Milton Friedman's 1970 essay against stakeholder capitalism still wins

Imagine hiring a plumber to fix a leak and finding, when the bill arrives, a line for "a donation to a cause the plumber cares about, made on your behalf." You would object, and you would be right, and no one would call you heartless. You hired him for the pipes. The money was yours. The cause was his. Yet when the same thing happens inside a corporation, with the money belonging to the people who own it and the cause belonging to the people who run it, we are told that it is a mark of moral progress.

This is the argument that the economist Milton Friedman made in a magazine essay on September 13, 1970, and it has aged better than almost anything written about business that decade. I want to set out what he said, put it next to the statement that America's biggest chief executives signed in 2019, and then do what a good argument requires: give the opposition its best case and answer it.

The terms

A corporation is a legal entity owned by its shareholders, who elect a board, which hires executives to run the business. A stakeholder is anyone affected by the firm: customers, workers, suppliers, neighbors, the community, the shareholders. Shareholder primacy is the view that the firm's managers should run it for the benefit of its owners. Stakeholder capitalism is the view that they should balance the interests of all the stakeholders. An agent is someone hired to act on another's behalf, and the agency problem is the risk that the agent will serve himself instead.

My claim is that Friedman was right, that the stakeholder view is a mistake in logic and in law, and that its practical effect is to give executives more power and less accountability. I will give the argument in numbered premises.

What Friedman wrote

The essay appeared in The New York Times Magazine on September 13, 1970, under a title that was a thesis: the social responsibility of business is to increase its profits. Friedman had a particular target. In those years, businessmen were being urged to take on social responsibilities, to fight inflation by holding prices down voluntarily, to hire the hard-core unemployed, to clean up the environment beyond what the law required. Friedman thought the whole idea was confused, and he said so in paraphrase-friendly steps. Here is the structure of his argument, in my words.

1. Only people have responsibilities. A corporation is an artificial person, and a corporate executive is an individual. When we say that "business" has social responsibilities, we are really saying that particular executives do.
2. The executive is an employee of the owners. He is hired to conduct the business in accordance with their wishes, which will generally be to make as much money as possible while obeying the law and the ordinary ethical customs of the society.
3. If he spends the company's money on something else, he is spending someone else's money. If he reduces returns to owners, he is spending their money. If he raises prices, he is spending the customers' money. If he cuts wages, he is spending the workers'.
4. That makes him a public official without election. He is deciding how much to tax, whom to tax, and what to spend the proceeds on, with no vote and no accountability beyond his own conscience. Friedman put the point in terms of taxation: the executive is imposing a tax and deciding how to spend it.
5. The proper place for social causes is the individual. The executive who wants to give to a cause may do so with his own money. The shareholders may do likewise with theirs, and many do.

That is the whole structure. It is a short essay. What is striking is that it is, in the strict sense, a conservative argument: it appeals to the sanctity of property, to the principle that you may not spend other people's money without their consent, and to the old American rule that taxation requires representation. Those who sniff at it as heartless have never explained why their causes should be funded by someone else's pocket.

The 2019 statement

Now fast-forward half a century. On August 19, 2019, the Business Roundtable, an association of the chief executives of large American companies, issued a new statement on the purpose of a corporation. It was signed by 181 of them. The document said that its signers shared a fundamental commitment to all their stakeholders, and it listed them: delivering value to customers, investing in employees, dealing fairly with suppliers, supporting the communities in which they work, and generating long-term value for shareholders. The previous versions of the statement had endorsed shareholder primacy. This one was widely reported as a break with it.

I will not mock the sentiment. Who is against treating workers and customers well? The question is what the statement does. It lists five constituencies and ranks none of them. It does not say what the executive should do when the constituencies conflict, and in business they conflict every day: a higher wage is a lower return, a lower price is a lower margin, a community donation is a smaller dividend. When you tell a manager to serve everyone, you have told him to serve whoever he chooses, because he can always point to one of the five to justify what he wants. A rule that serves five masters has no master.

The agency problem, which is the heart of the matter

This is where the technical part is not a footnote, because it is the strongest piece of the case. In 1976, the economists Michael Jensen and William Meckling published a famous paper on the theory of the firm, in which they described the agency costs that arise when the people who run a business are not the people who own it. The managers have their own interests: pay, status, comfort, a legacy. The owners cannot watch them all the time. So the owners must spend money on monitoring, contracts and incentives, and some loss remains. Those are agency costs.

Now see what stakeholder capitalism does to that problem. It removes the yardstick. Under shareholder primacy, the manager can be judged by a measurable result: returns to the owners. If they are poor, the board can fire him, and a rival can buy the company and replace him. Under a goal that includes everyone, no result is measurable and no failure is demonstrable. A chief executive who misses on earnings can say that he was investing in the community. One who is accused of mismanaging the company can say that he was serving the environment. The yardstick has been replaced by a rubber band.

I would put the point more sharply. A manager with a mandate to pursue the "public good" is a manager insulated from accountability. And it is no accident that the idea is popular among managers.

The legal history

The argument is not only moral. In the corporate law of the American states, the directors of a for-profit corporation owe their duties to the corporation and its shareholders. A century-old case makes the point. In Dodge v. Ford Motor Co. (1919), the Michigan Supreme Court considered a dispute in which Henry Ford, who controlled the company, wanted to hold back dividends to expand production and lower prices, partly for what he described as the benefit of the public and his workers. Two shareholders, the Dodge brothers, sued. The court held that a business corporation is organized and carried on primarily for the profit of its stockholders, and that the directors' powers are to be employed for that end. Ford was ordered to pay a special dividend. Courts in later decades gave directors wide discretion to take longer views and to consider other interests, and a conservative should acknowledge that: the business judgment rule gives the board room. But the law's default remains that the owners are the ones for whom the firm is run.

