CAMBRIDGE – Today’s equity-market volatility and declining stock indices could prompt worried policymakers on both sides of the Atlantic to turn their attention to corporate managers’ obsession with the share price of their firms.
Stock-market short-termism has long been thought to induce two big problems, which are often mixed together. First, many assume that stock markets pressure corporations to focus too much on quarterly earnings to the detriment of their customers, their employees, and the environment. Their short-term operations harm those around them; economies and societies suffer.
Second, stock-market short-termism is widely perceived to induce corporations to shortchange themselves. Because they use their cash to buy back their own stock, it is assumed that they invest less in new factories and do less research and development, which they will need to remain competitive in the future. If the stock market induces firms to sharply cut such investments, the broader economy suffers.
Let’s look more closely at each of these issues. According to the conventional wisdom, stock-market short-termism is behind much of both of these problems. But is it?
Consider the first notion – that stock-market short-termism makes firms disrespect the environment, employees, customers, and society. True, stock traders who want to complete a sale before the closing bell will not be thinking about a climate catastrophe in 2050. For traders, as the adage goes, what to have for dinner counts as a long-term decision.
This imagery – of traders unconcerned about climate catastrophe – leads policymakers and others to agree with a claim that is often heard at the World Economic Forum in Davos: “The finance world’s short-termism will destroy our communities, economies, and the planet,” as it’s been put. And it’s not just Davos. This widely held position has been front and center in the European Union’s deliberations on how best to restructure corporate governance to make Big Business more sensitive to stakeholders and the planet, and it is central to US discussions about how widely to separate executive discretion from stockholder influence.
Varieties of Profitable Behavior
Environmental and social justice issues are among the most important facing humanity. But tightly linking these problems to stock-market short-termism is a mistake.
Here’s what I mean. Corporate misfires must be divided into two categories: problems caused by the timing of when a corporation pays, and problems caused by the question of who pays. In the first category, a corporation sacrifices a higher value a decade down the road for a little extra profit today. This is a standard, basic case of short-termism, and it is widely thought to be a major contributor to climate change and social problems like treating employees and customers badly.
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In the second category, a corporation dumps effluents into a river today because it believes it will not be caught, or because it knows that the authorities do not regulate that effluent. The firm expects never to pay fully for the pollution. This is a “who pays” problem, not a short-termist “when” problem, because the firm’s long-term profit is never adversely affected. It’s someone else’s well-being that is damaged.
These are two very different channels through which a corporation can act, but they are lumped together in the public’s mind (and in many policymakers’ minds). Conflating them is a mistake. A “who pays” problem is not the same as a “when the corporation pays” problem.
Profit-seeking corporations and their executives have incentives to pass costs onto outsiders and keep the gains for themselves. It’s profit pressure – not short-termism – that pushes firms to pollute and disregard their climate footprints. Some executives will resist making others pay, because they are good citizens. But others will not – or simply cannot – resist profit incentives.
We can see this dynamic at the individual level when we (or many of us) drive our cars. Most of us do not want the planet to face a climate catastrophe, and we know that automobiles are a major source of greenhouse gases. But we drive anyway, not because we are blinded by short-termism, but because it’s convenient to drive, and our next car trip’s individual contribution to any future catastrophe is small. For car drivers, the convenience our cars provide in getting to work, going shopping, visiting family, and so forth is a real personal benefit.
We externalize the costs and pocket the gains. Time horizons have little to do with our driving to work, going shopping, or visiting relatives. Our real problem is selfishness, combined with knowing that our own contribution to the problem is small. For this calculus to change, something must make drivers internalize the costs of burning hydrocarbons. A tax that keeps the price of fuel high would help, whereas encouraging everyone to place more value on the long term would do little – or nothing.
Corporate incentives parallel car drivers’ incentives. Corporations pocket the profits while the costs of pollution and climate change are primarily borne by others – not by shareholders, and not by executives. Whether those profits are realized in the short run or in the long run is largely beside the point. What counts is that the profits come at the expense of others.
An Inconvenient Truth
By fixating on short-termism, corporate leaders, policymakers, activists, and the public have gotten the basic analysis wrong. The result is that public policy has too often aimed at the wrong target, while ignoring the most effective measures to remedy the problem.
One reason why this flawed analysis has persisted is that there really is some short-termism embedded in the stock market. It’s not made up, even if the extent of its impact is exaggerated. Another reason is that climate degradation looks like a problem of short-termism because the effects from the hydrocarbons that we are burning today will not be felt until much later. This leads us to focus on the collective short-termism of the system overall, rather than on the actual mechanism that matters: individual selfishness.
Often, blaming stock-market short-termism is expedient. To tackle selfishness – both of individuals and corporations – would be a politically fraught project. To make me drive less, policymakers need to tax me more when I fill up my tank. But taxing fuel has never been a vote-getter. In the United States, politically astute policymakers avoid even suggesting it.
Likewise, to make corporations emit less carbon dioxide, policymakers would need a stiff carbon tax, the costs of which would largely be passed on to consumers and employees. Why risk a public backlash and lose votes in the next election when you can instead blame the stock market’s short-termism?
