That’s the question being debated at the Creative Capitalism blog. I’ve made a small contribution on the idea, responding to the argument that the managers of companies have a fiduciary obligation to maximize profits. Joshua Gans has covered the same topic, and there’s lots more interesting stuff to read.
Fiduciary obligation
I’d like to tackle the notion of fiduciary obligation: that firms are obligated to act in the interest of stockholders or more specifically in Richard Posner’s formulation, to maximize corporate profits.
First, what is meant by obligation here? The obvious interpretation is that this obligation exists under statutory or judge-made corporate law. But if this were the main or only reason for arguing that firms should maximize profits the answer would be simple – change the law so that companies are free to take a broader range of goals into account. In fact, in many countries, such as Germany, companies are obliged to take worker interests into account, and capitalism does not appear to have collapsed as a result. But I somehow doubt that, if US law were changed to remove any obligation to maximize profits, or even to create a positive obligation to pursue broader social goals, Posner’s objections to creative capitalism would be resolved.
Alternatively, Posner argues that there is an equitable obligation to ‘keep faith’ with shareholders. As Posner says, if a company issues equity under the implied assumption that its managers will maximize profits, then decides to pursue other goals, shareholders can reasonably argue that an implicit contract has been broken. On the other hand, much of the corporate history of the US since the 1970s has consisted of the repudiation of implicit contracts with workers, and they have found little redress. In any case, such problems don’t arise for new companies, who state their policies at the outset.
So, presumably, the obligation to maximize profits is a matter of enlightened self-interest. Posner argues, plausibly enough, that a company that doesn’t maximize profits is weakening itself in competition with other firms. To be more precise, the probability of bankruptcy or hostile takeover is presumably increased by deviations from profit maximization. But this doesn’t mean that the probability of firm survival is maximized by maximizing profits. And there’s no obvious reason why socially concerned managers couldn’t conclude that the strategy that yielded them the best expected personal value, adjusted for the risk of corporate failure, was one in which the company pursued broad social goals.
If an argument is to be made against creative capitalism, fiduciary obligation seems a very weak reed. A better way of approaching the question would be to ask whether the goals of all concerned could not be better met if managers ran companies to maximize profits, maximized their personal rent from their positions (subject to appropriate legal constraints) and then used their own wealth to pursue social goals. This is broadly speaking what Gates has done: it’s the Bill and Melinda Gates foundation, and not the Microsoft corporation, that is fighting malaria.
But it’s far from clear that this neat separation will always apply. Pharmaceutical corporations, for example, face large fixed costs in developing medicines and low marginal costs in producing them. This situation creates a great deal of scope for different pricing regimes. It’s easy to describe cases where the socially optimal pricing rule is going to be very different from that which maximizes profits.
And it may well be that behaving as a good corporate citizen is conducive to long-term firm survival. This isn’t just a matter of buying PR as Posner suggests. If political actors generally regarded the activities of a firm as socially desirable, they will presumably be less likely to take action that might damage it. And while political perceptions do not always coincide with social reality, it’s hard to believe, in global terms that the strategies adopted by major pharmaceutical companies in recent decades have been either socially optimal or tailored to maximize the chances that the industry, and the firms that make it up, will survive in the long term in something like their current form.
John Quiggin 
It is a matter for the shareholders and the managers to sort out. Lets celebrate the diversity of approaches that might be taken.
Social concerns about things such as minimum income (minimum wage laws) and health insurance (US type compolsory health insurance) and paid maternity leave should not be state mandated corporate obligations. If they are to be manadated they should be provided by the state via means that burden the general taxpayer not the individual corporation. Minimum income via social welfare or negative income tax or a basic wage, health insurance via subsidised health care or preferably via a HEC style funding scheme. Or maybe not at all.
p.s. I’ve said more on the issue of HECS style funding for health care here:-
http://alsblog.wordpress.com/2008/04/04/medicare-should-be-like-hecs/
“And while political perceptions do not always coincide with social reality, it’s hard to believe, in global terms that the strategies adopted by major pharmaceutical companies in recent decades have been either socially optimal or tailored to maximize the chances that the industry, and the firms that make it up, will survive in the long term in something like their current form”
So the market will sort it out?
Shorter JQ: “If companies don’t adopt strategies that maximise their chance of long term survival they will fail – that may or may not be a sole focus on profits”
Hard to disagree with that – and a fairly powerful argument for policy makers to keep their hands off and let the market sift the winners.
This reminds me of a technician recalling when Telecom preceded Telstra and the corporate philosophy was to maximise service reliability, not profit. A more pressing example is what some call ‘decoupling’ of physical output from profit in energy distribution. An electricity retailer earns more profit the more kilowatt hours it can sell to customers. Thus TV ads advising households to turn off light switches are mere window dressing and there is no real intention to help customers cut electricity bills by say 30%. If profit maximisation remains the core objective perhaps bonuses could be introduced paid for by carbon auction revenue. Thus if Origin Energy helps a customer consistently save 30% on their utility bill they could be paid a bonus worth more than the foregone revenue. Profit restored, carbon pollution reduced. Such mechanisms would no doubt need fine tuning.
