What is the purpose of a business?

MAINSTREAM economics would have you believe that the purpose of business is to maximise profits.

If a business loses money it will soon go bust, this much is clear. Profit is necessary for any ongoing business operation, however the fact that a business makes a profit does not explain the purpose or raison d’être of the business. The Dalai Lama put it this way:

To state that the role of business is to make a profit makes as much sense as to say that the role of a person is to eat or to breathe. If a company loses money it dies, as does a person without food, but that does not mean that the purpose of life is eating.

Peter Drucker, father of the modern management profession, believed that:

Profitability is not the purpose of, but the limiting factor on, business enterprise. Profit is not the explanation, cause or rationale of business decisions, but a test of their validity.

Profitability allows a business to sustain itself, but it would be dangerous to make profit the most important objective of a business. A corporate culture that values profit above all else may lead to law breaking, excessive risk taking, unnecessary suffering for employees, or damage to society and the environment.

Instead of focusing on profit, a business should aim to satisfy customers while acting responsibly. By satisfying customers the business can occupy itself in a meaningful way. And by acting responsibly, the business can prosper without harming others. If the business can also make a profit then its activity will be self-sustaining.

Warren Buffett

WARREN Buffett is an American investor born in 1930 in Omaha, Nebraska. Buffett is often referred to as the “Oracle of Omaha” and is the world’s most successful stock market investor.

Buffett is the largest shareholder and CEO of Berkshire Hathaway.  He has an estimated net worth of around $US45 billion.  In 2010, Forbes ranked Warren Buffett as the 3rd richest man in the world.

Buffett is noted for his adherence to the value investing philosophy and it is arguable that Buffett’s most influential mentor was Benjamin Graham. Graham was an influential economist and professional investor and is considered the first proponent of value investing.

Bank Bailouts and other Moral Hazards

In the previous post on Moral Hazard, we learnt that Moral Hazard refers to any situation where a person is not fully responsible for the consequences of their actions. As a result, they may take greater risks than they would have otherwise.

Here are 6 examples of situations where Moral Hazards arise in practice.

1. Insurance

The provision of insurance is the most common example of Moral Hazard.

For example, if you have comprehensive private health insurance you’ll be more likely to visit the doctor. You may also engage in more risk taking activities because you are not responsible for paying the medical costs if things go badly e.g. you go bungy jumping and throw your back out.

Malcolm Gladwell provides the amusing example of Universal Pepsi Insurance:

“Moral hazard” is the term economists use to describe the fact that insurance can change the behavior of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you’ll drink more Pepsi than you would have otherwise.

2. Mortgage Securitisation

Mortgage securitisation is an insidious and often misunderstood example of Moral Hazard.

The US government, motivated by a desire to expand home ownership, has for many years actively encouraged bankers to make loans to people with poor credit ratings. Fannie Mae and Freddie Mac, two large government sponsored enterprises, have carried out this policy through a process known as “mortgage securitisation”. Mortgage securitisation involves:

  1. purchasing mortgages from banks and mortgage brokers;
  2. grouping these mortgages together into large pools; and then
  3. selling “shares” in these mortgage pools to investors.

Moral Hazard exists because the banks and mortgage brokers who originate the loans do not pay the cost if lenders default. As a result, they have an incentive to make as many loans as possible, even to people with extremely poor credit ratings. These loans are often referred to as NINJA loans because they are made to people with No Income, No Job and No Assets.

3. The Greenspan Put

The Greenspan Put is another example of Moral Hazard.

Since the late 1980’s the Federal Reserve has followed a policy of significantly lowering interest rates in the wake each financial crisis (this policy is often referred to as the Greenspan Put). Lowering interest rates has the effect of increasing the amount of money available to the economy which prevents the economy from deteriorating further and stops asset prices from falling. As a result, this policy encourages investors to take excessive risks because they know that the Fed will lower interest rates if things go badly.

4. Bank Bailouts

Following on from mortgage securitisation and the Greenspan Put, we arrive at bank bailouts.

The provision of bank bailouts by government is perhaps the most topical example of Moral Hazard. In 2008, in the wake of the sub-prime mortgage crisis, the US government created a US$700 billion Troubled Asset Relief Program (known as TARP) to buy financial assets from banks and other financial institutions. The bailout was intended to stabilise financial markets, make sure that credit markets remained liquid and to prevent a repeat of the great depression. A worthy goal, however one small problem with TARP is that it creates a big Moral Hazard. If banks know that government will bail them out, then they will continue to engage in excessive risk taking.

Bailouts are now even being provided to sovereign states. In May 2010, the EU and IMF agreed to provide Greece with bailout money to the tune of €110 billion.

We can expect more financial instability to come.

5. Private Equity

Private equity vehicles, popular until around mid-2007, are another example of Moral Hazard.

Let’s assume that investors give a private equity firm $100 million to invest. If the private equity fund makes a profit of $20 million after one year then the fund managers might take 20%, or $4 million. If the fund loses $20 million after one year then the investors lose $20 million and the fund managers pay nothing. Since the managers are not fully responsible for the consequences of their investment decisions they have an incentive to take excessive risk.

6. The Limited Liability Company

The limited liability company presents an often overlooked form of Moral Hazard (props to Stella Szeto for pointing this out).

A company will often link the amount that its executives get paid with the company’s performance on the stock market. The reason for doing this is to align the interests of the executives with the interests of shareholders, which makes sense on one level (see Principal-Agent problem).

If the company performs well and its stock price rises strongly then shareholders are happy and executives will get a bonus in the form of cash, shares and/or options. However, if the company performs poorly then shareholders lose, while executives still receive their base salary and are not required to compensate shareholders. As a result, executives have an incentive to take excessive risks in an attempt to inflate the company’s short term stock price.