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Four high-growth scenarios for Africa

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africagrowth

Can African countries sustain the relatively high growth rates they attained since 2000? At the start of 2017, putting aside the newsworthy political shifts and the fear of many that the developing world has entered a ‘secular stagnation’, this remains the most vexing question for those of us on the African continent.

It is not a question with an easy answer. The stellar economic performance of several African countries has created an ‘Africa rising’ narrative where further progress – and catch-up to the developed world – seems inevitable. A more pessimistic counternarrative argues that this growth, from a low base, is largely the result of favourable commodity prices and Chinese investment. Both narratives had, unfortunately, made little use of either economic theory or history.

Enter Dani Rodrik, professor of International Political Economy at the John F. Kennedy School of Government at Harvard University, who tackles this question in a new paper in the Journal of African Economies. He first shows that many African economies have indeed improved since 2000, but that many, including Senegal, the DRC, the Ivory Coast and Zambia, remain on levels below those immediately following colonialism (around 1960). The second fact he establishes is that the rapid growth of the last dozen years has not lead to a large structural transformation of the economy. Whereas rapid growth in south-east Asian economies during the late twentieth century resulted in the growth of manufacturing, a more productive activity than subsistence farming, high growth rates in Africa have not had any effect on the relative size of manufacturing. In fact, in many countries, the size of the manufacturing sector has actually declined since 1975.

Rodrik attributes these changes not so much to factors unique to Africa – like a poor business climate or weak institutions or bad geography – but to a global trend of deindustrialisation. Even Vietnam, a country which has recently experienced rapid growth, has not seen much growth in manufacturing.  And Latin American countries, which have decidedly better institutions than three decades ago, have also not seen much growth in manufacturing. Technological change – the move to automation, for example – is one likely reason.

So despite high growth rates, African countries have not industrialised – and, in fact, may have even begun to deindustrialise. This is why Rodrik is pessimistic about Africa’s future growth prospects. He nevertheless concludes by considering potential scenarios in which Africa can indeed sustain high growth, and identifies four possibilities: 1) To revive manufacturing and industrialise, 2) To generate agricultural-led growth, 3) To generate service-led growth and 4) To generate natural resource-led growth.

Let’s start with agriculture. Although many African countries have a lot of potential to expand their agricultural sectors, productivity in the agricultural sector remains low. Many farmers are subsistence producers, with low economies of scale. Such a scenario will require a reversal in the current trend away from agriculture. A recent study by Diao, Harttgen and McMillan show clearly how the share of agriculture is falling, particularly as women older than 25 are moving to the cities and into manufacturing and services. This trend seems irreversible, even if changes to technology (like seed varieties or market access opportunities) or institutions (like private property) are made, which means that an agricultural-led high growth scenario seems highly unlikely.

A natural resource-led strategy also seems unlikely for most African countries. Yes, most countries on the continent are well-endowed with resources, but the problems of the Natural Resource Curse and Dutch Disease are well known. It may be an option for some small economies, like Botswana has shown, but one has to question to what extent it can be sustainable beyond a certain level of income.

A third option is to reverse the trend of deindustrialisation. Because a growing manufacturing base seems to be, at least if we consider past examples of industrialisation, the only way to increase labour productivity over a sustained period of time, this is the option preferred by many development agencies. Yet there are many obstacles in the way of a thriving manufacturing sector, including poor infrastructure (transport and power in particular), red tape and corruption, low levels of human capital, and political and legal risk. But as explained earlier, Rodrik believes that even if these (very difficult) barriers can be overcome, it is not clear that manufacturing will return. The Fourth Industrial Revolution may completely alter the nature of manufacturing away from absorbing unskilled labour to capital and knowledge-intensive production. As I’ve said before, it is dangerous to follow a twentieth-century blueprint when production technologies are so different.

That leaves us with one scenario: services-led growth. Services have traditionally not acted as an ‘escalator sector’ as Rodrik explains. The problem is that services typically require high-skilled labourers, one thing that is in short supply in a developing economy. Rodrik does acknowledge, though, that the past will not necessarily look like the future. “Perhaps Africa will be the breeding ground of new technologies that will revolutionise services for broad masses, and do so in a way that creates high-wage jobs for all. Perhaps; but it is too early to be confident about the likelihood of this scenario.”

