Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.
Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.
Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.
We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions
This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.
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.
I have been digging into the debate about what Milton Friedman got right and wrong about the social responsibility of business. I am still in the process of organising my thoughts but this discussion on the “Capitalisn’t” podcast is, I think, worth listening to for anyone interested in the questions that Friedman’s 1970 essay raises.
I recently flagged a post by Aswath Damodaran on his “Musings on Markets” blog which offered a sceptical perspective on the claims being made in favour of ESG based investing.
The Knowledge at Wharton website has a summary of some research that offers another perspective on ESG and Socially Responsible investment approaches. The research is described as providing “… a theoretical framework for how ESG (environmental, social and governance) investing affects stock prices and corporate behavior.”
The 50th anniversary of Milton Friedman’s 1970 essay has triggered a deluge of commentary celebrating or critiquing the ideas it proposed. My bias probably swings to the “profit maximisation is not the entire answer” side of the debate but I recognised that I had not actually read the original essay. Time, I thought, to go back to the source and see what Friedman actually said.
I personally found this exercise useful because I realised that some of the commentary I had been reading was quoting him out of context or otherwise reading into his essay ideas that I am not sure he would have endorsed. I will leave my comment on the merits of his doctrine to another post.
Friedman’s doctrine of the limits of corporate social responsibility
Friedman’s famous (or infamous) conclusion is that in a “free” society…
“there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”
My more detailed notes on what Friedman wrote can be found here. That note includes lengthy extracts from the essay so that you can fact check my paraphrasing of what he said. My summary of his argument as I understand it runs as follows:
Friedman first seeks to establish that any meaningful discussion of social responsibility has to focus on the people who own or manage the business, not “the business” itself.
If we focus on the corporate executives who manage the business as agents of the shareholders, Friedman argues that these executive should only use the resources of a company to pursue the objectives set by their “employer” (i.e. the shareholders).
What do the shareholders want the business to do?
Friedman acknowledges that some may have different objectives but he assumes that profit maximisation constrained by the laws and ethical customs of the society in which they operate will be goal of most shareholders
The key point however is that corporate executives have no authority or right to pursue any objectives other than those defined by their employer (the shareholders) or which otherwise serve the interests of those people.
Friedman also argues that the expansion of social responsibilities introduces conflicts of interest into the management of the business without offering any guide or proper process for resolving them. Having multiple (possibly ill defined and conflicting) objectives is, Friedman argues, a recipe for giving executives an excuse to underperform.
Friedman acknowledges that corporate executives have the right to pursue whatever social responsibilities they choose in their private lives but, as corporate executives, their personal objectives must be subordinated to the responsibility to achieve the objectives of the shareholders, their ultimate employers.
It is important to understand how Friedman defined the idea of a corporate executive having a “social responsibility”. He argues that the concept is only meaningful if it creates a responsibility that is not consistent with the interests of their employer.
Friedman might be sceptical on the extent to which it is true, but my read of his essay is that he is not disputing the rights of a business to contribute to social and environmental goals that management believe are congruent with the long term profitability of the business.
Friedman argues that the use of company resources to pursue a social responsibility raises problematic political questions on two levels: principle and consequences.
On the level of POLITICAL PRINCIPLE, Friedman uses the rhetorical device of treating the exercise of social responsibility by a corporate executive as equivalent to the imposition of a tax
But it is intolerable for Friedman that this political power can be exercised by a corporate executive without the checks and balances that apply to government and government officials dealing with these fundamentally political choices.
On the grounds of CONSEQUENCES, Friedman questions whether the corporate executives have the knowledge and expertise to discharge the “social responsibilities” they have assumed on behalf of society. Poor consequences are acceptable if the executive is spending their own time and money but unacceptable as a point of principle when using someone else’s time and money.
Friedman cites a list of social challenges that he argues are likely to lay outside the domain of a corporate executive’s area of expertise
Private competitive enterprise is for Friedman the best way to make choices about how to allocate resources in society. This is because it forces people to be responsible for their own actions and makes it difficult for them to exploit other people for either selfish or unselfish purposes.
Friedman considers whether some social problems are too urgent to be left to the political process but dismisses this argument on two counts. Firstly because he is suspicious about how genuine the commitment to “social responsibility” really is but mostly because he is fundamentally committed to the principle that these kinds of social questions should be decided by the political process.
Friedman acknowledges that his doctrine makes it harder for good people to do good but that, he argues, is a “small price” to pay to avoid the greater evil of being forced to conform to an objective you as an individual do not agree with.
