"Casino Capitalism" and Limited Liability

Hans-Werner Sinn (2010) in his book “Casino Capitalism” argues that it is not irrational exuberance which causes capitalist crises but instead limited liability.  In fact, Sinn suggests that speculative investors exhibit rational behavior because, unlike gamblers who face a negative expected mathematical payoff, they have they promise “of huge private profits at the expense of society” leading to a payoff “above the stakes”.  

Sinn suggests that commercial limited liability flourished in medieval Italy in an arrangement referred to as “commenda”, driving economic advancement in cities such as Florence, Venice and Pisa.  Today, he suggests the high standard of living observed in the ‘West’ is a product of capitalism which “goes hand in hand with the corporation and limited liability”.  Sinn goes on to propose that this incentivises investment banks to become under-capitalized and engage in high risk behavior.  However, he also suggests that stockholders are the main source the problem as they are only interested in profits, and given the cushion of limited liability they encourage riskier behavior by banks.  Sinn suggests that this leads to the manifestation of Akerlof’s (1970) lemon problem – lower risk investment banks, unable to explain their safer position to customers, disappear as they cannot compete with the higher return offered by their higher risk counterparts.  

This limited liability proposition is particularly powerful as it provides a framework to explain the apparent irrational exuberance we observe in capitalist systems.  In essence, it identifies a lack of accountability as a product of limited liability which could potentially fuel a culture of crises.