Quarterly capitalism: The pervasive effects of short-termism and austerity

Quarterly Capitalism

Instant gratification is usually associated with limited attention spans, temptations to eat unhealthily or the tech-enabled on-demand economy in which many of us live. Each of these behaviours has known side-effects which we have identified and tried to limit.

However, in the complex economic system which is capitalism, the problems associated with the tendency to prioritise short-term over longer-term gains has only recently started to gain traction. Part of this slow uptake is attributable to the gradual recognition of the problematic symptoms, including increased inequality, dissatisfaction towards government policies of austerity and a general distrust of corporations. The side-effects have taken time to become noticeable.

In this blog post, I’ll take a look at the consequences of short-termism, ranging from financial and economic dimensions to the social implications. The unfortunate irony is that short-term behaviours often have the longest lasting effects.

(Im)patient capital

From a financial perspective, “short-termism” can be defined as “an excessive focus on short-term results at the expense of long-term interests”. In an excellent report published by the Roosevelt Institute entitled Understanding Short-Termism: Questions and Consequences, J.W. Mason takes a closer look at short-term corporate behaviours, including low levels of corporate investment, hoarding of cash on balance sheets, in addition to high levels of dividend payments and share buybacks. Mason highlights that dividend payouts to shareholders have risen dramatically, from around 50% of profits prior to the 1970s in the US, to around 90% since the 1980s.

At first glance, one could easy say: “So what if company X pays out a huge dividend to its shareholders? Its their company so the most important thing is that the shareholders are kept happy”. However this attitude misses some very important points, as highlighted by Mason:

“When financial markets demand immediate payouts, it makes long-term investment difficult. This is bad for demand today and bad for innovation and growth in the future. Shareholder payouts do not, in general, reallocate resources. By diverting funds from the corporate sector into the maelstrom of Wall Street, payouts may contribute to higher consumption among wealthy owners of financial assets and higher incomes in the financial sector, but they leave us all poorer than we would be in a world where the money had been used for productive investment.”

What Mason highlights is that corporates have become the engines of growth in the modern economic system. Their individual actions and behaviours matter for the system as a whole. When these firms decide to pay out large dividends or use company cash to buyback stock, they are sacrificing the opportunity to retain those funds to finance future growth. Put differently, instead of investing in researching and developing the next innovative product, firms are returning capital to shareholders, to the detriment of the system as a whole. Larry Fink, CEO of BlackRock, the world’s largest asset manager, recently wrote about this issue to the management of over 500 large US firms, highlighting the potential detrimental impact on future growth prospects.

Separately, short-termism also can put the longer-term viability of businesses at risk through the extraction of significant amounts of capital from firms’ balance sheets. A recent example in the UK  is that of retailer BHS, which is synonymous with businessman Sir Philip Green. The firm has come under intense scrutiny after being placed into administration with an unfunded pension liability of £571 million. Despite these significant long-term liabilities, the firm has paid out an estimated £580 million to its owners since 2000. In this case, the firm’s owners were able to extract significant short-term returns, whereas the longer-term liabilities will fall to the collectively funded Pension Protection Fund.

Starting long-termism

To combat short-termism, a range of mainly technical fixes have been proposed. In addition to Mason’s piece, the Roosevelt Institute has also published a companion piece entitled Ending Short-Termism: An Investment Agenda for Growth, by Mike Konczal, J.W. Mason and Amanda Page-Hoongrajok. The paper offers some solutions for combating the problem, including:

  • Restricting the size of dividends for firms with unfunded pensions liabilities – essentially to limit the likelihood of a BHS scenario.
  • Including employee representation on corporate boards to ensure oversight from broader set of the firm’s stakeholders, as currently commonplace in Germany.
  • Limits on the size of stock buybacks so that firms are compelled to use their earnings to invest for the future.

Similarly Andy Haldane, the Bank of England’s Chief Economist, has previously highlighted other effects of short-termism in this 2011 speech. Haldane shows how firms are generally willing to prefer funding projects with relatively short payback periods, even if projects with longer payback periods are expected to be substantially more profitable. Haldane views this phenomena as:

“… a market failure. It would tend to result in investment being too low and in long-duration projects suffering disproportionately. This might include projects with high build or sunk costs, including infrastructure and high-tech investments. These projects are often felt to yield the highest long-term (private and social) returns and hence offer the biggest boost to future growth. That makes short-termism a public policy issue.”

In order to shift thinking towards the long-term, Haldane and Konczal et al. suggest some additional solutions, focused mainly on shareholders as “owners” of the firm:

  • Greater voting rights to long-term shareholders who are more likely to engage with firms to ensure that firms invest for long-term value creation.
  • Higher taxation of capital gains for short-term shareholders and incentives for long duration shareholdings.

These ideas would act to reduce the incentive to hold shares in companies for short periods of time. However one area which isn’t specifically recognized is the skewed incentives of some financial institutions which end up promoting short-term share ownership. For example, investment brokers and financial exchanges tend to be compensated based on the level of trading activity, through volume related commissions or fees. In other words, the London Stock Exchange and the New York Stock Exchange are more profitable when investors buy and sell their stock holdings more frequently. However this is counter to the principles highlighted above.

I’ll return to this point later in this blog post as part of the discussion on taxes on financial transactions.

The rhythm of life

In the meantime, I’d like to focus on how short-termism in financial markets more directly impacts upon the real economy. Laura Bear from LSE’s Department of Anthropology takes up this task in her book Navigating Austerity: Currents of Debt Along a South Asian River. The book documents the seemingly unending state of crisis for the Kolkata Port Trust, as long-term development of the port is challenged by short-term cycles of austerity and cost containment.

