The Taming of the Government¹

IF FINANCE is so beneficial, why don’t we see more of it? Why, by and large, did robust financial systems start to emerge only in the nineteenth century, and why did they take off in many developed countries only at the end of the twentieth century? Why is a functioning financial system still a chimera in most countries?

Our answer will be both simple and detailed. Simple, because we will argue that finance does not develop primarily because those who control or influence the levers of power do not want it. Detailed, because we need to explain why this opposition to finance arises, what forms it takes, and when and why it can be overcome. In fact, addressing all these questions will take up the second part of this book.

A sine qua non for almost any institution of capitalism to work is that the property of each citizen be respected. This means more than simply allowing and enforcing each individual’s right to own private property: it also means respecting the rule of law more broadly by facilitating and enforcing private contracts, preventing arbitrary coercion, and preventing arbitrary taxation. All this is especially important in the case of finance—for savers will not be willing to reveal, let alone lend, their wealth when they don’t have the confidence that it will not be stolen or, equivalently, taxed away.

The critical element in ensuring security of property in most countries today is not how covetous other citizens are—a strong government can always beat down the greedy. It is not even how rapacious foreign invaders are—warfare in recent times has not typically been conducted for the express purpose of pillaging the property of enemy citizens. The critical element in ensuring security of property has been the commitment of a country’s government to respect the property rights of its own citizens.

Some countries have come a long way. The United States or the United Kingdom, models of rectitude in their respect for property today, routinely expropriated wealthy creditors in the past. Others are less respectful today than in the past, suggesting that governments do not have permanent sinecures on their ability to commit to respect their citizens’ property. Despite Rome’s being the cradle of law and Venice’s being the source of much innovation historically in business contracting, Italy today lags considerably behind some of its northern neighbors in measures of respect for the rule of law and respect for property. So if it is not something immutable in a people’s culture or psyche that causes them collectively to agree to respect property, what is it? Should citizens in developed countries be worried about whether their governments will continue to respect property? We seek an answer in this chapter.

Respect for basic property rights is only the first step for finance to develop. If, in addition, the government does not build the necessary infrastructure for finance, or if it shackles finance with regulations, the financial sector may again remain moribund. The primary reason why, even in constitutional democracies, the government might not take the necessary steps for finance to develop or, worse, move in the opposite direction is that governance is captured by small, powerful interest groups that prefer that others have little access to finance. In other words, the rapacious government is just the first hurdle. The next is the “democratic” government of the few, by the few, and for the few. Who the few might be is the subject of Chapter 7.

When can the power of these interest groups be overcome? In Chapter 8, we discuss the conditions under which finance becomes liberated from the shackles of these special interests. We argue that the recent explosion in financial development across the world has, in no small part, been due to the emergence of these favorable conditions. This then sets the stage for the third part of the book, which asks if financial development is an irreversible process. The answer, unfortunately, is “Not necessarily!” But we’re getting ahead of ourselves. Let us first ask why the government needs to be tamed and how this might happen.

The Main Argument

A property right is a form of monopoly. It gives the owner of an asset the exclusive right to use the asset and exclude others from its use. But what gives the owner this right? We might be tempted to answer, “the law.” While it is true that in modern developed societies, property rights are enforced by the legal system, this answer begs the question of what gives the law force. Why, in certain countries, is the law respected and enforced, even against the might of the government, while, in others, it is not?

One possible explanation is the nature of the government. Some have argued that by constitutionally enhancing the “countervailing” power of parliament and the judiciary, a government can offer a credible commitment not to expropriate its citizens.² There is, however, something incomplete in the argument that the government can show its commitment to respect property by setting up a more democratic political process, which keeps the arbitrary powers of the government in check. At the national level, most rules can be changed. The government can dispense with the democratic political process. Political power is therefore not easily conferred by legislative fiat or a change in the constitution. It is more fruitful to think of the devolution of political power and the security of property not as a political or legal phenomenon alone but partly as an economic phenomenon. This is the approach we take.

To do so, we need to go back in time, to when legal enforcement was doubtful even in countries where property is now well respected, and understand, step by step, how basic respect for property emerged. To root ourselves firmly in facts, we will examine how England moved in little over a hundred years from being a state under an arbitrary despot to being ruled by a constitutional monarchy. Before we do so, however, it is useful to preview the logic of our argument.

A property right is much more defensible when the owner manages the property much better than anyone else. There is a substantial cost to taking the property away, for the owner’s skills would no longer be available—certainly not to the extent that they were earlier—for generating value with the property. Thus, property that is owned by those who can manage it best is property that not only has the law to support it but also has economic value backing it. To the extent that the government respects economic value, because of either the power it can purchase or the taxes it can pay, an economically efficient distribution of ownership is much more secure than a distribution based on the accident of history or on the whims of the king.³

A political institution like parliament is not irrelevant here. To the extent that owners are dispersed, parliament can help them gather and coordinate their actions. But democratic institutions are an instrument, not the source, of their power. This is not just a matter of semantics. With the “wrong” distribution of property, a country will find it very hard to achieve the right balance between the power of the government and the power of the people, no matter how many democratic institutions it has.

At this point, all this may seem just conjecture, but we will now substantiate it. We will examine why respect for property rights emerged when it did in England and why it took so long for other countries to follow in England’s footsteps. While mainly historical, our analysis is relevant today, not just for countries like Russia that are attempting to establish secure property rights for their citizens but also for countries where property is secure today, so that its continued security can be assured.

The Rapacious Government

Security of property started with protection from foreign invaders. The generalized improvement in standards of living, which occurred in western Europe from the beginning of the second millennium, is attributable, at least in part, to the security of its eastern borders, which led to the end of the barbarian invasions. Thus, military security is an important element of economic and financial development. But it is not sufficient. Nor is it true that more military security is always better for finance. In fact, within western Europe, the cities that emerged as the most important financial centers (first Florence, Genoa, and Venice, then Hamburg and the cities of the Hanseatic League) were not the political capitals of the then military superpowers but independent political entities, very much exposed, with the possible exception of Venice, to the risk of foreign invasions. Why did they succeed where Paris, Vienna, and Madrid did not?

A nation’s military might does not necessarily translate into a sense of economic security for its citizens. In fact, through much of history it has been quite the opposite. The stronger a government’s military power, the greater is its need for funds to feed and pay its soldiers and the stronger is its temptation to simply take from its own citizens (especially if even-more-tempting alien citizens are not at hand). History is rife with examples of how the rich attracted the unwanted attentions of their own powerful monarch. The fate of the Templars in the early fourteenth century offers a salutary warning of what happened when a needy king went up against his citizens, no matter how morally and physically powerful they might be.

Members of the Military Order of the Knights of the Temple of Solomon, better known as the Knights Templar, were the first significant international bankers. They were recruited largely from the younger sons of nobility who stood no chance of inheriting titles or wealth. They devoted themselves to the church and initially lived near the ruins of the Temple of Solomon in Jerusalem, from which they took their name. They took upon themselves the duty of policing the highways used by pilgrims going to Jerusalem. Their lives were chaste and austere, and they reserved their passion for warfare. Because they apparently did not fear death, they were among the most feared warriors on earth.⁴

As a result of gifts from the grateful and the faithful, they grew in wealth. They came to own some of the strongest castles in the world. Given their military prowess, these served as ideal repositories for valuables in those troubled times. King John of England used the London temple as a repository for the crown jewels, and in 1261, his son Henry III, who was in trouble with his nobles, felt that the jewels would be safer if transferred to the Templar fortress in Paris.⁵

These castles formed a network of “branch offices,” which meant they could make cash available at both ends of the Mediterranean as well as in Paris or London, when needed and in the form that was locally accepted.⁶ A knight could deposit money in Paris and receive it in the appropriate currency in Jerusalem. Crusading knights used this network, the American Express of the Crusades, to keep themselves in funds as they traveled. Of course, the Templars charged a fee for both the exchange and the transfer. Local banking functions were also performed. A number of surviving parchments suggest that the temple in Paris operated what looks like a modern bank’s cash desk, open at prespecified times and allowing clients to deposit and withdraw money. Clients appeared to be a who’s who of the time and included the royal family, important church officials, nobles, and rich merchants.⁷

The Templars’ financial functions soon rivaled or exceeded their military functions. They were trustees for crusaders and administered their wills, they acted as revenue agents for various monarchs and popes, and they served as financial advisers for the rich and powerful.

Substantial amounts of money were in Templar vaults at any point in time. Unfortunately, while their castles were strong, they were no match for a determined sovereign. In 1263, during the conflict with Simon of Montfort, Prince Edward of England overcame Templar opposition to enter its treasury. He broke into strongboxes and seized money belonging to a number of barons and merchants. His son, Edward II, did a similar thing on his father’s death. Peter III of Aragon broke into the Templar treasury in Perpignan. In fact, the surprising fact is not that monarchs violated the Templar strongholds but that the violations were so few in number given the temptations and the impecunious state of royal treasuries. The restraint exercised by monarchs over the century and a half of Templar ascendancy must be attributed to the moral force exerted by the Templars as well as the concern that a raid demonstrating naked greed would undermine the monarchs’ own standing with the church.

In 1307, Philip IV of France, motivated by the terrible financial state of his economy and having already raised all the money he could through the traditional medieval sources of debasing the currency and seizing the property of the Lombards or the Jews, turned on the Templars. Philip began a propaganda campaign that aimed to strip the Templars of their moral standing. Templar leaders were arrested in a surprise raid and were accused of heresy, apostasy, devil worship, sexual perversion, and a number of other sins against the medieval code of morality.⁸ The Templar leaders confessed under torture, and even though they later recanted, they were found guilty and many were burned at the stake.

The properties of the Templars were carefully inventoried, lands rented out, and the treasury taken over by royal officials. The church, with no hope of expressing moral outrage, decided to join the predators. Pope Clement V abolished the order in 1312 and devoted his energies to securing some of its properties for other orders in the church. Thus, Philip succeeded in his aim of reducing the moral standing of the Templars and seizing its assets. But despite his protestations otherwise, the act in more commercially minded countries such as Italy was seen as one of pure avarice.⁹

The lesson from the demise of the Templars, which was repeated time and again, was that no agent, however powerful or sacrosanct, could protect wealth against a determined government. Interestingly, an important outcome of Philip IV’s depredations was that the church realized the threat monarchs represented to its own property. For this reason, it turned from accepting property as a necessary evil (after all, Jesus inveighed against riches) to stoutly defending it as an inalienable right. Clerical scholars started to argue that the state did not have rights over the property of its subjects, and secular scholars soon took this theme up, finding support for it in Roman law.¹⁰ Perhaps as a result, outright expropriation became more rare in western Europe and was generally targeted at infidels, such as Arabs or Jews.

Greed was not the only, nor even the most important, reason why governments coveted the wealth of their citizens. They were led to expropriate their own citizens by their desperate needs for funds to finance their military efforts. In the long run, states could fund expenditure through taxes. But war brooked no delay. The alternative to confiscating citizens’ wealth was to borrow—an alternative a modern government knows all too well. But this led to a paradox. It is both costly and unpopular to levy taxes on the wider population so as to pay a few creditors. One reason a government would repay its debt even in the face of these costs is to keep the spigot of future financing open. But if it had the ability to persuade a few citizens to put up more when it was in need (what in medieval times was euphemistically called a forced loan), then it had little incentive to repay old loans. Since creditors, as a result, had no punitive power over the government, they had no reason to trust the government to repay. This then made it all the more certain that the government would renege on any debt contracted in good faith and resort periodically to expropriation, disguised as forced loans or defaults.

The easy targets (after the usual suspects like the Jews had been shaken down) were, of course, the rich, especially financiers. The manifest usurer was anathema to the church and hence accepted prey. Financiers were also likely to keep their wealth in a liquid, and conveniently removable, form. This is an aspect that makes, even in modern days, financiers the likely target of government taxation or expropriation. In this, the governments’ logic essentially parallels that of the bank robber Willie Sutton, who, when asked why he robbed banks, answered, “Because that is where the money is.” In an atmosphere of forced loans and repeated defaults, finance, not surprisingly, did not flourish.

The resolution to this paradox was simple. The government had to find a way to make it more credible that it would repay. This would then make the route of borrowing and repayment via steady taxation more credible. The conventional wisdom is that the Venetian republic, the Netherlands, and in the late seventeenth century, England managed to devolve power to investors: government in these countries was more representative of the rich investor than were the absolute monarchies that prevailed elsewhere.¹¹ This then made it hard for the government to default. The process by which the devolution of power took place is much more controversial. To understand why, consider England.

The Transformation of the English Monarchy

The early Tudors, Henry VII and Henry VIII, were among the most rapacious and arbitrary monarchs. They had their way with all the institutions of governance that were meant to check their power—the aristocracy, the church, the parliament, and even the judiciary. Henry VII steadily expropriated the great lords whom he feared as threats to the throne. Henry VIII not only continued along his father’s path, but in one of the greatest land grabs in history, he dissolved the monasteries in England and took over their land, amounting by some estimates to over 30 percent of the landholdings in England at that time. This, however, was not enough. In addition, the Tudors resorted to repeated “voluntary” loans from rich citizens. Consider the plight of one Richard Reed, who did not contribute to one of Henry VIII’s levies:

The English army was then in the field on the Scots border. Reed was sent down to serve as a soldier on his own charge; and the general . . . received intimations to employ him on the hardest and most perilous duty, and subject him, when in garrison, to the greatest privations, that he might feel the smart of his folly and sturdy disobedience.¹²

The Stuarts continued the practice of expropriation. As late as 1672, in the infamous stop on the exchequer, Charles II suspended debt payments to bankers amounting to about £1.3 million, at a time when annual crown income was less than £2 million.¹³

Yet soon after, England had a constitutional monarchy. In the Glorious Revolution of 1688, the Stuart king, James II, was overthrown and replaced by William and Mary. The new monarchs agreed to a Declaration of Rights. The crown recognized the legislative supremacy of Parliament and also the need for parliamentary consent for a standing army in peacetime. Furthermore, judges were protected from arbitrary dismissal, strengthening individual liberties and the property rights of the citizens against the crown.

The consequences for the English government’s ability to borrow were extraordinary. In 1688, government debt was about £1 million, about 2 or 3 percent of GDP. Much of the debt was short-term (recall that creditors lend only short-term if uncertain of the motives of the debtor), requiring between 6 and 30 percent a year in interest, at a time when the Dutch government was able to borrow long-term at 4 percent per year.¹⁴ By 1697, government debt had multiplied seventeen times to about 40 percent of GDP, a significant portion of which was long-term. The proximate cause of the increase in government debt was war with France, but it also reflected the greater willingness of investors to supply the government with debt. Even while government debt mounted, interest rates came down, from 14 percent soon after the revolution to about 6 percent in 1697.