I don’t see an alternative, though. Yes, some countries, like Mozambique or Tanzania, will be able to expand their agricultural sectors – but higher productivity will probably mean larger farms with fewer workers. A few small countries will be able to benefit from natural resources – from diamonds to rare minerals like tantalum (used in cellphones and laptops); oil-producing countries will struggle, though, as the cost of renewable energies keeps falling. And some coastal countries may even develop their manufacturing sectors, like Ethiopia and South Africa. But for most of Africa, services offer the only reprieve from low productivity, low-wage jobs. From semi-skilled jobs like call-centres and virtual au pairs (apparently the next big thing) to professional services like accountants and designers and programmers, digital technologies must help leapfrog the barriers of poor infrastructure, bad geography and weak institutions. If it cannot, Dani Rodrik’s pessimistic vision of Africa’s future is likely to come true.

*An edited version of this first appeared in Finweek magazine of 26 January.

How Uber makes the world a better place

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The first thing students are taught in any introductory microeconomics course is that the price of something, let’s say chauffeur services, and the quantity of it that consumers want is depicted by a negative-sloping demand curve. The difference between what consumers are willing to pay for a chauffeur ride (the demand curve) and what the chauffeur asks (the market price), is what is known as the consumer surplus. The bigger the consumer surplus, the better for society.

But even though the idea of consumer surplus is used in many applications, measuring it has always been problematic. That is because, in the real world, demand and supply move together, and it is therefore difficult to establish the exact shape of a demand curve.

That was, until Uber. A team of economists (including Steven Levitt of Freakonomics fame) recently published an NBER Working Paper that uses almost 50 million UberX ‘consumer sessions’ to identify a demand curve for taxi services, and then calculate the consumer surplus that these services generate. A ‘consumer session’ is basically when someone logs onto the UberX app and requests the price for a proposed trip. The consumer either accepts the price and wait for an Uber driver to pick them up, or they don’t, and find alternative transport.

What makes Uber unique is that its prices vary according to demand (for its services) and supply (the availability of drivers). This unfortunately also means that it is not possible to simply calculate a demand curve when the price increases by 10%, because the increase might be the result not of greater demand by consumers for Uber trips, but of lower supply (having fewer drivers on the route). The research team use a clever trick to get around this. Say the algorithm predicts that the price must increase by 1.249. This is then rounded down to 1.2 for the consumer. Other times the algorithm suggests the price must increase by 1.251, but the app then rounds this up to 1.3. It is this discrete difference when the price is essentially the same which the authors exploit using regression discontinuity analysis.

uber_advertIf this sounds very geeky, the results are worth the wait. First, the authors find that demand is quite inelastic (around 0.5). This means that if prices increase by 10%, demand will only fall by 5%. Second, they compute the dollar value of consumer surplus in Chicago, Los Angeles, New York and San Francisco to be roughly $2.8 billion annually. This is more than six times Uber’s revenue in those cities. Put another way, for each $1 spent on an UberX ride at the lowest price, the authors estimate that the consumer ‘receives’ $1.57 in extra surplus. In short, Uber generates massive benefits for society-at-large.

Why does Uber generate so much consumer surplus compared to normal taxi operators? Another NBER Working Paper, written by Judd Cramer and Alan Krueger, suggests that it is because of the higher capacity utilisation rate of Uber drivers: “UberX drivers spend a significantly higher fraction of their time, and drive a substantially higher share of miles, with a passenger in their car than do taxi drivers.” There are four reasons for this. First, Uber’s better matching technology (an app that anyone can download on their phones). Second, the larger scale of Uber’s usage in comparison to taxi companies. Third, highly inefficient taxi regulations which limit the number of routes or time periods taxi drivers can operate. Fourth, Uber’s flexible labour supply model and pricing model which match supply with demand.

South African regulators have had varied responses to Uber’s entrance in the local market. There has been opposition from the taxi industry, sometimes violent. Proponents of Uber, on the other hand, often highlight the entrepreneurial and job-creating opportunities the service creates.

