </p>
<p>The type of risk that matters for discounting is the sensitivity of a project’s expected returns to the economy generally – known as the <a href="https://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/systematic-risk.aspx">systematic risk</a>. </p>
<p>Most government transport infrastructure is still used whether the economy is booming or in the doldrums, because most people keep on travelling to work or school and buying transported goods. But some projects are more sensitive than others to the state of the economy, and the discount rate should be higher for them. </p>
<p>If we incorporate risk and the cost of low-risk borrowing, the discount rate in 2018 should be around 3.5% for projects where systematic risk is low, and around 5% where it is high by the standards of transport infrastructure projects. </p>
<p>Both rates are substantially below today’s 7% standard central rate. Sensitivity testing remains important, of course, because precision is difficult. </p>
<h2>Better evaluations</h2>
<p>Lower discount rates will help to make clear which are the most valuable transport projects available. But they will also make the economics of all transport projects look better.</p>
<p>Our recommendations may therefore seem at odds with previous Grattan Institute analysis, which showed that Australian governments have <a href="https://grattan.edu.au/report/cost-overruns-in-transport-infrastructure/">systematically underestimated the cost of transport projects</a>, making many appear more attractive than they really were. </p>
<p>But our consistent goal is to improve all aspects of project selection and appraisal, so we can know which are the best projects to build and in what order. This accords with past work by both the <a href="https://www.pc.gov.au/__data/assets/pdf_file/0003/137280/infrastructure-volume1.pdf">Productivity Commission</a> and <a href="https://bitre.gov.au/publications/2005/files/report_110.pdf">Bureau of Transport, Infrastructure and Regional Economics</a>, arguing that the discount rate is not the appropriate way to deal with optimism bias.</p>
<p>Ultimately, using an artificially high discount rate comes at the cost of distorting public policy priorities. We should be aiming to improve every aspect of evaluation wherever better approaches are evident, so we build the right projects in the right order. Better discounting would be a big step in that direction.</p><img src="https://counter.theconversation.com/content/92265/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Grattan Institute began with contributions to its endowment of $15 million from each of the Federal and Victorian Governments. In order to safeguard its independence, Grattan Institute’s board controls this endowment. The funds are invested and Grattan uses the income to pursue its activities. Marion Terrill does not work for, consult, own shares in or receive funding from any other company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.</span></em></p><p class="fine-print"><em><span>Hugh Batrouney works for the Grattan Institute.
Grattan Institute began with contributions to its endowment of $15 million from each of the Federal and Victorian Governments. In order to safeguard its independence, Grattan Institute’s board controls this endowment. The funds are invested and Grattan uses the income to pursue its activities. Marion Terrill does not work for, consult, own shares in or receive funding from any other company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.</span></em></p>Despite a huge fall in interest rates, the federal government has been using the same rate to value prospective infrastructure projects since 1989.Marion Terrill, Transport Program Director, Grattan InstituteHugh Batrouney, Fellow, Grattan InstituteLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/457542015-08-18T01:39:18Z2015-08-18T01:39:18ZHow the Federal Reserve keeps the US economy from bonking<figure><img src="https://images.theconversation.com/files/91989/original/image-20150816-5103-vao2c9.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Running the economy is a bit like running a race... </span> <span class="attribution"><span class="source">Jogger wall via www.shutterstock.com</span></span></figcaption></figure><p>My buddy is training for his third Chicago Marathon. I’m preparing for a 10K mud-run. </p>
<p>He’s really fit and a family nurse practitioner, so I seek his advice on how to get in shape and what to eat. His advice usually focuses on pacing myself. </p>
<p>“You don’t want to push too far too fast – you’ll bonk for sure!” </p>
<p>Of course he’s right – you can push yourself while working out, but if you go a little too far too fast, you might end up on the pavement.</p>
<p>On the flip side, my bud asks me all types of questions about the economy. Last week he asked me a great question: “How much do you think the unemployment rate will go up if the Fed increases interest rates?”</p>
