The "Externality Machine"

I recently watched the documentary film The Corporation which stitches together an argument about the many ways the modern corporation is sociopathic. It condemns corporations for failing to be concerned with others, is amoral, etc.

The operational principles of the corporation give it a highly anti-social “personality”: It is self-interested, inherently amoral, callous and deceitful; it breaches social and legal standards to get its way; it does not suffer from guilt, yet it can mimic the human qualities of empathy, caring and altruism.

One of the great phrases from the film is ‘externality machine.’ An externality is an effect of an economic transaction on non-participants, according to economists. Pollution is a classic case of a negative externality. Dumping waste into a river causes no harm to the corporation, in fact it usually saves them money. But it does grievous harm to anyone who lives down river.

The criticism leveled by The Corporation is that companies routinely externalize their costs onto others and then reap the rewards of profits. So Walmart doesn’t provide it’s workers with health insurance, relying on Medicaid, and the taxpayers, to pay the costs.

This idea of externalizing costs and internalizing profits reminded me of an essay in the current New Left Review by Robin Blackburn. The essay is called “Finance and the Fourth Dimension.”

During the past two decades the financial and banking industry has developed an ever-growing number of financial vehicles to manipulate risk, such as derivatives, private equity and hedge funds. The result has been lucrative. “As a percentage of total US corporate profits, financial-sector profits rose from 14 percent in 1981 to 39 percent in 2001.” But where have the costs gone?

Blackburn lays out some of the scandals that have hit the industry, including the mutual fund scandal, LTCM, and others. The costs/risks have disproportionately fallen on pension plans, which then get bailed out by the government.

The foregoing sketch suggests that financial profits over the last decade have mainly taken the form of the cancellation of promises made to employees – exploitation over time – the erosion of small capital holdings by large and unscrupulous money managers and the swallowing of shoals of tiny fish by the shark-like financial services industry. Few of the gains from the reallocation of capital through superior risk assessment have been channelled to production. Financial profits have instead prompted a surge in upscale real-estate prices and the turnover of the luxury goods sector. The mass of employees and consumers have sunk deeper into debt. Yawning domestic inequalities have been compounded by escalating international imbalances, with an inflow of foreign capital covering a deficit on the US current account. With a sagging dollar, an oil price shock and rising interest rates, American households – the consumers of first and last resort – are likely to find the strain of carrying the world on their shoulders even more difficult. Financialization promotes such a skewed distribution of income that it ends by undermining its own credit-driven momentum.

The latest crisis is the backdating of stock options. Through statistical analysis Eric Lie, an economist, discovered the following odds.

Statistical analysis revealed that the odds of the favorable timing of 12 options granted to William W. McGuire, CEO of health insurance giant United Health Group (nyse: UNH - news - people ), from 1995 to 2002 was 1 in 200 million.

Similarly, for Jeff Rich, former CEO of Affiliated Computer Services (nyse: ACS - news - people ), the probability for the wonderful timing of his six grants was 1 in 300 billion on a random basis. And Louis R. Tomasetta, the CEO of Vitesse Semiconductor (nasdaq: VTSS - news - people ), got nine grants, with a 1 in 26 billion probability of their lucky dates of issue being picked by chance. Tomasetta was fired in May because of his role in the company’s options grants process.

Who wouldn’t want to be so lucky? It’s proof that being a CEO is like winning the lottery. There’s no link between performance and pay for these people.