Division of Research Working Paper Abstract

98-079

LIMITED LIABILITY AND THE BIRTH OF AMERICAN INDUSTRY: THEORY MEETS HISTORY

David A. Moss

Limited liability law is an intriguing institution which has elicited extreme reactions from both proponents and detractors over a long period of time. Throughout much of the twentieth century, a consensus existed within the academic community that limited liability was a vital and extremely valuable legal institution. Over the past two decades, however, that view has come under sharp attack within the law and economics literature, with some scholars even proposing the abandonment of the limited liability rule in certain cases.

The purpose of this paper is to evaluate existing theories of limited liability, and to offer a few new ones, against the backdrop of the historical record in the United States. Many state governments began extending limited liability to manufacturing corporations on a regular basis beginning in the first half of the nineteenth century. Although the historical record of these developments remains rather sketchy, it still offers some important clues about the original economic logic and significance of limited liability law. Three basic conclusions emerge from this paper. First, in a world of incomplete markets and positive transaction costs, limited liability law helps to create a default asset with an attractive payout-loss structure. Savvy investors could create comparable payout-loss structures by combining other assets even under an unlimited liability regime; but the existence of limited liability law eliminates the associated transaction costs. This was of particular significance in the early nineteenth century, when transaction costs were generally higher than they are now and when many of the more sophisticated financial instruments that are familiar today had yet to be created. Second, the externalization of risk onto involuntary creditors - which inevitably results from limited liability law and which has been so lamented in recent years - was in fact broadly consistent with the early-nineteenth-century emphasis on capital mobilization. This externality provided a modest subsidy to investors by shifting almost infinitesimal amounts of risk onto just about everyone in society. Third, it is possible that the adoption of limited liability law not only redirected capital (ideally to more efficient uses) but actually increased the amount of capital available by spurring aggregate savings via the lottery principle, which is identified and defined toward the end of the paper.

Finally, the conclusion considers the extent to which the history of this institution is still relevant to debates over the role of limited liability law today.

BGIE
74 pages