The Seventh Generation Paradox


Published on

Scott Herriott, Ph.D.
Co-Chair of the Department of Business Administration Professor of Management
Dean of the College of Arts and Sciences
Expansion Council Chair
B.A. summa cum laude, Dartmouth College
M.A., Ph.D., Stanford University

Professor Herriott’s research interests include issues of cooperative strategy in business policy. Specific projects include studies of electric utility power pools, cooperative advertising, risk pooling, partial acquisitions, information channels in markets, and the implications of Maharishi Vedic Science for theories of motivation, job design, and management decisions.

Published in: Automotive, Technology, Business
  • Be the first to comment

  • Be the first to like this

The Seventh Generation Paradox

  1. 1. 2nd Annual Deep Green Business Symposium Maharishi University of Management July 5-6, 2013
  2. 2. The 7th Generation Paradox Scott R. Herriott, Ph.D.
  3. 3. Wholeness of the Lesson The Great Law of the Iroquois instructed council members to make decisions with an eye to their consequences 7 generations into the future. The theory of finance has at its heart a consideration of the trade-offs between the present and the future. What kind of decision rule does the 7th Generation principle call for in financial terms, and what does that imply as the characteristics of a sustainable economy?
  4. 4. The Duration of a Discount Rate In the theory of discounted cash flow analysis, the discount rate defines the trade-off between money now and money in the future. A high discount rate “discounts” the value of events happening in the future. So a low discount rate suggests a longer-term perspective in decision making.
  5. 5. The Duration of a Discount Rate We formalize that concept as the duration of a discount rate, analogous to the duration of a bond or other cash flow, which is the PV-weighted average of the times at which cash is received. The discount factor applied to any cash at time T in the future is e-rT. Define d(r) =
  6. 6. The Duration of a Discount Rate This simplifies to Which calculates to a remarkably simple formula d(r) = 1/r This is the “average” time taken into consideration when using the discount rate r.
  7. 7. The Duration of a Discount Rate r Duration 0.5% 200 y 1.0% 100 y 2.0% 50 y 3.0% 33 y 4.0% 25 y 6.0% 17 y 8.0% 13 y 10.0% 10 y So we would have to use a discount rate of 0.5% to look out 200 years, on average.
  8. 8. Sustainable Growth The financial model for sustainable growth is given by the Gordon formula for the price of a company’s share of stock, assuming that dividends start next year at D1 ($) and then grows at a rate of “g” (percent per year) for all eternity. If “r” is the discount rate applied to the cash flow for the purpose of valuation,
  9. 9. Sustainable Growth If the growth rate equals the discount rate (g = r), then this model predicts an infinite price for the stock of the company. If g>r, the price is nonsense (negative). Why? Because if a company could reliably grow eternally at a rate faster than its cost of capital (r), it would immediately attract so much capital that it would absorb the entire economy. Therefore the sustainable growth rate must be less than the company’s cost of capital (discount rate).
  10. 10. The 7th Generation Paradox Therein lies the paradox. For sustainability, a long-term view is needed, which means a very low interest rate (discount rate). Yet sustainable growth must be at a rate lower that the discount rate. A sustainable economy is a stagnant economy.
  11. 11. The 7th Generation Paradox This is troubling, because we would like to think that a sustainable economy is an enlightened economy— functioning in alliance with natural law, exhibiting the effulgent creativity of nature. Is there a way off the dilemma of sustainability versus creativity?
  12. 12. Attempts to Resolve the Paradox 1. Which interest rate (discount rate)? 2. Shorten the time horizon? 3. What about risk? 4. Creativity in a sustainable knowledge economy
  13. 13. Which Interest Rate? We are dealing with a real (inflation- adjusted) discount rate, not the nominal rate that governments can manipulate through the money supply. US nominal 10-year T-bond is 2.5% US 10-year forecast inflation is 2.2% So the real T-bond rate is 0.3%.
  14. 14. Which Interest Rate? US nominal 30-year T-bond is 3.5% US 30-year forecast inflation?? 2.0-2.5% So the real 30-year T-bond rate is 1.0- 1.5%. That has a duration of 67-100 years. Should we settle for 1-2 generations? “Don’t try to value farther than you can
  15. 15. Risk-Bearing Rates US long-term real risk-free rate is about 1.5% The market (S&P 500) risk premium is historically about 7-8%. So the real, risk-bearing discount rate is about 8-9%. That has a duration of 11-12 years, violating the 7th Generation Principle quite severely.
  16. 16. Risk-Bearing Rates How to Bring Down the Risk Premium? Reduce the volatility of the market (coherence in collective consciousness through the practice of the Transcendental Meditation program) Reduce investors’ fear of loss (enlightened awareness, “inner happiness,” less dependent on possessions for a sense of stability in life)
  17. 17. Creativity in a Sustainable Knowledge Economy Apple Computer: From Garage to Fortune 500, but with a substantial infusion of capital. Facebook: Harvard student to billionaire in less than 4 years. The growth rate for wealth in an economy is not the same as the return on capital to investors.
  18. 18. Creativity in a Sustainable Knowledge Economy Returns to Creativity Entrepreneurship. Start your own company. Intrapreneurship. Contract with your employer to “carve out” your ideas and pay a percentage of revenues or profits. Employee Stock Option Plans. For all.
  19. 19. Creativity in a Sustainable Knowledge Economy Returns to Creativity These forms of return to creativity, which respect individuals rights to their intellectual property, are not addressed in current metrics for sustainability, such as the GRI or SA8000, nor even the Global 100 nor B-Corp. Rights to created property should be a component of sustainability metrics.
  20. 20. Summary The paradox is real, at least now. We need low discount rates to direct the flow of capital with a long-term vision. The return to capital is an upper bound for discount rates. Enlightened awareness will lower rates. Proper treatment of intellectual property will help, but how to direct R&D to the long-term?