Uncertainty, externalities and collective action problems: correcting the short-term bias through a multi-stakeholder approach
Francesco Denozza, Alessandra Stabilini
In this paper, we examine the extent to which changes in the rules of corporate governance, imposed by law, might allow greater weight to be given, in the decision making of actors in financial markets, to longer term objectives such as the protection of the environment and the reduction of inequalities in the distribution of wealth. We believe that the concern with short-termism in contemporary financial markets is amply justified, and that the growing relevance and spread of short-termism is due to certain identifiable factors, that we explore and discuss. Our thesis is that the involvement of a wider range of stakeholders in the decision-making of financial market actors (including professional investors and investee companies) can mitigate the negative effects of these factors.
l lavoro indaga la misura in cui modifiche legislative delle norme di corporate governance potrebbero consentire maggiore considerazione, da parte degli attori operanti sui mercati finanziari, di obiettivi di lungo termine come la protezione dell’ambiente o la riduzione delle disuguaglianze economiche. Noi riteniamo che la preoccupazione per il diffondersi del fenomeno dello short-termism è pienamente giustificata e che la crescente rilevanza e diffusione dello short-termism è dovuta all’operare di certi identificabili fattori che indichiamo e discutiamo.
La nostra tesi è che il coinvolgimento di una varietà di stakeholder nel processo decisionale degli attori dei mercati finanziari (compresi gli investitori professionali e le società destinatarie degli investimenti) può mitigare i negativi effetti di questi fattori.
Parole chiave: short-termism; corporate governance; stakeholders
1. Introduction. - 2. Individual choices and market responses: the peculiarities of financial markets and the case for corrective interventions. - 3. The value of financial products and the expectations on future returns: where short-termism comes from and why it is not simply a question of individual preferences. - 4. The short-long framework: comparisons and evaluations. - 5. Main factors possibly leading to short-term oriented visions in general … - 6. … and in financial markets: issuers, professional investors, and retailers facing uncertainty, externalities and collective action problems. - 7. A missing (and potentially decisive) actor: stakeholder involvement as a mitigant to short-term oriented behaviour. - NOTE
The European Commission  and a wide range of scholars  are currently addressing issues of corporate governance and the discipline of financial markets using a conceptual framework based on the contrast between short and long term, where – in simplified terms – a number of problems arise as a result of a short-term bias affecting market actors. We believe that this conceptual framework is able to capture the importance of the weight given to future (dis) utilities by actors in financial markets and, as such, serves as a useful analytical tool to frame the problems above. In this paper, we examine the extent to which changes in the rules of corporate governance, imposed by law, might allow greater weight to be given, in the decision making of actors in financial markets, to longer term objectives such as the protection of the environment and inequalities in the distribution of wealth. As a starting point, we believe that it is possible to identify, in the abstract, the factors capable of encouraging the take up of visions in which the weight of future (dis) utility is undervalued, and that of present (dis) utility is correspondingly overestimated, as well as the objectives and programmes most vulnerable to short-termism. In particular, objectives and programmes are all the more subject to the risk of being distorted by phenomena of inappropriate distribution of weights between the present and the future, the more uncertain (in the results and their distribution) and vague (in the various stages) they are. In this perspective, we believe that the recently growing concern with short-termism in contemporary markets, is explained, and may be justified, by factors connected with the expansion of the social role of financial markets. First of all, it is a well-known, observable fact that financial markets have, over time, been entrusted with multiple tasks and objectives that used to be entrusted mainly to States. Examples include the achievement of very long-term objectives, such as the payment of pensions and other socially relevant goals , which today depend mainly on the functioning of financial markets. Another factor justifying the growing concern with short-termism is the increased importance of financial markets in financing business corporations. Given that corporations govern our lives and «[…] determine what we eat, what we watch, what we wear, where we work and what we do» , the [...]
2. Individual choices and market responses: the peculiarities of financial markets and the case for corrective interventions.
Any dialogue starting from different, unclear, and unexplained assumptions is often useless. We are obviously well aware that our vision of financial markets is very different from that shared by many scholars , and especially from the vision of steadfast believers in the tendency of all markets towards equilibrium and efficient valuation of financial assets. A general discussion on this point cannot be started here, but a preliminary explanation of one’s convictions in this regard is in our opinion indispensable. We therefore start by clarifying the assumptions on which the arguments we are going to develop are based. We believe that financial markets are exposed to the risk of not reaching optimal equilibria [or even just «transient orders» ], not only due to the presence of market failures, but for structural reasons, inherent in the normal functioning of these markets. Prices for financial products, determined on the basis of the returns they will generate in the future, follow processes different from those that determine the prices of the goods purchased where there is a utility to be obtained from their consumption. The differences between these price setting processes means that the main market regulation mechanism, namely the law of supply and demand, does not necessarily function for financial products. It is well known that increases in the price of financial products can be seen as a correction of a previous (erroneous) undervaluation, and that an increase in the price may produce boost in demand rather than a decrease. It is also well known that the reverse is also true and that a decrease in the price of a financial product does not necessarily lead to an increase in the relative demand . Another peculiarity of financial markets is the magnitude of the phenomenon whereby the choices made by each market player affect not only the well-being of the person making the choice, but also the well-being of the other market participants. This phenomenon, which is generally not taken into consideration, or even concealed , occurs, to varying degrees, in every market. Since the preference of a consumer for a certain product x not only affects the price of that product, but also the price of the competing product y, which happens to be the favorite of another consumer, the choice made by the former also affects the latter. If we are dealing with consumer goods of relatively limited importance, [...]
