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:
- 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’.