9.3 — Companies, Shares and the First Bubbles

In 1602 the Dutch East India Company — the VOC — was chartered, and it did something no enterprise had done before.

It raised capital from the public that was permanent. Previous ventures had been funded voyage by voyage: investors put money in, the ship returned, the cargo was sold, the proceeds were distributed, and the partnership dissolved. The VOC's capital stayed in the company.

And an investor who wanted their money back could not demand it from the company — they had to sell their share to somebody else.

That requirement created a market in shares, which required a place to trade them, which is why the Amsterdam exchange became the world's first stock market. Everything from a modern IPO to a pension fund descends from that one design decision.

What a joint-stock company is

Four features, and each solves a specific problem.

Shared ownership in transferable units. Capital is divided into shares that can be sold without disturbing the enterprise.

Permanent capital. The company continues regardless of who owns it or who dies.

Legal personality. The company is a person in law — it can own property, sign contracts, sue and be sued in its own name. This is the medieval corporate form of Chapter 7.4, applied to trade.

Limited liability. A shareholder can lose what they invested and no more. Their personal assets are not at risk for the company's debts.

Limited liability is the one that changed the world and it is the one worth pausing on. Under an ordinary partnership, a partner is liable for the whole of the firm's debts. That is tolerable if you know your partners and watch the business. It is intolerable if you are one of two thousand shareholders who have never met the managers, because you would be risking your house on the judgement of strangers.

Without limited liability there is no passive investment, and therefore no way to assemble capital from thousands of people who cannot supervise the enterprise. With it, the small investor can participate. Limited liability is what makes large-scale finance possible, and it fully generalised in Britain only with the Companies Acts of the 1850s and 60s.

And it has a cost that Chapter 12.8 returns to. A structure in which the upside is unlimited and the downside is capped encourages risk-taking, and where the risk is borne by people outside the company — depositors, customers, the environment — the arrangement transfers it to them.

The VOC, and what a company with sovereign powers did

The VOC's charter granted it the right to make treaties, wage war, build forts, mint coin and administer territory. A commercial company was given powers of state, and the East India Company received the same (Chapter 6.16).

It was the largest company in the world for most of the seventeenth century, with hundreds of ships, tens of thousands of employees, and a monopoly of Dutch trade east of the Cape.

And its conduct in the Banda Islands should be recorded, because it is where the logic of a monopoly on a natural product reaches its conclusion.

Nutmeg grew on the Banda Islands and nowhere else (Chapter 8.4). The Bandanese traded with whoever arrived, which made a monopoly impossible. In 1621 the VOC's governor-general Jan Pieterszoon Coen led an expedition that killed or deported almost the entire population — estimates are that the population fell from around 15,000 to under 1,000 — and replanted the islands as plantations worked by enslaved people.

Coen's statue stood in his home town in the Netherlands into the twenty-first century, with the inscription describing him as having won by trade.

And the monopoly failed anyway, as monopolies on living things do. A Frenchman smuggled nutmeg seedlings out in 1770 and established them in Mauritius, and the British later took plants to Ceylon, Penang and Grenada.

The Amsterdam exchange

By the 1610s Amsterdam had a functioning securities market, and it had almost every feature of a modern one within a few decades.

Forward contracts, options, and short selling. Isaac Le Maire, a former VOC director, organised the first documented bear raid in 1609, selling VOC shares he did not own in the expectation of buying them back cheaper. The company complained and the authorities banned short selling, which is the first of many such bans and roughly as effective as the later ones.

Joseph de la Vega's Confusion de Confusiones, published in 1688, is the first book about a stock market, written by a participant. It describes rumour, manipulation, herd behaviour, the difference between value and price, and the psychology of traders, and its observations are almost entirely applicable today.

And there is one detail worth quoting. He advises never to give anyone the advice to buy or sell shares, because where perspicacity is weakened the most benevolent piece of advice can turn out badly.

The bubbles of 1720

Two enormous speculative manias ran simultaneously in Paris and London, and between them they established every feature of every bubble since.

The Mississippi Bubble

John Law, a Scottish gambler, economist and convicted duellist, persuaded the French regent to let him restructure France's finances.

His scheme, and it is genuinely clever. France was crushed by debt from Louis XIV's wars. Law founded a bank issuing paper money, and a company — the Mississippi Company — holding a monopoly on trade with French Louisiana. He then merged them and offered government bondholders the chance to swap their bonds for company shares.