<p>The unemployment rate won’t go up, I told him, because the Federal Reserve isn’t going to make a policy change until it is convinced that the economy is running fast enough that it needs to be cooled down. In other words, the Fed is trying to make sure the economy won’t bonk!</p>
<p>Most <a href="http://fortune.com/2015/08/13/federal-reserve-interest-rate-poll/">economists</a> still expect the Fed to raise rates next month; they feel that the economy needs to slow down so it doesn’t burn out. But calculating the “speed” of the economy is tricky; thus, pacing needs to be done judiciously.</p>
<p>So, what’s the Fed’s role, why does it care and what is it going to do?</p>
<h2>The Fed: our lender of last resort</h2>
<p>The Fed is the central bank of the United States, the lender of last resort (it doesn’t say “no” if a bank is in trouble and needs to cover its own deposits), and it establishes and monitors credit and oversees how money works its way around the economy. </p>
<p>Congress, when it wrote The Federal Reserve Act of 1913, <a href="http://www.federalreserve.gov/aboutthefed/section2a.htm">declared</a> that the Fed should engage in policy to ensure that unemployment and inflation aren’t too high and interest rates are stable. The act doesn’t, however, identify which of these three goals is primary, secondary or tertiary. </p>
<p>The Fed usually lets the economy and the preferences of its seven governors dictate which is most important. During the 2001 recession, for example, the Fed was very concerned with unemployment. As the economy started showing signs of declining corporate profitability and higher levels of inventory (a sign that people might lose their jobs), the Fed <a href="http://www.federalreserve.gov/boarddocs/press/general/2001/20010320/default.htmv">started</a> pushing interest rates lower to give the economy a boost and keep unemployment low.</p>
<p>In 1980, however, the Fed saw that double-digit inflation rates were dragging the economy down. In this case, the Fed focused more on stable prices by targeting higher interest rates in order to rein in rising prices. </p>
<h2>The Fed’s tool kit</h2>
<p>The Fed has three primary tools to accomplish these goals: a) the discount rate, b) open market operations and c) reserve requirements. </p>
<p>Depending on how each tool is used, the economy has either more liquidity (money sloshing through the system) or less liquidity. If the Fed cuts discount rates, purchases government bonds from large banks or decreases reserve requirements (or how much a lender must deposit at the central bank), then it is engaging in expansionary monetary policy. </p>
<p>The goal of expansionary monetary policy is to increase economic activity and decrease the unemployment rate. These are the types of policies that the Fed has engaged in since a few years before the Great Recession began in 2008 by lowering the federal funds and discounts rates. (The federal funds rate is an interest rate charged by one bank to another bank while the discount rate is the interest charged by the Fed to a member bank. More on this later.) The graph below shows both rates from January 2005 through this past June: </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=386&fit=crop&dpr=1 600w, https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=386&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=386&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=485&fit=crop&dpr=1 754w, https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=485&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/91992/original/image-20150816-5110-10zlr3q.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=485&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Interest rates have been near zero for many years.</span>
<span class="attribution"><span class="source">Federal Reserve Bank of St. Louis</span></span>
</figcaption>
</figure>
<p>The Fed <a href="http://www.federalreserve.gov/newsevents/press/monetary/20070918a.htm">noticed</a> the economy slowing and, to counteract this, targeted lower interest rates. These expansionary moves continued through the recession and settled at a low of 0.50% for the discount rate and 0.16%, effectively, for the federal funds rate.</p>
<p>Both of these rates are at or near the lower bound – they can’t get any lower than zero. That brings us to a fourth (unorthodox and rarely used) tool that the Fed has turned to: d) quantitative easing (QE). For QE, the Fed makes balance-sheet exchanges with large banks – the Fed exchanges money on its balance sheet for government securities on the bank’s balance sheet. This technique keeps liquidity up and interest rates low. </p>
<h2>The cost of expansionary policies: inflation</h2>
<p>But all these tools have a consequence, and one of them is inflation. </p>
