The Ethics of Free Markets

© R. McGarvey, 2005

Social Responsibility and Free Market Capitalism

Social Responsibility and Free Market Capitalism

In a landmark New York Times article (September 13, 1970), Dr. Milton Friedman laid out the case that managers in fulfilling their corporate duties should have no overriding social responsibilities: "...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."1. Given Dr. Friedman’s standing as one of the world’s leading free market economists at the time (leader of the Chicago School of monetary economics), his article carried great weight, and authority. Professor Friedman used his article to reinforce in blunt terms the modern theoretical separation between economics (good and liberating) and politics (bad and controlling). What was decidedly new in Dr Friedman’s arguments were the associations he drew: Busi­nessmen who talk this way (about social responsibility) are unwitting pup­pets of the intellectual forces that have been undermining the basis of a free society these past decades. In Dr. Friedman’s mind the very idea of ‘social’ responsibility for corporate managers was wrong headed, amounting to nothing less than socialism in disguise.

The publication of Dr. Friedman’s article contributed significantly to radical changes that were then taking place in American management practices. The late 1960’s saw the rise of a new and much more aggressive managerial class, often trained professionally, many with MBAs. Their arrival on the business scene completed the ascendancy of a narrowly focused, Wall Street inspired, ‘financial’ theory of the business; its fundamental premise (relatively new at the time2) was - a business exists to return on shareholder equity; its measure of corporate success or failure, the company’s quoted stock price. Dr. Friedman’s article could not have been more fitting or timely for the advocates of this management revolution. In tandem with other societal forces, the article contributed to the post war liberation of management from what many considered ‘hidebound’ corporate traditions; while simultaneously freeing management- as- a-class from any independent ethical responsibility for the larger consequences of their actions. The message was unmistakable; so long as management ‘played by the rules of the game’ they had no larger obligations; beyond, that is, increasing corporate profits.

Modern Business Practices

What followed over the course of 35 years is now history. A brief list of notables illustrates the new ethical reality of modern business plainly, Charles Keating3 of Savings and Loan fame, corporate raiders Carl Icahn, Henry Kravis, Irwin Jacobs, and - naturally - Michael Milken, the “junk bond king”, all were headline news in the 1980’s. More recently we have the ‘new economy’ and the accounting gymnastics of Enron, WorldCom, Adelphia, AOL Time Warner, Global Crossing, Tyco, etc.

The now defunct Arthur Andersen leads a list of formerly august accounting and financial institutions that have been involved or implicated in dubious practices. Major mutual fund players including Putnam Investments, Prudential Securities, Alliance Capital/Alliance Bernstein, Bank of America's Nations Funds, Charles Schwab, Federated Investors, Franklin Templeton, Fred Alger Management, Janus Funds, Massachusetts Financial Services Co. (MFS), One Group Funds, Pilgrim Baxter (PBHG), Putnam Investments and Strong Funds – were accused of defrauding their own unit holders through decades of so called ‘late trading’, prohibited after-market trading schemes4.

In 2003, some of the biggest investment banking firms on Wall Street reached a $1.4bn out of court settlement with the SEC and the State of New York. And while the firms admitted to no wrongdoing, the settlement alleged that during the stock market boom of the 1990’s these major investment-banking firms essentially conspired with their largest fee generating investment-banking customers to the detriment of investors. The list of names reads like a who’s who of Investment banking, Salomon, Merrill Lynch, Credit Suisse Group's CSFB, Morgan Stanley, Goldman Sachs, Bear Stearns, JP Morgan, Chase, Lehman Brothers, UBS Warburg, US Bancorp's Piper Jaffray.5

The insurance industry, not to be left out of the action, is now facing the wrath of New York’s attorney general. Among the famous institutions implicated in the ongoing investigation of industry price-fixing are broker Marsh & McLennan, insurer AIG, and ACE, a property-casualty insurer; coincidently these famous institutions are each in their turn managed at the highest levels by the father and/or sons of a single family6.

While clearly some of the above mentioned scandals are based on illegal fraudulent practices, what is interesting for our discussion is that many of these serious breaches were NOT technically illegal. Indeed, defenders of the status quo have argued that the senior management in these institutions were themselves victims; management was simply ‘playing by the rules’ and while their actions clearly disadvantaged some they were customary practices, nothing out of the ordinary.

