Limited Liability Law, Corporations, and Moral Hazard

David Moss in When All Else Fails: Government as the Ultimate Risk Manager points out (pp. 67-8) that opponents of a Massachusetts limited liability law explicitly made the moral hazard argument:

Another common counterargument was the traditional one: that limitations on liability would encourage reckless behavior. This represented an early articualtion of the moral hazard principle, though the term itself was not used. "Men who are restrained only by the limits of their capital stock," Representative Sturgis maintained, "do not and cannot feel under the apprehension of those who are restrained, each one by his own personal jeopardy,to the amount of all his means: to the extent of his very livelihood.... Your best security always is in the apprehension of your debtor."

Nonetheless, when it came to removing all obstacles to passive investment in corporations, the fear of the moral hazard of irresponsible corporate managers did not carry the day. In 1830 Massachussetts passed a limited liability law.

Moss indirectly also points up a moral hazard of allowing corporations with unlimited liability. When the creditors of corporations could count on all investors to be responsible for the corporation's debt they were thereby encouraged to provide easy credit (p. 66):

the effect was to make credit abundantly available to corporate managers, allowing (and even encouraging) them to borrow recklessly and engage in wild speculation. This is precisely the opposite of what had been argued in 1809, when lawmakers figured that unlimited liability would help to rein in reckless investing.

In 1809 legislators were counting upon corporate investors with unlimited liability to rein in recklessness of borrowing by corporate managers. However, I suspect that Moss' point (p. 64) that "passive investors were largely at the mercy of the corporate directors who managed their companies" was probably most accurate even in ca. 1800. Corporate managers had much control and if creditors--because of unlimited liability--were enticing them with easy borrowing, this was a moral hazard created by the nature of the corporation itself. This situation could have been an argument against corporations.

However, the proponents of a limited liability law used the recklessness of borrowing under unlimited liability as an argument for corporations with limited liability. But corporations with limited liability also were subject to the moral hazard of irresponsible managers. Limited liability might have made creditors more cautious but corporate managers primarily responsible to passive investors still had incentives to be reckless with other people's money. In fact, if limited liability applied to corporate manager-investors it is conceivable there was more manager moral hazard with limited liability than unlimited. With unlimited liability creditors would have an incentive to tempt corporate managers, but managers themselves, with unlimited liability, would also have an incentive to resist temptation.

One More Point About Hypocrisy Regarding 'Moral Hazard'

I have often been impressed with how arguments can be creatively twisted in public debate and in courts of law to support almost any outlandish position. In my last post I noted how first state governments passed legislation enabling corporations thus making it possible to collect the money of many passive investors and place it in the hands of corporate directors, and then these state governments passed limited liability legislation protecting investors from responsibility for corporate debts above the limit of their personal investment. I noted how both the allowance of corporations and limited liability law created their own 'moral hazards.'

It is interesting to note that when Massachussets was debating whether to pass limited liability legislation the then Governor, an advocate of limited liability, used the following argument (David Moss, When All Else Fails: Government as the Ultimate Risk Manager, 2002, p. 64):

"It is not reasonably to be expected," Governor [Levi] Lincoln had observed in 1825, "that prudent men, except under particular circumstances of personal confidence in their associates, should be ready to incur even the possible risk of utter ruin, for the chance of profit, in the joint stock of a manufacturing concern."

In other words, the Governor was arguing that since investors in joint stock corporations were only passive investors, they required the guarantee of limited liability to be encouraged to invest where they had no opportunity for 'personal confidence in their associates' because the corporate directors were likely not personal associates.

So first the state of Massachussets passes legislation enabling corporations thereby creating a class of passive investors and creating the moral hazard of directors risking other people's money; and then, arguing that this newly created class of passive investors would not be sufficiently motivated to invest unless the state limited their liability as well, created yet additional moral hazards both for corporate directors and passive investors. Instead of arguing that perhaps the state shouldn't have enabled corporations and passive investors in the first place, the Governor parlays the original bet on corporations into the perceived necessity to limit the liability of passive investors in order to provide them sufficient motivation to invest.

To me this is a fascinating use of argument. Instead of considering the hypothesized reluctance of passive investors to risk their money in joint stock companies as perhaps a reasonable hesitancy of 'prudent men', or considering this reluctance as a possible indication that joint stock companies may have been a flawed idea, Governor Lincoln argued that this reluctance to "incur even the possible risk of utter ruin" must itself be swept away by limiting the liability of passive investors and actively encouraging them to risk their capital in joint stock companies.

If one is convinced that corporations and passive investors and limited liability are essential prods to economic growth I guess the Governor's argument makes sense. But there is an interesting lack of concern about moral hazard when it is argued that initial moral hazards were not enough and now we are required to create yet additional moral hazards to encourage both corporate directors and passive investors to take risks they might not normally be willing to take. In this phase of American history government is aggressively intervening in the economy to encourage risk taking. Later it will be argued that workers must take total responsibility for themselves and any even imagined possibility of certain types of risk taking on their part must be severely discouraged.

