A Response to Peter Kleins Lecture: Corporations and the Free Market

A Response to Peter Kleins Lecture: Corporations and the Free Market
by Alex Merced

Listen to Peter Kleins Lecture here

 You've might have read in previous posts on Liberty is Now that I am one of the Libertarians who criticize corporations role in the free market. Although Let me make a few quick bullet points as far as where I do agree with Kleins lecture:

- I do agree that Limited Liability is not in itself illegitimate, through mutual contractual agreements one can delegate liability without special legal entities. Although, I think of liability as something you own, so through a contract your can transfer title to that liability, but unlike a C Corp it can't be completely separated from ALL owners, at least one owner will have to take title to the liability which is why a Limited Partnership I think is more akin to what is possible in a free market than a C Corporation.

- I agree several mechanisms prevent CEO's and other firm managers from being lazy, and making sure they are competitive, but this is not really from where I attack C Corporations.


The Premise of my Critic:

That due to the separation of management and liability unique to C-Corps that publicly traded companies are inherently unsustainable cause everyone in the checks and balance chain has short time horizons for example:

- The CEO and other Officers don't necessarily have ownership (though a lot of them do), although the overriding incentive is to keep their job, which means to please to shareholders proxy, the Board of Directors.

- The Board of Directors once again may or may not have ownership, but the overriding incentive is to keep their directorship and to do this they need to please the shareholders.

- Due the ease of getting in and out of an investment in a public company, investors tend to have short time horizons and will want short term gains, they don't care about the long term since they'll soon enough sell it and move to the next investment. So if Directors and Officers make decisions for the long term sustainability of the company that adversely affect the short term dividend and growth outlook be sure the shareholders will act to change the board.

Counter Point: Wait, won't a lot of this money be managed by professional money managers who should know better?

- Money Managers for Mutual Funds and Pension Funds also don't necessarily have ownership and are judged by their performance on the short term. So to keep their jobs, their time horizon is kept quite short, which is characterized by the number of pension funds that ran surpluses during bubbles but didn't change the allocation to more prudent variations to lock in those gains in order for the manager to keep their job. Now, most pension funds are under funded for the benefits they need to pay out.



Why is the Limited Partnership Better for Corporate Governance?

The General Partner - The people at the top of the totem pole making the highest decisions regarding the business has unlimited liability, so with that being the case, they have a stake in the long term sustainability in the company.

The Limited Partner - Has legitimate limited liability, yet can't liquidate their shares at a whim, they will need to find a buyer and get the approval of the general partner. Since the shares are less liquid, the limited partner wants the company to have a stable sustainable value so the value persists till he can find a buyer for their shares, meaning the investor now has a stake in the long term of the company.





Other Factors to Consider for Corporate Governance:

- To Moral Hazard of Public Unemployment Insurance on employer and employee incentives, versus the sustainable incentives of privately purchased unemployment insurance

Employee: If the employee has to pay higher premiums for more unsustainable jobs, then he might take a lower wage sustainable job cause he'll bring home more wages after the premiums, which will incentivize talent to go to sustainable firms not high paying unsustainable firms. Also if you work in a field where jobs are scarce, private plans can allow you to purchase more coverage beyond the 6 month standard at no cost to the tax payer. Employees can also lower their premiums by becoming more skilled and educated, since these would lower the risk of job loss.

Employer: If the employee won't work for the employer cause premiums are too high, this is an incentive for employer to develop a sustainable job atmosphere and company to lower those premiums.

- The effect of Corporate Tax Laws  many of the incentives for bizarre corporate expenditures is that they are tax write offs, and it's better that the company spend it on golden curtains and high priced furniture and than let the government take the same money from them in taxes.With simple tax reforms, corporation would have an incentive to be more frugal and let that money trickle to the bottom line for larger dividends to investors.

C Corporations and Moral Hazard

C Corporations and Moral Hazard
By Alex Merced

When confronting todays economics problems one thing we can agree across philosophies, theories, and economic frameworks is that Moral Hazard is rampant in the current system. The question then becomes how do you eliminate the moral hazard to return more realistic expectations in economic calculation.

The mainstream view on the left and right is that this moral hazard is created by "irrational" behavior cause by "too much" capitalism, so regulation must be enacted to reform this behavior and bring transparency to the market. As far as to handle the regulation issue, I've discussed how free market regulation can exist.

