Governance and Innovation (Routledge Studies in Global Competition)

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Governance and Innovation

This book focuses on the relationships between rules of decision-making and economic development, concentrating on the similarities and differences between old and modern modes of governance in both business and politics. Maria Brouwer uses concepts such as uncertainty and expectations to analyze political and corporate governance models from an economic theoretical perspective. Governance and Innovation analyzes the emergence of organizations and institutions conducive to commerce and growth and the relationship with political organization in both past and present in order to improve our understanding of economic development. The author shows how maritime trade spawned many organizational innovations in the past that still feature in modern innovative enterprise, and highlights how political governance can stimulate or hinder innovation, taking issue with existing legislation on bankruptcy and corporate governance. The effects of political governance on innovation are modeled to analyze how competition for novelty enhances the value of human capital. This book will be of great use to students and researchers engaged in political and corporate governance, leadership and entrepreneurship, as well as policy-makers interested in economic development. Maria Brouwer is Professor in Economics at the University of Amsterdam.

Routledge Studies in Global Competition Edited by John Cantwell, Rutgers, the State University of New Jersey, USA, and David Mowery, University of California, Berkeley, USA

1 Japanese Firms in Europe Edited by Fre´de´rique Sachwald 2 Technological Innovation, Multinational Corporations and New International Competitiveness The case of intermediate countries Edited by Jose´ Molero 3 Global Competition and the Labour Market Nigel Driffield 4 The Source of Capital Goods Innovation The role of user firms in Japan and Korea Kong-Rae Lee 5 Climates of Global Competition Maria Bengtsson 6 Multinational Enterprises and Technological Spillovers Tommaso Perez 7 Governance of International Strategic Alliances Technology and transaction costs Joanne E. Oxley

8 Strategy in Emerging Markets Telecommunications establishments in Europe Anders Pehrsson 9 Going Multinational The Korean experience of direct investment Edited by Fre´de´rique Sachwald 10 Multinational Firms and Impacts on Employment, Trade and Technology New perspectives for a new century Edited by Robert E. Lipsey and Jean-Louis Mucchielli 11 Multinational Firms The global-local dilemma Edited by John H. Dunning and Jean-Louis Mucchielli 12 MIT and the Rise of Entrepreneurial Science Henry Etzkowitz 13 Technological Resources and the Logic of Corporate Diversification Brian Silverman

14 The Economics of Innovation, New Technologies and Structural Change Cristiano Antonelli 15 European Union Direct Investment in China Characteristics, challenges and perspectives Daniel Van Den Bulcke, Haiyan Zhang and Maria do Ce´u Esteves 16 Biotechnology in Comparative Perspective Edited by Gerhard Fuchs 17 Technological Change and Economic Performance Albert L. Link and Donald S. Siegel 18 Multinational Corporations and European Regional Systems of Innovation John Cantwell and Simona Iammarino 19 Knowledge and Innovation in Regional Industry An entrepreneurial coalition Roel Rutten 20 Local Industrial Clusters Existence, emergence and evolution Thomas Brenner 21 The Emerging Industrial Structure of the Wider Europe Edited by Francis McGowen, Slavo Radosevic and Nick Von Tunzelmann

22 Entrepreneurship A new perspective Thomas Grebel 23 Evaluating Public Research Institutions The U.S. Advanced Technology Program’s Intramural Research Initiative Albert N. Link and John T. Scott 24 Location and Competition Edited by Steven Brakman and Harry Garretsen 25 Entrepreneurship and Dynamics in the Knowledge Economy Edited by Charlie Karlsson, Bo¨rje Johansson and Roger R. Stough 26 Evolution and Design of Institutions Edited by Christian Schubert and Georg von Wangenheim 27 The Changing Economic Geography of Globalization Reinventing space Edited by Giovanna Vertova 28 Economics of the Firm Analysis, evolution and history Edited by Michael Dietrich 29 Innovation, Technology and Hypercompetition Hans Gottinger 30 Mergers and Acquisitions in Asia A global perspective Roger Y. W. Tang and Ali M. Metwalli

31 Competitiveness of New Industries Institutional framework and learning in Information Technology in Japan, the U.S and Germany Edited Cornelia Storz and Andreas Moerke 32 Entry and Post-Entry Performance of Newborn Firms Marco Vivarelli 33 Changes in Regional Firm Founding Activities A theoretical explanation and empirical evidence Dirk Fornahl 34 Risk Appraisal and Venture Capital in High Technology New Ventures Gavin C. Reid and Julia A. Smith 35 Competing for Knowledge Creating, connecting and growing Robert Huggins and Hiro Izushi

36 Corporate Governance, Finance and the Technological Advantage of Nations Andrew Tylecote and Francesca Visintin 37 Dynamic Capabilities between Firm Organisation and Local Systems of Production Edited by Riccardo Leoncini and Sandro Montresor 38 Localised Technological Change Towards the economics of complexity Cristiano Antonelli 39 Knowledge Economies Innovation, organization and location Wilfred Dolfsma 40 Governance and Innovation A historical view Maria Brouwer 41 Public Policy for Regional Development Edited by Jorge Martinez-Vazquez and Franc¸ois Vaillancourt

Governance and Innovation A historical view

Maria Brouwer

First published 2008 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Avenue, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an informa business This edition published in the Taylor & Francis e-Library, 2008. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

# 2008 Maria Brouwer All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Brouwer, Maria. Governance and innovation / Maria Brouwer. p. cm. Includes bibliographical references and index. 1. Organizational change. 2. Economic development. 3. Institutional economics. 4. Political stability. I. Title. HD58.8.B758 2008 2007037741 658.40 063–dc22 ISBN 0-203-92951-9 Master e-book ISBN

ISBN13 978-0-415-43705-9 (hbk) ISBN13 978-0-203-92951-3 (ebk)

Contents

List of tables Preface and acknowledgments Prologue

viii ix xi

1

Governance and prosperity

2

Entrepreneurship and economic development

20

3

Organizations and uncertainty: the management of perceptions: from medieval Italy to Silicon Valley

44

4

Entrepreneurship and the state

61

5

Valuation and authority in failing firms: the role of reorganization in US and European bankruptcy law

81

6

7

8

9

1

Performance pay and uncertainty in entrepreneurial and bureaucratic firms

100

Executive pay and tenure: founding fathers, mercenaries and revolutionaries

120

Decision agents in corporate and political democracies: Venice, Florence and the Low Countries

141

Democracy and dictatorship: the politics of innovation

161

10 Waning and emerging empires Notes References Index

185 216 218 229

Tables

4.1

5.1 5.2 7.1

7.2 7.3 7.4

Financial development measured by stock market capitalization over GDP and the number of listed companies per million people, 1913–90 Outside finance as a percentage of GNP for five countries Creditors’ rights in five countries Comparison of compensation structures of Dutch CEOs of AEX listed companies in 2004 and of US CEOs of S&P 500 in 2002 Tenure data for founder/family CEOs Tenure data for non-family CEOs Average tenure of departed non-family CEOs, 1974–2005

77 84 85

129 130 131 131

Preface and acknowledgments

This book is the product of a journey that took me to several places and allowed me to meet many people. My stay in Amsterdam as a young student of economics was enlivened by meeting several people who guided me on my way. Tiny Fekkes-Peters, Suze Aleven, Madge Kalff-de Vries-Robbe´, Phia de Vries Robbe´-Polak and Jeanette de Vries Robbe´ were several of the noteworthy people I met then. My professional career started at Nijenrode Business School and from there to the University of Amsterdam with notable colleagues such as Rob de Lange and Derk Haank. My intellectual journey introduced me to Schumpeter’s writings on innovation, which resulted in a doctoral thesis and a book. After this, my interest in entrepreneurship took me to Boston on a study trip sponsored by Bert van Twaalfhoven, a Dutch entrepreneur. The visit to several venture capital firms during the Boston trip opened my eyes to the importance of finance for entrepreneurship. Several of my articles on entrepreneurship were published in Small Business Economics and I thank the editors Zoltan Acs and David Audretsch for their guidance. I also thank Albert Link, editor of the Journal of Technology Transfer, for his help in publishing my work. My interest in issues of management and strategy took me to Haarlem Business School and Nijmegen School of Management where I taught executive courses on Corporate Strategy and Organization Theory, and I am grateful to all my students for the interesting discussions we had. I would also like to thank the organizers of various Schumpeter Society conferences where I presented parts of the work: Stan Metcalfe (2000), Bob Lanzillotti (2002); Franco Malerba (2004) and Jean-Luc Gaffard (2006). Also thanks to EUNIP, Copenhagen Business School and the University of Antwerp for participation in their interesting conferences. Three papers that appear in this book were previously published in journals. ‘Weber, Schumpeter and Knight on Entrepreneurship and Economic Development’ was published in The Journal of Evolutionary Economics (2002) 12: 83–105. ‘Managing Uncertainty through Profit Sharing Contracts from medieval Italy to Silicon Valley’ appeared in the Journal of Management and Governance (2005) 9: 237–55, and ‘Reorganization in US and European Bankruptcy

x

Preface and acknowledgments

Law’, appeared in the European Journal of Law and Economics (2006) 22: 5–20. Thanks to Springer Publishers for their permission to republish these articles and editors Stan Metcalfe, Anna Grandori and Juergen Backhaus for their support. I also want to thank my students at the University of Amsterdam and especially Linda de Jong, Roderick Verkleij and Freek van Waveren whose theses contributed to Chapter 7 of the book. Yolande Vroons of the University of Amsterdam helped me prepare the manuscript. I also want to thank Routledge (Taylor & Francis) editors Terry Clague and Thomas Sutton for their support and assistance. Maria Brouwer, July 2007, Amsterdam

Prologue

The US government under President George W. Bush made the promotion of democracy and freedom a keystone of its foreign policy. However, there was less freedom in Venezuela, Russia and Thailand in 2006, according to a Freedom House report. Moreover, the performance of democratic countries was dismal in several instances. Nigeria, a formal democracy with an ailing economy, in spite of its rich oil resources is a case in point. Newsweek commentator Fareed Zakaria commented, ‘The basic problem facing the developing world to-day is not an absence of democracy but an absence of governance. This is what American foreign policy should be focused on’ (Zakaria, Jan. 29, 2007). Democracy thus is not enough on its own to create stable government that pursues peace and prosperity. This fact was also known by the people of the republic of Siena, who in 1297 commissioned Ambrogio Lorenzetti to paint frescoes depicting the ‘Allegory and Effects of Good and Bad Government’ on the walls of the Palazzo Pubblico. Good government was depicted as featuring an impartial judiciary endowed with wisdom and a city populated by virtuous citizens. Trade prospers under good government and the people are dancing in the streets. Bad government, by contrast, features crime, disease and a crumbling city. In the same vein, Ronald Reagan, in his farewell address of 1989, drew a picture of a shining city on a hill teeming with people of all kinds, living in harmony and peace; a city with free ports that hummed with commerce and creativity that was open to anyone with the will and heart to get there. The pictures of good government have not changed much in 700 years. Prosperity, peace and justice characterize good government. Both the Sienese and Reagan depicted good government by its results and not by its intentions. The question arises, how are these beneficial results created? The concept of governance refers to the allocation and exercise of authority (Zingales, 2000). Governance systems determine who is entitled to make decisions. Governance also indicates who is held responsible for the outcome of decisions and how this affects decision-makers. Governance encompasses both institutions and organizations. Institutions are ‘the rules of the game’ as recorded in laws and regulations. Examples of institutions are contract law, family law, property law, money and finance.

xii

Prologue

Economists agree that ‘good institutions’ are essential for economic development (La Porta et al., 1999). Upholding private property rights; the legal enforcement of contracts, an independent judiciary and a non-corrupt executive government branch promote economic growth. The same applies to an advanced financial and monetary system. Organizations are the players who play the game set by the rules. Democracy and autocracy are two political governance systems that differ with respect to how rules are made and decision-makers are selected. Democratic executives are elected for limited office terms at modest remunerations. They have to stick to the rules set by elected law-makers. Autocratic decision-makers, by contrast, obtain power by force or inheritance and have life tenure. They can change the rules without popular approval and use the country’s wealth for their own purposes. Democracy involves an open discussion of policies, whereas autocracy lacks open discussion. Leaders in both politics and business develop and execute strategies to achieve their goals. Executives only want to take risks, if expected profits outweigh losses. Commanders in chief, who win a war, can either seize the country or return home with a fixed pension. Successful business leaders can get a share of profits or a fixed salary. Modest remuneration should be paired with small losses in the case of failure. Executives in democracies and corporations do not have to give up their wealth or their life if their strategies fail. The stakes for failed autocratic leaders are usually higher. Democracies can elect a president with great authority or leave decisionmaking to a collective. Both democracy and autocracy can thus involve a single decision-maker. The same applies to the corporate world. Some corporations have a CEO, who is also chairman of the board, whereas others spread authority and responsibility over a larger group. Hence, both political and corporate governance show a rich variety of governance modes. Nations and corporations give up (some of) their authority, if they join an alliance or are acquired by another firm or nation. Historically, regional political entities were often subject to a higher imperial power. History records the existence of many empires from Mesopotamia to the British Empire and Germany’s Third Reich. Corporations also outgrew their home countries and expanded across national boundaries. Present instabilities of both political and corporate governance have spurred comparative and historical research on institutions and leadership. The law and finance literature points to the importance of ‘good for growth’ institutions and well-developed capital markets. The democracy and dictatorship literature wants to explain the evolution of government models (Acemoglu and Robinson, 2006, 2007). Historians like Niall Ferguson have investigated the characteristics of former and present empires. This book will add to this literature by studying the relations between individual motivation and the performance of organizations. Political and economic change is fueled by individuals who want to improve their station in life and that of their family. Initiative in the business world is often labeled entrepreneurship

Prologue xiii and is closely related to new business formation. Some societies promote entrepreneurship, while others forbid it. Freedom for political action also differs considerably among nations. Democracy features freedom of political organization, whereas dictatorship forbids it. But, freedom in the political and the economic realm do not need on a par. Democracies can curtail the freedom of business formation and curb international trade, whereas dictatorships can open their economies and allow the incorporation of new business.

Outline of the book Chapter 1 discusses the literature on globalization; democracy, empire and institutional innovation. Economic theory has developed the persona of the entrepreneur as the main economic ‘change agent’. The meaning of the term, however, has undergone some changes, as is recorded in Chapter 2, which discusses entrepreneurship in the works of Max Weber, Joseph Schumpeter and Frank Knight. Weber’s original work on medieval maritime enterprises distinguished between the financier as the principal and the leader of the venture as his agent. However, decision-making was not restricted to the principal as the captain had to use his own judgment in situations of contingency. Chapter 3 discusses Weber’s treatise in the light of modern principal-agent theory. Chapter 4 expands the analysis of maritime ventures to the Dutch and English Indian trading companies and discusses the role of the government in European entrepreneurship. Risk-sharing contracts and limited liability arose in the medieval citystates and spread to the rest of Europe. Limited liability is essential to modern bankruptcy law. Chapter 5 discusses changes in bankruptcy law in the US and some European countries. Chapter 6 investigates the use of incentive pay in small and large firms. Incentive pay is a feature of entrepreneurial firms that are subject to large uncertainty. Large incumbents can better diversify their risks and practice fixed pay. Promotion can be used to stimulate employee motivation, but will not work, if the outcome is known beforehand and if it is independent of performance. Chapter 7 discusses recent changes within the corporate world, involving CEO compensation and tenure. CEO tenure has been considerably shortened, while remuneration has increased. These developments can be explained by the increased responsibility of CEOs for performance, more than was common in the past. Chapter 8 discusses the political evolution of the Italian city republics and the Low Countries in the late Middle Ages. Florence and Venice developed new governance models that ranged from direct democracy to guild democracy and dictatorship. The call for a strong man prompted Florence to push democracy aside at several points in its history. The same happened in the Low Countries, where military leadership prevailed. This

xiv Prologue was not the case in Venice, where responsibility for military ventures was shared among appointed generals and elected executives. Chapter 9 discusses some appropriation models and their relationship to innovation. Autocrats can appropriate a surplus by monopolizing markets, paying people less than their market worth or by innovation. Innovation thrives on competition and is hardly reconcilable with autocratic allocation. Chapter 10 discusses the evolution of past and present empires. It discusses the relationship between empire and democracy and raises the question whether empire is still a viable governance model in our days.

1

Governance and prosperity

Institutional innovation Institutions, as the rules of the game, structure human interaction. Institutions need to be distinguished from organizations, who are the players of the game. Institutional change emerges out of the interaction between organizations and institutions (North, 1990: 70). The type of organizations that emerge in certain periods and places is largely determined by rules and regulations (ibid.: 5). Institutional change also occurs when people break the rules in crime or by regime change. The type of institutional change thus depends on the type of organizations that come to the fore in a legal or illegal manner. Organizations like the trading companies emerged in medieval Italy to finance maritime ventures. Liability problems arose that could not be solved by existing laws. New concepts like limited liability emerged out of discussions on how to solve the problems in a manner that satisfied all parties. Representative democracy emerged in city-states to curtail the authority and liability of political decision-makers. New organizations that undermine peace and prosperity are war gangs and exploitative autocracies. North argues that institutions exist to reduce the uncertainties involved in human interaction (ibid.: 25). People will abide by rules, if they know if they are applied judiciously. Certainty in this area facilitates human interaction, but uncertainty can also have positive effects. Certainty about the coming of disaster will paralyze people, whereas uncertainty will prompt them to change the odds in their favor. Likewise, people will stay passive, if they fear the outcome of their actions, but will jump at new possibilities if they expect gains to outweigh costs. Traditional societies inflicted grave consequences on those violating tradition, which kept society stable though stagnant. Modern societies diverge from tradition and create room for initiative. Nontraditional organizations like cities and corporations have developed new codes of conduct that encourage experimentation and innovation. North argues that institutional change is driven by transaction costs. The gains from trade that generations of economists have modeled are reduced by the costs of exchange. Transaction costs involve the costs of writing

2

Governance and prosperity

contracts, but also the problems of moral hazard. Parties to a contract want to maximize their own objectives regardless of how these affect others. Employees want to shirk; suppliers want to provide lousy products; employers want to exploit employees and sellers want to monopolize markets. Moral hazard increases the risk premium to transactions and curbs investment (ibid.: 33). But uncertainty due to moral hazard needs to be distinguished from uncertainty that springs from uncontrollable forces like competition. We do not want sports teams to control the outcome of a game; likewise we do not want companies to control the market. Ventures may fail beyond the fault of the parties involved; markets may clear at prices below costs; competitors may appear on the scene causing the demise of a company. Competition makes the outcome of investments uncertain but this type of uncertainty bolsters the trust in the fairness of the game, whereas uncertainty due to moral hazard can spoil the whole game. Investment is ultimately based on the expectation that parties to a contract will put in an effort to meet their obligations. Otherwise, we have to create a command economy, in which each person fulfills prescribed activities under close supervision. Such arrangements will hardly turn out to be profitable. Moreover, they will stifle innovation, which is based on investments in novelty. Innovation requires a discourse on how to improve things. Ideas will only carry weight, if people are deemed loyal to the organization. Organizations have developed several ways to cope with moral hazard. Novices had to swear an oath before they entered a monastic order. Guild members had to go through a period of training before becoming master. Modern business corporations have developed new ways of control, such as behavioral codes, performance pay, corporate training and rituals to cement a common corporate culture. Investment and trade thus assume that organizations find ways to curb moral hazard. This applies with the greatest force to organizations that surpass national boundaries. However, some eras were more conducive to international trade and investments than others.

The ebb and flow of globalization Globalization involves a process of expanding world trade and increasing the mobility of production factors. Investors nowadays move their capital around the globe at lightning speed; people leave their hometowns to move to domestic or foreign cities to flee poverty and political turmoil. Some people abhor globalization because of the alleged exploitation of people and the environmental damage it would cause. It is argued that globalization widens income differences both within and between nations (Hardt and Negri, 2000). Large multinational corporations would replace indigenous industries. Local communities would lose their cultural identity and submerge in Western mass culture. Others contend that globalization creates opportunities for the many who have been excluded from prosperity up till now and consider it the ultimate vehicle of emancipation.

Governance and prosperity

3

Globalization is also assumed to affect politics. Nation-states are assumed to wither away and a new empire would emerge that obeys the dictates of the large multinationals and pushes democracy aside (Forrester, 2000). Others argue that small ethnic enclaves and city-states are arising in the aftermath of the collapse of the Soviet Union (Kaplan, 2000). The political effects of globalization are thus not undisputed. Some see nations disappearing due to emerging empire, whereas others foresee political fragmentation due to waning empire. History shows periods of rise and fall of long-distance trade. Trade was more extensive in ancient Greek and Roman times than in the early and high Middle Ages (400–1000 AD). Trade peaked in the nineteenth century and declined after World War I to rise again after World War II. The 1913 level of trade was only restored in 1973 (Krugman, 1995). Historically, trade surged, when cities grew, whereas the decline of cities coincided with a decline of (longdistance) trade. This applies to the cities that arose in the river valleys of Sumeria, Mesopotamia and Egypt. Maritime civilizations such as those of Phoenicia and Greece endorsed the rise of autonomous city-states. Greek citystates obtained autonomy after the Mycenaean Kingdom fell apart. Trade flourished in Athens of Antiquity and Athenian colonies were established along the Mediterranean coast. Some Greek city-states spawned democratic government, such as fifth-century BC Athens. Not all Greek city-states, however, furthered commerce and democracy. Corinth was ruled by a small aristocracy; Sparta by two kings and five ephors. Trade played a minor role in the economies of both Corinth and Sparta (McNeill, 1963: 202). However, Athenian democracy was not stable; Athens repeatedly altered the ‘rules of the political game’. Tyrants overthrew democratic government and installed autocratic rule. Oligarchs threatened Athenian democracy in 411 and 404 BC in an attempt to reduce progressive taxation. Inter-city warfare also undermined city-states. Athens was beaten in the Peloponnesian War after Sparta had concluded an alliance with her enemies (431 BC). Military defeat brought the end of Athenian glory. Many colonies chose Sparta’s side and the ones that had supported Athens were overrun by Sparta’s allies. The feelings of solidarity that had characterized Greek city culture disappeared in the wake of defeat. Thucydides recorded how Athenian society was divided into camps of friends and enemies. Sophists and other Greek philosophers put Athenian leadership under heavy scrutiny after the defeat. Plato (427–347 BC) wanted to cure Athenian society by abolishing all economic and social change. Everybody in his Republic carried out his hereditary duties as slave, soldier or aristocrat. The slaves labored, the soldiers fought and the aristocrats ruled. Freedom of speech was limited. Plato’s idea of social and cultural ossification to ward off change was not novel and was practiced by many later civilizations that preferred stability to innovation. Greek cities lost their independence in the Hellenistic period. The freedom of the cities of Antiquity was swept away by a bureaucratically organized world (Weber, 1978: 335). Overseas trade declined and the countryside gained political weight.

4

Governance and prosperity

The example of Athens illustrates how city-states rose and fell due to internal and external causes. The same applied to old imperial civilizations, whose existence was threatened by recurrent barbaric invasions and cultural ossification. The need for river regulation and an irrigation policy in the Near East and in Egypt, and to a lesser degree also in China, caused the development of royal bureaucracies (ibid.: 1261). The bureaucracy was charged with construction tasks and with the organization of the army. The Mesopotamian King Hammurabi, whose empire extended from the Mediterranean to the Bay of Bengal, founded the first royal bureaucracy and codified existing law (the famous Hammurabi Code). His royal judges, tax collectors and garrison commanders were sent all over the empire and he communicated with them by way of written reports. The development of a written language and of codified law greatly facilitated trade. Merchants could reckon on a universal judicial system and on royal military protection. The market mechanism arose as a new coordinating device distinct from command, but this period of economic and cultural bloom was brief. Stagnation set in round 1500 BC, when officials were required to undergo long periods of training, which ‘could scarcely fail to produce in each successful pupil a thoroughly conventional mind. Schools became jealous corporations, guarding both professional standards and professional privileges with an impartial rigor. Science – especially mathematics – which had flourished under Hammurabi, came to a standstill.’ (McNeill, 1963: 60–1). Sailors from Phoenicia ventured as far as Britain and the Atlantic coast of Africa. However, Babylonian culture was deeply conservative and the cultural bloom of Hammurabi’s days was never restored (ibid.: 136). Literature was only available in old styles of writing. Simplified scripts were developed for commercial purposes but were not used by the ruling elite. The Mesopotamian valley civilization reached its end, when nomadic tribes invaded the empire, which then broke up into many smaller states. Imperial rule was re-established, when local warlords submitted to a successful leader. Hammurabi’s laws were re-established and trade revived. The Persian Empire succumbed to barbarian attacks in 200 AD. Nomadic tribes also overran India and China on several occasions; most notable were the raids by Genghis Khan. The same applies to Ancient Rome, whose decline was hastened by Hun invasions. Nomadic steppe peoples distinguished themselves from civilized societies by their lack of investments in infrastructural works, such as temples and palaces. However, nomadic societies were capable of military and organizational innovation. Warriors were not highly esteemed in oriental literate civilization, but military prowess was considered the main virtue of a man in the nomadic war bands. Many civilizations could not overcome the steppe peoples, once they had organized themselves in a confederation of tribes. A charismatic leader such as Genghis Khan could overcome tribal differences and organize people under his leadership. The horse-mounted nomads constituted a rather egalitarian society during periods of war. This changed, when they

Governance and prosperity

5

settled down in the conquered territories and changed to more permanent organizations. Both city-states and imperial bureaucracies established institutions conducive to trade. This does not apply to feudalism. Feudalism was first introduced by the Parthans in 400 BC, who established military aristocracies to supervise provinces. Aristocratic titles were first granted to the most courageous and successful warriors, but became hereditary later on. A peasant village provided sufficient income to a lord, who – in turn – defended his subjects against nomad attacks. Feudal organization was not conducive to long-distance trade due to contributions in kind made by its subjects. Feudal military organization was better equipped to ward off foreign invasions and suppress domestic rebellion than a bureaucracy. Feudal lords were eager to expand their territory. However, feudal strife would weaken stability and create tensions between emperor and local rulers. Mercenary and slave armies were sometimes used to counterbalance local feudal military power. Religious authority was also invoked to strengthen central authority. Another device to overcome the inherent tension between centralization and decentralization was to move the aristocracy to the capital for at least part of the year. The feudal model was adopted by the Byzantine, Carolingian, Arab and Ottoman Empires. The military success of Islam was due to the confederate tribal factor, which remained important in the first centuries of Moslem rule. Islam rewarded its warriors in a feudal manner and adopted feudal organization and ethics (Weber, 1978: 624–6). Several Moslem empires or caliphates existed. The last was the Abbasid Caliphate – located in Baghdad – which lasted from 750 till 1258, when it fell due to Mongol and Turkish invasions. The Moslem world then fragmented into many local lordships. The period of political fragmentation ended, when the Ottoman Empire espoused Islam. The exploitation of feudal fiefs constituted the most profitable enterprise in the Ottoman Empire and the locus of power resided in the countryside. Only a few towns in Anatolia and Iran approached the autonomy of the free towns of Europe during the same age (McNeill, 1963: 496). Central power was supported by a slave army of converted Christian boys from the Balkan, the Janissaries. Trade flourished in the Roman Republic, but the Empire replaced trade privileges by the distribution of land to the military. Land ownership became hereditary in imperial Rome and tributes to the state took the form of either compulsory contributions or compulsory labor. The entire grain harvest was distributed to the cities according to their needs; surpassing the market mechanism. Trade revived in the late medieval and Renaissance period, when citystates such as Venice, Florence, Antwerp and Amsterdam prospered due to overseas trade. European globalization developed by fits and starts after 1500. The Italian city-states were succeeded by Holland and Britain as the main maritime powers, which – in turn – were superseded by rising powers

6

Governance and prosperity

like the United States, whose growth surpassed that of Great Britain in the nineteenth century. International trade peaked in the nineteenth century and declined after 1913, when protectionism and mercantilism recurred. Capital also flowed freely between the continents in the nineteenth century and World War I constituted a watershed in this respect. The recent wave of globalization thus does not constitute a new phenomenon. Each new wave of globalization has occurred when new organizations emerge that thrive on trade. Both political fragmentation and integration can spur trade. The decline and fall of the Mycenean Empire and the Roman Holy Empire gave rise to city-states that reinvigorated trade. The British Empire promoted trade in the nineteenth century. The question whether either a strong empire such as the British Empire or a weak empire such as the Holy Roman Empire promotes trade and growth has not been answered unequivocally. The answer varies according to time and place, depending on the new organizations it spawns.

The end of history? The collapse of the Soviet Union in 1989 inspired some people to predict the end of the ideological quest for dominance. Liberal democracy had become the uncontested government of choice of millions of people around the globe, preferred to monarchy, communism and fascism (Fukuyama, 1992). People were to be organized in nation-states, whose relations were peaceful and based on the principle of mutual recognition. Autocratic regimes based on ideologies like communism and fascism had proved to be unsuited to cope with the exigencies of post-industrial society. Hence, there is no alternative to liberal democracy and capitalism in our times. Democracy expresses the equality of all citizens and therewith calls for the end of dominance both within and between nations, in Fukuyama’s view. The desire for recognition and prestige had driven people into bloody battles for domination in the past, making masters out of victors and enslaving the conquered. This Hegelian interpretation of history leaves no other distinction between people than that of victor and victim. However, the French and American Revolutions created opportunities for all people to become equal citizens in a democracy. Liberal democracy replaced the irrational desire to be recognized as greater than others with a rational desire to be recognized as equal (ibid.: xx). With equal and reciprocal recognition the reasons for tyranny and imperialism would end too, as nobody wanted to impose their will on others. Without the desire for superiority, history would witness its ‘last man’: a person without ambition. The end of history would thus entail the end of progress. Fukuyama’s Hegelian analysis of people’s motives is somewhat limited, in my opinion. The same applies to his analysis of democracy. I want to argue that although liberal democracy is based on the ex ante political equality of individuals, this does not need to imply that each person has equal authority.

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7

Some people rise to leadership, whereas others lack decision-making power. Some people gain wealth, whereas others do not. Fukuyama limits ‘recognition’ to the military powerful, whose superiority is ‘recognized’ by weaker people, but such ‘recognition’ is shallow, as it is involuntary. ‘Recognition’, in a liberal sense, refers to political and corporate leaders that are chosen. Democratic political leaders are chosen by the many, whereas entrepreneurs are initially chosen by a few investors. Investors in art and business gain, if they discern value before others do. Such ‘recognition’ is the main source of capitalist profits. It requires that investors hold different views on the value of a certain person or project. We could argue that ‘recognition’ is the essential ingredient of capitalism, which created a new peaceful game creating winners and losers, but benefiting all. Investment decisions are tested by the market, which can prove them wrong. An investor can refuse to invest in a certain venture, but is proved wrong, if other investors turn it into a success. Employers can refuse to hire certain workers, but will pull their hair out, if they become the star of their competitors. Economic theory points out that homogenous labor receives equal rewards but human capital is heterogeneous from the perspective of a business organization that wants to select those individuals that fit its organization best. Education is only an imperfect predictor of the value of human capital for a certain organization. Business firms, therefore, turn to unorthodox ways to select their favorite employees as Google did, when it developed an algorithm to select its employees, instead of relying on interviews and educational achievements. Liberal democracy is thus all about diversity and not the bland, homogenous soup of Fukuyama’s description. Liberal democracy can only achieve higher per capita growth, if its innovative powers exceed that of other governance systems. Innovation involves the introduction of novelty in economic life, whose value exceeds that of former ways of doing things. Successful innovation generates profits for investors and value for consumers. Liberal democracy has to be better at discovering the best people with the best ideas to out-compete other governance systems. Market competition forces firms to look for yet undetected human capital. The discrepancy between ex ante valuation and ex post realization generates profits and losses. Economic competition makes social positions volatile and therefore differs from feudal and bureaucratic governance, where a person’s fate was largely determined at birth. Only a few individuals could improve their position by joining the military or entering the royal palace. There were wars and battles, victories and defeats, but the greater part of the population remained unaffected by these changes. They tilled the land according to time-honored traditions, on subsistence incomes. Surpluses accrued to local and far-off rulers; shortages caused famines. Traditional societies largely lacked incentives for innovation and can be described more as a population of last men than our modern post-industrial society. Liberal democracy that offers incentives to individuals to improve their lives can better be described as a society of first men and women.

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Fukuyama’s analysis rests on the premise that the ‘best’ political system wins the contest, which ends the game. He argues that fascism was defeated together with Hitler, after which fascism lost its appeal and legitimacy. The collapse of the Soviet Union points to the economic defeat of communism. However, Fukuyama’s argument entails that democracy could also lose its appeal and be superseded by a new ideology or a militarily superior power. His argument of the end of history thus depends crucially on both the economic and military superiority of liberal capitalism. Arguably, capitalism won the race for production figures during the years of the Cold War, but has not yet won the hearts and minds of everyone.

The stability of democracy Francis Fukuyama predicted the end of history and the permanent success of liberal democracy. However, democracy has proven to be a rather unstable form of government. This applies to antiquity but also to modern democracies. History does not seem to support the hypothesis that democracy entails the ‘end of history’. The French Revolution did not mark the beginning of the end of history for France, but brought Napoleon and his drive for imperial power. The American Revolution did not prevent the occurrence of the American Civil War. The road to the end of history also made many detours in the twentieth century, when many European nations fell prey to autocratic regimes of both the Right and the Left. Fascism was based on the denial of the equality of all men and assumed the existence of a master race. Communism was based on the equality of all men, but some were more equal than others. Political leaders wanted to replace the vagaries of the market by state control of the economy and incomes. Consequently, people’s lives were put in the hands of a single authority, which turned out to be more interested in finding hidden enemies than hidden talent. The relationship between democracy and prosperity is also puzzling. Democracy was found to be positively related to per capita income (Lipset, 1959). The relationship between democratization and economic growth, however, is less obvious (Acemoglu et al., 2005). The positive relationship between democracy and income can be explained by the fact that, historically, democracy was the preferred governance model of commercial societies. Democratic government first arose in commercial city-states such as Athens, Venice, Genoa, Florence and the cities of the Low Countries. These governments were ruled by wealthy merchants, who wanted to preserve the rules of the game and protect property rights. The twentieth century featured many rapid movements from democracy to dictatorship and back in many countries. Many newly established democracies were unstable and fell prey to coups and revolutions. The history of Argentina is a case in point. Democracy was set up in Argentina in 1912, but a military coup led to the Peron era and a military regime. No Latin American democracy was stable in the twentieth century. The same

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applies to many Sub-Saharan democracies that emerged in the wake of decolonization. The development path of these newly founded democracies differs from British experience, whose democracy – once installed – was never threatened. Continental Europe, however, saw democracy alternate with dictatorship during the twentieth century in most continental European countries. We can argue that democracy provided new instruments for resolving disputes; such as the majority vote and consensus-building instead of using physical force. Yet, political disputes, which cannot be repressed, as in autocratic regimes, can destabilize democracy. Such disputes are not always resolved by parliamentary discussions, as the many regime changes in democracies in the past centuries testify. Hence, democracy carries the seeds of its own destruction in military coups and revolutions. Moreover, democracy can be abolished by democratic means. Democratically elected leaders can extend their tenure by decree. Such processes of aggrandizement could be witnessed in Germany, the Philippines, Zimbabwe and a host of other countries. Democracy is called stable, if it is not defeated by a foreign power or overthrown from within. The instability of democracy seems to follow naturally from the ever shifting balance of power between a rich oligarchy and a less well-endowed mass. Acemoglu and Robinson modeled coups as attempts by minorities (elites) to impose their will on the majority. Elites are always outvoted in democracies, since people’s opinions are derived from their economic position (Acemoglu and Robinson, 2006: 211). The poor would always outnumber the rich in societies without a middle class. The logic of the ‘median voter’, therefore, impels the masses to support revolutions that expropriate the rich and elites to support coups. Change of government would spell the end of the old game and the start of a new one on a clean slate! The analysis of Acemoglu and Robinson, which is based on the distribution of the national produce according to either majority rule or military force, is not representative of liberal democracy, in my opinion. That is because the market as an allocation and distribution mechanism is largely absent in their models. Acemoglu and Robinson’s models are based on the assumption that distribution is determined by politics, i.e. the tax rate. The fear of the wrath of the masses forces ruling elites in dictatorships to distribute some of the national product to the poor in order to keep them from overthrowing the government by revolution. Hence, the revolution constraint would stop the ruling elite from complete expropriation. Moreover, a revolution would diminish the national product due to the destruction of assets (ibid.: 121). Acemoglu and Robinson model revolutions as a collective action problem; some will undertake revolutionary activities for the benefit of the many. Hence, revolutionaries are scarce due to the public good character of revolutions and the inherent ‘free rider’ problems (ibid.: 123). Yet this seems to ignore the fact that many revolutionary leaders

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Governance and prosperity

assume political leadership after they succeed in overthrowing the incumbent government. Lenin, Mao and Fidel Castro became leaders for life. Moreover, many former revolutionaries were not ‘rewarded’, but were eliminated as they posed a threat to single political leadership. Revolutions and coups need to offer ‘glittering prizes’ to the few who succeed in grasping power in a post-revolutionary society. A failed politician in a democracy loses his job, but not his wealth or his life. However, failed attempts at absolute rule carry great risks of losing both property and life. We could, therefore, argue that revolution does not suffer from a free rider but from a high risk problem. Democracy introduced the concept of limited liability into the political realm. Dictatorship, by contrast, raised both the rewards and the risks of political entrepreneurship. Dynastic rule can stabilize autocracy. Stable democracy, by contrast, does not depend on individuals, but on institutions.

Democracy versus oligarchy Alexis de Tocqueville, who wrote a perceptive analysis of early American democracy, also identified democracy with equality. US incomes were rather equal at the time of his visit to the US in 1831–32. We can argue that the US economy at the time consisted of small enterprises, which did not allow great differences of wealth and income. Anyway, De Tocqueville was struck by the equality of condition that he found there. Another of his observations involved the degree of organization by voluntary associations in both politics and business. He perceived the US as a society without an elite, and therefore characteristically different from oligarchy. He foresaw that equality would also be Europe’s future. De Tocqueville, who was born into a French aristocratic family that survived the French Revolution, compares US democracy to oligarchy, which had prevailed in France during the 700 years before the Revolution. The French territory came to be ruled by a small number of families with hereditary succession. Equality increased in this feudal context by the opportunities for advancement opened by the Church and commerce. Consequently, military prowess became less important over time; education paid off and the value of nobility depreciated (De Tocqueville, 2001: 26–7). The Crusades limited the number of nobles and their possessions. Eventually, all privileges were abandoned and royal power increased. His analysis describes how oligarchy gave way to single rule in France. The French Revolution toppled this structure and installed democracy, which was, however, of an unstable nature. He attributed the several regime changes that occurred in post-revolutionary France to be flowing from two different tendencies, which arose in the French Revolution. The first was favorable to liberty, as it loosened the absolute power of the monarch. The second was favorable to despotism as it did away with provincial institutions and installed centralized administration (ibid.: 71). The remnants of feudalism that were present in France before the Revolution gave at

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least some people a voice. They could hold a dissenting opinion, since their possessions and hereditary title made them largely independent of royal power. Only independent people can hold an opinion of their own in De Tocqueville’s analysis. Their independence derives from the fact that they cannot lose their title and possessions. The question, however, arises whether these magistrates were also responsible for their opinions. Moreover, De Tocqueville does not answer the question how many divergent opinions can lead to one decision. This might have been superfluous in French oligarchic government, if oligarchs had jurisdiction in their own estate. It seems, however, doubtful whether such decentralized government could curb the evils of arbitrary power. People could only escape arbitrary power by moving to another jurisdiction. De Tocqueville argues that a centralized democracy can entrust all decision power to a single person, chosen by the people. He predicts that representative government will fall prey to what he calls ‘the tyranny of the majority’. He here touches on the heart of the governance problem; the effects of leaving decision-making to one or a few persons. Both nobles and kings were infallible in the oligarchic system; if something went wrong; it was blamed on the advisers. De Tocqueville suggests that the democratic leader cannot fail either, because he represents majority opinion (which in his view is crafted by the press). Nobody would want to deviate from majority opinion in a democracy at the expense of total isolation. De Tocqueville sees two antidotes to this tyranny of the majority. The first involves the decentralization of government, which leaves some decisions to local government. This would open up possibilities for people to choose their own jurisdiction. People can thus vote with their feet, if democracy allows freedom of movement. Another mechanism for institutional improvement involves the way the US judiciary operates. De Tocqueville describes how US judges can diverge from general principles by declaring that a decision along these lines in a certain case would violate the Constitution (ibid.: 73). Hence, an individual judge can rejuvenate the law by offering a new interpretation. De Tocqueville was most struck by the abundance of associations he found in the US. He points primarily to political associations, which in contrast to Europe were largely peaceful; they wanted to convince and not to fight (ibid.: 100). Freedom of association extended to the economic realm, where people were free to found their own businesses. Freedom of association heightened motivation, in his view, because people could choose their own organization, which unleashed the energy of multitudes. De Tocqueville considers freedom of association the main comparative advantage of democracy. The disadvantages lie in the realm of culture and quality. His aristocratic background led him to presume that art that is made for the masses must be of a lower quality than art produced for elites. He applied the same analysis to science. The detached scientist of former days, who was more interested in general principles than in practical solutions, would not thrive in a democratic society, in contrast to oligarchic

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society. His assumption that a hereditary elite would always feature the best and brightest seems beyond the mark. However, his idea that people whose position is secure are more inclined to speak their mind freely contains some truth. However, their opinions are uncontested in the absence of competition.

The end of empire? Both Fukuyama and De Tocqueville saw democracy as the government of the future. Niall Ferguson, however, advocates a return of empire. He argues that the end of history will not come, since the struggle for mastery is both perennial and universal (Ferguson, 2004: xxii). He advocates empire as the governance model of choice, since history shows that the absence of a world power leads to the darkness of anarchy. Ferguson discerns a period of a-polarity that prevailed between 843 and 1095 AD, when the two halves of the Roman Empire – Rome and Byzantium – had passed the height of their power and imperial power in the Abbasid Caliphate and imperial China was on a steep decline. He describes this period as one in which people were inward-looking instead of outward-looking. The a-polar period constituted the antithesis of globalization. The world was broken up into disconnected, introverted civilizations, which were susceptible to raids on urban centers by less civilized people such as the Vikings (ibid.: xxvi). However, not all empires are considered beneficial. Ferguson distinguishes between liberal and illiberal empires; the former promotes trade, while the latter curbs trade. Liberal empires establish and enforce the ‘rules of the capitalist game’ on territories under their jurisdiction. International trade requires that both parties agree on the rules of the game. This can be accomplished, if both nations adopt one set of rules, or when nations mutually recognize each other’s rules. Institutions can also be imposed on people by an imperial power. Foreign investment is hampered, when nations are expected to change the rules and declare former obligations null and void. Twentieth-century empires defaulted on their debts and introduced new laws that expropriated people. Drastic institutional renewal also occurs in democracies that redistribute wealth. Expected, institutional instability hampers economic growth, as it adds a risk premium to investments. The British Empire was able to eradicate the risk premium on foreign investments by removing the risk of default. Bond yield figures for Indian bonds were below 4 percent in between 1870 and 1914 (ibid.: 191). Empire was a better guarantee than adherence to the gold standard, which did not prevent countries from defaulting on their debt. Argentina defaulted in 1888– 93 and Brazil both in 1880 and 1914. Consequently, Argentine bond yields were more than 200 basis points higher than Indian yields in the pre-World War I period. Hence, the British Empire boosted investment. A large number of developing nations defaulted on their debts after 1945. Consequently, investments in poor countries have decreased to a much lower level than was the case before 1914 (ibid.: 189). New institutions such

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as the World Bank and the International Monetary Fund (IMF) could not change this trend. Liberal and illiberal empires differ with respect to their attitude towards trade, but most empires were multi-ethnic. Some empires made government the reserve of an ethnic master class; other empires allowed subjects of various origins to move up the ranks of military and government bureaucracies. Non-Romans could reach high positions in Ancient Rome. But the possibilities for upward social mobility of subject people were far from perfect in most empires. Access to the elite was largely determined by birth. Some bureaucratic empires used learning as a method of ascent; China and Byzantium are cases in point. Feudal empires used military prowess, but entry into the ruling elite was restricted and the vast majority lacked any possibility of social improvement. Another question involves the extent to which liberal empire improved the living standards of people under their rule. The figures of nineteenthcentury British rule are not unequivocally positive. Indian per capita income more or less stagnated under imperial rule; it grew by only 0.12 percent per annum between 1820 and 1950 (ibid.: 194). This differed considerably from the growth in the British Dominions (Canada, Australia) and the United States. Moreover, growth in the Dominions also largely surpassed that of Great Britain. India’s meager growth occurred in spite of large capital exports to India to build railroads and other infra-structural works. True, India did better under British rule than China at the time and India’s economic performance deteriorated after becoming independent (ibid.: 175). The same rather bleak performance of British imperialism appeared in Egypt, whose years under British rule (1882–1956) were characterized by stagnant per capita incomes (ibid.: 222). This also happened in spite of large capital exports from Britain to Egypt. The primary reason for British involvement with Egypt was the protection of British investments and of safe passage for British ships through the Suez Canal. The British had heavily invested in Egyptian government bonds, which would lose their value if the country was unable to repay its debts. Ferguson argues that Britain acted in the same way as the IMF does today with bad debtor nations; they reorganize the debt and put good policies in place. But Britain could bolster their policies by naval force, unlike the IMF. The economic successes of nineteenth-century British imperialism were thus underwhelming. This differed from the performance of nations that had just become independent, such as the Latin American countries, which gained independence at the beginning of the nineteenth century. These grew as rapidly as the US in 1870–1913. Independence or promotion to commonwealth status, which signaled the achievement of maturity as a nation, spurred economic growth. We can argue that the British, Dutch, French, Spanish and Portuguese Empires had outstayed their economic welcome. Nationalist groups in both India and Egypt expressed their desire for independence in an increasingly forceful manner. But many nations, after gaining

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independence, choose economic isolation instead of pursuing trade. Moreover, they are subject to coups and subsequent regime changes, which deter foreign investment. The dismal performance of many independent nations seems to indicate that imperial rule is preferable. Ferguson considers the present predicament of many nations as a failure of de-colonization. Many new nations were not up to the job of nation- and institution-building and instead fell prey to ethnic clashes and corrupt government, which transferred a large share of international aid monies to foreign bank accounts (ibid.: 180). The consequence of political instability was that capital flows have been diverted from the poorest nations to developed countries and emerging countries in Asia, like India and China. Britain invested four times as much in Africa in 1913 than in 2000. But Britain invested even more in independent countries in the Americas than in Africa and Asia in 1913 (Ferguson, 2003: 244). The question, whether the world needs a new liberal empire could thus be answered in the negative, if we look at nineteenth-century data. The question only gains relevance, if we compare it to twentieth-century performances of independent nations. Ferguson has selected a successor to British imperialism; he considers the United States the best candidate for the job (Ferguson, 2004: 301). The US, however, has no imperial ambitions. It is an empire in denial that does not want to occupy nations. However, Ferguson argues that the few successes of US attempts at nation-building after 1945, i.e. Germany, Japan and South Korea, involved lengthy occupations and large military deployments. We could argue that the three countries mentioned above crafted development models of their own. The three countries opened themselves up to trade, but kept foreign direct investment largely at bay. This differed from the nineteenth-century development model, which thrived on foreign investment. The late twentieth century saw a revival of foreign direct investment, when India, China and other emerging economies countries were opened up to foreign direct investment.

Ethnicity as an organization principle The break-up of twentieth-century empires triggered the formation of independent nation-states and the rise of new empires such as Nazi Germany, the Soviet Union and Japan. We could argue that the twentieth century saw the fruits of nineteenth-century liberalism go sour. The promise of independence and equality that looked so shining in 1913 was smothered in wars and revolutions that entailed the rise of murderous dictatorships. The twentieth-century empires were short-lived in contrast to former ages, when empires lasted for hundreds of years. Both Byzantium and the Holy Roman Empire existed for more than thousand years. The Ottoman and the Habsburg and Roman empires existed for more than 300 years. The Dutch, British, Spanish and Portuguese maritime empires also existed for hundreds

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of years (Ferguson, 2006: lxiv). The Soviet Union lasted less than 70 years; Hitler’s millennial empire only seven years (1938–45). The twentieth century also witnessed the birth of nation-states based on ethnic identity, which signified a departure from multi-ethic empire. Ferguson ascribes the rise of ethnic nation-states after 1900 to the backlash to assimilation that emerged at the end of the nineteenth century, when people came to sort themselves according to ethnicity. Ethnicity is defined as ‘a combination of language, custom and ritual inculcated in the home, the school and the temple’ (ibid.: xlvii). This definition makes ethnicity similar to culture. However, a culture that is determined at birth and not by choice. Ethnicity as an organizational principle is diametrically opposed to organization based on voluntary association. Ethnicity can influence organizations in several ways. Organizations can give people of various ethnic origins equal rights, which can result in an equal distribution of leadership positions among ethnic groups within organizations. Organizations can also prefer one ethnic group to others, which results in a subordinate position of some ethnic groups, as prevailed in many empires. Ethnic preference can also lead organizations to exclude people of different ethnic origin. Exclusion can also take different forms. Ethnic groups can build their own organizations within larger political entities. Both government policies and a preference for within-group marriages (endogamy) contributed to the model of ethnic self-organization that prevailed in many societies. This model was discernible in the US, where ethnic communities had their own business enterprises, churches, schools and neighborhoods. Self-organization and segregation were also common in Europe, where Jews, Armenians and other minorities lived in their own quarters. This dates back to old city-states such as Venice and Constantinople, where ethnic communities lived segregated lives; sometimes voluntarily, sometimes involuntary. The model of ethnic self-organization has some drawbacks, as it locks people into their indigenous culture. Ethnic communities are basically involuntary associations, as they organize people according to inalterable characteristics and, therefore, lack free entry and exit. The closed character of ethnic organizations made them prone to crime, as in the Mafia. Another model of ethnic exclusion came to the fore around 1900, when ethnic groups wanted to establish their own nation-states. Ethnic groups like the Greeks, Italians, Germans and Romanians established their own nation-states at the beginning of the twentieth century. Others, like the Armenians and the Jews, aspired to do so. Ethnic differences, which had played a part in empires, were exacerbated in the new nation-states. Minorities which were predominantly occupied in commerce lost the rights of self-organization that had prevailed in empires, where they could live by their own (family) laws. The principle of self-determination introduced by the American President Wilson at the Peace Conference of Versailles at the end of World War I involved nation-building based on ethnicity. The treaty concluded at Versailles ceded part of German imperial territory to Denmark, Poland, Belgium

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Governance and prosperity

and France. The treaty also involved the foundation of Czechoslovakia, Poland, Hungary and Yugoslavia as nation-states. Danzig became a ‘free’ city under the protection of the League of Nations. Poland expanded its territory beyond that of the treaty by wars against Russia, Ukraine, Lithuania and other countries. However, these new nation-states had sizable ethnic minorities, particularly Germans and Jews. Self-determination thus had its limits. It obviously did not apply to the United States, which was a multiethnic society. It also did not apply to minority groups within nations. It also did not apply to the Soviet Union. The expectations of self-determination held by the various ethnic groups within the new Soviet Union were brutally suppressed by Stalin. He dismissed the idea of a federal Union of Soviet republics and established a one-party dictatorship over an area that comprised almost the whole former Tsarist empire (ibid.: 157–8). A new multi-ethnic empire emerged out of the ruins of the civil war, epidemics and famine that raged from 1918 till 1922 and which cost about 6 million Russian lives. Ferguson argues that the main problem with the newly founded European nation-states was the contradiction between self-determination and the existence of minorities. Majorities were tempted to claim to be the sole proprietor of the nation and its assets (ibid.: 166). Discrimination gained importance as the role of the state increased in the 1920s and a national ethnic culture was imposed on minorities, which lost their own schools, theatres and universities. A policy of self-organization was thus no longer tolerated within the new nation-states. The most threatened minority were the Jews, who often lost their jobs in schools and universities in the new Eastern European nation-states. This differed from the widespread tendency towards cultural assimilation and intermarriage that had prevailed in Europe before the emergence of the new states. This applied particularly to intermarriages between Jews and gentiles, which had risen to large proportions before the 1930s. The number of mixed marriages in the German Reich had risen to 20 percent of all marriages involving a Jewish partner in 1914 (ibid.: 28). The Danish and Italian rates were comparable. Legal obstacles to marriage between Jews and gentiles were removed in most Western European countries and the US in the nineteenth century. Jews differed from other minorities by their prominent role in business and the professions in Western Europe and the US. Anti-Semitic parties arose concomitantly with the legal equality of Jews in Germany at the end of the nineteenth century, although their popular appeal was limited at the time. Ferguson argues that the formal equality of minorities in nineteenth-century Europe triggered a discriminatory response, which culminated in twentiethcentury policies of racial discrimination. This extended also to the Turkish state that emerged out of the former Ottoman Empire, which persecuted Armenians and expelled its Greek population. Twentieth-century nation-building differed from its nineteenth-century counterpart, when new nations experienced a huge influx of both people

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and capital. The population of the Americas became ethnically mixed due to the immigration of people from Europe, Africa and Asia. However, ethnic cleansing was the corollary of nation-states based on ethnicity. Mass migration ensued after the foundation of nation-states in Turkey and Greece. The same happened later in the twentieth century after the break-up of Yugoslavia and the foundation of Israel. These new nations differed from their nineteenth-century counterparts by their emphasis on ethnicity as a basis of nation-building in contrast to the ethnic heterogeneity that had characterized nations that arose in earlier times. The idea of ethnic homogenous nation-states raises two problems. The first involves the inferior position of minorities who lack the opportunity to create their own state. The second problem involves the wars that nations based on ethnicity want to fight to expand their territory and subjugate other peoples. Both Nazi Germany and the Japanese empire were expansive empires that wanted to vindicate their racial superiority by subjugating and/ or annihilating peoples they considered inferior.

The Cold War and after The defeat of the German, Italian and Japanese empires in World War II spawned the birth of a new host of nation-states. The same occurred in the Southern hemisphere, where new nation-states emerged out of collapsing European colonial empires. The bi-polar world of the Cold War divided nations into either friends or foes. The Soviet Union fought its ideological wars in the new nation-states largely by proxy. The direct intervention in Afghanistan constituted a rare exception to this rule as it preferred to spread its ideological message largely by supporting liberation movements abroad. The United States army fought several wars to protect their interests and their allies. The Korean War was a draw and the Vietnam War a defeat. The only war they won, the Cold War, was won without open military conflict between the two superpowers. The Cold War was won by manifest success and not by military force or persuasion. Ferguson notes the fierce hostility against liberal development models in both the West and the East at the time of the Cold War. Japan, China, North Korea, Vietnam and Cambodia all adopted non-liberal models of economic development in the twentieth century. The Soviet model of socialism plus one-party rule was more popular among new nations in the 1960s and 1970s than the American model of capitalism and democracy (Ferguson, 2006: 613). In a one-party system, the first winner takes all; socialism enabled the rulers to appropriate all the assets they wanted to seize. The US response was to support right-wing dictators in Guatemala, Argentina, Brazil, Uruguay and Chile who were as lethal to their enemies as the communist dictatorships. The US also backed Pol Pot in his war with Vietnam; Saddam Hussein in his war with Iran and the Mujahedin in Afghanistan. This were all moves in the game of chess played between the Soviet Union and the United States

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in far-away theatres, which undermined the credibility of the US as an advocate of liberalism and democracy. Moreover, many US allies turned into US enemies. Saddam Hussein and the Mujahedin illustrate this principle most clearly. Those alliances were not based on shared political preferences, but on the existence of a temporary common enemy. The attraction of communist ideology has waned after the collapse of the Soviet Union and its end as a sponsor state, but religion has taken its place. Khomeini, who established the Islamic Republic in Iran in 1979, wanted to purify Iranian society and challenge the United States. Al Qaeda established itself first in Sudan and then in Afghanistan and Iraq to fulfill its mission of removing the US from Saudi Arabia and the Middle East by overthrowing Arab governments sympathetic to the US and by destroying the state of Israel (Ferguson, 2004: 120). The establishment of a Moslem empire akin to the Abbasid caliphate may loom as a future goal, but is impeded by a lack of military power and sectarian strife among Moslems. The Islamist movement is not so much based on notions of racial, but of moral superiority. Western civilization is depicted as decadent and its influence should be completely removed from Moslem societies. Islamism also expands by proxy and supports adherents both in and outside the Middle East. Terrorism – not explicit warfare – is their preferred mode of combat. They also avoid elections. Terrorism had for long been the favorite mode of combat of liberation movements in Russia, Ireland, and Bengali in their struggle against imperial rule (ibid.: 121). The US attempt to bring democracy to Iraq ran counter to the sectarian and ethnic fragmentation that followed in the wake of the disappeared dictatorship. The installation of democracy tends to unleash centrifugal forces as it allows people to grasp political power for their own group by all possible means. The situation in the Middle East bears some resemblance to the wars of religion that ravaged Europe in the sixteenth century after the downfall of the Holy Roman Empire. The new nation-states that arose had state religions and either expelled religious minorities, or made them secondclass citizens. History shows that the collapse of empire provokes new forms of integration. The two opposite movements of fragmentation and integration are discernible in the twentieth century, but also in earlier times. Ferguson regrets the collapse of liberal empire and the descent into the hell of hatred that was characteristic of the twentieth century. However, it is questionable whether empire offers the best integrative device. Empire gave rise to feelings of superiority, which provoked resentment. These feelings of superiority that the English expressed towards their colonies were not limited to people of different ethnicity, but were also expressed towards the inhabitants of the New World. The colonists were treated as a mixed rabble of Scotch, Irish and foreign vagabonds, descendants of convicts and ungrateful rebels by the English (Ferguson, 2003: 91). However, British notions of superiority were proved false by the rapid growth of the (former) colonies of white settlement.

