Financial Update (April-June 1997)

Limited Liability Plays Vital Role in Level, Distribution of Economic Output

L iability, or the lack of it, has long played a role in the fields of economics, finance and law. From early times there has been debate concerning when and how to share losses arising from bad economic outcomes, whether due to bad decisions, acts of nature or some combination of the two. Decisions made about the allocation of liability have, by many accounts, been among the major influences in determining both the level and distribution of economic output.

Thomas H. Noe and Stephen D. Smith analyze this issue in a recent article in the Atlanta Fed's Economic Review. Noe is an associate professor and Smith holds the H. Talmage Dobbs Jr. Chair of Finance in the College of Business Administration at Georgia State University. Both authors are visiting scholars in the Atlanta Fed's research department.

Their article reviews a large and growing literature on the role of personal and corporate limited liability in the economy. As early as Adam Smith's 1776 criticism of emerging joint stock corporations, economists have been aware that liability structures influence decisions made by households, businesses and government agencies. The authors examine how and why limited liability has an important influence in functions such as credit rationing, investment and financing decisions on the part of corporations, and the lender of last resort function provided by central banks. In all of these situations, the benefits of limited liability, in terms of ease of transferability of ownership, are contrasted with the negative incentives that encourage those endowed with limited liability to play a game of "heads I win, tails you lose."

Noe and Smith's article may help policymakers better understand the possibly unintended effects of certain policies and programs.

Return to Index