On Limited Liability and the Development of Capital Markets: an Historical Analysis Thanks to Avner Greif and Aloysius Siow for Helpful Comments. Financial Support from a Sloan Foundation Dissertation Fellowship Is Gratefully Acknowledged

We study the consequences of the introduction of widespread limited liability for corporations, with particular reference to the liability reforms introduced in Great Britain during the nineteenth century. In the view that is most widely accepted, by reducing transactions costs associated with screening and monitoring in capital markets , limited liability increases eciency of capital markets and enhances investment incentives for individuals and rms. But the standard transaction-cost perspective does not explain several important s t ylized facts of the British experience, including the slow rate of adoption of limited liability b y rms in the years following legal reforms. We construct an alternative model of asymmetric information and default in credit markets that accounts for this and other features of the British experience. In the model, a rm's decision to adopt limited liability m a y b e i n terpreted in equilibrium as a signal the rm is more likely to default. Hence less risky rms may c hoose unlimited liability or forego investments entirely. We show the model may h a v e m ul-tiple, Pareto-rankable equilibria in which dierent proportions of the rms choose to incorporate with limited liability and dierent levels of aggregate investment result. Thus the choice of liability rule can lead to \development traps," in which protable investments are not undertaken, through its eect on equilibrium beliefs of uninformed investors in the economy. W e apply the theory to a data set describing the rst English rms to incorporate after the legislative reforms of 1856.