PLSC 270: Capitalism: Success, Crisis, and Reform

Lecture 6

 - Rise of the Joint Stock Corporation


Professor Rae explains how the growing scale and complexity of railroads in the US were foundational to the development of modern capitalism. Operating the railroad system required professional managers and new management techniques, and the scale of railroad financing gave rise to the formation of the joint stock corporation. Professor Rae then discusses how different forms of company ownership differ along liability, liquidity, financial scalability, accountability, and role of ownership dimensions. Joint stock corporations are shown to be extremely efficient ways to raise large amounts of money, even if they suffer principal-agent problems.

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Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 6 - Rise of the Joint Stock Corporation

Chapter 1. Introduction [00:00:00]

Professor Douglas W. Rae: Think back to — this is meeting six. It’s about the rise of the joint stock corporation. The joint stock corporation is, without doubt, the most important institution in the world economy today. Its only rival might be states or governments, but it is just a massively important thing. The question of how it got here and why it takes the form it does is our topic today. Let’s begin with Adam Smith. Would somebody — would one of you guys go up there and get that on slide one slideshow and I’ll rejoin it when we get there? Adam Smith, in talking about the invisible hand, is also at length to say that the productive use of the division of labor kicks in only when you get big markets, only where market scale justifies an elaborate division of labor and a large investment of capital, do you get the benefits of capitalism, really. In tiny markets where you’re making, for example, clothing for others in a village of a thousand, the possibility of a sophisticated manufacturing scheme which — [inaudible] — somebody who knows this stuff please do this. Navigator. Get it into navigator and then onto slide one and play slideshow and we’re set.

So Smith talks about scale of markets, and the great limitation on scale of markets until the early 1800s was the poor quality of land transportation. Ocean transportation had by that time gotten pretty good. Sailing ships had gotten better and better in the three or four hundred years before 1800, and steamships had improved that. But — I’m going to skip some slides — but the great interior of all the continents still relied on transportation systems, none of which were superior to a horse. The cheapest form of transportation was canal shipping where the motor power was essentially a horse on a draw path next to the canal. Then beginning in the 1820s and accelerating decade after decade into the 1860s, the railroad took over. For the first time ever one could move freight vastly faster than a horse, and vastly cheaper than any previous means of transportation. The cities grew up initially at the intersection of ocean shipping, coastwise shipping, and canals. They grew up because there was always an economic advantage to being at the junction point between the main systems of transportation. Rail took this and raised it by many powers.

The American Rail Network, this is a simplified map Rand McNally from 1944, and it’s about passenger rail. The real density of the U.S. rail network is about five times what this suggests. That density created exactly what Adam Smith contemplated: a gigantic market where the division of labor could be refined to a much higher level than ever before. One result of that — this is a contemporary map of greater New York, and the coloring is dollars of earned income per square mile. The densest places, right around in here, reach past ten billion such dollars per square mile.

The great cities of the world are invariably ones today which enjoy powerful rail transportation, generally supplemented by water transportation. But rail, and New York’s extraordinary advantage as a gateway to the interior of the United States, by water first up through the Hudson and then across the Erie Canal to the Great Lakes, and then beginning with the 1840s, a fabulous deepwater harbor for shipments to the rest of the world connected by rail to the entire continent.

Chapter 2. The Double Challenge Faced by Railroads [00:06:13]

The double challenge faced by railroads, two things, one they were very expensive to build, so finance capital, raising large amounts of money in order to construct railways, was one challenge. In some senses, an even greater challenge was actually running a railroad. It turns out that railroads get inordinately complicated after they get big. When they are one section of about forty or fifty miles, railroads are actually not very complicated things to run. But when they get to be hundreds or even thousands of miles, the logistics of management get extremely challenging. So you have two challenges; one is finance, the other is operations.

