The financial crisis

(I’d best point out that I’m not an economist, so the contents of this post may well be utter shite. If there are any economists reading, I’d be especially interested in your comments.)

A large part of the reason for the present financial crisis is an imbalance between risk and reward. If you’re a highly-paid employee of a bank and you make a risky decision that pays off, you get a big bonus. If the decision doesn’t pay off, you don’t have to pay your employer anything — the worst that might happen is they stop paying you. So that’s like playing poker where you can win a big pot but if you lose the hand you don’t have to pay anyting at all. In those circumstances, the optimum strategy is to take as many risks as possible. If those risks lead to the banking system collapsing and needing a $700,000,000,000 payout from the taxpayer, then that’s not an optimum solution for societry and such incentive schemes should probably be banned.

As well as at the level of individual banking employees, the same is true of the banking system itself, because of the nature of limited liablity companies. I’ll explain this by way of an example.

Scenario 1: Alice buys a house and pays for it by borrowing £100,000 from a bank that Bob owns. Alice later finds she can’t afford the repayments, so Bob’s bank (which is just a legal vehicle for Bob to own stuff) repossesses her house.

Scenario 2: Alice has £100,000. Instead of stuffing it under her mattress, she puts it in a savings account in Bob’s bank. Unfortunately, Bob’s bank takes Alice’s money and unwisely lends it to some people who can’t pay it back. Bob’s bank is bankrupt. However, Bob happens to own a house worth the same amount of money, £100,000. Can Alice repossess Bob’s house, to repay the debt? No, because Bob’s bank is a limited company, which acts as a firewall through which debt cannot pass.

So if Alice can’t pay her debt to Bob, her assets can be seized; but if Bob can’t pay his debt to Alice, the same isn’t true, which is not only unfair but forms an asymetry of risk. Because of this, it can make sense for a bank’s owners to instruct the bank to behave more riskily than it would do otherwise, because although they personally benefit from risks that succeed, they don’t personally lose from risks that fail.

So limited liability can cause financial institutions to behave more riskily than they would do otherwise. Now I’m not against people taking risks, but I do think that if they do they should be responsible for the downside as well as the upside (because otherwise they will tend to behave too recklessly). So I think all banks should be forced to choose between one of two options:

1. continue being a limited liability company, and be forced into restrictions on high-risk activities that it undertakes (e.g. highly geared investments)

2. become an unlimited liability company, and continue to be able to undertake the full range of activities it currently can.

Of course, for unlimited liability to work, it would have to be illegal for an unlimited liability company to be owned in full or part by a limited liability one.

Two consequences follow from this. Firstly, if a bank is restricted in what it can do, it may be able to create less money through fractional reserve banking. This might cause a recession because people don’t have enough money to buy things. To counter this, the government could create more money, e.g. by printing it and reducing taxes while keeping spending constant. If the government did this to the same extent that banks’ reduced lending reduced the money supply, this would neither be deflationary nor inflationary.

The second consequence is that some people may have owned shares in limited companies that now become unlimited companies and therefore the shares represent a potential obligation as well as an asset. This wasn’t something people bargained for when they bought the shares, so it would be unfair to obligate them in that way. So I suggest the government offer to buy any shares in a newly-unlimited company for £0.

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