What this research shows, though, is that Uber’s main benefit is the massive surplus it generates for consumers. According to the Levitt research team, one day’s worth of consumer surplus in the four US cities they analyse is worth about $18 million. “If Uber were to unexpectedly disappear for a day, that is how much consumers would lose in surplus.”

Aside from this consumer surplus, Uber services create many positive externalities, from lower congestion and pollution levels to semi-skilled employment to, perhaps more tenuously, greater social interaction and cohesion – I’ve had some fascinating conversations with Uber drivers, and know of one driver that was offered a scholarship by a client. But, most importantly, when regulators and policy-makers debate the pros and cons of Uber and other such services that will almost certainly appear in the next few years, it is worth remembering one of the basic principles of introductory economics: the immense benefits society derives from the additional consumer surplus.

*An edited version of this first appeared in Finweek magazine of 20 October.

Written by Johan Fourie

November 23, 2016 at 08:56

Africa should invest in itself

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africaconstruction

Imagine you receive the news tomorrow that an unknown, distant family member has passed on and left you a bequest of a million dollars. What to do? Spend it immediately on luxury consumption – a round-the-world trip, perhaps – or invest it offshore and live off the returns, thereby smoothing your consumption and protecting the wealth for your own and your children’s futures? There is another option, though: immediate investment in yourself, say by enrolling at Harvard for an MBA. This way you not only boost your personal future income, but more educated parents tend to have more educated (and healthier and connected) children, thus boosting the prospects of future generations.

This third option, in a nutshell, is what three new papers in the Journal of African Economies suggest for developing countries that have jumped on the Sovereign Wealth Fund-bandwagon. Sovereign wealth funds (or SWFs) are state-owned investment funds designed to preserve the high returns from non-renewable resources, like oil, for future generations. A quarter of the world’s economies still depend on non-renewable resources, and more than half of them now have some type of SWF, including many recently established funds in Africa: consider, for example, Ghana (2011), Angola (2012), Nigeria (2012) and Senegal (2012). Others, like Kenya, Tanzania and Mozambique, are finalising SWF policies. And these funds matter: Sovereign Wealth Funds are a quarter of Algeria’s GDP, 40% of Botswana’s GDP and over 100% of Libya’s GDP.

There is good reason for the turn to this type of investment fund. SWF have many good properties, as the experience of Norway since 1990 have shown. It converts temporary resource revenue into a permanent investment income. Best to keep it offshore, too, so as to avoid domestic inflation, real exchange rate appreciation and the contraction of other traded sectors (also known as Dutch disease). And why invest locally when all profitable investment opportunities would presumably have been financed already at the world interest rate if the capital account is open? For these theoretical reasons, and because of the practical successes of SWF across the world – Norway, Chile, Saudi Arabia – many African countries followed suit.

But the authors of the three Journal of African Economies papers question this logic. They argue that many African countries do not have open capital accounts, meaning that there are still many profitable opportunities to invest within Africa. Why then send precious investment funds abroad when the highest returns can be reaped locally? To return to our earlier metaphor, why invest your long-lost family member’s bequest in stocks on the JSE, when you don’t even have a high school education yet. Invest in yourself first!

In Africa, the focus should be on infrastructure. One set of authors, Rabah Arezki and Amadou Sy, argue for three stages of financing infrastructure with the help of SWFs: First, involve development banks, who are often more informed about viable investment projects, in the first phase of large projects that are often the riskiest. Second, offload more mature projects to arms-length institutional investors like SWFs. Third, develop an African bond market to facilitate this offloading.

The maintenance of infrastructure in Africa is of particular concern, and SWFs can play a role here. Arezki and Sy calculate that at least one-third of Africa’s investment needs are in maintenance, and suggest bundling construction and maintenance services in private-public partnerships as one way to overcome this (by making sure builders have an incentive to minimise maintenance costs).

South Africa does not have a SWF, although the idea of a supertax on mining profits has been mooted before. If we did decide to go this route, as many of our neighbours seem to do, the question becomes: who gets to choose how the funds are spent? Anthony Venables and Samuel Wills, another set of authors, argue that it should be done through the usual budgetary process; in South Africa’s case, that will be through Treasury. Another author, Joe Amoako-Tuffour, argues instead for a more independent SWF that take direct positions in investments. Whatever strategy is followed, it is important to remember an additional reason for Sovereign Wealth Funds: to minimise the misuse of resource rents by politicians.

