The Problem of Short Term Thinking

Capitalism, by ignoring the finite nature of resources and by neglecting the long-term well-being of the planet and its potentially crucial biodiversity, threatens our existence. Fifty and one-hundred-year horizons are important despite the “tyranny of the discount rate,” and grandchildren do have value. My conclusion is that capitalism does admittedly do a thousand things better than other systems: it only currently fails in two or three. Unfortunately for us all, even a single one of these failings may bring capitalism down and us with it.  

- Jeremy Grantham, Leading Investment Analyst

The main cause of future problems is the excessively short-term predominant political and economic model. We need a system of governance that takes a more long-term view. It is unlikely that governments will pass necessary regulation to force the markets to allocate more money into climate friendly solutions, and must not assume that markets will work for the benefit of humankind.

- Jorgen Randers, author of 2052: A Global Forecast for the Next 40 Years

Back in 1992, more than 100 world leaders, including George H.W. Bush, showed up for the Earth Summit in Rio de Janeiro. It was a two-week mega-event that attracted huge attention, highlighted by the signing of two groundbreaking treaties on climate change and biodiversity and grand declarations about creating a future green and equitable world. To put it mildly, the subsequent two decades have not lived up to the promises. George W. Bush effectively broke the climate treaty signed by his father, refusing to sign up to the Kyoto Protocol. Emissions have soared, resource plundering has intensified, nature is still on the retreat, the world has become less equitable, and climate change has gone from distant prospect to frightening reality. While the population bomb may be being defused, the consumption bomb is primed to destroy us all.

- Fred Pearce, Environmental Writer, On the Road Back to Rio, Green Direction has been Lost

 

Not surprisingly, scientific and economic leaders now identify that it is our attitude which is the major threat to a sustainable future. Short Term thinking, also called Short Termism is predominant in both government and the markets….the two key areas that drive global change. Studies in a new field that combines economics and neuroscience called Neuro-economics is shedding new light into our behavior, especially as regards the all important Discount Rate, which is at the very heart of the inability for our government and business leaders to make the right decisions.

Nate Hagan, a contributor to the popular Peak Oil website The Oil Drum shares a very telling story:

An Interview with a Friend...

Following the release of the initial segments of the recent IPCC report, I called a good friend to get his reaction. (After I told him I would post his responses, he requested anonymity – lets just call him Thomas)

Nate: What do you think about the IPCC report that came out today stating by the year 2100 global temperatures will rise between 3-7 degrees? And sea levels will rise by between 17-34 inches?
Thomas: I read “State of Fear” by Crichton – most of those scientists are just playing with models – they really have no idea how its all going to play out. Plus we are in a general warming trend anyways.

Nate: I disagree with that, but let’s assume the scientists are right, even conservative, would you change your behaviours or view of the world.

Thomas: Dude that’s 100 years from now. I’ll be dead. My kids will be dead. Its someone else’s problem.

Nate: Ok – what if instead of 17 inches, there would be a 17 foot sea rise by 2100?

Thomas: Well, I’ll still be dead and it will still be someone else’s problem. Though I imagine the world would be a wild place were that to happen. That’s alot of water.

Nate: Ok – what if instead of 2100, the 17 foot sea level rise would happen by 2050, maybe not in your lifetime but definitely in your childrens? And what about their children?

Thomas: It depends if it happened all at once or was gradual. If it was all at once, I’d either be prepared or deal with the consequences. I’d certainly tell my boys to buy land inland Oregon and California around 2045 though. Still – a long way off for me to worry about it.

Nate: Ok – imagine that it happened in 2015 – a 21 foot sea level rise.

Thomas: Dude – you do realize that Dennis Quaid movie was fiction right?

Nate: I know – just hypothetically

Thomas: Well, I’d probably move pretty soon from New York somewhere to the Rockies. I’d start moving my retirement assets out of stocks and into bonds because 17 feet is going to cause a hell of a recession, not to mention global upheaval. I wouldn’t change my job or anything but probably would prepare my children a little better to face a chaotic world. Would everyone know it was going to happen or just me?

Nate: Ok what if the Greenland ice sheet melted this summer and there was a 17 feet sea level rise this August?

Thomas: Well now youre getting plain nutty. But if that happened, I’d liquidate all of my investments, take my wife and kids on some expensive trips to Africa and other places that might be changed forever, then hunker down. Probably get stocked up Y2K like, just in case, and just enjoy life as best I could – what can I do anyways? These things all have a momentum of their own – nothing me or my family could do would make much of a difference. I like eating meat and I like my SUV. Nate you should work for Greenpeace or something.

This story is repeated all over the world and what it tells us is that there is a deeply entrenched view of reality which makes it difficult to make the big kinds of changes that are necessary. It all has to do with what is called the Discount Rate.

The Discount Rate

The ‘discount rate’ is a common term in financial markets. It’s the rate that the Federal Reserve charges its member banks as well as the rate that a stock analyst uses to discount a companies future earnings stream back to the present.

Example: Company X’s entire business plan is to sell a product in 10 years.

Assumptions:

  1. They make no money until 10 years from now
  2. At the 10 years mark, they make $100 million

Question: How much would investors pay for this company?

  1. Probably less than $100 mil, because that money won’t appear for another decade.
  2. First, they would determine what the risk was of actually getting that $100 mil 10 years
  3. Second, they would determine what an appropriate rate of return would be, say 15% per year.
  4. Discounted at 15% per year, $100 mil is $24.75 mil- that is what they should be willing to pay

So in this example, the discount RATE is 15% and the discount FACTOR is 24.75%, or how much something in the future is worth today.

The higher a discount rate the lower the discount factor will be:

  • A discount rate approaching 1, means things in the future have no value at all in the present moment.
  • A discount rate of zero means that $1 dollar in 2050 is worth $1 today

Emotions trump Logic

Research studies by Harvard economics professor David Laibson have shown that during economic games, subjects who choose the LL (larger long term reward) had their prefrontal cortex activated while those who chose the smaller short term rewards showed neural activity in the limbic system, or emotional mammalian brain. The implication is that Humans have 2 discount rates and suggests that we make decisions in different parts of our brain and also suggests that emotions have the ability to trump reason.