Finance in America: An Unfinished Story

The economic crisis of 2008 led to an unprecedented focus on the world of high finance--and revealed it to be far more arcane and influential than most people could ever have imagined. Any hope of avoiding future crises, it's clear, rest on understanding finance itself.
To understand finance, however, we have to learn its history, and this book fills that need. Kevin R. Brine, an industry veteran, and Mary Poovey, an acclaimed historian, show that finance as we know it today emerged gradually in the late nineteenth century and only coalesced after World War II, becoming ever more complicated--and ever more central to the American economy. The authors explain the models, regulations, and institutions at the heart of modern finance and uncover the complex and sometimes surprising origins of its critical features, such as corporate accounting standards, the Federal Reserve System, risk management practices, and American Keynesian and New Classic monetary economics. This book sees finance through its highs and lows, from pre-Depression to post-Recession, exploring the myriad ways in which the practices of finance and the realities of the economy influenced one another through the years.
A masterwork of collaboration, Finance in America lays bare the theories and practices that constitute finance, opening up the discussion of its role and risks to a broad range of scholars and citizens.

ISBN-13: 9780226502182

Media Type: Paperback

Publisher: University of Chicago Press

Publication Date: 11-16-2017

Pages: 528

Product Dimensions: 5.90(w) x 8.40(h) x 1.10(d)

Kevin R. Brine is an author, artist, and private investor. A Wall Street veteran, Brine spent over two decades as a board member and senior executive of a prominent investment management and research company and subsequently served on the board of a New York Stock Exchange insurance company. Mary Poovey has recently retired from her position as Samuel Rudin University Professor in the Humanities at New York University. She is the author of numerous books, including A History of the Modern Fact: Problems of Knowledge in the Sciences of Wealth and Society and Genres of the Credit Economy: Mediating Value in Eighteenth- and Nineteenth-Century Britain.

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CHAPTER 1

Early Twentieth-Century Origins of American Finance: The Rise of the American Corporation and the Creation of the Financial Reserve System

1.1. Valuing the New US Corporations

A nation's economy is simultaneously omnipresent and impossible to see, for an "economy" is a theoretical abstraction, a metaphor that seeks to present an array of disparate transactions, institutions, and conventions as a single, dynamic whole. By the same token, "finance," or the financial "side" of an economy, is also a metaphorical abstraction. Even though the "economy" and its financial "side" are metaphors, however, both abstractions can be treated historically, for the array to which each term refers undergoes change — in terms of size and complexity, in the institutions it contains, and in the theoretical concepts by which individuals struggle to understand their economic environment. One of the major stories of this book concerns the development of techniques and theories designed to render the economy and its financial side visible, and thus comprehensible and measurable: national income and product accounts, flow and fund depictions of the nation's capital, theoretical treatments of financial institutions and financial intermediation. Before these measuring instruments were formalized — indeed, before regional and state markets could be viewed as a national economy — the economy and its financial side attracted attention primarily when another kind of event drew attention to them. When a presidential campaign was waged in the name of "free silver," as was the 1896 campaign of William Jennings Bryan, or when a Wall Street panic exposed outrageous shenanigans on the part of bank trustees, as occurred in 1907, Americans undoubtedly turned their attention to the economy and its financial side. Even though modern analysts have estimated that the financial industry represented only about 1.5% of the nation's gross domestic product (GDP) in the middle of the nineteenth century and 3% by the century's end, economic and financial issues could — and occasionally did — become newsworthy matters. It was these episodes, as much as theoretical debates about technical matters such as the "quantity theory" versus the "banking theory" of money, that initially helped form images of an American economy and its financial side.

