Markets and the Long Term

The Economist has an article on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this  is to ensure that a large proportion of the manager’s compensation is in the form of shares or stock options. But it turns out that during the recent financial crisis, the more shares of a bank its CEO held, the worse the bank performed.

I believe that this is confounding two different problems. The agency problem relates to aligning an incentives of the agent (i.e. the CEO) to that of the principal (i.e. the shareholders).  The second problem is that of translating long term goals into short term actions.

Human beings are not very good at solving the second problem even when the principal and agent are the same people. We aren’t good at planning our own diet and exercise so that our long-term health is maximized. The challenge is not only the intellectual one of long-term planning, it is also one of the incentive to execute the plan. Who wants health food and rigorous exercise when fried stuff and indolence are so pleasurable?

So we try in various ways to arrange our affairs so that the next steps that will lead us to a good long term goal are more rewarding than the self-destructive, but pleasurable short term steps. This is difficult to do even in the absence of the agency problem complicating things. The agency problem makes it almost intractible.

The article complains that rewarding CEOs with stocks and options makes them focus on short term stock prices. Well, I don’t see how one can make us take short term steps towards a desirable long term goal except by rewarding us for those short term steps. The focus on short term stock prices would be a bad thing if it forced CEOs to focus on short term profits at the expense of survival two years down the line. Sometimes, that is indeed what happens. But at other times, especially during the dotcom era, the opposite was true. Managers of companies would focus on “long-term” projects that would supposedly make the company a superstar some time in the distant future, but they’d have no plan to make money next year.  Sometimes they truly believed in their plans. Other times, they just wanted to cash out by the end of the year to the greater fool.

Markets are often criticized for encouraging short-term thinking. This criticism is rather misplaced.   The market, especially the financial market, has mechanisms to translate long term costs and benefits into the short term. Humans then act according to those short term alignments of costs and benefits. People see these human actions and tend to think that it is the market that is encouraging short termism. But they are mistaken. It is human nature, not the market that is prone to short term thinking.  As we have seen, the market can just as easily encourage long-termism as it can encourage short-termism.

This point is important because people often want to “correct” the market’s short-termism through regulatory actions. Take global warming. We are talking of a time-frame of 50-100 years, but we are supposed to be taking the right steps this year. Even if we eliminate the market from the equation, there still remains the problem that we can’t expect people to take the right next steps just because those steps will benefit their grand children. You need to reward or punish them next year for the right or wrong steps this year. Do we know what the right next steps are? Do we know the global economy well enough to say with sufficient level of confidence that the rewards and punishments that we are proposing will in fact provide an incentive to take those correct next steps? Do we have a mechanism to impose those rewards and punishments, if not through the market, through the political system?

We haven’t found a way to make CEOs of companies behave, even though even the world’s largest company is a small system compared to the expanse of the world economy, even though the timeframes in question are much smaller and even though the CEO’s goals are vastly clearer. Given this, I can only look at the efforts to tackle global warming with bemusement.

9 thoughts on “Markets and the Long Term

  1. I must say I found this post unusually unconvincing.

    “It is human nature, not the market that is prone to short term thinking.” Faulting “human nature” is exactly the sort of thing statists do and are (rightly) ridiculed for. Any institution that is meant for humans must take into account human nature, right or wrong. Just as any institution that does not take into account natural human greed and corruptibility will likely fail, so also will an institution that cannot take into account systematic human irrationalities.

    Your post somehow smacks of status quo bias. Not every improvement of institutional design need come from govt. regulations, other alternatives to the existing system exist. To give an example, internal prediction markets have long been shown (see Robin Hanson’s work) to improve internal decision making in companies (as well as in other situations).

  2. But that is exactly what I am saying. I am not blaming human nature for the failure of markets. I am saying that human nature fails in some significant ways, and that the market often corrects for human nature.

    Often it does a good job of correcting. Sometimes it fails to correct, and sometimes it overcorrects. Obviously, as you point out, prediction markets, etc. are improving all the time. I don’t dispute any of these.

    My point is that those who claim that markets are a *cause* of short-term thinking have got it wrong. More pertinently, those who say that regulations or government action can “correct” the short-termism caused by markets haven’t grappled with the immensity of the problem they are grappling with.

    Having said all this, I stand by my point that *if* global warming is real and that *if* human action is needed to fight global warming, we are doomed to start late and make a lot of incorrect and counterproductive moves till we get it right. This is regardless of whether we use market measures or statist measures. I know that you have a lot of faith in the market and so do I. I also believe that the market can find a way to fight global warming eventually, and it will do a better job than statist measures. I say that this would be true even of a perfectly libertarian world (by whatever definition).

    I have no way of proving this, of course, but I say it on the basis of the fact that humans have no way of planning for something that far in advance.

