Global Capital Markets: Overview and Origins

At the turn of the twenty-first century, the merits of international financial inte- gration
are under more forceful attack than at any time since the 1940s. Even mainstream
academic proponents of free multilateral commodity trade, such as Bhagwati, argue that
the risks of global financial integration outweigh the benefits it affords. Critics from the
left such as Eatwell, more skeptical even of the case for free trade on current account,
suggest that since the 1960s “free international capital flows” have been “associated with
a deterioration in economic efficiency (as measured by growth and unemployment).”1
The resurgence of concerns over international financial integration is under- standable in
light of the financial crises in Latin America in 1994–95 and in east Asia in 1997–98.
Proponents of free trade in tangible goods have long recognized that its net benefits to
countries typically are distributed unevenly, creating domestic winners and losers. But
international financial crises such as those in east Asia have submerged entire economies
and threatened their trading partners, inflicting losses all around. International financial
transactions rely intrinsically on the expecta- tion that counterparties will fulfill future
contractual commitments; they therefore place confidence and possibly volatile
expectations at center stage.2These same factors are present in purely domestic financial
trades, of course. But oversight, adjudication, and enforcement all are orders of
magnitude more difficult among sovereign nations with distinct national currencies than
within a single national jurisdiction. And there is no natural world lender of last resort, so
international crises are intrinsically harder to head off and contain. Factors other than the
threat of crises, such as the power of capital markets to constrain domestically-oriented
economic policies, also have sparked concerns over greater financial openness.
The ebb and flow of international capital since the nineteenth century illus- trates
recurring difficulties, as well as the alternative perspectives from which policymakers
have tried to confront them. The subsequent sections are devoted to documenting these
vicissitudes quantitatively and explaining them. We believe that economic theory and
economic history together can provide useful insights into events of the past and deliver
relevant lessons for today.

The Emergence of World Capital Markets

Prior to the nineteenth century, the scope for international finance was relatively limited.
Italian banks of the Renaissance financed trade and government around the
Mediterranean and farther north. Later, London and Amsterdam became the key centers,
and their currencies and financial instruments were the principal focus of players in the
market. As the industrial revolution evolved, first in Britain, and as the Napoleonic Wars
stretched on, the importance of international financial markets became apparent in both
public and private spheres. Research now suggests that at certain times Dutch savings
helped augment British budget constraints in an era when war finance and
industrialization threatened to exhaust domestic saving supply, and when military crises
could demand extensive short-term financing and options for long-term smoothing via
borrowing.3
In due course, the scope for such trades extended to other centers that de- veloped the
markets and institutions capable of supporting international financial transactions, and
whose governments were not hostile to such developments. In the Eastern U.S., a broad
range of centers including Boston, Philadelphia, and Bal- timore gave way to what
became the dominant center of national and international finance, New York. By the late
nineteenth century both France and the Germany had developed sophisticated and
expanding international markets well-integrated into the networks of global finance.
Elsewhere in Europe and the New World similar markets began from an embryonic stage,
and eventually financial trading spread to places as far afield as Melbourne and Buenos
Aires.4As we shall dis- cuss later, after 1870 these developments were to progress even
further. With the world starting to converge on the gold standard as a monetary system,
and with technological developments in shipping (for example, steamships replacing sail,
the Panama Canal) and communications (the telegraph, trans-oceanic cables), the
construction of the first global marketplace in capital, as well as goods and labor, took
hold in an era of undisputed liberalism and virtuallaisser faire.5
Within finance, the technological and institutional developments were many:
the use of modern communications to transmit prices; the development of a very the use

obroad array of private debt and equity instruments, and the expansion of the scope for
insurance activities; the expanding role of government bond markets inter- nationally;
and the more widespread use of forward and futures contracts, and derivative securities.
By 1900, the use of such instruments permeated the major economic centers of dozens of
countries around the world, stretching from Europe, east and west, north to south, to the
Americas, Asia, and Africa. The key currencies and instruments were known everywhere,
and formed the basis for an expanding world commercial network, whose rise was
equally meteoric. Bills of exchange, bond finance, equity issues, foreign direct
investments, and many other types of transactions were by then quite common among the
core countries, and among a growing number of nations at the periphery.

Aside fromhaute finance, more and more day-to-day activities came into the orbit of
finance via the growth and development of banking systems in many countries, offering
checking and saving accounts as time passed. This in turn raised the question of whether
banking supervision would be done by the banks themselves or the government
authorities, with solutions including free banking and “wildcat” banks (as in the United
States), and changing over time to include supervisory functions as part of a broader
central monetary authority, the central bank. From what was once an esoteric sector of
the economy, the financial sector grew locally and globally to touch an ever-expanding
range of activity.

Thus, the scope for capital markets to do good—or do harm—loomed larger as time
went by. As an ever-greater part of national and international economies became
monetized and sensitive to financial markets, agents in all spheres—public and private,
labor and capital, domestic and foreign—were affected. Who stood to gain or lose? What
policies would emerge as government objectives evolved? Would global capital markets
proceed unfettered or not? From the turn of the twentieth century, the unfolding history
of the international capital market has been of enormous import. The market has
undoubtedly shaped the course of national and international economic development and
swayed political interests in all manner of directions at various times. In terms of
distribution and equality, it has made winners and losers, though so often is the process
misunderstood that the winners and losers are often unclear, at the national and the global
level. An aim of this paper is to tell the history of what became a trulyglobal capital
market on the eve of the twentieth century, and explore how it has influenced the course
of events ever since.

Stylized Facts for the Nineteenth and Twentieth Century

Notwithstanding the undisputed record of technological advancement and eco- nomic

growth over the long run, we must reject the temptations of a simple linear history as we
examine international capital markets and their evolution. It has not been a record of
ever-more-perfectly-functioning markets with ever-lower transac- tion costs and ever-
expanding scope. The mid-twentieth century, on the contrary, was marked by an
enormous reaction against markets, international as well as do- mestic, and against
financial markets in particular.6Muted echoes of these same themes could be heard once
again at the end of the twentieth century.