The investment banking industry for instance, while deeply implicated in practices that were disadvantaging their investment customers, were investigated and by and large absolved of legal wrongdoing. The mutual fund scandal is also troubling, in that while ‘late trading’ is clearly illegal, market timing as practiced by many in the mutual fund industry is not. Ironically, a mutual fund only places itself in jeopardy of censure if it violates its own stated public policy against such trades (and then allows them nonetheless). But perhaps the greatest irony of all is Enron, where a history of dubious off balance sheet transactions, although clearly intended to misrepresent the true state of the company’s finances were (for the most part) neither technically illegal nor (irony of ironies) non-compliant with GAAP (Generally Accepted Accounting Practices).

What is increasingly clear in retrospect is that during the 1990’s deception and fraud had in some sense become established norms in the upper echelons of corporate America.7 In the interests of maintaining a free and liberal economy perhaps we should be re-examining some of these ‘customs’. Perhaps a review of the ethical foundation of free market capitalism is in order, to identify just where the responsibilities of management begin and end in a free market system.

Classical Liberalism

The theory of laissez faire capitalism owes a great debt to the classical liberals, most importantly its earliest theorists Adam Smith and David Ricardo. On the question of social responsibility opinions varied amongst early liberals, but Adam Smith in The Wealth of Nations8 (1776) proposed one of the most popular solutions to the problem. Capitalists, he recommended, should be left alone to follow their own interests: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”9

Adam Smith championed a doctrine of natural liberty and supported the burgeoning late 18th century reform goal of lifting restrictions on trade; feeling that in removing societal restraints on the rights of property, the actions of individual businessmen would, in the larger collective sense, be guided by an ‘invisible hand’ that would advance the public interest: He (the business man) generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it..., he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end (the public interest) which was no part of his intention10.

What lay behind the ‘invisible hand’ concept was Adam Smith’s sincere belief that free and competitive markets were (are) in a sense self-correcting. This pragmatic doctrine clearly pleased entrepreneurs who made the assumption (not supported in Smith’s writings) that the ‘invisible hand’ absolved them of all larger public responsibilities.

Smith’s Theory of Moral Sentiments

To understanding Smith’s ‘invisible hand’ more fully it is necessary to investigate Smith’s earlier writings on the subject of moral responsibility: The Theory of Moral Sentiments (1759). In this we have a slightly different, and more fully developed idea of ethical responsibility. In The Theory of Moral Sentiments Smith identified three factors (or virtues), prudence, justice and benevolence that he felt govern an individual’s economic motivations. Prudence for Smith is relatively straightforward; it’s simply self-interest by another name. Everyone, he realized, whether prince or peasant has this sort of motivation. A ‘sense of justice’ is more complex, for Adam Smith it implies that rational individuals obey the law, and more importantly can be depended upon to obey the law most of the time. Benevolence is where Smith gets more controversial. For in Smith benevolence implies some sort of interest in people to do the ‘right’ thing even in the absence of specific law.

In The Wealth of Nations Smith deliberately focuses on elevating the virtue of prudence or ‘self-interest’ suggesting that it must be included in any commercial ‘bargain’ if it is to be entered into enthusiastically and voluntarily. Smith realized that the prevailing ‘mercantilist’ system of economic organization was characterized by vast concentrations of economic power and authority. Indeed during this mercantilist period, monarchical benevolence (in its many forms) was, for many, the key to riches in the form of Royal Charters and other monopoly restrictions on competition. It is clear that Smith viewed this restrictive system of economic organization as unworthy of a rational ‘modern’ society: In almost every other race of animals each individual, when it is grown up to maturity, is entirely independent and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only11.