Let’s start with operations. In the nineteenth century train collisions occurred at rates varying from about 400 to 1,000 a year in the U.S., and they were often ugly, and they reflected the challenge of management. This is a simple one section rail that operated in the 1840s and 1850s between Boston and Worcester, Massachusetts. Almost all the railroads built just one track. The question was: How do you run trains back and forth between these two cities without collisions? The solution, it’s in Chandler, that these people had was to instruct the engineers of the trains beginning at the two end cities to proceed to Framingham, and one turns — and each take a right turn so to speak — and sit there until the other train is in view. After the other train is in view and stopped, proceed to the end of your journey. Pretty simple management. And that railroad had only about fifty employees. It was four trips a day, and a very simple thing.

Characteristic of capitalism is that people are not content with small success. Therefore, they try to string together many short railroads on the theory that average cost will decline as scale of operation increases. The New York Central System, which was the glitziest of all the railways at its peak, it’s peak coming roughly from the period of World War I to the end of World War II, this railroad was created by splicing together dozens of little railroads. The Mohawk and Hudson ran between Schenectady and Albany, and it was the kernel from which this was formed. It’s one aggregation after another, and the construction of that marvelous terminal in midtown Manhattan which we’re all familiar with, and ultimately, after the thing reaches the end of its competitive lifecycle, and the New York Central Railroad was essentially at the end of its competitive lifecycle by the 1950s. It was there because? What was hard on railroads? What was hard on passenger railroads? Long haul passenger railroads? This is a soft pitch, guys. Yes.

Student: Introduced the highway system.

Professor Douglas W. Rae: Highway system. And on freight, what was the big competitor over land?

Student: Interstate highway.

Professor Douglas W. Rae: Okay, so the interstate highway system with trucking and ultimately de-regulated trucking which was much more efficient, the competitive position of railroads seemed to be terminal. And the Pennsylvania Railroad and the New York Central were combined in a bankruptcy proceeding in 1968 to form The Penn-Central System, which soon went bankrupt, and it went bankrupt because the two managements hated each other, and each did as little as possible to help the other succeed. The — this idea of a mortal lifecycle of the corporation is one which comes up again and again. A week from today we’ll do the Polaroid Corporation which begins as a brilliant innovative firm and ends up playing defense against other more brilliant, more innovative firms, only a generation and a half after it began.

What really happens with railroads if you don’t know how to run them, and the early railroads nobody knew how to run, was that as the railroad scope or scale got larger, average costs actually went up. The reason they went up was that you had to build a mammoth bureaucracy to run the thing. The Pennsylvania Railroad got to 50,000 employees fast. The challenge of how to organize that large workforce became severe. The first cut was spatial, without the kind of surveillance and information technology we have today, they had the telegraph fairly early on and that’s all they had. The control over a massive network — this is The New York Central System — meant that they cut the system into sections and created a set of authorities within each such section. The ones I’ve drawn here in red are merely illustrative.

Then there was a division of function. There were people who worried about railroad cars. There were people who worried about track. There were people who dealt with passengers, others with freight, finance, cost accounting, human resources, and so on. So you have all these functional stripes — all this is Chandler, and I’m just simplifying what he says — these functional stripes, and then you’ve got the geographic sections, and the question becomes, what do you with the intersections? The fundamental administrative question was, do you let the functional groups boss the geographic groups around, or do you let the geographic groups boss the functional groups around? What ended up happening was this pattern, which ultimately gives priority to the geographic groups. It creates enormous power at the top in general management. And the top people in American railroad, who were very well compensated, often took on ownership stakes, and were true big shots.

The functional people operated as staff to them; the people who did accounting, the people who did finance, the people who did construction, maintenance, and rolling stock and so on. Then there were several tiers of specific managers, superintendents with responsibility for geographic areas, and they too had functionally divided staff — people to worry about the rolling stock, the track, the construction, etc. — and the pivotal decision makers were always the people with a geographic focus. They were the ones who had to take all the factors, all the functions together, and make the thing work. They became the first general managers of the modern description that MBAs are training for. It’s essentially the origin of the managerially operated joint stock corporation. The Europeans used a different pattern, which gave priority to the functions, and by and large, the American system worked better. Now why are European trains so much better than American trains today? Anybody know? Let’s hear.

Student: Socialism.

