Streetwise Professor

October 22, 2020

“It’s Easy to Win an Argument With Milton, When He Isn’t There”

Filed under: CoronaCrisis,Economics,Politics,Regulation — cpirrong @ 6:30 pm

Raghuran Rajan is a smart guy who has done excellent and rigorus work, and is a gentleman to boot. But even such as he are capable of saying dodgy things, as in his comments to the FT on Friedman’s social responsibility article, in which he said the covid pandemic has exposed flaws in Friedman’s argument:

First, Covid-19 has threatened some companies with the extinction of shareholder value, subjecting businesses to a shock that, despite government intervention, has put their existence in question. “At this point,” Prof Rajan told me, “the best thing [a company with thin resources] could do is focus those resources on survival, because in surviving, it provides a decent job for its workers, it continues making that widget which people buy. It lives for the future.

Not all companies came into the crisis with thin resources. For the tech companies, nursing war chests replenished by tech-hungry consumers in lockdown, this should be a chance to go beyond bare Friedmanite requirements

Amazon, for instance, could “do more for its various suppliers, some of whom may be struggling small and medium business units”, said Prof Rajan. “It could find ways to provide them more credit to last through the pandemic that will get it more loyalty, because people will know it can be a source of insurance, rather than just a platform.”

. . .

This sort of action exposes the “missing part” of Friedman’s thesis, said Prof Rajan. He failed to recognise that “implicit equity stakes” — such as the commitment of a company to the partnership with its workers, suppliers or customers — are “as important, sometimes, as the explicit equity stake”

These things are missing how, exactly? Essentially Rajan is arguing that there are gains from trade to be realized to a corporation from adjusting explicit and implicit contractual terms with “stakeholders” such as workers, suppliers, and customers, in response to an economic shock like covid. But note: such adjustments would enhance the corporation’s profits, by allowing it to capture some of those gains from trade.

Indeed, according to the Friedman norm, such companies, acting as profit maximizers, would benefit not just themselves, but their workers, suppliers, and customers. Thus, rather than being some lacuna in Friedman’s framework, what Rajan emphasizes is precisely why profit maximization in the price system should be encouraged, as Friedman did. It provides an incentive for corporations to engage in mutually beneficial transactions, regardless of the underlying circumstances. That is, profit maximization guides optimal responses to circumstances, even crappy circumstances. Nay, especially crappy circumstances.

Or perhaps I should say “in the contractual system.” For what is involved here is negotiating contracts that maximize joint surplus. As Coase tells us, absent transactions costs, firms and their counterparties will do just that, and profit maximization (or utility maximization by workers, say) is exactly the engine that powers that result.

So the only way to make this critique coherent is to argue that transactions costs could somehow be reduced by reshuffling organizational forms or control rights. This Rajan does not do. Nor has anyone who burps up the term “stakeholders” and proclaims “QED!” Not that I have seen anyways.

As I said in my earlier post: if you are so smart, why aren’t you rich? Why haven’t you–or anyone else–come up with an alternative organizational form that allows the creation and capture of gains from trade that corporations leave on the table?

Indeed, the most coherent restatement of the “stakeholder” argument is that corporations have failed because they aren’t maximizing profits because they are failing to structure transactions with stakeholders that exhaust all gains from trade.

I’m tempted to cut Raghuran some slack because his remarks are impromptu statements made to reporter, rather than in an academic article–or even a blog post. But the fact that something in an FT article is far more likely to resonate than a weighty academic tome or even a not-so-weighty academic blog post arguably cuts the other way: one should be on particular guard against expressing flabby thoughts, when said thoughts may be read by millions–and hence mislead millions. And, to be honest, Raghuran’s thoughts about the errors of Friedman’s thought during times of pandemic are very flabby indeed.

In reading all these critiques of Friedman, 50 years on, I’m reminded of something George Stigler said. “It’s easy to win an argument against Milton when he isn’t there.”

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  1. I don’t bother with any argument that witters about “stakeholders”. I’d call it a silly idea except that it’s scarcely an idea at all.

    Comment by dearieme — October 23, 2020 @ 12:09 am

  2. I’ll try to present three arguments that idea of “Stakeholders” isn’t completely invalid:
    1. In Germany, for example, the unions get representation on the company board, and that seems to have produced some good outcomes, or at the very least, it has created a net good for society (at least in the opinion of that society) while not preventing their companies from becoming massively successful.
    2. The Prof argues that companies would have to be “failing to structure transactions with stakeholders that exhaust all gains from trade” for the Stakeholder argument to hold. But isn’t this the essence of the Warren Buffet school of thought? Essentially that companies often really aren’t maximizing their gains because they’re too focused on short term results – so he gives them some room and then reaps higher long-term gains in return. Could Rajan’s comments simply be seen as advocating that companies do this voluntarily?
    3. Personally, I try to avoid companies that I know treat their workers badly, and I know plenty of others who feel the same. I don’t know to what extent that would play out in the US, but being seen as a company who supported the country and its people during a crisis surely has a value…

    Of course, I can’t put any numbers to these…

    Comment by HibernoFrog — October 26, 2020 @ 8:20 am

  3. Let me explain what little I know about the British use of “stakeholders”. Long ago when I was young, when the government was contemplating a change of policy it would often solicit opinions from “interested parties”. The beauty of this was that you, HibernoFrog, or Mrs HibernoFrog, could decide if you were an interested party and accordingly drop them a line, explaining your interest and commenting on their suggestions.

    In, I suppose, the time of Toni Blair – that smirking jackanapes – government would instead decide who was a stakeholder, and ask them to comment. Quite a different thing, d’ye see?

    Comment by dearieme — October 28, 2020 @ 10:05 am

  4. @Dearieme: Yes, I can see how that’s not a terrific situation in government… But in the context of private companies, they are surely entitled to decide who their stakeholders are and to maximise their gains. I just wouldn’t exclude the idea that they are not fully achieving this by cutting back so aggressively. But then again, as they say, the first rule of business is to stay in business, so maybe they are knowingly passing up on future gains in exchange for a greater ability to absorb unexpected shocks in the present, which we could hardly blame them for…

    Comment by HibernoFrog — November 2, 2020 @ 2:56 am

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