China, the U.S., and Sustainability: Perspectives Based on Comprehensive Wealth by Kenneth J. Arrow∗, Partha Dasgupta**, Lawrence H. Goulder*, Kevin Mumford***, and Kirsten Oleson* June 2008 * Stanford University ** University of Cambridge *** Purdue University We are very grateful to Kirk Hamilton and Giovanni Ruta of the World Bank and Peter Klenow of Stanford for very helpful advice and for generously supplying important data for this project. We also thank Kenneth Chay, and T. N. Srinivasan for very helpful comments. Address Correspondence to: Lawrence H. Goulder, Department of Economics, Landau Economics Bldg., Stanford University, Stanford, CA 94305. E-mail: [email protected]. I. Introduction Policy analysts and policy makers are keenly interested in whether the performance of national economies is consistent with some notion of “sustainability.” This reflects growing concerns about environmental quality and about the depletion of oil reserves and other natural resource stocks. Economists and natural scientists have offered several notions of sustainability. An especially important notion – and the one on which this paper focuses – is defined with reference to human well-being. This notion of sustainability is achieved if the current generation leaves the next one with the capacity to enjoy the same or higher quality of life. Standard measures in the national income accounts – such as changes in per-capita GDP – may offer hints of whether a nation meets this sustainability criterion, but as is well known these measures do not fully capture many important contributors to well-being, such as the changes in the stocks of natural capital or in environmental quality. The issue of sustainability seems especially relevant to China today. Although estimates vary, per-capita GDP in China appears to have grown at an annual rate of over eight percent over the past 15 years.1 In terms of marketed goods and services, the nation appears to be making extremely good progress. At the same time, China has accomplished this GDP growth through significant reductions in its natural resource base. According to China’s State Forestry Administration, itinerant farming has contributed to soil erosion on a large scale, with desert expanding at a rate of 10,400 square kilometers per year. China’s cities rank among the world’s worst for air pollution, and all of China’s major waterways are classified as “severely polluted” by the World Resources Institute. This loss of natural 1 China’s official inflation estimates are lower than estimates from other sources (see, for example, Young (2003), lending to uncertainty as to real GDP growth rates. 2 capital offsets the positive contribution to the productive base from investments in reproducible capital. As a result, it is not immediately clear whether the China’s overall productive base is rising or even being maintained. As discussed below, the overall productive base is intimately connected to the ability of the nation to generate goods and services and thus maintain living standards – which is at the heart of our notion of sustainability. Furthermore, China’s rapid GDP growth has come at considerable cost in terms of environmental quality. Is per-capita well-being sustainable, given the losses of natural capital and environmental quality? The sustainability issue also applies to the U.S., but perhaps in a different way. A growing share of the U.S. capital base is owned by foreigners. The sustainability of well- being to U.S. residents is closely connected to the changes in per-capita wealth owned by these residents. Is per-capita wealth of U.S. residents rising and, if so, at what rate? This paper addresses these and other questions. Our overall objective is to shed light on on whether China and the U.S. are meeting a sustainability criterion. It can be shown (e.g., Arrow et al. 2004; see below) that, under a wide set of circumstances, intergenerational well-being is sustainable during a period of time if and only if a comprehensive measure of wealth per capita is non-declining during that same period. This comprehensive wealth measure encompasses a wider range of productive assets than those in traditional national accounts. It embraces not only reproducible capital but also human capital and many commercial forms of natural capital. In addition, the focus on wealth directs attention to the entire intertemporal stream of goods and services implied by today’s assets, rather than the current flow of income. This effort is in the general category of comprehensive wealth accounting. Some of the most important advances in such accounting have been made in recent years by Kirk Hamilton and his collaborators at the World Bank. Hamilton and Clemens (1999) explored whether comprehensive wealth is rising or falling in various developing countries. Arrow et al. (2005) built on the World Bank’s framework by incorporating technological change and considering population growth. In Where Is the Wealth of Nations? (World Bank, 2006), a World Bank team headed by Hamilton provides assessments of changes in comprehensive wealth for nearly every nation of the world. 3 The present paper aims to advance comprehensive wealth accounting in several ways. First, we offer a more theoretically consistent approach to valuing natural resources. This includes attention to how future changes in natural resource prices can influence comprehensive wealth measured today. This is especially important in regard to reserves of crude petroleum. Second, we offer an improved approach to measuring changes in human capital. While prior work used education expenditure as a proxy for the change in human capital, we employ a measure based on estimates of changes in educational attainment. Third, we explicitly distinguish between domestic and foreign holdings of a nation’s capital. Fourth, we introduce an improved treatment of changes in wealth connected with environmental damages associated with climate change.2 The paper is organized as follows. The next section lays out the main elements of our analytical framework. Section III then applies the framework to examine the