Nature and Ethics

From Adam Smith to Enron

When, in the late 17th century, bankers, merchants and shippers met in Edward Lloyd’s Coffee House they carried out their transactions based on the principle of “my word is my bond”. Indeed in English law a verbal agreement, sealed by a handshake, was legally binding, the written contract being only a memorandum of what had been agreed upon by both parties. This was the world analyzed by Adam Smith and David Ricardo in their theory of the market place. It was a market, as Ernesto Illy has often pointed out, based on three invisible pillars of Trust, Honesty and Respect, ethical principles that were taken for granted in that period.

In such an economic environment everyone knew where he or she stood. As a result, uncertainty had been reduced as much as possible. Smith taught that the market would exert its own “invisible hand”. Ricardo argued that markets worked most effectively when everyone did the best they could. A would supply B with the best possible raw materials, B would add value and sell then to C and so on. In those days of strong nation states, the market produced a win-win situation for its players, provided they all adhered to the same strong ethical standards.

Theories of the market place continued along the lines of Smith and Ricardo until John Maynard Keynes pointed out that there were some things that an unregulated market could not achieve by itself. One of these was to ensure full employment. This could only be achieved by programs of government spending. Writing in the 1930’s, Keynes’ ideas had a sudden and wide following – amongst the most notable was President Franklin D. Roosevelt. Keynes’s approaches led to the Bretton Woods agreement of 1944, which established the International Monetary Fund and the World Bank, as well as establishing the Welfare State in Great Britain. Again Keynes’s approach was based on ethical principles: that unemployment was not a good thing, that economists could also cost in benefits and the public good, and that a world bank should help to assuage poverty in developing countries. There were also sound economic principles at work in that the combination of a World Bank and the IMF should help to damp out the effect of market.

Keynes’s are said to have lead to the Welfare State. His motives may have been praiseworthy and at the time many leading business people saw merit in Keynes’s writings (even through they criticized him in public) since they believed his approaches could save capitalism from one of its major flows – long term unemployment and economic depression. However their practical application involved excessive bureaucracy and gave rise to considerable inefficiency. In the late 70s and 80s the pendulum began to swing and there was an inevitable and strong backlash into Thatcherism and Reganomics. Under the Washington Consensus, tariff barriers were removed and the global market progressively deregulated. Now the goal was monetarism and privatization and, in Great Britain, the dismantling of the Welfare State.

Along with deregulation, there was a move away from universality. Universality was one of the hard won achievements of economic development and is considered to be the mark of a modern country and essential to the creation and continued well being of the middle class. But believing that the market would regulate and so bring the best outcome for all, resulted in the gradual creeping back within Western nations of wealth disparities between the rich and the poor.

There was also an unexpected new factor, the growth of global electronic networks, which enabled financial speculation to take place at the click of a mouse. During the 1960s the amount of money being traded was around three times greater than money involved in the sales of goods and services. Today the factor is around one thousand times greater, so that within minutes enormous sums of money can be exchanged globally

It is the combination of these factors that has given rise to a new market environment, one in which the focus is on short-term profits and short-term goals. The result is an emphasis of expediency and an erosion of ethical standards. Additional contributing factors included the dot.com bubble, the growing acceptance of the notion that “Greed is Good”, the tide of MBA students making easy money in the markets, the tremendous influx of pension money and private investment into equities- all seeking to save in an easy and “assured” way for retirement.

It is within this atmosphere that the accounting scandals of Enron and Arthur Anderson, the collapse of Barings Bank, and the price-fixing scandal at the auction houses of Sotheby’s and Christie’s came to light. The result is the present crisis of uncertainty where no one can really trust the balance sheets and company reports of major businesses. The present market exhibits an unacceptable level of uncertainty, and there are also fears that global markets are now inherently unstable thanks to the unregulated flow of “hot money”.

What is to be done?

Clearly this state of affairs cannot be allowed to continue. Some level of control is needed. But who is to do the regulating and on what principles is this to be based?
Ethical systems are not universal. Some were founded on taboos and religions. Western society, for example, combined the Judeo-Christian ethic with the fruits of Greek philosophy.

