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H-NET BOOK REVIEW
Published by [log in to unmask] (July, 1997)
Jonathan B. Baskin and Paul J. Miranti, Jr. _A History of
Corporate Finance_. New York: Cambridge University Press, 1997. x
+ 350 pp. Tables, epilogue, appendices, notes, and index. $29.95
(cloth), ISBN 0-521-55514-0.
Reviewed for H-Business by Robert E. Wright, Temple University
<[log in to unmask]>
The Alleged Poverty of Positivism and the Modern Theory of
Finance
_A History of Corporate Finance_ is a solid contribution to
scholarship that should gain the interest of historians, lawyers,
economists, and business persons. Its unusual combination of
scope, clarity, and brevity, combined with its reasonable price,
may induce professors to make it required reading for advanced
undergraduate and graduate courses in economic or business
history, or in management education courses. Highly interpretive,
the book is more a work of synthesis than of original research in
primary sources. At 350 pages, the book is hardly comprehensive,
but it nevertheless manages to tie much temporally disparate
material into its thesis.
That thesis the authors lay out carefully in the introduction,
"History and the Modern Theory of Finance." Citing Keynes and
Schumpeter, Jonathan Baskin and Paul Miranti remind readers of
the "complementary" nature of history and finance and announce
their intention to employ "historical methods to amplify an
important contemporary paradigm" (pp. 1-2). That paradigm, the
"modern theory of finance," seeks to evaluate the "financing
question" (optimal capital structure decisions), and the
"dividend question" (distribution of income to shareholders). The
early leaders of modern finance theory were Franco Modigliani and
Merton H. Miller. Based on an abstract model, they argued that
"firms cannot increase value by issuing either debt or equity"
and that "managerial decisions are irrelevant" (p. 16).
Questioning conclusions based on what they consider to be
ungrounded, formalized models, Baskin and Miranti argue that the
modern theory of finance needs to take greater recognition of
"path dependence and historical evolution" (p. 3). To
substantiate their view, they describe the intellectual history
of economics (economiography?) since the diffusion of Karl
Popper's "falsifiability" philosophy of science, and, at the end
of each chapter, they test the assumptions and real-world
applicability of theoretical models. Generally, they find the
abstractions empirically deficient, and thus call into question
"the profession's current infatuation with models that lend
themselves to formal mathematical explication" (p. 23).
Divided into three parts, "The Preindustrial World," "The Rise of
Modern Industry," and "The Transition to the Contemporary Era,"
the main body of the work opens with a discussion of medieval and
renaissance finance. After a brief description of the medieval
commercial revival, Florentine and Venetian finance is treated at
some length with emphasis on enterprise organization. The authors
conclude, not surprisingly, that "other factors than those
considered in the modern theory as laid down by Modigliani,
Miller and others had been foremost in defining early financial
institutions" (p. 51).
Corporate finance in the age of global exploration, especially
the rise of joint-stock trading companies like the East India
Company, forms the basis of chapter 2. Baskin and Miranti
conclude that the "pecking order" hypothesis of Gordon Donaldson,
"the traditional explanation of funding decisions prior to Miller
and Modigliani," best explains the East India Company's financial
decisions (pp. 22, 84). Donaldson's hypothesis predicts
organizations will finance operations first from retained
earnings, then from debt, and lastly from the sale of additional
equity. With debt interest rates lower than equity returns,
business cycles violent, and the probability of losing control of
the company in an equity expansion high, East India Company
managers borrowed capital with short-term debentures.
Chapter 3 takes up the emergence of public markets for investment
securities from the Glorious Revolution to the final defeat of
Napoleon. Predictably, the Bank of England, John Law, and the South Sea
Bubble are the major subjects covered, but an interesting twist,
the notion that the "watershed of 1720" caused British and French
financial development to diverge markedly, enlivens the
discussion. If true that France turned "antitrade and antimarket"
after the "Law fiasco," the authors have hit upon a major
explanation for the Anglo-American victory in the struggle to
control North America (French and Indian War [1755-1764] or Seven
Years' War [1756-1763]) and an important cause of the French
Revolution (p. 114). In any event, Baskin and Miranti's main goal
in the chapter is again to attack the modern theory of finance by
pointing to the "high risk in economic affairs and poor
information" facing eighteenth-century investors. In that
environment, low-risk government debt was a more attractive
investment option than equities (p. 122).
