TT's Lost in Tokyo — by TokyoTom

Ed Dolan (Professor at Stockholm School of Economics in Riga, Latvia and editor of the Austrian classic, The Foundations of Modern Austrian Economics (online here), and author of the classic pamphlet TANSTAAFL: An Economic Strategy for the Environmental Crisis (1971), has a post up at his new economics blog that ties together the above subjects, each a favorite of my own.

As I noted in a recent post referring to BP and ocean ecosystems :

Aren’t there huge and obvious commons-related problems that stem from government ownership and “management” of resources – be they federal lands, the seas, our fiat currency, or our financial institutions and publicly-listed companies?

But enough of me; here is the meat of Mr. Dolan’s post, What Oil Spills and Financial Crashes Have in Common: Gambling with Other Peoples Money (emphasis added):

:What do the Gulf oil spill and the recent financial crisis have in common? Both of them are the result of risk-taking gone wrong. …

The real trouble comes when you have a chance to gamble with other people’s money. Then you start looking for strategies that usually give you at least a modest payout even though they involve a small chance of catastrophic loss. These are called negatively skewed risks. You take these risks, even if you know they have a negative expected value, because you think you will pocket a gain most of the time. You expect that when disaster finally strikes, you will be able to walk away with your past winnings in the bank while sticking someone else with the loss.

Several common situations in business life give rise to the temptation to gamble with other people’s money. Executive compensation plans that emphasize short-term bonuses, include golden parachutes, and lack clawback provisions are one example. Not only top executives face such incentives–mid-level traders, engineers, and analysts may also take risks in the hope of bonuses or promotions, with the expectation that the worst that can happen in case of catastrophe is that they lose their jobs. Stockholders may condone such risk taking because they are protected by limited liability.

Both the Gulf oil spill and the financial crisis had their origins in negatively skewed risks. Investigators in the Gulf disaster are looking at whether BP and its contractors underplayed downside risks when they made technical choices, ignored warning signs, and neglected preparations for dealing with a worst-case spill. In the financial crisis, negatively skewed risks involved excessive leverage, manipulation of ratings, design of complex securities, and several other factors.

What can be done? Regulations can be made stricter, but who will regulate the regulators? Who will ensure they are not captured by special interests? Compensation plans can be changed–but if shareholders do not take the initiative, can outsiders fix the system for them? Corporations can be held to strict standards of legal liability, but individuals who make bad decisions are not necessarily the ones to pay when their corporate employers are found liable.

There is no magic bullet. We can only hope that after a couple of really big disasters, people will be more alert to early warning signs the next time.

What Ed has failed to note is that both the financial crisis and the BP oil spill/Gulf crisis are examples of the “Tragedy of the Commons” – when the commons are either the government pocketbook itself, or resources owned/managed by the government. Solutions to management of the Gulf lie in giving more rights – such as “catch rights” and a veto over oil and gas development – directly to resource users like fishermen. With their livelihoods on the line, they would be much more diligent than government can ever be in making sure oil and and gas development proceeds safely.

I pulled out my peashooter the other day and levelled a few criticisms (“Risk-shifting, BP and those nasty enviros“) at  Lew Rockwell‘s Feel Sorry for BP?.  I don’t imagine that Lew noticed, but my buddy Stephan Kinsella did.

I have long noted the reflexive defense of corporations by prominent Austrians and the stubborn unwillingness to closely examine the role that the special grants to corporate investors that lie at the core of the problem of snowballing corporate statism, spiralling politicized rent-seeking battles, incompetent government and concupiscient and grand-standing politicians. So Stephan’s comments come as no surprise:

1.  Stephan chooses to set the stage with a bunch of labels –  “enviro-global-warming anti-corporation libertarian”. Whatever makes you happy, Stephan. I know you and others have a hard time resisting the urge, which is why I often playfully sign off as the resident friendly enviro fascist! Nah, couldn’t possibly be a “real” libertarian.

On corporations, the “environment”, and climate – as on central banking, fiat currency and the whole mess of banking and capital markets regulation – I’m simply anti-un-contracted-for-risk-shifting-and-government-enabled-moral-hazard and arguments against rent-seeking that ignore existing special deals.