And what of ethical philosophers? The best they can do is to provide tools for analysis rather than a list of rules. They ask, as did Plato, if ethics can be based upon a series of universal principles encoded into the fabric of the universe. Or, following Aristotle, if they are the natural actions of good people. Kant on the other hand suggested that ethics is something that must be learned and leads to duties that must be carried out. The Utilatarians, John Stewart Mill and Jeremy Bentham did not feel that motives or principles were as important as simply calculating which actions would produce the greatest happiness to the greatest number of people. In short ethics could be positioned anywhere along that spectrum that leads from principles to actions to results and implications.

Our present dilemma is simple yet paradoxical, we badly need sets of ethical principles that can be agreed upon by all so that corporate behavior becomes more regular and predictable, uncertainty is reduced and the threat of economic chaos or collapse is avoided. Yet we do not know where to look for such principles.

Maybe the answer is to take another look at the market itself. When we do, we discover that the market is a non-linear self-organized system. In other words, it can behave in ways that are similar to population fluctuations in natural environments, weather systems, complex chemical reaction, metabolic processes within the body and so on. Therefore, by looking at such systems in nature we may be able to determine rules that would act to stabilize and render more predictable, the dynamics of the market place and the behavior of corporations within that market.

But what is a non-linear system? Think of the accelerator on your car, when you press it gently the car slowly gathers speed – a small cause produces a small effect in a linear system. But push the pedal a little harder and the passing gear may be engaged and the car suddenly lurches forward and accelerates. This is non-linear behavior characteristic of a non-linear system – while in some contexts small inputs produce small outcomes; in others they may produce very large or even unpredicted outcomes.

Non-linear systems come about when a number of components, or for that matter corporations, begin to interact in ways such that the outcome of certain actions or decisions feeds back or influences others. In this way the system becomes greater than the sum of its parts. It takes on new and unexpected forms of behavior and, in turn, individual components are now embedded in a larger system, which has an influence on the way they act.

And what is self-organization? This happens when something – matter, energy, information, or for that matter money – flows through the system. Under such conditions what was previously chaotic, or a collection of self-interested individuals suddenly becomes an entire system with its own characteristic structure, dynamical behavior and internal laws. Clearly if we are to adopt sets of ethical principles for corporations and global markets we must understand the nature of self-organization.

A very simple example is that of a heated pan of water. Warm water, being less dense, rises to the top while cold water falls to the bottom. The result is the chaotic movement of tiny regions of water in competition. But at a certain critical rate of heating self-organized behavior can occur. When this happens hexagonal cells of moving water appear in the pan – there is a region where warm water moves collectively to the top of the pan and other regions where cold water falls. Order has emerged out of chaotic competition.

Clearly the market place is vastly more complicated than a pan of heated water. In the market’s case, self-organization is being created by a number of different flow-throughs including raw materials, goods, money and information. In turn this creates what could be thought of as a rich dynamical landscape with mountains, ridges, rivers and valleys – although mathematicians prefer to use terms like bifurcation points and attractors and so on.

Let us, for a moment, take another simple system, which illustrates the notion of an attractor, A lake contains trout and pike. If there are many trout in the lake then pike have a great deal to eat; they become healthy, breed and increase their numbers. But this means that trout are now exposed to more predators and so their numbers drop. With fewer trout available for food the pike population begins to fall and in consequence the number of trout start to rise again. In what is technically know as a limit cycle, trout and pike populations rise and fall in very regular ways. All this has been well documented with other species as well. What is of particular interest in the context of the market place is that even when perturbed by external forces – i.e. stocking the lake with baby trout or attempting to remove many of the pike – the dynamics soon returns to its original pattern. In other words self-organized systems can be strongly resistive to external attempts at control. Maybe this should send a message of caution as to the potential difficulties of controlling markets only through top-down systems of regulation.

Behavior like this could be compared to a ball rolling around in a smooth basin. The ball is relatively free to move at the bottom of the basin but would require much more energy for it to climb up the wall and escape. This aspect of the landscape – the basin or valley – is termed an attractor. In terms of the market place, it would suggest situations in which a corporation is relatively free to take certain actions but will meet the resistance of strong market forces if it attempts to move to a new form of behavior.

Another feature of the market landscape is a ridge that rises between two valleys. A ball placed on the peak of this ridge may be quite stable but the slightest puff of wind will cause it to fall down the ridge into one of the two valleys. This is known as a bifurcation point in which the slightest perturbation would cause a corporation, or some other aspect of the market to move into one or another radically new type of behavior, i.e. escape from the attractor.

