Mihir A. Desai said he had usually has two choices when giving a lecture — present a finely crafted jewel of an argument, or an overflowing garden that needs pruning.
Since it’s Chautauqua, “I have chosen the latter,” Desai said. “… I want to present something a little raw. That’s what you’re going to get today.”
At 10:45 a.m. Wednesday in the Amphitheater, Harvard Law Professor Desai critiqued the current state of financial markets in his lecture “The Era of Magical Thinking,” part of Chautauqua Lecture Series’ Week Five theme, “Innovation in Capitalism: How to Meet 21st-Century Challenges?”
At Harvard, Desai is also the Mizuho Financial Group Professor of Finance at Harvard Business School. His focus includes tax policy, international finance and corporate finance.
His research has been cited in publications including The Economist, BusinessWeek and The New York Times. He’s written for practitioners in the Harvard Business Review on how to reform the U.S. tax system.
Desai has testified in front of Congressional bodies, most recently with the Senate Finance Committee on corporate tax reform and inversions. He is currently a research associate in the National Bureau of Economic Research’s Public Economics and Corporate Finance Programs.
Desai began the lecture with an analogy that financial markets work as a system with lamps and mirrors. Mirrors are used to reflect economic reality. Lamps are used to show us the way forward.
“Lamps show us the future because that is what financial markets do,” Desai said. “They look into the future, try to figure it out and bring it back to the present. That’s why they’re beautiful and wonderful.”
However, he believes that financial markets aren’t in a positive state for multiple reasons, as they’ve abandoned the mirror and lamp system.
“They have become, I think, mechanisms for manufacturing wealth, extracting wealth and to some degree, redistributing wealth,” Desai said. “That’s not a mirror. That’s not a lamp. That is something completely different.”
This explains the title of the lecture and the concept of magical thinking, an idea where one’s actions don’t directly impact reality — in this case, the economy.
“It is the extrapolation of current conditions and deeply ahistorical, which is that we are on the cusp of a new moment that is unrivalled,” Desai said. “That is magical thinking. History doesn’t matter.”
The concept of magical thinking is detached from economic reality and doesn’t value traditional economics, according to Desai. It’s about growth of business over profit.
Desai presented a series of slides, showing a diagram displaying the complexities of American financial markets, which has complicated the flow of commerce. He proposed it should be simpler, as it was 150 years ago.
“Most of us had the privilege of working for ourselves,” Desai said. “You had a farm, you owned a farm and you ran the farm. You had a shop, owned the shop, ran the shop. What is the nature of modern capitalism? I have shares in Apple. Tim Cook doesn’t always take my calls.”
With these complications comes trust that companies will do the right thing for shareholders. Desai can’t be sure Tim Cook is telling the truth when meeting with shareholders. Modern capitalism in America has separated ownership and control. Desai owns; Cook controls.
“That’s why finance matters,” Desai said. “Capitalism relies on the allocation of capital, and that’s really complicated when there’s asymmetric information because you don’t know who is telling the truth.”
Financial markets have been dominated, and perhaps corrupted, by magical thinking, according to Desai.
To further his point, Desai displayed a Price-Earnings (PE) ratio chart showing a recent increase in valuation levels.
“Current valuation levels are extremely high and have been high for the last 10 years, 20 years, and are historically completely abnormal,” Desai said.
This preceded a period of low interest rates, which Desai credited to China’s rising influence. This gave way to cheap products, a remarkable change in the global economy and two decades of economic growth that Desai described as being “underwritten by remarkable fiscal irresponsibility.”
The past decade has seen a change and lull in the economy due to many stock investors looking for alternative means to the tradition.
“It’s crypto. It’s NFTs. It is meme stocks,” Desai said. “… It’s broader than financial markets. What has happened over the last 10 years? It is the widening of corporate ambition.”
He doesn’t believe companies should focus on social issues, as they aren’t equipped to speak on these topics. He noted how Pepsi likely won’t be the one to solve the climate crisis.
“We have come to believe that corporations’ primary virtue is to be social actors. That’s deeply magical thinking,” Desai said. “There’s a cult of entrepreneurship today. How do you change the world? You start your own business. That cult of entrepreneurship is magical thinking.”
With this belief, he described himself as a “cranky old man” who prefers more traditional ideas. Desai doesn’t think that AI is going to be the savior of the economy. He noted how historically new technologies are never the savior, describing AI as “a cycle of hype to generate returns.”
He described Elon Musk as the personification of this idea. While Desai can name 30 businessmen better than Musk, he believes Musk’s genius comes from the ability to work in the financial markets by creating a financial cult.
In such a cult, “you create remarkably unverifiable promises way out into the future,” said Desai. “You raise money at extremely cheap levels because you manufacture and you ensure that the first five years are remarkable returns.”
Desai noted how Musk follows the wealth and transforms his company into whatever is the most relevant way to creating the greatest possible revenue return.
“His wealth comes from convincing investors that Tesla is not a car company, it is a software company,” Desai said. “Now it’s not a software company, it’s an AI company. Why? Because that’s where the money is. That’s the source of his wealth.”
Desai believed that the further off the promise, the better. He noted Musk’s idea to go Mars as one of the far out promises and described the trust many have in Musk-like figures as “Messianic.”
Desai noted this wealth comes with power, which could be seen through Musk’s role in the Trump Administration.
While he believes in financial markets, Desai is not a fan of the current state of these markets. He showed three charts to indicate in his point.
The first were the stocks of companies known as the “Magnificent Seven” — the rare few that dominate the financial market. That chart showed increased stock value over a long period of time.
The second chart indicated more stagnant growth, made up of companies Desai called the “Unmagnificent 400.”
“To put it in technical terms, they’re probably not beating their cost to capital,” he said. “They’re hovering along and have been doing it.”
The last chart showed is a sharp increase, slight stagnation and then a sharp decrease. And, Desai said, it’s the second-best scenario for companies that will never be among the Magnificent Seven.
“People believe these promises during these periods (of sharp increase),” Desai said. “Then I sell at the peak, I raise money at the peak and then it falls apart. And I sell out at the top. I being who? Insiders, funders, sponsors, all kinds of folks. And I cloak myself in valuation. But I have ridden the roller coaster perfectly. I don’t have to get it perfect. If I am close to getting it right, I will win.”
According to Desai, these people have played the markets and won. This doesn’t account for the people who have lost. Oftentimes, these are the individuals who invested during the slight stagnation period.
This has drawn people to the idea of investing in huge payoffs as opposed to investing for long-term payoffs.
“I think everybody is looking for a lottery-like payoff,” Desai said. “What does that mean? I’m going to go work at that fund, that start-up. Why? I’m buying a lottery ticket. We’re all just buying lottery tickets. And I’m buying lottery tickets with my human capital.”
This idea is often perpetuated by young men, cited Desai. He calls this “Bronance.”
The concept of “Bronance” is focused on zero day options, which are stocks that expire day of. It’s based on short-term investment.
“They’re not deeply investigating the future of United Health to see if it’s a buy,” Desai said. “That’s not what’s going on, which is what we thought was going to go on in the mirror and the lamp world.”
With short-term investments, he believes magical thinking will die hard. There will be a point in time when enough promises go unfulfilled.
“So look, as an economist, it’s been a tough 15 years,” Desai said. “Every time you teach finance, someone is like, ‘What do you think about crypto?’ And I think it is a perfectly speculative asset with no underlying economic reality.”
Although the decline may not be sharp, Desai believes that this short-term economic trend will die.
“Hopefully, we return to the wonderful notions of value, value creation, common sense and tradeoffs that are where value is really created and is what economies should be doing,” Desai said.