<p>Inflation is primarily a monetary phenomenon – the more money consumers have the higher items will be priced. When a dozen hungry competitors on Survivor get US$100 to purchase food, pizza and cheeseburgers suddenly become more expensive. Similarly, when the Fed lowers rates, the economy will have more money and, usually, will experience an upward push in prices.</p>
<p>During the 2001 recession, the Fed reduced interest rates to get the economy moving again, eventually causing inflation to rise from 1% to 3% in 2004. As a result, the central bank reversed course and contracted the money supply by raising rates, which cooled growth and arguably kept inflation from increasing even more. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=392&fit=crop&dpr=1 600w, https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=392&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=392&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=493&fit=crop&dpr=1 754w, https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=493&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/91993/original/image-20150816-5110-1ogdb20.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=493&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">The graph shows how the Fed reacted to rising inflation mid-decade by cutting the Fed funds rate, thereby reducing inflation, as measured by the Consumer Price Index.</span>
<span class="attribution"><span class="source">Federal Reserve Bank of St. Louis</span></span>
</figcaption>
</figure>
<p>So, to return to my friend’s concern about what will happen when the Fed begins to lift interest rates again, how does this affect employment? The graph below shows, for example, that when the Fed began raising rates in 2004, the unemployment rate – which had been coming down thanks to the lower rates in effect since the recession – kept falling. Thus, when timed well, the central bank can keep the economy from overheating by raising rates without pushing up joblessness. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=385&fit=crop&dpr=1 600w, https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=385&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=385&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=484&fit=crop&dpr=1 754w, https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=484&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/91991/original/image-20150816-5083-18ue648.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=484&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Even as the Fed raised rates beginning in 2004, unemployment kept coming down, until the global credit crisis hit a few years later.</span>
<span class="attribution"><span class="source">Federal Reserve Bank of St. Louis</span></span>
</figcaption>
</figure>
<h2>Where is the economy now?</h2>
<p>The most recent economic recession officially <a href="http://www.nber.org/cycles/sept2010.html">ended</a> in June 2009. However, the economy hasn’t really returned to “business-as-usual” – the unemployment rate has fallen but at a slow pace (at the same time that the share of working-age Americans in the labor force has also declined). </p>
<p>So is the economy in a condition where the Fed should start contracting the money supply? There isn’t much inflation in the economy, as shown by the GDP deflator (shown below), the Consumer Price Index and the year-over-year change in the average hourly earnings of private employees. We use all three of these ways to measure inflation because each captures slightly different ways in which prices are fluctuating. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=357&fit=crop&dpr=1 600w, https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=357&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=357&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=449&fit=crop&dpr=1 754w, https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=449&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/91995/original/image-20150816-5085-1p9zyhh.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=449&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Inflation is hovering around 2%, below the Fed’s target, as measured by the GDP deflator.</span>
<span class="attribution"><span class="source">Federal Reserve Bank of St. Louis</span></span>
</figcaption>
</figure>
<p>All three of these inflation measures show inflation hovering around 2%. The Fed’s policy is loosely based on the <a href="http://www.investopedia.com/articles/economics/10/taylor-rule.asp">Taylor Rule</a>, which focuses on keeping inflation around 2%. Core inflation, as measured by the GDP deflator and the CPI, is below 2%, while wage inflation is finally starting to tick above 2%. </p>
<p>Does this mean the economy is in danger of bonking (overheating)? </p>
