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.

Milton Friedman: "The Social Responsibility of Business is to Increase its Profits," is Wrong

Milton Friedman, "The Social Responsibility of Business is to Increase its Profits," is wrong.

In his famous article, “The Social Responsibility of Business is to Increase its Profits,” (originally published in the New York Times Magazine September 13, 1970, see eg:http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html) Milton Friedman quotes himself from his book Capitalism and Freedom:

"there is one and only one social responsibility of business–to use it(s) 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 or fraud.”

This is his concluding line in an article dedicated to denigrating the idea of “social responsibility” in businesses, and in particular by corporate executives. For a corporate executive to act in a “socially responsible” manner, Dr. Friedman posits that “it must mean that he (the corporate executive) is to act in some way that is not in the interest of his employers.”  That is, any act, (not geared to maximizing profits,) in excess of the minimum required by law and custom is not in the interests of his employers. 

His conclusion is at least naïve.  Clearly, a business can increase its profits if  “it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud."  How much easier, though, to maximize its profit by externalizing all costs, by capturing and corrupting government, and altering the rules of the game to its convenience?  How much easier to profit by eliminating free and open competition, and legalizing deception and fraud? 

Dr. Friedman criticizes the 'socially responsible' postures taken by executives in and prior to 1970.  He further condemns socially responsible behavior by smearing it with the ‘socialist’ paint brush:   ”This is the basic reason why the doctrine of "social responsibility" involves the acceptance of the socialist view that political mechanisms, not market mechanisms, are the appropriate way to determine the allocation of scarce re­sources to alternative uses.”  Here Dr. Friedman makes no compromise. He essentially claims that market mechanisms are the only way to determine the allocation of scarce resources, denying any limitation to or failure of markets, or any use for political mechanisms of allocation.  But pollution control, and work place safety, are political allocations of resources, and ones which would be opposed by market mechanisms.  The failure of the market in the US to provide universal health care is another case in point, assuming universal healthcare is desired by a majority of the people.  

Milton Friedman's claim that the sole social responsibility of business is to increase its profits, places businesses into an adversarial relation to society.  That is, businesses become the enemies, the exploiters, of the society of which they are a part.  The logical conclusion of Dr. Friedman’s statement is that it is not a part of the social responsibility of business to behave in a socially responsible manner.  His implication, although I don’t think he realized this, is indeed quite the opposite, that a business should behave in a socially irresponsible, and even socially destructive, manner, if this increases its profit. This position is schizophrenic.  It is as if the hand was encouraged to act against the interests of the body of which it was a part.

There are ways of increasing a business’ profits which are damaging to the society of which it is a part. Indeed, it is a tendency of business to seek to externalize all costs. Thus, to pollute, to ignore worker safety regulations, to engage in mis-representation if not fraud, etc. If the business is in competition, and these things are permitted, it must do them, since its competitors, similarly situated, will also do these things.  Its competitors, if allowed to externalize costs by polluting, will do so, and so it must also.  Its competitors, if allowed to externalize costs by skimping on worker safety, will do so, and so it must do so also.  Further, business will seek subsidies by the government, and taxes by the government on its competition.

The conclusion of Dr. Friedman’s position implies the necessity that the corporate executive act without conscience.  This is necessary, since any operation of conscience within the confines of the executive’s office would be contrary to the profit maximization principle under which the executive, as an employee of the owners, is obliged to operate.  Indeed, profit maximization obligates the corporate executive to pollute and otherwise externalize all costs, so far as practically permitted, and to undertake the corruption of the regulating bodies, that is the corruption of government. 

