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Political Pre-conditions of the Stock Market

That ends our summary of what stocks essentially are, where they trade, and how their overall price movements are gauged. With every reader, I hope, now up to speed, the political dimension of the stock market can now be probed. To start off, the same question with stocks must be asked that was initially raised with bonds: why is the stock market allowed to exist at all? In some ways, this is a somewhat more puzzling question for equities than it was for bonds—at least once one gets over the feeling that the stock exchange is just part of the natural order, an appearance caused by its being a permanent fixture in capitalist economies. Interestbearing debt contracts go back more than 4000 years to Mesopotamia. At best, organized frameworks for the trading of equity stakes only go back roughly half that time to the ancient Roman republic. From the second century BCE, the Forum was the scene of trading in shares of the so-called publicani, companies to which the Roman state outsourced public works such as the construction of infrastructure and the collection of taxes. After the fall of the Roman Empire, it would not be until the late Middle Ages before the seeds of the modern stock exchange reappeared in the itinerant fairs of the period and the commercial republics of Northern Italy.[1] As trade increased between the Mediterranean and the Hanseatic League in Northern Europe in the thirteenth and fourteenth centuries, Bruges became a financial center where merchants met to deal in bills of exchange at the Place de la Bourse, a hotel owned by the van de Beurse family.

The word “bourse” stuck as a term designating a stock exchange. It was subsequently used to describe the Antwerp market once the financial nucleus of Europe had moved there from Bruges in the sixteenth century. Antwerp is usually credited as being the first regular stock exchange, but the Spanish plundering of the city in 1576 meant that it was soon overtaken by Amsterdam in the seventeenth century.[2] Trading there was dominated by the aforementioned Dutch East India Company and less so by its geographic counterpart, the Dutch West India Company. Toward the end of the seventeenth century, after the Glorious Revolution, the financial action began to shift to England. There, the coffee houses of London were buzzing with stock trading activity in the shares of the British East India Company and the Bank of England. This decentralized mode of trading eventually ended after the establishment of the LSE which, depending on how one wishes to interpret the history, took place either in 1773 or 1801.[3] Meanwhile, in 1792, brokers who had been plying their trade on the street curbs of lower Manhattan entered a pact to trade securities among themselves at preferred rates under a common set of rules. In part, this was an attempt to improve the then poor ethical image of the stock brokerage trade. But it was also a cartelistic ploy to reduce competition among themselves so as to be able to charge higher trading commissions. That pact is known as the Buttonwood tree agreement, because it was signed nearby a species of that tree at what is now 68 Wall Street. It represents the founding event of the NYSE.[4]

Recounting the origins of stock exchanges, of course, still leaves the question unanswered of how stocks got there in the first place to be exchanged. As I have already noted, shares of ownership traded on exchanges come with a unique feature that hugely enhances their marketability: limited liability. This legal protection was legislated by the state. Just as we saw with the bond markets, the trading of equities as we know it today only came into being as a result of a political act. With respect to the credit market, this consisted in allowing interest to be charged on loans. With stocks, it was the provision of limited liability as a matter of right to just about anyone willing to incorporate. This is not to say that there were no stocks being transacted before this watershed movement in the history of corporate law. It was not until the mid- to late nineteenth century that this legal shift was consolidated in the Western world and, of course, there were equity markets centuries before then. Still, up to this time, government bonds tended to dominate trading over shares. This divergence only began to narrow significantly after the general availability of limited liability gave rise to an explosion in the number of stocks listed. Investors were consequently drawn into the equity marketplace by additional opportunities of being assured a floor on potential losses.

