79. Capitalism and Freedom, Part 2

Note: This post is the seventy-ninth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

This week's post is a follow-up on last week's post on the book 'Capitalism and Freedom' by Milton Friedman.

Last week I promised to explore in more detail an example of where Milton Friedman got carried away with his 'market good, government bad' mindset. The specific topic I want to cover is Friedman's comment that,

"The view has been gaining widespread acceptance that corporate officials and labor leaders have a 'social responsibility' that goes beyond serving the interests of their stockholders or their members. This view shows a fundamental misconception of the character and nature of a free economy. In such an economy, 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 or fraud.¹"

As we'll see, the trouble with this statement is that while it is true that businesses have an obligation to pursue profits, Friedman unnecessarily constrains their other moral obligations, ruling out things like taking action to fight pollution as being a violation of a company's duty to pursue profits first.

This will be a lazy post for me, since I'm going to let Joseph Heath do most of the talking, via his essay, "A Market Failures Approach to Business Ethics" Really, you'd be better off just reading Heath's whole essay - it's easy to follow and not particularly long, but I'll summarize the main points here that are relevant to our Systems of Survival theme.

Heath first argues that the obligation of the business to earn profits is not a simple reflection of self-interest on the part of company shareholders but rather is a moral duty. The profits earned are a reflection of the ability of the shareholders ability to deploy resources where they are wanted/needed by the population - so the greater the profit, the greater the gain to society, and hence the duty to earn profits.

Naturally, many people will find this a little hard to swallow. Heath reasons that one reason people find this difficult to accept is that, unlike say a doctor's obligation to their patients, the obligation of a a manager to make profits is more like the indirect role played by trial lawyers in which an action which in and of itself has little moral justification (making money for shareholders / defending accused criminals) has value because of the role it plays within a system with various parts.

Heath:

"We understand implicitly that the professional conduct of doctors is to be entirely governed by their obligations to their patients, and thus that they are not permitted to let considerations of self-interest intrude. Profit-maximization has precisely the same status for managers.

...

Health is widely regarded as a good thing, and thus the doctor’s actions serve to promote a state of affairs that is morally desirable. This makes the doctor’s actions directly justifiable, even intrinsically altruistic. Things are more complicated in the case of business. It is not clear that profits are intrinsically good. Furthermore, when a manager makes a decision that disadvantages workers in order to benefit owners, the profit maximization imperative generates a distributive transfer that is by no means morally sanctioned. In fact, under the typical set of circumstances, the transfer will be regressive, and thus problematic from the moral point of view.

The asymmetry arises from the fact that profit maximization is only indirectly justified. It is useful to note that this problem is one that business ethics shares with legal ethics. The adversarial trial system imposes upon lawyers an obligation to do whatever is in their power to defend or advance the interests of their client, even when these interests are highly refractory to the concerns of justice. Thus the professional obligations of lawyers often conflict with the imperatives of everyday morality. What justifies their behaviour is the fact that they operate in the context of an institution with differentiated roles. The desirable outcome is a product of the interaction between individuals acting in these roles, none of whom are actually seeking that outcome. Justice is best served when there is both vigorous prosecution and vigorous defence.

Thus the effective trial lawyer 'promotes an end which is no part of his intention.'"

Next, Heath explains that the moral duty to seek profit flows from the first theorem of welfare economics which states that economic (pareto) efficiency is maximized when a bunch of conditions known collectively as 'perfect competition' are met, with one of the conditions being a number of firms competing to make the most profits.

Heath:

"Thus the primary reason for introducing the profit motive into the economy is to secure the operation of the price mechanism. The price mechanism is in turn valued for its efficiency effects. It allows us to minimize waste. The formal proof of this is often referred to as 'the first fundamental theory of welfare economics” (hereafter FFT), or else, in a nod to Adam Smith, the 'invisible hand theorem.' The central conclusion is that the outcome of a perfectly competitive market economy with be Pareto optimal – which means that it will not be possible to improve any one person’s condition without worsening someone else's."

Where things get tricky is that there are a number of other conditions for perfect competition (recall our earlier posts on Walter Schultz's 'Moral Conditions of Economic Efficiency')

The trouble is that competition only leads to efficiency if a number of conditions are met, the most commonly recognizes ones being the avoidance of force and fraud. As Heath notes, Friedman implicitly recognizes these moral obligations when he insists that the responsibility of the business is to, "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."

Where Friedman gets into trouble is in ignoring other possible violations of economic efficiency, most notably, the loss of efficiency caused by externalities that aren't priced into a business' products. For example, if company A drives company B out of business by offering lower prices, not because company A was better managed than company B but because company A lowered costs by dumping toxic chemicals into the water supply instead of paying to treat them like company B did, then this is not a gain in efficiency for society.

Heath:

"Despite some confusion, it is clear that Friedman's managers have genuine ethical responsibility to shareholders, and that this responsibility is derived from the FFT. The problem is that Friedman arbitrarily limits the set of obligations to those that support only some of the many Pareto conditions.

