Limited Liability Companies and Economic Crisis

Limited Liability Companies and Economic Crisis

Introduction

The structure of contracts in financial markets is deeply rooted in history. This column retraces the origins of financial contracting and explains why mutual fund banking proposals are wrong headed. It proposes to shift more of the functions of our current banking system away from limited liability back into partnerships. This would involve requiring hedge funds to be entirely separated from banks.

Economists often have a hard time understanding the reason why both wages and many financial contracts - such as bank loans and bank deposits - are fixed for certain periods of time in nominal terms. Would it not be better, it is often suggested, if all such financial assets could adjust in response to changes in the (market) values of the underlying assets, and if nominal wages could adjust flexibly in relation to underlying changes in demand and profitability. Surely this would eliminate the possibility of financial crises and serious unemployment. Indeed, this would be a better way of operating if we had complete and efficient (financial) markets, and everybody behaved with absolute honesty, so that everyone could have complete trust and confidence in everyone else.

Asymmetric information

Unfortunately these happy conditions do not pertain. Instead the borrower and the employer have far better information on the state of their business than the lender or worker. Under these circumstances, if the lender or the worker relied on the self-certified account of their business by the borrower/employer, what the lender/worker would invariably be told was that business was bad, and that the lender/worker would have to suffer a reduction in their payment as a result (Avery 1998). In order to keep the borrower/employer honest, the most obvious and sensible procedure is to negotiate a nominal fixed price contract which can be revised after a period, which involves a penalty on the borrower/employer if the contract is not honoured. The penalty for the borrower is bankruptcy, and the penalty for the employer is that, if he cannot pay the nominal wage, he has to fire workers, and therefore not produce as much as before.

The same analysis applies whether we are talking of banks lending to borrowers, or of depositors lending money to banks (Banerjee 1992). In a world in which human behaviour has left the Garden of Eden, a fixed nominal rate contract is usually superior to some kind of sharing process. Moreover, as has been clearly shown via behavioural economics, investors dislike losses much more than they value gains; so, even for those investments where the valuation varies according to market prices, there is frequently a stop-loss agreement of some kind. An example is the implied commitment that money-market mutual funds in the US would never 'break the buck'. And when Reserve Primary Fund did so, there was a massive and rapid run from such funds. Indeed, in many cases outside finance is only available in significant quantities if there is some available stop-loss fixed nominal value ...