There is no better example of this than the second smallest nation in the world: the Pacific island of Nauru with a population of 10000. In their paper, Samuel Wills, Lemma Senbet and Witness Simbanegavi note how the island, made almost entirely of phosphate, was the richest country in the world in the 1960s. Two-thirds of the phosphate revenues were invested in a Trust, which peaked at $100 000 per person. In 2004, after some questionable investment decisions that included a cruise ship that never left port and a Lamborghini for the police chief (to drive on an island of 21km2), the fund had only $3000 per person left.

The lesson is that we do not live in a world of benevolent dictators. Politicians make bad decisions often, and state-owned investment fund should be structured to avoid their misuse. But going to the extreme and parking all resource returns offshore is also not the answer for many African countries. Investing in local infrastructure and its maintenance may provide far higher returns for future generations – if the possibility of misuse can be curtailed.

*An edited version of this first appeared in Finweek magazine of 8 September.

Written by Johan Fourie

October 4, 2016 at 10:20

How FinTech must disrupt to be effective

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fintech

Although few would dispute that a strong financial industry is necessary for a thriving economy, the growth in finance over the last three decades, as a 2015 paper by Thomas Philippon in the American Economic Review shows, has not contributed to more efficient capital allocation. The cost of financial services – or more technically: the unit cost of financial intermediation – has remained roughly around 2% for the past 130 years in the US. This is not much different for other countries. Financial innovation has not benefited consumers in terms of lower costs as innovations in other industries have done.

Why this happens is not a theoretical puzzle. Innovation in finance is often geared towards rent-seeking and business stealing by incumbents rather than radical disruptions from new entrants. The problem is that such innovation does not improve the overall efficiency of the system; it results in private returns to incumbents but with low or no social returns. Although this is true for most industries, the ease of entry and competition in most industries make this less of a concern.

Finance, though, is characterised by high barriers to entry. The trend, at least since the 1990s, has been to consolidate further. The number of US banks and banking organisations fell, for example, by almost 30% between 1988 and 1997.

The South African banking sector followed roughly the same trajectory, with one exception: Capitec. Using improvements in information technology, Capitec has managed to reduce fees which have reshaped the South African banking landscape. But much of finance still remains expensive. Despite the new entrant, South African banks, like their US counterparts, generate large spreads on deposits. As Philippon argues in a recent NBER working paper, ‘finance could and should be much cheaper. In that respect, the puzzle is not that FinTech is happening now. The puzzle is why it did not happen earlier.’

That is why FinTech, or financial technology, is all the rage. The hope is that financial technology – including cryptocurrencies and the blockchain, new digital advisory and trading systems, artificial intelligence and machine learning, peer-to-peer lending, equity crowdfunding and mobile payment systems, to name a few – will result in innovation where the social returns surpass private returns. In other words, FinTech must disrupt to be effective. This sentiment is echoed in a wonderful new book, Money Changes Everything: How Finance Made Civilization Possible by William Goetzmann: ‘While finance can solve great problems, it also can threaten the status quo. It changes who turns to whom in an emergency. It reallocates wealth; it creates the potential for social mobility and social disruption.’

In July, Ronald Khan of BlackRock investment management firm gave the biennial Thys Visser Memorial Lecture at Stellenbosch University. Over three nights he delved into the details of investment history, theory and its future outlook. He explained how his firm is already using textual analysis and machine learning techniques – Big Data analysis – to improve their returns on global stock markets, and the impact this will have on the active management industry. I was surprised that not once did he mention that these innovations will lead to lower costs for consumers, but that the main purpose was to maintain the high returns (and cost structure) of investment firms.

This type of FinTech will not disrupt the industry, and thus won’t have the large social returns that creative destruction promises. It will most likely only reinforce the position of the incumbent. What is necessary, then, is to encourage start-ups to enter and compete with technologies that can disrupt. Here, according to Philippon, financial regulation can help. He emphasises three challenges that regulation can help address.