Let me emphasize again that the market itself creates this landscape, through the interaction of feedback of all its components – corporations, investors, and speculators. In turn, this landscape with its bifurcations points and attractors now influences individual corporations in ways they may not have anticipated. What is more, certain dynamical aspects of the market may not be that easy to modify through the application of external forces.

As to feedback itself. This is key in the establishment of self-organized systems. Feedback occurs when part of the output of a situation feeds back into the way the next decisions are made. Positive feedback has the effect of amplifying things and operates when a new product enters the market. Take, for example, the Betamax and VHS systems of videotape and video players. Both competed for the same market and engineers felt that Betamax was the superior system. But in its early days the market was very sensitive to ways in which a consumer chose either system. Through positive feedback, tiny market fluctuations caused VHS to have slightly more of the market, in turn more movies became available on VHS, more people bought VHS players and yet more movies were available to buy. In this way positive feedback allowed VHS to dominate the market.

However, once the market is established, negative feedback now begins to operate and smoothes out fluctuations in demand so that VHS continued to be the only player in town until the appearance of CD-ROM technology. Again it is the large-scale operation of negative feedback loops – consisting of goods, money and information – that stabilize the market and could render it resistant to exterior control.

Up to know I have used rather simplistic examples from natural systems. Let us move to something more complex – a deserted and vacant piece of land. This is a combination of natural resources air, water and earth and flow-through of the sun’s heat. Through self-organization, a percentage of these raw materials will be turned into something highly complex and sustainable.

At first the sun warms the bare earth, but this heat is radiated away at night. Yet gradually weeds and grasses grow, small bushes are found, then shrubs and even small trees. Dead leaves fall to the ground and become food for worms and insects which, in turn till and aerate the soil. Rotting vegetation also support fungi and other organisms. Gradually the complexity of the area begins to increase and shows even greater diversity of plant, insect and animal life until it reaches a position of maturity where the self-organized system will continue to sustain itself – powered by the heat of the sun – indefinitely.

And what of the sun’s energy? Now only a percentage is being radiated away at night. The rest is being used in photosynthesis to help the trees and plants to grow. In turn, some of this matter is used as food for insects and small animals that till the soil. Other parts of the matter rot to make the soil more fertile. These in their turn are food for larger predators whose droppings provide nutrients for plants. What happens is that energy is being circulated through a complex series of feedback loops where it becomes trapped, transforming matter in a complex series of ways.

The lesson to be learned from this system is that:
a) input is being shared as it passes through the system
b) the system survives because of its diversity
c) while individual components of the system may be in competition they are also contributing to the survival of the entire ecosystem as a whole.

Gentle Action: Macro and Micro Ethics

Clearly national and international action is required to establish new procedures and codes of behavior. In the case of accounting practices this is already taking place in the United States. The much discussed but never implemented Tobin tax on money flows may help to contain financial speculation. Global agreements could also be based on internationally agreed principles such as now exist in the fields of, for example, whaling. One such principle would be the survival of life on the planet, which also implies the survival of the world’s ocean and forests, control of greenhouse gases and so on. Another obvious moral principle would be that of the exploitation of child labor. Yet principles that may appear universal from within the context of the industrialized nations may not ring true for poorer countries, or groups of countries. Especially when there is a continued and continuing denial of the interconnectedness of actions. Clearly the First world has a strong moral commitment to the Third, which may require agreements to be made at the international level.

In this paper I am proposing that in view of the market’s non-linear, self-organized nature the monitoring of it should be approached in two ways – top down and bottom up. That is, not only at the macro economic level but also at the micro economic.

Ethical standards are badly needed, along with some protection to save the market from chaos or crash. These could be applied externally and individually by agreements reached through a number of internal agencies and bodies. Or via some central agreement – in which case it is important that the interests of poorer nations are also represented at the table.

As pointed out throughout this paper, exerting control on a non-linear system may not be as easy as we would wish, since the system could bounce back into previously established patterns of behavior. There is, however, another way in which change can be brought about in the dynamical behavior of a self-organized system and this is at the level of the individual couplings – or exchanges – of the various corporations, and other agents, involved. Changing the way these agents interact with each other at the local and micro levels can have a profound change on the global or macro level. Minor changes that have major impacts include the recent changes in the behaviour within the U.S. stock market such as the expensing of stock options and the role of stock analysts.