Some readers might demur, thinking that it doesn’t matter if selfishness is conflated with short-termism: Both are problems. But the longer we think this way, the more time and money we will waste on mis-targeted solutions. Proposed remedies for short-termism include measures to make executives more independent of stock-market pressure and transaction taxes on stock trading. But since the climate problem is not primarily due to short-termism, these policies would do little to address it, while distracting policymakers and the public from more effective remedies.
What the Evidence Shows
How about the second category of stock-market short-termism? Many worry that the stock market causes corporations to hurt themselves, by dropping good investments, burning cash in buybacks, and forgoing the R&D they need to ensure future competitiveness. Certainly, it’s widely believed that these are egregious problems with the American (and increasingly the European) corporation, and that the stock market’s short-termism is behind each of them.
But are these beliefs warranted? Are corporate executives egregiously focusing on reaping smaller profits now instead of more profits later, all to keep short-sighted investors happy?
The evidence for this kind of short-termism is mixed and suggests that the problem is only a minor one. Many studies look for such short-termism in publicly traded firms and cannot find it. Other studies find short-termism, but they typically find it to be small. In one compelling study, 78% of executives said they would sacrifice firm value in order to reduce earnings volatility. But most said they would make only a “small sacrifice,” whereas only 2% said that they were willing to make a “large sacrifice.”
Stock-market short-termism is often said to be inducing firms to invest less in hard assets such as machinery and structures. This kind of hard-asset investment is clearly declining in the US. But it has also been falling throughout the industrialized West, even in countries that are less oriented around stock markets than the US – a result that suggests that something other than stock-market short-termism is inducing the decline.
One likely explanation is that as manufacturing has moved to East Asia (particularly China), companies in the US and Europe have been investing less in fixed manufacturing capital. Another is that post-industrial economies invest more in intangibles and R&D now than before. Indeed, contrary to the short-termism thesis, corporate R&D spending in the US is growing – and growing at a faster rate than the economy. If one adds R&D investment to fixed-asset investment, the combined total shows that business investment in the US is growing, not declining. And although different stock-market arrangements might have led to even greater R&D spending, no one has shown that yet.
This result points to another example of how assessing problems incorrectly can lead to mistaken policymaking. If policymakers want to raise R&D further, is tinkering with the corporate time horizon the best way to do so? In the past, government-supported R&D has been a major source of US prosperity. But public support for R&D has declined in recent years, particularly since the 2008 global financial crisis. To his credit, US President Joe Biden and his administration have sought to reassess and reinvigorate public support for government-funded R&D. This is aiming at the right target.
Another commonly cited symptom of short-termism is stock buybacks, a practice that has become the bête noire of otherwise well-informed critics of the American corporation. The argument here is that buybacks amount to corporate self-destruction, because they sacrifice a firm’s long-term future for the sake of a pop in the stock price today. But this claim relies on a misanalysis of the process. While there certainly can be, and sometimes is, a manipulative element to firms’ repurchases, it is fanciful to present them as a first-order threat to the US economy.
Despite all the buyback talk, corporate cash for investment has been increasing. That’s because firms do not just buy back stock. Firms that do buy back their own shares are often profitable, and those profits give them extra cash. Not every buyback is coming out of profits, but many are. While some firms buy back stock, others sell newly minted stock to raise new cash. And with ultra-low interest rates for more than a decade after the 2008 crisis, American firms could, and did, borrow at a near-zero cost to replace existing corporate stock with long-term debt. This borrow-and-buy strategy is not ideal, but it is not primarily due to short-termism. Rather, it represents a long-term restructuring of American corporate balance sheets – a process that has been underway for more than a decade.
Moreover, the cash deployed toward buybacks does not disappear; it is recycled. Those who sell back their stock typically want to stay invested in the stock market, so they reinvest the cash. For many of us with pension funds and some savings in mutual funds, we may not even notice when these funds reinvest our buyback cash.
And smaller firms outside of the S&P 500 are importing capital via equity (by selling stock, not buying it back) while the bigger and older firms are exporting it (by buying back their stock with profits or new debt). That’s what we would want in a well-functioning financial market.
The Costs of Faulty Analysis
Public discourse on stock-market short-termism includes too many issues (climate change, biodiversity, labor relations) that have little to do with the stock market’s time horizon. These problems arise from profit-seeking and from mistakes, not from truncated time horizons. If we continue to attribute problems like corporate pollution to the wrong cause, we will continue to apply the wrong solutions. We will miss effective remedies while pursuing policies that could make things worse.
Giving more discretion to executives – a commonly-proposed measure against stock-market short-termism – for example, may simply empower people who are poor stewards of the environment. Policymakers would want to be confident that executives would respect the environment and the planet even if it is unprofitable to do so – a dubious proposition. And, if the US wants to preserve its economic prowess by boosting R&D, it first should restore the public investment that once sparked the US economic engine. The problem of stock-market-driven short-termism has become a red herring that too many of us chase, with ill effects.
And what about true short-termism – when firms invest too little today, dismantle R&D, and buy back so much stock that they lack the cash to operate well? Overall, the evidence shows that the short-termism problem is overblown, and may not be a significant problem at all.