First, regulation can help FinTech firms enter a more level playing field. This is complex, however, as some parts of the financial system, like custody and securities settlement, are inherently concentrated. For example, blockchain technology can improve the efficiency of the market, but it could also restrict entry which will see the incumbent firm increase its rents.

Second, regulation must be forward looking. Regulators must identify the basic features or principles of what the FinTech industry must look like within a decade or two, and implement the appropriate regulations when the industry is still small. It will be difficult to regulate once the industry is already established.

Third, FinTech will require additional regulations to protect consumers. One example which Philippon use is the use of robot advisers for portfolio management. The legal challenge here is that no robot will provide fail-safe ‘advice’, but it is highly likely that these robots will be better than their human equivalents.

Just how FinTech will disrupt the South African finance industry is anyone’s guess. But as long as the incumbents develop their own products (or continue to buy young start-ups), don’t expect consumers to benefit soon. If consumers are to benefit, regulators must find a way to make entry and competition a reality in an increasingly complex and technologically advanced industry.

*An edited version of this first appeared in Finweek magazine of 25 August.

Written by Johan Fourie

September 20, 2016 at 06:10

South Africa’s long walk to economic freedom after apartheid

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Towering above  his successor: How long before Nelson Mandela's long walk to economic freedom will end?

Towering above his successor: How long before Nelson Mandela’s long walk to economic freedom will end?

South Africa’s economy is in trouble. In June, StatsSA announced that the South Africa’s gross domestic product had fallen 1.2% in the first quarter of 2016. We are on the verge of a recession, hanging on by our fingernails. Weak and weakening capacity within national government to enact the necessary economic reforms stipulated in its own policy programme (the excellent National Development Plan) is largely to blame. And it is becoming increasingly apparent that the weakening capacity is the result of appointments based more on political affiliation than competency.

Global events have contributed to the malaise. The self-inflicted Brexit wound will hurt for a long time, and may even leave a permanent scar. Austerity measures implemented in the post-Great Recession era may have reduced government debt somewhat but had the political consequences of the rise of nationalists and fascists. As an older generation of political economists would have known but many modern-day macroeconomists may have ignored in their models, economics doesn’t happen in a political vacuum. England may have been first, but right-wing groups across Europe will only be encouraged by the UK’s ‘independence’. It wasn’t only austerity, though. Demographics played its part. Again, much was said about the economics of an ageing population, but few predicted that it would have political consequences too. Old people voted for Brexit; young people, who will suffer its consequences for longer, wanted to Remain.

It is in this context that I recently wrote a short paper on the economic history of South Africa since apartheid, and the road ahead. The paper is now available as a working paper. I divide the post-apartheid in two: the first 14 years of Nelson Mandela and Thabo Mbeki, and the next eight following the Great Recession and Jacob Zuma. While there is much to commend about the first period when the country reached GDP growth rates above 5%, the sad reality is that the last 8 have been dismal. A bloating state salary burden, ideological conflict within the ANC, and state capture have pulled the South African economy – and the poor’s prospects to enjoy social mobility – down.

I then outline a tentative plan for what to do next. The utopian dreams of the NDP are now worth little more than the paper they are written on. What is needed is a list of priorities of ‘low-hanging fruit’, policies that are affordable, politically acceptable and would support those most in need. I outline five such policies, beginning with family planning, early childhood development, education (schools and universities), and affordable and widespread broadband. Much more is needed, of course, to take us back to the optimism of the mid-2000s. But even with just a start in the right direction, I argue, we can benefit from the opportunities that a rising Africa and technological innovation have to offer.

How technology will shape Africa’s future

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Renewables

Much has been said about the economic future of sub-Saharan Africa. One camp is largely optimistic, claiming that the relatively high economic growth rates of the last decade (even during and after a global financial crisis) is evidence of ‘Africa rising’, a continent slowly emerging from three decades of slumber. Another camp is less optimistic, claiming that this growth was limited to natural resource industries benefiting from rapid Chinese growth. (To put Chinese growth in perspective: even though China grew at ‘only’ 6.9% in 2015, it added $714 billion to its GDP. In contrast, South Africa’s GDP in 2014 was $350 billion. In other words, China added more than two South Africas to the global economy in 2015 alone.)

