Friday, October 03, 2008

On Throwing Out the Baby With the Bathwater

Joel Bakan teaches law at the University of British Columbia and he is the author of The Corporation: The Pathological Pursuit of Profit and Power, and writer/co-creator of the documentary film ‘The Corporation’. He has a piece in today’s Vancouver Sun, which is fairly typical of many of the current crop of op-eds and columns around at present; they take the current financial crisis to kick their boots into either markets or government interventions in pursuit of their firm views on what’s wrong with international finance, or into those who have different views to theirs about what’s right about the way the economy is or is not working.

Ideologues Unanimous are holding packed meetings to celebrate their certainties, while foaming at their mouths when tossing their bile at whomsoever they regard as complicit in the failure of confidence within financial markets. It is amazing how many of them are so certain about the causes of the current problem – even down to naming the individuals whom they judge to be guilty – when if it were as simple as that we’d all be in the know too, but aren’t.

Lost legacy does not take sides in what is essentially a political problem. It observes; it doesn’t proselytize in the debate about the balance between free markets and free governments. It does express views on the alleged, asserted, and impugned contributions of Adam Smith in the ideologues’ obsessions.

Take Adam Smith’s alleged role in Joel Bakan’s article (HERE):

Meltdown is a sure sign that free markets don't work"

“To begin with, he [Milton Friedman] said, corporate firms have one, and only one, obligation -- to make as much money as they can for their shareholders. "A corporation is the property of its shareholders," he said. "Its interests are the interests of its stockholders. Now, beyond that, should it spend the stockholders' money for purposes which it regards as socially responsible but which it cannot connect to its bottom line? The answer I would say is no."

Second, Friedman told me, there is little, if any, legitimate place for government to regulate what corporations do in their pursuit of profit. Accordingly, he said, governments should wind up their roles as economic overseers. They should deregulate.
The meltdown on Wall Street was caused, in part, by the inherent contradiction between these two ideas. If corporations are designed solely to make money for their shareholders, and if governments have no place in regulating what they do, what is to stop them from acting recklessly and dangerously in their pursuit of profit?
Friedman's answer to this question -- which he borrowed from, and attributed to, Adam Smith -- was that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors. The popularity and influence of this idea, spouted by economists with near mantra-like devotion (at least until the past few weeks), is puzzling. Would you want an invisible hand to guide your surgeon's knife, or protect your neighbourhood from crime?

Why is the economy so special -- how is it that the invisible hand works there but nowhere else? The Wall Street meltdown suggests that, in fact, it does not

I have one major problem with Joel Bakan’s article.

Friedman's answer to this question -- which he borrowed from, and attributed to, Adam Smith -- was that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors.”

Milton Friedman was an effective propagandist for markets in preference to legislatures running an economy, and with this I have no quarrel in general. But like many commentators, he over-stepped the mark when he associated Adam Smith with parts of his advocacy.

Regular readers of Lost Legacy will be familiar with my constant corrective comments on the myth of ‘an invisible hand’ – to which Milton Friedman was a major disseminator – and they will know, as will all who actually read Adam Smith’s works (The Theory of Moral Sentiments and Wealth of Nations), that Adam Smith used in metaphor only once in each book and on both occasions it had nothing to do with his how markets work, as reported in Books I and II of Wealth Of Nations.

His sole reference to ‘an invisible hand’ in Moral Sentiments [TMS p 184) was about rich landlords having to distribute the produce of their farms to their employees, otherwise they would not survive the winter to labour in the fields in the Spring, despite their landlord’s illusions that their ownership of a beautiful and bountiful harvest was for their own consumption only. His sole reference to ‘an invisible hand’ in Wealth of Nations (WN IV.ii. p 456) is about the arithmetical consequences of risk aversion (the whole is the sum of its parts) and had nothing to do with markets (nor was it a theory, nor a principle, nor a paradigm - it was a metaphor).

Hence, Milton Friedman’s claim that Adam Smith believed or asserted ‘that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors’ is patently incorrect, false, and a myth. The contrary view that Adam Smith did write what Friedman – and many others, including Nobel Prize Winners, distinguished scholars and eminent members of our profession – say he did is a study in the psychology of unsubstantiated beliefs.

Now I do not assert that convincing such personages to the contrary is ever going to be easy – several distinguished colleagues at the recent 40th Anniversary Conference of the History of Economic Theory, in Edinburgh, remained ‘unconvinced’ in the discussion of my paper *(that was my failing, of course) and two at least were quite antagonistic of the very notion of an invisible hand being a mere metaphor, and nothing I said, even by reading out from Moral Sentiments or Wealth Of Nations, affected their firm views.

So it’s not surprising that Joel Bakan’s report of his conversation with Milton Friedman is sincerely believed by him to be the link between free markets and the errors that caused the present crisis. Though to be fair, he does qualify his own report about Adam Smith and Friedman’s assertion about the invisible hand: ‘which he borrowed from, and attributed to, Adam Smith’. Joel, after all teaches law and knows the weakness of unqualified assertions.

Where I agree with Joel’s article is that Friedman’s often pronounced belief that corporate bodies have no responsibility for anything other than making money for their shareholders. Such extravagant assertions are not correct, in my view. Corporations, like any other institution or natural person, have obligations, not the least of them, to conduct themselves within the law (including such regulations as are passed lawfully to make laws operational).

