What Does Financial Capital Owe Society?

The idea that private enterprise should be harnessed to the creation of social capital is an old claim given new resonance by the financial crisis. After beggaring millions of people and threatening the global economy with ruin, banks and other credit providers surely have an obligation both to run their businesses soundly and to meet a higher standard of social responsibility. While some argue this could hobble, distract, or damage corporate focus on the bottom line, let's be clear. It was not an excess of attention to social needs that caused the near total collapse of the world's financial system but almost every other kind of excess.

Milton Friedman defined the classic position against corporate social responsibility in an oft-quoted 1970 New York Times Magazine article, where he stated flatly that a corporate executive's responsibility is "to conduct the business in accordance with [shareholders'] desires, which generally will be to make as much as possible while conforming to the basic rules of the society." Friedman continued that "there are no values, no 'social' responsibilities in any sense other than the shared values and responsibilities of individuals."

Companies, in other words, should stick to their business. Any diversion erodes shareholder value, diminishes focus on what capitalists do well, and arbitrarily bends private investment to pursue public goals, often without accountability for either the choice of goals or the efficacy of their pursuit.

But corporations are creatures of public legislation and regulation. They enjoy limited liability, certification by the Securities and Exchange Commission (SEC), which helps them float stock, and a variety of other public investments that help them do business. Banks, as specialized institutions, have an even more extensive other layer of public benefits in ordinary times, as well as emergency aid in a crisis. These include access to credit from the central banking system, examination and certification of soundness, and deposit insurance. And in the current crisis, government has also used trillions of dollars of public funds to prop up banks' shaky balance sheets and guarantee the institutions' debt, while the Federal Reserve has opened its spigots to provide liquidity as necessary.


The contention that a corporation owes society something in return requires closer analysis. Some of the benefits that society expects are relatively cost-free or are spread so uniformly across business sectors that they do not impose noticeable costs. But in other cases, pursuing social goals may turn out to be less profitable or to take a measurable bite out of the company's total return.

Many of business' reciprocal obligations to society are fairly basic. As beneficiaries of government's basic civil-society functions, like national defense, corporations are expected to pay taxes and follow norms of good behavior. They may not commit fraud. We do not allow them to deny employment, credit, or other benefits on the basis of race, gender, national origin, age, or sexual orientation. Labor's right to organize and negotiate in its own interests generally is well established, though often breached in practice. Market forces alone cannot be left to assure safety in automobiles or in the air. More narrowly, the Community Reinvestment Act requires banks that take deposits out of communities to give something back, in the form of credit to low- and moderate-income as well as affluent borrowers.

Corporations didn't always accept that these citizenship responsibilities were theirs. Some still chafe at them. But they largely are accepted, at least in broad principle. Some, although not all, of these benefits impose costs on corporations. But they are the necessary cost of doing business in a civil society.

President Barack Obama has made clear that his administration will rely heavily both on broad business regulation and on exhortation to seek an increased level of social investment and responsibility from private interests. This is a healthy restoration of the principle of mutual dependency that was waylaid in a form of "extraordinary rendition" under the George W. Bush reign after decades of buildup dating back to the Reagan era.

For more than two decades, many have placed hopes in a movement for corporate social responsibility, or socially responsible investment, from which some of President Obama's optimism springs. The idea is that norms of good behavior can be cultivated among entrepreneurs and rewarded by consumers who will favor such enterprises. Many corporations pride themselves in pursuing a "triple bottom line" of benchmarks on good treatment of workers and stewardship of the environment, as well as conventional profit criteria.

There has been a proliferation of self-consciously green companies as well as mutual funds that market their services on the premise that investments in firms that have a social commitment can produce just as high financial returns as an ordinary portfolio. Recently, energy companies like Chevron and BP have launched extensive "green" advertising campaigns whose message seems to be aimed at convincing consumers that these are something other than energy companies that depend on fossil fuels for their profits. The hope is that these norms are contagious and that more and more corporate executives will appreciate that they can do well by doing good. But as Clive Crook observed in a 2005 Economist article, "Getting the most out of capitalism requires public intervention of various kinds, and a lot of it: taxes, public spending, regulation in many different areas of business activity. ... To improve capitalism, you first need to understand it."

The problem with these efforts -- sometimes sincere, sometimes just a more nimble form of marketing -- is that they often are overwhelmed by larger trends driven by the conventional bottom line. The largest banks have recently shuttered their community-development subsidiaries. Their investments in affordable housing, accessible mortgages, and community-based financial intermediaries are all shrinking along with their market capitalization. In the same two decades that corporate social responsibility has become trendy, large corporations have more aggressively busted unions, shifted to outsourcing, and cut health and pension benefits. It turns out that what we do to constrain and contour corporate behavior as citizens -- via government action -- is more potent than what we can achieve as investors or consumers.

As Brookings Institution senior fellow and New York University economist William Easterly notes, "Moral exhortation has a very limited effect on most people's behavior, much as we would wish it otherwise." So, relying on corporate good citizenship is not enough. Necessary complements are subsidy, regulation, and direct government involvement or sponsorship of enterprises with public purposes.

Sponsorship. Government has long offered specific public benefits to induce private enterprises to achieve social goals. This form of sponsorship trades social capital the government has in abundance -- land or its own credit, for instance -- to induce private capital to create broader social value, such as railroads, and credit and liquidity in various markets. This strategy can be a powerful lever in creating social investment, particularly if the government negotiates hard in return for its favors.