The now conventional explanation is that by constitutionally enhancing the “countervailing” power of Parliament and the judiciary, the crown offered investors the credible commitment that it would not attempt to expropriate them.¹⁵ Parliament represented both the moneyed interests of merchants and financiers (the Whigs) and the landed gentry (the Tories). Given its composition, the increase in its power as a result of the curbs on the power of the king made property and financial contracts much more secure. In turn, investors obtained the confidence to invest. Thus, the argument goes, the internal constitutional limitations on the English crown’s powers allowed it to raise large sums at short notice, giving it external strength and transforming England into a European nation of the first rank.¹⁶

There is, however, something incomplete in the argument that the government could show its commitment to respect property by setting up a more democratic political process, which kept the arbitrary powers of the government in check. If it were so easy to offer a credible commitment, why did other governments, especially those of other nation-states like France and Spain that were perpetually in financial need, not do so?

One possibility is that their situations were different. For instance, it could be argued that England’s government could be tamed more easily because it had no standing army to carry out its arbitrary orders, and finance for raising an army had to be approved by Parliament. Since many members of Parliament were also property owners, Parliament was unlikely to approve the raising of an army that could be used to expropriate the citizenry. By contrast, the French and Spanish kings had standing armies: external threats were more proximate, and they did not have the luxury of time provided by a Channel separating them from their enemies. Thus, the argument must go, these monarchs could not set up credible internal constraints on the power of their governments, even though they, too, desperately lacked for finance.

Too much, however, could be made of these differences in geography. It is difficult to believe that the absence of a standing army in England was the primary reason for the English king to be better able to curb his own powers. After all, even if England, surrounded by seas, was not as exposed to sudden foreign attack as France or Spain, the English king did have a smaller standing police force to keep internal peace and did use it to expropriate the citizenry. Or to see it another way, even if the constitution mandated that the king needed Parliament’s permission to raise an army, he could simply have ignored constitutional niceties once he was allocated the funds and turned the army against Parliament. The loyalty of the army would then have depended on who could give it a better deal in the long run. (After all, ancient Rome, too, tried to keep popular generals and their armies far from the center of power, but eventually the praetorian guard chose many of the later emperors.) That the king did not, or could not, attempt to turn the army suggests that other factors were at work.

Put yet another way, the great lords who surrounded the feudal monarch had powerful armies. Yet constitutionally bound government, and respect for property, emerged only after the demise of feudalism. Why only then and not before? There seems something missing in the argument that governments became better able to borrow by setting up the checks and balances on themselves that would curb their own baser instincts. What was the power that bound them?

Perhaps it is more fruitful to question whether it is possible for any government to set up countervailing power, especially the kind set up through constitutions. An alternative view is that the interactions between powerful national players are rarely governed by constitutional rules since, at the national level, most rules can be changed. Political power is not easily conferred by legislative fiat or a change in the constitution. Instead, it has much deeper roots, some lying in the ownership of property itself. It is more fruitful to think of the devolution of political power and the security of property as intertwined processes in which secure property eventually became the fount of political power.

Pursuing this line of argument, Parliament did not become powerful in England as a result of constitutional changes brought about in the Glorious Revolution of 1688; it was already powerful, as evidenced by its ability to depose two Stuart kings (Charles I and James II) in quick order. This then means that the constitutional changes largely reflected the power relationship that preexisted these changes, while the conflict between the Stuarts and Parliament was only a last-ditch stand by the king against an inevitable passing of the balance of power. Of course, constitutional change made the devolution more secure against reversal. Our point is that it was the culmination rather than the source of the transfer of power. Let us now explain.

The Decline of the Aristocracy and the Rise of the Market

A constitution is simply words on a piece of paper, and sometimes not even that. Parliament commanded no armies directly. How did it gain more power over the monarchy than did the powerful feudal lords with their loyal retinues who surrounded the medieval monarch? To see how, we have to delve deeper into history. The first piece of the answer is the decline of the great lords.

Henry VII, the Lancaster pretender to the throne, defeated Richard III unexpectedly at Bosworth Field in 1485, thus ending the War of the Roses between the House of York and the House of Lancaster. Given Henry’s questionable claim to the throne, he set about eliminating serious threats to it. One way was to directly attack the most powerful of the lords—and since power stemmed from landholdings, confiscate their land and sell it off in pieces so that no successor would pose a similar threat. Henry VIII continued this policy, executing, among many others, the Duke of Buckingham, who was the highest and richest among the nobility. The Tudors also took care not to create any new concentrations of power: they created no new dukes during their reign.¹⁷

While some of the most powerful lords were dealt with on trumped-up charges, not all could be eliminated in this way. The source of a lord’s coercive power came from his band of armed dependents. Since there was not much of a market for food or land, the surplus produced by a lord was used to feed a retinue of servants and marginal tenants.¹⁸ He offered them protection against other roaming bandits (or equivalently, in those times, other lords) and rented out land to them at low rates. In return, they offered their loyalty and arms to the lord, wearing his livery as a sign of their allegiance. The lord used his armed band to intimidate courts, rivals, and even the king.

To deal with these armed bands, Henry VII passed a series of acts asserting that the prime loyalty of every subject was to him, the king, and not to the subject’s local lord. He forbade the employment of royal officials by others. And he started enforcing an old law restricting the use of livery to household servants, making examples of those lords who continued to maintain a personal militia.

In the meantime, there was another equally compelling reason for the lords to disband their militias. As the market for food expanded, the surpluses generated by the land could be sold instead of given to servants and tenants. Feeding the retinue was no longer free. And as rents for land increased, and a market for land sales started flourishing (more on this shortly), lords started feeling the true cost of maintaining inefficient but loyal tenants. The more efficient tenants also felt the cost of spending time in the service of the lord rather than in the more profitable occupation of tilling their fields. They much preferred to pay a market rent in cash rather than pay a below-market rent and have further feudal obligations. Thus, as markets expanded, nonmarket obligations like military service came under pressure, a phenomenon we will see again and again under many guises.

Moreover, long years of peace under the Tudors left the lord unable to use his militia even to fulfill his traditional feudal obligations to the king. As the costs of maintaining militias became more apparent and the benefits declined, some lords disbanded their militias. The process became self-reinforcing. Since one of the benefits of a militia was protection against the militias of other lords, fewer militias meant even fewer benefits. Thus, over time, lords lost their coercive power due to pressure from the monarchy and from economic forces. A “Duke of Buckingham in the early sixteenth century, with his castles, his armories, and his hundreds of armed retainers,” gave way to “a Duke of Newcastle in the mid–eighteenth century, with his Palladian houses” and his political connections.¹⁹ The Tudors and the market they helped create had effectively crushed the coercive power of the aristocracy.

The Rise of the Squirearchy

What took the place of the aristocracy? The great confiscations by the early Tudors, culminating in the dissolution of the monasteries, brought a huge amount of land on the market. Some of this land was granted away, but much of it was sold, with great benefit to the crown’s coffers. Because they had a direct interest in the market value of the land, the English monarchs amended the law to give buyers better title to the land, allowing them to sell it further if necessary. The flourishing market for land had a number of effects in addition to what we noted earlier. First, the more prosperous farmers, the ones who generated substantial profits from their land, could buy more, while those who did poorly sold their land or had it seized and sold by creditors. Second, farmers who had scattered strips could consolidate their landholdings and manage the consolidated land better.²⁰ Third, prosperous professional men like lawyers and merchants could buy land, the age-old symbol of status, and bring modern management techniques to it.²¹ Land moved into the hands of more able farmers and more competent managers.

The consequence was the emergence of an intermediate class between the lord and the peasant, the squirearchy (or alternatively, the gentry), which was more intimately involved with the land than the former and more apt to take risk with new techniques than the latter. The archetypical member

was not tempted by great possessions into the somnolence of the rentier; was less loaded than most noble landowners with heavy overhead charges in the shape of great establishments; did his work for himself, instead of relying on a cumbrous machine to do it for him; owned, in short, his property, instead of being owned by it.²²

He was thus much more able to exploit the land he farmed, and much more closely linked to it, than either peasant or lord.

When landholdings were vast, the skills required to manage that land and generate revenues were supervisory skills: the feudal lord employed overseers who supervised a steep hierarchy at the bottom of which was the peasant. While the peasant had the capacity to get to know the land well and get the most productive value from it, without ownership, he had little incentive or ability to do so. In fact, in the early Middle Ages in England, and till quite late in other countries, serfs were not allowed to own property, had to pass on their earnings to their master, and were bought and sold with the land they tilled.²³ Moreover, to reduce the need for management, the individual peasant often had “no choice of date or of crop; he must plough and reap with the rest, and sow the same seed as they.”²⁴

While the great lord probably was tutored since early childhood to drive overseers and supervise his estate, he did not have an intimate relationship with the land: it was too vast for any one man to get to know well. Management was often simply the maintenance of tradition, which few lords transcended. As a result, the revenues generated from the land did not really depend on whether this particular lord owned it or whether some other person, who was equally capable of driving overseers and sticking with custom, owned it. In economic parlance, the income from the land to the lord was a pure rent: it derived simply from his ownership of the land, and there was little other economic link between the property and the owner.

Not only was property loosely linked to the lord, but the extent of security of property would have made little difference to the size of the revenues generated. Since the peasant exerting the effort did not own the land and farmed it at the pleasure of the lord, greater security for the lord’s ownership did little for the peasant. Of course, the lord may have had some additional incentive to make improvements to the land if he knew his tenure was secure, but given the kind of extensive agriculture he practiced, these would not have added substantially to revenues.

Given all this, the lord owned his extensive holdings only because he had a sufficient armed force to bloody the monarch’s nose. If the monarch did not fear questions about his own legitimacy when he expropriated other inherited land, if he did not fear that other lords would band together against him, and if the resistance this lord could mount to an assault was limited because his band had withered away, property could, and would, change hands whenever the monarch desired it. The inefficient structure of ownership was itself the cause for the insecurity of property. From the perspective of the monarch, one lord was just as good as another because each one’s supervisory skills allowed them to generate approximately the same surplus for taxation. The only security to property was then the favor of the sovereign. Property simply could not be secure when the owner was so replaceable.

The gentleman farmer, owning smaller (but not economically unviable) plots, was different. First, the very origins of his land, typically acquired through purchase using his own accumulated wealth rather than through inheritance or custom, indicated that he had a competency that was required of neither lord nor peasant. Second, on land he farmed himself, he was likely to make the decisions on what to plant and where, experiment with different crop rotation and irrigation techniques, understand how the weather mattered every season and which clump of trees provided beneficial shade, and so on. Both because he was competent and because he was closely involved in managing his land, the gentleman farmer was very effective in exploiting the land he farmed. In addition, he would also be more able to rent land out well, since his intimate knowledge of the land’s possibilities would allow him to pick appropriate tenants.

In short, the burgeoning market for land moved land to the highest-value user, the competent gentleman farmer. And as he became more familiar with it, his ability to generate value only increased, so that he was, given the circumstances of the times, far and away the most economically efficient owner of the land. Unlike the great lord, the intrinsic value of the land he owned would be far less if the gentleman farmer were expropriated, for his skills would then be unavailable to manage it. It would be better for a farsighted government to negotiate a steady tax from each of these farmers than to expropriate any one of them. In addition, security of property would enhance the taxes the gentleman farmer would pay because he would then have a greater incentive to invest in the land and create value.

While these economic concerns may not have been foremost in the Tudor monarch’s mind, the great lords were. In a further attempt to undercut the power of the lords, the monarchy devolved more and more of the duties of tax collection and dispensing local justice to the gentry.²⁵ But this then made the gentry even more indispensable to the monarch:

The plain truth was the law, as they [the gentry] practiced and understood it, and the local administration of England, had made the ordinary life of the country depend at every point on them, and hardly at all upon the Crown. The entire machine—law courts, parishes, poor law, city and country—could run very well without the king; but it could not run without the gentry. In other words, the gentry was essential to the power of the king, but he was not essential to theirs.²⁶

In short, even while the gentry were becoming economically more powerful, they were also becoming critical to land administration. From the perspective of the overall productivity of the agricultural sector, this was probably a good thing, for their administrative indispensability enhanced their sense of security in their property, which undoubtedly made them more productive and further reinforced the security of their property.

The rise of the gentry was a steady process. By one count, there were one thousand esquires in Henry VIII’s time (there is a certain latitude in who precisely qualified as an esquire, though typically this referred to the gentry), and this number had expanded to sixteen thousand by Elizabeth’s time. There is no doubting the fact that the steady rise in productivity of English agriculture dates from the time of the emergence of the gentry. Early historians thought it uncontroversial that the emerging gentry were much more productive than the lords and peasants they displaced.²⁷ Since then, ideology has embroiled the debate on who exactly was responsible for the increase in productivity, though there have been recent attempts to use large-sample data to extricate the facts from controversy.²⁸ The data suggest that the emerging gentry in the sixteenth and seventeenth centuries did contribute substantially to the productivity revolution.²⁹ The wealth of the gentry expanded in tandem. By 1600, it was rumored that the gentry were three times richer than the church, nobility, and rich peasantry put together.³⁰

So the decline of the aristocracy was accompanied by the rise of the squirearchy. We will argue that the squirearchy was more able to curb the power of the monarchy than were the great lords. How did this happen? After all, the squires were individually less powerful, and collectively more dispersed, than the great lords. What bound them together against the king?

Parliament and the Origins of Property

Large, dispersed groups have a harder time coordinating actions than narrow, focused ones, a point we come back to in later chapters. Despite being numerous and dispersed, significant portions of the gentry could come together. The origins of their property gave the gentry a common interest in defending it, while Parliament provided the common meeting ground where their actions could be coordinated. The gentry were thus able to overcome the impediments to collective action that typically plague large groups. Let us explain in greater detail.

In dissolving the monasteries, Henry VIII was taking on the might of Rome. Opposing forces could well question the legitimacy of his reign and could threaten it if given the appropriate backing of the holy church. He needed allies, and he found them by distributing church lands to the gentry so that “being bound by the same ties of private interest, they might always oppose any return to the dominion of Rome.”³¹ In the words of a British historian,

the participation of so many persons in the spoils of ecclesiastical property . . . was of no slight advantage to our civil constitution, strengthening, and, as it were, infusing new blood into the territorial aristocracy, who were to withstand the enormous prerogative of the crown. For if it be true, as surely it is, that wealth is power, the distribution of so large a portion of the kingdom . . . must have sensibly affected their weight in the balance. Those families . . . which are now deemed the most considerable, will be found, with no great exception . . . to have acquired no small portion of [their estates] . . . from monastic or other ecclesiastical foundations.³²

In consolidating opposition against Rome to protect their own position, therefore, the Tudors also consolidated opposition to future kings. Many among the gentry were especially wary of monarchs who had Catholic leanings or who sought ties with other Catholic monarchs.³³ The troubles faced by King Charles I (executed) and James II (deposed) were, in no small part, due to this.

