Thirty years ago, I was employed by First Boston Corporation, which was then a top-tier investment banking firm (it was acquired by Credit Suisse in the late 1980s). One of my lasting memories is from 1982 or 1983. At the time, a group of Japanese businessmen visited First Boston, hoping to raise capital via a private placement. In itself, that wasn’t surprising, as the Japanese were then in the early years of their stock market and real estate bubbles and were thought by many in the West as having discovered the financial/economic equivalent of the fountain of youth.
What was surprising is how the visiting delegation prepared for its visit to First Boston. Specifically, using newly-available Lotus 1-2-3 software (then limited to 128 columns!), they had prepared a 100-year (yes, a hundred-year!) spreadsheet of financial projections. To put it mildly, everyone at First Boston who was involved in the negotiations was dumbfounded. Nobody in the West would put together a 100-year projection, the obvious reason being that the uncertainty level looking out that far is off the charts. The less obvious reason involves the time value of money. In a world in which inflation is the norm, the value of money received in the future is less than the value of money received now. All financial decisions involve an estimate of the net present value of a stream of future receipts. For an investor in a stock, what matters is the net present value of a projected stream of dividends. For a businessman, what counts is the net present value of a stream of profits generated by a capital spending project.
The net present value of dividends or profits generated in the 50th or 100th year after a financial decision is made is very close to zero. Even if the projections made by the Japanese had been believed (which they weren’t), it wouldn’t have mattered.
All of this is by way of introduction to a recent essay written by Jeremy Grantham, co-founder and chief investment strategist of the Boston-based money management firm GMO (Grantham, Mayo, Van Otterloo, LLC). The essay, titled “Your Grand Children Have No Value (And Other Deficiencies of Capitalism)” is part of his latest quarterly letter.
It’s not often that a card-carrying capitalist writes about capitalism’s shortcomings. His words are thought-provoking, to say the least. That’s why I’m posting an extensive excerpt. Here it is:
Capitalism has gone through a Darwinistic series of trials and errors, which still continues. For the time being, capitalism has tuned itself to rapid growth at almost any cost. Circumstances such as the hydrocarbon revolution and the ensuing population explosion have allowed for both high growth and high profit margins to sustain the growth. Sustained high margins have in turn trained capitalists – or corporate executives if you prefer – to set high hurdles for all investments. The 14% hurdle for discount rates that was considered a minimum in the late 1990s, for example, halves the future value of a dollar every 5 years, so that in 10 years today’s dollar is worth 25¢; in 20 years 6¢; and in 50 years one tenth of one cent! It is hardly surprising that any event out that far is ignored.
For example, let us say that a firm’s current actions are going to cost society at large a billion dollars’ worth of harm in 50 years. Further, let us agree that all of the costs will definitely be imposed on the company. The company would feel that pain today as equivalent to only a mere $1 million hit to earnings. Why should they care?
In contrast, the income of typical individuals is likely to compound at most at 1.5% a year, their risk-free investments at an imputed zero % (today’s 30-year bond minus inflation), and an equity investment at perhaps 4%, net of inflation and tax. To take the highest of these three rates, the billion dollar pain at a 4% discount rate is going to feel to the average citizen, who faces the bill in 50 years, not like $1 million, but like $100 million. And for some societal purposes, 4% real is far too high. Surely, for example, shouldn’t the value, and hence cost, of a child’s life in 50 years be identical to the value and cost today? The reader can easily see how a corporation’s outlook on potential future damage might be a painful mismatch with that of ordinary individuals and society at large. The consequences of this not only can be disastrous but probably will be. A few painstaking readers might remember my “Farmer and The Devil” story of last July. In it I showed how a good capitalist farmer had to sign a contract in which the Devil guaranteed a quadrupling of the farmer’s income through very aggressive farming practices at the hidden cost of 1% a year of his soil. The farmer would enormously profit and eagerly re-up through the first several 20-year contracts only to end up with no soil, no food, and no people at about 100 years out. Yet each time the farmer re-upped, he did the sensible capitalist thing. In this case, Adam Smith’s “invisible hand” failed, and fatally so.
Damage to the “commons,” known as “externalities” has been discussed for decades, although the most threatening one – loss of our collective ability to feed ourselves, through erosion and fertilizer depletion – has received little or no attention. There have been no useful tricks proposed, however, for how we will collectively impose sensible, survivable, long-term policies over problems of the “commons.” To leave it to capitalism to get us out of this fix by maximizing its short-term profits is dangerously naïve and misses the point: capitalism and corporations have absolutely no mechanism for dealing with these problems, and seen through a corporate discount rate lens, our grandchildren really do have no value.
