SPECIAL ARTICLE

A Historical Perspective on the Role of Stock Markets in Economic Development

Vineet Kohli

Providing a critical appraisal of the new mainstream literature, which argues that successful late developers like Germany and Japan had strong stock markets in their early phase of development, this paper tries to track the size of stock markets over the 20th century using data provided by Raymond Goldsmith. It also presents historical case studies of Germany and Japan, which show that government intervention in the financial sector was rife in the early years and proved critical in shaping the size and role of stock markets in their economies. Besides, these case studies do not show that equity funding flourishes when governments adopt a hands-off approach towards the financial system.

A longer version of this paper was presented at a conference organised by the Centre for Economic Studies and Planning, Jawaharlal Nehru University, on 7 March 2011. I am grateful to C P Chandrasekhar, J Mohan Rao and R Ramakumar for comments and discussions on an earlier draft of this paper. Needless to say, all errors and omissions are mine. Vineet Kohli (vineetjnu@gmail.com) is at the Tata Institute of Social Sciences, Mumbai.

eveloping strong and liquid stock markets is an important pillar of the nancial sector reforms currently being pursued in a number of developing countries. For a time, it was believed that such reforms were not historically grounded because the successful late developers used the banking system (with extensive government intervention) for nancing development. In recent years, however, mainstream economists have developed alternative historical accounts of nance in developed countries. These reveal that late developers like Germany and Japan, till now considered as models of successful bank-based development, possessed strong stock markets in their early phase of development. Rajan and Zingales (2003a, b; henceforth RZ) claim that stock markets in Japan, Germany and some other European countries were more developed in 1913 than in 1980. Similarly, Hoshi and Kashyap (2001) argue that pre-second world war Japan had strong stock markets and it was only the exigencies of wartime nance that shaped the Japanese economy into a bank-based system. Fohlin (2007) has argued that on factors such as the cost of trading, stock markets in Germany were very well developed by the end of the 19th century. The sum and substance of these studies, therefore, is that strong stock markets were an important ingredient of development in the past and the current turn towards greater liberalisation of stock markets is, historically speaking, not unique. The purpose of this paper is to evaluate this literature. It does so by looking at the work of RZ. It also examines the size of stock markets in various countries from 1875 onwards using the data provided by Goldsmith (1985). The use of Goldsmiths data fails to conrm RZs central proposition that bank-based economies witnessed a sharp decline of stock market indicators over the 20th century. Second, the paper presents historical case studies of Germany and Japan. These show that even if early stock markets in these countries were exceptionally large, they were not qualitatively important for the purpose of providing liquidity and risk sharing. Neither do these case studies show that equity funding ourishes best when governments adopt a hands-off approach towards the nancial system and follow liberal policies towards capital ows. Instead, government (and central bank) intervention in the nancial sector during the early development of both Japan and Germany proved critical in shaping the size and role of stock markets within their respective economies. Three questions then detain our attention. What was the size of the early stock markets? What role did they play? What policies shaped them?
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1 Early 20th Century as a Golden Age of Stock Markets: A Critical Appraisal of Rajan and Zingales RZ examine various indicators of stock market development such as the market capitalisation ratio, equity issues as a percentage of capital formation and the number of listed companies and conclude that most economies, especially those in continental Europe and Japan, had more developed stock markets in 1913 than in 1980. France, Germany and Japan, among others, argue RZ, had much larger stock markets than the US at the beginning of 20th century but that their relative positions deteriorated as the century drew towards a close. Their data set reveals that the market capitalisation ratio in France fell from 0.78 in 1913 to 0.09 by 1980. Over the same period, it fell from 0.44 to 0.09 in Germany and 0.49 to 0.33 in Japan. On the other hand, the fall in market capitalisation ratio, from 1.09 to 0.81, was less pronounced in the UK, whereas the US witnessed an increase from 0.39 in 1913 to 0.46 by 1980. Moreover, in 1913, no distinction could be made between market and bank-based nancial systems, which according to RZ, is a post-second world war phenomenon. They conclude on a victorious note, Recent studies highlight the distinction between continental Europe and Anglo-American countries, but the early data do not conrm this. To explain what they have termed the great reversal of stock markets over the 20th century, RZ propose an interest group theory of nancial development. According to them, in the absence of strong property rights and public disclosure, lenders are not willing to spread credit beyond the close circle of borrowers with whom they enjoy close ties. The underdevelopment of nancial markets, therefore, becomes a source of market power, which the incumbents seek to protect by blocking efforts to develop a strong nancial system based on rule of law and transparency. The opposition of incumbents to stronger property rights and greater transparency, argue RZ, can be muted by the economys openness to trade and capital ows.1 For example, discipline imposed by capital ows may erode a governments ability to direct nance to incumbent rms through scal and monetary policy tools. In the circumstances, well-established industrial rms would like to attract nance from foreign investors who may require stronger protection under the law as a condition for their investments. RZ further argue that over the course of the 20th century, stock markets have waxed and waned in accordance with the movement in trade and capital ows. The high stock market indicators of 1913 were an outcome of openness to trade and capital ows that was characteristic of the gold standard era. However, from the 1930s, nancial markets entered a long period of decline as liberal policies towards trade and capital ows fell victim, rst, to the Great Depression and, subsequently, to the Bretton Woods regime. On a purely logical plane, the interest group theory of nancial development proposed by RZ is unconvincing. The power to create legal infrastructure for a market-based system that mandates greater information disclosure and respect for investor rights ultimately rests with the government. The government also decides on the degree of openness of the
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economy to trade and capital ows through its trade, industrial and nancial policies. If the government is weak in its dealings with existing incumbents, it may not be able to write or enforce market-friendly laws. If it is weak, surely the incumbents can also block any attempt on its part to liberalise trade and capital ows. Also, even if liberalisation strengthens property rights and improves disclosure, it is not clear that they should suffer a reversal when liberalisation is withdrawn. The second roadblock to RZs interest group theory of nancial development is posed by the contrary movements in openness and investor-friendly laws and institutions over the course of the 20th century. The US had no federal laws to protect shareholders till 1933. Such protection as was available to shareholders at the state level was progressively weakened from about 1885 as states competed with each other to make their territories attractive to companies.2 Proper disclosure requirements were imposed on security issuers only after a federal law of 1933. RZ acknowledge the improvements in shareholder protection brought about by the federal regulation of 1933, but maintain that the US was an outlier to the general trend of the deterioration of market-friendly institutions in the post-Great Depression period. However, the UK seems to have followed a more or less similar path of improvements in corporate disclosure and investor protection in the post-Great Depression era (Chefns 2003). Till the 1940s, directors duties towards shareholders were not enunciated in the law. Neither were companies required to provide information on current earnings till the company Act of 1948 made the public disclosure of an annual prot and loss statement mandatory (ibid). All in all, the movement towards greater investor protection and disclosure requirements becomes noticeable from the 1930s in the US and the 1940s in the UK, that is, much after the liberal capital and trade ow regime of the gold standard was destroyed by the Great Depression.
2 Movements in the Size of Stock Markets between 1875 and 1978: Estimates Based on Goldsmiths Data