Professor Douglas W. Rae: Socialism! Okay, yeah socialism is part of it. Please elaborate; let’s get from one word to ten. We got a mic?

Student: People seem to be more comfortable in states in the Eurozone with diverting taxpayer money to public project, such as infrastructure.

Professor Douglas W. Rae: Okay, this is particularly true of continental Europe I think. Where the trains have become, in many, not quite all cases, publicly operated systems. There’s another reason, there’s a historical reason.

Student: The price of gasoline.

Professor Douglas W. Rae: Price of gasoline, that’s another point. I hadn’t actually connected the dots. Gasoline there is roughly two or three times what it is here, so passenger train for short and middle sized runs makes a lot of sense. Big historical event, yes?

Student: They didn’t really have — the interstate highway kind of bloomed.

Professor Douglas W. Rae: Say again?

Student: Like they didn’t have like a highway system or [inaudible].

Professor Douglas W. Rae: Okay, I think — well some of them did. I mean the German Autobahn was pretty impressive, even if the Nazis built it, it was pretty good highway. What I’m fishing for here is World War II. World War II destroyed the European rail system, and because it was destroyed, and because of the U.S. Marshal Fund, which paid for an awful lot of reconstruction, they started more or less from scratch and made the thing work. We had this higgledy-piggledy remnant of a previous period, and never really made the investment by socialism or capitalism.

The challenge of finance was equally important, perhaps more important. Historically, projects that involved high capital investment were funded locally. People made investments within small circles, within one city, within the people who lived next — the zone where people living next to a canal or a segment of a canal would, in effect, buy bonds and finance the thing. Railroads were catastrophically expensive, they sucked up vast amounts of capital, and so a device as in this bridge, the Eads Bridge in St. Louis over the Mississippi, there were hundreds, even thousands of terrifically expensive construction projects to be financed. The mechanism chosen was the joint stock corporation. The forms of funding were of two main kinds, I’m going to get to some detail in a minute. One were railroad bonds where people in effect loaned money to the railroads and achieved a predictable income, relatively predictable income, from that investment in debt. The other was the joint stock, where you bought into the equity of the company and became a partial owner.

This is a world railroad grid, and I’d like you to just in passing notice the very uneven density of it, and the fairly strong correlation between the density of the railroad grid and the wealth of the place. The railroads were both cause and effect of capitalist development. Where there were railroads, there was capitalist development, where capitalist development, railroads. And colonialism had odd effects. Africa’s railway system got developed not so much to create internal markets as to get goods quickly and efficiently out for shipment to the metropolitan power, which controlled the colonization.

Chapter 3. The Joint Stock Corporation and Its Main Alternatives [00:20:16]

Now a chart, the dreaded chart. And here we have on the vertical dimension three major forms of ownership. Indeed, these are the three most important forms of ownership. Proprietorship means outright ownership. You just own it, end of story. Partnership means what it says, and interestingly, and for reasons you’ll probably figure out by the end of the hour if you don’t know it already, partnerships tend to be used in a certain kind of company. It’s a company where the value of the firm consists largely in the talent of its employees so that the big consulting firms, the big investment banks, the big law firms, all take the form of partnerships and they are — and that actually changes and one of the HBS cases you’re getting is the one where Goldman Sachs ceases to be a partnership and becomes a company. And of course third, the joint stock corporation.

Then we look at each of these with the five considerations across the top in mind. One is, what’s the accountability chain here? How do we keep people doing their job? How do we see the difference between a job well done and a job poorly done? The second is the role of ownership and the third is liability. Every one of these is a huge factor in understanding this. The fourth is liquidity. If I own something or a part of something, how easy is it for me to sell out? Finally scalability; to what extent can we start with something small and grow something enormous? The three forms vary importantly in each of these five dimensions, and I’m afraid I’m going to walk you through them.

