Renaissance to Enlightenment
Most of Europe was a collection of feudal agrarian societies before the Renaissance. Serfs paid rent to a lord for the use of land. That lord paid rent to a higher lord who in turn paid rent to a King. Lack of clear title for land ownership made exchanges in real estate very difficult. Consequently, tenants were unlikely to make more than minimal improvements to property because their hold on property was so tenuous. It was enough just to survive.
This “rent seeking” practice was ingrained in most of the monarchies of continental Europe. As the economies grew, rent seeking expanded into every aspect of life. Permission was needed from the government to engage in most economic activities. Permission was granted upon payment of fees to government officials. The King’s nobles, exempt from taxes themselves (along with clergy), were the ones who collected the fees. By paying a large fee to the King, one could purchase a position of nobility. In return, the King would grant the noble a monopoly on collecting certain fees in certain areas. These nobles might in turn sell rent collecting positions to others under them.
The result of this behavior was to create a highly corrupt government system that was utterly indifferent to economic productivity. It created an economy where prosperity was achieved by securing government favor and living a life of leisure off of the revenue exacted from productive workers. In France, this rent-seeking system eventually forced farmers to sell their lands and become indentured servants to the nobility. It also brought on the French Revolution at the end of the eighteenth century.
However, not all of Europe was dominated by despotic monarchies. The city states of Northern Italy were an important exception; Venice in particular. Venice’s inhabitants were the descendants of wealthy refugees who fled from the mainland of Italy when the Lombards attacked in the years following the collapse of the Roman Empire. Its geography made it an excellent defensive position as well as an ideal location for shipping traffic. Initially Venice aligned itself with the Byzantine Empire and its leading residents were considered nobility. However, they were nobles without landed estates and they were located at the far edge of the empire. From the start, their economy was tied to trade between the East and Europe.
The absence of dominant feudal systems and the focus on trade made cities like Venice, Florence, Pisa, Genoa and Milan the most economically innovative centers in Europe. By the thirteenth century these cities produced banking families that had outlets as far away as present day Germany, England and Portugal. They used and perfected the letters of credit method used by the Templar Knights and the monasteries. (In fact, the Knights may have learned their financing techniques from the city states.) The abacus, Arabic numerals and the concept of zero were made widely accessible in Europe in 1202. Schools sprang up to teach these skills and concepts in Northern Italy. Double entry bookkeeping was invented. By the fourteenth century these firms had created corporations complete with by-laws, corporate seals, charts of accounts and in some cases the concept of share ownership in the corporation. Family companies like Riccardi, Medici and Peruzzi dominated lending and finance all across Europe by the fifteenth century. (5)
It is important to note that these were indeed family businesses. During the Roman Empire, business failure and loan defaults could result in the complete confiscation of property and servitude for the defaulting party. This tradition carried over into Europe including the Italian city states. For this reason, all branches across Europe were run by family members partly because no family member would exact such draconian penalties on other family members. It was also for this reason that almost all commerce conducted up to this time, and for a few more centuries beyond, used debt financing. Partnership or share ownership with others meant that if the business went under, everyone connected stood to loose everything they had including their freedom. Lending meant only the capital lent was at risk.
The Northern Italian model of city state commerce quickly spread north to cities that had escaped dominance by the rising nation-states of continental Europe. Other cities and regions managed to gain some autonomy but the rural areas of continental Europe remained trapped in feudalistic relationships. The Northern Italian cities quickly declined as Spain expanded its despotic control over the area in the early decades of the sixteenth century. The center of commerce shifted to the great cities of present day Netherlands and England.
The story of Dutch commerce is of great importance to economic history. It played out primarily in the sixteenth through eighteenth century when France brought about its demise. For our purposes here, we will simply note that the Dutch, along with Spain, France and England began the world colonization process that eventually created the global economy (although initially with a highly destructive mercantilist mentality.) This expansion of trade and commerce led to continual refinements in market practices both at home and internationally. The Dutch were leaders in the development of joint-stock companies, the forerunner of the modern corporation but the next major leap forward in capital markets would come from England and from the United Sates during the Eighteenth Century to the present.
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 an 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.
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. (6)
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. They were making their own high quality cloth for export. These mills needed streams and rivers to operate, making it a highly decentralized industry and out of the reach of urban guilds. With the absence of feudalism that dominated rural continental Europe and the lower cost of rural living, the British had a distinct economic advantage. (7)
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. (8)
Thus, Britain entered the eighteenth century with 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 market 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 in 1705. 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. (9) 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 to create and operate. So much capital was needed 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, the United States and Western Europe 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 to present has largely been 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. And as we have seen in recent days, this work will continue to occupy us for the foreseeable future.
(5) Rodney Stark, The Victory of Reason: How Christianity Led to Freedom, Capitalism, and Western Success, (New York: Random House, 2005), 105-126.
(6) 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.
(7) Stark, 151-153.
(8) Stark, 155-158.
(9) William J. Bernstein, The Birth of Plenty: How the Prosperity of the Modern World was Created, (New York: McGraw-Hill, 2004), 169-173.