Why Stock Market Short-Termism Is Not the Problem in the US (or the EU) - A review of Mark Roe’s book
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Mark Roe, one of the most prominent voices in the short-termism debate, recently wrote an excellent book titled Missing the Target. Why Stock Market Short-Termism Is Not the Problem. The key message of the book is that blaming stock-market short-termism for societal problems is a widely held and politically attractive view, but one that is not supported by the academic evidence. Roe argues that many of those who blame stock markets for being short-termist ‘miss the target’, as the societal problems they identify are caused by factors other than stock-market short-termism. In this post, I summarize the different arguments of the book and reflect on its implications for European corporate governance.
Summary of the book
Chapter 1 of the book describes how the view that the stock market is excessively short-termist is widely held by academics, practitioners, and policymakers. Roe summarizes the perceived problem as follows. Investors hold their shares for smaller and smaller periods of time and demand immediate financial returns. This short-term pressure is transmitted to executives through campaigns from hedge fund activists and through executive compensation that is tied to the (short-term) stock price. To please their investors, executives cause corporations to return cash to investors through share buybacks, leaving insufficient funds for long-term investment. This harms the firm’s long-term wellbeing, as well as the broader US economy. In this view, short-termism even contributes to social inequality and environmental damage, as short-termist investors do not support treating workers and the environment well. The policy conclusion is clear: executives should be insulated from short-termist shareholder pressures.
Roe then analyzes the evidence for the short-termist view and finds it wanting. Chapter 2 of the book reviews the economy-wide evidence of short-termism in the US. Contrary to what the short-termism view would predict, Roe finds that share buybacks have not drained the cash necessary for investments from corporations, as cash outflows were offset by cash inflows from cheap borrowing due to the low interest rates after the financial crisis. In fact, cash piles of corporations have increased. In addition, investments in R&D are increasing (and not decreasing) in the US economy. Admittedly, capital expenditures (another type of long-term investment) have decreased over time, but Roe argues that this reflects technological change. Roe concludes that ‘the predicted economy-wide consequences of a vociferously short-term stock market have not yet been well shown’ (p. 45).
In chapters 5-7, Roe reviews the firm-level evidence in favor and against short-termism. Several studies investigate the behavior of firms subject to short-termist pressures. Although the firm-level evidence is mixed and the number of studies in favor and against short-termism is roughly the same, Roe argues that the studies finding no short-termism problem are more convincing. In addition, Roe argues that even if the firm-level studies were to find that firms make less long-term investments because of short-termist pressures, it would not necessarily follow that the US economy as a whole suffers from a short-termism problem. It may be that other firms, for example privately held firms, pick up the slack left by short-term oriented firms.
In chapter 3, Roe argues that the short-termism problem is also too often conflated with the problem of externalities. He distinguishes between ‘type A short-termism’, which is the claim that firms fail to invest sufficiently for the long-term because of short-termist pressures, and ‘type B short-termism’, which is the claim that short-termist pressures induce corporations to favor corporate profits over the interests of external stakeholders, such as workers, or the protection of the environment. Roe argues that so-called type B short-termism actually has little to do with short-termism and should rather be considered a problem of corporate selfishness, as corporations fail to internalize negative externalities.
One may wonder whether it would not be better to adopt the solutions proposed by the advocates of the short-termist view, even if short-termism turns out to be only a small problem for the US economy. Roe’s response to this argument is in chapter 4, where he argues that focusing on combatting short-termism risks diverting attention away from better solutions to real societal problems. Roe suggests that there are more effective solutions to societal problems than making corporate governance less short-termist.
In addition, in chapters 8 and 9, Roe analyzes the disadvantages of the proposals of the advocates of the short-termist view. The main policy proposal of these advocates is to insulate executives from financial markets. Roe argues that managerial autonomy can be defended because managers are often better informed than shareholders. However, insulating managers from shareholders also increases agency costs, as the risk of managerial slack and empire building increases. In addition, Roe argues that executives themselves may be the source of short-termist behavior. Executives likely favor good corporate results during their term of office (and not necessarily over the long term), as this helps them build their own reputation and may secure them an even better job.
