Limited liability, the ability to walk away from certain debts, is seen as one of the hallmarks of modern economics. In 2016, the Economist argued it is one of man’s greatest inventions that encourages investment by limiting people’s downside risk. Nevertheless, it has shortcomings. In the extreme, if people never have to own up to their debts, no-one would ever be willing to lend to them. In other words, there appears to be a trade-off.
In this research program I theoretically and empirically investigate this trade-off in the context of entrepreneurs, (non-financial) companies and banks. The central research question I ask is: What is the optimal level of limited liability that spurs economic activity?
Empirically, we know surprisingly little. In today’s world there is little variation in limited liability within a country and it is hard to make comparisons if the regime is the same for everyone. There are large differences between countries, but these may reflect deeper economic, cultural or institutional differences.
In this research program I use the 19th and early 20th century as a laboratory. During this time period rules on limited liability were introduced for the first time and subsequently underwent large changes. This provides a unique opportunity to study the effects of limited liability. I focus on three areas where limited liability plays a key role.
In the context of entrepreneurship, I analyze the impact of limited liability on patenting, the introduction of new technologies and, by looking at migration decisions, the best liability system in the eyes of entrepreneurs themselves. In the context of (non-financial) firms, I study the valuation and entry of firms who obtain (the option of) limited liability for their shareholders. In the context of banking, I look at the link between managers’ liability and their risk taking, and how liability rules affect financial fragility (in the form of bank runs) and the overall provision of credit in the economy
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