For example, Friedman argues that pollution reduction is one of the illegitimate responsibilities pressed upon managers in the name of 'social responsibility.' But pollution is a negative externality – a cost associated with some economic activity that is transferred to a third party without compensation. These externalities exist because the set of markets is incomplete. We cannot exercise property rights over the air that we breathe, for example. As a result, while we can charge people for dumping noxious substances on land that we own, we cannot do the same when they dump it in the air. For this reason, one of the Pareto conditions specifies that there must be no externalities. Any corporation that pollutes is essentially profiting from a market imperfection. This means that there is no difference, from the moral point of view, between deception and pollution – both represent impermissible profit-maximization strategies.

Friedman's decision to prohibit deception, while giving the wink to environmental degradation, is arbitrary and unmotivated."

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¹ This quote is from Capitalism and Freedom, page 133, but you can also refer to Friedman's article, "The Social Responsibility of Business is to Increase its Profits," which covers the topic of this post specifically.

78. Capitalism and Freedom (part 1)

Note: This post is the seventy-eighth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

This week's post is on the book 'Capitalism and Freedom' by Milton Friedman.

The Wikipedia article provides a good summary of the book and it's main arguments so I won't go into much more detail here. In general, the theme is on why we should limit the role of government in society and let the free market reign wherever possible.

Friedman is a descendant of Veblen in many ways, strongly of a commercial syndrome mindset and naturally hostile to the guardian syndrome. But where Veblen had the better of Friedman though, was in his willingness to see how people who were nominally part of the free enterprise system could end up mired in corruption by taking on guardian roles and mindsets and activities. Veblen recognized the guardian syndrome and saw it as a threat when it mixed with the commercial one. Friedman, on the other hand, seems not to even recognize the existence of the guardian syndrome and, perhaps as a a result, exhibits an almost childlike belief in the virtues of the free market.

In this time when the U.S. is turning into a plutocracy before our eyes, it's amusing to read Friedman's explanation of how wealth inequality is a safeguard of political freedom. And while Friedman goes on at length about the hazards of monopoly, the hazards of a perfectly competitive market go unmentioned (although surely Friedman must have read many critiques of perfect competition such as the one made by Joseph Schumpeter in 'Capitalism, Socialism and Democracy'.)

I guess, much in the same way that it is hard for us to judge the ancient Greek's views on slavery, it may be hard for me to judge the writings of Milton Friedman in the 1960's, a very different era with respect to views of government and markets. To the extent that Friedman wanted to explain that the mixed economies of the West were a better approach than full-on Communism, then certainly he is on solid ground. And to the extent that he takes on special interest groups (such as the American Medical Association) that are out to serve their own interests ahead of society, then he is still on solid ground.

But Friedman goes beyond this to advocating a wide range of free market policies without really thinking through his analysis completely. The next post will be a case study of one example from this book, the case of 'Corporate Social Responsibility'.

Not to say the book isn't worth reading. Friedman is a great writer and a clear thinker and there's certainly lots of valuable points to be made. It's just that given current circumstances, it all seems a little dated, overstated and reminiscent of tiresome level 2 thinking¹ at times.

Near the end of Capitalism and Freedom, Friedman comments that,

"The conversion of the intellectuals [to collectivist views] was achieved by a comparison between the existing state of affairs, with all its injustices and defects, and a hypothetical state of affairs as it might be. The actual was compared with the ideal.
At the time, not much else was possible ...

We now have several decades of experience with government intervention. It is no longer necessary to compare the market as it actually operates and government intervention as it ideally might operate. We can compare the actual with the actual.
If we do, it is clear that the difference between the actual operation of the market and its ideal operation - great though it is - is as nothing compared to the difference between the actual effects of government intervention and their intended effects."

The irony is that, at the time, Friedman himself was proposing a set of theoretical, ideal changes to the way society operated, comparing his ideal markets against how things actually worked the time. And here we are, decades later and so much of what Friedman recommended has been tried and failed. Central banks tried increasing the money supply in the manner Friedman suggested but found it unworkable and ineffective in practice. The financial meltdown of recent years disproved his theories about how the U.S. Federal Reserve (Central Bank) caused the great depression. School vouchers have been implemented in many places for many years to little noticeable effect. The Chilean pension system, modelled after Friedman's recommendations, had to be reformed (again) in 2008 because of the exact problems with coverage and cost that Friedman dismisses. The dismantling of social programs and anti-poverty measures and reductions in the level of union power has coincided with increases in inequality and poverty (since Friedman was writing in the early 60's), and recent years have made a mockery of Friedman's claims that the unhindered operation of the free market would result in the narrowing of class divisions or the advancement of popular culture by leaps and bounds or that greater reign for the free market would result in a less materialistic society.

At any rate, Friedman's book provides a good example of the commercial syndrome mindset applied to the question of the proper role of government. Friedman believed that collective action was almost always a bad thing because it forced people to go against their self-interest and thus would never work because people almost always follow their own self-interest. From this assumption of self-interest as the primary, at times sole motivator of humanity, flowed his belief in the supremacy of the market over collective action.

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¹ I remembered I had written a post about 'level 2 thinking' a while back, but only when I dug up the link did I realize that the quote that prompted that old post was also from Milton Friedman - I guess it's good to know I can be consistent even without the benefit of a properly functioning memory!