It is undoubtedly true that the explosion in sub-prime mortgages occurred after the 1999 deregulation of the banking system spearheaded by Phil Gramm. Nevertheless, many libertarians still seek ways to blame government interference with the free market for the economy’s present woes. It seems to me that the economic system that the libertarians think of as the free market is in fact a product of government interference.
In a market free of government interference, I would think that a man would only be free to make promises that bind himself and others who expressly authorize the man to make promises on their behalf.1 This would limit the acceptable forms of conducting business to the sole proprietorship and the partnership. However, in our society a man is permitted to make promises that bind an entity known as a corporation. The corporation is a fictional person authorized by government regulation so that investors can share in the profits of business ventures without risking the liability of being a partner. Absent the corporation, the only option available to people who wanted a return from a business without the obligation of overseeing its activities would be to loan the business money.
The corporation is a useful tool because it can lead to the more efficient use of capital. Suppose for example, that a man had an idea for a new restaurant. Restaurants are notoriously risky ventures with a high failure rate. On the other hand, a successful concept can be extremely profitable. The man might find it very hard to borrow the money to open the restaurant because the lender would consider his chances of getting paid back pretty poor and might charge a prohibitive rate of interest. On the other hand, an investor might be willing to buy stock in the restaurant because the profits upon success will be great enough to justify the risk of failure. The existence of the corporation can allow beneficial economic activity.
The problem with the corporation is a product of the very quality that is its reason for existence. The shareholder who stands to benefit from the success of the business is not on the hook for more than his investment if things go wrong. That provides an incentive for the corporation to ignore catastrophic risks if their probability is very small. Suppose that a business executive is presented with an opportunity that has a nineteen out of twenty chance (.95) of producing a 25% profit and a one in twenty chance (.05) of producing a loss of 2000%. If the executive is running a partnership, the expected return for his investors is the sum of the return on success times its probability plus the return on failure times its probability ([25% x .95] + [-2000% x .05]), or negative 76%. On the other hand, if the man is running a corporation, a shareholder’s loss is limited to the amount he invested so the expected return for a shareholder on the same venture ([25% x .95] + [-100% x .05]), or positive 19%. When an investor’s loss is limited, an otherwise foolhardy investment can suddenly look quite reasonable. The excess losses will fall upon third parties such as customers who do not get the orders they paid for, employees who do not get their salary, suppliers who go unpaid, or people who get injured by the corporation. If the third parties are unable to bear the loss, it may wind up being borne by society as a whole.
This is more or less what happened with AIG this week. The insurance giant entered into contracts to insure the debt of other businesses. The odds may have been good that these contracts would produce a generous return for AIG’s shareholders, however, there was a small chance that AIG would not be able to make good on its contracts in which case the losses would be astronomical. Unfortunately the worst case occurred and the federal government was forced to bail out the company this week.
Fifty years ago, most of the major investment banks on Wall Street like Morgan Stanley, Lehman Brothers, Bear Stearns and Goldman Sachs were organized as partnerships. In those days, their income came primarily from fees and commissions earned through transactions. They would help issuers bring securities to market by placing the securities with investors. However, they were limited in the extent to which they could buy the securities for themselves because they depended on the personal wealth of their partners and the willingness of those partners to take risks. It is said that they were in the transportation business rather than the storage business.
Over time, however, the investment banks started incorporating and going public. By floating stock, they got access to investors whose risk tolerance was different than the partners whose personal assets were on the line. As this happened, they started taking more risk. Trading for themselves became a bigger portion of their business. Like AIG, they wound up with positions that had a good chance of producing generous returns and a small chance of producing catastrophic losses. (Interestingly, the healthiest surviving investment bank is Goldman Sachs, which I believe was the last one to go public. Perhaps it best remembers how to manage risk like a partnership.)
Corporations have been around so long that it is easy to think of them as the essence of free market capitalism, but, in fact, they are legal constructs created by the government in order to separate the enjoyment of profits from the risk of losses. Corporations are incredibly useful tools for allocating capital efficiently and promoting general prosperity. Unfortunately, when the government abdicates responsibility for regulating the entities that it created in the first place, the risks end up being dumped on society as a whole and fewer and fewer people enjoy the rewards.
1 The Barefoot Bum informs me that promises as we know them would not exist in a market that was truly free of government interference because a promise can only be binding by virtue of government enforcement. "In a truly free market, promises cannot actually bind: you are rationally justified in trusting a "promise" only insofar as keeping the promise is in the long-term self-interest of the person making it." I confess that I am not equipped to argue the issue at that level of libertarian purity.