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Politics and economics are inextricably linked. Government establishes and enforces the rules of the game for the economy, thereby determining not only how much wealth is created, but also how wealth is distributed across society. The primary question of political economy is easily stated: for whose benefit does government set the rules? This paper examines the fundamental conflict of interest between maximizing the wealth of a nation, versus maximizing the wealth of particular interests. The same distortions and deceptions have been used for centuries to obscure how government sets the rules of the game to benefit particular interests.

We examine a central result in corporate finance – the Modigliani-Miller capital structure irrelevance proposition – from a Coasian property rights perspective. Building upon the work of Coase, Demsetz and Cheung, we develop an enabling methodology to study the impact of positive Coasian transaction costs. When the Modigliani-Miller assumption of default-free debt is relaxed in the analysis of corporate leverage, either long-lived transaction costs related to property rights must be explicitly assumed away, or long-lived transaction costs related to property rights must be incorporated into the analysis.

Risk matters when corporate debt has a positive probability of default. Lenders have traditionally used covenants to protect their property rights because the financing and operating decisions of firms can reduce the value of the firm’s outstanding debt. We examine the use of captive finance subsidiaries and special purposed entities (SPEs) to partition default risk within the firm. A more complex arrangement of property rights within the firm allows the parent firm to retain operating flexibility while offering lenders better protection. We conclude that capital structure is a relevant decision variable for corporate managers because firms are able to obtain leveraged finance at a lower cost when risk is partitioned using separate legal structures within the firm.