What do we already know about the evolution of global capital mobility in the last
century or more? No previous studies exist for the entire period and covering a
sufficiently comprehensive cross-section of countries; but many authors have focused on
individual countries and particular epochs, and from their work we can piece together a
working set of hypotheses which might be termed the conventional wisdom concerning
the evolution of international capital mobility in the post-1870 era. The story comes in
four parts, and not coincidentally these echo the division of the twentieth century into
distinct international monetary regimes.7

The first period runs up to 1914. After 1870 an increasing share of the world economy
came into the orbit of the classical gold standard, and a global capital market centered on
London. By 1880, quite a few countries were on gold, and by 1900 a large number. This
fixed exchange-rate system was for most countries a stable and credible regime, and
functioned as a disciplining or commitment device. Accordingly, interest rates across
countries tended to converge, and capital flows surged. Many peripheral countries, not to
mention the New World offshoots of Western Europe, took part in an increasingly
globalized economy in not only the capital market, but also goods and labor markets.8

In the second period, from 1914 to 1945, this global economy was destroyed. Two world
wars and a Great Depression accompanied a rise in nationalism and in- creasingly
noncooperative economic policymaking. With gold-standard credibility broken by World
War One, monetary policy became subject to domestic political goals, first as a way to
help finance wartime deficits. Later, monetary policy was a
tool to engineer beggar-thy-neighbor devaluations under floating rates. As a guard against
currency crises and protect gold, capital controls became widespread. The world
economy went from globalized to almost autarkic in the space of a few decades. Capital
flows were minimal, international investment was regarded with suspicion, and
international prices and interest rates fell completely out of synchro- nization. Global
capital was demonized, and seen as one of the principal causes of the international
depression of the 1930s.9

In the third period, the Bretton Woods era from 1945 to 1971, an attempt to rebuild the
global economy took shape. Trade flows began a remarkable expansion, and economic
growth began its most rapid spurt in history worldwide. Yet the fears formed in the
interwar period concerning global capital were not easily dispelled. The IMF original
design sanctioned capital controls as a means for governments to protect themselves from
currency crises and runs, and to lend autonomy by providing more power to activist
monetary policy. For twenty years, this prevailing philosophy held firm; and although
capital markets recovered, they did so slowly. But by the late 1960s global capital could
not be held back so easily, and its workings eventually broke the compromise that had
sustained the fixed exchange- rate system.10

In the fourth and final period, the post-Bretton Woods floating-rate era, a differ- ent trend
has been evident. Although fixed-rate regimes were reluctantly given up, and though
some countries still attempt to maintain or create such regimes anew, the years from the
1970s to the 1990s have been characterized by a seeming in- crease in capital mobility.
Generally speaking, industrial-country governments no longer needed capital controls as
a tool to help preserve a fixed exchange-rate peg, since the peg was gone. As a floating
rate could accommodate market sentiment, controls could be lifted. This was encouraging
to the flow of capital in all countries. In peripheral countries, economic reforms reduced
the transactions costs and risks of foreign investment, and capital flows grew there too—
at least until the crises of the latter 1990s reminded investors of the fragility of the fixed-
rate regimes that remained in the developing world. Increasingly the smaller peripheral
countries that desire fixed exchange rates seek credibly to give up domestic monetary
policy autonomy through currency boards or even dollarization, whereas larger develop-
ing countries such as Mexico and Brazil have opted for exchange-rate flexibilit

In the 1990s, the term“globalization” has became a catch-all to describe the phenomenon
of an increasingly integrated and interdependent world economy, one that exhibits
supposedly freeflows of goods, services, and capital, albeit not of labor. Yet for all the
hype, economic history suggests that we be a little cautious in assessing how amazing
this development really is. We will show that a period of impressive global integration
has been witnessed before, at least for capital markets, at the turn of the twentieth
century, just about a hundred years ago. Of course, that earlier epoch of globalization did
not endure. As the above discussion suggests, if we were roughly to sketch out the
implied movements in capital mobility, we would chart an upswing from 1880 to 1914;
this would be followed by a collapse to 1945, though perhaps with a minor recovery
during the brief reconstruction of the gold standard in the 1920s, between the autarky of
World War One and the Depression; we would then think of a gradual rise in mobility
after 1945, becoming faster after the collapse of Bretton Woods in the early 1970s.

For illustrative purposes, let us make the tenuous assumption that international capital
mobility or global capital market integrationcould be measured in a single parameter.
Suppose we could plot that parameter over time for the last century or so. We would then
expect to see a time path something like Figure 1, wher

the vertical axis carries the mobility or integration measure. It is reasonable, given the
specific histories of various subperiods or certain countries, as contained in numerous
fragments of the historical literature, to speak of capital mobility increasing or decreasing
at the times we have noted. Thus, the overall∪-shape of thisfigure is probably correct.

However, without further quantification the usefulness of the stylized view remains
unclear. For one thing, we do not know if it accords with empirical measures of capital
mobility. Moreover, even if we know the direction of changes in the mobility of capital at
various times, we cannot measure the extent of those changes. Without such evidence, we
cannot assess whether the∪-shaped path is complete: that is, have we now reached a
degree of capital mobility that is above, or still below, that seen in the years before 1914?
To address these questions requires more formal empirical testing, and that is one of the
motivations for the quantitative analysis which follows.

the vertical axis carries the mobility or integration measure. It is reasonable, given the
specific histories of various subperiods or certain countries, as contained in numerous
fragments of the historical literature, to speak of capital mobility increasing or decreasing
at the times we have noted. Thus, the overall∪-shape of thisfigure is probably correct.