But where is the root of his error?  Consider this quote from the article: “Society is a collection of individuals and of the various groups they voluntarily form.”  Society is hardly a mere collection.  It is dynamic, and its dynamic is non-linear. Society is not merely the collection of individuals, or even the mere collection of their actions.   The effect of everybody doing a thing, is quite different from the effect of just one or a few persons doing that thing.  Society is more than the sum of its parts. A business is more than the sum of its parts.  And the actions of businesses, and the other parts of society, combine in non-linear, and synergistic ways. There are returns of scale, and greater returns on the scale of integration of an entire society.  A business unconcerned with these interactions does society, and itself, disservice.  Dr. Friedman’s conception serves to atomize and divide, and reduce those social returns to scale, impoverishing society.  This is what we have seen, in the triumph of his error, and the rise of those who subscribe to it.

Consider instead a purely operational, and self-interested, definition of conscience: seeking to do that which is ultimately best for one’s self:  Seeking the larger good, with the expectation that one’s own welfare will be improved if that larger good is enhanced.  We do assume that the executive is interested indeed in maximizing the profits of his company. Then a goal of the business executive is the optimization of his society, (and by optimizing we can here mean purely maximizing the economy's growth rate,) since in an optimum society, his corporation itself is optimized, and in the long run, its profits maximized.  Thus, the executive with conscience will seek to participate in, and encourage the development of, a well regulated market, one which will enhance the value of his business to society, since in such a market growth is optimized for all businesses.  Therefore, rather than corrupting the regulators, he will seek regulation which maximizes the efficiency of resource allocation. Rather than competing in a race to the bottom, he will seek effective regulation that will encourage all businesses to good behavior. The business man of conscience, therefore, will speak out against corruption, and the capture of government by other businesses. As this will be in his own long term best interest.

The corporate executive’s duty to his employers is not uncritical obedience to the principle of short term profit maximization. Long term maximization requires the long term survivability of the society of which it is a part. 

Neither do the owners enjoy all incidents of property.  Ownership of property in any society is not an absolute.  It entails duties.  Society, and its government, retain the most important incidents of property, and this implies the obligation of the owners to ”socially responsible” behavior.   All individuals in society, by voluntary agreement, undertake this. 

While it is beneficial for each business to pursue its narrow interests, even to act in an unethical manner, (which Dr. Friedman in the larger sense implies is OK as long as it is within ‘the ‘rules of the game,’) it is bad for each business if all businesses act so.  Where all businesses sacrifice the larger good, sacrifice their ‘responsibility to society,’ for their narrower interests, all are poorer, and all lose. Where all businesses sacrifice the larger good, the larger good contracts.   

Even the winners lose. Therefore, it is in the interests of each business, to see that other businesses act in an ethical manner.  Thus, that the business exists in a well regulated market, and not a corrupt, environment.

We take Dr. Friedman to his logical conclusion, and that business indeed exists in an adversarial relationship to society, that its ultimate interests are contrary to the interests of society.  Then there is no intrinsic restriction to its activities in that society:  There is no limit on the things it can, or should, do, to gain profit. So business should seek to capture government,  and seek to ‘free’ itself from the constraints of regulation, and mitigate or corrupt that regulation.  Then when business captures government, and corrupts regulation, it must be that the government also acts contrary to the interests of society.  Therefore, it is in the interests of society, that the separation of business and state remain inviolate.  The Supreme Court’s decision Citizens United, therefore, must be considered inimical to society, at the least a terrible mistake, and those who support it, and profit by it, society’s enemies.

Clearly, it is in the interests of failing executives, and failing businesses, to corrupt government, and to legitimize deception and fraud.  Failing at production, they seek success through corruption.  Instead it is in the interests of successful executives and businesses to seek a well-regulated environment, and good government.

Society is captured by men who do not believe that the larger good is to their benefit, and therefore seek their own narrower self-interests, to the destruction of the larger good, and ultimately their own.

That our government is captured by executives and businesses, many of which would otherwise fail, that is to say, are not producers in any real economic sense, and so could not compete in a free and open market, bodes ill.   

Executives and corporations have taken Dr. Friedman's statement to heart.  His prescriptions have, so far as they have been carried out, done untold damage to the economy.