Sylla (2006), in a review of RZs 2003 book, Saving Capitalism from Capitalists, suggests that the size of US stock markets in 1913 has probably been underestimated by them due to the non-inclusion of gures related to curb and over-the-counter exchanges. This distorts their analysis by making other countries look more market-based than the US in 1913. It also exaggerates the relative decline of stock markets outside the US after 1913. Syllas suggestion is to use the gures provided by Goldsmith (1985), which, he believes, are more dependable. In the following, we go by Syllas advice and examine the movement of stock markets in different countries using Goldsmiths estimates. Table 1 (p 60) gives the market capitalisation to gross national product (GNP) ratio for 11 countries for which information is available in Goldsmith (1985) from 1875 onwards. Goldsmiths data also reveals a sharp decline in the average market capitalisation ratio in 1978 from its 1913 levels. While a decline in the market capitalisation ratio is undeniable, the other half of RZs claim, that the decline was more pronounced in what are
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today perceived as bank-based economies, does not survive the scrutiny of Goldsmiths data. Spearmans rank correlation coefcient between market capitalisation ratios in 1913 and 1978 is positive and statistically signicant. The value of the rank correlation coefcient is very high at 0.782 and the p-value is 0.0134. In other words, the ranking of different countries did not change much between these two dates. The decline was much sharper in the UK and the US than, say, in Germany, France or Italy, where stock market capitalisation shows remarkable stability between the two dates.
Table 1: Ratio of Market Capitalisation to GNP
1875 1895 1913 1929 1939 1950 1965 1973 1978

Belgium Denmark France Germany Great Britain India Italy Japan Norway Switzerland US Mean Median

