The Market Mind Hypothesis, page 8
In practice, the “spirit” of an action counts, as well as the action itself, and is often vastly more important. The relation of mutuality must be recognized. The man who expects to influence others must work more through their feelings and his own than through explicit physical stimulus and response. Frank Knight Economic Psychology and the Value Problem (1925)
In 2020 China, Russia, and Cuba won seats at the United Nations Human Rights Council (UNHRC). Considering the atrocious track records of their governments in that department this was heavily criticised, particularly by organisations like Human Rights Watch.
Why should investors care, especially those involved in ESG investing? Because human rights squarely belong to the ‘Social’ principle in ESG and are central to any broader human interest, including plain survival. To explain, ESG investing involves selecting securities that comply with Environmental, Social, and Governance criteria (for simplicity we include the related fields of responsible, sustainable and impact investing). The FT reports that Assets-Under-Management (AUM) of ESG funds amounted to almost US$ 3trillion at the end of 2021. In a best-case scenario PwC anticipates ESG funds could outnumber conventional funds by 2025. NN Investment Partners (now part of Goldman Sachs) estimates that the green bond market will grow to €2tn by 2023. Many hope that ESG investing, by nudging companies and governments, can help improve the world’s ESG conditions overall. I do too, but with caveats, most prominently that ESG will fail if mechanical economics prevails.
ESG is mainly about negative externalities: costs or damages caused by an economic agent that are not (financially) paid by that agent. Instead, the costs are suffered, in various forms, by other agents and society generally. There is a growing awareness that this needs correction, as in ‘the polluter pays’. From its mechanical perspective, mainstream economics likes to judge externalities (as the term suggests) as ‘external’ and separate from the core activities and purposes of agents. Within the broader theme of this book, we should instead see ESG as part of the 4E framework of the market mind: embodied, embedded, enacted, and extended in the environmental, social and governance aspects of the global society and the wider world. Not all externalities can be priced which prevents creating securities to help make markets more complete in covering these risks. Instead, economists like Kenneth Arrow and Amartya Sen have shown, more generally, that incomplete markets need individual and social values (e.g. ethical and moral norms), to fill their gaps. Knight is similarly clear: “the essential point is that economics is a branch of aesthetics and ethics to a larger extent than of mechanics” (1925a, p. 399). Ethics in commerce and markets has a long history, going back as far as Aristotle. I will return to this thought.
Regarding caveats, first, we cannot escape the dualist (mind~matter) complications in our economic system which can lead to the perceived separation I mentioned. As this book will regularly point out, to better understand these we have to be explicit about the physical and/or mental properties (assumptions) of the economic problems we confront, as well as those of any solutions. While many of the problems in the Environmental domain are largely physical in nature (CO2 emissions, microplastics), there are numerous mental, especially moral issues (see Gardiner, 200624). And while many of the problems in the Social domain are mental in nature, relating to fairness and/or justice, there are also physical issues, such as working and safety conditions. This duality consequently leads to conflicts (for instance, physically we need gas as a less polluting energy source, but mentally it doesn’t feel right to buy it from corrupt or totalitarian regimes). It also means that certain ESG problems are better tackled from within the physical economy, instead of the mental market.
Second, the timing and duration of aspirations and needs plays a role beyond economics’ traditional ‘time preferences’. The physical need for food or energy may be more urgent for one, whereas the need for safety or mental health may be more urgent for another. (See also my earlier comments regarding Maslow’s hierarchy of needs.) Moreover, it is difficult to foresee whether today’s polluter could be tomorrow’s clean-energy pioneer.
Third, we need to distinguish between the (individual) personal and the (collective) social dimension in markets. This reaches back to the teachings of Adam Smith. People often think of Smith’s invisible hand, organising markets, purely in terms of competition and selfishness, as captured in Smith’s legendary words in WN: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest”. What is generally overlooked is its contextualisation, made by Smith a few sentences earlier: “In civilised society man is at all times in need of the cooperation and assistance of great multitudes”. What’s more, in TMS Smith states that “to restrain our selfish, and to indulge our benevolent affections, constitutes the perfection of human nature; and can alone produce among mankind that harmony of sentiments and passions in which consists their whole grace and propriety” (p. 31). In general, Smith offers a nuanced view of economic man, considering both his personal and social aspects, which can help us with ESG issues.
In that regard, ESG investing offers interesting cognitive challenges to the ideal of homo economicus. In principle, it aligns non-monetary values of assets to personal or social values. This gets at the heart of some of the critique of mechanical economics: “there can be no such thing as a ‘value-free’ social science. Social scientists who consider the question of values ‘nonscientific’ and think they are avoiding it are attempting the impossible … [Economics tries] to determine what is valuable at a given time by studying the relative exchange values of goods and services. Economics is therefore the most clearly value-dependent and normative among the social sciences” (Capra, 1982, p. 190).
