My interest in corporate social responsibility and climate change has led me to reflect on the role of ethics in industry. Reading "Flash Boys" by Michael Lewis, "Moral Mazes" by Robert Jackall, and a collection of books and articles has given me a better idea about decision-making inside corporations and the challenges of regulating businesses. Many of these challenges seem to be outside the standard microeconomic framework that currently dominates policy analysis. In that framework, ethics seems quaint, but perhaps there really is no replacement.
There are many reasons to regulate the private sector: minimize pollution, improve worker safety, ensure fair prices, combat fraud, etc. If everyone's incentives were aligned then there would be no reason for rules to be enforced. In the standard economic analysis framework, the misalignment of incentives cause "market failures." This means that harms, known as negative externalities, are not being accounted for in the markets of the offending products. (They might lead to more spending in the markets such as the market for medicine). The market failures are caused by things like transactional frictions, principal-agent problems, and asymmetric information. Solutions to market failures involve regulating the private sector one way or another. The objective is to align the incentives of producers with the interests of society by increasing the cost of causing externalities through fines or taxes.
In applying this framework, welfare is typically equated with monetary value. Then businesses and individuals in them respond exclusively to monetary incentives, their decisions driven by exacting cost-benefit analysis. The cost of regulating then, is proportional to the amount the business stands to gain from the activity.
Is this the whole story? Does this mean ethics is irrelevant?
First I want to point out that the motivation to avoid regulation is proportional to how much "individuals" have to gain. This is not always the the same thing as the amount the business has to gain overall because the individual is primarily concerned with his/her own career. This is generally true for decisions in an organization. In other words, if an initiative has the potential to cause one manager to gain recognition and a bonus rather than sharing credit with other managers, that initiative is more likely to be championed and thus implemented. For example, according to Nassim Taleb in "Black Swan," a contributing cause to the subprime mortgage crisis was the misalignment of individuals and the business. The analysis of risk management divisions in banks were often ignored because individuals in the trading divisions stood to gain fantastically from increasingly risky activities.
Next, let us inspect the costs of regulation more carefully. At first glance, the cost is simply the size of the fine, subsidy, or tax. Most analysts also take into consideration the likelihood that the fine or analogous costs will be incurred. The cost to the regulating body of administering these programs and auditing activities is often left out of economic analyses. Both the regulators and the businesses participate in auditing and accounting activities, although for different purposes. The higher the tax, the more resources businesses will allocate towards evading it by either by masking its activities in its own accounting system or lobbying to cut the budget of the regulator. It is possible to make information arbitrarily difficult and time-consuming to assess, which greatly increases the cost to regulators. In Flash Boys, the exchanges created complicated order types. In addition, the documentation to the SEC about these order types seemed purposefully more complicated than they needed to be.
Complicity among individuals in the industry is another driving factor for the cost of regulating behavior. If all the businesses participate in obfuscating their activities, then they can all maintain the illusion that the level of complexity is necessary. Idolizing neoclassical economics and the free market at the expense of ethics then is very convenient for those who stand to gain. Believing in the wisdom of the invisible hand means that the value of one's work is evidenced by the amount one is paid. Those who feel no need to question the purpose of their activities can be counted on to be complicit.
Even if regulators manage to administrate a program, they still may not have enough resources or information to assess the effectiveness of the program. Measuring effectiveness often requires some additional information. For example, the Reg NMS rule sought to make markets more fair by mandating that financial intermediaries must trade public equities at the best price. However, financial intermediaries found other ways to scalp investors. Regulators neglected to collect the information needed to assess the prevalence of other kinds of unfair practices.
By now it should be clear that regulating private sector activities is often an elaborate cat and mouse game. A few fat mice are more strongly motivated and can more easily collaborate than millions of mice. The smartest cat must be at least as smart as the smartest mice or else the mice can easily confuse the cat.
Many conclude that regulating is indeed hopeless in many situations. Brad and his team gave up on the SEC, who had no ability to compete with Wall Street for the talent required to regulate. In order to sell his idea, Brad had to adopt rhetoric about being "long-term greedy." But in fact he was personally very compelled to take on the system because it is not "right." It is significant to me that only those who with an ideal about fairness even dared to pursue a market solution. Only ethics can provide enough drive to an individual to overcome the risk, the likelihood of a lower payoff, and the stress from causing extreme conflict among peers.
The culture around ethics and the purpose of one's job perhaps should be considered as another tool in policy-making. The structure of incentives in an organization governs the behavior of individuals. Moral Mazes describes the incentive structure of a hierarchical bureaucracy typical of large public corporations. There are many similarities with the environment and culture of these corporations with that of Wall Street exchanges and investment banks as described in "Flash Boys."
It may be possible to modify the standard framework of policy analysis to include this kind of ethical motivation as a part of individuals' welfare functions. It's not clear to me whether that is the most helpful approach. Instead, the study of polycentric systems an cooperation could potentially be applied to such environments in order to increase the value of transparency and ethical behavior. There may also be analytic tools from complexity theory and behavioral economics.
My theory now is that for any given industry, a minimum number of individuals with resources and talent who commit to acting ethically is needed to stunt the efforts of those who are amoral. On the flip side, a minimum number of talented amoral individuals is needed in order to implement an injustice. Complicity with an amoral system ultimately perpetuate the injustice systemically. It follows then that conviction matters. Resolve matters. Ethics matter.
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