FINANCE: HISTORICAL PERSPECTIVES

Finance is a field of specialization that studies all aspects of obtaining money and making decisions about the allocation of that money. There are many segments of this field by type—corporate finance, federal government finance, municipal finance, not-for-profit finance, and personal finance. This brief discussion will be an overview of corporate finance in the economy in the United States.

In the United States, major corporations and the financial institutions with which they associate are regulated by the U.S. Treasury, which implements fiscal and monetary policies; and the U.S. Congress, which enacts laws and regulations, intersect in their interests. A driver of finance in the United States is the goal to maintain full employment and to achieve a specified level of economic growth. Corporate finance is critical to such a goal.

The history of corporate finance in the United States began with rudimentary, unregulated means of securing funds in the early years of the newly established nation. By the end of the twentieth century, a level of progress that made the United States a financial leader in the global community was reached. The success of the finance function in corporate America is the result of a combination of business innovation in the design and strategies of securing funds and the governmental regulations that ensure integrity in financial markets. Yet, problems persist in what has become since the twentieth century a complex, fast-changing field of specialization.

EARLY AMERICAN FINANCE

In colonial United States, businesses were, for the most part, small and self-financed. The first settlers, however, who had been British subjects, were well acquainted with the corporate form of organization. As Joseph Davis noted, "before the end of the colonial period a considerable number of truly private corporations had been established for ecclesiastical, education, charitable, and even business purposes" (1917, p. 4).

Many of these early efforts were unsuccessful, and individuals who invested in them often lost their total contributions. The nature of financing problems in these early efforts is illustrated by the story of an organization called the Society for Establishing Useful Manufacturers. In November 1791, the legislature of New Jersey passed an act incorporating this enterprise, which likely manufactured such products as paper, textiles, pottery, and wire. Davis identified this company as "one of the pioneer industrial corporations of the United States and the largest and most pretentious of these" (p. 349). Plans for the new corporation were publicly announced, including the much-criticized strategy of raising capital by issuing public stocks. The emphasis on developing domestic industry and reducing dependence on imports was appealing to potential investors, and private citizens were getting encouragement from the newly formed federal government to undertake business activity on a broader scale than had been common at the time.

At the time the prospectus for this new enterprise was being circulated, Alexander Hamilton, the secretary of the Treasury, presented his Report on Manufacturers, which was prepared in response to President George Washington's direction "to prepare and report to the House, a proper plan for the encouragement and promotion of such manufactories as will tend to render the United States independent of other nations" (quoted in Davis, p. 362).

The requisite capital was indeed raised, with most of the subscriptions secured in New York. Shortly thereafter, panic ensued because the new enterprise was not progressing as intended. Leading officers and directors were involved in the speculative boom and had not given attention to the actual business of the new enterprise. Thereafter, the leaders, who were in possession of most of the paid-in funds, went bankrupt. This story reveals the lure of becoming wealthy quickly and of general incompetence among leadership. There were virtually no rules to restrain the behavior of the leaders; they readily, therefore, appropriated the funds for their own personal use.

The society was saved by a loan of $10,000 from the Bank of New York, and there is evidence that the secretary of Treasury was responsible in securing this financing. Nevertheless, there continued to be serious financial problems, throughout the period when facilities for the envisioned textile mills were being constructed. The newly appointed treasurer was supposed to be bonded, but he refused. He continued in the position nonetheless. When he retired in 1796, the treasurer's books and the funds were supposed to be left with the deputy-governor. The books, though, were never recovered. It is not clear whether all the funds were recovered. The operations were unprofitable and were discontinued in the same year.

R. E. Wright (2002) presents an interesting analysis of colonial business behavior using the framework of the theory of asymmetry in the principal/agent relationship. Wright concluded "that colonists did little to reduce moral hazard in colonial financial markets. Borrowers often acted in ways that were not in the best interests of lenders" (p. 27). It is Wright's position, however, that most colonial banks in the early national period learned to limit moral hazard by monitoring depositors' accounts and noting the use of funds that had been provided through loans.

