Market-dominated systems

• US, United Kingdom — relying on the stock market for financing
• equity financing ― through the selling of shares
• sell stocks and bonds — help from investment banks, but they don’t go in as owners

Owners:

• owners as largely passive — care very little — know even less

Secondary markets for shares:

• liquid — easy to sell if prices start to go down — only looking for the best return for the money
• reduce the bond between asset and owner of the asset — reduce the social stake in the company

Higher liquidity ― fewer social bonds …

• the shareholders meetings as stage managed affairs — glossy brochures that present positive pictures
• very few ask important questions — no one has enough knowledge — few care enough as long as the price of the shares is going up
• only exception ― managers of large funds ― but they often wield influence in other ways anyway …

Managers:

• managers as the only ones with a proper knowledge of the business — the only ones who both care and know
• very independent — do whatever they like — especially in companies with no dominant owners
• eg. Volvo — “owned by everybody” — that is, by nobody — until the Chinese bought it

Banking-dominated systems

• Japan, Germany — basically relying on banks — debt financing
• turn to banks for money — markets for stocks and bonds exists ― but far less important
• original owners less reason to invite outsiders — there are fewer owners — closer links managers — owners

Position of the banks

• locked into the company — long-term relationship
• the bank cares — checks the books — gives advice regarding how to run the company — strategic planning for the future
• often buys shares — stakes in the companies — represented on the board
• far less liquid investment on the part of the bank – cf. discussion of social bonds as a result

Advantages:

• banks take a strong interest in the way in which the corporation is run — checks the books — talk to management — participates actively in board meetings
• easier to monitor the performance of CEOs — fewer ‘hostile take-overs’ — more difficult to engage in —
• more of the stock held by banks and private individuals — also less need: the management is already controlled

Particularly important if there is little public information available

• early stages of industrialization — investors have problems making informed decisions about which stocks to buy
• transition from Communism in Eastern Europe

Disadvantages:

• less flexible — poor liquidity — more difficult to raise capital
• very costly to monitor companies — takes up a lot of the time and resources of the bank
• problems of too close ties — not enough exposed to the market — long-term social relationship lead to bad business decisions
• occasionally: unclear boundaries between help and corruption

Recent changes:

• more use of capital markets — more corporate bonds
• more “hostile take-overs” — as alternative to bank control — even if it is against a corporate culture
• although the trend should not be exaggerated … at least not yet …

Hirschmann: exit/voice

Download pdf

Hirschman on Nigerian railways

General availability of exit — a special social climate

• little loyalty — people cannot be trusted to stay with a product unless it is in their interest to do so

General availability of voice — another social climate:

• a lot of loyalty — people stay with a product, a company or a supplier because they know they can influence it

Low trust

• Anglo-Saxon model: many opportunities for exit — shift to new suppliers or to a new job — little loyalty to a company
• little trust — you need to build large companies to deal with the problem

High trust

• German/ Japanese model: more opportunities for voice — workers, suppliers, people who finance businesses — are locked into place — cannot escape
• more trust — you can rely on smaller companies and more flexible ways of organizing production

Virtue, debt and democracy

“Dutch finance”

• Beurs in Amsterdam

Dutch East India Company

• buying and selling shares in the company
• currency
• insurance against pirates
• recycling the enormous profits made

The Glorious Revolution, 1688

• William of Orange, from Holland:
• invited by both Whigs and Tories to invade, November 1688
• William sees England as an asset in his wars against France

On ascension to the throne ‑ agrees to:

• legislative supremacy of parliament
• parliamentary consent to a standing army — important issue for parliamentary sovereignty

War financing:

• same problem as his predecessors: wars cost money
• not granted enough money by parliament

Position of parliament:

• keep the king financially dependent on them
• make sure that many parliaments were called
• protect — extend — their rights

Solution to the problem of state financing

• the “financial revolution”
• state borrow more money from more sources at lower rates of interest

