This is a question that has always gnawed at the heels of capitalism and one to which the Nobel prize-winning economist, Milton Friedman, set out a definitive answer in his seminal article of 1970[i].  Whether you dismiss the question as a red herring, or as part of a socialist conspiracy (as Friedman suggested); in the absence of a coherent and convincing response it will always be a thorn in the side of a capitalist system that, otherwise, has a great deal to offer the whole of society.  Now, as we witness more evidence of corporate misdeeds and ineffective governance, the need to answer this question is more insistent than ever and critics of the profit motive will never be assuaged unless and until boards and Excos openly acknowledge the extent of their responsibilities, and accountabilities, to the society they are supposed to serve.

Friedman was unequivocal in his view that the sole responsibility of business is to make a profit and his pronouncements were at a time long before the Berlin Wall collapsed; when socialism still had its proponents. His argument also attracted weighty adherents in Ronald Reagan and Margaret Thatcher.  Whether he intended it or not (I would suggest not) he also provided exactly the sort of justification that would be seized on by avaricious shareholders and executives to provide the moral basis for lining their own pockets. Yet recent history suggests something must have been wrong with his analysis.  If we can pinpoint where his logic might be flawed then maybe we can finally produce a better answer: one that could reinvigorate a more moral and ethical form of capitalism that was always in the interests of the majority, rather than the few.

If Friedman were alive today he would be adamant that his theory was morally sound. It is based on the principles of freedom of individual choice within a free society.  His work could even be viewed as more idealistic than cynical in aiming to develop the perfect recipe for running the world.  In his model, the level of a company’s profits are a measure of the combined social conscience of its board and executives. There was a fatal flaw in his argument though: he failed to mention the crucial word, ‘value’.

Nevertheless, such was the power of his argument that it may well have contributed to the myth[ii] that American CEOs are under a legal obligation to maximize profits. This might not be true but they are under an obligation to maximize value; or at least to ensure that if they sell a company they do so at the highest possible value.  You might think there is no worthwhile distinction to be made between these two simple words – ‘profit’ and ‘value’ – but actually they represent entirely different business paradigms. One is focused on the company itself, the other is driven to satisfy societal need.

The standard, economist’s definition of value refers to ‘economic value’; defined as what someone is prepared to pay for what value they perceive.  Pinning value down has taxed some of the greatest minds that ever lived and is not an easy debate to follow. However, a legitimate business has to be defined as one whose purpose is to satisfy society’s interests with a CEO who takes responsibility for how that goal is achieved. Yesterday, the UK government’s report into the possibility of expanding Heathrow recommended a third runway on primarily ‘economic’ grounds, as though the other factors (e.g. environmental, demolishing homes) hardly mattered.  If anything has changed since Friedman’s time it is the recognition that many other things do matter and profit is a very poor proxy for value.

Friedman’s failure to use value as his criterion should have been his undoing. It is the undoing of any CEO today who has any pretensions to responsibility and yet hides behind profit, earnings per share or any other measure that might be impressive but says nothing about their maximization of the business’ potential.  One lesson we have all learned since Enron (et al) is that profit performance often hides underlying underperformance and, more importantly, the hidden symptoms of degeneration in corporate governance.

The debate today still seems to centre around an apparent conflict between two constructs; social responsibility and profit. So we either have to admit that there is indeed a conflict or, alternatively, come up with a means for ensuring they are mutually beneficial. Businesses cannot exist in a vacuum: they are populated by people who all have to reconcile their company’s profitability with their own values. This includes those executives who feel shareholder pressure weighing heavily on their natural inclinations to do good whenever they can.

The same executives will have multiple perspectives as shareholders themselves, customers, ordinary citizens and parents: all vying for coherence. Every single one of us has to cope with these apparent conflicts in our daily lives. The pilot flying onto a new runway at Heathrow has to live somewhere and earn a living whilst openly recognizing that their own living comes at the expense of someone else’s quality of life. The democratic process is the only way we have found, albeit imperfectly, to plot an acceptable course through these competing pressures.

The relationship between freedom, democracy and capitalism was Friedman’s main point but it was lost because his argument turned into a rant against what he saw as the threat of creeping socialism.  So we should re-read the article in its entirety; right down to the very last word.  Friedman’s exact words in his final paragraph were later reiterated and enshrined in his book ‘Capitalism and Freedom’[iii] .  He does indeed say that –

 “… there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits …”

but he finishes that same sentence with the proviso

… 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.

