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The Speculation Economy: How Finance Triumphed Over Industry

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As anyone who has the slightest interest in finance has noticed (and the boosters of the "Ownership Society" keep touting that most Americans are now stockholders) fiascoes like Enron and WorldCom have shown that many of today's corporate finance schemes are often just a house of cards. Mitchell's The Speculation Economy demonstrates that this is nothing new and the corporate prototypes for Enron and WorldCom became firmly established by the end of the Wilson Administration. The discretionary valuation models employed by the likes of Skilling and Lay at Enron and Ebbers at WorldCom were first dreamed up by fellows like "Sunshine Charley" Mitchell who was hired by the ancestor corporation of CitiGroup to set up its bond-selling operation in 1916. In those days before Glass-Steagall banks nevertheless had to be circumspect about selling securities, but they got around the restrictions by selling their stock printed on certificates with the stock of their investment companies printed on the reverse side. Neat, huh? This is only one of the many early schemes used by banks and investment promoters to turn the American economy from one of producers into one of financiers chasing deals. Indeed, Mitchell shows us a heritage in which the "Ownership Society" has a long pedigree.

Mitchell traces how it all started with New Jersey's need to pay off Civil War debt and the needs of business to find ways to combine industries for economies-of-scale and to control destructive competition. While reformers were focused on the harm caused to consumers by combinations that set prices--the anti-trust issue--business moved the competition of the market from production to Wall Street. Mitchell shows how the anti-trust battles and the investigations into corporate schemes actually helped sell the stock the promoters were pushing. It is a story that has not been told well because most history books focus on the "current events" approach that look at the newspaper accounts and give a face-value look back, or look back with hindsight. Mitchell looks at the events from the standpoint of a law professor of corporate finance who analyzes the transactions and the legal changes that molded the times. What is striking is how much the history comes alive in comparison with today's events.

In the interest of full disclosure, I must explain that I am one of Professor Mitchell's guinea pigs from his first corporate law class after he left Wall Street, and note that he is not related to me, nor am I or is he related to Sunshine Charley, though we all share a very common last name. The fact that I am one of Professor Mitchell's students does not make me biased. On the contrary, it gives me a special perspective on his insight because when he left Wall Street to teach corporate law, we were all very excited about the prospects awaiting us in those heady days of junk bond frenzy. The law firms were crawling all over campus seeking canon fodder for deals to help push the mountains of paper needed to justify the fees they were raking in. Professor Mitchell cautioned us and showed us in our Corporate Finance class how the valuations in those deals were skewed using the financing schemes of the day.

He has demonstrated in The Speculation Economy how the valuations of the nascent finance economy were just as skewed right from the beginning. Through the lens of history, Mitchell lets the reader see how the allocation of capital model we have today began not as a beneficent tool, but more as a promoter's pitch. Instead of the market being a great engine of efficiency, we see the other side, the 76 trombones of Professor Hill's Big Parade in which the instruments serve no purpose to anybody, but it's alright as long as everybody keeps playing. In the same way, the speculators who created the finance economy started a game of musical chairs by which capital is allocated. As long as the music keeps playing, everything is fine; the Big Parade keeps going round and round. It is only when the music stops that some get a chair and some are left out, but that is what capital allocation is all about, right? Somebody needs to lose once in a while for the system to work. When it all started back in the 1890s, people were not as sanguine about being left out, with no place to sit, and no money when the music stops for a moment as they are today. Back then, they had "panics." Today, we have "corrections" and "profit taking" because there are so many people and so much money in the market that it can absorb big fluctuations. Mitchell sets out in detail how the promoters used the legal system to change people's attitudes about the Big Parade and got them singing from the Music Man songbook.

One thing that stood out for me was the concern that people had as corporations grew and combined businesses using inflated stock schemes that resulted in "overcapitalization," which was the buzz word of the day in congressional hearings about trusts and the harm they posed to the country. Today, we look forward to overcapitalization in our assets; we expect it. We call it leverage. When shopping for a condo in a resort the salesman will tell you about the great "leverage" the condo produces. Upon deeper examination, what he means is that the condo does not provide enough rent to pay the note, but as an investment, the loss is a tax deduction, and the appreciation in price you will reap upon resale is great "leverage" on the note. That is great leverage as long as everyone agrees to keep playing the instruments, buying the paper, and going along with upwardly spiraling appraisals. Someone once said success has many parents, but failure is an orphan. Now, those condos are having a hard time finding buyers and the prices are crashing. They were "overcapitalized" to use the phraseology of the early twentieth century.

