35 The discreet charm of the “social interest rate”

Posted on December 5, 2011 by

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Let’s assume the 140 billion US$ fund to “fight” Climate Change is established in Durban. What kind of projects should each country invest in?

Investment means sinking costs now, in order to obtain benefits somewhere in the future. There are many “worthwhile” projects in disparate areas, including but not only climate change abatement measures: they’ll all bring costs and benefits, some big, some small, some soon, and some far into the future – which to choose?

Rational choice demands that costs and benefits streams within a project be compared: clearly a benefit in ten years’ time has not the same value as the same benefit tomorrow. A comparison may be made by bringing back all costs and benefits to the same base- and time-line. We discount benefits and costs with the “social interest rate” to a single common time-line – say today. This allows one to determine whether benefits, so recalculated, outweigh costs or not. I obtain a benefit/cost ratio. All B/C >1 are ranked, and implementation occurs from the best one down.

Before I move further, let me clarify one thing. The “social interest rate” in akin, but not congruent with the interest rate we know from everyday life. The mechanics are the same, but the choice of the number reflects different values. I use the term “social interest rate” to highlight the fact that its value reflects the wishes and the vision of the whole social group (somehow determined), not the narrow and skewed view of the financial markets, or God forbid of the minister of finance who holds the strings of the public purse. These two dance to a different tune (we’ll have to reconcile our dreams to the current contingent reality – the financial and budgetary context – soon enough).

Though we may use “dollars” to calculate the B/C ratio, the term simply (and roughly) explicates trade-offs to be made in order to achieve the desired goal, which may be “saving lives”. In order to “save X lives” Y dollars (or resources) have to be invested. It is morally not a matter of indifference how many lives one saves with fixed amounts of money or resources. The $ sign is does not mean “putting a price on life” – it just tells us what a choice entails, using “dollars” as units of account.

This also implies that if our goal is “saving lives”, we should assess, compare, and rank ALL projects which “save lives” – not just the segment thereof, which just grabs our attention, or is on the negotiating table. If “saving lives” is our goal, then it should be a matter of indifference whether we invest in fighting dysentery or we try to prevent climate change and its consequences. The “social interest rate”, when impartially used to compare ALL projects, helps us to do exactly that. It allows us to go beyond the narrow objective under discussion and compare across a wide variety of worthwhile projects.

The “social interest rate” only sets the stage for choice – it is a necessary condition. It is not a sufficient condition, however. To get to what is necessary we need to view the political, financial and budgetary context. The context defines both the scope and the limits of public investment. Even though we may not do all we should, the “social interest rate” would ensure that we do the right thing. Or does it?

A low “social interest rates” expresses our concerns for future generations. If the “social interest rate is low, we care a lot about future generations. That’s generous of us. Choosing a low “social interest rate” has its discreet charm – in form of consequences – which the altruistic planner should be aware of:

  • Low rates favor projects with large sunk costs. Today’s technology is thereby frozen far into the future. We risk plunging for technologies that may soon outdated and difficult to scrap – we’ve seen this with nuclear power. We lock ourselves into sort of paradigm: splurge now, regret at leisure.
  • Low interest rates also freeze our priorities way into the future. A commitment to say CO2 abatement programs becomes irreversible – we have sunk so much money into the projects – even should further science or experience reveal that our original fears were exaggerated, or should new issues need tackling at once. We lose flexibility, and possibly act in a paternalistic way.
  • We make large resource transfers to future generations. Both wealth and technologies should be more abundant in the future than today – on past experience. Why should we collectively subsidize groups who may be fully capable of taking care of themselves?

The future is uncertain – it contains many unknown unknowns. The best we can do is to commit irreversibly as few resources as possible.