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Moreover, a rentier empire like the British one, does not suit the United States. First, the US has a rapidly growing economy, in contrast to late nineteenth-century Britain, which was in relative decline. Second, the US is a net importer of human capital in contrast to the nineteenth century, when people left Britain in droves to build a new life in the (former) colonies of white settlement. The flight of capital and people indicates that opportunities outside the British Isles were considered more attractive than inside the country. The reverse applies to the United States, which attracts both money and people like a magnet. The countries of the European Union also attract many immigrants. But immigrant communities with high levels of unemployment pose a threat to the stability of European societies. The US seems to have largely overcome racial segregation by offering people opportunities in its buoyant economy. The US has become an ethnically mixed nation where the descendants of the Pilgrim Fathers constitute a minority, without losing its character through successful Americanization of newcomers. The people of the United States have one of the highest per capita incomes in the world. Their wealth is largely based on human resources and innovations in technology, organization and legislation.

2

Entrepreneurship and economic development

Introduction Economic growth is considered a normal phenomenon in developed economies. However, economic stagnation has been the norm for long periods of history. Per capita income in Western Europe was stagnant or even regressed in the first millennium (Maddison, 2001) and was below that of Africa, Asia and Japan in the year 1000. Many African, Eastern European and Latin American economies in our times have experienced zero growth or even decline. Economic growth occurs when more production factors such as capital, labor and natural resources are put to economic use (extensive growth) and when factor productivity increases (intensive growth). Economic theory has produced several explanations for productivity growth. Investments in both physical and human capital figure prominently as explanations in neo-classical growth theory. However, neo-classical theory can only partially explain the productivity growth of the past centuries. The best explanation for the rest is technological progress that made both capital and labor more productive. The question of what triggers technological progress is, therefore, important. Technological progress is associated with advances in knowledge and their diffusion. Both the generation and diffusion of new knowledge depend on how new ideas are generated and adopted. Scientific knowledge spreads in a wave-like fashion; a new idea is adopted by only a few in the beginning and then by more people. However, societies have not always been receptive to new knowledge. The adoption of novelty requires a positive attitude towards new ideas, which can discard past knowledge and brush aside tradition. The adoption of new knowledge could also entail a power shift, if old leaders are dethroned and replaced by new ones. Progress assumes that existing ideas and ways of doing things can be improved. Entrepreneurial theories of economic development assume that economic development is shaped by individuals who start new organizations. Capitalism is special since it channels ambition towards the economic arena instead of the military where it was located in feudal times. Theories of entrepreneurship span a long period, at least from Cantillon’s time up to the present. Many scholars have contributed to the literature on

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the subject. They all wanted to unravel the way in which entrepreneurial initiative has contributed to economic development (He´bert and Link, 1982). This chapter analyzes the contributions of three leading social scientists: Max Weber, Joseph Alois Schumpeter and Frank Hyneman Knight. Schumpeter defined the entrepreneur as the individual, who founds a new firm that has a comparative advantage vis-a`-vis incumbent firms. The definition of entrepreneurship as new firm formation also applies to Weber and Knight. All three authors wrote their theories during the first two decades of the twentieth century and were well aware of each other’s writings. Their work constitutes a fascinating debate on the motives and effects of entrepreneurship. Their theories explain why new ventures emerge and how they are financed. Weber held the view that Calvinist parsimony would finance investment, whereas both Schumpeter and Knight considered external finance to be the main source of entrepreneurial investment. Entrepreneurship had only been a sideshow in economic theory after World War II. Neo-classical economics had pushed the entrepreneur out of the economic model, leaving no room for enterprise and initiative but only for passive calculation (Baumol, 1968). Entrepreneurship escapes neo-classical modeling by definition due to its relationship to novelty and change. The lack of interest in entrepreneurship in the second half of the past century can be attributed to the widespread idea that entrepreneurship would become more and more obsolete as capitalism developed. Weber contributed to this idea by emphasizing that economic life would become ever more rational. Large bureaucracies would take over as the predominant organizational form of capitalism. Schumpeter also became convinced that large firms would become the main vehicles for innovation and economic progress. He predicted that market societies would evolve from competitive to trust capitalism, which in time would give way to socialism. Schumpeter also contended that the demise of capitalism would be hastened by an increase of rationality in all realms of life. People would no longer tolerate the irrational elements of capitalism such as the incidence of business cycles and income inequalities. Hence, he considered entrepreneurship in the sense of new firm formation to be a relic of the past. Knight did not have such a strong opinion on the matter, but he expected that large diversified companies would become predominant due to their ability to reduce uncertainty. The view that large firms would become increasingly important was supported by the facts in the developed world during the latter part of the twentieth century. Firms did get larger on average, but this trend has been reversed since 1973. The increased importance of small firms and start-ups is indicated by empirical research, which indicates that the share of large firms in employment has decreased since the 1970s in Europe, Japan and Northern America (OECD, 2000). Political and economic events of the turn of the twenty-first century thus seem to mark a break from the evolutionary path that these authors foresaw. Let us now discover which elements of Weber, Schumpeter and Knight’s works are most relevant for contemporaneous entrepreneurship.

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Life and work of Weber, Schumpeter and Knight The German social scientist Max Weber (1864–1920) exerted a great influence on American social science. Weber studied law in Berlin; held chairs in economics in Freiburg and Heidelberg before he became seriously ill and was kept from working for about four years. After then he lived as a private scholar in Heidelberg. He only accepted a regular appointment at the University of Munich one year before his sudden death in 1920 (Weber, 1947). Joseph Schumpeter (1883–1950) was born in Moravia, which now belongs to the Czech Republic but at that time was part of the AustroHungarian Empire. As a young boy he moved to Vienna with his mother after the sudden death of his father. He was a brilliant student of law and economics at the famous University of Vienna, where prominent economists such as Boehm-Bawerk and von Wieser taught. Schumpeter was an economic prodigy, who wrote a history of economic thought at the age of 25 (Schumpeter, 1908). After taking stock of existing theory, he wrote his own treatise, Theorie der wirtschaftlichen Entwicklung (Theory of Economic Development), which was first published in 1911. Schumpeter contended that all economic theories up to that date only applied to a stationary economy and could not explain development, i.e. productivity growth. He gained a professorship at the University of Cnernowitz, located on the borders of the Empire and was later appointed in Graz, in which provincial intellectual climate he did not feel well at ease. A brief career in politics followed in the aftermath of World War I, when he became Minister of Finance in the Renner Coalition Cabinet in Austria in 1919, but he was forced to resign after one year due to heavy political struggles over the issue of nationalization. Schumpeter became a banker, but this career was unfortunate, when the Biedermeier Bank, of which he was president, failed in 1925. He became a Professor of Economics in Bonn in the same year and moved to Harvard University in 1932, where he stayed until his death in 1950. He wrote two major works while at Harvard: Business Cycles (1939) and Capitalism, Socialism and Democracy (1943). Frank Hyneman Knight (1885–1972), a farmer’s son from Illinois, studied chemistry, German drama, and philosophy at the universities of Iowa and Cornell. He also studied with Max Weber in Heidelberg. He completed his doctoral dissertation in economics in 1916 at Cornell, which was published in 1921 as Risk, Uncertainty and Profit, while he was Professor of Economics at the University of Iowa. Knight moved to the University of Chicago in 1928 and published several works on ethics and economic reform, of which The Ethics of Competition (1935) and Freedom and Economic Reform (1947) are the best known (Knight, 1982). This chapter starts with Weber’s articles on Protestantism and the Rise of Capitalism, which were first published in 1904 and 1905 in the Archiv fu¨r Sozialwissenschaft und Sozialpolitik. Schumpeter’s Theory of Economic Development, which was first published in 1911, can be considered a refutation of

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Weber’s theory. He stated that not the Puritan ethic, but innovation could explain economic development. Weber sketched a historical sequence of business organizations from antiquity till the early twentieth century in General Economic History (GEH). He pointed out that many organizational forms were designed to support the status quo and thus unable to cope with change. Knight translated Weber’s book on economic history, which was published in German in 1923. Weber’s book was compiled from lecture notes of a class he had taught a year before his death. Knight was an ardent admirer of Weber, who he referred to as ‘the most outstanding name in German social thought since Schmoller’ in his Preface to General Economic History. Weber had more admirers among American academics. Talcott Parsons, a leading sociologist at Harvard, translated Weber’s essays on the Protestant ethic in English.1 The book was first published as The Protestant Ethic and the Spirit of Capitalism (PE) in 1930. Parsons also translated Part II of Weber’s Wirtschaft und Gesellschaft which had been published posthumously in 1921 and came out in English as Social and Economic Organization (SEO) in 1947. Apparently, prominent American scholars made great efforts to read German scientific publications, because of the fact that the German-speaking world was considered foremost in the social sciences at that time. Knight contributed to the debate by making uncertainty instead of rationality or innovation the central feature of his theory of entrepreneurship. In this way, he solved some of the puzzles, which had emerged from the works of Weber and Schumpeter.

Weber on Calvinism and economic development Weber sought the reason for the relatively rapid growth of western capitalism in the specific attitude to life of the Calvinist Puritans. In The Protestant Ethic and the Spirit of Capitalism (PE), his best-known book, he associated the economic rise of Holland, England and the American colonies with the presence of Puritan and Calvinist religious groups in those regions, such as the ‘Hervormden’, the Mennonites, the Methodists and the Baptists. These Calvinist groups distinguished themselves from Catholics and Lutherans by their specific concept of salvation, which cannot be attained through the church, but will only fall upon the predestined ‘elect’. The concept of predestination did not lead to fatalism, as Weber explained. ‘The true believer held it to be an absolute duty to consider oneself chosen and to combat all doubt as temptations of the devil’ (PE: 111). Lack of selfconfidence could be seen as a sign of insufficient faith. People were thus largely self-elected. Calvinism favored rationality in business matters, because material success acted as ‘proof’ of being one of the chosen (PE: 114). Weber calls the Calvinist attitude to life a rationalization of the world, because magic had been banned as a means of salvation (PE: 117). Calvinism also honored the acquisitive motive, whereas other Christian denominations had often denounced riches. Confession and good works had been

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replaced by duty and hard work and by abstinence of worldly pleasures. Calvinism – in Weber’s view – perfectly fitted a society of free laborers, who were no longer tied to master and soil by extra-economic considerations as in tribal and feudal societies. Such a situation existed in seventeenth-century England, after the enclosure movement had driven many peasants from the land. The Puritans, in Weber’s view, followed the example given by the Catholic monks, who also had applied rational methods to economic activities. Weber considered rationality the outstanding characteristic of both (industrial) capitalism and Calvinism. He drew a sharp line between adventurous and rational capitalism (PE: 20), placing speculative voyages for land and booty, the results of which could not be calculated in advance, in the first category. Weber thus portrays the Puritans as a group driven by religious zeal to apply rationality to the pursuit of economic activities. This differs sharply from the idea of the Austrian economists of his days, such as Menger and Boehm-Bawerk, who saw the equation of (marginal) utility to revenue as the main motivation of rational economic man. Such a scheme of things was insufficient to explain saving and entrepreneurship in Weber’s view, because economic man would only put in as many hours as were required to meet his daily needs. The Puritan, however, would be forward-looking. He would save to obtain wealth, which was considered a sign of godly approval. There was no room for feelings of class resentment in the Puritan world, because the unequal distribution of goods of this world was seen as divinely ordained in a pursuit of secret ends unknown to men (PE: 177). However, the wealthy could never rest in comfort, because their wealth would make it more difficult for them to lead the life of the righteous. But Puritanism also had its hard, judgmental side. The consciousness of divine grace by the elect and holy was accompanied by utter hatred and contempt for people who were considered sinners. Since the dividing line between saints and sinners was never known, sectarian divestitures were common among Puritans in order to keep a ‘pure’ church (PE: 122). Moreover, the formation of a new sect gave its followers the opportunity to escape from ecclesiastical regimentation of life as had happened in the Calvinist State churches, which amounted almost to an inquisition (PE: 152). Such despotism would enforce external conformity but weaken the motives for rational conduct, according to Weber (PE: 152). Calvinism thus had its authoritarian features, which is also apparent from the iron collectivist way Calvin had organized his church in Geneva, as Tawney wrote in his Introduction to the English translation of The Protestant Ethic. However, the Protestant religion could not prohibit the foundation of new sects due to its lack of central control. The late fifteenth and sixteenth centuries were a period of religious revolts and nation-building. Many cities in Southern Germany and Northern Italy had gained autonomy, when imperial power started to decline in the twelfth century (McNeill, 1963: 541). The French, English and Spanish nation-states

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arose out of the collapsing empire. The new monarchies in England and France protected the corporate liberties of the townsmen in exchange for royal taxes. Germany and Italy remained divided until the nineteenth century. The Reformation also emerged in this era of imperial decline. Lutheranism and Calvinism arose as major Protestant denominations. Religious sects such as the Huguenots and ‘Wederdopers’ emerged who wanted to establish their ideal communities and obtain state power. The collapse of imperial and papal powers ignited the wars of religion of the sixteenth and seventeenth centuries (1500–1650). The Lutherans had conquered some territories in the Habsburg Empire, which they were allowed to keep in the Peace of Augsburg (1555). Princes could choose which religion would prevail in their territories, whereas converted bishops had to give up their territorial claims. However, the Peace of Augsburg did not hold due to the rise of Calvinism and the fact that some converted bishops refused to give up their bishoprics. Catholic rulers wanted to re-establish Catholic rule in the territories, whose ruler had converted to either Lutheranism or Calvinism. The Cologne War (1582–83) started, when its Prince-Archbishop converted to Calvinism. A majority of Protestant electors in the Electoral College would threaten the Catholic foundation of the Holy Roman Empire. The Thirty Years War (1618–48) started, when Bohemia rebelled against Catholic rule. All major European powers were involved in a war that cost many lives from both battle and disease. The 1648 Peace of Westphalia divided Germany into many territories with de facto sovereignty. The Dutch Republic obtained independence in 1648. France, which had fought on the Protestant side, emerged as the main European power and Spain as the main loser. The wars of religion were fought, because states were considered religious homogeneous entities. The events of the sixteenth and seventeenth centuries demonstrate how the collapse of empire entails political fragmentation along ethnic/religious lines. The division between Catholic and Protestant states at the Peace of Westphalia curbed the freedom of religious association that existed in the Empire. Monastic orders and sects had been established during the Middle Ages and were often protected by feudal lords. This imperial tolerance could have extended to the new Protestant movements. Emperor Charles V had attacked the new religions, but his successor Rudolf II allowed the new sects to spread. It was the rise of the nationstates that caused the rise of religious homogeneity. The Dutch war of independence against Spain (1568–1648) was inspired by religious rebellion, but also constituted a tax revolt. The Reformers pillaged the Dutch Catholic churches and monasteries in 1566 at the beginning of their insurrection. Many Northern cities adopted Calvinism as a state religion. Amsterdam did so in 1578 and confiscated Catholic churches. The Dutch Calvinists obtained state power and constituted a theocracy for a limited period of time. However, some forces counteracted the movement towards a rigorous Calvinist state in the Netherlands. Most important was the loose federal character of the United Provinces, which lacked strong state power. The

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cities could, therefore, take their own stance in economic and judicial affairs. The city lawyers and magistrates were opposed to harsh persecution of the non-reformers. Moreover, the cities needed extra hands and, therefore, welcomed immigrants. Jews, who fled from Spain and Portugal after being extradited, could take shelter in Dutch cities, predominantly in Amsterdam. Catholics were tolerated after 1630, which meant that they could practice their religion, if it was done non-conspicuously. However, only members of the Hervormde Church could hold official positions in the sixteenth and seventeenth centuries in the Netherlands (Schama, 1987). Religious inflexibility was thus counteracted by the tolerance that commerce requires. The distinction between the preacher and the merchant has become a popular image of the dual character of Dutch culture. The Dutch have their principles, but they should not interfere with business! Some Dutch practices seem to fit Weber’s portrayal of Calvinist culture. Weber describes the repugnance of idleness and begging as a trait of the Puritan, who considers work a holy duty. This attitude is reflected in the harsh policies pursued by the seventeenth-century Dutch cities towards vagabonds, beggars and idle people, who were either put to work in the towns’ workhouses or deported (ibid.). This contrasted with Catholic (and Buddhist) attitudes that considered begging a respectable way of life. The Protestants lost their grip on Dutch government after the French Occupation of 1795–1806, which made everyone equal before the law. Many Catholic churches and monasteries were built in the nineteenth century. Religion remained a major organizational principle in the Netherlands until the 1950s. Each individual participated in organizations of a certain religious denomination, such as political parties, schools, hospitals, soccer clubs, and so on. This segregation of social life called ‘Verzuiling’ (pillarization) weakened in the 1960s. A special feature of Dutch segregation involves the right of each group to state funding of schools, hospitals and other services. A Calvinist state was never founded in England, because the Puritan sect members were outnumbered by the Anglicans. The English Puritans contested the authority of the state in religious and economic matters and were considered a threat to the English nation. Their fight against state monopolies and military conscription are cases in point. Weber considers this the main reason for the early emergence of a professional army in England. As a consequence they were kept from land leases and official occupations. Weber’s theory of the Puritan ethic applied equally to the businessman, the professional and the laborer (PE: 177). However, many Puritans took up entrepreneurship in England, since they constituted a religious minority to which other routes of social advance were closed. The same had applied to other religious minorities in the civilized world: Jews and Christians were the merchants and moneylenders of the Ottoman Empire. But those occupations were not highly esteemed in Oriental civilizations that placed them at the bottom of the social pyramid. A career in the state bureaucracy or

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army constituted the only road to social prestige in those countries. England and the Low Countries, just like the northern Italian cities of the thirteenth and fourteenth centuries gave more scope to commerce and manufacturing, which gave rise to an influential middle class of merchants and bankers.

Schumpeter’s Theory of Economic Development Schumpeter contributed regularly to the Archiv fu¨r Sozialwissenschaft und Sozialpolitik, which was edited by Weber in the 1920s (Augello, 1990). Schumpeter sketched a model of a dynamic economy in his Theorie der wirtschaftlichen Entwicklung (WE) in 1920. His theory can be considered a refutation of Weber’s hypothesis on the importance of the Calvinist attitude for economic development. He instead stresses innovation and leadership. Schumpeter defined the entrepreneur as the founder of a new firm and innovator, who breaks established traditions and opposes the old way of doing things. Schumpeter’s entrepreneur only undertakes those ventures, which turn out to be successful (WE: 177). The entrepreneur’s special leadership qualities enable him to see the right way to act. Others will follow in his wake. In order to introduce his innovations, the entrepreneur needs to withstand the opposition of the environment, which is usually hostile to deviating behavior and novelty. ‘All deviating behavior of a member of a community meets with disapproval from the other members’ (WE: 118). Moreover, the individual is also restrained from doing something new, due to the psychic and physical efforts it requires to leave familiar paths (WE: 120); it is the difference between swimming with the current and against the current (WE: 121). Schumpeter’s entrepreneur, however, takes a delight in this opposition (WE: 132). He is a creative non-conformist and not a religious dissident. He is warmly welcomed by the banking community that grants him credit to finance his attack on established positions. Bankers are supposed to be gifted with perfect foresight, for they can discern the best and brightest entrepreneurs without difficulty. Schumpeter’s entrepreneur is a leader, who breaks the ‘circular flow’, actively steering the economy away from old paths and opening up possibilities hitherto unknown. The circular flow describes a stationary economy, in which economic processes are repeated period after period without change. Prices and quantities do not vary in the circular flow and can be completely deduced from the data. The interest rate equals zero, and net investments are absent. Schumpeter used the concept of the circular flow as a point of reference to indicate the changes that are caused by the introduction of innovations. His concept of the circular flow had many predecessors as is indicated by the various references to the concept of a stationary state in his History of Economic Analysis (HEA). The first reference is to Plato’s utopian vision of a Perfect State, described in his Republic. Born out of dissatisfaction with the changes that Athens went through in

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his lifetime, Plato outlined the preconditions for a stationary Utopia such as a stationary population, constant wealth, division of labor according to ability and limited freedom of speech (HEA: 55–6). The authoritarian aspects of Plato’s Perfect State are absent in Schumpeter’s description of a circular flow, which is not directed by command, but by perfect competition and established routines. Schumpeter unravels how productivity increases are produced by the appearance of clusters of innovative firms, which set off (cyclical) waves of investments and disinvestments. Entrepreneurs who founded new firms introduce innovations, because established firms are reluctant to change their routines. Established businesses will postpone innovation until their old assets have become obsolete. New firms are not impeded by former investments and will, therefore, speed up economic progress by introducing innovations before incumbent firms would. Schumpeter pointed out that innovation could inflict losses on incumbent firms, which he labeled ‘creative destruction’. Schumpeter explains how innovations gain a premium due to lower costs or higher value. The differential with previous methods and products accrues to the entrepreneur until it vanishes due to competition by imitators. Schumpeter argued that the positive price–cost margin constitutes the source of all profits and interest payments. Consequently, all former theories of interest, including Boehm-Bawerk’s, were incorrect, in his view. Neither waiting nor the lengthening of the production period constitutes the source of interest and profits, but innovation is the source. Capital -deepening means that labor is replaced by capital, but it does not need to entail overall productivity increases. This can only occur, if fewer production factors are used to produce a certain product or the same quantity of production factors produces more value-added. Schumpeter sketched a theory, in which the interest rate equals the profitability of the marginal entrepreneur (Schumpeter, 1912: 383). Hence, innovative profits are split between interest payments and a residual that accrues to entrepreneurs. Entrepreneurial income reflects entrepreneurial quality; the best entrepreneur receives the highest incomes, whereas the marginal entrepreneur’s profits just suffice to pay his banker. Schumpeter agrees with Weber on the non-hedonistic nature of the entrepreneur. The entrepreneur does not resemble ‘economic man’, who weighs (marginal) costs and benefits and stops working at the moment when the costs of the extra effort (fatigue) exceed the extra satisfaction (WE: 126). Such behavior, according to Schumpeter, is characteristic of the circular flow. The entrepreneur – by contrast – is prepared to work countless more hours in order to achieve his goal. However, Schumpeter’s entrepreneur is not a Puritan. He does not abstain from the world, but participates fully in politics and culture. He is not motivated by the belief of belonging to the ‘elect’, since the banking community has already chosen him. The main difference from Weber’s picture of the entrepreneur thus involves the distinction between self-selection coupled with saving and selection by the financial

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community. Schumpeter’s entrepreneur is motivated by the joy of creating and by the pleasure success brings (WE: 141). He is not motivated by rewards beyond his lifetime, but wants to improve his social position (and that of his family). Leaders in former ages had largely based their leadership on military and bureaucratic expedience and not on commercial qualities. But innovative qualities can occur everywhere and are thus not system-specific, in Schumpeter’s view. The clan-leader could also lead his people into new territories, as could the feudal knight. However, not all economic and social systems are equally well equipped to innovate; he mentions India and China as two countries without much innovation to prove his point that economic development is not obvious and automatic (Schumpeter, 1912: 113). He also remarks that it is harder for individuals to break established traditions in primitive societies without upsetting others due to their communal way of living (ibid.: 119). Schumpeter considered entrepreneurial behavior to be non-rational, because it did not fit in with the model of ‘economic man’ designed by the marginalist school. Weber’s Puritan and Schumpeter’s entrepreneur are both forward-looking, whereas rational economic man is supposed to live only by the day. But such long-term thinking could be called rational by modern standards. Weber’s concept of rationality was not always perfectly clear. Schumpeter pointed this out in a seminar, which he gave at Harvard University in 1940; among those present were Parsons, Sweezy and Leontief. Schumpeter distinguished between formal or objective and substantive or subjective rationality in this seminar. Formal rationality applies, if costs and benefits can be calculated accurately: a means–end relationship. Subjective rationality refers to the achievement of absolute values irrespective of costs. Salvation fits in with the latter rationality concept. However, the two concepts coincide in Weber’s portrait of the Calvinist, who only engages in profitable enterprise. Schumpeter rejected Weber’s portrait of the scrooge capitalist and replaced it by the well-mannered gentleman, who wanted to build his own estate. But calculability also featured largely in Schumpeter’s work. The absence of uncertainty could explain why financiers are only meagerly rewarded by base rate interest payments, whereas the entrepreneur obtains the rest of the innovation premium in accordance with his capabilities. Hence, innovative investment is considered devoid of any risk. Schumpeter, however, did mention risk in the German edition of Theory of Economic Development, where he stated that foreseeable risk can be reduced to costs (Schumpeter, 1912: 49). Interest rates will rise by a certain percentage, if some of the new ventures are expected to fail (ibid.: 387). The percentage of failures can be calculated based on experience. Moreover, losses would mainly occur in the old firms, which were unable to adapt to new economic conditions in time (ibid.: 493). Schumpeter’s ideas on this matter lie at the foundation of Knight’s theory of profit, as will be demonstrated below.

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Knight on investment and entrepreneurship Frank Knight, in his seminal contribution to economics, Risk, Uncertainty and Profit, remedied Schumpeter’s disregard of uncertainty and in so doing laid the foundation for modern finance and organization theory. He was one of the founding fathers of the famous Chicago School in economics. Knight was acquainted with German economics texts. It seems, therefore, plausible to assume that he was familiar with Schumpeter’s Theorie der wirtschaftlichen Entwicklung, when he wrote his thesis, Theory of Profits and Uncertainty in 1916, which was published as Risk, Uncertainty and Profit (RUP) in 1921. Knight agreed with Schumpeter on the matter of capital deepening. He stated that the length of life of capital goods is a matter of choice and can never be a source of profits (Knight, 1939). Knight also agreed with Schumpeter that profits and interest can only exist in a progressive society, although interest could be paid for consumption loans (RUP: 328). Innovation is the source of profits and can only occur when investment is used to create new resources. Knight differed somewhat from Schumpeter on entrepreneurial motivation. He considered the desire to excel, to win the game, the biggest and most fascinating game yet invented, not excepting even statecraft and war, the main motivating force (RUP: 360). But his theory differs from Schumpeter’s on one essential point. Schumpeter did not deal with uncertainty, as was mentioned above. Bankers would always pick the right entrepreneurs. It might have been Schumpeter’s (and Weber’s) familiarity with the credit mobilier type of banking and the disastrous consequences of the failures of these banks that made them emphasize calculability. Knight, however, contended that only uncertainty can explain profits (and losses). Not all ventures will become successes; some will fail. However, which ventures will succeed and which fail cannot be predicted in advance. He also remarked that the profits (and losses) of change come largely in the form of readjustments of capital values. Hence, where Schumpeter assumed that bankers do not make mistakes in selecting entrepreneurs, Knight made errors the basis of his theory of entrepreneurial profits (and losses). The crucial type of decision in all organized activity, according to Knight, involves the selection of men to make decisions. Any other sort of decision-making or exercise of judgment is automatically reduced to a routine function (RUP: 297). Uncertainty needs to be sharply distinguished from risk in Knight’s view. Risk is calculable a priori and can, therefore, be treated as a cost. Experience can teach us what percentage of bottles is going to burst in a champagne factory. These damages can be included in our cost calculations (RUP: 213). Other types of risk, such as the incidence of fires, can be insured. ‘Uncertainty, in contrast, is uninsurable, because it depends on the exercise of human judgment in the making of decisions by men and although these estimates tend to fall into groups within which fluctuations cancel out and

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hence to approach constancy and measurability; this happens only after the fact.’ (RUP: 251). The major difference between risk and uncertainty thus consists of the possibility of making ex ante calculations of the incidence of an event. That can be done for fires, but not with respect to the outcomes of investment projects that can only be calculated after everything is said and done. Knight borrowed from Schumpeter the idea that entrepreneurs are not self-selected but chosen by investors, who – in contrast to Schumpeter’s portrayal – are not infallible but subject to error. Knight’s theory portrays investment as a discovery process. Many new ventures will be launched, but only some will survive and prosper. Such a sketch of events fits actual developments. Many new businesses were launched in the 1990s, of which a few obtained astronomically high valuations. This happened before they actually made profits, which supports Knight’s thesis that not actual profits but profit expectations are the decisive element in investment. The development of financial markets has made it possible to measure success by readjustments of capital values before actual profits have been reaped. We can also conclude that investment under conditions of uncertainty requires other methods of finance than debt. (High) chances of failure require a risk premium on interest, which curtails investment. Equity capital is therefore more suited to the task of financing uncertain ventures than debt. Knight pointed out that only the investor with above-average skills of perception would earn (excess) profits, whereas investors, whose perceptiveness was below average, would lose out on their ventures. Perceptiveness refers both to project choice and to the timing of investment. Knight contended that the average rate of return on investment does not need to exceed the riskfree rate of return in the long run (RUP: 284). Hence, both Knight and Schumpeter argued that investors as a group do not need to earn excess profits. Knight’s investor/entrepreneurs only need to be compensated for losses caused by uncertainty out of profits. Founders do not need to be residual claimants in Knight’s view. Their incomes could take the form of salaries. It is obvious that uncertainty in investment, just as in sports, only exists, if more than one company/team vies for the same prize and if the result cannot be predicted with any accuracy. The match would be superfluous, if the ‘best’ team can be indicated before the event. The same applies to the business world. Only one innovative firm needs to be launched, if the best innovator can be discerned ex ante. The best employee is also the best entrepreneur, if standards of excellence apply equally to entrepreneurs and employees. As a consequence, all investors would flock to the designated winner, which would drive up the price of that person to the point at which no profits are left for the investor. Moreover, this innovator has no incentive to start his own company but will earn exactly as much as an employee (Brouwer, 2000). I hold the view that Knight has corrected Schumpeter’s theory on an essential point. Profits (and losses) can only appear, if uncertainty is

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present. In fact, all profits would vanish, if the winning person or company could be indicated ex ante. If everybody had known beforehand that Microsoft would become the most successful company of the 1990s, investors would have rushed to provide funding and the list of prospective employees would have been infinite. As a consequence, Bill Gates could have obtained all the money he wanted at risk-free rates of interest and could have paid his employees just standard wage rates. However, Gates was funded by venture capital firms, which took equity shares in his firm. The same applies to him and his co-founders, who were also paid (partly) by equity shares. Most founders of ‘high tech’ start-ups receive modest salaries, but get equity shares in compensation. Microsoft became an enormous success and everybody was handsomely rewarded for their wise choices. However, a host of start-ups, which turned out to be failures and whose investments were largely lost, counterbalance the Microsoft success story. Uncertainty can explain many features of innovation, such as the relatively small size at which innovative ventures are launched. The rationale for this is that losses are limited in the case of failure. It can also explain why many start-ups are short-lived and why some grow very rapidly. Only firms that are expected to become successful will receive several rounds of finance to expand. Moreover, uncertainty is also a major motivating force. This applies to sports, but also to economics. No firm would invest in innovation, if it knew that it would lose out to an objectively better competitor. But this competitor in turn would have no incentive to disrupt existing routines, since this could hurt former investments. Both Weber and Schumpeter came to believe that innovation can proceed unhindered in socialism. This becomes plausible when we realize that both authors did not incorporate uncertainty into their theories.

Weber’s history of organizations Weber’s General Economic History (GEH) gives a powerful sketch of economic history from ancient times until 1920. He analyzes several historical forms of economic organization, such as the clan, ancient bureaucracy, the manor, the guilds and modern bureaucracy. The two volumes of Science and Society (SEO) analyze political organizations and legal systems in a crosssectional sense without pointing at an evolutionary trend. Some political organizations had flourished, but were overwhelmed by more powerful adversaries. Some legal systems such as Roman Law had succumbed to more primitive legislation. Hence, there is no progress discernible in governance systems. Weber discerns progress in the evolution of economic organizations from the late Middle Ages to the twentieth century. New organizations arose which were superior to former ones. Hence, economic development from that date is pictured as a process of organizational and institutional innovation, in which more rational forms prevail over irrational ones.

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Most primary organizational forms were directed towards protection of their members against outside aggression. This applies to the clan, which Weber saw as the primal organizational unit and as an agency of blood revenge and the prosecution of feuds (SEO: 128). The clans did not possess written laws; clan members were totally dependent on their leaders for their lives and livelihood. The clan and later the sedentary agricultural village were composed of several families. The power of the clans could only be broken, if a political system was established, which eroded the absolute power of the chieftain. All early civilizations, in his view, such as the Egyptian, Greek and Roman civilizations, had loosened the grip of clan and family on people and had established more rational forms of organization. Weber mentioned Ancient Egypt as an example of a huge bureaucracy with a very extensive division of labor. Officers in a bureaucracy are chosen on the basis of some kind of proven expertise. This contrasts with the selection of officers (such as the medicine man) in a tribal society, which relies largely on magic. Feudalism constitutes a form of political organization, which superseded kinship and blood ties and, therefore, embodies some rational aspects, in Weber’s view. In feudalism, the tribes are subjugated to an overlord, who in turn has been appointed by the emperor or prince. Feudalism emerged gradually through either the contracting out of taxation benefices to administrators (such as to the mandarins in China) or through the granting of fiefs to militaries (the feudal lords of the Occident and the Ottoman Empire). The power of the clans was completely broken in the Occident, but not in the Orient according to Weber (GEH: 45). Life on the countryside in occidental feudalism revolved around the estate or manor. Peasants were either obliged to pay fixed or variable fees (such as in sharecropping) to their landlords and/or were subjected to compulsory labor on the estate. A landed aristocracy replaced the clan leader in its task of defending the life and good of the people. But, the manor or oikos was not organized along rational lines. Holdings were usually of sub-optimal size. Income was largely determined by privileges and obligations, which were passed on from generation to generation. Part of the medieval populations lived in cities, which had their own organizations. The inhabitants of the towns in Western Europe usually did not start out as free men, but fell under the jurisdiction of a feudal lord. It was only when they became engaged in trade that they reached the status of mercator and of free citizen. The citizens of the medieval towns were relieved from feudal obligations but had to pay taxes to the emperor or king. The lords of the manor were opposed to town privileges. The prince and the emperor, however, were willing to grant privileges to the towns in order to increase tax incomes. The cities featured new economic organizations, such as guilds and maritime ventures. The guilds as associations of free craftsmen did not develop outside Western Europe (GEH: 137). Instead, every individual belonged to a clan or caste in the Orient. Guilds never existed in China, because clan organization was dominant. Guilds did not develop in

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India either, since the division of labor was organized along lines of castes, which can be seen as ritualistic guilds (GEH: 137). Craftsmen and merchants populated the towns, whereas peasants, who were attached to the land by feudal obligations and rights, populated the countryside. The establishment of the towns introduced trade, because the town people needed to be fed by agricultural surpluses, which were exchanged for handicraft and imported products on local markets or by peddlers. Towns were much more numerous in occidental than in Eastern Europe. Weber remarks that the power of the towns reduced that of the estates (GEH: 89). This happened first in the ‘free’ city-states of southern Germany and northern Italy. The cities thrived on trade and were the seedbeds of organizational and institutional innovations that favored market transactions. Its military basis made occidental feudalism rather unstable. The power of a king or prince was never absolute, as he had to rely on the military capabilities of local lords to sustain his power. The inherently instability seems to have contributed to the development of towns and therewith to commerce and enterprise in Western Europe. The emperor or king could curb the power of the aristocracy and expand its tax revenues by granting royal privileges to cities in exchange for a guarantee of their corporate liberties and protection against the feudal lords (McNeill, 1963: 542). Some cities came to develop their own military capability and supplanted the feudal lords. Towns established their own states. Italian towns such as Florence and Venice are cases in point. Free guilds became the dominant organizational form for craft workers in Western Europe after craftsmen had thrown off the feudal shackles. Weber indicated that several organizational forms were not up to the transition to a market economy. The manorial system in agriculture, which had existed in Europe for many centuries, was bound to shatter, when faced with market forces. The newly developed bourgeois interests of the towns promoted the weakening of the manor to expand their market opportunities. The manorial system curbed the purchasing power of the rural population due to the compulsory services and payments it demanded from the tenants. The manorial system also prevented the creation of a free labor market because it attached the peasants to the soil (GEH: 94). The guilds promoted production for the market, which gradually supplanted the division of labor within the manor. Where the guilds were not victorious or did not arise at all, home industry and tribal industry persisted (GEH: 147). This applies to Eastern European feudalism. Russian peasants could not break loose from the soil because of eternal rights and obligations to the estate and to the communal Mir organization until serfdom was abolished in the late nineteenth century. Weber considered Western guild organization to be more rational than the manor. Craft guilds promoted professional competence. People could only become a master and open their own shop after a long period of training. More importantly, admission to the western guilds was usually

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based on skills and not on family ties, although minorities were often excluded from the guilds. The guilds were first regulated by the town lords, who demanded both taxes and military services from guild members, but all these prerogatives were later acquired by the guilds (GEH: 148). The guilds used their newly won freedom to establish an effective monopoly in their trade. Guild regulation protected its members from competition. It was impossible to set up a shop without the guild’s consent. Moreover, the number of masters and therewith of shops was strictly regulated in order to restrain output. Equality prevailed within the guild organization. No master could improve his position beyond that of another. Hence, no shop could ever increase its market share. The guilds’ initial boost to progress petered out, when the adverse effects of their regulations became dominant. Moreover, guild members could own no capital of their own, and were therefore restricted to non-capital-intensive production methods. The few capital goods in existence such as grain and wood mills were often owned by the town or by a cooperative. New organizations appeared in the sixteenth and seventeenth centuries, which broke the power of the guilds. Journeymen, who were not allowed to become masters, set up their own businesses. They could do that outside the jurisdiction of the towns in the countryside; the putting-out system resulted from the attempt to escape guild regulation. Rural labor was amply available in England due to the enclosure movement. Production could expand beyond local demand to supply export markets (GEH: 94). But guild regulation persisted in many trades especially in Germany. The German princes more or less operated on behalf of the guilds and the guilds remained strong within Germany for a long time. The remnants of the guild system can still be found in some German trades, in which the Handwerkergesetze apply. The putting-out form of enterprise could thus only flourish outside the guild organizations. The same applies to the trading companies of the sixteenth and seventeenth centuries, which were organized in a corporate form. The Dutch East India Company (VOC) was a joint stock company with indefinite life, which raised capital by issuing shares to participating merchants. The VOC was preceded by maritime ventures that were organized along the lines of the Italian commenda organizations. The VOC existed from 1602 till 1790 and employed several thousand people in its heyday. It was a multi-plant company consisting of six local chambers. It employed shipyards and warehouses as well as organizing maritime expeditions. The VOC and other trading companies had many traits in common with the modern corporation. However, they were chartered by the state, and endowed with monopoly rights. As a consequence the VOC was considered to represent the national interest. The English adopted ‘the Statute of Monopolies’ in the early seventeenth century, which ended the Crown’s prerogative to grant monopoly rights. Monopolies could now be challenged in courts and disappeared rapidly from the English scene. Incorporation of voluntary groups spread rapidly in seventeenth-century Elizabethan England

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as is shown by the popularity of the joint stock company (North and Thomas, 1973: 154). The guilds were initially conducive to progress, but arrested progress later on. The guilds came to eschew novelty and wanted to maintain existing privileges and therewith the status quo. They began to show traits of caste organizations as in India, which forbade all use of new roduction methods. Guild organizations gradually gave way to capitalist organizations such as the joint stock company; but this process was initially limited to England and Holland. Other Western European nations such as France and Spain upheld monopoly privileges much longer and only allowed free incorporation at a much later date (ibid.: Chapter 10). Weber wanted to demonstrate in General Economic History that organizational and institutional change is not immanent to all types of societies. He emphasized that capitalist business enterprise could only emerge after production factors had become mobile and property rights had been established. Labor should not be bound to master and soil by hereditary and, therefore, irrational traditional ties. Migration dates back to ancient times, when people moved from the hills to the riverbed valleys of Mesopotamia and Egypt. The clan chieftain and also the father as the head of the family were robbed of (part of) their possessions and privileges, when new organization arose. The same happened when Greek and later Italian cities rose to prominence and contractual labor relations gradually replaced serfdom, royal privileges and communal land ownership Apart from labor, land also needed to become freely negotiable before capitalism could take off. Private property in land emerged during the seventeenth and eighteenth centuries in Western Europe, but the process knew several different forms and the dissolution of the feudal system therefore resulted in the different agricultural systems of today: ‘In part the peasantry was freed from the land and the land from the peasantry as in England; in part the peasantry was freed from the proprietors as in France; in part the system is a mixture as in the rest of Europe, the east inclining more to the English conditions.’ (GEH: 108). France became a country of small and medium-sized agricultural owners, when the estates were broken up and distributed among the peasants after the French Revolution (GEH: 99). The absence of primogeniture – in contrast to England – also contributed to the emergence of small lot sizes in France. The landlords were also expropriated in south and western Germany. The change was the same as in France except that it took place slowly and according to a more legal process (GEH: 100). ‘With the dissolution of the manors and of the remains of the earlier agrarian communism through consolidation, separation etc., private property in land has been completely established’ (GEH: 111). The West thus turned into a world which was dominated by a division of labor based on free labor and private property in land. An additional condition, which needed to be met before capitalism could flourish – in Weber’s view – is the establishment of a rational state. This means

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a state, which is based on rational law and expert officialdom (GEH: 339). He contrasted this with states whose officials were trained in ancient literature or religious texts as was common in the Orient. Many feudal empires such as China were foremost concerned with preserving their centralized power structure. Their local representatives were not selected by military or technical criteria but on their expedience in Chinese literature. Such vassals had to be completely loyal to the emperor, because another recruit could easily replace them. The mandarins were also prevented from building a local power base among the population, because they were continually transferred from one province to another and did not speak the local dialect. Rational law, in Weber’s view, was based on Roman law, which revived in great parts of the West, during the late Middle Ages and Renaissance. Weber considers its calculability to be the main advantage of Roman formal-legalistic law, which contrasts to materialistic, theocratic or absolutist law (GEH: 340–1). Roman law provided reasoned and consistent principles of jurisprudence. Most empires had only developed criminal law, apart from the famous Hammurabi Code of Ancient Mesopotamia that also addressed commercial matters.

The change agent Weber explained how new organizations arose that replaced old ones and boosted economic growth. Organizational innovation required freedom of organization and mobility of both capital and labor. However, new organizations had to persuade financiers, employees and customers to adopt their vision. Weber introduced the concept of charismatic authority in Social and Economic Organization (SOE) to explain why people leave old ways of doing things behind and adopt new ones. He distinguished three types of authority: legal-rational, traditional and charismatic. Some leaders derive their authority from tradition, such as the clan leader and the lord of the manor. Bureaucracy, by contrast, is based on rational-legal authority. We can summarize Weber’s historical view by stating that the Western world changed from traditional towards formal-legal societies. Traditional authority is opposed to change by definition. Legal-rational authority spurs efficiency, but it is doubtful whether it can break existing traditions. Both traditional authority and rational-legal authority were, therefore, suited to an established social system of a routine character (SEO: 64). Charismatic authority, however, wants to lead people away from existing traditions and beliefs and is, therefore, an agent of change. The charismatic leader – as described by Weber – promises people a better future. A charismatic leader is usually not elected, but is recognized or acclaimed by his followers (Weber, 1978: 1123). A charismatic leader has to deliver. The accuracy of his vision needs to be proven by events, or people will turn their backs on him. Schumpeter’s innovative entrepreneur, who leads the production process into new paths, has many things in common with Weber’s charismatic

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leader. They both oppose established authority and lead their flock in new directions. Charismatic authority loosens all former ties to family and clan and forges completely new loyalties. The people who have ‘recognized’ the charismatic leader are completely devoted to him in a non-rational way. There is no such thing as promotion or dismissal in the early stages of new religious movements or military bands; there is no hierarchy either. Hence the charismatic organization is exactly the opposite of the rational-legal bureaucracy. The charismatic organization also does not demand formal qualifications. Everybody who recognizes the greatness of the charismatic leader can follow him and become a member of his community. The charismatic leader expects much of his disciples. They are expected to achieve extraordinary things. Rewards are not formalized but consist of free gifts or booty, which are distributed on a communal basis. However, this charismatic organization cannot endure – in Weber’s view – and will in time turn into an organization based on either traditional or legal-rational authority. Charismatic leadership is temporary and turns into routine once its leadership has been established. This applied to monastic orders and religious sects, which stuck to old routines and came to eschew novelty. New leaders are chosen who preserve the heritage of the founder. The charismatic leader is often succeeded by his offspring, or by somebody he appointed before his death (ibid.: 1123). Some elements of charismatic leadership can be found in entrepreneurial start-ups. The (innovative) entrepreneur often has a mission. He believes in his own capabilities and those of his employees. No entrepreneur would ever start his business if he were not convinced of its ultimate success. Most of the time he needs to convince at least a few others to join him in his venture and to defer income until the moment of success has arrived. He also needs to convince financiers and ultimately customers of the superiority of his product. Many start-ups are organized along non-bureaucratic lines and the founders are prepared to put in many extra hours. The lack of hierarchy and formal roles and the vicissitudes of income as determined by stock options are also characteristic of start-up firms. This applies most forcefully to the founders of the organization, but also to employees, as the example of Microsoft demonstrates. More than a thousand of its (early) hires became millionaires, thanks to stock options. Weber’s hypothesis of the charismatic leader is certainly powerful, because it can explain why people are prepared to leave their old ways of life in order to start anew. His theory of the charismatic leader can explain the rise of Protestant sects. Dissidents are found in all times, but their rise is often arrested by repression. Examples of the persecution of deviants or dissidents abound. We can think of Ancient Rome, which persecuted the Christians, as well as of the Russia of Catharine the Great, which sent its religious dissidents off to Siberia. Religious dissidence was, therefore, limited to periods of imperial decline. This no longer applies to the Western world, where freedom of religion allows people to found new religious

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communities. The same applies to the business world. People are free to found their own firm, although it is easier in some countries than in others. The development of entrepreneurial finance varies among countries as does the regulatory burden.

Schumpeter’s later work Schumpeter wrote a second edition of his Theorie der wirtschaftlichen Entwicklung of about two-thirds the size of the original version. The new edition was published in 1926 and became the basis of the English translation, which appeared as The Theory of Economic Development (ED) in 1934. The second edition – apart from its smaller size – differs from the first on a number of points. First, all passages criticizing Boehm-Bawerk and other economists had been removed. Schumpeter presented his work as a piece of economic analysis and himself as an economist. The professionalization of the social sciences had advanced to a stage that seemed to require a strict demarcation between economics, sociology and history. Schumpeter thus complied with his critics, who had claimed that he had not produced a historical, evolutionary theory of economic change. Schumpeter returned to history in his Business Cycles (1939) and History of Economic Analysis (1954). Another criticism involved the emphasis Schumpeter had placed on the role of the individual in economic development. ‘One of the most annoying misunderstandings that arose out of the first edition of this book was that this theory of development neglects all historical factors of change, except one namely the individuality of entrepreneurs’ (ED: 60). Schumpeter is not prepared to give up his original position that the entrepreneur is the dynamic element in capitalism. He now puts a greater emphasis on the intuitive capacities of the entrepreneur: ‘He has the capacity to see things in a way, which afterwards proves to be true, although it cannot be proven at the time.’ Schumpeter even adds: ‘thorough preparatory work, and special knowledge, breadth of intellectual understanding, talent for logical analysis may under certain circumstances be sources of failure’ (ED: 85). Schumpeter made some superficial changes in his description of entrepreneurial motives, but he stuck to his former statement that entrepreneurial motivation is unlike that of economic man, who is balancing probable result against disutility of effort. The entrepreneur is still motivated by the dream of founding a private kingdom, which most closely resembles the position of medieval lordship. New motives involve the will to conquer, the impulse to fight; to prove oneself superior to others, to succeed for the sake of success. Pecuniary gain is therefore not the main motive for entrepreneurial action, but it is a very accurate expression of success, especially of relative success (ED: 93–4). Schumpeter’s rephrasing of entrepreneurial motives brought him more in line with Knight’s description of what moves the entrepreneur. Knight emphasized sportsmanship to explain entrepreneurship, whereas

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Schumpeter had stressed creativity in his first edition. They now both share the view that entrepreneurship can best be understood as an element of the game spirit and the ambition to win. However, Schumpeter rejects Knight’s definition of the entrepreneur as the capitalist and risk-taker. Schumpeter argues that the usual shareholder has no impact on company policy and hence cannot fulfill entrepreneurial functions (ED: 75). Schumpeter also strongly repudiates the Marshallian definition of entrepreneurship, which treats the entrepreneur as a manager. He draws a sharp line between managers and entrepreneurs. ‘The manager chooses from the most advantageous among the methods which have been empirically tested and become familiar at a certain point in time, whereas the entrepreneur looks for the best method possible at the times’ (ED: 83). He also firmly rejects Weber’s definition of the entrepreneur as the person with a calling. ‘The carrying out of innovation can no more be a vocation than the making and execution of strategic decisions’ (ED: 77). The elements of charismatic leadership that could be discerned in the first edition have now faded. Schumpeter still describes the entrepreneur as a leader, yet the heroism with which the entrepreneur was adorned in the first edition is largely gone. He now calls the entrepreneur a leader against his will, whose only followers are the imitating firms that rob him of his profits. The entrepreneur only needs to convince the banker who finances him (ED: 89). Schumpeter contended that the days of the heroic entrepreneur were almost over. The entrepreneur still needed to confront the opposition from the environment, but this opposition has largely succumbed in modern times. He attributed this to the increased calculability and rationality of the capitalist world. Schumpeter had first depicted the entrepreneur as the man of action who could lead society into new ways of doing things. This figure was replaced by the socially much less apt entrepreneur, who only cared about business and left politics to the politicians. This line of reasoning made Schumpeter predict that innovation could be delegated to experts without affecting performance. Schumpeter foresaw that innovation would become a matter of routine, executed by employees in R&D laboratories. He did not like this course of events, because the world would lose much of its splendor due to these changes. But he thought that increasing rationalization would make it inevitable. Hence, Schumpeter held the view that increased rationality spells the end of capitalism. The origins of Schumpeter’s bleak outlook on the viability of capitalism, which he exposed magnificently in Capitalism, Socialism and Democracy, can thus already be found in the second edition of Theorie der wirtschaftlichen Entwicklung. Schumpeter, however, came to retrace his steps and emphasized competition and liberalism as crucial conditions for economic development in his posthumously published History of Economic Analysis (HEA) (Brouwer, 1996). Schumpeter describes in HEA how competitive capitalism could only develop unfettered after liberalism had become the main political movement. Liberalism – in Schumpeter’s words – entailed the subjugation of

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politics to commerce and reigned only from the end of the eighteenth century till about 1900 (HEA: 761). We could, therefore, conclude that Schumpeter narrowed his theory even further at the end of his life. His theory now only applied to nineteenth-century Western and especially English capitalism, where the state had largely withdrawn from the economic arena and the bourgeoisie had become the leading class. Modern authors on Western history also hold the view that absolutism and its inherent monopolization of economic life have impeded Western economic ascent. North and Thomas explain the economic bloom of England and the Low Countries after 1500 by the absence of absolutism in those countries. A delicate balance was struck between central and local powers, in which neither got the upper hand. In England, the power of the crown was curbed by Parliament, which obtained substantial power under the Tudors (North and Thomas, 1973: 147). A federal form of government, which derived from a league of autonomous medieval towns, ran the seven unified Dutch provinces (McNeill, 1963: 581). However, these were the exceptions. Absolute monarchs ruled in France, Spain, Scandinavia, Poland and Hungary. Local taxes were abandoned and replaced by national taxes such as the French taille and the Spanish alcabala. Absolute rulers created vast bureaucracies whose functionaries were loyal to the crown. Trade, free incorporation and labor mobility were impeded. These measures prevented the emergence of a merchant class in countries that were governed along absolutist lines, which greatly hampered their economic progress (North and Thomas, 1973: Chapter 10).

Rationality of capitalist enterprise Weber defined capitalism as rational calculation applied to the pursuit of economic gain. Rational capitalist enterprise exists – in Weber’s view – when rational methods such as double entry bookkeeping and capital accounting are used (GEH: 275). He distinguished rational from adventurous capitalism. The latter is represented by the overseas trading companies of the sixteenth and seventeenth centuries whose ventures were subject to high uncertainty. This is attested by the fact that many people who embarked on ships of the East Indian companies never returned from their voyages. Weber dates the beginning of rational capitalism to seventeenth- and eighteenth-century mercantilist states. This period was characterized by monopolies granted by the state. Weber calls mercantilism the first rational economic policy, because this policy was primarily directed towards economic welfare instead of reassuring peace among rival groups and classes. Mercantilism meant that the state was run as a single firm. The objective of the state was to generate as much tax income as possible through national monopolies. Mercantilism favored managed instead of free trade. Schumpeter traced the origins of capitalism back to the medieval citystates that largely depended on commerce. ‘Capitalist institutions, such as

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big business; stock and commodity speculation and ‘‘high finance’’ had already established themselves firmly at the end of the 15th century, and had entailed the ascent of the bourgeoisie’ (HEA: 78). Schumpeter contended that capitalist progress was arrested by the rise of the absolutist nation-states that ascended from the fifteenth century onwards. ‘The rising bourgeoisie had to submit for centuries to come to the rule of a warrior class of feudal origins that milked the bourgeoisie to fight their endless series of wars’ (HEA: 144). It was only in the nineteenth century that capitalism regained its bloom under liberal governments, especially in England. Weber considered the ability to calculate profits in advance to be the most distinctive feature of (rational) capitalism, marking it off from its (irrational) predecessors. Capitalist enterprise would take the form of large bureaucracies that would reward people according to their abilities. However, to restrict rationality to capitalism seems somewhat misplaced, as Schumpeter remarked. The lord of the manor also behaved rationally within the feudal setting. The same applied to courtiers, who lived at the French royal court at Versailles, or aspirant Chinese mandarins, who made great efforts to become proficient in reciting Chinese verse. All these people used the possibilities open to them to improve their social position: a clear means–end relationship (Schumpeter, 1991: 325). Knight launched a more devastating criticism on Weber’s identification of capitalism with rationalism. He explained that all ex ante calculations can only be educated guesses of prospective returns. So, it is not so much rationality, but perception that makes a capitalist entrepreneur successful. We could argue that Knight’s financier ‘recognizes’ the innovator and his venture. It is essential that he is ‘recognized’ by some financiers but not by all. Competition among financiers assures competition among innovative firms. Perception can be considered subjective rationality. We might, therefore, argue that (objective) rationality is not the distinctive factor of capitalism. Investment can only be subjectively rational in competitive capitalist societies, where there is always a distinction between ex ante calculations and ex post results.

Conclusion Comparing the three authors, we can note that Weber did not pay attention to either financial matters or uncertainty. Savings funded investment and uncertainty was antithetical to his conception of capitalism as a rational system. Weber sketched the course of Western economic history as a process of increasing rationalization, which resulted in modern capitalism. Schumpeter contested Weber’s view of capitalism as a predominantly rational system, but adopted some of Weber’s points in his later work. Schumpeter attributed a central role to the financial sector, but largely neglected uncertainty in his work. His emphasis on credit as one of the main institutions of capitalism derives from his idea that capitalism allows people from all social classes to introduce innovations. It was Knight who explained how developed financial

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markets absorb uncertainty. Knight’s analysis stresses the game-like and intuitive and, therefore, largely non-rational aspects of entrepreneurship. The entrepreneur can perceive qualities in people, which remain hidden from the average observer. Only the more than average perceptive investor can make a profit, if capital markets are well organized. But capital and IPO markets (Initial Public Offerings) have only recently and in only a few countries achieved the degree of sophistication required for the smooth operation of investment under uncertainty.

3

Organizations and uncertainty The management of perceptions: from medieval Italy to Silicon Valley

Introduction Economic progress is not a smooth, continuous process, but has occurred in fits and starts. Some periods and regions have experienced periods of rapid growth, whereas stagnation, if not outright decline, has prevailed at other times and places. Technological progress is considered the main engine of economic development, but the merit of new technologies is not always obvious from the start. Societies, therefore, need mechanisms to find and select innovations and innovators. New ways of doing things exist as plans before they enter the economy through investments. Innovations can either be introduced by established or by newly founded firms. Schumpeter’s model of economic development was based on innovations that were introduced by new firms, unencumbered by former investments (Schumpeter, 1934). He mentioned the discovery of new trade routes, markets and organizations as innovation types as well as product and process innovations. Schumpeter emphasized the relationship between the innovative entrepreneur and his banker. Weber had advocated saving plus hard work as essential for economic development in his Protestant Ethic. However, his earliest work had centered on the relationship between the financier and the entrepreneur in the medieval commenda organizations. He cast this relationship in the principal–agent mode, which is still applied by modern organization theorists. Weber considered uncertainty, which prevents accurate prediction of future events, to be a negative investment-depressing force. Schumpeter also argued that investors should only choose people, whose qualities were obvious. Entrepreneurship was open to people of all walks of life, in Schumpeter’s view, since bankers would provide the qualified with credits. However, choosing too many entrepreneurs inflates credit creation and creates a depression. Knight, by contrast, contended that both uncertainty and profits derive from differences in perception among investors (Knight, [1921] 1964). The investor will select the venture, through which he expects to become most successful. Investors should hold different views on a project’s prospective worth. Otherwise all investors would flock to the same ventures and drive up the price of the ‘coveted’ people, who would be entitled to the whole residual.

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This chapter builds on Weber’s principal–agent analysis and proposes a revised principal–agent model based on Knightian uncertainty. Organizations conducive to entrepreneurship prevailed in highly successful regions such as medieval Northern Italy and late twentieth-century Silicon Valley. Medieval Italy spawned a revival of trade that later spilled over to the Low Countries and England. The rise of trade allowed a more efficient division of labor and created new institutions to facilitate trade. Both the sea loan and the equity-based commenda organization supported trade in medieval Europe. They share many characteristics with modern institutions such as venture capital and angel finance that were pivotal to the rise of Silicon Valley in the late twentieth century. Both regions featured contracts between investors and entrepreneurs that have similar characteristics. First, contracts were for limited time periods. Second, success and failure were measured impartially by market outcomes. The success of maritime ventures was determined in the product markets where they sold their cargoes. Success and failure of modern ‘high tech’ ventures are largely determined in financial markets that value companies at an IPO or acquisition. A third characteristic involves the sharing of profits between investor and entrepreneur. A fourth feature involves the limitation of liability to opportunity costs. The chapter discusses the evolution of medieval maritime organizations. Weber described the evolution of these organizations into limited liability companies with autonomous management. This feature sat somewhat uneasily with the link he posited between authority and liability. The person authorized to take decisions should be liable for failure, in his view. Weber’s definition of the entrepreneur as decision-maker could apply to both the investor and the captain of a maritime venture. Schumpeter reserved the term for the founder and leader of the venture. Knight designated the investor the main decisionmaker. Common parlance has not adopted the concept of entrepreneur as financier, but as founder of a venture. We will stick to this convention.