In concluding his discourse on the subject of self interest and the division of labour, Smith added, “Nobody but a beggar chuses to depend chiefly upon the benevolence of his follow citizens”12, underscoring his principle that relying solely on the benevolence of others or indeed any one of the other virtues in isolation (self-interest included) was insufficient to sustain a natural liberty. It is clear that Smith’s concept of natural liberty rests on individuals maintaining a balance between the three competing virtues of prudence, justice and benevolence: The man who acts according to the rules of perfect prudence, of strict justice, and of proper benevolence, may be said to be perfectly virtuous.13. For Adam Smith, a system of natural liberty was in this sense dependent upon conscious self-regulation, or self-command, as he preferred to call it. For Smith self-command was a crucial ingredient in the effective operation of a free market system: “But the most perfect knowledge of these rules (prudence, justice and benevolence) will not alone enable him to act in this manner; his own passions are very apt to mislead him- sometimes to drive him, and sometimes to seduce him, to violate all the rules which he himself, in all his sober and cool hours, approves of. The most perfect knowledge, if it is not supported by the most perfect self-command, will not always enable him to do his duty.”14

It is fair to speculate from a reading of Smith’s greater works that the ‘invisible hand’ for Smith is really personal morality, a function of that balance of virtues, (prudence, justice and benevolence) exercised with knowledge and self-command. It is the consistency with which individuals ‘do the right thing’, in essence self-regulate their behaviour, that creates the generalized freedom of action in a free market capitalist system. It is also clear from the example of post Soviet Russia - among others - that the absence of individual self-regulation creates an ethical vacuum leading to criminality, anarchy and eventually to government intervention (i.e. regulation or re-regulation) in the economy. Indeed following a period of unprecedented scandal, the United States is experiencing just such a period of re-regulation today. The extraordinary regulatory requirements of the Sarbanes Oxley Act are only one of many official over-reactions to ethical failure in corporate America. Such a reversal is happening to an even greater extent (in response to a far greater ethical failure) in Russia with President Putin’s heavy-handed re-ordering of economic and political power in Russia.

If we accept that the ‘invisible hand’ presupposes some measure of self-restraint and that ‘benevolence’ as Smith describes it implies a responsibility larger than maximizing corporate profits, what limits are we to place on these so-called ‘social’ responsibilities? As Professor Friedman pointed out, taken to its extreme social responsibility would simply replace prudent business managers with what amounts to (un-elected and unaccountable) public servants.

Manage with Knowledge and Self-Command

At the very least ‘social’ responsibility certainly implies that managers, if they are to serve the interests of the owners of the business, have a responsibility to look beyond their own personal self-interest. Managers must demonstrate sufficient ‘self-command’ to limit the worst excesses of the ‘culture of greed’15, which clearly overtook senior management in WorldCom, Adelphia, Enron and others during the 1990s. However in addition it’s important for managers to demonstrate knowledge and foresight; to appreciate the limitations that apply to the normal ‘rules of the game’ or established ‘customs’ in periods of economic transformation such as we are presently experiencing. The economies of the west are being forced to rapidly adjust to globalization at the same time they are undergoing a fundamental shift in their asset foundations, moving from economies dominated by traditional ‘industrial’ type assets to economies that are increasingly underpinned by a suite of intangible ‘knowledge’ assets16.

Just how radically and rapidly the ‘rules of the game’ change can be observed in the AOL merger with Time-Warner. AOL, an Internet service provider had, at the time of the merger, (January 2001) an astonishing market capitalization of $164 billion (Time-Warner’s market capitalization at the time was $83 billion). Few of Time-Warner’s senior managers or board members bothered to question AOL’s numbers, most simply followed the ‘rules of the game’, accepting Wall Street’s market-based valuation as true. A sober second look at AOL would have reveled that it was not ‘asset light’ as described in the press at the time; AOL was, in fact, underpinned by a variety of intangible assets, principally its very expensive brand asset. (Brand asset being a function of the attractiveness of AOL to new Internet subscribers and advertising customers and the willingness of existing customers to continue doing business with AOL.) Because intangible assets do not appear on the corporate balance sheet (they are generally ignored or lumbered collectively into ‘Goodwill’), few managers schooled in the ‘financial’ theory of the business would recognize brand as an asset at all. Therefore AOL’s brand and other intangible’s were never given a thorough examination, no qualification was ever put on the strength and sustainability of the AOL brand asset17. Because Time-Warner executives accepted the established customs, the ‘rules of the game’ they were completely unprepared for what happened next: the rapid collapse in 2001 of AOL-Time Warner’s share price and market capitalization.

