What is fair?
It’s a serious question for policy makers whose decisions affect the economic and environmental well-being of current constituents and generations to come.
A new study by Thomas Gilbert and Christopher Hrdlicka, assistant professors of finance at the University of Washington Foster School of Business, models a long-term form of fairness that takes into account the risk involved in managing shared assets—public pension plans, endowments and natural resources—equitably across generations.
Gilbert and Hrdlicka find that fairness across time and varying states of economic health requires the reduction of both investment risk and benefit payouts.
“If we value fairness across generations and economic states, we should expect our policy makers to take fewer risks in the investment of our shared assets, and to pay out less to us today,” says Gilbert. “At its root, fairness means less and less tolerance of any action that would put future generations at risk of suffering negative shocks in any state of the world.”
Shocks such as a global financial crisis that imposed austerity measures across the European welfare state, demographic shifts that threaten the solvency of the United States Social Security system, or a destructively changing climate that is widely credited to human pollution.
Fairness has been a component of economics since Adam Smith wrote “The Theory of Moral Sentiments.”
But the academic notion of fairness has traditionally focused on expectations, and abstracted away from uncertainty, according to Gilbert.
The same could be said of policy makers, who often profess fairness while largely ignoring risk and the long-term ramifications of their decision-making. So, for example, the leaders of a university might well consider the “fair” investment policy of the university’s endowment to be the one that promises the highest expected return.
“It may actually be seen as unfair to choose a no-risk or low-risk investment when you could do much better,” Gilbert says.
Anticipating a high return might even allow those leaders to increase the payout (grants and scholarships) to current beneficiaries (students)—without depriving future beneficiaries of equal or greater expected payout.
Expected returns are average returns over time. And timing matters. Higher expected returns come with greater risk. Greater risk means higher volatility—the inevitable ups and downs on the road to that generous expected return. But what happens to beneficiaries when that risky investment turns down, even temporarily? Is it fair to tell that unlucky generation of students that they will receive less, or even nothing at all?
A manager demonstrating what the authors call “stochastic” fairness would refuse to tolerate such inequality across time and economic states.
Safeguarding the public trust
Gilbert and Hrdlicka’s model addresses a fundamental dilemma of public asset management: how to please beneficiaries today while ensuring equity far into the future.
The model demonstrates that stochastically fair caretakers of university and non-profit endowments, sovereign wealth funds, and public pension plans would invest in lower-risk assets and reduce payouts from these shared assets, now and forever. These actions, Gilbert says, would ensure that we do not find ourselves in situations such as the economic quandaries faced by cities like Detroit and much of the EU, for instance.
“Policy makers in Europe have had to tell their people that, after 60 years of increasing benefits, they are the first generation that is going to get lower benefits than their parents,” he explains. “A stochastically fair policy maker would be unwilling to tolerate this and would have made decisions earlier that would have prevented this.”
A perhaps more complex application of the model addresses the management of natural resource depletion. Specifically, our environment which is becoming less habitable due—most scientists believe—to excessive emissions of carbon dioxide into the atmosphere. We have the choice of curtailing pollution today or continuing to pollute while investing in technologies that might fix the anticipated problems associated with global climate change. But those massive investments have a risk of failure.
The findings of Gilbert and Hrdlicka suggest that the stochastically fair way to address the coming crisis would be to reduce emissions now and for the indefinite future. This solution would avert the risky cost of developing speculative technologies and spread the economic sacrifice equally across all generations, but it’s the safest way to ensure that no future generation inherits an uninhabitable environment.
If we value the stochastic notion of fairness, that is.
“We are not making any normative statements about what policies should be put in place. We are not making a case that this is necessarily the right way to view the world,” Gilbert says. “But if we as a society value the notion of fairness over the long term and if we want our policy makers to make decisions accordingly, then we have written the complete model of how to think about it.”
“Fairness and Risk-Sharing Across Generations” is the work of Thomas Gilbert and Christopher Hrdlicka of the Foster School of Business.