0.64 0.64 0.39 0.16 0.58 0.02 0.07 0.04 0.14 0.80 0.54 0.36 0.39

0.58 0.74 0.23 1.56 0.03 0.11 0.32 0.27 0.82 1.02 0.57 0.45

0.87 0.88 0.66 0.45 1.21 0.05 0.06 0.41 0.40 1.23 0.95 0.65 0.66

0.69 1.26 0.23 0.35 1.54 0.09 0.27 0.76 0.47 1.37 1.94 0.81 0.69

0.34 0.66 0.21 1.82 0.14 0.25 1.18 0.28 1.49 1.05 0.74 0.50

0.32 0.39 0.25 0.18 1.10 0.12 0.19 0.24 0.11 1.26 0.58 0.43 0.25

0.24 0.33 1.08 0.48 0.83 0.14 0.57 0.46 0.33 1.16 1.25 0.62 0.48

0.18 0.29 0.58 0.38 0.64 0.13 0.27 0.28 0.22 0.69 0.79 0.40 0.29

0.18 0.28 0.39 0.38 0.76 0.12 0.10 0.39 0.21 1.02 0.78 0.42 0.38

Table 2 also fails to conrm RZs hypothesis. The decline in the size of stock markets between 1913 and 1978 was more pronounced in the UK and the US than France and Germany. If we delete the UK and the US from our sample of countries in Table 2, the mean value for the remaining countries is higher in 1965 than in 1913 and at the same level in 1973 as in 1913. Only in 1978 do we nd a sharp decline in the size of stock markets in this sub-sample. The great reversal hypothesis is contingent on the selection of particular benchmark dates and is not a general phenomenon that holds across date comparisons. All in all, Goldsmiths data shows that the observed decline in market capitalisation to GNP ratio between the pre-war and post-war dates is not an outcome of the decline in stock markets ability to fund long-lived assets. Rather the decline is probably an outcome of the fall in long-lived assets (as proxied by structures and equipments) relative to GNP. Finally, let us look at the size of the nancial sector relative to the real sector of the economy. Table 3 lists the share of nancial assets in national assets (dened as the sum of nancial assets, tangible assets and monetary metals) using
Table 3: Ratio of Financial Assets to National Assets
1875 1895 1913 1929 1939 1950 1965 1973 1978

Source: Authors calculations based on Goldsmith (1985).

The market capitalisation ratio may uctuate with no change in a stock markets ability to perform its fundamental function of funding long-lived assets. If, for example, with the same amount of long-lived assets, an economy is able to produce more GDP, there would be a fall in the market capitalisation ratio without any decline in the stock markets ability to provide funding. A better indicator of stock market size would, therefore, be market capitalisation relative to the size of longlived assets. Table 2 provides information on the market value of corporate shares as a ratio of structures and equipment (taken as a proxy of long-lived assets) at different dates in the sample countries for which information could be obtained from Goldsmiths dataset since 1875.
Table 2: Ratio of Market Capitalisation to Value of Structures and Equipment
1875 1895 1913 1929 1939 1950 1965 1973 1978

Belgium Denmark France Germany Great Britain India Italy Japan Norway Switzerland US Mean Median

0.28 0.49 0.34 0.24 0.38 0.12 0.28 0.23 0.26 0.43 0.37 0.31 0.28

0.30 0.56 0.00 0.37 0.51 0.11 0.30 0.25 0.35 0.48 0.40 0.33 0.35

0.39 0.58 0.47 0.40 0.47 0.13 0.31 0.38 0.41 0.48 0.43 0.40 0.41

0.38 0.59 0.44 0.27 0.60 0.16 0.40 0.54 0.50 0.55 0.54 0.45 0.50

0.39 0.54 0.00 0.36 0.63 0.19 0.42 0.58 0.42 0.54 0.51 0.42 0.42

0.41 0.51 0.35 0.29 0.64 0.22 0.29 0.35 0.44 0.48 0.50 0.41 0.41

0.39 0.49 0.55 0.44 0.60 0.29 0.45 0.45 0.44 0.50 0.54 0.47 0.45

0.43 0.53 0.44 0.43 0.56 0.31 0.52 0.48 0.46 0.46 0.50 0.47 0.46

0.40 0.50 0.41 0.43 0.53 0.29 0.50 0.50 0.46 0.48 0.47 0.45 0.47

Source: Authors calculations based on Goldsmith (1985).

