The Buck Stops Where? The Role of Limited Liability in Economics

In modern societies personal limited liability is the norm, given such conditions as finite wealth and the elimination of debtors’ prisons. In fact, over the last few centuries, many societies have taken this principle further by passing laws that allow investors in banks and other business enterprises to limit their losses to either their initial investment (pure corporate limited liability) or some multiple of their initial capital contribution. This latter liability structure might call for an additional infusion of funds on the part of investors up to some maximum (say, two times the investment) should an enterprise fail to meet its obligations from available resources. Bank shareholders, for example, were once routinely required to post at least some additional funds in the event of a bank failure. This practice ceased only after the substitution of public capital, in the form of government deposit insurance, for the private capital formerly used to support the system. Overall, changes in liability provisions, by many accounts, have been among the major influences on both the level and distribution of contemporary economic output as well as the allocation of financial resources in today’s financial markets. This article reviews a large and growing literature on the role of personal and corporate limited liability in the Over the last few centuries laws have increasingly protected individuals and corporations from liability resulting from bad economic outcomes. This evolution in liability provisions, by many accounts, has significantly influenced both the level and distribution of contemporary economic output as well as the allocation of financial resources in today's financial markets. Through a review of an extensive and growing literature, the authors of this article consider how limited liability affects investment, labor, and financing decisions made by individuals and corporations as well as government policies intended to promote economic growth or redistribute wealth. The authors first examine conflicts that may arise in labor markets because of certain rights held by providers of human capital or because some assumptions about personal limited liability may not be compatible with sustained production. The discussion then considers how liability rules influence the incentives of debtors, creditors, and managers. Finally, the authors look at the role of limited liability in the relationship between government and private institutions as it relates to economic growth and the provision of liquidity to the banking system. By providing an explanation of incentive structures under alternative liability regimes, this article should help policymakers better understand the possibly unintended effects of certain policies and programs.