The history of corporations includes the kinds of behaviours criticised by Adam Smith in Books IV and V of Wealth Of Nations regarding the awful behaviours of the East India Company and the people in it.

There is also the history of slavery, which history should not be confined only to the experiences of slavery in the British Colonies and afterwards in the USA, of which the British slave trade was stopped by law in 1808. There is also the unfortunate neglect of the millennia of experiences of slavery in eastern Europe, the near East and the Arab sphere of influence in Africa, and in India and China too until recent times. This history suggests that left to their own ideas of corporate responsibility there is a real danger that corporation, governments, and private individuals will behave irresponsibly and inhumanely unless the legislature intervenes.

Therefore, in advocating minimalist corporate responsibility, Milton Friedman was plain wrong. Working within the law and common decency, corporations are better suited to operating in competitive market economies. That part of Friedman’s outlook was right, considering the alternatives.

But overall I do not accept that Joel is right when he claims that "Meltdown is a sure sign that free markets don't work". In the absence of free markets, within the law and actining decently, he would soon notice the difference in Vancouver.

*Readers interested in the myth of an invisible hand can find it discussed in my book, ‘Adam Smith: a moral philosopher and his political economy’, Palgrave Macmillan, 2008, or in my paper, ‘Adam Smith and the Invisible Hand: from metaphor to myth’, 2008. The latter is available online if you write to: gavin –at – negweb-Dot com

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Blogger Paul Walker said...

Gavin. In the past you have commented on the (mis)use and (mis)interpretation of Smith's writings by a number of the members of the "Chicago School", including Friedman. With this in mind I found the following passage from Johan Van Overtveldt's book "The Chicago School" interesting. He is writing about Jacob

As a student of the history of economic thought, Viner also focused on utility theory (1937), methods of economic analysis (1925b), mercantilism, and Adam Smith. Viner was one of the first to draw attention to the fact that one had to be familiar with both the famous Wealth of Nations and The Theory of Moral Sentiments, written 19 years earlier,
to get a real understanding of Smith's world. "Smith was the great eclectic . . . Science, philosophy, theology, psychology, history, contemporary observation of facts-all of them were made to produce, under Smith's capable management, an abundance of evidence of the existence of an order in nature in which beneficent intentions towards mankind could be discerned (Viner 1927, 199,200).

However, Viner was also among the first to stress that "Adam Smith was not a doctrinaire advocate of laissez faire . . . He had little trust in the
competence or good faith of government. He knew who controlled it, and whose purposes they tried to serve . . . He saw, nevertheless, that it was necessary, in the absence of a better instrument, to rely upon government for the performance of many tasks which individuals as such would
not do, or could not do, or could only do badly" (Viner 1927, 231-2).

4:34 am  
Blogger Paul Walker said...

Let me add an addition comment here. This quote comes from Friedman's book "Capitalism and Freedom", a section headed 'Social Responsibility of Business and Labor'. Friedman writes

The view has been gaining widespread acceptance that corporate officials and labor leaders have a "social responsibility" that goes beyond serving the interest 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. Similarly, the "social responsibility" of labor leaders is to serve the interests of the members of their unions. It is the
responsibility of the rest of us to establish a framework of law such that an individual in pursuing his own interest is, to quote Adam Smith again, "led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good."

Fristly note that Friedman's view cover both firms and labour unions. Second note what Friedman writes about the firm, "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." and "It is the responsibility of the rest of us to establish a framework of law such that an individual in pursuing his own interest is, to quote Adam Smith again, "led by an invisible hand to ...". Friedman is aware that of the need for a legal framework with in which the firm must operate and that there is a need for competition, without deception or fraud. It is under these conditions that Friedman thinks the invisible hand will work. Albeit out of context.

5:09 am  
Blogger Gavin Kennedy said...

Apologies; I did not see your comments until this evening:


The reason why I am sceptical of the Friedman line on social responsibility that the firm meets its sole obligations when it uses ‘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’ is illustrated by the changes that take place in what is legally obligatory, what good behaviour suggests is acceptable, and what the managers undertake from one generation to another.

Slavery was legal in the United States until the 1860s, hence a corporate entity maximising its profits using slaves met Friedman’s standards of corporate responsibility by remaining within them. Similarly, firms in South Africa did so up to the end of apartheid. When the law changed, corporates change too, which Friedman considers sufficient.

Irresponsible pollution – which executives could see from how they were operating in their production processes. The long legislative struggles to curb child labour in the 19th century were defended by employers asserting they were doing nothing illegal, which was strictly true but it suggests there must be gaps in an argument to limit corporate responsibility solely to what made profits.

The case for the non-separation of a firm’s commercial imperatives from what is clearly morally, but not legally, wrong at a particular time, seems to me be within Adam Smith’s political economy.

This lies at the root of the use made by Friedman of the metaphor of the invisible hand and the alignment of the individual pursuit of self interest, in the example Smith gave immediately before using the metaphor, which example was a consequence solely of risk avoidance, and not a general principle of his in Wealth Of Nations.

There are over 50 examples given by Smith in Books I and II alone of self-interested individuals acting in a manner that had malign consequences for others and did not promote society’s interests.

7:00 pm  

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