The Goldman-Sachs hearings are stirring up new debates, and old ideologies, concerning what businesses do.  In an op-ed in today's Boston Globe, columnist Joan Vennochi puts much of the blame for the financial shenanigans on the public sector, arguing that "The private sector’s only legal responsibility is to make itself rich within the law of the land."

I beg to differ. The American Law Institute's "Principles of Corporate Governance" state that "Corporate officials are not less morally obliged than any other citizens to take ethical considerations into account." Making profits through normal business activities, such as running a service that brings lenders and borrowers together, is expected and encouraged. But pretending to provide such a service, while actually promoting defective financial products and wagering on their failure? That is simply is not normal or expected business behavior.

Why do we set our ethical expectations for business so low, as this columnist does? We may then get no better than we expect.

(The op-ed can be found at http://www.boston.com/bostonglobe/editorial_opinion/oped/articles/2010/04/29/washington_plays_wall_streets_games/)

Why do we often think that businesses must have the single goal of maximizing value for shareholders? As I discussed in an earlier post, profit maximization is not, in fact, legally required. In actuality, profit maximization…was invented by economists.

Invented. NOT discovered.

You probably assume that economists create knowledge by studying the phenomena at hand—that is, actual economies. Early physicists studied billiard balls and pendulums; astronomers study stars; and so of course economists must observe firms, markets, government budgets, and, in general, activities that contribute  to economic welfare (or ill-fare). That's the way science works: You observe something and then see if you can come up with some insight about why it behaves the way it does.

This is a misconception—thought a very  common and very understandable one— about how economists work. While true science is about exactly such open-minded, systematic inquiry, economists have by and large adopted a different definition of science: Science = Math. The more elegantly an economist can model something in mathematical form, the higher status his or her work gains within the profession.

So where did the idea that firms maximize profit come from? The story has roughly three stages:

1. Scottish philosopher Adam Smith suggested that economies might be understood as machines, driven by the energy of self-interest. Smith wrote at the time of the Industrial Revolution, when everybody was fascinated by machinery. The idea that a big chunk of society could be also thought of as if it were machinery seemed really exciting at the time. (Smith was actually a much more interesting thinker, but this is the part of his ideas that really took.)

2. The idea that one can split people into self-interested "economic" parts, on the one hand, and ethical and social parts, on the other, caught on.  This originated with British thinker John Stuart Mill in the early 1800s (though he was more interesting, overall, too).

3. In the late 1800s, the early "neoclassical" economists  realized that Smith's and Mill's ideas could be formally expressed in mathematical calculus. Assuming the economy is a machine, and assuming people are all self-interested in their economic lives, one can now elegantly model "the economy" as made up of profit-maximizing firms and utility (that is, satisfaction) maximizing households. Voila! Economics is now a "science"—at least according to the Science=Math definition!

The one fly in this ointment is that no one thought to check back to see if this "economy" invented in mathematical terms had much similarity to the one we actually live in, or if  people can really separate their economic and social selves, or if a mechanical metaphor is actually adequate for understanding economic life. Oops.

I was at a conference last week on Conscious Capitalism, and once again I was stunned by the persistence, even among some people in such a generally well-informed group, of the belief that firms have to—simply have to—maximize profits. It's required by law.  It's the nature of the market economic system. Any corporate leader who doesn't try to squeeze out the last penny of profit, at whatever cost to society and the environment, will inevitably be fired, sued, or lead their company into a hostile takeover or bankruptcy.  Or so it's said. 

If you really believe this, of course, then phrases like "corporate social responsibility" and "business ethics" are oxymorons—that is, self-contradictory, like "jumbo shrimp" or "personal computer." (How personal can a computer be?) 

If you really believe this, then the only way to a better society is to trust that beneficent governments will transparently reflect the will of the people, and put up lots of rules around corporations to keep them in line.  (Hmmm…governments have done such a good job lately…Or might putting the whole job on them be a bit risky?)  Or you look to a corporation-free future of small worker-owned cooperatives. (And we get there from here…How? When?  Soon enough to head off climate change and the like?) And—here's the kicker—you tell corporate leaders that you never expected them to be responsible, anyway. You hand them an ethical free pass.

But is it really true that business leaders have no choice but to go after profit at all costs?  Let's look first at the legal question. 

It turns out that there is no legal requirement that firms maximize profit—that is,  maximize value for shareholders. Really.  None. If you look at the state codes that set the terms for incorporation, they don't mandate this.  The codes just vaguely state that the purpose of a business is to be a business. If you look at case law, you can see that the courts don't mandate it either. While people who want to spread the myth like to trumpet certain old court cases, it's very hard these days to get a manager or  director of a company found liable for a breach of duty.  All they have to do is show they had a reasonable business purpose for their actions. And the courts  generally interpret such purposes broadly, to include long-term factors and the interests of employees, suppliers, other groups, and the larger community. If you don't believe me, check the legal scholarship listed at the end of this blog entry. ("Shareholder primacy" is legalese for the doctrine that leaders must always put the interests of corporate shareholders first.)

So if maximizing returns to shareholders is not mandated by law, where does the idea that firms have to single-mindedly maximize profits come from? I'll get into that in a later posting.  (Hint: I'm a member of the economics profession, and we'll take little trip behind the curtain of that particular Land of Oz.)

For more information:

Smith, G. (1998). The Shareholder Primacy Norm. The Journal of Corporate Law.

Stout, Lynn A. (2005). New Thinking On ‘Shareholder Primacy’.  University of California at Los Angeles School of Law.

Talley, Eric. (2001)  On the Demise Of Shareholder Primacy.  University of Southern California Law School.