by David Robertson, CFA
April 2019
With debt reaching ever higher levels, many pundits are placing odds on which particular manifestation is going to precipitate the next financial crisis. Corporate debt, leveraged loans and shadow bank debt are among the contenders. Investors hope to avoid the "Minsky Moment" when the financial system stops working and asset prices crash.
But what if investors are looking in the wrong place? What if the bigger problem is not a breakdown in the financial system, but a breakdown in the social system? What if it isn't monetary debts that can't be sustained, but longstanding social contracts? Perhaps the greater concern for investors should not literally be a Minsky moment, but rather a metaphorical one.
Look around the social, political and economic landscape and one would be hard pressed to find a better broad-brush characterization than "short-term oriented". Short-sighted corporate strategy and short-sighted public policy are defining characteristics of our age. At the individual level, short-term benefits normally come at the expense of longer-term welfare. At higher levels of decision making, however, short-term benefits often can accrue to one part of a population at the expense of another.
One of the ways in which the social contract is being violated is in the arena of pensions. The April 5, 2019 issue of Grants Interest Rate Observer addresses the issue in its exploration of what quantitative easing (QE) has accomplished:
April 2019
With debt reaching ever higher levels, many pundits are placing odds on which particular manifestation is going to precipitate the next financial crisis. Corporate debt, leveraged loans and shadow bank debt are among the contenders. Investors hope to avoid the "Minsky Moment" when the financial system stops working and asset prices crash.
But what if investors are looking in the wrong place? What if the bigger problem is not a breakdown in the financial system, but a breakdown in the social system? What if it isn't monetary debts that can't be sustained, but longstanding social contracts? Perhaps the greater concern for investors should not literally be a Minsky moment, but rather a metaphorical one.
Look around the social, political and economic landscape and one would be hard pressed to find a better broad-brush characterization than "short-term oriented". Short-sighted corporate strategy and short-sighted public policy are defining characteristics of our age. At the individual level, short-term benefits normally come at the expense of longer-term welfare. At higher levels of decision making, however, short-term benefits often can accrue to one part of a population at the expense of another.
One of the ways in which the social contract is being violated is in the arena of pensions. The April 5, 2019 issue of Grants Interest Rate Observer addresses the issue in its exploration of what quantitative easing (QE) has accomplished:
"Yes, asset values have risen, but so has the cost of associated liabilities - annuity contracts, the promises embodied in pension plans, etc. Put another way, the inflation that has failed to materialize at the checkout counter has registered in the cost of retirement. As interest rates have fallen, the number of dollars required to produce the same level of income as risen. Has the Fed been chasing its tail?"
Grants goes on to answer its own question:
"This is a story about interest rates, first and foremost. Falling rates, if they didn't cause the pension crisis, have clearly exacerbated it. Rising rates would help to alleviate it."
As Grants rightly points out, focusing on the effects of lower interest rates on assets only recognizes half of the picture. The other half is the effect of low rates on liabilities. The net effect of low rates on the promise of retirement depends crucially, then, on a person's age. While low rates can cause asset prices to rise and create a "wealth effect", low rates also cause liabilities to rise which creates a "liability effect". For any individual, the net effect depends on which component is greater. As a result, a singular focus on the "wealth effect" amounts to a policy bias in favor of older people at the expense of younger people.
In few places is long-term sustainability so deliberately sought as it is with central banks. Such institutions are generally designed to be structurally independent so as to mitigate political influence and ensure the credibility of the monetary system. As a result, it is essential that they keep their reputation of independence intact. If they don't, they lose their entire reason for being.
Nonetheless, there is always temptation. The Fed's foray into policies such as QE, which affects wealth redistribution and therefore properly falls in the domain of elected officials, was one such transgression. More recently, the Fed changed its policy course abruptly in a way that reeks of short-term motivations. Lacy Hunt summed up his concerns in the recent Hoisington Quarterly Review and Outlook:
In few places is long-term sustainability so deliberately sought as it is with central banks. Such institutions are generally designed to be structurally independent so as to mitigate political influence and ensure the credibility of the monetary system. As a result, it is essential that they keep their reputation of independence intact. If they don't, they lose their entire reason for being.
Nonetheless, there is always temptation. The Fed's foray into policies such as QE, which affects wealth redistribution and therefore properly falls in the domain of elected officials, was one such transgression. More recently, the Fed changed its policy course abruptly in a way that reeks of short-term motivations. Lacy Hunt summed up his concerns in the recent Hoisington Quarterly Review and Outlook:
"The Fed appears to have a high sensitivity to coincident or contemporaneous indicators of economic activity, however the economic variables (i.e. money and interest rates) over which they have influence are slow-moving and have enormous lags."
