sou · GOB311d5 · 2001-01-01 00:00:00 — By doing so, the Crown recognized the legislative supremacy of Parliament and also the necessity of parliamentary consent for a standing army in peacetime. Given that Parliament represented both the moneyed interests of merchants and financiers (the Whigs) and the landed gentry (the Tories), it was clear that property and financial contracts would be much more secure against the depredations of the Crown. Equally important, without a standing army, the Crown had no way of imposing its wishes on Parliament. Finally, the existence of an independent judiciary enforcing common law further strengthened the hands of public creditors against the Crown. As political economists and argue, the credible commitment not to interfere with property rights led to the development of government finance. So, somewhat paradoxically, as sociologist argues, the internal weakness of the English Crown allowed it to raise large sums at short notice, giving it external strength and transforming into a first rate European power. It did, however, take time for the English Crown to gain credibility, even after the Glorious Revolution, especially because of previous events such as the Stop on the Exchequer, when suspended debt payments amounting to about $ 1.3 million pounds (at a time when annual Crown income was less than 2 million pounds).43 Therefore, much of its initial funding was not direct but through large companies, prominent among which were , the , and the . By 1712, these three companies had loaned 15.8 million pounds to the government, which was approximately 62 percent of the funded debt.44 Each of these companies was granted a monopoly, which, in effect, was an indirect tax on the people. 43Carruthers, p. 44Carruthers, p. Volym D:102 Supplement 24 SOU 2000:11 over note issue, the East company had a monopoly of trade with the Indies, and the obtained the monopoly over trade with the South Seas (a monopoly which turned out later to be of value). In order to secure and preserve these monopolies, the companies repeatedly loaned money to the Crown. Thus the early joint stock company was set up, in part, as a device for the Crown to transform future monopoly rents into current funding. Since the shareholders of these companies were many, and included many prominent members of Parliament, the commitment made by the Crown (with the acquiescence of Parliament) to the companies was secure. While shareholders of the companies knew that they were secure from government expropriation, it was less clear that the management of the companies could not fiddle with the accounts or otherwise exploit investors. The absence of corporate governance would surely have hurt the companies' ability to raise money from investors, and thus also hurt the government, which depended so much for funding from these companies. Therefore, it was in the interests of the government to ensure the public investor was protected. Moreover, the companies were so intertwined in politics that it was almost inevitable their governance would resemble the emerging democratic political process. This was especially so because the two strong competing political parties each wanted a share of the power and patronage that came with control over the companies. As a result, early corporate charters, to which the Government had to give its assent, ensured that the directors of and the were elected. Even though voting was restricted to those who had a substantial stake – the allowed only those with over in shares to vote – the election of directors was a serious event, and trading at the time of the election of directors was , and especially so in blocks over 500 pounds.45 The negative influence that a strong government can have on corporate governance can also be seen in some periods of British History. After unsuccessful attempts at gaining control through elections over and the in 1710-11, the government of , which was backed by an overwhelming majority in Parliament, introduced a bill proposing the . Unlike the other two prominent companies, the power to appoint the first court of directors was vested in the Queen, with becoming governor. Thirteen of the appointed directors were from the list of unsuccessful candidates for the Bank and elections. Of course, could not completely 45 Carruthers, p. Politics, and Financial Development Volym D:103 antagonize the Whig moneyed interests because they were the primary source of funding, so some investor protections were built in. The point, however, is to suggest that the initial fortuitous political climate in , as well as the need for government finance, led eventually to the development of governance of joint stock companies. As the political scientist and historian, puts it, the four great differences between the absolutism of the king of [in the seventeenth century], and the relative limitation of the English monarchy werethat the former could strike taxes and make laws at pleasure and was served by a standing army and paid professional bureaucracy. There was a consistency in these powers. The King could levy new taxes, which the bureaucracy would collect, with the threat of the standing army always in the background to enforce payments. Taxes, though, take time to levy and collect, especially when the bureaucracy is as inefficient as the French then was. Thus the Crown had to borrow to finance wartime expenditure. A number of economists and historians have argued that the immense power of the French Crown, and its past record of defaults, prevented it from raising loans directly from the public. Furthermore, it was impossible to protect investor rights because of the unlimited personal authority of the king. Instead, the French Crown raised money at short notice in two ways. First, it borrowed through lesser state bodies such as the de . The advantage of borrowing through these lesser state bodies is that, unlike the king, they could be