Short termism n: electric boogaloo

Lots of people think businesses are short termist, especially nowadays, and that this is one reason why productivity growth seems a bit slower now, especially since the crisis.

I've always had trouble understanding the mechanism. In their view firms can either do more investment and raise total output and net income over time, or invest less and divest more money to shareholders through dividends. In this view society as a whole would be better off if we consumed less of this wealth and invested more of it. But short-termist fund managers and other shareholder advocates are pressuring firms explicitly and implicitly to do less investment and pay more out.

But even if a fund manager was a short-termist this wouldn't make sense. There are two main ways you can make money from shares: you can get money in dividends or you can sell some of your holdings on the market. Their very hypothesis holds that taking too much out in dividends damages firms, and does so obviously, in the long run. So it must be driving the price of the shares they hold down, or preventing them from rising as they otherwise would. This is a straightforward implication of their argument: if the investments are worth doing then they have a net present value above 1. Each £1 you invest would create more than £1 of firm value.

So short-termist shareholders have a simple decision: do £1 of investment, sell £1 of your shares, and net a profit—the amount that that investment adds to the firm's value in net present value; or take that £1 out in dividends. Even the short-termist does the investment. The argument doesn't make sense.

There are ways you can make the argument make sense. If markets don't price assets well, then maybe shareholders can strip firms and other suckers will still buy them, even though they've destroyed all this value. It doesn't seem plausible to me that top asset managers can both be worried about short termism and endlessly willing to suck it up and buy firms that self-sabotage by underinvesting. But even if this is the story, it's a different story. Excessive long-termism would cause an identical problem in a systematic market inefficiency story. So would any error. The short-termism story needs something like market efficiency to be a short-termism story.

Another way is that wealth holders and those they get to do investment for them are systematically too myopic relative to society as a whole. Investments are profitable if they have a net present value above one—that means that the cost now is outweighed by the returns later, discounted by the social discount rate, which we take to be proxied by the real interest rate. But maybe the real interest rate is not a good proxy for the social discount rate—we should be investing in much more marginal projects but those with money want to spend it, not invest it in stocks or lend it out via banks.

Does this sound realistic? It is widely accepted that the rich consume less of their income and wealth than the less well off. The world is widely perceived to have a "glut" of savings—not a dearth!

But hey, maybe firms are short-termist anyway, even if this channel doesn't work as an explanation why. A new paper (pdf) from Steven Kaplan at Chicago Booth questions this, firstly showing how short-termism worries have been pervasive since the 70s; and secondly attempting to provide some hard evidence against the hypothesis.

Some of his arguments against the short-termism hypothesis don't, to me, hold water. For example, high corporate profits now probably do suggest that firms weren't short-termist 10, 20, and 30 years ago. But it doesn't imply they're not short-termist now. If you feed your chickens the seed corn you can feed a huge flock this year, but you'll get your comeuppance soon enough.

And rising globalisation and falling worldwide poverty could just as much indicate myopia, in my view, as long-sightedness. Maybe American workers have higher wages, but maybe they also make higher quality products, you gain reputation capital by employing them, and maybe they're more loyal. These are popular anti-globalisation claims and need to be addressed with more granular info.

But some of Kaplan's arguments are very powerful. Kaplan points out that some investors, such as venture capitalists, are clearly not short termist, and put away money without any control or returns for 5, 10, or 20 years. But these investors are neither a growing share of the market, nor earn abnormally high returns—as they would if the rest of the market was, through short-termism, leaving profit opportunities on the table. And neither does private equity, the very function of which is to get around the shareholder-orientation and complicated structures of the public firm.

Kaplan also notes that US firms are less likely to be profitable when they go public. But this is precisely the opposite of what shareholder and firm short-termism predicts! That theory would expect higher profits, through investing less for the future and taking gains now—the eating of the seed corn I mention above. He also points to big, widely-publicised examples of firms whose investors have been willing to live with negative or minimally positive cash flows for years or decades: the 90s internet boom, Amazon today, biotech, and frackers, as well as many of the VC-funded tech startups like Uber. Is it possible to say both that Snapchat investors are crazy to value it so highly, and that they only care about short-term returns? I don't think so.

Short-termism is a perennial charge laid at capitalism's door. But the arguments don't work in theory, and nor they don't work in practice.