Friedman’s Legacy: From Doctrine to Theorem

This essay by Luigi Zingales (University of Chicago – Booth School of Business) offers a useful assessment of the rights and wrongs of Friedman’s shareholder responsibility doctrine.

Zingales argues that part of the problem with Friedman is that his argument is treated as a statement of doctrine to which one pledges allegiance as opposed to a theorem that can be used to analyse and understand what is happening in the real world.

Zingales therefore restates Friedman as a theorem for analysing the conditions under which it would be socially optimal for corporate executives to focus solely on maximising corporate profits. He refers to this as the “Friedman Separation Theorem” and argues that it holds if the following three conditions are met:

First, companies should operate in a competitive environment, which I will define as firms being both price and rules takers. Second, there should not be externalities (or the government should be able to address perfectly these externalities through regulation and taxation). Third, contracts are complete, in the sense that we can specify in a contract all relevant contingencies at no cost.

“Friedman’s Legacy: From Doctrine to Theorem” – Zingales – Pro Market 13 Oct 2020

Whether you agree or disagree with it, one of the great attractions of this doctrine/theorem is that it makes the life of a corporate executive much simpler. That gives the idea an obvious appeal.

Zingales notes that on a technical level, the Friedman Separation Theorem is a restatement of what economists refer to as the “First Welfare Theorem” (also known as the “Invisible Hand Theorem”) which holds that markets produce socially optimal outcomes under certain conditions.

Zingales argues that Friedman also recognised that he needed something catchier for his argument to impact public debate so he framed the argument around an appeal to the core American values of freedom, independence and the principle of “no taxation without representation” embedded in the story of the American Revolution.

Zingales works through each of the three assumptions he has identified as underpinning the Friedman Separation Theorem, highlighting the ways in which the are not valid descriptions of how the economy actually operates.

Zingales sums up his review by posing the question how should we interpret the practical implications of Friedman’s idea in 2020? His answer has two legs. Firstly he argues that we need to distinguish between small to medium size companies and their larger cousins which have power in various forms:

If you are a small to medium-sized company, .., a company with no market power and no real power to influence regulation or elections, maximizing shareholder welfare is the right goal to follow. Especially if this goal is pursued with attention not only to legal rules but also ethical customs, like Friedman advocated, but most companies ignored.

However, Zingales argues that we should also recognise the limitations of the Friedman Separation Theorem when we are dealing with corporate entities, and their executives, which have real power.

When it comes to super corporations, corporations that have market power, like Google and Facebook, or political power, like BlackRock or JP Morgan, or regulatory power, like DuPont or Monsanto, a single-minded pursuit of shareholder value maximization can be extremely bad for society.

This, Zingales argues, is the reason why he and Oliver Hart have advocated requiring boards of monopolies, like Google, or of firms too big to regulate, like Blackrock, to maximize social welfare, the utility of society as a whole, not shareholder welfare.

Zingales concludes that “Friedman was more right than his detractors claim and more wrong than his supporters would like us to believe”:

His “theorem” has greatly contributed to determining when maximizing shareholder value is good for society and when it is not. The discipline imposed by Friedman’s theorem also forces greater accountability on managers. In the world of 2020, the biggest shareholder in most corporations is all of us, who have their pension money invested in stocks. We are the real silent majority. Corporate managers finance political candidates, lobby for self-serving legislation, and capture regulation. They have the power to use our money to fight against our own interest. While Friedman did not anticipate these degenerations, he warned us against the risk of unaccountable managers. This warning will remain his most enduring contribution.

Irrespective of whether you agree or disagree with the proposed solution to the big company problem, Zingales essay is one of the better contributions to the Corporate Social Responsibility and Shareholder Value Maximisation debate that I have come across. It is a short read but worth it.

For anyone wanting to dig deeper, the collection of 27 essays that Zingales references in his essay can be found here.

Tony – From the Outside