Parliament provided the coordination the dispersed gentry needed to assert its recently acquired economic power. Parliament, historically, had been the institution whose consent the king needed to impose new taxes. It was the mechanism by which the king negotiated with his principal sources of taxes, and it was not easily dispensed with, especially once the king came to rely on the squirearchy to collect his taxes. This does not immediately mean that Parliament could stand up to the monarch. The early Tudors exerted almost absolute dominion over Parliament.³⁴ Elizabeth only had to pass the word to Parliament not to discuss a subject for it to desist. Her chancellor, on confirming a new speaker of the House of Commons, warned him against the House of Commons’ meddling in anything touching on “her majesty’s person or estate, or church government.”³⁵ His warning was obeyed scrupulously.

But as the gentry grew in wealth and power, and as they saw signs of revival of Catholicism, their opposition strengthened. Parliament had already become fractious toward the end of Elizabeth’s reign, complaining vociferously about the creation and sale of monopolies over such essentials as salt. By the time of her successor, James I, Parliament was actively voting down the king’s proposals and standing up for the right to free speech and the liberties of its members. James vainly threatened his Parliament: “I am a man of flesh and blood, and have my passions and affections as other men; I pray you do not go too far to move me to do that which my power may tempt me unto.”³⁶ But Parliament ignored him.

A simple economic calculus would explain why Parliament had become so confident. Suppose matters came to a head between the king and the Parliament about property or, equivalently, taxes. While honor and custom would sway a few, many citizens, especially those who were being recruited to fight, would decide on the basis of their pocket. The newly recruited militias would give their loyalty to those who would pay them regularly and well. As the saying goes, Pecunia nervus belli, or “Money is the sinews of power.” The king could promise to declare his opponents traitors, seize their lands, and use the proceeds as well as his own wealth to pay those who sided with him. Parliament could promise to do the same thing in reverse. So the side that would attract the greater following would be the side that could promise the militia greater wealth, both of its own and from seizing that of its opponents.

For reasons discussed earlier, the gentry were especially good at managing and generating wealth from their land. The king and the great lords had no such ties to their land. Far less would be lost if the king and the great lords were relieved of their holdings and the gentry retained theirs, than if the reverse happened. So the gentry clearly had the ability to promise militias more. There were, of course, other factors that added to their ability to attract a following. Much of the land tax collection machinery was in the hands of the gentry, so they were better prepared to fund the war while it was in progress. Furthermore, they were men with strong ties to the local population, while the king and lords were remote. The fundamental point, however, is that the balance of power had changed. If the monarchy were not farsighted enough to see this, it might very well take a civil war, a beheading, and a revolution to convince the monarchy that power had indeed shifted hands! Certainly, there were men in the midst of these revolutionary times who saw that matters had changed. Thus, Henry Neville, a member of Parliament, exclaimed to the House of Commons in 1658:

The Commons, till Henry VII, never exercised a negative vote. All depended on the Lords. In that time it would have been hard to have found in this house so many gentlemen of estates. The gentry do not now depend on the peerage. The balance is in the gentry. They have all the lands.³⁷

As an elected Parliament gained power over the monarch, the conditions for a constitutionally limited government were finally in place.³⁸ The Glorious Revolution formalized this state of affairs and enshrined the concept that taxation could not be arbitrary and required the consent of the people’s representatives. Less than a century later, this principle was reiterated in the American Declaration of Independence.

Recapitulation

Let us recapitulate. There were three critical steps on the way to a government that respects property rights. The first was the decline of the coercive power of the great nobles. This ensured that raw physical might no longer determined economic outcomes and that ownership was not the prerogative of an inefficient few. The second was the emergence of an intermediate class, the gentry, who were not just economically powerful as a class but also efficient exploiters of the land they owned. The third was the existence of Parliament as a coordinating institution. Without it, the dispersed gentry would have struggled to assert politically its new economic power. Thus, the Parliament, weak in the Tudor years when the gentry was emerging, became strong when the gentry became wealthy. The power of the Parliament was also strengthened by the commonality of interests among the gentry. Most derived income from land, and many owned land that was previously expropriated from the Catholic Church.

Thus, the emergence of property rights in England was due to a fortuitous combination of factors. Were all of these factors necessary? James Harrington, an Englishman who was a contemporary of Oliver Cromwell and studied the sources of power in his 1656 book Oceana, believed that the redistribution of land through the great Tudor expropriations (and the land sales by Stuart monarchs as they attempted to fund their extravagances) was solely what changed the balance of power. This belief in property as the fount of power—because those who have property have the ability to pay armies—is clearly enunciated in one of Harrington’s pamphlets:

All government is founded upon overbalance in propriety. [That is, governmental power derives from property; the man or men whose property exceeds (overbalances) the total wealth of others in the state controls its government.]

If one man hold the overbalance unto [over] the whole people in propriety, his propriety causeth absolute monarchy.

If the few hold the overbalance unto the whole people in propriety, their propriety causes aristocracy or mixed monarchy.

If the whole people be neither overbalanced by the propriety of one, nor of a few, the propriety of the people (or of the many) causeth the democracy or popular government.³⁹

There is a long tradition for the belief that widely distributed property leads to democracy and civil society. Some societies have suggested maximum limits on what can be owned, while others have suggested minimum limits: the Roman republic had an “agrarian law” that limited the land any one person could own. Jefferson’s draft constitution for Virginia, written in 1776, required that each adult have fifty acres of land.⁴⁰ Yet the argument that property is power is, at some level, circular. To claim that property leads to power is to presuppose that the government respects allocations of property. Else why could the government—which enforces property rights—simply not declare the property rights of the rebels null and void if it feels that they would fund armies against the government?

If we were to stress a single most important factor in the emergence of property rights, it would not just be the wider distribution of property but also the economic (or social) ties between the property and the owner, which is all that would persist in an atmosphere of anarchy. Thus, Harrington omits a vital step in his arguments: the sale of seized land and the flourishing subsequent land market led to property’s being held by those who could manage it much better. It was this—the economically efficient holding of property—that enhanced the security of property, because the efficient holders had the economic power to defend their property against others. In addition, of course, the ability for the gentry to coordinate action through Parliament helped convert their dispersed, but substantial, economic power into political power.

Would it have been enough to open a market for land? Was the expropriation of the great lords and the monasteries necessary for the wider distribution of power? While it is hard to answer such counterfactual questions categorically, we believe that the expropriations, despite violating property rights, somewhat paradoxically helped build future limitations on the monarchy. For one, the expropriations did redistribute wealth directly, spreading economic power. More important, the lords and monasteries owned a significant portion of the land in their localities. They were local monopolists. Even if smaller properties were more efficiently managed, like all monopolists, they may have preferred holding on to their land, managing it inefficiently, but squeezing monopoly profits out of the local populace. Thus, a market for land might not have moved land into more efficient hands were it not for the expropriations, which were a sort of antitrust action.

Our argument also suggests why government was much more participatory in the cities than in the nation-states. In the city-states, the dominant source of wealth was not land but trade and manufacture. The surplus generated by these activities was clearly closely tied to the expertise, incentives, and relationships of the owner of the business, much as land was tied to the commercial farmer. It made economic sense to respect property rights within the city and to give citizens (a word that originates from the French cité and was originally applicable only to residents of a city) the sense of security by allowing them to participate in government. As the old saying goes, Stadtluft macht frei, or “City air makes free.”

Clearly, the cities grew along with business, and there is no reason to believe that respect for property was highly developed in the early life of a city. But over time, the quantum of business grew, and businessmen demanded, and obtained, respect for property as well as participation in city government.

In the nation-states, by contrast, the dominant source of revenue was land. As long as property holdings were concentrated, the nation-state could not commit to respect property. Even if manufacture or trade started up, it would be hard for the nation-state to show respect for business property when business output formed only a small fraction of total output. Thus, it was only after the breakup of the feudal estates or after extensive land reforms that the group of gentry emerged who not only were strong advocates of the institution of private property but also forced government to respect it. This then paved the way for competitive industry to emerge. Of course, once industry became sufficiently important, the pattern of landholdings might become less important to the security of property.

English history offers some evidence of this sequence. One of the rights the king attempted to usurp for himself as industries grew was the right to grant industrial monopolies. Consider the following case, which vividly demonstrates that these monopolies contributed to the insecurity of property, the arbitrary power of the king, and the ruin of economic activity. In 1614, a scheme was concocted to

take from the Merchant Adventures [a trading company] their rights to export unfinished woolen cloth to the Netherlands and to give to a new company the exclusive right to export cloth. . . . It was estimated that the export of entirely finished cloth . . . would bring in an additional profit of 600,000 to 700,000 pounds a year to those engaged in the cloth trade. Of this the king was to have 300,000 pounds for his grant of the franchise to the new company. The Dutch . . . refused [to let in] the English finished cloth, and the new company came to a quick end. Yet before the Merchant Adventurers could recover their old rights, which they did at a cost of between 60,000 and 70,000 in bribes to James’ officials, the entire cloth trade had been disorganized. . . . As late as 1620 the English merchants were exporting only half as much cloth as they had sent abroad in 1613.⁴¹

Parliament saw the danger to the security of property (and its own power) from these monopolies and, in 1624, passed the Statute of Monopolies, which forbade the issuance by the king of patents of monopoly to individuals except in the case of new inventions. The antimonarch Parliament that served between 1640 and 1660 went further and virtually ended the practice of granting monopolies to corporations as well as individuals.⁴² So in addition to protecting the rights of landowners, the power of the landed gentry acting through Parliament placed constraints on the arbitrary powers of the king over industry.

Eventually, of course, industry became the source of security to property. Even though the landed gentry were instrumental in breaking the power of the monarchy, eventually, they used Parliament to further their own interests. The emergence of small and medium-sized farmers in the sixteenth and seventeenth centuries—the yeoman revolution—gave way to Parliamentary enclosures and the landlord revolution in the eighteenth and nineteenth centuries. While the former movement was progressive and enhanced productivity, the latter redistributed wealth to the newly politically powerful.⁴³ By then, however, industry had come into its own—as evidenced by the battle over tariffs on food that it eventually won—and power shifted to new defenders of property.

Other Countries

We have focused on England because it is the canonical example of the emergence of constitutionally limited government. It is useful to see briefly whether other countries that developed constitutional government fit the mold.

France is often the canonical counter to Britain. Historians have puzzled over why France did not achieve constitutionally limited government until the nineteenth century. One reason is simply that the nobility and the church in France were all too strong before the French Revolution. Even a powerful king like Louis XIV only played the grandees off, one against the others. When he died, they regained their power.⁴⁴ Since French kings could not suppress the great lords, they tried to enlist the peasantry’s support by protecting their property rights against encroachment by the lords.⁴⁵ So the peasantry in France held a substantial portion of the land, but in small, relatively inefficient holdings.⁴⁶ Land sales also did not take off, in part because the king had no incentive to make alienation easy, for that would allow the peasants to sell out to, or be dispossessed by, the lords, and in part because, unlike England, there was no initial grand sale of expropriated land to jump-start the land market. So the gentry did not emerge as a class. Finally, since the king levied and collected taxes through a centralized bureaucracy directly from the peasants, he really had no need to summon any form of Parliament on a regular basis.

The French Revolution and the confiscation and sale of the properties of the church and the aristocracy had some of the effect in France that the Tudor expropriations had in England. It reduced the land and power of the nobility, strengthened the then minuscule French gentry as well as the rich peasant farmer, created a national market for land and food by abolishing internal impediments to trade, and created a more permanent institutional structure of representative government. As a consequence, the productivity of French agriculture increased substantially in the nineteenth century.⁴⁷ The political and economic effects of these changes were undoubtedly critical in fostering the late, but substantial, French industrial revolution.

If our arguments hold generally, then they should not be valid just historically but also more recently. Very crudely, our arguments suggest that in predominantly agricultural countries, the security of property—clear laws facilitating the ownership of property and its sale as well as a judiciary and a government that respect them and enforce rights—should be low where land ownership is highly concentrated. Not only do big landowners have the ability to defend their property through private armies or through their influence over the local apparatus of the state, but they also have no incentive to see the infrastructure of a free market emerge to challenge their power.⁴⁸

Statistical analysis suggests that the prediction seems to be borne out by the data. When a country is heavily dependent on agriculture, a high concentration of land ownership does seem to be associated with a lower level of protection of private property.⁴⁹

This leads us to a final question. If wider (but not too wide) distribution of land led to participatory politics and respect for private property, why did every country not undertake land reform? Why till 1861 were the vast majority of Russian serfs tied to the land and without protection from their overlords and from the government? Why did it take the French Revolution, the Napoleonic conquests, and the revolutions of 1830 and 1848 for land to be distributed in continental Europe in a way more conducive to intensive commercial farming and greater respect for property rights?

One reason may be the nature of the land in some countries. Some lands lend themselves to intensive farming, while others lend themselves to a mode of agriculture such as plantations that is more extensive. This may partly explain why Costa Rica has had a more democratic history than Colombia.

The argument that the necessary technology of production does not permit an ownership pattern favorable to the emergence of strong property rights applies not only to land but also to industry. When industry consists of large monopolies, which exist only because the government affords them privileges, the government is likely to have little respect for property. For example, firms in extractive industries have value largely because of their rights to extract and really do not utilize huge amounts of human ingenuity. In countries that are abundant in natural resources—such as Zaire—the government can extract large amounts of money simply by withdrawing a mining privilege from one company and auctioning it off to another. Of course, eventually bidders realize they will have to factor in the cost of future bribes that will be needed to keep their privileges. The outcome, however, is that the government will have little incentive to respect property rights. Only a few countries have overcome the curse of being richly endowed with mineral resources.

But the most important reason why countries did not attain the appropriate distribution by design may be that the self-interest of the government and the nobility did not permit land reform, even if it would benefit the country as a whole. Certainly, an individual lord could not hope to gain by dividing up his land and selling the pieces to the peasants who farmed it. If other lords did not follow suit and force an eventual change in the climate of property rights enforcement, our revolutionary lord would find that the peasants to whom he had sold land enjoyed even less security of tenure now that the lord was not present to protect them. Moreover, any wealth the lord gained from the sale would itself be up for grabs, now that he could not hold out the prize of grain or below-market rents to enlist the support of his peasants in battle.⁵⁰

The sovereign might also not have had the incentive to move to distribute land widely. After all, even if property rights became more secure, and the land became more productive, he would lose power. In many cases, it would be in the monarch’s self-interest to continue coercive-extractive policies, even if detrimental in the long run for the country—as Louis XV is famously supposed to have said, “France will last my time.”

