Customer Loyalty – From the outside

Corporate social responsibility – going back to the source

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.

Tony – From the Outside

“The World’s Dumbest Idea” by James Montier of GMO.

Anyone interested in the question of shareholder value will I think find this paper by James Montier interesting.

The focus of the paper is to explore problems with elevating Shareholder Value to be the primary objective of a firm. Many companies are trying to achieve a more balanced approach but the paper is still useful background given that some investors appear to believe that shareholder value maximisation is the only valid objective a company should pursue. The paper also touches on the question of how increasing inequality is impacting the environment in which we operate.

While conceding that the right incentives can prompt better performance, JM argues that there is a point where increasing the size of the reward actually leads to worse performance;

“From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be”

The following extracts will give you a sense of the key points and whether you want to read the paper itself.

“Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).” — Page 7 —
“This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.” — Page 9 —
“This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997”— Page 10 —
“The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector” — Page 11 —
“The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) … shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%…. ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).” —Page 13 —
“Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself.” — Page 14 —
“… management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.”” — Page 14 —

Why this blog?

making sense of what I have learned about banks with a focus on bank capital management.

Late in 2017 I decided to take some time out from work (the paid kind to be precise). My banking career has spanned a variety of roles working in a large Australian bank but the unifying theme for much of that time was a focus on bank capital management. This is a surprisingly rich topic (yes honestly) and one that I am not done with yet. Accordingly, I want to devote some of my time out to an attempt to make sense of what I have learned and apply that knowledge to topical banking issues. It was suggested that I write a book but I have opted for a blog format in part because it will hopefully allow for a two way dialogue with like minded bank capital tragics.

An alternative title for this blog was “The education of a banker; a work in progress” which sought to convey the idea that I believe I have learned quite a lot about banking over the past four decades but the plan is to keep learning. Some of the perspectives I offer are to, the best of my knowledge, based on very firm foundations while others are ones which reasonable people can disagree upon or outright speculative. To the best of my ability, all of the views expressed will be “lightly held” in the sense that I am just as interested in identifying reasons why they might be wrong as I am in affirmation.

I settled on “From the Outside” based on an informal survey of a group of like minded people with who I have already devoted many emails and coffee catchups debating the issues I intend to explore. The title highlights that I bring a perspective forged working inside a bank over many years but now looking at the questions from the outside. Each reader will need decide for themselves whether I achieve a balanced view or have become irredeemably institutionalised. I will seek to correct what I believe to be unfounded criticisms of banks (for the record, I don’t think the current ROE major Australian banks are targeting is excessive) while at the same time there are other areas where I believe Australian banks need to do better (engaging with long time customers in a way that recognises their loyalty would be a great place to start).

The focus of the blog will no doubt evolve over time (and hopefully in response to feedback) but the initial plan is to explore a sequence of big picture themes in parallel with topical issues that arise from time to time. I also plan to share my thoughts on books and papers I have read that I think readers might find worth following up.

The big picture themes will likely encompass questions like the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture, prudential regulation etc. Topical issues would encompass discussion papers, academic research, opinion pieces, prudential regulation and anything else that intersected with banking, finance and economics.

I am currently working my way through APRA’s Feb 2018 discussion paper on Revisions to the capital framework for ADI’s. I think there is a lot to like in the proposals APRA has set out but also some gaps and possible unintended consequences that are worth exploring.

… and so it begins

Tony

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