Joseph Mariathasan: Markowitz, Friedman and the crucial debate on ESG
I had the privilege of spending a few days in June in San Diego with Harry Markowitz, joint winner of the 1990 Nobel Prize for economics, founder of modern portfolio theory and still going strong at the age of 91. We had some great discussions on a number of subjects in the company of another innovator in finance, Yves Choueifaty, founder and CEO of TOBAM.
One of the areas we touched upon was environmental, social and corporate governance (ESG) risks. Some might put it down to a generation gap, but Markowitz’s views on ESG seem to mirror those of another Nobel Laureate in economics, Milton Friedman, who argued in 1970 that companies’ sole responsibility was to maximise profits.
However, Markowitz’s views are also similar to those voiced more recently by Henrique Schneider, an economist and vice president of the Swiss SME association SGV/USAM. It is an argument that advocates of ESG in investment – and I am certainly proud to be in that category – need to tackle head-on.
Speaking last month at an industry event, Schneider said it was “dangerous to want to change the world with other people’s money”, and argued that Swiss Pensionskassen should integrate ESG principles only if it became legally binding for them to do so – which he claimed was unlikely.
Friedman promoted the idea of the supremacy of shareholder value maximisation over all other objectives. In his 1970 article in the New York Times, he argued that “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”. That philosophy is reflected in Harry Markowitz’s view that it is up to the state to set the legal framework under which companies should operate.
Are Markowitz, Friedman and Schneider all wrong? This is a fundamental question for ESG advocates, and one that is too often swept under the carpet by investment firms claiming to incorporate ESG into their investment criteria – and I have yet to meet a firm that tells me it does not incorporate ESG into its investment process.
The Friedman viewpoint on ESG is attractive because it has the certainty and simplicity behind it akin to the laws of physics. Isaac Newton’s law of gravity states that any two objects exert a force on each other directly proportional to the product of their masses and inversely proportional to the square of the distance apart. That law can be verified experimentally, and even Albert Einstein’s general theory of relativity simplifies to Newton’s laws in less than extreme environments.
Economics, however, is not an experimental science – despite the tendency for economists to experience “physics envy”. Economics ultimately is the study of human behaviour. It is messy, can change with time, and includes ideals such as altruism and long-term time horizons.
Friedman’s views influenced generations of academics and corporate executives. If a company were to take ESG criteria into account, it would – according to Friedman’s analysis – be in direct conflict with the duties of company management.
“What does it mean to say that the corporate executive has a ‘social responsibility’ in his capacity as businessman?” he wrote. “If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers.”
He went on to question whether an executive should “make expenditures on reducing pollution beyond the amount that is in the best interests of the corporation or that is required by law in order to contribute to the social objective of improving the environment”.
Friedman’s viewpoint would mean that, if the law did not keep pace with industrial activity, corporations would have a license to pollute since it was both within the law and in their interests not to spend money on reducing pollution. Shareholders would not lose, even if it cost society much more to remove that pollution and deal with its consequences.
Celebrated economist Adam Smith is widely regarded as the father of capitalism. Yet even he, according to a biography by Jess Norman, believed that “markets are sustained not merely by incentives of gain or loss, but by laws, institutions, norms and identities, and without those things they cannot be adequately understood”.
It is also worth bearing in mind that, as well as writing The Wealth of Nations with its famous concept of the “invisible hand” of self-interested traders directing the economy for the common good, he also wrote The Theory of Moral Sentiments. Morality, he stated, was natural and built into us as social beings. Smith saw no contradictions between his two major works and, by some accounts, regarded The Theory of Moral Sentiments as the more important of the two.
Perhaps the proponents and opponents of incorporating ESG into decision making need, as Norman argues, the wisdom to follow the thoughts of Adam Smith in their full implications. The crucial debate with which ESG advocates must engage relates to whether or not the interests of shareholders should trump those of all other stakeholders in a company. That debate has not yet been resolved – and it needs to be.