Tuesday, August 13, 2013

Regulating the ‘Invisible Hand’

Regulating the "Invisible Hand'

The ‘invisible hand’ has come to imply the idea that the pursuit of narrow self interest by individuals results in the best social outcome.  Adam Smith, who first used the expression, more narrowly applied it to the concept of markets: “specifically that it is competition between buyers and sellers that channels the profit motive of individuals on both sides of the transaction such that improved products are produced and at lower costs.” http://en.wikipedia.org/wiki/Invisible_hand

The generalized idea is not valid.

In general, action by the members of a society must not only be self seeking, it must promote the well being and goals of that society. To put it in economic terms: Society must profit, and the action of individuals must, in that respect at least, be virtuous. Indeed, every prosperous and stable society has elevated the idea of virtue among its citizens, and devised means to encourage it.  Those most esteemed were those who contributed the most to society.  They were those who were held to be the most virtuous, and received the greatest rewards.  Those who were merely self serving were held in contempt, what ever their material income.

While an individual person may or may not be inclined to virtue, a corporation, however, cannot be virtuous, unless forced by law and circumstance of competition.  Only the pressures of competition make a productive corporation stay productive, that and the force of law required to make the corporation internalize its costs. 

For instance, we hear about banks, and other corporations, ‘socializing costs while privatizing profits.When this happens, it is no longer certain that the activities of the corporation are actually of benefit to the economy.   These activities may actually harm society, that is make society poorer, and everyone, on average, worse off.  (Though the owners and some of the employees of the corporation may, of course, be better off.)  Indeed, it is always the case that society is the poorer when the externalized costs are greater than the profits the corporation makes.

For the act of production requires the internalization of cost. The very act of production requires the benefits of production outweigh the costs, and if many of those costs are externalized, their weight is no longer determined by the market.  Thus, while the corporation may reap a profit, the costs to society may outweigh the benefits society receives.

This can be seen from the fact that, when all costs are internalized, the net benefit a company makes to society is equal to that company’s profit. That is, society comes out ahead by the profits of the company. If, when all costs are internalized, the company breaks even, then society breaks even.  But if costs are externalized and the company breaks even, then society pays these costs, and loses.

The profits a company makes are what society is willing to pay the company above the company’s costs.  (Note that in a situation with perfect competition, where there are no profits, there is no growth.)  If society is not willing to pay the company above its costs, its activity is only of use to society to maintain society, and the company itself, in their current state of economic activity. The company makes no profits, and does not grow, and society does not grow. 

If costs are internalized, and the costs are greater than society is willing to pay, then society will cut back on that activity.  That is the company is operating at a loss, and it will contract. 

If there are any externalized costs, and these are less than the total profit, then society will grow at a rate less than the company. 

If externalized costs are greater than the profit, then the company will grow, but society will contract. 

Now  the officers of a corporation can only pursue that corporation’s narrow profit.  In a free but limited market, this may yet be beneficial to society.   However, producing corporations are at a competitive disadvantage to corporations which do not produce, but manipulate the economy to enhance their collection of rents from that economy.  Corporations which do not produce need have no real costs, except those they inflict on society for profit. 

Given the opportunity, then, the officers of a corporation must externalize, or socialize, costs, where it increases profits, no matter the harm inflicted on the larger society.  Thus there is always the pressure on a corporation to change into something which is non-productive, a rent collecting corporation, and a parasite on society.    

And while the producer, constrained by competition, might be virtuous naturally, the monopolist and the rent seeker will not be.  The monopolist, unconstrained, will provide a service, perhaps essential to that society, at a cost that society may ill afford, a cost possibly greater than the benefit that service provides.  The rent seeking corporation will extract resources from society without net benefit to that society.

Regulation is necessary, and should be designed to force corporations to internalize costs, which would otherwise be externalized, and discourage the collection of rents, or excess profits. (And one might argue that that is all regulation should be designed to do.  One might also argue that the conservation of stocks of resources is a separate reason for regulation, although this might be under the cover of internalizing all costs.)

Where these costs cannot be directly internalized, they should be countered by government activity, supported by corporate tax. 

Since regulated industries are less competitive, they should be protected against unregulated, and subsidized, competition, especially foreign competition, by tariff, if needed. Indeed, failure to do so results in an economic race to the bottom.  Domestic producers are forced to externalize costs onto their society, or go out of business. This process is essentially the taking of resources out of the market, destroying it. It is the exportation of demand.

A nation should in any case be more concerned with securing its domestic market for its own industry than securing foreign markets.  All countries cannot be net exporters, but all countries can balance their trade. 

Virtue is corrupted where virtue has become a measure of success at self-serving.  A society requires its members to include social costs in the calculation of their profit in order to survive, (since society as a whole must also make a profit) and corporate society, a la Milton Friedman, cannot do this. See:  http://anamecon.blogspot.com/2012/06/milton-friedman-social-responsibility.html

The expansion of the idea of markets to other activities of society is destructive to those activities. And those activities are essential to the function, and even the identity, of society.

Indeed, the idea of the self-serving ‘invisible hand’ is inadequate to explain the stability and persistence of societies. Virtuous behavior, in particular on the part of a society’s leaders, is required for that society to maintain itself and prosper.   Since it may be impossible for the law, even where not co-opted, to restrain corporate behavior, in particular the indiscriminate externalization of costs, the corporate state may be unstable, and incapable of sustaining itself in the long, or even the medium run. The structure of corporations, and their place in society, far from encouraging virtue, may even exert a corrupting influence on their officers, who are also many of society’s leaders.  This is especially true as society’s competitive structure is increasingly replaced by oligopolistic and monopolistic structures.  These structures naturally seek rent and externalize costs.

Unlike people, corporate persons, except as they are constrained by law, cannot be good citizens.  Thus, if the law is inadequate to constrain them, 'Corporate Society' may only exist as a transition state to a decapitalized future.

Regulation may be inadequate to secure the future, but it is nonetheless necessary.