Another factor about an overcapitalized economy is the so-called "wealth effect" of people whose assets keep going up in value. They have no more money in the bank, but on paper they look wealthier and have more "leverage." They can borrow more. On what can they borrow? They can borrow more money from the bank because the bank is loaning more money on appraisals it was approving for the whole neighborhood. Everybody was getting wealthier on the appraisals, but the music had to reach a crescendo. People starting buying houses as a business: "flip this house." Everybody was doing it and a lot of money was changing hands, but was it real money, or was it "overcapitalization?"

What individuals were doing on an individual scale with houses and their local banks in the last decade is the same thing banks and corporations with investment companies were doing to form so-called "trusts" at the turn of the twentieth century. They created an enormous wealth effect that still operates today. Mitchell explains how it all got started and the legal levers that had to be pulled to make it happen. The law went through major changes to create the finance economy. It had to be liberated from valuation models of the past. Business needed discretion to set the value of its assets. Mitchell's history demonstrates that law determines value and value is the ultimate measure of wealth, not cash. To borrow George Goodman's phrase, the Speculation Economy laid the foundation for Supermoney, value that was worth more than cash. Mitchell's narrative lays out how the liberation of the law made it possible for stock to be used as an uber currency to buy companies. History shows how corporate finance developed into a wealth industry that was superimposed onto the extractive, agricultural, and manufacturing industries that produce the goods of life. Finance took over the levers of life.

The lesson of the last few years, as Enron leveraged derivative contracts on top of derivative contracts and then bankers freed from Glass-Steagall restrictions took finance to new heights by leveraging as many American Dreams as possible into securities, trying to turn home mortgages into the right to print money, is that discretionary valuation models can get out of hand. Maybe, greed is not so good. The Speculation Economy shows through historical and legal analysis -"Just the facts M'am"--how it got out of hand in the formative years of the new finance economy. Mitchell does not go any farther than that. He lets the facts speak for themselves. He leaves it for the reader to decide and to search for more information about what happened after 1919. How did the groundwork laid by Sunshine Charley and others lead to the Crash of '29? Did it lead to the Crash? Were the valuations in the 1920s skewed, or was it just the brilliance of opening up a new world of valuation? Was the problem that the financiers were way ahead of the rest of society and it has taken all this time for everyone else to catch up, or is it all just a house of cards waiting for a stiff breeze of reality to blow it down? Is Enron just an example of "creative destruction?" What should be done about the mortgage crisis? How should the asset-backed securities be marked down? What about Fannie Mae? How deep is this mess and will it affect the global economy? How can all of these mortgage-based investment securities that were bundled and then traded around the world be unwound, discounted, re-valued, or whatever as the local legal systems deal with the individual debt scattered all over the United States in thousands of cities and counties? Hey, maybe it's not that big a deal? Maybe the market is big enough, global enough to absorb anything and just keep on growing?

Mitchell does not go into any of these forward-looking questions. His book is a fascinating expose' of how the finance economy came to be. It is the starting point for any discussion of all the other questions about valuation and where the economy should be headed. The book is not so much about arguing for this policy or that policy. It is about the facts behind the policy choices. The research stands on its own. The writing stands on its own. He does not preach or grind any axe. Well, maybe he does a little in the Epilogue, but that is what epilogue's are for. However, he does give students of history and law a tool with which they can understand more about the corporate finance economy that determines the value of their wealth. Any lawyer who does one iota of corporate work should read this book as continuing legal education to understand better the history of corporate law.

Cicero said: "Not to know what has been transacted in former times is to be always a child. If no use is made of the labors of past ages, the world must remain always in the infancy of knowledge." Mitchell has made excellent use of the labors of past ages. I recommend The Speculation Economy to all who have any interest in corporations, business, history, economics, or law. It has sixty or so pages of footnotes and bibliography, making it a good reference for the topic. For anyone interested in trying to cope with the question--"How free should corporations be to allocate capital, other people's money, in the financial markets, and how much accountability should they be required to give in the process?"--The Speculation Economy is the place to start gathering the necessary information to wrestle with that question. It is an important question because the history of the formation of the Speculation Economy as well as the last decade have shown us that sometimes there is more sizzle than steak. If there is too much sizzle, somebody is going to get burned.