The analysis of medieval maritime ventures Maritime ventures in medieval Italy Maritime ventures of old were subject to uncertainty. Sailing ships could be wrecked by storms or fall into the hands of pirates. Trade routes could be lost to competitors. The destination was never reached and the riches that were expected to await the adventurers sometimes were never found. Transport over land also had its hazards, but was considered safer. Uncertainty was increased by the fact that all investments in cargo, ship and crew could be lost in the case of failure. We can say that events like ship wrecks literally sunk the investments. We will analyze medieval commercial partnerships using Weber’s (1889) essay on the topic and some succeeding publications. Weber studied the contracts and judicial decisions of several Italian city-states to explore the

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evolution of these partnerships. Venice, Pisa and Genoa were pivotal areas of maritime trade, whereas Florence and Piacenza were oriented towards overland trade. Maritime partnerships can be traced back to ancient times. The Roman foenus nauticum or sea loan was preceded by the Greek sea loan that was mentioned by Demosthenes in a speech he gave in 340 BC. The sea loan was a contractual relationship between an entrepreneur and an investor and was especially designed to bear the risks of trade. However, medieval maritime organizations differed from their predecessors, in Weber’s view, ‘The Middle Ages attempted to establish independent rules for the risk that maritime trade carried’ (Weber, 2003: 63). The medieval legal rules for maritime partnerships emerged through decisions made by special commercial courts. Court judgments were codified as happened in Pisa in the Constitutum Usus and in Genoa in the Rota Genoa. These procedures allowed the law to adapt to changing circumstances. Weber described how someone could rise in early medieval Venetian society. He could secure credit or obtain money from the upper-class families and try to amass riches through trade. This would allow his ascent into the Venetian nobility up to the closing of the Great Council. He could either carry on trade after returning home successfully or retreat to the countryside. He could also invest his fortune in new ventures (Weber, 1995: 324). Italian maritime partnerships were of two broad categories: the sea loan and the commenda. The sea loan was a contract between an entrepreneur and an investor to buy and sell goods on a certain journey. The risk attached to the sea loan is expressed by the customary interest rate of 35 percent that these loans carried in Pisa (ibid.: 206). Genoa, where sea loans were in extensive use, had standard rates for each destination. The interest rate to Syria was usually about 50 percent; to Sicily the rate was customarily between 25 and 30 percent, to North Africa from 20–30 percent and to Sardinia and Corsica from 10–20 percent (Hoover, 1926: 505). The rates differed with the length of the journey and the expected risk. The entrepreneur did not have to repay the sea loan, if failure was caused by peril beyond his control, as he was only liable for avoidable damages. Principal and interest payments were only due if the ship arrived safe in the harbor. The entrepreneur got some days or weeks (depending on the destination) to sell his merchandise and pay off his debt and interest (ibid.: 502). At the end of the thirteenth century, merchants could obtain loans by mortgaging their share of a ship or the cargoes. It was no longer necessary to mortgage their private possessions and those of their family (ibid.: 509–10). The commenda organization that was especially popular in Pisa and Venice also developed into a contract which featured limited liability of both investor and entrepreneur. The commenda organization was based on equity instead of debt and became the most popular organizational form of maritime ventures in medieval Italy. This development had nothing to do with the ban on usury that was proclaimed by the Catholic Church, since the

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commenda organization had already become popular before the canonical prohibition of the sea loan in 1234 (Weber, 2003: 138). Commenda partnerships were common in twelfth-century Pisa. The Venetian Collegantia even dates back to the eleventh century. Commenda-type partnerships consisted of investing and managing partners (the stans and the tractator). Agency problems could be avoided, if the investor personally sailed on the ship but investors remained at home most of the time. The manager’s compensation consisted of a share of profits in the commenda organization. Weber distinguished between the unilateral commenda and the bilateral commenda (Societas Maris). Investing and managing partners were different people in the unilateral commenda. The managing partners did not contribute to capital and were entitled to one quarter of the profits. This differed from the Societas Maris, where the venture’s leader contributed one-third to capital and was entitled to half of the profits. Entrepreneurial shares were identical in the two cases, since the entrepreneur of the Societas Maris received his share plus one-third of the share of the profits of the investing partner(s): 1 1 1 3 ¼ þ  2 4 3 4 Hence, profit shares of one quarter were common for entrepreneurs in those days, who only invested their human capital. We may note here that standardized rates prevailed in both sea loans and commenda contracts. Interest on the sea loan was considered an insurance premium in medieval Europe. Insurance premiums cannot be exactly established, if the risk cannot be quantified. The equity-financed commenda organization was, therefore, better equipped to deal with Knightian uncertainty than the sea loan. Most commenda contracts were concluded for the length of one journey or round trip. Profits were distributed after the merchandise was sold. Venetian commendas were founded for a certain period of time instead of a journey. In 1271, the city of Venice restricted this period to two years. Weber reserved the term entrepreneur for the party that was authorized to make decisions. The investor was the entrepreneur, when the non-investing partner was not authorized to represent the venture in transactions with third parties. Weber contended that the captain was only an entrepreneur, if he were on an equal footing with the investor(s). This applied to general partnerships, where both authority and liability were shared and decisions were taken collegially (Weber, 2003: 122). Partnerships, in which authority was not shared, were considered associations between persons who were not socially equal (ibid.: 147). Joint liability indicates social equality, in his view. We could argue that the main strategic decisions had already been taken before the journey started. The captain knew where to go to and what to buy. But, he had to act according to his own judgment in situations of

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contingency. Contact between captain and investor was not possible while at sea, but could be conducted, although with considerable delay, at sea ports. A principal–agent relationship involves that the principal hires an agent to achieve his goals. The agent has to follow the principal’s instructions, but this causes problems, if the principal is not always around to supervise the agent. The relationship between stans and tractator, therefore, represents an essential principal–agent problem. An agent can only be held liable if failure is due to neglecting the principal’s instructions. Commenda organizations – like sea loans – distinguished between failures that were due to avoidable mistakes and those that were not. The tractator was not liable for the whole investment, if the venture failure was not his fault. The burden of proof in this case rested with the investor (ibid.: 82). The tractator was only personally liable for the debts he incurred on his own account during the voyage. Side contracts could occur, when the tractator did not have the authority to act on behalf of the other partners. The authority of the tractator increased, as the commenda organization developed. The commenda became an organization with a common fund (hentica) and tractators, who could act on behalf of the company. Jurisprudence shows this evolution of the commenda organization into a legal person (ibid.: 171). The commenda became a limited liability company, in which liability of both stans and tractator were restricted to their investments in the venture in the case of bankruptcy. The investor was only liable for the amount of his investment, and his personal creditors could not seize the partnership fund in case of personal bankruptcy. The tractator’s liability was also limited to his opportunity costs (ibid.: 77). The commenda organization further evolved into a corporation with many investors and one managing partner. Shares became widely held and the commenda organization became a banker’s business, in Weber’s words. Weber notes that this evolution towards a separate fund had progressed further in Pisa and Venice than in Genoa (ibid.: 136). Weber’s interpretation of the evolution of maritime enterprise Weber interprets the evolution of the commenda organization as the development from a general to a limited partnership (Weber, 2003: 179). The early commenda organizations were general partnerships, in which authority and liability were shared equally. Both investor and captain could lose their personal wealth in the case of failure. Investors became limited partners, when their numbers grew and they all contributed to a separate fund. The investors only had an impact on decision-making, if their numbers were few. The tractator could follow his own judgment, if he could act on behalf of the other socii without consultation (ibid.: 179 fn). Hence, Weber pointed out the separation between ownership and control in corporations in his 1889 thesis. Berle and Means made this distinction popular in their 1932 classic. Weber argued that the tractator who operated on behalf of a widely

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dispersed fund had great autonomy. This applied to the Venetian Collegantia, which often counted thousands of investors. Weber noted that the common case was that wherein the tractator was the person in authority (ibid.: 130). However, the tractator could lose only his share of profits in limited partnerships. His personal property remained unaffected, if failure was not his fault. The combination of limited liability and full authority of the tractator struck Weber as odd. He argued that the tractator should be held personally liable, if he was the sole decision maker. But, his view on this matter was not supported by what he found in the documents (ibid.: 134). Weber identified rational capitalism with calculable risks in his later work. He came to portray maritime ventures as belonging to an era of adventurous capitalism due to the incalculability of their profits. Liability figures largely in his best-known work, The Protestant Ethic and the Spirit of Capitalism. The Calvinist Puritan believed that commercial success and failure were divinely ordained and predestined one’s position in future life. Liability was thus extended beyond this lifetime. We could, however, argue that limited liability of the tractator is plausible, even if he acted without consulting the investors. That is because the traveling partner could not diversify his risks the same way as investors could. The captain and his crew were thus more committed to the venture. Liability for unforeseen events would be an inappropriate incentive under these conditions. People would be deterred from undertaking entrepreneurship, if they (and their family) were held personally liable for things beyond their control. Diversification was common among medieval investors. Andrea Barbarigo, a fifteenth-century Venetian merchant, invested his capital in various ventures (Lane, 1944). Undeterred by losses in many ventures, he persevered until gains greatly exceeded his losses. The spread of the commenda organization Limited liability was specific to maritime ventures. The medieval societas terra organization resembled the commenda organization, but lacked its limited liability features. The tractator assumed the risk in the societas terra that was created to organize overland ventures for the citizens of Piacenza. The investors were limited partners and had no voice in decision-making. The entrepreneur was personally liable in the societas terra and ‘only an Act of God relieves him of the obligation to have to return the investment in full’ (Weber, 2003: 82). Weber argued that adventurous capitalism preceded rational capitalism, which features mass production (Weber, 1995: 310). However, many institutional innovations sprang from European long-distance trade. The bill of exchange, weights and measures, double entry book-keeping and commercial law were institutional innovations that originated in Europe after 1100. These diverse innovations and institutions created large-scale markets and stimulated growth and commerce (North, 1990: 130).

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Commenda organizations became less popular in Italy after 1500, but spread to other parts of Europe (Kohn, 2003). The corporation with limited liability became popular in England in the fourteenth century. The North German Hanseatic Union also used commenda-type contracts in the fifteenth and sixteenth centuries. The same applies to the Spanish trade with the Americas in the sixteenth centuries (Postan, 1973). Commenda-type contracts became extremely popular in the Netherlands in the sixteenth century for investments in shipping companies (rederijen). The companies undertook voyages to the Baltics, Africa, the Americas and the Indies (Gelderblom, 2003). The rederijen preceded the large trading companies such as the Dutch East India Company. The latter was founded in 1602 and had – in contrast to the rederijen – a monopoly on Dutch trade with the East Indies. The rederijen hardly took on any debt and were almost completely financed by equity. Additional capital was furnished by issuing additional shares (Riemersma, 1952). The rederijen were enterprises of indefinite duration in contrast to the commenda organizations. However, profits were paid out after every voyage and shareholders could decide either to abandon the enterprise or to continue participation (Christiensen, 1941). The captain usually received one-eighth of profits. Many shareholders in the shipping companies were passive and were not involved in the company’s decision-making. Joint stock companies arose in England in the sixteenth century. Firms were formed for a single venture and profits were distributed after the venture was concluded (Baskin, 1988). However, the end of the venture could be postponed in the case of failure. Initial shareholders could be called upon to invest additional capital to make the company successful. However, they could not be forced to pay up and many refused to do so (Shammas, 1975). So, investment was de facto limited to the initial deposit. Weber’s view of principal–agent relationships Weber made extensive use of the term ‘agent’ in his insightful analysis of maritime partnerships. His treatise can be considered a predecessor of modern analyses of principal–agent relationships. Weber describes maritime ventures primarily as voluntary associations of people, whose interests are aligned. The principal–agent relationship in maritime ventures was characterized by the principal’s trust in the agent. This transpires from Lane’s description of how Andrea Barbarigo, a Venetian investor selected his agents: ‘He had to pick an agent, who was expected to show good judgment in his appreciation of market situations’. Barbarigo’s business letters to his agents contained numerous expressions of affection and trust (Lane, 1944: 99). The relationship between principal and agent was expressed in the maxim: ‘If you distrust a man do not employ him, if you employ a man do not distrust him’ (ibid.: 107). Principal–agent theory addresses the incentive problems facing principals who have to rely on agents for the execution of certain tasks. Principal– agent problems arise in all situations in which people work together. Weber’s

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picture of the principal–agent relationship differs from modern approaches stressing moral hazard problems of agency. This literature assumes that agents are inclined to pursue their own goals instead of the principal’s. Moral hazard problems were attenuated in maritime ventures that were formed for one specific voyage or a limited time period. The venture was dissolved after the merchandise was sold and everyone had received his contractual share of profits. The limited length of the venture and its mission as stated in the contract thus reduced possibilities for post-contractual opportunistic behavior. Rational bureaucracy featured as the organizational ideal in Weber’s later writings. He foresaw bureaucracy becoming the dominant organizational form in all types of society, both capitalist and socialist. Rational bureaucracy would imply a strict hierarchical order of command with the leader at the head of the organization (Weber, 1978: 120). Bureaucracy – in his view – is superior to other forms of organization in its precision, stability, the stringency of its discipline and its reliability (ibid.: 223). Authority in rational bureaucracy rests on expertise. Communication is unidirectional and limited in Weber’s bureaucracy where one person gives orders. However, innovation requires more sophisticated modes of communication and selection. This applies particularly to the valuation of human capital in ‘high tech’ ventures in both emergent and established firms.

Modeling investor–entrepreneur relationships A model when investor and entrepreneur have identical perceptions The commenda contracts depended on the risk perceptions of both the investor and the entrepreneur. We model the investment decision of an investor, who is seeking entrepreneurs to start new ventures such as setting up a ship for sail to faraway shores or starting a technology firm. The investor has to decide on several issues. He needs to decide how much to invest; whom to hire as entrepreneur, how to govern the venture and how to reward the entrepreneur. We assume that the entrepreneur is presently employed and receives wages equal to Y. His present wages are a fixed income and constitute his opportunity costs. The potential entrepreneur considers his talents to be underestimated up till now and deems his worth to be Y þ Z. His extra worth needs to be ‘recognized’ by an investor. We assume that one investor perceives an entrepreneur’s extra worth and is prepared to pay a bonus equal to Z over his present income Y, if the outcome were certain. But, competition or natural hazards make the outcome of the venture uncertain. Two outcomes are possible; success or failure. The entrepreneur’s income in the case of success exceeds that of failure (W s > W f ). Both investor and entrepreneur attach certain probabilities to the occurrence of both states. We will first assume that investor and entrepreneur attach identical probabilities to the occurrence of the two states. An investor favors a certain entrepreneur over others, because he perceives his

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chance of success to be higher. We’ll assume that both the investor and the entrepreneur of his choice expect to accomplish their mission with an 80 percent chance of success. There are two constraints to such a contract (Shy, 1996: 398). The first constraint involves that a prospective entrepreneur will only enter into a contract with an investor, if he expects to earn Y þ Z. The second constraint involves that the investor will hire this person and not somebody else. The agent will only choose entrepreneurship, if he expects to receive his ‘full worth’ as entrepreneur: The incentive constraint for the entrepreneur is: 0:8W s þ 0:2W f  Y þ Z ! W s  1:25ðY þ ZÞ  0:25W f

ð3:1Þ

The second constraint involves that the investor will only enter into a contract with the entrepreneur of his choice, if he does not expect to pay a higher income to this entrepreneur than to an entrepreneur whose chances he estimates lower. We assume that he expects the other entrepreneur’s success rate to be 40 percent. The incentive constraint for the investor is: 0:8W s þ 0:2W f  Z  0:4W s þ 0:6W f 0:4ðW s  W f Þ  Z ! W s  W f  2:5Z

ð3:2Þ

W f  W s  2:5Z The wages to be paid in cases of success and failure can be calculated from this: W s ¼ 1:25ðY þ ZÞ  0:25ðW s  2:5ZÞ 3 Ws ¼ Y þ Z 2 Wf ¼ Y  Z The entrepreneur thus receives a bonus of 1:5Z, if the venture is successful and pays a penalty of Z below his opportunity costs Y, if the venture fails. The entrepreneur will thus receive less than he would get in a position with a fixed remuneration in the case of failure. The investor expects to pay and the entrepreneur expects to receive: 3 E W ¼ 0:8ðY þ ZÞ þ 0:2ðY  ZÞ ¼ Y þ Z 2

ð3:3Þ

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Hence, the principal does not expect to pay more than Y þ Z. This applies to all success and failure ratios. Uncertainty thus does not affect expected remuneration, but entails that revenues will differ for the two states. We could call this an expectational equilibrium where the entrepreneur expects to receive and the investor expects to pay Y þ Z. When investor’s and entrepreneur’s perceptions differ The entrepreneur will only enter the agreement, if he expects to earn Y þ Z. We have assumed this far that investor and entrepreneur have identical perceptions. However, we can demonstrate that risk-loving persons have higher chances on entrepreneurship. The entrepreneur would expect to earn more than Y þ Z, if he is more confident than the investor. We explore what he would expect to earn, if the entrepreneur estimates his chance of success to be 90 percent, whereas the investor’s estimate is 80 percent: 3 W Eent ¼ 0:9ðY þ ZÞ þ 0:1ðY  ZÞ ¼ Y þ 1:25Z 2 Hence, the entrepreneur expects to receive more than the investor expects to pay, if he is more confident of the venture’s outcome than the investor. Accordingly, the entrepreneur will expect to earn less than Y þ Z, if he is less confident than the investor. Optimistic persons are thus more inclined to become entrepreneurs than pessimistic ones. Optimism could induce entrepreneurs to conclude agreements with investors, who are only prepared to pay low entrepreneurial bonuses. Investors will thus prefer confident entrepreneurs to less confident ones. Pessimistic entrepreneurs would only enter contracts with investors, who are prepared to pay high premiums; which makes them unlikely candidates for entrepreneurship. Weber’s idea that people who think they are predestined to be successful will enter more easily into entrepreneurship can thus be modeled in this way. Why investors’ perceptions should differ The model can be put in more general terms. We assume that the chance of success for the entrepreneur that is chosen by a certain investor is estimated at 1  a, whereas the chances for the entrepreneur, who is rejected by a certain investor are estimated at 1  bð0 < b; a < 1; b > a). Another investor can hire the rejected entrepreneur. The incentive constraint for the entrepreneur then takes the following form: ð1  aÞW s þ aW f  Y þ Z 1 a ðY þ ZÞ  Wf Ws  1a 1a

ð3:4Þ

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The incentive constraint for the investor is shown in (3.5). The investor would not want to pay more to the chosen entrepreneur than to a nonfavored entrepreneur: ð1  aÞW S þ aW F  Z  ð1  bÞW S þ bW F ðb  aÞðW S  W F Þ  Z Z WS  WF  ba

ð3:5Þ

The investor would always expect to pay Y + Z: E W ¼ ð1  aÞW S þ aW F Y þZ a  W F  þ aW F E W ¼ ð1  aÞ½ 1a 1a EW ¼ Y þ Z

ð3:6Þ

We can conclude from (3.6) that the investor always expects to pay Y þ Z equal to what was demonstrated above. Equation (3.5) indicates that the difference in revenues from success and failure narrows, if investors’ perceptions are further apart and widens, if their perceptions are more aligned. In the above example with probabilities of 0.8 and 0.4; the difference between success and failure W s  W f amounts to 2:5Z. However, if one investor were to attach a probability of 0.95 to a certain venture, which another investor only estimates to be only 0.05, the difference between success and failure would shrink to 1.11 Z. This points to the fact that the investor who considers success almost certain is prepared to pay only a small bonus in the case of success. The expected wage in the case of success would approach Y þ Z and the wage paid in the case of failure would approach Y , if b  a are further apart. A situation, where an entrepreneur is pursued by several investors, paints a different picture. Entrepreneurs who get identical offers from more than one investor can demand a bonus equal to Z upfront. Investors would have to pay Y þ Z irrespective of outcomes, if investors valuate entrepreneurs equally. That is because W s ¼ W f , if b ¼ a in (3.5). W s ¼ W f then ¼ Y þ Z in (3.4). Hence, an entrepreneur who is favored by more than one investor can seize the entrepreneurial premium Z irrespective of the actual outcome of the venture. We can distinguish two opposite cases of coinciding preferences. The first involves an entrepreneur that is each investor’s first choice. All investors would then choose the same entrepreneur and reject all others. We can conjecture that such an entrepreneur can bid the entrepreneurial premium Z up and demand a high ex ante income. He is the manager that every corporation wants to employ. This implies a bidding process, which would leave investors without (surplus) rates of return. The opposite case

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involves indifferent investors, who do not prefer one entrepreneur to another. Investors might not want to pick a particular venture, but to create a portfolio in order to spread their risks. Complete diversification would signal that investors are indifferent among investment projects, which reduces the bonus Z. But, entry into entrepreneurship would be reduced in both cases of coinciding perceptions. Investors who all favor one potential entrepreneur foreclose entry into entrepreneurship to all others. Investors who are indifferent to all entrepreneurs cannot choose. Their inability to pick entrepreneurs entails that they will diversify their investments among an existing set of entrepreneurs. Entry into entrepreneurship is stimulated, if investors have clear, but differing opinions about the prospective worth of entrepreneurial ventures. The difference between ex ante and ex post valuations triggers investment due to the hopes of above normal rates of return. Share of profit contracts Contracts between investors and entrepreneurs are usually designed in a way that entitles an entrepreneur to a share of profits. Investor and entrepreneur usually both have an equity stake in the business. The profit share of the entrepreneur is independent of perceived risk and amounts to his perceived worth as a percentage of total investments (I) as perceived by one investor. Hence, an entrepreneur, who leads a venture, whose perceived worth is Y + Z will obtain: Y þZ I as a share of profits. Share of profits contracts entail that the entrepreneur will receive nothing in the case of failure. The income that entrepreneurs receive in the case of success will then equal (see 3.5): Ws ¼

Z ba

Inserting W f ¼ 0 in (3.4) would make the wage that would be paid in the case of success: Ws ¼

Y þZ : 1a

Combining the two equations gives us an indication of the size of the entrepreneurial premium:

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Organizations and uncertainty ba Y Z¼ 1b

It follows from these two equations that: Ws ¼

Y ; if W f ¼ 0: 1b

Hence, an entrepreneur would receive twice his opportunity costs, if other investors would attach a probability of 12 to his venture and four times his opportunity costs, if other investors estimated his chances of success to be 14. The entrepreneur’s remuneration in share of profit contracts is thus determined by his opportunity costs and by how other investors perceive his venture. This type of contract differs from the bonus contracts discussed above where the revenue in the case of success was negatively related to the difference in perceptions between investors. The expected revenue in the case of profit-sharing contracts, by contrast, is positively related to other investors’ opinions. We could explain this by identifying 1-b with general investor sentiment. Little will be invested, if the investment community at large expects low returns on entrepreneurial ventures. Consequently, a venture that is launched during an investment slump can reap high revenues once the general mood has improved. Both investor and entrepreneur can benefit from the change of mood. Entrepreneurial investments are subject to recurrent waves of over- and under-investment. More capital will flow into the market, if outcomes exceed expectations. The reverse will happen if the investment community was too optimistic. The perceptions of the investor community thus determine the amount that is invested in new ventures. Venture finance will only be viable in the long term, if unexpectedly high profits balance unforeseen losses. Equity finance creates self-adjusting expectational equilibria.

Investments and uncertainty People will be drawn to entrepreneurship as long as some glittering prizes are to be won and if losses can be curtailed. Share of profit contracts extend the upside gain and limit entrepreneurial losses to opportunity costs. Equity finance will be preferred to debt, if uncertainty about a venture’s outcome prevails. Sunk costs will increase uncertainty and contribute to a choice of equity over debt. We assume that an investor grants a loan of one unit to each venture, in which he participates. Both principal and interest will be paid at the end of the period that is assumed to be one year. An expected success rate of 80 percent (4 out of 5) would require an ex ante rate of return of 1.375 to obtain a realized rate of return of 10 percent, if we assume that the whole investment were lost in the case of failure [x.ðn-1Þ ¼ 1:1n. For, n ¼ 5; x would be 1:375]. An expected failure rate of 40 percent would require a return of 1.83 times the initial investment to reap

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an overall rate of return on investment of 10 percent. Unexpected gains can balance out unexpected losses in equity finance. This differs from debt finance, where interest rates of 83 percent are inadmissible. It can also be demonstrated that incentive contacts in which investor and entrepreneur share profits do not hurt the investor. The investor would need returns on his investment of 2.43 if the entrepreneur has an equity stake of 25 percent (1:83  43 ¼ 2:43). However, a profit-sharing agreement would save him Y þ Z per venture, if entrepreneurs do not receive wages. Assuming that the entrepreneur’s profit share of 14 equals his worth as estimated by the investor means that the investor can reduce his investment to 34th of the sum he would invest without a profit-sharing contract. Hence, a profitsharing agreement does not affect his rate of return under these conditions. Equity finance also addresses moral hazard problems. Debt finance would heighten moral hazard problems, if credits were granted to entrepreneurs under conditions of limited liability (Jensen and Meckling, 2000). The entrepreneur would be the sole residual claimant in the case of success, which could inspire him to take undue risks. Equity finance means that both the entrepreneur and the investor are in the same boat. The above model indicates that share of profit contracts do not affect investors’ expected profits. The model also indicated that people would only choose entrepreneurship, if they expect to earn more as entrepreneur than in other lines of occupation, which points out the selection function of such contracts. Investors have to search for people they value more than their present employers. Another conclusion that can be drawn from the model is that entrepreneurship thrives on differences of opinion among investors. Investors as a group will only receive long-run ‘normal rates’ of return, if markets for entrepreneurial capital are competitive. Only the more perceptive investors would earn above average returns on their investments, whereas others lose out. Competition among investors spurs diversity, because investors have to look for hidden potential. Perceptive investors who favor entrepreneurs without easily observable characteristics that reveal their ‘true’ worth can earn high rates of return. Competition will thus spur perceptiveness, which can explain why investors constitute a specialized profession. Another conjecture of the model involves that entrepreneurial profit shares would tend to standardize in competitive capital markets. Chosen entrepreneurs would all receive equal profit shares in the case of success, if the perceived worth of each entrepreneur amounted to (Y þ Z) for a class of ventures, requiring equal investment outlays (I). This hypothesis was borne out by the facts in the case of maritime ventures. We noticed that the profit shares of the entrepreneur in the commenda enterprise were standardized at 25 percent. We could argue that ships were more or less identical and required equal investment expenditures. Ventures can be governed in several ways. Investor and entrepreneur could enter into a partnership and decide collegially. Authority could be

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delegated to the entrepreneur, if equity is widely dispersed among many shareholders. We can also conjecture that each venture should be of limited duration, if equity shares are illiquid, to allow investors to periodically re-allocate their capital. Liquidity of shares would remove the limitation on enterprise length of life. But high liquidity would increase the entrepreneur/manager’s authority at the expense of investors.

Comparing old and new venture capital Modern organizations feature limited liability of both shareholders and managers. The separation between ownership and control that Weber noted in the medieval commenda organizations can also be found in modern corporations. Modern public corporations have an indefinite length of life in contrast to their medieval counterparts. We conjectured above that indifferent investors would impede entry into entrepreneurship, since they would only diversify from a set of existing entrepreneurs. We can, therefore, argue that some investors should specialize in picking novice entrepreneurs in an expanding economy. This consideration casts some doubts on the alleged evolutionary path of commenda organizations from private partnerships to publicly held corporations. It seems reasonable to assume that both types of organization coexisted in medieval times as they do in modern economies with their mix of private and public companies. Modern economies have institutions that specialize in selecting new ventures. Retired businessmen with some money to spend (angels) can fund novice entrepreneurs. US venture capital firms have specialized in seeking and financing new ventures of non-kin. European venture capital, by contrast, was less inclined to fund new enterprises (Brouwer and Hendrix, 1998). American venture capital firms are usually limited partnerships and act as intermediaries between investors and entrepreneurs. They raise capital from a variety of investors and establish venture capital funds with a limited length of life (usually 10 years). Investors are wealthy individuals, companies and institutional investors. The investors are limited partners and the managers of the fund are general partners or venture capitalists. Both types of partners have limited liability. Venture capital funds invest in equity or convertible securities of companies without collateral. They especially finance ventures in ‘high tech’ industries. Investments in those companies can be considered sunk. The average time that passes before a company receives a first round of venture capital is one year. Investment takes place in rounds of limited length (roughly one year) (Gompers, 1995). This staged investment process allows venture capitalists to revise their opinions regularly and resembles commenda practices, where opinions could be revised after each journey. Successful companies have usually received several rounds of investment before exiting the venture capital fund. A venture capital

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firm usually comprises several funds. Each venture is picked by a lead venture capitalist, who monitors the venture. Founders receive a part of equity in return for their human capital and may invest some capital of their own. A venture capitalist usually monitors several ventures and can thus spread his risk. The entrepreneur/founder lacks possibilities to diversify his human capital and is thus most committed to the venture. We noticed above that entrepreneurs were entitled to standard profit shares in medieval ventures. The same happens in venture capital, where the standard venture capital ‘cut’ for venture capital managers amounts to 20 percent. Successful funds can raise more capital, but usually do not increase their stake. Only very successful funds could bid up their stake. This happened with the later Kleiner & Perkins funds, where the venture capital stake was raised to 30 percent (Kaplan, 2000: 201). The venture capital firm can diversify its investments through syndication. Several venture capital firms usually participate in a deal. We hypothesized above that entrepreneurship would flourish, if investors’ preferences differed. Syndication seems to run counter to this idea. However, venture capital decisions are not coordinated. Entrepreneurs who were rejected by one venture capital firm were able to obtain finance from another. The venture capitalist fulfills the Knightian entrepreneurial function of selecting the venture. The founder is the entrepreneur in a Schumpeterian and Weberian sense, if he leads the new enterprise. Authority is shared in venture capital-backed firms, as both venture capitalist and founder(s) have seats on the board of directors. Ultimate authority remains with the venture capitalist, who can fire the CEO/entrepreneur and/or cause the company’s demise by withholding further finance (Sahlman, 1994). This is similar to commenda finance, where investors could also decide not to conclude new contracts with a certain entrepreneur. Executive authority can be assigned to the founder, if he becomes the new firm’s CEO, but can also be assigned to non-founders. Sometimes, the venture capitalist becomes CEO, as happened at Tandem Corporation where Perkins of Kleiner & Perkins was the first CEO (Kaplan, 2000). Venture capitalists who become CEO usually leave the venture capital firm to avoid conflicts of interest due to over-commitment. There are also instances where an investor acts as CEO. That happened in the early days of Netscape, when Jim Clark, a main investor, led the company. Jim Clark, a former Stanford professor and founder of Silicon Graphics, obtained one-third of Netscape equity in exchange for his directorship and an investment of $4.5 million in the company. Noyce and Moore also invested $245,000 each, when they founded Intel after leaving Fairchild Semiconductors in 1968. The Netscape and Intel deals resemble the Italian Societas Maris organization, where the entrepreneur is also a main investor. We can argue that founders who became wealthy in a former venture had to show their commitment by investing part of their wealth in the new start-up. CEOs of new companies can also be recruited from the existing management pool. This happened at Netscape, where Jim Barksdale of McCaw

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Cellular was hired to become CEO, when Jim Clark gave the position up. Sequioa Capital hired Tim Koogle, an in-house venture capitalist at Motorola, to become CEO of Yahoo instead of founders Jerry Yang and David Filo. Venture capitalists have to look for hidden potential with low opportunity costs. This can explain why they look for new graduates or college dropouts. People with low opportunity costs are attractive, but are also considered risky. This can explain why some very successful entrepreneurs were college drop-outs. Bill Gates, the founder of Microsoft, who dropped out of Harvard at age 19 to found Microsoft is the most telling example. Oracle founder Larry Ellison and Steve Jobs and Steve Wozniack of Apple fame were also college dropouts. Their opportunity costs might have been too low to attract venture capital initially. This happened to the founders of Apple, who were rejected by two venture capital firms. The initial funding of Apple came from Markkula, who had made his fortune when Intel went public. He helped Jobs and Wozniack to write a business plan, wrote some software and invested $91,000 in exchange for one-third of the company. Oracle bootstrapped its growth by obtaining CIA assignments in its early days.

Conclusion Maritime ventures of old have triggered many organizational and institutional innovations. The robustness of profit and property-sharing arrangements to manage uncertainty is demonstrated by the similarities in the general structure of contracts backing entrepreneurship. Limited length of life, limited liability and profit-sharing contracts characterize both medieval maritime ventures and modern ‘high tech’ enterprises that are financed by venture capital. The use of equity finance prevails in both time periods. Modern venture capital firms also finance ventures of non-kin, whose outcomes are uncertain. Silicon Valley ventures display organizational forms that were found in medieval Italy. The pool of venture capital-backed entrepreneurs is composed of novice and seasoned entrepreneurs. Novice entrepreneurs invest their human capital in return for a share in the venture. Seasoned entrepreneurs, who made a fortune in earlier ventures, have to demonstrate their commitment by investing both human and financial capital in repeat ventures. The contracts concluded with these two groups of entrepreneurs resemble those of the commenda and Societas Maris organizations of medieval times.

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Introduction The previous chapter explained how uncertainty causes investment outcomes to differ from expectations. This applies primarily to individual ventures, but also to entrepreneurial investment as a whole. Such deviations from expectations do not need to affect investment expenditures, if longterm average expectations are upheld. Average rates of return meet expectations, if profits exceed losses enough to satisfy investors. Expected average rates of return can be as low as the risk-free interest rate, if capital markets are perfectly competitive. Imperfect capital markets will reach equilibrium at higher expected rates, which curbs investments. The expected rate of return is influenced by the institutional set-up of (national) capital markets and government policies. Well-developed financial markets will fund more investments than weakly developed financial markets. The concept of expectational intertemporal equilibrium was developed by Edmund Phelps and Milton Friedman. An expectational equilibrium is one of self-fulfilling expectations.We can refer to the natural rate of unemployment as an expectational equilibrium. The natural rate of unemployment is determined by institutional arrangements with respect to wage determination, job security, real interest rates and productivity increases. Lower real interest rates boost employment and reduce the natural unemployment rate, since they increase investments. Social welfare programs increase the natural rate because they reduce the gap between work and non-work income (Phelps and Zoega, 1998). Disequilibrium includes both random expectations errors and fundamental disequilibrium (Phelps and Zoega, 1997: 283). Random deviations do not need to affect long-run expectational equilibrium, if the economy veers back onto its long-term trend after a crisis or recession. The economy does not need to depart for long periods from longrun growth paths, if former expectational equilibrium can be restored. Long-run expectational investment equilibrium requires that financial markets withstand crises and develop to higher degrees of sophistication. The analysis of medieval entrepreneurial ventures indicated what happens, if each entrepreneur is preferred to others by only one investor. We can express

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this by saying that investors have different private valuations of entrepreneurial hopefuls. Each investor chooses different entrepreneurs and each entrepreneur only receives one bid that exceeds his opportunity costs. The ex ante valuation of all chosen entrepreneurs tends to be identical. This transpires from the fact that entrepreneurs received equal profit shares in Italian commenda organizations. We can argue that equal profit shares indicate an equal playing field for entrepreneurial ventures. Each chosen entrepreneur is considered to be fit to play the game and expected to be successful. Constant shares of profits also prevail in modern venture capital contracts, where fund managers receive 20 percent of profits. It also prevails in hedge funds, where fund managers also receive 20 percent of profits. Ex post outcomes can differ considerably among ventures. This does not need to hurt investments as long as average expectations are met (in the long run). It was pointed out above that a diversity of investors’ views is essential for the launch of a multitude of ventures. Entrepreneurs that are valued equally by more investors can ask their (high) worth upfront. We can compare this to bestseller authors, who can ask a fixed fee before the book is published, whereas less popular writers depend on royalty payments, the size of which is determined after publication. The fact that somebody has written a bestseller reduces uncertainty about their future publications and triggers a bidding war. Only a few books would be published, if publishers all chased the same authors. Private valuations thus stimulate diversity. Investment decisions are also interrelated. Better than average returns are reaped, if investors collectively underestimate future profits. The opposite will happen, if they overestimate future profits. We could call this the common value problem of investment. Investors who come in late and pay high prices for stocks suffer from the winners’ curse, if it turns out that they have overestimated the stock values and share prices collapse after buying. These swings in investor mood generate boosts and busts on the stock market. Investments will decline, if average returns on investments fall below expectations, whereas investments increase, if returns exceed average expectations. The market will correct these deviations from expectations. However, investments can be completely frozen, if busts are considered to be caused by misconduct and fraud. These allegations come to the surface at almost every stock market collapse and have led to regulations on investments that forbade certain financial instruments. This applied to the reaction to Tulipmania in Holland in the seventeenth century and to the legislation that was triggered by the South Sea Bubble Company of 1720 (Day, 2006). These institutional changes arrested financial development and shut down stock markets for long periods. Some argue that the Sarbanes– Oxley Act also curbed investments in new US ventures. Political decisions can damage investor confidence more severely than private misconduct. Inflation erodes savings and curbs investments. Governments can decide to nationalize businesses and expropriate owners. Such decisions can be made by a parliamentary majority or by an autocratic

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ruler. Both types of government can change the rules of the game. But, such changes need to be unpredictable or investment will be curbed from the onset; nobody would want to invest, if it was certain that expropriation would occur. Unpredictable shifts of governance have occurred at several points in history. Some have benefited investors as happened in medieval Italy when institutions conducive to trade were developed. Other changes have hurt financial development by transferring the losses of risky enterprise to the people at large. This undermined confidence and created a new expectational equilibrium at low levels of external investment. History shows several dry spells of external investments. Financial markets have grown into the capital markets of our day only by fits and starts. The capital market allows a plurality of views to exist simultaneously and weeds out the ‘wrong’ opinions as time passes. It is essential to this process that successes cannot be predicted accurately. Both investors and entrepreneur are convinced that their valuations are correct, but it is the market who decides who wins and who loses. We can argue that the view of the perceptive investor is corroborated, whereas the view of losing investors is not supported by the market. Firms tap different financial sources, if they grow from start-up to large company. Successful ventures that survive the early years can become listed companies and enter a different league. But former success does not guarantee future successes and uncertainty is perpetuated after listing, although at lower levels. Uncertainty is reduced by diversification. State guarantees will only reduce uncertainty, if the state is bound to fulfill its obligations and does not default on its debt. However, state-led enterprise is usually of the monopoly type, which stifles diversification. Moreover, granting royal privileges to only a few firms destroys the level playing field of investments. One firm that is preferred to all others by the state seems to make it more or less infallible. Government can change the rules to the benefit of the state monopoly, but this blurs the line between private and public authority and confuses responsibility. Government chartered monopolies raise governance problems that differ from those of competitive enterprises. Clashes of opinion between the monopoly firm and the state would lead to the prevalence of either the state’s or the company’s view. This differs from clashes within private firms, where dissidents can leave and join another organization. The demarcation of authority between the investor and the entrepreneur was discussed at length before and after Weber’s treatise. Differences of opinion can arise, if authority is shared between investors and entrepreneurs. A clash of opinions is most productive, if it does not represent a conflict of interests, but arises among people pursuing a common goal. It was noted above that contracts between investor and entrepreneur were designed to align the interests of the two parties. Different opinions can still arise, if parties have different views on the best way to move forward. Such differences can be solved in several ways. One party can persuade the others and reach agreement or one of the parties can leave the venture. We can also

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imagine that decision-making is delegated to a single person, as happened when the commenda ships were at sea and the captain was on his own. We can argue that the investor, who has tied up his investment in the venture for a certain period should also be allowed to express his views. This applies with less force to investors who can easily sell their shares on the stock market; shareholders of listed companies can vote with their feet. Investors in privately held companies have more control of the company than a widely dispersed group of shareholders. Limited liability means that nobody can lose more than their opportunity costs. This applies, if both capital and labor can easily be redeployed. Labor can endure spells of unemployment in between jobs, which entitles them to severance payments. This does not apply to investors, who lose their investment. We can argue that investors only lose their opportunity costs, if their investments fail, whereas employees can also lose their future income, if they are not easily rehired. The consequences of ‘wrong’ decisions are restricted under conditions of limited liability and perfect markets. A permanent loss of income in the case of failure would hamper entrepreneurship; people would avoid risk and adapt their behavior to a common standard. However, conformism eliminates the competition of ideas and therewith hurts progress. The rewards and penalties for adopting new ideas should thus be balanced to encourage novelty. This applies to all realms of social life that seek to progress. Business and science are prominent examples. Each business is a hypothesis that can either be supported or rejected by the evidence (Phelps, 2006). Competition in the market for ideas determines which people are allowed to launch their ventures. Competition in product markets determines which ventures will be successful. The market test consists of the confrontation between the ideas of a few people and a relevant audience. Democracy requires that ideas are acceptable to the majority. Markets, however, also allow ideas to survive that appeal to small segments of the population. Capital markets have developed institutions that promote diversity and absorb uncertainty. The development of maritime ventures in medieval Italy demonstrated this. However, institutional development did not follow a straight upward line, but is characterized by many lapses back into autarky and internal finance. We will now investigate financial development in the Low Countries in the seventeenth century, England and France in the eighteenth century and in the developed world in the nineteenth and twentieth centuries.

From rederijen to the Dutch East India Company The shipping companies (rederijen) that sprang up in the Low Countries at the end of the fifteenth century resembled the commenda-type organization. They were organized for one trip around an entrepreneur and several (often unnamed) investors, who were repaid after the ship returned. Only the main investors had a say in how the business was run. They were the active

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partners, whereas other investors remained passive (silent partners). New business opportunities arose after the Portuguese discovered a route to the Indies. The Dutch merchants sailed to Lisbon to buy spices and other goods to sell in Amsterdam and beyond. The Portuguese had discovered a trade route to the East in 1595, which gave them a monopoly in the spice trade of that region. The Spanish king acquired Portugal in 1580, after which date the port of Lisbon was closed to Dutch merchants. The Dutch Revolt of 1568 that started the 80 years war with Spain triggered the Spanish reaction. The closure prompted the Dutch to find their own routes to the East. The first attempt to reach the Indian Ocean from the North failed and van Heemskerck and his crew were forced to stay out the winter of 1596–97 in their self-built house at Nova Zembla. A second attempt to round the Cape of Good Hope in 1597 was more successful. Houtman and his crew returned home after two and a half years, but had lost 160 of the 249 men who started the journey (Frentrop, 2002: 51). The lucrative spice trade attracted many other entrepreneurs and investors. Twenty-two ships set sail to the East Indies from Dutch towns in 1598; only half of them came home safely and made money. The East Indian route was thus a risky business, but this did not deter people from taking part in these ventures. The ships were useful for the government of the seven Dutch provinces as they could fight the Spanish in the East in the Dutch war of independence (1568–1648). The military role played by the Dutch merchants was one of the reasons for the States General to regulate the East Indies trade. Competition among ships from various towns in Holland and Zeeland were deemed to undermine the military effort. Moreover, the English had set the example by establishing the East India Company in 1600. Maritime ventures had military aspects in those days, as the sailors had to fight off competitors and establish ports and forts on foreign shores. Several models were developed to govern foreign strongholds. The Venetian model involved setting up an administration and a naval force in port cities, while leaving trade to private ventures. The Venetians assumed government in several locations; Crete is a case in point. They founded their own communities in others, as happened in Constantinople, the seat of the Byzantine Empire. Competition between Italian cities often evoked warfare. Constantinople, for example, was a Venetian stronghold for long periods of time, but was the territory of the Genoese for brief spells in which they held the favor of the Byzantine emperor. The Portuguese model was to set up state enterprises that combined commercial and military functions. The Portuguese had strongholds on the Banda Islands and Ceylon. The Dutch, however, developed a third model. The Dutch provinces established a private company with a monopoly charter to conduct both trade and military protection. The design was planned by the Secretary of State of the seven provinces, Johan van Oldenbarneveldt. The Dutch East India Company (VOC) was chartered in 1602 and incorporated all former shipping companies from Holland and Zeeland. The VOC

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had six chambers, located in Amsterdam, Rotterdam, Enkhuizen, Hoorn, Delft and Middelburg. The Dutch East India Company raised 6.45 million guilders, a huge amount in those days. The British East India Company, by contrast, only raised 820,000 guilders, when it was chartered in 1600 (Frentrop, 2002: 59). But the British East India Company was engaged in only commerce and left fighting to the military. Amsterdam merchants provided more than half of the capital (57.4 percent). The province of Zeeland was the second largest contributor with 20.1 percent. Enkhuizen, Hoorn, Delft and Rotterdam all provided less than 10 percent. The VOC fought vigorously to oust the Portuguese from their Indian strongholds and take over their trade. They expelled the Portuguese from the Banda Islands which gave them a monopoly on nutmeg and mace. The Dutch obtained the cinnamon monopoly in 1658, when the Portuguese were driven from Ceylon (Wikipedia). The Dutch East India Company became the owner of fortifications, which tied up capital (Frentrop, 2002: 57). The same applied to the vessels that needed to stay in harbor in order to defend the stronghold. The investments in the East Indian trade required longer lead times for investors than former ventures. The Dutch East India Company, therefore, obtained a monopoly charter for a period of 21 years; the entire capital was redistributed after 10 years with the proviso that old shareholders needed to pay half of the new capital. The effective depreciation period was thus 20 years (ibid.: 57). The monopoly charter was granted by a government, which was formed after the renunciation of Habsburg rule and the declaration of a republic in 1588. The seven provinces and their organizations were treated as trustworthy partners by other nations. The VOC was a capital-intensive undertaking in contrast to its predecessors, as it built its own ships. This differed from Venetian practices, where ships were built at the communal shipyards. The new trade thus required larger investment outlays over longer periods than the former shipping companies. We can argue that institutional changes made it possible to raise huge sums of capital for longer periods than was customary at the time. The monopoly charter was an institutional change that was intended to boost profits. Payment was not required in full at the time of foundation of the VOC, but was paid in installments. Shares in the VOC were held by wealthy merchants, but also among large numbers of the population. In Amsterdam, 80 people invested more than 10,000 guilders and more than 1,000 invested a smaller amount. The same distribution roughly applied to other cities. More than half of capital was raised from small shareholders. The total number of shareholders exceeded 1,400; the majority were located in Amsterdam. The 70 directors of the VOC were large shareholders. Small shareholders did not have a say in the company’s management, similar to the governance structure of the shipping companies. Small shareholders had a continuous exit possibility on the second-hand market, which emerged immediately after the VOC was founded. A futures market for VOC shares also emerged as VOC shares were traded on the Amsterdam bourse from 1611 onwards.

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The 70 directors were divided among the six city chambers. Investors paid up at their own chamber. The 70 directors constituted the executive bodies that took care of affairs in the six cities. Ships that sailed from a certain port also had to return and unload their cargo there, and the local chambers paid for fitting out the ships. Hence, the VOC resembled a corporation with six divisions. A council consisting of 17 men (the Heeren 17) designed the grand strategy of the VOC. The Heeren 17 was appointed by the 70 directors. Amsterdam did not have a majority vote, as it could only appoint eight of the Heeren 17, although it provided more than half of capital. Zeeland got four of the Heeren 17, whereas the other cities appointed one member each. The seventeenth member was to be appointed by each chamber in turn except Amsterdam. It was specified in the Charter that the Heeren 17 would convene in Amsterdam for the first six years, followed by two years in Zeeland, and so on (ibid.: 63). The VOC Charter had few disclosure requirements to small shareholders. The chambers got reports every three months. Merchants who had invested more than 50,000 guilders had the right to peruse the books but this right was denied to small investors, who had to wait ten years before results were presented to them. However, the establishment of the Amsterdam Bourse in 1611 strengthened the liquidity of investments in the VOC, which compensated for their lack of control. Shareholders could always recoup their money as long as the stock traded above par. The commander of the latest fleet (the admiral) was the highest authority in the overseas region. The commander, Jan Pietersz Coen, founded the city of Batavia (now Djakarta) in 1619. He held the title of Governor-General of the Indies, the highest official overseas. Governor-Generals were appointed by the Heeren 17 for a limited period of time. However, this policy was soon abandoned, and Governor-Generals often served long periods (up to 25 years). The Governor-General had to comply with the wishes of the Heeren 17, but had some leeway in doing so as he operated at long distance. He could conclude contracts on behalf of the VOC. Trading posts of the VOC were established in the Cape of Good Hope, Ceylon, India (Hougly) and Japan (Decima). Sailors earned a fixed fee and also got a share of the profits. Directors who did not agree with VOC policy resigned. One example was Isaac Lemaire, who resigned as director in 1605. He wanted to venture into South American territory, which also fell under the VOC monopoly charter. He offered a petition to van Oldenbarneveldt, who dismissed it. He then tried to drive down the share price by going short. However, the Heeren 17 petitioned the states of Holland in 1609 to forbid futures trade in VOC shares. Share price dropped from 180 to 126 based on rumors of mismanagement and the loss of several vessels and strongholds in the Indies. Losses reached one million guilders at that time, but the government decided in favor of the incumbent management and restricted futures trade (Frentrop,

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2002: 75). Moreover, the VOC was relieved of the obligation to pay out after ten years. The second accounting session, which was due in 1622. also failed to materialize. Complaints about the absence of disclosure to small shareholders were again dismissed by the States General, which ruled that the VOC charter should be extended for another 50 years and that all directors would retain their seats. The dissenting investors’ request that onethird of all directors would step down every two years, which would make room for directors from their own ranks, was thereby dismissed. However, investors’ protests induced the States General to change course and amend the corporate governance code of the VOC in 1622. A committee of Nine Men was established to oversee the operations of the VOC on a continual basis. They could inspect the ships and the goods that were stored in the warehouses. Directors were no longer appointed for life but only for a three-year period. They could only be reappointed after another three years. The directors were paid by commission (1 percent of revenues) and not by a fixed salary. A fixed dividend was to be paid to investors annually, which was set at 12.5 percent in 1632. This amounted to twice the interest paid on loans. The fixed dividend reduced small shareholders to perpetual bondholders. Frentrop argues that this was in line with their lack of participation rights (ibid.: 103). Further amendments to the VOC Charter were made in 1623, when the Nine Men were allowed to peruse the purchase accounts on an annual basis. They were also permitted to attend meetings of the Heeren 17, but did not have voting rights. The Nine Men were held to strict confidentiality concerning matters discussed by the Heeren 17 (ibid.: 96). The VOC was dissolved in 1798, when the Batavian Republic was founded under French tutelage and Napoleon’s brother Louis became king of the Netherlands. Governance changes implemented by the VOC in 1622 were inspired by different governance arrangements that had been adopted by the Dutch West India Company, which was chartered in 1621. Both trading companies competed for funds. The West India Company (WIC) was granted a monopoly charter for trade with the Americas by the States General for a period of 24 years. We could argue that the initial monopoly granted to the VOC was split in two. The West India Company had staggered boards of two years with six-year terms for all directors. The West India Company granted the right to fit out ships to each town that had invested more than 100,000 guilders (ibid.: 108). The WIC had five chambers: one based in Amsterdam and four regional chambers located in Middelburg, Rotterdam, Hoorn and Groningen. The first WIC directors were appointed by the Provincial States. The appointees chose their successors from a binding slate prepared jointly with the chief participants. Amendments to the WIC governance code were made on the instigation of investors. More disclosure requirements were offered and the influence of incumbent directors on appointing directors decreased. New directors were chosen by the Provincial States or town magistrates of the chambers from a slate of three names made up by the incumbent directors and chief investors. The West India

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Company collected 7.1 million guilders in a period of two years, 2.8 million of which was a subscription from the Amsterdam chamber (ibid.: 110). WIC operations were coordinated by the Heeren 19. The WIC established settlements in North America (now New York); the Netherlands Antilles, the Caribbean, Surinam and Guyana. In 1630, the Dutch took over some possessions in Brazil from the Portuguese (modern Recife), which were lost to the Portuguese in 1654. In Africa, posts were established on the Gold Coast (now Ghana) from where the slave trade was conducted. The original WIC folded in 1674 and a new reorganized company was formed, which lasted until 1791.

The state and risk absorption Institutional development helped economic development in seventeenthcentury Holland. The Dutch East India Company combined ventures from different towns to different destinations. Such diversification enabled risk spreading within the VOC. The long length of life of the VOC contributed to achieving a long-run expectational equilibrium with positive profits. The VOC developed into a company with fixed dividends, and investors could earn additional profits on the stock exchange. The Dutch East India Company fared better than its British counterpart. The people who invested in the second British East India Company, which lasted from 1617 to 1623, lost money (Ferguson, 2003: 21). The monopoly charter of the trading companies did not protect them from foreign competition. The English and the Dutch fought three wars between 1652 and 1674 to obtain control of the trade routes from Western Europe to Asia and the Americas. The Dutch were victorious at this point in time and obtained control of trading posts on the West African coast (ibid.: 21). Hostilities between the Dutch and the English came to an end, when Stadtholder Prince William of Orange invaded Britain and ascended the British throne after the Glorious Revolution of 1688. He was backed by London merchants who wanted to combine the Dutch and British East India operations. A merger between the two East India companies brought hostilities between the British and the Dutch in the Indies to an end and led to a division of markets between the two nations. Indonesia and the spice trade were left to the Dutch, whereas the English could develop the Indian textiles trade. The demand for textiles soon outgrew the market for spices to the benefit of the English. Moreover, the British could learn from Dutch modern finance. The Bank of England was founded in 1694 on the model of the Dutch Wisselbank, which was founded in 1609 to manage the government’s borrowings as well as the national currency. London also imported the Dutch system of a national public debt funded through the Stock Exchange where long-term bonds could easily be bought and sold. These sophisticated financial institutions allowed the British government to borrow at reduced interest rates (ibid.: 23). We can argue that trustworthiness validating low rates of interest

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on government debt depended on the assumption that the government would not default on its debt. Ferguson points out how nations that developed political representation contributed to financial development. The identity of the prince and the government in feudal times made princes notably non-creditworthy. After all, the lender had no legal means to compel the borrower to repay the loan. Private enterprise was better able to raise money than government at the time. The separation of the ruler’s private finances from that of the state enabled the state to become creditworthy and obtain loans. The first government borrowing occurred in Genoa and Venice in the late Middle Ages, where the town councils borrowed on a commercial basis from the newly developed banks (ibid.: 2001). The Dutch Republic raised money on the capital market through the VOC. The Government borrowed two million guilders from the VOC in 1672 that raised the money on the capital market. The Heeren 17 decided the next year to distribute these national ‘bonds’ among the shareholders of the VOC as a dividend (Frentrop, 2002: 116). VOC shares thus obtained features of government bonds with fixed rates of interest. King William III could borrow £1.2 million at 8 percent interest, which was guaranteed by Parliament in 1694. Hence, the formation of a state where decisions were not made by a single ruler, but by a representative assembly (States-General, parliament) allowed the rise of a market for government debt. A single ruler could more easily renege on his promises than a representative assembly that had tied itself to the promise not to devalue the currency. This differed from an autocratic ruler who could raise taxes at will or print money to repay his debt. The British Parliament, however, created a fiscal system, in which expenditures were tied to revenues, which laid the ground for the development of a capital market (North, 1990). Arguably, private enterprise was deemed more reliable by investors than the government in the seventeenth century. The loans paid a certain interest, which was returned to shareholders as a fixed dividend. The liquidity of the shares allowed shareholders to reap extra income through appreciation of the equity, or an extra loss, if share price fell. The financing of government debt by private trading companies developed into a system, in which the companies were prepared to pay the government to grant them monopoly rights. This happened in France, where the Scot John Law founded the Mississippi Company in 1716. The Mississippi Company obtained monopoly rights on trade in French Louisiana for 25 years. The Mississippi Company was organized along the lines of the British South Sea Company, which was founded in 1711 and obtained a monopoly on West Indies trade. Both companies raised money from the public that was loaned to the government in exchange for a trade monopoly (Frentrop, 2002: 121). However, the South Sea Company was barred from using its monopoly on West Indies trade, because Louis XIV did not allow Britain four safe harbors in the region at the Treaty of Utrecht that concluded peace with Spain. The

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South Sea Company obtained a contract to supply the Spanish colonies with slaves, which did not consume the £10 million it had raised before the negotiations were completed (ibid.: 122). A new life for the South Sea Company emerged in 1713, when it successfully conversed government shortterm to long-term debt with a corresponding reduction of interest rates paid on the annuities (Dickson, 1967: 92). Several new equity issuances were made by the South Sea Company until its share price collapsed in 1720. The French Parliament had too little influence to credibly underwrite government loans in the manner of its English counterpart (Frentrop, 2002: 123). Government revenues were increased by the use of inflationary schemes. In 1701, Louis XIV introduced a law under which citizens were compelled to swap their coins for government paper bills. The value of the paper bills declined to half their face value soon after issue. The Mississippi Company’s operations in Louisiana were a failure and the Company, like its South Sea Company counterpart, changed its activities from commerce to a restructuring of government debt. Law obtained a charter for a new central bank in 1716, which could issue bank notes. The bank obtained the right to collect taxes on behalf of the French king. The Mississippi Company was financed by converting government debt into shares of the company (Ferguson, 2001: 313). The company could raise up to 100 million livres in this way. The government paid 5 percent interest on this capital, which gave the company a working capital of over four million livres (Frentrop, 2002: 124). The bank issued 240 million livres of additional bank notes to finance a new equity issue for the acquisition of French trading monopolies on China, Senegal and Guinea, together with the tobacco monopoly. A new share issue of 1719 was used to buy the rights to the French Mint. The company took over all the government’s debt in 1719 in exchange for the right to take over tax collection (ibid.: 125). John Law’s bank became the Banque Royale; a position akin to that of the Bank of England. His bank controlled the money supply by its monopoly on issuing bank notes. The bank extended its monopoly on tax payments with a monopoly on transactions exceeding 600 livres. The public was no longer allowed to use silver but had to use the paper money. The price of the shares of the Mississippi Company grew rapidly from 500 livres in May 1719 to 10,000 livres in December of the same year, but the financing schemes fuelled inflation and confidence in the bank notes issued by Law soon collapsed. Investors were forbidden to convert their bank notes into gold, which heightened the public mistrust. The price of the Mississippi Company shares fell sharply at the beginning of 1720. A government guarantee to pay 9,000 livres in bank notes for all shares offered further fuelled inflation and gold and silver coins were taken out of circulation. The value of bank notes halved within half a year. The price of the shares was reduced to 5,000 livres. There was a run on the bank, which further precipitated the collapse of both equity trading and paper money and with it that of the French economy. French experience of these two

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financial instruments had lasted less than two years (Frentrop, 2002: 136). Gold and silver were reinstated by edict in October 1720. The crashes of 1720 had more grave consequences for France, since the Mississippi Company was closer connected to the French state than the South Sea Company was to the British government. The stock market bust was not limited to France and Britain, but also extended to the Netherlands. Many companies went bankrupt in the crisis of 1720, which left its mark for a period of over 100 years on West European economies.

