Capital Mobility and the Origins of Stock Markets.

Political institutions play a role in shaping factor mobility across sectors, space, and borders. I provide an illustration of this accepted, though hardly researched, idea by looking at the emergence of modern capital markets in the nineteenth century. The rise of corporate finance threatened to redeploy financial resources away from land and traditional sectors to heavy industry. I argue that mobilized and integrated markets flourished in the absence of blocking coalitions that had an interest in keeping finance local. I argue and show that the power of blocking coalitions was a reverse function of the degree of centralization of state institutions. I start by providing a conceptual interface between the abstract notion of capital used in trade models and the diversity of its actual occurrences as cash, debt, equity, buildings, patent, machinery, and so forth.

Unanswered Questions

The current notion of capital mobility--as conceived by (and used in) the asset specificity literature--is uncertain. Building on the work of Wolfgang Stolper and Paul Samuelson, the asset specificity literature shows that capital mobility--how capital flows across sectors of production--has redistributional effects. [1] For instance, given two factors, labor and capital, and two sectors sing both factors in different proportions, factor mobility homogenizes factor prices--wages and return to capital--across sectors. A corollary is that a change in product prices redistributes income across factors. In contrast, if factors are unable to switch employment across sectors, that is, if factors are (sector-)specific, then factor prices vary across sectors, and a change in product prices redistributes income across sectors. Therefore, lobbying for rents proceeds along sectoral lines with factor specificity and along factor lines--or not at all in light of the collective action dilemma faced by large groups--with fa ctor mobility. [2] Furthermore, building on insights from the industrial organization literature, political economists identify sources of factor specificity in barriers to entry, such as sunk investment costs, R&D intensity, learning by doing, brand name, patent, and so forth. [3] In a study of Norwegian firms, James E. Alt et al. argue that firms with large R&D expenditures create specific assets for the production of products with no close substitutes and difficult to dispose of in case there is no demand for the product. As a result, Alt et al. argue, R&D-intensive firms have a clear propensity to lobby for subsidies or market protection. [4]

The asset specificity literature rests on a notion of capital that is made up of dissimilar elements. Capital comes in two ways: (1) production capital, which includes machinery, stocks, the buildings that house them, and intangibles like patents; and (2) financial capital, referring to all financial assets, long and short term. The asset specificity literature does not deal with the dichotomy well: either it shuns financial capital to concentrate its attention on production capital exclusively, [5] or, alternatively, it treats production and financial capital as separate factors of production, with the latter systematically more mobile than the former. [6]

This classification of capital into its primary elements can only be a preliminary step in the study of capital mobility. The next step is to recombine their interactions--how the mobility of each element impacts that of the others. Production and financial capital are not two separate factors but represent the two sides of the balance sheet of a typical nonfinancial firm, with production capital on the assets side (buildings, machinery, and stocks) and financial capital on the liability side (equity and debt). Capital mobility is that of the side that is more mobile.

Which side is more mobile depends on whether or not there is a financial market. Absent a financial market, investors and creditors have concentrated stakes in few firms and even fewer sectors; they cannot easily exit a money-losing investment in specific (low liquidation value) assets, nor enter a profitable one, making lobbying for the regulatory protection of that investment a plausible option. In contrast, in the presence of a financial market, investors and creditors each own a diversified portfolio of corresponding instruments. [7] Little lobbying is likely to come out of a large number of small claimants; they are more likely to reduce--or write off-a stake in stagnating sectors and concentrate future investments in growth sectors. [8] The initiative to lobby, if any, is more likely to come from management (and labor), whose loyalty to the firm is higher than the investors' and the bankers', in order to prevent investors and bankers from walking away from the firm. In the presence of an efficient finan cial market, lobbying is more likely to reflect high financial capital mobility than low production capital mobility.

Therefore, in the presence of a modern financial market, nothing can prevent a dollar made in one sector from being invested into another sector; capital moves away from declining sectors to growth sectors, irrespective of asset specificity. All it takes is for large investors to modify their relative holdings of stocks in these sectors; the induced change in share values allows the growth sectors to incur more debt while forcing the declining sectors to reimburse past debt. In the presence of a financial market, therefore, capital mobility reflects intersectoral changes in expected profitability, not relative liquidation values of assets employed in different sectors, let alone conversion costs.

Only if the financial system is undeveloped is this transfer dependent on the degree of asset specificity--on whether entry by new firms is or is not possible. If entry is not limited (low asset specificity), then financial capital flows to growth sectors in the form of direct investment financed through profit retention by nonfinancial companies. If entry is limited (high asset specificity), then financial capital does not move across sectors, and capital mobility then reflects the liquidation value of physical assets--or, in the event that the unbolted value is unacceptably low or nonexistent, the conversion costs of these assets. The relationship between financial market development and capital mobility with respect to a given sector is thus heteroskedastic--financial development is a sufficient, though not a necessary, condition for capital mobility. But considering all sectors together and assuming that sectors with specific assets are equally distributed across national economies, capital mobility is h igher on average in financially developed economies than in undeveloped ones.