IANAE (where E=economist) so this is probably naive, but it’s always seemed to me that as corporations do not have a right to life, but only exist at the whim of the society within which they operate (there are many potential corporations that do not exist because society will not permit them), then the corporation is beholden firstly to society, and secondarily to shareholders. Or is this just a restatement of JQ’s final paragraph?
A good piece JQ, and I would go further. Philosophically, the fiduciary obligations excuse was disposed of by John Boatright (“Whats so special about fiduciary obligations”) many years ago. Milton Friedman tried to argue that the purpose of a firm was to make a profit because fiduciary obligations by managers to shareholders overrule any moral obligations they might hold to act in the social interest. This is just false. As Boatright pointed out, fiduciary duties are themselves a subset of moral obligation. Its like saying you can’t eat fruit because you must eat apples. Hence managers of firms have the same moral obligations as anyone else, which they must balance against their duty to shareholders.
Of course moral obligations are not legal obligations. However when observing a (moral) issue is clearly in the interests of a society as a whole, rational societies pass laws to make sure that happens. Otherwise we’d still be relying on the honour of alcoholics not to drink drive.
I also dislike Posners characterisation of this question as always being a conflict between profit and some abstract social good. More often it is a conflict between short term profit and indirect (but real) social harm that is difficult to cost in the short term.
A few perspectives. Corporations do not operate in a corporation only world. There are many privately owned companies in the business mix, and corporations may well feel a need to match social programmes where such activities support sales. There are many companies for whom a good public opinion improves profit (McDonalds), there are companies for whom public opinion has no bearing at all (Hughes Tool and Die), and there are even situations where a negative perception can improve profit (bad behaviour by celebrities improving box office). Export dominant businesses may see no value in public perception in their base country but may spend heavily in their target countries to improve profit and market penetration. There are companies for whom much business opportunity is derived through direct public contact. So I would say that there are no hard and fast rules. There are only probabilities. The only thing that I would expect is that in the corporation (presumably people heavy) a good internal opinion can be fostered by a good external perception of that business and productivity gains can be an important part of profitability.
At the very extreme end is the possibility of a business that is manned entirely by machines, and I would expect that for such an entity a good public perception would be essential to avoid the risk a complete human alienation.
Also, not every investor may be interesting in only maximising profits, no matter what other aims may suffer.
There are investors who either do not want to suppport ‘bad’ business with their money or who want to further ‘good’ aims through their investment.
For a discussion of ‘ethical investment’ see Wikipedia
http://en.wikipedia.org/wiki/Ethical_investing
Khr,
An example would be green power where the cost is higher but there is the added benefit of improving the environment.
We are currently seeing the end game of profits being maximised at the cost of everything else. The result will be total collapse. No point arguing. Just wait and see.
“I’d like to tackle the notion of fiduciary obligation”
Yes but perhaps very topically we also need to tackle the fiduciary environment in which all these firms now operate and that foreboding of Ikonoclast that I also share, although not for his reasoning. Rather it is for the extreme moral hazard for all created by central bankers in cahoots with profligate govt nowadays. The sine qua non corporate entity. Now while Australia has run overall govt surpluses recently, the US has been reckless with the public purse, although I suspect much of our surpluses are funny money ones if the reluctance to spend them now is any guide. The world is now awash with fiat money chasing real returns and we’ve seen the results of it chasing real value in commodities just recently, albeit there is some real demand factor there. Also the biggest culprit in the US has been running wars on credit, or simply resorting to the printing press. The Goldbug has an interesting take on that historically, which those of you who are wary of the military solution, would do well to heed-
http://www.news.com.au/adelaidenow/story/0,22606,24075243-5006368,00.html
If a gold standard is not a good hedge against war then it certainly is against extreme fiduciary moral hazard now. If firms have a fiduciary duty not to live off their capital, or flog it hard for short run shareholder and CEO returns, then that applies equally to the biggest corporate entity of all. Those of Keynesian bent, now have to ponder the world their Rudds and particularly their Obamas are about to inherit as a result of funny money surpluses and the fast failing international ponzi scheme. The panicked players affected are now scrambling for any available chairs now the central bank music has stopped playing its siren song. It’s obvious there aren’t enough chairs to go round and resort to the courts and law will be totally futile in the long run. Nevertheless that’s what’s beginning to happen if you read the signs here-
http://www.news.com.au/adelaidenow/story/0,22606,24070156-5006368,00.html
and here-
http://www.news.com.au/adelaidenow/story/0,22606,24075243-5006368,00.html
Foreclosure free zones and wanting your money back from predatory lenders when the biggest predatory lender of them all was the US Fed? Get off the grass! Now to top it all off we have serious questioning of the value of those manipulated fiat currencies-
http://www.news.com.au/adelaidenow/story/0,22606,24075286-5006368,00.html
Where’s the greatest fiduciary responsibility of them all we may well ask ourselves now, with a mooted statistic, that if you invested in the S&P 500 stock index 11 years ago, you would be line ball in real terms today and no doubt that time span is fast lengthening even now. This damning indictment of international central banking/govt profligacy in an aging developed world economy. When will we ever learn the hard lesson of real savings and investment for the future? In our courts?