This chapter examines some of the developments that helped make the US economy and its financial side imaginable before theoretical measures like GDP were available. Some of these developments were unmistakable and have deservedly attracted historical attention, for, at the end of the nineteenth century and in the first decades of the twentieth, America was undergoing sweeping changes: the largely agricultural nation was experiencing a gradual shift of its population to urban centers; a decentralized and complex banking system was being consolidated; and family-owned businesses were being absorbed by the massive businesses that contemporaries called "trusts" or "corporations." Other developments, by contrast, were harder to see — if not wholly invisible to citizens. Alongside an account of some of the most obvious developments of these decades, we present a history of one of the most consequential but neglected behind-the-scenes developments: the transformation of the theory and practice of accounting. While invisible to most contemporaries and often overlooked by historians, developments in accounting made the rise of the American corporation possible; they underwrote the operations of the Federal Reserve system after 1913; and the corporate accounting structure that was eventually normalized became the backbone of the national income and production accounts created in the 1930s and 1940s. These developments in accountancy, in turn, were responses to and eventually provided an answer to a pressing social question: how should the new corporations be valued?

The problem of corporate valuation became pressing at the beginning of the twentieth century for two reasons. First, there was no precedent for placing a dollar value on these new companies' assets, which consisted of not only familiar physical holdings such as buildings and machinery but also intangible forms of property such as the "goodwill" and "earning potential" the corporation claimed from the companies it absorbed. Second, glowing advertisements drawn up by company promoters often predicted profits that, in the absence of any track record, looked too good to be true. Worries about what contemporaries called stock "watering," as well as debates about "capitalization" and "excess" earnings, began to appear in contemporary publications, as the public wondered how to evaluate and understand the implications of this new company form. These issues were eventually addressed, albeit indirectly, by measures taken in the humble realm of accounting.

The impact on the American economy of what historians call the first merger movement was unprecedented. During a very brief period — between 1888 or 1889 and 1903 or 1904 — the ruthless competition that had pitted countless numbers of small businesses against each other since the end of the Civil War was supplanted by a form of "co-operation," conducted by approximately 150 large corporations, many of which were formed through the consolidation of previous rivals. One contemporary opined that the new conglomerates added over three and a half trillion dollars of capital value to the US economy, and a modern historian has estimated that more than 1,800 private companies disappeared through consolidation between 1895 and 1904. In 1903, Edward Sherwood Meade, economist at the University of Pennsylvania's Wharton School, argued that "the trusts control the greater part of the output in the industries in which they are formed, 75, 90, 95 per cent being common figures." The range of industries affected by corporatization was broad: following the precedent set by the late nineteenth-century railway companies, new industrial corporations took over energy providers (Standard Oil), food production (American Sugar Refining Company), the manufacture of incidentals and notions (Diamond Match Company, International Thread Company), and the leisure industry (American Bicycle). While spokesmen for some of the new corporations tried to argue that, like the railways and utilities (e.g., gas and street railway companies), these corporations were "public goods," most defended this new way of doing business with some version of the marginalist economic theories we will examine in a moment. Conglomeration, insisted economists like Jeremiah Jenks, professor of political economy at Cornell, was essential to controlling the "wastes" associated with competition, thus increasing productivity at the "margin." "It would seem that if there is any real economic function of combination of capital, whether it has attained monopolistic power or not, it is this: saving the various wastes of competition, in great part by providing for the direction of industrial energy to the best advantage."

The legal imprimatur for the new corporations was provided by a series of rulings, beginning with the Supreme Court's Santa Clara decision in 1886, which indemnified each corporation as a legal "person" with many of the rights an individual enjoyed. Before New Jersey adopted an "enabling" corporate law in 1896, incorporation in the United States required an act of legislation, but the Supreme Court's broadening of the corporation's constitutional standing helped transform corporate privileges into a generally available right. Beyond the legal status conferred by incorporation, what distinguished the new corporations from the private, often-family-owned businesses they supplanted were novel modes of ownership and management. Unlike the family concern, whose partners contributed the company's working capital, reaped its profits, and collectively assumed responsibility for its debts, the new corporations were owned in part-shares by large groups of investors who were often not acquainted with each other or the day-to-day operations of the firm. The interests of the promoters, underwriters, shareholders, and managers who brought a new corporation into being and kept its capital flowing were protected by the law of limited liability, which limited the personal liability of each individual to the amount he contributed to the firm. Because ownership was separated from management in the new corporations, the firms required new accounting procedures that could keep track of the costs of complex production processes, distinguish the capital that kept the firm afloat from the income eligible for disbursement as dividends, and gauge the relative effectiveness of managers' financial decisions. Because shareholders could buy or sell financial interests at any time, corporate accountants also had to provide periodic summaries and records of cash flows so that individual shareholders would know what they owned. As we will see in chapter 4, these features were still matters of intense legal and theoretical interest in the 1930s, by which time their impact on the American economy was visible to everyone.

