Limited Liability and Market Calculation

Via the always fascinating Kevin Carson, I found a great argument for viewing the state grant of limited liability for corporations as a subsidy. While Vinay Gupta gets a few things technically wrong, he starts a debate we as a society sorely need to have.

It surprises me that I can't find an analysis of how large this subsidy to investors is! Possibly, if this question was analyzed, we would discover that limited liability protection is the largest goverment programme there is, perhaps even larger than the military. Plausible? Well, consider the total size of the stock market - the market capitalization of the entire economy. Now imagine insuring that. Limited liability moves a lot of wealth from creditors to investors in any given year, through bankruptcy proceedings - how much wealth is transferred in a given year? This may explain why limited liability creates wealth so fast: by taking an intangible like "risk" and providing an equally intangible "protection from risk" goverments subsidied real, tangible spending with a vast, intangible subsidy.

Well said! Markets are fair only to the extent that liability is conserved inside every activity. People act responsibly because there are consequences for irresponsibility. Adam Smith pointed out the productive power of markets when he said, "It is not the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest." In the same sense, we don't rely on their benevolence to protect us from the harms they might visit on us through corner-cutting, pollution, etc.

If we start unbalancing the picture by taking away the need for some actors to fully account for the costs of their actions, it's not hard to see that you've provided an incentive for them to rack up costs - benevolent though they may seem. There is a vast array of "intangible" interests that the market moderates - but it can only effectively account for them if they are actually worked into the decision making process of economic actors. The market makes these intangible interests tangible through the calculation of costs in the production of goods and services.

Of course, these costs - intangible as they may be - don't disappear from reality just because they don't go on the corporate ledger. Rather, the costs are simply shifted to another party - usually, the public. So think about it: first, you socialize the costs by legal fiat, and try to distract people from the root of the decision making process that creates them. Then, when these intangible effects that are supposedly so hard to quantify percolate into the tangibility of affecting actual humans and their lives, it's left to the environmentally and socially conscious among us to try and refashion these intangible effects into terms movers and shakers - you know, politicians, lobbyists, corporate big-wigs - can understand. And yet, it's the left who's accused of having no economic sense!

It would be one thing if the profits that investors made off this damaging activity were also shifted to that party. This is where limited liability comes in: it says that investors are only liable up to the value of their investment, and no more. The wealth that was created in the course of the damage can't be touched - only the initial investment. This is why many argue that corporations exist as vehicles for maximally internalizing profits while simultaneously externalizing costs onto others to the greatest extent.

So it is indeed true that there is a dollar value for the grant of limited liability to investors - think about how many stock market players are spending their time trading shares. The stockholders of a given corporate entity hire managers to run this massive force of accumulated wealth with the legal obligation to turn a profit. Multibillion dollar entities have the capability to do much more damage to third parties than you or I can even dream. It is the nature of economies of scale that there are also diseconomies of scale. Yet investors don't spend their time worrying about the full costs of that possible damage, since they can only lost, at most, the initial cost of their investment. Unlimited profitability, limited liability - quite a privilege indeed!

Truly productive enterprises don't need gimmicks to function. Vinay asks whether data exists that documents the value of this subsidy, but there's another question to consider: what is the opportunity cost of this limited liability subsidy? If investors had never had a blanket grant of immunity from fully calculating their true costs, how much cleaner or balanced would industry be? Would we have these huge inequalities of wealth if large scale capitalization didn't get a sweetheart deal? Would we have more competitive sectors of industry if everybody had to compete, not just on the price of their widget, but the full risks of producing that widget - including dumping waste, emissions, etc.? We'll never know, but it does make one wonder.

One of the reasons entrepeneurs stand to make money in a free market is that they assume risks - this is natural and good, since it requires players to be fully interested in all the effects of their activities. In order to have an efficient market of true comparitive advantage where everybody benefits from the calculations inherent in the market, we can't simply ignore risks just because the state says it's OK. If we do, we should expect what some call "market failure". However, is the market really to blame if risky, destablilizing, and hazardous behavior is subsidized from the get-go? And how many of the uncomfortable side-effects of capitalism are really just products of a market that is constantly correcting for faulty programming?

SIDE NOTE: I've been meaning to mention a great post and comment thread on Kevin's blog about corporate personhood, and this seems as good a place as any to mention it.

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Written on Monday, July 03, 2006