I have translated this chronicle by Lars Pehrson, CEO of Merkur Cooperative Bank, to Faroese and English. The chronicle can be read in the original Danish version here and in the Danish paper Information here.
The chronicle was published in Information on July 8, 2012, and is as relevant now as ever. It’s rather thought-provoking that even prominent figures working within the financial sector recognize how the current economic system is steering society into trouble, and that it is therefore crucial to think differently. The biggest issue is that we lack politicians who are up to the task or capable of thinking far-sightedly and with vision. And when the press doesn’t apply more pressure, things are unlikely to change. All the power factors in society—political authorities, the financial sector, and the press—seem unable to think outside the traditional boxes. Unfortunately. Because a shift in mindset is absolutely necessary. In the long run, we cannot afford to continue as things are.’
Elin Brimheim Heinesen
It’s not just individuals who are short-sighted. Our legislation promotes our vices. The result is climate change, pollution, and economic crises.
Amidst the frustrations over the countless national and economic special interests that blocked necessary progress at the recently concluded Rio+20 summit, we must not forget a crucial obstacle to finding solutions to the climate, resource, and energy crises: our inability to think long-term in economic and financial matters.
It’s not just that short-sightedness is inherent in human nature, we have also structured ourselves with mindsets, incentives, and rules that always prioritize the present over the future. That is why we pump the last drop of oil at full capacity instead of saving some for 100 years from now. That is why we cannot implement effective fisheries regulation: we want to sell the fish now! That is why we continue to pollute our environment, no matter how many times we are told it will be expensive or disastrous for the future – we want to keep the profits now and not spend any of it on cleaning up.
That is why investors have their eyes fixed on the next quarterly earnings reports of large listed companies (a phenomenon called quarterly capitalism). And when we also lose our sense of reality and allow the financial system to detach itself from the real economy, we can, in principle, earn more money in one day or one minute through speculation than through decades of painstaking work on product development and production.
Dangerous cocktail
Politicians have their own short-term horizon, stretching to the next election. Just think of all the things that are not resolved because one chamber of the US Congress is up for election every two years.
The combination of political and financial short-sightedness is a cocktail that can have dramatic consequences. The financial crisis should have taught us that. In the 2000s, Danes celebrated under the housing bubble, politicians pushed forward with risky loan types and tax freezes. The financial sector exploited this opportunity to increase lending in real estate. Across the board, loans were granted against home equity, and hundreds of billions of kroner were pumped into the economy in this way.
The money poured into the treasury through taxes on all the new cars that were bought with borrowed money, VAT from high private consumption, etc. The Minister of Finance enjoyed the responsibility, and tax cuts were handed out so that the party could continue.
When the bubble burst, the state had to support the banks, without seriously beginning to discuss whether the financial system could function in a different way. That is still not being done. We have just seen it all repeat itself in Spain: housing bubble and resulting boom – followed by a downturn with bank bailouts in the 100 billion euro range.
In addition to politicians’ desire to appear successful up to the next election, they have also largely adopted the financial logic that makes the future disappear from sight. The phenomenon is very unsexily called the ‘discount rate’. It is a percentage that the Ministry of Finance uses when future costs or revenues are to be converted into present value.
In Denmark, this rate is as high as six percent per year. An outrageously high figure, which means that both costs and revenues that are triggered in the future dwindle to nothing as long as the time horizon is only a few decades. The reasonableness of such a high discount rate has been discussed from time to time, and several have suggested a reduction. However, a search on the Ministry of Finance’s website yields no other result than that the factor is still six percent. This is one of the reasons why we are not investing enough in, for example, infrastructure and energy transition.
Supporting the Big Players
The short-sighted economic logic, which is particularly linked to the shareholder value paradigm that a company’s task is to create the greatest possible value for its owners in the shortest possible time, has in recent decades slowly but surely infected financial legislation down to the detailed accounting rules that banks and pension funds must follow.
Let me give a couple of examples of the effect of such rules:
As is well known, banks must calculate a solvency ratio, which expresses the relationship between the capital base (equity and other subordinated capital) and its assets and other risks. That number must not be lower than eight percent. In principle, this means that every time 100 kroner are lent out, the bank must have at least eight kroner in equity.
However, it has become permissible to make the calculation in a more complicated way, taking into account the risk of the various loans. Such calculation systems are very expensive to develop, therefore only the large banks can afford it.
The effect of the method is that some loans come to weigh significantly less. If a loan is only given a weight of 20 percent, it means that the bank can now lend 500 kroner on the basis of the same eight kroner in equity. Leverage increases, and the whole system becomes less transparent.
The problem is that the risk is not always captured by these complicated models. We saw this at the outbreak of the financial crisis in the US, where the largest banks were hit first.
Short Sight is a Virtue
Down to earth, the consequence of the principle is that large banks are favored over smaller ones. They need relatively less capital to carry out the same business and can thus more easily earn more money.
Large companies are favored over small and medium-sized enterprises. This is partly because large companies often have a rating, which small companies do not. A high rating is one of the things that triggers a down-weighting in the Basel system.
Large companies can borrow cheaper – significantly cheaper – than smaller companies. When the bank only has to tie up a fifth of the capital, it can achieve a higher profit, even with a lower interest margin. It is not unusual for a large company to pay two percent, while a smaller and still creditworthy company pays six-eight percent for loans for comparable activities.
It is not difficult to see what this means for the business structure. It is the large companies that are particularly tied to the shareholder value paradigm and therefore must focus short-term on the quarterly report. But an economy with many small and medium-sized enterprises is more dynamic, and the economic exchange in the form of trade in the local area is more intense.
More jobs are created in such an economy, and it must therefore be in the long-term interest of society to promote it. Instead, we have built a system that, through almost invisible mechanisms, leads to the opposite. Pension funds are also driven to short-sightedness. The rules in the area mean that they place most of their funds in listed securities – bonds and shares. This is justified by the concern for the safety of pension savers – regardless of the fact that listed securities can also be subject to bubble formation.
Thus, the development on the financial markets becomes decisive for the annual statements of the return that the pension companies compete on. In order to stand out in this competition, the pension fund must constantly have the short horizon in mind. This is regrettable, because the enormous funds of the pension funds hold unique opportunities to create long-term value for society and thus also for their own pension savers, who are to grow old in this society. But to exploit the potential, we must develop methods to measure long-term, real value creation, so that it does not lose out to the fluctuations on the stock exchanges.
Lars Pehrson is the CEO of the Danish bank Merkur Andelskasse