But if it’s easier, just keep calling me”anti-corporation” and continue to lump me in with “enviro-fascists”.

 2.  I had wondered: 

Even if one concedes that some criticisms of BP will be unfair, how can BP possibly be cast [by Lew] as the LEADING victim – as opposed to all of the others whose livelihoods or property are drastically affected by this incident, which they had no control over whatsoever?

Stephan’s lame response?

BP is a victim in the sense that a terrible tragedy just happened to it, and it’s gonna cost it dearly. It’s the leading victim assuming the others damaged are going to be compensated from BP. The point is it’s a bad thing that’s happened to it.Why not feel sorry for them?

Really, Stephan?  BP deliberately measures and takes risks as part of its business; no one else who has been or maybe injured had a clear concept of such risks or either assumed them or had any ability to control them. Clearly, BP is the one that has interfered with others’ use and enjoyment of their own property, of common property and of government-owned property; in law, we call them “tort-feasors”.  They are not a “victim” in any sense that we commonly apply in situations like this. Empty word games like yours turn reality in its head. Right, Toyota is a victim when its cars’ brakes have problems, TVA is a “victim” when its coal fly ash dams break, and so are others who “unintentionally” injure the health or damage the property of others – when latent risks materialize or they are caught at it and suffer some economic loss as a result.

It’s hard to believe you want to further support Lew’s absurd claim that BP is the leading victim now – we simply have assume that in the future, BP or someone else will throw some compensation at all of those other unworthy, insignificant passive victims. Nice.

Sure, it’s too bad that this happened, all around. BP gambled (heroically?) to make money; everyone has lost. Poor BP!

3. Lew: “The incident is a tragedy for BP and all the subcontractors involved. It will probably wreck the company”

Me: 

The incident will certainly be costly for the firms involved, but the firms will survive the death of employees, and there is certainly very little risk indeed that BP will be “wrecked” by the spill. Far from it; it is unlikely that BP will even bear the principal costs of cleanup efforts, much less the economic damages to third parties that federal law apparently caps at $75 million.

Have you not heard of “INSURANCE”? A little thinking (and Googling) would tell you that BP (and its subcontractors) has plenty of it. To the extent BP is NOT insured, it has ample capability to self-insure, unlike all of the fishermen, oystermen and those in the tourist industry who are feeling significant impacts. Insurers will bear the primary burden, not BP.

Stephan:

Obama has threatened BP and they have caved in, agreeing to pay above the $75M cap. And the cap was in exchange for a tax on oil companies to be put into the Oil Spill Liability Trust Fund for such emergencies–do you think that BP will be able to get that tax refunded? Naah.

Sounds like you’re agreeing that this incident is unlikely to “wreck”BP, given insurance, self-insurance and the $1.6 billion Oil Spill Fund. But it sounds like you also are suggesting that BP has every right to negotiate with government for liability caps. Interesting.

4. Lew:   “we might ask who is happy about the disaster: 1. the environmentalists, with their fear mongering and hatred of modern life”

Me:

Sorry, but this is perverse: enviros might feel that they have been proven right – and you might be annoyed that they can make such a claim – but they certainly aren’t “happy” with any of the loss of life, damage to property or livelihoods of the little guy (or of bigger property owners), or to a more pristine marine environment that they value.

Stephan: 

Aren’t happy? Have you seen, say, Spill Baby Spill, Boycott BP! ? And another tolerant, caring liberal on Slate’s Political Gabfest Facebook page said, “I don’t get the calls for pity. Boohoo another oil giant might have bankrupted itself.” These misanthropic sickos oppose nuclear power, which makes fossil fuels necessary. They act like they hate BP. Why? For making a mistake? Mistakes are inevitable. For drilling for oil? Why? We need oil.

Let me repeat: some might feel vindicated and be eager to use this incident to bash BP, etc. – people/firms certainly are fighting over government – but that doesn’t make them “happy” that disaster has occurred.

You apparently missed it, but there were plenty of “misanthropic sickos” on Lew’s comment thread who expressed thoughts similar to “I don’t get the calls for pity. Boohoo another oil giant might have bankrupted itself.”