Both camps, of course, have elements of the truth. Many African countries, some of them very poor, have seen high economic growth rates over the past few years, growth that was and remain essential in lifting many thousands of people out of poverty. But it is also true that much of this growth has been limited to resource sectors that do not have the same spill-overs into other parts of the economy that manufacturing, for example, has. This raises doubts about its sustainability.

In April, the United Nations Economic Commission for Africa published a new report that clearly sides with the more cautious view. African countries are stuck in low-productivity, primary sector exports; the fall in the price of commodities, like oil in the past 18 months, has swelled budget deficits in places like Sudan, Nigeria and Angola. It is likely to have political consequences too.

To combat such vulnerability, the authors advocate ‘smart’ industrial policies to ‘upgrade’ the commodity sectors and promote the ‘development of higher-productivity sectors, especially manufacturing but also some high-end services’. They acknowledge that there are two trends working against such industrial policy action. First, a shrinkage of the ‘policy space’ due to the establishment of the WTO and the proliferation of bilateral and regional trade agreements. Simply put, countries have less scope for raising tariffs or other creative industrial measures than before. Second, the strengthening of global value chains makes ‘nationalistic’ industrial policy less effective. But this does not deter them: ‘There are still many industrial policy measures that can be used. Moreover, if anything, these changes have made it even more necessary for developing country industrial policy-makers to be ‘smart’ about devising development strategy and designing industrial policy measures.’

So what are these so-called ‘smart’ industrial policies? Unfortunately, after spending 156 pages explaining the need for ‘smart’ policies, the authors give us only one page of very vague principles: policy-makers ‘need to identify the ‘right’ policies’; policy-makers ‘need to induce foreign firms to create linkages with the domestic economy’; and policy-makers ‘should pay attention to the possibility of upgrading not just through the development of capabilities to physically produce goods but also through the development of producer services, such as design, marketing, and branding’. So much for practical guidelines!

The authors have missed a golden opportunity to actually think more creatively about Africa’s economic future. Technology is changing Africa’s comparative advantage. Global manufacturing will become increasingly capital intensive as robotics and technologies like 3D-printing (not mentioned once in the report) advance. What we consider low-skilled labour-intensive manufacturing (shoe-making, for example) may, overnight, become high-skilled, capital-intensive (once shoes can be printed), with production switching from countries like Vietnam and Bangladesh back to the developed world. Cheap labour will become less of an advantage as robotics becomes more affordable.

An additional factor that makes manufacturing in Africa so expensive is trade costs. We have few large cities on the coasts with easily accessible port facilities. How can landlocked Zambia compete with similar-sized Cambodia? Zambia has a railroad that goes through two other countries before it reaches the eastern coast of Africa; Cambodia’s capital has a river port that can receive 8000-ton ships. And statistics confirm this: the World Bank calculates that the cost to import a 20-foot container to Cambodia is $930. It is $7060 in Zambia. It is difficult to see how any ‘smart’ industrial policy can mitigate these massive cost differences.

Does this mean Africa is doomed to remain a primary good exporter? Not necessarily. Mobile technology is revolutionising the way Africans do business. It is a technology that negates Africa’s rugged terrain, leapfrogging the need for expensive fixed-line infrastructure. If it can receive the necessary investment, broadband and wireless technologies will do the same. This will allow Africans to provide services to a world that would have been impossible to reach only a decade earlier.

Can services alone propel Africa into the industrialised world? Apart from a few small economies – Singapore and Luxembourg – there is little past evidence that it can. A pessimist may thus proclaim little hope for the continent; an optimist may instead remember that technological innovation has a way to revolutionise existing industries. It is already happening: consider the much higher returns of Ugandan farmers after mobile technology allowed them access to real-time market prices for their goods. Or how Airbnb has empowered middle-income South Africans with a spare room to benefit from the country’s thriving tourism industry. Or how renewable technologies – also completely neglected in the UN report – will affect African countries’ power generation and distribution capabilities, supplanting the need for coal and other minerals.

What is clear is that the image of factories with thousands of low-skilled labourers working 8 to 5 jobs belongs to a previous century. To imagine that industrial policy can somehow transplant that image to Africa in the twenty-first century is fictional. The smartest industrial policy we can hope for is instead a belief that Africans have the agency to shape their own destiny, as long as they have access to the hard (fast and affordable internet and reliable electricity) and soft (IT colleges and programming degrees) infrastructure that will allow them to benefit from the technologies of the future.