Friedman was obviously supremely clever; clever enough to realize that these few words would get him off the hook in the face of any accusations he was promoting immoral or unethical business practices.  His words are classical economic theory that would only be uttered by a professional, academic economist.  Any CEO facing the wide range of challenges they do today (environmentalism, diversity, global competition, regulation) should understand this theory just as well but will also know it is only a theoretical construct that is unlikely to pertain in their lifetime.  CEOs of banks, especially over the last two decades, were allowed to make up their own rules with the tacit approval of governments and their regulators.  In such circumstances, Friedman would invoke his own proviso and declare that all bets were off for any hope of socially responsible banks.  So we are now all still in the process of living with the consequences and having to clean up the mess that our democratic system created.

The system is not comprised only of CEOs and regulators though; it is every single one of us. The Greek pensionersqueuing up today, to get enough cash to live on, are all players in their own game. The employees of the banks, that hold our money, allowed themselves to behave in a way that was dictated by their masters; irrespective of whether their social conscience told them to act otherwise.  In a whole system, blaming others is hypocritical and we cannot afford to wait for enough whistleblowers with the integrity and courage to raise the alarm. The only possible solution is to agree what the purpose of the system is and then to check that each and every one of us is doing our utmost to make the system work in all of our interests.  That is not socialism; it is what capitalism should always have been.  If Friedman had emphasised that social responsibility in organizations has to mean everyone working towards the same social ends, then his prescription would have been correct. Profit is then produced morally and moral profit produces moral value.

So what is the particular prescription of the Maturity Institute? It is very simple: it has to be because unnecessary complication bedevils effective corporate governance of the people. Maximizing societal value has to be the only legitimate purpose for any organization; whether for profit or not. MI defines value as the provision of the best possible quality product or service at the best possible cost (and demands that environmental and other externalities are openly acknowledged and fully factored in).  Moreover it demands that each and every organization is able to demonstrate that every single person involved with the organization is not only behind that purpose but encouraged and enabled to use the best of their talents, abilities and efforts towards that end.

Friedman’s limited version of the profit motive does conflict with societal value.  For example, Microsoft’s historically super-profits came from a combination of defending its virtual monopoly with a dictatorial, bullying management style that placed profit maximization above everything else.  Yet those same ingredients failed to maximize both Microsoft’s profits and society’s value because they inhibited human potential and innovation.  Society also lost out from Microsoft not playing by the rules and having an explicit strategy to use its dominant market position to force better competitors out of business. Regulators eventually fined Microsoft for its bad behaviour but lawyers and fines do nothing to resolve the problems of value destruction and poor corporate culture.

This is the legacy that Microsoft’s current CEO, Satya Nadella, may well have helped to create but now he is having to repair the damage.  But how can a CEO change a culture that was spawned by a rapacious purpose; without completely changing the purpose of the organization itself?  Friedman’s theoretical model, even with its proviso, assumed away the predictable behaviour of real human beings. Executives and shareholders who have primarily selfish interests cannot maximize value for anyone, including themselves, because there is little incentive for everyone else who is part of the same, whole system.  Management pressure and coercion, in pursuit of a goal which is not in everyone’s interest, is bound to be self-defeating and the irresponsible behaviour patterns that inevitably follow are not easily eradicated.

Meanwhile, over-regulation is the knee-jerk reaction to poor governance and mistrust; and the existence of conflicting objectives provides fertile soil for both.  This is a vicious circle.  The resulting legal costs and fines meted out to the banks (and other corporations who flout the rules) may nominally be borne by the culprits but we all end up paying the final bill when profit is the only responsibility of business.

Republished with permission from The Maturity Institute.

[i]From his New York Times article of 1970 entitled ‘The Social Responsibility of Business is to Increase its Profits’

[ii] The myth of maximizing shareholder value

[iii] University of Chicago Press; 40th Anniversary edition (15 Nov 2002)

About Paul Kearns:

Paul Kearns has been specialising in putting a hard value on ‘human intangibles’ for over 25 years. As a career professional in the field of human capital management he was one of the founders of the Maturity Institute (MI), a multi-disciplinary body he now chairs, which measures organizational effectiveness and produces comparative company ratings. These are compiled into OMINDEX which mirrors conventional, ‘AAA’ credit rating. MI has produced clear evidence to reveal strong links between corporate governance, human capital management and company valuation. This has drawn attention from the investment community and regulators at the New York Fed and the Bank of England.

Paul is also a prolific writer of books and articles concentrating on professionalism and effective strategies in human capital management and has been teaching at executive and MBA level for many years.

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