Introduction

During the latter half of the twentieth century, two new types of business organization emerged for attracting investment capital: the conglomerate and the leveraged-buyout (LBO) partnership. Unlike center firms, these enterprises sought efficiency in financial innovation rather than in managerial or in technological innovation. And while both conglomerates and LBOs shared broadly similar objectives, the circumstances and rationales that supported their formation differed sharply.

As to conglomerates, their promotion during the 1960s and 1970s was initially predicated on the assumption that economic synergism could be achieved by applying modern management techniques to the combining of heterogeneous businesses. Although the diversification drives of conglomerates seemed superficially similar to the creation of center firms, the theoretical underpinnings lending support to these activities were not comparable to those that explain the policies of center firms and thus require a different understanding of the financial system.

Conglomerate acquisition was more sensitive to portfolio theory than to more effective coordination and control of complementary businesses. Nor did conglomerates usually penetrate industries in which operating economies of scale and scope could be realized. In fact, there was little evidence that conglomerate growth resulted from superior management. Instead, the growing size of these companies made possible the achievement of economies in financial transacting. In addition, their success in the financial markets stemmed from ma nipulating the looseness both in financial accounting standards relating to the measurement of consolidated net income and in tax rules relating to the allocation of unapplied credits and loss items.

This appendix describes how businesses in ancient civilizations adjusted to the problems of financial risk. As in the medieval period, the greatest accumulations of wealth derived primarily from agriculture and trade. But the organizational innovations that bolstered the scale and scope of leading Italian business enterprises in the Middle Ages were lacking during antiquity. Instead, the largest and most important organizations during these early times were those of government. The following three sections identify several important institutions that were developed to reduce risk and increase the efficiency of financial transacting in the Babylonian, Greek and Roman periods.

Babylonian Beginnings

Babylonian civilization contributed three fundamental notions to the advancement of finance: (1) control of usury by interest-rate ceilings, (2) fixed-income obligations and defining the rights of creditors and (3) mortgage lending secured by liens on a wide array of chattels.

Economic surpluses created by irrigation agriculture provided a florescence of banking and commerce. By about 1800 B.C. the Code of Hammurabi began to formalize business and financial relationships regulating landownership and rental, agricultural employment, commercial transactions and loan contracts. In farming regions, grain, particularly barley, served as a medium of exchange. In urban centers, however, merchants both transacted and maintained their accounts using silver weights. Liquidity was enhanced through the maintenance of silver deposits at temples. Exchanges were evidenced at these locations through symbolic transfers of ownership.

The Code also standardized lending arrangements. For example, to be enforceable, all debt contracts had to be drawn up in the presence of an official witness. The law was also sensitive to the problem of usury. It stipulated a rate maximum of 20 percent on silver-based loans and 33.3 percent on grain loans.

Introduction

The development of large-scale trading enterprises (discussed in Chapter 2) was an essential part of the growth of national economies. Similarly, the financial requirements of nascent nation-states nurtured the growth of broad, anonymous financial markets. Although the prototypes of modern public debt instruments first appeared in the Italian city-states of Genoa and Venice and in the Low Countries in Antwerp and Bruges, the markets for these obligations reached great efficiency in England between 1688 and 1815. The primary impetus for innovation was in financing the heavy economic burdens in the form of high taxes and huge public debts that stemmed from the warfare between the island kingdom and France as they vied for European political leadership. In this competition English political and business leaders proved resourceful in forming economic institutions that helped to achieve political stability and to ensure their nation's leadership in international markets: The Bank of England was formed in 1694 and the Board of Trade was revived in 1695.

Several factors placed British public finance on a much firmer basis. Foremost were the political reforms, resulting from the Revolution of 1688, that established Parliament as the key agency in managing national fiscal affairs. This substitution of the rule of law for the divine right of a monarch made investor interests more secure. The guarantee of the nation-state was better protection than the personal promise of the sovereign. The standardization of contractual details for governmental debt obligations allowed for their uniform market pricing and rationalized the relationship between lenders and the state.