Exploring the social aspects further, the challenges also concern the intersubjective. On the very first page of TMS, for example, Smith emphasises sympathy which we nowadays understand as empathy. ESG appeals to one’s conscience which concerns Smith’s “man within the breast” (TMS; please ignore Smith’s gender label). The “man within the breast” is the representative within you of Smith’s “impartial spectator”. In turn, the impartial spectator is an idealised, morally supreme being, a global citizen representing the best of humanity. Smith’s moral arguments are not religious, nor relativistic, but rather based on aesthetic naturalism (Fudge, 2009): humans are naturally inclined to (similarly) judge certain actions as despicable and others as agreeable. Underlying this more broadly Smith, like others, reasonably assumed that society can only survive if humanity is ‘good’, in the sense that humans care about other humans, including future generations. Still, this is not a given and we have to work at it. Suggesting a real-life thought experiment, Smith asks each of us how the impartial spectator would judge a situation based on the inner judgement (“inner sentiment”) of your man within the breast: how does that situation make you truly feel? In other words, Smith asks, if only for that situation and for a moment, to bring out the best of humanity in you.25
We can apply this to our ESG case, without becoming sententious. For instance, how do you (again, thinking of yourself as representing ‘the best of humanity’) feel about your ESG-fund holding oil stocks?26 Or, suffering a case of green washing, seeing your green bond turning brown upon closer inspection? Conscience and self-reflection are human traits, yet difficult to quantify. Involving ethics and morality, ESG investing also epitomises normative economics, reminding us of David Hume’s warning that the rules of morality are not the conclusions of our reason. Is it commendable that your ESG-fund invests in a bank of which the stock price has risen because its fraudulent actions only received a slap on the wrist by revolving-door regulators (in turn, due to the larger externality of regulatory capture)?
Mainstream critics have argued that ESG distorts the function of economics and markets. Some argue that companies only survive by, and should thus exclusively focus on, serving their customers well. Others argue, in the tradition of Friedman, that they should serve shareholders only. In both cases, the argument is that self-interest trumps all. But what if, perhaps unbeknown to those customers or shareholders, their children will suffer the companies’ externalities? Or, vice versa, what if those companies suffer the externalities (say, pollution) caused by their customers or shareholders? Besides my earlier Smithian nuances, the arguments by criticasters reflect, again, the outdated reductionist aspect of the mechanical worldview that we can keep causes and effects neatly separated. Other perceived conflicts within ESG are similarly the result of flawed economic thinking. It should be replaced by the 4E-cognitive view of economic reality, as will become clear throughout this book. For example, on enactment in terms of Predictive Processing (see Subchapter 3.3), there should be a clear understanding of ESG criteria as inputs (i.e. as risk factors) for ex-ante perception (via our analytical models and screens) and ESG criteria as outputs for desired/resulting action (corporate behaviour).
Simply put, ESG deals with externalities that individuals cannot solve. In many cases markets—seen as collaborative effort, not just self-serving—can help. There are a growing number of examples where markets can start pricing solutions to externalities (like CO2 emission rights). In other cases morals need to fill the gap and ESG allows an individual “man within the breast” to collaborate with others to attempt representing the impartial spectator. This makes ESG complementary. It is less about quantity, and more about quality; less about the letter, and more about its spirit.
Then again, I’m old-fashioned and my ESG views are, shall I say, traditional. Back in 1998 I premiered my thoughts in a supportive article on sustainable investing (a first by a mainstream bank in the Netherlands). It was published in a Dutch newspaper and later included in the book People, planet, profit (Van Poll, 1999). In 2006 I also wrote a report—one of the first from the Scottish buy-side—on the investment implications of climate change.
My thinking, however, was shaped even earlier, in part by trailblazers like Calvert Investments in the US and the Dutch ASN and Triodos banks. More importantly, as an answer-seeking MBA-student at the University of Groningen I had the pleasure and privilege to intern in 1990 with the late Willis Harman. Harman was professor emeritus at Stanford University, a cognitive science pioneer, and one of the original futurists. Based on research that started in the 1970s, his 1988 book, Global Mind Change, presciently identified four major challenges the world would increasingly face:
Environmental sustainability (climate change, biodiversity-reduction, deforestation, pollution).
Inequality (the equity and justice challenge as he called it).
Marginalisation (non-inclusion, populism versus globalisation; think also Raghuram Rajan’s The Third Pillar, 2019).
Worldview challenge (inaccurate economic thinking).
The first three are now generally recognised as the main challenges within ESG, which Harman considered all part of Governance in that it is the responsibility of corporations (as the dominant institutions in capitalist societies) to address. Crucially, however, the fourth challenge plays a key role because it frames and thus determines how we economically deal with the other challenges. As Harman points out, the fact that the current economic paradigm led to, “the successes in achieving the goals of the existing order” shows “how profound the required changes may be”. Particularly now that unintended consequences of this paradigm threaten to overwhelm its successes.
The sad truth is that as long as we maintain a mechanical economic worldview we cannot properly deal with the other challenges. As will be discussed, mechanical economics has a fatal blind spot namely consciousness (and its related issues, like mental causation). It ignores the consciousness that animates ESG’s conscience, feelings, and ethics in general, and that raises the awareness of emerging ESG-risks in particular.
