Are financial markets ‘short-termist’? A crucial gap in Haldane’s argument
17 May 2011
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18 May 2011
Government and Institutions
A couple of weeks ago, I went for a walk in Ashdown Forest. I followed the instructions perfectly and everything seemed consistent with the map. However, clearly something was wrong and, instead of doing a circle as intended, we came back by the same route to avoid the wrong conclusion. On returning, I noticed that I had missed one vital step at the beginning of the walk.
Andrew Haldane – one of the most-well-regarded managers at the Bank of England – made a similar error in his recent paper on short-termism which has met with wide approval amongst financial journalists. He demonstrated in a completely self-consistent paper that certain empirical results demonstrated myopia and short-termism by investors. However, he made an elementary slip at the beginning but, instead of turning back, he continued to erroneous conclusions.
Haldane came to that conclusion that financial markets and companies were short-termist by assuming that the time preferences of savers were such that the interest rates that savers require on their investments were the same over all time periods. In other words, Haldane assumed that, if a saver wanted a return of 4% per annum over a one-year period, he would want a return of 4% per annum if his saving was for a 20-year period. If this were the case, we would expect the cash flows from investment projects to be discounted at the same rate of interest however far in the future they stretched.
This is a fundamental error. There may be many reasons why savers demand higher rates of return over longer time periods: if they do so, financial markets – and managers acting on behalf of company shareholders – should reflect this by demanding higher returns from longer-term projects. The market is then working well if it reflects the time preferences of savers.
Haldane might counter this by suggesting that the evidence also demonstrates that long-term projects have become more disfavoured over time. He might argue that there is no reason to assume that savers have suddenly become less interested in committing to the long term. Unfortunately, there are several reasons why they might become less interested:
Pension funds and insurance companies have represented a huge proportion of all saving and therefore we can expect these changes to have a significant effect.
Furthermore, accounting regulation has made the shorter-term recognition of profits easier but does not necessarily allow the value created by very long-term investments to be recognised in company accounts – we may have created the worst of all worlds as far as encouraging short-termism is concerned in this respect.
Haldane’s solutions are predictable. He does not suggest removing the discouragement for long-term saving or the regulatory developments that have made institutional investors reduce their long-term equity holdings. He suggests that politicians should have a greater role to play. Those very politicians that have built up debt amounting to 500% of GDP and undermined the incentives to save should be charged with encouraging long-termism! Even if there is a problem here – and I am not suggesting that there is not a problem, merely that Haldane has omitted to analyse the most crucial part of the argument – it does not follow that we should entrust the solution to people who have no incentives at all to be ‘long-termist’.
Andrew Haldane – one of the most-well-regarded managers at the Bank of England – made a similar error in his recent paper on short-termism which has met with wide approval amongst financial journalists. He demonstrated in a completely self-consistent paper that certain empirical results demonstrated myopia and short-termism by investors. However, he made an elementary slip at the beginning but, instead of turning back, he continued to erroneous conclusions.
Haldane came to that conclusion that financial markets and companies were short-termist by assuming that the time preferences of savers were such that the interest rates that savers require on their investments were the same over all time periods. In other words, Haldane assumed that, if a saver wanted a return of 4% per annum over a one-year period, he would want a return of 4% per annum if his saving was for a 20-year period. If this were the case, we would expect the cash flows from investment projects to be discounted at the same rate of interest however far in the future they stretched.
This is a fundamental error. There may be many reasons why savers demand higher rates of return over longer time periods: if they do so, financial markets – and managers acting on behalf of company shareholders – should reflect this by demanding higher returns from longer-term projects. The market is then working well if it reflects the time preferences of savers.
Haldane might counter this by suggesting that the evidence also demonstrates that long-term projects have become more disfavoured over time. He might argue that there is no reason to assume that savers have suddenly become less interested in committing to the long term. Unfortunately, there are several reasons why they might become less interested:
- It is relatively recently that long-term saving became financially unrewarding for most people as a result of the extension of means-tested benefits and the increased taxation of pension funds. Short-term saving through ISAs has become relatively more rewarding.