To move from the problem of long time horizons to the short-term common good, it is quickly apparent that capitalism in general has no sense of ethics or conscience. Whatever the Supreme Court may think, it is not a person. Why would a company give up a penny for the common good if it is not required to by enforced regulation or unless it looked like that penny might be returned with profit in the future because having a good image might be good for business? Ethical CEOs can drag a company along for a while, but this is an undependable and temporary fix. Ethical humans can also impose their will on corporations singly or en masse by withholding purchases or bestowing them, and companies can anticipate this and even influence it through clever brand advertising, “clean coal” being my favorite. But that is quite different from corporate altruism. Thus, we can roast our planet and firms may offer marvelous and profitable energy-saving equipment, but it will be for profit today, not planet saving tomorrow.
It gets worse, for what capitalism has always had is money with which to try to buy influence. Today’s version of U.S. capitalism has died and gone to heaven on this issue. A company is now free to spend money to influence political outcomes and need tell no one, least of all its own shareholders, the technical owners. So, rich industries can exert so much political influence that they now have a dangerous degree of influence over Congress. And the issues they most influence are precisely the ones that matter most, the ones that are most important to society’s long-term well-being, indeed its very existence. Thus, taking huge benefits from Nature and damaging it in return is completely free and all attempts at government control are fought with costly lobbying and advertising. And one of the first victims in this campaign has been the truth. If scientific evidence suggests costs and limits be imposed on industry to protect the long-term environment, then science will be opposed by clever disinformation. It’s now getting to be an old and obvious story, but because their propaganda is good and despite the solidness of the data, half of the people believe the problem is a government run wild, mad to control everything. So the “industrial complex” (or parts of it) fights to increase the inherent weaknesses of capitalism. They deliberately make it ever harder to reach the very long-term decisions that will serve us all. The influence of the Tobacco companies in deliberately obscuring the science to protect profits at a huge cost to society in health costs and lives is a perfect analogy to the energy industries that work hard to confuse the public on scientific measures of damage to health and the environment. Yet it is one that is surprisingly forgotten.
Of all the technical weaknesses in capitalism, though, probably the most immediately dangerous is its absolute inability to process the finiteness of resources and the mathematical impossibility of maintaining rapid growth in physical output. You can have steady increases in the quality of goods and services and, I hope, the quality of life, but you can’t have sustainable growth in physical output. You can have “growth” – for now – or you can have “sustainable” forever, but not both. This is a message brought to you by the laws of compound interest and the laws of nature. However, you can try to have both. But many, when given the choice, select “Growth, and to hell with the consequences.” Alternatively they adopt a hear-no-evil approach to life and listen exclusively to good news. The good news for such people is that there are always a few experts lacking in long-horizon vision, simple common sense, or whose co-operation has been rented, like “expert” witnesses at a murder trial, who can be dragged out to reliably say that everything will always work out fine. (One famous professor went seamlessly from saying tobacco smoking was just fine to saying continuously pumping out greenhouse gases would also be without consequences). The optimists offer as evidence that we will always be in the best of all possible worlds, not our species’ tough million or so years of trial and painful error, but only the last 200 years, when hydrocarbon and other resources have given us a temporary reprieve. This reprieve does not make the finite magically infinite, but the 250 years of the hydrocarbon intermission can feel like forever. Capitalism certainly acts as if it believes that rapid growth in physical wealth can go on forever. It appears to be hooked on high growth and avoids any suggestion that it might be slowed down by limits. Thus, it exhibits horror at the thought (and occasional reality) of declining population when in fact such a decline is an absolute necessity in order for us to end up gracefully, rather than painfully, at a fully sustainable world economy. Similarly with natural resources, capitalism wants to eat into these precious, limited resources at an accelerating rate with the subtext that everyone on the planet has the right to live like the wasteful polluting developed countries do today. You don’t have to be a PhD mathematician to work out that if the average Chinese and Indian were to catch up with (the theoretically moving target of) the average American, then our planet’s goose is cooked, along with most other things. Indeed, scientists calculate that if they caught up, we would need at least three planets to be fully sustainable. But few listen to scientists these days. So, do you know how many economic theories treat resources as if they are finite? Well, the researchers at the O.E.C.D say “none” – that no such theory exists. Economic theory either ignores this little problem or assumes you reach out and take the needed resources given the normal workings of supply and demand and you can do it indefinitely. This is a lack of common sense on a par with “rational expectations,” that elegant theory that encouraged the ludicrous faith in deregulation and the wisdom of free markets, which brought us our recent financial fiascos. But this failure in economic theory – ignoring natural limits – risks far more dangerous outcomes than temporary financial crashes.