During the merger movement itself, many economists, like most Americans, did not know quite what to make of the changes transforming American businesses. Were corporations good for society or harmful? Were they an inevitable part of the evolution of American capitalism or an opportunistic attempt to monopolize the nation's resources? Should new tax policies redistribute the corporations' "excess" profits or should tariffs protect them from international competition? Of all the concerns that swirled around the new corporations, most vexing were those concerned with valuation. Should a corporation be valued by the tangible assets it held, like buildings, machinery, and money in the bank? Or should it be valued by its "intangibles" — its earning potential, the "goodwill" that carried over when one company merged with another, and the money pledged to the company but not yet paid for shares? In a series of cases decided between 1886 and 1900, the US Supreme Court gradually expanded the definition of "property" to include the right to a reasonable return on investment in intangible assets. These decisions constitute the legal framework in which we can best understand finance as claims. They also led the Yale economist Irving Fisher to redefine "capital" to encompass these claims, which are based not only on legal provisions but also, in practice, on investors' expectations. They also opened onto, and eventually came into alignment with, the redefinition of "capital" that Irving Fisher set out in 1906 in The Nature of Capital and Income, a landmark in financial theory that we examine in chapter 2, section 5.

The Supreme Court's ruling that intangible assets constituted property did not help contemporaries value the bonds and securities the corporations wanted to sell. In 1900, the Chicago lawyer and company promoter John Dos Passos explained that the valuation dilemma turned on different understandings of capitalization. "Capitalization is of two kinds; there is a capitalization based on the actual value of the property and a capitalization based on earning power. ... You will find two classes of people in this country — one in favor of the former method and one in favor of the latter." Each position was supported by both economists and some state legislatures. The first, which favored including in a firm's capitalization only tangible assets, valued (typically) by their historical cost, was endorsed by William Z. Ripley of Harvard and Jeremiah Jenks of Cornell. It was written into the laws of Massachusetts and Connecticut. The second, which included intangibles like goodwill and earning power, was favored by the Wharton School's Meade, who was the nation's first specialist in corporate finance, and, with some reservations, by the New York lawyer Thomas Conyngton, who wrote about corporations under the pseudonym Francis Cooper. This method combined parts of marginalist economic theory with financial concepts drawn from actuarial science, even though neither Cooper nor Meade offered a theoretically consistent defense of privileging earning power over tangible assets. This mode of valuation was enshrined in the corporate laws of New Jersey, West Virginia, and Delaware.

In today's terminology, "capitalization" most often refers to the total dollar value of a company's issued shares, and one can calculate the size of a company by multiplying its outstanding shares by the current market price of one share. In the early twentieth century, a company's promoter set the "par" price of shares when the firm filed for incorporation or, in anticipation of that filing, when the promoter sought financial backing from an underwriter. Instead of using a theory of valuation agreed upon in the corporate world, promoters seem to have based capitalization on some mixture of the value of the assets the new corporation actually held, the goodwill they assumed the corporation would carry over from the companies it absorbed, and the promoters' own hopes and expectations for future earnings. Given this process, which was invisible to the relatively small number of individuals who might have wanted to purchase shares, no one could understand what the promoter had done or judge the fairness of the figure published as the corporation's capital value.

