{"id":3371,"date":"2009-08-12T18:33:00","date_gmt":"2009-08-12T13:03:00","guid":{"rendered":"http:\/\/www.ravikiran.com\/blog\/?p=3371"},"modified":"2009-08-12T18:33:00","modified_gmt":"2009-08-12T13:03:00","slug":"markets-and-the-long-term","status":"publish","type":"post","link":"https:\/\/www.ravikiran.com\/blog\/classic\/200908\/markets-and-the-long-term\/","title":{"rendered":"Markets and the Long Term"},"content":{"rendered":"

The Economist has an article <\/a>on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this \u00a0is 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.<\/p>\n

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).\u00a0 The second problem is that of translating long term goals into short term actions.<\/p>\n

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?<\/p>\n

<\/p>\n

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.<\/p>\n

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.\u00a0 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.<\/p>\n

Markets are often criticized for encouraging short-term thinking. This criticism is rather misplaced.\u00a0\u00a0 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\u00a0is prone to short term thinking.\u00a0 As we have seen, the market can just as easily encourage long-termism as it can encourage short-termism.<\/p>\n

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?<\/p>\n

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.<\/p>\n","protected":false},"excerpt":{"rendered":"

The Economist has an article on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this \u00a0is 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 […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[2],"tags":[330,77,328,288,329],"_links":{"self":[{"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/posts\/3371"}],"collection":[{"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/comments?post=3371"}],"version-history":[{"count":2,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/posts\/3371\/revisions"}],"predecessor-version":[{"id":3373,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/posts\/3371\/revisions\/3373"}],"wp:attachment":[{"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/media?parent=3371"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/categories?post=3371"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.ravikiran.com\/blog\/wp-json\/wp\/v2\/tags?post=3371"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}