How can the state deter short-termism in finance and facilitate a better environment for the ‘patient capital’ needed for growth?
Consider two countries – China and Italy. As recently as 1990, these economies were equal in size as measured by aggregate GDP at purchasing power parity exchange rates. But let us now put these countries on quite different trajectories for capital accumulation. Let China begin investing at double-digit rates for 20-plus years, while Italy accumulates capital at a rate of only two per cent per year. By 2013, China is now seven times larger than Italy. Indeed, China is creating an economy the size of Italy’s every two years; an economy the size of Greece’s every quarter; and an economy the size of Cyprus’ every week.
GDP may not be all that matters, as economists are increasingly coming to accept. But, as these figures suggest, it nonetheless matters a lot if we care about improvements in living standards over lengthy time spans.
Growth in the long term
Societies are accustomed to becoming better off, generation by generation. Yet, looking across the span of human history, this has often not been the case. Measures of global GDP have been constructed back to 1 million BC. Statistical agencies were thin on the ground back then, so these numbers need to be treated with an even greater degree of caution than today’s GDP releases. Nonetheless, the secular patterns they reveal are striking.
Up to around 50,000 BC, as best we can tell, world GDP per capita was essentially unchanged. Generation after generation, there was little – if any – improvement in living standards. Things improved, progressively, after that. By 1750 AD, world GDP per capita had almost doubled, having risen at a heady rate of 0.0025 per cent per year. Today’s economists would call that an anaemic recovery. But for perhaps the first time in human history, living standards were at least now rising.
From 1750 AD onwards, the world entered a third growth era; a golden era. Since then, GDP per capita has risen 40-fold, at an annual rate of around 1.5 per cent per year. On average, each generation has been perhaps one third better off than its predecessor. So what explains these phase shifts in growth?
How humans developed patience
There is no one explanatory factor, but one key element is what sits between our ears. Something important neurologically happened to humans around 50,000 years ago. Neanderthal man died out and Homo sapiens became dominant. That meant prominent brow ridges were replaced by high, straight foreheads. And they did so for a reason – namely, to accommodate growth of the prefrontal cortex region of the brain.
Modern neurology tells us that this part of the brain is responsible for patience, the ability to defer gratification. It is the part crucial for investment. In primitive societies, this meant investment in the very basics of survival – food, water, shelter, defence – but also in the institutions which helped sustain these basics: families, communities, tribes, civilisations.
After 1750 AD, the great leaps forward were in one sense different – industrial rather than agrarian. Yet they had essentially the same mix of physical, human, and social capital accumulation underpinned by a new set of institutions – schools, governments, judicial systems, even central banks. Patience generated investment, and investment, in turn, generated growth.
The important work of Daron Acemoglu and James Robinson has recently shown that societies that have not invested in institutions have tended to fail. In other words, institutions – the organisational form of patience – are crucial for societal development.
What these historical episodes demonstrate, above all else, is the importance of one very basic human and societal attribute in generating rising living standards: patience – the willingness to defer gratification, to build physical, human, and social capital, to create and sustain institutions, and to innovate.
What patient people do
Patience, we are told, is a virtue. But recent evidence has demonstrated just how much of a virtue. For example, we know that patient people are, predictably enough, more likely to save than spend. They are also more likely to stay on in higher education, to have a job, to vote, to join a gym, to save on energy. Most interestingly, cross-country evidence suggests that patient societies are also more technologically innovative.
So given its importance to innovation and growth, you might ask: what factors determine the patience of individuals and societies? We now know quite a bit about this too. A number of individual and societal characteristics are important, including gender, income, wealth, and age. So too are long-term cultural values. Unfortunately, none of these factors are easy to change, at least quickly.
But there is one further factor, every bit as important, which is amenable to change: the environment for decision-making. Importantly, this includes the role of government and other institutions in nurturing patient decision-making. For example:
- By creating incentives to save and invest rather than spend;
- By creating institutions that promote education and skills;
- By creating infrastructures that support innovation; and
- By providing nudges which shape long-term behaviour, be it attending a gym or saving on energy.
Fast food and fast thought
Let me illustrate the importance of even small interventions on patient decision-making with an example that is at the same time both trivial and profound. A few years ago some psychologists assessed how individuals’ decision-making was affected by sending subliminal images of two iconic 21st century fast-food images – the ‘golden arches’ from McDonalds and Colonel Sanders from Kentucky Fried Chicken. These cues, despite not even entering people’s consciousness, had a dramatic impact on measured levels of patience: the mere subliminal sight of Colonel Sanders raised people’s one-year discount rates by around a third. Fast food made for fast thought.
The deeper point here is that time-saving technologies, including fast food, are meant to nurture patience by stretching time. In practice, they appear to have done the opposite, encouraging the fast-thinking part of the brain. And it is not just fast food. The most important time-saving technology of our lifetime – the web – is believed by some to have induced a neurological bias towards short-term decision-making. Be it the rise in payday lending and attention deficit disorders or falling levels of job and marital tenure, there are signs that society may be becoming more impatient.
Short-termism and finance
From fast food, then, to fast finance. Many of these societal trends are evident, in amplified form, in finance. Modern capital markets rarely give the impression of valuing the long term; they delight in profits being distributed rather than reinvested.
