Wednesday, 18 May 2011

Are financial markets ‘short-termist’?

A common attack made by critics of financial markets is that suffer from 'short-termism'. They failure to take into account the long-term effects of what they are doing. This claim was made for the U.K. by Andrew Haldane, one of the most-well-regarded managers at the Bank of England in a recent paper. But at the blog of the Institute of Economic Affairs Philip Booth notes a basic error in Haldane's argument.
Haldane came to that conclusion that financial markets and companies were short-termist by assuming that the time preferences of savers were such that the interest rates that savers require on their investments were the same over all time periods. In other words, Haldane assumed that, if a saver wanted a return of 4% per annum over a one-year period, he would want a return of 4% per annum if his saving was for a 20-year period. If this were the case, we would expect the cash flows from investment projects to be discounted at the same rate of interest however far in the future they stretched.

This is a fundamental error. There may be many reasons why savers demand higher rates of return over longer time periods: if they do so, financial markets – and managers acting on behalf of company shareholders – should reflect this by demanding higher returns from longer-term projects. The market is then working well if it reflects the time preferences of savers.
Assuming a constant rate of time preference does seem a bit odd, if nothing else a longer term investment is riskier than a short term one and thus demanding a higher rate of return makes sense.

1 comment:

Anonymous said...

Your walking into the many many arguments about "Discount Rates" - Social rate of Time preference and social opportunity cost of capital.