In chapter 9, Roe analyzes other policy proposals by advocates from the short-termist view, including limiting stock buybacks, eliminating quarterly reporting, heavily taxing short-term trading gains, and giving more voting power to long-term stockholders (so-called loyalty voting rights). Roe argues that none of these proposals are likely to be effective. He also points out that these proposals come with their own costs and risk diverting attention from the real issues and solutions.
In the last part of his book, Roe then explores why the short-termist view has become so widely accepted, despite the lack of evidence. He argues that stock-market short-termism is often blamed for evolutions that are caused by disruptive technological change (chapter 10) and that this is intuitively appealing because of the negative connotations associated with short-termism (chapter 11). He also identifies interest groups, such as executives and employees, that benefit from the policy proposals of the short-termist advocates (chapter 12). Finally, Roe argues that stock-market short-termism functions as a useful scapegoat for politicians (chapter 13).
Reflections on the implications for European corporate governance
One limit of Roe’s book is that it is focused on short-termism in the US and does not offer evidence on short-termism in other jurisdictions, such as the EU. Such a limit to the scope is well-justified to keep the analysis focused, but it does mean that there is room for future research.
Short-termism has received attention some attention in the EU, for example with the EY study, which concluded that '[s]hort-term time horizons that fail to capture the full extent of long-term sustainability risks and impacts could amount to overwhelming environmental, social and economic consequences for companies, shareholders, investors, and society at large' (p. vi). However, the EY study has received vehement criticism for its poor empirical methodology and biased literature review from many academics, including from Mark Roe himself (see also this summary of an ECGI workshop, where participants were very critical of the EY report). Faced with such criticism, the European Commission scaled back its ambition and focused on sustainability due diligence in its proposed directive and only to a very limited extent on corporate governance. Nevertheless, several EU member states seem to consider short-termism an important problem: Belgium, France, the Netherlands, Italy and Spain have already allowed loyalty voting rights, supposedly to combat short-termism.
Roe’s analysis suggests, however, that the short-termism problem may be used by European politicians as a scapegoat for broader societal problems, or as a justification for favoring certain interest groups, such as executives and controlling shareholders (this last point is consistent with reports that loyalty voting rights were introduced in Belgium after lobbying by the Federation of Enterprises in Belgium (FEB), an organization representing large corporations).
I would argue that there are several reasons to believe that investor-driven short-termism may be even less likely to pose a problem in Europe. Firstly, corporations in continental European countries more often have a controlling shareholder than corporations in the US. Corporations with a controlling shareholder will face less pressure from shareholder activists, as activists are unlikely to win a vote in the general meeting against a controlling shareholder. Controlling shareholders are also said to have a longer time horizon, because they derive private benefits from remaining in control of the corporation. This may be especially true for family ownership, due to a desire to transfer the family business to the next generation.
Secondly, executive compensation is less likely to transmit short-termism from the stock market to managers in Europe, because compensation is less heavily based on the stock price. Share grants and stock options make up a smaller portion of executive compensation in continental Europe than in the US, and fixed pay a larger portion.
Thirdly, shareholder activism has been much rarer in continental European corporate governance than in the US. This implies that the argument that shareholder activists are the cause of short-termism carries much less weight for continental European jurisdictions. However, this conclusion may change in the future, as European shareholder activism seems to be on the rise in recent years.
In conclusion, there are reasons to believe that stock-market short-termism is even less likely to be present in Europe than in the US. Because short-termism in continental European corporate governance has not yet been systematically analyzed, further research on this topic would be particularly welcome. Roe’s book does not solve this gap in the literature, but its careful and comprehensive analysis provides a useful starting point, not in the least because of its analysis of why the short-termism view has been so successful politically, despite the lack of empirical evidence.
Tom Vos is a Visiting professor with the Jean-Pierre Blumberg Chair at the University of Antwerp (Belgium).
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