Key mechanism — this is Douglass North …

• parliamentary consent – parliamentary control – lowers interest rates – people dare to lend money
• the parliament basically goes in and backs up the loans with taxes

Mutually beneficial relationship between king and people

• for the king — loans on better terms since he is backed up by the people — the taxing power of the parliament guarantees the
  loans
• for the people — they have a way to control the actions of the king — not able to do just anything — the king is requires to seek their consent or at least not stir up their opposition

Two innovations:

• Bank of England
• joint-stock companies – among which the South Sea Company was the most notorious – and the London stock market

The Bank of England

• set up in 1694
• answer to the problem of how to obtain long-term loans — permanent — “perpetual” loan

Basic idea:

• gather a capital through subscriptions from the public
• sold out in 12 days – for 1,200,000 pounds
• lending the entire sum to the king at 8 % interest

Right to issue notes

• the king’s promise to pay back the loan ‑ security for value of the notes
• the notes can be redeemed — repaid in coins

Loans to private borrowers

• the notes go as loans to private borrowers

Earn interest twice!

• first on the government debt
• second on the loans to private individuals

Advantages:

• translate many small investments by many individuals into big loans — in this case to the state
• short-term investment into long-term loan
• over time, the interest rate goes down
• the loan is secure

State finances and warfare:

Success in war as a result of:

• improved state finances
• a permanent — long-term — state debt
• guaranteed not by the king only, but by the parliament

Better security — lower risk

• more money from more people at lower interest

Outcome:

Internationally:

• a stronger English state in world politics
• unique position of England in the world — origins of British world power — what later is to become the
  British empire

Domestically:

• a weaker king domestically — controlled by the people  — controlled by the creditors 

The stock-market

• early 18th century ‑ the English economy booming
• people had money to invest

Joint-stock companies

For over-sea’s trade

• very risky and long delay between payment and profits

Company form

• invite shareholders to share risks and profits – eg buy a part of a boat
• a way to raise funds — pool risks

In England — the big three:

• English East-India Company
• Bank of England
• South Sea Company

Monopolies:

• monopolies on trade with a particular part of the world
• monopoly as a way to guarantee profits under risky circumstances ― perhaps not such a bad idea, even in economic terms
• but also a way for the king to make money – selling the right to trade for a fee to the highest bidder

The stock companies and state debt

• source of loans to the king

No essential difference between Bank of England and the others

• South Sea company was not at all preoccupied with trade
• the loans were on long-term – precisely what the king needed!

Financial institutions created a rival elite

• not just ‘landed interests,’ but ‘monied interests’
• strong opposition between the two

Two party system – Whigs and Tories

• divisions appear within the parliament based on land and finance

Julian Hoppit, ‘Attitudes to Credit in Britain, 1680-1790’

“Stockjobbing”

• A “stockjobber” in the 18th century was a market participant involved in the buying and selling of securities, acting as a middleman in the early stock markets. They were often viewed with skepticism due to their speculative activities.

“Projector”

• In the 18th century, a “projector” referred to an individual who proposed or designed large-scale, often ambitious or speculative, projects or schemes, typically in the fields of engineering, finance, or business. These projects were frequently innovative but also risky, and the term sometimes carried a negative connotation, suggesting overoptimism or impracticality.

“Joint-stock company”

Attitudes to credit

• credit as one of the defining characteristics of the 18^th century

Great social implications

• especially when credit was given to poor people, not just to rich

The ‘problem of credit’

• judged by moral standards as much as by economic cost-benefit analysis

Public debt

• some worried in the early 18^th century — fewer worried after that — it was under control
• attention shifted to private debt

Consumer credit:

• credit given by shopkeepers or money-lenders — pawnbrokers

Moral censure:

• wrong to go into debt to pay for everyday consumption
• cash economy celebrated together with good house-keeping

Benjamin Franklin: ‘neither a lender nor a borrower be’

