S1E9. "The paper is based on a prescriptive rather that descriptive view of political economy"
One equation, two approaches
This post is part of a series on the history of how economists model the future with the Ramsey formula, based on joint work with Pedro Garcia Duarte. See episode 1 , episode 2, episode 3, episode 4, episode 5, episode 6, episode 7, episode 8. Full Paper here
In my previous post, I explained how the rise of climate modeling in just a few years helped establish the Ramsey formula as a framework for thinking about and debating discounting. At the same time, this development unraveled the previous tentative consensus. To better understand the specifics of what happened, it's worth examining the exchanges that occurred between 1992 and 1996 among a small group of key players.
A catalyst was, as I mentioned earlier, a September 1992 IIASA workshop in Austria. It provided the crucible for discussions on the economics of climate for IPCC purpose, with the last-minute addition of a session on discounting, “by popular” demand. But why such casting?
Nordhaus’s participation was unsurprising. When we last encountered him in 1980, he was inching toward a full model of optimal growth with an integrated a carbon cycle, as well as damage and abatement functions. The 1980 model only had constant physical flows, but it allowed him to study alternative Co2 emission abatement paths and calculate the associated social cost of carbon. By 1991, his full dynamic model, named DICE (Dynamic Integrated Climate-Economy model), was operational, with a summary appearing in Science. It confirmed his earlier idea that in the steady state of such model, the discount rate was defined by the Ramsey “equilibrium” formula, aka the time+growth discounting (to use his words). The model also reinforced the critical importance of discount parameter choices in determining the efficient abatement path. He equated the discount rate with the real rate of return, which he calibrated to be 6-7% in developed countries. Based on this, he concluded that a moderate abatement policy was warranted.
The importance of the discount rate in determining optimal Co2 abatement was further highlighted by the work of another participant in the impromptu workshop. Earlier that year, William Cline had published a whole book on the economics of climate change. A public institution economist with a career in macro and agricultural development and trade at the US Treasury, Brookings, and the Peterson Institute, he had recently undertaken a study of the economic consequences of greenhouse gas emissions at the request of the Institute of International Economics. He viewed this as the most significant long-term development question facing the world. “Long term” was key in his analysis. Drawing on early IPCC publications and the work of scientists like Eric Sundquist, Cline concluded that the relevant time horizon was approximately 300 years, considerably longer than previously envisioned. This extended timeframe led him to develop a cost-benefit analysis that recommended much higher emission control rates than other early climate economic analyses.
Nordhaus, in the 1994 book that extensively covered DICE, rather suggested that the difference between his analysis and Cline’s was the choice of a discount rate. Cline, influenced by discussions with EPA colleagues and Bradford's work, had revisited Ramsey's 1928 article and Lind's collective work. After Reagan took office, many US institutions had adopted a 10% discount rate on public investment, but there were dissenting voices. Cline derived the discount rate from utility theory adding up pure time preference (which he set to zero) and expected declining marginal utility – he did not use a full microfounded general equilibrium growth setting. This led to a low discount rate of 1-2%. Nordhaus pushed back, arguing that “while this [Cline’s] approach is philosophically satisfying, it is inconsistent with actual societal decisions on saving and investment.” He insisted that “it is essential that the discount be based on actual behavior and returns on assets rather than on a hypothetical view of how societies should behave or an idealized philosophy about treatment of future generations.” As you can see, the later Stern-Nordhaus debate was nothing new.
Meanwhile, Manne and Richels had refined their previously covered 1970s energy model to include greenhouse gases emissions. With Robert Mendelsohn, they were developing MERGE, another integrated general equilibrium model. They also published a book on the economic costs of carbon dioxide, heavily relying on ETA-Macro simulationsemphasizing the importance of considering technological development and scientific uncertainty. Using discount rates of 5-6%, they reached conclusions similar to Nordhaus's. Despite grappling with the sensitivity of discount rate choices for two decades, Manne had not specifically written on the topic. Nor had Tom Schelling, who chaired the session. While primarily known for his application of game theory to conflict, cooperation, and nuclear deterrence – work that would earn him a Nobel Prize – Schelling had been involved in climate policy since 1980. At President Carter's request, he had attended a summit on the carbon dioxide problem and subsequently joined a US National Academy of Science committee to examine "the policy and welfare implications of climate change." By the early 1990s, Schelling had developed a sustained interest in climate modeling.
The IIASA session prompted both Manne and Schelling to articulate their views on discounting. A month later, Schelling penned a long letter to the session’s participants. It still wasn’t clear whether the time preferences were those of an individual single agent or policy makers, he remarked. Even in the case of a “genuine ‘single agent,’... there is no theoretical or empirical reason in psychology or physiology for expecting….a uniform discount rate.” Schelling also highlighted the difference between time preferences and “preference over succeeding generations of human beings,” suggesting that people don't really distinguish between what happens in 150 years versus 250 years. He proposed comparing people's willingness to sacrifice for distant generations with their willingness to give international aid.
“The readers of the Washington Post are presumed more interested in infant mortality in the hospitals of Washington, DC, than in those of Boston, and more interested in those around the nation than in hospitals in China, India, or Nigeria,” he concluded to back up his skepticism that discount rates should be as low as Cline wanted them.
At the next IIASA workshop, in October 1993, another session in “intergenerational assessment” was organized. Schelling now had a full paper, as did Manne (along with Lind and Ferenc Toth, one of the workshop organizers with Nordhaus, Richels and Nebojsa Nakicenovic. Links to later published versions).
Manne also took issue with Cline’s low discount rates, but for different reasons. As a computation-oriented researcher, he emphasized that very low discount rates implied unrealistic sacrifices from the present generation, therefore, unrealistic saving rates and investment take-up. In a letter to the session's participants on the eve of 1994, Manne grappled with the issue: “[But] in one's role as a trustee [for the world's future], one should certainly assign a positive weight to the welfare of people in the 22nd century.” He proposed that “to avoid several mathematical paradoxes and ‘horizon effects,’ it may be useful to assign a continually declining discount factor to the utility of future consumption. On logical grounds, this seems preferable to assigning a positive weight to the welfare of one or two cohorts in the future, but zero thereafter.”
A month after, he told Schelling they were converging on a common position, and explained that he and Cline had altogether different responses to what wasn’t just an ethical and theoretical question, but, as always, also a matter of tractability.
All these discussions set the stage for the IPCC team's draft of the discounting chapter, which was completed later in 1994. IPCC coordinators sent it to reviewers. One reviewer, an ecological economist from a US environmental studies department flat-out rejected the whole discounting approach, along with utilitarianism and cost-benefit analysis. But this critique didn't seem to make much of a dent in the draft.
The second review was more nuanced. It endorsed the “welfare tradeoffs between generations” framework, including the Ramsey formula (its parametrization was discussed). However, the reviewer also pointed out that “the paper is based on a prescriptive rather than descriptive view of political economy (his italics). It virtually ignores the observable fact that the marginal productivity of capital…is in the range of 4-6% per year on the OECD countries.”
This main point of contention was reiterated in the review's concluding paragraph. Significantly, the language used in this review was adopted in the revision of the draft and came to frame subsequent debates on discounting. Now, before I reveal who this mystery reviewer was and wrap up with how the IPCC chapter and the Ramsey formula's story played out, I'll leave you with he usual pre-finale cliffhanger. Any guesses on who it might have been?
