Thursday, October 2, 2008

Corporations and a free market

I've spent some time recently going over comments made on various blog and news posts regarding the current financial crisis.

Whenever someone complains about grotesquely large CEO salaries, golden parachutes, short-sighted boards or the herd mentality of stock holders, you are almost guaranteed to find a few posts later a reply along the lines of: "Suck it up. That's how the free market works. Capitalism at its finest."

This confuses me.

Few things are less representative of a free market than the modern corporation. It exists only because of very specific laws enforced by governments. Partly by design, partly by historical accident, this framework distorts the notion of 'ownership' into something scarcely resembling the original idea.

A truly free market would see all companies and their owners have unlimited liability (unless they bought insurance). 'Unlimited liability' means that if something goes wrong with the company - say, it goes bankrupt - then its creditors are free to take the money they are owed from the owners of the company.

A basic protection that requires only a touch of regulation is limited liability. In this case, the creditors are only able to take from the owners an amount of money equal to the owners' investment in the company. If you had $100 in a Betamax firm and $1000 in a VHS firm, as well as $10,000 in the bank, if the Betamax firm went bankrupt its creditors would only be able to ask for $100 from you.

This already distorts the notion of ownership from that found in a free market. Because investors are partially protected from risk by the legal framework, there is an incentive, everything else being equal, to spread one's wealth among as many different companies as possible.

('Different' is the key word here. If the companies are all equally profitable but in completely different fields, then the more companies you spread your money about, the less likely you are to lose it completely. Suppose each company has a 50% chance of failure. Put your money in one, and there's a 50% chance you'll lose it all. Put your money in two, and there's a 25% chance you'll lose it all.)

In other words, limited liability already provides an incentive for an investor to split her attention among many different companies. I have a nagging suspicion that this may lead to weakened leadership and less capable entrepreneurs.

A corporation goes even further. Not only is liability limited, but the company itself is considered a legal entity, and if 'the corporation' goes bankrupt, then creditors may only try to get their money back from 'the corporation' - not from anyone who may hapeen to own shares of stock in the company.

These shares of stock are meant to be shares of ownership. This is why they (should) pay dividends, a share of the profits. By and large, they stopped being treated like shares of ownership long ago, and are now closer kin to horse race gambling chits.

'Ownership' has become so distributed in most corporations as to be meaningless. This is recognized in that they are run by a board of directors, ostensibly acting on behalf of shareholders. Unfortunately, most shareholders want nothing more than to play hot potato with their stock, selling it the moment they feel the price is high enough. This leads to an often lamentable focus on the short run, with predictably disastrous long-run consequences.

None of this would be possible without the laws that allow limited liability and incorporation. Modern corporations are antithetic to a free market, not symptomatic of it.

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