The problems involved in accurately valuing equities persisted
into the nineteenth century, the age of massive infrastructure
improvements. With particular emphasis on canal and railroad
corporations, the authors describe the evolution of preferred
stock, a hybrid between debt and equity financing. Preferred
stock paid a guaranteed dividend, but conferred no voting
privileges, thereby allowing managers to maintain control over
the corporation. Also, unlike bond payments, dividend payments
could be suspended without forcing the corporation into
receivership. The creation of preferred stock, the authors
believe, supports the "pecking order hypothesis" more than the
modern finance theory. By incorporating the fixed-income and
non-voting characteristics of debt instruments into a hybrid
equity form, managers transcended some of the limitations of the
pure debt market and staved off the flotation of true equities.
After 1900, the authors admit in the next chapter, a broad,
impersonal market in common stock arose in both Britain and the
United States. Managers, however, continued to prefer retained
earnings, fixed debt, and preferred stock over the flotation of
common stocks. The main body of the book concludes with two long
chapters of in-depth analysis of the financing of center firms,
conglomerates, and leveraged-buyout partnerships. Not
surprisingly, the pecking order hypothesis again emerges as the
key means of understanding successful corporate financing
strategies. By downplaying the successful initial phase of the
post-1960s merger movements, the authors portray conglomerates
and LBOs as failures inspired by the over-simplistic models of
academics. For instance, they label Henry G. Manne's contract
theory "underspecified" because it fails to account for the
effects of government regulation and the importance of manager
tenure (p. 287). However, Baskin and Miranti admit that although
the pecking order hypothesis generally "predicts the progression of
corporate financial preferences, it does not provide guidance
with respect to either the relative weight placed on these
alternative sources or the rates at which this process
progressed" (p. 297).
The basis of _A History of Corporate Finance_ is Baskin's
dissertation and 1988 _Business History Review_ article, "The
Development of Corporate Financial Markets in Britain and the
United States, 1600-1914: Overcoming Asymmetric Information."
Baskin died before completing revisions, but Paul Fink, Baskin's
father, arranged for Miranti to bring his son's contribution "to
fruition" (p. ix). Probably because of the difficulties of
editing a half-posthumous piece, the book suffers, in places,
from an over-rigid style, poor balance, and uneven organization.
Over one-half of the book, for instance, covers the twentieth
century.
Also, the epilogue and two appendices seem out of place. The
former reads like a conclusion except for the formulation of an
original algorithm that purports to explain the relationship
between short-term, firm-specific factors and long-term
environmental elements in financial development. If truly
significant, the algorithm should be explained in the
introduction and applied throughout the narrative. Appendix A, a
short description of finance and informational asymmetries in the
ancient world, rightfully belongs in chapter 1. Appendix B,
"International Patterns of Corporate Governance," contrasts
Anglo-American financial markets with their equivalents in Japan
and Germany. The main contention is that, because of its
transmission of "reliable information" to investors, the
Anglo-American financial system is more efficient and conducive
of economic growth than the "opaque regimes of Japan and Germany"
(p. 322).
Although probably correct and extremely interesting, the
presentation is _ad hoc_ and, at 8 pages, too truncated to be
entirely convincing. I hope that Miranti will take up a broad,
comparative study of financial institutions since the late
nineteenth century as his next major project.
Although an outstanding study that will deservedly gain a wide
audience, the book ultimately fails to reconcile the methods and
outlook of history with those of economics. The belated algorithm
is a step in the right direction, but still short of creating
realistic (adequately specified) models that can be
quantitatively tested. Though it is true that some past models
have been unrealistic in some regards, nothing in this book will
convince economists to abandon formal, mathematical theorizing.
Baskin and Miranti, in other words, have rightly called the
modern theory of finance into question, but have not set forth a
completely viable alternative.
Copyright (c) 1997 by EH.Net and H-Net, all rights reserved. This work
may be copied for non-profit educational use if proper credit is given to
the author and the list. For other permission, please contact
[log in to unmask] (Robert Whaples, Book Review Editor, EH.Net.
Telephone: 910-758-4916. Fax: 910-758-6028.)
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