The effects of the initial distribution of land may persist long after the distribution is no longer optimal, as we noted in the introduction to the book. For example, even after the emancipation of indentured or slave labor reduced the profitability of the large Latin American haciendas, the owners did not disband them. The need to maintain a ready pool of unskilled, poorly educated labor may explain why many of these hacienda-dominated countries did not pursue universal education and economic and social rights as vigorously as others did.⁵¹

If initial distributions of landholdings tend to persist in the absence of forcible reform, the legacy of history may explain why some countries, or even parts thereof, were lucky while others were not. For example, northern Italy and southern Italy are extremely different in their economies, today northern Italy being much more progressive than southern Italy. Estates were much larger in the South and the peasants far poorer. A number of historical factors, including the Norman conquest of the South in the eleventh century and the greater devastation caused by the plague in southern Italy in the fourteenth century, could account for the differences in land distribution.⁵² In turn, these differences may partly explain the disparity in economic progress between the North and the South that persists even today.

The legacy of historic land distribution patterns seems to be important in India also. Areas in which property rights over land were given over to large landlords by the British in colonial times have significantly lower agricultural investment, lower agricultural productivity, lower rates of literacy, and higher rates of infant mortality in recent years.⁵³ The growing disparity between the booming west and south of India and the relatively stagnant central and northeast areas is probably, in some measure, a legacy of history.

Similarly, some former colonies of European powers developed stronger respect for property rights earlier than others: the initial European settlers migrated en masse to a colony if the climate was hospitable and the land disease-free—leading to the emergence of a group of yeoman farmers who formed a solid base for representative, constitutionally bound government. By contrast, landholdings in a colony were much more concentrated, and industry much more extractive, if the land was inhospitable so that only the minimum number of Europeans migrated to oversee large holdings worked by native labor.⁵⁴ These latter countries would have had to await the emergence of a viable manufacturing and trading class to establish secure property rights, but the emergence of that class would itself be held back by the absence of property rights and finance.

Finally, some governments care more about their own power than the prosperity of their citizens, giving us examples of the consequences of inappropriate redistributions of property. Fearful of their role in supporting the institution of private property, Stalin exterminated the yeoman farmers in Russia, the kulaks, in the 1920s and 1930s and gathered their land into large collective farms. The collectivization of Russian land caused enormous losses in agricultural production—but served the intent of removing the yeomanry, a strong force for private property, completely from the Russian landscape. Government could move ahead with communism unopposed.

More recently, formerly socialist economies have attempted to figure out how to distribute state-owned property to private citizens so as to ensure a smooth transition to capitalism. Some economists have argued that it does not really matter who owns the property; all that matters is that property find its way into private hands.⁵⁵ Our arguments suggest otherwise. Property in the wrong hands, especially if concentrated, can be very detrimental both to reducing the power of the state and to the emergence of free markets. The Russian republic provides one clear illustration. In an underhand deal to win support for the 1996 presidential election, Boris Yeltsin agreed to give a few powerful operators some of the best Russian companies at bargain-basement prices. This was just the most egregious of events by which Russian industry and finance became dominated by a few, whose primary competence was contacts rather than business acumen. It is little wonder that these “businessmen” came to be known as oligarchs, reminiscent of the reactionary feudal lords who stood in the way of capitalism.

Not only do these oligarchs oppose the development of free markets and free access to finance, but they also offer little countervailing force to a powerful state. Since their empires are not built on competence, they can be taken away as easily as they were acquired. The government of Vladimir Putin has, in fact, cut some of these oligarchs down to size and assumed significant power. Whether the oligarchs are replaced by others in a game of merry-go-round or whether the oligarchs are done away with so that a truly competent and competitive business class emerges is a matter to be seen. In that lies the future of Russian democracy and free market enterprise.

Summary

Historically, the greatest obstacle to the development of free markets, especially free financial markets, was the rapacity of governments. We have argued that the emergence of a class in England that individually was large enough to farm commercially and take risks but was not individually strong enough to protect itself created the demand for a constitutionally limited state. Institutions like Parliament and the administrative machinery served to coordinate this class and give it political power, which then resulted in the limitations on government it sought.

These safeguards were extremely important to ease the path of government finance. Unlike with land or industrial assets, most financial assets are held passively: the holder has no great expertise in generating value from those assets. Since the government suffers only a loss of reputation if it expropriates the cash or gold held by its citizens or if it repudiates the debt it owes them, the holders of financial assets are the first to be targeted by a government in need. It is rare for a troubled modern government to take the land farmers own or the machines firms have to pay its bills, but it is perfectly willing to pay public creditors only a fraction of the amount it owes. Finance therefore has to come within the perimeter of defenses built against the government by other forms of property for it to flourish.

But when investors feel safe, a country can benefit greatly because it can borrow to fund national enterprise and not be limited by what it can raise in the short run through taxes. As historian Richard Ehrenberg, writing in the early part of the twentieth century, puts it, “England would not have been the Great Britain of today, it would not have conquered half the world, if it had not incurred a national debt of 900,000,000 pounds between 1693 and 1815.”⁵⁶

The emergence of representative government is, however, only the first battle toward financial freedom. By becoming representative, government can obtain a greater latitude to borrow and can reduce the threat its people face from it. But it need not make the government interested in broadening access to finance. Government, even in a democracy, can be captured by a small, well-organized class that has little interest in seeing broad-based access to finance. This is what we turn to now.

CHAPTER SEVEN

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The Impediments to Financial Development

THE FIRST STEP in the long march toward a first-rate financial system is to tame the government, to make it more respectful of its citizens’ property so that citizens can create wealth in security. The devolution of the ownership of property toward those who can best use it is a crucial step in this process. Power invariably moves to the people as property becomes more efficiently and widely distributed.

This is just the first step. The most appropriate government for the financial sector is not necessarily a passive one. For instance, at minimum, the government has to enforce private contracts. But often, it may be called upon to do more. The cost to aggrieved parties of initiating enforcement is often so large as to make contractual protections worthless. A small shareholder, who buys a few shares in the market, will find it prohibitively expensive to enforce her rights against violation by the firm’s insiders. Without a supervisory agency or some other mechanism to mitigate wrongdoing by insiders, minority shareholder rights will not be protected and outside equity financing will remain small.

More generally, markets do not arise in a vacuum. To function, they need infrastructure. Much of this infrastructure benefits every market participant, regardless of whether she has contributed to build it or not. Uniform standards in information disclosure, for instance, benefit both firms and investors, but no firm or individual will want to incur the entire cost of creating the standards or enforcing them. Market infrastructure is thus what economists call a public good: it benefits many, not all of whom can be charged for the benefits they get.

This does not immediately mean the government has to step in to provide the public good. Private parties provide public goods sometimes, especially when they can capture a large enough share of the benefits to pay for the public good’s cost. Our university, for instance, captures enough of the benefits from additional security on campus that it pays for a private police force to patrol the area. In the same way, the New York Stock Exchange benefits enough from a reputation for good governance of its listed companies that it imposes its own strict standards of disclosure and governance on them. Nevertheless, in many situations, no easily organized group of participants captures enough benefits from the public good to provide it. Because too many beneficiaries have no incentive to pay and prefer a free ride, the private provision of public goods is often insufficient.

Whenever these coordination and free-riding problems are present, the government can play an active role in promoting the infrastructure needed for finance (and markets in general) to develop. But just because government can do good does not imply that it will do good. Governments in even the most democratic societies may not closely reflect the will of the public or its best interests: the same coordination and free-rider problems that suggest a need for organized intervention also impede the public’s ability to direct that intervention toward its own greater good.

The reason is that even though democratic governments respond to pressures, the average individual, who is an anonymous member of a large, heterogeneous group, does not have the incentive to exert himself to see that his preferred policies are enacted. Instead, he usually prefers that others exert themselves for the cause. But when everyone thinks this way, committed lobbyists from small, homogeneous, motivated pressure groups—rather than the larger public—end up determining the political agenda. Therefore, while the first step to financial development is to contain the excessive power of the government over its citizens, the second step is to contain the power of small pressure groups over the government agenda. Who these groups are and why they want to hold back finance is the subject of this chapter. How to reduce their influence is the focus of the next one. But first, let us ask why organized intervention is needed to set up market infrastructure.

The Need for a Central Authority

In Chapter 1 we have already discussed how court inefficiencies and delays can jeopardize lending. More generally, market transactions require a central authority to enforce them promptly and at low cost. To see the importance of such an authority, consider how Poland and the Czech Republic attempted to create equity markets after the fall of the Berlin Wall.

The two countries, starting with a similar level of economic development, took very different paths.¹ Vaclav Klaus, the Czech Republic’s libertarian prime minister, strongly believed in the market’s ability to organize itself. Driven in part by ideology, the Czech Republic embarked on a massive privatization plan before setting up a robust market infrastructure. The Polish government, by contrast, proceeded more gradually. It first introduced very strict disclosure standards. Then it created the analog of the U.S. Securities and Exchange Commission (SEC), whose task was to ensure the enforcement of these disclosure standards as well as other rules meant to protect minority shareholders. Only later did it proceed with privatization.

Several years later, events seem to vindicate the Polish approach. While the Czech stock market started bigger, it quickly lost momentum as small investors began to realize that they lacked effective protection. Stories of investors’ being defrauded by insiders, and of large institutional investors’ allying with corporate insiders against minority shareholders, became common. Of course, eventually small investors become sophisticated enough to demand safeguards, but by then, they had been burned. According to an estimate, corporate insiders in the Czech Republic, on average, capture 58 percent of the value of a company for themselves over and above their legitimate shareholding, compared to an insignificant 1 percent that is captured in the United States.²

First impressions count: Once investors become convinced the market is unfair, extensive reform may not be enough to bring them back. It may not be possible to get investors to pay attention to the reform, so that they can be convinced that things have changed. The consequence of the investors’ unfortunate initial experience was that Czech firms lost an important source of financing. Between 1996 and 1998, no companies raised funds through public share offerings.³

By contrast, the initially smaller Polish market quickly grew to surpass the Czech market, as the Polish authorities showed their willingness to prosecute violations of small shareholders’ rights. Consequently, the value captured by insiders in Poland was a much lower 12 percent of the value of a company.⁴ Knowing that their rights were better protected, investors gained confidence in the Polish stock market, and both new and existing companies were able to raise capital (U.S. $2.5 billion in the period 1996–1998).⁵

The point is that dispersed investors may find it prohibitively costly to become informed or to enforce their rights; hence, they need an organization like the SEC to represent them and laws to protect them. As another example, consider the effects of the 1933 Securities Act, which mandated the disclosure of corporate information with the accompanying threat of punishment for violations. Following the passage of the act, investors priced equities in the United States more accurately.⁶ Mandatory disclosure—one explanation goes—made the information that firms disclosed more credible. As investors became more informed, the volatility of securities prices was reduced. Over time, the reduction in price fluctuations benefited ordinary investors, enabling them to make better investment decisions and reducing the ability of informed but unscrupulous traders to take advantage of them.

Interestingly, the NYSE had many of the rules that were required by the Securities Act of 1933 even prior to the act. So one argument about what was lacking is that it was the force of the law behind these rules, and the Securities Act certainly provided this. More generally, firms in countries that have better statutes protecting shareholders tend to have higher market values relative to book value, suggesting that investors expect to get more of the money firms generate and are thus willing to pay a higher price for these stocks.⁷

Of course, the existence of laws on the books does not mean they are enforced. While, at the end of 1998, laws prohibiting insiders from trading on privileged information existed in 87 of the 103 countries with a stock exchange, only 38 of them prosecuted violations.⁸ The enforcement of laws prohibiting insider trading can benefit the ordinary investor because she does not have to worry about losing out by trading with someone with inside information. With lower costs of trading equity, shareholders will demand a lower return from firms, allowing firms to raise funds more cheaply. Indeed, after the law against insider trading starts being enforced, the rate of return shareholders demand in a country falls, implying that shareholders demand less as a compensation for risk when they know that they will not be cheated. So another argument for why the Securities Act of 1933 “worked” is that enforcement by the federal government was seen as more credible because it may have been seen as less subject to capture by insiders on the exchanges.

A central authority also solves coordination problems. For instance, study after study has shown that better accounting standards help make firms more transparent, making it easier for them to inspire confidence in investors. Of course, firms can adopt a policy of better disclosure by choosing a transparent accounting standard on their own: nothing prevents a German firm from also disclosing its accounts using more transparent U.S. standards. But without sanctions for improper disclosure or omissions, this would just be cheap talk, of very little value as a signal. Moreover, each firm would have the incentive to choose a method of disclosure that puts it in the best light. This would be problematic because disclosure serves two purposes: informing the investor about the firm and giving him a standard with which to compare it to other firms. If each firm chose its own idiosyncratic method of disclosure, comparability across firms would be lost—a problem that is apparent among the private equity funds, where investors complain about the difficulty of comparing fund performance when each fund can choose the method of disclosing performance that it prefers.

Of course, there are benefits of competition among standards, and eventually one standard will drive out another. The central authority may insist on the wrong standard, either because it is mistaken or because it is influenced by a particular group of self-interested firms. Nevertheless, the virtues of ready comparability stemming from a single, even if biased, centrally imposed standard can help avert the confusion from competing, even if slowly convergent, standards.

Why the Government?

Some of what we have listed above can be done both by the government and by organized private bodies. But in many instances, the government enjoys a natural comparative advantage. Certain penalties, such as exclusion from future activities, can be enforced by private organizations, but there are limitations on how much punishment they can inflict. For one, certain harsh remedies like incarceration are, in civil societies, a monopoly of the government.

Equally important, private sanctions can always be negotiated down. A trader who violates the rules of the Securities Dealers Association can attempt to persuade the association to change the rules that led to his exclusion or, easier still, find a loophole. If he is a prominent member, he may have some success doing so, with the association preferring the easier route in the short term despite the longer-term loss of reputation. By contrast, a violation of securities laws will lead to penalties, with the government prosecutor having only narrow room to negotiate. Changing laws is a much costlier and more cumbersome process than changing association rules—one reason why the law is more likely to be enforced. Another reason is that a federal prosecutor will be more distant from the trader than exchange officials, making him more likely to enforce the rules.

Of course, in corrupt economies in which the government bureaucrat is willing to “negotiate” everything, the government may be worse than the Dealers Association because, unlike the association, the government bureaucrat has little to gain privately by punishing transgression. However, once a government progresses beyond the predatory phase, as discussed in the previous chapter, it should well be capable of harsher sanctions than private associations.