Belgium Denmark France Germany Great Britain India Italy Japan Norway Switzerland US Mean Median

0.13 0.59 0.21 0.07 0.33 0.01 0.06 0.03 0.08 0.20 0.49 0.20 0.13

0.11 0.45 0.13 1.23 0.02 0.08 0.26 0.15 0.30 0.54 0.33 0.20

0.19 0.47 0.40 0.14 0.90 0.04 0.04 0.33 0.18 0.36 0.74 0.35 0.33

0.17 0.13

0.08

0.10 0.14 0.22 0.08 0.86 0.09 0.11 0.37 0.05 0.29 0.51 0.26 0.14

0.07 0.14 1.18 0.35 0.58 0.06 0.39 0.47 0.04 0.35 0.81 0.40 0.35

0.07 0.14 0.63 0.15 0.36 0.06 0.23 0.29 0.03 0.45 0.48 0.26 0.23

0.05 0.09 0.36 0.15 0.26 0.04 0.07 0.28 0.02 0.27 0.41 0.18 0.15

0.62 0.28 0.09 0.08 1.23 1.57 0.05 0.08 0.16 0.23 0.13 0.14 0.56 0.83 0.44 0.35 1.36 0.73 0.46 0.43 0.23 0.21

Goldsmiths data. The results are startling. The extent of nancial deepening increased between 1913 and 1978. The mean value of the ratio of nancial to national assets increased from 0.40 in 1913 to 0.45 in 1978. Table 3 shows that nancial deepening increased till 1929, after which it levelled off in subsequent years. The claim that the shift to capital controls harmed nancial sectors is hard to maintain. Also, in the 50 years or so after 1929, there were some incredible examples of nancial deepening. There was Italy, where the ratio of nancial to national assets increased by 25% between 1929 and 1978, and India, where the increase over the period was an incredible 80%.
3 A Case for Broadening the Scope of Enquiry

For Denmark, India and Switzerland, structures include both residential and nonresidential structures. For Belgium, market capitalisation has been divided by reproducible tangible assets due to lack of availability of data. Source: Authors calculations based on Goldsmith (1985).

Strong stock market indicators do not necessarily imply that stock markets are qualitatively important for risk diversication and liquidity provision. For example, if a large number of shares are issued to a few investors, who then obtain liquidity by pledging their shares with the banking system (as in the Japanese case), stock markets will appear large but that does
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not necessarily mean they are qualitatively important. Similarly, large stock markets do not necessarily imply the adoption of market-friendly policies in the nancial sector. For example, government-owned or supported banks may buy (or, as in Japan, lend against the security of) shares issued by the corporate sector. This may coexist with curbs on issuing and trading of shares (as in the German case). Correspondingly, it is difcult to infer the nature of policies with regard to capital ows simply on the basis of their volume. RZ rightly point out that capital ows during the gold standard era were large but this does not necessarily imply that countries did not impose any control on capital accounts. Moreover, capital ows may be dominated by government borrowings that need not stimulate stock markets in the recipient country. Therefore, to draw the correct lessons from the history of developed countries, a closer inspection of their nancial histories is required. The next part of this essay presents case studies of Germany and Japan, two well-known bank-based systems, to answer some of the qualitative questions we have posed in this section.
4 Germany: Differential Treatment of Banks and Markets

