1 Introduction 2 Bilateral Financial Contracts

Notes 1 INTRODUCTION 1. There is already a considerable literature on free banking, with books on the subject by Hayek (1978), L. H. White (1984a, 1989), Selgin (1988), Dowd (1988a, 1989, 1993a), Glasner (1989a), Salsman (1990), Horwitz (1992), and Sechrest (1993). There are also many books that discuss free banking (e.g., Timberlake, 1991, 1993; Cowen and Kroszner, 1994) as well as numerous recent journal articles on it. In addition, there is also a very large earlier literature on the subject (e.g., Wesslau, 1887; Hake and Wesslau, 1890; Meulen, 1934; Smith, 1936; and many others). 2. The use of conjectural history to examine financial and monetary issues has a long pedigree. Menger (1892) made effective use of it, and so did Karl Marx before him. A conjectural history was also used by Meulen (1934), and they have been used more recently by Selgin and White (1987), Selgin (1988a), Dowd (1988b, 1989), Glasner (1989a), Horwitz (1992), Sechrest (1993) and various others. 3. There are many other examples one could choose. Amongst these are medieval Celtic Ireland (Peden, 1977), Viking Iceland (Miller, 1990), and the nineteenth century American West (Anderson and Hill, 1979). The reader might also look at Rothbard's (1978) insightful overview of some of these and other historical anarchies. 4. The theory of private legal systems is discussed, among other places, in D. Friedman (1978), Rothbard (1978), the Tannehills (1970) and Wooldridge (1970). As is well-known, Nozick (1974) attacked the viability of free-market law and order by claiming that the anarchy would collapse into an ultra-minimal state, but Nozick's position has itself come under devastating attack from libertarian anarchists whose work suggests that anarchy is indeed stable (e.g., Childs, 1977). I find their arguments very persuasive, but all that matters for my purpose here is that the state keeps 'out of the way'. Readers who have difficulty with libertarian anarchism can therefore assume there is a state if they wish, but only one that adopts a strictly laissezjaire approach towards the financial system. 5. There are of course many specialised financial institutions, as well as 'regular' banks and mutual funds, and some of these specialised institutions (e.g., pension funds and insurance companies) play important roles in the financial system. However, I cannot discuss these institutions here, and can only suggest that readers interested in these institutions look at the relevant specialist literature. 2 BILATERAL FINANCIAL CONTRACTS 1. To the extent that this earlier literature did attempt to explain why particular contract forms are used, it argued that debt was used because of its tax advantages over equity, but there had to be some scope for equity because exclusive reliance on debt would involve excessively high expected bankruptcy costs. However this sort of explanation is very limited: it does not explain why debt was used before it received its modem tax advantages, and debt was issued hundreds of years before income and corporation taxes; it does not explain why debt and equity have the 476 Notes 477 particular features they have; it not explain why there should be bankruptcy costs in the first place; and recent work suggests that it might not be empirically valid anyway (e.g., Mac.IGe-Mason, 1990). We should therefore begin by explaining contract structure in the absence of taxation, and we can always consider taxation at a later stage if we wished to examine its effects (e.g., as in Gertler and Hubbard, 1993). 2. If the constraint that verification is costly is to 'bite', there must be some limit to A's exposure to pecuniary or non-pecuniary penalties, as well as to P' s wealth. If A can expose himself to unlimited penalties, verification costs can be reduced to an arbitrarily low level by making verification stochastic, with a low probability of verification being matched by ferocious penalties if A is found out to be lying. If the penalties and verification costs are suitably chosen, A can be 'trusted' to be telling the truth when he claims that output is low because he has no incentive to lie. The higher the penalty, the lower the required probability of verification, and the lower are verification costs. In the limit verification costs go to zero and the costliness of verification is irrelevant. However, if A's liability is limited, a comparable outcome can also be achieved if P's wealth is unlimited. Instead of imposing ferocious penalties on A if he is verified and found to be lying, P offers him fabulous rewards if he is verified and found to be telling the truth. As the reward rises, the probability of verification required to induce him to tell the truth falls, so verification costs can be reduced to a level arbitrarily close to zero provided that P has sufficient wealth to make his promised rewards credible (see also Guesnerie, 1992, 306-307). 