Sorry, it's a totally crazy proposal. What he is proposing is moving liability beyond a certain point to the stockholders. Try this scenario on. Your 401K is invested in a mutual fund which holds some portion of AIG, maybe your equivalent is 10 shares. AIG holds some significant percentage of the $60 trillion in derivatives out there. Are you prepared to pledge your assets to cover your share, say $100,000? Thought not. (Lloyds of London works that way. That's why they dont let us join.)
It's exactly the fear of this scenario which forces the system to police itself. Removing this incentive reduces the incentives individuals have to police their earnings. If they were subject to serious losses, there'd be more market incentive for an independent entity to step forward to guarantee shareholders against these kinds of losses. Those entities, in turn, with their money on the line, would police the guaranteed institutions themselves. Call it malfeasance insurance.
This is a much more natural system of incentives than the current ratings boards, who are paid by the entity being rated and hold only a limited, indirect personal stake in their failure or success to rate correctly.
But why would anyone invest in stocks under the scenario he describes? The idea that if I invest $1 in the wrong company may mean that I lose my home and everything else I own simply means that I won't be investing in the market. Period.
Imagine the case of someone with all their money in index funds, I would now be liable for EVERY SINGLE PUBLIC COMPANY. People would flee the stock market so fast it WOULD go to near 0.
No, the key is to threshold it so it only applies in the extreme cases.
For example, let's say, bankruptcy only lets you discharge 100% of the first $1 trillion. After that, some combination of owners/officers/executives are responsible for (say) 0.1% of obligation beyond $1 trillion.
With these thresholds, it hardly applies to "every single public company".
This makes absolutely no sense. Have any of these companies racked up losses beyond $1 trillion? And even if they have, who is going to pay for the other 99.9% of their losses? This makes no difference to anything, except that you're now making some investments too risky for anyone to touch. The key, however, is not that the super-risky investments are the ones where companies look risky. They're just ANY company in certain industries.
So you wouldn't invest unprotected. Insurance was invented to solve this specific problem: socializing the costs of unlikely but disastrous occurrences.
The vast majority of companies will be fine the vast majority of the time, so there's plenty of opportunity for an organization to sell inexpensive insurance which covers for those rare cases where the pot boils over.
What you're suggesting sounds suspiciously like AIG and the whole "credit default swaps" mess. What about when the insurance company goes under and needs a bailout?
It probably doesn't make sense to allocate ALL of AIG's losses to shareholders, just enough to create some disincentive.
Also, with this mechanism, the market would figure out over-leveraged companies with liability exposure and beat down the share prices.
Finally, maybe the answer is to allocate losses not to shareholders, but to officers, directors, and highly compensated employees, bounded by the company compensation to each person.
In other words, if you create a "too big to fail" company that fails, you might start to be personally liable for what the company's paid you in the past, and has promised to pay you in the future. The idea, again, is not to get back all of the loss, but to dis-incent extreme, leveraged risk taking by management.
These people didn't create a too big to fail company, they were hired by a too big to fail company. When I'm taking a job as an engineer I should have to inspect all the books to make sure they're clean or else I could lose all my personal savings? Forget it.
Don't allocate it to the shareholders at all. Allocate it to the executives. Arnold Kling got there first with a proposal that institutions that are obviously "too big to fail" and as such have a government guarantee should be bound by a spirit-of-the-law (S)contract, rather than the letter.
"I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.
I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law."
Its certainly not a complete solution and a reactionary one at that. But some free thought on "corporate personhood" is certainly in order. I'm in favor of letting the debate get out of hand for a bit to stretch our minds.
I don't think it's that crazy, just totally different from what we expect. It would make sure that those who make the risks actually PAY for the risk should it sour. The type of leverage that you talk about is irresponsible when it is associated with bad assets, like sub primes.
Don't assume that they could go after all you're worth, either. No one would associate with an investment, that, if gone awry, would ruin them financially. The point is that liability would be determined on the market between individuals, and there wouldn't be a one size fits all LLC.
No one would associate with an investment, that, if gone awry, would ruin them financially.
One thing we've learned in this crisis is that leverage causes companies that appear healthy to go under very very quickly. So you're saying that people would steer clear of investments that might ruin them financially? Fine. You've just killed off our entire financial industry, our real estate industry, and a good portion of other industries that rely on leverage to do business.
In case you didn't notice, these industries have serious flaws (caused by many things we won't get into here), that leverage magnifies.
Besides, there's still no legal basis for llcs, just convention.
That's what leverage does: it magnifies. That doesn't mean that these industries are inherently bad. We need a strong banking system and a strong real estate industry.
And what do you mean about no legal basis for LLCs? I'm pretty sure every state has a legal basis for LLCs.
The idea sounds good if you have a chip on your shoulder about rich people, which the author clearly does, but the proposed system is insane. Good economies encourage people to work and invest. This is a MASSIVE disincentive to do both. It is no coincidence that many of the world's poorest economies are found in regions where the government thinks like this.
You didn't finish the sentence: "It's a massive incentive to do both..." in the form of a single company over the liability limit.
The obvious hack is to slice the company into (company size)/(liability limit) pieces, but while typing up my complaints about how easy that is, it occurred to me that we have anti-trust, anti-racketeering, and anti-price-fixing laws in place that are basically solving the same problem, so maybe it could work after all with a sufficiently clever law.
Upvote for accuracy. This is the best solution to many problems. Liability should only be limited between two parties through a contract. It's ridiculous how by paying the government a higher percentage of your profits you better protect your own assets if your company hurts a third party (ie pollution).
This would easily be the easiest way to solve many problems, as the author points out, but it is also the only time I've had to grant credence to the argument it leading to a race to the bottom. Usually you only hear left-wingers say that when they complain about free markets or sweatshop labor abroad, but this is a reform that might actually drive out business abroad. I don't even think America has the economic clout to make this an effective measure when the status quo is so widespread.
It's a great idea, but at a time of psuedo-protectionism taking hold in and each territory at local and state level trying to carve out their own economic niche industry, it's as politically nonviable as it will ever be.
One more thing: Don't assume that they could go after all you're worth, either. No one would associate with an investment, that, if gone awry, would ruin them financially. The point is that liability would be determined on the market between individuals, and there wouldn't be a one size fits all LLC. There would probably be enough to discourage irresponsible behavior, but not so much to make investors fearful.