However, without further quantification the usefulness of the stylized view remains
unclear. For one thing, we do not know if it accords with empirical measures of capital
mobility. Moreover, even if we know the direction of changes in the mobility of capital at
various times, we cannot measure the extent of those changes. Without such evidence, we
cannot assess whether the∪-shaped path is complete: that is, have we now reached a
degree of capital mobility that is above, or still below, that seen in the years before 1914?
To address these questions requires more formal empirical testing, and that is one of the
motivations for the quantitative analysis which follows.

the vertical axis carries the mobility or integration measure. It is reasonable, given the
specific histories of various subperiods or certain countries, as contained in numerous
fragments of the historical literature, to speak of capital mobility increasing or decreasing
at the times we have noted. Thus, the overall∪-shape of thisfigure is probably correct.
However, without further quantification the usefulness of the stylized view remains
unclear. For one thing, we do not know if it accords with empirical measures of capital
mobility. Moreover, even if we know the direction of changes in the mobility of capital at
various times, we cannot measure the extent of those changes. Without such evidence, we
cannot assess whether the∪-shaped path is complete: that is, have we now reached a
degree of capital mobility that is above, or still below, that seen in the years before 1914?
To address these questions requires more formal empirical testing, and that is one of the
motivations for the quantitative analysis which follows.

1.3 The
Trilemma: Capital Mobility, the Exchange Rate, and
Monetary Policy
We seek in this paper not only to offer evidence in support of the above stylized view of
global capital market evolution, but also to provide an organizing framework for
understanding that evolution and the forces that shaped the international economy of the
twentieth century. Thus, given the stylized description, we must answer the immediate
question: what explains the long stretch of high capital mobility that prevailed before
1914, the subsequent breakdown in the interwar period, and the very slow postwar
reconstruction of the worldfinancial system? The answer is tied up with one of the central
and most visible areas in which openness to the world capital market constrains
government power: the choice of an exchange rate regime.11

Themacroeconomic policy trilemma for open economies (also known as the

“inconsistent trinity”proposition) follows from a basic fact: An open capital market

deprives a country’s government of the ability simultaneously to target its exchange rate
and to use monetary policy in pursuit of other economic objectives. The trilemma arises
because a macroeconomic policy regime can include at most two elements of
the“inconsistent trinity” of three policy goals:

(i)full freedom of cross-border capital movements;

(ii)afixed exchange rate; and

(iii)an independent monetary policy oriented toward domestic objectives.

If capital movements are prohibited, in the case where element(i) is ruled out, a country
on afixed exchange rate can break ranks with foreign interest rates and thereby run an
independent monetary policy. Similarly afloating exchange rate, in the case where
element(ii) is ruled out, reconciles freedom of international capital movements with
monetary-policy effectiveness (at least when some nominal domestic prices are sticky).
But monetary policy is powerless to achieve domestic goals when the exchange rate
isfixed and capital movements free, the case where element(iii) is ruled out, since
intervention in support of the exchange parity then entails capitalflows that exactly offset
any monetary-policy action threatening to alter domestic interest rates.12

Recognition of the trilemma leads to our central proposition, that secular move- ments in
the scope of international lending and borrowing may be understood in terms of this
trilemma. Capital mobility has prevailed and expanded under circum- stances of
widespread political support either for an exchange-rate-subordinated monetary regime
(for example, the gold standard), or for a monetary regime geared mainly toward
domestic objectives at the expense of exchange-rate stability (for example, the
recentfloat). The middle ground in which countries attempt simul- taneously to hit
exchange-rate targets and domestic policy goals has, almost as a logical consequence,
entailed exchange controls or other harsh constraints on international transactions.

It is this conflict among rival policy choices, the trilemma, that informs our discussion of
the historical evolution of world capital markets in the pages that follow, and helps make
sense of the ebb andflow of capital mobility in the long run and in the broader political-
economy context. Of course, the trilemma is only a proximate explanation, in the sense
that deeper socio-political forces explain the relative dominance of some policy targets
over others.

12The choice betweenfixed andfloating exchange rates should not be viewed as

dichotomous;

nor should it be assumed that the choice of afloating-rate regime necessarily leads to
a useful degree of monetary-policyflexibility. In reality, the degree of exchange-
rateflexibility lies on a continuum, with exchange-rate target zones, crawling pegs,
crawling zones, and managedfloats of various other kinds residing between the extremes
of irrevocablyfixed and freelyfloating. The greater the attention given to the exchange
rate, the more constrained monetary policy is in pursuing other objectives. Indeed, the
notion of a“free” float is an abstraction with little empirical content, as few governments
are willing to set monetary policy without some considerations of its exchange-rate
effects. If exchange rates are subject to pure speculative shocks unrelated to economic
fundamentals, and if policy makers are concerned to counter these movements, then
monetary control will be compromised.

1.4 A Brief Narrative

The broad trends and cycles in the world capital market that we will document reflect
changing responses to the fundamental trilemma. Before 1914, each of the world’s major
economies pegged its currency’s price in terms of gold, and thus, implicitly, maintained
afixed rate of exchange against every other major country’s currency. Financial interests
ruled the world of the classical gold standard and

financial orthodoxy saw no alternative mode of sound finance.13Thus, the gold

 standard system met the trilemma by opting forfixed exchange rates and capital
mobility, sometimes at the expense of domestic macroeconomic health. Between 1891
and 1897, for example, the United States Treasury put the country through a harsh
deflation in the face of persistent speculation on the dollar’s departure from gold. These
policies were hotly debated; the Populist movement agitated forcefully against gold, but
lost. The balance of political power began to change only with the First World War,
which brought a sea-change in the social contract underlying the industrial democracies.
Organized labor emerged as a political power, a counterweight to the interests of
capital.14

Although Britain’s return to gold in 1925 led the way to a restored interna- tional gold
standard and a limited resurgence of internationalfinance, the system helped propagate a
worldwide depression after the 1929 New York stock mar- ket crash. Following (and in
some cases anticipating) Britain’s example, many countries abandoned the gold standard
in the early 1930s and depreciated their currencies; many also resorted to trade and
capital controls in order to manage independently their exchange rates and domestic
policies. Those countries in the