<p>That’s why Fed governors are taking the timing of raising its interest rate targets so seriously. Other measures, such as the duration of unemployment, suggest that wage inflation could indeed take off. The pool of employment candidates is getting smaller, and employers might have to offer higher wages to attract the best candidates. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=364&fit=crop&dpr=1 600w, https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=364&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=364&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=457&fit=crop&dpr=1 754w, https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=457&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/91994/original/image-20150816-5124-24f7ar.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=457&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Wage growth plunged during the recession and has since begun to gradually increase.</span>
<span class="attribution"><span class="source">Federal Reserve Bank of St. Louis</span></span>
</figcaption>
</figure>
<h2>Of punch bowls and bonking: what does it mean?</h2>
<p>William McChesney Martin, the chair of the Fed’s board of governors from 1951 to 1970, <a href="http://www.federalreservehistory.org/Media/Material/People/113-140">quipped</a> that it was the role of the central bank to remove the punch bowl just as the party got going. But we’re not a nation of punch bowls. These days, we’re more like a nation of Fitbit wearers, tracking our steps and performance as we walk or run.</p>
<p>The economy has been chugging along, going from fast-paced steps to a medium-fast jog. Like a runner, we’ve moved into a groove where we’re sort of comfortable being slightly uncomfortable. We know the unemployment rate is falling but not fast enough, wages are gaining some momentum but barely outpacing inflation. The economy’s pace is not in obvious need of a coach’s intervention. </p>
<p>Except – to torture my analogy – the Fed’s view is that it has manipulated the wind so we’ve been running with a zephyr at our backs for a long time. There is no real doubt that the economy has legs and can do this on its own; the Fed sees this. </p>
<p>The Fed is probably going to make a move in the next few weeks, likely increasing the federal funds target by 50 basis points to about 0.5% and increasing the discount rate by the same amount. When it does, there will probably be a little movement in the equities markets but very little else. If the Fed were to make this move sooner (and without warning), there could be a significant uptick in activity. </p>
<p>The Fed’s view of this race differs from ours – we think we’re running a marathon, but the Fed knows it’s one of those crazy 100-mile-endurance-race-across-Death-Valley deals. It is the job of the Fed to slow us down just enough that we can keep racing.</p><img src="https://counter.theconversation.com/content/45754/count.gif" alt="The Conversation" width="1" height="1" />
My buddy is training for his third Chicago Marathon. I’m preparing for a 10K mud-run. He’s really fit and a family nurse practitioner, so I seek his advice on how to get in shape and what to eat. His advice…Thomas More Smith, Assistant Professor in the Practice of Finance, Emory UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/301572014-08-11T20:25:05Z2014-08-11T20:25:05ZThomas Piketty, climate change and discounting our future<figure><img src="https://images.theconversation.com/files/55770/original/2jnwjx3j-1407219362.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Economist Thomas Piketty has warned "climate change cannot be eliminated at the stroke of a pen".</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/40285098@N07/5665816965/in/photolist-7K4jVg-niKZFc-oaq5R6-oaAmk5-9CHHfh-9CEMCn-9CEMZp-9CHGRu-nT8RvT-ocwgiX">Parti Socialiste du Loiret/Flickr</a>, <a class="license" href="http://creativecommons.org/licenses/by-nc-nd/4.0/">CC BY-NC-ND</a></span></figcaption></figure><p>French economist <a href="https://theconversation.com/topics/thomas-piketty">Thomas Piketty</a> and his book <a href="http://www.amazon.com/Capital-Twenty-First-Century-Thomas-Piketty/dp/067443000X/ref=sr_1_1_title_2_har?s=books&ie=UTF8&qid=1402906558&sr=1-1&keywords=capital">Capital in the Twenty-First Century</a> are a <a href="https://theconversation.com/coming-to-an-arena-near-you-economists-the-new-rock-stars-28496">global publishing phenomenon</a>. </p>
<p>But while Piketty’s writing on wealth inequality has been <a href="http://www.nytimes.com/2014/05/31/upshot/everything-you-need-to-know-about-thomas-piketty-vs-the-financial-times.html?_r=0">widely debated</a>, far fewer people know that he has some useful things to say about climate change and public capital.</p>
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<span class="attribution"><a class="source" href="https://www.flickr.com/photos/swanksalot/13984456397/in/photolist-7K4jVg-niKZFc-oaq5R6-oaAmk5-9CHHfh-9CEMCn-9CEMZp-9CHGRu-nT8RvT-ocwgiX">Seth Anderson/Flickr</a>, <a class="license" href="http://creativecommons.org/licenses/by-sa/4.0/">CC BY-SA</a></span>