The chain of accountability in a proprietorship is pretty simple. I own it, I run it, I’m the boss. I hire and fire the employees, I make the business decisions, I don’t submit plans to anyone else, I just do it. In a very small enterprise, that has its advantages. In a partnership things are more complicated. The trouble with a partnership is this: Every partner has a right to participate in management, and I can’t admit a new partner without the consent of the other partners. Now the work around for this is the hybrid form, which creates a general partner who runs it, and then a bunch of limited investment partners who participate passively, and lots and lots of things take that hybrid form. The pure partnership is very awkward. You’ve got to talk to everybody all the time; it’s like being married to a room full of people at once. What a nightmare!

The corporation, the chain of accountability is very different, and it looks like this. You’ve got investors over here; you’ve got capital markets with brokerages, stock exchanges, and such like; then you’ve got a board of directors, then top management, then layers of other management, and then layer upon layer of regular employees. And the chain of accountability is the white line. I’ve made this one a little crooked because it is a little crooked. How many of you own a stock in a specific company? Not — can we get a mic down to this gentleman here with the olive colored shirt please? Is it a publicly traded company?

Student: Yes.

Professor Douglas W. Rae: Name it please.

Student: Sasol.

Professor Douglas W. Rae: Pardon.

Student: It’s called Sasol; it’s a South African oil company.

Professor Douglas W. Rae: Okay, and you take an active role in running the company?

Student: No.

Professor Douglas W. Rae: Do you like everything the management does?

Student: No.

Professor Douglas W. Rae: Why don’t you fix it then?

Student: Because I don’t own enough shares to make a difference.

Professor Douglas W. Rae: Okay, and if you called up the CEO and said, “I don’t like what you’re doing,” how would you imagine the conversation would run?

Student: Very short.

Professor Douglas W. Rae: It would be short and what would his suggestion — his not indecent suggestion be?

Student: Pound sand.

Professor Douglas W. Rae: Pardon.

Student: Pound sand.

Professor Douglas W. Rae: Okay, pound sand or sell the damn stock. You don’t like it, get out. The characteristically weak control that investors have here puts enormous importance on the exit option. Indeed, the exit option becomes dominant. And in day trading, for example, what people are doing is owning companies for very short periods, owning tiny slices of companies for very short periods, and exercising no influence or accountability but just, “I don’t like it, I’m gone,” or, “I believe the price is going to fall, I’ll short the stock and get out.” What you’ve created here is a brilliant device for scooping up small amounts of investment from a large amount of people, a large number of people, so that with a joint stock corporation you can have thousands, tens of thousands, hundreds of thousands of investors. They don’t know each other, they don’t talk to each other by and large, only the large institutional investors track the company’s behavior with any care, the specific fundamentals of the company, and the distancing — think about proprietorship, where the boss is in the shop; and partnership, where the owners are the partners who actually do it. We’ve come a long way from that with the joint stock corporation, and it’s an extremely efficient device for raising money in that way.

The internal operation, on the other hand, is complex. You’ve got market mechanisms of exchange outside the firm, but inside the firm you’ve got to manage people, you’ve got to incent them, motivate them to do what needs doing for the firm. The board of directors plays a symbolically central role in all this because they pick top management, and top management is accountable to them, at least in theory. If you think about the recent crisis in American capitalism, a lot of it has to do with the fact that boards have failed, sometimes catastrophically, to exercise any real accountability on top management. The characteristic problem, which I’ve mentioned to you a couple of times, about the firm is so-called principal agency; I hire you to do something, and you go off and do it or not. For example, let’s suppose I run something as simple as a bar and I hire you — I’m not there in the evening and I hire you to run the bar. I give you an hourly wage, and I let you keep your tips, what might occur to you as a way to maximize your income at my expense?

Student: Free drinks.

Professor Douglas W. Rae: Free-who said it? Free drinks or the very deep pour; you order a scotch, I pour you a double. You save the $5 and give me $2 of it. The characteristic of this situation is that you have — what’s your advantage over me in scamming me this way?

Student: I keep the tips.

Professor Douglas W. Rae: You keep the tips. But how do you manage to get away with it? If you called me up and said I’m going to do this, I’d say you’re fired. But you get away with it. Why?

Student: You’re not there.