“gold bloc,”which stubbornly clung to gold through the mid-1930s, showed the

steepest output and price-level declines. But eventually, in the 1930s, all coun- tries
jettisoned rigid exchange-rate targets and/or open capital markets in favor of domestic
macroeconomic goals.15

These decisions reflected the shift in political power solidified by the First World War.
They also signaled the beginnings of a new consensus on the role of economic policy that
would endure through the inflationary 1970s. As an immediate consequence, however,
the Great Depression discredited gold-standard orthodoxy and brought Keynesian ideas
about macroeconomic management to the fore. It also madefinancial markets andfinancial
practitioners unpopular. Their supposed excesses and attachment to gold became
identified in the public

mind as causes of the economic calamity. In the United States, the New Deal brought
a Jacksonian hostility toward eastern (read: New York) highfinance back to Washington.
Financial products and markets were banned or more closely regulated, and the Federal
Reserve was brought under heavier Treasury influence. Similar reactions occurred in
other countries.

Changed attitudes towardfinancial activities and economic management un- derlay the
new postwar economic order negotiated at Bretton Woods, New Hamp- shire, in July
1944. Forty-four allied countries set up a system based onfixed, but adjustable, exchange
parities, in the belief thatfloating exchange rates would exhibit instability and damage
international trade. At the center of the system was the International Monetary Fund
(IMF). The IMF’s prime function was as a source of hard-currency loans to governments
that might otherwise have to put their economies into recession to maintain afixed
exchange rate. Countries ex- periencing permanent balance-of-payments problems had
the option of realigning their currencies, subject to IMF approval.16

Importantly, the IMF’s founders viewed its lending capability as primarily a substitute
for, not a complement to, private capital inflows. Interwar experience had given the latter
a reputation as unreliable at best and, at worst, a dangerous source of disturbances.
Encompassing controls over private capital movement, perfected in wartime, were
expected to continue. The IMF’s Articles of Agreement explicitly empowered countries
to impose new capital controls. Article VIII of the IMF agreement did demand that
countries’ currencies eventually be made convertible— in effect, freely saleable to the
issuing central bank, at the official exchange parity, for dollars or gold. But this privilege
was to be extended only to nonresidents (not a country’s own citizens), and only if the
country’s currency had been earned either through merchandise sales or as a return on
past lending. Convertibility on capital account, as opposed to current-account
convertibility, was not viewed as mandatory or desirable.

Unfortunately, a wide extent even of current-account convertibility took many years to

achieve. In the interim, countries resorted to bilateral trade deals that required balanced or
nearly balanced trade between every pair of trading partners. If France had an export
surplus with Britain, and Britain a surplus with Germany, Britain could not use its excess
marks to obtain dollars with which to pay France. Germany had very few dollars and
guarded them jealously for critical imports from the Americas. Instead, each country
would try to divert import demand toward countries with high demand for its goods, and
to direct its exports toward

economic goals.15

countries whose goods were favored domestically.

Convertibility gridlock in Europe and its dependencies was ended through a regional
multilateral clearing scheme, the European Payments Union (EPU). The clearing scheme
was set up in 1950 and some countries reachedde facto convertibility by mid-decade. But
it was not until December 27, 1958 that Europe officially embraced convertibility and
ended the EPU.

Although most European countries still chose to retain extensive capital con- trols
(Germany being the main exception), the return to convertibility, important as it was in
promoting multilateral trade growth, also increased the opportunities for disguised capital
movements. These might take the form, for example, of mis- invoicing, or of accelerated
or delayed merchandise payments. Buoyant growth encouraged some countries in
furtherfinancial liberalization, although the U.S., worried about its gold losses, raised
progressively higher barriers to capital outflow over the 1960s. Eventually, the Bretton
Woods system’s very successes hastened its collapse by resurrecting the trilemma.
Key countries in the system, notably the U.S. (fearful of slower growth) and Germany
(fearful of higher inflation), proved unwilling to accept the domestic policy implications
of maintainingfixed rates. Even the limited capital mobility of the early 1970s proved
sufficient to allow furious speculative attacks on the major currencies, and after vain
attempts to restorefixed dollar exchange rates, the industrial countries retreated tofloating
rates early in 1973. Although viewed at the time as a temporary emergency measure,
thefloating-dollar-rate regime is still with us a thirty years later.

Floating exchange rates have allowed the explosion in internationalfinancial markets

experienced over the same three decades. Freed from one element of the trilemma—fixed
exchange rates—countries have been able to open their capital markets while still
retaining theflexibility to deploy monetary policy in pursuit of national objectives.

There are several valid reasons for countries tofix their exchange rates– for example, to
keep a better lid on inflation or to counter exchange-rate instability due tofinancial-market
shocks. However, few countries that have tried have succeeded for long; eventually,
exchange-rate stability tends to come into conflict with other policy objectives, the capital
markets catch on to the government’s predicament, and a crisis adds enough economic
pain to make the authorities give in. In recent years only a very few major countries have
observed the discipline offixed ex- change rates for at leastfive years, and most of those
were rather special cases.