3. These CSV models should not be confused with the superficially similar 'plunder' models of Border and Sobel (1987) and Mookherjee and Png (1989) which arrive at the conclusion that certain forms of non-debt contracts are optimal. These models analyse a fundamentally different problem- the problem faced by brigands and tax collectors in the process of extracting wealth from their unwilling victims - while we are concerned here with situations where people deal with each other by mutual choice. 4. Moral hazard refers to the tendency of insurance to encourage behaviour on the agent's part that produces the event(s) against which the agent is insured. For example, if an agent has fire insurance, he might behave in a way that makes a fire more likely. In this literature, our main focus is the agent's choice of effort, but there can also arise moral hazard over the agent's choice ofproject, where the latter (or strictly speaking, some important feature of it) might be unobservable. This latter type of moral hazard is formally similar to adverse selection, so we shall discuss it in the context of adverse selection in the next sub-section. 5. It is sometimes claimed in the literature that credit rationing can also occur in adverse selection cases where investment projects differ in their degrees of riskiness in ways that the lender cannot observe (e.g., Jaffee and Russell, 1976; Keeton, 1979; Stiglitz and Weiss, 1981). The argument is that higher interest makes marginal profits unworthwhile and, since the borrower's expected profit rises with the riskiness of the project, leads the low-risk projects to be displaced from the pool of investment projects the lender faces. The lender might therefore prefer to keep interest low and ration credit to prevent the expected losses he would face if he raised interest and let the investment pool deteriorate. However, the problem with this line of reasoning is that the optimal contract in these circumstances is actually equity, not debt (see, e.g., Hart, 1986; de Meza and Webb, 1987). The issue of credit rationing does not arise because a loan is a form of debt and there are no loans to ration. 6. The basic idea behind Myers under-investment can be seen through a simple example. Taking all figures to be in net-present-value terms for simplicity, suppose 478 Notes a firm has previously issued debt with a face value of $20 to fund an investment project, and it is now apparent that the project will succeed with probability one half and yield a return of $20 that enables the firm Gust) to pay its debt, and that it will fail with probability one-half and yield a return of nothing. (Note, therefore, that the value of the firm to its shareholders is zero.) If the firm has no assets, the expected value of the firm's debt is $10 and the creditors have suffered an expected loss of $10 also. Now suppose that an additional investment opportunity becomes available that requires an input of $10 from the shareholders but yields a return of $15. The new investment is clearly socially worthwhile because it converts $10 into $15, but shareholders will still refuse to fund it because too many of the gains go to existing creditors. If they proceed with it, the total expected shareholder return will consist of $15 (i.e., the return on the new project) plus one-half times $20 (i.e., the expected return on the old project) minus $20 (i.e., the full repayment of the old $10 debt, plus the additional $10 required from the shareholders), or $5. The shareholders therefore expect to lose $5 on the additional investment. The creditors however get repaid their full $20, instead of their currently expected payment of $10, and make an expected gain of $10. The shareholders thus pass up a socially worthwhile investment opportunity, because too many of the expected gains go to debtholders. 7. The legal system therefore has a relatively straightforward task: to ensure that contracts are honoured, period. By contrast, contemporary bankruptcy law often forces courts have to make all sorts of 'judgmental' [sic] decisions: judges have to assess what course of action would be in the best interests of the different parties, how much to 'trust' management that claims it can reorganise a firm successfully, and so on. The need to make such decisions imposes severe burdens on those who have to make them, creates incentives for interested parties to invest resources trying to influence those 'judgmental' decisions, and the process involved can be very time-consuming (especially, for example, if a dissatisfied party appeals a decision). The legal procedure suggested here is far more efficient: the court merely needs to establish facts and then pass a more or less automatic (and presumably reasonably rapid) judgement.

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