April 10, 2020
Carolyn Sissoko, University of the West of England
Coronavirus and the immense economic costs associated with repressing its growth has provoked a debate over how to distribute those costs. Many law professors have argued that large, heavily-indebted corporations, such as airlines and private equity owned companies, that cannot afford the losses imposed by the coronavirus crisis need to be put through a government supported, expedited, and managed bankruptcy process along the lines of how the GM failure was managed in 2009 (e.g. Morrison and Saavedra 2020; Morgan Ricks; Ayotte and Skeel 2020). Underlying this approach is an emphasis on the importance of shareholders being wiped out – or at a minimum ending up sharing ownership with those who assist in the restructuring of the company. Several macroeconomists by contrast take a very different approach. They argue that the extent of the economic disruption caused by the coronavirus crisis is so great that it’s costs should be treated as a problem for the government, not for business. (E.g. Smith 2020; Bullard interview 2020. See also Farmer 2020.) Objections to the shareholder bailout approach are often immediately classified as concerns about “moral hazard” and then dismissed on the basis that it is unreasonable to expect businesses to prepare for an event such as the current crisis.
What underlies the gulf between these legal scholars and macroeconomists? Lawyers have a nuanced understanding of corporate structure and its economic consequences (see e.g. Pistor 2019), whereas macroeconomic models typically simplify this structure to the point of ignoring it entirely. As a result, the lawyers consider shareholder losses even, or perhaps especially, in the event of unexpected and unforeseeable risk to be fundamental to how capitalism is supposed to operate. Implicitly, the lawyers understand that private sector risk-bearing plays an essential role in supporting state capacity and that turning this structure on its head is extraordinarily dangerous to our economic order. The macroeconomists by contrast are not in the habit of modeling the macroeconomic role played by corporate shareholders as risk-bearers in the economy and often have difficulty understanding this relationship. References to “moral hazard” are evidence of a purely microeconomic approach that fails to comprehend a macroeconomic risk-bearing role for the corporation.
What is a corporation? A corporation is a legal form that separates ownership of assets from control over the assets and from liability for the obligations associated with the assets. The corporate form both protects corporate assets from the shareholders (and the creditors of the shareholders) and shifts the risks of the corporation from the shareholders to the corporation’s employees, creditors, and the state. Corporations developed with these significant protections for shareholders in order to increase the willingness of the wealthy to invest not in land but in risky enterprise controlled by others – and the growth of corporations is associated with economic growth. The trade-off for the shareholder is that even though the investment is risky, the potential loss to the shareholder is limited to the amount of the shareholder’s investment. To the degree that the corporation incurs debts or causes tortious harm on behalf of the shareholder, the shareholder is shielded from liability for the actions the corporation took on the shareholder’s behalf. This liability shield means that much of the risk of corporate activity is borne by the corporation’s employees, suppliers, the public at large (in the event of torts), and the state.
Thus, the corporate form itself is means of providing public insurance to corporate shareholders against the loss of their wealth. The justification for providing this insurance is to induce wealthy shareholders to bear risk for the economy as a whole: the shareholders bear the first loss in exchange for being assured that that loss is limited, and reaping significant rewards if the corporation has profits instead of losses. Indeed, the only economic function of the shareholders in a publicly-listed company is to bear risk: the shareholders do not control the company and have minimal say in its management.
Private-equity-owned companies are, as the name implies, privately held. As a result, the private equity fund does control the company. In practice, however, the owners of the private equity fund do not control the companies they own, instead they are limited liability partners who, just as in the case of standard corporate structure, cede control to a group of managers. Just as in the case of corporate shareholders, the only economic function that the limited partners in a private equity fund perform is to bear risk for the economy. Indeed, it’s not entirely clear what the macroeconomic function of this two-tiered limited liability structure would be – though it has obvious private advantages to the managing partners of the private equity fund who get to combine control with the public insurance of limited liability for the actions of the firms they control.
Because the function of the shareholders in a public company and of the limited partners in a private equity fund is to bear risk, the idea that government support would protect the shareholders and limited partners from losses doesn’t make a lot of sense. The shareholders in a public company and in a private-equity-owned company can be replaced by a Chapter 11 bankruptcy process that converts debt into equity while allowing the corporation to continue operating. Indeed, this is the basic nature of our economic structure. The reason to avoid shareholder bailouts has nothing to do with “moral hazard.” Afterall, the shareholders and limited partners don’t even control the corporation. The reason to avoid shareholder bailouts is because the shareholders are there to bear risk for the economy.
A full understanding of this point requires an understanding of how private sector risk-bearing plays an important role in supporting state capacity. That is, the reason certain governments have a remarkable capacity both to borrow and to serve their citizens is because these governments are not alone in bearing risk, but have mechanisms that take advantage of private risk-bearing capacity. The financial revolution and the subsequent development of the public stock market provides the best illustration of this point.