Now to Austrian Economics aficionados like myself usually take a different approach and believe that this moral hazard took generations of distorting economic calculation to create. This has been done via institutions like the federal reserve, IRS, and FDIC. Although I take it a step farther and say that the modern legal corporate structure is fundamentally flawed to a free market working, cause it separates or moves liability from two major players in enterprise, the executives running the enterprise and the Shareholders.

So let's see the effects...

Shareholders: Since Shareholders in a C Corporations have no direct legal liability or tax liability by virtue of ownership of these shares it makes disposing of these securities a decision made with very little cost except the opportunity cost of future gains that weren't realized if they continued to hold the shares. This makes the shareholder willing to sell the shares at a moment notice when the price goes up, and makes the value of company in itself in the long term a very slight consideration. Unlike this, Limited Partnership shares still separate legal liability as a Limited Partner but you retain the tax liability and you can't just dump the shares at a moments notice, this incentive creates a culture where investors do their due diligence and are concerned about the long term outlook of the company in case it takes time to find a buyer of the share.

Executives of Company: The executives and the Board of Directors are beholden to the shareholders... yet the make up of the shareholders is constantly changing due to shareholders having such a short time horizon as explained above. If the shareholders are not pleased with the short term returns from their investment, they can pressure the removal and change of these executives. Although if the company is built on unsustainable policies for short term growth, the executive doesn't own the capital in the enterprise so the concern of losing their position is a greater incentive to not change these policies to something sustainable. In a limited partnership the General Partner runs the company and must have a 1% interest in the company itself creating a dual incentive since their own capital is tied up in the venture and they have unlimited liability. While they are still beholden to the limited partner, the limited partners do have an interest in sustainable corporate governance because of the liquidity of their investment.

So essentially the C Corporation has opened a greater array of investors to the capital markets, but at the cost of moral hazard and short term thinking that results from the "Liquidity" of these investments. What I conclude is that if we're going to have a more SUSTAINABLE foundation and capital structure we need more active people running these enterprises, meaning they need more active investors which will never happen with the current C Corporation structure of liability. While some advocate creating artificial liability in the C Corp, why bother when you already have a business structure proven to create more sustainable businesses in the Limited Partnership.

Bottom Line, abolish the C Corporation.

Does Wall Street Contribute to the Economy?

Does Wall Street Contribute to the Economy?
by Alex Merced

 One of the complaints I keep hearing about is that Wall Street doesn't contribute anything to the economy. Well, Wall Street, which is just a moniker for the "Finance" industry has done a great job of facilitating it's function in the economy. The function of the finance industry to facilitate financing (lending and investment), and the only way it does this is not only by creating and selling securities as the detractors would like to believe. Derrivatives, Prorietary Trading, and all the other fun politically unpopular stuff that Wall Street does helps create liquidity and demand. If these securities arn't liquid (which really just means has lots of demand), then it makes it hard to sell new securities for new companies cause the amount of investors becomes less. So yes these trading markets where firms and investors make money for themselves do serve this financing function, but does that mean everything is working as it should... no.

Risk and Reward help dictate how investors align their capital over time, and we have seen that investors, company executives, and everyone has seen their time horizons shrink demanding profits and returns on their investments quicker than ever before. When peoples time horizons shrink, more risk must be taken to achieve their goals in this time horizon, so one must study how culturally time horizons have shrank. Here are many factors I would consider:

1) The advent of C Corporations seperated those with Capital at Risk from those making the business decisions. Even in a Limited Partnership the General Partner who ran the business had to at least have %1 stake in the venture but now in a C Corporation the CEO is beholden to shareholders who are looking for short term gains since their securities can easily be sold at a moments notice. In a limited partnership, Limited Partners with Limited Liability can't just sell their shares on the fly so they have a stake in long term stability of the company and invest based on long term outlook instead of short term price fluctuations. C Corporations truly separated the liabilities of failure and liquidity from investors and executives and allowed them to operate in a short term gain framework.

2) Growing Government with low interest rate policies have put inflationary pressures on the returns needed by investors, plus the taxation that comes later on from these policies. So just to preserve the purchasing power they currently had investors had to make more gains faster, and of course Broker/Dealers are going to facilitate finding a way to do so.

So we need to return to free market values with realistic time horizons, but as long as we seperate liability from capital via legal institutions like the C Coporation (SIPC, FDIC, and the Federal Reserve don't help either), and tolerate growing government in distorting economic calculation to finance it's operations the Finance Industry won't have the capacity to return functioning in a sustainable manner, and no amount of regulation can make up for natural risk and reward.