The starting point of most discussions on the German nancial system is the work of Alexander Gerschenkron (1962) on the role of universal banks in the course of German industrialisation. Gerschenkrons central thesis was that large German rms relied heavily on the services provided by universal banks in the early phases of development. Large universal banks provided long-term nance through the renewal of short-term loans. Banks, however, did not indenitely renew their short-term loans but sought funding for them by taking their borrowers public at a suitable time (Reisser 1911). Usually, banks underwrote and placed shares of the issuing rm. However, if the demand turned out to be weak, the banks did not refrain from holding the shares of issuing rms. Large rms, therefore, did rely on security issues, but the success of an issue was not so much guaranteed by the free interaction of buyers and sellers in the market as by the participation of large banks. More recent research on German banking, however, has not been kind on this hypothesis. The accusation is that Gerschenkron basically provided a theory of large-rm nance in the course of development since only large rms issue shares that can be underwritten, placed and purchased by banks. However, till very late in German development, joint stock companies were more an exception than the rule. Rules regarding the formation of joint stock companies were extremely strict in Germany with case-by-case permission required till 1870 and general incorporation allowed only after that (Edwards and Ogilvie 1996; Guinnane 2002; Jonker 2003). Since Gerschenkron was mainly interested in large-rm nance, he ignored the crucial role played by other segments of the German banking sector that served smaller rms and farmers (Deeg 2003; Guinnane 2002). Savings banks were
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the largest segment of the German banking system that by 1913 accounted for 24% of total nancial institutions assets, compared to a marginally lower share of 22% held by large universal banks (Guinnane 2002). Savings banks were mainly owned by city and provincial governments and their deposits were used to nance local infrastructure (such as housing and canals) as well as the decits of sponsoring governments. Similarly urban cooperatives nanced local craftsmen and workers, whereas rural cooperatives mainly provided long-term loans (sometimes as long as 10 years) to farmers. All in all, savings and cooperative banks played much of the same role of providing long-term nance that Gerschenkron mainly credited large universal banks with. The basic Gerschenkronian hypothesis, therefore, needs to be broadened to argue that all banks played an important role in the course of German development by providing long-term nance. And what explained the ability of German banks to assume the risks associated with long-term lending? Here the role of various public and voluntary institutions that guaranteed the liquidity of these banks is often appreciated. Large credit banks relied heavily on the liberal liquidity support of the Prussian bank and its successor, the Reichsbank (Tilly 1991).3 The easy provision of liquidity by the Reichsbank in support of industrial development was inconsistent with the logic of the gold standard. Germany, therefore, never fully complied with all the requirements of the gold standard and adopted measures that were tantamount to capital controls. The Reichsbank, for example, never really allowed banks to export gold. There was no written rule but banks observed this diktat because they feared reprisal from the Reichsbank in the form of denial of access to its discount window in times of liquidity shortage (Broz 1997). The ease with which German banks could access central bank liquidity allowed them to provide long-term nance to industry, even though this nance took the form of securities. Savings banks that provided long-term nance for local infrastructure construction were the creation of local governments. But besides their government ownership, they relied extensively on Landesbanken (Guinnane 2002). These were nancial institutions set up by regional governments to help designated entities. They worked as clearing houses for the savings banks, invested their surplus funds and lent to them in periods of liquidity crunch (Guinnane 2002). Credit cooperatives also developed their regional organisations known as centrals. The centrals were owned by member cooperatives, took deposits from them and also lent to them on both a short-term and long-term basis. In 1895, the government set up a central bank for cooperatives called the Preussenkasse to provide liquidity to credit cooperatives. Sometimes the centrals and on other occasions the member cooperatives approached the Preussenkasse for help (Deeg 2003; Guinnane 2002). In sharp contrast to its encouragement of long-term banking, the German government took a largely negative view of stock market development. The limited role of joint stock
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companies, highlighted in the discussion on the role of universal banks, is also a piece of evidence against any signicant role for stock markets. As we have already pointed out, till 1870 free incorporation was not allowed. Permission for general incorporation in 1870, however, resulted in unrestrained joint stock company formation and investor losses (Fohlin 2007; Guinnane 2002; Michie 2006). New laws, therefore, had to be made to check this tendency. A new law on company formation in 1884 increased the minimum share size and also required that all equity be subscribed before a company came into being. This made company formation difcult and further increased the role of large banks in share placement and underwriting activities. More drastic were the various stock market regulations and taxes imposed in the 1880s and 1890s. In 1881, a at rate stamp duty was imposed on brokers transactions with outside investors. The tax was subsequently extended to cover transactions between brokers. Bankers also had to pay a duty of 1.5 per thousand over the value of securities oated by them. In 1885, the at rate on turnover was converted into a percentage rate to be applied at 0.1 per thousand. In 1894, these duties were doubled after sharp price falls caused bankruptcies among private banking houses in 1890 and 1891 (Jonker 2003). Moreover, in 1896, a new stock exchange law banned futures transactions as being tantamount to speculation (Michie 2006: 97). This law also brought stock exchanges under the supervision of the imperial government. Finally, in 1900, even small transactions (less than 600 marks) that had hitherto escaped turnover duties were brought within the ambit of taxation (Fohlin 2007). The impact of these taxes and regulations was to channel most of the securities business abroad and, to the extent it was still carried out in Germany, to internalise it within and between large German banks (Jonker 2003; Michie 2006; Reisser 1911).4 Stock markets became less relevant as the banks sought to offset against one another within the bank the large number of buying and selling orders that came pouring in from customers (Reisser 1911: 620). In other words, banks took over the stock markets role of providing liquidity to shares. As a contemporary observer, Reisser (1911: 772) believed that the effect of heavy-handed policies was the loss of ever-increasing amounts of business for the bourse.5 On the other hand, Fohlin (2007) argues that the impact of such regulations on stock market turnover was not great. There is little evidence of reduction in stock market turnover in the years in which the regulations were imposed. It is possible that the many taxes and regulations imposed between 1881 and 1900 led to a general dampening of investor interest without causing signicant trend or intercept breaks in specic years. More to the point, data presented by Fohlin brings out the reality that, in 1913 prices, stock market turnover on the Berlin Stock Exchange in 1912 was more or less the same as it was in 1884, notwithstanding the many uctuations it saw in the intervening period.6 Since the German
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economy grew in this period, this suggests that the valuetraded ratio must have fallen.