Professor Douglas W. Rae: I’m not there. You have the eyes and ears on the scene, and I don’t. You’re the agent. You have so-called information asymmetry, you know a lot more than I do about what you’re doing, and so the characteristic problem for people trying to manage inside the box, inside the firm, is to keep others for whom — for whose achievements or malfeasance they’re accountable — to keep them motivated and honest. The role of ownership; the sole proprietor runs the thing, simple as that. Partnership, they are all there except if you have the general partner, but in general, say in a law firm they are all involved, they will typically create an executive committee and maybe a managing partner, but pushed to shove in a disagreement about the firm, they are all part of management. You make them that because they are your assets. In a good law firm the real assets are the lawyers.

In the corporation the ownership role is, as we saw a few minutes ago, strongly attenuated. Now in actual fact there are cases where stockholders rise up against management and throw the board out and with a new board throw the management out. It does happen, it’s just rare. And it’s rare because the transaction costs, just the time and effort required to organize the shareholders, is quite extreme. Stocks; this is a 1998 tabulation of the percentage of U.S. households by income strata, higher in yellow and lowest in green, who directly or indirectly own companies. The gist is just what you would think it would be. You have a majority of people with six figure incomes, and you’ve got to inflate a little bit here from 1998 to now, people with relatively high incomes are predominantly owners of companies. The rate of ownership scales down with income, which makes quite a lot intuitive sense, but most of the stock is held in very small parcels. And the putting together of — forget a majority — putting together enough to be noticed, which begins at about 5%, is a major task.

Liability; with a proprietorship, if you do a harm to someone else, a tort ,as lawyers say; if you sell someone a contaminated bottle of drinking water, they can sue you without limit. If your proprietorship is worth $100,000, and you’ve also got a home worth $300,000, and savings worth another $100,000 to make $500,000, they can go after all of that. There is no protection against lawsuits in the proprietorship form. With partnerships things are as bad or worse. Let’s suppose Tim here and I are partners, and Tim for reasons known only to himself, creates a catastrophic train wreck on the line between New Haven and New York one day and does it in the name of our proprietorship, maybe we’re in the business of something for trains. And I’m on vacation in Europe, and Tim calls me up and says, “We’ve killed 110 people, things are really a little bleak.” My problem then, of course I’m sorry for Tim, I’m sorry that Tim will suffer from this; but I’m even sorrier about me because the principle of joint and several liability applies to partnerships so that the litigant can choose among the partners and go after all the deepest pockets. That is a really major flaw in the ownership structure design from the individual point of view.

The most striking single thing about the joint stock corporation is that it has limited liability. By limited liability we mean if you own 100 shares and they have a value of $7 a piece, there’s $700 worth of capital, the most you can lose is that $700 no matter what the firm does. The firm could blow up the Atlantic coast and your liability would be limited to the $700 which would be, in effect, you can lose all of your investment but you can’t do worse. Now that’s a hell of a deal, that’s an enormously attractive deal, and if you think about the purpose of the joint stock corporation it’s easy to understand. It’s easy to understand because we want people to make investments over something they can’t control and can’t really see inside very clearly.

Now we will — I’ll ask you before the term is over to have a look at a quarterly filing by a company so you get to see about what investors can see. If you can’t control it and have no very powerful surveillance over its behavior you wouldn’t want to invest in it unless you were granted relief from liability, and that’s exactly the design. There was 100 years ago a race to the bottom among the American states in how generously they treat corporations under the law. The reigning champion among American states for corporate law is Delaware. Delaware corporations abound everywhere, and in particular, in places that aren’t Delaware or even close, because these provisions are tightest from the corporate point of view.

Liquidity; proprietorships are hard to sell. In fact, often it’s impossible to really get the value out of them when you sell them outside the family. Often, in fact, with say retailing, the value of the firm is substantially the goodwill toward the owner the customers have. When the owner sells it to somebody else the value may go to zero, although I was just — I had a boat in the marina on Lake Champlain for a long time and I got tired and more tired of the management of the marina; lazy, grasping, unreliable, and I was talking to somebody on the phone yesterday and they said, “You know there are new owners up there,” and I thought: Hazzah! I may take my boat back. The proprietorship is a very delicate creature.