Manage Beyond the Letter of the Law

Whatever else ‘social’ responsibility might mean, it certainly implies heavily that sound ethical judgment must supplement the ‘letter of the law’. The Enron story is illustrative of how managing to the letter of the law can be astonishingly damaging to long-term shareholder value. Enron was (prior to 2001) a company that was known for its innovative spirit creating whole new industries with novel, exciting business models. Unfortunately for long-term shareholder value, so new were its ‘novel’ industries, new economy business models etc. that the company’s auditors and legal advisors hardly knew what to make of them; opening the door to all sorts of nefarious practices by Enron’s management.

As it turns out very few of the fancy accounting maneuvers or special purpose vehicle (SPV) structuring options put together by Enron management with their Andersen (auditing) partners were technically illegal – at the time. Nor indeed were its maneuverings greatly at odds with prevailing management and/or accounting customs. What is clear in retrospect is that most of the more creative activities existed in the legal ‘gray zone’ where the law and accounting standards had yet to catch up with the fast pace of economic change. The cumulative affects of these practices however, were fraudulent, devastating to Enron’s debt holders, shareholders, employees and it’s own long-term prospects. Eventually various individuals did go over the legal line, but at every step of the way had Enron’s senior management applied ethical judgments18 to its own motivations (clear intent to mislead), and/or looked rationally ahead at the ultimate consequences of its actions (potential bankruptcy), there is no doubt they would have seen a vastly different picture19; perhaps they might have done things differently.

Accommodate Societal Change before it bites you on the behind

Despite Adam Smith’s noted scepticism about "those who affected to trade for the public good" there is certainly implied in Smith’s notion of benevolence a necessity for management to proactively respect larger societal changes, issues that Dr. Friedman dismisses out of hand: … businessmen believe that they are defending free en­terprise when they declaim that business is not concerned "merely" with profit but also with promoting desirable "social" ends; that business has a "social conscience" and takes seriously its responsibilities for providing em­ployment, eliminating discrimination, avoid­ing pollution and whatever else may be the catchwords of the contemporary crop of re­formers.20

The 20th century was one of the most revolutionary in history, characterized by dramatic societal changes, in particular by a wholesale elevation of the interests of women, working men, visible minorities, the handicapped and other historical ‘underdogs’ in society. No senior manager today can ignore these major societal changes in their approach to marketing, hiring policy or planning; to do so would put their organizations at risk of losing precious market share, becoming involved in serious litigation, or worse. As for pollution; ask Lloyds of London if the Exxon Valdez or Asbestos pollution are problems or merely the catchwords of reformers. Perhaps in 1970 corporate managers could pretend to ignore the consequences of pollution, today they cannot. Pollution’s rise to prominence was simply a matter of society coming to grips (often retroactively) with externalities, something Samuel Brittan referred to as the “spillover effect… in other words, costs and benefits imposed on others, which are not taken into account in an unregulated market”21. Pollution is a serious social - and business issue - to suggest that it is beyond the scope of management responsibility, or worse - socialism in disguise - is irresponsible.

Preserving Free Market Capitalism

Dominic D'Alessandro, the head of Canadian insurance giant Manulife Financial Corporation, complained recently that the corporate governance pendulum "may have swung too far.” More to the point he added: "It is now becoming fashionable to believe that corporate (management) behaviour should always be viewed with suspicion…this is a very dangerous premise upon which to develop a governance regime.22” Unfortunately for Mr. D’Alessandro (and others who value free market capitalism) that is precisely the lesson that legions of legislators and regulators around the world are taking from the events of the recent past. If individual senior managers are unable or unwilling to regulate themselves, it is clear that governments’ will – eagerly – step in and regulate for them.

The question we all face today is the eternal one in any free enterprise system: will capital continue to enjoy its traditional freedom of action - the full run of its ‘animal spirits’ - as John Maynard Keynes described them23? Or is global capitalism going to be subjected to an ever-growing host of bureaucratic constraints? The next steps taken in this arena could dramatically influence the future of capitalism. It is becoming increasingly clear that if we are to maintain a free market system founded in the principals of natural liberty, the burden of responsibility falls upon each and every one of us as individuals. It’s no exaggeration to suggest that without greater knowledge and ethical accountability – including meaningful behavioural reforms at the management level - the very existence of a self-regulating free market system could be imperilled.