Lawrence Mitchell provides an excellent chronicle of the events between 1897 and 1919 when our corporate landscape shifted from independent factories, controlled by entrepreneurs, to one driven by financiers, promoters, and business managers focused on stock price.

He breaks the history of this important shift into three rough phases:

(1) Antitrust reform proposals and the federal incorporation movement tried to compel corporate disclosure of financial information to reveal the true value of corporate capitalizations. The merger wave of 1897-1903 brought middle-class Americans to the market.

(2) Antispeculation drove efforts to maintain the safety of banks and the national economy. 1903-1914 saw steadily increasing investments in common stock, as well as bonds and high quality industrials/railroads by a growing middle class.

(3) Consumer protection treats investors like consumers, seeking to provide information to individual investors so they can make self-reliant, informed investment decisions. Common stock overtakes bonds as the investment of choice in the 1920s.

The stock market took the place of our fabled frontier for the middle class, which hopes to strike it rich by speculating on stock. Financiers profit, whether industrial profits are high or nonexistent.

In the past, the typical stockowner "gave at least as much attention to the asset value behind the shares as he did to their earnings records," according to Graham and Dodd. Now buyers care more about price trends, reputations and rumors. '

Regulation, as it evolved, is of little use to the actual shareowner because it is focused on the disclosure of the terms sale, rather then the details of governance... due diligence in purchase, not in ongoing operations. The result is less of an emphasis by investors on fundamental value and more of an emphasis on expectations that are built upon the expectations of others... behavioral economics and the tea leaf reading of "technical analysts."

"The natural response is for management to do what it has to do in order to meet the market's expectations, no matter how unrealistic those expectations may be." CEOs face "irresistible incentives to maximize stock prices at almost any cost to the corporation's long-term health."

The strength of our economy, the health of our people and planet, may depend on our ability to take a longer-term multigenerational assessment of our welfare. Corporate governance is no longer a private atomistic matter. Mitchell's contribution to our understanding of how and why we took this deadly path may help us find a better route to a more sustainable future.

Mitchell's book is an excellent exploration of the evolution of the corporation, and even though it is historical in nature, the book offers important insights for our own era's obsession with stock prices and short-term gains. In this meticulously researched book, Mitchell details the origins and evolution of finance, and the way in which making money through speculation came to displace making things as a corporate priority. The book is a tour de force, expertly written and researched, filled with nuggets of thoughtful information, and will be of interest not just to those steeped in business history but also those interested in regulation, markets, and the development of the business corporation. This book is also so timely given the excesses of Enron, WorldCom, and now the mortgage markets and may help us understand the many downsides of a speculative economy.

This is the most important book I've read in ten years. I picked it up skeptically, as I am not generally a fan of historical work, but I was an enthusiastic convert by page 5. Mitchell's extremely readable style and incisive commentary pulled me in and kept me intrigued throughout the telling of what is truly the corporate Ur-story. I learned more in a day's reading of this book than in my twenty years of teaching about corporate finance and the modern corporation.

Six years after his remarkable "Corporate Irresponsibility," Lawrence E. Mitchell provides an eye-opening account of how American capitalism as we now know it was always a matter of choice. Based on a comprehensive, historical research, Mitchell tells the story of the formation of the giant corporation in the early 20th century as the moment in U.S. history when economic and business decision-makers replaced long-term production with short-term stock value as the nation's economic compass. Straightforward and clearly written, this book is not only a huge contribution to scholarship in business, public policy, law, and history, but also a great source for researchers, practitioners, and graduate students in these fields. It teaches us how the social institutions we consider today as almost "natural" (in this case, the stock market and the business culture and regulatory landscape that surround it) were in fact made by public policy makers and business leaders not that long ago to reflect their political preferences and economic interests. Therefore, Mitchell's book is not only a thorough study that points to current problems and their roots but also an optimistic call for change and its prospects.

Lawrence E. Mitchell has distilled his exhaustive research into the American stock market of the late nineteenth and early twentieth centuries. The result is an engrossing tale. It features a cast of political and financial wheeler-dealers, and those who sought to control the excesses and to give the investor the information needed to fairly evaluate companies and their shares.

This fascinating and informative study is a MUST for anyone who is willing to put money at risk in the equity market, and a look at how the "tail" of share prices often wags the "dog" of the American economy.