Why would an institution specifically designed to manage long-term sustainability venture so recklessly into short-term behavior? Why would the Fed take such great risks with is reputation? It's hard to say, but John Dizard at the Financial Times argues that the gig is already up: "Central bank independence in Europe and the US is about as dead as vaudeville".
Another way in which long-term sustainability is expressed is through the investment behavior of corporations. The exercise of investing is inherently about replenishment. In order to sustain growth, companies must not only replace depreciated assets, but they must also invest additional capital in order to increase future production.
This hasn't been happening. Capital spending has not been sufficient to increase capacity. Gillian Tett explores potential causes in the FT:
Another way in which long-term sustainability is expressed is through the investment behavior of corporations. The exercise of investing is inherently about replenishment. In order to sustain growth, companies must not only replace depreciated assets, but they must also invest additional capital in order to increase future production.
This hasn't been happening. Capital spending has not been sufficient to increase capacity. Gillian Tett explores potential causes in the FT:
"It may just reflect the changing nature of capital expenditure: it is possible that today's technology-focused investments are delivering more productivity bang for the buck than traditional investments, thus requiring fewer dollars. Or it may show that executives have always been privately uneasy about the longer-term growth outlook, even amid the Trumpian boom. Or maybe it just reveals that corporate America is lamentably short-term in its thinking, preferring to spend its cash on quick-fix tricks to boost the share price, rather than engage in long-term investment."
Evidence of lamentably short-term thinking is interesting because it contrasts so sharply with positive sentiments for longer term sustainability. Climate change, for example, is a popular topic because it is serious threat to the sustainability of the planet. Interest in alternative energy and alternative forms of transportation are significant for the same reasons. The businesses of ride sharing, room sharing, and co-working are all popular in large part due to more efficient utilization of expensive assets.
Critically, however, expressions about long-term sustainability often do not manifest themselves in robust implementations. Often, they are only given lip service. For example, the FT reported the findings of CDP, a non-profit environment and investment research provider:
Critically, however, expressions about long-term sustainability often do not manifest themselves in robust implementations. Often, they are only given lip service. For example, the FT reported the findings of CDP, a non-profit environment and investment research provider:
"While companies have launched or revamped products to appeal to increasingly climate-conscious consumers, few have made structural changes to prepare for the impact water scarcity, heat damage and increasingly stringent government regulations will have on business performance."
It would be one thing if company management teams were just being lured into short-term behavior, but if they are, their shareholders are also pushing them in the same direction. Markets are not currently rewarding more responsible behavior over less responsible behavior. According to the sustainability chief of a big European food company (from the Economist):
It is, "Easier to wait for disaster to strike, then write it off as a non-recurring expenditure." If you spend money on planning and preparing, "You will be penalised [by the market]."
As a result, many accounts of "sustainability" are more about stories than about real strategies. As good as the ideas may be, there is nearly zero tolerance to sacrifice anything in the short-term in order to facilitate their development.
The college admissions scandal captured this irony perfectly. One of the key figures from the scandal was Bill McGlashan, who was an executive at the large private equity firm, TPG Capital. McGlashan seemed to understand the power of marketing long-term sustainability goals. According to the FT, he raised $2 billion for a social impact fund along with the former U2 singer, Bono, and was hailed as "TPG's house do-gooder".
While burnishing the virtuous image of a person deeply concerned about the long-term, however, McGlashan was also described as "a hustling opportunist". The FT suggested he was "an enthusiastic participant" in the admissions scandal based on phone conversations recorded by the FBI:
The college admissions scandal captured this irony perfectly. One of the key figures from the scandal was Bill McGlashan, who was an executive at the large private equity firm, TPG Capital. McGlashan seemed to understand the power of marketing long-term sustainability goals. According to the FT, he raised $2 billion for a social impact fund along with the former U2 singer, Bono, and was hailed as "TPG's house do-gooder".
While burnishing the virtuous image of a person deeply concerned about the long-term, however, McGlashan was also described as "a hustling opportunist". The FT suggested he was "an enthusiastic participant" in the admissions scandal based on phone conversations recorded by the FBI:
"I would do that in a heartbeat," he [McGlashan] responded after a crooked admissions consultant laid out a ploy to have Mr McGlashan's son admitted as a prized football recruit to the University of Southern California - even though he did not play football - in exchange for a $250,000 payment. "I love it. I love it."
It seems pretty clear that there was little to no concern that the activity may not be right (or legal). There seemed to be little to no consideration that the activity might imperil the acceptance of students with greater merit. And there seemed to be little to no consideration that the behavior could serve as a bad role model for countless others.
To an important extent, the incident laid bare a tacit formula for success in this day and age: Actively promote your association with long-term sustainability projects while simultaneously operating on the basis of taking short cuts and cheating. The primary "skill" required is an ability to compartmentalize (or ignore) the hypocrisy that one is blatantly undermining the other.