Take public equity markets. These, and the accompanying rise of the public limited company, were one of the great financial innovations of the 19th century. Why? Because, as a perpetual instrument, public equity ought to be ideal for financing long-term investment, be it railways, or car manufacturers, or software houses. And for perhaps a century that is just what it did.
Yet, today, the omens are not encouraging. Fifty years ago, the average share was held by the average US investor for around seven years. Today, it is seven months. Equity contributes almost nothing to the net new financing of UK companies. McKinsey & Company has argued that global equity markets may be entering a long-term period of decline.
That naturally begs the question – why? The short answer, it seems, is short-termism. Investors in public equity markets value too little long-term projects yielding distant returns, and too much the instant gratification of dividends or stock buy-backs. The upshot is that companies are put off from investing in those long-horizon, high-risk, high-innovation projects in the first place.
In my own research, I have tried to estimate this short-termism bias in public equity markets. On average, returns one year ahead appear to be discounted around 5-10 per cent ‘too much’. That may not sound much, but it can have a dramatic effect on long-term project choice.
Imagine a project that provides an annual income stream of $10 and requires a $60 initial outlay. If the ‘true’ discount rate is eight per cent, this project earns a positive net present value (NPV) within a decade. A rational company would undertake it. But with excess discounting of 10 per cent per year, investors believe the project would never break even. The project would never be financed by public equity markets.
If this irrationality was confined to financial markets, it perhaps would not matter much. Unfortunately, it is not. Surveys of company chief executives and CFOs indicate that they turn down positive NPV projects because of the need to keep short-term investors sweet. Studies comparing privately owned and publicly traded companies indicate the former may invest more than twice the latter.
Over time, these differences would translate into a material impact on the capital stock and growth. A rough back-of-the-envelope calculation for the UK suggests that output could be up to 20 per cent higher without these short-termism biases. That is a whole generation’s worth of growth.
The final question, then, is how best to create this better environment for patient capital and growth. From a potentially long list, let me offer three areas I think are ripe for reform.
Reforming taxation and regulation
For example, why does the tax code, globally, continue to bias against equity and towards debt? This, too, was a 19th century invention that may have outlined its usefulness. It is, in effect, a tax on long-termism.
As for financial regulation, this may embed some of the same incentives – for example, regulation of pension fund and insurance companies. As long-term institutions, they are ideally placed to finance long-term investment. Yet, regulation in practice tends to attach higher regulatory charges to longer-duration instruments, even though they may do a better job of supporting growth. If you like, regulation weighs risk but not return.
Risk-based regulation and accounting rules tend also to weigh more heavily when the market slumps. This, perversely, is when patient capital is often most needed. Ideally, we would want long-term investors to act counter-cyclically, stepping in to take on risk when it is cheap. More often, it appears, the opposite is happening.
The good news is that some reorientation of regulation is underway. Regulation is taking on a more macro-prudential dimension. Think of it as regulating for the needs of the real economy, for return as well as for financial risk. Macro-prudential regulation aims explicitly to support long-term, diverse sources of financing, and it also aims to dampen, not amplify, financial cycles.
As one example of that, the Bank of England and European Central Bank recently initiated a joint programme to stimulate securitisation markets in Europe, including for SMEs. This should increase the diversity of the financial system, with more long-term financing coming from long-term institutions. As another example, the Bank has recently lowered the bar for new entrants into the banking market, to encourage greater competition and diversity.
Institutions that nudge
You would expect someone who has spent their whole working life in a 320-year-old institution to tell you how important they are. And in fact, in an increasingly impatient society, their role has never been more important. National and multi-national development banks are testament to the power of patient state-backed institutions in catalysing investment, innovation, and growth. And here in the UK, the British Business Bank and Green Investment Bank have similar aspirations.
But this catalytic role for institutions extends much beyond direct financing. It is also about providing the right nudges and prompts for innovation. Another experimental study, similar in spirit to the fast food one, looked at the impact of subconscious images of two company logos: IBM and Apple. People shown the Apple logo exhibited much greater levels of creativity than those shown the IBM logo. A subliminal nudge was sufficient to catalyse innovation. Institutions can create that creativity nudge at a societal level.
Reforming the PLC
That great 19th century innovation, the PLC, placed power in the hands of shareholders because they were there for the long term. Yet, today, those same shareholders are unrecognisable, their holding periods and long-term incentives much diminished.
This poses a challenge to the PLC model, at least as operated in the UK and US. Giving primacy to the interests of short-term shareholders may come at a cost – the cost of short-termism, suboptimally high hurdle rates, a failure to invest and innovate. Shareholders today may be part of the short-termism problem.
There are corporate governance models globally that lean against this bias, by explicitly recognising the interests of a broader set of stakeholders – debt holders, workers, customers, suppliers, wider society. On average, these corporate governance models appear to have done a better job of sustaining investment and nurturing innovation. For macroeconomists, their success should come as no surprise. As China shows, long-term investment holds the key to future growth.
Andrew G Haldane is chief economist at the Bank of England and executive director of monetary analysis and statistics
This essay forms a contribution to Policy Network’s pamphlet Mission-Oriented Finance for Innovation: New Ideas for Investment-Led Growth
The image is The Late Train by axbecerra, published under CC BY 2.0