Discussion The Dutch East India Company, the South Sea and Mississippi Companies all converted government debt. The Dutch East India Company, however, did not collapse, in contrast to its British and French counterparts. We can explain the different fates of the companies by their different origins. Both the South Sea and the Mississippi Companies started as single state-chartered monopolies, in contrast to the Dutch East India Company, which combined numerous maritime enterprises (rederijen). These enterprises had maintained an expectational equilibrium featuring long-term positive rates of return on those investments for some time. Meeting those expectations supported a continuous flow of investment into these entrepreneurial ventures. The Dutch East India Company obtained a monopoly charter, but followed in the footsteps of the rederijen by decentralizing its operation among the six chambers. The state supported the VOC in difficult times by lifting the obligation to repay shareholders, which effectively created the first corporation with an indefinite length of life. However, this did not stop investors’ trust and money continued to flow into the VOC and thereby into the coffers of the Dutch government. We can argue that the close relationship between private enterprise and public finance did not collapse, because the Dutch government did not default on its debt and the VOC ventures were on average profitable enough to sustain increasing investments. However, the close relationship between private and public finance posed a distinct danger. The public/private companies of the late seventeenth century could not fail without pulling the government down with them in their collapse. This scenario became a reality, when the South Sea and the Mississippi ventures turned out to be failures. Measures taken to prevent a collapse actually intensified the problem. This happened with the passage of the Bubble Act of 1720 by which the British Parliament outlawed the non-chartered companies that had arisen on the stock market boom. The Act intended to curb competition for the South Sea Company by prohibiting companies to raise money on the securities market without a government license. Consequently, the government became the sole ex ante judge of commercial ventures. This prevented the launch of enterprises representing different views of individual investors. Risk actually increased due to a lack of diversification caused by the

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requirement of ex ante government approval. The Bubble Act, therefore, prevented a return to a new expectational equilibrium featuring high investments in entrepreneurial enterprise. By contrast, entrepreneurial investment evaporated for more than a century to come after the South Sea bubble burst. The eclipse of the listed company that could raise capital in the form of shares from a large part of the public had become a fact. Authors on the topic agree that the 1720 bubble and its aftermath robbed industry for more than a century to come of capital that could have been available for economic development (Hunt 1936; Baskin, 1988). Economic growth in Western Europe as a whole stagnated and only took off after 1820 (Maddison, 2004).

Waves of investments The crises of 1720 marked the end of an era that featured the merger of government finance and entrepreneurial investments. The practice pioneered by the VOC to relieve the military burden of the new Dutch state was turned on its head, when taxes were used to finance the trade companies. The creation of new joint stock companies came to a halt in France, England and Holland after 1720 and only slowly re-emerged after 1820. Public opinion in both France and the Netherlands had turned against financial markets. The British government was reluctant to grant licenses to raise money as a joint stock company under the Bubble Act; only public utilities such as canals and railways obtained a license. Other companies founded in Britain took the form of partnerships, which did not have limited liability (Frentrop, 2002: 139). Private corporations with limited liability re-emerged in Britain at the beginning of the nineteenth century after the Bubble Act was withdrawn in 1825. The 1720 stock market crash constituted the largest price fall in British financial history (Ferguson, 2001: 307). Several stock market crashes took place in the nineteenth and twentieth centuries but the severity of the burst of the South Sea bubble remained unsurpassed. Joint stock companies appeared at an even slower pace in the European continental countries, where the state remained an important economic player. Dutch incorporation was hurt by the need for royal approval in the newly established monarchy of 1813. The Dutch king William I took the lead in Dutch entrepreneurship. He founded the Nederlandse Handelsmaatschappij (NHM or Dutch Trading Company) in 1825 especially to conduct trade with the East Indies. We can consider the NHM to be the successor to the VOC, which had been wound up in 1798, when its assets were nationalized. The VOC was unable to pay dividends after 1781 and was moving towards bankruptcy, a process that could not be stopped by the States General. The Dutch Trading Company resumed the monopoly on trade with the East Indies. The king participated in NHM equity and guaranteed a dividend

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of 4.5 percent, which exceeded the 3 percent paid on government bonds. The six-person board of the NHM was appointed by the king. Supervisors (commissioners) were nominated by the various towns participating in the venture and were also appointed by the king (Frentrop, 2002: 147). However, the NHM was not successful in its early years; the equity was trimmed by a third, but it was still unable to achieve a 4.5 percent dividend. By 1830, the company’s activities were limited to Java. It had built up a debt with the king of three million guilders in order to pay its dividends. The NHM introduced the culture system to secure a continuous stream of revenues. Plantations were established on Java, which were run by the NHM under a monopoly charter to ship all goods produced in Java (especially coffee) to the Netherlands. This turned out to be a profitable state-run enterprise, which allowed the Dutch king’s debt to be repaid (ibid.: 149). We can argue that the Dutch had adopted the Portuguese model of colonization where trade was carried out by state-run enterprises at the time of the NHM. The plantations used both indigenous labor and immigrants from India. Freedom of incorporation increased, when the Dutch Code of Commerce was approved by Parliament in 1838. Incorporation of a company still required royal approval, but this could only be denied on good grounds (ibid.: 155). Freedom of incorporation was enhanced in England with the passage of the Joint Stock Company Act of 1844, which allowed firms to be incorporated without the permission of Parliament. The first general incorporation law in the United States was in 1837 in the state of Connecticut. The new era differed from the past with respect to the role of the state. The government had tried in the past to guarantee dividend payments, which turned shares into bonds. But government interference did not reduce, but instead increased risk, due to a lack of diversification. John Law became the favored entrepreneur of the French government and his demise affected the whole economy. The monopoly charter did not protect the ventures against the uncertainties of entering unknown territories and the competition from other (chartered) companies. The new liberal era of the nineteenth century restricted the role of the state to that of a guarantor that the game would be played according to the rules. The rules had become more liberal in the first half of the nineteenth century, when free incorporation and limited liability were on the increase. Prudent monetary and fiscal policies aimed at achieving price stability and balanced budgets. The exchange rate was stabilized by the adoption of the Gold Standard in the nineteenth century. Great Britain and many countries in their sphere of influence adopted the Gold Standard. Britain, Portugal, Egypt, Canada, Chile and Australia had currencies that were convertible into gold on demand, but France and the other members of the Latin Monetary Union as well as Russia and Persia were on the bi-metallic system, while most of the rest of the world was on the Silver Standard. All trading countries, with the exception of China, Persia and a handful of Central American countries, had adopted the Gold Standard by 1908 (Ferguson, 2001: 189–90). The Gold Standard

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acted as a guarantee for sound monetary and fiscal policies. Governments promised not to print money or to default on their debts. Governments thus needed to bind their hands to gain confidence and attract capital. However, this was only a promise, which could be broken. This is in fact what happened in the financial crises of the nineteenth century that rocked Argentina, Brazil and Chile in the period 1880–1914, when both Argentina and Brazil defaulted on their debt. Ferguson argues that belonging to the British Empire was a better guarantee of no default than the Gold Standard; the only risk was the possible collapse of the British Empire. The British Empire imported institutions to their colonies, such as British administration, commercial law and a judiciary that promoted growth. British bonds had the lowest average bond yields in the period (ibid.: 191). Latin American bond yields, by contrast, were much higher. Britain financed the construction of railroads and other infrastructural work in Rhodesia, Nigeria, India and other colonies. Being part of the British Empire thus actually facilitated growth, in Ferguson’s view. Arguably, ‘natural’ interest rates can be quite low, if currency crises and government defaults are deemed non-existent.

The political economy of financial development The nineteenth century was an era of rapid economic growth. Sound monetary and fiscal policies and the diffusion of ‘good’ institutions over the globe contributed to this effect. Hard currencies and balanced budgets created a good environment for financial development, which grew rapidly in that era. Financial development points to the availability of external finance for business operations. Common indicators of financial development involve the value of outside equity and debt over GDP and the number of firms listed on the stock exchange on a per capita basis (Rajan and Zingales, 2003). Financial and economic development were found to be closely related (Demirguc-Kunt and Maksimovic, 1998). The rationale for this relationship lies in Schumpeter’s and Knight’s ideas on entrepreneurial investment; ample availability of external finance reduces the costs of obtaining money and so enhances the possibilities for the foundation of new firms. Moreover, competition between entrant and incumbent firms allocates capital more efficiently than when capital is only allocated to incumbent firms (Rajan and Zingales, 1998). Hence, financial development spurs economic development. External finance will be amply available, if creditors and shareholders expect to make a profit on their investments. Expectations of making money on government bonds are not met, if currencies devalue due to money printing and governments default on their debts. Such bad government policies affect equity investment by raising the interest rate. The government can raise money by levying taxes, if investor confidence has waned, but business has to rely on internal funds, if it cannot raise external finance.

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Standards for government policies such as the Gold Standard and budget rules contribute to financial development, if the investment community expects them to be maintained. Government debt remained the largest part of security trade in the nineteenth century and encompassed 70 percent of all securities quoted on the London Stock Exchange in 1853. This figure fell to 10 percent in 1913, but the effects of the world wars drove the percentage up again to 64 percent in 1950. The failure of the infant equity markets had a lasting impact on financial history (Ferguson, 2001: 311). The burst of a stock market bubble does not need to shake investors’ confidence as long as it is not caused by government actions. Moreover, the alleged excesses that lead to a crisis should not be remedied by government regulation that curbs profits and thereby investment opportunities. Bubbles might induce a cyclical pattern of regulation, limiting financial development after they burst, ensuing a long period of damage to be undone. Such regulation helps explain the emergence of the stock market drought of the eighteenth century, as pointed out above. Investors and the public at large were convinced that shares were too risky and shied away from the stock market. Regulation inhibited free incorporation. Cycles of investor confidence can even last a century, as happened after 1720. Both outside equity and debt increased at a rapid rate in the nineteenth century and the beginning of the twentieth century, as did the number of listed companies. Financial development was not restricted to the US and Europe, but extended to Egypt, Cuba, Brazil, Australia and Japan, which all had comparable levels of financial development in 1913, as measured by stock market capitalization over GDP and the number of listed companies per million people (see Table 4.1). India’s financial development lagged behind that of other countries with a stock market capitalization of 2 percent of GDP, which contrasted dramatically with the 109 percent of the UK at the time. Russia, Argentina, Chile and Brazil were also relative laggards with stock market capitalization percentages below 25 percent. We could argue that the financial development of some Latin American countries was hampered, because they had defaulted on their debts around the turn of the twentieth century. Argentina defaulted in 1888–93 and Brazil in both 1898 and 1914 (Ferguson, 2004; 2001: 190). However, indicators of financial development fell after 1929 to regain strength only after 1980 (Rajan and Zingales, 2003). In most countries, equity markets were larger relative to GDP in 1913 than in 1980. Only by the end of the 1990s did they exceed their 1913 levels. Within the Western world, the UK and the US were least affected by the decline of the stock markets. Austria and Egypt never regained the levels of stock market development they had in 1913. Continental Europe and the UK were more financially developed than the United States in 1913. France’s stock market capitalization in that year as a percentage of GDP was twice that of the US. The ‘Grand Reversal’ points to the decline of former most financially developed countries such as France, Belgium and Austria that were replaced

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Table 4.1 Financial development measured by stock market capitalization over GDP and the number of listed companies per million people, 1913–90 Country/Year

Stocks 1913

1990

Listings 1913

1990

Australia Austria Belgium Brazil Chile Egypt France Germany India The Netherlands The UK The US

0.39 0.76 0.99 0.25 0.17 1.09 0.78 0.44 0.02 0.56 1.09 0.39

0.37 0.17 0.31 0.08 0.50 0.06 0.24 0.20 0.16 0.50 0.81 0.54

62 39 109 12 21 17 13 28 1 66 47 5

64 13 18.5 4 16 11 15 6.5 7 17 30 26

by the US as the financial centre of the world during the twentieth century. The UK more or less held its own as did Switzerland and the Netherlands. The decline of financial markets set in after World War I when inflation was rampant in several countries and was precipitated by the Depression of the 1930s that followed the stock market crash of 1929 and by World War II. Financial markets only regained strength long after the end of World War II. We could argue that investors’ trust was again shattered as it had been in 1720 and that it took a long period before trust was regained. This was due to a turn towards autarky following the crash. The decline of financial markets occurred concomitant to a decline of world trade, which lasted till the 1970s, indicating a link between international trade and financial development. Per capita income grew slowly from 1913 to 1950 and more rapidly thereafter. The fall in financial development was considerably more pronounced in continental Europe than in the UK and the US. This applies particularly to France, Austria and Belgium that belonged to the top group of financially developed countries in 1913, but had moved to the second tier in 1990. Japan, India and the US were least affected by the decline of financial development, but Latin American stock markets experienced a large setback. Their decline was hastened by the defaults on government debt in Brazil, Chile, Argentina, and Mexico in between the two world wars, which spawned periods of high inflation in those countries (Ferguson, 2001: 192). Inflation in Brazil became a problem in the 1930s after the Great Depression. Getulio Vargas secured the presidency after a civil war and dismissed Congress. A state of emergency was declared by Vargas in 1937 and an authoritarian regime was established. Brazilian inflation was also sky high, reaching levels of over 80 percent in the 1960s (Musacchio, 2006). Rampant inflation occurred in Austria and Germany after World War I, which greatly eroded savings in those countries (Rajan and Zingales, 1998:

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14). The UK, the US, the Netherlands and Switzerland were largely spared the damages of World War I and the ensuing expropriation through hyperinflation. Countries that were spared the inflationary aftermath of World War I did not lose trust in the market economy. Financial development recovered relatively quickly in countries, where the middle classes were not expropriated through inflation and/or dictatorship. Government-induced inflation offers one explanation for the long recovery time of financial markets in some countries. A concomitant explanation involves the pressure exerted by interest groups of incumbent enterprises that were opposed to liberal legislation (Rajan and Zingales, 2003). They argued that incumbent firms can finance themselves through cash flows and do not need outside finance. Ample outside finance would assist the start-up of new companies and therefore intensify competition. Financiers who prefer to do business with a small group of insiders also reduce entrant competition. Rajan and Zingales call financial practices that establish exclusive relationships between a financier and a company ‘relationship lending’. Consequently, competition in both financial and product markets is impaired, if financial development is impeded by government legislation. Incumbents can also ask organized labor to assist their cause to establish a political majority. Another explanation for the collapse of financial development in between the two world wars can be found in the rise of dictatorship in the 1930s. Authoritarian leadership in Germany, the Soviet Union and Italy reduced the dependence on international trade. A move towards dictatorship reduces financial development with autarky in the causal role (Rajan and Zingales, 2003). Openness to trade was restricted in the 1930s as a way to curb the effects of the Depression. Country after country abandoned the Gold Standard and devalued its currency. Protectionism was used to prevent currency competition between countries but the surge of protectionism eroded financial development. Stock and bond markets declined till well below their pre-1913 levels. Autarky thus spread like a virus when ever more countries closed their markets for trade. Rajan and Zingales apply the same argument to explain the increasing trade openness that emerged after 1980. Countries did not want to be left out of the globalization game, when this was deemed to benefit their economies. Rajan and Zingales (2003) also argue that the welfare states that arose in the 1930s and thereafter were incompatible with the Gold Standard and strengthened a tendency to autarky. These policies impeded financial development for decades after World War II, which contrasted sharply with the quick financial recovery that occurred after World War I (ibid.: 7). The government share of national income in 17 developed economies rose from 12.7 percent in 1913 to 45.6 percent in 1996 largely due to the introduction of social insurance and welfare. Hence, autarky was partly prompted by the recession that followed the 1929 crisis, but was strengthened by deliberate policy choices after that date. Governments wanted to absorb uncertainty

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caused by the Great Depression by insuring their citizens against unemployment and sickness and guaranteeing them a pension at retirement age. Autarky – or beggar your neighbor policies – seemed a good device to boost national industries, but worked against economic recovery, when all countries adopted it. The Bretton Woods Agreement allowed national governments to control capital movements, on the instigation of Lord Keynes (ibid.: 39). The breakdown of the Bretton Woods system led to the abandonment of capital controls, which were effectively removed by the end of the 1980s in Europe, Scandinavia and Japan. The breakdown of the Bretton Woods system spurred financial development. The US and the UK were the big movers in the new age of financial development and cross-border capital flows that ensued. The number of listed companies per capita grew fastest in the Anglo-Saxon and Scandinavian countries, but never regained its 1913 level in the continental European countries. The continental European countries thus opted for a model that was not conducive to financial development, which showed most clearly in the decline of the number of listed companies these countries experienced in the post World War II period. The number of listed companies per capita fell in France, Germany, Belgium, Austria and the Netherlands after 1950, which contrasts sharply with the US. Arguably, financial markets in many European countries did not facilitate creative destruction, but were geared towards protecting incumbent firms (ibid.). Impediments to free incorporation created an expectational equilibrium wherein less investment is financed by equity issuances and more by cash flows or borrowing against collateral. Such equilibrium reduces entrepreneurial investments and protects incumbent firms. More external investment at equal rates of return could emerge, if investments were spread over a wider population of firms; both old and new. This could cause a wider spread of return rates than could be obtained by investing in a fixed population of incumbent firms. But average returns could remain unaffected at higher outside investment levels. In fact, research shows that the development of stock markets is positively related to the administrative ease in founding a new firm. This indicates that well-developed stock markets facilitate creative destruction through new firm formation (Djankov et al., 2002).

A new empire for the twenty-first century? Some eras feature virtuous circles, wherein cross-border trade, financial development and growth increase in tandem. However, such development can turn into vicious circles when both trade and financial markets collapse in times of crisis. Trust is not easily regained, if the crisis was government instigated. The 1720 crisis was a case in point. The crisis of 1929 had a long aftermath, which was not primarily due to government being instrumental in creating the crisis. The 1929 stock market crisis, however, spurred a loss of confidence in (capital) markets and witnessed several experiments in

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replacing the market by state control. This applies to the Soviet Union and fascist Germany. But the loss of faith in the working of (capital) markets also spawned increased government control of the economy in France and the US, where Roosevelt’s New Deal wanted to control prices and wages. Its main instrument, the National Recovery Act, was, however, declared unconstitutional by the Supreme Court. The stock market crisis of 2000 did not shatter confidence in financial markets, which soon regained their upward movement, although employment lagged behind and stayed above its ‘natural rate’ for some time (Phelps, 2004). The contemporary era of globalization features investments by corporations and not by hybrids of private and state enterprise. The spread of institutions conducive to growth is not imposed on people, as in colonial times, but comes from voluntary agreements between nations. The prospect of growth is sufficiently alluring to make countries want to join the capitalist game. We can argue that countries that want to play the capitalist game will voluntarily adopt its rules. Expropriation of assets by a government through seizure or the printing press inducing rampant inflation breaches the rules of the game and deters foreign investment. Consequently, governments should refrain from expropriation policies in order to build a reputation as a reliable trading partner and profitable receiver of foreign direct investment. Obviously, such self-restraint is not practiced everywhere, but history demonstrates that financial self-restraint of governments is a prerequisite for maintaining the trust of financial markets.

5

Valuation and authority in failing firms The role of reorganization in US and European bankruptcy law

Introduction Financial development is hindered, if government defaults on its debt or pursues inflationary, monetary policies. Such failure to live up to expectations shatters the previous expectational equilibrium and damages investment. Failing firms, however, do not need to create the same effect. Losses of failing firms can be compensated by profits made by others without undermining investor confidence. Limited liability restricts losses to opportunity costs. Failing firms usually retain some value, which restricts losses below the opportunity costs of all claimants. Several groups of claimants can be distinguished in bankruptcy procedures. Employees have claims on wage payments; tax authorities on tax and social security payments; creditors want to retrieve their loans and shareholders want to recoup their investments. Failing companies can either be liquidated or continue their existence in reorganization. Reorganization should be preferred to liquidation or acquisition, if more value is preserved in that way. Company bankruptcy law sets rules to either liquidate a company or restructure its debt in reorganization. The US has a larger share of reorganization in bankruptcy proceedings than European countries, which demands an explanation. Differences in the incidence of reorganization could ensue from differences in bankruptcy legislation. US bankruptcy proceedings are considered debtor-friendly in contrast to tougher policy stances taken by other countries. Bankruptcy law orders the various claims and regulates authority. The owners of the company have the authority to take decisions in normal times, which can be delegated to a CEO. Creditors usually have no authority, as they are assumed to receive secure interest payments. However, authority structures are reversed in bankruptcy proceedings. Creditors assume decision rights and the incumbent management is often ousted. Hence, shareholders as residual claimants lose their decision rights, if the residual evaporates and turns into losses. Many variations on this theme can be found in bankruptcy legislation. Some national laws put the rights of the tax authority and of employees above those of creditors.

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Creditors do not constitute a homogeneous group, but groups of creditors have different rights. Some creditors have secured their claim against collateral; others have priority rights meaning that their claims supersede those of other creditors. The chapter starts out by analyzing the differences between common and civil law legislations. The effects of legal origin on creditors’ rights are discussed. The chapter then discusses US bankruptcy procedures and practices and compares them with European countries. Recent changes in bankruptcy legislation in the UK, the Netherlands, France and Germany are discussed in order to find out whether bankruptcy legislation is moving toward a common model.

Legal origins and their consequences The law and finance literature analyzes the effects of differences in legal origin, especially the difference between civil and common law, on economic performance. Common law is of English origin and prevails in Anglo-Saxon countries and former British colonies. The judge has a great degree of discretion in common law systems. He may do anything that has not been explicitly forbidden, as long as his judgments are reasonable and comply with the rule of precedent. Common law evolves gradually through decisions in specific disputes. Judges’ rulings can set the tone for future judicial decisions, if higher courts uphold them. The civil law tradition is the other widespread legal system. It depends on legal statutes and comprehensive codes. It may, therefore, be less flexible, but more calculable. The legislator in civil law systems wants to provide rules for as many situations as possible. The judge can only use his discretion, if the legislator either overlooked the problem or left it deliberately open for the courts (Buetter, 2002: 29). Civil codes originate in the French Code Napoleon of 1804. The French Revolution created the desire to replace the fragmented system that had prevailed hitherto with a uniform legal system. Custom law was applied in the North of France, while Roman law ruled in the South (Danet, 2002). The Code Napoleon abolished feudal rights and offered equality under the law to everybody (although not to married women). The Napoleonic Code was imposed on subjugated territories during Napoleon’s rule. However, many of these countries voluntarily adopted the Napoleonic Code after the French defeat. The French Civil Code also had a paramount influence on the Dutch Civil Code (Burgerlijk Wetboek) of 1838. Several attempts at writing a new Dutch Civil Law had failed, because these proposals had been rejected by Parliament (Meijer and Meijer, 2002). The country adopted the French Code Civil, because it constituted a coherent legal system and was acceptable to broad social groups. The States of the Rhine Confederation also adopted the French Code to break up the stalemate between aristocratic and bourgeois interests in Germany (Weinacht, 2002). The German Civil Law of 1896 is considered an offshoot of the Code Civil, but constitutes a separate class due to its differences from the French Code. Scandinavian law countries are also considered to differ from both

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common and civil law countries. Legal origin, therefore, divides countries in four groups: (1) common law countries; (2) French civil law countries; (3) German civil law countries; and (4) Scandinavian law countries. Countries that become independent can either make up new laws from scratch or adopt a foreign Code completely. The latter procedure seems preferable for both reasons of practicality and legal principle. Legal codes that have proved their value for many centuries pose a smaller risk than a new code that has not withstood the test of time. Many former colonies adopted the legal codes of their former rulers. This applies among others to Australia, Canada, the United States, India and Nigeria that adopted the English common law system. Argentina, Spain, Italy, Belgium, Mexico and Portugal are a few examples of countries that adopted the French Civil Code. Japan, China and Switzerland are countries with legal systems of German origin (La Porta et al., 1998). Codes differ in the degree to which they allow systematic review and revision. French civil law, by putting the state above the courts, relegated the judges to a minor, bureaucratic role (Dawson, 1968). In England, by contrast, the law was put above the crown, which limited the monarch’s ability to alter property rights and grant monopoly rights (Beck and Levine, 2004: 12). Moreover, a common law system is supposed to be more open to a discussion of legal interpretations than a state-dominated system.

Legal origin, financial development and creditors’ rights Financial development The law and finance literature launched the hypothesis that financial development is related to legal protection of shareholders and creditors. Law and finance researchers argue that common law countries are more conducive to economic development due to the greater autonomy of the judiciary in those countries and less procedural formalism (Beck and Levine, 2004: 9). Moreover, common law countries do protect outside investors best against expropriation by insiders (i.e. management). Evidence was found supporting the hypothesis that common law countries were financially better developed than (French) Civil Code countries in the 1990s. Cross-country research found that French civil law countries have smaller stock markets; less active initial public offering markets; and lower levels of bank credit as a percentage of GDP than common law countries (La Porta et al., 1997). The large involvement of the state in French civil law countries seems to hinder the development of financial markets in these countries. The Netherlands is exceptional within the group of French law countries, because it has a welldeveloped equity and especially debt market. The predominance of debt over equity finance is characteristic of civil law countries. Debt finance is especially important in Germany and Japan. Debt finance is nine times more important than outside minority equity finance

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Table 5.1 Outside finance as a percentage of GNP for five countries Minority equity finance The United States The United Kingdom France The Netherlands Germany

0.58 1.0 0.23 0.52 0.13

a

Debt finance

b

0.81 1.13 0.96 1.08 1.12

Source: La Porta et al. (1997: 1138). Notes: a: Ratio of stock market capitalization held by minority owners and gross national product in 1994. b: Ratio of bank debt of the private sector and outstanding non-financial bonds to GNP in 1994.

in Germany and four times more important in France. External debt finance is twice as important as equity finance in the Netherlands. This differs from common law countries, where outside equity and debt finance were almost equally important. Table 5.1 summarizes the data for the five countries investigated in this chapter. Creditors’ rights The effects of external investors’ (shareholders and creditors) rights on financial development were examined for a number of countries in a crosscountry analysis. La Porta et al. (1998) and Beck and Levine (2004) found that shareholders’ rights are more developed in common law than in civil law countries. French legal origin countries have weakest liability rules and information disclosure requirements of managers vis-a`-vis shareholders. Weak shareholders’ rights could explain the relative underdevelopment of equity finance in civil law countries in the 1990s. La Porta et al. define creditors’ rights as the inability of management to seek protection from creditors’ claims in bankruptcy proceedings (La Porta et al., 1998: 1116). Managers are considered insiders, who can expropriate outside investors to benefit themselves. La Porta et al. investigated the prevalence of four creditors’ rights in bankruptcy proceedings in a cross-country fashion: 1 Filing for a reorganization petition does not imply an automatic stay on the assets of the firm, so that secured creditors can still gain possession of the assets. 2 Secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm. 3 Creditors can decide whether a reorganization petition should be filed (and not managers) 4 Managers are removed during reorganization proceedings.

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La Porta et al. found that creditor protection was twice as high in common law origin as in French law origin countries. German law origin countries ranked in between. The position of secured creditors is strongest in German origin countries, where they are always paid first. The large majority of common law countries also adhered to this principle (except Sri Lanka and New Zealand). Secured creditors were only paid first in two-thirds of French origin countries. Secured creditors in France, Greece and a number of Latin American countries are only paid after the state and/or employees are compensated. Legal origin thus makes a difference. The United States diverges from the characteristic pattern of common law countries with respect to most creditors’ rights as shown in Table 5.2. The US has an automatic stay; management does not need creditor consent to petition for reorganization proceedings and management usually stays in reorganizations. The only right upheld is that secured creditors’ claims rank first in US bankruptcy proceedings. The US pattern differs from UK and German practices, where all four creditors’ rights are upheld. More importantly, only US bankruptcy law knows the construct of the ‘debtor in possession’, which implies that incumbent management continues to control the firm in reorganization proceedings. This differs from arrangements, where management is not ousted, but in which management has to take instructions from a court-appointed administrator as happens in European reorganization proceedings (Hahn, 2003). This difference was not captured by the La Porta et al. methodology. La Porta et al. (1998) concede that measuring the strength of creditors’ rights is more complicated than measuring shareholders’ rights as the rights of some creditors might prevail at the expense of others. Especially the rights of secured and unsecured creditors might be opposed. Arguably, La Porta et al. approached creditors’ rights from an angle that emphasizes the conflicts of interest between managers and creditors which risks neglecting the conflicting interests among creditors. Moreover, the conflict of interest approach overlooks the fact that all parties could benefit Table 5.2 Creditors’ rights in five countries

The US The UK France The Netherlands Germany

No automatic stay

Secured creditors paid first

Creditor consent required for reorganization filing

Management does not stay

0 1 0 0 1

1 1 0 1 1

0 1 0 1 1

0 1 0 0 1

Source: LaPorta et al. 1998, p.1137. Note: 0 = not applicable; 1 = applicable.

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from an optimization of the value of the distressed company, if there is more to be distributed. Robustness of bankruptcy law The legal origins approach seems to imply that institutions are long-lasting. The colonial past determines the legislative system adopted by countries and thereby the quality of their institutions (Acemoglu et al., 2001). However, bankruptcy laws have been subject to recurrent revisions and thereby have changed to a considerable extent. Common law countries can change their laws by judicial rulings, whereas civil law countries use the legislature to do so. Civil law countries are more subject to drastic overhauls of existing legislation than common law countries. The reversal of financial development noted by Rajan and Zingales can, therefore, be explained by drastic changes in legislation. This is the approach taken by Musacchio, who relates the decline of the Brazil bond market after 1920 to political changes and changes made to bankruptcy legislation (Musacchio, 2006). Brazil is a French civil law country that gained independence from Portugal in 1821 and adopted the Napoleonic Code which was strict with debtors in default, considering them criminals. During most of the nineteenth century, debt repudiation by businesses and individuals was considered a crime, often punished by jail sentences (ibid.: 17). The same harsh approach was adopted by common law countries such as England for the larger part of its history. The concept of limited liability only gradually evolved after the repeal of the Bubble Act in 1825. I would doubt the positive effects of such harsh legislation on financial development. The decriminalization of bankruptcy could, in my view, constitute a more important issue than the comparative strength of creditors’ rights in various legal origins as is illustrated by the slow growth of Brazilian external debt before 1890. A strong bond market developed in Brazil only after 1890, when bondholders obtained priority in new legislation issued that year. The bond market evolved rapidly from 5 percent of GDP in 1880 to 18 percent in 1920 (ibid.). The dictatorship that was established in 1930 affected bond markets badly because of the inflationary policies pursued by the Brazilian dictatorship. New bankruptcy legislation was only installed in 1945, whereby the tax authority and employee claims obtained priority over those of creditors. After 1945, secured creditors became third in line after the labor and the Treasury (ibid.). The same strong position of the Treasury and labor can be found in French civil law countries, such as France and the Netherlands, as will be pointed out below. Legal origin thus makes a difference but this is due more to the way legal practices are changed than to the alleged inherent anti-investor character of civil law. The greater influence of politics in civil law countries makes them more susceptible to pressure from interest groups. Changes conducive to financial development are introduced in periods when

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business groups are in control. This happened in Brazil at the end of the nineteenth century, when commercial associations had a large influence on government. This contrasts with the situation in 1945, when an authoritarian regime, which relied on the support of organized labor, introduced legislation benefiting this group. This appeared in the new Constitution of 1937, which featured legislation on minimum wages and compulsory union membership (ibid.). However, such legislation can deter investment, which could explain the weak financial development of French civil law countries. The dearth of foreign finance in French civil law countries applies to companies both in and out of bankruptcy. An unintended consequence of bankruptcy legislation that gives priority to state and employee claims is that it prevents the reorganization of debt and other claims and, therefore, contributes to the liquidation of companies in distress.

Bankruptcy law Goals of bankruptcy law Bankruptcy law constitutes a way for creditors to sort out their claims collectively through liquidation of the debtor’s assets or by reaching agreement in an insolvency or reorganization plan. However, creditors usually are not a homogenous group. Some creditors have more rights than others. Priority creditors’ claims rank above those of general creditors. Secured creditors, who have a mortgage or lien, are usually paid before other creditors. Bankruptcy law serves two broad goals. It wants, first, to achieve an orderly assessment of claims. Managers could withdraw assets from the estate (fraudulent conveyance) or illegally advantage one creditor at the expense of others (voidable actions). Bankruptcy law protects creditors by forbidding such actions, irrespective of legal origin. The other broad aim involves the maximization of the value of the company and its assets. A failed company can either be wound up by selling its assets piecemeal or it may be sold as a going concern at an auction. The firm can also be continued after reorganization proceedings. Several bankruptcy laws contain the possibility to reorganize the firm by giving it a new capital structure. Chapter 11 of the 1978 US Bankruptcy Law is the best- known statute of this kind. A firm should be kept intact, if it is more valuable as a whole than in pieces. Hence, a firm should be sold as a going concern or continued, if it is more valuable than the sum of its individual assets sold separately. This applies particularly to companies whose investments are sunk. Nineteenth-century railroads, whose tracks had only value if they were part of a network, are cases in point. Modern investments in physical networks such as electricity and telecom also fit this picture. Sunk assets will only recover their scrap value, if they are detached from the network and sold piecemeal. Reorganization could also be the preferred bankruptcy mode, if a firm’s human capital is considered especially valuable to the firm.

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‘High tech’ firms are cases in point. Human capital resembles sunk costs if it is not easily retrievable on the job market (Baird and Rasmussen, 2001). We could also argue that a company valuation involves not only a valuation of existing assets, but also of growth options. A valuation that exceeds the value of fixed assets could indicate that its value is expected to increase. Looking at bankruptcy law from a valuation perspective casts doubt on the rationale of some creditors’ rights. Do rights that imply a liquidation of the company really serve creditors well? Are creditors always better off, if incumbent management is ousted? Does the absence of an automatic stay always benefit the collectivity of creditors? Should secured creditors always be allowed to immediately seize the assets? These creditors’ rights rule out reorganization of the company and hurt creditors, if firms were more valuable in reorganization than in liquidation. Researchers in fact found that reorganization raises company values above liquidation levels. Reorganized companies in the US lost little pre-bankruptcy value, in contrast to liquidated companies. This difference could not be explained by the greater indebtedness of Chapter 7 (liquidation) cases, which were not ‘deeper under the water’ than Chapter 11 (reorganization) cases (Bris et al., 2004). Chapter 11 seems especially conducive to the survival of young firms as it allows a larger share of young US quoted firms to survive periods of recession and exchange rate instability than young UK firms (Bhattacharjee et al., 2004: 11). The incidence of reorganization Bankruptcy modes vary distinctly among countries. Reorganization is the preferred bankruptcy mode for US public corporations (Gilson, 2001, 23). About a quarter of all US bankruptcy petitions are reorganization (Chapter 11) cases.1 The confirmation rate of Chapter 11 cases is about 20 percent, which would lead to the conclusion that reorganization emerges in about 5 percent of all US bankruptcy cases. The European figures are considerably lower. About 7 percent of all Dutch insolvent firms file for reorganization (surseance van betaling) and 2 percent are actually reorganized (Boot and Ligterink, 2000). A high percentage of reorganization petitions are withdrawn immediately after filing, mainly because the company enters liquidation proceedings.2 Petitioning for reorganization sends a signal to creditors that the company is in distress. Secured creditors will run to retrieve their money, if they learn of the company’s dire financial situation in the absence of an automatic stay. The number of French reorganizations resembles Dutch statistics, as about 2.5 percent of French bankruptcies end in reorganization (Kaiser, 1996: 82). Reorganization was sought in only 0.39 percent of all German bankruptcy cases in the 1985–92 period (ibid.: 73). Reorganization in the UK mainly occurs, if the company falls under a CVA (Company Voluntary Arrangement) following administration. About 75 percent of companies that open a CVA procedure survive. However, CVA procedures are rather rare and constituted about 2 percent of all English

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bankruptcy procedures (ibid.: 82). We could, therefore, conclude that less reorganization takes place in EU countries than in the US.

The rationale of US bankruptcy law and practice There are several reasons for the small numbers of European reorganization in bankruptcy cases. Most of them ensue from the different perspectives on bankruptcy that exist on both sides of the Atlantic. EU countries consider bankruptcy the result of preventable failures. Arguably, remnants of the criminal view on bankruptcy still influence European bankruptcy proceedings, irrespective of legal origin. The US view, by contrast, could be briefly characterized as recognizing that failure does not need to rule out future successes of incumbent managements. Investors, whose expectations of the company’s performance were not met, do not need to turn their back on the venture, but can give it a second chance by inserting new capital. This also applies to the entrepreneur, who can stay in charge of the company. US bankruptcy law is often considered benign to debtors. The discharge principle in personal bankruptcy, which allows individuals to make a new beginning, illustrates this. The right of discharge was a novelty at the time the first US bankruptcy laws were designed and caused a major shift in the social, moral and economic perception of bankruptcy and credit. It opened the way for voluntary bankruptcy, which has never developed in England (Weisberg, 1986: 30). Chapter 11 proceedings are usually initiated by management, but can also be initiated by creditors. Petitions filed by management make bankruptcy proceedings voluntary. Involuntary bankruptcy petitions – filed by creditors – are overwhelmingly Chapter 7 (liquidation) petitions (Block-Lieb, 1991). We can thus argue that voluntary petitioning favors reorganization, which in turn is triggered by the fact that incumbent management can stay in charge in US reorganization proceedings. Voluntary bankruptcy also stimulates timely bankruptcy petitions, at a point in time where the value of the company has not dwindled to a level where it is beyond rescue. Management should stay in reorganization cases, if their human capital adds to the value of the firm. Removing incumbent management and appointing an external trustee could decrease the value of the company. A positive valuation of human capital by investors opens the way for management to get second chances. Small companies whose greatest asset consists of the human capital of the owner/manager can be continued for this reason. US bankruptcy practice is compared with the operations of venture capitalists who also have to decide at several points in time whether they want to continue to finance start-up firms (Baird, 2001: 194). Another feature of US reorganization proceedings involves the reversal of the absolute priority rule, stating that senior creditors should be satisfied before junior (unsecured) creditors and their claims – in turn – rank before those of equity holders. The absolute priority rule is distorted, if founders/

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managers are allowed to preserve their equity in reorganization proceedings. This should happen, if the value of their human capital is estimated to exceed the value of their equity (Baird and Rasmussen, 2001). A reversal of the absolute priority rule can accompany an infusion of new capital by old equity holders, which is often the only possibility for the firm to make a new start (Baird, 2001: 201). Old and new capital providers are identical in many Chapter 11 cases, since it is difficult to find new investors for ailing firms. Old equity holders can be allowed to recover some of the pre-petition values of their claims in reorganization, when they provide new capital (Beranek et al., 1996). New capital always gets priority over old capital in Chapter 11 proceedings, since new capital is essential to the survival of the company. The reversal of the absolute priority rule in a majority of Chapter 11 cases is often described as a debtor-friendly feature of US bankruptcy laws. However, creditors’ interests are safeguarded under Chapter 11. All claims and interests are sorted into various classes: secured and unsecured creditors, priority creditors and equity-holders. Classification does not follow strict rules. Each class needs a majority vote, representing two-thirds of the claim value, to accept the reorganization plan. US legislation differentiates between impaired and non-impaired classes. A class is considered nonimpaired if it does not lose any pre-bankruptcy rights in bankruptcy. Creditors whose loans are reinstated under pre-bankruptcy conditions are not considered an impaired class. A reorganization plan is accepted, if all impaired classes accept it. The absolute priority rule is reinstalled, if one impaired class rejects (Baird, 2001: 209). Immediate full payment of high priority pre-bankruptcy claims such as specified obligations to employees and employees’ benefits is required, if this class does not approve the plan. The tax authority is not considered an impaired class. High priority tax claims are deferred and should be paid within a period of six years (ibid.: 201). Taxes that are withheld on employee paychecks need to be negotiated with the tax authority (ibid.: 202). The absolute priority rule can thus only be reversed, if impaired classes either accept the plan or are fully compensated. Secured creditors are deemed to have accepted the reorganization plan, since they are not considered an impaired class, if pre-petition conditions of their loan continue to prevail. Secured creditors can file a motion to lift the automatic stay, which will be granted, if the secured assets are not essential for the company’s operations or are in peril. The secured assets are not surrendered to secured creditors, if the court has confirmed the plan. Under-secured creditors’ rights are protected by the election clause in US Bankruptcy Law. They can either choose to have their whole claim secured without immediate payment, or choose to be paid the foreclosure value and vote with general creditors for the unsecured part of their claim. The unsecured part of the claim may also constitute a separate class. The court can decide to confirm a reorganization plan that has been accepted by at least one impaired class (a cram down). But the court can only confirm the plan, if dissenting impaired classes receive at least as much

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as they would have received under Chapter 7 (liquidation). This is called the best interests of creditors test. We could argue that US bankruptcy law ensures that reorganization only emerges, if the company is worth more in reorganization than in liquidation. Sunk costs and human capital make the company worth more as a whole than in pieces. The extra worth over collateral value can be expressed by the infusion of new capital into the company. This can be used to persuade general creditors to accept the deal. Unsecured creditors are the greatest beneficiaries of higher valuation. Voting power in US reorganization proceedings lies with impaired classes (mainly unsecured creditors). Hence, decision power is allocated to the group of creditors that are the main beneficiaries of the excess value created in reorganization. The importance of unsecured creditors in US reorganization cases is also expressed by the fact that the creditors committee in Chapter 11 cases consists of seven large unsecured creditors (ibid.: 199). We might, therefore, argue that the higher incidence of US reorganization cases cannot be attributed to weak creditor rights, since creditors will only accept a reorganization plan, if this serves their interests. It could better be explained by the fact that decision rights are given to the group that benefits most from an increased valuation. However, reorganization can only emerge, if investors value the company above the value of their collateral. Some scholars note that continuation of large companies under the same management is becoming increasingly rare (Baird and Rasmussen, 2003). Baird and Rasmussen attribute these changes to the better operation of modern capital markets than in the days of the railroads. The sale of a company at an auction should be preferred to continuation, if it enhances valuation above what old equity is willing to pay.

Explaining EU and US reorganization rates We would expect the economic logic of sunk costs and human capital to force all companies that are more valuable as a going concern to survive intact. There are some indications that this is indeed the case. The percentage of surviving firms does not differ dramatically between countries, only the method of survival differs. Reorganization is the common method in the US for companies to survive bankruptcy intact, whereas other methods prevail in European countries. Acquisition in liquidation proceedings prevails in England. Sweden has a mandatory auction system for companies in distress. Informal workouts are the most common method for survival in Germany. A firm can also restart, if third parties buy the assets piecemeal. An investigation into Dutch bankruptcy cases showed that such cases are not exceptional. Many Dutch firms that were declared bankrupt re-started after an acquainted party had acquired the assets (Couwenberg, 1997). We could, therefore, state that fewer European bankruptcies result in reorganization, because other methods prevail. Reorganization is the most efficient method to resuscitate a company, if it realizes the highest value of the company. A

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company that is revived in other ways might hurt the competitive process, if the (new) owners got the assets or the company at too low a price. Successful reorganization requires that no party can seize assets or otherwise prompt a company to close down. The absence of an automatic stay and strong rights of secured and priority creditors in European countries are underlying reasons for the rare occurrence of formal reorganization in these countries. But the strong position of some claimants may hurt others. Unsecured claims are often worthless in liquidation and can recover more in reorganization. Unsecured creditors’ claims in English liquidations are usually completely eliminated (Franks et al., 1996: 95). Suppliers recovered 5 percent of their claims in French insolvency cases (Robert, 1994). Dutch unsecured creditors recovered 1–2 percent of their claims in liquidation (Boot and Ligterink, 2000: 26). This contrasts with the 20 percent that US unsecured creditors recovered in Chapter 11 cases (Baird, 2001: 82). A study of Arizona and a New York district Chapter 11 cases even showed recovery rates of 40 percent for unsecured creditors in emerging reorganizations, whereas they received nothing in 95 percent of liquidation cases (Bris et al., 2004: 15).3 The differences between recovery rates in liquidation and reorganization are also large in Germany. Unsecured creditors received an average of 50 percent in German composition (reorganization) and 4 percent in liquidation cases (Kaiser, 1996: 82). However, the German courts deny most firms access to reorganization procedures because of a lack of assets. We could conclude from these figures that the lack of reorganization in Europe hurts unsecured creditors most. The scant occurrence of reorganization in Europe could be understood as a preference for quick solutions. Legal codes that are geared towards a quick sale of the company lose least time. The UK, Swedish and Finnish codes (before 1994) all favored a quick sale of companies that had entered bankruptcy. Thus differs from Chapter 11 rules, which allow the incumbent management 120 days to prepare a plan. After this period, the exclusivity of the debtor can be lifted and creditors can present their own plans. The plan should be accepted within 180 days of filing of the petition. However, most reorganization cases are extended beyond this period. Liquidation, however, is usually no quicker than reorganization (Bris et al., 2004). Liquidation proceedings took over three years in 45 percent of all liquidation cases in the Netherlands to come to a conclusion (Boot and Ligterink, 2000: 24). The average time spent in compulsory liquidation in Germany is 27.5 months (Franks et al., 1996: 90). This exceeds the average time spent in Chapter 11 cases, which amounted to 27 months (Franks and Torous, 1994).

The evolution of European bankruptcy law Pressure for convergence Bankruptcy law would be unnecessary, if each creditor were fully informed on the future financial situation of the debtor at the time the contract was

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signed. Creditors would not sign a debt contract, if they could foresee the debtor’s bankruptcy in the near future. However, uncertainty about future states makes bankruptcy a desirable action to prevent a further deterioration of the company’s value. Optimal bankruptcy law would allow the realization of the maximum value of the company at the lowest possible costs. Reorganization would occur in all cases in which sunk costs and firm-specific human capital are pivotal. An optimal bankruptcy regime would start bankruptcy at the appropriate time and conduct the process without undue delays. A bankruptcy petition comes too late, if the value of the company’s assets has largely dissipated. Timely initiation and execution of either liquidation or reorganization procedures are, therefore, paramount. Creditors may not have a clear picture of the actual financial situation of a company, if there are many creditors that all operate at arm’s length from the company. It could, therefore, be preferable, if the debtor, who knows the company best, could initiate bankruptcy in order to save as much of the company’s value as possible. Involuntary bankruptcy (initiated by the creditor) is the norm in Europe. This contrasts sharply with US practices, where over 90 percent of corporate bankruptcies are voluntary (initiated by the debtor) (Baird, 1991). Involuntary bankruptcy may come too late. The debtor might want to continue the company as long as possible for his own sake or that of his employees and hide the real financial situation of the company from creditors. This applies particularly, if managers expect to be removed in bankruptcy proceedings. Voluntary bankruptcy could, therefore benefit investors that operate at arm’s length of the company. Most European bankruptcy statutes stipulate that only the debtor can file reorganization petitions. But European management is often not allowed to stay in a reorganization, in contrast to the US, where incumbent management remains in control in about half of reorganization cases (Franks et al., 1996: 89). The US debtor in possession also has the right to compose a (first) reorganization plan. European management, by contrast, is usually not allowed to propose a rescue plan, which is assigned to a court-appointed curator or a trustee appointed by the main creditor. It seems, therefore, questionable, whether European management will be as eager to file for reorganization as its US counterpart. Another difference between the US and Europe is that many European codes – in contrast to the US – lack an automatic stay. Secured creditors can, therefore, exercise their rights in both liquidation and reorganization procedures. Another difference involves the acquittal of labor contracts, which is not allowed under some European reorganization codes. France and the Netherlands are cases in point. Reorganization requires new capital to get priority over old capital, which was also not allowed in many EU codes. The dearth of reorganizations has prompted European lawmakers to amend their bankruptcy codes to encourage reorganization and preserve

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value. However, European practice still differs from US practices, due to the absence of the debtor in possession construct. Management responsibility is handed over to an administrator or trustee in most European reorganization cases. A practitioner remarked that European legislation is still aimed at protecting creditors’ interests ahead of preserving the enterprise value. Restructuring through negotiation or as a consensual process is not the norm in Europe. As a consequence, post-petition finance is largely absent in European reorganization cases. Companies have to rely on cash flow funding and are forced to corporate downsizing in order to generate cash in bankruptcy (Tilley, 2005). We will discuss the amendments to bankruptcy legislation in four European countries below. The Netherlands Dutch bankruptcy proceedings are usually initiated by creditors who deposit liquidation petitions when the debtor does not meet his obligations. Reorganization (surseance van betaling) has existed for a long time in Dutch bankruptcy law. The Dutch bankruptcy law of 1893, however, did not provide for an automatic stay in reorganization. Secured and priority creditors kept their rights in reorganization cases. Management had to transmit control of the company to a court-appointed curator, who could compose a reorganization plan in collaboration with management. Reorganization petitions needed to be accepted by three-quarters of creditor votes present at the meeting, representing at least two-thirds of debt. We could argue that the Netherlands, as a French civil law country, had strong creditor rights at the time, similar to Brazil. Dutch bankruptcy legislation is also characterized by a strong position of the tax authority and labor, which is characteristic of contemporary French civil law countries. Dutch banks often attempt to reach an informal solution, when the company gets into dire straits. However, the time for informal solutions can be cut short, if the tax authorities use their rights to confiscate some assets to satisfy their claims. A race for the assets could ensue, if the bank expects a seizure by the tax authorities. Moreover, creditors seek contract forms that evade the tax authorities’ claims on assets. But these rental constructions entail the immediate closure of the company in bankruptcy proceedings. Another impediment to successful reorganization under Dutch law is the impossibility of ending employment contracts in reorganization, while they are automatically ended in liquidation. New legislation to increase the chance of reorganization was opposed by the tax authority and the banking community. A 1992 revision of the Dutch bankruptcy law allowed for a ‘cooling-down’ period of a month for all creditors in both liquidation and reorganization proceedings. However, the Dutch tax authority kept its special right of recourse on all moveable assets that are required in the profession of the debtor. The assets stay in the company during the ‘cool-down’ period. New capital gets priority over old capital in reorganization proceedings under the 1992 Code.

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Further amendments of the code were proposed to Parliament in 2000 and 2001, but had not yet been accepted in 2007. The proposed amendments involve a lengthening of the cool-down period to a maximum of four months. Collective lay-off plans of employees should become possible. Each reorganization petition should be accompanied by a reorganization plan or a plan needs to be delivered within 21 days after petition. The bankruptcy court has to decide within 28 days on the acceptance of a petition. The court should only accept reorganization petitions, if it deems the reorganization feasible, meaning that the firm can survive after reorganization. The suggested procedures differ from existing practices, where the courts automatically grant a reorganization petition, if a qualified majority of general creditors accepts the petition. Amendments have also been proposed with respect to the special recourse rights and rights of attachment of the Dutch tax authorities. It was suggested that eliminating these rights could stimulate reorganization. It was suggested that the tax authority should waive their priority rights and vote with the general creditors on acceptance of the petition and the reorganization plan. Other creditors with priority rights would also lose their rights, if they voted with general creditors. Management can stay under the revised code, but has to accept instructions from a court-appointed administrator. It is also suggested that public utilities such as electricity companies could be forced to continue supply in reorganization. The same suggestion was made with respect to other suppliers, whose cooperation was deemed essential to the survival of the company. Their claims should be paid in cash, or be secured. The proposed amendments also involve the acceptance of a reorganization plan by a common majority of the members of a committee of general creditors present at the meeting. This differs from the twothirds majority that is now required. The possibility of a cram down was also mentioned in the amendments to Dutch bankruptcy law. The court should only enforce a cram down, if creditors who voted against the plan would not be worse off than in liquidation. We could conclude that the (proposed) amendments to Dutch bankruptcy law would make it more similar to US Chapter 11 in some respects. This applies to the longer cooling-down period. However, a period of four months is still far below the US norm, but other suggested amendments would make it less similar. The introduction of a preliminary feasibility test of the reorganization plan by the courts deviates from US practices. Dutch legislators wanted to weed out non-viable reorganization attempts by this amendment. We doubt, however, whether judges or their hired experts can easily identify potential reorganization successes. Moreover, there is no obvious party in Dutch reorganization proceedings with the incentive to pay more than the liquidation value of their claims. Equity-holders are not mentioned in the suggested amendments; nor is an infusion of new equity or a reversal of the absolute priority rule. This can be explained by the dearth of outside equity finance, especially in small Dutch firms. New capital

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could come from bank loans but the banks opposed the suggested lengthening of the cool-down period. Secured creditors would prefer liquidation to reorganization, if they can quickly regain the full value of their claim by selling the assets. Banks do indeed recover the larger part of their claims in Dutch bankruptcies as loans are usually based on collateral value. This applies with the greatest force to small firms. We could argue that the infusion of new finance by old equity or debt holders forces investors to reveal their perceived worth of the company and let unsecured creditors share in the valuation. However, secured creditors need to postpone the fulfillment of their claims to enable reorganization. They have no incentive to promote such legislation. Germany The old German Code already distinguished between liquidation (Konkursordnung) and reorganization proceedings (Vergleichsordnung). However, reorganizations were extremely rare under the old law. The extremely low occurrence of formal reorganizations in Germany (< 1 percent) could be attributed to the stringent conditions that German firms had to meet before they could file composition (reorganization) petitions. Debtors had to repay at least 35 percent on unsecured claims in reorganization. The courts rejected most reorganization petitions. Three-quarters of all cases were not allowed to enter bankruptcy due to insufficiency of assets in 1980–92. Secured and priority creditors maintained their rights in composition proceedings and could repossess their assets and so precipitate the closure of the firm. German directors are personally liable for late filing (later than 21 days before the company becomes insolvent). Insolvency can ensue, when a company is over-indebted; a situation which is not clearly defined and on which the courts decide (Tilley, 2005). The lack of composition proceedings can also be attributed to the preponderance of out-of-court settlements between German banks and distressed companies. The new German Insolvency Code of 1994 (Insolvenz Ordnung, Ins. O) which came into effect in 1999 opens up more possibilities for reorganization. The new legislation allows for a three-month moratorium, in which time a court-appointed administrator could propose a reorganization plan to the creditors committee that can decide whether they prefer reorganization to liquidation. Both secured and unsecured claims can be stayed for three months under the new law. New finance receives priority to pre-petitioning debts. The threshold recovery rates that had to be repaid before a reorganization plan was accepted by the court were lifted under the new law. The works council needs to agree on a reorganization plan involving plant modification (Ins. O, sect. 121). The administrator must negotiate both the lay-offs and social plan with the employees’ representatives. However, the court may replace their approval by a judicial decision (Pochet, 2002: 351). Some authors argue that the new German Code is a rather flexible piece of legislation that largely resembles Chapter 11 of the US Code (Franks et

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al., 1996: 90). But, the main difference with the US is that management loses control in German composition proceedings. There is also no reversal of the absolute priority rule. Another aspect of new German bankruptcy legislation involves the preponderant role of higher-ranked creditors in reorganization proceedings. The creditors committee is composed of secured and higher-ranked creditors only. Secured creditors can vote on the reorganization plan, if the debtor is personally liable to them, if they waive their rights, or if they are not fully compensated (Ins. O, sect. 237). Lower-ranked creditors have no voting rights (Ins. O, sect. 77), which contrasts with practices in other nations, where general creditors dominate decision making in reorganization proceedings. Claims of lower-ranking creditors are deemed waived unless the insolvency plan provides otherwise (Ins. O, sect 225). Another element of the Insolvency Code involves a ceiling for new debt, which cannot exceed the value of the value of property listed in the survey of assets (Ins. O. sect. 264). This section demonstrates clearly that new finance is not related to investors’ valuation of the company as a going concern, but to the value of the assets only, which surely stifles reorganization. France The 1985 French bankruptcy code opened possibilities for a negotiated settlement (regle´ment amiable), the French form of voluntary bankruptcy. A firm that wants to renegotiate its debt contracts can invoke this procedure. Each creditor can refuse to participate in such a settlement procedure. The negotiations are kept secret from non-participating creditors. The settlement regime does not have an automatic stay. These factors could explain why the negotiated settlement is seldom used (Kaiser, 1996: 71). The judicial arrangement (redressement judiciaire) that was also introduced by the 1985 Bankruptcy Law, has an automatic stay (observation period) that can take a maximum of 18 months. New capital gets a superpriority status. However, reorganization or acquisition under the judicial arrangement is hampered by the fact that the (new) owner needs to assume all employment contracts (ibid.: 72). These preconditions make the sale of an intact company rather rare. Only 3 percent of French bankruptcies ended in the sale of the company in 1987–93. French creditors (both secured and unsecured) lost almost all their rights in company sales that were conducted under the 1985 French law. They were not allowed to vote on the reorganization plan. The 1994 revision aimed to repair this shortcoming of the 1985 code (ibid.: 72). The courts play a preponderant role in French bankruptcy cases. Out-of-court settlements are rare in France, in contrast to Germany, where they are common (Pochet, 2002: 368). Whether a firm is insolvent is determined by the courts and does not follow from a precise accounting definition (Tilley, 2005). Bankruptcy mainly involves small and medium-sized family firms, since listed firms are protected by the state from failure (Pochet, 2002).

