Common Threads of Depression

In 1890, the Silver Purchase Act threatened to cause inflation – to the benefit of farmers and miners, at the expense of business interests and banks. As the Great Depression of the 1930s raged, real wages of labourers continued to climb.

The most recent financial crisis was characterised by defaulting sub-prime borrowers, who were lent more money than they could afford. It is no coincidence that in each case, depression was invited or prolonged by politics championing a reallocation of society’s resources.

The World Without Limited Liability

It was suggested recently here that limited liability had proven inappropriate for the banking system. Gambles which are rational from the perspective of individual banks can threaten the economic system, when business confidence is affected by the aggregated effect of all these risks.

Banks are all interdependent. There were other problems that contributed, but no doubt the contribution of stockholders and traders who were indifferent between leaving a company destitute, or insolvent and indebted for millions. Is it possible though to imagine a world without limited liability?

How to Reform Risk Management

In recent times, traders have been accused of taking excessive risks. Unfortunately, the structure of remuneration in financial markets tends to exacerbate animal spirits by creating incentives for risk-taking.

Traders benefit dramatically in prestige and bonuses when successful. Meanwhile, they don’t suffer when they do badly as society foots the bill. This agency problem in finance is described as the ‘Trader Option’.

Regulating Government Intervention Away

Government intervention in the banking sector was motivated by an unwillingness to let banks fail due to ‘systemic importance’. Meanwhile, there was no efficient market for risk because banks expected to be bailed out in their hour of need, even though diversity in this area is extraordinarily beneficial. The solution is smart regulation to eliminate the need for massive government intervention.