Corporate finance has been influenced by two distinct patterns of governance in the world's leading securities markets. At one end of the spectrum are the similar systems that have emerged in the United States and the United Kingdom and are characterized by freely competitive markets, transparency in corporate affairs and regulatory structure to protect investors from the incompetency or dishonesty of agents. These are quite different from the uninformative, opaque regimes of Japan and Germany, where powerful private and/or governmental institutions dominate local markets through informal, cooperative relationships.

Reliable information strengthens the Anglo-American financial markets, facilitating the pricing of securities and thereby enabling the market to allocate capital efficiently. In addition, it augments economic growth by increasing opportunities for profitable transacting by investors.

Complementary monitoring patterns – one professional and the other governmental – provide assurances in the Anglo-American markets of the reliability and currency of corporate information. The agencies were originally limited to boards of directors, public accountants, attorneys, investment bankers and other professionals whose scope of fiduciary responsibility derived largely from a path-dependent process involving legal precedents. The state later provided a second level of monitoring, which also reinforced the position of professional groups.

In Britain the connection to government was initially defined in various companies acts that mandated filing corporate financial statements with the Board of Trade (now the Department of Industry and Trade). Before 1986, regulation of the share market remained largely in the hands of the Stock Exchange, attorneys, accountants and other professional groups. In a highly homogeneous society like Britain, such an informal system worked relatively well because of a more general willingness of the public to defer to the judgments of respected professionals.

Introduction

This chapter focuses on the financing of what economist Robert T. Averitt, in his book The Dual Economy (1968), has termed “center firms,” which represent one of three leading classes of enterprises that figured prominently in the development of contemporary corporate finance. (The other two – the conglomerate and the leveraged-buyout partnership – are discussed in Chapter 7.) The importance of center firms from the standpoint of financial history derives from their robust industrial capacities, which have contributed strongly to national economic vitality. In evaluating center firm finance, this chapter lays greatest stress on the role of management in devising financial policies that sought to satisfy two sets of interdependent priorities. The first was functional, involving the integration of finance both in the basic procedures designed to ensure effective coordination and control of operational activities and in the strategic planning processes that are dedicated to ensuring the future profitable employment of enterprise resources. The second set of priorities was contractual, involving the definition of financial relationships to reconcile the often dissimilar interests of managers and other constituencies, such as shareholders and creditors, whose actions might impinge in important ways on the firm.

The dynamism of center firms was partly attributable to their leadership in three types of investment that were critical for industrial growth: research and development, product innovation and capital goods production. The center firms that Averitt studied were in a limited range of activities (Table 6.1). For instance, all but three of the forty-one industrial categories studied by Averitt were classified under five two-digit Standard Industrial Classification (SIC) classes: oil, rubber, chemicals, machinery and metals.

Introduction

The last quarter of the eighteenth century saw the start of a great economic expansion that changed corporate finance in fundamental ways. The age of global exploration was waning and the discovery of new lands in the Western Hemisphere brimming with untapped resources was no longer to be counted on to provide economic growth. Boundaries imposed by the closure of geographic horizons underlined the need for the conservation of dwindling natural stocks. Robert Malthus, for example, thought that the ultimate survival of the human race depended on a sharp restriction of population growth. Sensitivity to demographic pressure emanated from a high, constant birth rate, lowered death rates and the alienation of a growing portion of the population whose connections with the land were severed by estate enclosure. Others, such as David Ricardo, responded to the problem by arguing that a greater abundance could be achieved by allocating scarce resources more efficiently. This latter reaction took several forms. First, a growing body of scientific knowledge was used to develop improved products and manufacturing processes. Second, new forms of business organization and management were created to enhance productivity by more effective coordination and control of economic affairs. Third, new beliefs were emerging about the gains to be realized by eliminating distortive impediments to freer trade.