Woops! That Goldbug link is here-http://thegoldbugnet.blogspot.com/2008/07/issue-number-one.html
My take is Keynesians may well want to ponder now their predicament of a ‘starve the beast’ long term succession strategy by neocons, using the very underhand method Keynesians are so fond of. I’d suggest the long term solution for Keynesians now is an offer they can’t refuse, albeit I’m no believer in such conspiracy theories. The eternal tempation of their printing press is simply too great for all political persuasions I’d warrant.
companies don’t have goals, corporations still less. people have goals, almost always concerned with short-term and local conditions.
just as pollies must win the next election, at whatever cost, ceos must deliver a balance sheet that makes investors happy. it seems foolish or disingenuous to talk about social goals when political or commercial society has no way to compel compliance with the long-term wishes of the people in it.
I see more and more are beginning to have that overall fiduciary duty thrust upon them now-
‘NATIONAL Australia Bank chief executive John Stewart said the global credit crunch had not yet reached its low point.
Back in May, Mr Stewart said the worst of the current crisis in debt markets may have passed in mid-March, when the US Federal Reserve helped rescue US investment bank Bear Stearns. “It’s now apparent that that was not the bottom,” he told investors.
“The US mortgage crisis, which started with sub-prime has moved to other classes of mortgages including prime resulting in the recent US government move to rescue Fannie Mae and Freddie Mac.
“And if you’ve any doubt about this you just have to look at what’s happened on Wall St overnight.
Mr Stewart said the margins on credit default swaps had recently risen to a higher level than at the time just before Bear Stearns was rescued.
“Clearly the market believes that there is a lot more bad news to come and that we’re not at the bottom.”
NAB shares today dropped 10 per cent, helping to drag the broader market down, after it announced an extra $830 million loss on its exposure to complex US mortgage-backed debt securities.
“Today’s announcement gives me no pleasure, but it is, I believe, the right thing to do,” Mr Stewart said.’
Ikonoklast,
Good to see you. You have any concrete suggestions yet or will you just keep running around with that sign reading “We’re all DOOOOOOMED!”
Come up with an idea of what we are actually going to replace it with.
On the other hand, Observa, company execs do spend a lot of words either ramping themselves personally or covering their behinds after screwing up, which has, at best, a nebulous relationship with company profitability. Taking it a step further, clearly working on reduced salaries would improve the business bottom line.
As the Mogambo Guru puts it Andrew, we’re all ‘freaking doomed’ although he is looking at it from a much bleaker US perspective. We’ll all manage cleaning up the copious empties with a terrible hangover no doubt, but some circumspection over behaviour the night before is in order. Pay as you go rather than opening the bar to all and sundry to share the tab later is always the more sensible approach, despite Jim’s reservations over some who will belt the plastic hard and have deeper regrets. Creating overarching moral hazard for all is hardly the stuff of sobriety, diligence and good order in general human endeavour. On that point it might be interesting to plot CEO remuneration against money supply and see what light shines where for Jim. All that rustles might be good for CEOs but redeemable gold and silver currency might be the battlers’ best friend in the long run. Zero fiat money for some of them now, will no doubt improve that fiat bottom line in pretty quick time. Unwinding central bankers’ malinvestments I believe they call it, not that our central bankers would comprehend that for an instant.
observa,
Ikonoklast is one of those who believes the whole capitalist system is going to crash around our ears soon. The only problem with that, of course, is that he (like all the prophets of doom before him) has no idea what he is going to replace it with – much less any idea why it would be any better.
Much brighter ones than him has fallen into that trap (notably Marx) so unless and until I hear anything sensible in that line I will keep asking for it.
Not in any real expectation that I will be adequately answered, though.
andrew reynolds,
from whence does your incredible authority come?
if you opened your eyes you would see that the capitalist system as it has been known for a couple of generations is crashing round our ears,
and if i could presume to know ikonoclasts thoughts, i would bet he would replace it with a system that involved more regulation, more valuing of the planet over profits, more genuine attempts to make income equitable
in fact i’ll go further,
you think you understand capitalism,
but i dont think you do,
capitalists dont want competition, they hate it,
they want cartels, monopolies or arrangements with compliant governments,
jpmorgan would have been as happy running the us finances in the ‘capitalist’ economy as he would have been organising the capital and industry of stalins russia,
anything but genuine free markets
they are a utopian dream equally as ridiculous as the idea that everyone can own everything and all get along
So – more regulation, a change in value system, and more equitable income. Do tell us how you propose to do this. I am fascinated.