• accused of charging usurious rates — few defenders

Shop credit

• not as objectionable
• often necessary to survive — help people through hard times

Corporate credit:

• trade credit
• dominated the discussions regarding private credit from 1770

Forms:

• bills of exchange, book debts, accommodation notes

Credit and Fortuna

The fickleness of credit

• takes a long time to build up
• is easily destroyed
• cf. fortune — Fortuna

Charles Davenant, 1698:

of all things that have existence only in the minds of men, nothing is more fantastical and nice than Credit; it hangs upon opinion, it depends upon our passions and hope and fear; it comes many times unsought for, and often goes away without reason, and when once lost, is hardly to be quite recovered.

Credit compared to a fickle woman — Swift:

credit is ‘so nice, so squeamish, so capricious;you would think they were describing a Lady troubled with Vapours or the Cholick’

• Swift was a conservative and critical of credit

Moral critique:

• widespread use of credit — spread of a new amorality

Recklessness:

• allowed businessmen to trade on a far greater scale than their own limited capital allowed
• tempted businessmen — especially young ones — to invest in risky schemes — high profits, but also
  high risks
• encouraged a spirit of gambling

Extravagance:

• people driven by vanity
• attempt to emulate the life of their social superiors
• driven on by ambitious, ostentatious, wives
• paying less and less attention to their business

Social dislocation:

• social fabric eroded — unpredictable forces unleashed
• created an illusion of substance

Allowed the erosion of traditional patterns of social hierarchy:

• people’s ‘eager desire of being seen in a sphere far above their capacities and circumstances’
• ‘ancient distinctions are therefore much confounded’

Cf. illusion vs. reality

• as a kind of make-believe — cf. the Puritan attack on theater
• completely divorced from reality and real values

In defense of credit:

Economic advantage:

Economic benefits outweighed the moral cost

• without a stock market productive ideas would not get off the drawing board
• serious implications for the economy
• in particular in capital intensive industries like glass making

Boosts output and employment

• credit “as necessary to a Trading Nation, as Spirits are to the Circulation of the Blood in
  the body natural”
• business cannot be conducted without credit

General shortage of money in parts of England

• inevitable delays in payments of contracts
• many made a different between proper — improper use

Political difference

• the critics of credit would have to be conservative — dedicated to a stagnant state both politically and economically
• Swift, conservative ― Defoe, liberal

Reliance on credit actually encouraged good behavior

Defoe:

• credit ‘will keep Company with none but the Industrious, the Honest, the Laborious, and such, whose Genius, the
  Bent of their Lives, tends to Maintain her good Opinion’

People could command credit only if they fitted a widely held pattern of good behavior, including not only economy, hard work and
ability, but also the circumscription of passions such as avarice an luxury

• in the end credit went to the creditable
• credit was given to the most worthy — the most assiduous and honorable
• credit could easily be lost if virtue was replaced by vice

For and against a funded public debt

Arguments in favor

• not clear what the alternative would be:
• no reserves  no interest in new
  taxes

• drew idle funds into circulation
• improved economic climate:

• contributed to a fall in interest rates
• rates down from 8 to 3 %  below
  the limit for usury
• David Hume:
• ‘interest is the barometer of the State, and its lowness is a
  sign, almost infallible, of the flourishing condition of a people’

Arguments against public debt

• but many were also highly critical … above all the landed elite
• the landed elites formulated their opposition in the language
  available at the time
• i.e. as a ‘decline in civic virtue’ — cf.
  ‘republican tradition’ — arguments that recur in the United
  States — discuss on Monday

‘corruption’

• cf. Aristotle on freedom through politics in the agora — free men,
  etc.
• republican ideal — independent, landed, gentry as the ideal
• only they are in a position to make disinterested decisions in the
  best interest, not of themselves, but of the community
• corruption