3. The value of financial products and the expectations on future returns: where short-termism comes from and why it is not simply a question of individual preferences.
We now need to underline another peculiar feature of financial markets, namely the way financial assets are valued. Let’s go back to the law of supply and demand. The phenomenon according to which, all other things being equal, a decrease in prices causes an increase in demand (and vice versa), is a consequence of the fact that buyers base their decisions on the utility they will derive from the purchases they make. If the price of an otherwise identical good decreases, and the good is able to provide the same utility as before, it is evident that the buyer will derive a greater utility from the purchase (i.e., the same utility from the purchase but less loss of utility because the disbursement is less). Consumers may be induced to dismiss other alternatives and prefer the purchase of the asset in question. This reasoning assumes that the utility provided by a certain good to a given subject is an objective, in the sense of “subjectively” certain, datum. All other conditions being equal, a definite unit (the first, the second, the third, etc.) of a given good, procures a given utility to a given subject. People are normally able to evaluate the utility that they will get from the purchase of a particular good. The assumption does not hold in the case of financial products . The value of assets purchased in order to realise future returns, depends on uncertain estimates about expected yields and on the probability that an asset will appreciate over time. It is therefore a value that may change, even if the preferences of the decision maker remain the same . It follows that the valuation of a financial product is rarely reducible to a simple means-ends calculation in a context of given and unchanging (at least in the short period) preferences. The value of financial products generally depends on complex judgments relating to unpredictable and often absolutely incalculable [absolutely uncertain, in the sense of Keynes and Knight ] future events. That is, it depends not only on preferences, not only on “technical” calculations (calculations which, in any case, are never purely objective and outside the actor’s prejudices) but, above all, on a “political” evaluation that must give a “weight” to two distinct factors (immediate sacrifice of liquidity / future returns) which, as they are not in the same homogeneous space or timeframe (one is present, the other is future), [...]
4. The short-long framework: comparisons and evaluations.
We now turn to look at what short-termism means. In a widespread view, it is the use of too high a rate of discount of future returns. Market actors using a higher discount rate are more short-term oriented while those using a lower rate are more long-term oriented. This is a simple comparative observation. From another viewpoint, one can try to establish what the generally appropriate rate should be in the given circumstances, and qualify (at this point not as a simple observation, but as an evaluation with an implicit negative judgment) short-termism as the use of a higher rate and long-termism as the use of a lower rate. The short / long term framework can ground judgments which are non-evaluative if they are limited to ascertaining that a behaviour is more oriented to the short (or long) term than another behaviour. They become evaluative when they claim that a behaviour is too short- (or long-)term oriented, in the sense that actors use an excessively high (or low) discount rate for future returns. In order to decide what is, and what is not, excessive, a parameter is obviously needed, one that is able to define the rate appropriate in a given situation. In this perspective, reference to short and long termism, states that a given behaviour differs significantly from the normal. Given that “normal” cannot be defined in a manner that is valid in absolute terms for all situations, it is natural that, in any given situation, there can be a reasonable discussion as to what the “normal” is, and what level of deviation from that normal should be considered as excessive. In conclusion, the judgment (the judgment not limited to ascertaining that a certain behaviour is more less short-term oriented than another) is always relative, depending on the chosen purposes and on the programmes developed to achieve them.