A major technological advance, the substitution of coal for wind and water as the energy source for industry, was maximized in Britain. Major improvements in steam engine design, introduced by Thomas Newcomen and James Watt, transformed two leading manufacturing sectors, textiles and iron, and catapulted Britain into the position of the world's leading industrial economy during the first half of the nineteenth century.

Introduction

This chapter focuses on investors' growing interest in corporate common stock during the first four decades of the twentieth century. Although broad, anonymous markets for equity-share trading emerged in many centers worldwide, our discussion concentrates on developments in the foremost market for these securities of this period, the New York Stock Exchange (NYSE) on Wall Street, where a growing population of middle-class investors goaded by the prospects of capital gains and increasing dividends committed resources to industrial and utility shares. The increasing importance of equity is reflected in NYSE statistics: total annual share turnover rose from 159 million in 1900 to 1.1 billion at the height of the 1929 boom; the value of preferred and common stocks underwritten amounted to $405 million in 1910 and increased to $9.4 billion in 1929; and Standard and Poor's Composite Common Stock Index (1941–43 = 10.0) zigzagged upward from 6.15 in 1900 to 26.02 in 1929. The transition to broader common stock ownership in the United States was facilitated by the rise of what Alfred D. Chandler has termed “managerial capitalism.” Large-scale, hierarchical business enterprises whose activities were controlled by professional managers became the source of great economic efficiency in both the manufacturing and utilities sectors. Although first evident during the last quarter of the nineteenth century, firms of this caliber came to full flourish during the 1920s, many growing strongly because of their ability to exploit opportunities associated with the advent of the internal combustion engine or electrical power.

The Two Lenses of Economic Theory

History and statistics have long been thought of as vital adjuncts in scholarly efforts to further the understanding of economics and allied fields such as corporate finance. In his classic work, The Scope and Method of Political Economy (1890), John Neville Keynes, for example, characterized the nature of the relationship between these two specializations as essentially complementary. Inherent in this view was the belief that economic understanding could be brought into sharpest focus only by blending the unique perspectives afforded by each discipline, like the images cast by the separate lenses of a stereoscope.

Although in general accord with Keynes about the relevance of these two types of knowledge, Joseph A. Schumpeter later expressed, in his History of Economic Analysis (1954), the controversial opinion that historical studies were the more important. In his view economics was a uniquely historical process whose significance could be fully grasped only when viewed in a broader social context which incorporated events, institutions, individuals and organizations. In contrasting history with statistics and theory as a focus of scholarly endeavor, he wrote:

Of these fundamental fields, economic history – which issues into and includes present day facts – is by far the most important. I wish to state right now that if, starting my work in economics afresh, I were told that I could study only one of the three but could have my choice, it would be economic history that I would choose. And this is on three grounds.

This study of the role of institutions and organizations in the establishment of capital structures to finance the activities of large-scale business enterprises was begun by Jonathan Barron Baskin. My connection with the undertaking began when I was asked to review Baskin's original work. I was very favorably impressed by the approach of that work in explaining how the persistent problem of asymmetric information that divides the interests of corporate managers and investors shaped institutional arrangements in finance, a point brilliantly developed in Baskin's essay “The Development of Corporate Financial Markets in Britain and the United States, 1600- 1914: Overcoming Asymmetric Information,” which appeared in the Business History Review and won the Newcomen Society Prize in 1988.

My review suggested that the study might be strengthened if its focus was broadened by incorporating more examples of how particular firms or classes of firms historically resolved the capital structure puzzle. Besides bolstering the persuasiveness of the study's central findings, such an approach would provide support for Baskin's argument that theory building in finance could be enriched by a better blending of historical and quantitative research methods. A new synthesis could be achieved by reinterpreting the findings of a broad body of historical studies using the analytical constructs that guide contemporary financial research.

Baskin's revision was cut short by his untimely death. The project eventually moved forward again because of the loving commitment of Paul W. Fink, who, cherishing the memory of his gifted son, wished to see his major contribution to scholarship in financial history brought to fruition.

