The Blue Line Imperative

Chapter Two

The Global Capital Market

"In 1750, most people would probably have said that the pre-industrial configuration of the world's economy was largely a permanent state of affairs. That the world had always been like that and probably always would be and they would have had the facts on their side."1

- Michael Spence, Nobel Economics Laureate, 2001

We've argued that, in order for the gears of consumerism to kick into motion, three things were necessary: first, good ideas; second, time and resources for the entrepreneurs with the ideas to develop them into useable stuff; and third, a way to get that stuff to market and ultimately, into the hands of consumers. We've argued further that it is our role as consumers that has driven the massive social and political changes of the last 400 years. If the difficulty of borrowing money to start a business or develop an idea was a major force in keeping humankind at a level of subsistence, then some seismic shift must have occurred that led to today's circumstances where we clearly get our stuff by the bucketful.

So what changed? What strange mechanism emerged to ensure capital could be allocated efficiently and fairly? What system arose that could somehow naturally and objectively direct the right funds to the right people? At one point in our existence, getting funding for good ideas was nearly impossible. The risks were enormous and the rates excessive. Something happened to get the Cost of Funding (COF) down to a level at which investors could lend money without risking everything they owned, and entrepreneurs could accept the loans without signing away their lives as collateral.

The initial action that started moving money into the hands of those who could do something useful with it, was a small experiment launched by the Dutch in the fall of 1606. The direct result of this action is the rise in standard of living and extended life expectancy we all enjoy today. But we'll get to that, since it didn't just happen overnight. Before this monumental brainstorm, there were a number of false starts.

One example of this was to drive innovation through attractive incentives. For instance, we've long depended on ships to transport raw materials and tradable goods. But for millennia, shipping was a treacherous method of transportation for a variety of reasons, not least trying to navigate vast bodies of water to get from one point on the map to another. Errors were common, as was the resulting frequency of wrecks, lost ships, and dead crew.

The main issue was a notoriously resistant beast called longitude. For centuries, measuring how far a ship had traveled east or west from a fixed point proved sailing's most difficult test. In 1675, King Charles II of England set up the Royal Observatory in Greenwich to try to solve the thorny longitude issue. The idea behind the Observatory was to produce charts to help sailors find their longitude by tracking the position of the moon relative to various stars. Since timepieces in the seventeenth century were still inaccurate and unreliable, this idea seemed the best alternative, but it proved of little use. In 1714, the British Government increased the incentive to willing entrepreneurs by announcing what became known as the Longitude Prize, whose reward was the immense sum of £20,000 to anyone who could come up with a method to assess longitude to within five-tenths of a degree. Clockmaker John Harrison eventually invented a timepiece that was so accurate that the judging committee declared his result a fluke and refused to award the money - at least not until the King intervened, at which point they found it prudent to cooperate.

In a similar vein, Napoleon offered a prize for innovation in food preservation for his army, leading to the development of modern canning. And the Orteig Prize spurred Charles Lindbergh to make his transatlantic flight.2 Although not a prize as such, it's fair to say that President John F. Kennedy's exhortation in 1961 that "This nation should commit itself to the goal, before this decade is out, of landing a man on the moon and returning him safely to earth,"3 had a similarly galvanizing effect to that of the Longitude Prize, and led more or less directly to Neil Armstrong setting foot on the moon in the summer of 1969.

More recently, the X Prize Foundation, whose mission is "to create radical breakthroughs for the benefit of humanity, thereby inspiring the formation of new industries, jobs and the revitalization of markets that are currently stuck,"4 has offered a series of multi-million dollar prizes for specific innovations in space travel, automotive propulsion, and human genomics.

The problem with these types of incentives and prizes is twofold. First, they are time-specific and self-contained. Second, they serve to orient vast amounts of effort and energy around objectives defined by the few; they are not part of a larger, ongoing mechanism that aids a continuous flow of funding to those with valuable ideas for moving humanity forward. Prizes can thus produce particular results at specific times, just as sporadic impulsion from government leaders can spur accomplishments - who doesn't still get misty-eyed at the moon landing? - the inventions and advances these practices generate are unpredictable and unreliable. In the grand scheme of human endeavor, they are drops in the ocean. It is another event that initiated and sustained the constant stream of innovation we witness today. By the time the British Government announced the Longitude Prize, this event had already come to pass, and it would have a much more dramatic, far-reaching, and long-lasting effect: a group of Dutchmen decided to share ownership of their company with anyone willing to pay for it.

In 1602 shares in the Dutch Vereenigde Oost-Indische Compagnie (VOC, better known as the Dutch East India Company) were issued, suddenly creating what is usually considered the world's first publicly traded company. While commodity exchanges had existed in various forms since early civilization (the UK is dotted with ancient Corn Exchange buildings that are now used as art and entertainment centers), and brokers trading in bank debts had plied their trade since at least the twelfth century, it wasn't until this event that company ownership truly changed and the common man saw opportunities he had never seen before.

There are other claimants to the title of first public company, including a twelfth-century water mill in France and a thirteenth-century company intended to control the English wool trade, Staple of London. Its shares, however, and the manner in which those shares were traded, did not truly allow public ownership by anyone who happened to be able to afford a share. The arrival of VOC shares was therefore momentous, because as Fernand Braudel pointed out, it opened up the ownership of companies and the ideas they generated, beyond the ranks of the aristocracy and the very rich, so that everyone could finally participate in "the speculative freedom of transactions."5 By expanding ownership of its company pie for a certain price and a tentative return, the Dutch had done something historic: they had created a capital market.

Not surprisingly, the idea of shared company ownership quickly caught on and spread. What began in Amsterdam soon moved to the Dutch colony of New Netherland in Colonial America, which included a little island called Manhattan. Share-trading also began to catch on in England and elsewhere in Europe, and started to travel further around the world, reaching Bombay, Hong Kong, and Tokyo by the second half of the nineteenth century. During those 250 intervening years of propagation, capital markets had generated enough money to help set in motion another significant event, the Industrial Revolution.

Thanks to the Dutch, capital markets had taken root and quickly expanded. But the value creation imperative - the natural process by which the right ideas are enabled and the wrong ones rejected - would not perfect the process for some time, because certain inherent issues needed to be purged first from the overall system.

One serious glitch in the early days was that shareholders were liable for all of the debts of the companies in which they held shares, proportional to the number of shares they owned. The great grandfather of Scottish novelist John Buchan was a shareholder of the City of Glasgow Bank in the mid-nineteenth century. Bad loans and speculative investments, coupled with a certain amount of fraud, caused the bank to fail spectacularly in 1878, with debts of over £6 million. The company's shareholders were liable for its debts, which meant many of them had to pay far more than the value of their original shareholding - including Buchan's ancestor who lost everything.6

If the older Buchan had won his appeal to have the Companies Act applied to his case, things wouldn't have been so bad. This act extended limited liability to all companies in England in 1856 (the East India Company had had limited liability status since 1662), which effectively assured shareholders that, even if the company in which they had invested were to go belly-up, they would lose no more than the value of what they had originally paid. Thus, one snag in the original design of the capital markets was fixed, and a boost to growth was the outcome. As William Bernstein put it, ". limited liability is a near-absolute requirement for healthy public participation in company...