Cost-Benefit Analysis and Business Ethics

For my undergraduate thesis in economics, I chose to write about cost-benefit analysis and its discontents. Cost-benefit analysis, or CBA, refers to any process whereby the monetary costs of pursuing some particular course of action are weighed against the monetary benefits in order to decide whether that course of action is "worth" pursuing. In my thesis I argued that, for one thing, many public goods such as clean air and safe working environments are not monetizable and that to value these things in terms of money is unjustifiable, since the value of not being killed on the job or being able to breathe the air is more than just monetary. Not everyone agrees with the assertion that not all things can be valued in terms of money. In fact, most of the important policy makers in this country would seem to disagree. I'll leave aside that aspect of CBA though, and focus on a less controviersial application of cost-benefit accounting.

So let's say we have a firm. Like all firms, the management in dedicated to maximizing share-holder value, which translates as maximizing revenue and profits. Now, let's say that a regulation is passed requiring the firm to reduce it's toxic waste output, since the pollution is causing cancer and birth-defects in a nearby town. The question for the firm is whether or not to comply with the regulation. Both complying and not complying might entail monetary costs and minimizing these costs is the job of the CBA analyst.

The costs of complying with the reg might include things like new equipment to filter discharge and increased labor costs to install and maintain the filters. The costs of not complying with the reg would include fines from the regulatory agency and lawsuits and/or settlements with injured residents. Cost-benefit analysis tells us that if the costs of complying are more than the expected cost of non-compliance, then we should ignore the regulation. If, on the other hand, the expected costs of fines and lawsuits outweigh the costs of new equipment, etc., then the firm should go ahead and comply.

While the costs of compliance are fairly well known and can pretty much be taken for granted, the actual cost of non-compliance is not so clear. There may be a fine associated with exceeding pollution limits, but that number must be adjusted to account for the possibility of violations going unnoticed. Even a large fine will not be much of a deterrent if the chance of getting caught is low. The same goes for lawsuits against the company. An expected payment to harmed individuals can be multiplied by the probability of any individual actually suing and having a court find in their favor. So the basic calculation that the firm performs ends up looking something like this:

If F(pc) + L(ps)(pj) < C then do not comply.

If F(pc) + L(ps)(pj) > C then comply.

where F is the fine for noncompliance, pc the probability of getting caught, L the expected lawsuit costs, ps the probability of someone suing, pj the probability of an unfavorable ruling, and C is the cost of complying with the regulation).*, **

Or, put another way, if C-[F(pc)+L(ps)(pj)] > 0, then crime does pay and the firm will purposefully violate the regulation. That is, of course, so long as they are acting to maximize revenue and reduce production costs.

The firm, by itself, will probably not be able to much affect C, but it could take definite action to alter the values pc and pj. For instance, a firm might lobby in favor of bills to reduce the number of regulators or to reduce the funding of regulatory agencies. A firm would also want to lobby for self-reporting laws that limit or erase a company's liability if they turn themselves in. This is almost a best case scenario for the firm. It is then free to violate the regulations and, when it seems likely that charges are about to be filed, report the violations themselves and avoid some or all of the fine(!). Altering pj would include things like trying to make sure friendly judges get elected in areas where cases are likely to be heard, and to have cases moved if the local courts are unfriendly.

Anything that can be done by the firm to minimize pc and pj is likely to be money well-spent, since even a small change in either one could drastically alter the cost-benefit analysis. The ethical CEO, of course, is obliged to maximize share-holder value and it would therefore be unethical for the CEO to not pursue whatever tactics, so long as they don't cut into profits, that s/he thinks likely will reduce the left-hand side of our first two equations. Not to do so would be to increase the firm's overall costs which would ultimately cut into the profit-margin and dividends of share-holders. And besides, if your firm is not doing it, some other firm probably is and will be able to capture market-share from you by exploiting their better ability to economically avoid regulation. This is the market's way of punishing unethical behavior.

This is not to suggest, however, that firms might actually do anything illegal, or that some CEOs might be so callous as to purposefully violate the law if it seems profitable to do so. It is not my intent to suggest that some savvy businessperson might encourage legislation that would make it easier for persons like him/herself to disregard the law of the land. Far be it from me!

But it is the case that this is what cost-benefit analysis and contemporary business ethics recommend, and it may well explain why so many large American corporations commonly ignore laws and regulations. Sometimes it pays to break the law, even if you do get caught. And if it pays (your stockholders), says business ethics, then you have every right, even a responsibility, to do it.

*The calculation is, of course, somewhat more complex than I'm presenting here; namely there being more variables on the left-hand sides of the inequalities, but the underlying logic is the same, regardless.