The rest of this is also packed with nonsense.  Funny that Austrians fail to overlook that enviro opposition to nukes and to other fossil fuels is more than a little related to government’s dirty role in the industries, including liability caps like those present here. Do Austrians “hate” banks, securities firms and AIG for making “mistakes”? But aren’t mistakes “inevitable”? And don’t we need lenders and insurers? And a domestic auto industry?

Just what do these utilitarian arguments have to do with libertarian principles, anyway?

5.   Me:

[Lew’s] projection of happiness at damages to common resources/private property and hatred of modern life is especially perverse, given your own explicit recognition that government ownership/mismanagement of commons, and setting of limits on liability both skew the incentives BP faces to avoid damage, and limit the ability of others (resource users and evil enviros) to directly protect or negotiate their own interests. Why is the negative role played by government any reason to bash others who use or care about the “commons”?

Stephan: No libertarian is in favor of liability caps. What is he talking about?

Simple, Stephan. Lew explicitly recognizes that government has screwed up  the ability of enviros and others who have conflicting preferences about the use of resources to engage in voluntary transactions that would advance mutual welfare – yet he chooses to bash those whose preferences are frustrated by government, while feeling sorry for those whose preferences are favored. What is remotely even-handed – or Austrian – about this imbalance? Is it simply that it’s okay for those who make omelets to take eggs from others, since the omelet “makers” are being “productive”?

6.  Me:

We have seen Austrians – sympathetic to the costs to real people in the rest of the economy – rightly call for an end to a fiat currency, central banking and to moral-hazard-enabling deposit insurance and oversight of banks. In an April 9 post by Kevin Dowd on the financial crisis, we even had a call “to remove limited liability: we should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly” – but Dowd’s comments simply echoed in the Sounds of Silence. Why do you and others refuse to look at the risk-shifting and moral hazard that is implicit in the very grant of a limited liability corporate charter – not only in banking, but in oil exploration and other parts of the economy?

Stephan:

Removing artificial caps on liability has nothing to do with the limited liability of passive shareholders in a corporation. Their liability is limited simply because they are not causally responsible for the torts of employees of the company in which they hold shares.

I suspect this is the key reason why Stephan troubled himself to respond, but surely he can see it is not only counterfactual, but dodges any consideration of the consequences of limited liability in terms of fuelling industrialization and fights over using government to check corporate excesses. Investors then and now deliberately choose to conduct business activities through corporations precisely because government absolves owners from any liability in excess of enterprise assets.  While it is possible for voluntary counterparties (employees, lenders and others doing business with the firm) to agree in advance to limit their resources solely to enterprise assets, those who are injured by acts of companies or their employees and agents do not in advance choose the nature of the those who are responsible for harming them. Accordingly, the broad blanket grant of limited liability to corporations is clearly anti-libertarian.

Accordingly, dividends received by shareholders from risky activities are not clawed back if risks are realized and claims exceed corporate assets. Further, shareholders are given disincentives from too closely directing manage risk (for fear of claims that they have direct responsibility for torts). When combined with other corporate attributes (unlimited life & purposes, relative anonymity of ownership, remoteness of owners from communities in which the firms operate, and ability of powerful firms and wealthy investors to influence judges, legislators, bureaucrats and other officials), we have seen a steady erosion of common law and growth in the regulatory state – as citizens fight to limit the risks and costs that corporations impose on individuals and communities. Is Stephan unaware of the central role of corporations in rent-seeking battles? In the perversion of the 14th Amendment – designed to protect emancipated slaves and Chinese coolies – into a weapon to elevate corporations over the states, and to permanently shift power to the Federal government?

Just as most commentators overlook the massive moral hazard and risk-shifting that is part and parcel of the federal oversight of banking (necessitated by deposit insurance and fractional banking), so do Stephan and Lew insist on keeping their eyes closed to the legacy of risk-shifting, statism and escalating fights over increasingly incompetent and corrupt government. Why?

[It looks like I’m having formatting problems; sorry, readers!]

I left the following comment on Kevin Dowd’s excellent April 9 Mises Daily piece, “The Current Financial Crisis – and After”, a transcript of a talk he apparently made at the Paris Freedom Fest on September 13, 2009 (emphasis added):

TokyoTom April 22, 2010 at 8:27 am

Kevin, many thanks for this lucid, spot-on and frightening piece.