  3. The banks/banking system has a different set of incentives today. It is hardly a free market.Considering that money itself is monopolized by the govt and money flows from the govt/fed to the commercial banks and down the chain, those at the top of the chain have their incentives aligned with keeping this fount of money going.

    In a true free market, money wouldnt be a monopoly nor would it flow top-down from the fed-to-the-pensioner.

    No amount of stock options or bonuses can correct this.The way forward could be to end the govt monopoly over money. The banking industry would shrink down and adjust to its true value in the economy and not comprise 30-40% of the S&P profits (admittedly that was in the bubble years of 2002-2007).

    In more free/competitive industries I dont see why stock options couldnt work along with bonuses.

  4. I find it worrisome that you are making quite strong claims (global warming can be handled by markets alone) and then casually stating that you don’t have any evidence for them.

    I think markets are well-suited for solving some problems and not so well for others. In the case of global warming, standard reasoning says profit-maximizing firms shouldn’t care, as carbon emissions are an externality. I am no fan of govt. regulation, but there are a ton of alternatives here which seem worth consideration to me – gas taxes, cap-and-trade, geo-engineering etc. And there might well be new insights into group-coordination/rationality waiting to be discovered here (akin to how Thomas Schelling discovered new stuff in light of the cold war nuclear armageddon scenario), insights that may never be discovered unless people realize there’s a big problem and nobody really has a clue how to solve it.

  5. Wow, it IS unusually unconvincing.

    1) Isn’t the market nothing but an aggregation of human behaviour? If you’re agreed in theory and premise with the behaviourists (about hyperbolic discounting, etc.), how are your recommendations so different from the ones they make – why do you (and others like you) consider subject matter expertise to be so important in say, science, but not in policy?

    2) Not everything reduces to incentives, at least in the way that we formally study them. Incentives are great at explaining the average truth, the usual explanation for why something happens. They fail miserably when explaining fringe behaviour or initiatives to tackle fringe issues. By fringe here, I mean not unimportant, but at the edge of our knowledge, efforts and motivations. Of course, one can use a slippery definition of ‘incentives’ and then everything can be considered a function of incentives.

    And at the end of it all, I am still wondering what your point is. Is it that we won’t be able to ‘solve’ global warming, assuming that it is a problem in the first place?

  6. Maybe you sound convincing, because you have simply taken the Economist´s paradox, restated it and applied it to Global Warming.

    – The agency problem can be aligned by stock/stock option grants to CEOs

    – The “discounting the long-term” is best resolved by the market as well. (Market prices are the best way to discount the future).

    – Despite 1 and 2, CEOs who were granted most stock/stock options failed their banks. (Economist paradox)

    – Given the Economist paradox, how is one to “solve” global warming when the markets seem to indicate no need, or in some cases, the markets don’t exist at all. (call this the RKR Paradox).

    The RKR paradox has been alluded to by Jared Diamond (there was a good interview with him in the FT recently). Here is a link to the interview:

  7. avataram,

    This idiot has one. You have two.

    Now, go and change diaper rather than lurking around pages that restate the fucking obvious. Anthropologists as silly as Scott Carney know humans respond to instant rewards and don’t react well to longer term amelioration.

    At least this Ritwik is only changing bulbs. He can be excused.

  8. I agree with Ritwick. The market is nothing but aggregate of the human behaviour, influenced by both the short term and long term goals, and moderated by the incentives, both direct and hidden. That means, that market will be able to give a solution as partial and imperfect as the humans involved in it.

    But the society moves forward, not due to the ‘average’ of the human beings, but due to those ‘leaders’ who move the society forward slowly and slowly, apart from the normal incremental growth that comes from learning (only humans seem to have this gift!). The question is whether the ‘corrective action’ of the market is by the ‘real leaders’, or just by some bureaucrat(s), sitting in the top.

    Any problem of the humanity can be solved only by two ways. One, the incremental ‘improvement’ in the thoughts and actions of the society as it slowly moves forward due to the learning from ‘trial and error’.

    Second, the contribution by the leaders, who are thrown up by the society, based on the circumstances. (E.g. Buddha -monetary economy and sudden greed.) Market is not capable to deal with all the problems of the society.

  9. You are confusing bad strategy with long term orientation in the case of the dot com bubble. Most of these companies were losing huge amounts of money before they were listed i.e. they had flawed business models.So it was’nt a question of long term versus short term at all.

    Secondly, are you advocating a do nothing approach to global warming?. Well the Cap and trade mechanism has worked well with Sulphur Dioxide emmissions, so there is no point why it should not work with CO2.

    Rearing a child is also a long term goal, fraught with uncertainty and disutility for parents. But does that stop people from having children? or from saving up on tuition. Throughout history masses have taken short term pains for a better future: Case in point India’s freedom struggle.

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