Limited liability is at the nub of it all. Paul Frijters points the finger.
Roman men engaged in commerce had a problem: Roman law did not recognise limits to the liability of their actions, so if some enterprise went badly wrong, they and their whole family could end up as slaves to pay off damages.
One solution was to let their slaves do the trading and only invest them with a certain amount of money, the “peculium,” that represented the liability of the master. This legal invention reduced the degree of personal responsibility and stimulated risk-taking.
Throughout the centuries limited liability was refined and extended further to become a dominant feature of capitalist society.
One key invention was the notion that a firm could be a legal entity, as if it were a person, an invention often credited to medieval Florence. This invention allowed investors from different countries to buy into a venture, shielding other assets of the owners, stimulating more risk taking and allowing the Italian city states to trade throughout Europe.
“The obvious disadvantage of Limited liability, which we saw on full display in the 2009 Financial Crisis, is irresponsible risk-taking by those who control choices inside firms.”
The world’s first true limited liability company was the Dutch East India Company founded in 1602, allowing many traders to pool parts of their resources such that they could undertake very risky endeavours without any being personally liable for the potential damages. New York adopted the legal structures of the limited liability company in 1811, and London in 1855. Many of the world’s largest commercial entities are limited liability companies. This invention allowed first the Dutch, and then the Americans and the British to establish large international commercial empires.
The obvious disadvantage of limited liability, which we saw on full display in the 2009 Financial Crisis, is irresponsible risk-taking by those who control choices inside firms. In a limited liability company, a manager gambles with the shareholder’s money: heads he wins, tails the actual owners lose. This makes him less averse to risk-taking and gives him an incentive to lie about the true risks.
The advantage is exactly the same as the disadvantage: risks get taken that would not be taken otherwise. The crucial point is that new technologies and new markets have benefits far greater than can be cornered by the person(s) discovering them: there is an externality in endeavours that pay off. That externality is partly captured by the whole firm, but extends far beyond even the largest of firms.
If you think of the markets and opportunities discovered by the Romans, the Florentines, and the East India Company to the societies they came from, it should be clear that the commercial fruits of some of the risks taken were very large, in the order of thousands of times the value captured by those who decided on the initial risks. As well as the collective wins from the largesse created by irresponsible risk-taking, new knowledge was created that benefitted a whole economy indefinitely.
So what looks like casino-capitalism is in fact simultaneously the key societal benefit of limited liability. Our systems have, over the centuries, learned that the benefits of the largesse created by the gambles that pay off outweigh the negatives of the gambles that don’t pay off. Our systems have extended limited liability far beyond the legal structure of companies.
Bankruptcy laws protect all market participants from the full consequences of their actions and also limit liabilities. Even an owner-manager is not truly liable for all the damage his/her company might inflict. Similarly, the welfare state provides a safety net to workers and owners alike, no matter how badly their choices have worked out, encouraging all of them to take more risks.
“Limited liability is about individuals not taking responsibility for the
full consequences of their actions.”
Limited liability also applies to the public service, where ministers and other heads of spending groups make decisions on public money. Heads of large charities too decide on the funds put there by others. These budget controllers do not personally bear the risks of their actions. Only heads of family firms or self-employed firms are truly liable for their choices, and even for them, limited liability safety nets operate.
It is a most wondrous construct that is almost the exact opposite of the narrative of libertarians or market fundamentalists about how capitalism functions. Limited liability is about individuals not taking responsibility for the full consequences of their actions. It limits ownership as it essentially codifies and protects the lack of property rights. Standard economics overplays the importance of private property and individual responsibility: the core legal inventions supporting capitalism are those that have moved away from the Roman notion of full ownership and responsibility.
International statistics look in the wrong place for entrepreneurs. They mainly count owner-managers as entrepreneurs. They miss the most important category of risk-takers: managers and planners inside large organisations.
One major effect is on the orientation of the whole social system. Limited liability creates a layer of managers and decision makers who are focused on growth. They make investment plans that require the actual owners to consent, whether those are shareholders or the country as a whole. If the investments work out, the owners get a large cut but the proposer, of course, also takes a sizeable cut. If the investments don’t work out, the owner or the community lose the investment and the proposer suffers very little.
So limited liability has created a system of professional optimists who make plans for expansions, hiding the risks to others as much as they can. These professional optimists create complexity and obfuscation to get their plans passed. They act like a pack, accentuating each other’s stories of what is possible, pointing to the examples of success and pretending that the examples of failure are aberrations and not applicable to them.
“So limited liability has created a system of professional optimists who make plans for expansions, hiding the risks to others as much as they can.”
This is where the waves of optimism in capitalism comes from: from the joint incentives of everyone with some sway over the money of others, which is pretty much the whole upper layer of all large organisations. Their jobs and wealth depend on over-optimism, no matter what interest rate prevails or how abundant Chinese funds are. That over-optimism will invariably run out of luck at some point. So limited liability gives us the growth orientation, the business cycle, and a whole class of people who will try to fool us about real risks. We have set it up that way.
The professional optimists created by our limited liability institutions are not necessarily oriented towards areas with positive social externalities. As individuals and as a group they are local opportunists oriented towards creating more surplus, whether through finding new technologies, new markets, or by re-writing regulation and getting lower taxes.
We should look at whether we can improve on the current set of limited liability institutions, with less liability in areas where innovation is likely to have large positive externalities, and more liability where the externalities are negative or close to zero.
I, for instance, see no use for limited liability when it comes to the creation of money via mortgages, or the business of tax evasion. Innovation in those areas creates private wealth, but little net social wealth.
I also see little use for extensive limited liability in those areas where we are already close to the technological frontier, such as (arguably) education, basic health, and policing. The growth entrepreneurs in those areas will look for ways to create market power and demand for useless services, which is arguably why the US private health system is at least twice as expensive and has worse outcomes than the UK’s public health system.
We can experiment with increasing limited liability within parts of the public sector where innovation is urgently needed, such as (arguably) finding ways to tax the Internet or to combat online political advertising. The essential trick is that you, on the one hand, appoint professional optimists who come up with ambitious plans based on their smaller scale experimentation, and on the other hand, have a group with a real incentive to pay attention and to either approve or stop those plans. One can make that process entirely transparent and, for instance, use external juries to approve risks on behalf of the public.
One can think of higher-order institutions that judge the degree to which limited liability should apply to a particular sector or institution, deciding when it’s time for other organisational principles, like pure command and control. One could. for instance, think of lifting limited liability protection in areas that have large negative effects on the world’s ecosystems. Making managers personally responsible for the health effects their actions have on those they lead, which currently is the law in Queensland, Australia, is another example of a targeted limitation on the limited liability principle.
“The professional optimists created by our limited liability institutions are not necessarily oriented towards areas with positive social externalities.”
We should openly recognise that the basis of capitalism is a set of institutions that limits ownership and responsibility to encourage managers to take risks true owners would not take. We should then experiment with degrees of liability depending on likely social benefits, and we should try and replicate the essential trick inside public services.