Industrial Revolution to Present
It is over the last two centuries that we have seen an exponential growth in capital markets and capital formation. The key to this growth has been the creation of mechanisms that allow for the aggregation of enormous sums of capital for large enterprises. Other than the owner’s personal equity, nearly all business financing was secured in the form of debt up until the nineteenth century. What changed?
The European discovery of America in 1492 set off a global expansion of trade. For at least the next two centuries mercantilism held sway as the dominant economic way of thinking. According to mercantile thought, there is a fixed sum of wealth in the world. The way to power and wealth was to amass capital and keep it within the nation. Domination and extraction of resources were the operative policies of all European nations when it came to international commerce although it was especially pronounced with Spain and Portugal. It was essentially an extension of the rent-seeking mentality inherited from feudalism.
As trade expanded, the need to finance ever more complex and risky ventures began to develop. In response, the Dutch led the way with the joint-stock company. A company, like the Dutch East India Company (formed in 1601) would be given a monopoly for trade in a certain region. Individual investors could buy dividend paying shares. The British and others soon followed but the Dutch with their highly developed financial markets had a distinct advantage. (Many forget that the Pilgrims were living in Holland prior to their departure for America and they organized as a British joint-stock company. In fact, an issue that plagued them for years was that they had made landfall and settled north of the area they had been given a patent for, placing their territorial claims and economic improvements in jeopardy.)
Most of the seventeenth century was a time of great turmoil in England while Holland was under constant threat from France. The turning point was the Glorious Revolution in 1688 when Willem III of Holland was invited to assume the British throne as William of Orange. With him came a number of Holland’s best financial minds. Part of the Agreement was that Parliament would have supremacy in law and in exchange the monarchy would receive regular funding. The combination of Dutch financial expertise and British rule of law, especially with regard to property rights, spelled the demise of the Dutch and the rise of the British as the financial center of the world.
The British had yet another advantage in their rise to financial power. Before the Renaissance, Britain was viewed much like a giant sheep ranch, supplying wool for markets in Italy and Holland. By the end of the fourteenth century, the British developed water wheel powered fulling mills and were making their own high quality cloth for export. These mills needed streams and rivers making it a highly decentralized industry. With the absence of feudalism that dominated rural continental Europe and the lower cost of rural living, the British had a distinct economic advantage.
Also of significance during the same time period was the transition to coal fuel. Wood was becoming scare in the fourteenth century and England made the transition to coal. Some industries began to locate near coal mines. Elaborate systems of horse drawn railways were created for transporting coal to distribution points in England. The net effect of the water and coal power was to create a broader and more widely dispersed middle class.
Thus, Britain entered the eighteenth century with a secure property rights, a broadening middle class, and the best financial minds of the age. By mid-century theorists like Adam Smith were articulating for the first time a full-blown theory of economics that grasped the idea that wealth creation is not a zero sum game. By each person concentrating on what they do best and exchanging with others doing likewise, both parties win and wealth is created. The sum total of wealth grows and everyone can participate in that wealth creation. Smith and others provided the intellectual foundation for modern economic thinking. However, the major catalyst for change in capital markets was technological.
The eighteenth century marked the beginning of the industrial revolution. A steam mechanism had been developed for pumping water out of mines in England in1705. Sixty years later James Watt would make improvements to this technology that would make it a viable power source for a variety of applications including factories and trains. We will visit the impact of technological innovation shortly but the central focus here is that the technology quickly gave birth to enterprises requiring massive amounts of capital investment create and operate. So much capital that no small group of investors could finance it out of their own wealth and debt financing would be cost prohibitive because of the massive amount needed. An effective means of raising equity capital was needed.
As result, the modern corporation was born. By the 1830s in the United States, and shortly thereafter in Britain, investors in corporations were held liable only for the sum of money they invested. No longer was an investor putting their entire fortune and personal liberty at risk by buying shares in a company. This enabled company ownership to be divided up into thousands of tiny pieces thus enabling thousands of investors to contribute to the capital formation of a corporation. Later in the nineteenth century, bankruptcy laws were written in England and the United States that forbade the imprisonment for debt default. This was a tremendous boon to risk taking entrepreneurship.
Information technologies also played a role in the development of capital markets. With the invention of the telegraph in the 1840s, information could for the first time move faster than a human being on a horse or train. The growing integration of the capital markets through communication technology increased the rate at which capital could flow; a process that is in effect to this day. The story of the twentieth century was largely about the expansion of and refinements of capital markets including the formation of institutions and regulations that limit their abuse and provide a measure of stability.