My colleague, Richard Green, writes about What Milton Friedman Got Wrong:

Friedman had two fundamental problems with business regulation. His first is that the business would capture the regulator, and therefore use regulation to establish monopoly power….

His second, though, is just wrong. He argues that in order to preserve their reputations, businesses will self-regulate. Among other things, this ignores that managers often have short-term horizons. It also ignores that when large businesses implode, they leave victims with whom they never engaged in a transaction in their wake. BP did nothing illegal–how’s that reputation thing working out? And having now read a whole lot on Goldman-Abacus (including the SEC complaint, the response on GS’s web site, the offering circular, and excellent commentary from James Surowiecki, Yves Smith and others), it is not clear to me that Goldman did anything illegal or actionable (but I could be persuaded to change my mind). It is just that what it did (including investing long in CDS) should be unambiguously illegal and actionable. I can’t think of anyone who had a bigger reputation franchise than Goldman.

In Capitalism and Freedom, Friedman makes both of these arguments, which I would argue Richard mixes different types of business reputations. In so doing, he exposes the biggest problem with Friedman’s assumptions about reputations serving as sufficient regulation for businesses within markets.

Businesses have different types of reputations: what Friedman is talking about is that quality of their products or customer services. So if a dentist is a hack, he won’t get much return business after a certain point because he’s just not very good at his job. The market will sufficiently regulate him. However, the usual problems apply here: prior to things like Yelp, for example, information problems could keep a lousy dentist in business for quite some time. Then there’s the fact that government inspections do a lot to reveal information: so upfront where the customer can see everything looks great but you go in back and it’s a cesspit, and the only way this becomes discovered without inspection is after a bunch of children die from salmonella. Hardly a welfare gain; and the problem with terrible doctors is that they can, in fact, kill somebody. Which is all well and good to let the market regulate until it’s your kid. So information is one issue.

Green, by introducing Goldman-Sachs and British Petroleum, has moved the discussion forward in a productive way. Unlike dentists or doctors, these companies’ customers have little reason to demand the sort of welfare-enhancing behavior that Friedman suggests can occur through reputations. As producers, BP and GS have accountabilities to shareholders and to customers, and those of us outside those groups have only regulation, goodwill, ore ethical consumer behavior in order to try to press “green” or “ethical behavior” accountability vis-a-vis the companies’ primary accountability: producing goods and services to sell. BP’s potentially self-regulating reputation does not rest on how well it cleans up or responds to the oil spill. It rests on whether it produces oil and makes money.

The market will discipline the latter behavior pretty sharply; the former it will discipline only insofar that its customers value public accountability. The structure of the oil biz helps a lot here: how are you planning to boycott BP? Do you even know where your gas comes from?

In fact, BP has had a terrible reputation for green behavior, or at least it should, having manufactured one corporate greenwash document after another while blowing up small towns in Texas after numerous safety violations, long before this particular spill.

In GS’s case, there is a premium placed among its shareholders and customers for higher returns, and none of them–if all the post-crash discussion is to be believed–look under the hood of the money machine.

So nobody’s watching, or more particularly, nobody with the power to affect change is watching.