So the executive who wants to chase social goals with the company's money is not exercising a right that the law gives him. He is spending something that is not his. If he wants to give his own wages to a cause, he is free to. That is the difference.

The steelman

The best version of the case against Friedman is not that businesses should be charities. It is this. A firm that treats its workers badly will lose them. A firm that pollutes its neighborhood will face a backlash. A firm that ignores customers will lose them. Therefore, serving stakeholders is how a firm makes money in the long run, and the stakeholder view is just Friedman's view with a longer time horizon. Furthermore, no firm is an island: it depends on a society with working institutions, a healthy workforce and public trust. A firm that has no regard for those things is eating the seed corn. And the law, in any case, is imperfect, so Friedman's phrase about obeying "the basic rules of the society" leaves out things that no rulebook captures.

That is a good argument, and it deserves a numbered answer.

1. If serving stakeholders pays, Friedman already endorses it. His essay does not tell a manager to ignore workers or customers. It says that if spending on them increases the long-run value of the firm, it is a legitimate business expense, and he used the example of a company providing amenities to a small-town workforce. The disagreement is about spending that does not pay. There, the long-term-value argument is either true, in which case you don't need a new theory, or false, in which case you are admitting that you are spending the owners' money for other reasons.
2. The yardstick still matters. If the justification for any expense is "it helps the long-term interests of the firm," the manager can be held to that. If the justification is "it helps the community," he cannot. The shareholder standard is demanding and testable. The stakeholder standard is flexible and unreviewable.
3. Employees and communities already have protections. They are called contracts, wages, labour law, environmental law and tort law. The answer to a firm that pollutes is the rule against pollution, enforced by the courts, not the hope that its chief executive will be a good person. A society governed by law needs no one to be good. If you want to see how fiduciary loyalty works in a context where the stakes are retirees' savings, see ESG investing with your pension money bends the fiduciary duty owed you.
4. Democratic decisions belong to the democratic process. If the voters want to require every company to adopt a policy, they can elect a legislature that will pass it. What they should not accept is a system in which unelected executives decide what the social goals are and bill them to someone else. This is the "taxation without representation" principle in a modern suit.

The Founders, again

I said that this was a conservative argument. Here is why. The Declaration of Independence lists among its grievances that the King imposed taxes on the colonists without their consent. The principle that those who pay must have a voice is not a footnote to the American story; it is its beginning. A chief executive who uses the shareholders' funds for a cause they did not choose is exercising, in miniature, the power the colonists denied to the Crown. And the shareholders are not all billionaires. They are pensioners, teachers and savers whose retirement accounts hold the shares. For a look at how the business of the firm is a matter of private property, as the Fifth Amendment treats it, see the Constitution.

I will also say what I think the stakeholder idea is really about. It lets a company talk like a nonprofit while earning like a business. It wins applause from the press and goodwill from the regulators. It places a premium on the ability to signal virtue, which is a scarce resource, and a company that has been given a vague mandate has more room to avoid being held to a clear one. Profit, for all its flaws, is at least something you can count. For why that count matters, see profit is a signal, not a sin, and what a loss tells a company.

Who gains when the goal goes vague

There is one more consequence, and it is the one that should interest anyone who distrusts concentrated power. A firm told to serve everyone is a firm that is easy for regulators and activists to lean on, because every demand can be dressed as a stakeholder interest. The big incumbents, with their compliance departments and public-affairs staffs, can absorb that pressure and even turn it into a competitive weapon, as big companies love the regulations their small rivals cannot afford explains. The small rival with one owner and no lawyers cannot. A clear duty to owners is therefore also a protection for the little guy, who would rather compete on price and quality than on who can afford the best reputation department.

And the rule of the market is a hard one for every executive, which is why the better ones welcome it: a firm that stops serving customers is replaced by one that does, as Creative destruction, why the buggy whip makers lost and America won shows. No amount of good intentions in the corner office changes that. The stakeholders who really hold a firm to account are the customers who can walk away and the owners who can sell, and those are the two groups whose interests Friedman's rule protects.

A short test

If you want to judge any corporate initiative, ask four questions. Whose money is it? Did they agree to its use? What would the shareholder, as a private person, have chosen to do with it? And what does the measurable result look like? If the initiative passes all four, it is probably good business. If it fails them, it is probably someone else's cause, funded with other people's property.

The case in brief

1. Friedman's essay of September 13, 1970 argued that a business's social responsibility is to make money for its owners within the law and ethical custom, because executives are agents spending other people's money.
2. The Business Roundtable's August 2019 statement, signed by 181 chief executives, committed to all stakeholders, but ranked none of them, leaving managers with discretion and no yardstick.
3. Agency costs, the problem described by Jensen and Meckling in 1976, grow when the goal cannot be measured, so stakeholder capitalism raises them.
4. The law, from Dodge v. Ford onward, treats a corporation as run for its shareholders, with wide room for the board's business judgment.
5. The cure for real harms to workers, customers and neighbors is law, contract and the courts, not executive discretion over other people's money.

What you can do: if you own shares through a retirement plan or fund, find out how it votes on shareholder proposals, and write to the plan's administrator asking for the policy in writing.