The second area in which governments might be better is in imposing an agreement on all, not just the narrow parties to a contract. Consider, for example, the concept of limited liability discussed in Chapter 2—the idea that a firm (or an individual) can walk away from its debts if unable to pay. While it may seem commonplace today, there was a time when it was thought that limited liability was a fraud perpetrated on the unsuspecting public investor by those who had influence enough to obtain such protection from the sovereign. It was felt that under limited liability, the rich lured the poor investor into a venture under the pretext that it was well capitalized and then left the venture to its own devices at the slightest hint of trouble without bearing any of the costs. An editorial in the Times of London in 1824 thundered:

Nothing can be so unjust as for a few persons abounding in wealth to offer a portion of their excess for the information of a company, to play with that excess for the information of a company—to lend the importance of their whole name and credit to the society, and then should the funds prove insufficient to answer all demands, to retire into the security of their unhazarded fortune, and leave the bait to be devoured by the poor deceived fish.⁹

But limited liability, as we have argued, is essential in a modern stock market, in which large sums have to be raised from a dispersed set of investors. It is, however, not simply a contract between two parties. Limitation of liability would be for naught if the owner’s liability were limited only vis-à-vis parties with which the firm wrote contracts but unlimited vis-à-vis third parties. No one would buy shares if the buyer’s entire wealth were at risk from suits by individuals who bought a defective product made by the company, or by the government attempting to recover the costs of environmental cleanup. This is why a stockholder enjoys limited liability even against noncontractual parties who have claims against the firm. Such a legal device, absolving the owner of any liability greater than the amount invested, and under a variety of circumstances, is a form of property right, held against one and all. Its universal applicability is impossible to achieve through private contract; it requires legitimization by the government.

More generally, finance makes use of a number of legal constructs such as priority (of debt), security (collateral), and bankruptcy, which attempt to specify property rights. But property rights are not simply a contract between two parties; they are a set of rights the individual holds against all comers, whoever they may be. For example, traditional Roman law defined the ownership of a piece of land as an unlimited right usque ad inferes et usque ad sidera (“from the center of the earth to the stars”). Such rights need the broad support of society through its agent, the government. Private contracting cannot substitute here.

In summary, we believe that there is a role a central authority can play in setting up the infrastructure for the financial system, and sometimes, but not always, the best institution to play this role is the government. An analogy may make our stand clear. Think of a downward-sloping field that needs to be irrigated. The force of gravity, if allowed to work, enables water to flow everywhere. This is the libertarian view. But there typically will be obstructions in the field, and channels will have to be cut to enable speedy irrigation, even if, given enough time, water will seep through everywhere. This is the interventionist view.

A more moderate libertarian view is that sometimes channels are needed, but farmers can organize privately to dig them. By intervening, the government will impede such private efforts. The interventionist recognizes the possibility that farmers may organize privately but argues that it will take time, there will be some tasks that are beyond private organizations, and perhaps most important, it may be prohibitively costly for the public to overcome the costs of organization and free-rider problems to create the necessary private organizations.

Thus far, we seem to have espoused the interventionist cause. But now it is time to recognize that the very forces that impede private organizations from voluntarily forming to undertake large public works will also prevent public organizations like the government from working in the public interest. Instead, even in a democracy, governments may work in the interest of a privileged few rather than the larger public and dig the wrong channels. This is what we now turn to.

Why Might the Wrong Channels Be Cut?

Given the undoubted benefits of financial development that we have documented, one might think that, in democracies, there would be strong political support in favor of finance and the government would be directed to create the necessary infrastructure. Unfortunately, this is not the case. Even in a democracy, not all voices are heard equally loudly, and policy making is often captured by powerful special interests that thrive because of the peculiarities of democratic governance. But what group has a vested interest against financial development? And how does it succeed in controlling the political agenda?

In order to illustrate the political obstacles to financial development, we will first explain which groups are likely to capture the government’s policy agenda, and then we will argue that such groups often have an antifinance bias in countries with an underdeveloped financial sector. In many ways, the arguments we present are not specific to governments: they apply equally to private organizations formed for public purposes, as long as the large mass of people influenced by the organization’s actions are dispersed and unable to coordinate actions.

Two economists, Mancur Olsen and George Stigler, argued in separate works that small, focused interest groups have disproportionate power in a democracy.¹⁰ These ideas, which have taken firm root at the University of Chicago, are simple but powerful.¹¹ An example should make the underlying rationale clear.

In many cities in the developed world, the number of taxis on the road is strictly regulated. Most cities give out a certain number of medallions, each of which gives the owner the right to run one taxi. In New York, this number is precisely 11,787, and no new medallions have been issued in the last fifty years. Anyone who wants to operate a taxi has to buy a medallion from an existing owner. If the number of medallions is scarce relative to the demand for operating taxis, the price of medallions will rise since their supply is strictly limited. Prices of medallions can indeed be very high (over $200,000 in New York), suggesting that demand far exceeds supply.¹²

From an economist’s perspective, this is an aberration. The high price of medallions suggests that there are potential entrants who would like to run taxicabs but are not allowed to. Such restrictions on the operation of the market seem unseemly. Yet the public rarely protests, even when it is habitually inconvenienced by the near impossibility of finding taxis.

When City Hall is asked, it will usually explain the restrictions on medallions as some combination of aesthetics, environment, and quality of service. More licenses for taxicabs would lead to more crowded streets and less-civil drivers. Moreover, cutthroat competition among drivers would not be good for the general public since medallion owners would have a lower incentive to maintain their cars or hire well-mannered, knowledgeable drivers.

These arguments are specious. Most cities do not impose minimum qualifications for taxi drivers. Medallion owners have no greater incentive to hire better drivers (or maintain cars) simply because their business is protected from entry: if anything, they have less incentive than if they faced competition. The real reason to restrict competition is the obvious one: medallion owners benefit from it.

How can the medallion owners get away with it? The answer is simple. Governments in democratic countries respond to pressure. Organized groups can exert more pressure than unorganized groups: they can pay for television advertisements, they can speak to City Hall functionaries, they can contribute influential amounts to campaigns . . . Which groups are the easiest to organize? A small group such as the owners of taxicab medallions has common interests and meets regularly at industry functions. It can quickly put together an agenda on which each member can agree. By contrast, the general public consists of people with widely differing motives and tastes. Everyone comes from different locations. It is hard to get everyone to meet, let alone speak with one voice.

Customers benefit from a competitive taxi market. But each one of them receives only a small benefit from an increase in the number of taxis, often too small to justify any political involvement. Furthermore, customers are dispersed, with many living out of town, so that the cost of coordinated action becomes prohibitively expensive. It is also costly for any one of them to inform himself about the details of the issue—whether the taxi owners and City Hall really have a sound economic case or whether they are camouflaging greed with high-sounding economics. Such rational ignorance is exacerbated by the ease with which any individual customer can hide among the large numbers of fellow customers and attempt a free ride on their political activities.¹³

By contrast, each taxi owner is greatly affected by entry and has the incentive to become well informed about his political options. Owners therefore form a small and well-identified group, which can easily act in a coordinated fashion. As a result, even in a democracy, their interest often prevails, despite the inefficient entry restrictions they advocate.

Economists cannot see inefficiency without asking whether there could be a better way. If the taxi owners are so politically powerful, could they not agree to forgo their privileges in return for a payment by customers? After all, everyone would be better off. Unfortunately, such bargains do not take place. One reason is that if such an offer were made, the public would no longer be ignorant. The arguments the taxi owners make for maintaining restrictions on the number of medallions would be revealed as specious (after all, they are willing to forgo restrictions for money, so it cannot be that society will embark on the road to perdition if the number of medallions is increased). Not being ignorant any longer, the public could vote to expand the number of medallions, leaving the taxi owners worse off. More generally, political privileges are often so tenuous that they cannot be traded, because the act of trading them will destroy them.¹⁴ Now let us try to understand how such a framework can explain why financial development may be retarded.

The Small Groups against Financial Development

Financial development appears to be so beneficial that it seems strange that anyone would be opposed to it. However, financial development is not always win-win. It could pose a threat to some.

Consider, for instance, established large industrial firms in an economy, a group we will call industrial incumbents. In times of stability, these incumbents typically do not need a developed financial system to ensure their access to resources. They can finance new projects out of earnings from existing businesses—as most established firms do—without accessing external capital markets. Even when their business does not generate sufficient cash to fund desired investments, they can offer the assets they already own or their reputation as collateral against which they can borrow. Typically, as we have seen, even a primitive financial system is geared to providing funds against collateral or reputation—so industrial incumbents rarely suffer from a lack of funds even if the system is underdeveloped.

Indeed, they may be hurt by financial development. To begin with, we have seen in Chapter 5 that financial development breeds competition, and competition erodes incumbents’ profits. Financial development also requires more transparency, which will directly hurt incumbents’ traditional ways of doing business through contacts and relationships. Consider some examples. In 1991, the Bronfman family was permitted by the Canadian tax authorities to move 2 billion Canadian dollars to the United States without paying capital gains taxes. When the auditor general complained that the transaction “may have circumvented the intent of the tax code,” the government finance committee attacked him for violating the Bronfmans’ right to privacy.¹⁵ In a similar vein, in India, a borrower can take money from one state bank, default, and obtain a fresh loan from another state bank. Banks do not share information about defaulters, in part because there is a law (which is finally being repealed) preventing widespread dissemination of information about defaulters. The privacy of defaulters and their right to maintain access to the public till are deemed more important than the public’s money, but this is, of course, natural in an economy dominated by incumbents.

Incumbent financiers may also not fully appreciate change. While financial development provides them with an opportunity to expand their activities, it also strikes at their very source of comparative advantage. In the absence of good disclosure and proper enforcement, any financing that is not against solid collateral is “relationship-based.” The incumbent financier gathers information from his wide-ranging informal contacts rather than from publicly available sources. He recovers payments not by using the legal system but by threatening and cajoling, using the many informal levers of power he has developed over the years. Key, therefore, to his ability to lend are his relationships with those who have influence over the firm, such as managers, other lenders, suppliers, and politicians. Equally important is his ability to monopolize the provision of finance to a client so that his threat to cut off credit carries weight. Such monopolies are more likely if there are no public records of a client’s repayment history so that the client is locked in to his financier because only the latter knows his credit history: any other financier approached by the client would be wary of lending, wondering whether he was being approached only because the incumbent financier had deemed the client too risky.

Opaque borrower histories and inadequate legal infrastructure provide formidable barriers to entry behind which the incumbent financier adapts to enjoy large profits. By contrast, disclosure and impartial enforcement tend to level the playing field and reduce barriers to entry into the financial sector. The incumbent financier’s old skills of being well connected become less important, while new ones of credit evaluation and risk management become necessary. Financial development not only introduces competition, which puts pressure on the incumbent financial institution’s profitability and its relationships, but it also makes the financier’s skills—his human capital—redundant.

In short, free markets tend to jeopardize ways of doing business that rely on unequal access. Thus, not only are incumbents likely to benefit less from financial development, but they might actually lose. This would imply that incumbents might collectively have a vested interest in preventing financial development.

They may also have the ability to affect policy: incumbents are a well-defined, focused, small group. In small countries, they have attended the same elite schools, frequent the same clubs, and often intermarry. They may be able to keep finance underdeveloped because those who benefit most from development, potential entrants, are small, poor, and unorganized, while the vast ill-informed majority do not know enough, or feel enough pain, to stir out of their complacency.

But this raises a question. Rich incumbents have other ways to protect their market share. Why choose to leave financial markets underdeveloped to do so? After all, this could end up hurting the incumbents, who might occasionally need external finance. Why not ban entry into industry or finance outright? Such a ban could be better targeted at rank outsiders, leaving insiders to enjoy the benefits of a more developed system.

There are, however, some advantages for incumbents from leaving finance underdeveloped as opposed to directly banning entry. First, direct entry restrictions often require very costly enforcement. Enforcement becomes particularly difficult, if not impossible, when the product whose market is restricted has many close substitutes. Enforcement is further complicated by the possibility that entrants can innovate around banned items. Each new threatening innovation has to be identified, categorized, and then banned. The bureaucracy that implements this “License Raj” will absorb a substantial part of the profits on its own and may compete for power with incumbents. By contrast, leaving finance underdeveloped is an act of omission, with few of the costs entailed by an act of commission, such as the use of the apparatus of the state to stamp out entry. Malign neglect may be as effective as active harassment but much easier to implement!

Second, the active enforcement of restrictions on entry is a very public, and therefore politically transparent, process. In a democracy, citizens have to be convinced that restrictions on entry benefit them, and this is a hard sell when they are faced with the poor service and extortionate prices of the local monopoly. By contrast, the malign neglect that leads to financial underdevelopment is less noticeable—it goes with the grain to have comatose bureaucrats who do not act rather than have overly active ones—and can be disguised under more noble motives. For example, the requirements that firms that list have to be profitable for a number of years before listing can be sold to the public as a way of protecting them from charlatans rather than as a way of preventing young, threatening, albeit unprofitable, entrants from raising finance. The requirement also obviates the need to improve accounting standards, something that would tend to level the playing field between the established and the fledgling.

Third, the more technical the barrier to entry is, the more costly it is for the general public to overcome their rational ignorance and find out whether it is justified. While most people can appreciate that a flat ban on entry has perverse effects, the same cannot be said for more technical norms that restrict access to finance. Take the above-mentioned listing requirement. For most voters, it would take considerable effort to find out whether it is justified: after all, are they not being protected from charlatans? If it is rational for the public to stay uninformed about technicalities, incumbents will find it easier to use that route to get their way.

Finally, the problem with entry restrictions is that they do not give a clear rule about which of the incumbents will get the right to monopolize new areas of the economy that emerge as a result of innovation or expansion. The fight over the right to enter these areas, especially when outsiders join in, can be messy, costly, and very public. It also will take profits from incumbents and give them to the bureaucracy that administers the system. By contrast, when the financial market is underdeveloped, the set of potential competitors for any new business is well defined and small—restricted to those incumbents that currently have financial surplus. This is the reason why, in less-developed capital markets, diversified business groups are dominant.¹⁶ Because they have internally generated funds, these incumbents naturally enter new sectors even when they have no specific expertise in that area. Opportunities are allocated to those that happen to have resources, without a messy fight.

In short, while votaries of free markets like George Stigler have pointed out that regulations often are instituted to protect the regulated from competition, they also tend to be dismissive of the need for any regulation at all to create a market. By contrast, as we argue in the beginning of this chapter, some regulatory and supervisory infrastructure is needed for a competitive market to flourish. If so, private interests can be opposed to that regulation. Lack of regulation can be as protective and as much of an entry barrier as excessive regulation or outright prohibitions on entry!

