sou · GOB311d5 · 2001-01-01 00:00:00 — Before interpreting the data, three caveats are necessary. First, the 1913 datum for the is in fact from 1923 (earliest available). Second, the 1913 reported datum for the represents domestic issues only, foreign subscriptions are five times as large. Finally, the 1913 data represent the actual issue value only for the , the , and . For the other countries they represent the nominal value, which is a lower bound for the issue value. Thus, they would underestimate the true value. and appear as the biggest equity issuers, roughly of GDP. , , , and the are in second position with roughly of GDP. , , and are last with roughly . These results seem to confirm the one from Goldsmith reported in column III of Table 2.B. Again, it is very difficult to see a clear difference between Common countries and Civil countries. Since the data, albeit collected from different sources, are fairly homogeneous, we can also attempt an intertemporal comparison. The importance of equity issues seems to have dropped dramatically in , , , , , and . It has remained in the , , and the . It has dropped a in the . It is possible that this might reflect only seasonal factors. In , for instance, equity issues have been curtailed in recent years, following a severe drop in the index. If we exclude , the major drop is concentrated in . Is this just a coincidence or a more generalized phenomenon? Politics, and Financial Development Volym D:91 To explore this issue we make use of a third source. We obtained historical stock market capitalization data from , a company that specializes in collecting historical financial information. It claims to be the most extensive, comprehensive collection of financial historical data in the world. Yet, their coverage of market capitalizations around the world is quite sparse in the earlier part of this century. Data for the starts in 1900, for the in 1924, for the major countries in 1929, for in 1930.38 In addition, we purchased data on stock returns from them, which are much more complete and start from the 1910s. Thus, we can compute the ratio of stock market capitalization to GDP for several countries in 1929. In order to obtain a measure of stock market capitalization for 1913 we extrapolated the data backward for a number of countries in two ways. The first simply takes the earliest datum available and extrapolates it backwards to 1913 using the return of the local stock market index. This estimate is correct if equity issues equal to delisting at every single point in time. There are biases. Delistings (other than mergers which would have no effect for our purposes) probably take place at very low values of a stocks capitalization, so they would have relatively minor effect. Issuances take place at high stock market values. So a more conservative estimate is to subtract the League of Nation data on equity issues from the final value of the stock market capitalization before extrapolating the data back using the actual return on the index. If equity issues were typically made when the market was high, we understate capitalization in 1913. of Nation data start for most countries in 1913, but it does not report the information for the years 1914-1922. These are the years surrounding WWI where we do not expect many issues.39 These data are reported in Table 4. 38Interestingly, for a number of European countries data on stock market capitalization are available before WWII, but not after it until the 1970s. This, by itself, is a good indicator of the drop in importance of the equity market in these economies. 39Because the data on the market capitalization of the (later Amex) starts only in 1938, in previous years we inflated the value of the capitalization by the ratio of the value of the Curb and the value of the in 1938. Volym D:92 Supplement 24 Evolution of Stock Market Capitalization over GDP 1913 (a) 1913 (b) (a)assuming equity issues= delistings (b)assuming equity issues = data from league of nations and delistings = 0 Sources: , League of Statistical Yearbook, Goldsmith (for GDP data). A few facts are worth noticing. First, the enormous value of the ratio in . Note that this is not an estimate, but the actual datum. In the U.K. the magnitude of the ratio between stock market capitalization and GDP peaked in 1929, to drop dramatically in later decades. In fact, in 1960 this ratio was only . It would be useful to keep in mind that this was the period of nationalization in . Once we take out the , there is no difference between the rest of the countries. In fact, the relative size of the stock market in many European countries exceeds that of the . Although the coverage is not continuous, in Table 4 we can follow the behavior of this indicator through the different decades of this century. Interestingly, all the countries experienced a major drop in the importance of the equity market after WWII. This is not true only of the defeated countries, but also of the . Only in the did the stock market regain its pre-war level of importance quickly. In all the other cases, the ratio in 1997 was below the ratio in 1913. The overall results are striking. So striking that one worries they might be a statistical artifact. To eliminate this suspicion it would be useful to have some microeconomic evidence that the effect macro statistics are capturing is indeed real. Such evidence is provided by Politics, and Financial Development Volym D:93 Calomiris (1994). He compares the underwriting costs of new equity issues in and in the at the beginning of the century. Underwriting costs can be considered a proxy for the efficiency of capital markets (the smaller the cost, the higher the efficiency). The spread charged by U.S. banks on issues of common equity was about , while the one charged by German banks was only . This would also explain why between 1896 and 1913 German firms issues substantially more equity than U.S. We started this work noticing