Saving Capitalism From Short-Termism: How To Build Long-Term Value and Take Back Our Financial Future. Alfred Rappaport. McGraw-Hill 2011, pp.235, $30.00 Capitalism and the viability of the free market system are in crisis, perhaps to a degree not seen since the Great Depression. Protesters in New York City and other major American cities are rallying [...]
Saving Capitalism From Short-Termism: How To Build Long-Term Value and Take Back Our Financial Future. Alfred Rappaport. McGraw-Hill 2011, pp.235, $30.00
Capitalism and the viability of the free market system are in crisis, perhaps to a degree not seen since the Great Depression. Protesters in New York City and other major American cities are rallying against what they perceive to be corporate greed and malfeasance, Senate Democrats are pushing for a millionaire’s tax, and public support for free trade is on the decline. With unemployment at 9.1% and the very real possibility that the United States will soon be entering a second recession within a matter of three years, it is imperative that policymakers reflect upon what went wrong in 2008 so as to better comprehend how we have managed to get into such a mess in the first place.
In Saving Capitalism From Short-Termism, Alfred Rappaport (Northwestern University) argues that the business culture’s emphasis on short-term results rather than long-term value creation has had a deleterious impact on the American economy. “Short-termism, the obsession with short-term results irrespective of the long-term implications, was a prime factor in the recent global financial crisis.” He warns the reader that failure to address short-termism will harm economic vitality, individuals’ sense of financial security, and the free market system’s dominance. When corporate executives focus singlehandedly on meeting quarterly earnings expectations rather than on creating long-term value for the corporation, trouble ensues. The author contends that, in an era in which professional managers are entrusted with other peoples’ money, there are inevitably conflicts of interest between the managerial class and the shareholders and beneficiaries whose interests they are expected to serve. “More broadly what is in the best interests of corporate and investment managers, or at least is perceived to be in their best interests, may not serve the collective interests of the economy—a sobering lesson that the global financial meltdown delivered forcefully.”
As to what he perceives to be the main problem, Rappaport points to the practice of rewarding managers for “short-term performance rather than longer-term value creation.” Those with a background in finance will appreciate Rappaport’s discussion of why earnings are of limited usefulness when gauging a company’s value. His writing can be pithy, such as when he analogizes short-termism to a disease, with the obsession over earnings being the carrier of said disease.
A particular strength of Saving Capitalism From Short-Termism is Rappaport’s ability to make his work relevant to those interested in better understanding what contributed to the financial crisis of 2008. He first distinguishes between failures in the public and private sectors and posits that, “an essential cause of the epic collapse was a collection of perverse, short-term financial incentives.” He does not subscribe to the notion that getting rid of government bailouts would have reduced managerial risk taking. “The evidence,” he argues, “suggests that overconfidence, groupthink, and short-term performance incentives dictate the level of managerial risk taking and that eliminating bailouts would not meaningfully affect that risk-taking behavior.” Even if one accepts the veracity of this statement, it remains the case that a sizeable amount of the public views bank bailouts in a negative light, and that, in politics, perception may matter even more than reality.
While Rappaport may be too dismissive of the moral hazard perils of public sector bailouts, he is more persuasive in arguing that all of the private sector culprits, ranging from homebuyers, appraisers, and lenders to credit rating agencies, corporate boards of directors, Wall Street investment banks, and institutional investors reacted to incentives that promoted short-termism. “Each private-sector culprit,” writes Rappaport, “responded to incentives that offered outsized short-term rewards that overwhelmed the long-term risks.” It should be noted that he does not let the public sector, notably Congress and the Federal Reserve, off the hook. He points out that that they magnified the harmful impact of the private sector incentives, singling out the Community Reinvestment Act of 1977, political pressure on Fannie Mae and Freddie Mac, the easing of credit standards, lax regulation in the financial services sector, and low interest rates.
Given the author’s argument that deeply flawed incentives induced private sector actors to engage in behavior that was deleterious to the financial system and the economy in the aggregate, it is not surprising that he would argue for changing the incentive structures that predominate in today’s business culture. In the second half of the book, Rappaport proposes a series of changes that he believes would reduce the current overemphasis on short-termism. These include, but are not limited to, redesigning new compensation programs that reward employees for long-term value creation; changing corporate policies and behavior; overhauling corporate financial reporting, with an emphasis on the corporate performance statement; and replacing asset-based fee structures for investment managers with performance fees. Those without a business or legal background will likely not find this discussion particularly accessible. Readers with an interest in corporate governance will, by way of contrast, find much of Rappaport’s discussion to be worthy of serious consideration.
In conclusion, in Saving Capitalism From Short-Termism, Rappaport provides a comprehensive and straightforward argument why the contemporary business culture’s narrow focus on short-termism is both misguided and detrimental to the economic health of this country. Many of Rappaport’s observations are on point. It may, unfortunately, take an even greater financial crisis than the one that occurred in 2008 to foster the changes that he believes are necessary to creating long-term value.
Jon Lewis (c) 2011