changes in per-capita comprehensive wealth in China and the U.S. over the period 1995-2000. Section IV offers conclusions and suggests directions for future work. II. Methodology A. A Sustainability Criterion Researchers have offered a great many definitions of sustainability, as evidenced by Pezzey’s (1992) survey of the various notions. Our sustainability requirement focuses on intertemporal welfare. (See Arrow et. al. [2004, pp. 150-154] for discussion and references). According to this approach, the (intertemporal) welfare of any one generation is determined not merely by its utility for current consumption but also for the care it has 2 Human well-being depends critically on levels of health. Recent work by Nordhaus (2002) and Cutler and Richardson (1997) suggests that changes in health can have a value comparable to changes in GDP or other traditional income measures. In the near future we plan to integrate health in the comprehensive wealth framework described in this paper. 4 for future generations. We let V denote intertemporal welfare. One possible expression for V is: ∞ V(t)=∫ e−δtU[c(u)]du (1) t where t is time, δ is the subjective rate of discount of utility (time preference), U is satisfaction or felicity at any moment of time, and c is an aggregate vector of different kinds of consumption. The c vector includes not only marketed goods but also amenity values of natural resources, and various dimensions of health. The criterion of sustainability is that V is non-decreasing: dV /dt ≥0. (2) The possibilities for consumption are determined by an economy’s productive base, an index of the quantities available of a number of types of capital. The capital assets include (1) manufactured capital goods, referred to as “reproducible capital,” (2) human capital, the productive capacity inhering in human beings and acquired through education,3 and (3) various kinds of natural capital. Natural capital includes land and various mineral resources. Production of new goods takes place according to a technology which relates the use of various forms of capital to outputs. For simplicity, and again in accord with standard models of economic growth, this analytical framework assumes there is one output, which can either be consumed or added to reproducible capital. Natural resources may be nonrenewable, as with minerals, or renewable, as with forests. In the former case, the stock of the natural resource in any period is reduced by the quantity extracted (the flow) in that period. In the latter, the stock is increased by its natural rate of growth as well 3 We follow the general precedent of empirical studies in growth economics in measuring human capital by some function of the embodied years of education (see, e.g., Klenow and Rodríguez-Clare [1997], and Mankiw [1992].) Of course, studies in human capital have also considered human capital as being formed by experience (e.g., Becker, Philipson, and Soares [2005]), but the data we draw on have not made use of this or other refinements. 5 as being reduced by the flow used. The rate of change in the stock of a particular kind of capital is called the investment in that kind of capital. Investment in nonrenwable natural resources is necessarily negative. The output generated by the productive base divides between consumption goods and services and investment in reproducible capital. We assume that allocation rules (which may include functions of market prices) determine the allocation of output between consumption and investment, and that the allocation system is autonomous, by which we mean that V is not an explicit function of time. Hence the stocks of the different kinds of capital in the next period are determined by the stocks in the present period and the (fixed) allocation rules. By proceeding from period to period this way, the entire future course of capital stocks and therefore of flows of investment (by following the allocation rules) is determined.4 Given the stocks of the different kinds of capital, K (i = 1,…n) at some time i t, the values of K and consumption c are determined at all future times u ≥ t. Hence ι U[c(u)] is determined for all u ≥ t, and, from (1), V(t) is determined as well. Hence we can write: V(t)=V[K (t),K (t),…,K (t)]. (3) 1 2 n Therefore, from (2), sustainability requires that dV /dt = ∑n (∂V /∂K )(dK /dt)>0. (4) i=1 i i The theory we are invoking here does not require that intergenerational well-being, V, have the functional form given in equation (1). Let q ≡ ∂V /∂K and I ≡ dK /dt. The i i i variable q is the marginal contribution of the ith type of capital to intertemporal welfare, i 4 We abstract from uncertainty. For the purposes of determining sustainability over a short period of time, this is a legitimate approximation. However, for many policy purposes, uncertainty about the future should not be ignored. 6 and thus may be thought of as the shadow price of that kind of capital. I is the time i derivative of the capital stock K or, in the usual terminology, the investment in that capital. i It follows that dV /dt =∑n q I . (5) i=1 i i Thus, dV/dt is the value of the new investments in different kinds of capital evaluated at the shadow prices. This suggests an interpretation of dV/dt as the change in wealth evaluated at constant prices, i.e., the change in real wealth. Since we are including all forms of wealth, including natural resources, we refer to this as the change in comprehensive wealth.5 Hence, from (4), the criterion for sustainability is precisely that real wealth is increasing. The shadow prices are the prices that would prevail if all commodities were traded in competitive markets and if there were perfect foresight. Thus the shadow price for a nonrenewable resource such as oil is the discounted value of future use. It is therefore the price at which the owner of the well would be indifferent between selling the oil now and holding it for future sale. More precisely, the shadow price is the difference between the sales price of the oil and the cost of its extraction; it is the price paid for the scarcity of the resource. The shadow prices are stated above in units of utility per unit capital. In view of the arbitrariness in the choice of units for utility, it is useful to employ a different numéraire; a natural choice is the aggregate commodity which can be used for either consumption or reproducible capital. This is the same technique as is used in ordinary price indices. Let reproducible capital be given the index 1 in the enumeration of types of capital. Then define the shadow prices of the different kinds of capital measured in terms of reproducible capital, 5 In a similar spirit, Hamilton and Clemens (1999) introduced the term “genuine savings,” where the modifier “genuine” distinguishes more comprehensive savings (savings that contributes to increased natural resource stocks as well as reproducible capital) from narrower, standard notions of savings. 