No one else has mentioned it, so allow me to focus on a piece of your essay that I think has very wide implications that our leading lights at LvMI have been doing their best to ignore: the moral hazard and risk-shifting generation that is INHERENT in the state grant of LIMITED LIABILITY to corporate shareholders, and that has helped to encourage irresponsible behavior and increasing (and ultimately unsuccessful) regulation in the banking sector. It has also fuelled the cycles of corporate regulation, rent-seeking and political corruption.

I couldn’t agree more strongly with what you said here:

“the financial-services industry needs serious reform. Hard to believe as it might be, there was once a time when the industry was conservative and respected, when it focused on providing straightforward financial “products” to its customers and did so well. We have got to get back to that. No more financial hydrogen bombs blowing up the financial system.

“The key to this is corporate-governance reform. I am talking, not about tinkering with the number of nonexecutive directors or a new Sarbanes-Oxley, but radical reform to make the banks accountable and to rein in the moral hazards that have run rampant. And the key to good corporate governance is to remove limited liability: we should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly.”

I believe that, as argued by James Glassman and William Nolan in a Wall Street Journal op-ed last February that referred to von Hayek, unless and until owners and executives have “more skin in the game” – like the conservatively managed private partnership Brown Brothers Harriman, we will continue to ride a tiger of selfish risk-shifting, moral hazard, and ever more disruptive government regulation.

I have argued in a series of posts, starting with my review of Huebert and Block’s criticisms of Long, the state grant of limited liability to shareholders (in particular the grant vis-a-vis those injured by corporate acts and involuntary creditors, which is a pure grant from the state and cannot be contracted for) has led to a number of perverse results, which can be fairly clearly seen in the financial crisis.

I hope your post will contribute to a much more serious examination by Austrians of the role played by the state grant of limited liability to corporate shareholders in facilitating flawed and irresponsible risk-taking by executives and traders, as well as in perversely fuelling a vicious cycle of rent-seeking and further counterproductive regulation, both within and outside the financial sector.

[But I’m not holding my breath.]

Sincerely,

TT

No, I didn’t write this press release (but I did add emphasis!). I note my related posts are here.

DATE: January 21, 2009

FOR IMMEDIATE RELEASE

CONTACT: Jeff Milchen, American Independent Business Alliance
406-582-1255  

INDEPENDENT BUSINESS ADVOCATES AND PUBLIC INTEREST GROUPS CONDEMN SUPREME COURT’S RULING ON CORPORATE MONEY IN ELECTIONS

CALL FOR CONSTITUTIONAL AMENDMENT TO OVERTURN COURT DECISION

BOZEMAN, MT – A coalition of public interest organizations and
independent business advocates condemned today’s ruling by the US
Supreme Court allowing unlimited corporate money in US elections, and
announced that it is launching a campaign to amend the United States
Constitution to overturn the ruling.

The coalition
includes the public interests groups Voter Action, Public Citizen, and
the Center for Corporate Policy, as well as the American Independent
Business Alliance (AMIBA). They contend the Court’s ruling in Citizens United v. FEC
poses a serious and direct threat to democracy and to fair market
competition. Immediately following the Court’s ruling, the groups
unveiled a new website – FreeSpeechforPeople.org – devoted to this campaign.

“The Supreme Court has leaped into unabashed activism on behalf of
corporate power,” said Jeff Milchen, co-founder of the American
Independent Business Alliance. “Some reports have wrongly suggested the
Roberts Court is ‘pro-business,'” said Milchen, “but overturning these
precedents is radically anti-business when viewed from the perspective
of America’s six million or so independent businesses.“

“Independent business owners often face a decidedly uneven playing
field when competing against major corporations due, in part, to tax loopholes, subsidies, federal handouts
and preferential treatment bestowed by politicians,” added Milchen.
“Opening electoral contests to direct corporate campaign spending
further undermines fair market competition and recklessly endangers
democracy.”

AMIBA is a
non-profit network of 70 communities across the U.S. that have formed
local Independent Business Alliances to help local independent
businesses compete successfully and prevent major chains from driving
out local businesses.

