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Thursday, April 01, 2010

Corporations, Social Insurance, and Unchecked Power

James Madison was not a fan of corporations:

Early Americans had a far more comprehensive and nuanced understanding of corporations than the Court gives them credit for. They were much more comfortable with retaining pre-Revolutionary city or school charters than with creating new corporations that would concentrate economic and political power in potentially unaccountable institutions. When you read Madison in particular, you see that he wasn't blindly hostile to banks during his fight with Alexander Hamilton over the Bank of the United States. Instead, he's worried about the unchecked power of accumulations of capital that come with creating a class of bankers.

More here: What the Founding Fathers Really Thought About Corporations, by Justin Fox. [See also: The Founders were deeply skeptical of corporations, by Michael Giberson.]

When thinking about corporations, I think it's useful to keep this in mind:

David A. Moss, a Harvard Business School professor ... explains that the first application of social insurance in our latitudes actually was aimed ... at ... supporting the growth of modern capitalism. Its main instrument to that end was the legal sanction of the principle of limited liability of the owners of corporations.
Prior to this form of social insurance, the owners of a business were legally liable with their personal wealth for damages the business might have inflicted on others. With limited liability, the corporation’s shareholders are liable only up to their equity stake in the company. ... Beyond that, someone else in society — often the taxpayer — bears the financial risk for damages attributable to the corporation.
One wonders how many business executives and members of chambers of commerce ... realize that the limited liability of shareholders is social insurance.

In return for this protection, it's not unreasonable to impose regulation on corporations that, should they fail, impose large damages on society that do not have to be paid be the owners and managers. (As is the case with too big too fail financial institutions, e.g. do you think the behavior of banks might have been different if the bank managers' personal assets were at stake in a bank failure, with a high likelihood that bank failure would leave the managers penniless? In the current financial meltdown that was so costly to society, many managers paid little penalty when the firms they managed failed.)

For a managers and owners, if failure in the future is likely, the game here is simple. Transfer as much wealth as possible as fast as possible from the corporation to managers/owners where it will be safe from creditors and others who face costs if and when the corporation fails.

I'm not suggesting an end to limited liability -- though clawback provisions that return assets to the corporation are needed to give managers an incentive to maximize long-run rather than short-run gains and to prevent the looting of troubled firms. Only that the regulation of firms that benefit from substantial amounts of implicit social insurance is needed to align the incentives of managers with stockholders and, more generally, society at large.

    Posted by on Thursday, April 1, 2010 at 11:34 AM in Economics, Market Failure, Regulation | Permalink  Comments (25)


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