Wednesday, July 6, 2011

The sickness of short-term-ism -- it's everywhere

I'm currently working hard to finish an OpEd for Bloomberg Views on the matter of economic discounting - the method economists use to calculate the present value of anything (costs or benefits) that come in the future. Of course, the situation is often that an investment (cost) is required now to ensure some good outcome (benefit) in the future, possibly the far future. So the cost, being in the present, doesn't get discounted, while the benefit, being in the future, does. Very convenient for anyone who doesn't want to make changes.

This matters hugely if you do any kind of calculation over reasonably long times. Say the benefit of preserving some marine habitat so it's still thriving 500 years from now is somehow estimated (in present dollars) to be $500 trillion. That sounds big. But discounting at 7% per year -- a figure championed by many economists, including William Nordhaus at Yale -- you have to divide this by a factor of about 1500 trillion to get its present value. So you compare the cost of building a sanctuary to protect the habitat, included at full value, versus the benefit of the future marine habitat reduced by 1500 trillion. The benefit therefore counts, effectively, for almost nothing (about 33 cents) if you look on reasonably long time scales -- and gets reduced even more for longer times.

I've posted earlier about this paper which seriously questions the basic analysis behind this kind of discounting. It finds instead that a more logical form of discounting is so-called hyperbolic discounting, which follows a slowly decaying power law form rather than an exponential. This form values the far future much more strongly than exponential discounting, and really should be what people use in cost/benefit calculations. Currently, they don't, so that such analyses systematically undervalue the future. It's hard to think of anything in basic economics with more serious repercussions than this.

On a closely related matter, I highly recommend this recent speech by Andrew Haldane and Richard Davies of the Bank of England. It is entitled "The Short Long" and produces quite a lot of empirical evidence to suggest that business and the capital market in general are becoming ever more obsessed with short-term-ism -- i.e. with excessive valuation of the immediate at the expense of the future. And it's important to emphasize that this is the conclusion from WITHIN the standard economic perspective that accepts exponential discounting; using the correct hyperbolic discounting would make the mis-valuation much worse. Why have we become so bad at planning and investing for the future. From the speech:
"Our evidence suggests short-termism is both statistically and economically significant in capital markets. It appears also to be rising. In the UK and US, cash-flows 5 years ahead are discounted at rates more appropriate 8 or more years hence; 10 year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely valued at all. The long is short. Investment choice, like other life choices, is being re-tuned to a shorter wave-length. Public policy intervention might be needed to correct this capital market myopia."