Friedman also considers the idea that shareholders can themselves choose to contribute to social causes but dismisses it. This is partly because he believes that these “choices” are forced on the majority by the shareholder activists but also because he believes that using the “cloak of social responsibility” to rationalise these choices undermines the foundations of a free society.
That is a big statement – how does he justify it?
He starts by citing a list of ways in which socially responsible actions can be argued (or rationalised) to be in the long-run interests of a corporation.
Friedman acknowledges that corporate executives are well within their rights to take “socially responsible” actions if they believe that their company can benefit from this “hypocritical window dressing”.
Friedman notes the irony of expecting business to exercise social responsibility by foregoing these short term benefits but argues that using the “cloak of social responsibility” in this way harms the foundations of a free society
Friedman cites the calls for wage and price controls (remember this was written in 1970) as one example of the way in which social responsibility can undermine a free society
But he also sees the trend for corporate executives to embrace social responsibility as part of a wider movement that paints the pursuit of profit as “wicked and immoral”. A free enterprise, market based, society is central to Friedman’s vision of a politically free society and must be defended to the fullest extent possible.
Here Friedman expands on the principles behind his commitment to the market mechanism as an instrument of freedom – in particular the principle of “unanimity” under which the market coordinates the needs and wants of individuals and no one is compelled to do something against their perceived interests.
He contrasts this with the principle of “conformity” that underpins the political mechanism.
In Friedman’s ideal world, all decisions would be based on the principle of unanimity but he acknowledges that this is not always possible.
He argues that the line needs to be drawn when the doctrine of “social responsibility” extends the political mechanisms of conformity and coercion into areas which can be addressed by the market mechanism.
Friedman concludes by labelling “social responsibility” a “fundamentally subversive doctrine”.
But the doctrine of “social responsibility” taken seriously would extend the scope of the political mechanism to every human activity. It does not differ in philosophy from the most explicitly collectivist doctrine. It differs only by professing to believe that collectivist ends can be attained without collectivist means.
That is why, in my book “Capitalism and Freedom,” I have called it a “fundamentally subversive doctrine” in a free society, and have said that in such a society, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”
Hopefully what I have set out above offers a fair and unbiased account of what Friedman actually said. If not then tell me what I missed. I think he makes a number of good points but, as stated at the beginning of this post, I am not comfortable with the conclusions that he draws. I am working on a follow up post where I will attempt to deconstruct the essay and set out my perspective on the questions he sought to address.
Anyone with more than a casual interest in business will be familiar with the increased focus on Environmental, Social and Governance (ESG) issues. There are sound arguments being made on both sides of the debate but I will admit upfront that I approach the topic with a somewhat ESG positive bias. Given my bias, it is all the more important to pay attention to what the sceptics are calling out rather than looking for affirmation amongst the true believers.
A post by Aswath Damodaran titled “Sounding good or Doing good? A Skeptical Look at ESG” is one of the better contributions to the ESG debate that I have encountered. I discussed one of his earlier contributions to the debate here and it is clear that he is not a fan of ESG. I am still working through his arguments but I like the analytical framework he employs and the way in which he supports his arguments with evidence.
I intend to do a couple of posts digging down into the ESG debate using Damodaran’s post and few other sources but want to start by laying out his arguments with some very limited comments.
Damodaran starts by framing ESG as part of a tradition of business ideas that have tended to prove to be more noise than substance, describing the ESG “sales pitch” as follows
“Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society’s best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors”
There is no doubt that ESG, like many other business ideas, is prone to being over-hyped. There is room to take issue with the question of whether this is a fair description of the ESG movement as a whole. My gut feel is that presenting the “sales pitch” version is not representative of ESG advocates who genuinely believe that ESG can address problems in the ways the market currently operate, but it will be more productive to focus on the specific weaknesses that Damodaran discusses.
Damodaran starts with the problem of measurement
“Any attempts to measure environment and social goodness face two challenges.
– The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do.
– The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.”
Assuming the measurement issues can be resolved, the second problem is identifying exactly how incorporating ESG factors into the business model or strategy contributes to improving the value of a company. Damodaran uses the following generic model of value drivers to explore this question
Figure 1: The Drivers of Value
Using this framework, Damodaran identifies two ways in which a company can derive benefits from incorporating ESG principles into its business strategy
Goodness is rewarded – i.e. companies behave in a socially responsible way because it creates positive outcomes for their business
Badness is punished – i.e. companies behave in a socially responsible way because bad behaviour is punished
Damodaran also identifies a third scenario in which “The bad guys win”
“In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services, either because they are cheaper or because of convenience, employees continue to work for them because they can earn more at these companies or have no options, and investors buy their shares because they deliver higher profits. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance.”