*An edited version of this first appeared in Finweek magazine of 2 June.

Three hundred years of firm myopia

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voc-rede-van-texel_w1190_h734_1

Three centuries ago, on 24 June 1716, a very important letter arrived from Amsterdam in Cape Town; a letter that, according to John X Merriman two centuries later, would change the future of what would become South Africa. Written by the Board of the Dutch East India Company (the VOC), the letter requested the Council of Policy in Cape Town to reflect on the economic needs of the still small and fragile colonial settlement. In particular, the Board wanted to know whether the Council of Policy would recommend more European immigration to the Cape or whether an increase in slave arrivals would be preferred.

A year later, seven members of the Council responded. Six members recommended that slavery was the better choice. The reason was simple: slaves could supply cheaper labour than European wage labourers. And because all agricultural output had to be sold to the Company stores in Cape Town, cheap labour meant that the Company could pay farmers less for their produce, allowing the Company to make a very decent return when reselling the produce to passing ships.

One member of the Council of Policy, however, disagreed. Dominique Marius Pasques de Chavonnes instead made a case for encouraging European immigrants. Though slavery would be more profitable in the short run, he argued that the settlement of free people would be better for the economy, and thus for the Company, in the long run.  Free men have an incentive to invent while slaves do not, he said, pre-empting what Adam Smith would write in his Wealth of Nations half a century later. And invention is the root of productivity and prosperity.

It’s no surprise that the shareholders in Amsterdam chose the advice of the six men that appealed to their immediate interests. After 1717, European immigration slowed considerably, and slave arrivals from modern-day Malaysia, Indonesia, India, Madagascar and Mozambique increased. The Cape became a slave economy, with high levels of inequality, an inequality that has still not abated. In 1776, Adam Smith would write in his Wealth of Nations that ‘of all the expedients that can well be contrived to stunt the natural growth of a new colony, that of an exclusive company is undoubtedly the most effectual’. DM Pasques de Chavonnes and Adam Smith had recognized the myopia of firms.

Although it has a long history, such short-termism is rising. The trend towards financialisation (higher levels of stock liquidity), diversification and hostile takeovers of the 1980s increased the separation between firm ownership and control. Managers’ incentives to maximise their own utility were no longer aligned with maximising the utility of the firm. To realign these incentives, managers were increasingly compensated with stock options. The result has been a sole focus on higher share prices to the detriment of the long-term sustainability and growth of the firm, for example, by investing less in research and development.

There is now evidence that clearly shows the negative impact of financialisation on innovation. A 2014 paper in the Journal of Finance use exogenous variation in liquidity generated from financial regulation and finds that an increase in liquidity causes a reduction in future innovation. The authors propose two possible reasons: a higher likelihood of hostile takeovers and more institutional investors, like pension funds, who rely on less information and monitoring. The consequences are that short-term boosts in shareholder value come at the expense of the long-term profitability of the firm.

So what can be done to prevent managers from succumbing to these short-term pressures? One solution is to offer managers contractual protection like severance pay agreements. This seems to have a positive impact on innovation; Xia Chen and co-authors of a 2015 paper in The Accounting Review, find that firms with CEO contractual protection are less likely to cut R&D expenditure to avoid earnings decreases. They are also less likely to engage in real earnings management. More detailed analysis reveals that the larger the duration and monetary strength of the agreement, the less likely the CEO is likely to cut R&D expenditure. The effect is also larger for firms in more homogeneous industries, and for firms with higher transient institutional ownership.

Hedge funds and their supporters are eager to point out that not all short-termism is bad and that the evidence on various firm outcomes is mixed. That may be true, but what the recent evidence begins to suggest is that at least one factor that we associate with sustainable firms – innovation – seems to suffer when managers’ priorities shift from the future to the present. Managers that focus too much on short-term gains may, much like the VOC shareholders three-hundred years ago, shift a firm down a path from which it is unlikely to return.

*An edited version of this first appeared in Finweek magazine of 17 March.