5 Japan: Bypassing Market Development Japan is usually considered to be a classic case of Gerschenkron-style industrialisation. The role of banks was most obvious in the Japanese nancial system in the post-second world war period. However, no such consensus exists for an earlier period. Hoshi and Kashyap (2001) point out that the stock and bond markets occupied pride of place in the pre-second world war Japanese nancial system. The same view has been echoed by Miwa and Ramseyer (2000) and Hamao, Hoshi and Okazaki (2005). The nding of these authors is that stock markets played an important developmental role in this phase of Japanese capitalism. On the other hand, Teranishi (2007) and Ishii (2007) have been more circumspect in attaching any signicant role to pre-war Japanese markets. Hoshi and Kashyap (2001) present evidence to show that the nancial system in pre-war Japan was mainly market-based. In 1900, securities accounted for 55% of the nancial assets of the household sector, whereas deposits accounted for 29.5% of the same. A similar picture emerges when one examines the liabilities of the corporate sector. Averaged over 1902-15, paid-in capital and reserves accounted for 82% of the total liabilities of joint stock companies. Hoshi and Kashyap (2001), therefore, conclude that the Japanese nancial system in the pre-war period was market-oriented. This conclusion has been challenged by both Teranishi (2007) and Ishii (2007). Teranishi (2007) shows that equity nancing was important for large joint stock enterprises but just as in Germany, there were a large number of unincorporated enterprises that could not issue any equity. If the focus is broadened to include these enterprises, Japans status as a bank-based system remains intact. In each of the quinquennia between 1881 and 1915, the share of borrowings in the outstanding liabilities of the non-nancial sector uctuated between 51% and 70%, whereas that of equity (including inside equity) remained between 24% and 38%.7 Teranishi (2007) also shows that the share of borrowings falls, while that of equity increases in the pre-war period. In the period 1936-40, both equity and borrowings accounted for about 40% of the liabilities of non-nancial enterprises. He ascribes this trend to the falling share of small enterprises in Japans industrial economy and not to the increasing importance of stock markets within the nancial system. But Teranishi points to another noteworthy feature of the pre-war Japanese nancial system. He argues that while in quantitative terms stock markets did increase in importance in the pre-war period, their qualitative role in liquidity provision and risk sharing was still limited. Trading on Japanese stock exchanges in this period was mostly xed term. In such trading, investors (usually) squared up their positions through offsetting transactions within the settlement period. On the settlement date, only the price difference was paid or received without any requirement of actual shares changing hands. The settlement period for transactions was three months. From
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1922, xed-term trading for a one-week settlement period was also started but investors could postpone the delivery by a month on the payment of a fee (Hamao, Hoshi and Okazaki 2005).8 Such transactions, whatever other purpose they served, did not provide immediate liquidity to those who owned claims on long-term capital.9 On the other hand, spot transactions were rare, accounting for only one-fourth of total trading on the Tokyo Stock Exchange and less than 5% of total trading on the Osaka Stock Exchange during the Meiji period (Teranishi 2007). Moreover, even if banks did not provide direct nance to companies, they certainly played an important role by providing nance to owners of equity. Large joint stock enterprises, such as those in railways and cotton spinning, formed in the last two decades of the 19th century, were more or less wholly nanced by equity capital (Ishii 1991). The purchase of equity was, however, nanced by loans from the banking system that were secured by the collateral of equity shares.10 Banks accepted the collateral of shares because the Bank of Japan provided advances against the security of these shares. In other words, liquidity for holders of shares was underwritten by the central bank. This point is perhaps most forcefully made in Tamakis (1995) history of Japanese banking.11 Lending against shares was started by the Bank of Japan as a last resort measure in the crisis of 1889 but soon became the the most favoured method of advancing for the Bank (Tamaki 1995: 67). However, the indebtedness of shareholders interfered with the risk-sharing role that equity owners are supposed to play. To prevent default on bank loans, shareholders were anxious to have dividend payouts at least sufcient to cover interest charges on loans (Patrick 1967: 283). For companies in formative years, low protability implied that prots had to be fully paid out. This means that the much-touted advantage of equity over debt nance, namely, the compressibility of dividend payments compared to xed interest commitments to lenders, was perhaps not as obviously applicable in early Japan. Firms could very well survive without paying dividends, but not their shareholders who were in debt to the banking system. Bank nance on the security of shares also allowed initial investors to leverage their own investments and aided the control of corporations by the few. Most of the Japanese corporations in this period were rmly in the control of a few wealthy investors. For this reason, public placement of shares was avoided and shares were issued to existing shareholders at par value.12 This factor impeded the growth of an equity culture among households and was also detrimental to the progress of specialised investment bankers that could arrange the equity issues of rms (Teranishi 2007). Moreover, to promote long-term nance, the Japanese government established a large number of development banks in this period. The Yokohama Specie Bank was set up in 1880, the Japan Hypothec Bank was created in 1896 and the Industrial Bank of Japan was established in 1900. These banks provided long-term nance to agriculture and industry, sought to bolster the foreign exchange position of the government by oating
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loans on the London money market and, in the years following rst world war, undertook a number of rescue operations by advancing loans to industries that were ailing in post-war depression (Tamaki 1995). Finally, there is little evidence that the Japanese government tried to attract foreign investment for the purpose of stock market development. To nance its recurring external decits, the Japanese government directly borrowed in international markets. For this purpose, it enlisted the services of the Yokohama Specie Bank and the Industrial Bank of Japan. The latter also oated securities of municipal governments and private companies in international nancial centres. However, in the case of foreign loans of these semi-government or private entities, Specie was appropriated by the government, which, in turn, paid the ultimate borrowers in the form of Bank of Japan notes. It was widely held by Japanese policymakers in those days that non-government entities were to be encouraged to borrow abroad to prevent the inundation of London money markets with Japanese government bonds (Tamaki 1995). To the extent required, private foreign investment was strategically cultivated by the Japanese government to prevent the entire responsibility of nancing external decits from falling on its shoulders. Between 1870 and 1913, government borrowings accounted for 82.5% of foreign capital, whereas company and municipal borrowings stood at 9% and 7.8% respectively. Foreign direct investment (FDI) stood at 0.7% of total foreign capital in this period (Bytheway and Schiltz 2009). Foreign investment in domestic equity, even if we view the entire amount of FDI as that, was close to zero.13 Foreign capital in early Japan, therefore, had little relation to the domestic stock markets.
6 Concluding Remarks