Consequently, mechanical approaches don’t get ESG’s spirit. As applied to ESG, a mechanical worldview quantifies risk factors as rules to screen and filter securities. Bluntly, exposures to the environment, employees, and/or regulations are considered relatively risky. Simply avoiding such exposures is preferred over trying to improve those factors. Guess what happens to the resulting quantitative rankings of stocks? Companies that produce nothing physical (e.g. outsource pollution), have scarce human resources (e.g. outsourced employment), enjoy moats (e.g. exercise monopoly power) and avoid transparency (e.g. exploit offshore havens) rank best. Unsurprisingly, they include many tech stocks. These rankings also end up in ESG indices because they are often based on such mechanised approaches. Yet, that is hardly in the spirit of ESG.
By the way, that doesn’t mean such screening-favourites do not get criticised (what happened recently to Apple Inc regarding its compliance with demands by the Chinese authorities demonstrates this). The main ESG drive comes, in that regard, from responsible investment institutions seeing through such screens and actively challenging companies on their strategies and policies. Still, while commendable I suggest we should widen our scrutiny and include investment firms themselves to prevent hypocrisy. Hedge fund legend Sir Chris Hohn took a first swipe. Going forward, here is my challenge to (especially investment) firms who claim to be ESG champions: how consistently are you practising what you preach? For example, do you also do business in countries run by dictators who murder their political opponents (including journalists)? Or trade with lawless counterparties that trample on international laws? Or operate in countries that claim to protect the environment but do the opposite, like tolerating deforestation or sending their fleets into fragile waters? If so, can you please square this circle (without resorting to the trivial ‘every little helps’)? Returning to the issue of human rights a large global bank, for example, states on its website that: “We are striving to be at the forefront of ESG … [supporting] socially, responsible themes”. How consistent is that with its chairman stating to its CCP hosts, in 2022, that his and other global bankers are all “very pro-China” at a CCP sponsored financial forum in (oh irony) Hong Kong? Unfortunately, there are countless examples of these.
Coming back to the start of this note, the link between ESG and economics is historic. As far as morality and human rights are concerned, the link was firmly established with Smith’s TMS partnering with WN. Second, there is the horrific historic record of central (repressive) planning by totalitarian regimes which inevitably fails their people and their economies. For ESG to succeed, we need to buy into its spirit which—using cognitive (not politically charged libertarian) arguments—is about free minds being able to address externalities (in other words, to allocate their costs). ESG needs recognition of its moral underpinnings as well as (e.g. Smithian) approaches that incorporate human values. It doesn’t need wokeism for this (which seems to have hijacked some of ESG). It certainly doesn’t need algorithmic short-cuts. And if efforts would purely result in a growing number of compliance staff, it would clearly miss ESG’s spirit.
Finally, why focus in this note on the S in ESG? Because I believe that, largely due to mechanical economics, we particularly risk getting the S wrong, which is about (collective) humanity. And if we get the S wrong, resulting in growing human rights abuses, inequality, and so on, we will never get the broad commitment and support within society required to meet the wider ESG ambitions. So, unless we revise mechanical economics more broadly, including reversing its treatments, ESG investing will become meaningless. Then Benjamin Graham’s long-term weighing will indeed, one way or another, be done by a careless, bureaucratic machine.
This year (2023) marks the 75th anniversary of the Universal Declaration of Human Rights. Dedicated to all the human rights activists especially those working in countries with repressive regimes.
What makes the market so attractive for collective cognition research? First, the relationship between individual investors and Mr Market is unique because investing largely takes place anonymously. It means that, as an individual investor, you do not directly trade with me (another individual), nor any other person. You trade with Mr Market. That’s the only one you know. Well, kind of. You know him to be a composite investor, a collectivity. In fact, by investing you become part of the market, often joining a particular crowd, like bulls or bears. These crowds have meetings and also communicate via their terminals and computers, sharing their archetypal narratives of boom and bust. Importantly, as we know, people act differently in crowds. Crowd emotions are contagious and their moods affective. For researchers it means that as we observe the market’s mentality via price moves—including non-linear ones from derivatives—we cannot reduce it to individual mentality.27 Consequently, we do not know how individual decisions become aggregated in prices. For example, we lack insight into asymmetries in information and their impact. This makes the market unique: whereas we can identify the role and impact of individual behaviour in teams, riots and other manifestations of group behaviour, this is impossible in the market. Simple individualistic assumptions about heuristics, intentionality, rationality, as well as their aggregations, are seriously lacking.
Second, and referring to the practical challenge of bridging mind with matter, financial markets perform an economic meta-adaptation in that they solve a crucial problem for society: to allocate capital, in a reasonably efficient way, to investments which eventually find their way into physical assets, including the physical activity they produce, in the real economy. In the words of Bill Miller, legendary (ex-)fund manager of the Legg Mason Value Trust:
One of the things capital markets do is consider possible worlds. The level and direction of prices reflect the markets’ assessment of the probabilities of possible worlds becoming actual. There are advocates for many of these views. Investors consider the risks and rewards and allocate their money accordingly. (Zenios and Ziemba, 2007, p. 879)
