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long ago: an electronic medium of exchange and a system of indexed
units of account for defining important prices.
The Invention of Modern Stock Markets
The development of modern stock markets in the nineteenth century
was a cardinal development in the management of business risks. Be-
fore the nineteenth century, stock markets were so small as to be in-
consequential for society at large. The creation of modern stock mar-
kets allowed a fundamental separation between the owners of
enterprises and their founders and managers, so that the latter could
pursue highly risky ventures without exposing themselves to the risks.
With large international stock markets, the risks can be spread over in-
vestors all over the world so that by great diversification, the impact of
the risks is much reduced.
But how to create these markets on a large scale was by no means
obvious. Practical and psychological problems were important ob-
stacles only gradually overcome. In fact, the stock markets that we
know today represent a nonobvious invention for which human finan-
cial engineering was the vital element.
An essential factor that has promoted the development of modern
stock markets is the guarantee, in law, of limited liability for investors
in stock. The definition of a corporate stock as we know it today is a
claim on the profits of a company, but no obligations on the part of a
stockholder beyond paying for the stock. The stockholder has limited
liability, meaning that he or she can lose no more than the purchase
price of the stock.
This essential limited liability concept was not clearly defined for the
market as a whole until the nineteenth century, although some indi-
vidual stocks did have limited liability provisions in their charters be-
fore then. A breakthrough of worldwide significance occurred in the
United States with an 1811 general act of incorporation in New York
State. Not only did this act set the precedent of allowing any business
that satisfied minimum requirements to incorporate, but it also initi-
ated the radically new step of specifying that all investors in New
York corporations have strictly limited liability.
7
Before this act corpo-
rations were usually creatures of government, enjoying a government-
sanctioned monopoly, and incorporation was not available to business
at large. Moreover, creditors of failing companies could in principle
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seize all the personal assets of each stockholder, even those holding few
shares, until the debt was repaid.
Clearly, the limited liability required by this New York law was of his-
toric importance. Before the passage of this law, investors could in
principle lose their homes, life savings, and everything else, and even
conceivably end up in debtors’ prison, simply by owning a few shares
in a company that later fails. Thus, investing in stocks could possibly
have disastrous consequences for the investor. With such a frightening
possibility, one would naturally be wary of investing in stocks.
Despite the obvious problem with unlimited liability stocks, limited
liability was not obviously a good idea to lawmakers at the time. His-
torian David Moss has chronicled an extensive argument against lim-
ited liability around the time of the 1811 New York law.
8
In considering
proposals for limited liability stocks, many legislators thought that pro-
tecting stockholders from the full consequences of the company’s
losses might spur the company to pursue excessively risky strategies.
With limited liability, the stockholders would never have to pay the full
extent of the losses they incurred if things turned out very badly, but
they would stand to gain all of the profits they earned if things turned
out very well. We would say today that these legislators were concerned
about the moral hazard associated with limited liability, though the
term moral hazard had not yet been invented.
Moreover, the U.S. Constitution, in Article 1, Section 10, specifies
that the states shall make no law “impairing the obligation of con-
tracts.” Corporations were free before 1811 to sign contracts with their
creditors preventing creditors from attaching the debts of sharehold-
ers, if such terms were mutually agreeable. The essential character of
the limited liability laws that first appeared in New England in 1811 is
that they required such contracts, thus diminishing freedom to make
contracts. It was certainly not obvious that a law forbidding certain
kinds of contracts, those implying unlimited liability, is a good thing.
Should not free citizens be allowed to sign any kind of contract that they
want? Moreover, unlimited liability hardly ever caused serious problems
in practice since there were hardly any actual examples before 1811 of in-
nocent shareholders being pursued for the debts of corporations.
But the New York experiment was obviously successful judging from
the number of successful incorporations there, and eventually all states
copied the New York law. California was the last to do so, in 1931. The
New York law, which gave New York a head start as a financial leader
major financial inventions
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in the world, was also the inspiration for incorporation and limited lia-
bility laws in the United Kingdom, Germany, France, and ultimately
virtually every other country of the world today.
9
Limited liability also fostered public acceptance of corporate stocks
because investors tended to overestimate the minuscule probability of
loss beyond initial investment. Psychologists have documented such a
human tendency to sometimes overestimate small probabilities.
10
With
unlimited liability, investors’ imaginations could run wild with the fear
that investing just a small amount in a stock would spell disaster.
With limited liability, stockholders have no fear of disaster. They can
lose no more than the amount they put in to buy the stock. And yet
they can imagine the possibility of a bonanza many times larger than
the amount that they put in, a probability that they are likely also, given
what we know about human psychology, to exaggerate in their imagi-
nation. Thus, as David Moss has argued, limited liability stocks suc-
ceeded so well because the human tendency toward exaggeration of
small probabilities can make stocks a matter of pure pleasure: often
only the potential upside is on investors’ minds. Stock investing be-
comes like buying lottery tickets, which many people describe as pleas-
urable: the investor can savor the possibility of making a lot of money
without worrying about any big troubles. Framing stock investments
this way enhances the demand for stocks, encourages a great many in-
vestors to buy small numbers of shares in many companies, and thereby
dramatically increases the supply of capital for corporations.
Limited liability also allowed investors to hold a highly diversified
portfolio. Without limited liability, broad portfolio diversification was
potentially a very bad idea because failure of any one investment could
result in the seizure of all of one’s assets. With the many investments of
a highly diversified portfolio, the probability that one of them would
spell serious trouble was perhaps not so small. While we today think of
portfolio diversification as an obvious fundamental principle for in-
vestors, the principle was not valid and not even generally conceived of
until the advent of limited liability laws. Framers of corporate law were
not even thinking about portfolio diversification, but one invention led
to another, from limited liability to a fundamental investing principle
of diversification.
The demonstration of the value of the limited liability stock markets
in New York State in the early nineteenth century revealed an impor-
tant fact about moral hazard—that concerns that limited liability stocks
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