The key determinant of capital mobility across countries, therefore, is the degree of development of the capital market, or, to be precise, corporate securities markets. What accounts for the origins of corporate securities markets? A survey of the literature reveals four rival lines of argument: economic development, information asymmetry, government intervention, and legal origins. First, historians generally hold the general level of economic development as the prime suspect for financial market development. [9] A larger pool of savings implied a higher demand for investment instruments. A second explanation points to the seeding role of prior public-debt markets. [10] Efficient stock markets, in addition to a columnar building and extra phone lines, have to be liquid--a collective dilemma, since each one trades if he or she anticipates the others will trade. [11] Private entrepreneurs and investors could not overcome this free-riding problem but used the services of investment bankers and institutional i nvestors that had built their reputation dealing with debt or government-financed railway bonds in countries where this was the case.

The third explanation stresses the role of rules favoring disclosure of financial information and curtailing insider trading on privileged information. Environments characterized by information asymmetry between investor and entrepreneur negatively impact securities market development. [12] The fourth and most recent theoretical foray into the growth of stock markets emphasizes the common law or civil law origins of the legal system. Rafael La Porta et al. show that countries with poor investor protection against expropriation by insiders, as reflected by legal rules and the quality of law enforcement, have shallow and narrow capital markets. [13] These rules and the quality of their enforcement, they show, vary systematically by legal origin--common law is more apt than civil law to reduce contracting uncertainty between the parties to a security issue. [14]

All four accounts treat markets as an efficient response to an environment characterized either by a plentiful supply of capital (saved wealth) or by low transaction costs (fixed costs defrayed by the state treasury, investment information, or judicial enforcement). They treat supply, public debt, and rules as parametric, exogenous to investors' choice. Missing are the main tools of the political, trade--redistribution, conflict, rent seeking, and politicians. And yet, it would be quite unprecedented if the advent of corporate securities markets had no redistributional effects, elicited no opposition, triggered no rent seeking, and yielded no compensation in the form of regulatory obstacles to capital mobility.

In the following, I offer a political account of the origins of corporate securities markets. I argue that markets developed as a result of a conflict between corporate financiers and traditional sectors, mediated by politicians, and of which the outcome was influenced by the degree of centralization of state institutions. Financial capital mobility is embedded in political institutions. I assess the empirical validity of this claim, first, by developing the exemplary cases of Britain, France, and Germany in some detail. I then proceed to test on a nine-country data set two general hypotheses: that local banks crowded out markets, and that centralization was associated with markets. Building on the empirical findings, I draw several theoretical consequences for the study of financial capital mobility: the relation between various forms of financial capital mobility, the role of political institutions in locking in factor specificity, and the presumed impact of financial capital mobility on the tariff.

The Argument

The development of a corporate capital market was part of a larger financial revolution involving the creation of a money market and the concentration of banking. Together, these three developments threatened to divert capital away from traditional sectors--agriculture, artisans, shopkeepers--to heavy industry. The potential losers had four options: [I] use their political power to block the development of financial markets, [2] beef up the alternative local banking sector and starve the financial center from capital, [3] put pressure on the central government to make the new markets work for traditional sectors, or [4] do nothing. The path they selected reflected two parameters: their political power and the degree of state centralization. Where they had no power, they did nothing and corporate finance developed unhindered. Where the potential losers enjoyed political power, but where the state was centralized, they pursued the third option--they made the market work for them. As a result, corporate finance developed almost unhindered. Where they enjoyed political power and where the state was decentralized, they pursued the first two options--they regulated the markets out of existence and starved them out of resources. I first provide background on the financial corporate revolution, then enumerate the available strategies, and last derive market outcomes.

The advent of corporate securities markets was, along with money markets and banking concentration, one of three mutually reinforcing components of the financial revolution of the late nineteenth century. [15] Corporate securities markets, first, were a functional response to the second industrial revolution. The banks could not finance the large immobilization of capital in steel, chemicals, electrical machinery, and communications (telegraph, telephone) by means of loans--they would have been too large and would have undermined the banks' liquidity (their capacity to call in loans to face eventual deposit withdrawals). Markets allowed banks to transform long-term loans to industry into securities, recoup their liquidity, and lend anew. [16] Still, few individuals were willing to merely take over corporate financing from the banks and immobilize their savings in the form of securities of risky private ventures. They could get an honest return at no risk by buying public debt. The creation of a secondary mar ket for corporate securities, allowing the owner of a security to sell it at any time, is what earned stock markets their …