One puzzling case, Thailand, has dropped off the list—with a resounding crash. Even
Hong Kong, which operates as a currency board supposedly subordinated to maintaining
the Hong Kong-U.S. dollar peg, suffered repeated speculative attacks in the Asian crisis
period. Another currency-board country, Argentina, has now held to its 1:1 dollar
exchange rate since April 1991, a remarkable stint of more than ten years. To accomplish
that feat, the country has relied on IMF credit and has suffered unemployment higher
than many countries could tolerate. It has suffered especially acutely since Brazil moved
to afloat in January 1999—its politics and economy are both in crisis, and the government
is openly considering switching from a pure dollar peg to a dollar-euro basket. The
European Union members that maintained mutuallyfixed rates prior to January 1999 were
aided by market confidence in their own planned solution to the trilemma, a near-term
currency merger. For most larger countries, the trend toward greaterfinancial openness
has been accompanied—inevitably, we would argue—by a declining reliance on pegged
exchange rates in favor of greater exchange-rateflexibility. Some coun- tries have opted
for a different solution, however, adopting extreme straitjackets for monetary policy in
order to peg an exchange rate. If monetary policy is geared toward domestic
considerations, capital mobility or the exchange-rate target must go. If, instead,fixed
exchange rates and integration into the global capital market are the primary desiderata,
monetary policy must be entirely subjugated to those ends.

The details of this argument require a book-length discourse (Obstfeld and Taylor 2002),
which allows a full survey of the empirical evidence and the historical record, but we can
already pinpoint the key turning points (see Table 1). The Great Depression stands as the
watershed here, in that it was caused by an ill- advised subordination of monetary policy
to an exchange-rate constraint (the gold standard), which led to a chaotic time of troubles
in which countries experimented, typically noncooperatively, with alternative modes of
addressing the fundamental trilemma. Interwar experience, in turn, discredited the gold
standard and led to a new and fairly universal policy consensus. The new consensus
shaped the more cooperative postwar international economic order fashioned by Harry
Dexter White and John Maynard Keynes, but also implanted within that order the seeds
of its own eventual destruction a quarter-century later. The globalfinancial nexus that has
evolved since is based on a solution to the basic open-economy trilemma quite different
than that envisioned by Keynes or White—one that allows considerable freedom for
capital movements, gives the major currency areas freedom to pursue internal goals, but
largely leaves their mutual exchange rates as the equilibrating residual.

Regulating Global Capital Markets: Somali Pirate Capital Markets, the

South Sea Bubble and the Limits of Law

The 21st century has seen its share of efforts to extend the power of the state to
regulate economic activity in new and increasingly comprehensive ways. The economic
scandals at the start of the 21st century and the economic collapse of 2007-2008 provided
national governments, and international organizations more than enough excuse to push
ambitious agendas for control. Underlying these efforts are notions of fairness, investor
protection, fairness, and the protection of the integrity of markets. The conventional
narrative of the organization of economic activity is founded on notions of legitimacy
tied to law and the central role of legislator, administrator, judge and lawyer in the
management of economic activity. See, Larry Catá Backer, From Narrative to Narrator:
Remarks at "Business Law and Narrative Symposium" at MSU, Law at the End of the
Day, Sept. 16, 2009. In the absence of this public oversight, commercial activity is
suspect, markets lose their integrity and organized economic activity loses its welfare
maximizing effects. A recent story and an old scandal remind us that the narrative of
state intervention in markets through regimes of positive law may be as much about the
preservation of the power of the state as it is about the objects of regulation. In the
absence of state intervention is may be possible to run credible capital markets. At the
same time, markets in a highly regulated environment may produce the greatest
corruption of systemic failure.
The recent story describes the development of capital markets to fund the increasingly
lucrative business of piracy, currently centered in Somalia. In a country without a
credible state apparatus, and little by way of effective positive law, a credible market
based economy may be elaborated without the intervention or management of the state.
In Somalia's main pirate lair of Haradheere, the sea gangs have set up a cooperative to
fund their hijackings offshore, a sort of stock exchange meets criminal syndicate. Heavily
armed pirates from the lawless Horn of Africa nation have terrorized shipping lanes in the
Indian Ocean and strategic Gulf of Aden, which links Europe to Asia through the Red
Sea.
The gangs have made tens of millions of dollars from ransoms and a deployment by
foreign navies in the area has only appeared to drive the attackers to hunt further from
shore. It is a lucrative business that has drawn financiers from the Somali diaspora and
other nations -- and now the gangs in Haradheere have set up an exchange to manage
their investments. One wealthy former pirate named Mohammed took Reuters around the
small facility and said it had proved to be an important way for the pirates to win support
from the local community for their operations, despite the dangers involved. "Four
months ago, during the monsoon rains, we decided to set up this stock exchange. We
started with 15 'maritime companies' and now we are hosting 72. Ten of them have so far
been successful at hijacking," Mohammed said. "The shares are open to all and
everybody can take part, whether personally at sea or on land by providing cash, weapons
or useful materials ... we've made piracy a community activity." Daniel Wallis, Somali
sea gangs lure investors at pirate lair, Reuters, Dec. 1, 2009.

Like early stock exchanges in Northern Europe, the Somali exchange has become
something of the center of economic and communal life in the city. "Haradheere's "stock
exchange" is open 24 hours a day and serves as a bustling focal point for the town. As
well as investors, sobbing wives and mothers often turn up there seeking news of male
relatives missing in action." Id. And it has brought a certain amount of wealth to this
part of Somalia. "Haradheere, 400 km (250 miles) northeast of Mogadishu, used to be a
small fishing village. Now it is a bustling town where luxury 4x4 cars owned by the
pirates and those who bankroll them create honking traffic jams along its pot-holed, dusty
streets." Id.