This is not to say that direct entry restrictions are not used. Around the world, to start a generic business, an entrepreneur typically needs to follow ten bureaucratic procedures, requiring sixty-three days, with a cost equal to one-third of the average per capita income.¹⁷ In some countries, however, the restrictions are more severe. In Bolivia, the number of procedures is twenty, with a cost equal to 2.6 times the average per capita income. These regulations do not seem to be used to screen out bad producers or protect the environment but rather to restrict entry. Of course, if the true objective is to limit entry, then it is efficient to use multiple methods, including keeping finance underdeveloped.

This is, in fact, what happens. If incumbents use multiple methods, and financial underdevelopment is similar in purpose to bureaucratic entry barriers, their use should be strongly positively correlated. They are! Countries requiring a lot of procedures to start a business also tend to have an underdeveloped capital market, with a low equity market capitalization to GDP ratio.¹⁸ This negative relationship suggests that financial underdevelopment is another form of entry barrier.

Summary

It is useful to reflect on the different points we make about power in the previous chapter and in this one. We argued in the previous chapter that the taming of the government did not take place when the lords and their associated retainers had coercive power. Instead, it seemed to take place as their concentrated coercive power gave way to the economic power of the gentry and as property migrated into the hands of those who could use it well. Not only did proprietors have the economic power to defend their interests (and with coordinating institutions like Parliament, the ability to translate economic power into political power), but it was also in the sovereign’s own interest to respect property rights and allow more participation in governance, for that would help him ensure that owners created the most economic surplus. They then paid the most taxes into the treasury coffers. These taxes could form a far more lucrative and stable form of revenue than periodic expropriation. Thus, wider and more efficient property holdings led to more participatory governance and more respect for private property rights.

But even if the government does become participatory and more respectful of property, there is no guarantee that it will work in the public interest. Small, well-focused groups can sway government policies toward their interests at the expense of the public. Since financial markets rely on the government for good policies, these policies may never be enacted when well-organized incumbents oppose them. This then leads naturally to the question “When are the special interests opposed to financial development overcome?” That is the subject of the next chapter.

CHAPTER EIGHT

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When Does Finance Develop?

IS FINANCIAL development doomed never to take place because incumbents are so powerful? Clearly not! Some countries have enjoyed strong financial systems at certain points in time, and there has been a worldwide boom in the financial sector in the last few decades. This must mean that sometimes incumbents cannot get together to block development, and even if they do so, the tyranny of incumbents can be broken and development unleashed.

One reason, as our earlier comparison of Brazil and Mexico suggests, is political change. The ideas of the French Revolution, distributed via Napoleon’s conquests throughout much of western Europe, picked up momentum with the revolutions of 1830 and 1848. By the 1850s and the 1860s, governments in Europe had become much more participatory. Arguably, the Napoleonic land reforms had the effect of diminishing the power of the then establishment, the landed nobility, and giving more political power to rich peasants, would-be industrialists, and financiers. With the growing economic importance of the business and professional class, financial reform followed quickly. For example, firms were allowed to incorporate freely with limited liability in France in 1863, Spain in 1869, Germany and Belgium in 1873 . . . Stock exchanges also emerged around this time. Many new firms were formed, and new financial institutions like the Crédit Mobilier in France sprang up to take on the establishment and provide credit to the upstarts.

A second reason for incumbents not to oppose development blindly is that they themselves can benefit from financial development when their investment opportunities are high relative to their ability to finance them. A sudden expansion in required scale, perhaps because of an opening of new markets for their products, increases their demand for financing. Alternatively, a sustained period of poor economic conditions may deplete incumbents’ reserves of cash, forcing them to seek finance and allowing them to be more amenable to financial development when the economy turns up.

Finally, and perhaps most important, increased competition resulting from forces beyond the control of incumbents—in particular, competition as a result of technological changes and competition stemming from open borders—can reduce incumbents’ incentives to use financial underdevelopment as a barrier to domestic entry. We now examine all these in greater detail.

Political Change and Financial Development: The Story of Crédit Mobilier

It is perhaps best to illustrate the impetus given to development by political change with a brief sketch of the rise and fall of the Société Générale de Crédit Mobilier in France in the second half of the nineteenth century.

The fall of Napoleon in 1814 (with a brief comeback in 1815) heralded a long period of relative peace in continental Europe. The industrial revolution picked up speed, and soon there was a tremendous need for credit to fund the expansion. But even in France, one of the most technologically advanced countries in western Europe, the financial system was grossly underdeveloped.

At the center of the financial system in France stood the Bank of France. It had been started by Napoleon, who was influenced by the success of the English government in mobilizing credit from the Bank of England. Napoleon, too, sought a ready source of credit for his military adventures with the Bank of France. But unlike the Bank of England, the Bank of France 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.”¹ Perhaps one reason the bank had such great difficulty raising money even at the height of the French Empire’s success was that it was little more than an extension of an all-powerful government, and it had no ability to refuse the extensive demands made on it. The initial reluctance of private investors to trust it with their money proved justified. With the fall of the empire in 1814, the bank went into virtual liquidation.

This established financial institution was, however, too valuable a tool for the government and the establishment to simply let die. While there were some moves to privatize the bank at this point, the Restoration government in France preferred having it under its own control. As Baron Louis, the then finance minister, told the representatives of the bank, “You 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.”²

From the beginning, the Bank of France stood as a bulwark against financial development because it feared the competitive threat to its own position.³ The bank opposed the setting up of joint stock banks. In part, this was because many of the grandest proposals were influenced by the doctrines of the eccentric philosopher Henri de Saint-Simon. Saint-Simon believed that the hereditary nobility and the landed aristocracy were parasites and the future lay in the hands of industrialists and bankers. The free flow of credit to industry was the key to progress, and his more sensible and enterprising followers proposed schemes marrying banking and industry. But the government of the Restoration (correctly) feared that these proposals struck at its own legitimacy—after all, the hereditary nobility and the landed aristocracy were its political base.⁴

It therefore took successive political revolutions to overcome the forces of incumbency. Even though the Revolution of 1830 weakened the aristocracy and put progressives in government, the Bank of France retained enough influence to oppose innovations, especially the founding of new financial institutions. The Revolution of 1848 further weakened the establishment, and a grievous blow was struck by the coup d’état that brought Louis Bonaparte to power. The new government was fully aware that the financial establishment, especially the Rothschilds and the Bank of France, had close connections with the Orleanist monarchy that had just been overthrown. So it made haste both to constrain the powers of the established financiers and to build up counterweights. One of the decisive actions it took was to force the Bank of France to extend more credit to emerging industries like the railways (which did not have ties to the ancien régime). It also authorized new kinds of financial institutions such as mortgage banks. Soon, France had a national market that could supply mortgage financing to even the smallest borrowers at reasonable prices. But perhaps the boldest move was to authorize the formation of the Société Générale de Crédit Mobilier in 1852.

The promoters of the Crédit Mobilier were Emile and Isaac Pereire, brothers who had been strongly influenced by Saint-Simon’s economic ideas. They had a vision of a vast financial conglomerate that would be financed through equity and bond issues and would diversify risk by lending to a variety of industries. By controlling the flow of credit to these industries, it would be able to fine-tune production and thus make sure that all parts of the economy moved in harmony, without periods of overcapacity and unemployment. The liabilities of this giant intermediary would be safe and liquid because it was so well diversified and because it was governed by the most reputable captains of banking and industry (including, of course, the Pereires).⁵ Thus, the Crédit Mobilier was part trust fund, part bank, part cartel. Modern banking theory would suggest that some of its functions were incompatible. Nevertheless, to the government of the Second Empire, it looked like the very institution to challenge the dominance of the Bank of France and the Rothschilds.

The proposal for the Crédit Mobilier was predictably opposed by James Rothschild, who wrote a letter to the government characterizing the scheme as fraught with speculation, irresponsibility, and monopoly.⁶ Nevertheless, there was great support for the venture among the public, so much so that a market developed in its shares even before issue, when they fetched a price that reached four times the par value of the stock.⁷ Since it had the support of the government, and because it had caught the public imagination, it was impossible to stop the Crédit Mobilier from being set up.

It soon had enormous impact, not just in France but also in continental Europe. In its first year of operations, it bought a large stake in the Crédit Foncier, the newly created national mortgage bank, with which it shared directors and coordinated operations. It financed through direct lending and underwriting a number of railroads and merged some of them together. It reorganized the coal industry in Loire and participated in setting up the Darmstädter Bank, which was modeled along the lines of the Crédit Mobilier itself, in Germany. It financed a number of other undertakings in France and neighboring countries and subscribed to a government loan.⁸ The economic historian Rondo Cameron provides a measure of the rapid growth in its importance to the French economy. By 1856, four years after it commenced operations, it handled all financial operations for sixteen large financial and industrial enterprises, with a combined capital of 1 billion francs, over one-fifth the capitalization of the Paris Bourse.⁹ It had considerable effect on the formation and financing of large-scale enterprises, and soon every government in western Europe considered setting up its own version.

Some of the best-known banks in France today were set up during this period of ferment when the government encouraged rather than opposed new business formation. The Crédit Lyonnais incorporated under the new limited-liability laws in 1863 and the Société Générale in 1864. Numerous new joint stock banks were set up in other countries of continental Europe.

Parenthetically, such periods of economic and political ferment are extremely important. After all, the entrant of today becomes the incumbent of tomorrow. If the leaders of the financial and industrial sectors emerge extremely competitive from such episodes, they are less likely to press for inefficient regulations hampering entry.

Despite serving as an example—and in many cases, a catalyst—for financial development, the Crédit Mobilier itself faced increasing problems. These had to do with the way it was financed and the control its opponents had over it. The firm was set up initially with substantial equity capital. It could also issue short-term debt and take deposits from the companies it had promoted (its affiliates). These, and its ability to recover loans made to, or to sell the securities it held in, affiliate companies in the booming market, were sufficient for it to provide financing to new ventures when times were good. But with the depression of 1857–1858, many of these sources dried up. Instead of affiliates’ being net sources of funds, they became net drains, requiring large loans to help them through the troubled times. As public financial markets dried up, the Crédit Mobilier became their only hope.

Moreover, instead of following sound banking practice and maintaining a diversified portfolio, the Pereires became infected with the hubris that often strikes successful financiers—that anything they touch will turn to gold. One of their early promotions was a company set up in 1854 for urban reconstruction in Paris. The Société Immobilière, as it became known, soon became enmeshed in another one of the Pereires’ projects, the proposed Suez Canal. Anticipating that its opening would transform Marseilles into one of the world’s largest ports, the société bought large tracts of land around Marseilles and started developing them with funds from the Crédit Mobilier. But investment in land, especially when the principle is “build it and they will come,” is fundamentally illiquid. By 1865, the Crédit Mobilier had 55 million francs in loans to companies, of which fully 52 million were to the société.

Crédit Mobilier’s fundamental problem now emerged. It had little ability to fund illiquid investments because the government controlled its access to long-term funding. And the government was influenced by Crédit Mobilier’s rivals, the Bank of France and the Rothschilds, who, seeing that the government of Louis Bonaparte was likely to be around for some time, had wormed their way back into its favors.¹⁰ So when, in September 1855, the Pereires announced a long-term bond issue, the government asked it initially to postpone the issue to avoid burdening the capital market with excessive issues and then forced it to postpone the issue indefinitely.¹¹ The Pereires did not help their case by repeatedly attacking the policies of the Bank of France. So when again, in 1863, the Pereires proposed doubling the capital of the Crédit Mobilier, the proposal was again turned down.

As its loans to the Société Immobilière grew, the Pereires finally got permission to raise new capital, in return for a number of modifications in its statutes, restricting its freedom of action further. But it was already too late. The new capital was simply poured into the bottomless pit of the Société Immobilière. Shareholders grew restive, and Crédit Mobilier’s share price plummeted. On the verge of bankruptcy, the Pereires found other financial institutions reluctant to lend and approached the Bank of France for a loan to extricate themselves from the mess at the Société Immobilière.

As Rondo Cameron puts it, “The first reaction of the regents [of the Bank of France] was outrage and indignation. That they should be asked to save the men and institution that for 15—nay, 37—years had by both word and deed attacked and attempted to overturn their privileges and position!”¹² Eventually, however, the Bank of France felt that the total collapse of a large institution like the Crédit Mobilier could have repercussions on the whole economy and decided to intervene, at the very least to ensure an orderly liquidation. In return, it demanded the resignation of the Pereires brothers from their posts. Somewhat ironically, it was a former governor of the Bank of France who replaced Isaac Pereire as chairman and presided over the restructuring of the firm. While the Crédit Mobilier did not really expire till the Great Depression in the 1930s, henceforth, it was a shadow of its former self.

The demise of the Crédit Mobilier contains, in many ways, the classic cautionary lessons on how to run a financial institution. Diversify, do not throw good money after bad, match assets with liabilities, maintain liquidity, or at least make sure you have friends who are willing to supply liquidity when you are in need . . . All these lessons were ignored. The Crédit Mobilier may not even have been particularly good at financing its clients: its clients were not particularly damaged by Crédit Mobilier’s demise, suggesting either that it was never very special or that its clients had seen the handwriting on the wall and had acquired alternative sources of finance by the time it became incapable of lending.”¹³

Nevertheless, the story of the Crédit Mobilier also reflects how important political change is to financial reform. It shows how an upstart financial institution, by devising new financial and industrial arrangements, can shake up the entire financial and industrial establishment, far more perhaps than direct political intervention ever could. It also shows that the establishment will follow the upstart’s lead if its strategy is of any value and may eventually beat it at its own game. So even if the upstart is short-lived, it can forever change the practice of finance. In order to preserve their position in Austria, for example, the Rothschilds were forced to set up a Crédit Mobilier–like institution, the Creditanstalt, which was at the center of the Austrian financial system till the Great Depression.¹⁴ In more recent times in the United States, we have seen how the financing of hostile takeovers by Drexel Burnham Lambert eventually led top-tier commercial and investment banks to overcome their own scruples about antagonizing the blue-blooded industrial establishment. They were forced by the competition from upstart Drexel to finance the takeover of such hoary firms as Singer and RJR Nabisco, against the desires of the incumbent management.

The comparison is particularly apt. Like the Crédit Mobilier, Drexel Burnham Lambert, too, stepped on many toes and found it had few friends in the establishment when it ran into difficulty. That the Federal Reserve did not find it imperative to orchestrate its rescue cannot be unrelated to the number of enemies Drexel made through its financing decisions. Plus ça change, plus c’est la même chose!¹⁵

New Opportunities and Financial Development

The new financial and industrial firms that emerge during a period of political change eventually do become established incumbents—if they do not die first. But they do not always want to use their powers to kick away the ladder of financing that took them to their perch: industrial incumbents will also benefit from financial development when their investment opportunities are high relative to their ability to finance them. A sudden expansion in required scale, perhaps because of an opening of new markets, increases their demand for financing and hence their willingness to press for financial development. Efficient producers are especially likely to see opportunity rather than threat in new markets.