“Free speech rights are for people,
not corporations,” says John Bonifaz, Voter Action’s legal director.
“In wrongly assigning First Amendment protections to corporations, the
Supreme Court has now unleashed a torrent of corporate money in our
political process unmatched by any campaign expenditure totals in US
history. This campaign to amend the Constitution will seek to restore
the First Amendment to its original purpose.”

The public
interest groups say that, since the late 1970s, a divided Supreme Court
has transformed the First Amendment into a powerful tool for
corporations seeking to evade democratic control and sidestep sound
public welfare measures. For the first two centuries of the American
republic, the groups argue, corporations did not have First Amendment
rights to limit the reach of democratically-enacted regulations.

“Today’s ruling, reversing longstanding precedent which prohibits
corporate expenditures in elections, now requires a constitutional
amendment response to protect our democracy,” says Jeffrey Clements,
general counsel to Free Speech for People.

Jennifer Rockne, AMIBA’s director, added “Even before the banking meltdown, ninety percent
of Americans thought large corporations have been granted too much
power. It’s a remarkable moment for the Court to re-invent the
Constitution to expand corporations’ influence and a slap in the face
to America’s independent business owners.”

In support of
their new campaign, the groups point to prior amendments to the US
Constitution which were enacted to correct egregiously wrong decisions
of the US Supreme Court directly impacting the democratic process,
including the 15th Amendment prohibiting discrimination in voting based
on race and the 19th Amendment, prohibiting discrimination in voting
based on gender.

“The Court has invented the idea that
corporations have First Amendment rights to influence election outcomes
out of whole cloth,” says Robert Weissman, president of Public Citizen.
“There is surely no originalist interpretation to support this outcome,
since the Court created the rights only in recent decades. Nor can the
outcome be justified in light of the underlying purpose and spirit of
the First Amendment. Corporations are state-created entities, not real
people. Corporate spending on elections defeats rather than advances
the democratic thrust of the First Amendment.”

Milchen
believes the effort will succeed, but makes no predications on a
timeline. “This will be a sustained campaign that will ultimately unite
the vast majority of Americans who recognize the Bill of Rights is for
human beings, not corporations,” said Milchen. “We have no illusions
about the size of the task we are undertaking, but five Justices have
effectively outlawed the republican form of government promised by our
Constitution. We will be as patient as necessary to succeed.”

For more information on the constitutional amendment campaign, see freespeechforpeople.org .

-30-

Related articles and websites:

Brenda Wright, Director of Demos and co-author of the amicus brief we submitted for this case, on the decision http://www.acslaw.org/node/15160

Not all business sided with the Court ruling:
http://www.freespeechforpeople.org/node/34

My Twitter comments can be found here and here, both in reverse chronological order (most recent posts first).

Below I`ve copied, in chronological order, just those comments that relate to the recent Supreme Court decision on the ability of Congress to regulate the “free speech” of corporations.

I left the following comment at a recent Mises Blog post by Stephan Kinsella, but the number of links included apparently triggered the spam filter and held up the comment.  According, I post it here, so I can re-comment with a cross-link here.

Stephan, we have extensively discussed this matter previously, focussing mainly on the point that Vincent Cook raises, namely, the consistency with libertarian principles of the state grant of limited liability as against parties who become unwilling “creditors” of the firm as a result of being injured by the actions of the firm.

You continue to dodge this point just as Block and Huebert have explicitly begged the question in their latest effort (emphasis added):

“As long as there is no fraud, as long as all those who deal with corporations know full well that in case of any dispute, they will only be able to sue for an amount up to the full capitalization of the corporation and not have access to the shareholders’ personal assets, there can be no problem with the libertarian legal code.”

It goes without saying that injured persons don`t choose ahead of time who will injure them, much less the whether the liability of their tortfeasors will be limited to corporate assets. [IOW, when it comes to limited liability corporations, there IS a fairly glaring problem with the libertarian legal code.]