"One wealthy former pirate told Reuters that the stock exchange had won local support
by making piracy into a "community activity," which may underscore the root of the
problem for nations seeking to battle piracy as a symptom." Jeremy Hsu, Somali Pirate
Exchange Lets Investors Bet on Hitting a Ransom Jackpot, Popsci, Dec. 2, 2009. Of
course, the result belies the conventional narrative of the critical need for state
intervention to manage markets. Ironically, it also brings home a reality that should have
become apparent in the now half century war against drugs--merely declaring an
activity"illegal" will not suppress markets in activity with respect to which there is
demand. The standard narrative of law and economics suggests that behavior may be
legislatively controlled--the effects of state power and the legitimacy producing effects of
formal governance--is belied not only by the flourishing pirate trade but also by the
development of markets to finance such activities.
As for the pirate stock exchange, it seems like just another natural step for Somali
communities that increasingly depend on illegal activities for economic subsistence.
Somali pirates put a percentage of their ransom money back into their communities to
pay for hospitals and public schools. Reuters quotes a woman who contributed a rocket-
propelled grenade to one group of pirates and eagerly anticipates the dividends. This
suggests that all the high-powered Navy weapons or non-lethal gadgets in the world
won't solve that problem -- much as we love our anti-pirate gadgets. Id.
But the converse is not true--that state regulation can prevent or manage market activity
and protect the integrity of capital markets. The story of the South Sea Bubble is worth
recounting after the collapse of 2007-08. It serves as a reminder that state may not be the
answer. This story is drawn from the masterful account in Malcolm Balen, A Very
English Deceit: The Secret History of the South Sea Bubble and the First Great Financial
Scandal, (London: Fourth Estate, 2002).
The similarities of the current economic situation in the United States and the economic
collapses in England 1720 and France 1719 are striking. A careful read might find you
checking and then re-checking the copyright on The Secret History of the South Sea
Bubble, just to make sure Balen’s historical perspective or re-telling of events had not
been skewed by the crash of 2007. Central themes of “rescue packages”, “saving banks”
and “corruption” are all too familiar in this book. The copyrights were in fact in 2002 and
2003, an eerie reminder to the axiom of history oftentimes repeating itself. It is evident
that Balen could foresee the United States’ economic “bubble” growing to an
unsustainable size with the quotes of overconfidence from 1999-2001 he chose to preface
each chapter.

The book begins with meticulous description about the atmosphere surrounding the
building of St. Paul’s Cathedral in London, 1710. The people’s worship was said to be of
money, not God. The architect, Christopher Wren, designed the top of the cathedral to
resemble a sort of bubble which was so delicate that it needed a second inner bubble to
support it. The economic scene included bank rivalries and stock jobbers in Exchange
Alley. The bubble on the cathedral is symbolic of the era and fragility of the stock market
investments when they grow to an unsustainable size.

John Law, the instigator in Frances’ economic collapse of 1719, was originally from
Britain. Law fled the country early in his career after he was involved in a dual, which
left the other participant dead. The dual was over a lady acquaintance and much of the
details are left up to the imagination, sadly one of the most interesting background
descriptions in the book. During his years abroad, Law made a fortune as a gambler and
acquired a taste for finance. He observed the Bank of Amsterdam and their currency
system. In a time where coins were frequently clipped and instantly devalued, Law had
the radical idea of paper money whose value was backed by land.

Law attempted to persuade a few countries of his idea, and finally found a taker in France
where the national debt was at an all time high of three billion livres. The country was
desperate and decided to give Law a shot in 1716. France would join the club of only six
other countries that used paper notes at the time. Law created a bank that would issue
paper notes and also act as a trading corporation to buy and sell property. It would lend
money at a fixed rate of interest and the gold and silver in the ducal treasury would act as
its reserves. Law created the Mississippi Company who sold shares to investors hoping to
capitalize on the rich mineral prosperity of Louisiana and Mississippi. He deported the
sick, prisoners and low income citizens to cultivate the land after having no other
volunteers. Needless to say his empty promises of returns on land development in
America popped France’s economic prosperity like a bubble. Where people had once
rushed to buy stock because the prices were rising so quickly; they could now practically
use the paper currency for toilet paper as it lost almost all its value. The Plague followed
soon after, which many French citizens viewed as punishment for their foolish admiration
of investing in the get rich quick schemes.

John Blunt made his reputation through his idea of using lottery monies to help pay off
the national debt in Britain. He and his partner, who was involved in the government,
would sell tickets with a certain number of guaranteed winners. Although, the lottery was
briefly successful, Blunt saw a potentially bigger return through buying the country’s
debt and selling stocks. Blunt used the Sword Blade Bank to create the South Sea
Company, which was initially supposed to be a trading company but never actually
generated a profit. The South Sea Company was the front for the stocks in 1720 and
filtered money through the bank, where citizens would buy at a days’ rate and as the
company grew, the stocks would increase. Blunt was much more underhanded than Law,
and bribed many government officials with free stock or highly discounted prices. The
Company went through four different phases of selling stock, each time at a higher price,
and many people made money hand over fist. Blunt issued generous credit and payment
plans and kept little money in the reserves. When the word finally spread that The South
Sea Company was collapsing and wasn’t actually based on trading or any sort of real
income producing business, it was too late and the stock dropped well below what most
people owed. Instead of an actual business plan or improved method of business, such as
Law’s paper notes having value backed by land or gold, Blunt had made millions on his
ability to corrupt government officials and inflate stock prices.
Most of Britain’s government officials and the King’s party had dirty hands, which made
rectifying the economic collapse difficult. Robert Walpole, one of the only objectors to
The South Sea Company buying the government’s debt, saw his opportunity to seek
revenge on his political enemies and take control of the chaos. Walpole was able to save
the monarchy and the masterminds behind The Company to create political leverage,
while at the same time persecuting a minority of government officials who had received
bribes to satiate the blood thirsty public. With this power he was able to put friends in
recently vacated government positions and secure control over the country. The parallels
to the events of 2008-2009 are worth considering.
Plague provided the excuse. Fear of contracting France’s plague caused England to
quarantine its’ ports, leaving dozens of ships unable to unload their cargo. Churches were
attempting to regain ground it had lost through the stock explosion by condemning those
who had fallen weak to money and the Plague was their punishment. “Walpole had
calculated that he needed the crisis to run out of control, and for the anger of investors to
grow and be heard ever louder, in order to pitch the ruling duopoly…out of power…”
Walpole sought political power and revenge against his colleagues. He aimed to sweep
out the corruption, but not too far or else he himself could be entangled. Walpole began
working out his new rescue deal with the Bank of England and then presented it to the
King before the House of Commons. He aimed to show his support of his party and the
King enough so that they would have favor with him before, for lack of better words, shit
hit the fan. Walpole’s new plan included both the Bank of England and the East India
Company acquiring a quarter each of the South Sea stock, and each would offer some of
their own stock to annuitants in exchange for South Sea shares. Therefore, at least
shareholders would own shares in reputable businesses.