History presents a complicated picture on the role of stock markets in the development of developed countries. The claim that stock markets were exceptionally large at the dawn of the 20th century and suffered prominent reversals in bank-based economies is questionable. Moreover, the historical record shows that equity nance to companies is perfectly compatible with strong regulation and taxation of equity markets (as in Germany) as well as with an underdeveloped trading platform (as in Japan). On the other hand, history also shows that assigning an industrial role to central banks may be vital for equity funding of rms either directly, by providing renancing against shares (as in Japan), or indirectly, by providing liquidity support to universal banks that undertake share issue activities (as in Germany). Neither is there any evidence that capital mobility was indispensable for the provision of equity nance to domestic companies. Instead, equity nance may take place alongside (and even necessitate) capital controls (as in Germany) or with negligible foreign investment in stock markets (as in Japan). This reading of history is in sharp contrast to the mainstream insistence on employing liberal policies towards trade and capital ows for domestic nancial development.
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Notes
1 RZ are not alone in recommending trade and capital openness for domestic nancial development. A similar case for openness has also been made, among others, by Mishkin (2006). 2 See Chefns (2003) and Coffee (2001). 3 This role of the German central bank had also impressed Piero Sraffa, who emphasised it in his lectures on continental banking delivered to Cambridge undergraduates in the spring term of 1929 and 1930 (De Cecco 2005). Reisser (1911) reveals that a recurring complaint against the Reichsbank was that it lent to the banks against nancial or nominal bills that were not backed by bona de commercial transactions. 4 Large banks could effect transactions between their large customer base without attracting any taxation or regulatory oversight. Smaller banks, on the other hand, continued to rely on brokers or other banks, thereby attracting taxes. 5 For a recent account, see Michie (2006: 137-38). 6 In 1884, turnover on the Berlin Stock Exchange was about 40 billion marks (at 1913 prices), whereas in 1912 it was only marginally higher. 7 The non-nancial sector includes large joint stock companies, partnership rms and individual and family-based organisations. 8 This practice appears very similar to the muchcriticised badla (contango) system that prevailed on the Indian stock markets before the reforms of 2001. 9 Since, unlike in a spot transaction, shares are not immediately converted into cash. Also, even if the initial transaction is not reversed within the settlement period by a seller wishing to liquidate his position, the seller faces the high risk of default from the buyer due to the leveraged nature of transactions. It is likely that genuine investors interested in deliverybased trading transacted off-exchange for this reason. 10 A calculation based on Ishii (1991) shows that in 1890 for the ve leading cotton spinning mills, 96% of the xed assets were nanced from paid-up capital. For 41 railway companies, the comparable gure in 1900 was 92%. On the role of equity as collateral, Ishii (2007: 78) reports that in 1896 two-thirds of all industrial shares and two-ninths of all banking shares were pledged to banks as security. 11 Also see Patrick (1967) and Ishii (1991). 12 In the period 1914-17, 72% of the increase in authorised capital took the form of assignments to existing shareholders. The corresponding gure for 1933-37 is slightly lower at 68.9% (Teranishi 2007). 13 Also see Ishii (1991) on the near absence of foreign investment in domestic equity in Meiji Japan.

