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Corporations Can Shun Shareholders, But Not Profits

Karl W. Smith

(Bloomberg Opinion) -- Jamie Dimon says he intends to move beyond the staid maxim that corporations should act to maximize shareholder value, and he has persuaded 180 of his fellow CEOs to join him. They propose a new ethos in which corporations such as JP Morgan Chase & Co. will be accountable to all stakeholders — including not only employees, customers and shareholders, but also society at large.

It certainly sounds enlightened — and if Dimon’s goal is merely to sound enlightened and thereby improve JP Morgan’s image, then his move is a smart one. If, however, he genuinely means what he says, then his proposal is misguided. Its implementation will be at best wasteful and at worst harmful to investors, workers and society.

The new approach, described in a deceptively modest one-page document called “Statement on the Purpose of a Corporation” issued by the Business Roundtable, comes across as a rejection of Milton Friedman’s famous dictum that the social responsibility of business is to increase profits. So it’s useful to check what the Nobel laureate in economics actually said.

In his essay, published in 1970, Friedman made no mention of “shareholder value.” His lodestar was profits (or, in the case of a non-profit corporation, the provision of the public good as laid down in its charter). Corporate managers can and have boosted share prices by engaging in accounting chicanery, obscuring tail-risks, jawboning the financial press, gaming earnings estimates and, in general, making decisions that look good in the short term but mask longer-term problems.

All of these, Friedman wrote, are explicit violations of management’s social responsibility because they involve deceit on the part of someone entrusted with the savings and livelihood of others. Even white lies are violations of social responsibility.

As an example, consider General Electric Co. under the leadership of CEO Jack Welch. For almost 20 years, Welch massaged the company’s earnings reports by adjusting transfers from its highly profitable GE Capital division to the parent corporation. This made it appear as if GE was steadily increasing profits at a moderate pace, when in fact profits were swinging wildly from quarter to quarter. Shareholders liked the stability and predictability of GE’s earnings and made the company the most valuable in America. The press ate it up too, turning Welch into a mini-celebrity. Employers and customers benefited as well, as the stability meant that GE could avoid rash layoffs and price increases.

It was society that suffered. Welch had created the impression that U.S. heavy industry still offered solid, predictable returns if only managers had the foresight to adopt the investments in technology and leadership philosophy that he promulgated. Not only was this untrue, but pretending it was true encouraged false hope and complacency just as competition from China was challenging American manufacturing.

Friedman understood that the competitive market was a better aggregator of knowledge about ideal investments, management strategies and the overall future of the economy than any single CEO could ever be. But that aggregation can only occur when market participants have accurate information on which to base prices.

To his credit, Dimon — who is chairman of the Business Roundtable — has pushed back against the excessive focus on share prices at the expense of long-term profits. To the extent that he is now simply doubling down on that philosophy, his current project is both healthy and consistent with Friedman’s admonishments.

But Dimon seems to have something a bit more expansive in mind. In the annual shareholder letter he published in April, he lists several chronic social ills, including an ineffective education system, a dramatic decline in labor force participation and poor federal budgeting. His diagnosis is plausible and maybe even correct. But there is no reason to believe he (or most other CEOs) has special insight into matters outside his business.

In public education, for example, Dimon laments how poor inner-city schools set children up for a life of poverty. “We know what to do,” Dimon writes, and proceeds to outline an agenda of increasing vocational education and including local businesses in curriculum design. In fact, research on vocational education shows mixed results, helping students who specialize in advanced coursework in a single concentration but making it harder for them to adapt to changes in the labor market.

The purpose of all this is not to criticize Dimon, whose concern appears authentic. It is only to observe that holistic thinking about economic and social systems is intuitively counter to the type of thinking often needed to excel in business. Understanding this surprising and complex divergence between market incentives and overall economic outcomes has been at the heart of economics ever since Adam Smith identified it as “the invisible hand.”

Asking corporate managers to focus more on improving society and less on making profits may sound like a good strategy. But it’s a blueprint for ineffective and counterproductive public policy on the one hand, and blame-shifting and lack of accountability on the other. This is a truth Milton Friedman recognized nearly five decades ago — and one that all corporate stakeholders ignore today at their peril.

To contact the author of this story: Karl W. Smith at ksmith602@bloomberg.net

To contact the editor responsible for this story: Michael Newman at mnewman43@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

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