The political dependence of the stock market might be contested on the argument that the legislative sanction of limited liability merely recognizes individual rights of contracting. In this view, publicly traded corporations are not essentially creatures of the state, but rather voluntary associations whose right to jointly determine their own economic affairs as they see fit has simply been politically acknowledged. 1 1 Yet this is to impose a moral interpretation on the historical facts. For it presupposes that individual rights exist above, and prior, to the state. This may well be true, but it requires a separate philosophic argument. In any event, the individual rights account does not deny the role of politics in underpinning the exchange of corporate shares. It merely speaks to the nature of the state’s agency, maintaining that it legally enables the stock market rather than creating it as its child. Most importantly, though, is that limited liability does not simply touch upon the interests of those individuals that contract together to form a corporation. By limiting the downside of the equity holders, limited liability transfers the residual risks of the business to society. More specifically, that risk is shifted to customers, suppliers, and lenders in addition to the local communities and governments with which a corporation interacts. Say a limited liability company negligently sells thousands of poisoned food items for which a court fixes damages above the value of its assets. All those who suffered harm as a result of the tainted produce will end up having to bear part of the cost. After all, the company will not have enough to pay all the damages and the remainder cannot be obtained from the shareholder’s other assets. To put it in economic terms, limited liability poses negative externalities. As the guardian of society’s interests, it naturally falls to the government to figure out whether these externalities are compensated by the economic benefits that limited liability brings in encouraging the equity financing of sizable commercial organizations.

There is another argument that seeks to minimize the role of politics in grounding the stock market. This is the thesis that the limited liability [5]

guarantee can be adequately explained on the basis of its economic logic. Not only, so the argument goes, does that guarantee reduce the need for investors to monitor the internal workings of firms, it allows ownership stakes to be readily transferable, thereby bringing the price system to bear in aggregating information about the company’s situation. Where this situation is bad, and the share price is consequently low, management can be held accountable for its unsatisfactory performance by the prospect of someone buying enough shares on the cheap to assume voting control of the firm. Transferable parcels of ownership also make it easier for investors to diversify their holdings. They are then more likely to take a chance on risky ventures promising high positive spillovers to society. This is precisely because such commitments will constitute a smaller part of investors’ portfolios and be balanced off against securities. “The advantages of limited liability”, Frank H. Easterbrook and Daniel R. Fischel have written, “suggest that, if it did not exist, firms would have to invent it”.[6]

A good deal of credence must be granted this economic argument. Favoring it is the fact that most advanced countries, notwithstanding differences in culture and politics, had converged toward the legal recognition of limited liability by the end of the nineteenth century. Even so, if economic logic always and everywhere dictated the laws and policies of states, prosperity would be far more widespread around the world than it is today. For what prevails is not simply what makes most economic sense, but what makes most sense to those groups in the community wielding the greatest political power to set the rules. Moreover, the question whether limited liability should be generally granted was the subject of contentious political debate among great political and philosophic minds. To assert this was predetermined by economic factors would be tantamount to brushing off the articulation of the various arguments put forward as nothing more than hot air. It should not be forgotten either that, amid the consensus on the virtues of limited liability, different practices and institutions have evolved to distinguish the organizational structure of the corporation from one country to the next. In Germany and Japan, forms of corporate governance evolved that give less priority to the interests of shareholders than in Anglo-Saxon nations. The result is that the stock

Stock market capitalization as % of GDP, selected countries, 1988-2012. Source

Fig. 5.2 Stock market capitalization as % of GDP, selected countries, 1988-2012. Source: World Bank

market has traditionally played a smaller financial role, relative to banks, in Germany and Japan compared to the Anglo-Saxon universe. Figure 5.2 illustrates this by comparing stock market capitalization as a percentage of GDP across Germany and Japan in addition to the USA and the UK. Only politics can account for this difference.

The political foundations of equity markets are best understood by reviewing the legislative changes that took place in Britain during the mid-nineteenth century. This is when the country was spearheading the industrial revolution and when it represented the most developed of the relatively few democracies then in existence. Interestingly enough, the background for the story of limited liability in Britain was an historical event that had taken place two centuries earlier, a stock market mania that swept the imagination of the public. The hype and enthusiasm was such that it even made a fool of Isaac Newton, one of the greatest intellects the human race has ever known. Coming to a head in 1720, coincidentally enough around the same time of John Law’s Mississippi Company affair, the South Sea Bubble revolved around a publicly traded firm that had taken over the British government’s liabilities in what was essentially a scheme to swap debt for equity. 1 3 In order to entice investors to buy 13 [7]