Mitchell's book is a must-read for anyone interested in the history of the American economy. Long recognized as one of the leading legal scholars on business issues, Mitchell proves with this book that he is a formidable historian as well. He traces the development of the economy from one in which leaders of industry saw themselves as producers of goods and services to an economy in which executives began to think of themselves as producers of financial wealth, for a narrow group of investors. This has had a profound effect on the way companies are run and on the economy as a whole.

The Speculation Economy describes how the characteristics of our business environment developed into what they are today. After reading this book, I looked at our current financial manipulators with a far better understanding of the footsteps in which they tread. For example, the credit crisis of 1907 was the consequence of shenanigans which are paralleled by our recent greedy mortgage practices and which have also resulted in a major credit crisis. Then, J.P. Morgan was the center of the effort to rectify the problem, much as the consortium of banks is acting today. As an aside, the activities of Morgan are much more fun to read about.
During the latter part of the nineteenth century and the first two decades of the twentieth,the focus of American business segued from making money by creative production to making money by creative financial machinations. The story told by the author is both thoroughly researched (check the voluminous endnotes and the bibliography) and compellingly written. The interplay of politics and business is described through the actions not only of Morgan, but also, among others,
Carnegie, McKinley, Teddy Roosevelt, Taft, Rockefeller, Henry O. Havemeyer and Woodrow Wilson. The cast of characters also includes many other players and the author takes pains to incorporate them in his story with personal details which make them three dimensional. Neither does the author forget about the social background against which his story develops. The economics plays out against the America which was growing in those years before and during the First World War.
Well worth reading.

"The Speculation Economy" is really two ill-matching books in one volume.

One book -- by far the more interesting -- tells the story of the creation of American financial capitalism between 1880 and 1920. This was the era when giant corporations were formed via mergers financed with watered stock, and when middle-class American consumers developed an appetite for share ownership. The result was an economy comprised of large corporations driven by the need to show returns to widely dispersed investors. It's an interesting story that explains where the modern American economy comes from. This books gets five stars.

The second book -- alas -- reconstructs the political and legislative maneuverings behind various now-obscure corporate reform efforts in the early 20th century. I don't know why Mitchell included this tedious material, which could have been reduced in length or left out altogether. Maybe, having done the research, he felt compelled to include it. In any event, this books gets three stars.

Together the two books have an average score of four stars.

Mitchell(M) has done a great job in this book .He allows the reader to clearly understand the crucial differences between entrepreneurship-enterprise and speculation.The former leads to booms and economic growth.The latter leads to bubbles,manias,panics,and crashes.

There is one small area where M could have improved the book.He correctly cites the work of Veblen and Keynes .The works of these two philosopher -economists clearly demonstrates that an economy that produces debt finance,as opposed to physical assets,is on the road to self destructing.However,Mitchell appears not to have realized that this was the message of the Thomist,Canonist,and Scholastic philosophers of the Middle Ages.In 1776,Adam Smith updated their conclusions but did not explicitly cite their work in his The Wealth of Nations(See Smith's careful appraisal on pp.280-340,Modern Library(Cannan)edition).Smith is very clear.First,the rate of interest must be permanently fixed in the long run at a low level a little bit above the prime rate of interest.Second,no loans can be made to projectors(speculators),prodigals,and imprudent risk takers.Loans are to be made to the sober people only.What happens if the speculators get their hands on bank loans in order to leverage their debt position ? The aggregate savings of the nation will be wasted and destroyed.(For Smith's conclusion see Smith,1776,pp.339-340;Modern Library(Cannan)edition).
M correctly emphasizes the importance of the Glass-Steagall Act that was aimed at preventing the speculative excesses of the period Mitchell examined in his book(1897-1919)after the collapse of the American banking system in the early 1930's.This act was a half way successful attempt to implement the ancient wisdom of the Scholastics and Adam Smith.Prevention is the key word here.It is easy to see that, as long as a Bill Casey was head of the Securities and Exchange Commission,the firewall created by Glass-Steagall would have prevented the speculative waves of the 1980's( the Drexell- Lambert- Milkin-Boesky junk bonds fiasco),of the 1990's(the Nasdaq and dot.com fiasco),and of the 2000's(sub prime mortgage backed bonds)from severely weakening the American economy of 2008.