The complex role that promoters played in company flotation helps explain why such evaluations were so difficult. Most contemporaries considered the promoter essential to the formation of a large corporation, for, given the complexity of the transactions involved, someone had to initiate and superintend the process. Writing in 1896, T. C. Frenyear argued that the promoter's "push" was the critical element in company flotation — and that it should be compensated as such. "The conception, the originating, the organizing of an enterprise is the fundamental element of value in it. ... The most brilliant and the most workable plan may amount to no more than a dream, without push. ... He who takes the ideas of a genius, worthless ideas, clothes them with outward form and makes them effective; he who takes the gold of the capitalist and gives to it a productive power; he who takes the strong and willing laborer and directs his work in more healthful and profitable channels, is entitled to no mean share in the benefits brought about through his efforts."

Even if contemporaries acknowledged the promoter's importance, the way promoters were compensated led many to suspect that the promoter's interests were too closely related to the value he assigned the corporation. Promoters were often compensated at least partly in company shares, and because the shares of a prospective company had yet to trade on a public exchange, each share's initial value simply represented a percentage of the company's total capitalization, which the promoter set. Since the laws of some states allowed the promoter to include in the company's capitalization intangibles and earning potential, it seemed to some that promoters were serving their own interest by overstating the corporation's value. After all, the promoter was not compensated until he sold his shares, and he could only drive the price of shares up by making the company seem more valuable than it might actually have been.

The controversy over whether the promoter was "watering" a company's shares originated in this process. In contemporary parlance, "watering" stocks referred to any of a number of practices, all of which were thought to misrepresent the relationship between the corporation's legitimate assets and its total capitalization. As Ripley explained, the "baldest and simplest form" of pumping "water" into a corporation's stated value was "simply to declare a stock or bond dividend without putting any additional capital into the company; this constituted an outright gift to shareholders. "Stocks could also be watered in other ways: a corporation could issue bonds to purchase securities declared necessary to expand its operations, and then sell the securities and distribute the income in dividends without retiring the underlying debt. Stock watering was thought to be especially prevalent when companies merged. "The constituent companies may be so gerrymandered that successful ones with surplus earnings may average their rate of return downward by combination with other properties less favorably situated," Ripley pointed out. "A weak corporation, whose stock is quoted say at $50, may be merged in a second corporation whose stock is worth $150 per share. The latter may then issue new stock of its own in exchange for the $50 stock, share for share. Such an operation as this ... establish[es] fictitious capitalization par in excess of the worth of the investment."

(Continues…)

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Table of Contents

Introduction
I.1 The Story
I.2 What’s in a Name? Our Interpretive Position
I.3 The Archive
I.4 Our Readers and Why This Matters

1 Early Twentieth-Century Origins of American Finance: The Rise of the American Corporation and the Creation of the Federal Reserve System
1.1 Valuing the New US Corporations
1.2 The Growth of American Public Accounting
1.3 Early Twentieth-Century Banking and the Federal Reserve System
1.4 The Principles of American Banking

2 Early Twentieth-Century American Economic and Financial Theory
2.1 The Institutionalism of Thorstein Veblen
2.2 Late Nineteenth-Century American Neoclassical Price Theory and the Real US Economy
2.3 Early American General Equilibrium Theory
2.4 An Early Model of Expectations: The Fisher Effect
2.5 The Financial View
2.6 The Quantity Theory and the Banking View of Money
2.7 Frank Knight’s Theory of Uncertainty
2.8 American Public Finance: The Personal Income Tax

3 Statistics in America and the Governance of the Modern State
3.1 The Statistical Theory of Demand
3.2 The Harvard Business School Case Method
3.3 State Data Collection
3.4 Index Construction and the Dissemination of Data
3.5 The Challenges of Early Statistical Compilations
3.6 The Dispute over Index Numbers
3.7 The Harvard Barometer Project
3.8 The Pujo Investigation and the “Money Trust”