Let me pose a simple question. If there were an extra thousand years of oil supply – of onshore traditional oil – available at, say, a production cost of $200 a barrel in addition to the actual 40 years of mixed-cost reserves that we have today, what difference would it make in today’s price? Remarkably, the answer is “none.” Today’s price is concerned only with the intermediate-term workings of current costs of current barrels and current demand. Yet every rational reader knows that this should not be the case: that the existence of huge reserves (or the lack thereof) should indeed influence today’s price in a world concerned about its very long-term well-being. In addition to ignoring the depleting supplies of high quality materials, no concern at all is shown for our current devastatingly erosive and resource-intensive global farming practices.
As described above, the current U.S. capitalist system appears to contain some potentially fatal flaws. Therefore, we should ask what it would take for our system to evolve in time to save our bacon. Clearly, a better balance with regulations would be a help. This requires reasonably enlightened regulations, which are unlikely to be produced until big money’s influence in Congress, and particularly in elections, decreases. This would necessitate legal changes all the way up to the Supreme Court. It’s a long haul, but a handful of other democratic countries in northern Europe have been successful, and with the stakes so high we have little alternative but to change our ways.
It would certainly help if the general public were better educated, especially in science. The same applies, unfortunately, to Congress itself. This body is desperately short of scientists and basic familiarity with things scientific. Our key problems need to be addressed by people very familiar and comfortable with science. It is said that eight of the nine senior leaders in China’s government are scientists. At that high a level, of our 535 Congressmen and the President and Vice President, less than a handful – arguably only two or three – would pass the test. (I suppose you could throw in the Supreme Court Justices if you wanted to.) It is said, on the other hand, that about 100 Congressmen do not believe in evolution. Without a respect for science in Congress and with science in the general public declining as an interest, some of the painful new issues are going to be hard to address. (The percentage of students graduating with degrees in science as a proportion of total U.S. graduates is the 60th highest by country these days!) This lack of scientific familiarity is made worse by the fact that everyone loves to hear good news, Americans more than most.
The tough news we must sooner or later grasp is made tougher by the skilled, energetic denials, well-funded by powerful industries that fear their profits would be threatened. Libertarians seem to feel that even if the bad news were true, the necessary regulations would be so distasteful that they would really prefer that the science were different, and they deem it so, putting desired political theory over science.
Meanwhile, China gets on with it and science is accepted in what used to be our normal way until the last decade or two. And I suppose they have some unfair advantages, among them leaders with scientific backgrounds and higher science scores for the general public, but they also have the luxury of a leadership that does not face election campaigns. Lucky them. The critical consequences are that they waste no time in challenging climate problems (the same is true of India) and, even more importantly perhaps, they begin to really worry, almost panic, about their long-term access to crucial resources. In contrast to our political log jam and failure to face long-term issues, they have moved rapidly to exploit new sustainable energy sources, to tie down resource deals, and to promote improved resource efficiency.
The U.S. and Canada are blessed with natural advantages that are unrivaled (at least if you include security, which, in a desperate, resource-constrained, warming world might hurt New Zealand, that otherwise would look hard to beat). Yet the relatively uncontrolled variety of capitalism that exists in the U.S. today may negate many of our advantages. Solutions to these issues – far more important than any others – need a delicate mix of capitalism and wise, democratically-controlled government regulation. That might sound like an oxymoron to far too many people. If we can’t make it sound, plausible, and acceptable in the next few decades, then we are in deep trouble for the world really, really needs U.S. leadership on these critical issues.
Karl Marx went on and on about the tendency of capitalism to so fixate on growth that in time it would forget the need to put on a friendly face for society and would drive home too clearly and brutally its advantage over labor. Ironically, in some way he and Engels looked forward to globalization and the supranational company because they argued it would make capitalism even more powerful, over reaching, and eventually reckless. It would, they claimed, offer the capitalists more rope to hang themselves with or, rather, to be hung with, in the workers’ revolution. The rope for the job, they suggested with black humor, would be bought from briskly competing capitalists, eager till the end for a good deal. Well, time marches on and it’s going to be hard to have a workers’ revolution with no workers. Organizing robotic machine tools will not be easy. However, Marx and Engels certainly got the part right about globalization and the supranational company increasing the power of capital at the expense of labor. To interfere with Marx’s apocalyptic vision, we need some enlightened governmental moderation of the new globalized Juggernaut (even slightly enlightened would be encouraging) before capitalism gets so cocky that we have some serious social reaction.
But for me capitalism’s complete fixation on growth at all cost that Marx concentrated on is not as important as the other issues discussed here. 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.