So how does it happen that long-term welfare can so pervasively lose out to short-termism? Part of it can be understood through the work of behavioral economists like Dan Ariely. In a 2014 interview with Peak Prosperity Ariely explains:
To an important extent, the incident laid bare a tacit formula for success in this day and age: Actively promote your association with long-term sustainability projects while simultaneously operating on the basis of taking short cuts and cheating. The primary "skill" required is an ability to compartmentalize (or ignore) the hypocrisy that one is blatantly undermining the other.
So how does it happen that long-term welfare can so pervasively lose out to short-termism? Part of it can be understood through the work of behavioral economists like Dan Ariely. In a 2014 interview with Peak Prosperity Ariely explains:
"So first of all the creation of bubbles turns out to be one of the easiest things to do in a lab setting. So you put people in the lab and you kind of create an experiment in which they all trade some fictitious product and the most common behavior that you observe are bubbles. Because if you think about it the natural inclination is to see what other people are doing and to try and follow other people."
"In psychology this is what is called "social proof." It is about our herding instinct ... it is almost instinctual that we look at the behavior of others and infer something about the value of the different options."
This herding tendency often surprises us. Partly, it is a more powerful tendency than we realize and partly it often takes over without us even realizing it. Our herding tendency can also conflict with our self-beliefs: "We think that we are motivated by goals and by high order aspirations, and so on. The reality is that we are not."
These tendencies alone would be enough to facilitate a fair amount of short-termism, but the environment nudges us even further. Ariely points out: "And the world right now is all about tempting us to do things that are in the world’s short interest and not in our long term interest." It's almost as if the odds are stacked against our long-term interests.
The condition of long-term sustainability being subjugated to short-term interests may seem almost intractable, but David Brooks provides some hope by reframing the analysis in the New York Times:
These tendencies alone would be enough to facilitate a fair amount of short-termism, but the environment nudges us even further. Ariely points out: "And the world right now is all about tempting us to do things that are in the world’s short interest and not in our long term interest." It's almost as if the odds are stacked against our long-term interests.
The condition of long-term sustainability being subjugated to short-term interests may seem almost intractable, but David Brooks provides some hope by reframing the analysis in the New York Times:
"[Cass] Sunstein’s book [How Change Happens] is illuminating because it puts norms at the center of how we think about change. A culture is made up of norms — simple rules that govern what thoughts, emotions and behaviors are appropriate at what moment."
"Most norms are invisible most of the time. They’re just the water in which we swim. We unconsciously absorb them by imitating those around us. We implicitly know that if we violate a norm, there will be a social cost, maybe even ostracism."
With this context, it is easy to see how short-termism infects society. People act in their own short-term interest because it is easier, almost automatic. Other people observe short-termism as the norm and instinctively imitate it. Compliance is encouraged because we understand that we might incur a social cost if we violate the norms. Short-termism becomes a self-fulfilling prophecy.
It may be easy to dismiss considerations such as culture and norms as not particularly relevant to investment considerations, but to do so would be to miss an important reality. Public policy and corporate decision making are very much functions of culture and norms and capital markets are very much social institutions.
Indeed, even investors such as pension fund managers, who are specifically tasked with managing long-term interests, are finding it hard not to be lured into short-term behavior in this market environment. Amin Rajan describes the phenomenon in the FT:
It may be easy to dismiss considerations such as culture and norms as not particularly relevant to investment considerations, but to do so would be to miss an important reality. Public policy and corporate decision making are very much functions of culture and norms and capital markets are very much social institutions.
Indeed, even investors such as pension fund managers, who are specifically tasked with managing long-term interests, are finding it hard not to be lured into short-term behavior in this market environment. Amin Rajan describes the phenomenon in the FT:
"However, the fresh highs scored by the markets have turned the tables by increasing regret risk: sadness at missing out on what is the longest bull market in history with no reversal in sight."
This is unfortunate in one respect because such performance chasing "has little to do with actual investing”. As Stuart Dunbar noted in a recent paper, "equity markets are no longer conduits between savers planning for a decent nest-egg and borrowers who deploy savings to create wealth, jobs and skills." As a result, it undermines the entire purpose of investing. Nonetheless, Rajan describes one group of pension managers as:
"Investors who hold that central banks’ quantitative easing has overinflated asset values by borrowing against future returns. [They believe] It seems wise to go after juicy returns while they last and let time heal all wounds."
Such behavior is also unfortunate in terms of what it says about society as a whole. The inclination by some managers to grab "juicy returns" while they can, while forsaking their fiduciary duty to avoid buying "overinflated assets", and also while absolving themselves of any responsibility for future consequences, comes across as strikingly antisocial behavior. Such behavior is not the hallmark of a strong or resilient society but rather of one that is cannibalizing its future.
