Streetwise Professor

October 11, 2020

Milton Friedman vs. 21st Century Lilliputians on Corporate Responsibility

Filed under: Economics,Exchanges,Politics,Regulation — cpirrong @ 3:57 pm

This year marks the 50th anniversary of Milton Friedman’s article on the “social responsibility of business,” in which he argued that business has one responsibility: to maximize profit. The anniversary has unleashed numerous retrospectives, most of them negative, and most of the negative treatments being given by people who have to crane their necks to see the soles of Friedman’s intellectual shoes.

The criticisms can be grouped into two basic categories: (a) the need for “stakeholder capitalism” as opposed to shareholder capitalism, and (b) the need for corporations to work to achieve social goals, such as environmental objectives or racial justice.

Both criticisms are unavailing and unpersuasive. The stakeholder capitalism critique founders on the is-ought fallacy. The social goals criticism founders on the Knowledge Problem.

Stakeholder capitalism advocates elide the “is” and jump right to “ought.” This is a fatal intellectual error, well described by Chesterton’s Fence.

Put differently, before advocating stakeholder capitalism as a superior substitute to shareholder capitalism, it is wise to ask: if stakeholder capitalism is so great, why doesn’t it already exist?

After all, there are numerous alternative ways of organizing and governing the cooperation between and coordination of suppliers of inputs (one subset of “the stakeholders”) to produce output that is sold to consumers (another subset of “the stakeholders”). There are many ways of allocating control rights and cash-flow rights. The corporate form, which makes the shareholders the residual claimants with residual control rights is just one. You can have sole proprieterships, partnerships, worker cooperatives, consumer cooperatives, mutual companies, and even anarcho-syndicalist worker communes:

Yet the corporate form that Friedman focuses on dominated then, and dominates today. It evidently conforms to the “survivorship principle” (a concept elucidated by Friedman’s partner in crime, George Stigler). That is, its dominance is consistent with its efficiency–its maximizing the size of the pie. (I recall a quote, which I thought was attributable to Bertrand Russell but which I cannot track down: “Efficiency is the highest form of altruism.”)

Moreover, this increasing the size of the pie effect must outweigh any distributive inequities “inherent in the system”: its survival means than no coalition of “stakeholders” (e.g., workers, or workers and customers, or workers and suppliers of capital) can make themselves better off by setting up an organization with different control and cash-flow rights than the shareholder corporation. Maybe the distribution of benefits within a corporation is inequitable, according to some theory of justice, but efficiency apparently trumps equity.

Henry Hansmann’s excellent book “The Organization of Enterprise” examines various alternative organizational forms, and finds that the efficiency of different forms of organization (e.g., producer cooperative, mutual) depends on the fine details of the nature of the production and marketing processes, and in particular the effects of these on the costs of contacting. My paper on the organization of financial exchanges provides a very interesting example. Exchanges organized as non-profit mutuals (pretty close to what Dennis advocated) were efficient under one set of technological conditions (floor trading) but not another (electronic trading): when technology changed, organization changed. Almost immediately. (Cf., the wave of exchange demutualizations in the early-2000s.)

Put differently, if “stakeholder capitalism” (or anarcho-syndicalist communes) were so great, either on efficiency or distributive grounds, we would see it in an even moderately competitive environment. Its absence makes it clear that it ain’t so great.

Sorry, Dennis. With the exception of the exchange thing. For a while, anyways.

So what about broader “social” goals? In this regard, it’s well to remember Hayek’s injunction that the addition of “social” as a prefix to any concept, e.g., social justice, usually renders the concept meaningless, or at best confuses rather than clarifies. Moreover, it’s imperative to remember another Hayekian concept: the Knowledge Problem.

The very existence of costs (e.g., pollution) that are not amenable to contract, and hence supposedly require unilateral corporate action to address, demonstrates the enduring legacy of one of Friedman’s colleagues, Coase. The transactions costs of some corporate activities are clearly too high to mitigate efficiently via contract. So, apparently, CEO’s are supposed to take an Olympian perspective and address these problems unilaterally.

