The Tension Between Innovation and Ethics

Following up on my recent post about how innovation often trumps politics, I'd like to explore a related topic, the role of ethics in innovation. With "don't be evil" Google in the crosshairs of antitrust and privacy investigations, it's worth asking, is innovation fundamentally amoral? Can innovation and ethics coexist?

Ethics and Innovation

People in their everyday lives do take ethics into consideration in their judgments. They consider whether they're fairly representing themselves in description in an online dating site, or a job application. Even when there are no legal consequences of deception or ethical expediency, people weigh the ethics of their actions as a real factor in their decision making.

Innovators -- in finance or technology -- may take ethics into consideration in their business concept, but they don't have to. There's no one to force them.

And consideration of other factors beyond innovation itself may actually intrude on the focus and energy that enables innovation in the first place. By getting prematurely distracted by ethics, would-be innovators may be decreasing their likelihood of making a breakthrough.

Ethical Arbitrage
By explicitly not taking ethics into consideration, innovators can engage in ethical arbitrage, a term I will define below.

In order to make a profit, most investors engage in some form of arbitrage, meaning they identify and take advantage of a pricing discrepancy between what something is worth and what it costs to buy it. Provided that the price moves toward the fair value soon enough, the investors can sell and make money.

To the extent that people allow their decisions to be altered by ethics, rather than pure economics, they create the potential for ethical arbitrage. Here's how it works: find people who do consider ethics in their pricing. Buy from them and sell to people who don't value the ethics. The difference in price is the profit that can be earned from ethical arbitrage.

Ethics and Economic Rationality
People who value ethics and people who don't can be equally rational, in the classical economic sense. All of the same Chicago School microeconomic models apply to prices with ethical -- and emotional and psychological -- components as well as to prices that are purely financial.

Ethics in Financial Innovation
With financial innovations like collateralized debt obligations (CDOs) and credit default swaps at the center of the economic collapse of 2008, there's hardly a better testing ground than financial engineering for the role of ethics in innovation.

The financial engineers of 2008 believed that they had access to reliable ways of measuring fair value using mathematics like the Gaussian copula to price CDOs. With better measurement, they could take advantage of the difference between the true price -- in theory given by the formula -- and the actual price on the market. Although in principle a classic example of arbitrage, in practice, they badly underestimated the risk, and grossly inflated prices, which led to a meltdown when the prices really did return toward sensible levels.

Nowhere in this explanation does ethics or morality appear. Few mainstream philosophers believe that mathematical models possess ethical content in and of themselves. Mathematics can describe a formal relationship among variables, and formulas may be true or false or even undecidable. They may be used for ethical or unethical purposes. Their authors may be unscrupulous or righteous. But the models, by themselves, are an-ethical.

No morality yet.

In the economy, and the financial industries especially, profit drives valuations. Corporations have a legal obligation to shareholders to maximize long-term profitability. They do not in general have any charter to behave ethically, so long as they obey the law and their questionable ethical behavior does not harm their sales or business dealings.

Investment bankers, private equity partners, mutual fund managers, and financial advisors are all just doing their job when they act within the law to earn returns for their investors. Except in the special case of funds with ethical clauses, such as socially responsible mutual funds, the managers have no contractual obligation to consider ethics at all.

By engaging in ethical arbitrage, financial innovators can profit from amorality. In fact, they're rewarding for doing so.

And the very institutionalized disregard for ethics in pricing can -- and more often than it should, sometimes does -- cross over into an-ethical treatment of the client and prevailing law. In order to retain trust and succeed, financial firms must vigilantly enforce a culture of ethics in dealing with their clients, and relentless amoralism in pricing.

To bring ethics into investment decisions, financial firms would need to choose deals to steer clear of, even though they are legal and profitable. And in order to disregard profitable business opportunities, they would need a disclosure in their financial reports.

Conclusion
The rational role of ethics in decision making creates the opportunity for ethical arbitrage, exploiting the price discount or premium many people and organizations place on ethics.

In corporations and financial industries, where profit maximization is often the sole motive, amorality is rewarded and encouraged within bounds

For other innovators, ethics may be a distraction that decreases the likelihood of innovation.

But ethics also creates its own space for innovation, precisely because so many people do value ethical behavior. The very fact that ethical arbitrage is possible also implies that ethics is deeply human and presents a sizable market for ethical entrepreneurs.

(Note: for simplicity, I have treated ethics and morality as interchangeable terms.)

Related posts:

Does Innovation Trump Politics?
Ethics: There's an App for That