shares, the South Sea Company was granted a monopoly over English trade with Spain’s colonies in South America. Though the potential of this market was limited by Britain’s chilly relations with Spain, investors wildly bid up South Sea shares, setting off a wave of enthusiasm that spread to other corners of London’s burgeoning stock market. With all sorts of half- baked ideas attracting equity financing, including a company that planned to trade in human hair, Britain’s Parliament moved to cool down the frenetic activity in London’s coffee houses. Ostensibly, this was justified on the public’s interest in protecting investors and maintaining the integrity of the marketplace. Actually, though, British politicians were motivated more by the desire to protect the South Sea Company from other firms competing for equity funding.[8] [9] The result was the Bubble Act of 1720, which restricted the joint stock corporate form to those companies that obtained parliamentary approval.

By greatly raising the barriers to public incorporation, this legislation certainly hindered the stock market. It restricted the listing of shares to companies adept at political lobbying and well connected to Britain’s lawmakers. Yet this constraint did not immediately make itself felt. Businesspersons like Matthew Boulton and James Watt of steam engine fame appeared content organizing their commercial operations within partnerships. But all this changed with the invention of rail transport, whose infrastructure required huge investments of capital beyond what wealthy families and individuals could possibly muster on their own. 1 515 Canals, roads, and bridges also entailed big upfront costs, as did the mass production processes made feasible by the industrialization of the economy. Initially, Parliament simply approved the granting of charters for such projects. However, that was proving time consuming and expensive in addition to providing legislators too much temptation for graft. Thus, the Bubble Act was finally repealed in 1825, more than a century after its passage—such was the persistence in historical memory of the hostility toward company shares instigated by the losses that investors sustained when the South Sea Bubble imploded. In 1844, William Gladstone shepherded passage of the Joint Stock Companies Act permitting firms to obtain a corporate charter by simply registering with the government. What this law did not contain, though, was the provision of limited liability.

Leading the effort to include this pivotal right was Robert Lowe. To the extent that he is remembered at all today, he appears as a British politician known more for his involvement in education policy and his opposition to the extension of the franchise than for his contributions in amending and codifying the law of companies. 1 6 Indeed, a biographical reference book on British politicians makes not a single mention of Lowe’s legislative efforts in the corporate arena.[10] [11] A free market advocate of the classical school of economics, Lowe nevertheless had to confront the towering figure represented by Adam Smith in his drive to attach limited liability to the framework of incorporation. Though often overlooked nowadays by many of his followers, the eighteenth-century author of The Wealth of Nations opposed joint stock corporations. Smith argued that the interests of the directors and managers who supervised and ran such firms invariably clashed with those of the shareholders who owned them. As Smith explained this misalignment:

being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not of their master’s honour, and very easily give themselves a dispensation for having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.[12]

Besides citing the authority of Smith, Lowe’s opponents pointed to the transfer of risk entailed by limited liability to creditors, suppliers, customers, employees, and the wider community. Opponents also insisted that limited liability would encourage frenzied speculation in stocks. Vested interests, too, put forward arguments against Lowe. Well-to-do businesspersons were anxious about having to compete against organizations that could more easily tap equity financing than they could under the status quo. Status-conscious members among the higher socio-economic echelons of British society worried that a general right of incorporation would empower the poor to start up new ventures and upset the class structure.

The arguments that decided the battle in favor of Lowe’s cause were of the sort that one would expect to emerge victorious in a democracy. First, Lowe invoked the cause of individual freedom, a core principle of that regime. More precisely, he appealed to individual property rights, which implies a person’s entitlement to use their possessions in dealing and combining forces with others on whatever terms the parties can voluntarily agree upon. “The principle”, Lowe said, “is the freedom of contract, and the right of unlimited association—the right of people to make what contracts they please on behalf of themselves, whether those contracts may appear to the Legislature beneficial or not, as long as they do not commit fraud”.[13]

