Today, in Paul Krugman's NYTimes Op-Ed, he discusses the structural similarities between the Irish and U.S. financial crisis.
Describing the effect of compensation in destabilizing our financial system, Krugman writes:
Third, key players had an incentive to take big risks, because it was heads they win, tails someone else loses. In Ireland this moral hazard was largely personal: “Rogue-bank heads retired with their large fortunes intact.” There was a lot of this in the United States, too: as Harvard’s Lucian Bebchuk and others have pointed out, top executives at failed U.S. financial companies received billions in “performance related” pay before their firms went belly-up.
My personal interest in the nexus between Limited Liability and "Moral Hazard" has recently led me to contemplate how limited liability legitimizes corporate management's over-sized compensation even where such payouts have the effect of leaving a corporation under capitalized vis-a-vis long-term risks.
In his op-ed, Krugman makes no mention of limited liability. No surprise as I'm the first to admit I'm pretty out there on this issue. Rather, he is discussing the fact that our current system of corporate management creates incentives for corporate management to create short-term profits without regard to the risks of long-term losses, however large they may be, such short-term profits create.
This disconnect between short-term and long-term interests was created when ownership and management was separated.
And that separation of management and ownership was made possible by limited liability.
As lawyers like to say, limited liability was the but for cause of this divergence of interests.
As recognized by Mark Smith in "A History of the Global Stock Market," it was not until the advent of limited liability that stock markets became a viable investment option. The risk of complete liability had the effect of substantially depressing share prices to the point of making liquid markets impossible. As Smith writes, "As this risk [of personal liability for corporate losses], became more widely publicized, it had the effect of noticeably dampening middle-class interest in stock investing."
Modern capitalism would have never have come to exist without the incredibly radical act of allowing the government to become the insurer of last resort. Without providing limited liability for investors, stock markets would have never grown to their current scale. Stock markets would have remained at best illiquid, thinly-traded markets. The separation of management from ownership, a necessary prerequisite to the whole moral hazard problem, would have never come to pass.
Illiquid markets would have never created the dispersed ownership structure that now typifies modern corporations. Shareholders would have remained insiders. Managers would have remained shareholders. And being such, they would have continued to make decisions that accounted for the long-term interests of their business enterprise.
If they blew up, they'd feel it personally. They wouldn't be retiring with large fortunes intact.