the variability of various indicators of financial development across fairly homogenous countries and we asked why such differences existed. We can rule out at least one answer, with all the caveats about not having enough data to perform tests of statistical significance. Differences in the nature of the legal system cannot be directly responsible. The legal system did not change over the decades, so why did the level of financial development? To explain why and are less financially developed than the today, we do not have to look at the distant past. We need to understand what happened in between the two wars, that changed the course of financial history. Having ruled out the other major causes, we are left with only one: politics. This is what we explore next. Volym D:94 Supplement 24 6A Political Economy of Financial Development Given all the benefits of financial development, it is somewhat surprising how few countries in the world have sophisticated financial markets. Clearly, a well developed legal, accounting, and regulatory infrastructure are necessary for a well functioning financial system. Why dont countries copy more successful models? Fixed costs, while initially important, are not a major impediment in the long run nor, as we have argued, is the nature of the legal system. The impediment, we believe, is to be found through an analysis of the political economy of financial development. In this section, we attempt a simple calculus of consensus à la . The two main players in this analysis are the interest groups and the Government. Interest groups pressure the government to favor them. The nature of the government – whether democratic, oligarchic or a monarchy – will determine which group has more saying and to what extent its wishes get translated into actions. Until the beginning of the 20th centuries governments were at best oligarchic. Thus, the calculus of consensus can be limited to the dominant elite, which had the biggest impact on the government. In the 20th century the analysis is further complicated by the growing influence of the masses. But the government does not simply reflect the wishes of the dominant interest group, it also has its own agenda. This is clearly the case in a monarchy, but also in a democracy where the entrenched government bureaucracy has its own perks and survival at stake. Thus, asking why some political systems oppose financial development is tantamount to asking why some influential groups or the Government (or both) oppose financial development. 6.1Why the Dominant Elite Development? To illustrate in a simple way the various political forces at work, we assume that there exists a magic law able to eliminate all the imperfections present in a real world financial market, transforming it into a textbook-like perfect capital market. This fiction will allow us to Politics, and Financial Development Volym D:95 study, in a highly stylized framework, who will gain and who will lose by an improvement in financial markets and, thus, identify supporters and opponents of financial development. It will also identify when this opposition is more likely to be successful and what forms it might take. One of the main consequences of the approval of our hypothetical law will be a reduction in the rents from the ownership of current resources; In an imperfect world , some own-capital is needed to fund projects – outsiders do not have the information or control to fund a hundred percent. By contrast, in a perfect capital market, projects can be funded entirely from financiers, and the proverbial inventor in a garage can bring his ideas to fruition without possessing any family wealth. Thus, the approval of our hypothetical law will have two main distributional effects. First, people with an initial endowment of resources, whom we will call the rich (or equally, the well-connected) will no longer earn an excess return because only they can get opportunities financed. Second, competition in output markets will increase because of increased entry from those wealthy in ideas, diminishing the rents existing producers might have enjoyed. Since existing producers tend to be owned by todays rich, the rich will lose again. Another distributional consequence of the approval of our hypothetical magic law would be the loss in value of reputation. In a perfect capital market, i.e. a market with perfect disclosure and perfect enforcement, reputation is worthless. By contrast, in a world with no disclosure and no enforcement, investors will have to rely exclusively on the reputation of the issuer. Thus reputation, very much like the initial endowment, becomes necessary to start any economic activity. But reputation is something that takes time to accumulate, cannot be purchased, and can be transferred to others only with difficulty. Since the rich or well-connected typically are better known, they will lose from an increase in transparency and enforcement. Capital markets also tend to point out inefficiencies and cross- subsidies, and increase the risk that underperformance will be penalized. Moreover, they are brutal in that they do not recognize past investment or favors unless explicitly contracted for. If contracting is imperfect, those who are likely to underperform, or legitimately fear the risk that they might underperform, will lose from financial development. Of course, a perfect capital market increases the availability of funds for profitable projects and it improves the return on capital invested. These benefits occur to everybody. Thus, the extent of opposition depends on whether the share of benefits a particular group can appropriate is sufficiently large to compensate for the losses suffered. Volym D:96 Supplement 24 For example, if the rich have become so because they had ideas in the past, and will continue to have them in the future, the benefit produced by an increase in the number of projects they can undertake will more than compensate for the reduction in the value of their initial endowment. By contrast, if the rich made their money in the past through passive ownership of resources such as land, the loss they suffer in the value of their endowment and reputation may dominate any gains. In other words, an economy dominated by self made entrepreneurs is likely to push more for financial development than an economy dominated by the landed gentry. 