Efficient Frontier
William J. Bernstein
Efficient Frontier
William J. Bernstein
Government and the Birth of Market Capitalism
Manifestly, market capitalism requires capital. The engine of the modern Western economy requires fueling by a torrent of other people’s money. This flow of capital is a new historical phenomenon; before 1800, the incessant economic growth we have come to expect was in fact unknown in the world. The history of the rise of world prosperity is in large part the history of these capital markets. Even today, governments are among the most voracious consumers of capital, typically for military adventure; in the premodern era, they were virtually the only ones capable of raising large amounts of funds.
The origins of the modern capital markets rested in the military needs of the sixteenth century Dutch Union. Amazingly, Holland was not yet fully independent from the Habsburg Spaniards, against whom they were fighting a brutal war of independence. The special genius of Dutch finance was getting everybody into the act; anyone with a few extra guilders was as liable to purchase government securities as someone today would be to plow savings into a money market or stock mutual fund.
The Dutch provinces and cities ("Holland" existed as a loose confederation of these entities, without a strong central government) issued three kinds of securities. Obligatien were short-term notes. These were "bearer bonds" that their owners could readily sell for cash at any time to a bank or broker. Losrenten were perpetual annuities, very similar to Venetian prestiti. These were not bearer bonds; instead, the holder of the debt recorded his name in a public ledger and received regular interest. They could be sold in the secondary market, and upon the death of the holder passed to his heirs. Last were lijfrenten, similar to losrenten, except that payments ended with the death of the holder. The yields of these instruments is of note. In the 1570s, the decade before the provinces declared their independence, losrenten yielded 8.33% in perpetuity. The Dutch do not take the word perpetuity lightly: In 1624 a woman by the name of Elsken Jorisdochter invested 1,200 florins in a bond used to finance dike repair paying 6.25%. It was free of all taxes, similar to a modern municipal bond. Handed down to her descendants, about a century later the rate was negotiated down to 2.5%. In 1938, it came into the hands of the New York Stock Exchange, and as late as 1957 it was still being presented for payment of interest at Utrecht.
Lijfrenten, because their interest payments ceased with the death of the holder, required a higher yield—16.67%. The difference between these two rates speaks volumes for European life expectancies at the time. Although the Dutch financial markets were advanced, they were not sophisticated enough to vary the interest of lijfrenten according to the age of the purchaser! By 1609, these rates had fallen to 6.25% and 12.5%, respectively. The cessation of hostilities with Spain in 1647, and the Spanish recognition of Dutch independence the following year had an electric effect on interest rates: not only was the survival of the Republic assured, but its demand for capital was greatly diminished. By 1655, the government could borrow at 4%, a rate of interest not seen since the apogee of the Roman Empire. Finally, in 1671, Johan de Witt, Holland’s Grand Pensionary, was one of the first to apply to finance Pascal’s new theories of probability, and arrived at a working formula that varied the interest paid on lijfrenten to purchasers of different ages.
The Dutch appetite for foreign investing was truly remarkable, even to the modern observer. Dutch foreign investment in 1800 stood at approximately 1.5 billion guilders, or twice its annual GDP. By comparison, U.S. investment abroad is less than half of annual GDP. This highlights the international character of flows of capital from nations with mature economies and excess wealth to those nations requiring it for development. In the seventeenth century, the major axis of flow was from Amsterdam to London, as the English transformed themselves from a backwater into a world power. In the nineteenth century, the by then highly developed English economy became the major source of capital for the developing United States, which in its turn became the major source of capital for the twentieth century’s developing nations. And so it goes.
The experience of Dutch finance after 1770 was not at all agreeable. By the end of the Napoleonic War, the world’s first mutual funds—aggregations of Dutch loans abroad—traded for about one quarter of their original prices; this is a good indicator of the devastation suffered by Dutch bondholders. The Dutch were once again in the vanguard of another trend in modern finance: the shearing of small investors by the great investment banks. Plus ça change. The bonds of foreign nations, many of which would not survive the global conflict no matter which side won, were priced to yield just slightly more than the secure 4% domestic issues—a rotten deal for credulous small investors, but profitable to the underwriters just the same. The recent touting of hyped-up dot-com stocks to a gullible public by mendacious investment bankers would not have surprised the average Dutch investor of 1800.
The reasons for the decline of Dutch financial dominance after 1750 are complex. For starters, Amsterdam never developed the kinds of vigorous central bank and regulatory bodies charged with protecting the investing public that later developed in Britain and the U.S. At the end of the day, the Dutch found themselves overwhelmed by the financial and military colossus slowly rising on the other side of the North Sea, which they themselves had helped build with their capital.