Bear links experiences of austerity during her ethnographic fieldwork along the Hooghly River in India to the way in which developing countries are increasingly subject to the short-term rhythms of global financial markets. This link is the result of development financed by sovereign debt, which is subsequently traded on the government bond markets. As Bear states on page 194 of her book (emphasis mine):

“Commercial banks have been incentivized to lend more to riskier sovereign clients by the high yields on their bonds. This has been further supported by the use of short-term quarterly reports to shareholders, which has oriented investors to quick profits… Government bonds are usually just one part of an investment portfolio of securities, so they are bought and sold according to the trading rhythms in other equities, derivatives and securities. In recent years the rush of investors toward and away from them has come to echo the fortunes of other sovereign debtors and the peaks and troughs of the equity markets. This introduces unpredictable volatility in the costs of borrowing for governments.

This observation demonstrates the ability for seemingly long-term decisions, such as the financing of government infrastructure projects, to be transformed and affected by short-term swings in investor sentiment in unrelated markets.

To summarize the process behind Bear’s observations, let’s consider a stylised example of the Indian government wishing to finance the development of its port facilities by borrowing from international debt markets, as illustrated in Figure 1. Ideally, the government would issue bonds which covers the duration of the lifespan of the infrastructure project, usually in the order of 20-30 years or more for a new port facility. This project would likely create jobs, expand trade and stimulate economic growth, allowing the government to raise tax revenues which more than offset the cost of borrowing. Investors in developed countries such as the UK and US, including pension funds and insurance companies, attracted by the high yields on offer, would purchase these bonds as part of their diversified investment portfolios.

Figure 1: Debt, financial crisis and austerity

Source: CURRENTLY UNDER DEVELOPMENT based on Bear (2015).

However, for many developing countries such as India, it is almost impossible to borrow for such lengthy terms. In most cases, developing country governments are only able to issue bonds with a maturity of up to 10 years. This means that in the middle of the life of the project, the government will be required to seek a new round of borrowing to cover the remaining period until the project’s conclusion.

Now suppose that after 10 years, a crash in US equity markets results in large losses for many investors, including the pension funds and insurance companies which bought the Indian government bonds. These investors, due to certain solvency requirements, may be forced to sell their holdings, especially those assets deemed to be ‘risky’. Consequently, even if the Indian economy remained strong and the port facility was an ongoing success, the borrowing costs for the Indian government would rise dramatically as demand for these types of assets dries up.

How would the Indian government be forced to react in such a situation? With a higher cost of borrowing, the government would need to extract higher returns from the port, most quickly achieved by cutting costs associated with labour, maintenance and operations. Hence by implementing these austerity measures, seemingly distant effects (a fall in the value of US equities) will have a lasting impact on the lives of many associated with the port facility. Ultimately, if the Indian government is unable to generate enough revenues from the project, it’s possible that the only choice will be for the project to privatized.

What I’ve described above is clearly an oversimplification of the mechanisms studied by Bear. Nevertheless, the general logic of the hypothetical example holds true, and is consistent with Bear’s observations with respect to the Kolkata Port Trust in India.

By linking economic development to the investment channel, volatility due to short-term investment behaviours becomes transmitted to the real economy. These effects are most obviously observed among developing countries where opportunities for sustainable growth have become subjected to the mood of ‘the market’.

‘Social calculus’ of debt

In order to remedy the negative effects of short-term behaviours in an increasingly intertwined global financial system, Bear calls for ‘social calculus’ for sovereign debt which “… traces the effects of forms of government financing on redistribution and social relations” (p. 204). Examples of this social calculus include:

  • Greater democratic accountability for central banks and debt management offices through direct elections, instead of the status quo where these positions are usually appointed by the government of the day.

  • Creation of an international tax authority, focussed on transparency and redistribution to the world’s poorest, consistent with Piketty’s suggestions. As part of this, the roles of the World Bank and IMF would be redefined or substituted by this new organization.

  • Banning the trade in derivatives on sovereign bonds and their proxies (eg municipal bonds, infrastructure development bonds) and extending the maturity of the actual bonds to at least 30 years in order to shift the focus to long-term commitment on the part of investors.

I would argue that the first two points above are very much achievable. Direct election of public officials such as police commissioners and judges is already common in many places (although be careful what you wish for). Meanwhile, calls for a global tax authority are getting louder in the wake of the Panama Papers revelations.

While I commend Bear’s call to end the trade in derivatives on sovereign debt, the pragmatist in me considers this to be unlikely. An alternative would be to extend a financial transactions tax (FTT) to include derivatives transactions. Although many in the finance industry would cry foul over such a measure, my counterargument would be that longer-term investors would be unconcerned.

FTT is already used across many physical securities (eg stamp duty on UK stocks) and centralized clearing of derivatives has become more commonplace, meaning that applying the tax to derivatives should be relatively straightforward. An advocate of this measure is Adair Turner, former chair of the UK’s financial regulator. This charge would be a drop in the ocean for long-term investors while acting as a hurdle for short-term or high frequency traders. Introducing this levy would enable participants to recognize the social costs of short-termism.

Neoclassical economists are likely to argue that introducing measures such as FTT, increasing taxes on short-term capital gains or extending debt maturities to 30 years are likely to increase market ‘frictions’ and reduce trading liquidity. However this attitude ignores the idea that the less liquid the investment, the more committed the investor needs to be to the long-term success of such an investment. Investors, in the presence of lower liquidity, are more likely to be actively engaged with their investments and conduct more thorough pre-investment due diligence. Yes, these are financial ‘frictions’, but they also act to limit the social externalities of short-term behaviours.

Through a reorientation towards long-term thinking, the financial system can become a tool which serves to benefit society as a whole, rather than a mechanism which extracts and distorts.

Quarterly capitalism: The pervasive effects of short-termism and austerity

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