Therefore ethical principles must be applied not only at the top but also at the bottom. For example, by creating a new sensitivity towards ethics, by having the topic discussed at meetings such as this one at Centromarca what could perhaps be called a “field of active information” is created. Both corporations and individuals experience the effect of this field of meaning, which can produce subtle changes in attitudes and behavior. After all, people like to agree and be in accord with each other. Most of us would be very happy if we thought those around us also acknowledged the importance of ethical principles.

Individual corporations and institutions have to come to the perception, and agreement, that they are part of a larger interconnected system and that what they do can benefit or harm others and even, ultimately, themselves. If we want to continue with a sustainable market-based economy then it is very possible that we will need a “Ten Commandments” for corporate behaviour, rules of conduct that are accepted and acceptable in and of themselves

In other articles I have written about the dangers inherent in our persistent desire to control the world around us. So often when governments look at poverty, crime, hunger, economic stagnation and so on, they seek to exert control from outside the system – for example, imposing some economic or farming program on a third world nation. In so many cases the nature of the program is vastly more simplistic that the inner complexities experienced in that country. The result is that that program has unexpected side effects and may end up doing more damage that the original “problem” caused. The alternative is to allow the solution to emerge out of the situation itself in a much more intelligent and subtle way. This is what I have termed “gentle action”, a movement that emerges out of the whole. I have a similar “gentle action” notion in mind when I suggest that subtle behavioral changes, emerging in an economic system that is immersed in what could perhaps be called “a field of ethical meaning” could have major effects on the overall dynamics of the market.

Natural Ethics

Finally what are the ethical principles that can be extracted from a consideration of natural self-organizing systems?

a) Transparency and Openness
Self-organized systems survive because of their feedback loops. Feedback allows the market to foster innovation; negative feedback protects that which has been established. It is vital that information and meaning should flow through the system and not become blocked. This means transparent accounting, open declarations of intent and action, and coherence between a corporation’s public image and ethical statement and its internal culture of trust and respect for others.

b) Respect for Competition
Natural systems flourish because of their inherent diversity. If any one species became too big and started to dominate the system that environment would decline. Competition is necessary to keep an ecosystem flexible with multiple feedback loops and pathways whereby energy and matter and also goods, money and information can flow. It also helps to ensure overall efficiency.

c) Reciprocity and Cooperation
Even when elements of a system are in competition they are at the same time contributing to the well being of the system as a whole. Likewise a corporation is nourished by the market and those around it -suppliers, customers and even competitors. To maintain the health of the entire system it is the ethical obligation of each corporation to the whole.

d) Acknowledge Redundancy
Nature tends to achieve the same end in a number of different ways. As a consequence, nature does not appear particularly efficient. On the other hand when situations change, or damage occurs to a system, redundancy means that the system can continue to function. Block a major blood vessel in the leg and other smaller vessels take over the job of transporting blood. Likewise it may be important to respect a level of redundancy in each corporation and acknowledge that maximizing efficiency could make a business over-rigid and incapable of making quick adjustments when the market changes.

e) Respect Creativity
Charles Darwin remarked that probably the most important agent in an entire ecology is the humble earthworm that spends much of the day searching for food and, in so doing, is constantly turning over and aerating the earth. Likewise every corporation is made up of workers who have their own natural creativity and skills. Some are earth worms, others dragonflies. By offering them respect as fellow human beings it may be possible for a corporation to draw on their inherent creativity. It is the combination of all their micro interactions that makes the corporation what it is. The corporation is not only determined top down but also bottom up. It too creates a field of active ethical meaning.

Being respected gives each employee a greater sense of responsibility and can unleash creativity at all levels of the organization, which in turn may result in unexpected suggestions and innovations.

f) Accepting Uncertainty
Uncertainty and limits to control are facts of life that must be accepted about any non-linear system. There will always be a degree of “missing information” which at times can make us uncomfortable. Likewise we may not always be able to control what occurs around us. The result depends on whether we view this in terms of insecurity and lack of control or in terms of a door into new possibilities and relationships.

Acknowledgements

I would like to thank Dr Ernesto Illy for first posing this question of corporate ethics to me, and Centromarca for inviting me to contribute this paper and Dr Arthur Cordell for helpful discussions. I would also like to thank the participants at the conference “Corporate Ethics, Globalization and Economic Uncertainty” held at the Pari Center for New Learning, 16,17 November, 2002, for their particular insights. (That meeting was made possible by the financial contributions of Centromarca, the Templeton Foundation and Banca Monte dei Paschi di Siena.)