5. Main factors possibly leading to short-term oriented visions in general …
The usefulness of an analytical framework based on the contrast between the short / long term depends on the nature of the situation and especially on the objectives pursued by the actors. A conceptual scheme based on a comparison between the weight given to present utilities and the weight given to future utilities is obviously more useful in the analysis of certain situations and less in the analysis of others. It depends particularly on the distance into the future of the utility pursued (or of the impending disutility), on the uncertainty of the objective, on the linearity of the programmes that can be developed, etc. There are purposes and programmes that, in a given circumstance, require a very high immediate sacrifice, the rejection of which can be considered as short-termism, and purposes and programmes that, again in a given circumstance, have opposite implications. The evaluations of short or long-termism, and the very usefulness of resorting to the scheme that contrasts them, depend on the nature of objectives and programmes. Given that the problem of short-termism is ultimately a problem of possible distorted evaluations of the costs and benefits of objectives and programmes the implementation of which takes place over a time span that is not short, it may be important to understand what factors may affect, and possibly alter, this evaluation. Going over the list of factors contained in a classic treatment of the subject, and trying to condense its most useful ideas for our purposes, it seems to us that four macro factors deserve to be especially considered: absolute uncertainty, herd behaviour, possible conflict between immediate preferences and second order preferences, possible externalization and the resulting misalignment of relevant interests . Let us briefly examine how these factors generally work. Absolute uncertainty (both that relating to the evolution of the context and that relating to the actor’s future conditions) is perhaps the main factor that can cause errors in the evaluation of the weights that are attributed to costs and benefits. An explanation of the contemporary spreading of short-termism and the related concern can then be sought in the greater uncertainty that currently hangs over our future in a situation in which Keynesian ordered markets no longer exist, in which no public body (let alone nation states) is able to carry out significant planning (and thus offer reference points to operators) and [...]
6. … and in financial markets: issuers, professional investors, and retailers facing uncertainty, externalities and collective action problems.
Setting objectives for complex and long-lasting social processes, such as the reduction of inequalities, a higher level of respect for human rights and the protection of the environment, immediately raises the problem of the weight to be given to present and future (dis) utilities. It is clear to anyone that the pursuit of these and other long-term objectives may require immediate and significant sacrifices in the short term. Willingness to bear these sacrifices depends on the evaluation of the cost of the short-term sacrifice and on the importance attributed to the objectives in question. Which brings us back to the question of “weights” and the impact that myopic short-term views can have on the overestimation of immediate (dis) utilities and the correlative underestimation of future (dis) utilities. People believing that the markets already ensure the best possible balance between all needs, have no reason to worry about short-termism, and probably not even about anything else. Those, in turn, who believe that these goals (reduction of inequalities, protection of human rights and defence of the environment) are not universal objectives concerning us all, have no reason to worry about anything, or maybe better put, will only be concerned from the possible negative consequences of the phenomena in question that could reverberate on them. Even people believing that these problems do exist may still be unconcerned with the functioning of financial markets if they think that these markets already perform at their best, or that the task of coping with problems connected with long term objectives should be better tackled by law through explicit and specific rules . These actors have little reason to worry about short-termism in financial markets but might instead ask themselves the extent to which states, weakened by decades of neoliberalism, can succeed in imposing unwelcomely strict rules on economic actors that control resources greater than the gross domestic product of the states themselves, and whether it is really possible to solve this kind of problem resorting only to specific mandatory rules . People believing that these social and environmental objectives are in everyone’s interest, that the functioning of financial markets can undermine them, and that poorly rational behaviour  incompatible with these goals may easily occur in contemporary financial markets, have good reason to carefully consider the [...]
7. A missing (and potentially decisive) actor: stakeholder involvement as a mitigant to short-term oriented behaviour.
Our thesis is that active involvement of stakeholders could contribute to overcoming some of the problems indicated and to improving the effectiveness of the European Union’s policies. First of all, we reiterate that our thesis is not based on the unsustainable hypothesis that stakeholders other than shareholders are necessarily carriers of altruistically oriented long-term visions. The thrust of our thesis is that the obligation to dialogue with stakeholders and, ultimately, to define programs including fixed points of agreement with them (or some of them), is in itself (regardless of the subjective orientations of the various subjects involved) able to incentivize a greater consideration of the longer term, even if only because this orientation makes possible agreements and compensations between the various conflicting interests, which would be impossible to propose in a short time horizon. Obviously our thesis has nothing to do and should not be confused with the “stakeholderism” aiming at obliging or incentivizing boards of directors to take into account the interests of other stakeholders in addition to that of the shareholders – as for example via the definition [by mandatory rules or by shareholders’ choice ] of a “corporate purpose” including stakeholder interests. Rather, we are thinking of giving stakeholders a channel of access to directors and managers, enabling them to make their voice heard and therefore to enter the decision-making process  (even without granting them any decision or veto power ). In fact, in regulatory contexts in which directors are appointed by the shareholders, and where only shareholders are entitled to take legal action against directors and managers, manipulating the definition of the corporate purpose seems a rhetorical exercise and, in some respects, useless and in others harmful. It is useless, where shareholders strictly control the directors and are therefore able to force directors to respect their will despite formal rules to the contrary. It is harmful, where directors and managers, not directly controlled by a group of shareholders, by exploiting generic references to possible duties towards stakeholders other than shareholders, break free from any legal constraint, and can decide, from time to time, and almost at their discretion, which interests to protect and which to disregard at any one time . Instead, we are proposing [...]