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The United Kingdom Most UK companies that have filed for bankruptcy go into liquidation. Some 22 percent go in receivership, which is the main alternative to immediate liquidation. A creditor whose security is backed by a floating charge can initiate administrative receivership. Administrative receivership is not a collective procedure and mainly serves the interests of the creditor secured by a floating charge. Reorganization is discouraged, because new finance does not get priority over antecedent debts. The receiver is personally liable for all postcommencement financing (Kaiser, 1996: 75). Employment contracts are usually terminated upon the commencement of receivership and the company or its assets are sold within days or weeks after receivership has been declared. Unsecured creditors usually do not recover anything on their claims. The UK 1986 Insolvency Act introduced the administration proceeding to facilitate reorganization. Administration is a collective procedure and allows an automatic stay. Creditors with a floating charge could, however, frustrate the appointment of an administrator by installing a receiver instead. The 2002 Enterprise Act remedied this shortcoming. The administrator has the power to negotiate deals. He can terminate contracts with suppliers and contractors. However, he does not have the power to postpone interest and capital repayments. Unsecured creditors are the main beneficiaries of administration proceedings, which occurred in 2 percent of bankruptcy cases in 1998 (UK Department of Trade and Industry, 1999). The 1985 UK Companies Act introduced the Company Voluntary Arrangement (CVA), which is aimed at reorganization. It was set up to create more possibilities for reorganization, but depends on the willingness of all parties to cooperate. The CVA neither allows an automatic stay nor priority of new financing (Kaiser, 1996: 75). Management has to hand over control of the company to a bankruptcy professional. Managers are reluctant to start CVA proceedings, because they fear these professionals will be more interested in burying the company than seeking its recovery to health (UK Department of Trade and Industry, 1999). The 2000 amendment to the Insolvency Act allowed a mandatory moratorium and a debtor in possession regime for small companies (< 50 employees). We may conclude that secured creditors’ rights still prevail in UK bankruptcy law, although some amendments have been made lately to stimulate reorganization of small companies.

Conclusion The law and finance literature argues that creditor rights promote financial development. A cross-sectional analysis showing that common law countries have better creditor rights and more financial development supports their view. However, both legislation and financial development are subject to change, as was demonstrated by the great reversals after 1913. A case study of bankruptcy legislation and bond markets in Brazil highlighted how

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politics interferes directly with investors’ rights. The claims of the state and organized labor came to prevail over creditors and shareholders in French civil law countries. This differs from countries with different legal origin, where shareholders and creditors’ rights prevail. The US has developed rather unique bankruptcy proceedings, where the failed management can stay in charge and unsecured creditors decide on the reorganization proposal. Reorganization is welfare-promoting, since it increases firm valuation above collateral value. The recognition of these positive effects of reorganization spurred reform in a number of EU countries. The reforms, however, have not raised the number of reorganizations substantially. We can explain this by several features of EU bankruptcy legislation that were untouched. Management does not get a second chance, but is either ousted or subject to the orders of an administrator in European bankruptcies. Hence, we cannot expect European managers to be as willing to initiate reorganization proceedings as their US counterparts. Another impediment to reorganization in European countries involves the protection of secured creditors’ rights and those of the tax authorities and employees. The differences between the countries’ bankruptcy legislation can only be partly contributed to the difference between common and civil law regimes, in my opinion. More important than legal origin is the attitude adopted towards bankruptcy. Most European countries see bankruptcy as management’s personal failure and are not willing to allow them a second chance, in contrast to the US. Reorganization is efficient, if it enhances the value of the company above the value of its assets. Such surplus value can be realized, if either old or new investors can bid up the value of the company by infusing new capital into the company. A reversal of the absolute priority rule can assist in obtaining new finance, but this is not included in European amendments to bankruptcy statutes. This can be explained by the fact that new (equity) finance is not sought in most European reorganization cases. The role of the judiciary is considered to be more restricted in civil than in common law countries. However, judges in continental European countries have great power to decide in bankruptcy cases. Courts decide on the feasibility of a reorganization petition in the Netherlands. German and French courts decide, whether a firm is considered to be insolvent. German courts can reject insolvency procedures due to lack of assets, thereby denying that the firm’s value can exceed the value of its assets. Courts thus have a major say in estimating the viability of a company in these countries. This contrasts with the US (and the UK), where investors’ valuations decide on the fate of a company in reorganization proceedings. The notion that civil law judges have less discretion than their common law counterparts thus does not seem to apply to estimations of a company’s value. We could argue that civil law countries deem courts better valuators of companies than investors. This seems a more important explanation for the lack of financial development in those countries than the absence of creditors’ rights.

6

Performance pay and uncertainty in entrepreneurial and bureaucratic firms

Introduction Employee motivation and compensation are important governance issues. Two different approaches on these issues have been developed, representing different expectations of employee behavior. Principal–agent theory focuses on the moral hazard aspects of labor contracts; employees are expected to prefer leisure to work, they want to free ride on others’ efforts and need to be motivated by financial stimuli. Management and labor have different goals and are portrayed as antagonists. Principal–agent theory also presumes that employee behavior is not fully determined by either routine or discipline, but allows some discretion; obedience is not automatic and needs to be evoked by providing incentives. The other approach views the firm as a goal-oriented, unitary organization. Management theory, as taught in corporate strategy and management of change classes in business schools, often adopts this approach. The different views on employee attitudes ensue diametrically opposite hypotheses with regard to the relationship between uncertainty and incentive pay; the character of discourse and the role of subjectivity in hiring and promotion decisions. Remuneration and promotion policies are an important part of a firm’s operations. Organizations can either pay fixed wages or pay employees according to performance. Recruitment and promotion decisions can be based on past performance or on more subjective criteria. Apart from remuneration, the organization of discourse within firms is an important matter for firms that want to tap the human capital of their employees. Communication can be limited to superiors giving instructions to subordinates. But organizations that want to use their human capital more fully can stimulate lower echelons of employees to contribute to discourse on strategies and practices. The character of organizational discourse is shaped by expectations of participants’ intentions. An exchange of views among groups representing opposing interests differs from a discussion among people who pursue a common goal. Decision rules are required to end the discourse. A discussion can end, if one view or interest prevails or if a compromise is reached. Discussion among parties representing opposite

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interests tends to end in a compromise, if both parties have power. A discussion among people pursuing a common goal can be decided by majority vote or by a single decision-maker. Entrepreneurial ventures may feature joint decision-making, when both ownership and authority are shared among founders and financiers. Uncertainty makes business outcomes unpredictable and creates a divergence between the initial valuations of people and projects and their realizations. Uncertainty can be absorbed by risk-sharing contracts. The introduction of profit centers and autonomous teams in hierarchical organizations ties employee compensation closer to performance measures. Performance pay that is related to profits shifts risk from the firm to the employee. I, therefore, hypothesize that organizations that are subject to high uncertainty will tend to use performance pay as a risk-sharing device. Such contracts will attract risk-loving people, who expect risk-sharing contracts to boost their income above fixed pay. Risk-averse people, by contrast, are attracted to bureaucratic organizations that can better absorb risk through diversification. Entrepreneurial and bureaucratic organizations will attract different types of people. Organizational diversity allows individuals to find the organization that suits them best. This approach to performance pay differs from the one adopted by agency theory, which hypothesizes that performance pay is less suited for situations characterized by high uncertainty, because such uncertainty blurs the relationship between effort and performance. Agency theory and the expectations approach developed in my analysis of risk-sharing contracts thus represent opposite views on the relationship between uncertainty and performance pay. The two approaches also differ with respect to the role of discourse in solving a clash of opinions. The conflict of interest approach taken by principal– agent theory resembles a zero sum game. People’s positions in the debate are largely determined by the interest group they belong to. Discussion takes the form of negotiation; one group’s loss is the other’s benefit. Discussion among people pursuing a common goal, by contrast, can create value by bringing new ideas to the fore that benefit the whole organization. Such exploratory discussion cannot easily be integrated in principal–agent theory, which assumes that the employee (agent) wants to minimize his efforts and use the organization for his own purposes. Individual employees do not need a voice, if change is absent or if the ‘right’ way to move forward is evident. Exploratory discussion is only required, if the right decision is not obvious. Ideas should not remain tacit, but be expressed openly. Such an exchange of ideas, however, requires that people expect their ideas to be assessed fairly (Osterloh and Bruno, 2000). People will sit on their ideas, if they fear that others will benefit from their ideas, or if they think that expressing their ideas might actually harm them. Another difference between the two approaches involves the appreciation of subjectivity in the valuation of people. Subjectivity is usually described as

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favoritism and has rather negative connotations. Weber described favoritism as the privileges that rulers grant to subjects based on personal preferences in patrimonial organizations (Weber, 1978: 1135). People with access to the ruler could become their confidantes and favorites through flattery. Other rivals are undermined in palace intrigues. Bureaucracies, by contrast, select their officials through formal processes and use objective criteria. The absence of favoritism makes rational bureaucracy superior to patrimonial modes of governance, in Weber’s view. His rationality concept presupposes that the best person for each job can be unequivocally determined ex ante. Organizational psychologists point to the positive effects of a cohesive corporate culture on employee motivation. A distinctive corporate culture will attract people who fit the mold, which facilitates communication and instills a sense of purpose. Subjective evaluation does not need to impair and can even enhance motivation, if organizations only employ favored people. Employees, in turn, will choose the organization that fits them best. The crucial variable here is the availability of employment alternatives as expressed by positive opportunity costs. People, who have a choice, will only join an organization, if they prefer it to others. Likewise, a firm will only hire people whom they expect to outperform others at the same wage. The firm’s hiring decisions are thus similar to that of the financier, who selects certain employees. An employee, who feels under-valued will look for another job. The possibility of multiple appraisals in labor markets thus curbs managerial opportunism. It prevents the firm from appropriating the larger part of human capital by reneging on implicit contracts, which has been conceptualized by economic organization theory as the ‘hold-up’ problem. Weber contended that bureaucracies are inadequate change agents and introduced the persona of the charismatic leader to explain change. The founder of a new firm is sometimes depicted as a charismatic leader, who needs to convince both financiers and employees to choose him and forego other opportunities. Change and uncertainty are two sides of the same coin. Change requires different types of communication from what is used in traditional and command-type organizations. However, change cannot be restricted to new firms.

Uncertainty, incentive pay and the theory of the firm Uncertainty exists, if initial valuations diverge from realizations. Uncertainty can exist at the level of the individual; the organization and the system. An individual might be uncertain about his valuation within an organization. The fate of an organization might be uncertain due to intense competition. Burgeoning start-ups and intense foreign competition add to the speed at which firms enter and exit the market. But such competition might spur the expansion of the system (region or industry) and enhance job security and income at that level. Losing a job is less serious, if one is quickly rehired. (Re)hiring will be facilitated, if failure is not attributed to

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personal flaws, but to events that lie beyond an individual’s control. Uncertainty may bring the demise of a firm irrespective of efforts. A harvest may be lost due to bad weather; a firm might lose out in global competition. Economic competition resembles sports in that respect. The only certainty we have in a contest between two teams is that it is impossible for both to win. But the match would be unnecessary, if we knew beforehand which team would win. Agency theory assumes an agent is in control of his effort level and will only exert maximum effort, if the appropriate incentive structure is put in place. Performance pay schemes relate employee compensation to output indicators instead of input measures, such as hours worked. Performance pay can reduce monitoring costs, if employees receive piece rates instead of a fixed wage. Performance can be measured at the level of the individual, the group, or the organization as a whole. Individual incentive schemes that are related to particular tasks might distort employee effort away from organizational goals. Employees might excel at a certain task, say, hitting a keyboard, but this might be unrelated to company performance, if secretaries use their lunch hour to hit one single key. Incentive schemes that are related to company performance, such as profit-sharing schemes, are subject to other types of distortion such as free riding. Free rider problems are exacerbated by large firms size. Incentive pay as a motivational device thus suffers from several distortions The agency literature assumes a negative relationship between the use of performance-related incentive schemes and uncertainty. This negative relationship is called ‘the workhorse of agency theory’ (Prendergast, 2002b). Uncertainty should discourage the use of incentive schemes, because it weakens the relationship between effort and performance. Another argument states that agents want to be insured against risk and demand a premium, if income fluctuates, making incentive pay more expensive than fixed wages (Baker, 2002). These hypotheses on the relationship between risk and uncertainty are, however, not corroborated by empirical evidence. No tradeoff between risk and incentives was found in several studies on the subject. Some studies found a positive relationship between uncertainty and incentive pay (Prendergast, 2000; 2002a). This applied particularly to sharecropping and franchising schemes. The results for executive pay were inconclusive. Empirical research also showed that performance-related pay is prominent in small publicly traded firms but largely absent in large ones (Rayton, 1997). This indicates a positive relationship between uncertainty and incentive pay, since small corporations are less likely to survive than large ones. Several explanations have been put forward to explain the clash between theory and empirical evidence. Prendergast argues that incentive pay will be more widely used, if employees have more discretion (Prendergast, 2000). Incentive pay should be paid to people who can control their performance. However, the principal–agent problem only arises, if agents have discretion and can set their effort levels below maximum. We can argue that individual

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incentive pay is appropriate for employees carrying out individualized tasks. Piece rates paid for individualized, repetitive jobs in agriculture and manufacturing fit this description. Employers would not be interested in hiring workers for such jobs at a fixed remuneration, if they can pay piece rates. Fixed pay would cause adverse selection, since only the least productive workers would prefer fixed to variable pay for such jobs. The moral hazard problem of shirking can be counteracted by piece rate pay, although setting a standard for a ‘normal day’s work’ may pose problems. Sharing contracts at the level of the team or the company as a whole is differently motivated and uses different performance measures. Team output can be measured by sales and/or by quality measures such as customer satisfaction. Performance pay that is related to firm profits fits an entrepreneurial venture, but is less suitable for large organizations due to free rider problems. Performance pay schemes related to corporate profits are usually used to motivate higher management. These people have to act based on their personal valuations and can be considered residual claimants. Arguably, performance pay contracts are especially suited to share uncertainty among decision makers, which can explain the absence of a trade-off between uncertainty and incentive pay. Another explanation for the lack of support for a trade-off between uncertainty and incentive pay states that uncertainty would reduce the negative effects of favoritism. Favoritism implies that some employees are rewarded based on superiors’ likes and dislike, irrespective of their performance. Supervisors were found to distort performance reports on workers based on their personal preferences (Prendergast, 2000). Distortions emerge, when superiors willfully deviate from judging a worker’s ‘true’ value, which is known to them. These distortions are more serious, if pay is related to reported performance (Milkovich and Newman, 1999). Supervisors’ reports will thus contain more false statements, if the stakes are higher. ‘Better incentives are paired to worse sorting’ (Prendergast, 2002b: 118). Uncertainty is supposed to weaken the effects of favoritism, because it blurs the relationship between individual effort and performance so that reports become more randomly distributed as uncertainty increases (ibid.). But increased randomness would only decrease the average ‘falseness’ of reports, if supervisors favored inferior to superior performers under certainty. Only under this condition would an increase of uncertainty reduce the number of ‘false’ reports. Subjective evaluations are part of implicit labor contracts in contrast to explicit contracts that are based on objective performance measures such as piece rates or profits. Implicit contracts make compensation dependent on perceived attitudes such as cooperation and dependability. But implicit contracts are not enforceable in courts. Management is, therefore, inclined to renege on such contracts and lower its evaluation of employee performance once they are hired (Baker et al., 1994). The firm would only comply with the implicit contract, if it wants to keep the employee. The worker is supposed to leave the firm, if he finds out that management reneges on an

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implicit contract. We could argue that Baker’s argument would lead to the conclusion that only favored employees would stay with the firm. Organizations can thus only renege and ‘cheat’ an employee more than once, if he cannot obtain a second opinion on his ‘real worth’ from another organization. Competition among employers is heightened, if they have different views on a person’s worth. Agency literature depicts subjective evaluations of people as unfair or irrational (Milkovich and Newman, 1999), but subjective criteria are common in hiring and promotion decisions. Some authors argue that subjective evaluations are essential to the existence of firms, because contracts based on objective performance measurements can also be concluded in spot markets (Baker et al., 1999). A firm can only be worth more than its parts, if some of the firm value is not (yet) captured by markets. Organizing people in firms presumes that value is created, when people combine efforts instead of being their own employer. Coase explained the organization premium by pointing to transaction costs of concluding contracts in spot markets (Coase, 1937). However, his theory of the firm might be less applicable in modern times where human capital has become the predominant asset. The uncertainty surrounding the valuation of human capital has enhanced perceptive qualities as a precondition for success. Management of large firms has to excel at selecting people and projects to exceed average outcomes in its industry. It can either pay its preferred people a fixed wage or one that is based on results, depending on the character of the firm. A firm represents a unique combination of physical and human capital. This means, in my opinion, that it concludes contracts with people at prices that others do not want to pay. Perception can add value just because valuations of people differ. This view of the firm differs from the transactions costs argument put forward by Coase, whose theory assumes that allocation via the market is more costly than allocation within organizations. My view of contracts as unique combinations of financier and entrepreneur/firm and employee allows diversity and generates both profits and losses. This view contrasts with that of Zingales, who posits that explicit contracts can cause neither unexpected losses nor profits (Zingales, 2000: 1631). Organizational capital, in his view, consists of implicit contracts that are not easily reproduced in markets (ibid.: 1633). However, uncertainty implies that somebody’s value is estimated differently by different employers. My view also fits in with the view of the firm as a collection of growth options (Myers, 1977). However, growth options can turn out to be decline options.

Models of compensation under uncertainty The approach I have developed can explain why the hypotheses of agency theory are not supported by the facts. Uncertainty creates diversity of views and thereby profits and losses in entrepreneurial ventures, irrespective of

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efforts. Large organizations differ from small entrepreneurial start-ups as they are better equipped to absorb uncertainty through diversification. Their large size allows big corporations to pay fixed wages, but raises another set of problems. How should employees be motivated to do their utmost, if they receive fixed wages? The effects of uncertainty on incentive pay will be discussed for bonus schemes and promotion premiums. Bonus schemes We assume that uncertainty prevails and that the expected chance of success of a venture is estimated to be 1b irrespective of effort. The employee will receive a base pay in the case of failure ðwo Þ and base pay plus a bonus in the case of success. The principal values the agent at an ex ante worth of wo þ e. Principal and agent are both risk neutral. The principal expects to pay and the employee expects to receive wo þ e for each success rate. An increase of uncertainty thus does not affect the expected wage, but the actual wage paid in the case of success exceeds the expected wage and increases with uncertainty: 1 b1 o Þw Ew ¼ wo þ e ¼ we þ ð b b 1 e ½w  wo  ¼ e b ! we  wo ¼ be The actual bonus paid in the case of success thus equals the inverse of the chance of success of the venture times e. The bonus should amount to 2e, if the chance of success were 12 and 3e, if the chance of success were 13 d. Compensation would be completely performance-related, if nothing were paid in the case of failure ðwo ¼ 0Þ. The agent is then a residual claimant and entitled to a share of revenues. Performance pay is used as a risk-sharing device in these examples. Such schemes would allow participants to share in the gains that high-risk ventures can incur. Tournaments Employee compensation does not depend only on basic pay and bonuses, but also on promotions. Promotions that are based on relative employee performance are called tournaments (Lazear and Rosen, 1981). One employee will always be promoted in a tournament irrespective of firm performance. We model a contest between two employees. Both employees have an equal chance of being promoted, if they exert equal effort. This could either be no effort or a positive effort. Promotion will be determined

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by tossing a coin, if the two employees perform equally. Hence, each employee has a chance of 12 to be promoted, when they both exert either high or no effort. We first assume that the chance for an employee to perform well is 1b ð0 < 1b < 1Þ if effort is exerted and zero if no effort is exerted. If one person puts in effort and the other does not, the zealous person’s chance of promotion is the sum of the chance that he will outperform the lazy person and 12 times the chance that they perform equally. His chance of promotion would then equal: 1 b1 1 1þb  þ ¼ : 2 b b 2b The lazy person has a residual chance of being promoted: b1 : 2b If a zealous person has a chance of 12; of performing well, his chance of promotion would be 34, whereas the lazy person has a chance of 14 of being promoted. The promotion premium should be sufficiently high to induce both people to exert effort: e represents the additional income the new rank offers, if effort could be correctly measured by performance and only one person exerts effort. The promotion premium will increase with uncertainty: 1 e 1 o b1 e bþ1 o w þ w e> w þ w 2 2 2b 2b ! we  wo ¼ 2be The promotion bonus is thus twice the size of the performance bonus discussed above. Four times the performance bonus should be paid, if the chance to be promoted while exerting effort were 12. We could argue that the promotion premium only needs to be paid to one person, whereas both employees can receive bonuses. But, the promotion premium needs to be paid irrespective of corporate performance. Promotion premiums seem most suited for bureaucratic firms with a continuous income stream. We can also conclude that promotions are completely random, if both employees exert equal effort. Subjective evaluations (favoritism) can decrease the zealous person’s chances of promotion, if lazy people can also get good reports, irrespective of performance. If the chance of getting a good report were positive for both the zealous and the lazy person, then the lazy person’s chance of a good report would be lower than that of the zealous person: csl  csz ;

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and the promotion premium would need to increase to

ðcsz

2e  csl Þ

to exert effort (see Appendix). Hence, the promotion premium would equal 8e, if the chance of a good report were 14 for the lazy person and 12 for the zealous person. Favoritism thus increases the promotion premium, because it increases uncertainty. Randomness increases further, if the lazy worker can undermine the zealous person’s performance. Such uncertainty enhancing favoritism would make tournaments rather costly, which could explain why tournaments are rarely used to promote employees. The widespread use of subjective evaluations in hiring and promotion decisions, however, indicates that favoritism has some merits. It was assumed above that the zealous person was not aware of the boss’s favoritism. Such covert favoritism would heighten promotion premiums. But overt favoritism, in contrast to covert favoritism, would reduce promotion premiums. The expected chance of promotion would equal either zero or one, if employees were aware of their superiors’ preferences. The promotion premium would equal e, if it were clear that a supervisor would give one employee a good report irrespective of performance. Overt favoritism can thus reduce the size of incentive pay, because uncertainty about a person’s perceived worth is eliminated. The favored agent would lack an incentive to exert effort. The same applies to the non-favored agent. Favoritism thus undermines motivation in a principal–agent model.

Favoritism, intrinsic motivation and corporate culture The negative effects of favoritism can be halted, if people derive utility from working in a certain organization. Intrinsic motivation theory contends in unison with principal–agent theory that people use the organization to pursue their own goals (Osterloh and Frey, 2000). However, intrinsic motivation theory posits – in contrast to principal–agent theory – that people derive positive, psychological rewards from exerting effort. Extrinsic motivation instruments such as monetary rewards would crowd out intrinsic motivation, in their view. Intrinsic motivation theory differs from organizational psychology by its emphasis on the pursuit of individual instead of common goals. Organizational psychology, by contrast, stresses the importance of goal congruity and corporate culture for organizational performance. The presence of a corporate culture implies that people share the same goals and behave according to shared norms (Schein, 1992) Organizational culture is assumed to shape a person’s behavior by internalizing values and beliefs. People would judge situations according to internalized norms. Consequently, culture shapes people’s behavior within organizations,

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in this view. Strong corporate culture crowds out informal cultures, in which people’s behavior is determined by peer and not by corporate norms. A person’s informal status can diverge from his formal status, if lower echelon managers’ favorites differ from those of corporate management. A strong corporate culture, by contrast, would not allow such discrepancies. Monetary incentives seem superfluous as a motivating device in culturally homogeneous organizations, but can fulfill a risk-sharing function. Performance pay, as a risk-sharing device, does not need to affect corporate culture or crowd out intrinsic motivation. The tenuous or even positive relationship found between uncertainty and performance pay could so be explained. People who share in the downside of risky ventures should also share in the upside. This approach to performance pay can explain the widespread incidence of performance pay in environments, characterized by high uncertainty. It could explain why performance pay schemes are more amply used in small than in large firms and why most pay schemes are egalitarian and based on horizontal equity (Baker and Hall, 2004; Baker et al., 1988). The implications of intrinsic motivation and corporate culture theories in promotion decisions are straightforward. Promotions should be given to persons who are expected to improve the performance of a team or business unit and not to persons with the best individual performance. An organization can establish cultural homogeneity by changing people’s behavior, which is a cumbersome process. Cultural homogeneity is, therefore, usually achieved through hiring, firing and promotion policies. These policies will reflect a firm’s preferences with respect to employee behavior, i. e. their values and ways of communicating. Pfeffer, who views organizations largely as relational entities, predicted that organizations will display a tendency for similarity among their personnel (Pfeffer, 1983). Similarity can be of different kinds. Pfeffer emphasized similarity of demographic variables such as age, education and gender. He argues that such demographic similarity facilitates trust and communication among employees (Pfeffer, 1991). Demographic variables are easily observable in contrast to personality characteristics. Schneider’s ASA (Attraction–Selection–Attrition) model of homogeneity within firms, by contrast, is based on similarity of personality characteristics (Schneider, 1987). He argues that people are not randomly assigned to organizations, but move in and out of organizations by self-selection. People choose and shape their environment through these processes. Authors in the field of organizational psychology mostly start their discussion of corporate culture by referring to a new firm, whose culture bears the stamp of the founder (Schneider, 1987: 1999). Founders can influence the ‘personality’ of the start-up and create a new environment. They will attract people of their liking, who are expected to like each other due to common personality traits. Sorting based on personality characteristics would yield outcomes that differ from sorting based on demographic characteristics, if personality types vary among people of identical education, gender and age. Schneider’s relative homogeneity hypothesis, stating that

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personality types do not vary within but vary between organizations was supported by empirical evidence (Jordan et al., 1991). Managers were grouped into types according to differences on Extraversion/Introversion, Thinking/ Feeling, Judging/Perceiving and Sensing/Intuition dimensions. Different corporate personalities were not only found among organizations belonging to different industries, but also among organizations belonging to the same industry (Schneider et al., 1998). It might be obvious that old-line manufacturing firms attract people that differ from ‘high tech’ recruits, but different accountant firms were also found to employ people with different personality attributes. The data thus support the view that people are sorted among firms based on personality types. Such differentiation may occur due to differences in goal orientation. Some organizations might be service oriented, whereas others strive for technological superiority (Schneider, 1987: 443). These results indicate that organizations with different personality characteristics can survive in the same industry and that there is no one best personality type for similar organizations. Organizational psychology places some problems raised by principal– agent theory in a different light. Motivation would be less of a problem in culturally homogenous organizations, where everybody is expected to exert maximum effort to achieve commonly shared goals. Moreover, people, who favor each other, would not be tempted to undermine each other’s efforts or free ride on others; selecting the ‘right’ people could thus largely remove problems of motivation, sabotage and free riding. The differences between agency theory and the organizational psychology literature can be expressed in terms of Theory X and Theory Y organizations. Theory X assumes that workers need to be cajoled into working; they work only for money and are not to be trusted. Theory Y assumes that workers are trusted to be creative and further the goals of the company (McGregor, 1960). The relative cultural homogeneity hypothesis predicts that organizations prefer different personality types. Uncertainty about what constitutes the ‘best’ personality type is essential for diversity. Otherwise, a certain personality type would be generally favored and others disliked. This could either force people to conform to the favored personality type’s behavior or cause a sharp separation between favored and non-favored personality types within organizations. Such a dichotomy would increase income inequalities, if generally favored people are well rewarded and non-favored people only meagerly rewarded. A related argument states that different organizational cultures can only survive, if corporate culture does not predetermine success or failure. Financiers would only fund companies with the ‘best’ corporate culture, if they knew what that were. But, financiers have to act on the basis of subjective evaluations of established and nascent companies and their stated strategies. Divergence between plan and performance will only be noted, if measurable targets are stated openly. Communication of corporate plans is a prerequisite, if approval from external agencies is sought. This distinguishes the situation of the externally funded entrepreneur from the self-employed person.

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Strategy development and uncertainty Valuing human capital Strategic action is forward-looking and involves setting goals and indicating ways to achieve them. Strategic action is how an organization copes with the environment (Burgelman, 1991). Mere adaptation is not enough in many innovative industries; firms need to select projects based on informed guesses about their future worth. Project generation might be a one-man show of the business leader, but could also be the result of a more collective effort. People can choose an organization with an authoritarian leadership style, if that suits them. Religious sects often have authoritarian leaders. But modern leadership wants to utilize human capital within the organization. The strategy development literature discusses several ways to generate and select projects within organizations. Employee willingness to share ideas with colleagues is, however, not questioned in this literature as their willingness to contribute to the organization is taken for granted. This seems obvious for people who were hired for their human capital. Some, however, argue that this literature takes a rather utopian view of benevolent cooperation and neglects incentive issues (Dosi and Marengo, 2000: 82). The contribution of knowledge workers to a common knowledge pool is depicted as a prisoner dilemma problem; nobody would want to share knowledge, if they doubt their colleagues’ willingness to share (Grant, 1996). The fear of free riding would thus keep each individual from revealing his knowledge. As a consequence, equilibrium is attained, in which little knowledge is shared. Several ways out of this no-sharing expectational equilibrium have been sketched. The intrinsic motivation literature argues that personal relationships and a team spirit can overcome free rider problems and trigger knowledge sharing (Osterloh and Frey, 2000). A distinction is made between tacit – non-tradable – knowledge and explicit knowledge having a market price. Employees are only willing to share tacit knowledge, if they feel emotionally loyal to an organization and its constituents, but will withhold information, if they expect their knowledge input to be improperly assessed (ibid.). Only tacit knowledge can create a competitive advantage for a firm, since tradable knowledge would disseminate easily, in Osterloh and Frey’s view. The concept of tacit knowledge also implies that a particular individual’s knowledge contribution to team output cannot be measured and paid accordingly. Osterloh and Frey depict cooperation as a prerequisite to sharing tacit knowledge, whereas explicit knowledge is shared as a matter of fact. Tacit knowledge will be less easily shared, because it is subject to collegial and not to market valuation. Consequently, tacit knowledge allows an organization to ‘hold up’ its employees and reduce the valuation of their human capital at will. Knowledge sharing will thus stop, if people do not consider assessments ‘fair’. Yet fairness seems difficult to establish, if market

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valuations cannot provide a yardstick. Tradition could offer performance standards, but these would impede innovation. Knowledge sharing can thus easily break down, when knowledge is tacit, because a person’s perception of his own worth can only be validated within the organization. Tradable knowledge – by contrast – opens possibilities for multiple valuations, which would allow an individual to join the organization, which values him most. Osterloh and Frey’s argument that tradable knowledge cannot provide a competitive advantage is not convincing, in my view, because it presumes that the value of an idea can be non-ambiguously determined. But the value of an idea or proposal is usually shrouded in uncertainty. Some will attach a high value to a proposal, whereas others will consider it to be worthless. Investing in knowledge is thus based on expectations, which differ among investors/employers. A person is motivated to share tradable knowledge with colleagues, if he expects them to value his contributions more than outsiders and he will leave the organization, if he does not. Cooperation within teams makes individual performance dependent on team performance. An individual thus has an incentive to select the team he deems most likely to be successful. But such a search is impossible, if only current employers and team members can appreciate a person’s worth. I, therefore, argue that the possibility of multiple appraisals is crucial to knowledge sharing. A knowledge-sharing equilibrium is only sustainable, if people, who feel undervalued, can leave the organization. Labor mobility can thus solve disputes, which would undermine cooperation without the possibility of exit. Project selection Uncertainty about the value of ideas and projects raises the need for project selection procedures. Burgelman (1991) designed the variation–selection– retention framework to model strategy development, which resembles Schneider’s Attraction–Selection–Attrition model. The main elements in his approach, however, are not people but project proposals. The model implies that various strategic initiatives are generated within organizations (variation); some of which are selected. Retention refers to the ultimate success or failure of a project as determined in the market place. Project evaluation differs from personal evaluation, if a person’s worth within the organization is not deemed to be identical to that of his projects. The three-pronged approach to strategy-making especially fits innovative firms that allow their employees to work on new projects. Project generation can be induced by internally generated ‘rules’, as was the case at 3M. One rule stated that 3M employees could spend 15 percent of their time on nonprogram activities. Another rule prescribed that 25 percent of 3M sales should consist of products that were introduced in the past five years. Employees of Oticon – a Danish hearing aid firm – were free to propose as many projects as they wanted and with whom they wanted (Foss, 2003).

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Different ways to discuss and select projects can be found among innovative companies. We can expect that corporate culture will influence strategic discourse and decision-making. Both Digital Equipment Corporation (DEC) and Intel used what they called ‘constructive confrontation’ to select projects. The DEC culture forbade employees from simply obeying orders; they were supposed to follow their own judgment and challenge their superiors. Schein was surprised and sometimes appalled by the confrontational argumentation style he found at DEC (Schein, 1999). People were supposed to defend their ideas vigorously to obtain approval from colleagues. Such consensus-seeking decision-making raised questions about minority rights. Can people be forced to renounce their project, if they fail to get support from their peers? Moreover, it is difficult to reach consensus, if everybody is supposed to stick to his own view. DEC’s emphasis on personal autonomy conflicted at times with consensus-seeking. Engineers were allowed to continue work on projects that did not obtain group approval. This could lead to competing project teams as happened in the case of the personal computer, where three DEC teams were competing with each other (ibid.). No consensus needs to be reached, if senior management decides on project selection, as was the case at Hewlett Packard (ibid.). Discussion was used at HP to raise ideas and obtain information. Discussions were not confrontational and no consensus needed to be reached, since decisions were made by top management. This was also the practice at Oticon, where a central committee decided on project acceptance and continuation (Foss, 2003). Hierarchical decision-making makes superiors responsible, whereas collegial/consensual decision-making assumes shared responsibility. Collegial decisionmaking could fit a start-up, where everybody shares in the risk of the company. Hierarchical decision-making in large, diversified companies makes sense, since it can mitigate tendencies to conformism that may feature in collegial decision-making. People would not present projects, which they did not expect to be backed by their peers, if decisions were made collectively. Moreover, risky projects are avoided, if failure could hurt one’s career; managers would only back projects for which an assured demand existed (Christensen and Bower, 1996). People will only propose risky projects, if they share in both profits and losses (as in start-ups), or if project outcomes do not affect their income. They will certainly not propose risky projects, if they only participate in the downside. Consequently, hierarchical decision-making can curb risk-avoiding behavior in large organizations. Hierarchical decision-making fits in with fixed remunerations. Large companies can better hedge their bets and guarantee income than entrepreneurial start-ups. Large companies, will, therefore attract risk-avoiding people, whereas small companies will attract people with a more entrepreneurial mind-set. The lifelong employment tradition at HP fits in with hierarchical decision-making. Hewlett Packard was able to go through many technological transformations in its lifetime without much conflict until the early twenty-first century. It moved successfully from instruments

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to computers and then to desktop publishing and printing (Burgelman and Grove, 1999). Intel had both induced and autonomous processes for strategy-making. Induced strategies sprang from rules of thumb such as ‘maximize margins per wafer start’. Such rules brought internal selection in line with external (market) selection forces (Burgelman, 1991). Intel had to change course in the 1980s after it had lost the main share of its memory chip business to the Japanese. The move out of memories and the focus on microprocessors could no longer be guided by existing rules of thumb, but required a drastic reorientation. Microprocessor development required a choice between two different chip varieties: the CISC and the RISC chip at one point in time (Burgelman and Grove, 1999). Two different teams carried out development on the two different chips. Intense debates ensued before the choice was made in favor of CISC. Some of the disappointed RISC adherents left the company. Project evaluation should be removed from employee valuation to generate an open discourse in bureaucratic firms. Corporate survival does not depend on the success of one project, but on the average rate of return of a portfolio of projects. Corporate policies that disentangle personal from project evaluation allow people to abandon projects without losing prestige. This can be achieved, if a person’s remuneration and career prospects within large organizations are not affected by the success or failure of a certain project. A ‘learning organization’ presupposes that people stay within the organization even after their projects were rejected or failed in the market. 3M installed procedures to achieve such a ‘learning organization’. Division managers were responsible for project selection at 3M, which occurred according to a staged process (Bartlett and Mohammed, 1994). Lower echelon managers could comment on the project at each stage. However, only the division manager was held responsible for the market performance of a portfolio of projects as their performance was measured against several financial targets; each division should grow by 10 percent p.a.; have operating margins of 20 percent and a ROI of 27 percent. Senior management, who were responsible for project selection, were thus also held accountable for the outcomes of their decisions. Middle managers, by contrast, were not and failures would not harm their career. 3M’s procedures resemble those of Hewlett Packard, where middle managers were also not held responsible for project failures. Several managers of a failed project were even promoted (Rogers, 1997). Discourse at both 3M and HP seems to have been more ‘safe’ than at Intel and DEC. Both 3M and HP are also depicted as companies that originated from a group of like-minded people without even having a clear strategy or project portfolio, when they started (Collins and Porras, 1994).

Managing change Change can be imposed on an organization, if it is no longer in sync with the environment and fails. Change can also occur through deliberate actions.

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Organizations that want to outpace market growth need policies to achieve their goals. The same applies to organizations that want to reverse or prevent decline. Rapidly growing companies can couple discourse on strategic initiatives to recruitment. Software-maker Trilogy used its corporate university to select both people and projects. The company grew rapidly after its foundation in 1989. Trilogy University (TU) was established in 1995 by Joe Liemandt, Trilogy’s CEO and one of its founders. Trilogy campus recruits are trained for 12 weeks at TU in contrast to other orientation programs that usually take three days (Tichy, 2001). The program consists of three parts. Recruits learn about Trilogy technologies in the first; work on a project in the second; and find their place in the organization in the third month. Recruits who cannot find a sponsor are not hired. Most of Trilogy’s innovations come from these orientation programs, which involve the participation of the CEO and of Trilogy’s brightest engineers. The program builds bonds between new recruits and seasoned managers and immerses them in Trilogy values. A formal bureaucracy might replace the exuberance of the pioneering days, if start-ups grow to large size. A new brand of people may be required to fit in with the new organization, as happened in the case of DEC. But large bureaucracies may become complacent and stuck in their ways. Schneider notes that culturally homogenous organizations would tend to resist change due to a lack of diversity within the organization (Schneider, 1987: 445). The organization would be so perfectly matched to a certain environment, that it would be unfit to survive, when the environment changes. If we stretch this argument, we might conclude that change only comes about through the birth and death of organizations and not through changes within established organizations. However, change that only occurs through new firm formation is unsustainable. Investors would avoid established firms and flock to new firms. A level playing field between old and new firms is required to make success unpredictable. This presumes that mature firms are capable of change. However, some bureaucratic organizations can only survive, if they are ‘reborn’ as a different personality. This is what Schneider means, when he advocates Total Organizational Change (TOC), which involves a change of both processes and the nature of interpersonal relationships. Hierarchical command relationships between superiors and subordinates should be changed to relationships in which lower level employees are empowered instead of just following instructions (Schneider et al., 1996: 96). Bureaucracies need to transform command relationships into personalized relationships and to transform communication in a way that furthers the goal of the organization. Transformational change thus wants to transform corporate culture from a command organization to one in which employees have a voice. We can also argue that a change of corporate personality type will entail the depreciation of some people while increasing the worth of others.

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A well-documented transformational change project is that of General Electric under Jack Welch; who was GE’s CEO from 1980 to 2000 (Tichy and Sherman, 1993). Welch was convinced that change was required at GE, because productivity was stagnating, while foreign competitors were bound to invade GE’s markets. He introduced performance pay at several levels of the GE organization. The first measure Welch took after his appointment in 1980 was to establish some performance measures for the six sector managers; who each controlled a multi-billion portfolio of businesses. Welch required that each business had to become either first or second in its (global) market, had to show well above average returns on investment and have some competitive advantage (ibid.: 108). Welch did not want GE to be a niche player, but pressed managers to pursue a cost-cutting and productivity-enhancing strategy. Businesses that did not meet the targets would be fixed; they would be either closed or sold. Upper management had some latitude in achieving these goals. In the end they could not escape reducing costs through downsizing. However, across the board lay-offs were not appreciated. They had to lose those employees they thought contributed least to the company (ibid.: 93). This indicates that lay-offs based on subjective performance evaluations by upper management were encouraged. GE divested 117 business units, from coal mines to Light ‘N Easy Irons, during Welch’s first four years, liquidating one-fifth of GE’s 1981 asset base of $21 billion (ibid.: 102). The immense re-shuffling reduced GE personnel by 170,000 out of 412,000. GE’s promise of lifelong employment and the security of seniority-based promotions were shattered in the process. New businesses were later added through plant openings and acquisitions. GE’s portfolio moved away from manufacturing and into services and high tech. A further step in the transformation of GE involved internal restructuring. The number of hierarchical layers was reduced from nine to six. The reshuffling opened opportunities to remove high-level resisters and replace them by executives who were hand-picked by Welch for GE’s most important jobs (ibid.: 82). Spans of control were increased from six to 12 people. The number of profit and loss centers was reduced from over 300 to 50 (ibid.: 84). The sectors were eliminated and 13 group directors were appointed, who reported directly to the CEO. De-layering strengthened the CEO’s grip on the company. His personal choice of key players strengthened the psychological contract and bolstered corporate culture. Central staffs were cut considerably; 80 percent of central planning officers left the company. Group managers had great authority to allocate both capital and people. The reduction of the number of profit centers increased possibilities to hedge risks through diversification. Group directors’ pay was related to productivity, growth and profitability. The use of incentive pay for lower echelons also increased considerably after Welch took office. Company-wide performance targets were set, such as increasing the number of inventory turns and increasing the operational margins. These targets embodied GE’s cost-cutting strategy.

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Another area of change involved communication and decision-making. Processes encouraging open communication replaced the old order and command systems. Communication was considered a vital element of GE’s new culture. GE’s corporate university Crotonville acted as the stage, where the CEO regularly discussed policy issues with the CEC (Corporate Executive Council). The idea was to reach consensus through constructive dialogue. Welch expected that only the best ideas would survive a heated exchange of opinions. He saw communication as ‘a dialogue of equals; a constant interactive process aimed at creating consensus’ (ibid.: 75). The tone of the debates was set by the concept of ‘boundarylessness’, meaning that communication should overcome functional, national and status boundaries. This should prevent communication being clad in jargon that was unintelligible to the uninitiated. However, the CEC was not collectively responsible for decisions taken. The ability to relate effectively to other people became a main consideration in promotion decisions (ibid.: 196). Promotion was thus largely based on personality characteristics favored by the CEO; such as candor, openness and self-confidence. Favoritism was consistent within the company and did not differ between groups and business units. Favoritism pressed non-favored persons to exit the company in droves; two-thirds of the business leaders were replaced by 1986. We can argue that the possible negative effects of favoritism were mitigated by the openness with which the new policy was pursued. The CEO extensively propagated the new values. Appraisals were subject to interpersonal scrutiny as managers could watch their peers perform in organized debates. Subordinates’ views of superiors were also used as an input in performance reviews. The Crotonville experience was repeated at lower levels of the organization in so-called ‘work-out’ sessions, in which employees could express their ideas. The sessions were tightly organized; took about three days and were conducted at an off-site location. Employees discussed ideas without the manager’s presence during the first two days. Suggestions were presented during the last day. Managers had to respond to suggestions either on the spot or within a few days or weeks at a maximum (Slater, 1999). Discussion was thus restricted to colleagues, while superiors had decision-making power. No consensus was sought in these ‘work-outs’, since senior management took the decisions. These open debating sessions limited possibilities for griping and brought managerial decision-making into the open. Communication was optimized, while the hierarchical structure was preserved. Personnel were encouraged to make suggestions to increase productivity and received a bonus for each idea that was accepted.

Conclusion The chapter introduces a new perspective on the hierarchy–market dichotomy by arguing that valuations within the firm are intricately related to market valuations of human capital. Markets and hierarchies only constitute

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two distinct coordination mechanisms, if opportunity costs equal zero. This would be the case, if labor were immobile and tied to a certain organization. Market economies, however, are characterized by labor mobility, which states that human capital is positively valued on external markets. Consequently, the different approaches towards employee motivation adopted by agency and management theories can be explained by their different assumptions involving labor mobility. Agency theory is most applicable in the absence of labor mobility, whereas both organizational psychology and strategy development literatures assume that people can choose the organization of their liking. The latter theories assume goal congruity among an organization’s members, whereas agency theory assumes that principals and agents pursue opposite interests. Valuations of people and projects will vary under conditions of uncertainty and induce sorting process. Cooperation and knowledge-sharing seem natural, if people can choose the organization of their liking. Labor mobility can thus overcome the moral hazard (prisoner dilemma, hold-up) problems noted by agency theory. Uncertainty affects pay modes, but in a different way than agency theory predicts. Agency theory hypothesizes that uncertainty impedes incentive pay as it distorts the relationship between effort and performance. Uncertainty can, however, enhance the use of incentive pay, if it is used as a risk-sharing device. Risk-loving people will join entrepreneurial organizations, which have a high chance of failure. Risk-averse people, by contrast, will join hierarchies, which can provide more job security. These different attitudes also affect governance structures. Employees who are sheltered from risk in large diversified corporations can leave decision-making to senior management. Companies that have outlived the early days need to establish processes to evoke and select new projects in order to prolong growth. Selection of projects does not need to coincide with that of people in large organizations. The ‘implicit’ contract is broken, if the company’s growth is arrested or turns into decline. Organizations can take on a new cultural identity, if they go through a lengthy transformation process.

Appendix: derivation of promotion premium under favoritism If both employees put in either no effort or positive effort, their chance of success would equal 12. If one employee puts in effort and the other does not, then the zealous person outperforms the lazy one; chance then equals: csz ð1  csl Þ: They end up equally high; chance then equals: csz  csl :

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They end up equally low; chance then equals: ð1  csz Þð1  csl Þ: Chance of the zealous person being promoted is the sum of the chance of outperforming the lazy person + 12 times the chances of ending equally high or equally low = 1 ð1 þ csz  csl Þ: 2 Chance of the lazy person being promoted in the same manner ¼ 1 ð1 þ csl  csz Þ: 2 Promotion premium ¼ 1 e 1 o 1 1 w ¼ w  e  ð1 þ csl  csz Þwe þ ð1 þ csz  csl Þwo 2 2 2 2 2e e o w w  s cz  csl :

7

Executive pay and tenure Founding fathers, mercenaries and revolutionaries

Introduction Corporations became a common organizational form of enterprise in the twentieth century. The nineteenth century witnessed the rise of the modern listed corporation and of stock markets. However, many corporations were tightly controlled, with founding families (or states) having large stakes. Moreover, the issue of preferred and anonymous shares eroded the decision power of (small) shareholders. Corporations can be compared to democracies, since shareholders have voting power, but the principle of one share– one vote was not always upheld as the history of the Dutch East India Company testifies. Moreover, managers have a great degree of autonomy in decision-making. This applied to the leaders of maritime ventures and to the managers of modern listed companies. Managerial autonomy is greatest, if equity is widely dispersed among shareholders and least if there are large committed shareholders, as in family firms. The so-called ‘managerial firm’ – a firm with dispersed ownership – has agency problems, because managerial decision-making is devoid of direct shareholder interference. However, corporate governance legislation places managerial decisionmaking under the control of the shareholders. Such control usually takes the form of ex post acceptance or rejection of managerial strategy at shareholders’ meetings. Shareholders can also vote with their feet by selling their shares. Liquidity has been the answer to a lack of shareholders’ influence since the times of the Dutch East India Company. Boards of modern corporations are composed of managers and outside directors in one-tier companies. Two-tier companies have an executive and a supervisory board. Board members can either be shareholders as in family firms, managers or independents. Board members can either receive a fixed remuneration or variable pay. Fixed payment was common among corporate executive, but this changed. CEO remuneration in the US has increased rapidly since the 1980s (Jensen et al., 2004), in particular, the variable part of US executive pay rose after 1986. Stock options and shares became popular in the US and the phenomenon also spread to Europe. The increased

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importance of performance pay seems to fit agency theory, which advocates a larger role for incentive pay in order to align the interests of shareholders and (top) management. But the increased importance of incentive pay is assumed to have contributed to the wave of fraud allegations that accompanied the internet bust. Several other corporate governance practices have also changed. This applies to CEO turnover rates, which increased slightly in the US, but have increased rapidly in Europe since 1990 due to a rapid increase of forced CEO dismissals. Another change involves CEO succession. The number of outside CEO hires has increased in the last decade; again to a greater extent in Europe than the US. Methods of succession have remained rather robust; CEOs are still appointed after a single nomination instead of being elected from among rivals as some have proposed in order to bring corporate governance more in line with public governance (Frey and Benz, 2005).

Corporate governance and the executive Corporate governance involves rules about decision-making. How are decision makers chosen; is decision power concentrated in one person or are decisions made collegially? Both laws and company statutes contain rules on how to select and remunerate corporate executives. The question of how decision power should be allocated in corporations has been answered in various ways. Weber held the view that the financier should have authority. However, authority was shared with the leader of the commenda organization, who also owned part of the company. Some decisions were made ex ante by the financier; these involved the destination of the voyage; the choice of captain; and the share of the profits accruing to the various participants. However, many contingencies could arise during the voyage requiring decisions by the captain. Later developments involved the rise of corporations with an indefinite length of life, widely dispersed ownership and liquidity. The East India trading companies were the first of this type of organization. Small shareholders had no decision power in the trading companies, in contrast to large stockholders, who had board seats. But the long distance between board and executives in the trading companies gave the latter a large degree of autonomy to decide in contingencies. Authority and ownership in commenda ventures were shared among contributors of financial and human capital, who both were committed to the enterprise during its contractual life-time. Shareholders of modern corporations are not committed, if they can easily sell their shares. This does not apply unequivocally to large shareholders. Family members who hold large blocks of shares cannot easily sell them, as this would mean the end of the family firm. The same applies to firms where the state is a large shareholder. The withdrawal of these shareholders would change the character of the corporation. Moreover, the exit of large committed insiders like a founding family can send the stock price southwards. Entrepreneurs are also committed

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shareholders and cannot easily sell out without undermining investor confidence. Chief Executive Officers (CEOs) of large corporations are deemed to be committed. The CEO who accepts a job at a rival firm is considered disloyal to his constituency, both shareholders and employees. CEOs, therefore, usually have tenure; they are appointed for life (until retirement). Questions of CEO tenure and remuneration have become central in the corporate governance literature. We can argue that both tenure and fixed remuneration will prevail, if uncertainty is absent. Ex ante uncertainty is eliminated, if all investors choose one entrepreneur to invest in. A process of eliminating competition through monopolization occurred in the seventeenth and eighteenth centuries, when trading companies obtained a monopoly charter. State involvement gave a superficial guarantee of fixed rates of returns, which blurred the distinction between shares and bonds. However, a lack of diversification in chartered companies actually increased the risk of these ventures, which led to a huge depreciation of equity. The diversified corporation reduces uncertainty by spreading risk. Theoretically, risk can be reduced to market risk, if corporations were perfectly diversified. The CEO of a corporation who eliminated uncertainty through diversification would be entitled to only moderate fixed wages, since he is easily replaceable as he only mimics the market. Division heads and project managers can fail, but not the company as a whole and thereby the CEO, if diversification is deemed perfect. Perfect diversification, however, is impossible, since the diversified corporation cannot capture future developments and can lose out on opportunities. Recent research found that diversified corporations traded at a discount on stock exchanges (Rajan et al., 1997). Shareholders prefer to spread risk themselves instead of leaving this to corporations. Executive boards take decisions. Two models of decision-making can be distinguished. One states that board decisions are taken collectively, whereas the other assumes decision-making by a single person. Collective responsibility would reduce both the authority and the responsibility of the CEO, whose function could be reduced to that of a ceremonial head of state. Councils with collective responsibility often granted immunity to all its members. Chairmen and members of collegiate assemblies in old democracies were chosen by lot or by rotation for short periods of time. Athens of Antiquity comes to mind, but also medieval Venice, where the position of chairman of the Council of 10 was rotated monthly among the three capii (Norwich, 1989: 499). These election procedures prevented election of the ambitious and worked to curb opportunism. Responsibility for failure was delegated to executives like generals and secretaries-general. Delegation constitutes a mode of shifting responsibility to lower levels. A delegation model, therefore, implies the existence of a hierarchy. Executives have little responsibility in a hierarchy and, therefore, are easily replaceable. This could lead to either very short office terms or lifelong tenure. The corporate world

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has preferred tenure to short appointments. CEOs of managerial firms have tenure, because the CEO position is at the top of the apex and is a reward for previous work. This makes it different from political office that fell to people by lot. The CEO position requires investment and would become less attractive, if it were bestowed on people for limited periods of time. Forced CEO dismissal constitutes a breach of an implicit contract. A CEO who can be easily ousted from power by internal rivals hurts the company. This can explain, why a CEO who is ousted is often succeeded by an outsider. Wars of succession within family firms can be avoided, if strict rules for succession exist, such as primogeniture. Failure could cost lower management a promotion, but not their job. Good reasons exist not to let failure stand in the way of promotion as this would induce risk-avoiding behavior. But immunity for both higher and lower management no longer prevails, if the company actually fails. Executives would lose their job and shareholders the value of their equity in bankruptcy. Authority shifts to creditors in bankruptcy proceeding, who face the (unexpected) risk of losing their opportunity costs (interest and principal), if they are unsecured. Executives, who lose their job, can lose more than opportunity costs. Their future income stream will disappear, if they are not rehired on equal terms by another corporation. This would be the case, if failure is considered their ‘fault’. Such a conclusion is more easily drawn in the case of the CEO of a large corporation than of an entrepreneurial start-up. A failed entrepreneur, who is rehired at his (former) opportunity costs, only loses the extra value investors attached to his human capital. Founders, who successfully start a new company after dismissal can return, as happened when Steve Jobs returned at the top job of Apple after making Pixar a success. The return of the founder (or sometimes one of his descendants) at the company helm indicates that the original vision of the company is still upheld. Such continuity is not present, if a new CEO is hired without a link to the company after the previous CEO dismissal. CEOs of large failed firms, however, are not easily redeployed. CEOs can lose their job not only due to liquidation, but also if they disappoint shareholders. Lower than expected performance can make shareholders decide to dismiss executives. A CEO will lose his future income, if he is not rehired or is bound by non-compete clauses. Corporations can compensate executives for the loss of future income in cases of forced dismissal. Such severance pay indicates that a dismissed CEO is not easily rehired. A CEO, who is rehired at equal conditions, indicates that other firms do not share the negative opinion of the ousted CEO. But a failed CEO is usually not welcomed by other corporations, which indicates unanimity among shareholders of various corporations. This can be explained by the fact that shareholders want to diversify risk by spreading their equity. They are not committed to a certain company and, therefore, do not have an opinion on a company and a CEO that differs from market valuation. Shareholders

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increasingly diversify by composing an equity portfolio and not by investing in a diversified corporation.

