NIESR Discussion Paper No. 369 16th November 2010 Kenneth J. Arrow, Stanford University Partha Dasgupta, University of Cambridge Lawrence H. Goulder, Stanford University Kevin J. Mumford, Purdue University and Kirsten Oleson, Stanford University National Institute of Economic and Social Research, 2 Dean Trench Street, London SW1P 3HE SUSTAINABILITY AND THE MEASUREMENT OF WEALTH The last two decades have witnessed growing concern that the pattern of economic growth in many countries is not sustainable because of the depletion in stocks of many natural resources and the deterioration in the quality of various environmental services. These concerns have helped spawn a growing literature on “sustainable development.” This emerging literature expands traditional growth-accounting approaches by giving considerable attention to natural resource stocks and environmental quality. Sustainability and the Measurement of Wealth by Kenneth J. Arrow, Stanford University Partha Dasgupta, University of Cambridge Lawrence H. Goulder, Stanford University Kevin J. Mumford, Purdue University and Kirsten Oleson, Stanford University October 2010 We are most grateful to Kirk Hamilton and his colleagues at the World Bank for very helpful comments and making their data available to us. I. Introduction The last two decades have witnessed growing concern that the pattern of economic growth in many countries is not sustainable because of the depletion in stocks of many natural resources and the deterioration in the quality of various environmental services. These concerns have helped spawn a growing literature on “sustainable development.” This emerging literature expands traditional growth-accounting approaches by giving considerable attention to natural resource stocks and environmental quality. This paper aims to advance this literature. We extend earlier work by offering a fully consistent theoretical framework that offers a clear criterion for sustainable development. This framework yields an empirically implementable measure of whether a given national economy is following a sustainable path. We apply this framework to five countries that differ significantly in terms of their stages of development and resource bases: the United States, China, Brazil, India, and Venezuela. 1.1 What Should Be Sustained if Development Is to Be Sustainable? As sustainable development must refer to a path of development that sustains (prevents the diminishing of) something, our first requirement is to state what that "something" should be. In a landmark report, the Brundtland Commission (World Commission, 1987: p.70) defined sustainable development as "... development that meets the needs of the present without compromising the ability of future generations to meet their own needs." Note that the definition makes no mention of human well-being. Relatedly, it makes relatively weak demands on intergenerational justice. In the Commission's view, sustainable development requires that future generations have no less of the means to meet their needs than we do currently; it requires nothing more. As needs are the austere component of well-being, economic development could be sustainable in the Commission's sense without having much to show for it. Note also that the Commission's definition is directed at sustaining the factors that go to meet needs. In their view "sustainable development" requires that relative to their populations each generation should bequeath to its successor at least as large a quantity of what may be 1 called an economy's "productive base" as it had itself inherited from its predecessor. That raises another problem with the Commission's reasoning: it does not explain how the productive base should be measured. We take the view that economic development should be evaluated in terms of its contribution to intergenerational well-being. Specifically, we identify sustainable development with economic paths along which intergenerational well-being does not decline. In view of what is already known about the relationship between real national income and social well-being in a timeless economy (e.g., Samuelson, 1961), we should expect that there is a measure of an economy's productive base that reflects intergenerational well-being. We show below that intergenerational well-being would not decline over a specified time-period if and only if a comprehensive measure of the economy's wealth were not to decline over the same period. By wealth we mean the social worth of an economy's entire productive base. Because the productive base consists of the entire range of factors that determine intergenerational well- being, we will sometimes refer to wealth as comprehensive wealth.1 What are the raw ingredients of wealth? It is intuitive that an economy's productive base comprises the entire range of capital assets to which