That’s where the Knowledge Problem kicks in. Pray tell: where are CEOs supposed to get the information to lead them to make the appropriate trade-offs? The virtue of contract is that it provides a means of generating information about costs and benefits in order to make the altruistic–i.e., efficient–choice. But with “externalities,” contracting is a prohibitively expensive means of acquiring this information, and acting on it in an efficient eay. So where does this information come from?

CEOs–and heaven forfend, their HR departments–are usually sufficiently arrogant to believe they know.

They’re wrong: pride goeth before the fall.

Meaning that corporate decisions made pursuant to environmental or “social justice” goals are certain to be wrong. Very wrong.

Funny, isn’t it, that those who fault corporations for decisions that affect those with whom they have contractual privity blithely assert that they should make decisions with those with whom they do not? This is intellectual incoherence of the highest order.

There is another allegedly anti-Friedman argument, raised by the likes of the FT’s Martin Wolf: Friedman argued that corporations should maximize profits subject to the rules of the game, but since corporations make the rules of the game, this argument has no force and indeed cuts the other direction.

For one thing, Wolf’s argument is superficial and conclusory: “I also increasingly realize that I have changed my mind because I no longer believe in the contractarian view of the firm: that it is merely an aggregate of voluntary contracts which reflect the freedom of individuals to choose.” OK, Marty, I guess you are such an Olympian figure that your opinion, unsupported by argument or evidence, should suffice your disregarding the contractarian perspective and proceeding to other considerations.

But more importantly, one of Wolf’s more substantive arguments has, well, more substance: corporations have undue influence over the the political system, and therefore exert influence that results in the adoption of inefficient, and arguable inequitable, policies.

Well, yes. And Friedman would agree. Wolf’s criticism (and those of others making a similar point) of one Friedman article focused on one particular issue overlooks altogether other major–and indeed primary–streams of Friedman’s thought.

The precise reason that Friedman (and Stigler) opposed regulation and advocated small government was precisely because governments almost always advance special interests at the expense of efficiency and equity. Friedman always–always–asserted (justifiably) that he was NOT pro-big business. He was pro-market (which makes it particularly perverse that the Pro Market blog–which clearly steals from Friedman–repeatedly distributes garbage that traduces Friedman and others of his ilk, such as Aaron Director).

In this, Friedman was merely echoing Adam Smith–who never had a kind word to say about businessmen (a point that Stigler, the eminent Smith scholar of his era, made repeatedly).

Meaning that if your problem (and yeah, I’m looking at you Marty) is with undue corporate influence, rather than reshaping corporations in some way, maybe you should see that they are just responding rationally to the incentives inherent in a political system that gives the government almost unlimited authority to create rules that distribute rents.

That is, don’t limit corporations, limit governments. Corporations are just maze-bright rats. If you don’t want them gaming the maze, take away the cheese.

So to tar Friedman (and by extension other old-school Chicago types) with the brush of enabling corporations to write the rules of the game in their favor, is to ignore a major element of Friedman’s (and other old-school Chicago types’) worldview.

I’m also at a loss to figure out what particular changes to corporate organization and governance will miraculously transform them into more broad-minded entities that eschew exploiting the political system for their benefit. Look at Germany, or Japan, which have more “inclusive” models of governance, and which include other “stakeholders” in the formal governance process. Do you think they don’t influence the government to advance their interests? As. Fucking. If.

And if your response is: “give governments more power,” you are totally hopeless. Due to their comparative advantage in exercising influence over government–something that Wolf et al, in agreement with Friedman believe–that will just give corporations more power to do harm, not less.

In sum, Friedman’s latter-day critics, conveniently arguing when he is in the grave, and therefore unable to demolish them (as he surely would), totally fail to come to grips with his arguments, and in particular the arguments of his entire body of work, not just one article. “Stakeholder capitalism” is a vapid, vaporous concept that fails to address Deirdre McCloskey’s pithy phrase: “if you’re so smart, why aren’t you rich?” Claims that corporations should adopt a new objective function that encompasses “social” objectives, and not just profit, founder on the Knowledge Problem. Defensible criticisms that corporations exploit the political system are not arguing against Friedman–they are agreeing with him, yet arriving at wrongheaded conclusions.