Coming to Lowe’s defense was John Stuart Mill, the greatest thinker of the period. Mill observed that the alternative modes of organizing production for big commercial undertakings consisted in choosing between the joint stock corporation and the government-run enterprise. While acknowledging the managerial incentive problems highlighted by Smith, Mill argued that these were slight in comparison to the shortcomings of socialized mass production. Now, it is true that history and current practice reveals state-owned corporations co-existing with democracies. But it usually only does so in a narrow set of industries whose import to the public interest can be pointedly and plainly drawn, such as public transportation and electrical utilities. A general policy of socializing large-scale activities would be in tension with liberal democracy’s commitment to private property. So it is no surprise that Britain’s democracy did not opt for that alternative against the limited liability corporation. Not sharing the upper-class anxiety that Lowe’s proposal aroused, Mill also contended that the helping financial hand offered to the poor argues in favor of making limited liability a general right. A century and a half of experience since Mill stated this argument has taught us that the poor are not so easily assisted by that right. Companies typically are only able to widely sell shares via an IPO after having already successfully operated for some time. They will have usually already obtained financing from the management’s personal resources along with family, friends, angel investors, and venture capitalists. Crowdfunding, in which entrepreneurs can raise equity funding through Internet platforms, may yet change this, but we must still await the final verdict on whether this will help the poor start and grow businesses. All this being said, the success of Mill’s debating move to tie the general provision of limited liability to the interests of the poor chimes with democracy’s devotion to equality.

Acclaimed as the Magna Carta of company law, limited liability was established as a right attached to incorporation in the Joint Stock Companies Act of 1856, subsequently brought under the 1862 Companies Act. One might question whether this legislation actually reflects the laissez-faire principles that Lowe advocated on its behalf.[14] A truly hands-off approach on the part of the government, it could be argued, would simply permit individuals to incorporate, enabling the resulting firm to be treated legally as a person. The company would then be left to obtain any limitations on its liability through contractual negotiations with whatever parties it opts to interact with in producing its goods and services. Such parties would include each of the governments under whose jurisdiction the company operates. These governments, in turn, would enforce the terms of the negotiated contracts through the courts. In any event, limited liability would very probably be a non-negotiable demand by corporations and so would end up being included in all its agreements. The state may as well automatically provide it and save companies the contracting costs. That it is non-negotiable is suggested by the fact that, even before Britain changed its laws, political bodies around the world, including the national governments of Sweden and France as well as the state governments of the USA, were compelled to offer limited liability in competing against each other for the economic benefits of having companies locate in their territories. In fact, the prospect of losing business to foreign jurisdictions was a not inconsequential factor that propelled the passage of Lowe’s Joint Stock Companies Act.[15]

This legal framework, along with similar legislation around the world, did more than just elevate the role of the stock market in the economy. Between 1863 and 1869, there were 4998 firms that registered as joint stock companies in Britain. By the 1910-1913 period, the number had leapt to 30,420, making for a tenfold increase in the rate of joint stock company formations from 714 to 7605 per year.[16] Not all these enterprises ended up with their shares listed on the stock market. Yet a good number did, inasmuch as the number of securities listed on the LSE soared from 500 in 1853 to over 5000 in 1913.[17] Comparable growth was witnessed in the USA on the NYSE, whose listings rose from approximately 114 in 1859 to around 600 during World War I.[18] At the same time this was happening, though, corporations grew to become mammoth organizations, dominating numerous industries as a result of consolidation. Adam Smith originally worried that the inefficiencies of joint stock corporations meant that they could not succeed without the state granting of a monopoly. It turned out instead that once such corporations were given full legal sanction, they would become, if not always technically monopolies, sufficiently close to it to worry many observers. J.P. Morgan’s investment bank financially engineered much of this concentration of economic power by arranging the required mergers and acquisitions, while managing the issuance of securities for the newly forged corporate giants. None of this would have been possible without the stock market and the combining of individual investor forces it brings about.