Our previous discussions on the Mises Blog took place here and here: 

And an earlier related discussion on the Mises Blog was here:

I have commented extensively myself on the consequences of this grant – which I see as fuelling risky corporate behavior and a cycle of “rent-seeking” fights with private interests seeking to use the state as a check against corporations – in a number of blog posts, such as the following:

http://mises.org/Community/blogs/tokyotom/archive/2008/11/26/corporations-amp-the-state-some-criticisms-of-huebert-and-block-s-criticisms-of-long.aspx

http://mises.org/Community/blogs/tokyotom/archive/2009/03/03/when-will-tom-woods-and-other-quot-free-market-quot-intellectuals-have-second-thoughts-about-limited-liability.aspx

http://mises.org/Community/blogs/tokyotom/archive/2009/02/26/the-curse-of-limited-liability-wsj-com-executives-traders-of-big-financial-corporations-generate-risky-businesss-while-smaller-partnerships-are-much-more-risk-averse.aspx

http://mises.org/Community/blogs/tokyotom/archive/2007/10/16/fighting-over-the-wheel-of-government.aspx

http://mises.org/Community/blogs/tokyotom/search.aspx?q=limited

http://mises.org/Community/blogs/tokyotom/pages/legal-resources-on-the-state-creation-of-limited-liability-for-shareholders.aspx

Tom Woods, in his recent “Another “Free Market” Intellectual Has Second Thoughts” post at the Mises Economics Blog, notes with great disappointment that Richard Posner is about to publish a book that will apparently abandon the free market and call for greater government intervention.

While I share Mr. Wood’s disappointment that Posner and others are not more vigorously defending free markets, I suggested in comments on Mr. Wood’s post that perhaps free market intellectuals are not yet really pulling their own weight in examining and describing the flaws in the market system that contributed to the current financial crisis, or in explaining the types of reforms that would actually be appropriate.  In particular, it seems to me that the role played by the state grant of limited liability to corporate shareholders in facilitating flawed and irresponsible risk-taking by executives and traders, as well as in perversely fuelling a vicious cycle of rent-seeking and further counterproductive regulation, should be much more seriously examined. 

In short, I believe that, as argued by James Glassman and William Nolan in a recent Wall Street Journal op-ed, unless and until owners and executives have “more skin in the game”, we will continue to ride a tiger of selfish risk-shifting, moral hazard, and ever more disruptive government regulation.

I copy below my comments on Tom Wood’s post:

Tom, it’s hard to judge an unpublished book, but I suspect you’re
right to do so. Has Posner given any more solid clues as to where he’s
headed?

However, as it’s clear that things went wrong, I can’t help but
wonder when can we expect to hear more from you and others on what
government factors (besides the Fed, Freddie and Fannie) “fatally
deformed” the financial markets, and laying out a “new, genuinely
free-market paradigm for the economy”. Isn’t there a good book or two
in there from Austrians?

It seems to me that that James Glassman and William Nolan have a key
insight into the type of reforms needed in a WSJ piece that refers to
von Hayek. They argue that “an irresponsible attitude toward risk led
to terrible mistakes in judgment” and conclude that “bankers need more
skin in the game”. How to move in that direction?  Glassman and Nolan
point to the success of the Brown Brothers Harriman partnership, which
lacks the limited liability feature of modern corporations, and specifically recommend that governments recognize (by less burdensome laws and regulations) that entities like partnerships where owners face unlimited personal liability are more responible risk managers.

As I have argued in a series of posts, starting with my review of
Huebert and Block‘s criticisms of Long, the state grant of limited
liability to shareholders (in particular the grant vis-a-vis those
injured by corporate acts and involuntary creditors, which is a pure
grant from the state and cannot be contracted for) has led to a number
of perverse results, which can be fairly clearly seen in the financial
crisis:

TT

The February 25 Wall Street Journal carries an insightful piece of commentary by James K. Glassman (president of the World Growth Institute and a former undersecretary of state) and William T. Nolan (president of Devonshire Holdings and former associate at Brown Brothers Harriman & Co. in the early 1970s) .

The Glassman and Nolan piece, entitled “Bankers Need More Skin in the Game; Partnerships may be a more trustworthy business model than corporations,” echoes in the context of Wall Street financial institutions the theme of inappropriate managerial risk-taking that I have previously blogged on a number of times regarding the consequences of  the “limited liability” corporate form.  Glassman and Nolan point to the sterling performance of Brown Brothers Harriman & Co., the oldest and largest partnership bank in the U.S., founded in 1818.