- Over the time period Haldane regards as relevant, tax relief on life insurance policies and contractually required membership of pension funds has also been abolished.
- The erosion of contracting-out of the second state pension scheme has replaced private long-term saving by government via inter-generational transfers.
- Very-long-term investors such as pension funds and life insurance companies have been increasingly discouraged from holding equities and encouraged to hold bonds by regulatory and tax changes. Future regulatory changes to insurance will exacerbate this. This means that companies are less likely to reflect the needs of long-term investors.
Pension funds and insurance companies have represented a huge proportion of all saving and therefore we can expect these changes to have a significant effect.
Furthermore, accounting regulation has made the shorter-term recognition of profits easier but does not necessarily allow the value created by very long-term investments to be recognised in company accounts – we may have created the worst of all worlds as far as encouraging short-termism is concerned in this respect.
Haldane’s solutions are predictable. He does not suggest removing the discouragement for long-term saving or the regulatory developments that have made institutional investors reduce their long-term equity holdings. He suggests that politicians should have a greater role to play. Those very politicians that have built up debt amounting to 500% of GDP and undermined the incentives to save should be charged with encouraging long-termism! Even if there is a problem here – and I am not suggesting that there is not a problem, merely that Haldane has omitted to analyse the most crucial part of the argument – it does not follow that we should entrust the solution to people who have no incentives at all to be ‘long-termist’.
2 thoughts on “Are financial markets ‘short-termist’? A crucial gap in Haldane’s argument”
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Philip
Your point that politicians built up a debt of 500% of GDP is moot.
There is a fairly well-reasoned argument that it was commercial organisations and consumers that built up large debts and had to be bailed out by the state to prevent a banking collapse and economic crisis much greater than that experienced in the 1930s.
The various temporarily state owned assets will be sold off to generate returns and cash for taxpayers in the future. Due to market conditions it is likely that this ownership will last longer than a week or two, which immediately makes outside the scope of short-term. The likelihood is of state ownership lasting years; in fact already two and a half are on the clock. So the state and therefore politicians have already acted with a longer term perspective to their decision making by these purchases of distressed private sector banking assets. Meanwhile, those market participants that rely on short-term fluctuations in market prices to generate their rents continue to be very active in markets such as commodities, BRIC stocks and some currency markets currently. UK inflation in particular and economic recovery has been adversely affected by such short-term market speculation in commodities.
It was the poor decisions of those in the commercial sector, such as extremely-well paid bankers; seeking ill-advised mergers for commercial returns; short or long term, or providing insurance against adverse short-term stock price market movements, or speculative property developments that generated the greatest losses of all in the private sector.
We wait to see whether the private sector managers, brought in at high cost, through the “market rate” salaries will be able to create the commercial rents to generate a return on the state’s emergency investment. Only markets can decide their fate. Clearly markets have failed to regulate the market of executives and their pay in the past, only the future will tell if it will fail similarly again.
There are simple solutions to subjects like pensions, whereby consumers may be encouraged to invest more in them. Its well known that many are under-invested in pensions currently. A little carrot and stick in this area would help both the funds and consumers pensions; both in the long-term of course.
Jonathan – most of your comments are moot. Not least I think we need to ask the question why banks behaved in the way they did. Is it anything to do with the fact that to avoid the short-term consequences of financial institution failure, governments (especially the US government) underwrote the financial system in so many ways? Secondly, only a tiny proportion of that 500% is to do with the banking crisis – most of it is social security debt built up as a result of politicians setting up systems that involve making payments to people before capital funds have been built up. Thirdly, i think that given the incentives that people face (and the proportion of disposable income that is taken in tax) it is highly unlikely that small nudges will dramatically change behaviour. Thank you for your thoughtful comments – they are moot, not necessarily wrong!