American Business Goes Galt 1

Risk and reward have to balance or businesses won't hire.

Our media have noticed that our economy is recovering somewhat from the real estate bubble which the government helped trigger by urging banks to loan money to people who couldn't pay it back.  They note that corporate profits have increased greatly and they wonder why profits aren't being invested in creating more jobs.

The liberal explanation is that businessmen are too greedy to "share the wealth" by hiring more employees.  They don't understand that the only reason greedy businessmen go to the trouble of hiring anyone in the first place is that they expect that each and every employee will produce more value for the business than he or she costs.  Truly greedy businesspersons hire, and hire, and hire some more until their employees are doing all the work which the business can hope to sell at a profit.

Businesses have accumulated enough money to hire and there are people who'd like to work - but nobody's hiring.  It almost seems like Ayn Rand's famous phrase of "going Galt" - a situation where talented businessmen voluntarily decline to build businesses, "going on strike" against government greed and intrusive regulations, with the result that normal people lose their jobs and the economy collapses.

How have we reached this point, where there's plenty of money around but nobody wants to invest any of it?

Too Much Risk Kills Rewards

To understand, you have to go back a bit into business history.  There are essentially two ways to organize a business - partnerships and Limited-Liability Corporations, known as LLCs.  A partnership with only one person is called a sole proprietorship.

Partners split the profits based on some mutually agreed formula.  The down-side is that partners are individually liable for any and all debts.

Starting in 1688, Lloyd's of London was organized as a partnership.  Lloyd's "names," who shared in the profits, were liable for losses "to their last collar stud."  When the Titanic went down, the "names" personally coughed up the 1 million pounds for which the "unsinkable" ship had been insured.

As Jamie Dimon could tell you, our modern economy has created rather staggering risks which are difficult to calculate.  In 1994, Lloyd's switched from "unlimited liability" to a limited liability corporate model where losses were limited to whatever the investor put in.

Major investment banks and similar firms also followed the partnership model until quite recently. Goldman Sachs was a partnership from the day of its founding in 1869 until 1999!  Partners shared the profits in good times but were personally liable for losses.

As with Lloyd's, changing to the limited-liability model changed their incentives completely.  As partners, they'd wanted the company to do well, but worried about risks because they could personally be left holding the bag if anything went wrong.  After the IPO, they were now stockholders, protected from liability like any other stockholder.  They might lose value in their shares, but they couldn't be forced to give back whatever cash they'd already pocketed.

It made sense to take much bigger risks.  If the risk worked out they'd get a whopping cash bonus, but if not, well, someone else would pay the price as with the recent JPMC losses.

The Up-Side of Limited Liability

We can easily see the down-side of limited liability - company managers pocket huge bonuses in good times but don't lose when their bets go bad.  This imbalance annoys protesters like the Occupy movement who want to end all forms of capitalism.

There is, however, an up-side to limited liability - it makes a lot more people willing to invest.  Would you invest in GM or Ford if putting your money in made you a partner with unlimited liability?  Of course not - you'd have no influence on management and wouldn't want to take the risk of being wiped out if they messed up.  With limited liability, the value of your investment can go to zero, but you won't lose more than you risked in the first place.

A stock market was needed so that people could buy and sell shares of businesses.  These two inventions - limited liability corporations so that investors could lose no more than they put in and stock markets so that many investors could buy and sell stocks in businesses were the driving engines of the economic growth we've had since the 1700's.  Limited liability and stock markets also made it possible for the American middle class to become investors.

Regulating the Goose

Governments have regulated business conduct, reporting, and liabilities since the dawn of time.  At the time of the Roosevelt Depression, for example, American law stated that an investor in a bank was liable for up to 10 times as much money as he'd put in.  This was supposed to make banks less risky.  It also meant that a bank which was having a bad patch and might have been able to find new investors couldn't - nobody would take on liabilities 10 times the value of their investment.

Unlimited liability nearly took Lloyd's down - they couldn't find enough "names" who were willing to risk everything they had by associating with Lloyd's.  By changing to a limited liability corporation, they raised a lot more money and became a bigger player in the insurance market.

Unfortunately, as with Goldman Sachs, limiting liability made Lloyd's willing to take bigger risks.  The British government noticed this.  Although Lloyd's had regulated itself for 300 years, the government announced in 1998 that starting November 30, 2001, Lloyd's would be subject to the Financial Services Authority.

Public limited-liability companies need to be regulated to protect investors.  They need to be large to be able to operate internationally as companies like GM, GE, and major airlines do.  Industries like oil and integrated circuits need huge scale to operate at all.  To grow big enough to operate, such businesses need to be able to raise capital from as many investors as possible.

Such businesses grow so large that even boards of directors have trouble keeping managers under control.  That's why governments specify auditing and reporting requirements.  Investors won't buy stock in big companies unless they think they'll be treated fairly.  They want to know how the business is doing.  They want to know the risks so they can decide which company offers them the best chance of profiting on their investment.

Reporting and accounting requirements should minimize fraud and make it possible for investors to make informed decisions.  Making it possible for successful businesses to raise money to expand contributes to economic growth.

Never Let A Crisis Go To Waste

Regulation is a constant battle between the regulatory agencies who seek more power, politicians who seek opportunities to extract campaign contributions in return for getting regulators to back off, accountants and lawyers who want businesses to be required to pay them high fees to shuffle more paper, and businesses who don't want the government looking over their shoulders and professional leeches of various sorts sucking away all the money.

The Enron scandal offered an opportunity for the pro-regulation forces to pass more laws.  One change was called "mark to market."  Instead of carrying assets such as land or buildings on their books at what they'd paid for them, businesses had to estimate what the buildings would be worth if they were sold today and list them accordingly.  This provided work for armies of cost estimators.

"Mark to market" nearly sank banks who owned mortgages which were being paid but which they couldn't sell because nobody was buying mortgages.  Mark to market required that assets be valued at what a seller would pay without taking the income stream into account.

When there was no market for mortgages at all, banks had to value their mortgages at zero even if payments were coming in every month.  Transparency requirements meant that they had to report these fictitious losses.  This reasonable-sounding change to financial regulations not only imposed the cost of re-estimating value every quarter, it also made banks look like they were in much worse shape than they were.  This made the banking crash much more painful than it need have been.

This far, we've discussed the foundational capitalistic ideas that power our economy - limited liability of corporations, and stock exchanges where anyone can invest without taking on unlimited risk.  The next article shows how these mechanisms are breaking down to the point that jobs aren't being created rapidly any more.

Will Offensicht is a staff writer for and an internationally published author by a different name.  Read other articles by Will Offensicht or other articles on Business.
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