Looking to the future (Image: Yoshikazu Tsuno/AFP/Getty Images

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SHORT-TERM thinking is a criticism often levelled at corporations and banks by anti-capitalist protesters, and they may well be right. A lack of concern for the future is built mathematically into economic theory, and this carries through to the behaviour of companies and governments. But a different way of putting a financial value on the future is changing that.

Economists assume that society will gradually get richer, typically by about 3 per cent a year – occasional crashes notwithstanding. To account for this, they “discount” future events: models might value a resource at $100 if it’s immediately available, but only $97 if it is only available in a year’s time.

The problem, says economist John Geanakoplos of Yale University, is that models shave off the same percentage every year. As a result, the value of assets decreases exponentially, and is effectively zero within decades or centuries. So economics effectively ignores far-future events, even if they are world-shattering.


Economics effectively ignores far-future events, even if they are world-shattering

Exponential discounting’s reign is an accident of history: early 20th-century economist Paul Samuelson introduced it as a simple solution but emphasised that it wasn’t necessarily right. In fact real humans do not discount exponentially. Questionnaire studies show that the rate at which we discount resources with time decreases gradually, not exponentially: we behave as if resources do still have a value significantly greater than zero in the distant future.

This is known in the trade as hyperbolic discounting, and although individuals and some markets display it, economists dislike it on the grounds that it is “irrational”. That’s because under hyperbolic discounting, a person has a strong preference for getting something today rather than tomorrow, but only a weak preference for getting it on day 100 rather than day 101; yet when day 100 arrives, they will strongly prefer to get the resource immediately.

In an as-yet-unpublished paper co-written with J. Doyne Farmer of the Santa Fe Institute in New Mexico, Geanakoplos claims to have shown that when you don’t know how the economy is going to change, this seemingly illogical behaviour makes mathematical sense. The pair took economic models normally used by Wall Street banks to make financial decisions that affect the following few decades, and ran them over longer timescales. When they plugged in hyperbolic discount rates, they found fewer mathematical inconsistencies in the models than when they used exponential ones. This, they say, shows that hyperbolic discounting makes more mathematical sense over extended timescales.

Economists remain sceptical about hyperbolic discounting. It is inherently inconsistent, so could lead to inconsistent policies, argues Cameron Hepburn of the London School of Economics. He has shown that using hyperbolic discounting to manage a fishery could well lead to its collapse (Environmental and Resource Economics, DOI: 10.1007/s10640-010-9354-9).

But a consensus is growing that discount rates do need to fall, the further you project into the future, albeit not hyperbolically. Since 2003, the UK government has been using declining discount rates to assess the impacts of policies that have ramifications lasting more than about 30 years. Other European countries are following suit, and Hepburn says the US administration is discussing using hyperbolic discounting as well.

There are many ways to make the discount rate fall besides hyperbolic discounting, says Hepburn. He contributed to the 2006 Stern Review on the Economics of Climate Change, which included a declining discount rate. The review concluded that it was better to spend now to avoid climate change, rather than pay for the consequences later. The report was criticised by many economists for its approach, but Hepburn says its methods are now becoming more widely accepted. The best solution may be to model the future using a range of discounting methods, then take an average, says Matthew Salois of the University of Reading, UK.

While the most useful discounting methods will be debated for years to come, the important thing is to force economists to rethink their assumptions. “If you change the intellectual climate, you’re going to change the political climate,” Geanakoplos says.