people have access. Wealth therefore includes not only reproducible capital goods (roads, buildings, machinery and equipments), human capital (health, education, skills), and natural capital (ecosystems, minerals and fossil fuels); but also population (size and demographic profile), public knowledge, and the myriad of formal and informal institutions that influence the allocation of resources. We will see presently that reproducible capital, human capital, and natural capital enter quantitative estimates of sustainable development in a somewhat different way from population, public knowledge, and institutions. With a complete set of competitive markets, it would be relatively straightforward to calculate wealth. One could observe the prices of assets as they are traded, or alternatively consider the present value of the flow of income generated by the assets, as revealed through forward markets. In the world as we know it, though, many of the productive assets and the goods and services they generate (e.g. public goods, human capital, institutions) are not traded; in addition, forward markets often do not exist for the associated income flows. Calculating the                                                              1 Recent efforts to arrive at more broad-based national income accounts express a similar spirit to the present study in showing an appreciation for more comprehensive accounting. Important steps for improved national income accounts for the U.S. are provided in Jorgenson, Landefeld, and Nordhaus (2006). 2 value of human capital, for example, has proved to be exceptionally difficult because there is no direct market for such capital. At least as problematic is the estimation of the health component of human capital (see below) and the shadow value of the stocks of various forms of natural capital (e.g., ecosystems). 1.2 Wealth and Well-Being That movements in wealth should be used to judge the sustainability of development paths was proposed by Pearce and Atkinson (1993), who defined sustainable development to be an economic path along which (comprehensive) wealth does not decline (see also Hamilton, 1994). Although the Pearce-Atkinson definition was not founded on the more basic notion of intergenerational well-being, the paper influenced a bold program of research at the World Bank's Vice Presidency for Environmentally Sustainable Development, where researchers sought to estimate the composition of the wealth of nations and their movements over time (Serageldin and Steer, 1994; Serageldin, 1996; World Bank, 1997). These publications did not explore the connections between movements in wealth and changes in intergenerational well-being. The connections were identified independently by Hamilton and Clemens (1999) and Dasgupta and Mäler (2000). Assuming a constant population and constant total factor productivity, Hamilton and Clemens showed that at a full optimum intergenerational well-being increases at a date t if and only if comprehensive wealth increases at t. Dasgupta and Mäler also assumed constant population, but imposed no restriction on the way economies can be mismanaged; nor did they restrict production possibility sets to be convex. They showed that even in dysfunctional, non-convex economies intergenerational well-being increases at a date t if and only if comprehensive wealth increases at t (Proposition 1 below). They also uncovered the connection between sustainability analysis and social cost-benefit analysis by showing that even in the latter, wealth is the implicit criterion function. A change in comprehensive wealth at constant shadow prices is what may be called comprehensive investment. In addition to their theoretical finding, Hamilton and Clemens (1999) extended the empirical work in World Bank (1997) by constructing an improved set of estimates of comprehensive investment (they called it "genuine saving") in 120 countries for the period 1970-1996. To official figures for national saving, the authors added the value of net additions 3 to fossil fuels and minerals, forest cover, carbon in the atmosphere, and public expenditure on education. Although comprehensive wealth in a few of the countries in their sample was found to have declined during the period, the authors estimated that it had increased in the vast majority of countries. However, as population had grown in all countries, it was unclear how the Hamilton-Clemens findings on sustainable development were to be interpreted. It may seem self-evident that when population size does not remain constant, wealth per capita tracks intergenerational well-being, but the intuition is unreliable, and in any case requires confirmation by a formal proof. Dasgupta (2001) identified a set of conditions, both on the concept of intergenerational well-being and on technological possibilities, under which