Commenting on democracies, Aristotle once observed that their attachment to equality was so paramount that they would ostracize for a time anybody in the community whose power was perceived to have become exorbitant.[19] In the late nineteenth and early twentieth centuries, the legal persons we call corporations, and the persons who led them (the robber barons being the pejorative term for them that has ever since stuck), naturally became the objects of this democratic suspicion. In the USA, this provided fuel to the progressive movement that sought an enhanced role for the state to counter what its adherents saw as the oppression and social injustices being perpetrated by a system of monopoly finance capitalism. Prior to World War I, the progressives could already point to a few successes. There was the Sherman Anti-Trust Act, passed in 1890 to prohibit anti-competitive practices and subsequently affirmed by the US Supreme Court against John D. Rockefeller’s Standard Oil, which the justices ruled had to be broken up. A few measures regulating working conditions and product safety were also implemented. So too, a good deal of the power that the New York commercial banks wielded over the money supply had been transferred to the Federal Reserve in 1913.

By this time, too, the progressives had largely succeeded in changing the definition of liberalism in American political discourse. In its classical expression, liberalism represented a posture of wariness toward the state. In its later progressive expression, liberalism came to embody a hopefulness about the state’s capacity to positively advance the public interest. In view of the etymological and historical connotations of the term “liberal”, the concept of freedom thus underwent a significant qualification in political thought. The older consensus frayed according to which the meaning of freedom encompassed liberty in the economic sphere in addition to the political and cultural realms of society. Economic freedom increasingly came to be seen as special pleading for large corporations to do as they pleased in controlling people’s lives. Inasmuch as stock markets made those corporations possible, it must be assigned a responsibility in redefining a key politico-philosophical notion associated with democracy.

  • [1] B. Mark Smith, A History of the Global Stock Market: From Ancient Rome to Silicon Valley(Chicago: University of Chicago Press, 2003), 11.
  • [2] B. Mark Smith, A History of the Global Stock Market, 15-16.
  • [3] Ranald C. Mitchie, The London Stock Exchange: A History (Oxford: Oxford UniversityPress, 2001), 32-36.
  • [4] Charles R. Geisst, Wall Street: A History From Its Beginnings to the Fall of Enron (Oxford:Oxford University Press, 2004), 11-14.
  • [5] Henry N. Butler, “The Contractual Theory of the Corporation”, George Mason UniversityLaw Review 11, no. 4 (1989), 99-123.
  • [6] Frank H. Eastebrook and Daniel R. Fischel, The Economic Structure of Corporate Law(Cambridge: Harvard University Press, 1991), 47.
  • [7] While there are numerous accounts of the South Sea Bubble, the most engaging is givenby Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds, 46-88.
  • [8] Ron Harris, “The Bubble Act: Its Passage and Its Effects on Business Organization”, TheJournal of Economic History 54, no.3 (1994), 610-627.
  • [9] John Micklethwait and Adrian Wooldridge, The Company: A Short History of a RevolutionaryIdea (New York: Modern Library, 2005), 47-49. This book provides the most succinct andaccessible account of the origins and evolution of the limited liability corporation.
  • [10] For an account of this debate, see Andrew Gamble and Gavin Kelly, “The Politics of theCompany”, in The Political Economy of the Company, eds., John Parkinson, Andrew Gamble,and Gavin Kelly (Oxford: Hart, 2000), 29-34; Paul Halpern, Michael Trebilcock and StuartTurnbull, “An Economic Analysis of Limited Liability in Corporation Law”, University ofToronto Law Review 30, no. 2 (1980), 118-119; John Micklethwait and Adrian Wooldridge,The Company, 49-52.
  • [11] Laybourd, Keith. British Political Leaders'. A Biographical Dictionary (2001) ABC ClioSanta Barbara, California pp. 210-211.
  • [12] Adam Smith, Wealth of Nations, V.i.e.
  • [13] Robert Lowe, Law of Partnerships and Joint Stock Companies, Hansard, February 1, 1856
  • [14] Tibor Machan, Libertarianism Defended (Hampshire, UK: Ashgate, 2006): 304-305.
  • [15] John Micklethwait and Adrian Wooldridge, The Company, 50—51.
  • [16] Ranald D. Mitchie, The London Stock Exchange, 93.
  • [17] Ranald D. Mitchie, The London Stock Exchange, 95.
  • [18] Giesst, Charles R. Wall Street. A History, 47 & 267.
  • [19] Aristotle, The Politics, Bk. III, Chap. 13.
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