** Another aspect that could be added to the C sides of the inequalities would be the forgone benefits that would have resulted from non-compliance.  For instance, a non-complying firm might be able to sell its goods cheaper than competitors who are complying with the regulation, since noncomplying firm's costs will be less.  This will likely steal away some of the competition's customer base which could prove a long-term benefit, even if the firm eventually has to comply and raise prices.  

Economic Scare Tactics and the Social Security Crisis

In light of the recent banking bailout by the Federal Reserve, to the tune of 7.7 trillion dollars or so, one thing, at least, should be perfectly clear. The Federal Reserve has as much money as it wants to have. All of the funding for the Fed's numerous bailout "facilities," which kept banks foreign and domestic solvent through the 2008 credit crunch and beyond, came not from increased taxation or borrowing, the two ways we generally think of governments (and government institutions) paying for things. The money the Fed was handing out to banks worldwide came not from any normal funding source but, as Ben Bernake put it in testimony before Congress, through the simple expedient of "keystrokes." The Federal Reserve created trillions of dollars and pumped them into the banking system by, literally, typing some numbers into a computer.

In what follows, I shall refer to the above as Point One: the Federal Reserve can create money from nothing and distribute it to whomever it pleases.

Now, we come to the scare tactics. The tactics I will refer to are a recurring trope in political debate, and there are many instances I could point to on a near daily basis. I will focus, in the interests of brevity, on just one here: the rhetoric surrounding the Social Security Trust Fund.

We are told almost continually by our politicians and the pundits on TV that the Social Security Trust Fund is insolvent, that it's going broke, that it will run out of money in 15, maybe 20 years...maybe sooner. For the sake of argument, let's assume that it runs out of money tomorrow. Let's assume that the Social Security fund balance shows $0.00 come the first of the month when the next round of checks are set to be mailed out to SSI recipients. Now let's assume that Treasury sends the checks out anyway. What would happen?

Well, the people who got their SSI check last month would get it again this month and, just like every other month, take it to the bank and deposit or cash it. The banks, of course, will take the Treasury's check and credit the amount to the depositors account. The depositor will then start spending it or leave it in the account for future use. In either case, the bank will send Treasury's check to the Federal Reserve which will then credit the bank's account at the Fed with that same amount. Now some may argue that the Fed may refuse to accept the Treasury's check and credit the bank, if the SS Trust Fund is empty. Perhaps, but this would be a purely political decision, and in no way a required one by the Fed.

Refer to Point One. There is nothing stopping the Fed from simply adding the necessary amount of funds to the SS Trust Fund to cover the next round of checks, and then transferring those funds to the banks' accounts, using nothing more complex than keystrokes. Just as the Fed created money for the banking interests, it could easily create money for the common interest. There is nothing to stop the Fed from continuing to honor Social Security checks presented to it, regardless of the trust fund, no financial constraint at all.

But wait, won't creating money like this be adding to the amount of it in circulation and thus lead to devaluation of the dollar and price inflation, which everyone knows is the worst possible thing that could happen? The answer, as is often the case in economics, is: it depends.

But before tackling that issue, I would like to point out that the question is not can we keep making Social Security payments after the trust fund runs out, but whether or not doing so would be a good idea. This is not what we hear coming from either side of the aisle though, in the present discourse surrounding Social Security. We are told, misleadingly, that it is "going broke." That claim, though it may be earnestly believed by some of those proclaiming it, amounts to nothing more than an empty scare tactic. The lesson that we should have gotten from the bailouts is that the Fed can decide what goes broke and what doesn't, and that's just as true for the Social Security Trust fund as it is for Goldman Sachs or Lehman.

Now, on to the question of inflation. To really illustrate what I'm saying, let us not only assume that the Treasury has continued to send out Social Security checks after the trust fund balance has reached zero and that the Fed has continued to honor those checks, but let us also assume that, realizing that the trust fund no longer needs to be funded by taxpayers, the Government stops collecting Social Security taxes. According to the economic punditocracy, this should be even more inflationary. Not only is there more money available due to the Fed's creation of new money to cover SSI checks, now there is also additional money available to consumers in the form of higher paychecks due to reduced taxes. So, would this scenario lead to inflation? The answer, of course, is it depends.

Inflation occurs when all of the goods and services an economy produces are being purchased and there is still money available that people want to spend. In such a situation, prices are bid up as consumers are willing to offer more money for (relatively) scarce goods and services. If the output of the economy is growing so that every year there are more goods and services available than the year before, then the supply of money must be increasing at an even faster rate for inflation to occur.

If, however, we find ourselves, like today, in a situation in which our economy has goods and services that are not being bought and with resources that are under- or un-utilized, then an increasing supply of money will not create inflation. The new money will only allow the market to clear, in the sense of all goods and services being able to find someone with the finances and willingness to purchase them at current prices.

