------------ EH.NET BOOK REVIEW --------------
Published by EH.NET (June 2009)

Lawrence E. Mitchell, _The Speculation Economy: How Finance Triumphed over Industry_. San Francisco: Berrett-Koehler, 2008.  xiii + 395 pp. $25 (paperback), ISBN: 978-1-57675-28-7.

Reviewed for EH.NET by J. Peter Ferderer, Department of Economics, Macalester College.


It is rare that a book about the history of legislation, much of which failed, could have so much potential to shed light on a contemporary economic crisis.  Lawrence E. Mitchell, Theodore Rinehart Professor of Business Law at the George Washington University Law School, has written such a book.

Mitchell examines the evolution of security market regulation in the United States during the Progressive Era (1890-1913).  Although federal involvement did not reach its modern form until the New Deal, much of the groundwork was laid during this period.  Transformation in thinking about the role of government in security markets paralleled broader social and economic changes.  While the goals of regulation changed, _disclosure_ was the primary regulatory device emphasized at each stage of the process.  In the end, Mitchell concludes that the regulatory course taken in the United States has allowed finance to shape corporate decision-making in a way that is detrimental to society.

One of the interesting themes of the book is the struggle between states and the federal government for authority.  Since the birth of the nation, the creation and regulation of corporations had been the domain of the states.  This institution was preserved by concerns about federal power, dedication to the notion of states’ rights by Southern Democrats and fears of creeping socialism.

Despite the inertia, fundamental social and economic changes created political pressure for federal regulation.  These included the merger wave from 1897 to 1903 which created giant corporations, dramatic increases in wealth, the democratization of security market participation, and the Panic of 1907.  World War I increased the pressure because it required intrusive federal intervention in the financial system which served as a powerful precedent for future regulation and the Liberty Bond drives brought even more Americans into contact with security markets.

The theoretical foundation for change was provided by a group of young economists, including Richard T. Ely, John Bates Clark and others, who questioned the utility of laissez-faire competition. They argued that giant corporations could be beneficial to society (owing to scale economies) and that it was the state’s role to prevent their excesses.  One of the participants in these discussions was Woodrow Wilson, Ely’s former Johns Hopkins student, who Mitchell credits with playing a major role in shaping modern securities market regulation.

Initial efforts at securities regulation at the federal level were motivated by antitrust concerns.  In an attempt to attract corporations, states began to liberalize their chartering laws in the 1890s.  New Jersey was the first state that “presided over the degradation of corporate integrity” and it soon became the “mother of trusts” (p. 31).  Although New Jersey eventually reversed course under the leadership of Governor Woodrow Wilson, a race to the bottom led a number of other states (notably Delaware and West Virginia) to embrace corporate liberality.

Allegedly, the incorporation laws of these states were highly problematic because they led to overcapitalization or “stock watering.”  Industrialists were accused of using new shares as currency to buy competitors and monopolize product markets.  Corporate managers were accused of watering stocks to gain control over enterprises which they then mismanaged for their own benefit.  The antitrust problem had become a corporate governance problem.

One solution was federal incorporation law which would “subjugate corporate behavior to some notion of responsible public conduct” (p. 139).  However, this path was blocked by conservative Republicans during the first decade of the twentieth century (seen most vividly by the 1903 Senate rejection of the Littlefield Bill) and federal incorporation never came to pass.  While some modest reform emerged (for example, the Department of Commerce Bill of 1903 which focused on investigation and publicity), “business was allowed to organize, capitalize and manage as it saw fit” (p. 139).

After the Panic of 1907, the goal of regulation shifted to increasing stability of the financial and economic system by reducing speculation.  The philosophy underlying regulatory efforts also changed with more emphasis on publicity as a solution to corporate misbehavior.  The Hepburn Bill, which failed in 1908, was important because it marked the first time that federal securities regulation was introduced in its own right, independent of antitrust considerations, and focused on investor protection.  The Owen Bill of 1914 would have required that stock exchanges be incorporated under state law so that the government could insist on effective self-regulation.  To protect investors, the bill would have mandated that exchanges require listing corporations to disclose more information.

Finally, the Taylor Bill of 1920 illustrates how far the regulatory philosophy had shifted since the federal incorporation movement.  According to Mitchell, it was: “... classic Wilsonian economic progressivism ... relatively unintrusive, disclosure-oriented regulation, designed for the needs of business to be largely self-regulatory... Speculation was still a concern, but the focus had shifted from the stability of the economy through the behavior of financial institutions to the well-being of the American people, who had become the new corporate financiers... The new legislation accepted the speculation economy that had been embraced by the American people as the natural and correct order of things financial” (p. 266-67).

The Taylor Bill failed to pass, but was the clear and direct predecessor to modern securities regulation embodied in the Securities Act of 1933.

Mitchell does a masterful job analyzing the evolution of federal securities market regulation during the Progressive Era.  His ability to sift through numerous pieces of legislation and long committee reports to tell a coherent and reasonable story about this important part of American history is quite impressive.  With this said, however, I do find Mitchell’s characterization of the “speculation economy” to be problematic.

Mitchell claims that a new form of speculation emerged at the turn of the century as corporations altered their capital structures (and investors their portfolios) away from bonds, with contractually fixed coupon payments, to preferred stock with less certain dividends and, ultimately, to common shares with even more uncertain dividends.  While “traditional speculation” (short selling, buying on margin, etc.) had always been part of the system and periodically played a role in financial panics, it did have a permanent effect on the structure of the American economy.  In contrast, the new speculation exerted a “stranglehold” over industry.  While the industrialist of the nineteenth century “produced profit to his own satisfaction and at his own pace” the “managers of the giant new combinations had to satisfy the demands of a hungry market increasingly populated by common shareholders who expected their dividends ... the dominance of finance over industry had begun to move to a new and powerful level” (p. 196).  He argues that, in recent years, changes in corporate governance and theoretical developments in financial economics have paved the way for the “financial domination over industry” to become “the full-blown triumph of the stock market over industry” (p. 274).

While it is difficult to read these passages without thinking about mortgaged-backed securities, default-debt swaps and other recent innovations driven by the pursuit of corporate profit, it is far from clear that the stock market is to blame for our current problems.  A more benign explanation for the rise of “new speculation” (or what might be better labeled “risk-taking”) is that it represents a normal response to fundamental economic change.  For example, the merger wave at the turn of the twentieth century should have stabilized profits around a higher mean growth rate.  If this was the case, the risk of common shares should have diminished.  Moreover, the rapid rise in wealth over this period should have reduced risk premia given the diminishing marginal utility of money.  This is not to deny the existence of episodic irrational exuberance and panic, which seems to be part of the human condition.  However, secular changes in risk-taking -- as witnessed by the shift from bonds to common shares or the more recent emergence of securitization -- are a natural response to fundamental changes in the real economy and an important source of rising living standards over the long-run.

Despite this criticism, this is an important book.  Mitchell links many complex strands of thought and his detailed analysis of Progressive Era legislation sheds new light on the history of securities market regulation.  One cannot help but wonder if the outcome of A.I.G. would be different if it had been incorporated by the federal government rather than the state of New York.  Perhaps Charles Littlefield was on to something in 1901.


J. Peter Ferderer is Professor of Economics at Macalester College, where he teaches courses in macroeconomics, economic history and behavioral economics, and currently serves as the President of the Minnesota Economic Association.  His most recent article is “Advances in Communication Technology and the Growth of the American Over-the-Counter Markets, 1876-1929,” _Journal of Economic History_, 68(2), June 2008.

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