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<p>In particular, Piketty discusses the discount rate and the differences in approach between <a href="http://www.cambridge.org/au/academic/subjects/earth-and-environmental-science/climatology-and-climate-change/economics-climate-change-stern-review?format=PB">Lord Nicholas Stern</a> and Yale economist <a href="http://cowles.econ.yale.edu/books/nordhaus/balance.htm">William Nordhaus</a>.</p>
<p>The discount rate weighs future people’s benefits against costs borne by present people. It is the key to understanding action on climate change. The different views of Stern and Nordhaus go to the heart of how the planet addresses the climate change problem.</p>
<h2>Pay now or later? And at what cost?</h2>
<p>It seems to me that the main issue in terms of addressing the climate change problem is that, if we agree to reduce emissions now – and there is currently no global agreement in sight that provides for such reduction – people living in the future will benefit, not those living today. But we will, today, bear the costs of reducing such emissions. </p>
<p>Stern in <a href="http://www.cambridge.org/au/academic/subjects/earth-and-environmental-science/climatology-and-climate-change/economics-climate-change-stern-review?format=PB">The Economics of Climate Change</a>, better known as the Stern Review, concludes that strong action on climate change is urgently required; Nordhaus’s view is not so much. Nordhaus thinks climate change requires only a modest response now, with more significant action delayed for decades (read more in <a href="http://cowles.econ.yale.edu/books/nordhaus/balance.htm">A Question of Balance</a> and <a href="http://yalepress.yale.edu/yupbooks/book.asp?isbn=9780300189773">The Climate Casino</a>).</p>
<p>The discount rate accounts for these different approaches. It weighs future people’s benefits against costs borne by people in the present. If a cost benefit analysis uses a high discount rate, it discounts future benefits to a high degree, giving little weight to the interests of future people – on the basis that future people will be cleverer, richer and they’ll work it out (the Nordhaus approach). In contrast, Stern uses a low discount rate, and asks the present generation to make urgent sacrifices for the sake of future people.</p>
<h2>Piketty’s take on discount rates</h2>
<p>Piketty views Stern’s opinion as more reasonable. He argues, though, that more urgent need is: </p>
<blockquote>
<p>to increase our educational capital and prevent the degradation of our natural capital. This is a far more serious and difficult challenge, because climate change cannot be eliminated at the stroke of a pen (or with a tax on capital)</p>
</blockquote>
<p>He <a href="http://www.amazon.com/Capital-Twenty-First-Century-Thomas-Piketty/dp/067443000X/ref=sr_1_1_title_2_har?s=books&ie=UTF8&qid=1402906558&sr=1-1&keywords=capital">asks</a> whether we really know what we should invest in and how we should organise our response to the challenge. Should we “count on advanced research to make rapid progress” in renewable energy, or should we immediately impose limits on carbon consumption? Piketty’s view is that no one knows how these challenges will be met or the role of governments “in preventing the degradation of our natural capital in the years ahead”.</p>
<p>And no one does know. Piketty’s uncertainty is shared by Oxford’s John Broome, who <a href="http://www.amazon.com/Climate-Matters-Ethics-Warming-Norton/dp/0393063364/ref=tmm_hrd_title_0">notes</a> the current generation: </p>
<blockquote>
<p>will be sacrificing some of its own well-being for the sake of greater well-being that will come to people far in the future. Is the sacrifice worthwhile? Does it improve the world on balance? This is a question of weighing: How do increases in future well-being weigh against sacrifices of present well-being?</p>
</blockquote>
<p>Put another way, these questions highlight why the market may fail to adequately address the climate change problem. As Harvard’s Martin Nowak <a href="http://news.harvard.edu/gazette/story/2014/06/tomorrow-isnt-such-a-long-time/">says</a>: “Even if you want to cooperate with the future, you may not do so because you are afraid of being exploited by the present”.</p>
<p>The prevailing view at the international level about action on climate change seems to be, “Why should I care about future generations? What have they ever done for me?” And it’s those views about what future generations are worth that will determine climate change policy in 2014 and beyond.</p>
<h2>Smoke, mirrors – and emissions trading</h2>
<p>A larger question that Piketty doesn’t address is the usefulness of emissions trading schemes. </p>
