Rate of interest

Hotelling’s argument highlights the importance of interest rates in the management of biological resources. If a person can earn an 8% return per year by investing in industrial expansion through stock or bond markets, he or she has little incentive to invest in trees that only increase in value at 3% per year or in the preservation of tropical forests, which have little measurable economic return. By economic logic, biological resources that are not increasing in value as fast as the rate of interest should be exploited and the revenues put into industrial capital markets. The rate of interest affects how, by economic reasoning, people discount the future. If the rate of interest is 10%, one dollar one year from now is worth only $0.91 today, since one can put $0.91 in the bank today and, earning 10% interest, it will be worth $1.00 next year. The problem is that $1.00 one decade from now is only worth $0.34 today, two decades from now a mere $0.11 today. Clearly, discounting at 10%, a species has to have a very high value in the distant future to be worth saving today. With a lower rate of interest, it would be discounted less and hence worth more. Thus, lower interest rates appear to favor conservation.

It has long been argued, for example, that trees that grow slower than the rate of interest will never be commercial. Imagine that it costs $10 to plant a tree seedling. Imagine that the rate of interest is 10%. An entrepreneur has the choice of putting $10 in the bank earning 10% or planting the tree seedling and harvesting it at a later date. Each year, the money in the bank (MIB in Figure 2.5) increases in value: to $10 x (1.1) or $11.00 at the end of the first year, to $10 x (1.1)2 or $12.10 at the end of the second year, to $10 x (1.1)3 or $13.31 at the end of the third year, and so on. As long as the value of the tree grows faster than the money in the bank, it is a commercial tree species (CTS) and it pays to invest in the tree. Eventually, of course, the tree would begin to grow more slowly and when it is only growing in value as fast as money in the bank (th in Figure 2.5), it pays to cut the tree. But if the tree never grows in value faster than money in the bank, it is a noncommercial tree species (NCTS), and it never pays to plant the tree in the first place. Slow growing trees such as teak and many other hardwoods will be cut down and not replanted when interest rates are even moderately high. The World Bank considers returns of 15% to be acceptable and hence has rarely financed timber projects except those with very fast growing species such as eucalyptus. Historically, development aid has financed the replacement of natural forests of mixed species by monocultural forests of fast growing species on this understanding of economic efficiency. High interest rates encourage transformation of ecosystems toward faster growing species.

This Informational Box is an excerpt from An Introduction to Ecological Economics by Robert Costanza, John H Cumberland, Herman Daly, Robert Goodland, Richard B Norgaard. ISBN: 1884015727

Glossary

Citation

Norgaard, R. (2007). Rate of interest. Retrieved from http://www.eoearth.org/view/article/155662

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