sued in court.46 Of course, since the King ultimately also had power over the courts, this turned out to be a protection of doubtful value. Second, the sale of venal offices was another source of funding. The purchaser paid for the office up front, and made additional investments down the line to acquire additional powers. In return, the government paid an annual interest, and conferred status (occasionally, minor nobility) on the purchaser. In the 1660s, forty six thousand offices had been sold (with many offices being split over time as the need for new funding arose) for an amount approximating four to five times the annual revenue of the crown. Of course, there was no requirement that the purchaser be qualified for the 46 valuable was the right that if a city failed in its obligations to a creditor, the creditor could take actions against the person and property of any citizen of that city who fell in his power. Thus cities that traded a lot obtained the ability to borrow by giving creditors this extreme power. Volym D:104 Supplement 24 office, and since many of these offices included actual duties such as collecting taxes or serving as magistrate, the efficiency of administration fell over time. Nevertheless, unlike loans to the crown, the offices carried their own security since the Crown could not do away with them with destroying a substantial part of the administrative machinery. The French Revolution did not change matters much because, while power was taken away from the crown, it was concentrated again in the central government. The French did not have a true parliamentary democracy until the constitution of the Third Republic was passed in 1875.47 It is useful to see the effects on two major components of a modern economy – limited liability corporations and the banking system. For reasons of space, our description will only be a sketch. The legal forms of business organization permitted by the French Civil Code of 1807 were simple partnerships, limited partnerships in which only the partners had unlimited liability, and true joint stock or limited liability companies. In order to incorporate as a limited liability company, a firm needed special permission from . This body granted charters sparingly, and usually only to industries it deemed in the public interest.48 It was not until the depression of 1857, and under pressure from the now strong industrial interests that the state was persuaded of the greater resilience of limited liability companies, and passed laws in 1863 and 1867 that allowed free incorporation. Contrast this with the developments in . While the Bubble Act of 1720 did place constraints on the incorporation of limited liability companies, common law courts made their own judgement as to which companies did not contravene the spirit of that law. So, for example, in 1811, the issue of widely held, and transferable, common stock by an unincorporated bread manufacturer was deemed to be legal.49 Since allowing the transfer of a stock essentially implied that its previous owner could not be held liable for the firm's debts, this judgement allowed limited liability for a venture if its intent seemed honorable. Therefore, even though the Bubble Act was repealed only in 1825, and companies could get limited liability without the necessity of a charter from the government in 1855, common law allowed many of the trappings of limited liability to corporations much before then. There are two important points to reiterate from this discussion. First, common law allowed more legal and financial innovation (for example, in corporate form). Second, the civil code could speedily adopt 47Finer, p. 48Cameron, p. 49Powell, p. SOU 2000:11 Politics, and Financial Development Volym D:105 innovations that emerged under the common law system when it so desired. It took over a century and a half for the common law system to work out the limited liability form to its satisfaction in 1855, and at the risk of some understatement, only about a decade for the French civil code to adopt the main outlines of this legal innovation. This then reinforces our claim that the greater ability to innovate is, by itself, not the reason the common law system financial development. Instead, it is partly the ability of the decentralized common law system to innovate around the political impediments placed by the center that enable it to financial development. By contrast, in civil law countries, the centralized control of the legislative process ensures that the powers that be can stand in the way of anything against their interests. To illustrate this point, consider the differences between the broad actions of and those of . After came to power, he sought a ready source of credit. Given the success of in mobilizing credit for the English government, a bank seemed a natural device. was capitalized at , but unlike , had difficulty placing its shares in spite of the personal example of the First Consul and his decree requiring government agents to purchase shares and deposit their surplus funds in the Bank; almost two years elapsed before the entire capital was paid in. was more than an extension of the government (perhaps indicating why it had difficulty raising capital), and it had extensive demands made on it. With the fall of the Empire in 1814, the Bank went into virtual liquidation. While there were some moves to privatize the Bank at this point, the Restoration government felt it was too valuable a resource to lose. As Baron , the then Finance minister told the representatives of the want to be independent, but you will not; you will have a governor, I will name him, and he will not be the one who currently occupies the post. Between 1800 and 1848, stood as a bulwark against financial development because competition threatened its position.52 opposed the setting up of joint stock banks. It initially resisted setting up its own branches in other cities, and did so