In the 1850s and 1860s, the dramatic reduction in the cost of transportation suddenly expanded the potential size of the market that each firm could service. In order to enable their firms to penetrate foreign markets, countries started espousing the cause of free trade. They also moved to the gold standard. The fixing of exchange rates in terms of gold allowed producers to be more certain of the prices they would get for exports (as well as the costs of their imported inputs), thus allowing them to produce for trade with greater confidence. The gold standard also encouraged intercountry flows of capital, which benefited both capital-rich countries like England that could invest their surplus and capital-poor countries like Sweden that could industrialize rapidly using foreign capital. Thus, the expansion in markets also led to an expansion in the need for financing as well as in the supply of financing.

Incumbents’ attitude toward financial development can change over time, as financing needs change. In continental Europe, for instance, World War I represented an important turning point in these needs, especially for heavy industry. Before the war, high investment needs made heavy industry very dependent on external financing. As a result, the cause of financial development was strongly supported by powerful industrial firms in these countries. After the war, however, inflation and war profits freed many of these firms from the need to raise funds on a continuous basis. For example, Ansaldo, an Italian producer of heavy machinery, was very dependent on bank financing before the war. After the war, it was flush with cash, so much so that it twice attempted to take over the very bank that had financed its development before the war.¹⁶ In short, changes in the financing needs of major players (rather than the needs of the larger public) can contribute to a significant shift in the political attitude toward finance.

New Technologies and Competition from the Outside

Technological change can also make it less profitable for incumbents to keep out potential local entrants. This is because technology can make it possible for competition to seep in from across political borders. Because political entry barriers are no longer airtight, incumbents may also abandon their support for other forms of entry barriers, including financial underdevelopment. An example of a regulatory entry barrier in the United States that succumbed in large part to the competitive pressure brought about by technological change is the law prohibiting banks from opening branches.

The United States Constitution prevented its constituent states from issuing their own money and from taxing trade between states. As a result, early in their history, states had to look for new sources of revenue. One important source was banks. States restricted entry into banking: a bank charter purchased on payment of a substantial fee to the state was required to undertake banking business in a state. Furthermore, states often held shares in banks and also taxed their profits.¹⁷

Bank profits were therefore a disguised tax on the people, with private bank owners making profits and passing a significant portion on to the state in the form of taxes and dividends. The state could maximize taxes by maximizing bank profits. This would imply giving a bank charter to only one bank for the entire state. But that would put too much power in the hands of one bank. Equally inconvenient from the state’s perspective was to give charters to many banks, for that would force them to compete away profits, thus allowing the undeserving public rather than the needy government to get the benefits.

States therefore decided on a halfway measure. More than one bank would be given charters, but banks would not be allowed to open multiple branches within the state. Some states even had unit banking laws, restricting each bank to just one branch. The effect of these restrictions was to give each bank a monopoly over a small area surrounding it, enabling the bank to make profits. But they also ensured that the state was not beholden to one bank. Thus, restrictions on intrastate branching became the norm. Moreover, since states did not receive fees from banks incorporated in other states, they prohibited out-of-state banks from operating within their borders.

In general, these restrictions were extremely inefficient. By preventing good banks from expanding, and all banks from diversifying beyond their local territory, the branching restrictions made banks, on average, less cost-effective and more risky. Yet the restrictions persisted, initially because the state needed them to raise revenue, and later, because the small banks that emerged as a result needed them to survive and were willing to pay the state’s legislators to ensure that the status quo prevailed.

This illustrates an important point about entry restrictions. Once the restrictions are in place, some constituencies will emerge that owe their existence to the restrictions and are not competitive enough to survive without them. There will be a natural tendency for these constituencies to grow more powerful over time: as time passes, those that are hurt by the restrictions will wither away, reducing the opposition. Restrictions will also provide the current and prospective profits with which the incumbents that benefit can pay for their political defense. By contrast, opponents of entry restrictions have nothing to offer supporters but competition. Competition erodes, rather than shores up, the prospective profits needed to pay for political assistance. Is it any wonder, then, that anticompetitive forces are so powerful?

In the case of branching restrictions, the natural supporters were small banks, which survived at an inefficiently small scale only because the branching restrictions protected them against large, cost-efficient banks. Other financial institutions such as insurance companies also supported restrictions because they feared that large banks would enter insurance and would be very effective at distributing insurance through their branches. Large banks were opposed to branching restrictions because they prevented their natural growth and diversification. It stands to reason that small banks and insurance companies would collude to keep in place the restrictions on intrastate branching. Through much of the twentieth century, their preferences prevailed. Starting in the early 1970s, however, many states relaxed their restrictions. What made them do it?

The answer is technology.¹⁸ Branching restrictions help a bank create a local monopoly for itself only if it is hard for other banks to do business with the bank’s customers at a distance. But technological innovations erode the effects of distance. Automatic teller machine networks enable a bank to provide cash to its customers no matter where they are, without having a local branch. Credit-rating agencies maintain detailed and timely records on customer creditworthiness so that a bank without a local presence can make loans to individuals without being subject to undue risk. In short, technological advances allow banking business to be conducted at a distance, eroding local monopolies and making them less valuable to maintain.¹⁹

While the broad timing of the deregulation across the various states in the United States, starting in the 1970s, corresponds to when these major technological advances became commercially important, there were differences among states as to when each one deregulated. The timing of when a particular state deregulated offers evidence of the strength of the private interests against deregulation in that state. The removal of restrictions on branching occurred sooner when the state had fewer small banks and more small, bank-dependent firms (which had a strong interest in facing more competitive banks). Also, the presence of a large insurance industry in that state led to delays in deregulation.²⁰

Deregulation also had the predicted consequences. Small banks lost market share, and in states where banks could enter the insurance sector, the insurance sector shrank. But in general, borrowers benefited because they obtained lower average interest rates on their loans, and the state economy benefited because growth rates of state income increased (as we have noted earlier).²¹ Special-interest groups were indeed holding back economic progress, and technological change may indeed have been the only way that their incentives to oppose entry could be altered.

Openness and Financial Development

We have just seen that technological change can put pressure on incumbents to alter archaic financial regulations, since these become less useful in preventing competition. Another instance in which incumbents find financial underdevelopment less useful as a tool is when an economy is, or becomes, open to the entry of foreign goods and capital. The easiest way to think about this is as follows: Incumbents can manipulate the political process in order to suppress domestic competition. But open borders subject them to competition from entities that are not governed by the domestic political process. This has a number of consequences.

For one, there are fewer profits to protect in the system: given that the economy is open, incumbents cannot use domestic political action to restrain foreigners. Moreover, given that prospective profits from restraining domestic entry will be limited (how much damage can domestic entry do when one is bearing the full brunt of the foreign peril?), both the incentive to keep restraints in place as well as the ability to pay politicians for their support diminishes. Finally, in the face of foreign competition, even established domestic incumbents find a need to rely on the domestic infrastructure—for example, established firms finally find that the high cost of domestic finance hurts. So not only do they not want to oppose financial development, they become active supporters.

Of course, whether a country’s borders are open is itself, in part, a political decision. We will not examine that decision in this chapter, because it is part of a larger question of whether a country’s economy is willing to be market-oriented, which is the focus of subsequent chapters.

We have been a little quick thus far in arguing that openness fosters competition, which, in turn, fosters financial development. Some forms of outside competition may, in fact, make incumbents even more eager to suppress financial development. It is therefore useful to examine separately the effects of a country’s openness to trade (that is, to competition in goods and services) and the effects of its openness to capital flows (that is, to competition in the financial sector). It is also illuminating to separate out the reactions of industrial incumbents from financial incumbents.

Consider first a country that is open to trade alone. While foreign markets bring opportunity, openness also brings foreign competitors to domestic markets. Foreign entry drives down domestic profits. Lower profits mean that established firms have lower cash flow from operations, making them more dependent on external finance. At the same time, outside opportunities (or the need to defend domestic markets against superior foreign technologies) increase the need for incumbents to invest more and to manage their risks better.

Such competition was responsible, in part, for the liberalization of the financial sector in Spain in the aftermath of its accession to the European Community in 1986.²² Till then, the domestic financial system in Spain was dominated by a cartel of the seven largest banks, which controlled 72 percent of deposits and was able to maintain the cost of credit significantly above the European average.²³ The increasingly competitive environment resulting from the entry into the European Union highlighted the disadvantages imposed on the industrial sector by the financial system, forcing a major shift in policy. In 1988, the socialist government of Felipe González approved a major reform of the capital markets, a proposal by an ad hoc government commission that had been ignored for over a decade. That a socialist government pushed for the development of financial markets when its right-wing predecessor did not suggests that, under the pressure of foreign competition, ideology may play a very limited role.

What happened in Spain is probably an exception. Just because incumbent industrial firms need external finance does not mean the country will improve transparency and access to finance. In fact, given their greater need for finance, industrial incumbents may press for greater financial repression so that the available finance flows their way. Financial incumbents also may be unwilling to trade the increased competition in the financial sector (from greater transparency and access) for the additional industrial clientele that reforms may generate. It may be far more profitable to support the existing relationships with industrial incumbents and ply them with the greater amounts of capital they now need.

Instead of pressuring the government into improving the quality of the domestic financial system, therefore, industrial incumbents may petition it for further loan subsidies in the face of foreign competition. Government lending is pernicious for two reasons. First, it responds to political needs rather than economic opportunity. Second, cheap government funding tends to crowd out a public capital market since investors do not have the benefit of subsidies and cannot supply funds at the same rate. Funds will tend to be intermediated by the banking sector, which can petition the government for a share of the subsidies. Since the banking sector cannot compete with the government without subsidy, it will become little more than a government agency in charge of distributing credit according to government plans, even if not directly owned by the government.

This is in fact what happened in France after World War II. At the end of the war, French industry was largely composed of small and medium-sized firms. They had been isolated from international competition during much of the interwar period. Unlike in other countries in Western Europe, agriculture was still a dominant employer in the economy. Over the next thirty years, internal and external competitive pressures forced the economy to be transformed in two important ways. First, agriculture gave way to industry, and second, industry restructured and consolidated so that it came to be dominated by large firms.

Outside competitive pressures forced industrial change, but instead of allowing the financial markets free rein in effecting these changes, the government decided, for reasons we explore in more detail in the following chapters, to control the pace of change by taking over the financial sector.

For example, the French government intervened extensively in the labor-intensive textile industry. Even though the average firm was small relative to producers in other European countries, and even though it used outdated machinery, the government blocked new plants that would have higher productivity and potentially bid up wages. It directly subsidized wages to prevent layoffs and imposed a number of restrictions to prevent foreign competition. A fund was set up exclusively to provide monies that would preserve the small-scale nature of the textile industry.²⁴ Thus, initially, the objective seemed to be to preserve the industry in its antiquated form by providing finance.

Over time, economic forces did play themselves out, albeit slowly. Employment in the industry dropped, aided by government funding that helped smooth plant closures. The thrust of government intervention now turned to facilitating mergers, again with the carrot of government-directed credit. While government intervention certainly prevented the rapid layoffs that would have occurred if the industry had been exposed to competition, it also prolonged the pain and allowed the industry to become much less productive than its Dutch or German counterpart. And when, in the early 1970s, new competition emerged from developing countries, the industry was particularly unsuited to meet it. This unleashed yet another bout of government intervention, more aggressive than in the past, as decisions on what firms to rescue were made, not by creditors but by the government.²⁵ Intervention invariably creates its own future justification.

Government intervention in the allocation of credit was thus pervasive. As late as 1979, a Bank of France publication reported that 43 percent of all credits to the economy were made with some kind of privilege or subsidy, and 25 percent of corporate lending was subsidized directly.²⁶ Much of the control emanated from the treasury, a small group of approximately one hundred bureaucrats comprising the elite of the elite. As a French businessman who began his career in the treasury remarked:

You live with a profound belief that France is the center of the world, that Paris is the center of France, and the Trésor is the center of Paris. . . . The Trésor’s influence and prestige extend into every part of France. It represents the State inside the three largest banks: Crédit Lyonnais, Banque Nationale de Paris, and Société Générale. It also has a viselike grip on the finances of the French public sector, one of the biggest in the West, and on government subsidies.²⁷

In short, governments may intervene to mitigate the effects of outside competition, and this may further reduce the transparency of, and the access to, the financial system. Thus, openness to trade flows (that is, industrial-sector openness) alone may not be enough to convince either, or both, dominant interest groups to support financial development. This suggests that there were other factors in the Spanish experience that made it different from the earlier French experience, so that external competition spurred financial development in the former and government intervention in the latter.

It is when both cross-border trade flows and capital flows are unimpeded that industrial and financial incumbents will have convergent incentives to push for financial development. Industrial incumbents, with depleted profits and the need for restructuring operations to meet competition, will require funds. But it is important to note that, with free cross-border capital flows, the government will not be able to respond by stepping up the flow of credit to incumbents: as product markets become more competitive, the risks in, and information requirements for, lending will increase. The potential for large errors from the government’s directing the flow of credit will increase. Moreover, the ability of the government to provide large subsidized loans to favored firms will decrease as mobile international capital forces governments to maintain a balanced budget. The government’s role in the financial sector will diminish.

This is, in fact, what eventually happened in France. During the 1950s and 1960s, the French government limited the political price it had to pay for the extensive subsidized credit it doled out, financing the credit through an expansion in the money supply. This meant that instead of paying taxes to finance the government’s large expenditure, citizens financed it by accepting higher inflation and thus a lower value for their holdings of money. During this period, France was forced to devalue the franc three times (without counting the tariffs introduced in 1954, which were meant to mimic the effect of a devaluation).²⁸ But these devaluations were few and far between and were swallowed by the public.

Matters came to a head in the 1980s. Even though François Mitterrand came to power in 1981 with a program to increase subsidies and the state’s role in the economy, the environment had changed. With the breakdown of the Bretton Woods agreement (more on this later) in the 1970s, international capital mobility had increased. With the accession of Mitterand’s socialists to power, capital started fleeing France, partly because the rich were escaping before the anticipated confiscatory policies of the socialists and partly because the sensible foresaw that the exchange rate would come under pressure as the socialists continued loose budgetary policies. Almost inevitably, the French devalued in October 1981, then did so again in June 1982. By March 1983, France was again on the brink of running out of reserves as it tried to defend the franc.

The additional external pressure from free capital flows forced the socialist government to do an about-face. Recognizing that either it had to completely close down the economy to trade and capital flows or else it had to balance its budget and cease meddling in the functioning of the economy, it chose the latter. Only a few years after having nationalized the entire banking sector, the French socialists became strong supporters of a free market French financial system, so much so that in 1986, they inaugurated in Paris that ultimate symbol of a market economy, a futures market!