FINANCE IN THE 1800S

On the brink of the nineteenth century the United States had a dismal record of successful corporations, as illustrated by the effort in New Jersey discussed above. The country was a world of small mercantile businesses. As of 1790, for example, there were only three banks, three bridge companies, a few insurance associations, and a dozen canal companies. Some businesspeople, however, began to see the value of the corporation: The risks of manufacturing made the limited liability of the corporation appealing.

Several states enacted useful laws. In 1811 New York passed a law that allowed for the incorporation of certain kinds of manufacturing concerns with less than $100,000 of capital. Connecticut, in 1817, and Massachusetts, in 1830, granted limited liability, which was the first step in movement for general incorporation acts. The intent of such acts was to encourage the financing of entities through the corporate structure and to protect the public that might be inclined to invest in these new enterprises. In the same period, the government was significantly involved in the financing of businesses. As Thomas C. Cochran noted:

The capital needs of banking and transportation brought state participation in business organization. Few such pioneer enterprises seemed possible without substantial state, county, or municipal purchases of stocks and bonds. The credit of the state was generally substituted in part for that of the private company by issuance of state bonds and use of the proceeds to buy the company's securities. (1966, p. 219)

At the same time, Cochran noted some of the serious drawbacks of the new ownership:

Free and secret transferability of corporate owner-ship encouraged grave abuses on the part of unscrupulous financiers. It was possible for managing groups to profit personally by ruining great companies and then selling out before the situation became known. (p. 219)

Nevertheless, there were conscientious men who were interested in productive efficiency as well as the quest for wealth. Among the individuals Cochran identified was Nathan Appleton:

Nathan Appleton … turning from mercantile pursuits in 1813, joined with some of the Lowells and Jacksons, put his capital into large-scale textile manufacture.… Appleton came to be looked upon as the business leader of Massachusetts.… By 1840 he and his Boston associates had created in eastern Massachusetts a miniature of the corporate industrial society of the twentieth century.

They controlled banking, railroad, insurance, and power companies as well as great textile mills scattered all over the state. It was the large "modern" corporation controllable by strategically organized blocs of shares, and virtually self-perpetuating boards of directors that made this concentration of power possible, but it must be remembered that it was also this device for gathering together the savings of thousands of small investors that had produced the great development. (p. 220)

There were remarkable developments throughout the 1800s. Jonathon Baskin and Paul Miranti, for example, pointed out that the "last quarter of the eighteenth century saw the start of a great economic expansion that changed corporate finance in fundamental ways" (1997, p. 127). It was during this period that there was extensive development of railroads, which independently became strong bastions of finance capitalism. During this period, preferred stock and debt became popular means of financing corporations. During the final decades of the 1800s, relatively widely distributed financial journals and newspapers began to appear. Such publications provided information for prospective investors.

U.S. FINANCE IN THE 1900S

The economic success of the United States at the turn of the twentieth century was reflected in the optimism evident in the U.S. secretary of the Treasury Lyman Judson Gage's comment in the Annual Financial Review, a supplement to the New York Times (January 1, 1900). His observation was that "the year we have just passed through has been one of great prosperity, the future has no cloud."

Much credit in providing resources was given to banks. Joseph Schumpeter, in his theory of economic development, highlighted the role of bankers as the source of funds for entrepreneurs, who themselves often lack financial resources. Schumpeter noted: "In an economy without development there would be no such money market.… The kernel of the matter lies in the credit requirements of new enterprises.… Thus, the main function of the money or capital market is trading in credit for the purpose of financing development" (1934, pp. 122–127).

Schumpeter undoubtedly was fully aware of the U.S. experience and the influence of American bankers in the impressive growth of the American economy from the mid-1800s through the early decades of the twentieth century. Of the leaders in finance, some of the most impressive of the bankers were the Morgans. As Ron Chernow, in his history of the Morgans, concluded: "The old pre-1935 House of Morgan was probably the most formidable financial combine in history. It financed many industrial giants, including U.S. Steel, General Electric, General Motors, Du Pont, and American Telephone and Telegraph" (1990, p. xi).