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Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, 25, pp 77-88. Jonker, J (2003): Competing in Tandem: Securities Markets and Commercial Banking Patterns in Europe during the Nineteenth Century in D J Forsyth and D Verdier (ed.), The Origins of National Financial Systems: Alexander Gerschenkron Reconsidered (London: Routledge), pp 64-86. Michie, R (2006): Global Securities Markets: A History (New York: Oxford University Press). Mishkin, Frederic S (2006): The Next Great Globalisation: How Disadvantaged Nations Can Harness Their Financial Systems To Get Rich (Princeton, NJ: Princeton University Press). Miwa, Y and J M Ramseyer (2000): Banks and Economic Growth: Implications from Japanese History, Discussion Paper, CIRJE-F-87. Patrick, Hugh (1967): Japan in Rondo Cameron (ed.), Banking in the Early Stages of Industrialisation: A Study in Comparative Economic History (New York: Oxford University Press), pp 239-89. Rajan, R and L Zingales (2003a): The Great Reversals: The Politics of Financial Development in the Twentieth Century, Journal of Financial Economics, 69, pp 5-50. (2003b): Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (Princeton, NJ: Princeton University Press). Riesser, J (1911): The Great German Banks and Their Concentration, in Connection with the Economic Development of Germany (Washington DC: Government Printing Ofce). Sylla, R (2006): Schumpeter Redux: A Review of Raghuram G Rajan and Luigi Zingales Saving Capitalism from the Capitalists, Journal of Economic Literature, 44, pp 391-404. Tamaki, N (1995): Japanese Banking: A History, 18591959 (New York: Cambridge University Press). Teranishi, Juro (2007): Were Banks Really at the Center of the Prewar Japanese Financial System?, Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, 25, pp 49-76. Tilly, R (1991): Germany in R Sylla and G Toniolo (ed.), Patterns of European Industrialisation: The Nineteenth Century (London: Routledge).

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References
Broz, J L (1997): The Domestic Politics of International Monetary Order: The Gold Standard in David Skidmore (ed.), Contested Social Orders and International Politics (Nashville: Vanderbilt University Press), pp 53-91. Bytheway, S J and M Schiltz (2009): The Dynamics of Wakon Ysai (Japanese Spirit, Western Technology): The Paradoxes and Challenges of Financial Policy in an Industrialising Japan, 1854-1939 in Dawn Bennett, Jaya Earnest and Miyume Tanji (ed.), People, Place and Power: Australia and the Asia Pacic (San Francisco: Black Swan Press), pp 57-79. Chefns, Brian R (2003): Law as Bedrock: The Foundations of an Economy Dominated by

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