NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

In Professor Gautam Kaul’s course “Finance and the Sustainable Enterprise” at the Ross School of Business, we recently had a lengthy and very profound discussion on sustainability and interest rates. (See/hear Professor Kaul discuss his course in the above YouTube video.) Yes, that’s right: interest rates. You didn’t read this wrong. (And please don’t stop reading now. I promise you interest rates are very interesting.)

For those of you who have not taken an economics or finance course, an interest rate is the cost of borrowing money for a given period of time. For example, when you take out a loan from the bank, the interest rate is the price you pay to borrow money over a certain period of time, say a year. A pretty simple concept to grasp, right?

In class, Professor Kaul pushed us to think more insightfully into the concept of interest rates. Irving Fisher, the great economist of our time, stated that interest rates are important because time has value. If time is taken away, there need not be a discussion on interest rates. So the first thing to keep in mind when thinking about interest rates is the value of today vs. the value of tomorrow.

Take for example a risk-free treasury bill. Why is do you think the real interest rate (taking into consideration inflation) is greater than zero? One word: impatience. Time has value because we humans are innately impatient. We would rather have something today rather than tomorrow.

Think about it. Would you prefer $100 today or $100 tomorrow? I’m sure most of you would answer today. Impatience implies that interest rates are greater than zero. (Note: there was a point when interest rates were less than zero. It was during the depression, when the value of time was negative. Why do you think this was the case?)

After this brief discussion on interest rates, Professor Kaul presented to the class an interest rate equation that is a function of two items: 1) impatience and 2) technological progress. Consider the following equation:

Interest rate =–+ ηx

Where:

? = impatience

η = elasticity of marginal utility

x = technological progress.

Again, as we have stated previous, people are inherently impatient and therefore ? is generally assumed to be positive. η is a coefficient and is generally assumed to be 3 by most economists. x is the growth rate per capita consumption, or the advancement of technological progress. x is also typically assumed to be a positive value.

However, is x always going to be a positive value? Perhaps the past 100 years has convinced us that tomorrow will always be better than today, and that the future holds a world of plenty compared to today. It’s easy to believe that because when we look back in time, we have more today than we did in the past. Why shouldn’t this trend continue? Philosophically, holding this belief that the future will definitely have more than today, it is easy to have the mentality, “Why not consume more today? Tomorrow will be just fine?”

But is this true? Will ? and x always be positive? Should ? be positive at all?

Consider this excerpt from the article “Deep Discount” published in the Economist:

If global GDP grows by 3% a year [in the next 200 years], the value of the world’s output in 2200 will be $8 quadrillion (a 16-figure number). But in present-value terms (using a discount rate of 7%), that stupendous sum would be worth just $10 billion. In other worlds, it would not make sense for the world to spend any more than $10 billion today on a measure that would prevent the loss of the planet’s entire output 200 years from now.

What this is saying is that to value the worlds output in 200 years using discount rate of 7% would mean that sustainability is only a $10 billion problem in today’s terms.

In class, Professor Kaul said that if we, as humanity, believe that sustainability is a big issue, and use a 7% discount rate to measure the problem, we might as well not even have the discussion. Why? Because if saving the future is only a $10 billion problem, do we really believe it’s a problem?

Perhaps we need start valuing the future more than we currently do (i.e. lose the impatience) and stop thinking that the future will be a world of plenty. Because at our current rate on consumption, our future may be in jeopardy.