Introduction

Although trade remained an important means for generating wealth, the primary channels of international commerce began to change radically in the fifteenth century because of oceanic discoveries. The advantages enjoyed by the Italian city-states as entrepots for the trade between Europe and the East first started to decline as explorers charted new sea routes around Africa. The process started with the Portuguese, who, encouraged by Prince Henry the Navigator, opened trade with the African Gold Coast in 1448. By 1488, Bartholomew Dias anchored at the Cape of Good Hope, which served as the base a decade later for the voyage of Vasco Da Gama to Calicut on the Indian Malibar Coast. The frontiers of trade were further broadened by trans-Atlantic exploratory expeditions. In 1492, the Genoese captain Christopher Columbus found America while searching for a Western route to Asia on behalf of Ferdinand and Isabella of Spain. In 1498, the Venetian Sebastian Cabot, in search of a North Atlantic route to the Indies, laid claim to Newfoundland for the English Crown. In 1500, the Portuguese Pedro Alvares Cabral led a voyage that first landed in Brazil and then continued to India. The zenith was reached in 1519–22 with the Spaniard Ferdinand Magellan's global circumnavigation.

The extended economic horizons opened by the increase in geographic knowledge created a favorable environment for the development of innovative organizations capable of conducting large-scale, long-distance trading activities. Foremost in this regard was the jointstock company, which, while appearing at many European commercial centers, reached maturity in England.

Two questions remain for this epilogue. First, how can the long-term environmental factors that have invigorated institutional innovation be integrated in a general statement with the traditional firm-specific financial parameters that usually inform decisions about corporate capital structure? Second, what specific patterns of environmentalinstitutional interaction were evident historically?

The Integration of Environmental and Firm-Specific Factors

Concerning the first question, it is appropriate to use the example of the capital structure problem, which has, through time, been sensitive to two sets of variables. Long-term factors have, as we have seen in this study, influenced the capital structure of firms through four dimensions of evolution: social governance structures (including bodies of law and political arrangements); communication modalities; knowledge of science and technology; and knowledge of management. These are important because they facilitate the establishment of financial institutions that enhance the capacity of corporations to concentrate capital and realize gains by reducing risk perceptions, achieving economies of scale and/or scope, overcoming market imperfections, and enabling the entity to accommodate unexpected externalities. Although the influence of these environmental elements is omnipresent, their effects are generally not central in short-run analysis and decision making because they change only over the long term, and these changes are irregular in both rate and scope. Thus, because they generally exhibit in the short run a stable rather than a dynamic character, they are rarely seen as exerting much direct or identifiable influence over financial planning decisions.

Introduction

The influences that the perennial problems of information and risk have exerted on finance have been evident since the dawn of civilization. Beginning in Mesopotamia nearly five thousand years ago, the Sumerians and their Babylonian successors perfected rudimentary contracts for rationalizing commerce, finance and private property ownership. These basic and powerful ideas eventually spread far beyond the Fertile Crescent to become key elements in an intellectual diaspora carried by trade among the peoples of the Eastern Mediterranean. Later during the Greco-Roman era new financial institutions facilitated the expansion of economic activity. Coinage, bills of exchange and new modes of public finance were broadly transmitted through the expansion of the empires of Alexander and the Caesars.

These ideas, carefully preserved by ecclesiastics during the barbarian invasions of the seventh through ninth centuries A.D., again influenced Western thinking with the economic revival of the later Middle Ages. Economic recovery together with the formation of international trading linkages between Northern and Southern Europe gave rise to and was, in turn, facilitated by an expanding financial sector. A leading center for this development was the Italian city-states, which are the central focus of this chapter. Many of the practices emergent there were basic to what we know as modern international finance, including foreign exchange conversion, bills of exchange, specialized project financing, portfolio diversification and deposit acceptance. Improvements in the legal system also facilitated economic expansion. New contractual forms and financial instruments helped to reduce risk and to enhance the efficiency of international trade and finance.