Damodaran argues that the evidence supports the following conclusions:
A weak link to profitability
“There are meta studies (summaries of all other studies) that summarize hundreds of ESG research papers, and find a small positive link between ESG and profitability, but one that is very sensitive to how profits are measured and over what period, leading one of these studies to conclude that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement”. Breaking down ESG into its component parts, some studies find that environment (E) offered the strongest positive link to performance and social (S) the weakest, with governance (G) falling in the middle.”
2) A stronger link to funding costs
“Studies of “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less commonly held by institutions, and that they face higher costs for funding, from equity and debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and fossil fuels (especially in the last decade), but these findings come with a troubling catch. While these companies face higher costs, and have lower value, investors in these companies will generate higher returns from holding these stocks.”
3) Some evidence that ESG focussed companies do reduce their risk of failure or exposure to disaster risk
“An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls (because they cost too much) can cause a disaster, either in human or financial terms. That disaster can not only cause substantial losses for the company, but the collateral reputation damage created can have long term consequences. One study created a value-weighted portfolio of controversial firms that had a history of violating ESG rules, and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. The conclusion in this study was that these lower excess returns are evidence that being socially irresponsible is costly for firms, and that markets do not fully incorporate the consequences of bad corporate behavior. The push back from skeptics is that not all firms that behave badly get embroiled in controversy, and it is possible that looking at just firms that are controversial creates a selection bias that explains the negative returns.”
Damodaran sums up his argument
“There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.”
There is a lot more to say on this topic. The evidence that certain types of companies do get punished for failing to be socially responsible is especially interesting. I see a fair degree of cynicism applied to the ESG stance adopted by the Australia banks but I suspect they are a good example of the type of company that will in fact benefit from making real investments in socially responsible business strategies.
whether some companies are built on “structurally fair” foundations that make it easier for them to be perceived as “good” or “fair” companies; and
what exactly does it mean to be an “ethical” company
This extract will give you a flavour of the author’s analysis of the Costco business model
Sustainable Capitalism? – What Costco shows us about the blurry relationship between ethical and fair
Costco shows that … simply providing your customers the feeling that they aren’t getting ripped off, and doing so in a way that matches mainstream views of acceptable externalities, is all that is required for success. If this sounds reductive, it’s because it is. The key to Costco’s success is just how straightforward the alignment of stakeholders within its business model are.
That being said, there are externalities associated with Costco’s business model, even if they aren’t viewed by the mainstream as such. The main thing here is a retail model that promotes rampant consumption, and the fallout from this which includes broad waste and sustainability concerns. Interestingly, because of Costco’s large purchasing power, dominance over its supply chains, and upper-middle class income of its shoppers, it generally has more progressive product standards than other retail brands in comparable price tiers.
Lehrer argues that the foundation is to provide customers with “the feeling that they aren’t getting ripped off“ thereby building that elusive intangible asset of Trust that many companies routinely include in their statement of corporate values (e.g. “a Trusted Partner”). However, equally important is that the company can do this “in a way that matches mainstream views of acceptable externalities“.
This qualification regarding externalities is the interesting part.
Other companies may have a credible claim to being able to provide a good or service cheaply but the often unasked question is what is the full cost of the good or service; i.e. is the low cost at the company/consumer level based on paying workers a subsistence wage with uncertain working hours, or reliance on an external supply chain with dubious environmental and labour standards. Lehrer notes that Costco could be vulnerable to criticism on a number of fronts (e.g. its business is, at its heart, a mass consumption model) but Costco is protected by virtue of adopting a position which fits community standards. Costco can afford to spend some of its efficiency dividend on progressive product standards but it is not necessarily pushing the boundaries of what might be done because it is also sensitive to what its customers are willing to pay for being good.
This framework (i.e. is our business built on an operating model that is structurally fair) offers a useful perspective when thinking about financial services companies. Initiatives such as the Bankers’ Oath have a contribution to make in addressing the cultural issues in banking but I suspect that there is as much value (potentially more) in exploring the structural features of the industry that create the pressure to cut corners in the pursuit of financial targets.
I don’t expect anyone will change their mind about bankers and banking in general on the basis of this post. I do hope to make the point that there are subtle structural challenges in banking that complicate the capacity to do good. Developing a better understanding of the structural issues is I think essential to crafting a lasting solution to the cultural issues. I don’t have any neat answers but I do feel that the issues covered in Bryan Lehrer’s analysis of Costco offer some insights.