It might also be the case that even in the face of an increasing supply of money, an economy might still not be able to sell it's entire produce. In that case producers might be forced to lower prices to clear inventories and/or scale back production to match the new lower level of demand.

So, whether or not actions like funding Social Security by simply "creating" the money to do so, will end up being inflationary, has mostly to do with the state of the economy. An increasing (relative) supply of money in an economy where everyone who wants a job has one, where people have the amount of work they desire, and where demand is sufficient to purchase economic output, will create inflation as more and more money chases around the same number of goods and services, driving up prices. But this is a scenario far removed from the one we find ourselves in today, with high unemployment, even higher underemployment and skill-mismatch, and massive amounts of idle productive equipment, vacant factories and mills, and millions of vacant homes. Without any increase in the money supply, in this scenario we would expect prices to decrease not increase, as too many goods and too much labor chase around too little money, driving prices down and leading to deflation, not inflation. Money creation and "unfunded" government spending might offset this dynamic, or stop it altogether, but fears about inflation seem rather out of place at the moment.

But again, the debate we hear over Social Security revolves not around inflationary concerns, but over a fictional, politically created, solvency issue. In the brave new world of modern central banking, there are no solvency issues that cannot be addressed with a few keystrokes, as the Federal Reserve demonstrated so ably during the financial crisis. The question is who should these keystrokes be used to benefit? Right now there's nothing stopping Congress from directing the Federal Reserve to honor all SSI checks, regardless of the balance in the trust fund account, thus solving the Social Security "crisis" without cutting benefits or increasing taxes, yet we are never told this by our political "representatives." Year after year we are fed the same lines of B.S. about how Social Security will go broke unless we cut benefits and raise the retirement age again, or else increase all our taxes to pay for those spoiled, entitlement-grubbing seniors.

But the Federal Reserve tipped it's hand too much when it created 7.7 trillion dollars out of nothing. The cat is out of the bag and we should all now be well aware that Ben Bernake can create money from keystrokes. There is nothing new in this power, just in most people's awareness of it. The question is, will we be content to let the Federal Reserve Chairman be the one who gets to decide how to use this power, or will the people of the United States actually seek to gain control over the currency of the United States? Will we demand that those seeking to represent us distinguish between economic necessity and political policy, or will we continue to be cowed by their economic scare tactics?

A Love Letter to Wells Fargo (an Immodest Proposal)

My Dearest Wells Fargo,

There is something I have to admit to you. It's a little embarrassing and I hope you won't think I'm a big dork after I tell you this. Wells Fargo, I think I love you.

I've been obsessed with you for quite awhile now. I've scoured your facebook page and your website, stared longingly into your big, beautiful plate-glass windows and dreamed of your stagecoach sweeping us both away to some distant tropical isle, perhaps the Cayman Islands where 19 of your foreign subsidiaries are located. I even looked up your by-laws on the internet (I know, that stuff is personal and I probably shouldn't have, but like I said, I'm obsessed...I can't help it).

I have to admit, some of my obsession has to do with your money. Don't get me wrong, I'm not a gold-digger or anything, but how could I not be impressed when I saw that, despite making $37 billion in profits in 2009 and 2010, you still managed to finagle a $2.5 billion tax refund! Rich and clever too, how could I not be impressed? And then, after taking over $166 billion in bail-out money from Congress and the Federal Reserve, you still had the nerve to pay your CEO $5.6 million in cash and $13 million in stock! You've obviously got some huge balls to go along with that giant wad you're sitting on. Be still my heart!

Now, I know there's been a lot of talk about how you've been screwing people left and right (taxpayers, your customers) but I don't believe a word of it. Such a distinguished and upstanding corporation like yourself (not to mention handsome) couldn't possibly be involved in such impropriety. And that's why I'm going to just go ahead and do it...Wells Fargo, I'm asking you to marry me!

After all, you're 160 years old, don't you think it's time you finally settled down? Granted, I'm quite a bit younger, but who says a May-December romance can't work? Just look at Ashton and Demi or Michael Douglas and Catherine Zeta-Jones. I know what you're probably thinking, "Occupy Bozeman isn't even a corporate person, how can we possibly get married?" Well, I'm filing my articles of incorporation on Tuesday and paying extra to have the Secretary of State expedite them, so no worries! Soon I'll be a corporate-person just like you and then we can get corporate-married! I can hardly wait!

I look forward to hearing your response. We've had our differences in the past, but you know what they say: "opposites attract!" I can almost hear the Justice of the Peace now, pronouncing us "Corporate Husband and Limited-Liability Wife." What a blissful day it shall be!

Love and Kisses,

Occupy Bozeman