6.2Financial Markets and the Government The development of financial markets affects the governments own agenda. On the one hand, it makes it easier for the government to raise financing. On the other, it creates private sector competition for the funds of citizens and foreigners, which may reduce the governments share or increase its cost of funding. Some governments may find it better to keep the market underdeveloped so that citizens have no option but to park their funds with it (or its agents). Of course, the system of government affects its willingness and ability to intervene. A centralized power is the biggest impediment to financial development. When the property rights of citizens are not well developed, strong governments cannot commit not to expropriate. Almost by definition, financial markets and institutions tend to concentrate a lot of wealth in one place. In so doing they make it easy for the Government to grab resources at a very low cost (or, in more modern terms, to collect taxes at a low cost).40 Of course, the Government incentive to expropriate the financiers depends crucially on who the financiers are and who controls the Government. A monarch supported by the landed aristocracy typically found irresistible the temptation to expropriate the financiers from the city, especially the foreign Lombards and the Jews. By contrast, law bound (and weaker) 41Governments cannot expropriate, allowing finance to flourish. Even when naked expropriation is not possible, one cannot escape the fact that powerful centralized governments usually have agendas. 40See and (1998). 41This shows the power of anti-usury laws in preventing financial development. Not only did they prevent a large fraction of the population from entering the financial markets, they also made it easier to the monarch to expropriate the financiers. Politics, and Financial Development Volym D:97 markets typically have only one agenda, to make money. It is always tempting for the government to alter the rules of the market so as to direct the resources of the market in a favorable direction, rather than pay the appropriate price. This is especially true when the government faces an outside threat to its survival – when it wants to transform the entire economy into a command and control system because that, rather than uncoordinated markets is the quickest way to mobilize resources. The long term damage to markets can, of course, be considerable. For example, centralized power has an incentive to create oligopolistic banking systems to replace financial markets, because these can be persuaded with favors and threats unlike an arms length market. Moreover, once created, hierarchies are concentrations of power, and unlike dispersed markets, can coordinate to oppose change. Markets also require and create a high degree of transparency, which can highlight the inefficiency of the actions of centralized power. This is inconvenient, especially in a democracy (democracies, of course, can be centralized). Finally, centralized power might undertake activities that would otherwise be undertaken in the private sector and further the development of markets. For example, a railway system became imperative for a countrys infrastructure during the 19th century. As already mentioned, this spurred the rise of financial markets in the . In many European countries, however, the fear the private sector would lag behind in railway construction lead to direct Government intervention. By directly financing the construction of railways, the Governments may have overcome the short term disability created by inadequate private financial markets, but unwittingly prevented the emergence of private institutions that would have found railway financing a good way to overcome fixed start-up costs, with negative long term consequences. Similarly, during the 16th and 17th centuries the power of the Spanish fleet, which protected the ships traveling back from the New World, eliminated much of the need for insurance This greatly retarded the development of the insurance markets in as compared to or the Netherlands.42 42 (1998). Volym D:98 Supplement 24 6.3Interaction Between Politics and the Even if the nature of the interest groups that hold political power at the center or the Government own agenda are the primary determinants of financial development, the legal system can play an important role, by affecting the influence these groups have. In particular, there are several reasons why the Common system can better resist the political pressure against financial development. First, the English common law tradition emphasizes restraining the government and protecting the individual, making more difficult for the Government to interfere with private property. Thus, in the early stages of financial development, Common helps protect the rights of the individual against the state, and hence fostered the development of private finance. Second, Common evolves at the periphery, and innovates around legislative or administrative roadblocks set up by the center. In , for instance, in 1720 an act of legislation (the Bubble Act) placed constraints on the incorporation of limited liability companies. Common law courts, however, made their own judgement as to which companies did not contravene the spirit of that law. Thus, the decentralized nature of decision making enables Common countries to overcome the anti-market dictates of the Government. Finally, Common is based primarily on judicial precedent, rather than upon the act of a