The Glassman and Nolan editorial is worth reading in whole, for purposes of discussion I excerpt portions here (bolding is mine):

“Of all the causes of the financial meltdown of the past few years, the easiest to understand is that an irresponsible attitude toward risk led to terrible mistakes in judgment. But where did this casual approach to risk originate?

“A major culprit, we believe, is a change in the way Wall Street financial institutions are organized. During the late 1970s and ’80s, much of the responsibility for risk was transferred away from the people who made the financial decisions. As a result, leverage rose from 20-1 to 40-1 or higher, creating shaky towers of debt, which, as we know, eventually collapsed. …

“The trick is to find a way to encourage sensible risk-taking, while dampening the impulse to take chances that can throw an economy into recession and force taxpayers to bail out a banking system.

“Can government accomplish this feat through rule-making and regulatory oversight? It is unlikely. As the Nobel Prize-winning economist Friedrich von Hayek correctly emphasized, no one — not even a politician or a bureaucrat — can gain the broad and deep knowledge necessary to make wise enough rules. Moreover, in a $14 trillion economy, you can’t hire enough overseers to pore over everyone’s books.

“There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you’re less likely to take the kinds of risks that expose the rest of society to your failures.

“A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren’t protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). Unfortunately, the partnership is a legal form of business organization that was largely abandoned by banks over the past quarter-century. Our advice is to bring it back. …

“Even John Gutfreund — the man who kicked off the dramatic change in investment-banking culture and structure when he took Salomon Brothers, a longtime partnership, public in 1981 — confirms our thesis. Michael Lewis wrote in the December issue of Condé Nast Portfolio that Mr. Gutfreund now believes “that the main effect of turning a partnership into a corporation was to transfer financial risk to the shareholders. ‘When things go wrong, it’s their problem,'” said Mr. Gutfreund.

“But when the personal wealth of executives is put at risk, as it is in a partnership, their behavior changes. Risk aversion increases. Few partnerships would leverage themselves to the hilt to load up on risky subprime loans.

“How do we know this? Luckily, for this financial experiment, there is a control case: Brown Brothers Harriman & Co. ….

“Some would say that BBH is sui generis. Would its structure work more broadly for financial institutions? It already is. As large brokers merged into huge corporations with greater concentration in real-estate finance, corporate finance migrated to private equity firms and hedge funds, which are generally structured as partnerships. While many of these new engines of finance have suffered in the recent meltdown, they generally didn’t engage in such extreme risk-taking and thus haven’t become wards of the state.

“We know from Alfred Chandler, the great business historian, that “strategy determines structure.” Similarly, structure determines behavior — in this case, a healthier attitude toward risk. It is unlikely that a partnership will grow to the size of a Bank of America or Citigroup, but, while size can boost efficiency, it also poses systemic risk. As partnerships — and corporations with partnership attributes — replace behemoths, the current crisis will spawn structures for future success.  …

We do not believe that government should require banks to be partnerships. Rather, investors — and governments — should recognize the extra safety inherent in doing business with partnerships.“

I have previously argued that one of the key state interventions that has fuelled the rent-seeking and risk socialization that we see today is the grants of blanket limited liability to shareholders, along with the grant of legal personhood (with unlimited purposes and life and Constitutional rights) to corporations:

Limited liability has enabled corporate managers to act without close shareholder oversight and management; this I believe has played a key role in the vast misalignment of incentives that Michael Lewis and David Einhorn describe at the NYT, and in the risk mismanagement that Joe Nocera of the NYT describes at length in the NYT Magazine.  Those taking large bonuses (whether in the financial industry or large corporations) were essentially playing with OPM – Other People’s Money – and capturing the upside of short-term gains while leaving shareholders and taxpayers holding the bag for loses.

I hope that you and others here will look more deeply at the role of the state in the problem of misaligned incentives that continue to corrupt American capitalism.

It is not clear what Glassman and Nolan intend with their reference to “corporations with partnership attributes”, but I would note that corporations that make use of an unlimited liability structure (as American Express once did) share the main “partnership attribute” – that the owners of the firm may be, if the assets of the firm are insufficient, personally liable to creditors for all debts of the firm (other than those whose creditors agree in advance to limit recourse), particularly for torts to involuntary third parties.  The availability of the unlimited liability corporate form in various jurisdiction should be further investigated.