The financial revolution represented a turning point in European history, because it took place in Britain and was the foundation of Britain’s capacity to win wars and build an empire (Dickson 1967; Roseveare 1991; Baugh 2011; Scott 2011). At the heart of financial revolution sat reliance on private sector risk-bearing both in the form of the Bank of England, which was chartered as a corporation, and in the form of private sector finance of British long-term debt. The market in public sector debt was the foundation upon which the market in corporate securities developed in the early 18th century.
From 1660 to 1763 Britain experienced a financial revolution that had several components: (i) the transformation of the state including (a) an annual budget approved by Parliament, (b) capacity to impose taxes and have them accepted by the populace, and (c) the growth of a professional and highly specialized administrative state; (ii) the transformation of government debt into annual issues of marketable, redeemable, long-term debt bearing an interest rate of 3 to 5%; and (iii) the transformation of private lending through both the Bank of England, which stabilized the value of sterling, and an active market for government debt, which supported borrowing from both domestic and foreign lenders.
The financial revolution has been widely recognized since the Seven Years War as the foundation of Britain’s pre-eminence during the years in which the Empire was consolidated. A comparison with 18th century France can illustrate how the financial revolution affected borrowing capacity: in the Seven Years War much of the French war effort was financed by short-term debts to suppliers at relatively high interest rates (Scott 2011: 433). Not only was this a less effective means of raising funds for the war, it left France with a crushing burden that destabilized the French financial system (ibid.). For this reason, the French sought (unsuccessfully) to emulate the British financial system which was described as “one of the wonders of the world”. (Ibid. See also Baugh 2011: 15).
It is worth emphasizing some of the aspects of the British system of public debt that made it so effective. The interest payments on the debt were fully funded by taxes. The debt was technically perpetual, which protected the state from the risk of being forced into default, but the debt was in practice supported by a variety of mechanisms for redemption. The relatively high interest (4 or 5%) debt that was issued at the height of a war was typically redeemed in a peacetime conversion to lower-rate debt. The long-term debt was also supported by a “Sinking Fund” that dedicated specific tax revenues to the purpose of paying off the debt. While there was an active market in government debt, the state did not raise funds on the market (despite efforts to do so in the mid-18th century). Instead, the state placed its debt privately with wealthy financiers who had the capacity to hold the debt over time and could use the public market to slowly rebalance their holdings of public debt (Dickson 1967: 226-28). Finally, in exigent circumstances the British government also had access to short-term debt, the issue of which was supported by the Bank of England. On the other hand, this short-term “unfunded” debt typically comprised 5% or less of the total debt burden, and even at the height of the Napoleonic Wars rose only to about 8% of the debt burden (see Thomas and Dimsdale 2017: Table A29).
A cornerstone of the Financial Revolution was the Stock Exchange where the long-term government debt traded – allowing the private investors a way of exiting their investment and providing market liquidity to the government debt. After the Napoleonic Wars the issues that traded on the Stock Exchange expanded to include a large number of private issues, and by the middle of the century there was a robust market in corporate securities.
This review of 300-year-old history is just a reminder that private sector risk bearing sits at the very heart of state capacity. Government capacity is not some kind of stand-alone phenomenon that can work independent of private sector risk bearing. It is instead a consequence of a robust institutional structure that makes it possible for burdens to be widely shared, not just by taxes but also through private sector losses on risky investments.
In short, the reason not to bailout corporate share-holders is not “moral hazard,” but because such a bailout represents a shift in the nature of burden sharing in a capitalist economy. It is the norm in macroeconomic models to treat corporations as pass-through vehicles (precisely what a corporation is not from a legal perspective), to abstract from bankruptcy (Goodhart and Tsomocos 2011), and to assume that the corporation’s income flows directly back to the shareholders – or even as in the case of Guerreri et al. (2020) back to the workers. The deficit of careful analysis by macroeconomists of the corporate form and of the role that it can play in macroeconomic risk-bearing naturally raises doubts about the degree to which macroeconomists can provide useful advice about the structure of corporate bailouts. The legal profession has the advantage of having thought long and hard about these issues. This debate matters today, because the Federal Reserve has – appropriately under the circumstances – stepped in to provide extraordinary support to US corporations. These actions have taken place so quickly, however, that the end game of these new policies has not yet been specified. Almost all of the support to the larger corporations is in the form of debt, and the Federal Reserve will, when the public health crisis is over, almost certainly have on its hands some corporations that are viable only as long as they have continued access to Federal Reserve lending and will be bankrupt without it. The lawyers will argue that government supported and managed bankruptcies should take place with significant losses to shareholders – even though such a policy will undoubtedly cause significant distress in the stock market. What will the macroeconomists say? Hopefully they will update their models and join the lawyers in demanding that the private sector, not just the government, bear the losses of coronavirus.