With the diminished role of the government, competition in the industrial sector and in the financial sector can reinforce each other when the economy is open to both trade and capital flows. The healthiest industrial incumbents will be able to tap the now open foreign markets for finance. These firms, able to compete in international markets, may not be much worried, or affected, by domestic entry and thus may not oppose domestic financial development. While the not-so-healthy industrial incumbents may be the hardest hit by foreign competition, there are reasons why they, too, may not oppose financial development and may in fact support it: they will need finance. And their existing financiers will be reluctant to lend to them on the old cozy terms.²⁹ Difficulty in financing will lead these firms to push for greater transparency and access so that their own access to finance improves. Unlike the case when the country is only open to capital flows, industrial incumbents now will also push for financial development. The accompanying threat of domestic industrial entry will now seem relatively minor, given the competitive state of the markets for goods and services.

Moreover, as the domestic financial sector loses some of its best clients, domestic financial institutions will want to seek new clients among the unborn or younger industrial firms that hitherto did not have the relationships to obtain finance. Since these clients will be riskier, and less well known, financial institutions will have no alternative but to press for improved disclosure and better contract enforcement. In turn, this leveling of the playing field will create the conditions for more entry and competition in the financial sector.

This then gives us the missing link for the Spanish experience. The salutary combination, not only of open borders to trade but also of prospective cross-border capital flows as a result of increasing European monetary integration, and not the former alone, gave strong impetus to the financial-sector reforms in Spain to which we referred earlier. European monetary integration has also provided a tremendous boost to stock markets around continental Europe, so much so that the Deutsche Bourse from Germany, a stock market from a traditionally bank-dominated country, seriously considered being the senior partner in a merger with the London Stock Exchange.

Other influences will kick in over time. As the domestic financial incumbents improve their skills, they will seek to compete abroad. As they look for new clients outside, they will be forced as a quid pro quo to increase access for foreigners and dismantle domestic regulations that give them their privileged competitive positions. For example, the German government banned lead underwriting of deutsche mark bonds by Japanese financial institutions until Japan agreed in 1985 to allow foreign securities firms to act as lead underwriters for bonds denominated in yen.³⁰ Foreign financial firms that enter the domestic market are likely to be another powerful constituency for financial development. Since they are not part of the domestic social and political networks, they would prefer transparent arm’s-length contracts and enforcement procedures to opaque negotiated arrangements. It is not a coincidence that these are the very requirements of would-be domestic entrepreneurs who are also outsiders to the domestic clubs.

The Japanese corporate bond market offers a good example of financial development’s being forced from the outside. In 1933, the Japanese banks, with the blessings of the Ministry of Finance, formed a Bond Committee, which determined which firms could issue bonds, on what terms, and when. The committee established a collateral principle—“Corporate bonds shall not be issued without sufficient collateral”—and required that only banks should serve as trustees of the collateral, in return for a substantial fee. This effectively brought all corporate debt financing under the control of banks, which, in turn, were given directions by the government on whom to favor.

The most important players had little incentive to object to the Bond Committee when it was set up, even though it significantly restricted the access of firms to the corporate bond markets.³¹ Each individual firm might have been better off if it could have obtained arm’s-length bond financing also instead of being restricted to bank financing. But initially no one wanted to upset the main bank and risk losing access to credit if economic conditions deteriorated. And restrictions on financing also restrained entry, and therefore competition, in the industrial sector. Therefore, as a collective, firms did not oppose change.

With the exception of the securities firms, other financial institutions also benefited, because they could charge higher rates for long-term financing, so they did not challenge the banks. The important securities firms were co-opted. Even though there were hundreds of securities firms, the big four—Nomura, Nikko, Daiwa, and Yamaichi—took turns lead-managing whatever issues were permitted and captured 75 percent of underwriting commissions.³² If they challenged the Bond Committee, their oligopoly might be threatened as well as the cozy fixed commission they enjoyed. The Japanese government was happy with the status quo because it could be confident that there would be no unpleasant defaults in the bond market and because, as a consequence of the restrictions, money flowed through the banking sector, where it was easier to direct. The only clear sufferer was the individual investor, but she could be ignored: as with all situations in which those who bear losses are small and dispersed, it was very hard for individuals to overcome inertia and free-rider problems to organize and fight the system.

With all the important players happy with matters, change had to come from outside. International capital flows were the source of this change. As it became easier to borrow abroad in the 1970s, mature Japanese firms attempted to reduce their costs by replacing bank debt with public debt. For this, they went to the Euromarket—an offshore financial market that was not under the control of the Japanese government—where there were no collateral requirements and there was a wide range of instruments, maturities, and currencies in which they could issue. From accounting for only 1.7 percent of Japanese corporate financing in the early 1970s, Euromarket issues went on to account for 36.2 percent in 1984.³³

Initially, Japanese banks tried to keep domestic restrictions on bond issuance—because they did not have the right to underwrite bonds in the domestic market—while they attempted to participate in underwriting some of the Eurobond issues. Japanese securities firms were opposed to this because they felt that banks would use their muscle to strong-arm clients into using them as lead underwriters. Perhaps more important, they feared that this would be a way for banks to eventually demand domestic underwriting powers. So Japanese banks and securities firms fought over clients in the Euromarket. The conflict, however, benefited the firms because there was no concerted attempt to hold them back from issuing in the Euromarket.

Meanwhile, there had been foreign pressure in the domestic market. In 1978, the U.S. retailer Sears requested permission to issue unsecured bonds in Japan. The Japanese government had little ability to deny the issue without inviting retaliatory action, especially when a Japanese retailer, Ito Yokado, announced that it would issue unsecured dollar bonds in New York later that year. The face-saving measure the Japanese government adopted was to draft conditions for firms to be eligible to issue unsecured bonds tailored so that forty foreign firms and only two Japanese firms, Toyota and Matsushita Electrical, qualified. In March 1979, Sears became the first firm to issue unsecured corporate bonds in Japan since 1933. Soon after, Matsushita Electrical followed.³⁴ The collateral principle had been breached!

Despite the increase over time in the number of firms that met the criterion for issuing unsecured bonds in the domestic market, there were still enough restrictions—such as a single issue date each month and the requirement that firms could not issue more than twice their net worth—that the domestic market continued to be unappetizing. The Bond Committee continued to oppose the establishment of bond-rating agencies for fear that its rules would be rendered redundant. After all, it had thus far succeeded in keeping Hitachi, with a top-quality AA rating in foreign markets, from being eligible to issue unsecured bonds in the domestic market.

However, as droves of firms continued to flee to the Euromarket, banks came around to the view that it might be better to trade some of that underwriting business in return for giving up their ability to act as spoiler in an increasingly irrelevant domestic bond market. So in the late 1980s, banks agreed to a horse trade whereby they agreed to relax the criteria for which firms were eligible to issue unsecured domestic bonds in return for the ability to act as lead underwriter for Japanese corporate issues in foreign markets.³⁵

Thus, competition from the Euromarket forced changes that allowed Japanese firms to tap domestic Japanese bond markets. It was not so much that the political power of various parties was changed, but the appeal of the status quo was reduced as profits evaporated, and incumbent financial institutions gave up their opposition to change. The primary virtue of competition from outside markets and institutions is, then, that foreign competitors are not part of any domestic cartel and therefore offer an opportunity for the public interest to prevail.

The Systematic Evidence

Thus far, we have provided anecdotal evidence supporting our thesis of how financial development takes place. A more systematic analysis of the patterns of financial development across countries and over time also supports our basic thesis. There was a surge in financial development in most European countries during the second half of the nineteenth century. During this period, the so-called bourgeois revolutions, bolstered by land reform, increased the political influence of the emerging industrial class. At the same time, the reduction in transportation costs, with the consequent expansion of markets, created great opportunities for investment and thus great needs for finance. This fortunate convergence between political change and the need for finance created the ideal conditions for financial development. Following the example of France under Louis Bonaparte, governments started to actively promote the development of their financial sectors. As a result, by the beginning of the twentieth century, advanced countries in Europe reached very high levels of financial development, higher than what we have seen as recently as 1980.

Consider the accompanying comparison between three different indicators of financial development in 1913 and in 1980 for a number of developed countries. The indicators are measures of financing (such as stock market capitalization) divided by measures of economic activity (such as gross domestic product).

One way to measure financial development is to look at the role played by banks in intermediating funds. This is what our first indicator, the ratio of deposits to GDP, captures. That this ratio dropped by 20 percent between 1913 and 1980 suggests that banks played a relatively bigger role in the allocation of savings at the beginning of the twentieth century.

Of course, it would be simplistic to draw any conclusion about financial development on the basis of this information alone. As financial markets develop, banks lose some of their importance; thus, the evidence could reflect the greater importance of financial markets in the latter part of the twentieth century. But this is not the case. If we use a similar indicator to measure the development of equity markets (the ratio of stock market capitalization to GDP), we find that in 1980, equity markets were less than half the size they were relative to GDP in 1913. In fact, for all countries except the United States and Norway, the ratio of stock market capitalization to GDP was smaller in 1980 than in 1913.

Even this measure is not perfect. For example, in 1980, Norway had a very high stock market capitalization to GDP ratio, not because the equity market played a big role in financing industry there, but because Norway found oil in the North Sea. Coupled with the second oil shock, which multiplied oil prices in 1979, the value of Norwegian oil companies increased tremendously. More generally, the level of equity market capitalization may reflect other factors besides the importance of the equity market in financing firms.

However, our third indicator, the fraction of investments financed through equity issues, also suggests a pattern similar to the first two.³⁶ In all countries except the United States, equity issues were a more important source of investment funding in 1913 than in 1980. On average, the fraction of investment financed with equity dropped from 13 percent to 2 percent over the period (and even in 1990, it had not reached the level it had reached in 1913). Overall, the different indicators give a remarkably consistent picture: in most countries, financial systems were highly developed in 1913, certainly in comparison with the picture in 1980.

There was, however, a fair amount of diversity across these countries. The equity market in 1913 was much more important in England, Belgium, and France than in the United States. The differences cannot be explained on the basis of differences in economic development alone. For example, per capita income in Japan was only one-fourth that of the United States, but its equity market was much more developed. What explains these differences across countries? What explains why these differences changed over time? And what explains the decline in all measures of financial development between 1913 and 1980?

One possible explanation is that the incentive and the ability of domestic incumbents to hold back domestic financial development was different across countries and over time because of differences in the degree of openness of the country’s goods and financial markets. We can check this. If our conjectures are right, a country’s domestic financial development should be positively correlated with its degree of openness to product and capital flows.

The twentieth century had two periods when the world was relatively open to capital flows. One was the period we have just examined, the beginning of the twentieth century. At that time, many countries adhered to the gold standard, making gold effectively the common currency of international trade and finance. Cross-border flows of capital were relatively unhindered, and capital traversed the globe looking for the highest return, whether it was to be found in Brazilian silver mines or Indian railways. Our analysis suggests that during this period of plentiful capital flows, incumbents would have had the least political will and strength to oppose financial development in countries that had the fortune to trade extensively. Thus, for any level of demand for finance, countries that were more open to trade at that time should have had much better-developed financial markets.

Consider, therefore, a plot of the size of a country’s equity market in 1913 against its openness to trade multiplied by the extent of its industrialization.³⁷ Countries that were more open to trade did, in fact, have bigger equity markets for any given level of industrialization (which is a proxy for the demand for finance).

Of particular interest is the United States, which despite being among the most industrialized countries in the world at this time, has a relatively underdeveloped equity market because it was relatively closed to trade.

We can graph other measures of the ease of access to finance in a country, such as the number of exchange-listed companies or the quantity of public corporate issues, and we find a similar pattern: before World War I, countries that were more open to trade had better capital markets.

Cross-border capital flows fell precipitously, for reasons we will come to, in the decades between 1930 and 1980 and started increasing only in the last part of the century. By the end of the century, they had regained the levels (relative to measures of economic activity such as world gross domestic product) that they had at the beginning of the century. A graph for 1997 similar to the one presented here for 1913 shows a similar pattern. Countries that were more open to trade at the beginning and the end of the century had deeper financial markets.

More analysis of the data suggests that the positive relationship between trade openness and the size of a country’s equity market is much weaker, or nonexistent, in the period between 1930 and 1980, when cross-border capital flows were much smaller. Thus, both cross-border trade and capital flows may indeed be necessary for financial development.

Of course, all we have documented are correlations between openness and the size of capital markets. Econometric techniques show that the former is likely to cause the latter.³⁸ Even so, this is only an indirect verification of the possibility that open borders curb the power of incumbents. The skeptical reader will want more direct evidence that openness influences financial development—in particular, that it works because it curbs the power, or alters the incentives, of incumbents.

There is such evidence. As described earlier in the book, Forbes magazine publishes a list of billionaires around the world every year, classifying them as those who inherited their wealth or those who created it through their own entrepreneurial efforts. We have argued that it is easier for a poor but talented entrepreneur to make it on her own in a developed financial system in which there is widespread access to finance. So in a developed financial system, the fraction of self-made billionaires should be higher. Conversely, in an opaque system, which protects incumbents against competition, it is easier for heirs, however incompetent, to retain their fortunes. As we described in Chapter 5, self-made billionaire wealth is higher in countries with a more transparent and developed financial system. More important, countries with lower barriers to foreign direct investment have a lower ratio of inherited billionaire wealth to GDP and a higher ratio of self-made billionaire wealth to GDP.³⁹

Lower barriers to foreign competition and lower incumbency seem to go together. It is unclear how much this is because countries dominated by incumbents create high barriers to competition penetrating from outside and how much it is because foreign competition erodes the economic might of incumbents. Regardless of the mechanism, the conclusion is clear: foreign competitors seem to make common cause with domestic entrants in making life difficult for domestic incumbents.

This conclusion is bolstered by evidence of the impact of the enactment of the Canada–United States Free Trade Agreement (FTA) in 1988.⁴⁰ The FTA lowered trade barriers between Canada and the United States and, perhaps more important, eliminated all kinds of discriminatory taxes on investors that had previously limited capital flows between the countries. The agreement was unexpected. Canada and the United States had reached the final stages of negotiations on freeing trade several times before but had balked. This time, the conservative government of Brian Mulroney, which favored free trade, called for a snap election on the issue. Polls did not augur well for the conservatives, but they astounded everybody by being elected with a clear mandate. Since markets were surprised by the election results, one way to see how the FTA impacted various kinds of firms is to see how their stock price reacted on the announcement.

The stock price of firms controlled by heirs of the original founder—our classic incumbents—was most adversely affected by the election results, while the stock price of entrepreneur-controlled firms went up. The market’s verdict was unmistakable: open borders are indeed inimical to entrenched incumbents.