The decision power of shareholders Shareholders are entitled to the residual, and exercise ultimate authority as they can dismiss executives. Corporate decision-making is often delegated to appointed managers. Shareholders do not need to exercise judgment, but can compose a diversified portfolio to eliminate specific risk. Many shareholders are not interested in influencing corporate policy and do not show up at shareholders meetings. The shareholders meeting resembles the meetings in direct democracies, where the populace could either veto or acclaim a nominated leader and its policies. The constituents could neither nominate a leader nor could they contribute to strategic initiatives. The shareholders meeting features direct democracy and gives great discretion to executives to decide as they see fit. This seems obvious, since strategic decisions are usually made by a few and not by the many. We can argue that strategic decisions are made by people, who can act on their private views. This can be either board members or lower management in the corporate world. Shareholder authority is most limited in widely held organizations with dispersed ownership. Widely dispersed equity allows managers to pursue their own goals, possibly to the detriment of shareholders. A controlling shareholder, by contrast, can exert influence and, therefore, curb agency problems. But such concentration of equity capital poses problems of its own, if controlling shareholders can pursue strategies that benefit them at the expense of minority shareholders (La Porta et al., 1998). Controlling shareholders are of various kinds: families, the state, banks and pension and trust funds. Families differ from other controlling shareholders, because they often provide the CEO. This happens in the majority of cases in the Anglo-Saxon world, but is less common in Germany, Austria and the Netherlands (ibid.: Table 5). State control is absent in the Anglo-Saxon world but common in Austria, Italy and Israel. Institutional investors (pension funds) as controlling shareholders are important in the Netherlands (ibid.: Table 3A). Family firms dominate in French civil law countries. We can argue that all types of corporate control restrict decision-making to a single group. Widely held firms allow great discretion to professional management, whereas controlling shareholders can appoint their favorites. Consequently, both widely and closely held corporations suffer from agency problems. Management has decision power in widely held corporations and controlling shareholders in closely held firms. Small shareholders can be duped in both cases. But shareholders in listed companies can vote with their feet and abandon companies whose decision-makers they dislike. I want to argue that agency problems do not need to affect stock market development, if investors can choose between different control types. The

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domination of a single controlling shareholder type, by contrast, prevents shareholders from moving among control types. We would expect countries that feature one controlling shareholder type and no widely held stocks to have relatively underdeveloped stock markets. This conjecture is indeed supported by evidence from countries where widely held stocks are (almost) absent. Argentina, Mexico, Portugal, Austria, Belgium and Israel fit this picture. All these countries have relatively underdeveloped stock markets (Djankov et al., 2005). Sweden, Finland and the Netherlands, by contrast, have well-developed stock markets. These countries combine widely held stocks with controlling shareholders of various types (La Porta et al., 1998). Countries with a variety of controlling shareholders and widely held stocks provide competition among the various control types. Consequently, controlling shareholders cannot use their voting power to benefit themselves at the expense of others, as this would induce shareholders to flee to other stocks. The situation is different, if widely held corporations are (almost) absent and one controlling shareholder type dominates. These countries have relatively underdeveloped stock markets. The existence of controlling shareholders thus does not need to affect financial development. This seems reasonable, since companies emerge as entrepreneurial firms with a controlling shareholder (the founder). Families may continue to provide CEOs for long periods to come. However, families only remain in control, if these companies are expected to perform as well as companies with other control types. Ford and IBM are examples of public companies that were successfully led by several generations of one family. The population of family-led firms thus consists of both entrepreneurial firms such as Microsoft and heirled companies. Families can maintain important equity stakes after the CEO post goes to a non-family member. Controlling shareholders can influence strategy by talking directly to executives or by acting at shareholders meetings. Family-controlled firms will exert influence by talking directly to executives either at board meetings or informally. However, other controlling parties are often hesitant to express their private views on corporate policy. In fact, by taking a stance, shareholders run the risk of being held responsible for company performance. Moreover, shareholders who express a certain view on strategy have to keep their shares as long as the battle of ideas with corporate management continues to be credible. Shareholder authority is thus not compatible with liquidity. This can explain why institutional investors were never able to use their voting power directly to replace boards and CEOs (Del Guercio et al., 2006). We can argue that corporations with family blocks and state ownership are most stringently controlled, since these groups of investors are committed and will not easily sell their shares. However, this does not apply to pension funds, which must realize at least average rates of return on investments and need liquidity to obtain this. The size of the stake that investors have in a company is thus less important than their intentions. Do they

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want to express a view on the company’s future or are they indifferent? Private investors exercise private views. They can value some entrepreneurs above others as is the case in venture capital. Private equity, however, can also buy a stake in companies they believe would perform better under new leadership. Private equity funds buy shares of companies they deem undervalued and force changes on the company by taking them private or by other means. Activist shareholders differ from their passive counterparts, because they express a view on how to improve the company. They can achieve their goals either by persuasion or by hostile acts. Hostile acts are undertaken by using their shareholders rights, which differ from country to country. US shareholders can launch a proxy fight to remove board members and replace them by their favorites. A proxy fight is won, if a majority of all shareholders supports the proposal. Hedge funds are private equity funds, which usually take a small equity stake in targeted corporations. Hedge funds can with an activist policy stance exert power by influencing other shareholders. Hedge funds are partnership funds, where investors need to lock in their capital for a fixed period of time, usually in between six months and two years (Bratton, 2007). Investors delegate decision-making to hedge funds managers, who have a large degree of autonomy. Hedge funds can have clear opinions on how to improve performance, which they can communicate to both the board and the media by sending ‘big boy’ letters suggesting some sharp reversal of strategy usually by breaking up or selling the company. These structural actions proved to be most successful measured by stock price gains. Breaking up a diversified company allows them to cash in on the diversification discount, which is estimated at 15 percent (Berger and Ofek, 1995). Shareholders can express their opinion on the initiative either by selling or buying shares. Wide approval of their ideas, as expressed by rising stock price, forces managers to follow up their ideas. A proxy fight can be launched, if management does not want to accept the call voluntarily. Most of the time the threat of such action alone suffices to make managers accept the hedge fund proposals. Hedge funds cannot be persuaded, but stick to their published views. This and the threat to follow up on their ideas is the core of hedge fund policies (ibid.). Legislation on shareholders’ initiatives differs from country to country. Shareholders of Dutch listed companies obtained more rights, when a new governance code (the Tabaksblat code) came into effect in 2004. The new code allows shareholders holding more than 1 percent of shares to submit shareholders’ motions ahead of annual shareholders meetings. TCI, a British hedge fund, used this opportunity to announce in February 2007 that it would put a motion to break up, spin off or sell ABN-AMRO, the largest Dutch bank, on the shareholders’ meeting agenda. The new Dutch Code also forced the management to gain approval for major changes in the identity or character of the company at a shareholders meeting. This allowed

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the VEB, a group representing shareholders, to block ABN-AMRO’s intended sell-off of Lasalle to Bank of America by a court decision in May 2007. However, this decision was overruled by the Supreme Court in July 2007. Decisions at Dutch shareholders meetings need to be made by an absolute majority of shareholders present. Company statutes can require that these shares represent one-third of issued capital. However, if the required portion of issued capital is lacking, a new meeting can be convened at which a majority decision prevails. Dutch shareholders also have the right to summon a special shareholders meeting. Hedge funds have used the newly won shareholders’ rights to attack incumbent management of a host of listed Dutch companies.

The changing role of the CEO The rapid rise of executive pay in the US after 1985 constituted a break with the past. Median executive pay of S&P 500 companies declined from 882,000 in the 1930s to $843,000 in the 1980s (in 1988 US$). The major part of executive pay was fixed in the 1974–86 period; the earnings/pay sensitivity only amounted to 0,185 percent for large and 0.8 percent for small corporations. The ratio of CEO pay to total firm value declined from 0.11 to 0.03 percent in this period (Jensen and Murphy, 1990). Moreover, CEOs were appointed for life and were seldom (openly) dismissed for poor performance. Average job tenure for CEOs amounted to 10 years in 1974–86. Lost future incomes due to dismissal were reduced by severance pay, golden parachutes and the like. Jensen and Murphy explain these practices by pointing at implicit regulation and labor market considerations. Public disapproval of high rewards had truncated the upper tail of the earnings distribution of top executives, while equilibrium in the managerial labor market prohibited large penalties for poor performance. Both influences, in their opinion, helped to limit the dependence of pay on performance (ibid.). They depicted CEOs as riskaverse people, who neither participated in the upside nor the downside of their company’s performance. The lack of incentive pay in those days might be attributed to the immobility of stock prices. But Jensen et al. argue that executives in the 1970s had little incentive to increase company share prices (Jensen et al., 2004). Half of variations in CEO pay were due to differences in company size at that time. They argue that size related pay in those days induced managers to expand their companies through diversification without creating value (ibid.). I would argue that corporations in those days were run as organizations where CEOs had immunity due to diversification and delegation of responsibility to executives in the field. Jensen and Murphy (1983) criticize the lack of incentive pay of the 1970s, which, in their opinion, was out of step with insights from agency theory on optimal contracting. Agency theory advocated performance-related pay to align managers’ and shareholders’ interests and prescribed the dismissal of

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failing CEOs without compensation. The optimal contract, according to Jensen and Murphy, was one, in which the CEO owned the company. Hence, the CEO should be the sole residual claimant and incur all (excess) profits. Such a contract would be devoid of agency problems. But the corporation would die in the process and the economy would be composed of self-employed people. Jensen and Murphy suggest writing binding contracts for CEOs with a much larger share of income and (personal wealth) at risk and forbidding entrepreneurs from selling equity while in office to align shareholders and management interests. Their wishes seem to have been partly fulfilled, since the share of variable CEO pay increased considerably after 1985. However, more stunning was the increase in total pay which rose from $850,000 in 1970 to $14 million (inflation adjusted US$) in 2000 at the height of the internet boom, to fall again to $9.4 million in 2002 for S&P 500 companies (ibid.). The larger part of this rise (and fall) was due to variations in wealth from stock options, since cash pay increased from $850,000 in 1970 to $2.2 million in 2002. CEOs were no longer paid like bureaucrats, as was the norm when their remuneration was closely tied to firm size and when they received small rewards for excellent performance and even smaller penalties for failures. However, the fulfillment of some of Jensen et al.’s, recommendations met with a rather cold reception in their later work, where they question the integrity of important parts of the remuneration process and the fiduciary responsibilities of boards and remuneration committees (Jensen et al., 2004). CEOs benefited from stock market gains after 1984, but their losses were still curtailed. CEO employment agreements nowadays encompass compensation for executives terminated for reasons other than moral turpitude, gross negligence or felony convictions. Jensen et al. regret that the second part of their recommendations has gone unheeded. ‘Notably, compensation cannot be denied for termination due to incompetence and we are unable to understand how such provisions could be in the interests of the firm’ (ibid.). Their agency framework causes Jensen et al. to depict CEOs as decisionmakers, who could be induced to take the ‘right’ decisions, if they were to bear the consequences. But it seems nearly impossible to expect managers always to take decisions that turn out to be the ‘right’ ones, since this would deny the inherent uncertainty caused by market competition. Another recent change involves the increasing prevalence of outside hires for the position of CEO. External hires amounted to 26 percent of CEO appointments of companies in the Forbes Survey of the 1990s, whereas this was 16 percent in the earlier two decades. Outside hires were paid 15 percent more than inside appointees (Murphy and Zabojnik, 2004). Jensen et al. explain the higher remuneration of external CEOs by pointing to the managerial labor market, which would drive up the remuneration of external CEOs (Jensen, et al., 2004). Corporations need to bid up for external CEOs in order to attract them from existing employment. This would indicate that external CEOs are hired from higher management of other firms.

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CEO turnover of S&P 500 companies increased slightly during the 1990s from 10 to 11.3 percent (ibid.). UK turnover increased slightly from 6.48 percent before 1992 to 7.24 percent after the date, when the Cadbury Code was implemented (Dahya et al., 2002). This means that average CEO tenure of UK companies decreased from 15 till 13 years, still well above the US average. CEO turnover has increased by 170 percent from 1995 to 2003 for a worldwide sample of 2,500 companies. Turnover among European CEOs was twice that of the US in 1999–2001. Almost half of European CEO turnover was performance-related, against 20 percent in the US. The trend was most significant in Germany, where the level of forced CEO turnover was highest (Booz, Allen & Hamilton, 2002). The importance of forced dismissals decreased in the US in 2003 and 2004, but not in continental Europe, where almost half of all CEO turnovers were performance-related in 2004. CEO tenure in Europe became shorter than in the US for the first time in 2003 (Booz, Allen & Hamilton, 2004). The US and UK systems of corporate governance seem more robust than their continental European counterparts. An examination of recent changes of remuneration and tenure in large Dutch corporations may shed some light on continental changes of corporate governance.

Executive compensation and tenure in large Dutch companies CEO remuneration Executive remuneration in large Dutch companies has risen sharply but was still far below the US average. Average executive pay of AEX listed companies amounted to 3.7 million euros in 2004, which was far below the $9.4 million their US counterparts received in 2002. The structure of compensation, however, shows some striking similarities. The importance of base pay amounted to 22 percent of total compensation in the Netherlands and 19 percent in the US. Cash pay (base pay plus bonuses) constituted 42 percent of total CEO compensation, which was somewhat above the US average, where cash pay Table 7.1 Comparison of compensation structures of Dutch CEOs of AEX listed companies in 2004 and of US CEOs of S&P 500 in 2002

Dutch CEOs US CEOs

Total pay (million)

Fixed pay (%)

Bonus (%)

Benefits and others (%)

Stock options (%)

Shares (%)

3.7 euro 9.4 USD

22 19

20 17

8 17

14 47

36

Source: Jensen et al. (2004); Verkleij (2005). Notes: Shares and stock options were valued at grant date (using the Black and Scholes formula).

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plus bonuses constituted 36 percent of CEO compensation in 2002 (Jensen et al., 2004). Shares and stock options constituted 50 percent of total CEO pay in the Netherlands and 47 percent in the US. US and Dutch CEO compensation structures were thus largely identical (Table 7.1). The main difference was that shares were important in Dutch listed companies, but not in the US. Dutch CEO demographics We carried out a longitudinal study of CEO demographics in 15 large companies listed on the Dutch Stock Exchange.1 Average CEO tenure was 13.8 years from the moment of foundation till 2003 for these companies. However, we found that family succession increased tenure by a large margin. Average tenure for CEOs, who came to the board through family succession, was 25.3 years. This contrasted sharply with average tenure of 9.1 years for nonfamily CEOs (see Tables 7.2 and 7.3). Average CEO tenure declined over time, mainly due to the lessening impact of family succession. The last family CEO left in this group of companies in 2002, when Nutricia became Numico. Other companies with family succession were Philips, Ahold and Heineken. Alfred Heineken and Albert Heijn both retired as CEOs in 1989. Average tenure for non-family CEOs declined over time, although in an erratic way. Tenure for non-family CEOs who departed during the 1974–86 period was 5.7 years and increased to 6.8 years in the 1987–2003 period (Table 7.4). However, most recent events indicate a shortened CEO tenure of 5.2 years for CEOs who departed in the 1995–2005 period. These new developments fit in with international developments, which point at shortened CEO tenure in recent years, especially in Europe. Our research also pointed to another development: the rise of the externally hired CEO. One in four CEOs who were hired after 1986 came from outside the company (or were less than one year with the company before CEO appointment). This constitutes a clear break with the past, since outside hires were completely absent in the 1974–86 period. Another phenomenon was the internationalization of Dutch company boards. Slightly more than half of AEX CEOs in 2005 were of foreign Table 7.2 Tenure data for founder/family CEOs Company

Period

No. of CEOs

Average tenure

Ahold Hagemeyer Heineken Numico Philips Wolters Kluwer Total

1887–1989 1900–1940 1860–1989 Intermittent 1891–1977 1889–1957

3 1 4 3 6 2 19

34 40 32.25 18 14.33 34 25.3

Source: de Jong (2003).

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Table 7.3 Tenure data for non-family CEOs Company

Period

No. of CEOs

Average tenure

ABN–AMRO AEGON AHOLD AKZO Nobel Buhrman Fortis Hagemeyer Heineken ING group Shell Numico Philips Reed Elsevier Unilever Wolters Kluwer Total

1824–2000 1914–2001 1989–2003 1956–2002 1938–1998 1914–2001 1940–1999 1989–2003 1942–1998 1892–2000 intermittent 1977–2000 1952–1999 1930–1999 1957–2000

20 10 2 7 4 10 6 2 6 8 3 5 3 8 8 102

8.8 8.7 7.0 6.6 15.0 8.7 9.8 7.0 9.3 8.6 12.0 4.8 15.6 8.6 5.3 9.1

Source, Linda de Jong,‘Continuiteit en Verandering’ (2003). Table 7.4 Average tenure of departed non-family CEOs, 1974–2005 Average

1974–86

1987–2003

1995–2005

Dutch companies US companies

5.7 years 10

6.8 9

5.2

origin. This differed sharply from the period before 1986, when all CEOs were Dutch. These figures provide a clear illustration of the recent internationalization of large Dutch corporations. External recruitment and internationalization were related to a certain extent, since 67 percent of externally hired CEOs were foreigners, while 33 percent of internally hired CEOs were foreigners. None of the newly hired outside CEOs had been employed as CEO before. Externally hired CEOs received higher remuneration packages than internal hires. The average compensation package for internal hires was 3.5 million euros in 2004, while external hires received an average of 6.2 million euros in the same period. The difference was largely composed of variable pay, since average base salaries were identical for both groups of CEOs at 1 million euros. External hires gained a much larger percentage of total compensation in the form of shares and stock options than internal hires. The share of bonuses and pensions did not differ for both groups of recruits. This finding is in line with international findings. Johnston (2005) found for the UK that total compensation was 23 percent higher for external than for internal hires, which could be completely attributed to larger long-term incentive pay for this group.

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CEOs then and now We can argue that the increase in forced dismissals and external hiring are two sides of the same coin. External hires operate on (international) labor markets for CEOs and can demand higher compensation packages than internal hires. Higher compensation can also be explained by the higher risk of dismissal of externally recruited CEOs (Allgood and Ferrer, 2000). Outside CEOs are often called for after the corporation has suffered a crisis, sometimes caused by forced dismissal of the former CEO (Johnston, 2005). A forced dismissal prompts a company to recruit externally, since the expected appointment of an inside hire could spur wars of succession. The external hire can, therefore, be considered a change manager, who needs to improve company performance. We can imagine that taking the helm of companies in distress has a greater risk of failure. CEO pay increases can be explained by the higher risk of dismissal to which they have become exposed. The retreat of the diversified corporation has undermined the hierarchical/delegation model and made executives of large corporations more like their counterparts in entrepreneurial start-ups. But dismissed CEOs face a larger devaluation of their human capital than entrepreneurs, if they cannot be rehired. An increased hazard rate can be compensated for by higher remuneration and severance pay. But, the breach of the implicit contract through CEO dismissal works both ways. Successful CEOs can move up to a larger company. One-third of externally recruited CEOs in the US had been CEO at another company in the early twenty-first century (Kopinski, 2005). This is a break with former practices, where job-hopping CEOs were rare. CEO mobility raises remuneration, if companies only hire successful CEOs. But, CEO mobility raises questions about commitment. An externally hired CEO can express his commitment to the organization by receiving a large share of his compensation in the form of variable pay. We can argue that the significant changes in the Dutch market for CEOs indicate an evolution from heirs of founding fathers to mercenaries, who sell themselves to the highest bidder. The erosion of the diversified corporation and its hierarchical/delegation model involves a shift towards single strategic decision-making by the CEO, who is ultimately responsible for company performance. A shift from collective to single decision-making can indeed be observed in large Dutch corporations. Boards used to be collectively responsible for decisions taken. But many Dutch companies have moved towards a model whereby board members are individually responsible for their area of expertise, while the CEO is responsible for strategic decisions and overall company performance. Aegon, Numico, Royal Dutch Shell, Reed Elsevier, KPN, SBM Offshore, van der Moolen, Fortis and Versatel diverged from the collective responsibility model and made the CEO ultimately responsible. The ratio of CEOs’ and other board members’ remuneration in the

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non-collegiate firms exceeded that of companies with collective decisionmaking by a large margin (van Waveren, 2006). The dearth of new companies on the Dutch stock exchange contributed to the decline of the family firm. Most companies in the AEX index of 2005 were companies with a long history as is demonstrated by our longitudinal research of 15 companies (out of 25). Other AEX companies such as TNT, KLM and KPN were former state-owned firms. A few companies such as ASML and Getronics were divested from larger companies. A new influx of start-ups could have kept the family-led firms in place. The influence of family firms in the US is continuously renewed due to the influx of new entrepreneurial firms such as Microsoft, but these entrepreneurs were largely missing in the Netherlands. The inclusion of the navigation equipment company Tom Tom in the AEX in 2006 was a rare exception to this rule. An influx of entrepreneurial firms broadens the recruitment base of CEOs beyond those of incumbent top management. More tumult emerged in the Dutch corporate world, when private equity and hedge funds appeared on the scene in 2006. The publishing house of VNU was attacked by hedge funds, which criticized its (acquisition) strategy. It was bought out by private equity and its management was replaced. The same happened to retailer Vendex/KBB. Shell was attacked by hedge funds and forced to merge with its British sister company. Other companies such as Stork, Ahold and ABN-AMRO were harassed by hedge funds, which demanded the break-up or sale of the company up in order to create value for shareholders. The strategy of a considerable percentage of large Dutch companies thus came under fire and their existence as a listed company was threatened. All the attacked AEX companies featured collective responsibility, which indicates that activist shareholders prefer single to collective decision-making. We can compare the actions of private equity with conquistadores and hedge funds with revolutionaries. Private equity buys out firms and establishes new leadership. Hedge funds arouse the populace by demanding radical changes. They sometimes pave the way for private equity. We can consider hedge funds to be a new group of shareholders, whose influence largely exceeds their equity share. Most Dutch company statutes have followed the provisions of the Tabaksblat Code and allow shareholders with at least 1 percent of equity to submit proposals at shareholders meetings. Hedge funds with small equity shares used this possibility and shook up the Dutch corporate world. TCI’s attack on ABNAMRO was the most spectacular. Their activism contrasts sharply with Dutch pension funds, whose influence on corporate strategy is small. Pension funds want to balance their portfolios continuously in order to escape specific risk. Moreover, their influence is limited by a mandate that forces union officials on pension funds boards to pursue socially responsible strategies that focus on people, planet and profits, which leaves little room for drastic action. These policies extend to supervisory boards, which are required by law to take the interests of all stakeholders into account and

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not only those of shareholders (de Jong et al., 2006). Recent Dutch legislation has strengthened the independence of supervisory boards and weakened the ties between managers and supervisors.

Changes of regulation Corporate governance regulation states the rules of the corporate game as it defines the authority of executives, shareholders and supervisors. Agency theory has long held the view that malfunctioning directors could stay in place too long. They, therefore, welcomed the actions of raiders in the 1980s and 1990s, who through hostile take-overs and LBOs removed CEOs and replaced equity by debt finance to curb the moral hazard problems caused by free cash flow. We can argue that the present rise of activist shareholders constitutes another interference model. Hedge and private equity funds managers, who differ with incumbent management on strategy can impose their will and remove the incumbent managers. A change of strategy can be imposed either through acquisition or by persuading other shareholders. These attacks on incumbent management increase the CEO dismissal risk. However, the installation of change-in-control agreements in CEO contracts allowed severance pay packages to compensate for these risks. US regulation aimed to limit these payments by imposing a special excise tax on compensations exceeding three times the executive average remuneration, which had the unintended consequence that such severance pay became standard. These agreements figure in 70 percent of CEO contracts of 1,000 large companies. The same unintended result emerged, when regulation capped CEO base pay at $1 million, which also became the standard (Jensen et al., 2004). Hence, regulation that wanted to limit CEO pay seems to have increased it by setting a standard that exceeded executive pay in many companies. New US regulation came with the Sarbanes–Oxley Act of 2002 that was triggered by the Worldcom and Enron scandals. The Act required the audit committees of all public companies to consist entirely of independent directors; it made rules requiring officers of companies to take personal responsibility for financial disclosures and required an assessment of the effectiveness of internal controls by management (the Section 404 requirement). Other countries, i.e. the UK and the Netherlands, followed suit in revising their corporate governance rules. The Dutch Tabaksblat Code was adopted by Parliament in 2003 and came into effect on January 1 2004. The Code applies to listed companies, which have their registered seat in the Netherlands. The new code wanted to bring Dutch governance rules and practices in line with the best in the Western world. The new code comprises voluntary guidelines, but firms need to explain when their practices diverge from the best practices suggested by the Code (the ‘comply or explain’ principle). The ‘comply or explain’ principle also figures in the UK Cadbury and Combined Codes. The shareholders meeting needs to approve divergences from best practices of the Tabaksblat Code. The Code suggests that deviations

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from best practices should be accepted by a majority of votes cast at the shareholders meeting, representing at least one-third of issued capital. The Tabaksblat Code is much more elaborate than its UK counterpart as it contains 116 best practices; twice as many as the UK Code. The Tabaksblat Code wants to strengthen the independence of supervisory board members and outside directors (The Tabaksblat Code opened the door for one-tier board structures in anticipation of EU regulation.) All supervisory board members (except one) should be independent. Independence excludes former employees, managers, business relations and shareholders with more than 10 percent of shares. The chairman of the supervisory board shall not be a former member of the management team. A supervisory board member shall not be granted any shares in the company and his remuneration is not dependent on the results of the company. These guidelines constitute a break with the past, when former CEOs often became chairmen of supervisory boards and important shareholders also obtained supervisory board seats. Other guidelines involved the quality of internal risk management and control systems and the protection of whistleblowers. The Tabaksblat Code emphasizes independence in order to prevent illegal and excessive appropriation by management. It closely follows the spirit of Sarbanes–Oxley in this respect. Several best practice provisions in the Tabaksblat Code involve management remuneration and tenure. The Code stipulated that variable remuneration shall be related to previously determined and measurable long- and short-term targets. Options to acquire shares shall only be exercised three years after grant date or at the end of employment. Shares shall be retained for at least five years after grant date or till the end of employment. The number of shares also shall depend on the achievement of clearly quantifiable targets. An initial provision involved that variable pay should not exceed half of total executive compensation. However, this provision was discarded after severe criticism. It was also in conflict with existing practices of Dutch listed companies as was demonstrated above. Severance pay in the case of dismissal shall not exceed one year’s salary (the fixed remuneration component) with a maximum of two years in cases, when directors who have been with the company for a long period are dismissed within their first term. But the report emphasizes that mismanagement or fraud on the part of a board member should not be rewarded. Arguably, these provisions neglect the increased hazard rates for CEOs and mean a breach of implicit contracts based on CEO commitment. Most Dutch companies did not appoint CEOs for definite terms before 2004. One of the best practice provisions of the Tabaksblat Code states that executive board members should be appointed for a period of four years with the possibility of one period re-appointment, which would bring the maximum tenure of board members to eight years. This provision only applies to new CEO appointments. The Tabaksblat Committee argued that such a guideline would bring Dutch practices into line with international arrangements. However, it was noted above that US and British directors

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stay on for considerable periods of time. They need to be re-appointed on an annual basis, but this is mostly only a formality. This best practice could befit boards with collective responsibility for decision-making, which used to be common in the Netherlands, but goes against the move towards single decision-making that characterized the early years of the twenty-first century. The Code gave more powers to shareholders, as mentioned above. Shareholders got the opportunity to vote by proxy, but the provision of share certificates, which keeps legal ownership with the trust office, remained intact. Certificates can be exchanged for ordinary shares with voting rights, but shares lose trading privileges in the process (De Jong et al., 2006). Incumbent management was not challenged at shareholders meetings until recently. De Jong et al. analyzed the minutes of 54 large Dutch listed companies in the 1998–2002 period. There were no shareholder-sponsored proposals in this period. Management-sponsored proposals were seldom rejected (9 out of 1,583), but were not always unanimously accepted (ibid.). Pension funds and other institutional investors’ presence at general shareholders’ meetings was low and declining (35 percent or less). The new corporate governance rules and the appearance of activist shareholders have, however, reshaped the Dutch corporate landscape into a battlefield, where foreign invaders increasingly win territory.

Decision and control rights Corporations have emerged and withstood the times as organizational forms, because they allow the collection of large amounts of capital. Moreover, the separation of ownership and control allows talented individuals, who are not born wealthy, to assume management positions. On the downside, however, it is argued that the separation of ownership and control creates agency problems. Managers might be tempted to pursue their own interests by expanding the company’s size at the expense of profitability. The issuance of shares and stock options makes the CEO a residual claimant and aligns his position with that of shareholders, who are the main residual claimants. Agency theory states that residual claimants should also have residual control. Open corporations separate decision from control by the installation of boards that need to ratify and monitor decisions taken by management: These boards have the rights to ratify and monitor the decisions that are initiated and implemented by top-level managers. Without separation of decision management from decision control, residual claimants have little protection against opportunistic actions of decision agents, and this lowers the value of unrestricted residual claims. (Fama and Jensen, 1983) Fama and Jensen thus depict management as decision agents, whose actions need to be scrutinized by outside directors (or supervisors), to curb managerial

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opportunism. The concept of ratification points at ex post approval or rejection of managerial decisions. We can argue that rejection of major initiatives is identical to CEO dismissal. Fama and Jensen’s statement that effective control limits the decision discretion of individual top managers seems to miss the point of the CEO’s role as decision agent. The CEO is entrusted with decision power, because he is assumed to be better at this than (other) shareholders. Shareholders might either share the CEO’s ideas or lack a view on the future of the corporation and how to achieve it. A CEO can thus stay in place unless shareholders no longer support him either by voting with their feet or at a shareholders meeting. Fama and Jensen’s ideas on the separation of decision-making and control were not borne out by US practices before the adoption of the Sarbanes–Oxley Act. The CEO fulfilled a dual function as both chief executive and chairman of the board in almost all large US corporations in 1988 (Dahya and Travlos, 2000). This differed from European practices, where the CEO was often not the chairman (as in the UK), or where two-tier boards prevented such a dual role for the CEO. The residual control model assumes that controllers can veto strategic initiatives by management. Supervisory board members in two-tier board systems seem to fit this picture better than outside directors in one-tier board systems. The one-tier board model does not fit the veto model, since all board members can discuss strategic decisions, which mixes decision-making and decision control. But collective decision-making – not discussion – is uncommon in the US, since CEO duality makes the CEO solely responsible for firm performance. The distrust of management’s motives, as expressed by principal–agent theory, suggests that losses can be prevented by adequate risk management, but this ignores the uncertainty that is inherent in all investment decisions. Most losses do not derive from opportunism or fraud, but from errors of judgment. Mergers and acquisitions that turn out to be disappointing or innovations that falter are cases in point. No risk management or audit system can eliminate these risks. Moreover, the decline of the diversified corporation increased risk. Fama and Jensen (1983) portrayed outside directors as representing shareholders’ interests. However, recent changes in corporate governance in the US and EU countries have emphasized the independence of outside directors and supervisory board members. Independent directors are assumed to be better controllers than ‘entrenched’ directors and supervisors with important equity stakes in the company. Regulations in the US and the UK require that more than half of board members are independent. The Tabaksblat Code has followed these examples and demands that all supervisory board members but one should be independent. The emphasis on independence constitutes a break with old practices, in which the CEO was chairman of the board (US), or retired CEOs chaired supervisory boards in the European two-tier systems. Moreover, it robs (large) shareholders of their board seats and signals the eclipse of the listed family firm.

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Increased independence could explain the rise of shareholder activism in recent years. Discussions at board meetings have been replaced by discussions with hedge funds either behind closed doors, but increasingly through the media. Activist investors want to dictate to management what to do instead of letting them discuss this in the boardroom. Such activism has triggered a cultural revolution in which the idea of consensual decision-making which was characteristic of Dutch governance collapsed. Recent regulations want directors to be independent to strengthen the financial control function of directors to avoid fraud and to keep management remuneration within ‘reasonable’ lines. Former management is not deemed to be independent. The emphasis on independence puts control in the hands of supervisors and outside directors, who have little knowledge of the company and also lack incentives to pursue profit maximization, since their remuneration is fixed. An independent board can thus be expected to be less involved with strategic decision-making than a board consisting of insiders and stakeholders. Hence, independent control, which wants to cure agency problems deriving from fraud, intensifies agency problems deriving from lacking goal alignment. We can argue that recent regulations increase the authority of the CEO instead of reducing it. Independent directors can hardly criticize strategic initiatives and their main responsibility is to guarantee compliance with administrative procedures. Regulatory reforms emphasizing supervisors’ independence and shareholders’ rights, therefore, increase the CEO hazard rate. Supervisors in two-tier board systems have always been less engaged in strategic decision-making than outside directors in one-tier systems. Nonexecutive directors of one-tier boards can do more than just ratify decisions taken by management; they can also participate in the development of strategy, which differs from the role of members of the supervisory board in twotier board systems (Hopt and Leyens, 2004). Two-tier board models can be found in, among others, Germany, the Netherlands and Denmark. The authority of supervisory boards is restricted to post-decision approval of decisions taken by management, since the supervisory board cannot directly become involved in managing the company (ibid.). Separation of decision and control rights, therefore, seems more easily achievable in two-tier board systems. We could, therefore, expect CEOs to be more easily dismissed in two-tier board systems. The increased emphasis on supervisory board independence can, therefore, have contributed to the recent rise in involuntary CEO dismissals in continental European countries. This hypothesis is supported by research, which found that a higher proportion of outside board members increases the likelihood of US CEO dismissal (Weisbach, 1988).

Can corporate management learn from political governance? The fraud allegations that erupted after 2000 have inspired some authors to advocate a return to the bureaucratic firm or to install democratic procedures

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in companies (Frey and Benz, 2005). They see it as an advantage of the bureaucratic firm that it does not reward based on performance, but on professional achievements. Such compensation schemes would kindle intrinsic motivation instead of extrinsic motivation as incentive pay is assumed to do. Advancement in bureaucracies, according to Frey and Benz, is regular and largely determined by seniority (ibid.: 380). Employment is guaranteed for fixed terms and often for life. This freedom allows employees to offer criticism in contrast to non-bureaucratic organizations, where evaluation by superiors prevents employees from speaking their mind. Bureaucracy gives people autonomy – in their view – because they are free to do as they see fit as long as they follow the rules (ibid.: 382). Arguably, this picture fits the diversified corporation with its hierarchical/delegation governance model. However, the diversification discount moved firms away from this model towards the entrepreneurial model with higher hazard rates. Frey and Benz use two different public governance models to improve corporate governance: public administration and democratic government. Public administration is similar to the bureaucratic model depicted above. The common element in both public governance systems, according to Frey and Benz, constitutes participation. They argue that corporate governance shares some features with democracy. The shareholders meeting can be compared to parliament; the company board is comparable to the members of the cabinet (ibid.: 385). Frey and Benz advocate democratic principles of rotation; restricted terms of office and elections for CEOs. Most political posts in democracies are only granted for limited periods of time (usually four years), whereas re-election is often reduced to one extra period. Frey and Benz argue that limited tenure reduces susceptibility to corruption. But, these practices are diametrically opposed to the life long tenure characteristic of bureaucracy. Moreover, CEOs are usually nominated and elected by acclamation instead of by a ‘real’ choice between two or more candidates. The idea that CEOs should be elected from several contenders, akin to political office, seems to ignore that corporations are unitary goal-oriented organizations, in which there is little room for an opposition and party politics. Introducing elections could cause a schism and would force the losing party to leave the organization. Designation of a successor by the former CEO, as happens in many corporations, fits in with charismatic leadership. Such modes of succession have the advantage, that no war of succession is required to appoint a new CEO. Corporate governance can thus better be compared to direct democracy and bureaucracy than to representative party democracy. The decline of the hierarchical/delegation model has increased forced dismissals, external recruitment and increased CEO remuneration. A CEO who is equally valued by more than one corporation can demand his value upfront, because uncertainty regarding his valuation is eliminated by multiple bids. A CEO who is elected by a majority of shareholders among contenders could also raise his remuneration. Recent developments all

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indicate a shift away from collective and towards single leadership without immunity. Consequently corporate governance moves away both from the bureaucratic model and from the representative democratic model. Corporations come to resemble direct democracies with a single decision-maker, who can be dismissed by the majority of shareholders.

Conclusion Recent changes in CEO pay and demographics point to increased CEO responsibility for a company’s fate. They earn more, if they are successful and are dismissed, if they fail. The decline of the diversified corporation has contributed to this development. New regulation on corporate governance has unintentionally strengthened this trend towards sole responsibility. The move towards greater independence of supervisory boards and outside directors is a case in point. Regulation that wanted to curb managerial authority and compensation, therefore, caused the opposite. The Dutch corporate world experienced a revolution, when activist shareholders demanded management obey their wishes or leave. This differed drastically from former arrangements, where family succession was common and forced dismissal was rare. Recent developments contrast sharply with past practices and Dutch corporate culture featuring consensual decision-making.

8

Decision agents in corporate and political democracies Venice, Florence and the Low Countries

Introduction Delegation of decision-making is common in both political and corporate life. Shareholders delegate decision-making to managers, who, in turn, can delegate this to lower management. Delegation raises questions of responsibility and liability. The same issues arise in democracies, where people choose leaders to develop and execute strategy. Corporations can be considered shareholder democracies: ‘Democracies can be defined as that institutional arrangement for arriving at political decisions which realizes the common good by making the people itself decide issues through the election of individuals, who are to assemble in order to carry out its will.’ (Schumpeter, 1974: 250). Schumpeter’s definition involves the election of decision-makers and discussion as essential features of democracy, but democracy can also involve a single decision-maker. This happens in direct democracy, where a single leader is chosen by acclamation. He can discuss his strategies with a council (of elders) or with private advisors. Direct democracy differs from representative democracy, where people are chosen to represent a certain group and assemble in councils. Representative democracy can take several forms; people can either be chosen by lot or by the ballot box. Election by lot occurred in the old republics of Greece and medieval Italy, where political parties were absent, and people were organized by neighborhood and/or guild. Party democracy is a relatively new phenomenon. Old republics were either direct or corporatist democracies. Corporations feature elements of direct democracy, when leaders are chosen by acclamation from a single nomination. Political and corporate executives can either have tenure or a definite time in office with limits on re-election. Directly elected leaders, who were chosen by the people at popular gatherings at public squares had tenure. They could stay in office until they failed. CEOs also have tenure until they fail. Directly elected leaders usually had duality, they were both chief executive and head of state (chairman of the board). Duality features in corporations where the CEO is also chairman of the board. Representative democracies usually have leaders with limited time in

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office, but exceptions to this rule exist. The position of head of state can even be hereditary, as is the case in constitutional monarchies. The distribution of seats among groups in representative democracy can either be predetermined in a constitution (corporatism) or by the ballot box (party democracy). Corporate governance resembles corporatist democracy, when people are chosen based on group membership. A CEO of a family firm can be chosen based on family ties; board members can be chosen based on their union membership or large share of equity. Employees and shareholders can have a fixed number of board seats identical to the corporatism that prevailed in some old republics. Comparing governance modes of corporations and old republics can shed some light on what implies good governance. The Italian city-states were involved in both military and economic competition. There was neither a clear winner nor loser, since all Northern Italy thrived in the late Middle Ages. Economists who studied the relationship between political autonomy and city growth in pre-industrial Europe (1050–1500) discovered this. They concluded that absolutism curbed city growth, whereas political autonomy promoted it (De Long et al., 1993). The population of all Northern Italian city-states grew at a rapid rate in this period. All these cities were characterized as autonomous by the researchers. But political institutions differed vastly among these city-states. Some of the cities studied had some form of democracy; Venice and Florence are cases in point. Others were ruled by a single family, as was Milan under Visconti and Sforza rule. Some cities changed from democratic to single family rule as happened in fifteenth-century Florence, where Cosimo de Medici came to rule behind the scenes. Hence, Italian city-states were ‘free’ from domination by an empire in the period studied, but were sometimes ruled by a single family.

Political and corporate governance Direct democracy often features duality. The Venetian doges before 1172 combined political and military leadership and led the armies in the field. The Roman consuls also combined the two roles in the days of the Roman Republic. Modern representative democracy features the subordination of military to political leadership, but such subordination was absent in direct democracies. The political executive of modern democracy is commanderin-chief, but leaves the execution of military strategy to appointed generals. Modern corporations are sometimes compared to autocracies (Frey and Benz, 2005). Corporate executives are usually not elected, but are chosen from a single nomination; CEOs often have tenure; corporate leadership can be hereditary as in family-led public firms. I would argue that corporations can better be compared to direct democracy than autocracy. Shareholders have the same rights that the people of Venice and Florence had at mass meetings. Citizens, assembled in the town square, could either acclaim or veto certain decisions; such as the commencement of war or the appointment

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of a leader. The Venetian leader; the doge, needed the acclaim of the popular assembly; the arengo, before he could assume his position in the early days of the republic. The doge could also call for an arengo in emergencies. It is obvious that the doge did not call for an arengo to be dismissed, but doges of the early period could be deposed by a popular uprising. Shareholders have a constitutional right to dismiss the CEO at the shareholders meeting. Business firms can combine the positions of chief executive and head of state, if the CEO is also chairman of the board. CEO duality does not exist in European two-tier board systems, but is common in the US, although the Sarbanes–Oxley Act discourages it. The position of head of state was often a mere formality in old representative democracies. Historical examples involve the chairman of the Athenian Council in its period of radical democracy. Executives were elected by lot in ancient Athens and only presided for a few days. The same applies to the chairman of the Florentine Signoria, who was appointed for a few months. Leaders in representative democracy have limited liability. They can lose their job, but not their wealth or life. This did not always apply to direct democracy, where leaders were sometimes expropriated or even killed, if they failed. This applied to the early years of the Venetian Republic, when doges were sometimes slain by rivals in coups. We can argue that democracy turns into autocracy, when leaders assume power by force and not through elections. Autocratic leaders usually lack limited liability and lose everything when they lose in battle or are killed by rivals. Corporate leaders, however, have limited liability. Dismissed corporate executives are usually compensated for the loss of future income. Corporate leaders cannot cross the line between democracy and dictatorship, if they cannot gain power by physically eliminating their opponents. Democratic politicians have limited liability. They can re-enter the political arena at a later date; work the lecture circuit, or assume a Senate seat. The Roman consul, who was elected from the Senate for a one-year term, could re-enter the Senate after his term had ended. The Senate only decided on the commencement of war and the conclusion of peace treaties; everything else was left to the discretion of the consul. Continuity of government in Rome was enhanced by the appointment of two consuls. Rome also had features of corporatism. The tribunes, representing the people, had veto powers over new legislation. An orderly democracy requires that a losing party will neither lose citizenship nor possessions. This differs from deposed autocratic leaders, who often lost both their possessions and their life. Some authors have advocated more corporate democracy (Frey and Benz, 2005; Bebchuk, 2005, 2006). Bebchuk argues that shareholders should be given the right to change governance arrangements as laid down in the company statute. They should also be allowed to initiate strategic decisions such as mergers and divestitures (Bebchuk, 2005: 836). At present, shareholders can either acclaim or veto corporate strategy and leadership. However, Bebchuk

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wants shareholders to have both legislative and executive powers. He argues that more value-enhancing decisions would be taken, if shareholders could intervene directly in company affairs. Shareholders, who satisfy some minimum ownership and holding requirements, should be allowed to place proposals on the corporate ballot. However, the recent rise of shareholder activism makes Bebchuk’s recommendations superfluous, in my view. Shareholders intervene in corporate strategy inside and outside of shareholders meetings by making proposals to the board or shareholders. Moreover, proxy procedures allow shareholders to delegate their voting power to activist groups like the Dutch Association of security owners (VEB) that represents shareholders at meetings. It seems more plausible to give shareholders a say in constitutional decisions. Bebchuk argues that such decisions should be taken by a majority of shareholders in two subsequent board meetings (ibid.: 839). But his radical shareholder democracy could disenfranchise minority shareholders due to the holding requirement. Moreover, the right of initiative to change the constitution could lead to a continuous fight for power between stakeholders, as demonstrated by the numerous changes in the constitution in some old republics. Bebchuk also advocates that incumbent directors need to be (re)elected by shareholders every other year from among rival management teams (Bebchuk, 2006: 11). The race between incumbent and contending management teams should be fought on equal terms, since both groups should have equal access to company funds (Bebchuk, 2005). Frey and Benz also advocate the election of executives from competing teams. They argue that corporate governance could learn from public governance by installing institutions that restrict terms of office, restrict reelection and rotate leading positions to put more effective limits on the executive than present arrangements allow (Frey and Benz, 2005: F387). CEO tenure should be limited to a four-year period with the possibility of one re-election. They also advocate a separation of powers as in two-tier board systems. Employee participation, as in German co-determination, will improve corporate decision-making, in their view, because it will involve more people. Moreover, participation rights stimulate contact between employees and management, which improves feedback. Arguably, these advocates for corporate democracy want to change corporations into party democracies, where political leadership prevails. Some European countries have forms of co-determination that allow employees to choose their own representatives. However, these arrangements give employees a minority vote. The most extensive form of employee democracy – in Germany – gives employees less than half of the voting rights on the supervisory board and one seat on the board of directors. German co-determination resembles the old corporatist systems, in which certain social groups had a predetermined number of seats on the executive council. Medieval Florence, where the major guilds held the majority of seats in the executive council (Signoria) for most of the time resembles

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modern systems of co-determination. Florence was a corporatist society, where the captains of the guilds had jurisdiction, a system resembling that of the Roman tribunes. But Florentine corporatism was not always considered fair: The lesser people and the plebs had no representation and were at the mercy of the magistrates of the guild that governed them, from which it did not appear to them that they got the justice they judged was suitable. (Machiavelli, 1988: 121) Frey and Benz argue that more democracy could repair the deficiencies of corporate governance that agency theory cannot reach. Agency theory wants to install incentive structures to align shareholder and management interests and thus curb moral hazard. But the manipulation of earnings and stock prices by management points to the incompleteness of agency theory, in their view (Frey and Benz, 2005: F378). I doubt, however, whether more democracy – defined as more people involved in decision-making – can solve moral hazard problems. Democracy is a governance system, which leaves decision-making to elected individuals. Decision-making by everyone is usually impractical. Executives can either be chosen for their views or for their membership of a certain group. Executives in old democracies were usually chosen from a minority of the population that was deemed eligible for office. The absence of political parties ensured that executives did not need to campaign and make promises. Yet, people, who were not chosen for their ideas but for group membership, could not be held responsible for their decisions. This applied particularly to people who were chosen by lot. The Athenian and Florentine executives, who were locked in their palaces night and day during their short tenure did not come up with long-term plans, but reacted to contingencies. They could not be held responsible for failure, because they had never promised anything. Arguably, they were independent and continuously monitored, but they were incapable of designing and executing a strategy. Only, a person who is chosen for his ideas can be held responsible for failure. Another aspect of democracy involves freedom of expression. Frey and Benz argue that corporations deny their employees democratic rights, since they have to follow orders and cannot speak their mind freely (Frey and Benz, 2005). Public administration, by contrast, has more room for expression than business. ‘Public employees can make suggestions for improvement and criticize the course of events, even if their superiors do not necessarily agree’ (ibid.: F380). Private sector employees, by contrast, would not want to speak their mind, since superiors have discretion over their reward. Pay in public administration, by contrast, is determined by clearly defined bureaucratic rules and is independent of subjective evaluations. ‘Promotion does not depend on any specific output performance, which gives them the freedom to monitor and criticize the behavior of their

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superiors’ (ibid.: F380). Their idealized picture of public administration hinges critically on the assumed unbiased measurement of a person’s worth in public administration, which is contrasted to subjective measurement in companies. Corporations do not allow dissent and people are completely dependent on the capricious mood of their superiors: ‘As long as superiors do not violate the law, they can to a large extent instruct an employee to do anything they like. The only option to a dissenting employee is to leave the firm, an action that often involves substantial costs.’ (Frey and Benz, 2005: F382). Max Weber’s bureaucracy model was based on the idea that subordinates do not need to have a voice, since superiors always know best. It is only in the presence of uncertainty that discussion is required. Dissidents are valuable, if their perception of future events is superior to mainstream views. But freedom of expression is am empty right, if nobody listens. Participation is only valuable, if there are rules about procedure. Frey and Benz do not indicate how ideas expressed by public officers can affect bureaucratic decisions. It seems unlikely that majority rule will prevail in public bureaucracy, where hierarchy is the decision model of choice. This does not differ dramatically from decision-making in large corporations. Corporations want employees to express ideas in order to benefit from their human capital. They can participate in strategy discussion, but their participation does not extend to decision-making, if senior management decides on the acceptance or rejection of a project proposal. Management can thus veto employee proposals. However, the same occurs in public bureaucracy.

Governance in three republics Public and corporate governance share some features such as election of executives, and organized discussion. Corporate and political governance differ, when people can easier change corporate than political citizenship. Employees can change employers or start their own company. Shareholders can sell their shares on stock markets. Political freedom implies that people can move between parties. But citizenship is less easily changed in our days than in the days of the city republics that largely grew through immigration. City-states were goal-oriented organizations, whose success or failure was largely determined in military and/or commercial ventures. Medieval Northern Italy had many autonomous cities. A change in the distribution of power in these cities occurred by changing the constitution and not by the ballot box, due to the absence of political parties in those republics. Machiavelli praises those republics, whose constitutions have withstood the times, like Rome. This differed from medieval Florence, where various social groups were involved in a continuous fight to change the constitution in their favor. Corporations share more characteristics with city-states than with the party democracies of our days. The division of deciding power between corporate stakeholders (management, shareholders and employees) can only be re-allocated by a change of the company charter and not by election.

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Factious rivalry between Guelfs and Ghibellines or Blacks and Whites was rampant in medieval Florence and other cities. Conflicts were not resolved by the ballot box, but by the sword and popular uprisings. Florence fell prey to autocratic rule due to a lack of procedures for solving conflicts through discussion. The losing family in these conflicts was often expelled and expropriated. Bankruptcy was declared on political grounds. The principle of limited liability was thus not firmly established in medieval Florence in both political and economic life. The same applied to the early Dutch Republic; where factious strife also brought autocratic rule. Both corporations and old republics wanted to grow in numbers and wealth. But commercial expansion required the use of the military in old republics. The responsibility for the success or failure of these expeditions had to be vested somewhere. This could be a directly elected leader, who combined the positions of head of state and chief executive. Responsibility could also be delegated to an appointed general. Old republics evolved in different ways. Venice became a representative democracy, where military leadership was subordinate to political leadership. Military leadership, however, came to prevail in both Florence and the Dutch Republic. Venice Venice obtained its political autonomy gradually. It hovered between loyalty to the Frankish king and the Byzantine emperor and came to lean more heavily towards the East. It had a commonwealth status within the Byzantine Empire from 800 till 1000 (Norwich, 1989: 25). Venice obtained jurisdiction over all its citizens both for criminal and trade law under the dogeship of Piero Tribuno (888–912). The doge was both the political and military leader in early Venetian history. Dogeship started as a tenured, hereditary position. People could assemble in the arengo, but there was no council in Venice before 1172. The doge governed from his own house with or without the help of consultants. Dogeship was a hazardous job in the early days of the Venetian republic. Doges actually led the forces in battle and also had political and judicial authority. Only one-third of doges before 1172 died a natural death while in office, as can be deduced from Norwich’s History of Venice. Two-thirds were deposed or killed. The populace deposed doges, who did not want to wage war, who lost in battle or were deemed too powerful. Deposed doges had to leave the city. Doge Pietro Candiano IV was killed by the populace in 976, because he had become too powerful. One of the Partizipazio doges (829– 36), who refused to deal with the Dalmatian pirates, was forced to abdicate. This also happened to Pietro Candiano II in 939, Vitale Candiano in 979 and Tribuno Memmo in 991. The doge as military leader was thus held responsible for defeat and was deposed, if he failed. Some doges, who first won and then lost in battle died in office, as happened to Piero Tradonico (836–64), who lost against the Saracens after he had first been successful in

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war. Doges were also forced to resign due to factious strife between the Frankish and Byzantine fractions. Abdication was forced by popular uprisings, since constitutional procedures of dismissal were lacking. The Venetian populace only rose to make room for a new leader from one of the wealthy families and did not change oligarchic into popular rule. Dogeship was hereditary in the early days, when there was no constitutional succession. Individuals and families could rise on the waves of commercial success. The number of rich families grew steadily in Venice as commerce flourished whereby the eligibility for dogeship expanded. Deposition was the usual response to failure for doges, who were appointed for life. This resembles tenured CEOs in modern corporations. Shareholders can force a CEO to resign, if the company does not perform as expected. But the dismissed CEO’s fate is better than that of doge Michiel II, who was killed by the populace in 1172 after military defeat against the Byzantines. This event triggered institutional reform in Venice. The Great Council was installed in 1172, counting 480 Venetians, who were nominated by the six sestieri (districts). A senate of 120 members elected by the Great Council was established. The election of the doge went to 11 electors. The number of councilors was extended from two to six. The former two councilors or tribunes had largely lost their function, since the doge no longer consulted them. But the newly appointed six councilors were in constant attendance of the doge. He and his family lived in the ducal palace. The doge was escorted by a cortege, if he left the palace on state business. The chief executive of Venice thus came under continuous scrutiny after 1172; his every step was watched. All decisions needed to be discussed with the other members of the cabinet. All these constraints on the doge’s freedom of movement made him rather unsuited to lead the troops in war. An exception was doge Enrico Dandolo, who led the Venetian fleet in spite of his blindness and old age (80+). He died in Constantinople in 1205 during the Fourth Crusade. However, other doges after 1172 left maritime warfare to the captain-generals. The power of the doge was still further curbed in 1229, when the new doge had to sign a promissione, in which he swore to renounce all claims on revenues of the state, the only exception being his salary and his share of the tribute from some Istrian and Dalmatian towns and some specified quantities of apples, cherries and crabs from Lombardy and Treviso (Norwich, 1989: 151). A board of five correctors was installed, who had to see whether the promissione was followed. Thus, fixed remuneration came into use after the doge lost the military command. We can compare this with the position of the CEO of a large diversified company before the 1980s, who left decision-making to division heads. Other institutional reforms involved the installation of a new election procedure for the doge. Doges were elected in a procedure that combined nomination and election by lot. The new selection procedure that was set up in 1268 was intricate and involved several stages (ibid.: 166).1 The Great Council was closed to newcomers in 1297, when only incumbents became eligible for

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election (ibid.: 183). Its membership expanded from 210 to over 1,200 after the announcement of the impending closure, which took effect in 1298. Another institutional reform was made after a conspiracy to overthrow the doge in 1310 was discovered. A Council of Ten was installed, which became a permanent body in 1334. The council was in charge of internal security and also had to decide on war and peace. The Council of Ten with the doge and his cabinet of six became the main executive and judicial body in fourteenth-century Venice. The members of the Council of Ten were unpaid. The council had three heads who each served for one month. The three heads or capii were locked in the ducal palace and not allowed to go out into society during that period to prevent them from being exposed to bribes and baseless rumors. The attempted coup of 1310 also inspired the Great Council to install an intelligence network consisting of spies and undercover agents who collected information in and outside of Venice (ibid.: 197–8). The end of direct democracy in Venice thus also ended the era of doge duality, in which he was both captain-general and head of state. Generals of the post-1172 era could be either citizens or outsiders. The latter were called condottiere and led mercenary armies. Naval command, essential to Venetian commercial success, was seldom hired externally, but was performed by native captain-generals. Both doges and CEOs are decision agents, who are hired to design and execute a strategy. Decision agents differ from the agent in principal–agent theory, who executes orders given by a principal. We can argue that the early doges were decision agents, who neither had to obey orders nor confer with others. This differed from appointed generals, who took instructions from the Council of Ten and/or an appointed committee of savii (wise men). These committees decided on the main outlines of strategy. The captaingenerals had to follow their instructions, but could decide on contingent matters. Venetian captain-generals were called to account after losing a battle. This happened to Marin Morosoni, the commander of the luckless expedition against Trieste in 1280, who was put in prison and punished (ibid.: 171). The Venetian general Pisani, who was defeated by the Genoese in 1378 was deprived of his command; sent to six months in prison and debarred from all offices in the republic for five years (ibid.: 249). He had gone into battle on the instruction of the Venetian authorities against his own (better) judgment, but was still held responsible. General Querini, who had lost against the Genoese, was sentenced to heavy fines. So failing generals could lose both freedom and wealth. But losing generals could regain citizenship by a decision of the Great Council, if they were found to be without fault in following instructions. This happened to Pisani, who was reinstated (ibid.: 253). Antonio Grimani was elected to the Venetian naval command in 1499. The Venetians were defeated in the second battle of Sapienza by the Turks. Antonio Grimani was put in prison and sentenced to exile by the Great Council. But he was reinstated and

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became doge in 1521 at the age of 87 (the oldest doge ever elected). Nicolo` Canal, an admiral, who refused to defend Negroponte in 1470, was banished and had to pay a fine of 500 ducats and his captain-general’s salary and expenses were forfeited (ibid.: 351). This sentence was considered lenient by contemporaneous observers. He would have faced capital punishment, if he had been charged with betrayal of the state. However, Norwich argues that the man was a diplomat and obviously unfit for the job, which put some of the blame on the persons who had appointed him. Native captain-generals could obtain second chances, if they had failed without fault, but defeat always led to a career setback and to banishment, imprisonment and fines. This differed from Roman practices. ‘Rome did not punish its generals, who had failed due to ignorance, but rewarded and honored the person concerned’ (Machiavelli, 1998: 186). This was inspired by the idea, that generals should not be too much encumbered by fearing punishment for mistakes on the battlefield. Their minds should be free and unembarrassed as Machiavelli approvingly explained. We can argue that captain-generals’ liability was more limited than that of the doges of earlier times. The early doges could lose their life and lifetime incomes and that of future generations, if they failed. The appointed captain-general only lost (part of) his lifetime income. But condottieri could even lose their life if successful, if they were no longer trusted. This happened to the successful condottiere Carmagnola, who was of low birth. He was first hired by Visconti, Duke of Milan, who handsomely rewarded him with an annual income of 40,000 florins a year, exempt from all taxes. Carmagnola changed allegiance and entered the service of the Venetians in 1425, who paid him 12,000 gold ducats a year. Carmagnola reneged on his contract with the Venetians in 1429 and came out with even more favorable terms. He was granted supreme jurisdiction over all his forces and granted a fief with an annual income of 6,000 ducats above his annual wage of 12,000 ducats, whereas 2,000 ducats was common for doges at the time (ibid.: 304). The era of condottieri warfare was characterized by 9 to 5/good weather fighting. The condottiere and his mercenary army refrained from fighting for the larger part of the time. Carmognola’s zeal also left something to be desired. He first turned to the baths of Abana to heal his fever, before he appeared on the battlefield. Carmagnola’s expeditions were not without success, but the Venetians came to question his loyalty in the campaign against Milan, when he sought excuses not to confront the enemy. He ultimately defeated the Milanese, but was not eager to follow up on his victory. The Venetians were under the impression that Carmagnola wanted to found his own dynasty (ibid.: 307). Suspicion against him rose to the extent that he was indicted by the Council of Ten; brought to the city, put to trial and decapitated on the San Marco Piazza in 1432. Condottieri received a fixed salary and a bonus, if they were successful. Successful condottieri were retained in peace times to prevent them from seeking the employment of their enemies (Machiavelli, 1988: 230–1). A

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condottiere could evoke contesting bids to increase his reward. A designated winner like Carmagnola could theoretically appropriate the opportunity costs of defeat without moving a finger. Condottieri who were successful in battle were not expected to rule the conquered territories as was customary in feudal times. Condottieri warfare spared the citizens from direct participation in war, but imposed high taxes on the population to pay for the mercenary armies. Machiavelli comments that cities neither benefited much from success nor were severely hurt by failure under condottieri warfare. ‘Enemies were not eliminated so that victories first emptied the treasury, then impoverished the people and still did not secure you from your enemies’ (ibid.: 230). The inconclusiveness of condottieri warfare can be explained by the absence of feudal incentives. Condottieri differed from native generals, who were paid a fixed salary and were promoted, if successful. Venetian generals could become head of the administration of another city or colony (podesta), which made them more eligible for the doge position. Colonies fell under Venetian jurisdiction in contrast to feudal fiefs, where the local ruler had jurisdiction. Podestas were paid a fixed sum, which contrasted with feudal exploitation where tax harvesting was common. English colonialism, which established an administrative system with qualified bureaucrats receiving fixed pay, resembles the Venetian system. Florence: corporate democracy and Medici rule Machiavelli ascribes the autonomy of Florence to the weakening of the German emperor and the division between church and empire that emerged in the eleventh century. In 1201, the conflicts between the Guelfs (Church) and the Ghibellines (emperor) were solved and a constitution was established. The city was divided into six districts and ruled by 12 ancients – two from each district – who ruled for one year. Each district had its own militia with a Gonfaliniere at its head, who also served for one year (Machiavelli, 1988: 55–7). The judicial function was administered by a podesta. This position was first created by Frederick Barbarossa (the German Emperor) and was akin to the position of consul of a Roman colony. The Florentine constitution changed regularly. In 1207, a law was passed which made it obligatory for the chief judge, the podesta, to be a foreigner (non-Florentine), who was supposed to rule more impartially. He presided over a court consisting of two judges, who bore the title of collaterali, and four notaries. A mixed system emerged, when a Capitano del popolo was appointed in 1250, who was also a foreigner. Capitani del popoli were also appointed in other Italian cities such as Orvieto, Assisi and Perugia and resided in the Palazzi del Commune. They could veto legislation and had jurisdiction over their constituencies akin to the Roman tribunes. The Ordinances of 1293 stated that a government of nine priori were to be selected at random from eight bags: six from the major and two from the