4 American Finance in the Interwar Period
4.1 Transformations in the Interwar Period
4.2 “New Era Talk” and the Speculative Mania of the 1920s
4.3 Investment Trusts and the Crash of 1929
4.4 The New Deal for the American People: Mortgages for All
4.5 Public Disclosure and the Modern Corporation
4.6 Security Research
4.7 The Dividend Discount Model

5 US Finance: Equity and Fixed Income Market Research 1920-1940
5.1 Midwest Agronomists and the Fortuitous Conjunction
5.2 Stock Market Skepticism and Sample Theory
5.3 Stock Forecasting
5.4 US Common Stock Indexes and Fixed Income Duration

6 Measuring and Taxing the US Economy in the Interwar Period
6.1 The Keynesian Revolution
6.2 Compiling US National Income and Production Aggregates
6.3 The Brookings Institution and the Expenditure Approach
6.4 Input-Output Accounting for the US Economy
6.5 Interwar American Fiscal Policy

7 Models of Economies and Finance, 1930-1940
7.1 “Little Model Worlds” and the Econometric Society
7.2 John Maynard Keynes, John R. Hicks, and Mathematical Economics
7.3 The IS-LM Model
7.4 Modeling the Financial View: Marschak’s “Theory of Assets”
7.5 The Keynes-Tinbergen Debate
7.6 A Macroeconometric Model of the US Economy

8 Postwar Economics in America, 1944-1970
8.1 Postwar Mathematical Economics and Econometrics
8.1a The Mathematical Foundations of American Keynesianism
8.1b The Econometrics of the Probability Approach
8.1c Mathematical Probability Theory
8.1d Game Theory and Bayesian Probability
8.1e Linear Programming of Activities
8.2. Measurement, Monetarism, Keynesian Stabilization Policies, and Growth Theory
8.2a Measuring Financial Flows
8.2b Financial Intermediaries
8.2c The First Theoretical Account of Financial Intermediation
8.2d Monetarism
8.2e The Fed on Trial
8.2f The Celler-Kefauver Act
8.2g From Institutionalism to Keynesianism in US Monetary and Fiscal Policy, 1950-68
8.2h Neoclassical Growth Theory

9 Modern Finance
9.1 Origins of Modern Portfolio Theory
9.1a Hedging
9.1b Correlation Analysis and Diversification
9.1c Subjective Probability Theory
9.1d Linear Programming and Finance
9.1e Competitive Equilibrium Theory
9.2 The Years of High Theory
9.2a The Capital Asset Pricing Model
9.2b The Mathematics of Random Processes
9.2c The Canonization of Modern Finance
9.3 Options Pricing Theory, Financial Engineering, and Financial Econometrics
9.3a The Theoretical and Mathematical Pillars of Modern Finance
9.3b Arbitrage Theory
9.3c The Options Pricing Model
9.3d Options Pricing in Continuous Time
9.3e Three Approaches to Pricing Derivatives
9.3f The Arbitrage Theory of Capital Asset Pricing Model
9.3g A Manual for Financial Engineers
9.3h Financial Econometrics
9.3i Efficient Capital Markets II
9.3j Behavioral Finance

10 The Transformation of American Finance
10.1 The Inter-Crisis Period: The Volcker Deflation to the Lehman Bankruptcy, 1982-2008
10.2 Early Signs of the Transformation
10.3 Macroeconomic Theories during the Inter-Crisis Period
10.3a New Classical Macroeconomic Theory, Dynamic Stochastic General Equilibrium Models, and Real Business Cycle Theory
10.3b Developments in Information Technology, New Keynesian Macroeconomics, the New Neoclassical Synthesis, and Hyman Minsky
10.3c New Research Initiatives
10.4 The Transition to a Market-Based Financial System
10.4a Deregulation and the Growth of Finance in America after 1980
10.4b Securitization and the Shadow Banking System
10.4c Structured Investment Vehicles
10.4d Credit Derivatives
10.5 The Market-Based Financial System in Trouble
10.6 Final Thoughts

Notes
Bibliography
Index Show More