A detailed how, please.
Oh – and also why you think it would be better. Again, precision, please.
not so fast there ace,
firstly you used the term ‘us’ as if everyone wants some sort of complete treatise by me on how to run soceity when in fact its just you,
but you’re no fool so why talk like one,
if a perfect plan on how to run soceity was easy it would have been cracked before,
of course you know this perfectly well, so its a just a chance to put forward some sort of claim to superiority,
calm down i say
like a lot of difficult concepts it easier to say what it is not, rather than what it is,
it is not:
– company profits put before human life
– denial of climate change for profit reasons
– decimation of communities and traditional cultures for profit
– control and poisoning of food supplies for profit
– war for profit
– socialising of risk and privatising of profit
– bosses earning many hundreds of times what thier workers earn
-paper money inflation on purpose at the expense of working people
– bullshit philanthropy by the filthy rich
– 24hr media propoganda to support the filthy rich elites
and that is the tip of the iceberg
al loomis said
“political or commercial society has no way to compel compliance [of companies] with the long-term wishes of the people in it”
Huh ?
First, there is the law.
Second, why do companies pay so much attention to shareholder values ? Reading you literally, the shareholders wouldn’t be able to compel them either ?
khr,
In reality, there are many ways to do it and history is littered with the carcasses of companies that have failed to heed consumer desires. Companies can only succeed in the long term by satisfying their customers first. Shareholders, management and other stakeholders have to come after the customers – in the long term at least.
Ikonoklast, however, was just about to give us some details on how he is hoping to get to this place with more regulation, a change in value system and more equitable income.
I know, it is just on the tip of his tongue…
I wasn’t moralizing Observa, if that’s what you’re saying, I was just saying that execs do a lot of stuff, some of it clearly improves the bottom line, some we’re not sure about, and some clearly doesn’t. It’s impossible for me be really clear on what your saying because you seem to avoid writing anything at all like a refutable statement so I may have been talking about something different to what you thought we were.
to be fair to ikonoclast andrew he never said any of that, i did, imagining what ikonoclast might possibly think
i suspect you are well aware of that but choose to pursue it this way anyway,
this consumer desires thing is rubbish by the way andrew,
companies create consumer desires in a lot of cases,
since freud looked into the mind and his nephew worked out to make a lot of money out of it the concept that businesss, especially big business responds to consumer desire is farcical,
have you read any jk galbraith,
if i may be so bold as to presume for a second time today what someone thinks,
i bet you think galbraith was not a serious economist and is not to be taken seriously
I didn’t really want a house with furnishings a car and those overseas holidays. These were all false desires created by “companies”. Tricky devils. 😉
smiths,
I have read Galbraith. I have also read Hayek and Mises. While I would regard all of them as serious economists (as I do our host here) I do not agree with all of them equally.
If you are right, smiths, why does any company ever fail? They create the demand for their products, ergo they have no need to ever fail.
As I said, though, smiths – and this challenge is also open to you (as it was on the last thread on which you avoided it) what would you replace it with? Even J.K. Galbraith accepted the system broadly. Your rhetoric indicates you want to bring it down. If so, what (precisely) would you replace it with?
I will expect more avoidence of this question and more attempts to diverge.
.
Terje,
Yes – why would I really want that big screen TV when I could have, say, a book – oops that is a consumer product too. What do I really want?
There is no failure of the capitalist system here. The market working perfectly now to clean up the excesses of central bankers over the last decade or more. The moral hazard was created by a Keynesian mindset that believes in the ability of an omniscient elite to control ‘inflation’ with some sort of overarching interest rate that is supposed to do the trick. What a preposterous, presumptuous notion that really is when you think about the complex structure and dynamics of our economy, let alone its interaction with the RQW. Our Reserve experts would target inflation at +2-3% for us all. Why not minus 2-3% you may well ask? Ask but but won’t get any answer from these supposed experts at tending every sniffle and sneeze issuing from the sum total of 20+ million individual endeavours and their decisionmaking. How on earth would they know what set of underlying interest rates is truly being thrown up to match that supply and demand for savings and investment? The answer is obvious now the market has taken that lever completely out of their hands and relegated them to impotent bystanders. We need a medium of exchange, a unit of account and a store of wealth, forever beyond their clumsy, childish grasp and the mentality that goes with it, not to mention the ever present temptation for such children.
observa,
IIRC the reason for the 2-3% goal is that a small amount of inflation is considered “healthy”. The last justification I remember hearing was that this allows wages to drop without people noticing.