What Goes Up Doesn’t Always Go Up

The latest disaster in the financial markets has once again shown that some of the biggest risks investors face derive from the excesses of free markets themselves.  This time it was unregulated lending, leverage and speculation.  In 2000 it was over-optimistic and at times corrupt Wall Street analysts, gobbling up creative corporate accounting that massaged income statements to show profits where there were none.

Some of the other systemic risks embedded in financial markets are barely on the radar screen of most investors.  These range from unregulated pollution causing global warming, to the worrisome increase in nuclear proliferation during the Bush years.  Preventable increases in sea levels might warrant more investor attention than, say, which large-cap growth manager should be hired or fired.  There might not have been a worse piece of news for long-term investors over the last decade than Pakistan’s A.Q. Khan passing on nuclear secrets to other countries, yet there is no widespread investor effort to reduce the nuclear threat.

Why don’t investors pay more attention to these massive risks, and try to do more to reduce them?  The answer lies in an almost totemic belief that markets go up in the long run.  In fact, financial asset values don’t inevitably rise, even over twenty and thirty year periods.  Market outcomes are conditioned by the public and private governance systems in which they operate.  By influencing these governance systems, investors working together can reduce market risk and positively influence long-term market outcomes.  To do so, however, will require accepting that markets do not magically inflate, and that investor passivity is in fact a very risky strategy.

Some large institutional investors are starting to wake up to the latent risks in the system and their role in mitigating them.  Investors responsible for over $15 trillion in assets have signed on to the UN Principles for Responsible Investment, which state that ‘environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios.”  Investors with over $7 trillion in assets (including Trillium Asset Management Corporation) have joined the Investor Network on Climate Risk (INCR), which has been pushing for more analysis and disclosure of the potential impact of climate change on corporate performance.  Capitalizing on the regime change in Washington, INCR’s members are advocating strongly for improved public policy to ensure global emissions reductions.

It is an enduring irony, last learned during the troubles of the 1930s and 1960s, that no group has a greater self-interest in vigorous public governance than the investor class.  The door has opened for substantial public policy reform not only in the financial sector, but also on other critical issues affecting long-term investor outcomes.  These range from energy and the environment, to health care, income distribution, and global security.  With the widespread use of mutual funds and other diversifying strategies, virtually all investors large and small have a stake in eliminating environmental, social and governance failures in the service of their long-term portfolio returns.  Investors of the world, unite!. 

Strategic View

Do Markets Need Government?

When I studied and taught economics 25 years ago, the basic model of efficient markets was straightforward. Investors and businesses maximize profit, consumers seek value for money, workers search for lucrative jobs. Competitive market forces were central, although market failures were acknowledged: the maldistribution of income and “externalities” such as pollution and crime that are not reflected in market prices. The role of government was to efficiently remediate these failures, to regulate, tax or otherwise “get the prices right.”

What happens, however, when self-interested capitalists understand that social inequities and externalities like pollution and nuclear proliferation do long term financial damage to their portfolios? Short term profit-driven activities (e.g., extracting oil) may turn out to be terrible long-term investments (rising sea levels threatening major cities and markets). What if markets begin to demand, either for altruistic or self-interested reasons, better performance from corporations on multiple bottom lines? In such a system, does the role of government diminish?

It is tempting to say yes. Institutions with long term horizons, such as foundations and public pension funds, are teaming up with social investors to address “extra-financial” market risks, taking action through the Investor Network on Climate Risk (or INCR, which represents $4 trillion in assets), signing the UN Principles for Responsible Investment (more than $10 trillion in assets), and insisting that companies report on extra-financial performance through the Global Reporting Initiative. These massive investor networks own large chunks of the global corporate sector. If they demand that corporations act responsibly, externalities should diminish, reducing the need for regulation.

In fact, these market forces are extremely useful and leading to meaningful change as companies respond accordingly. Carpet manufacturer Interface‘s vision is “to be the first company that, by its deeds, shows the entire industrial world what sustainability is in all its dimensions: people, process, product, place and profits – by 2020 – and in doing so …become restorative through the power of influence.” But not every company embraces such a deep vision, and systemic performance on social and environmental issues is simply not improving fast enough. Government remains the only actor that can ensure a price on externalities (through taxes and regulation), while requiring full disclosure of extra-financial information.

When government is needed most, it is too often seduced by lobbyists and beholden to corporate interests. This is an old problem, identified a century ago by Woodrow Wilson, who warned that “the government, which was designed for the people, has got into the hands of the bosses and their employers, the special interests. An invisible empire has been set up above the forms of democracy.” But wise investors and corporations understand government’s crucial role. That’s why members of INCR have been calling for the Securities and Exchange Commission to mandate environmental reporting, and employer coalitions are requesting that the government regulate carbon sooner rather than later.