A VIEW FROM ENGLAND

An English journalist, William Lawson, wrote an interesting account of finance in the United States in 1906. He declared in his introduction that he had studied American finance for twenty-five years, traveled throughout the United States, and seen most of its financial institutions from the inside. He developed a highly favorable opinion of the astuteness of the leadership in finance. Among his comments was:

It is only a few years ago that New York was a financial satellite of London. How long will it be before London becomes a financial satellite of New York?… Till lately the idea prevailed that it was to grow in the ordinary grooves, and was to be like other countries, only much bigger. But that is not to be its prosaic destiny. It is to be a country of its own—a nation by itself.… Gradually, it is breaking loose from all European models and precedents.… [T]he U.S … probably always will be, a country by itself is particularly true of its finance. (p. 7)

DISCONTENT EXPRESSED

The success of the American economy at the brink of the twentieth century also introduced alarm because of the growth of monopolies and the abuses of business as revealed by muckrakers, for example. Reporters, such as Ida Tarbell (the story of Standard Oil) and Lincoln Steffens (an account of civic corruption in Minneapolis) when published in McClure in 1903 captured the attention of the public. The reform efforts of President Theodore Roosevelt in first decade were appealing to many citizens.

At the same time, investors became increasingly interested in corporate common stocks, as reported by Baskin and Miranti. As these historians noted, "New York Stock Exchange statistics: total annual share turnover rose from 159 million in 1900 to 1.1 billion at the height of the 1929 boom" (1997, p. 167). The role of finance continued to be impressive.

IMPETUS FOR REGULATION OF SECURITIES IN THE UNITED STATES

Prior to 1929 there was little support for federal regulation of securities markets in the United States. As noted on the Securities and Exchange Commission (SEC) Web site, "During the 1920s, approximately 20 million large and small shareholders took advantage of post-war prosperity and set out to make their fortunes in the stock market. It is estimated that of the $50 billion in new securities offering during this period, half became worthless" (SEC).

Public confidence shifted dramatically with the stock market crash of 1929. For the economy to recover, the public's faith in the capital markets needed to be restored. The outcome was the passage of two acts by Congress, the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were established to provide structure in the functioning of financial markets and to provide government oversight.

CHANGES IN FINANCIAL STRUCTURE

The role of banks changed during the twentieth century as businesses became larger and the types of financial institutions increased. Raymond Goldsmith's 1969 study provided a comparison of the main types of U.S. financial institutions in 1900 and 1963. Goldsmith's analysis revealed that in 1900, 62.9 percent of total assets of all the financial institutions were held by commercial banks; by 1963 that percentage was 32.2. Thrift institutions, including mutual savings banks, savings and loan associations, credit unions, finance companies, insurance organizations, and investment companies were active participants in financial services.

Shares of assets held by banks and thrift institutions continued to decline. While the two types of financial institutions held 55 percent of total assets in 1963, the two types held only 22.7 percent by the end of 1999, as reported by the Federal Reserve Board. The Federal Reserve Bank has been a critical participant in all aspects of finance in the United States through its monetary and credit policies.

THE ROLE OF THE SEC

The Securities Exchange Act of 1934 included the establishment of the SEC, which was charged with enforcing the newly passed securities laws, promoting stability in the markets, and protecting investors. The SEC operates on the premise that all investors should have access to certain basic facts about investments prior to purchase. The key means of achieving this is through requiring that all publicly owned companies disclose relevant financial and other information to all citizens.

The SEC oversees key participants in the financial world, including stock exchanges, broker-dealers, and investment advisers. Through its enforcement authority, the SEC brings civil enforcement actions against individuals and companies that violate securities laws. Typical infractions relate to insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them.

THE ROLE OF STOCK EXCHANGES

Stock exchanges have played a significant role in the financing of U.S. business enterprises through providing a means of buying and selling securities. The first stock exchange in the United States was established in 1790 in Philadelphia. Two years later, the New York Stock Exchange (NYSE) was formed when twenty-four stockbrokers signed an agreement to trade with one another beneath a buttonwood tree outside what is now 68 Wall Street. The NYSE is the largest stock exchange in the world.

The NYSE's first client, in 1792, was the Bank of New York, and its first office, set up in 1817, was a rented room at 40 Wall Street. It achieved its first million-share day on December 15, 1886, and its first billion-share day on October 28, 1997.