only the cities started setting up competing . But having determined to expand outside , it quickly got the government to refuse to charter any new banks. It also took advantage of crisis to take 50Cameron, p. 51Cameron, p. 52Cameron, p. Volym D:106 Supplement 24 over competing note issuing banks (obviously with government support) so that in 1848, its monopoly over note issue extended over the whole of . Interestingly, it was only after the Revolution of 1848 that financial development resumed. Again the reason was political. As economic historian, Rondo puts it, the characteristic institution of the Second Empire, the Societe Generale de , also came into existence in 1852 as a part of the government's attempt to provide a counterweight to the influence of and the financiers of the haute banque, most of whom were hostile or at best lukewarm to the new regime. Finally, even though the monopoly of was slowly whittled down, it had lasting effects. this failure [to reorganize the commercial banking system], which affected even large enterpriseswas especially serious for the numerous small industrialists who could not interest the great bankers in their enterprises or, if they could, feared loss of control and independenceThus resulted the schizophrenic development of French industry and commerce, traces of which can still be seen today: on the one hand a highly capitalized, technically efficient and progressive sector, on the other a sector composed of small firms, undercapitalized, traditional but tenacious. The contrast with is striking. While had similarly tried to protect its privileges against encroachment, it was far less successful because it was a private entity, because it was in the interests of the Tories to see its powers contested, and because the common law system allowed alternatives like the country banks to emerge. As a result, there was far more competition in financial services, with attendant benefits to industry. 7.4British and Spanish colonies The differing degree of centralization and the nature of the powerful elite can also explain why the financial development of British colonies today appears so much greater than those of former Spanish colonies. As historian argues, the English were either escaping religious or political persecution, or trying to improve their lot. They immigrated in entire communities, with people from every social strata and skills represented. A goodly portion represented non-conformists, indentured servants, and even convicts. Thus, the homogeneous social composition of English colonies favored a political consensus for financial development, as did the entrepreneurial spirit of the early colonizers. SOU 2000:11 Politics, and Financial Development Volym D:107 The English colonies also benefited from a weak and decentralized Government. Their political system reflected the tension between Crown and Parliament, leaning to the Parliamentary side. The colonies were certainly the of the Crown, and yet not one colony lacked a legislature whose minimalist function was to set taxes.53 In fact, some colonies were essentially joint stock corporations, with the original charter providing that the Governor and his eighteen assistants had to be elected annually by the stockholders and furthermore, requiring quarterly meetings of the entire body. The English government essentially viewed the Empire as a huge trading organization, and interfered with the activities of the colonies only in so far as it affected trade.54 The Spanish colonies were quite different. The Spanish immigrants were for the most part, adventurers, soldiers and officials, in short, a ruling stratum. 55 Their purpose was largely extractive. As puts it 56 It was the sacred thirst of gold that carried Oieda, Nicuessa, and de [to ]. Whenever those adventurers arrived upon an unknown coast, their first enquiry was always if there was any gold to be found there; and according to the information they received concerning this particular, they determined either to quit the country or to settle in it. The of uncountable wealth implied that the Spanish Crown always had a strong interest in its colonies. Spanish colonies were organized as hierarchies directly under the control of Castile. All important decisions, as well as many unimportant ones, were made in , and a stream of rules and laws flowed to the colonies with the purpose of binding and guiding the administration. The Spanish, therefore, transported their hierarchical system and their aristocracy (at least the attitude and mentality of their aristocracy) to the colonies. The deficiencies of the centralized system that we have referred to earlier, again demonstrated itself. , with typical understatement, writes57 53Finer, p. 54Finer, p. 55Finer, p. 56Smith, Book IV, Chpt VII, p. 57Smith, Book IV, Chpt VII, p. Volym D:108 Supplement 24 The Spanish colonies, therefore, from the moment of their first , attracted very much the attention of their mother country; while those of the other European nations were for a long time in a great measure neglected. The former did not, perhaps, thrive the better in consequence of this attention; nor the latter the worse in consequence of this neglect. And later,58 There is more equality, therefore, among the English colonists than among the inhabitants of the mother country. Their are more republican The absolute governments of , , and , on the contrary, take place in their colonies; and the discretionary powers which such governments commonly delegate to all their inferior officers are, on account of the great distance, naturally exercised there with more than ordinary violence. Thus the English colonies were set up in such a as to facilitate the political forces leading to financial development. By contrast, the colonies of (and ) accentuated the forces that served to hinder financial development. 