legislator. Thus, a new political climate is less able to transform the structure of the law. For example, attempt to cartelize the U.S. economy failed not because of political opposition, but because of the resistance of the U.S. Supreme Court, which struck down several key pieces of the New legislation. In European and in Governments did not find such resistance and successfully cartelized many sectors, starting from the banking one. Politics, and Financial Development Volym D:99 In the previous section we concluded that there are two important factors determining the likelihood of financial development: the calculus of its costs and benefits for the different political constituencies and the power and centralization of Government. In what follows we undertake a brief historical analysis of the conditions surrounding the emergence of major financial centers to verify whether they are broadly consistent with the predictions we highlighted. Till the late middle ages, the dominant elite in many European countries were the landed aristocracy. Traditionally, farming was a very low- capital intensity business, but for the cost of the land itself. The aristocracy inherited the land or received it from the Crown, in return for which it met its feudal obligations. There was to benefit from a financial system; Trade was considered degrading (itself evidence of a cultural bias against new comers), and most wealth was embodied in land, which generated investible surplus. However, the aristocracy had a lot to lose from financial development. First, the emergence of a merchant class could jeopardize its political domination. Second, the ease of access to external funds in the absence of profitable investment opportunities could translate into a surge of luxury consumption by the young nobles eventually leading some aristocratic families losing their land. This would have lead to a separation between land ownership and nobility, which could undermine the stability in the ruling elite. The to prevent such disruption can explain why, in a society dominated by nobles, it was so difficult, if not impossible, for the nobles to sell their land. Contrast this with , the epitome of the Italian city-state. was born as an insular power, with no territory on the mainland. As a result, the aristocracy who ruled the Republic were essentially mercantile, and could benefit greatly from financial development. Not surprisingly emerged in the late Middle Ages as one of the financial capitals of the world, the cradle of major financial innovations. Double entry book-keeping was invented there by Fra , as were certain insurance contracts. The Venetian commenda, a Volym D:100 Supplement 24 form of limited partnership, is also the most direct ancestor of the modern joint stock company. Venetian Public Debt was bought by foreigners, drawn by reputation for servicing it through thick and thin – in fact, served as the equivalent of Swiss Banks of our time, holding funds with no questions asked. It is also not coincidental that power in was surprisingly widely distributed among the citizenry, considering the times. was a republic with checks and balances on the power of its government. Its executive, legislature, and judiciary, right up to the Doge, were elected, and except for the Doge who was a life appointee, held tenure for only a short time. The short tenure not only protected against incipient dictatorship, it also ensured that all eligible citizens got a turn at governance. There was always a strong chance that the roles would be reversed in the near future when a supplicant faced an official. This implied that governance, at least for eligible citizens (approximately one fortieth of the entire population) was likely to be fair. As insurance, those that displayed dictatorial tendencies while in office were often banished. Consistent with the political theory, all the early financial centers of the Modern world, starting with and , going on to and the cities of the , and culminating in , emerged in independent political entities controlled by the bourgeoisie (bourgeois literally means inhabitant of the city). The bourgeois was not a landlord but a or a merchant, who needed access to external funds to finance his working capital. By contrast, none of the political centers of big and powerful centralized states (, , or ) emerged as important financial centers. was the first of the large nation states to have a well developed financial system, and was at the center of it. How did emerge as a financial center in the 17th and 18th centuries? In part, it was the devastation produced by the two Dutch-Spanish wars during the 17th century, which significantly weakened . But it was also the fortuitous coincidence of the two crucial catalysts predicted by the theory: an elite who could benefit from financial development and a weak Government. We review them in turn. In , as in most other Nation States at that time, the dominant elite was the landed aristocracy (gentry). But unlike other States, the English landed aristocracy in the 17th century could benefit from a development of the capital markets. The agricultural revolution, started Politics, and Financial Development Volym D:101 by the enclosure movement, transformed British agriculture into more of a business. And as a modern business, British agriculture required capital and generated a surplus that could be invested. Thus, British aristocracy, unlike aristocracy elsewhere, had valuable opportunities to invest extra funds and, after the initial dividends, more funds to be reinvested in the capital market. This made it better disposed towards the development of a financial system. One should also not understate the strength of the mercantile constituency, fortified by prowess. At the same time, financial development was facilitated by the weakness of the British Crown. The Glorious Revolution of 1688, which put and on the throne, also forced them to agree to a .