By controlling the allocation of capital, financial markets hold the key to the great challenges of our time, such as the fight against poverty, climate change, and cancer. In his latest book, ‘Ethical Asset Valuation and the Good Society’, TSE co-founder Christian Gollier suggests that this power can only be harnessed if we can determine the financial prices that are compatible with the public good. In particular, he shows how the valuation of long-term risk and time, based on transparent moral principles, can help to guide our choices for the future.
Can financial markets decentralize an efficient allocation of scarce resources? There are strong arguments for believing that markets are not good at eliciting our collective values or aligning private interests with the public good. Agency problems such as moral hazard and adverse selection inhibit market efficiency, and the inability to trade with future generations prevents markets from efficiently valuing assets and investments that benefit future generations. More importantly, corporate profits do not fully internalize the impacts from production on social welfare. For example, the emission of greenhouse gases remains mostly free of charge, despite their destructive impact.
If markets are unable to aggregate our collective values, how can we evaluate private and public acts? How should we, for example, compare environmental protection with job protection, lives in Bangladesh versus purchasing power in Europe, workplace safety against corporate profits, reduced inequality versus growth, or more consumption today or in 200 years? Debating social values should be at the root of our democracy. If these values are incompatible with observed market prices, then public authorities should implement corrective actions.
The price of time
Two prices drive most financial decisions: the price of time, which is the interest rate, and the price of risk. The choice of interest rate determines whether we do too much, or too little, for future generations. Too high an interest rate inhibits investment for the future. Too low an interest rate induces excessive investment, forcing people to sacrifice too much current well-being.
The level of our collective aversion to inequality is a key determinant of the socially desirable interest rate. In a growing economy, investing for the future increases intergenerational inequality. So the interest rate should be the minimal rate of return on a safe investment that compensates for this increased inequality. If Western consumption per capita continues to grow at 2 percent per year, people living two centuries from now will be more than 50 times wealthier. This context justifies a high discount rate of 4 per cent per year.
However, deep uncertainty engulfs the distant future. Just as households make sacrifices by saving more when their future income becomes more uncertain, we should collectively make more effort to improve a more uncertain future. To encourage investment, we need to lower the discount rate slightly below twice the anticipated growth rate of consumption for risk-free benefits materializing within the next two to three decades. For more distant time horizons, deep uncertainty justifies discount rates close to 0 per cent.
The price of risk
Many investments for the future increase collective risk, as their benefits are larger when consumption is greater. Penalizing risk-increasing actions therefore reduces investment, which inhibits innovation and growth. Has the tradeoff favored the maximization of growth, or the minimization of risk?
It is socially desirable to adjust the discount rate to the risk profile of each investment project by adding an investment-specific risk premium. In keeping with the calibration of the interest rate, a risk premium of around 1 percent should be used at short maturities, for projects whose risk profile is similar to the macroeconomic risk. But because of the deep uncertainty surrounding the distant future, an aggregate risk premium of 2.5 percent should be used for very long maturities.
Financial markets penalize firms that increase the aggregate risk by raising their cost of capital. A 1-to-2.5 percent risk premium is in line with the equity premium imposed by markets on riskier firms. Much more worrying is the absence of any formal penalization of risk in the evaluation of public policies in most countries.
Many countries have established implicit prices to evaluate the actions of public institutions. These include prices for human lives, time lost, natural assets, and carbon, in sectors as diverse as energy, transportation, health, science, and education. These prices are subject to much debate among experts; but these debates remain inaccessible to the public, and this is unacceptable.
Ultimately, collective decisions should be made by comparing costs and benefits, using a coherent system of values. This includes a value for delaying consumption (an interest rate), a value for risk acceptance (a risk premium), and values for all the non-monetary impacts of our actions.
As well as improving our decisions, cost-benefit analysis is an important tool in the fight against populism. Lack of evaluation reinforces the impression that policies are driven by ideology rather than the common good. Instead, democracy can be strengthened by forcing politicians to make explicit the values on which their decisions are made.