A Word on Moral Hazard

The mainstream media would have us believe that the fundamental ethical issues confronting business leaders today are primarily personal in nature, and that the ethical failures are failures of character.  The view that the various forms of corporate malaise which afflict our society are the collective result of unconscionable decision making on the part of a limited (or even a widespread) pool of bad actors ignores the larger structural issues which precipitate unethical behavior.  To ignore these factors (while not excusing those who make unethical or ethically questionable decisions) is to condemn oneself and society to the role of the proverbial ostrich with its head in the sand.

I will pause for a moment to point out that ostriches don't actually stick their heads in sand, and that the origin of this myth was the product of the instinctive habit of ostriches to move about with their heads inches above the ground, in combination with the instinctive habit of man to draw wildly false conclusions based on limited information- a point which, while off-topic, seems strangely relevant in a charming sort of way.  Nevertheless, let us move on and examine an alternative theory on the root causes of failures in corporate ethics, and attempt to determine whether this theory does, indeed, support a valid paradigm- or if we are merely hunting for subterranean ostriches.

Let's first start with the assertion that, absent other factors, a free market does not reward unethical behavior, provided that force, coercion, and fraud are avoided (we can come back to these later).  Assuming that we are talking about the complex world of ethics through which regulations are allegedly to guide us, rather than the basics of "Johnny wouldn't give me his Twinkie so I socked him one in the nose," by and large bad actors exist.  Fortunately for ethical business owners everywhere, reputation is a commodity, and unethical actors distort markets for only a short period of time, because consumers are very smart when integrated over time- that is, while they may make buying mistakes early, they generally will not make them often.  The ruthlessness of the market ensures that those who act unethically will not stay in business long, and limits the damage that bad actors can do by punishing and ultimately rehabilitating or eliminating them from the market.  If you doubt the truth of this, by all means try starting an internet business and ruthlessly scamming your customers*; tell me how your revenue outlook is in a year.

*Don't start an internet business in order to scam your customers; I am just making a point here.

We might think of the market as a giant sports field, with the market actors including vendors and consumers making up the teams.  The role of Government, then, ought to be that of referee- and at most groundskeeper.  The goal is to ensure a level playing field, not to award points to those that are unable to compete soundly.  It is also most certainly not to accept money from lobbyists from either team in order to ensure that they get the loopholes built into the rulebook that they are looking for.

If unethical behavior is itself punished by a free market (and I submit that it is), then how can it be that even in our highly regulated economy unethical behavior can run so apparently rampant?  Here we must attempt a paradigm shift: aside from fraud, the vast majority of unethical behavior in the business world is not extra-regulatory, or aregulatory, but rather occurs through the exploitation of the regulatory system itself.

Let me repeat that: the regulations are the vehicle which enables unethical behavior and market manipulation. In a society where force, coercion, and fraud are criminal (and strictly enforced), it is only through regulation that companies can truly create uneven playing fields.  For instance, absent regulations, if a market was cornered and prices rise (as they are expected to) there is a point at which the expected profit that might be earned by a competitor outweighs the requisite investment to enter the market, and entrepreneurs and venture capitalists will recognize and act upon the opportunity.  Thus it is only at the mutually beneficial point of selling high enough quality products at low enough margins and providing good enough service that a company could ever come close to cornering a market.  Any deviation from this course is a market vulnerability which will be exploited by a competitor.

However, in a regulated environment, one can imagine a number of ways that advantages can be gained by lobbying for loopholes, manipulating the regulators, leveraging ambiguities in regulatory languages, and so on.  It is in that moment at which Government claims the power to intervene in markets that the moral hazard is created which ultimately contributes directly to ethical failure.  It is because of the plethora of methods which are both practical and legal and which allow bad actors to take advantage of the regulatory matrix that this is the case.

Taking advantage of regulations is true anti-competitive behavior.  It is, to use the sports analogy, paying the groundskeeper to flood the field to slow the other team down, or having an extra timeout awarded to you because you happen to be the home team.  It is having the rules changed to benefit you and not the other market players; it is not competitive behavior, and in the sense of being just and equitable, it is certainly not ethical.  For this reason, it is not the market actors, but rather the system itself which grants the power to choose winners and losers that is ultimately the root of persistent unethical behavior in the marketplace.  We cannot look to individuals to change their behavior within a system that rewards that behavior, but must rather reform the system by removing the moral hazard introduced by intervention.