Welcome to America, Home of 「The Speculation Economy」

With the financial world still in relative chaos, it』s time to take stock of some basic questions. Here are a couple: Is Wall Street doing more harm than good right now? How did it get to be such an integral part of the economy in the first place?

To answer that, we spent some time with Lawrence E. Mitchell, a George Washington University law professor who authored a new book called 「The Speculation Economy: How Finance Triumphed Over Industry」 (Berrett-Koehler Publishers Inc.)

Deal Journal: It』s so easy not to even ask how things got to be a certain way. You tracked the roots of the modern corporation. What did you find?

Lawrence Mitchell: Before 1889, for the most part, a company couldn』t buy stock in another company. In 1893, New Jersey came up with a law that allowed companies to buy stock in other companies. The most important part is that New Jersey said boards of directors had the final say on the value of the property. Now they had a way to combine and take over a corporation by printing stock. You could print as much stock as you needed to buy these companies.

In 1896, we came out of a huge depression. There was all this surplus capital around. Financiers and promoters, and later J.P. Morgan, said 『wow, look at this. We can buy these companies for little or no cash. We can make bundles of money.』 For example, when Morgan put together U.S. Steel in 1901, it was capitalized at $1.4 billion, and Morgan took $62.5 million in stock. In 2007 dollars, that was a $1.4 billion fee, which was then dumped on the market. They were printing huge amounts of stock, compensating sellers with it, and all the stock got dumped on the market.

DJ: Then came the huge explosion in the stock market.

LM: Trading volume in 1897 was 77 million shares on the NYSE, almost all railroads. By 1901, that was 265 million shares. During this time, and depending whose numbers you use, anywhere from $8 billion to $20 billion of capitalization got shoved into the U.S. economy, almost all of it stock.

DJ: So what』s the matter with that? This capital was helping build new businesses and the economy at large.

LM: In most of these offerings they raised some working capital. But most of it was secondary sales. Industrial jobs grew no faster than they did previously. It was speculative.

DJ: And that』s the legacy you describe in your book.

LM: It transformed the entire financing of American business. Prior to this time, businesses were financed with retained earnings, founder savings, maybe some local debt and equity kicked in by friends. Common stock has an unlimited upside. And so the market began to demand that corporations focus not so much on the steady production of goods and services, but on shoving dividends out the door.

Today, 20% of GDP comes from manufacturing and 32% comes from finance. It kind of makes you wonder what finance was financing.

DJ: But part of the success of America has been its ability to innovate with finance.

LM: A tiny, tiny fraction, less than 3%, is for new offerings. The rest is secondary trading. If we』re not financing productivity, what are we financing? You start to see this sort of second-order level of remove from production and industry, of finance taking on its own independent logic, where money is moving from one pocket to another but not landing any place where it』s making any difference.

DJ: So we』re in danger of falling down the rabbit hole of finance?

LM: I』m deeply worried that unless we pay attention to restoring a basic balance to our economy, and redirecting finance to its original goal – which was to finance productivity – then we』re going to find ourselves in the long term in very bad shape.

DJ: How can we fix the problem as you see it?

LM: My favorite is that we revisit long-term capital gains taxation. You could take it industry by industry, one year versus 10 years, creating a sliding scale capital gains tax. For day traders, if they trade within a month, tax 90% of the gains, and over 10 years, extend tax forgiveness.

DJ: Seems like a pretty tough mission to get it changed.

LM: Thorsten Veblen said in 1903 that 『industry and finance are two different things. The well being of the nation depends on it.』