Striking it rich; the rise and fall of popular capitalism.(The World of Business)

Thursday, August 12, 1982, didn't seem like a momentous day in American history. Events in the Middle East dominated the news. In Los Angeles, Henry Fonda died at seventy-seven after a long illness. In sports, the White Sox handed the Yankees their third straight loss. Wall Street was quiet. With the economy stuck in a slump, there was little interest in buying stocks. The Dow Jones Industrial Average fell by 0.29 points, ending at 776.92. The Nasdaq fell by 0.93 points, to 159.84. Nobody realized it at the time, but when the closing bell rang at the New York Stock Exchange the last bear market of the twentieth century had ended. The following morning, the Federal Reserve, led by Paul Volcker, cut short-term interest rates by half a per cent in an effort to revive the economy. It was the third rate reduction in a month, and it worked. From then on, the stock market and the economy recovered in tandem. By the end of 1982, the Dow was trading above 1,000. The greatest bull market ever -- one that would see the Dow rise more than tenfold and the Nasdaq rise almost thirtyfold -- was under way.

Stock markets are like electricity and airplanes: extremely useful inventions that sometimes go haywire. They transfer resources from people with money to businesses that have projects they don't have enough money to finance. This may sound trivial but it isn't. Economic systems that have relied on other methods of mobilizing savings for investment, such as government fiat (the Soviet bloc) or the banking system (Germany), have run into problems. Stock markets also provide incentives for innovation and hard work. If an entrepreneur sets up a successful company, he or she can issue stock to investors in an I.P.O., a process known as "going public." The promise of striking it rich in the stock market gets a lot of people out of bed in the morning.

The New York Stock and Exchange Board opened for business in 1817, but it wasn't until the eighteen-sixties that large-scale capital-raising began in America. During the Civil War, the banker Jay Cooke successfully organized the sale of five hundred million dollars' worth of federal government bonds, thereby demonstrating that Americans were willing to part with hard-earned cash for paper securities. In 1869, Cooke took over the Northern Pacific Railroad and tried to sell a hundred million dollars' worth of bonds to pay for further expansion. This proved impossible, and on Thursday, September 18, 1873 -- the first "Black Thursday" -- Cooke's bank failed, just a day after he had President Ulysses S. Grant to dinner. Fear swept Wall Street, creditors rushed to withdraw their deposits, and several other banks collapsed. The New York Stock Exchange was forced to close down for ten days, and public faith in the financial markets was destroyed for a generation. Mark Twain captured the popular attitude in "Pudd'nhead Wilson" when he wrote, "October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February."

It wasn't until after the First World War that Americans returned to the stock market in large numbers. Following the invention of the Federal Reserve System, in 1913, many economists came to believe that the new science of monetary policy had rendered recessions obsolete. In 1927, Barron's, the financial weekly, hailed a "new era without depressions." (In September, 2000, the same publication would carry the front-page headline "CAN ANYTHING STOP THIS ECONOMY? DESPITE RECENT SIGNS OF A SLOWDOWN, EXPECT THE ECONOMY TO REMAIN ROBUST, WITH NO RECESSION IN SIGHT.") The mood of optimism spread to the stock market, and millions of people bought shares for the first time -- only to be caught out in the stock-market crash of October, 1929. For a generation after 1929, the stock market reverted to being a province of the rich. Middle-class families kept their money in the bank, in real estate, or in other investments.

The reemergence of popular capitalism at the end of the twentieth century was largely an accident. During the nineteen-seventies, a number of economists were concerned that Americans were saving too little for retirement, thereby putting the Social Security system under strain and depriving businesses of the funds needed for investment. To encourage thrift, Congress came up with a series of tax incentives for saving. In 1974, the first individual retirement accounts (I.R.A.s) were introduced, but the standards for qualification were strict, and they didn't really catch on. In the Tax Reform Act of 1978, legislators loosened things up a bit by allowing workers to contribute their cash bonuses to retirement savings accounts on a tax-deferred basis. The wording of this clause, No. 401(k), was vague, and it attracted the attention of R. Theodore Benna, an employee-benefits consultant in Langhorne, Pennsylvania.

One Saturday afternoon in 1980, Benna, who was then thirty-nine years old, was helping one of his clients, a local bank, to redesign its employee pension plan when he had a thought. If cash bonuses could be sheltered from tax under clause 401(k), why couldn't regular income be sheltered in the same way? There didn't appear to be anything in the statute that specifically ruled it out. "My approach was that if the code doesn't say, 'Thou shalt not,' then thou should be able to," Benna, a devout Baptist, later recalled. He designed a retirement plan that would allow employees to contribute a portion of their paychecks to a savings account on a pretax basis. A few months later, Benna's own firm, the Johnson Companies, launched the first 401(k) plan. In November, 1981, the Internal Revenue Service gave Benna's creation its official blessing. With legal approval, the new savings plans spread rapidly, and by 1985 more than ten million employees had one.

Through their 401(k) plans, tens of millions of middle-class families were introduced to the stock market. In most cases, the initiation took place through mutual funds -- investment companies that pool their shareholders' money and invest it in a range of financial assets. At the beginning of 1980, the total amount of money invested in stock and bond mutual funds was just forty-nine billion dollars. In 1995, Americans invested more than a hundred billion dollars in stock funds alone, and the figure went up from there. The growth of 401(k) plans and I.R.A.s transformed the mutual-fund industry and supported the bull market. Mutual funds poured money into the stock market, and the rise in stock prices drew more money into these funds. By the end of 2000, there was more money in mutual funds than there was in the banking system -- about seven trillion dollars, of which about four trillion was in stock funds. New funds were being created every day. At the start of 2001, the number of mutual funds topped eight thousand, which meant that there were more mutual funds than there were stocks listed on the New York Stock Exchange and the Nasdaq combined.