When the plan was presented, Parliament was thirsty for blood and would not be satisfied
until people were found to blame. “Parliament began to flex its muscles, as the full scale
of corruption began to emerge, Walpole would maneuver to undermine the actions of his
parliamentary colleagues without leaving any evidence of his involvement in the cover-
up he had orchestrated.” The Commons immediately formed an inquiry committee to
investigate the South Sea Company. The Parliament wanted everything accounted for
starting from December 1719, but it was too late the South Sea Companies cashier Robert
Knight was already orchestrating a cover-up. Knight took steps to erase and fill in holes
with fake names in the accounting ledgers where they had recorded the bribes and
discounted share offerings.

When Parliament reconvened in January 1721 after the Christmas break, Walpole had
promised to protect some, and was waiting for the opportune moment to guide the
direction of the inquiries. The House of Commons then required that the South Sea
Company’s Directors pay £25,000 in bail money and were presumed guilty until proven
innocent. The worst sanction yet, would be the Commons’ refusal to appoint the
Director’s lawyers. Trials were held in both the House of Lords and the Commons
against the Directors of the Company. In the hustle and bustle of organizing the trials and
deciding who and how those involved should be punished, Knight knew the stacks of
evidence he had been keeping in his office would soon be discovered. “As the days went
by in the run-up to [Knight’s] own appearance before the Commons’ inquiry, Knight
desperately approached government ministers to try to blackmail them into protecting
him.” In Knights questioning he kept silent about the Company’s dealings, and planned
his escape with the ledger in tow. Knight had transferred enough money to live on to
foreign banks in his preparations, and when word spread of his departure it “stripped
away the veneer of official respectability which had masked the Company’s disreputable
dealings over the past year, so that the Commons saw for the first time the true nature of
the South Sea enterprise.” The country was in an uproar and demanded that Knight be
caught. The ministry continued to clean house by stripping all directors in the Company
of their public offices, except of course the King, and continued to imprison and seek
restitution from others. The most unexpected turn of events was when Blunt caved and
told the inquiry committee everything, even names of government co-conspirators.

Walpole now feeling things have utterly spiraled out of control, enters the scene from
stage left, and begins to play the game. “While Walpole publicly protested that he wanted
Knight to be extradited, and that he was doing everything he could to make it happen,
behind the scenes he had resolved to keep him abroad at any price, rather than bring him
back to give evidence.” Walpole knew that if Knight came back, the King would be
incriminated; therefore it was in Walpole’s best interest to keep the Kings favor in his
pocket. As it happened a British police officer in Brussels tracked down Knight, not
knowing the true intentions of the King, and placed him inside the Citadel of Antwerp.
The ledger was sent back to London, but was mysteriously lost en route. Walpole’s
political dance continued and protested that Knight be returned to London, at the same
time at the behest of the King a special envoy was sent to Vienna. Colonel Charles
“Churchill had been ordered to persuade the Governor of the Austrian Netherlands…that
Knight’s extradition posed insoluble difficulties for the British government. The delay of
Knight’s return continued, and the measures taken to conceal Walpole and the King’s
true intentions were extreme. Finally in September 1721, a letter was written on behalf of
the King stating “…[the King] is pleased to express the wish that Your Excellency should
order the Governor of the Antwerp Citadel to enlarge Knight from confinement, allowing
him not only to have liberty to walk on the Citadel, but to escape…” Thus, the Emperor
released Knight to live in exile abroad, where he would remain for many years.

Walpole then began strategically placing his friends and family in the government offices
vacated by the South Sea scandal. February 1721 marked the beginning of the end for the
committee’s inquiry, when they presented their initial findings to the Commons for a full
2 ½ hours. They revealed actual worth of stock and what it had been sold for, and
“unraveled the process by which shares had been ‘sold’ for notional prices with no record
of a date and without any money changing hands…” The committee reported that the
Company had gone well beyond bribery and corruption, but that “there were no financial
checks and balances placed upon it by Parliament, despite the fact that it had taken upon
itself the role of guardian of the nation’s finances through its purchase of the national
debt.” The Commons began to prosecute and sentence those revealed to be involved in
accepting the bribes, and Walpole maneuvered once again to save those he felt important.

You may be asking yourself, what happened to Blunt and Law? By a vote, Blunt was
allowed to keep just £1,000 (which was later raised to £5,000) and “retire to Bath to
contemplate the ashes of his career.” By April 1722, Walpole had secured his anticipated
control in government. He oversaw both “the Lords and the Commons and established
Whig supremacy for a century.” Law was finally allowed to return home to London, by
Walpole’s granting, and later died in Venice at age 58.
Both the story of governmental collusion in regulated markets in the crude for of the
South Sea Bubble of the early 18th century and the modern story of the rise of
unregulated capital markets in pirate activities remind us the simple binary relationship of
private economic activity and public regulation may not provide either the legitimacy or
integrity necessary to preserve a welfare maximizing framework. Moncentric
governance evidences both its thrust--to acquire power, and its limits. It suggests that
value of recent powerful efforts to try to fashion forms of polycentric governance. See
Larry Catá Backer, On Challenges to Operationalizing a Transnational Framework for
Business and Human Rights--the View From Geneva, Law at the End of the Day, Oct.
13, 2009. Just as the South Sea Bubble produced a crisis that proved irresistible to
institutional actors seeking to use it as a pathway to strengthen their personal power and
rearrange power allocations among stakeholders in the national economies of the time, so
the economic crisis that started in 2007 has appeared to produce the same temptations--
for management, and power shifting among political and economic actors. Managing
risk may be more about control than economics. And indeed, as in the early 18th
century, the principle object may be the management of political stability than economic
productivity. Yet this is undertaken in a context in which capital can hardly be managed
by single states, and economic culture is not as easily dictated by a dominant global
culture. Governance has not managed to overcome the state yet it has undone national
efforts to assert comprehensive political authority over economic actors.