American Hypocrisy About Government 'Meddling'

In David Moss' When All Else Fails: Government as the Ultimate Risk Manager it is clearly laid out how much help state and federal governments provided for business and manufacturing in the late 1700s and throughout the 1800s: governments provided loans, allowed businesses to raise money through lotteries, provided cash awards for high quality textile products, passed laws enabling incorporation allowing companies to raise money from many passive investors, and passed laws allowing investors to assume only limited liability if the company failed to pay its debts.

Again, many people thought these aids were a good idea and if you do too that is fine. They probably were a good idea. But if government intervention was 'good' when it was helping businessmen to accumulate the fabulous wealth and power they did in the 19th and 20th centuries, why did it become 'bad' when governments turned to help workers and consumers in the late 19th and 20th centuries? I believe it is because having accumulated the vast wealth and power businesspeople had, they then used this to actively promote an ideology protecting their privileges and power. Since many attempts to help workers and consumers would cost businesses somewhat more, and since regulations inhibited the freedom of business to do what it pleased, businesspeople and their many allies within universities, the press, the legal profession, among politicians, et. al. aggresively promoted the laissez faire philosophy that said it was very bad for the government to 'meddle' in the economy.

It had been great for government to do all those things to help business but that was long ago and few remembered or reminded us about all that government had done. After the industrial revolution had completely changed the face of American society creating a huge working class and huge cites where before an agricultural society had existed, now it was bad for government to 'meddle' by passing child labor laws, legislating to protect women workers, passing laws for workers compensation for on the job injuries, etc.

And one of the major arguments used by opponents of legislation to aid workers was that such laws would create 'moral hazard.' If we passed legislation protecting workers against on the job injuries then workers would be encouraged to be more careless and would be discouraged from saving for their own security. Horrors! However, earlier legislation allowing businesses to incorporate and attract many passive investors and limiting the liability of these passive investors--this legislation won the day. Yet, a momemt's thought suggests that allowing corporations and limiting the liability of investors obviously created its own 'moral hazards.' Allowing corporate directors to raise large amounts of money from passive investors would encourage corporate directors to be more careless with Other People's Money than they would have been with only their own at risk. As David Moss wrote (p. 64):

With little or no control over the day-to-day affairs of their corporations, passive investors were largely at the mercy of the corporate directors who managed their companies.

This limited responsibility of corporate directors would encourage irresponsibility or 'moral hazard.' The passage of limited liability laws protecting investors from responsibility for corporate debts also would create moral hazards: such laws protected the director-investors too, thus encouraging them to take more risk with their limited responsibility, and these laws would encourage investors to be less careful with their investment dollars because their corporate debt responsibilities were limited. But, somehow all these pro-business 'moral hazards' that seemed to have worked out well for economic growth were forgotten. When it came to protecting workers and consumers imagined 'moral hazards' were conjured up to oppose and defeat such legislation.

Why Is 'Moral Hazard' a Problem for the Less Privileged But Not for the More Privileged?

The concept of "moral hazard" is an interesting one; one definition is "if you cushion the consequences of bad behaior, then you encourage that bad behavior (see On the Genealogy of Moral Hazard, Tom Baker, Texas Law Review, December 1996, 75 Tex, L. Rev. 237)." This was a concern with business fire insurance in the 19th century because the latter might increase the likelihood of arson by an unscrupulous businessman. I'm not entirely sure why this isn't an argument against all insurance; if the insurer takes on a good deal of the risk of loss wouldn't the moral hazard argument suggest that the insured would have less incentive to protect against loss? Insurance could be considered a relative of socialism in that it replaces individual responsibility with social responsibility. Of course insurance began with the more privileged classes; merchants wanted to protect themselves against being wiped out by loss of a shipment so they devised methods of sharing risk. When the gentry does it it's not a problem.

Former-Congressman Dick Armey was fond of saying, "social responsibility is a euphemism for individual irresponsibility." This implies that insurance encourages individual irresponsibility as do limited liability legislation, business bankruptcy legislation, etc. However, demagogues like Armey don't attack the latter, they save their venom for legislation that would protect less privileged individuals against risk.

In an interesting book called When All Else Fails: Government as the Ultimate Risk Manager David Moss describes how it was a terrific idea to protect business from risk in the United States in the 19th century by the use of limited liability legislation for corporations, controls on the issuance of bank notes, bankruptcy legislation to give businessmen a 'fresh start', etc. However, when we get to the beginning of the 20th century and there is a movement for workmen's compensation legislation, or social insurance to protect workers against unemployment and provide for old age, now come the privileged classes and their hired guns screaming that such protections would create 'moral hazard', workers will be motivated to take less care in the workplace, be less motivated to find work, and be less motivated to save for their own retirement.

And we still hear the same worn arguments to this day. If government is called on to help bail out the savings and loans at taxpayers expense that's necessary, however, if government could solve the healthcare insurance mess this would lead to moral hazard and people either using too much health care or not taking good enough care of their health.