• not really the problem of bribes etc — rather the
  problem of dependence — of compromising your free and
  disinterested position by making yourself depend on others
• increasing dependence of free citizens on each other and on the
  ruler
• Charles Davenant:
• ‘these gimcracks and new devices of funds, stocks, exchequer
  bills, malt and lottery tickets, have turned the brains of a great
  part of the city; there is not such a thing left as publick spirit,
  and in its room we have set up knavery, extortion, and
  self-interest’³
• free citizenship

• citizens needed resources that made them free
• best: land  who were
  dependent on no one
• you could see the interests of the whole 
  take the point of view of the entire community
• English parliament: full of land-owners
• monied interests

• too dependent on the king
• no independent sources of wealth
• too confined to their own points of view
• uncertain source of virtue:

• land not a commodity  at least
  not in theory
• but monied interests 
  their source of independence commodified 
  depended on the rise and fall of the values of the papers they were
  holding
• the rise and fall of the stock-market corresponded to the rise and
  fall of their independence and freedom
• strong implications for their personality 
  made for a very unstable republic

Financiers amassed substantial fortunes

• the old social and political order was being undermined
• led to bad policies:

• public credit prolonged wars
• supported a vast military establishment
• gave new careers and positions that could be filled by the
  government and the Crown 
  danger of nepotism
• intense fear of stock-jobbing and ‘bubbles’

• the unreality of wealth based on money
• divert talents and effort to scheming rather than hard work
• size of the debt

• initially a worry
• less of a worry after the mid-18^th century 
  when state finances were in order and the economy was growing

General point

• gentry ― saw financial wealth as suspect:
• lacked the tangibility of land – unclear what it consisted in
• objected to

• the social marginality of the investors
• too many non-conforming Protestants – Jews
• foreigners – Tory xenophobia
• unfair

• the new lenders seemed to make money off the government and
  the landed interests
• the stock market was booming yielding increasingly higher profits
  while the gentry paid increasingly higher land taxes
• government debt – a much better source of income than anything the
  gentry could come up with
• strong opposition to ‘stock jobbing’

Loans ― political logic:

• crucial distinction in European history ― all about methods of
  public finance ― with far-reaching implications …

• important for understanding role of parliament – ultimately origin
  of democracy
• dependence on money leads to political dependence on the people

the king dependent on the people

• go and ask parliament for more money:

• yes – but only if we are given privileges
• increased bargaining power of the parliament – e.g.
  England, Dutch Republic, Sweden

the king independent of the people

• but if king – independent source of income:

• through taxes or sale of monopolies, titles or jobs
• king did not have to rely on parliament
• reduced bargaining power
• explains Absolutism in France, Prussia, Russia

loans rather than taxes

• people (creditor) dependent on the king — that he will repay
• dependent on the people, but not on the taxes granted by the
  parliament
• that is, it creates a different kind of tie between the king and
  some of the people
• political consequences:

• likely to support him ― they want their money back
• especially if a new, revolutionary, regime will default on the loans
• a stake in the state
• talk more about this in the second lecture!
• problems trusting a king

• he is sovereign – he can set the law – doesn’t have to repay –
  you cannot claim his collateral – cannot take him to court
• very common to default on loans
• likely to demand higher interest rates to compensate for the risk
• kings needed money – but were considered a bad risk — which
  meant that the terms were bad — ie high interest rates

The king’s dilemmas:

Finding money

• but without making himself a prisoner of the people
• making it credible that he would repay – reduce the interest rate
• but credibility/trust could only come when the king could be
  controlled

thus

• the king free of the people
• high interest rates, bad terms on loans
• the king constrained
• lower interest rates, good terms on loans
• ie

• the financial situation of the king made it in his self-interest to
  be constrained
• absolutist rule and good state finances could not be combined (at
  least not in the long run)

Today:

• how the English king solved this problem
• or rather: how it was solved for him

Explains:

• external dimension  England’s
  position in the world
• domestic dimension ­ rise
  of liberalism and, later, democracy 
  both in England itself and in the United States