It is in this sense that one can appreciate the understated insights recently elaborated by
Peer Zumbansen, in his excellent work, The Next 'Great Transformation' of Markets and
States in the Transnational Space: Global Assemblages of Corporate Governance &
Financial Market Regulation (June 6, 2009). CLPE Research Paper No. 9/2009 ("The
corporation at the end of the 20th century was no longer primarily seen as an
organizational entity, but had become a financial vehicle, operating in a regulatory
framework largely out of control of domestic company law legislation. This emerging
regulatory environment consists of supra-national legislation directed at increased
efficiency of regional and global financial markets on the one hand and increasingly
incentive-oriented, indirect regulation of corporate governance rules, placed to a large
degree within the discretion of market actors. The financialization of corporate
governance and the emergence of a transnational legal pluralist regime of applicable rules
and standards" Abstract). The Somali markets for pirate enterprises provide a nice
example of Zumbansen's insight that
The corporation had become a nodal point for an ephemeral crossing, interlinking and
overlapping of financial vectors, channelled through the glass structure of the legal
person, with almost to no relation to the original ‘business’ of the corporation. A dream
fulfilled, with money flowing in and out of the firm, the corporation had become a virtual
realm for strategic investment. Id., at 9.
The resulting financialization of the corporation has produced a change in both the
behavior of stakeholders and the character of regulatory approaches. Corporate
autonomy has not freed it from regulation and the state so much as made both as much an
object of consumption and part of the calculus of production, in the way that labor and
distribution channels are for the production and distribution of goods. Larry Catá Backer,
Economic Globalization Ascendant: Four Perspectives on the Emerging Ideology of the
State in the New Global Order. University of California, Berkeley La Raza Law Journal,
Vol. 17, No. 1, 2006. The nature of that challenge, and the changing face of finance
were nicely illustrated by the new form of in-kind micro investment made possible in
regulation free environments, like that of the capitalization of piracy. Consider the
following:
Piracy investor Sahra Ibrahim, a 22-year-old divorcee, was lined up with others waiting
for her cut of a ransom pay-out after one of the gangs freed a Spanish tuna fishing vessel.
"I am waiting for my share after I contributed a rocket-propelled grenade for the
operation," she said, adding that she got the weapon from her ex-husband in alimony. "I
am really happy and lucky. I have made $75,000 in only 38 days since I joined the
'company'."
Daniel Wallis, Somali sea gangs lure investors at pirate lair, Reuters, Dec. 1, 2009. The
consequences for development, the extent of political management of economic activity,
the role of the state, and the form of effective governance cannot be underestimated. It is
to Somalia, perhaps, rather than to the overwrought markets in New York, London and
Shanghai that the future of global capital markets, and the financialized corporation, will
be shaped for large segments of global economic actors operating below the level of elite
actors. And this is a reality that has begun to shape some of the outreach of those well
developed markets as they seek to protect their culture, behavior rules and the unity of
their markets. June McLaughlin recently described efforts by the exchanges of
developed states to help acculturate new financial exchanges in Uganda. June
McLaughlin, SITI in East Africa, Muzungu on Africa, Dec. 28, 2009 ("A securities
training institute has been launched in East Africa. The Securities Industry Training
Institute (Siti East Africa) is based at the Uganda Securities Exchange (USE) in Kampala,
Uganda."). The initiative is financed by the IFC in its role in promoting development
through "capacity building." I will leave her with the last word of this essay--a last word
tinged with tremendous irony and insight:
Africa has many progressive initiatives. This education is run by the IFC but I don’t care
about that. I no longer care where people come from. I only care about people as humans.
What difference does it make anyway? Enough crazy politicians want to seem effective
and make us sit for the last hour of a transatlantic flight. Well ok. June McLaughlin, SITI
in East Africa, Muzungu on Africa, Dec. 28, 2009.
The future belongs, in a perverse way and to a certain extent, to "Somalia".

History
The history of financial institutions must be differentiated from economic history and
history of money. In Europe, it may have started with the first commodity exchange, the
Bruges Bourse in 1309 and the first financiers and banks in the 1400–1600s in central
and western Europe. The first global financiers the Fuggers (1487) in Germany; the first
stock company in England (Russia Company 1553); the first foreign exchange market
(The Royal Exchange 1566, England); the first stock exchange (the Amsterdam Stock
Exchange 1602).
 Milestones in the history of financial institutions are the Gold Standard (1871–1932),
the founding of International Monetary Fund (IMF), World Bank at Bretton Woods, and
the abolishment of fixed exchange rates in 1973.Globalization of capital markets has
received new momentum and it will continue to be of major importance for the years to
come. Partly, the increasing integration of financial markets and the rise of foreign direct
investment is a consequence of world trade expansion. But in addition to this underlying
trend, the worldwide collapse of socialist systems and the opening up of big economies
like India and China have fuelled the development of globalized capital markets. This
book takes stock of recent developments with emphasis on emerging capital markets.

There were lessons to be learned form the past, in particular that a global financial
system, although it is efficient due to its size and diversity, is a vulnerable institution. The
experience was that financial crises occur unexpectedly and their strong contagion effects
spread worldwide. From this experience, the question of what makes a financial system
sound receives a prominent role on the research agenda of economists. Also, the question
arose as to how the role of monetary policy should be defined under a changing global
financial architecture. Evidently, a regime of flexible exchange rates between the major
currencies does not provide for autonomy in pursuing domestic monetary policy
strategies. The interdependence of monetary policy requires its contribution in securing
financial security. These issues are addressed in this volume.