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minor guilds; the ninth was the Gonfaliniere of Justice. The position of Gonfaliniere of Justice was important, as he was the head of the militia and had to protect the people from attacks by the nobles. All nine priori moved to the Palace of the Signoria, where they had to stay for two months. They were paid a modest amount to cover their expenses. Members of the Signoria could not be re-elected for a period of two years (Hibbert, 1979: 26). The Signoria were assisted by 12 Buoni Uomini (Good Men). The constitution of 1293 robbed the aristocracy of its privileges, since the new priors were elected from candidates nominated by the 21 guilds (Najemy, 1979). The aristocrats could now only participate in Florentine government by entering one of the guilds. Military leadership of the Gonfaliniere turned out to be inadequate. In fact, military leadership in Florence came to be contracted to outsiders. The lack of indigenous military leadership led to popularly acclaimed dictatorship at several points in Florentine history. This happened in 1313, when the Signoria had to call in the help of Robert, the King of Naples, to defend the city. Robert sent Lando of Gubbio, who was given full power over the citizens. ‘But, he was a rapacious and cruel man, who went about the town accompanied by many armed men and took the life of this one or that according to the will of those who elected him’ (Machiavelli, 1988: 79). The same happened in 1326, when Charles, Duke of Calabria and son of the King of Naples, obtained the leadership of Florence for a period of ten years. ‘The Signoria did nothing without the consent of the duke. At the end of one year he had extracted 400,000 florins from the city, notwithstanding that by the agreement made with him he was not to have more than 200,000.’ (Machiavelli, 1988: 84). His reign ended prematurely with his untimely death in 1329. We can note here that democratically approved single rule was expensive. Another dictator, Walter, Duke of Athens, was called for in 1340, when Florence wanted to restore its rule over Lucca and Pisa. He also acted on behalf of the King of Naples. He was first elected protector, then captain of men-at-arms in 1342 and was later elected commander and lord of Florence for life in a meeting of the people at the Piazza della Signoria. His tenure was a rather unintended consequence of this spontaneous mass gathering. The Duke of Athens took the lives of several members of the great families – the Medici, the Rucellai and Altovito – and condemned many to exile and fines, which increased his popularity. ‘The people praised the frankness of his spirit with loud voices, and everybody encouraged him publicly to find out frauds among the citizens and punish them’ (ibid.: 91). But his reign was cruel and unjust and he had to flee in 1343 due to conspiracies by the great families that wanted to murder him. We could conclude that Florentine democracy was not very robust and its constitution was changed each time the balance of power shifted from one side to the other. The Ciompi revolution of 1378 led to a short period of rule by the leader of the Florentine wool carders guild. The Ciompi seized

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the Signoria palace and Michele Lando was proclaimed Gonfaloniere di Gonfalon, commander-in-chief. But the Ciompi leaders had to flee in 1381 after they lost a battle. The minor guilds lost their grasp on the Signoria and the Ordinances of 1293 were reinstalled. The inherent instability led time and time again to the installation of a single foreign ruler, as mentioned above. At other times, one of the wealthy families ruled behind the scenes. The method of pre-selection opened up opportunities to control the Signoria, which was used by the families to get their favorites elected as priors. The Albizzi family de facto ruled Florence in the early fifteenth century. Giovanni di Bicci de Medici who was Gonfaliniere of Justice in 1421 was asked by the members of the great families to take over the leadership of the city, but declined the offer (ibid.: 155). There was a continuous fight for the control of the Signoria among the great Florentine families. The losing parties were expelled and often expropriated. The Albizzi family wanted to get rid of Giovanni’s son, Cosimo de Medici. Cosimo was arrested in 1433 and a Balia (a reform committee) was installed by a parlamento (a popular gathering), which could be convened by the Signoria at the call of the Vacca (bell). The Balia had to decide on Cosimo’s fate. Cosimo was convicted of treason and banished to Padua for ten years and with him many of his family members. They were excluded from office for life. But Cosimo returned to Florence in 1434 after the Albizzi had lost their grip on the Signoria. The defeat in war against the Milanese had weakened the position of the Albizzi family. A new Balia was summoned, which reinstated Cosimo and revoked the past sentences. The Albizzi family and their supporters were now banished (Hibbert, 1979: 58). Cosimo gained the title of Pater Patriae from the Signoria. He was a kind of informal leader, since his position was not constitutional. Cosimo had made a fortune in banking and manufacturing, which he spent generously on the promotion of science and the arts. He gained support from different quarters of Florentine society by remaining elusive and non-committal (Padgett and Ansell, 1993). Impartiality was considered the main virtue of rulers in those days. Eyewitnesses described him as sphinx-like. Cosimo wanted to look impartial to protect his position against the wrath of the other families. Bonds were cemented with Florentine families either through business deals or marriage. But he could break his opponents through the tax system, which happened occasionally (Hibbert, 1979: 61). Cosimo’s position was strengthened, in 1458, when a Balia decided to continue the procedure of pre-election of the Signoria by the accoppiatori for another ten years. Cosimo became the de facto sole ruler of Florence through his grip on the Signoria. ‘Political questions are settled at his house. The man he chooses holds office. He is who decides peace and controls the laws. He is King in everything but name’ (ibid.: 63). Machiavelli describes how Cosimo mixed grace with power: ‘He was the most reputed and renowned citizen as an unarmed man, of whom not only Florence but any other city had memories. He lent money to the nobles, was merciful to the poor, built many churches

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and chapels, but behaved as any modest citizen.’ (Machiavelli, 1988: 281). His son, Piero de Medici, was ill advised after Cosimo’s death in 1463 to recover the monies Cosimo had lent to several citizens (ibid.: 288). The demise of many merchants, who failed to recover their debts, damaged Piero’s reputation. But Piero succeeded in maintaining power and withstood the attacks made on his position by the Pitti family. He was succeeded by his son Lorenzo after his death in 1469. Medici power was not undisputed. Lorenzo barely survived an attempt at his life by the Pazzi family. Lorenzo, like Cosimo, was more a diplomat than a general. He went to Naples to seek peace negotiations with the king, which was not without risk. Lorenzo, on his return, called for a Balia, which installed a new council (the council of 70) at the expense of the powers of the Signoria. Lorenzo was not successful in business and lost the main part of the Medici fortune through bad investments (Hibbert, 1979: 158). The losses were partly compensated from the city’s coffers. Lorenzo was succeeded by his son Piero in 1492. The French invaded Tuscany in 1494 to obtain Naples and wanted Florence to comply with their venture. Piero went out to negotiate a peace, but this was not acceptable to the Signoria and the people, who denounced it, after being called by the Vacca to a Parlamento. Piero had to flee Florence, when he and his family were sentenced to death. The French king left after being paid a huge sum. Florence came now under the influence of the Dominican monk Savonarola, who predicted misfortune, if the Florentines did not change their ways. But the Florentines were not prepared to put up with him for long. He was sentenced to death and was executed in 1498. Arguably, representative democracy was changed to popularly acclaimed single rule in Florence. The opposite happened in Venice, where direct democracy changed to representative democracy. Directly elected rulers were held responsible and paid with their wealth and even their life, if they failed. Piero Soderini was appointed Gonfaliniere for life in 1502 by a Balia. Machiavelli served as chancellor and advisor to Soderini and the Ten of War. Machiavelli despised the use of condottieri and their mercenary armies and advocated a return of the militia. But Florence lost Prato to the Spanish invaders in 1512, who were assisted by the Medici. Soderini fled the city and the Florentines had to agree to the return of the Medici. The militia was abolished. Machiavelli was tortured; convicted of conspiracy and sentenced to a year’s confinement. He retreated to his farm near Florence after his release and never returned to public life. He wrote his works while away from Florence and died in 1527.2 The imperial army of Germans and Spaniards sacked Rome in 1527, where a Medici pope resided. The Medici were expelled from Florence. But the Medici pope Clement VII then joined his forces with those of the Emperor. Florence was besieged in 1529 and the city was forced to surrender in 1530. Medici rule was firmly re-established under imperial protection. Alessandro Medici returned and took the title of Duke, promising allegiance

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to the Emperor Charles V. Alessandro was stabbed to death by a relative. Cosimo de Medici I succeeded him in 1537 and was crowned Grand Duke of Tuscany. The Signoria and the position of Gonfaliniere were abolished by decree. Medici rule withstood the times and lasted until 1737, when Austrian troops occupied Tuscany. Many Italian city-states lost their political autonomy after 1500 by becoming part of an empire or kingdom. Leading families, such as the Medici, cemented family relations with the great dynasties through marriages, which stabilized their rule (Weber, 1978: 1321). Venice, however, remained a republic until it was taken by Napoleon in 1797. The Low Countries The Dutch provinces were imperial possessions before gaining independence. The Dutch provinces of Holland and Zeeland became part of the Burgundy Empire under Philip the Good in 1428 and part of the Habsburg Empire by inheritance. Imperial authority was delegated to local stadthouders, who were chosen from the nobility. Stadthouders could convene meetings and were head of the judiciary. Charles V became lord of the Burgundy states in 1506 and the ruler of the Habsburg Empire in 1519. He gained the title of Holy Roman Emperor in 1530. The Habsburg Empire became a global empire with large European and American territories under its reign. The European territories, however, were geographically dispersed and encompassed (parts of) Austria, Spain, Italy and the Netherlands. The province of Friesland became part of the Empire in 1515. The Frisian stadthouder also ruled over the province of Overijsel from 1528 and over Groningen and Drenthe from 1536 onwards. The province of Utrecht was conquered by the Habsburgs in 1528, who defeated the incumbent prince/bishop. The cities of the Low Countries were quasi-independent city-states in the late Middle Ages, resembling the autonomous Italian medieval city-states. Charles V appointed a governor as his main executive in the Low Countries in 1506. The appointment of a governor of the Low Countries interfered with feudal military arrangements, as the governor held the title of supreme commander. Governors were foreign nobles and members of royal families. The council of guild masters governing the city of Utrecht was replaced by a regent in 1528. Charles V also increased the authority of the central government in matters of law and taxes. The Burgundy Empire consisted of 17 provinces and encompassed the Netherlands, Belgium and parts of Germany. Brussels was the capital of the 17 provinces, where the governor resided. In 1556, Charles passed his throne to his son Philip II, who – in contrast to Charles – spoke neither Dutch nor French. The Habsburg Empire fought wars against the French, the Turks and Protestant princes in Germany. The Netherlands paid heavy taxes to fund these wars, but did not endorse them because they were fought against

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important trading partners (Wikipedia). Heavy taxes, centralization of government and suppression of Protestantism sparked discontent among the nobles. The Dukes of Burgundy had installed the States General as the government of the 17 provinces in 1464. It was composed of members of the high nobility, including the stadthouders. The provinces of Holland were represented in the States General by a land’s advocate or raadspensionaris. The first raadspensionaris was appointed in 1480. The States General objected to Philip’s tax proposals and demanded the withdrawal of Spanish troops in 1558. Petitions to Philip by the high nobility remained unanswered. Some influential members of the States General such as William of Orange and the Counts of Egmont and Hoorn asked for tolerance towards Protestants, but Philip rejected their plea and urged sterner oppression. These three and several other members of the Estates General resigned as stadthouders in protest. A league of 400 nobles presented a petition to the governor, to suspend persecution in 1566. The petition was sent to Margaret of Parma, an illegitimate daughter of Charles V, who became governor of the Low Countries in 1559. The iconoclast movement by Calvinists raged over the Netherlands and destroyed churches and monasteries in 1566. Philip had lost control even before he answered the petition by the nobles. Margaret of Parma resigned in 1567 and the Duke of Alba was appointed her successor. He took harsh measures and installed a special court that superseded local courts to judge anyone who opposed the king. No one, not even the high nobility, was safe. The Counts of Egmont and Hoorn were arrested for high treason because they pleaded for tolerance and were executed in Brussels in 1568. More than 1,000 people were executed under Alva’s reign, which fueled unrest. William of Orange: the stadthouder of Holland, Zeeland and Utrecht and the most influential signer of the petition, fled the country. All his lands and titles were forfeited by the Spanish king and he was branded an outlaw. William of Orange led the military expedition against Philip in 1568, which marked the start of the 80 Years War. Most of the important cities in the province of Holland declared loyalty to the rebels. Amsterdam remained a Catholic city till 1578. The Southern States declared their loyalty to the Spanish king in 1579, which meant the end of the cooperation among the 17 provinces. The seven Northern provinces were united in the Union of Utrecht in the same year. Several Southern cities, like Bruges, Brussels and Antwerp joined the Utrecht Union. The 17 provinces were now divided in two camps. The rebel provinces sought a new governor among incumbent monarchs. Elizabeth I, the English queen declined the offer. The Duke of Anjou, the younger brother of the French king, accepted on the condition that the Netherlands officially denounced any loyalty to Philip. The Oath of Abjuration was issued in 1581, which proclaimed that Philip was no longer considered rightfully king. Anjou’s authority was, however, restricted by the States General and city governments, which annoyed him and he left in 1583. The States General then decided to rule as a republican body. William

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of Orange took on the role of governor and military leader, whereas the raadspensionaris became political leader. The raadspensionaris was appointed for a period of five years, but could be reappointed without limit. The Oath of Abjuration prompted Philip II to re-conquer the rebel provinces. Spanish authority and the Catholic faith were restored in Flanders, Brabant and some of the Northern provinces. A large part of the population of Antwerp fled to the North. William of Orange was assassinated by a supporter of Philip II in 1584. Maurice of Orange; William’s son, was appointed Captain-General of the Dutch army by the States General in 1587. Maurice also held the position of stadthouder of Holland and Zeeland. He acted on behalf of the States General, which was the supreme authority in the Union and convened in The Hague. The representatives were elected by the seven provinces, which each had one vote from 1593 onwards. The Southern Netherlands kept their own States General at Brussels. The raadspensionaris became the highest ranking civil servant in the Union as he represented the provinces of Holland and Zeeland in the States General. The function of stadthouder was decoupled from membership of the States General, when Maurice took office. In theory, stadthouders were elected by the provinces. But the princes of Orange Nassau became de facto hereditary stadthouders of Holland and Zeeland and supreme commanders of the land forces. The raadspensionaris, as the representative of the provinces of Holland and Zeeland, became the chief political executive. Two tenured executive positions emerged: that of raadspensionaris and that of supreme commander. The latter was officially subordinate to the former, as the States General decided on military missions. Johan van Oldenbarnevelt, who had become raadspensionaris in 1587, also became the chairman of the States General. He founded the VOC and concluded a truce between the United Provinces and the Spanishcontrolled Southern states in 1609, which lasted 12 years. Maurice had strongly objected to the truce. During the truce, two factions emerged in the Dutch camp along political and religious lines. The Arminians were on one side; they were well-to-do merchants, who accepted a less strict interpretation of the Bible than did classical Calvinists. The Gomarists, were on the other side. Johan van Oldenbarnevelt was in favor of religious diversity, whereas Maurice supported the Gomarists. The relationship between the stadthouder and the raadspensionaris became tense, as Maurice resented the authority of the States General in military matters. His father, William I of Orange, was known as William the Silent, as he refrained from speaking out on political matters. Maurice had not inherited this feature and took side in the religious conflict. He overturned the decision by the States General of 1617 to allow the cities to deploy mercenaries, which he considered to undercut his military leadership. He accused van Oldenbarnevelt and some others of treason and had them arrested. Van Oldenbarnevelt was executed in 1619 after a trial. The execution was heavily criticized by parts of the population. Maurice’s seizure of power strengthened the position of

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Calvinism as the main religion and of the stadthouder as main executive. A clash between raadspensionaris and military commander had happened before. Paulus Buys, who was raadspensionaris from 1572 till 1585, was a supporter of William I of Orange. He clashed with the Earl of Leicester, who became Lord Regent on behalf of the British queen after William was murdered. The Earl, however, put Paulus Buys in jail and he was only released after paying a ransom of 25,000 florins, which was largely paid by the Dutch cities. The tension between the two executives continued after the Netherlands had gained independence in 1648 at the Treaty of Munster (and Westphalia), which also ended the Thirty Years’ War. The new republic consisted of seven provinces: Holland, Zeeland, Utrecht, Guelders, Overijsel, Friesland and Groningen. In practice, the princes of Orange Nassau became hereditary stadthouders of the seven Provinces. Johan de Witt became raadspensionaris in 1653, at the time, when there was no stadthouder. The States General had decided not to appoint a stadthouder after the sudden death of William II in 1650. De Witt supported the struggle to prevent any member of the House of Orange from regaining the stadthoudership. He was supported by the wealthy merchant class, whereas the artisans supported the Orange faction. De Witt appointed Jacob van Wassenaer Obdam as supreme commander of the confederate fleet. The Dutch navy became the winner of the second Anglo-Dutch War. A peace treaty was concluded in Breda in 1667. At that moment the Republic was one of the Great Powers, dominating world trade and was the wealthiest nation in the world. However, the disastrous year of 1672 became de Witt’s undoing. The republic was at war with the French, the English and the bishops of Cologne and Munster in that year. The Orangists took power by force and deposed de Witt. He was assassinated by a carefully orchestrated lynch mob in The Hague together with his brother Cornelis, who was a successful navy commander. Many historians assume that his adversary: William III of Orange was involved in the scheme, since he protected and rewarded the killers. William III continued the Orange tradition and became both supreme commander (captain-general) and stadthouder. The position of raadspensionaris had now become subordinate to that of stadthouder. William III was married to Maria Stuart, the eldest daughter of the Catholic king James II. William marched against his father-in-law and won the war. He and his wife were crowned as king and queen of England, Scotland and Ireland in 1689. The Glorious Revolution of 1688 meant the end of the struggle between king and Parliament and the revision of the English financial system. William had no heirs, which led to the second stadthouderless era which lasted from 1702 till 1747. William IV took over as stadthouder in 1747, but died four years later. He left a three-year-old son William V, who assumed the stadthoudership. His authority was undermined by the Patriots. William did not undertake any action, but left this to his brother-in-law, King Frederick

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William II of Prussia, who sent an army. William fled to England in 1795, when revolutionaries returned to the Netherlands supported by the French Army. In 1813, his son William VI (King William I) returned to the Netherlands and became the first Dutch monarch.

Conclusion The histories of Venice, Florence and the Dutch Republic all point to a balancing act between the chief military and political executive in republics. One solution involved the combination of both positions in one person, who was elected by popular acclaim. The dual position of the early Venetian doges is a case in point. Such direct democracy, however, lacked discussion in councils. A second solution involved the supremacy of political over military leadership in a dual system. The later doge became the political leader, who was not liable for failure. Florence and the Dutch republic took the other road. Military leadership became dominant in both republics. Florence subjected itself to popularly acclaimed foreign rulers in times of distress and later to the Medici family. The Dutch republic opted for dual leadership of the House of Orange Nassau after two political executives were eliminated in the early days of the independent republic. The arrival of single leadership was assisted by factious quarrels in both republics. We can argue that both Florence and the Dutch republic had representation, but democratic procedures for dispute resolution failed due to factious strife. The positions taken by the contenders in Dutch religious dispute prevented the achievement of consensus. The fixed positions that were taken also entailed a ‘winner takes all’ type of game and the elimination of limited liability. Defeat led to the expropriation of the leaders of the losing party and even to their death. Representative democracy, by contrast, features limited liability. This applied to the later Venetian doges, who had immunity. Single leaders, by contrast, were deposed after failure. One in three Venetian doges was expelled or forced to retire in the period before 1172; one in three early doges was slain by a successor; killed in war or by the people. Only one in three doges of the early period died a natural death while in office. This differed from the period after 1172, when only one in five doges was forced to resign. A doge could refuse to resign, as his tenure was constitutional. Antonio Grimani, who was doge from 1521 till 1523, acted in this way. Moreover, later doges got a pensione, when they abdicated and retired (usually to a monastery) similar to CEOs of our days. This differed from deposed doges before 1172, who neither received a pension nor a place to stay within the city. Hence, the 1172 Constitution limited liability for Venetian doges, but also limited the gains from victory. They received a small fixed income in contrast to popularly acclaimed leaders. The many contractual restrictions put on the later doge limited his liability, but also his freedom of movement. Liability was also limited for Venetian generals, who could be reinstated if they were found without fault.

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The position of the doge as a tenured executive fits in with several aspects of the CEO of a large diversified company, who delegates execution of strategies to lower management. The position of single leaders resembles that of entrepreneurs, who have a great chance of failure. But corporate governance limits liability to opportunity costs, which differs from political entrepreneurship. The institution of the Balia inserted a large dose of direct democracy in Florentine politics, which led to single rule on different occasions. The losing party in Florentine family feuds lost both citizenship and wealth (if not taken to safety). The single leaders of Florence had to flee to save their life after they were defeated or lost the trust of the populace through abuse of power. This can be explained by the largely non-constitutional nature of Florentine leadership. Limited liability was also lacking in Florentine commercial ventures, where family and company capital were identical in many cases (Weber, 2003). This contrasted with the commenda organization of maritime cities such as Venice, which evolved towards a limited liability company, whose shares were widely held. Cosimo de Medici obtained informal sole leadership in the fourteenth century by taking a neutral position in factious strife. The same applied to William I (the Silent) of the Netherlands. They were both called Pater Patriae and were acceptable to large parts of the population. Single rule seemed the obvious solution to factious strife, but led to hereditary rule by a single family and ultimately to foreign domination or the conclusion of foreign alliances through marriage. Venice had subordinated military to political leadership. The successful general could not appropriate the conquered territories, but could take a bureaucratic post. The successful captain-general in the Netherlands, by contrast, could appropriate political power. The Dutch captain-generals stood at the head of mercenary armies that fought on land. They were part of the aristocracy in contrast to commanders hired by Venice. Naval command was in the hands of admirals appointed by the States General. The maritime forces were crucial for the protection of international trade-routes, but the admirals lacked political power. A difference between navy and army command in Venice can also be noticed in Venice. Battles on land were delegated to mercenary armies and their commanders, whereas sea battles were fought by appointed admirals.

9

Democracy and dictatorship The politics of innovation

Introduction Cross-country analyses found that legal protection of property rights, limited and efficient government and a relatively benign and uncorrupt bureaucracy are good, growth-promoting economic institutions (North, 1981; Easterly and Levine, 1997). Secure property rights were found to be an essential precondition for private investments in physical and human capital (Djankov et al. 2002; 2003). We know what ‘good’ economic institutions are; but the best way to achieve them is less clear (Kaufman and Kraay, 2004). Institutions refer to the ‘rules of the game’ in a society that shape human interaction by structuring incentives (North, 1990: 3–4). Institutions change over time, but the direction of change is indeterminate. The idea that inefficient institutions are weeded out due to competition among organizations is not supported by the historical facts. Some periods and countries have shown growth, whereas others declined. Institutions can either emerge through agreement among constituents as in a democracy or be imposed on a population by an autocratic decisionmaker. Both democracies and dictatorships can use their political power to transfer resources to privileged groups. Uncertainty about the growth-boosting effects of democracy derives from its assumed anarchic tendencies (Djankov et al., 2003). Some argue that a benevolent dictator can outperform democracies due to his dedication to the common good (Olson, 1993; 2000). The economic success of some (formerly) autocratic countries like Taiwan and South Korea support the notion that dictatorship can spur economic progress. However, cross-country analysis points out that dictatorship is negatively related to per capita income. Most developed nations are democracies, but dictatorships had a large range of growth rates (Glaeser et al., 2004). Some dictatorships spurred growth, whereas others did not. One can argue that developing nations will develop democracy as a by-product of growth. This thesis is supported by the examples of South Korea, Taiwan and Singapore, which became democracies after several years of rapid growth. We have to look for other variables to explain institutional development, if both democracy and dictatorship can develop good – growth-promoting –

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institutions. Some have pointed to the role of trade. History shows that societies that are open to trade grow more rapidly. Athens, the Italian citystates and the Low Countries are cases in point. Examples also abound in our days. Apart from the Asian Tigers, a host of countries that increased their trade share of GDP grew rapidly (Dollar and Kraay, 2001). China and India are the most prominent examples, but a host of other countries ranging from the Dominican Republic to Malaysia have increased both trade and growth since 1980. Openness to trade and good institutions go together, but changes in trade can predict growth better than changes in institutions (Dollar and Kraay, 2002). This would indicate that trade triggers the creation of good institutions. Moreover, opening up to trade does not increase poverty within countries (Dollar and Kraay, 2004). The chain of causation between institutions and growth has also been addressed from a different angle. Institutional economists argue that human capital is a more basic source of growth than political constraints on the government (Glaeser et al., 2004). Educated people are more inclined to settle their disputes peacefully instead of referring to force (Lipset, 1960). Countries that emerge from poverty seem to accumulate human and physical capital under dictatorships and tend to improve their institutions, once they become richer. Glaeser et al. conclude, based on a cross-country analysis, that initial levels of human capital measured by years of education are a good predictor of growth (Glaeser et al., 2004). This would imply that investment in human capital precedes institutional development. But autocracies are not inclined to invest in human capital as is testified by the majority of poor countries, which combine dictatorship and illiteracy, whereas developed countries have educated populations (ibid.). I want to support the view that trade promotes institutional development and economic growth. A country that opens up to trade indicates that it accepts the basic rules of the game of international trade. History offers numerous examples of city-states that thrived on trade and developed organizations and institutions that boosted growth. A loss of autonomy and the appearance of rivals signaled the (relative) decline of the Italian city-states. Arguably, the incentive structure changed when city-states became part of an empire that taxed away their profits. A nation would lose its credibility, if it reneged on contracts. History has provided us with several examples, where government changed the rules in its favor and at the detriment of investors. European investment in new ventures halted in the eighteenth century, when several bubbles burst. Government policies of default and inflation through money printing led to a sharp decline in equity investments for long periods. Governments that change the rules of the game in their favor in periods of distress change expectations and depress investments. Organizations also have to live by the rules to create time-consistent expectations about the outcomes of investment. Economic theory – in its neo-classical form – has difficulty explaining why people would live by the

Democracy, dictatorship and innovation 163 rules instead of behaving egoistically and maximizing their gain at the detriment of others. Game theory indicates that people will only refrain from such behavior, if games are repeated and allow retaliation (Axelrod, 1984). People who work in organizations expect their relationship with the organization to last for some time to come. Egoistic rule-breakers will be shunned by the organization. Some argue that parties in an exchange will renege on the contract to their own benefit. But no contract would be concluded if both parties expected the other to renege. Moreover, employees who feel unfairly treated by their employer, who reneges on an implicit contract, will leave the firm and look for another job. Consumers who feel cheated by a certain salesman will avoid his merchandise. Actually, firms can increase their price and profits by issuing warranties (Shy, 1995). The breakdown of expectations with respect to a certain vendor will desiccate his business. Firms that change the rules of the game in their favor, therefore, will lose out to more trustworthy competitors.

Democracy, dictatorship and the common good Autocracy is defined as government by a non-elected leadership, which can be a single person, a tightly knit group or a party. Autocratic rule can emerge democratically as in the case of the elected dictator of the Roman Republic and the popularly approved Athenian tyrant, who rose to power in situations of emergency. These absolute rulers operated within a given institutional structure and lacked tenure. Some elected dictators exceeded their term and turned into autocrats. Other autocrats seized power by force irrespective of popular will. Some autocracies were constitutional as in the case of hereditary kingship. Democracy, by contrast, features elected leadership and organized discussion; it allows citizens to express effective preferences about policies and leaders (Glaeser et al., 2004). I shall use the terms dictatorship, despotism and autocratic rule for all systems, in which a singular non-elected authority has indefinite length of office and can change and apply the rules in his favor. The rules in democracy are set by elected lawmakers and executed by an impartial judiciary. But, contemporary research indicates that modern democracies are not always ‘free’ as they do not guarantee the rule of law and respect civil rights (Zakaria, 1997). Economists define ‘good’ institutions as public goods, if nobody can be excluded from their benefits. Some economists have addressed the question of whether democracy or dictatorship is most equipped to realize the ‘common good’. The question used to be answered in the favor of democracy. History provides us with numerous examples of successful societies that had some form of democracy. Democracy and liberalism were closely related in the days of the commercial city-states. But democracy is not always capable of dealing with crises as many old and modern examples illustrate. ‘Good institutions’ should be robust and be maintained in and out of crisis in order to maintain profit expectations.

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The political theory of institution-building argues that institutions are built by those in power to stay in power and to redistribute resources to their group. Both democracy and dictatorship are inclined to benefit their constituencies. Politicians can rise to power in a democracy on promises to expropriate the few rich people at the benefit of the poor majority (Jensen and Meckling, 1977). Dictators, by contrast, are inclined to exploit the many for the benefit of an elite group. Both democracy and dictatorship might thus violate property rights and redistribute wealth according to political imperatives. This might explain why a relationship between democracy and economic growth was difficult to find in recent data (Barro, 1996; Glaeser et al., 2004). Collective action theory points to the free rider problems that prevent democracies from attaining the common good; nobody feels inclined to produce public goods, if everybody benefits from the efforts of a few. This applies particularly to large groups, where the relationship between effort and result is shallow. Hence, large interest groups might fail to achieve their goals due to free rider problems (Olson, 1982: 31). Small groups, by contrast, can better internalize the gains from collective action, but are primarily interested in enlarging their piece of the pie, instead of enlarging the pie (ibid.: 44). Moreover, an increase in the number of small lobbies would lead to political stalemate and stall decision-making (ibid.: 65). Distributional coalitions, once in power, are exclusive and do not want to expand the membership (ibid.: 69). Olson emphasizes the weakness of democratic decision-making due to interest disparities. As a consequence, democracies might tend to pursue the interests of small well-organized minorities, akin to dictatorships. Olson’s analysis presumes that the collective good – maximum welfare – is easily discernible, but that conflicting interests and free rider problems prevent governments from pursuing it. He argues that a dictator can more easily obtain the ‘common good’, as he does not need to make compromises to satisfy several competing interest groups. He can change the ‘rules of the game’, if this is efficient and benefits social welfare. Olson’s analysis resembles the Coase theorem stating that collective welfare can be optimized, if property rights are in a single hand (Coase, 1960). A single owner will be inclined to internalize externalities, as his interests are all-encompassing. Democracies might be less suited to achieve the collective good due to their difficulty in internalizing all externalities and free rider problems. Arguably, a benevolent dictator can outperform a democracy, in this view. The old republics discussed in the previous chapter were unified, purposive organizations. But, with the wisdom of hindsight, we can say they did not always choose the right strategies or the right leaders. Olson disregards uncertainty and how to deal with failure. Consequently, discussion about strategies is superfluous in his analysis, since the right way forward is always clear. Discussions in councils that are open to public scrutiny, become unnecessary if we disregard uncertainty. Hence, an important feature of

Democracy, dictatorship and innovation 165 democracy is lost, if the ‘best’ decision can be unequivocally determined ex ante. Communication can then be restricted to giving commands. Another question involves the stability of both democracy and dictatorship. Democracies might collapse due to coups and revolutions, while dictators might be continuously challenged by contenders. New rulers can pursue hit-and-run strategies by pillaging the country or transferring its wealth to foreign bank accounts. It goes without saying that such drastic changes of the rules of the game shatter expectations and deter investment. This differs for stable governance systems. Liberal democracies fit this mold. The same applies to autocratic rulers that intend to stay. Olson argues that a stable autocrat, who has monopolized theft, will be inclined to provide protection and even produce public goods to further efficiency. We could call this the logic of autocratic action. He analyzed stable autocratic rule in his analysis of stationary bandits (Olson, 1991; 2000; McGuire and Olson, 1996). Stability distinguishes stationary bandits from warlords, eager for booty, who do not establish governance structures (Olson, 2000: 6–12). Some power structures remain fragile, when rivaling warlords continuously contest territorial claims. But some autocratic regimes existed for centuries, when war bands established governments once their power was firmly established. Olson’s analysis resembles that of Weber on the origin of kingdoms and nations. Weber emphasizes domination, whereas Olson stresses the public goods aspects of dictatorship. Kingship will arise, in Weber’s view, if charismatic war leadership becomes permanent and a repressive apparatus for the domestication of the unarmed subjects is developed. (Weber, 1978: 1135). A despot would thus refrain from ransacking the country, if he expects his rule to last for an indefinite time. Autocratic rule can be called stable, if it has ruled unchallenged for a considerable period of time. Dynastic rule, as was the case in the Chinese, Japanese and Occidental empires, supports stability of autocratic rule. Autocratic rule can be based on mere repression, or be legitimized by religion, secular ideology or tradition. Many autocracies were bifurcated societies with a small leading elite and a majority of the population with few or no rights. Civil liberties like freedoms of expression, organization, demonstration, travel and religion are usually absent in autocratic regimes, since they were found to be closely related to electoral rights (Barro, 1999: 162). Olson identifies autocracy with non-market appropriation. Autocrats can use their political power to maximize total welfare and distribute an economic surplus as they see fit. They can spend on the military and other public goods. He argues that stable autocracies would want to promote efficiency by reducing theft below the 100 percent rate to leave some incentives intact and maximize tax collections (Olson, 2000: 8). I shall discuss Olson’s claims for both static and dynamic efficiency in stable autocracies. The first concept refers to efficiency within the borders of existing knowledge; the second to the introduction of new knowledge embodied in innovations.

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Stability and growth Olson (2000) mentions several cases of stable autocratic rule, such as the unchallenged Mafia boss, the Chinese emperors and Stalin’s rule. He suggests that stable autocratic rule may support economic growth by stimulating both static and dynamic efficiency. This differs from older views on the matter, contending that political, economic and social stability are correlated. Regimes that cling to power want to freeze the political and economic structure. Machiavelli expounded this view in a vivid picture of ancient Sparta as a society that opted for preservation of the political, social and economic status quo. Its defeat in the war with Argos in 669 BC prompted it to give up all ambition and to revise its constitution. The new constitution, written by Lycurgus, gave great power to the royal dynasty and a Council of Elders. Spartan society under Lycurgus’ law was stable and lasted for 800 years. Nobody could reach a higher station in life than he possessed at birth. Sparta sought the preservation of the social structure by forbidding the entry of newcomers. All intermarriage between Spartans and non-Spartans was prohibited. Trade was also considered a threat to social mobility. ‘Nobody might come there with merchandise or any manufactured goods’ (Machiavelli, 2003: 282). Hence Sparta strove for autarky. Commerce was strictly regulated and left to the ‘minor’ people, who could harbor no political ambitions. Sparta did not depend on ‘foreign’ trade, since it could live on the produce of the conquered territories. Each Spartan owned his own plot of land that was worked by the subjugated Helots. Spartan citizens did not engage in economic activities, but spent their time in the military up to the age of 60. Landownership was distributed equally among Spartan citizens. The Helots worked the land according to time-honored routines. But the Helots kept a longing for the freedom they had enjoyed in earlier times. They were subject to terrorist acts, perpetrated on them by the Krypteia, a group of young Spartan men, who roamed the countryside each year to kill Helots. Machiavelli argues that stability was furthered by killing ambition. However, keeping a society stationary proved to be a delicate procedure. Sparta did not succeed in keeping its population stationary. The number of Spartans declined steadily after Lycurgus’ law was established, mainly due to a falling birth rate. Spartan society possessed many features of Schumpeter’s stationary state; a society in which production, population and social positions were fixed at a certain level that remained unchanged. Plato expressed his desire for a stationary society after Athens’ defeat in the Peloponnesian War. Everybody in his Republic would carry out his hereditary duties as slave, soldier or aristocrat. Both the Spartans and Plato opted for stagnation to prevent (further) decline. Many autocracies of old also preferred stagnation to change to preserve the political power of the leading group. Imperial China and Japan are cases in point. They held the view that growth would undermine the status quo and unleash destabilizing forces. Stagnation, by contrast,

Democracy, dictatorship and innovation 167 curbed dissent, because nobody was expropriated and nobody could have any ambition. Distributional shares were fixed according to time-honored principles. We can argue that these rulers held a long-term view. They sacrificed present income to safeguard future political power and income for their group. Stability was further advanced, if rulers refrained from military ventures to expand their territories. Expanding states can motivate their constituents by promising them a better life. But expansionary policies can fail and undermine the authority of the leader. Stable, dynastic dictatorship is, therefore, inclined to refrain from military aggression. This applies to imperial China, Byzantium and Japan. Emerging dictators, by contrast, want to win the people’s support by promising riches from appropriating domestic or foreign wealth.

Stable dictatorship, appropriation and static efficiency We will take a closer look at the static efficiency properties of different autocratic methods of appropriation. Static efficiency requires the optimal allocation of production factors, which is achieved in a perfectly competitive economy. Each production factor would receive its marginal worth and produce according to best practices in perfect competition. Welfare is maximized and can be measured by consumer surplus. However, perfect competition would leave the dictator no excess profits to appropriate, since price equals per unit costs. We use the perfect competition model as a benchmark to analyze the appropriation policies of autocratic rulers. An autocrat can create rents in two different ways. He can either raise prices in a monopoly fashion and appropriate monopoly profits on domestic or foreign markets. Or he can reduce wage costs of domestic or foreign labor below market levels and collect the difference. This leaves us with four different modes of autocratic appropriation. 1 Monopolistic appropriation in local markets An autocrat can appropriate monopoly revenues by taxing privately owned businesses. Neighborhoods under single family Mafia rule could be taxed in this manner. The same applies to feudal tax farming, where tax privileges were contracted out to local tax collectors. We assume a market for goods or services depicted by a linear demand function; P ¼ a  Q. Marginal costs of firms in the protected line of business amount to c1. We assume that marginal costs cover wage incomes at market rates. Price would equal c1 and output amounts to a  c1 in perfect competition. Welfare, measured by consumer surplus, equals ða  c1 Þ2 : 2

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A stationary bandit in such a situation demanding protection costs equal to a  c1 2 per unit would lift price to the monopoly level and maximize his income. Output would be cut in half by such a move and price would rise by 12 ða  c1 ). Consumers lose out in monopolistic autocracy. The Mafia boss incurs monopoly profits of ða  c1 Þ2 : 4 Total welfare, however, declines by ða  c1 Þ2 8 due to the emergence of dead weight loss. The autocrat has maximized his tax incomes, but the installation of a theft monopoly raises prices and harms consumers. Moreover, the installation of a theft monopoly would make half of the workers in the protected industry jobless, if employment is proportional to output. Olson and McGuire (1996) argue that maximum expropriation is realized by imposing a lump sum tax. However, the amount of rents would remain unaltered, if the Mafia family demanded protection costs of firms equal to their share of monopoly profits in a lump sum manner. Both forms of taxation compel the protected businesses to work cost efficiently, since they would lose income, if they did not. All losses due to inefficient operation would thus be borne by the firms. A monopoly policy, however, always creates inefficient allocation due to misallocation. Production factors are withdrawn from the protected businesses and remain idle or are reallocated, for instance, in the protection business. Such a policy can thus never achieve maximum welfare. Olson and McGuire argue that protection is a public good, since less would be produced without protection. We can imagine that production will collapse, if firms expect to be ransacked by competing bandits any time. But business would be better off, if it were protected against crime by a police force in a consensual democracy. Business would only be marginally better off, if it were taxed by a majority in a redistributive democracy instead of a dictatorship (McGuire and Olson, 1996). We can argue that a monopoly strategy will only work, if the protected industries are local and not exposed to competition on world markets.

Democracy, dictatorship and innovation 169 Typical Mafia-protected lines of business such as retailing and restaurants comply with these requirements. Domestic monopolies were established by both autocratic and democratic states. Royal monopolies were established in England under the Stuarts, in France under the Bourbons and in Russia under Peter the Great. State monopolies, however, are not inclined to achieve cost efficiency, due to a lack of competition. 2 Monopolistic appropriation of foreign markets Autocrats can also attempt to monopolize world markets. However, monopoly of foreign markets is harder to achieve, if foreign governments resist monopolization of their domestic markets. Moreover, international competition is difficult to control in renewable goods markets as experiences with the control of coffee, copper and other commodities prices have demonstrated. The control of world oil prices by OPEC countries can be considered a successful example of a monopolization strategy of foreign markets. 3 Autocratic appropriation through exploitation of domestic labor Autocrats can suppress wages to the extent that incomes hit subsistence levels. Appropriating a surplus by lowering wages is more rewarding, if productivity is higher. Revenues of ðw1  w2 Þ ða  c1 Þ accrue to the autocrat, if wages are reduced from w1 to the subsistence level of w2. A surplus can be generated by autocratic control of both product price and wages. Wholesale prices can be fixed at low levels, while retail prices are set at a level that allows the autocratic government to reap profits. Surpluses are twice as high for a wage-suppressing than for a monopolizing policy of the same magnitude due to the higher volume of output of the former policy. Moreover, total income remains unaffected by an exploitation policy, since output remains unchanged. Workers on subsistence wages can spend less, but their demand can be replaced by autocratic demand on conspicuous consumption and/or military spending. Socialist dictatorships from the USSR to Mao’s China have applied these methods to generate surpluses. A socialist dictator can maintain output at the perfect competition level ða  c1 Þ by imposing output quota, while wholesale price c2 is set below the competitive level of c1. A surplus ðc1  c2 Þ ða  c1 Þ accrues to the socialist dictator pursuing this policy. That was how Mao during the Great Leap Forward created an agricultural surplus that accrued to the government (Gabriel, 1998). Autocratic appropriation can be technically efficient, if labor productivity is not affected by wage suppression. Socialist appropriation shares some features with feudal arrangements, in which a (local) lord appropriates a surplus on agricultural production through compulsory labor and sharing arrangements. Such arrangements prevailed in China before 1949 and were also common in Mogul India,

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Tsarist Russia and medieval Western Europe. Serfs were hindered in their mobility and bound to the estate by eternal obligations and privileges. This differs from socialist states that can move their people as they please. Feudal systems needed to restrict mobility to keep rural incomes below market levels. Only a few people were allowed to move to the imperial center to share in the luxuries of the court or participate in government. 4 Appropriation through exploitation of foreign labor Dictators need to sell part of their production on international markets, if they want to buy foreign goods. Selling on world markets implies that revenues are unpredictable and subject to fluctuations. Moreover, people need to be reallocated according to market imperatives, which could interfere with autocratic desires to bind people to their birthplace. Many autocracies, therefore, strove for autarky and minimized international trade. This does not apply to the plantation economies, which were specifically established to serve world markets. Plantations that used slave labor for the production of goods that are sold on faraway markets fit this category. The practice dates back to Roman times, when garrisons were stationed in conquered territories and land was distributed among colonists. The Portuguese, French, English and Dutch established plantations in Latin America after they had conquered these territories. African slaves were robbed of their rights after being conquered or abducted, and sold in regions where slave labor was common. The Arab world was an important buyer of slaves. African slaves were traded to the Americas in the seventeenth and eighteenth centuries to work on plantations (Maddison, 2004). Such slavery existed until the abolition movements of the nineteenth century ended these practices. Indigenous people also worked on plantations in Indonesia and Spanish Latin America. Labor was imported from India to staff the Indonesian plantations. Investments in plantations could be sizable and were usually undertaken by private firms. This applies specifically to English and Dutch settlements established by the West Indian trading companies. Investments in the silver mines of Mexico and Peru were undertaken by Genoese and German bankers and not by the Spanish state (ibid.: 37). Plantation economies were specialized and had to import food (ibid.). Plantation owners exploited slaves, whose maintenance costs could be put at subsistence level. The slave traders and the former slave owners appropriated part of the rents that were generated by plantation production. Revenues also needed to be shared with the home government. The Spanish government charged a 20 percent tax on all silver from its colonies. The English and Dutch also imposed excise taxes on colonial wares that were sold on home markets. The goods from the colonies were first directed to their home markets, but were soon sold abroad. Products such as coffee, sugar and tobacco were new to Western Europe, but rapidly became mass commodities as their prices declined due to competition. A monopoly strategy

Democracy, dictatorship and innovation 171 was unsustainable for products that were produced by private enterprises (Ferguson, 2003: 15). Revenues could vary with demand and the size of the harvests. The vagaries of the market for their products pressed plantation owners to keep their workforce flexible. This could be done by returning indigenous populations back to subsistence farming in periods of weak demand or by limiting the import of slaves. Plantations became the preferred organization of staple crops in the Americas.

Dictatorial (dis)incentives for dynamic efficiency Gains from innovation We can argue that an exploitation policy could achieve static efficiency in contrast to a monopoly strategy. The Olson approach, however, largely ignores uncertainty, distribution and incentive issues. Can autocracy also spur dynamic efficiency? Olson (2000) argues that an autocrat wants to invest in innovation, as this would augment his income. A monopolizing autocrat can increase his monopoly profits by introducing a cost reducing innovation. His income will increase by 1 1 e½a  c1 þ e; 2 2 if he appropriated the additional revenues brought about by a unit cost decrease equal to e in a monopolized industry. A monopolist will share efficiency gains with consumers since he maximizes profits by transferring half of the efficiency gain to consumers by lowering price. But employment will fall, if demand is not very price elastic. An autocrat, who generates a surplus by exploiting labor, will keep prices at the previous level and absorb the whole efficiency gain himself. A wagesuppressing socialist or feudal ruler could expand his income by eða  c1 Þ; if he fully appropriated the benefits from a cost-reducing innovation. Labor can only remain fully employed in the existing line of business, if production expands at a sufficient rate. An autocrat thus either needs to seek new geographic markets to sell increased output or redeploy labor to other uses. Autocrats will seek innovation, if this increases their surpluses. This would be the case, if the revenues of innovation exceed its costs. Costs of innovation can consist of R&D expenditures and investments in physical structures. Innovation costs also consist of the reallocation of people and capital prompted by innovation.

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I would argue that autocracies are inclined to impede innovation for several reasons. They lack incentives to increase efficiency, if dismissed workers come at their expense. This applies to the Mafia boss, who cannot dismiss family members. A feudal dictator, whose subjects are bonded to village and soil, would lack the incentive to invest in innovation, if redundant labor could not be easily redeployed within his territory. Arguably, such autocrats have to internalize all innovation costs in contradiction to a firm, which can leave reallocation of production factors to the market. The devaluation of capital of firms that lose out in innovation is absorbed by the shareholders of those firms, whereas autocrats have to deduct losses due to creative destruction from their gains. A related argument involves that innovation was hindered by tradition in autocracies. People’s behavior was not directed by commands, but by timehonored routines in many autocracies of old. Tradition could mitigate autocratic oppression, but also hindered economic innovation and progress. ‘Everything new will be resisted, if it is expected only to benefit the favored few’ (Weber, 1978: 1094). Another impediment to autocratic innovation is the absence of individual incentives due to a lack of property rights. Autocrats could trigger innovation by providing (intellectual) property rights to individuals and firms (Olson and McGuire, 1996). Intellectual property rights would entitle innovative firms and individuals to appropriate the profits from innovation until they expire. But many autocracies were wary of providing property rights that cannot easily be withdrawn by the ruler, since this would interfere with their powers to allocate production factors and surpluses as they pleased. Indeed, many stable autocratic regimes did not seek innovation. This applies to the economies of both China and India, which remained stagnant between 1500 and 1870 (Maddison, 2004). The Chinese Emperors introduced extensive agricultural innovations to accommodate a growing population. Per capita production, however, did not rise. Indian agriculture, by contrast, did not allow for an increase of population before 1820 (ibid.). This contrasts with plantation exports from Latin America, which increased rapidly from 1500 to 1820 (ibid.). We can argue that plantation products were sold in competitive markets, which triggered growth in contrast to autarkic autocratic systems. Favoritism and innovation Autocratic non-market appropriation involves the appropriation of surpluses by a privileged group and a suppressed group. Power relations between those groups needed to stay intact to keep the appropriation regime in place. Innovation implies the selection of people and projects that are expected to become successful. Selection can occur by competitive financial markets or by a single authority. Competitive selection implies divergent views, whereas one view prevails in autocratic selection. Many

Democracy, dictatorship and innovation 173 autocratic regimes valued the worth of suppressed people at low levels. Their worth was determined by tradition and put at subsistence level. Feudal regimes fostered stability of the social structure by keeping people employed in occupations and places designated by birth. Peasants remained peasants and rulers remained rulers in stable feudal autocracies. Nobody is expropriated, if the unequal distribution of incomes and wealth dates back a long time. No ambitions need to be kindled, if there never was any prospect of improving one’s station in this life. Possibilities for social advance were scant for people who did not belong to privileged ethnic or social groups in most times and places. This applies to slave labor, the feudal serf and the Asian peasant, who were not allowed to choose an occupation of their liking. The Indian population was divided along strict caste distinctions, in which each caste had its own occupation. A person’s worth was completely determined at birth in these structures. Chinese imperial bureaucracy knew some social mobility. People could enter the ranks of officialdom, if they passed an imperial exam on classic Chinese literature and Confucian texts. However, social mobility was slowed down by the long learning period that was required to pass the exam. Only sons of the land-holding elite, who spoke Mandarin, could prepare for the imperial exams. Exams were also used to recruit officials for the Indian Office. British bureaucracy opened opportunities for social ascent of both Brits and Indians (Ferguson, 2003: 189). Yet, the higher ranks within the British Civil Service were initially not open to Indians (Lal, 2004: 34). British bureaucracy in India was efficient as it used a minimum of officials to govern, but dynamic efficiency was lacking as is demonstrated by the low growth of per capita income in India under British rule. Arguably, a person’s worth in colonial India was still largely determined by tradition and remained fixed over his lifetime. Modern dictatorships do not rely on tradition, but on command. Labor can be reallocated at will. This applied to the USSR, where people were deported to new industrial towns in undeveloped regions. Forced relocation also occurred in Mao’s China, Pol Pot’s Cambodia and Communist Vietnam, where people were moved from cities to the countryside. Zimbabwe, a democratic state, also pursued policies of forced migration in the early twenty-first century. Moreover, people who were no longer trusted were easily devalued in autocracies. Stable status hierarchies, based on tradition, can make people complacent with their lot, but lack incentives for innovation. Arbitrary autocratic rule, by contrast, may provide incentives to people to promote their case. Favoritism implies that people close to the ruler can rise to tremendous power, but are always in danger of a sudden dramatic downfall for purely personal reasons (Weber, 1978: 1088). Flattery and palace intrigue will prevail, if the ruler’s opinion determines one’s fate. Positions are precarious, if the ruler’s preferences are unsteady. Some people will fall from grace, while others become favorites. Favoritism in old autocracies was restricted to circles close to the ruler, while tradition ruled the lives of the larger part of the population.

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Modern – ideology-based –regimes, by contrast, demand ideological servitude from all their subjects. Every person has to model his/her behavior according to autocratic wishes. Secret or moral police scrutinize a person’s behavior and can bring about a person’s social demise. But autocratic restrictions on behavior are largely arbitrary. Intellectuals and artists can turn from friend to foe overnight as is illustrated by Stalin’s cultural policies. We would argue that such arbitrariness should kill all ambition and provoke dissent. This would be the case, if obtaining the regime’s favor was perceived of as depending purely on chance. Favoritism, however, implies the predominance of subjective judgments. People are not convinced that there is no pattern in the madness and will spend time trying to figure out the hidden rules of the game. Believing they are able to crack the code of the ruler’s favor stabilizes modern dictatorships, as tradition did in earlier times. Autocratic subjective selection differs from its competitive counterpart, because only one view prevails. A person’s opportunity costs can be reduced to zero at the autocrat’s whim, if he is not bound by tradition. Favoritism does not need to rule out innovation. But autocratic favoritism stifles innovation by curbing freedom of expression and promoting conformism. People would not dare to speak their mind, if this could cost them their income and their life. The concept of limited liability does not apply to autocracy. Moreover, members of the incumbent elite lack incentives to innovate, if their position is secure and independent of performance. Innovation is stimulated, by contrast, if market forces determine success or failure, and if losses are limited. Equity finance and limited liability contracts are institutions conducive to innovation. Both autocratic and democratic regimes could set up such institutions but such incentives would impair the power of the autocratic ruler to allocate and reward people according to his wishes. This can explain why freedom of incorporation and entrepreneurial finance are conspicuously absent in most autocratic regimes. This obviously applies to socialism and feudalism, but also to modern societies. Close links between governments, banks and industrial enterprises in many developing countries allow ruling elites to determine the allocation of capital and thereby the fate of firms and its managers (La Porta et al., 2003). Lal observes that making the banking system the creature of the government’s will creates enormous moral hazard problems (Lal, 2004: 131). The banks have no incentive to select credit proposals with respect to expected revenues, but decide on political grounds. As a consequence, governments needed to bail out banks in Korea and Japan, when ‘bad debts’ accumulated. We can argue that both favoritism and competitive markets create uncertainty about a person’s lot. Some people rise, while others fall; fortunes are built and destroyed in financial markets. However, rise and fall would not depend on a ruler’s favor or wrath, but on market forces. Uncertainty created by markets prompts initiative, if big prizes can be won and losses can be limited to opportunity costs. Moreover, competition among investors forces them to be non-conformist and look for new talent. Such search

Democracy, dictatorship and innovation 175 processes are characteristic of both commercial city-states and modern ‘high tech’ districts.

Investments in human capital Some economists have argued that investments in human capital are a good predictor of growth irrespective of governmental form (Glaeser et al., 2004). Most people in dictatorships, however, are uneducated, so dictatorship seems to impede investments in human capital. This can be explained by a limited demand for human capital in autocracies. Education was usually the training ground for officials. Military training was common in warrior states, such as Sparta and in feudalism. Literary training was common in patrimonial and bureaucratic states. Mass education was not sought in imperial China, because of a limited need for officials. Only a few persons were permitted entry to the annual Chinese imperial exams each year. The same applied to colonial India. Moreover, many autocracies of old wanted to further stability by freezing learning. Novelty is only sought, if things are deemed improvable. Many autocratic regimes stopped adopting new knowledge at some point in their history, because they thought they had reached the zenith of their performance. This applies to ancient Mesopotamia, where learning stagnated around 1500 BC. Science, especially mathematics, which had flourished under Hammurabi came to a standstill (McNeill, 1963: 601). The Roman Empire started its cultural decline in the early third century, when its literature, jurisprudence and schools deteriorated (Weber, 1978: 389). Islamic, Chinese and Japanese cultures also became conservative, after they had reached a cultural pinnacle deemed incapable of improvement. Education concentrated on learning by rote and on writing according to established literary conventions. The same applied to Moslem learning, which became canonized after 1200. All innovation in Moslem science was banned after that date (McNeill, 1963: 503). These civilizations did not produce new knowledge and were also reluctant to adopt foreign knowledge. English merchants, who brought a number of new technical devices to China in 1792 found that the Chinese were not interested in anything foreign (Maddison, 2004: 62). The ‘not invented here syndrome’ thus dates back a long time! Some socialist autocracies in Eastern Europe, by contrast, were dedicated to mass education, which constituted the main way to social ascent. The most talented students can be chosen by the regime to fulfill positions in the state apparatus. However, the history of the former USSR countries indicates that high level of schooling does not ensure high returns to investment in human capital. The same applies to India, whose human potential was only utilized, when its markets were opened to trade and foreign investments. Glaeser et al. (2005) argue that high levels of education trigger a change to democracy, as happened in the US, the UK and the former Soviet states. Autocracy will become untenable, when people are better educated, as this

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stimulates participation in civic activities. However, autocracies usually lack civic organizations due to a ban on free incorporation. Freedom of incorporation is essential for dynamic efficiency, which requires a competition of ideas. History indicates that democracy is better equipped to allow such competition than autocracy. Democracy, which lacks institutions conducive to growth and innovation, is not stable. This fits in with the French experience, where democracy did not take root after the revolution of 1793. The many short-lived democracies that arose after countries were freed from colonial power also support this notion. We can argue that both Britain and the US already had institutions favoring commerce before democracy took hold. The same applied to the Netherlands, where economic growth accelerated under Spanish rule. Institutions conducive to market exchange triggered its ‘Golden Age’. The absence of free capital and labor markets precludes the possibility of multiple appraisals in autocratic states. Instead, a single arbiter, who can depreciate and appreciate a person at will, determines a person’s worth. Centralized autocracies leave little room for ‘second opinions’. We can argue that investment in human capital in autocratic regimes suffers from the hold-up problem; an autocrat with great discretionary powers can always renege and depreciate investment in human capital. This applied to the Chinese imperial official, who could be removed from his position at will (Weber, 1978: 1037). Modern despots have executed policies of mass depreciation of human capital. This applies to the exodus of intellectuals from the cities to the countryside in Maoist China and Pol Pot’s Cambodia. Intellectuals were no longer needed, since everybody had to become a farmer in a subsistence economy. The installation of autocracy was thus tantamount to mass depreciation of human capital. Consequently, people will refrain from investing in their human capital, if they expect this to be valued by an arbitrary authority and will invest in political capital instead.

Autocratic government and international trade Autocratic regimes usually preferred monetary surpluses to appropriations in kind. Ancient Egypt, the Caliphate, Imperial China, the Ottoman and Byzantine Empires and the Sultanates are examples of autocratic rule, which relied on the generation of a monetary surplus to run their armies and bureaucracies. Autocracies could create monetary surpluses through policies of exploitation and monopoly as was indicated above. Most autocrats attempted to generate surpluses on domestic markets. State run enterprises usually exploit monopolistic industries that are not subject to international competition. The chartered trading companies of the seventeenth century diverged from this pattern as they wanted to establish monopolies on internationally traded products. The newly emerging European nation-states competed for territories and trade routes among each other akin to the Italian city-states.