Several useful lessons can be taken from this and one is that change can happen quickly. We all understand at some level that extreme short-termism puts long-term interests at risk and at some point the dissonance becomes too great. As Brooks notes, “We’re living in a moment when norms are in maximum flux.”. He goes on:
Several useful lessons can be taken from this and one is that change can happen quickly. We all understand at some level that extreme short-termism puts long-term interests at risk and at some point the dissonance becomes too great. As Brooks notes, “We’re living in a moment when norms are in maximum flux.”. He goes on:
"From time to time, a norm stops working or comes into dispute. People are slow to challenge a broad norm, because they don’t want to say anything that might make them unpopular. But eventually some people notice that, actually, there are a lot of people who secretly think a certain norm is wrong or outdated."
"When this happens, permission is granted to go public with your private thoughts. More and more people speak up and you get rapid, cascading change. There used to be a social penalty for supporting gay marriage. Now there’s a social penalty for not supporting it."
Sometimes undercurrents can build up over time and cause change to happen fairly quickly, as with gay marriage. Sometimes forces can cause change to happen almost overnight, as with the #metoo movement. One day you’re a powerful celebrity, the next you’re a vilified degenerate. The same thing can happen to your portfolio if you accumulate overinflated assets. One day you’re feeling wealthy, the next day you’re wondering how you could lose so much money.
Another useful lesson is that change for the better is not entirely outside of your control. As Brooks notes, our own behavior affects others around us and sometimes in ways more powerful than we can imagine:
Another useful lesson is that change for the better is not entirely outside of your control. As Brooks notes, our own behavior affects others around us and sometimes in ways more powerful than we can imagine:
"But we all have the power to create cultural microclimates around us, through the way we act and communicate. When a small group of people shift the way they show approval and disapproval, it can shift the social cures among wider and wider circles. Suddenly, revolutions. The whole school of fish has shifted course in rapid ways that would have astounded us beforehand."
There is no doubt that taking a stand on things can be hard and often requires courage. It doesn't always work out. But even little things like refusing to take a short cut can make a difference. Sometimes it works in ways far bigger than we can possibly imagine. Sometimes we learn that there were a lot of people who felt exactly as we did but did not have the courage to act on it.
We can also demand more of our leaders. We expect leaders to make tough decisions and to demonstrate exemplary behavior. Instead we often get people who are simply cheating more aggressively than anyone else. Not only are they terrible examples to follow, but they make things worse by propagating bad behavior. To exalt such people is to endorse their behavior.
Finally, while there is always tension between short-term and long-term interests, the costs of imbalance are normally borne by individuals. When imbalances emerge between short-term and long-term interests in society, costs are borne by groups of people of different ages. Since younger people are the future of any society, it doesn't make sense to imperil their welfare, because ultimately it imperils the welfare of society as a whole.
Yet this is exactly what seems to be happening. Many of the individual motives are not hard to understand. It is easy to seek payoffs today for expenses that are abstract and deferred far into the future. It's even easier if those future expenses are borne by other people. It's even easier yet when those expenses are diffused across a broad group of people who have difficulty coalescing resistance to such vague threats.
There are limits, however, and we may be reaching them. When nobody takes responsibility for ensuring long-term sustainability and when people imitate other people who are sacrificing the long-term for the short-term, social contracts devolve into broken promises. When discontent reaches a high enough level and a lot of people recognize that the norm of short-termism is wrong, things can change quickly. It may well be that the limit that is breached first is not one of debt, but of disgust.
We can also demand more of our leaders. We expect leaders to make tough decisions and to demonstrate exemplary behavior. Instead we often get people who are simply cheating more aggressively than anyone else. Not only are they terrible examples to follow, but they make things worse by propagating bad behavior. To exalt such people is to endorse their behavior.
Finally, while there is always tension between short-term and long-term interests, the costs of imbalance are normally borne by individuals. When imbalances emerge between short-term and long-term interests in society, costs are borne by groups of people of different ages. Since younger people are the future of any society, it doesn't make sense to imperil their welfare, because ultimately it imperils the welfare of society as a whole.
Yet this is exactly what seems to be happening. Many of the individual motives are not hard to understand. It is easy to seek payoffs today for expenses that are abstract and deferred far into the future. It's even easier if those future expenses are borne by other people. It's even easier yet when those expenses are diffused across a broad group of people who have difficulty coalescing resistance to such vague threats.
There are limits, however, and we may be reaching them. When nobody takes responsibility for ensuring long-term sustainability and when people imitate other people who are sacrificing the long-term for the short-term, social contracts devolve into broken promises. When discontent reaches a high enough level and a lot of people recognize that the norm of short-termism is wrong, things can change quickly. It may well be that the limit that is breached first is not one of debt, but of disgust.
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