7.5The Contrast with the An interesting, middle of the road, example is represented by the . The Union of in 1579 created a decentralized structure where the members of the States General, the national parliament, were selected by the different provinces. Delegates had to refer back to their respective provincial assemblies often for instructions.59 Even though the Dutch was one of the most heavily taxed people, the United Provinces did not have a centralized tax system. Money was raised at the provincial level and then funneled to the center. Each province had a quota, and extraordinary wartime expenditures were appropriately shared. Large and sudden expenditures were financed through public borrowing. The Dutch government, unlike the English Crown, established a reputation for servicing its debts quite early. In part, this was because the democratic tradition emerged earlier, allowing political curbs to be placed on the powers of the government. Since government debt was widely held (around 1670, the Dutch Mercury stated that in the province of alone, there were 65,500 persons who had or were able to invest money in annuities), much of it by the ruling elite, there was 58Smith, Book IV, Chpt VII, p. 59Carruthers, p. Politics, and Financial Development Volym D:109 chance that the government would willingly default on its debt.60 In fact, investment in home securities was so popular that it was often considered a favor to be allowed to invest in them; and repayment was a source of regret and even called forth tearful remonstrances from creditors, because in no other place could money be put out so quickly and safely. Contrast this reputation with that of the English Crown before the Glorious Revolution. It is no wonder that the Dutch government could borrow at an interest rate of 4 percent while had to pay up to 12 percent on his borrowing.62 Even after the Glorious Revolution, the English Crown had to establish a reputation for repayment, and convince investors that their power to secure repayment was adequate, before it could borrow large long term funds directly from the public. As a result, it had to rely substantially on the joint-stock companies for funding. By contrast, the Dutch Republic, which could borrow directly, never felt the urge to convert public debt into company shares. In fact, several provinces and cities like , , and , forbade the of new joint stock companies.63 So both in and the Dutch Republic financial development could take off because the elite wanted it and power was decentralized. The major difference between the two countries was in the political strength of the two Governments. The English Government, caught in the struggle between the Crown and Parliament, was politically weak. The Dutch Republic, instead, could count on a strong popular base. Thus, it had no need/incentive to favor the formation of investor friendly corporations. A second difference was that even though the Dutch parliament was indirectly elected, it was firmly under the control of the provinces, and by extension, influential investors. This then seemed to be an adequate means of governing the (also known as the VOC), the largest and most famous of the Dutch joint stock firms. Operating control of the VOC was vested in 17 directors, 8 of whom were nominated by , 8 by the other large provinces, and one directorship rotated among the smaller provinces. In short, since the state enjoyed the confidence of the public (at least, the influential among them), there seemed need for a separate governance structure for corporations. Shares had no voting rights, and trading was especially at dividend time, in contrast to the English common stock companies where trade was especially 60Carruthers, p. 104-106, , 350-351. 61Ehrenberg, p. 62Carruthers, p. 63De Vries, p. Volym D:110 Supplement 24 important at the time of election of new directors.64 Because of the greater credibility of Dutch public governance, independent corporate governance did not develop in the Dutch Republic to the extent that it did in . 7.6The Triumph of the Bourgeoisie On the basis of the historical account so far it is hard to separate the influence of the legal system and that of politics. As puts it, Fortunately for , the law was sufficiently loose and its administration sufficiently lax that the obstacles to innovation were not insurmountable. 65 So was it the law or was it politics? Only the subsequent events of the 19th century provide us with a chance to disentangle the two effects. During the 19th century the opportunities provided by the Industrial revolution made it extremely costly not to have an efficient financial system. At the same time, various Revolutions brought the bourgeoisie in power in most countries in Europe. In fact, according to (1848), governments became business committees of the bourgeoisie. Thus, by looking at the level of financial development of the most important developed countries at the turn of the century we can distinguish the two hypotheses. If the main explanatory variable is the legal system, then countries with a common law system should stand out for their level of financial development. By contrast, if politics is important, then all developed countries should have a similar level of financial development. The evidence reviewed in Section 6 is supportive of the latter interpretation. Besides , which, thanks to the early move, continued enjoying the benefits of being the financial capital of the world, all other developed countries had a similar level of financial development. Interestingly, many countries that today had underdeveloped markets, back then had very flourishing markets. Thus, a persistent variable, like the nature of the legal system, cannot by itself explain the retreat of the market. It can, however, if coupled with a change in the political environment. This is what we are going to explain next. 64Neale, p. 65Cameron, p. Politics, and Financial Development Volym D:111 World War I and its aftermath changed everything.