7 p =q /q , (i =1,…n), (6) i i 1 and the change in comprehensive wealth in the same terms: dW /dt =∑n p I (7) i=1 i i Here p = 1, from (6). Hence sustainability requires that 1 dW /dt >0. (8) The formalism used here permits a measure of comprehensive wealth, as well as of the change in comprehensive wealth. In the notation already used, W =∑n p K . (9) i=1 i i This explicit measure of comprehensive wealth is designed to replace the rough approximations used in Arrow et. al. (2004, Table 1 and Note, p. 163). B. Measuring Investments and Determining Shadow Prices 1. Natural Capital To value the changes in natural capital, we need to consider both the net investment (DK) and the shadow price to apply to that investment. The net investment in a nonrenewable resource is simply the negative of the amount used up. The shadow price is related to the rental value of the resource. As is well known since the classical analysis of Hotelling (see, e.g., Dasgupta and Heal [1979]), in a competitive setting the rental value of a nonrenewable resource should rise at the rate of interest (the marginal productivity of 8 capital). If we abstract from externalities associated with use of the resource, then the rental value will correspond to the resource’s shadow price. For renewable resources, such as forests, the shadow price is again the rental value (price less cost of cutting), but the net investment equals the increase in the forests due to natural growth and planting less the amount used up. 2. Capital Gains in Nonrenewable Resources To the extent that the rental value of a nonrenewable resource rises through time, owners of the resource stock should expect to receive capital gains. Similarly, future consumers should expect to pay higher real prices. Other things equal, this implies a reduction in real wealth. Thus the impacts on real wealth of a given nation’s residents will depend on the extent to which the residents own (and sell) or consume (purchase) the resource in question. In the empirical application below, we account for these wealth impacts. It appears that these impacts have not been addressed in any of the prior literature.6 It may be noted that in a closed economy there is no need to adjust wealth for capital gains or losses, since the future gains to owners will be exactly offset by the losses to future consumers For each country, the capital gain is equal to the stock of the resource times the rate of increase of the shadow price (i.e., the rate of interest). Summing over all countries gives the total capital gains to that resource. The corresponding capital losses by purchasers must be equal to this sum. In principle, it should be allocated among individual countries in accordance with their future purchases of oil. In the empirical application below we have approximated by giving each country a capital loss equal to total capital losses to consumer times that country’s share of current consumption. 3. Human Capital 6 In particular, Arrow et. al. (2004) failed to take account of the capital gains to countries with large oil reserves. As a result, that study might have understated the sustainability of Middle East countries (see Table 2, p. 163, and discussion on p. 165). 9 We follow the methods introduced by Klenow and Rodríguez-Clare (1997), which builds on the earlier work of Mincer. That is, it is assumed that education is taken to earn a market rate of interest for the period of education. Assuming, as a first approximation, a steady state, the amount of human capital per worker is proportional to eρΑ , where ρ is the appropriate rate of interest (taken to be 8 ½% per annum) and A is the average number of years of educational attainment. The stock of human capital, then, is the human capital per worker multiplied by the number of workers. This quantity is adjusted for mortality during the working life. We assume that the labor market is sufficiently competitive that the marginal productivity of human capital is equal to its shadow price and also equal to the real wage. Hence the shadow price of human capital is equal to the total real wage bill divided by the stock of human capital. 4. Technological Change In the presence of technological change, the rate of growth of wealth is increased beyond that indicated by the growth in the stocks of individual kinds of capital, as displayed in (8).7 We follow the treatment of Arrow et. al. [2004, fn. 7, pp. 153-4], adjusted to a different specification of the production function. Arrow et. al. assumed that output is a function of reproducible capital and labor, so the elasticity of output with respect to capital was assumed to be a constant α less than one. We now follow Klenow and Rodríguez- Clare (1997, 2005) in making output a function of two kinds of capital, reproducible and human. Thus the elasticity of output with respect to all forms of capital is now one. Hence, from Arrow et. al. (2004, fn. 7), where α is set equal to 1, the adjustment to the rate of growth of real wealth is obtained by adding the Hicks-neutral rate of technological progress to the rate of growth of the aggregate of other forms of capital. 7 Another way of looking at this is to consider the stock of knowledge as one form of capital. Then the growth in knowledge will be one form of investment, so that (8) does not have to be altered. 10