Most of us tend not to think of capitalism as a moral system. The prevailing view of the free market, among laypeople and economists alike, is that it's one step removed from the law of the jungle. But the fact is that capitalism has always had an explicit moral framework that runs as a thread through the writings of Adam Smith, Milton Friedman, and Friedrich Hayek among other foundational thinkers.
"Many economists think of it as a positivist system that does not impose morality upon society, but this is not the case," says Harvard Business School Associate Professor Karthik Ramanna, who holds appointments as the Henry B. Arthur Fellow, supporting the research and teaching of business ethics, and as a Marvin Bower Fellow, helping faculty launch innovative new business agendas. "Capitalism delivers on certain normative goals such as individual freedom and a fairness of opportunity that are essential to legitimizing that deployment of self-interest."
In other words, capitalism earns its legitimacy through the idea that the pursuit of self-interest explicitly delivers on certain moral goods for society. Individuals could criticize that moral framework—a Marxist, for instance, might argue that capitalism ignores issues of fairness in outcomes—but they can't say that it doesn't exist.
“Our task is not to take immoral people and make them moral. Our task is to add texture to the dominant ethical framework of the markets, which defines what is moral.”
Capitalism's moral logic was perhaps most famously articulated by free market champion Milton Friedman when he said that "the social responsibility of business…is to increase its profits." That sentiment puts faith in the market to distribute wealth in the freest, fairest and most efficient way possible—indeed, Friedman went further to say that any attempt to curb the free market was harmful to the good of society.
This is the view Ramanna grapples with in a new working paper, Managers and Market Capitalism, cowritten with Rebecca M. Henderson, the John and Natty McArthur University Professor. Henderson and Ramanna agree with Friedman's moral framework—but only when certain conditions are met. In many cases, they say, it is incumbent upon managers to shift their ethical framework in order to preserve the system of capitalism itself.
In their view, capitalism has two powerful things going for it. First, it has been shown to be incredibly effective in leading to economic growth. "We don't know any better way to solve this problem," argues Ramanna. "If you look around the world, capitalism has lifted hundreds of millions of people out of poverty where previously deployed systems did not."
Second, capitalism tends to be self-correcting. When the free market does fail, the market itself steps in to correct the problem. For example, when investors lack information to properly determine the value of a stock, a raft of institutions—including ratings agencies, analysts, auditors, and accounting standards—rush in to fill that gap. Even in cases where a certain company dominates a market to create a near monopoly, entrepreneurs can find competitive advantages to create new opportunities—think IBM and Apple, United Airlines and Southwest, or Myspace and Facebook. "Markets make markets work," says Ramanna. "That is the good news about capitalism. We don't want to throw the baby out with the bath water."
But that doesn't mean markets always work to self-correct structural problems. The snag, as Adam Smith first identified in The Wealth of Nations, is that free markets require certain conditions in order to function—among them, well-defined property rights, enforceable contracts, non-collusion between parties, and complete knowledge that puts everyone on a level playing field. And while some of these conditions are self-fulfilling in markets, they argue, some are not. Take accounting standards, for example. While it's essential from a standpoint of complete knowledge to have everyone calculating their financials in a comparable and consistent manner, there is no profit motive for a private institution to produce accounting standards. Some public intervention is necessary—and that public intervention manifests itself as institutions operate not through a competitive market process, but through a democratic political process.
Therein lies the rub. Once the market is open to politics, then that market can be corrupted. That is especially true in cases Ramanna and Henderson call "thin political markets," that is, when business interests possess a specialized knowledge unknown to other constituents in the process and face little political opposition. That stands in contrast to a "thick" political process, in which diverse views are able to provide input with no one party able to receive a special voice.
"As the chairman of Goldman Sachs or Citigroup or IBM, you have a substantial capacity to structure the rules of the game when it comes to accounting standards for your industry," says Ramanna, noting that in the case of accounting standards, the knowledge is so esoteric that it only resides in a few individuals, who are most likely embedded in corporations. "If you happen to engage in a political process that structures institutions that underlie capitalism, what are your obligations?"
The traditional free-market answer to that question is that your obligation is to increase profits for your shareholders, period. If that means undermining accounting standards in order to achieve short-term gains, then the traditional free-market logic would say you are not only entitled, but also obligated to do that.
Not so fast, say Henderson and Ramanna. They argue managers have another interest, not just to serve as agents for their shareholders, but also to serve as agents for the system as a whole. It is not in the long-term interest of a society that deploys capitalism to allow its corporate managers to set up an accounting system that distorts the market—potentially leading to corporate scandals or an economic crash—and undermines capitalism itself. Rather, in these "thin" political processes where self-interest can undermine the integrity of capitalism, a manager's moral obligation is put aside his or her own self-interest in order to preserve the interests of the system as a whole.
Of course, that's not an easy sell to someone in a highly competitive market trained to exploit any advantage. This is where norm-setting becomes important, the authors say. Ramanna points to norms that have shifted in the history of capitalism, not necessarily in a company's self-interest. "We have been able to shift the moral boundary of self-interested corporate behavior when it comes to employing child labor and indentured labor," he says. "Part of this norm-shifting was done by carefully laying out the evidence and then building a strong logical case for what is consistent with the ethical imperatives that legitimize capitalism. CEOs are usually not immoral people. When they lobby for self-serving accounting rules, they are acting in the context of an ethical framework that legitimizes self-interested behavior.
Our challenge is to provide evidence and arguments for why the 'self-interest' ethical framework does not hold water in the case of 'thin political markets,'" he continues. "In this sense, our task is not to take immoral people and make them moral; it is to add texture to the dominant ethical framework of the markets, which defines what is moral."
The next step in that goal, says Ramanna, is to determine what institutions might be necessary to shift the ethical consensus. He and Henderson have begun to look at increased disclosure on corporate accountability—particularly as it relates to lobbying—as one possible way to fill the information gap. Further, some industry groups have begun to push a concept called "ethical lobbying," in which they take on only clients that agree to broaden their focus to consider systemic interests beyond self-interest, a trend that Ramanna and Henderson think has potential to help change the prevailing mindset.
"Ethical norms don't shift in an instant; these are the kinds of shifts that take place over a generation," says Ramanna. "But if enough CEOs and lobbyists get together and say there is something not quite right about what we are doing, then we may be able to start changing norms."