<p>But it is a a question addressed in another important – albeit less famous – book, Philip Mirowski’s <a href="http://www.amazon.com/Never-Serious-Crisis-Waste-Neoliberalism/dp/1781680795/ref=sr_1_1?s=books&ie=UTF8&qid=1402908278&sr=1-1&keywords=never+let+a+serious+crisis+go+to+waste">Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown</a>, published late last year. </p>
<p>Mirowski <a href="http://www.amazon.com/Never-Serious-Crisis-Waste-Neoliberalism/dp/1781680795/ref=sr_1_1?s=books&ie=UTF8&qid=1402908278&sr=1-1&keywords=never+let+a+serious+crisis+go+to+waste">offers</a> a powerful critique of neoclassical economics. He argues that, for neoliberals, humans can never be trusted to know whether the environment is in crisis or not because:</p>
<blockquote>
<p>both nature and society are dauntingly complex and evolving; therefore, the neoliberal solution is to enlist the strong state to allow the market to find its own way to the ultimate solution.</p>
</blockquote>
<p>Emissions trading is a an elaborate “<a href="http://en.wikipedia.org/wiki/Bait-and-switch">bait-and-switch</a>” strategy, in which politicians are diverted from an original intention to reduce emissions into the endless technicalities of instituting and maintaining markets for carbon permits. The not unintended consequence is that the level of emissions continues to grow apace.</p>
<p>Once emissions trading is established, lobbying and “financial innovation” results in excess emissions trading permits and offsets, such that any cap on emissions never prevents emissions from growing. Mirowski argues that the “engineered glut of permits” – as we’ve seen with <a href="http://carbonmarketwatch.org/wp-content/uploads/2014/07/ETS-POLICY-BRIEF-JULY-2014_final_.pdf">the European Union’s emissions trading scheme, a problem Europe is now struggling to solve</a> – is not temporary, as unused or excess permits can be banked for future use. </p>
<p>It’s well understood, Mirowski <a href="http://www.amazon.com/Never-Serious-Crisis-Waste-Neoliberalism/dp/1781680795/ref=sr_1_1?s=books&ie=UTF8&qid=1402908278&sr=1-1&keywords=never+let+a+serious+crisis+go+to+waste">continues</a>, that emissions trading stifles technological innovation to curb emissions. Funds that ordinarily might have been used to alter energy infrastructure are “pumped into yet another set of speculative financial instruments, leading to bubbles, distortions of capital flows, and all the usual symptoms of financialization”.</p>
<p>For Mirowski, emissions trading does not curb global warming because it was never intended to do so; in practice, emissions trading – carbon permit trading – does not reduce emissions. Global experience to date might suggest that this is, in fact, correct.</p>
<h2>Why this debate about the future matters now</h2>
<p>Discount rates and emissions trading, of course, have present policy relevance. </p>
<p>At the end of next year in Paris, the world will meet to discuss whether developed and developing states alike will agree to emissions reduction targets from 2020 on.</p>
<p>In my view, the odds of such an agreement are about as good as seeing another Piketty proposal - a modest global tax on wealth - come true. Piketty understands such a proposal is “utopian”.</p>
<p>But in the meantime, in the United States the Environmental Protection Agency recently <a href="http://www2.epa.gov/carbon-pollution-standards">issued draft guidelines</a> on fossil fuel power plants, and has set a national target of a 30% reduction in carbon emissions from such plants by 2030 on 2005 levels. </p>
<p>Under the EPA plan it’s left up to individual US states to set their own emission reduction targets and how to meet those targets. And, at the state level, emissions trading schemes appear to be the preferred option. The <a href="http://www.rggi.org/">US Regional Greenhouse Gas Initiative</a> is an emissions trading scheme comprising nine northeastern states. <a href="http://www.arb.ca.gov/cc/capandtrade/capandtrade.htm">California</a> also has an emissions trading scheme. </p>
<p>Apart from the EU, a number of <a href="http://www.worldbank.org/en/news/feature/2014/05/28/state-trends-report-tracks-global-growth-carbon-pricing">developed and developing states around the world</a> have also set up emissions trading schemes, including New Zealand, parts of China, Kazakhstan, Quebec and elsewhere. </p>
<p>These emissions trading schemes offer some hope that, together with other action, “bottom-up” approaches might result in an alternative to international action on emissions reductions.</p><img src="https://counter.theconversation.com/content/30157/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>David Hodgkinson does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>French economist Thomas Piketty and his book Capital in the Twenty-First Century are a global publishing phenomenon. But while Piketty’s writing on wealth inequality has been widely debated, far fewer…David Hodgkinson, Associate Professor, Law School, The University of Western AustraliaLicensed as Creative Commons – attribution, no derivatives.