It's a pretty simple formula: regulate an industry and you instantly politicize it. Which is another way of saying that you monetize the industry for politicians...
All the other talk -— about “systemic risk” or pension funds or low-liquidity real estate millionaires -— is just the sound of a policy in search of a rationale. And that policy, of course, is the enrichment of politicians. That's always the policy.
Of course loyal readers (hi mom!) will know that I think "systemic risk" is very real, and that it will hit us all like a rocket-propelled two-by-four, soon. But I quite agree with the cynicism about policy and politicians. So what is to be done?
Here's a simple suggestion. Investment funds should not be permitted to be limited liability entities. As legal entities, they should be restricted to organization as ordinary partnerships.
This isn't really regulation at all — It simply amounts to the state declining to confer the privilege of limited liability to certain kinds of organizations. Limited liability is rife with moral hazard problems, but most people (including emphatically myself) would argue that its advantages far outweigh its disadvantages for nonfinancial businesses.
But limited liability, like copyright, is a legal oddity conferred for a specific purpose: to encourage entrepreneurs to start and invest in risky but productive ventures. The businesses that investment funds put their money in should certainly be limited liability ventures. But the risks taken by the investment funds themselves are speculative financial risks. When a fund invests without leverage in a corporation, the fund's own limited liability status is worthless. With or without limited liability, the fund can lose all of, but no more than, the value of its investment. But if a fund borrows from a bank to invest ten times its own money in that same corporation, the fund's limited liability status is a big deal. It lets the funds investors reap investment gains from much more money than they own, while risking no more than the same meagre amount as in the unleveraged case.
There's no reason the state should grant investment funds a special dispensation to encourage this kind of risk. Fund investors should be allowed to take speculative financial risks, sure. But fund investors should be responsible for all the money they lose if things go sour. They shouldn't be able to let the bankruptcy of some shell corporation or LLP shield them from the consequences of speculative financial foolhardiness.
It's one thing to socialize the risk faced by an entrepreneur starting a productive business. It's quite another thing to socialize the risk of taking on leverage to achieve speculative financial gains. Limited liability is a privilege, not a right, and an oddity from a libertarian perspective. It should not be extended to leveraged investment funds.
|Steve Randy Waldman — Tuesday October 31, 2006 at 9:51pm||permalink|