An economy with a well-functioning price system with the right kind of taxes and restrictions and where managers follow Friedman’s dictum that firms should maximize shareholder wealth will likely achieve a more responsible outcome than one where some investors and managers (but not others) try to achieve responsible outcomes.
There is a wide consensus that some actions in a capitalistic economy can have damaging effects for society and are not responsible in the sense that such actions are inconsistent with sustainability. For brevity, I will focus here on actions that have negative externalities – they impose costs on other economic agents for which these agents are not compensated. An example is pollution. Pollution can be beneficial for a firm, but it hurts economic agents who are not compensated for the damage caused to them. The existence of actions with negative externalities is not intrinsic to capitalism. There are many ways that such actions can be made less likely in a capitalistic economy, but not all approaches are equally efficient. When choosing among approaches to reduce negative externalities, the approaches that have the least cost in terms of economic growth should be chosen and care should be exercised to avoid approaches that could end up in making it less likely that common goals will be achieved.
Though literally capitalism means that capital is owned by the private sector rather than the state, the more useful definition is that capitalism is a system where individuals can pursue market opportunities freely. Capitalism is an economic system and economic agents take actions within that system. Capitalism as such is indifferent as to whether actions are responsible or not. However, a capitalistic economy can make irresponsible actions less likely. In such an economy, individuals respond to price signals. If something has a high price, they will typically buy less of it. The role of price signals is crucial for the allocation of labor and capital to be efficient. When price signals are distorted, the economy grows more slowly or not at all. It is well-established among economists that such a system will deliver optimal outcomes if there are no negative externalities.
Externalities are problematic when the actions that lead to costs imposed on other agents do not have a price; if they did have a price, firms would be less likely to take such actions. For instance, if there is no price on pollution, firms will pollute more than if they have to pay for pollution. The obvious response to this problem is to impose costs for negative externalities. Such costs can be imposed through the legal system, in the form of prices, or in the form of restrictions on behavior.
When institutional investors or managers use other people’s money, they should only pursue responsible outcomes that those who provide the money – the capital – want.
Investors have preferences. They are free to pursue goals that are inconsistent with wealth maximization for a given level of risk. They can decide not to invest in firms that are responsible for particularly onerous negative externalities. By exerting their preferences, investors can influence prices. For instance, in the stock market, investors can affect the cost of capital for firms that are high carbon emitters. By exerting their preferences, investors can impact the direction of the economy and the choices made by firms. If investors prefer lower profits but cleaner air, they can invest accordingly and doing so will change the price signals to which corporations respond as long as enough investors behave that way.
When institutional investors or managers use other people’s money, they should only pursue responsible outcomes that those who provide the money – the capital – want. Otherwise, the door would be opened for agency distortions that would hurt capital providers and decrease trust in the investment management industry. If management decides to increase wages beyond the market level to reduce inequality, it does so at the expense of the providers of capital. Effectively, management is stealing from them if they did not sign on for this course of action. Similarly, institutional investors who decide to invest in a way that pursues their preferences for responsibility when their mandate does not give them this goal are failing in their fiduciary duty. They are effectively expropriating the providers of capital by delivering lower pecuniary performance to extract from firms non-pecuniary benefits in the form of achieving outcomes that they find socially preferable. The use of other people’s money should not be a way for institutional investors and firms to pursue preferences that shareholders do not have.
Institutional investors can push responsible policies on management of firms through engagement. Success of such policies at the level of a firm or a number of firms may not make the economy more responsible. Such policies could just lead to an inefficient outcome. For instance, if the goal is to reduce carbon emissions, what is relevant is the ultimate reduction in emissions and not what a particular firm does. Firms trying to achieve some outcome concerning emissions on an individual level may lead to a highly inefficient reduction in emissions. It is economics 101 that emissions should be reduced more where the cost of doing so is lower. To achieve an efficient outcome, the price system has to be used or activities have to be restricted. Solutions that do not involve the price system often lead to distortions and inefficiencies. An economy with a well-functioning price system with the right kind of taxes and restrictions and where managers follow Friedman’s dictum that firms should maximize shareholder wealth will likely achieve a more responsible outcome than one where some investors and managers (but not others) try to achieve responsible outcomes. Institutional investors should not try to be successful central planners for our economy by telling firms what projects they can and cannot take with the intent to achieve societal goals. There is no reason for them to think that doing so will be successful in achieving these goals in an efficient manner. They could end up just creating demand and supply imbalances that impose costs on the economy instead of achieving societal goals.
To push economic agents to take responsible actions, the focus should be on selecting the most efficient ways to achieve responsible outcomes.
The bottom line is that policies exist that can make agents within a capitalistic economy undertake responsible actions. I have discussed here the issue of dealing with negative externalities, but my approach applies more generally to other issues where an unchecked economy may produce problematic results from the perspective of society. To push economic agents to take responsible actions, the focus should be on selecting the most efficient ways to achieve responsible outcomes. Often, such outcomes are best achieved through legislation and government policies. Trying to convince firms to take actions that benefit society beyond the goods they produce and the people they employ may or may not make an economy more responsible, but if it does make an economy more responsible, it is likely to do so inefficiently compared to well-chosen policies that change the price signals for firms.
René Stulz is an ECGI Fellow and the Everett D. Reese Chair of Banking and Monetary Economics and the Director of the Dice Center for Research in Financial Economics at the Ohio State University.
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