What Happened to Business Prudence?

More than 200 years ago, Adam Smith determined that economic self-interest advanced the wider commercial good as if led by an invisible hand. Such a self-seeker, he added, "frequently promotes (the interest) of society more effectually than when he really intends to promote it."

But what happens when it's government that defines profit opportunities, and a country's culture deprecates commercial self-interest to the point that business leaders who "do good" are praised over those who "make good"? What happens when the invisible hand is replaced by the grip of regulation, subsidies and "social" responsibility? The current financial crisis provides the answer.

For decades, government has intervened in the mortgage market, in the name of the "public interest." There was the creation of Fannie Mae and Freddie Mac, the Home Mortgage Disclosure Act of 1975 and the Community Reinvestment Act of 1977, the Financial Institutions Reform Recovery and Enforcement Act of 1989 and the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.

There was the demand in 2000 by HUD that Fannie Mae dedicate fifty percent of its business to low- and moderate-income families. And there was President George W. Bush pushing homeownership for all as the way to prosperity.

Through laws and administrative regulation, Stan Liebowitz and other free-market scholars have shown, governments have pushed private businesses to go far beyond prudent, self-interested profit-making.

In 2000, for example, the Fannie Mae Foundation identified the "Outstanding Accomplishment" of Countrywide Financial Corp. as making almost one-sixth of its mortgages to blacks, Hispanics and Native Americans.

The foundation then went on to praise the firm's "companywide fair lending task force, employee training in fair lending, recruitment of minority employees, employee compensation systems that do not penalize for making small loans and comprehensive 'We House America' campaign to expand homeownership opportunities."

Did anyone bother to ask whether such do-goodism might be at odds with old-fashioned prudence, or whether, in the final analysis, it might be bad for its intended beneficiaries? Did new-model business leaders dare to think there could be unintended consequences from the post-'60s creed of corporate social responsibility?

The brass at Countrywide were too busy basking in their honors to really care. In 2000, for example, La Opinion, the country's leading Spanish-language newspaper, named Countrywide Home Loans "Corporation of the Year." Perhaps the company's leaders thought narrow prudence would stand in the way of such gifts as the $25,000 they gave to the League of United Latin American Citizens for "educational programs on home buying."

And Countrywide was hardly alone in the assault on invisible-hand decision-making. A decade ago, a senior managing director at Bear Stearns said this about mortgages made pursuant to the Community Reinvestment Act:

"While credit scores can be an analytical tool with conforming loans, their effectiveness is limited with CRA loans. Unfortunately, CRA loans do not fit neatly into the standard credit score framework. We believe a broader array of credit analysis data is needed to get a clearer perspective of the situation."

Certainly, the people formerly employed by Bears Stearns now have a clearer perspective on the value of those mortgages.

All this might have been learned from the Enron debacle. In response to generous government subsidies, that company moved from its natural gas core into solar power, wind power and other government-dependent "green" energy plays. Enron tried to monetize its political bets by sounding the climate alarm and calling for government regulation of carbon dioxide emissions.

In its prime, Enron was arguably the most politically connected and politically correct company in America, and even created a subsidiary to invest in inner-city, minority-owned businesses. Sure, the company lost money in all of this, but it received a climate protection award from the EPA and a corporate conscience award from the Council on Economic Priorities, among other honors.

And yet, when the company collapsed, progressives screamed about corporate greed rather than about the perils of corporate welfare and "social" responsibility.

Milton Friedman foresaw it all in a prescient 1962 article arguing that business can effectively serve only one master — its owners — by winning profits in accord with investor expectations, while respecting legal and ethical norms.

Friedman warned against attempting to serve multiple masters: "If businessmen do have a social responsibility other than making maximum profits for stockholders," he asked, "how are they to know what it is?" More important still: What will result?"

Noted Adam Smith, in an observation that has turned out to be more true than he could have imagined: "I have never known much good done by those who affected to trade for the publick good,"

Government regulation and political correctness are at the root of recent organizational failures that, in turn, have resulted in massive taxpayer-financed bailouts. New government intervention is trying to address the problems created by prior intervention—and futilely, it appears.

The remedy is a reliance on invisible-hand profit-making where the good can really crowd out the bad. A new legal relationship between government and the economy is required—free-market capitalism in place of political capitalism.

With this should come a new understanding of the proper philosophy of entrepreneurial capitalism—tough-love prudence in place of the amorphous doctrine of "corporate social responsibility."