If the shares rose, the debt was converted into equity in a profitable enterprise and the state was solvent.

The shares rose spectacularly — roughly twentyfold in about two years — on a promoted prospect of American wealth. The word "millionaire" was coined in Paris during this episode.

And Louisiana was a swamp with almost no colonists and no gold. When holders began converting shares back into coin, the bank could not meet the demand, the price collapsed, and Law fled France in disguise. He died poor in Venice.

The consequence was long. France distrusted paper money and banking for the rest of the century, which meant it financed its wars by taxation and short-term borrowing at high rates — one of the reasons its fiscal crisis of 1788 became a revolution (Chapter 10.3).

The South Sea Bubble

The same scheme, in London, at the same time. The South Sea Company took on a large part of the British national debt in exchange for a trading monopoly with Spanish South America — a trade Spain had no intention of permitting.

The company's actual business was negligible. Its share price rose roughly eightfold in 1720 and collapsed in the autumn.

Isaac Newton lost a large sum, and the remark attributed to him is the best line in financial history: he could calculate the motions of the heavenly bodies but not the madness of people.

The political fallout produced the Bubble Act, which restricted the formation of joint-stock companies without a royal charter, and it was on the statute book until 1825. The first great financial fraud produced a law that suppressed the corporate form in Britain for a century.

What every bubble does

The pattern was described by the economist Hyman Minsky and it is remarkably consistent.

Displacement. Something genuinely new appears — a technology, a market, a policy change — and it genuinely does create value.

Boom. Prices rise on the real prospect. Credit becomes available. More people enter.

Euphoria. Prices detach from any plausible earnings. New arguments explain why traditional valuation does not apply this time. People who have never invested before enter, often with borrowed money.

Profit-taking. The informed begin to sell quietly.

Panic. Something small triggers the reassessment. Everyone tries to exit at once and the exit is narrow. Leverage forces sales, which lower prices, which force more sales.

The tell that is most reliable is leverage. A price rise funded by savings deflates painfully; a price rise funded by borrowing collapses violently, because falling prices force liquidation regardless of anyone's judgement.

Tulip mania, in the Dutch Republic in 1636–37, is the most cited and is the least representative. Recent scholarship suggests it involved a small number of participants in a specialised market, that the economic damage was limited, and that the standard morality-tale version comes largely from a hostile pamphlet literature at the time and from Charles Mackay's colourful 1841 book. It is a poor example and it is quoted constantly, which is itself a lesson in how history gets transmitted.

Better examples: railway mania in 1840s Britain, the 1929 crash (Chapter 9.9), Japan's asset bubble to 1989, the dotcom bubble to 2000, and the housing and securitisation bubble to 2008 (Chapter 12.8). The technology in each case was real and the valuations were not.

What the corporate form did

Set against the bubbles, the achievement is enormous.

It made possible enterprises no individual could fund — railways, canals, steel mills, shipping lines, and later everything at industrial scale.

It separated ownership from management, which allows professional managers and passive owners, and creates the principal-agent problem: managers may act in their own interest rather than the owners', which the whole apparatus of corporate governance, auditing and disclosure exists to constrain and which it constrains imperfectly.

And it created the institutional investor. Your pension, your provident fund and your insurance policy are pools of many people's savings invested in shares, which means most shares are now owned by intermediaries acting for people who have never heard of the companies concerned.

Where this shows up in your life

Every company you deal with is this form. The two letters after an Indian company's name — Ltd — are the limited liability of this chapter.

Your provident fund and any mutual fund you hold are downstream of the VOC's design decision that a share must be sold rather than redeemed.

And the practical use of this chapter is the bubble checklist. When you are told that traditional valuation does not apply, that the asset can only go up, that people with no expertise are getting rich, and that borrowing to buy is sensible — all four together — you are looking at the euphoria phase. It has been the same since 1720 and de la Vega described it in 1688.

What the next page covers

We now have money, credit, public debt and the company. Chapter 9.4 asks the question the rest of this Part is built on: what actually makes a country rich? It goes through the candidate explanations — resources, geography, culture, colonies, institutions and human capital — tests each against the evidence, and states what the best current work supports. It is the framework Chapters 9.13 and 9.14 use to compare East Asia with India.