The seventeenth century was less kind to England. For the first half of the century, Parliament and the courts skirmished with the Stuarts—James I and Charles I—culminating in the defeat of the Royalist army by the parliamentary forces at Naseby in 1645 and Charles’ beheading in 1649, ending a brutal civil war. Even before this conflict broke out, state finances were shaky. Incredible as it seems to the modern reader, the English crown, like almost every other European monarchy, possessed no reliable source of funding. A prime source of revenue was the sale of monopolies, as well as the sale and renting of state lands, import and export tariffs, and the like, most of which served to stifle enterprise and trade. English monarchs, like royalty everywhere, were forced to borrow to finance their expensive military adventures. They frequently defaulted, and since it is very difficult to dun a sovereign, interest rates remained relatively high. After the restoration of the Stuart monarchy, this debt grew so large that it became increasingly difficult to service, resulting in the most infamous loan default in all English history: the "Stop of the Exchequer" in 1672, in which Charles II bankrupted much of the banking community that had extended him credit.
The Glorious Revolution of 1688 brought an end to nearly a century of civil strife, and the English "invited" the Dutch stadholder (a most peculiar institution—an appointed, and at times hereditary, ruler) Willem III to assume the British throne as William of Orange. He did not come alone; Holland’s financial elite, sensing that Amsterdam’s days as the world’s financial capital were numbered, followed him across the North Sea. The Portuguese Jews of Amsterdam, having been driven by the Inquisition from Spain to Lisbon to Holland, arrived in London en masse, as did the legendary Barings and Hope families. Abraham Ricardo, father of the economist David Ricardo, was perhaps the best-known of the Portuguese Jewish immigrants.
Dutch ideas came with them; the English enthusiastically copied "Dutch finance," and within a few short decades following the devastating civil strife of the seventeenth century, their capital markets eclipsed those of the Dutch. Naturally, frictions arose. Grumbled Daniel Defoe:
We blame the King that he relies too much
On Strangers, Germans, Huguenots, and Dutch
And seldom does his just affairs of State
To English Councillors communicateThings rapidly improved under the new regime. First, the old royal reliance on short-term loans was replaced with Dutch-style long-term government debt whose interest and principal payments were backed by excise taxes. Next, the English Treasury began cooperating with the banking community, experimenting to see which kinds of debt were best received by the investing public (that is, attracted the lowest interest rates). Trust was restored by parliamentary supremacy; the fact that commercial interests were well represented in the House of Commons reduced the likelihood of government default.
Most critically, the English learned how to transfer the cachet of its newly solvent government debt to the riskier capital needs of private companies. In 1697, the Bank of England (a private company until it was nationalized in 1946) pioneered a technique known as "engraftment," in which it assumed government debt. In practice, this meant that private holders of government bills and bonds exchanged them for Bank of England shares. This government debt, now in the hands of the Bank, provided a steady stream of income, provided collateral for further borrowings, and also informed the Bank of the intentions of further governmental borrowing needs, a valuable stream of information indeed.
Finally, in 1749, Henry Pelham, the Chancellor of the Exchequer, consolidated the confusing array of government loans into a single series of bonds, the famous "consols," which, like prestiti and losrenten, never matured and provided perpetual interest. They trade London to this day.
Although state borrowing may at first blush seem irrelevant to commercial lending, in fact, a healthy market for government debt is the essential first step for the successful delivery of business capital. The reasons for this are twofold. First, government debt is the simplest to price and sell. Since the mechanisms for the pricing and sale of commercial capital are the same, a successful market for government debt must exist before a commercial debt market can function smoothly. Second, government debt provides an essential benchmark, that of the "risk-free" investment. Government bonds and bills, which trade actively, give businessmen and entrepreneurs a continuous accurate measure of the rate of return demanded by perfectly safe enterprises. This forms a "baseline" to which can be added a "risk premium": the amount of extra interest demanded because of a loan’s risk. For example, at the time of Pelham’s conversion, consols yielded 3%, the lowest possible rate available to that most reliable of borrowers, the government. Thus, a moderately risky commercial venture might require a 6% rate, and a speculative one, in excess of 10%. The presence of an easily observable risk-free rate makes it easier to price and sell commercial capital.
In the U.S. as well, the establishment of a large and liquid market for government bonds helped smooth the way for the capitalization of private needs. In 1862, when Lincoln’s treasury secretary, Salmon P. Chase, failed to float a $500 million war issue, he called on Jay Cooke for help. The well-known Philadelphia investment banker used the newly invented telegraph to deploy an army of 2,500 agents to sell the bonds directly to the public; he floated an even larger issue just before the war ended. Beginning in 1870, Cooke used the same techniques to raise capital for the Pennsylvania Railroad. His method split the task between two groups. The first constituted the underwriters, who purchased a company’s debt at a discount; they bore the risk of being left with a large amount of unmarketable securities in the event that sales should fail. The second group was the large number of distributors who sold the issue directly to the public. In this manner were the vast capital needs of the new nation met.
Today’s mullahs of market fundamentalism blandish the pre-1900 era as one of blessed unfettered capitalism; nothing could be further from the truth. The vigorous modern culture of stock and bond investing required vigorous premodern jumpstarts from strong government institutions. Today, as in the past, the inevitable costs and inefficiencies of government supervision of capital flows are almost always outweighed by the resultant transparency and trust.