I agree with Glassman and Nolan that governments should recognize the better risk management that partnerships are likely to conduct, but not merely in the financial sector but in other industrial, commercial and professional fields as well.   Such recognition could take the form of eased regulations, for example.  I favor aggressive pursuit of this “carrot” approach to encouraging better risk management and less shifting of risks to shareholders, government and citizens generally.  However, this fails to consider what should be done about existing public companies and other limited liability corporations.  I would urge more aggressive veil-piercing, both judicially and by statute.

In any case, it is gratifying to see this topic getting some of the attention that it deserves.

There’s an interesting article in the Feb. 22 Times Union on the ineffectiveness of the New York oil spill fund:

Oil polluters pass on spill costs to public

The New York Environmental Protection and Spill Compensation Fund pays to clean up oil spills if polluters won’t handle it themselves. While the state is supposed to get that money back, it is owed millions by companies that won’t settle up. In more than 1,100 cases — some dating back to the early 1980s — the state has recouped just 17 cents on every dollar it spent.

As I’ve noted previously on several occasions, the limited liability that states grant to owners of corporations means that owners of polluting firms can walk away, leaving citizens and states holding the bag for risks and clean-up costs; this is true not only for the New York emergency oil spill clean-up fund, but for ordinary pollution damages where individuals are seeking compensation.  This problem is manifest in, and has been compounded in, New York, where the gas tax-funded clean-up fund system is clearly not working; not only has the fund been bailed out by general taxes, but the gas tax being used to fund it has been increased eight-fold since 1978, and the fund argues that it lacks sufficient enforcement tools.  At least part of the problem may be that the fund administrators find it easier simply to clean up and increase taxes than to try to pursue polluters.

As New York ponders reforms, the New York legislature ought to consider explicitly “piercing the corporate veil” by providing that the owners and executives of polluting firms – including shareholders of public companies – have direct personal liability for clean-up costs.

That may do wonders in incentivizing them to make sure that the firm that they own and/or manage (or an insurer on its/their behalf) promptly reimburses the fund for clean-up costs.  One suspects it might even cut down on the number of oil spills!

William Anderson (an adjunct scholar of the Mises Institute and economics prof. at Frostburg State University) has a thoughtful New Year’s Day post, pointing out how Paul Krugman fails to understand the causes of ouir economic stagnation and financial meltdown.

I posted the following comment, in which I argue that the state grant of limited laibility (which I have discussed in several recent posts) is a key to understanding the Great American Ponzi scheme:

Bill, I agree with the thrust of your criticisms of Krugman, but have a few small quibbles.

First, while you rightly condemn “most economic regulation … of the command-and-control variety”, you blame all of this on “the whims of bureaucrats and environmentalists” and completely fail to note that state and federal environmental regulation (i) initially responded to real environmental problems and (ii) also represents the successful efforts by established firms to raise barriers to entry and to cartelize their industries.  See Roger Meiners & Bruce Yandle, Common Law and the Conceit of Modern Environmental Policy, 7 Geo. Mason L. Rev. 923, 926-46 (1999), and Walter Block, Environmentalism and Economic Freedom: the Case for Private Property Rights..

Second, while you are correct that Krugman fails to understand the role of the state in creating the distortions that underlie our current problems, it seems to me that you have neglected one of the key state interventions that has fuelled the rent-seeking and risk socialization that we see today – the grants of legal personhood (with unlimited purposes and life and Constitutional rights) to corporations and blanket limited liability to shareholders.

Limited liability has enabled corporate managers to act without close shareholder oversight and management; this I believe has played a key role in the vast misalignment of incentives that Michael Lewis and David Einhorn describe at the NYT, and in the risk mismanagement that Joe Nocera of the NYT describes at length in the NYT Magazine.  Those taking large bonuses (whether in the financial industry or large corporations) were essentially playing with OPM – Other People’s Money – and capturing the upside of short-term gains while leaving shareholders and taxpayers holding the bag for loses.

I hope that you and others here will look more deeply at the role of the state in the problem of misaligned incentives that continue to corrupt American capitalism.