1 The Social Responsibility of Business is to increase its Profit, Milton Friedman, The New York Times Magazine, September 13, 1970

2 In My Years with General Motors, Alfred P. Sloan Jr. GM’s share price hardly merited a mention and finance took a back seat to production, divisional structuring and most importantly GM customers. Peter Drucker, who studied Sloan’s management system, would later coin his own (Sloan inspired) theory of the business: A business exists to create a ‘customer’. In Drucker there is a cause and effect relationship between customers (cause) and profits (the effect) that had to be taken into consideration by management.

3 Binstein, Michael and Charles Bowden, Trust Me: Charles Keating and the Missing Billions, New York: Random House, 1993.

4 Mutual Fund Industry Fraud Investigation, http://www.lieffcabraser.com/mf_main.htm

5 Wall Street settles analyst scandal, http://news.bbc.co.uk/1/hi/business/2981865.stm

6 The Insurance Scandal: Just How Rotten? The insurance industry is the latest financial sector to have its darkest secrets exposed to the light. The Economist October 22, 2004

7 Dr Friedman identified few qualifications on managements’ actions “That responsi­bility is to… make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom. It is clear that rewarding ‘insiders’ became a behavioral norm, or ‘ethical’ custom in the 1990s.

8 Technically, “An Inquiry into the Nature and Causes of The Wealth of Nations”

9 Book I, Chapter II, page 18. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, published 1976 by the University of Chicago Press, Edited by Edwin Cannan. Cannan’s edition of The Wealth of Nations was first published in 1904 by Methuen and Co.

10 IBID, Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book IV, Chapter II, p477

11Book I, Chapter II, page 18. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, published 1976 by the University of Chicago Press, Edited by Edwin Cannan. Cannan’s edition of The Wealth of Nations was first published in 1904 by Methuen and Co.

12 IBID, Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter II, page 18.

13 Part II, Section III, chapter 1, page 387. Adam Smith, The Theory of Moral Sentiments, Published by Liberty Classics, Indianapolis, USA. This edition of The Theory of Moral Sentiments follows the text of the ‘New Edition’ published in London in 1853 by Henry G. Bohn.

14 IBID, Adam Smith, The Theory of Moral Sentiments, Part II, Section III, chapter 1, page 387

15 For a fuller description of this phenomenon see Roger Lowenstein’s “Origins of the Crash”, Penguin, NY 2004 particularly chapter 3, p34 – 54,

16 See Britain & Overseas, August 2004 “The politics of Political Economy” and B&O winter 2004 “The Knowledge Economy” These two papers by the author speak to the expansion that is taking place in the property matrix, and its effect on the underlying asset foundation of western business.

17 Fools Rush In, Steve Case, Jerry Levin, and the Unmaking of AOL Time Warner, Nina Munk, HarperCollins New York, NY. p 179

18 Western ethical philosophy distinguishes three aspects to any action that an ethical value can be attributable to: (1) Motives, (2) Means and (3) Ends or Consequences of action. In other words, ethical value can be attributed to the motives or originating logic behind a given course of action, the means by which an action is undertaken and ultimately the ends or consequences of actions. These motives, means and consequences can all independently be assigned ethical value and in many cases can be judged quite differently.

19 The Smartest Guy’s in the Room, The Amazing Rise and Scandalous Fall of Enron, Bethany McLean and Peter Elkind, Penguin Publishing, London, WC2R ORL, UK. P 151, Chapter 11, Andy Fastow’s Secrets.

20 The Social Responsibility of Business is to increase its Profit, Milton Friedman, The New York Times Magazine, September 13, 1970

21 What's Wrong with Economics? , Samuel Brittan: Chapter 21 of Economic Consequences of Democracy, Gower, 1977, 1988

22 The Globe and Mail, May 3rd 2005, Report on Business

23 “Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." Keynes, J., 1936, General Theory of Employment, Interest and Money, New York: Harcourt Brace 1936, pp. 161).