Sponsorship has deep roots in the financial and credit sectors. Government bank charters have long played a critical role in helping to promote capital formation as well as savings by individuals and institutions. Guarantees of deposits, mortgages, and other financial instruments extended the government's sponsorship in return for providing consumers and society with specific benefits, such as long-term mortgages with fixed rates.

Regulation. Sometimes, the most effective route to a social goal is regulation. Automobile companies, for instance, were required to comply with the Corporate Average Fuel Economy standards for gas mileage long before President Obama became "auto executive of the year" through auto company bailouts. The Community Reinvestment Act changed norms in the banking industry because it used government's power to grant or withhold benefits sought by banks. There is a long history of government regulation, both to compensate for market failures and to prevent anti-social corporate behaviors.

Subsidy. But when government is seeking to bring private investment into specific new areas, particularly those where costs are uncertain or where returns for the capital invested will be lower, sponsorship and subsidies are more appropriate. In a sponsorship model like Fannie Mae and Freddie Mac, government attracts private investment to specific activities in return for certain privileges and benefits. Part of this bargain was a requirement that the companies invest in mortgages serving lower-income people and communities, even if these provided a lower return than other mortgages.

And as the fate of Fannie and Freddie demonstrates, constant vigilance is required in public-private partnerships lest the profit motive corrupt or endanger the public purpose. Real capital was put at risk through this partnership. While shareholders profited for many years through their growth and profitability, the companies' recent losses, driven by bad management decisions and weak oversight by their regulator as the mortgage market morphed into a carnival of crazed risk-taking, have wiped out nearly all common and preferred share value. But as their nominal owner today, the government is using them both to actively funnel subsidies in the form of cash and forbearance to beleaguered owners whose mortgages they hold. Freddie Mac in a recent SEC filing estimated the cost of these indulgences to be as high as $30 billion. Because of their hybrid heritage, both institutions have been far more active and responsive to the mortgage default crisis than any of the fully private investor trusts or Wall Street banks that created them to peddle the vast bulk of toxic mortgages.

The model has its critics. National Economic Council Director Lawrence Summers might have been channeling Friedman when he recently wrote disapprovingly about creative capitalism and the roles of Fannie and Freddie: "Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance."

With friends like this in high office, it is even more important for progressives to focus hard on just how sponsorship, subsidy, and regulation can be applied in new, as well as old, contexts as the financial crisis abates, and where each tool is most appropriate.


As powerful as they are, sponsorship and regulation alone will not provide economically sustainable interventions to reduce poverty. Private capital, for instance, will not underwrite money- losing housing investments, nor should it. Government must provide the subsidies that make low-cost housing possible.

These subsidies can be provided either directly, through budget expenditures, or indirectly, through tax credits and other subsidies to attract capital to certain investments.

Subsidies provided through the Low Income Housing Tax Credit and the New Markets Tax Credit, for instance, have the virtue of certainty, predictability, and low bureaucratic overhead. They only work if private capital agrees that the investments meet a market test of economic sustainability.

But many subsidy needs cannot be met through tax incentives, and many economists oppose them as a noxious perversion of the tax system. Tax subsidies are also wasteful, in that a large proportion of the subsidy "leaks" in the form of allowing well-to-do investors to reduce their taxes as a way of getting to serve social goals. Direct subsidies are the alternative, as when Congress gave the Department of Housing and Urban Development (HUD) new authority and cash in 2009 to invest more than $2 billion to insure completion of affordable housing projects jeopardized by the financial crisis. Such cash investments sometimes are a more efficient way to subsidize specific activities, and often are needed to reach very low-income groups because tax incentives cannot be made lucrative enough to do so.

Community development financial institutions (CDFIs), a hybrid form of social capital, have benefited from a combination of direct social investments from private banks and subsidies from government. The Treasury Department's CDFI fund provides seed and matching capital grants and loans to qualified CDFIs. In past years, banks also made investments at preferential terms in CDFIs, in part because such investments were favorably regarded in reviewing compliance with the Community Reinvestment Act, and in part because CDFIs' seed investments in predevelopment expenses for housing, health care, and education facilities often led to opportunities for sponsoring banks to make market-rate loans and investments in the final products.

Low Income Housing Tax Credits, Section 8 housing rental subsidies, Community Development Block Grants, investments in CDFIs, and other explicit subsidy interventions acknowledge that government has a singular role in providing capital to achieve certain results that the private sector cannot provide. The partnership model seeks to maximize private investment in such endeavors but recognizes that subsidies must be provided in order to do so.

As a consequence of the financial crisis, the federal government now holds stakes worth $199 billion in more than 500 banks, has guaranteed trillions more, and functionally owns Fannie Mae, Freddie Mac, and American International Group. The old financial regulatory system and its assumptions have been swamped by decades of weakening federal capital markets regulation. As Treasury Secretary Timothy Geithner testified in March 2009, "To address this will require comprehensive reform. Not modest repairs at the margin but new rules of the game."

These new rules will definitely include a more comprehensive acceptance of the federal government's ultimate role in managing moral hazard and systemic risk. We need a more comprehensive and aggressive agenda for using the levers of citizenship, sponsorship, and partnership, as well as explicit regulation and subsidy, to assure that the financial system that emerges from this wreckage benefits not only shareholders and management but taxpayers who are ultimately at risk and the society in which they live.