We should all wish that our current thoughts, when evaluated from the perspective of 50 years, hold up so well as Milton Friedman’s. I guarantee that that will not be said of anyone carping on him today.

Friedman was small in stature, but a giant Gulliver in thought. His Lilliputian critics today prove the point.

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  1. Really cannot comment except to say you are correct. I wish the Stigler Center thought as much, or the people like Jamie Dimon. Prof Steve Kaplan did an excellent job in a recent virtual Booth debate on this topic. Companies that stray from building shareholder value by delighting their customers will open themselves to competition. Period. That’s good business not just capitalism

    Comment by Jeffrey Carter — October 11, 2020 @ 6:11 pm

  2. One caveat for us at CME it wasn’t electronic trading that incentivized us to demutualize. It was because we thought we had built a lot of value in our seats that wasn’t being recognized by the existing market. The only way to access that value was to find a market that would recognize the value that was being created. That forced us to demutualize into common shares rather than memberships. It also forced us to go from the non-profit member run model to a classic corporate model of governance. If we would have kept our old model of governance, the marketplace would have dinged us on value.

    FYI, a full CME membership in 1994 traded at just over $1MM. In 1998, it traded down to a low of $280k. (I joined the CME board in December of 1998.). If you bought a membership at the low, the stock that was allocated was 18,000 shares. At the high before splits and dividends the stock traded $714 in Dec of 2007 or $12.8MM. You also got to keep your B share, which traded back to $1MM in 2007.

    That’s a lot of value creation.

    Comment by Jeffrey Carter — October 11, 2020 @ 6:20 pm

  3. One of the most overlooked values of the free market system is that once the exchange between the parties is completed, there is no longer any obligation between the parties. In all other systems of economic allocation, Kings, Popes, government bureaucrat, when you receive the favor of the Lord, Cardinal, or Al Gore you must maintain an obligation to your better. If you do not, your next meal may not arrive.

    I would also argue that another factor that is overlooked on free market exchange is that it is the only system that can actually create “consumer surplus”. This is because commodities are allocated to those who value it the most. In all other systems, allocation are done on a political valuation. The King will give his favorite Duke the best land and the best government offices, and the choice of the new products from the New World. He may not value the sinecures as much as other individuals and may not be able to develop those gifts the way other individuals can to increase social welfare, but he gets them because he is the friend of the King.

    Multiply this out on a macroeconomic basis and that is why controlled, governmental allocation never can work to deliver anything but poverty to all but the favored few.

    Comment by MARK — October 11, 2020 @ 10:14 pm

  4. Professor, I wanted to ask, have you ever met Friedman? I know that you are big admirer of his works and ideas.

    Comment by mmt — October 12, 2020 @ 4:50 am

  5. ‘Hayek’s injunction that the addition of “social” as a prefix to any concept, e.g., social justice, usually renders the concept meaningless’.

    He was too generous: “social” usually implies “contra”. Thus social justice is injustice, social housing fills up disproportionately with anti-social tenants, and so on.

    Comment by dearieme — October 12, 2020 @ 6:04 am

  6. @mmt. Alas, no. He retired from Chicago when I was a junior in high school, and was not on campus by the time I was a student there. I consider myself his intellectual grandson. He was the thesis advisor to my thesis advisor, Lester Telser.

    Comment by cpirrong — October 12, 2020 @ 12:17 pm

  7. @cpirrong Thanks!

    Comment by mmt — October 13, 2020 @ 12:04 am

  8. A translation:

    Stakeholder usually means me or my favorite group of extortionists That is selfless advocates.
    Capitalism means money. Very bad except if in my hands or my friends.
    Synonyms: gimme, gimme,gimme or we’ll outlaw you and tax you to death.

    Comment by Sotosy11 — October 16, 2020 @ 7:09 pm

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