per capita wealth tracks intergenerational well-being (Proposition 3 below). In an important publication, World Bank (2006) extended the empirical findings in Hamilton and Clemens (1999) by estimating changes in (comprehensive) wealth per capita in year 2000 in 120 countries. Obliged as they were to work with so large a sample, limitations in data compelled the authors to ignore changes in a number of potentially important capital assets. Our aim in this paper is to offer a more complete and consistent theory of the way comprehensive investment should be estimated, and to apply the theory empirically. Our empirical investigation focuses on a small set of countries that differ significantly in terms of their stages of development and resource bases. 1.3 Plan The plan of the paper is as follows. In Section 2 we develop a basic theory and identify the propositions we need. In Section 3 we extend the theory to enable it to embrace technological change and population growth. Section 4 discusses issues relating to the implementation of the theory. In Section 5 we use data for the period 1995-2000 to study whether economic development in a selected number of countries was sustainable. Section 6 concludes and includes discussion of some of the most glaring weaknesses in our empirical work. 4 2. The Basic Model We assume a closed economy. Time is continuous and denoted variously by s and t (s ≥ t ≥ 0). The horizon is taken to be infinite. Let C(s) denote a vector of consumption flows at time s. C(s) includes not only marketed consumption goods but also leisure, various health services, and consumption services supplied by nature. Consumption goods are indexed by j. Let K(s) denote the stocks of a comprehensive list of capital assets at s. For simplicity, we assume that demographic changes, movements in total factor productivity, and changes in import and export prices are exogenous. Capital assets are indexed by i. 2.1 A Definition of Sustainability To fix ideas, we assume for the moment that population is constant. Let U(C(s)) be economy-wide felicity (utility flow) at s. Denote intergenerational well-being at t by V(t). We assume that  ∞   V(t)=∫ [U(C(s))e−δ(s−t)]ds,   δ ≥ 0.  (1)  t where δ is the felicity discount rate. Thus, intergenerational well-being is the discounted flow of the felicities of current and future generations. An economic forecast at t is the pair of vector functions {C(s),K(s)} for s ≥ t. Assume that the integral in expression (1) converges for the forecast. We now state Definition 1. Economic development is sustained at t if dV/dt ≥ 0. (2) To save on notation, we avoid writing down an explicit dynamical model of the economy. We note that even though the sustainability requirement (condition (2)) is defined at a particular moment in time, the element V requires a forecast of the economy's future beyond t. That future depends on the economy's stock of assets at t; it also depends on the evolving structure of technology, people's values and preferences, and institutions beyond t. The stock of assets at any moment s in the future would be determined by the stocks at the “previous” date.2 By                                                              2 We qualify with quotation marks only because in continuous time there is no “previous” date.   5 proceeding from moment to moment this way, the entire future course of capital stocks would be determined. With a theory of political economy that is reliable enough to track the co-evolution of economic development and the economy's institutions, we could trace institutions at s to capital stocks and the prevailing institutions at t. With no reliable theory of political economy available, changes in institutions have to be treated as exogenous events; this is what we do here. Thus, given K(t), K(s) and C(s), and thereby U(C(s)), are determined for all future times s ≥ t. Hence from equation (1), V(t) is determined as well. Therefore we can write V(t) = V(K(t),t). (3) In equation (3) V depends directly on t to reflect the impact of time-varying factors that we treat as exogenous. These include changes in the terms of trade, technological change, unexplained population growth, and unexplained changes in institutions. By "unexplained" we mean exogenous and thus distinct from the changes that are endogenous to the system. Hence t can be regarded as an additional form of capital asset, an interpretation we will adopt presently. Note that we do not assume the economy to be on an optimum trajectory (see Dasgupta and Mäler, 2000). 2.2 Shadow Prices For simplicity of notation, we take felicity to be the numeraire. Let q(t) denote the j shadow price of consumption good j at time t. Then q(t) = ∂U(C(t))/∂C(t). (4) j j We assume that V(t) is differentiable in K.3 Differentiating V(t) with respect to t in (3) and using (2) yields a criterion for sustainable development at t: dV(t)/dt = ∂V /∂t + ∑ [(∂V(t)/∂K (t))(dK (t)/dt)] ≥0  (5) i i i Presently we will relate this criterion to prices and investment. Define p (t) ≡ ∂V(t)/∂K (t), for all i.  (6) i i The variable p(t) is the (spot) shadow price of the ith asset at t. This price represents the i contribution to V(t) made by K(t) both through the goods and services it helps produce as well as i through direct enjoyment of the stock itself. A wetland is an example of a capital asset that contributes to V both ways; health is another. In imperfect economies (e.g., those experiencing                                                              3 For a justification see Dasgupta (2001: Appendix).   6 the tragedy of the commons) an asset's shadow price can be negative even when its market price is positive.4 At any date an asset's shadow price is a function of the stocks of all assets. Moreover, the price today depends not only on the economy today, but on the entire future of the economy. So, for example, future scarcities of natural capital are reflected in current shadow prices of all goods and services. That means that shadow prices are functions of the degree to which various assets are substitutable for one another, not only at the date in question, but at subsequent dates as well. Of course, if the conception of intergenerational well-being involves the use of high discount rates on the well-being of future generations (i.e., if δ is large), the influence on today's shadow prices of future scarcities would be attenuated. Intergenerational ethics plays an important role in the structure of shadow prices. Equations (5) and (6) imply that the ratios of shadow prices are marginal social rates of substitution among the various capital assets. In an economy where V(t) is maximized, these marginal rates of substitution equal their corresponding marginal rates of transformation. As the latter are observable in market economies (e.g., border prices for traded goods in an open economy), shadow prices are frequently defined in terms of marginal rates of transformation. However, marginal rates of substitution in imperfect economies do not necessarily equal the corresponding marginal rates of transformation. In our empirical application below, we sometimes use market prices as shadow prices for various forms of capital assets. In cases involving assets over whose production and distribution the market mechanism is known to be especially deficient, we invoke additional information to assess the shadow prices. 2.3 Comprehensive Wealth To arrive at a measure of comprehensive wealth that accounts for certain exogenous changes (e.g., changes in total factor productivity), we need an additional shadow price. Let time also be regarded as a capital asset. Also, let r(t) be the shadow price of time at t: r(t) = ∂V/∂t. (7)                                                              4 Although we use felicity as our numeraire in this theoretical section, for convenience in our empirical work in Section 5 we use consumption as the numeraire. The sustainability criterion we develop below (Definition 2) is unaffected by the choice of numeraire. 7 We can now use shadow prices as weights to construct an aggregate index of the economy's stock of capital assets. Refer to that index as comprehensive wealth, W. Formally, we have Definition 2. An economy's comprehensive wealth is the (shadow) value of all its capital assets; that is, W(t) = r(t)t + Σp(t)K(t). (8) i i As observed earlier, comprehensive wealth is the dynamic analogue of real national income and involves the same reasoning as the one that is familiar in studies of the welfare economics of timeless economies. A critical linkage in our analysis is between changes in comprehensive wealth at constant prices and changes in intergenerational well-being. Proposition 1. A small perturbation to an economy increases (resp., decreases) intergenerational well-being if and only if holding shadow prices constant, it increases (resp., decreases) comprehensive wealth.5 Proof: Let Δ denote a small perturbation. Then ΔV(t) = [∂V/∂t]Δt + Σ[∂V/∂K(t)]ΔK(t). (9) i i But by definition, p(t) = ∂V(t)/∂K(t) and r(t) = ∂V/∂t. Therefore, equation (9) can be re- i i expressed as ΔV(t) = r(t)Δt + Σp(t)ΔK(t). QED (10) i i 2.4 Comprehensive Investment Now p(t)ΔK(t) in (10) above is the shadow value of net investment in asset i, and r(t) is i i the shadow price of time t. Letting I(t) = ΔK(t)/Δt, we can write equation (10) as i i ΔV(t) = r(t)Δt + Σp (t)I(t)Δt.6 (11) i i                                                              5 We are considering a closed economy here. Exogenous price changes in the international prices facing a small country that exports natural resources are a different matter. There, capital gains have to be included. See Section 4.2.   8