A study of all securities markets by the SEC in 1961 revealed that the over-the-counter securities market was fragmented and obscure, leading the SEC to propose to the National Association of Securities Dealers that it develop an automated over-the-counter securities system. Such a system was completed and began operations in February 1971; it is known as the National Association of Securities Dealers Automated Quotations (NASDAQ) system. The world's first electronic stock market, by the end of 1999 it ranked second, below the NYSE, among the world's securities markets in terms of dollar volume. Technological advances have introduced online buying and selling of securities.

THE BEGINNING OF THE TWENTY-FIRST CENTURY

The new century began with stunning disclosures of corporate scandals. Such disclosures vividly revealed the inadequacy of the rules and regulations of corporation reporting. No objective, thorough investigation of the alleged fraud in financial reporting existed.

Congress, however, passed the Sarbanes-Oxley Act of 2002, which changed markedly the regulatory environment in which publicly owned corporations function in the United States. The act established a new governing board, the Public Company Accounting Oversight Board. That board assumed all professional responsibilities, including those earlier delegated to the public accounting profession. The board has responsibility for auditing rule making and for monitoring of all publicly owned corporations reporting to the SEC.

The opinions of the success of the new regulations are mixed. As of the end of 2005, there continued to be shocking disclosures of misrepresentation of financial information, insider trading, appropriation of company funds for personal use by top executives—including chief executive officers—and other violations of corporate governance in the United States.

THE PLACE OF THE FINANCE INDUSTRY

The finance industry continues to be of central importance in the United States. The Bureau of Economic Analysis, part of the U.S. Department of Commerce, reanalyzed gross domestic product (GDP) by industry data based on the North American Industry Classification System, which was introduced in the 1990s. The analysis for the period from 1987 to 2000 showed that the industry category, "Finance, insurance, real estate, rental, and leasing (FIRE)," was the number-one contributor to "value added by industry group in current dollars as percentage of Gross Domestic Product for selected years."

These are the figures for the finance category:

The advance-industry estimates for 2004 noted that FIRE comprised a larger share of current-dollar GDP (20.7 percent) than goods-producing industries (19.6 percent) in 2004.

THE GLOBALIZATION OF FINANCE

The transformation of capital markets from the national level to the global level increased considerably during the final decade of the twentieth century. Leadership is provided through the International Organization of Securities Commissions (IOSCO), which was organized in the early 1970s. More than 90 percent of the world's financial activity was represented among the more than 181 national security regulators who were members of IOSCO in 2005. One of the key goals for 2005 was to strengthen capital markets against financial fraud.

see also Finance

bibliography

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Chernow, Ron (1990). The house of Morgan: An American banking dynasty and the rise of modern finance. New York: Atlantic Monthly Press.

Cochran, Thomas C. (1966). Business organization and the development of an industrial discipline. In Thomas C. Cochran and Thomas B. Brewer (Eds.), Views of American economic growth: The agricultural era. New York: McGraw-Hill.

Davis, Joseph Stancliffe (1917). Essays in the earlier history of American corporations (Vol. 1). Cambridge, MA: Harvard University Press.

Gage, Lyman Judson (1900, January 1). Secretary Gage reviews the nation's finances. The New York Times Supplement: Annual Financial Review.

Goldsmith, Raymond (1969). Financial structure and development. New Haven, CT: Yale University Press.

International Organization of Securities Commissions. http://www.iosco.org

Lawson, William Ramage (1906). American finance: Part first.—domestic. Edinburgh and London: Blackwood.

National Association of Securities Dealers Automated Quotations. http://www.nasdaq.com

New York Stock Exchange. http://www.nyse.org

Schumpeter, Joseph A. (1934). The theory of economic development: An inquiry into profits, capital, credit, interest, and the business cycle. Cambridge, MA: Harvard University Press.

Securities and Exchange Commission. (n.d.). The investor's advocate: How the SEC protects investors and maintains market integrity. Retrieved November 14, 2005, from http://www.sec.gov/about/whatwedo.shtml

U.S. Department of Commerce. Bureau of Economic Analysis. http://www.bea.gov

Williamson, Harold F. (1951). Growth of the American economy (2nd ed.). Englewood Cliffs, NJ: Prentice-Hall.

Wright, R. E. (2002) The wealth of nations rediscovered: integration and expansion in american financial markets 1780-1850. New York: Cambridge University Press.

Mary Ellen Oliverio