The partnership is worse. Let’s suppose that all of us are the partners of Wiggin & Dana law firm in New Haven. We’re all partners, except Morgan here, and Morgan is a brilliant student just finishing the Yale school and I’m his advocate. I say Morgan I’m going to make you a partner. What do I have to do to make that happen? In theory, there are ways to shortcut this, but in theory I have to get the consent of all of you. And then suppose I say, “I’m tired and old and I want out. I’m going to sell Jim Alexander my partnership,” and Jim Alexander is generous enough to offer me a large sum of money for that partnership. Can I just send all of you a memo about Jim now being a partner? No, you’ve all got to approve it. The illiquidity of the partnership as a result is notorious. The corporation is designed for liquidity. You don’t even ever have to see the physical stock certificates, they are just electronic bits. The time it takes to sell securities is that. And the transaction costs are extremely low compared to the other two.

Now scalability, can we make this thing big or not? The answer here is in data, these are — can you read this from the back? There are about 18 million proprietorships in the country; a million and a third partnerships, five million corporations, and their average gross revenue per year are these numbers. The standard story of a proprietorship is the dry cleaner on the corner who makes $1,000 a week and feels good about it. These are actually gross revenues not net. What that means is that the actual take home may be pretty small. The ratios are suggestive of scalability. The joint stock corporation is made to get big. There are several subtypes of corporation, but probably the most profound threshold for corporations is the public offering, the initial public offering. When you take a firm from private to public, that is when you, for example, an S corporation is a very private kind; you can only have 75 shareholders, you get some tax breaks, but you can’t market your shares to a wide public. When you go public — Jim you’ve been through that, going public with a company, is that right?

Jim Alexander: Yes.

Professor Douglas W. Rae: Is there a mic for Jim? What’s the process? This is Spinnaker Exploration.

Jim Alexander: You have to interest various investment bankers in your, quote, story, unquote, as they call it. You eventually choose a group of people that you feel comfortable with and who feel comfortable with you, you convert their analysts to thinking you have good prospects, you draw up a prospectus, which is both a selling, and most importantly, a legal document describing — ostensibly describing to the investors the principle risks and potential returns of the investment. You make sure that you have what’s viewed as a good lawyer helping you with that, a lawyer with a good reputation, make sure that you have audited financials by a firm of the highest reputation, and then eventually when the timing is right you go around the country for several weeks talking to prospective institutional investors because retail investors at most retail firms won’t buy with the smart money, which is deemed to be institutional, it’s not buying. Typically you end up with a group situation where maybe 20% to 40% of your company is sold in the IPO, new money coming in which typically pay down debt, and you end up with 200 to 500 shareholders whom you then have to keep happy, at least for the first year or else bad things happen to you.

Professor Douglas W. Rae: Good! Thanks. The gigantic corporation is the most productive, not the most creative necessarily, but the most productive player in the economy. As you can see here, nearly 90% of all the business done in the American economy is done by corporations so that the — an analysis of American capitalism or world capitalism which neglects the joint stock corporation neglects the most important player. We will be focused on those, ones like the Pennsylvania Railroad here, as we go forward. Now on Wednesday — how far did we get with solving the case distribution problem? How many of you owned the cases before today? Where did you get them?

Student: RIS.

Professor Douglas W. Rae: You got them from RIS.

Student: It’s the Yale bookstore that’s giving up [inaudible].

Professor Douglas W. Rae: Okay, somebody who — did it work out — keep the hands up a second I want to get a count. How many of you acquired one today? Okay it looks like we’re getting there. The — you got the set of three right? Okay cardiothoracic systems for Wednesday. Sharon Oster, Dean of the Management School, is going to teach the case. There will be no slides and she’ll walk around talking to you and asking you, “What are you going to do with this problem?” You’ll find that she is a — she teaches the straight Harvard Business School technique and so we’ll all have fun watching that. She’ll doubtless cold call me.

[end of transcript]

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