Democracy, dictatorship and innovation 177 European expansionist policies differed from those of stable autocracies, which closed themselves off from the outer world at some point in their history. These regimes restricted international trade and suppressed the rise of a merchant class (Weber, 1978: 1101). The Middle East (both the Byzantine and Moslem Empires) led in world trade from the seventh to the twelfth century AD. Byzantine feudalism became centralized, when an urban aristocracy occupied official positions. The decline of the merchants of Constantinople was hastened, when the Byzantine aristocracy became envious of their wealth and demanded their demise. Both domestic and foreign trade became the reserve of foreigners in the Byzantine Empire. Defense of maritime trade routes was contracted out to the Venetians, who obtained a license on Byzantine sea trade in exchange for naval help against the invading Normans in 1082. The Byzantine Empire had no fleet to speak of and depended completely on Venice (Norwich, 1989: 73). The Venetians defended Constantinople, when it was attacked by the Ottoman Empire, but they failed in 1453, which brought the Byzantines under Ottoman rule. Maritime trade was not reinvigorated under Ottoman rule. Jews and Christians were the merchants and bankers of the Ottoman Empire, who were held in low esteem and were heavily taxed. The empires of the Far East either lost their sea routes to European sailors or surrendered them voluntarily. The Portuguese won supremacy in the Southern Ocean in the early sixteenth century, but were supplanted by the Dutch and the English in the late sixteenth century. Chinese social structure teetered on the verge of a fundamental change analogous to the rise of the bourgeoisie in medieval and early modern Europe (McNeill, 1963: 525), but the transformation never took off and social stability was restored, when imperial China secluded itself from the outer world in 1424. China had been a sea-faring nation, but the Ming dynasty forbade all long-distance trade and the construction of seagoing vessels. The fleet was burnt and even the memory of the extraordinary expeditions was effectively suppressed (ibid.: 526). Confucian bureaucracy reinstalled its grip on China and overseas trade was left to foreign merchants. The same applies to feudal Japan that forbade all foreign trade under the Tokugawa Shoguns. The local Samurai were disarmed and their seagoing ships were burnt in 1636. Foreign trade was restricted to the island of Decima and was conducted by the Dutch. Many old autocracies thus forbade their subjects to participate in maritime trade and curbed the rise of an indigenous merchant class. The destruction of their naval capacity prompted them to outsource maritime trade and the defense of trade routes to foreigners. Weber explains these policies by the limits entrepreneurial ventures put on autocratic power and the ruler’s wide latitude for favoritism. ‘He could continuously create wealth and destroy it again by granting favors and confiscating possessions’ (Weber, 1978: 1099). A rising mercantile bourgeoisie, by contrast, would demand property rights, freedom of incorporation and capital markets to valuate their assets, severely limiting the ruler’s discretion. The stable autocrat, therefore, did not

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want to leave investments to an entrepreneurial class, who, in time, would press for representation. Good governance was sacrificed for the continuation of dynastic power. Good government comprises protection of property rights, control of corruption, voice and accountability and is positively related to per capita income (Kaufman and Kraay, 2004). We could argue that good government renounces its powers to single-handedly determine a person’s fate, but leaves this to market forces. An opposite movement – of opening up to trade – can be discerned in our times. The removal of authoritarian rule in the former USSR opened possibilities for trade. Both India and China decided to open up to trade; the first a democracy; the latter a communist state. These developments resemble the erosion of Occidental feudalism and the subsequent rise of city-states and nations in the late Middle Ages and early modern Age. Venetian, Portuguese, Dutch and English merchants traveled to foreign shores to buy and sell goods. They accumulated wealth due to specialization and the diffusion of innovations. The question arises, why did these governments stimulate trade and installed institutions conducive to trade? We can argue that ancient city-states had to rely on trade, because they were too small to be autarkic. This applies with the greatest force to Italian medieval citystates, such as Venice, which lacked a hinterland for most of their history. Another reason is that many city-states wanted to expand in both numbers and wealth. Their policies were the opposite of Sparta’s inertia. Weber stressed that city-states were founded as voluntary associations with the purpose of improving the situation of their members. City-states wanted to grow in numbers to increase their military and economic power. Growth was extended beyond local birth rates due to an open immigration policy. People could escape serfdom by moving to the city. Mobility between cities was also high, as is demonstrated by the wanderings of many scientists and artists of these days. Medieval city-states allowed the incorporation of associations, such as guilds, business enterprises and monasteries. Legislation furthering commerce first arose in the independent city-states of Antiquity and the Middle Ages. People, who join an organization of their own free will, demand to be treated fairly. City legislation had to meet these expectations. Property rights, contract legislation and an independent judiciary were institutions that guaranteed newcomers a level playing field with incumbents. The city-states of Northern Italy experienced rapid growth from 1100 to 1500 (De Long and Shleifer, 1993). Both Venice and Florence knew some form of democracy, whereas Milan and other city-states were mostly under single-family rule. However, all Italian cities prospered during the period under investigation. We can argue that all Italian city-states furthered trade, irrespective of government, since rivalry among cities prompted them to offer conditions of life that were comparable to those of other cities. The medieval city-states emerged under Occidental feudal arrangements, which, in Weber’s words, constituted an extremely decentralized type of domination (Weber, 1978: 1079). Weber developed the hypothesis that

Democracy, dictatorship and innovation 179 Occidental feudalism differed from its Oriental counterparts due to the contractual relationships between lord and vassal (ibid.: 1073–4). Contractual feudalism promoted decentralized imperial organization. The Occidental fief was the vassal’s personal property for the duration of the feudatory relationship. Fiefs and benefices became hereditary, although the successor had to prove his capability for vassalage (ibid.: 1074). Occidental, contractual feudalism, however, obliged the lord to accept a vassal, if the candidate met some prescribed requirements. Moreover, no arbitrary obligations could be imposed on the Occidental vassal. The fief could only be taken back from the vassal in the case of felony, which was decided by a collegiate vassal court (ibid.: 1079). Alienable property rights gave Occidental vassals political power. French benefice holders were represented in parlement and could organize a general strike in the form of a mass resignation, if they disagreed with the ruler. These benefice holders stopped having a voice the moment the king appeared in their midst. The king could formally impose any legislation he wanted, but their property rights allowed the benefice holders to question the validity of the royal claim and impose their own authority. Alienable fiefs had a market-determined value, which forced the French king to compensate his vassals for the surrender of their benefices. Lacking the resources to meet their demands, Louis XV could only give in to their wishes (ibid.: 1039). Occidental vassals were usually exempt from making contributions to the lord, which forced Occidental feudal lords to obtain their incomes largely from privileges granted to cities. Attempts by Occidental feudal rulers to increase centralization of taxation faltered, when they met fierce opposition in the parlement or Estates General. Hence, the Occidental feudal system established property rights, which gave local rulers a large degree of autonomy. Feudal lords used their property rights to maximize their revenues at the expense of their subjects. This differed from the city-states that used their privileges to expand their economies through commerce. Oriental feudalism, by contrast, was not contractual. Relationships between lord and vassal were either more personal (Japanese Samurai) or more detached than in the Occident. Oriental feudal rulers increased central power by establishing a standing army. Islamic rulers became independent of their knights, when they instituted personal slave armies of Turkish and Negro slaves, which replaced the tribal Islamic army in 833 (Weber, 1978: 1015). Ottoman power was also supported by a slave army, which was recruited from the Balkans (the Janissaries). Such armies required payment of part of locally appropriated surpluses to the imperial center. Central appropriation was also crucial to Chinese autocracy, which relied on a standing army. A large share of the Chinese surplus went to the imperial center and its bureaucracy (Maddison, 2004). Occidental, contractual feudalism contrasted with the favoritism featuring Oriental arrangements. Property rights of benefices given to Chinese Mandarins, officials of the Sultanate and the Ottoman Empire were limited due

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to the great discretionary powers of the ruler. Arguably, discretionary rule can only prevail, if alienable property rights are lacking. A benefice that can be withdrawn by a unilateral act of the ruler is not a property, but a personal privilege.

Democracy and taxation Kings wanted to replace feudalism by monarchical bureaucracy. Such replacement emerged haltingly in the European nation-state. Tax farming by local lords was replaced by bureaucratic tax collection. Ferguson depicts how autocratic appropriation through monopoly of state industries and exploitation of labor was gradually replaced by democratically approved income taxes (Ferguson, 2001: Chapter 2). The road from autocratic appropriation to democratic bureaucracy was, however, a lengthy one for most nations. Representation that is limited to wealthy elites tends to put the tax burden on the commoners by imposing indirect taxes; such as sales and excise taxes. But indirect taxes also triggered opposition. Consequently, governments came to rely on new financial instruments to cover military expenditures. The founders of the Dutch East India Company wanted private enterprise to pay for warfare, a policy that was later copied by the French with disastrous results. State involvement in the finance of business ventures led to financial crises like that of 1720 in England. The struggle between nobles and king was resolved in favor of the English nobles, when Parliament obtained the exclusive authority to raise new taxes and the right to audit government spending (ibid.: 81). This differed from French experience, where the nobles refused both to pay taxes and to give council to the king. The French Estates General convened less than ten times between 1355 and 1789, which points to the unwillingness of nobles to accept royal proposals (ibid.: 81). Their unwillingness to discuss matters can be explained by the great authority of the French king. He could only be made to listen, when vested interests threatened to withdraw their allegiance, as happened in 1774. English nobles, by contrast, could discuss affairs of state with the king, which made them co-responsible for the outcomes of his actions. Participation in decision-making also entailed paying for expenses akin to business undertakings. Representative democracies thus could use income taxes to raise revenues. Venice imposed an income tax: the decima. The first English attempt at an income tax was a 20 percent levy on all incomes in 1692. However, many of these income taxes were later repealed. They were often imposed as temporary measure in times of war. However, this did not prevent the English government from becoming heavily indebted in times of war. This applied with even greater force to France and Spain that had not built up a tax-collecting bureaucracy. Britain had a comparative advantage with respect to raising money in the eighteenth century due to its tax-raising capacity, which cemented its creditworthiness.

Democracy, dictatorship and innovation 181 Medieval bankers granted loans to individual rulers to finance their wars. The rise of city-states and nation-states allowed the issue of public debt guaranteed by parliament. But many nation-states defaulted on their debt. France under the ancien re´gime and Spain are cases in point. Spain defaulted 14 times on her debt between 1557 and 1696. Pre-revolutionary France defaulted 11 times on its debt between 1714 and 1788, which was largely due to its inability to collect taxes (Ferguson, 2001: 141). Another way to reduce the debt burden was by devaluing the currency. Both France and Spain became non-creditworthy debtors and could only raise debt at elevated interest rates. Britain, by contrast, was a trustworthy creditor and could raise much higher debts at lower costs than her rivals. The Italian city-states were also considered creditworthy. Yield on the consolidated debt of Genoa in the second half of the fourteenth century fluctuated between 5 and 12 percent. In fifteenth-century Florence, yields ranged between 5 and 15 percent. The Habsburg regime’s credit rating, by contrast, declined due to successive defaults from 18 percent in the fifteenth century to 49 percent by 1550. Dutch financial innovation made yields fall from 8 percent in 1580 to 2.5 percent in the 1740s (ibid.: 171–2). Ferguson argues that the ability of Britain to raise public debt at relatively low costs explains the rise of Britain as a global power in the eighteenth and nineteenth centuries. Britain was also victorious in most wars, which increased her tax-raising capacity.

Imperialism and international trade Naval capacities of city-states and nation-states were used to protect trade routes. We noted above how Oriental empires licensed maritime trade to foreigners. By doing so, they outsourced both trade and the military protection of trade routes. We already pointed to the Venetian defense of Constantinople. Chinese, Indian and Japanese maritime trade was licensed to the Dutch and the English, who established trading posts and forts along their coasts. The conflicting demands of revenues generation by feudal lords and centralized control led autocrats to license trade to foreigners. This curbed their incomes, but prevented the rise of a merchant class. However, outsourcing forced them to adopt the institutions conducive to trade that these foreigners required. Moreover, foreign traders did not want to be expropriated and defended their structures against attacks. The Indians came to outsource both defense and administration to the English. The British East India Company got permission from the Mogul Emperor to establish trading posts in Madras, Bombay and Calcutta in the seventeenth century (Ferguson, 2003: 27). The Emperor Aurungzeb wanted to close trade and expropriate the English merchants in 1698. The English, however, prevented this from occurring. Persian and Afghan invasions brought the Mogul Empire to the brink of collapse in the 1740s. Central rule was further undermined, when local rulers carved out their own kingdoms. The English defended their trading posts with armies, which were largely recruited

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from the indigenous population (Ferguson, 2004: 29). The English monopolized Indian foreign trade, after defeating the French, who also claimed India. Robert Clive became Governor of Bengal in 1757, with local Indian support after he won the Battle of Plassey (ibid.: 36). The British East India Company was granted the civil administration of Bengal, Orissa and Bihar under the Treaty of Allahabad, which gave the English the right to tax their subjects. The crumbling of central power under the Manchu dynasty in China in the nineteenth century also gave Western powers leverage (Lal, 2003: 285). Hence, military protection of trade routes could lead to imperial control in cases where local government was unable to defend its territories. Institutions in many former colonies still bear the stamp of their former rulers. The beneficial effects of British colonization have been demonstrated by several studies. Lal emphasizes the beneficial effects brought about by the Pax Britannica, such as free trade, protection of property rights and the Gold Standard (Lal, 2004: 107). The British Raj imposed a tax burden of only 6 percent on the Indian population, while the Moguls had levied a 16– 18 percent tax (ibid.: 4). Indian per capita income grew under British administration after it had been stagnant for centuries, although at a snail’s pace. Imperial properties were protected by British legislation, whereas local rules continued to prevail in other realms. Interference with local traditions met with great resistance, as the British experienced when they wanted to stamp out customs such as widow burning (sati) in India in 1837 (Ferguson, 2003: 143). International trade prospers, when imports are not taxed more heavily than domestic goods. The British embraced this principle, when they repealed the Corn Laws in 1848. Britain further promoted trade by choosing a unilateral free trade stance. It opened its markets to foreign products without demanding reciprocity. International trade grew rapidly under the Pax Britannica, which lasted from 1850 till the end of World War I. Lal argues – in agreement with Olson – that all empires, from Mesopotamia to the Mongol empires, brought peace and prosperity, because they restricted the damages due to war (Lal, 2004: 36–7). Long-lasting empires thus brought stability, but most empires were not capable of raising productivity after they had exhausted the benefits that a larger scale brought. The impetus to innovation was kindled by the desire to protect the status quo. The example of the Pax Britannica indicates that property rights need to be guaranteed, before foreign investment spirals. Glaeser et al. (2004) argue that some dictators have chosen to protect property rights in order to generate prosperity. South Korea is mentioned as an example of a benevolent dictatorship, which chose capitalism and property rights after 1950, to boost the country’s growth (ibid.). We can argue that property rights were respected under the Pax Britannica due to Britain’s military force. We can argue – in the same vein – that South Korea had no choice but to open up its country to trade, as in effect it was a US protectorate. The same argument applies to

Democracy, dictatorship and innovation 183 Taiwan. Singapore, as a city-state, cannot opt for an autarkic policy, as it is too small to do so. The recent rise of China and India is not based on military protection by Western forces, in contrast to Taiwan and Korea. China chose a policy of opening up to foreign trade and investment in 1978. Direct foreign investment to China has grown rapidly since 1995 and is concentrated in exportoriented companies and advanced technology sectors. More than half of all Chinese exports in 2004 came from foreign investments (Preeg, 2005). Chinese investments in human capital have accelerated since 1995. Chinese R&D expenditures grew by 22 percent per annum from 1995 to 2002. Chinese science doctoral degrees increased by 14 percent per annum from 1995 to 2001. Arguably, this acceleration happened in response to foreign demand for educated workers. Autocratic regimes might want to open up to foreign trade to stimulate technology transfer through foreign direct investment. But foreign investment that is not protected by home-grown legislation and courts is considered risky. Moreover, foreign investors will only want to invest, if they can freely sell on domestic markets and export their wares. Such policies would restrict autocratic regimes to appropriate surpluses. Hence, openness would limit the options of autocratic rulers. Some part of the surplus needs to be paid to workers who have come to the cities, while foreign investors also want their due. We can argue that refraining from rent appropriation would dismantle the economic reason for dictatorship. However, part of the productivity increases due to foreign investment can be taxed away. Government can also steer resource allocation by their control of capital markets and exchange rates. China steers foreign investment by giving tax incentives to high technology firms. Several hundred joint US/China R&D facilities were built in 2004. Allowing foreign investment implies the entry of alternative bidders for human capital. Chinese people can earn many times their former agricultural incomes in the cities in the new industrial zones. Foreign direct investment and the technology transfer that accompanies it can bring China up to the technological frontier. Western innovation could, however, be curbed, if China and its allies do not respect intellectual property rights.

Conclusion The discussion of what triggers the emergence of good-for-growth institutions has intensified recently. Both democracy and dictatorship seem capable of guaranteeing property rights, but also of expropriation. Most autocracies of old were wary of innovation, as this could undermine their political power. Both trade and investment in human capital have figured as candidates to explain good-for-growth institution-building. I would argue that trade is the more powerful explanation. International markets can solve the hold-up problem of human capital investment inherent to allocation

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undertaken by a single authority. Dictatorships will open up to trade, if they want to boost both growth and technology transfer. Political and economic theories of institution-building clash at the moment that rulers let their own interest prevail over efficiency considerations. Studies have demonstrated which institutions and governance structures stimulate growth. Developing nations can copy these institutions. The same applies to modern technology. However, history testifies time and time again that rulers voluntarily decline to adopt ‘best practice’ technologies and institutions. That is because growth entails change and therewith a reshuffling of social and economic positions. Schumpeter pointed out that creative destruction due to market forces is a positive sum game as gains exceed losses due to a devaluation of assets. This, however, does not apply to expropriation by state forces. Investors who expect such expropriation will refrain from investing. The history of economic growth thus points out that growth prospers, when rulers refrain from pursuing the interests of a dominant family or group. A monopoly strategy will thwart both static and dynamic efficiency. The same applies to an exploitation strategy that relies on the involuntary deployment of labor. The economic explanation of institution-building thus only prevails, if it squares with political conditions. Cities that rose from declining empires had to make membership attractive, which led to the domination of economics over politics. Autocracies often avoided international trade to preserve political power. But the benefits of participating in international trade have convinced some hitherto closed economies to open up to trade. However, history is rife with examples of thriving nations that lost global prominence due to a loss of autonomy, inertia and the emergence of authoritarian regimes. Institutional development, therefore, is not a linear process, but proceeds through boosts, interruptions and backlashes.

10 Waning and emerging empires

Introduction Political governance can take many forms, from representative democracy to autocratic rule. The concept of empire refers to military control over territories that previously were autonomous. Inequality is central to the concept of empire. This applies primarily to inequality of military power between rulers and ruled. Inequality can extend to social status, political rights and income between people in the metropolis and the periphery. Inhabitants of the mother country may be wealthier; have more political rights and a higher social status than people of the periphery. History records many empires, ranging from the Mesopotamian, Persian, Roman and the British, Dutch, French and Portuguese empires to the twentieth-century empires of Nazi Germany and the Soviet Union. However, the character of these empires differs considerably. The literature distinguishes between land-based and sea-borne empires, formal and informal empires and liberal and illiberal empires. Empires can aspire to military dominance along a vast, contiguous strategic frontier. This applied to land-based empires like the Persian and the Mongol Empires. Empires, whose reign was based on the control of sea routes, did not have clear frontier lines. The European seaborne empires of Athens, Venice, Spain, Holland and Britain are cases in point. The concept of formal empire refers to government by foreigners. Arguably, all empire is formal to a certain extent, as it is based on military power. This distinguishes empire from direct foreign investments by private enterprises that lack military protection. Formal empire can be restricted to military strategy and foreign policy or also encompass local government. The extent to which empire is formal differed between times and places. Sea-borne empires grew out of private ventures that constructed fortifications and harbors on foreign shores to fend off pirates and rivals. Early imperialist ventures of the East Indian trading companies were restricted to small trading posts along the Indian Ocean and the China Sea as the naval guns of the English, Dutch and Portuguese did not allow them to extend their rule inland. ‘In this early phase of their interaction with the East,

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European relations with the native powers were one of caution and equality, based on mutually beneficial trading interests’ (Lal, 2004: 27). Dutch and English rule in Asia became more formal over time. Local governance structures, however, were largely kept intact in countries like India and Indonesia in contrast to the empires in the Americas. Colonization constitutes a strong form of formal empire and involves the establishment of new settlements by large and organized groups of migrants in occupied territories, as happened in the colonies of white settlement in America and Australia (Ferguson, 2004: 169). The concept of liberal empire refers to empires that promote peace, free trade and free navigation. The nineteenth-century British Empire is hailed as an empire that installed the first liberal international economic order (Lal, 2004: xx). Illiberal empire, by contrast, exploits subjugated peoples. The distinction between liberal and illiberal empire matches the distinction between market and autocratic appropriation. Autocratic imperial appropriation uses monopoly and exploitation to appropriate revenues on foreign territories, which contrasts with commercial appropriation using markets. Formal empire can be either liberal or illiberal, depending on whether military force is used to subjugate people or to protect people and structures. The various forms imperialism took cannot be explained by the imperator; Britain and Holland applied different types to different countries and times. The magnitude and character of investments that were required in different situations might explain the various forms of empire. Venetian investments in ships and cargoes were locked up for a shorter time than Dutch and English investments in East Indian ventures. The Venetian empire was weakly formal. Empire became more formal, when the amount of investments increased, while the risk of expropriation was considered high. The larger amount of sunk investments in Asian and American trade entailed the installation of state chartered monopolies in both Britain and the Netherlands. The example of Egypt also illustrates the relation between sunk investment and empire. In 1876, the Egyptian government comprised an English Finance Minister and a French Minister of Public Works. European involvement in Egyptian government accompanied investments by the French and English governments in the Suez Canal and the Egyptian debt. An attempt to remove foreign influence by Arabi Pasha, who had seized power through a military coup, prompted the British to stage a military intervention, which led to the deposition of Arabi Pasha and his government in 1882. British military intervention led to the deployment of British troops in Egypt (Ferguson, 2003: 233). Egypt had become a British protectorate, harboring a Britain-friendly government. This deployment ended in 1956, when 80,000 British troops were withdrawn from the Suez Canal military base in Egypt on the request of President Nasser, who had gained power through a military coup in 1952. The nationalization of the Suez Canal in 1956 prompted Britain (and France) to invade Egypt. However, the US

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refused to support the initiative and the campaign failed, which forebode the collapse of the British Empire in Africa (ibid.: 354–6). Formal empire, therefore, is voluntary, if it was installed on the request of local rulers who called in the help of greater powers to protect them. The Indian Mogul, who sought British help in the 1740s, is a case in point. Venetian rule over Mediterranean islands was also often solicited in order to prevent rulers who were considered less benign from seizing power. In 1881, the Kings Bell and Aqua of the West Cameroon’s River in Africa asked Gladstone, the British Prime Minister, to become part of the British Empire, which was, however, rejected (Lal, 2004: 46). But military intervention to install friendly regimes as Britain did in Egypt requires force to become voluntary. Likewise, another regime change can make empire involuntary, as happened when Nasser appeared on the Egyptian scene. Egypt stopped being a British protectorate, when the government built up its own military capacity. We can, therefore, distinguish between protectorates and occupied territories. Another question involves whether imperial relationships lead to greater dependence or independence. Moreover, how do democracies relate to one another militarily? The concept of empire has gained weight lately due to a debate on US foreign policies after the collapse of the Soviet Union. Should the US assume the role of liberal empire in the twenty-first century, akin to Britain’s role in the nineteenth? Moreover, is empire a viable concept in the twenty-first century?

The benefits of liberal empire Britain promoted a liberal, international, commercial and financial system that spread free trade and promoted peace in the nineteenth century after Napoleon’s defeat (Ferguson, 2004: 9). British rule was beneficial, because it installed the rule of law in its colonies and invested in infrastructure and education (ibid.: 25). Both Ferguson and Lal advocate a return of liberal empire to boost prosperity and peace. US hegemony would provide public goods, such as peace and the diffusion of ‘good-for-growth’ institutions. Both Ferguson and Lal depict the world at the beginning of the twenty-first century as unipolar, the US being the only world power. Both fear an a-polar world, which would resemble the darkest time of the Middle Ages. The world has always known empires, which brought peace and prosperity from the times of the Egyptian Empire that ruled for almost 3,000 years to the British Empire in India, whose rule lasted 190 years. Lal argues that these empires had higher standards of living than the eras that preceded and followed imperial rule. Per capita income decreased after the fall of the Roman Empire and it took more than 500 years to achieve the level that was obtained under Emperor Augustus again (Lal, 2004: xxiii). India under British rule did better than China in the nineteenth century. Many Sub-Saharan countries saw their economic performance deteriorate after independence. They

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both argue that British colonies did relatively well in the nineteenth century. This can be explained by modern economic growth theories that stress the importance of ‘good’ institutions for economic growth. The British Empire performed the role that the International Monetary Fund fulfills nowadays. It wanted to stabilize currencies and practiced ‘free trade’. Liberal empire needs to be distinguished from empire, whose good deeds are restricted to bringing peace where there was anarchy. This is the main benefit of empires that were great civilizations like China, India, Greece and Rome (ibid.: xx). Empires bring peace, when they impose order and stability. The Pax Britannica emerged, because Britain was not challenged by other empires. This differed from earlier and later periods, when Britain fought with other European nations over the control of trade routes and territories. We can, therefore, argue that it was not empire but hegemony that brought peace in Europe after 1815, though not to other parts of the world. The British Empire was at its pinnacle in 1900 and ruled large parts of Africa, Asia, Australia and the Americas. Imperial rule had evolved from largely informal to formal in Asia and Africa. A reverse development took place in the colonies of white settlement, which had obtained either self-government or dominion status at that time (Ferguson, 2003: 250). British institutions were also adopted by Latin American countries like Brazil and Argentina after they obtained independence in the nineteenth century. Ferguson dubs this de facto imperialism, which took the form of foreign investments and free trade agreements (ibid.: 245). He argues that formal empire was better for investment than informal empire based on agreements. This transpires from the higher risk premiums that Latin American investments bore. He explains the huge capital outflows from Britain to the rest of the world in the nineteenth century by the high returns these foreign investments brought in the days of empire. About 30 percent of British overseas investment went to Asia, Africa and Latin America between 1865 and 1914. Most was portfolio investment in infrastructure; especially railways and in plantations to produce tea, coffee, cotton, indigo and rubber (Maddison, 2001). The British Empire succumbed in the twentieth century due to exhaustion caused by fighting two world wars. Both Ferguson and Lal deplore the end of the age of liberal empire and would welcome an encore. They advocate the return of liberal empire along British lines in order to boost peace and prosperity around the globe (Lal, 2004; Ferguson, 2004). The situation at the beginning of the twenty-first century after the collapse of the Soviet Union is similar to that of 1900, when Britain was the sole world power. However, the US is an empire in denial (Ferguson, 2004). The concept of liberal empire does not specify how much the imperial center should invest in the governance of peripheral countries. This could amount to nil, if all investments were private as in the age of the trading companies, or it could comprise public investments in military, administration and infrastructure. Moreover, it also does not specify the status of dependent nations in such an empire. Would they have the status of dominions

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with armed forces of their own? Would they be protectorates without a military, but with the deployment of imperial troops on their grounds? Moreover, will a US empire stimulate private investment above levels that would have resulted in its absence? And if this were the case, would the US then benefit from imperialism? The jury is still out on the question, whether British imperialism paid off. Adam Smith had already proclaimed in 1776 that imperialism did not benefit Britain as the same benefits from trade could be obtained without the empire. The anti-imperial party in Britain also held the view that the fruits of foreign trade and investment could be picked without investing in the empire (Lal, 2004: 52). However, the British Empire was empire on the cheap as it only spent 2.5 percent of its national product on defense (Ferguson, 2003: 247). Ferguson argues that these investments were worth their while, since they reduced the risk of investing abroad. But the inequality of empire seemed to have hampered investment. This is illustrated by the fact that the majority of British capital outflow in the nineteenth century went to Western offshoots like the US, Canada, Australia and New Zealand. These countries were either independent or had obtained dominion status. Starting with the Roman Empire, public costs of colonialism have exceeded public benefits in many cases. About a third of the revenues of the Roman Empire came from tributes paid by Egypt, Syria, Gaul and Spain. However, the costs of maintaining the Roman Army exceeded those benefits. The Spanish Empire siphoned 121 million ducats from the American territories between 1548 and 1598, but the fighting in the Netherlands alone cost more than double that amount (Ferguson, 2001: 398). Many imperial ventures were also commercial failures and required government support. The Mississippi Company is a case in point. The Belgian king Leopold’s mining adventures in the Congo also failed. Bankruptcy was only prevented by a government bail-out (Lal, 2004: 81). The share price of the British East India Company fell from an all-time high of 280 in 1767 to 120 in 1785, which was far below its emission price of 195. The price increased by fits and starts after that date. People who invested after 1767 lost money on their investments (Ferguson, 2003: 47). The decline of share price began, when the East India Company took over the administration of the Bengal, Orissa and Bihar provinces in 1767. After 1800, the opium trade was the main source of income of the East India Company, whose revenues just sufficed to pay the interest on its debts in the first half of the nineteenth century (ibid.: 166). The Dutch East India Company had been profitable for a long time, but it stopped paying dividends in 1781. Government aid could not stop its demise in 1798. Formal empire had more chances of being profitable, when a market for imperial possessions arose. The United States bought large amounts of its territory. The Americans bought Louisiana in 1803 for 15 million from the French and the Spanish by offering them government bonds. Neither of the two previous owners saw any strategic value in these possessions. Other

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Southern states like East Florida, Oregon, Arizona and New Mexico were also acquired for cash from Spain, Great Britain and Mexico. Alaska was bought from the Russians in 1867 for $7.2 million (Ferguson, 2004: 40). Their bid for Canada, however, failed. The United States expanded its territories overseas in 1899, when it obtained the Philippines and Cuba in the Spanish American War. The United States paid Spain $20 million for the Philippines. US rule was contested by Philippine revolutionaries. US overseas territories, apart from the Philippines, encompassed several islands that were desirable as naval bases: Samoa, Guam, Midway and Hawaii, which became the fiftieth state in of the Union in 1893. The Philippines became independent in 1946. and the other islands concluded contracts of free association with the US. The young Union, after extending its territories on land, thus behaved similar to other seaborne empires that wanted to protect their maritime trade routes by establishing strongholds on islands.

Empires and alliances The nineteenth century saw the rise of formal empire in Africa and Asia and the devolution of empire in the colonies of white settlement. The white man’s burden prompted Europeans to spread their government to areas that were deemed incapable of self-government. These were mainly the nonwhite colonies in Asia and Africa, where formal empires were established in the nineteenth century and Ireland, which had a parliament before 1800, but was denied home rule until 1914. European influence in Africa was first restricted to the trade posts that were established by the English, British and Dutch on the Gold Coast, Ghana and Lagos. These were mostly used for the slave trade in the eighteenth and early nineteenth centuries. The ownership and investments in diamond and gold mines in inner Africa after 1850 led to the rapid colonization of Africa, which was transformed from a continent populated by numerous tribes into 40 nation-states by 1900. The continent was carved up among the European nations – Britain, Prussia, France, Italy and Belgium – with or without the consent of local rulers. The pioneer work was left to private corporations, but after they were established, the government stepped in and installed some form of colonial rule (Ferguson, 2003: 299). Dutch imperialism took on a more formal character, when it was revived under King William I in 1815. The Dutch introduced the Culture Regime in 1830, which obliged all planters to produce export products on one-fifth of their plots, for which they received planters’ wages. Dutch administrators received a percentage of revenues. The Culture Regime was abolished in 1870 to create more room for Dutch business that produced new crops like sugar, rubber and tobacco. A war of expansion was fought after 1870 to open up ever more territories for Dutch plantations and oil explorations. Building a formal empire in Asia and Africa contrasted with British policies in the colonies of white settlement, which evolved to dominion

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status in the nineteenth century. Some colonies were thus upgraded in the nineteenth century to a status that was more or less equal to that of the motherland, whereas others became more subordinate. Britain’s relations with its dominions constituted a form of voluntary empire, in my view, which borders on alliance. It resembles the leadership of ancient Athens, where Athens led the other Greek city-states in a unified effort against the Persian Empire in the fifth century BC; the Delian League (Ferguson, 2004: 9). Ferguson depicts alliance as a form of empire. But I want to suggest that alliance differs from imperial governance. Members of an alliance contribute to the common military force and participate in decision-making. The democratic character of alliance is demonstrated by the Delian League whose members all had one vote. But the League developed into an empire, when conquered islands became colonies (like Scyros) or cities were forced to join the league. The city of Carystus that benefited from the league’s protection was forced to enter and pay tribute to Athens. Members were also not allowed to leave the league. Naxos wanted to secede and was enslaved. The same happened to Thasos and Lesbos that revolted against Athens. The early league members paid their share in ships and men, but members that joined later paid their share in the form of monetary contributions (Wikipedia). Athens received ever more tributes from the league members. The treasury was first located at the island of Delos, but was later moved to Athens. Pericles’ rivals saw this as a means to appropriate the league’s contributions and use them to build public works like the Parthenon and the Acropolis. Hence, alliance turned into empire, when contributions took the form of tributes and decision-making was centralized. Both Athens and Sparta vied for allies. The movement of Greek cities between the two leagues triggered the Peloponnesian War that led to Athens’ defeat and subsequent decline. Empire can thus emerge out of alliance and alliance can grow out of empire. Alliance requires equality among its members. Military and economic superiority sits uneasily with a one nation/one vote system, as was the case in the early Delian League. Moreover, the voluntary character of alliance allows nations to secede, which hampers its stability. Alliance also requires non-interference in domestic politics or it turns into an empire. Military participation is another important feature of alliance. A nation that relies on protection by foreign troops stationed on its territory is a protectorate. Mediterranean islands like Corfu were subsequently protected by the Venetians, the Turks and the English, who also governed the island. An imperial possession is usually not a democracy. Seaborne empires like Athens, Venice, Genoa, Holland and Britain had some form of democracy at home, but not in the territories under their control. The quintessential inequality of empire involves that government of imperial territories is not democratic. Alliances, by contrast, feature equality among their members. Empire thus ends, when democracy steps in. Member states downgraded to protectorates when the Delian Leage took on imperial features. They were no

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longer part of an alliance that presumed collective decision-making and a concerted military effort. Democracy requires that people have a voice and is, therefore, hardly compatible with the subordination of one nation to another. Democracies can either organize their own army or join a military alliance. Democracy can be temporarily stalled, when foreign assistance is called for in a situation of emergency. Such interim management would turn into autocracy, if the people could not depose the ruler, as happened in sixteenthcentury Florence, when the Medici came to rule under foreign auspices. Most empires were of long duration, whereas alliances were often shortlived. It was mentioned above how the Delian League fell apart due to Athens’ imperial policies. Other European leagues also proved to be unstable. The Italian city-states concluded many pacts among them, the papacy and other European powers in the sixteenth century. However, shifts of allegiance were swift. Pope Julius II created the League of Cambrai between the papacy, France, Spain and the Holy Roman Empire against Venice in 1508. The Alliance collapsed in 1510 due to strife between the pope and the French king. Pope Julius then allied himself with Venice against France. The papal–Veneto alliance was extended to comprise Spain, the Holy Roman Empire and England to form the Holy League in 1511, which drove the French from Italy in 1512. Later the Venetians allied with the French (1513–16) and regained the lost territories so that the 1508 map of Italy was restored in 1515 (Wikipedia). The Italian wars of the sixteenth century were inter-imperial fighting for the control of cities. Eventually Italy was redistributed among the large powers. Only Venice remained independent.

The mission of empire The mission of the trading companies was to make a profit for their investors. They did not intend to bring Western culture to the Orient. By contrast, early Dutch and British settlers often went native at the times of the East India companies, marrying native women or taking them as concubines. The Victorian age increasingly legitimized imperialism by notions of a mission to spread Western civilization (Ferguson, 2003: 113). Certain behavior and practices were deemed unethical and should be banned. Slavery was deemed unethical by Christian sects like the Quakers and Methodists. Slaves were sent back to Africa by English merchants to start a free life in Sierra Leone under British protection. The capital was appropriately called Freetown. The slave trade was abolished in 1803; slavery in 1833 (ibid.: 118). Slavery was abolished in the puritan Northern United States in 1780. The impetus to convert India to Christianity came from the same Protestant source as the opposition against the slave trade (ibid.: 138). Christians wanted to stamp out Indian practices they deemed barbaric such as infanticide and widow burning. This policy differed diametrically from the policy pursued by the East India Company, which forbade missionaries to preach to Indians

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(ibid.: 135). In 1813, however, the company’s charter came up for renewal and the company’s control of missionary activities was lifted. Dutch ethical policy in Indonesia began in 1901, when Queen Wilhelmina announced that the Dutch accepted an ethical responsibility for the welfare of their Indonesian subjects. The Dutch invested in irrigation projects, education and health care, but on a small scale. People were forced to relocate away from overpopulated Java to Sumatra and other parts of the Archipelago. However, only a tiny fraction of the population of Java was transferred. The ethical policy ended in 1930 with the beginning of the great Depression. Ethical policies were inspired by the idea that all men are equal, which rules out slavery. However, equality would also undermine empire, which rests on the inequality of rulers and ruled. Ethical policies would thus change empire into alliance. The Indian Army largely consisted of native Indians, who also fought in wars outside India. Some 60,000 Indian soldiers were killed on the battlefields of World War I. Half of all soldiers who were mobilized by Britain in World War II were from the Dominions; especially Canada and Australia, and also from India. We can, therefore, argue that the British Empire already had features of an alliance in the first half of the twentieth century, when a large part of its military came from outside the homeland. Soldiers of the Indian Army were recruited from the high warrior castes, but remained subordinate to their British superiors. This failure to allow open recruitment for the highest offices led to nationalist ‘creole’ revolts in both India and other European colonies, which eventually destroyed the empire (Lal, 2004: 40). But a dominance of Indians in the highest ranks of administration and army is incompatible with empire, in my view. Military participation would have made India ripe for home rule similar to the white dominions. However, the formal empire was strengthened in 1857, when the British Crown took over Indian administration from the East India Company after a mutiny. The Crown installed a bureaucratic system to govern India: the Indian Office. The Indian Mutiny of 1857 had religious features as the native soldiers of the Indian Army protested against the alleged vilification of their religion because they were forced to use animal fat to lubricate their cartridges. British women and children were killed in the turmoil, as were thousands of British servicemen. The mutiny changed the atmosphere of British–native relationships from redemption to revenge. Many mutineers were killed in the aftermath. The mutiny, however, did not deter but heightened the missionary effort to India as the only possible way to civilization. The large participation of Indian soldiers in the two world wars sparked the liberation movement that was led by Mahatma Gandhi. The Indians were promised responsible Indian government in 1917 by Sir Edwin Montagu. India obtained some form of representation in that year, but this was representation without power (Ferguson, 2003: 330). The resistance went from passive to active and a demonstration was violently crushed at Amritsar in 1917. The massacre of Amritsar took 379 Indian lives.

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Arguably, military participation is a necessary, but not a sufficient condition for a country to move up to alliance status. Members of an alliance need to agree on basic values to be able to fight for a common cause.

Imperial rise and decline Economic and military power Empire implies that the metropolis is economically more advanced than the dominated regions. The Venetians, Dutch and English had a relatively elevated standard of living in their heydays. This triggered the hypothesis that economic and military might are intertwined (Kennedy, 1998). The wealthiest nation can spend most on the military and, therefore, wins the war. The argument goes that the Allies defeated the Axis powers in World War II, because the US had the economic advantage, but history provides us with many examples of economically backward nations that were militarily superior to more advanced societies. The nomads of the steppes who invaded Mesopotamia and China are a case in point. The Mongols invaded Asia and Europe and established a rule over these territories that lasted from 1206 till 1503. The Muslim surge of the seventh century also did not rest on economic supremacy. The Muslim victory of the seventh century cannot be explained by either economic or military strength, but only by guerilla tactics and the strength of their religion (Lal, 2004: 23). The Kennedy hypothesis does not seem to stand the test of time with respect to these wars of conquest. It also does not apply to the seaborne imperialism of the old city-states. The Athenians, Venetians and Dutch were wealthy but small in numbers, when they established their empire. The British defeated the French in spite of their smaller numbers. Ferguson’s hypothesis of British hegemony states that Britain had the financial advantage as it was more creditworthy than France. France had lost its credibility by defaulting on its debts. I want to argue that the outcome of war cannot be predicted with any accuracy. This seems obvious, since nobody would want to wage a war it is sure to lose. Consequently, war would be unnecessary, if the outcome were certain. Nations would subject themselves voluntarily to the hegemon to spare themselves the ravages of war. But a hegemonic power will always provoke rivals who want to topple it. Attacks on established empires were not without success in the past. Charismatic warlords created a following that lived on booty and were convinced of their success. The nomads from the steppes were convinced they could beat more wealthy adversaries; the Spartan soldier did not acknowledge defeat; the Muslim fighter was convinced of victory. The Boers of South Africa, who fought a long time against the British, also believed in the help of non-earthly powers. So, history is full of unlikely winners and losers of military battles. This resembles start-ups that want to challenge a dominant firm. Corporate history is rife with unlikely winners and losers. The proverbial fight of

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David against Goliath is repeated over and over again in the corporate world. Microsoft overtook IBM, but cannot rest on its laurels as it is itself challenged by Google. Economic competition is a positive sum game. Entrepreneurial investments dry up, if they are expected to bring negative profits. Investments in empire, however, are often continued beyond profitability. The costs of victory The wars European nations fought against each other were more costly both in money and human lives than their overseas ventures. The four most lethal conflicts in modern history have been World War II and World War I, the Thirty Years War and the Napoleonic Wars – in that order (Ferguson, 2006: xxxv). Some wars brought gains to the imperial victors as occupied nations were taxed and indemnities were paid by the losers. Napoleon placed high levies on conquered territories such as the Netherlands, but the revenues were exceeded by the indemnities that had to be paid after Napoleon’s defeat at Waterloo (Ferguson, 2001: 398). Napoleon’s defeat brought the victorious allies indemnities of about £78 million, but Britain alone had paid almost this amount as subsidies to her continental allies (ibid.: 398). The reparations that were paid after twentieth-century defeats were even less, if compared to the costs of war. The victorious allies demanded $31 billion in reparations from Germany at the end of World War I, but the victors’ total war expenditures had amounted to $58 billion, not including the loss of human lives. The Germans did not pay more than $4.5 billion between 1919 and 1932, when payments were frozen. This was almost the amount they managed to borrow from the United States in that period and never repaid (ibid.: 399). The resolution of World War II was even less economically successful for the victors. The total amount of reparations payments asked from the defeated Axis powers was only $7 billion. The total US war efforts amounted to $275 billion and that of Britain $91 billion. Marshall Aid constituted a strange form of reverse reparations. For democracies, therefore, it is clear; war does not pay (ibid.: 399). Twentieth-century democracies did not use their victory to milk the conquered nations. Nineteenth-century imperial victors, by contrast, wrought huge sums from the conquered nations. This applied to Napoleonic France, but also to Russia, which managed to wrest enormous sums of money from Turkey in the peace settlements of 1829, 1878 and 1882, although these payments were insufficient to cover its military expenditures. The indemnity that Japan wrested from China in 1895 was twice the cost of that war (Ferguson, 2001: 397). Germany perfected the art of profitable warfare. Frederick the Great had made a profit on its conquests of the Silesian mines, which he seized from Austria between 1740 and 1745 (ibid.: 397). Probably, the most profitable war of the nineteenth century was the German war against France of 1870 (Franco-Prussian War), which led to indemnities of five times the

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costs of German military expenditures. Hence, the imperial wars of the nineteenth century were profitable for the victorious nation. Europe was the theatre of many wars in the past centuries between nation-states that all wanted to expand their territories and ask ‘reparations’ from defeated nations. The costs of the two world wars in both lives and goods changed this pattern. The two world wars cost lives all over the globe, especially in Europe and Asia. China had experienced earlier carnages. The invasion of Genghis Khan cost 37 million lives in the thirteenth century, 10 percent of the world’s population at the time. The Manchu contest over China in the seventeenth century cost an estimated 25 million lives. The majority of the victims of these conquerors died from famines and epidemics that arose in the wake of the invasions. Rebellions in the nineteenth century by Christian and Muslim groups took about 40 million Chinese lives (Ferguson, 2004: 652). The costs of imperial victory are huge. But the aggressor does not take the costs it imposes on the seized territories into account, but counts all newly obtained possessions as profits. Moreover, the conquered territories could provide exploitation revenues for times to come. The costs of stable empire Stable empire is beneficial, as it keeps the peace. Yet many stable empires applied autocratic methods of appropriation and came to hinder trade. McNeill developed the hypothesis that a centralized government inhibits trade. He describes the expansion of commerce in China in the period before 1000, when central power was weak and urban merchants and artisans could make headway against the landed and official classes. However, the imperial tradition was restored under the Sung dynasty and landed officials restored power (McNeill, 1963: 525). Chinese bureaucracy balanced between landed and urban interests, but bureaucracy was firmly restored under the Ming dynasty in 1450. The Roman Empire became centralized after 121 AD in the reign of Marcus Aurelius, after which its growth stopped (Lal 2004: 34). Empires had a tendency to stagnate, once they were established. Chinese per capita income rose until the Mongol invasion, where after its population declined and per capita income stagnated. The population rose under the Ming dynasty, but per capita income did not increase. The Indian Empire became stagnant in the third century BC and remained that way for 2,000 years (ibid.: 37–8). The Roman Empire was also stagnant. Both population and income per head hardly increased in the 200 years after the death of Augustus in 14 AD (Goldsmith, 1984). Empire thus brought peace and order, but not prosperity. The choice seems to be between empire or anarchy; stagnation or decline. But both Ferguson and Lal argue that liberal empire provides a way out of the dilemma, as it promotes growth. But, this did not apply to the British domestic economy, which grew at a slower pace than its rivals from 1870 till 1914; the heydays of the British Empire. The main benefit of liberal empire, in my

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view, is that it allows the rise and decline of empire by non-violent means. Economic competition creates winners and losers in what is essentially a positive sum game, in contrast to the war game. Liberal empire, which uses the market as an allocation mechanism, allows nations to reach a par with the mother country and surpass it. The US, which became the military and economic world leader after 1918, proves the capacity of liberal empire to reverse roles. The rather short history of the British liberal empire demonstrates that liberal empire either dissolves into an alliance or disintegrates through war. The costs of declining empire Ferguson argues that the decline of empire entails great uncertainty, when old organizations crumble and new political organizations emerge. States arose out of declining empires, but he argues that a world of nation-states is unstable (Ferguson, 2004: 170). New empires will arise out of the ruins of the former and vie for hegemony through bloody wars. The havoc that was wrought after the collapse of the Habsburg, Hohenzollern and Ottoman Empires at the end of World War I illustrates his case. New nation-states were formed in Eastern Europe on the basis of ethnicity, which separated people that had been living together for centuries and entailed many bloody conflicts. State formation also occurred after World War II when the winding up of the British, Dutch, Portuguese, Belgian and French empires entailed a process of decolonization. But, ‘the hypothesis that imperialism caused both poverty and war, while self-determination would pave the way to peace and prosperity, was proven to be largely false in both cases’ (ibid.: 173). Independence led to ethnic conflict, civil war and failed states. Standards of living have worsened after independence in many Sub-Saharan African countries. The same applies to the fall of the Roman Empire that was followed by a period of anarchy and continuous Hobbesian war and a long period of economic decline (Lal, 2004: 18). But nation-building was not a new phenomenon. The Greek city-states emerged out of the decline of the Mycenaean Empire; European city-states grew out of the declining Holy Roman Empire. These examples illustrate that devolving empire does not need to wreak havoc, but can spur both growth and democracy. The devolution of the British Empire also spawned prosperity in the white Dominions that became ever more autonomous in the nineteenth century. The same applied to Latin American countries that loosened their ties with Spain and Portugal. The nations that emerged out of twentieth-century wars, however, did not prosper. The fall of an empire can thus trigger totally different events; it can either lead to descent and anarchy, or to the rise of new organizations that foster growth and innovation. The difference, in my view, can be explained by the way new organizations emerge. Nations that emerge peacefully out of declining empire have a greater chance of being successful than new nations that emerge out of war.

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Yet many twentieth-century nations that emerged out of declining empires failed. Moreover, twentieth-century events demonstrated that new democracies were not robust. Democracy peaked in 1922, 1946 and 1994. The first democratic wave emerged in the aftermath of World War I, when new democratic nation-states arose in Europe. But these democracies all collapsed before 1940. The defeat of Germany in 1945 restored democracy in north-west, but not in eastern and southern Europe. The decolonization that followed World War II led to short-lived democracies in many liberated countries. The third democratic wave, which emerged after the devolution of the Soviet empire came about peacefully and could, therefore, be more successful. We can argue that a peaceful decline of empire demonstrates the weakness of imperial governance and the strength of the new organizations. The collapse of empire due to military defeat, however, spawns organizations that are not necessarily superior to their imperial predecessor.

Organizational and institutional innovation Organizations maximize their objective functions under the restriction of the rules of the prevailing game. Merchants will maximize revenues from trade, whereas warlords will maximize booty. Absolute regimes cling to their political and economic power and maximize state income at the expense of collective welfare. The city or polis constituted the fundamental cell of Greek and Roman civilization and reappeared as the main organization of European civilization in medieval Italy. Cities and monasteries differed from involuntary associations like tribe, caste and house community, since they were open to people from all walks of life and places. They had to be attractive to newcomers in order to survive and grow. City culture was inclusive and wanted to reduce social distance by suppressing differences in life style among citizens. Medieval Florence had sumptuary laws that prohibited ostentatious forms of dress, cooking and home decoration (Hibbert, 1979: 22). Citystates promoted general education by setting standards that facilitated learning. The use of the vernacular is a case in point. Literature was no longer written in Latin in the medieval city-states. The Bible was also translated into the local language. Commercial cultures also facilitated learning by introducing scripts that contained a limited number of signs. Mesopotamian society had already adapted the Aramean language to simplified scripts of about 30 signs to tackle the problems of merchants (McNeill, 1963: 146). The Latin and Cyrillic alphabets were also relatively simple, compared to Chinese and Japanese scripts. Literacy was promoted and social differences were suppressed by these innovations. Not all city-states were democratic, but commerce stimulated discourse between financiers and entrepreneurs, guild masters and pupils, rulers and ruled. Discourse took place in marketplaces, bourses and councils.

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Rulers and subjects in autocratic regimes, by contrast, belonged to impermeable social groups and different cultures. Communication between people of unequal status was hampered by social and cultural barriers, different languages and mistrust. Communication between rulers and ruled was superfluous in traditional societies, as peasant activities were largely shaped by hackneyed traditions. Subjugated people are not allowed to speak their mind freely, because of a lack of rights. Both opportunistic and innovative actions, which are often hard to distinguish from one another, are ruled out under such conditions (Ghoshal and Moran, 1996: 26). Communication, however, is essential to organizations that want to innovate and grow. Communication can both enhance and lower a person’s worth. This already applied to medieval Florence where Machiavelli attributed recurrent tumults largely to calumniators who stirred up hatred among people. Liberal societies thrive, when communication tends to increase people’s worth instead of diminishing it. Moreover, successful organizations have rules of the game that are known to all. The existence of written laws and an independent judiciary is one of the characteristics of civilized societies. But the law was often an instrument in the hands of the ruling class. Most legal systems hardly addressed commercial matters and were predominantly engaged with criminal law. Moreover, most legal systems were rigid and hardly able to cope with new situations. Common law is often described as more flexible than civil law as it allows judges more room for interpretation. Common law allows some subjectivity in judicial decision-making. However, their interpretations can be overruled by other judges or by law-makers. Flexible law thus requires a discourse on laws and their application. City-states developed commercial law and institutions to discuss legal matters. Athens introduced special courts that could deal speedily with commercial matters (Weber, 1988: 210). Ancient Rome spawned the famous jus gentium in which contract law and property rights were established that applied to both Roman and non-Roman citizens. An elaborate jurisprudence on commercial matters arose out of discussions among wealthy businessmen in ancient Rome. Their comments formed the basis of the jus gentium which coexisted with the ius civile that was specific for each group (Schumpeter, 1954: 56). Roman law was codified under the Emperor Justianus and submerged after the fall of the Western Roman Empire. The Roman legal heritage was preserved by the monasteries and reappeared in the medieval universities, especially at Bologna. Italian jurists took Roman commercial law as the basis for systematic codification. Impartiality in judiciary matters was achieved by the appointment of people who were independent from the state. Some cities chose outsiders to apply the law as happened in Italy in the podesta system. But the nation-states that emerged in Europe in the sixteenth and seventeenth centuries broke up corporate autonomy and replaced democratic institutions by royal decree. ‘All these organizations that had engendered their own bodies of law were fused into

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the compulsory organization of the nation-state that became the sole source of legitimate law. The French Revolution completely eliminated all forms of associational autonomy’ (Weber, 1978: 724). Judicial arbitrariness reemerged in the absolutist monarchies of Spain and France. Common law that had prevailed in Spain up to the end of the fifteenth century was regularly pushed aside by the king, who ruled by edict (Powelson, 1997: 231).

Nation-building and democracy History does not show a linear development from autocracy to democracy, but an erratic one. Periods of democratization were succeeded by autocratic eras and the reverse. Nation-states, in contrast to cities and monasteries, are involuntary associations of people. People usually obtain nationality at birth. Nation-states, in contrast to empires, often define themselves in ethnic terms. Sixteenth-century nation-states like Britain, France, Spain and the Dutch Republic had state religions. Religious minorities were expelled from Spain, Portugal and France. Ethnic exclusivity is hardly compatible with democracy, which is based on equal rights. Democracy waned in the Low Countries, but also in France and Spain. Britain remained democratic, but democracy only re-appeared in continental Europe in the nineteenth century. Legal discrimination of people of different religions and cultures was banished after the Napoleonic wars. Jews, Catholics and Protestants obtained equal rights in nineteenth-century France, Germany and the Low Countries. People, who had lived by the rules of their religious community, obtained citizenship and equality before the law. A separation between state and church was one of the consequences of the French Revolution. But legal equality did not abolish social differences between people in Western societies. Equality among social groups can be achieved, if all groups in society are deemed to have equal chances of success. Expectations of a person’s worth should not be determined by race or other external characteristics. As a consequence, equal amounts are invested in people belonging to different groups and average incomes would not differ among groups. But income equality does not emerge, if ex ante labels of superiority and inferiority are attached to people based on ethnic (or religious) differences. This applies even more forcefully, if communication is organized along ethnic lines. Racism appeared as a new ideology in the nineteenth century that kept people apart. Intermarriage between Indians and Britons was formally banned in British India in 1835. Interracial sex was sharply condemned after the 1857 mutiny (Ferguson, 2006: 20). Slavery was abolished in the US after the Civil War, but was replaced by laws forbidding intermarriage and intercourse between blacks and whites in the Southern states (ibid.: 24). Segregation policies prevailed in South Africa, where the Boers forbade all interracial sex between white women and black men in the state of Transvaal in 1897, which was followed by legislation in Cape Town, Orange Free State and Natal. The policy was copied by neighboring Rhodesia. Racial

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and cultural differences impeded the installation of political representation in non white colonies. The beginning of the twentieth century saw democracy proceeding in several countries ranging from Russia to Portugal and China, where absolutist monarchies were driven to liberalize or were overthrown (Ferguson, 2001; 358). But, these democracies were short-lived and soon succumbed to dictatorship. Most European constitutional monarchs were forced out of office in the first half of the twentieth century and replaced by an autocratic ruler. The second in line to the Portuguese throne was assassinated in 1908 and the last Portuguese monarch went into exile in 1910 after a coup. A dictatorship under Salazar was established. The Spanish king left the country in 1931. Spanish democracy succumbed in a bloody civil war, which led to a dictatorship under General Franco. Mussolini took power in Italy in 1922 with the consent of the king and the army. Mussolini obtained his mandate in good Roman tradition for one year but extended his mandate subsequently. The Soviet Union eliminated the Tsar family and democracy in 1918. The German emperor was also expelled and a one-party state was established in Germany in 1933. The new democracies that arose in Eastern Europe after the end of World War I were extremely short-lived. The Hungarian president of 1932 installed a de facto dictatorship; authoritarian rule was established in Lithuania in 1926. Authoritarian kingdoms were established in Albania in 1928 and in Bulgaria in 1934. Dolfuss took control of Austria in 1933. Authoritarian regimes were also established in Latvia, Estonia, Greece, Romania and Yugoslavia in the 1930s (Ferguson, 2001: 361). The nation-states that were founded in Eastern Europe after World War I pursued policies of ethnic homogeneity. Large ethnic minorities that remained within the new nationstates became second-class citizens, who could be excluded from the benefits of a state that took on ever more economic functions, while increasing their taxation (Ferguson, 2006: lviii). The decline of democracy in the inter-bellum can be explained by new ethnic and ideological division lines that were drawn among people. We can argue that democracy that is not based on the ex ante equality of people is unsustainable. A majority that downgrades minorities to second-class status without possibilities for reversal is doomed to turn democracy into autocracy. Only Great Britain, Ireland, Switzerland and Sweden remained democratic in Europe after the German invasion of 1940. All other European nations were ruled by foreign or home-bred autocratic regimes.

Twentieth-century European empires Collapsing empires The new European nation-states of the twentieth century were born out of defeated and collapsing land empires. The Russian Romanov Empire emerged

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in 1613 as a vast land empire encompassing Finland, Poland, the Ukraine and large parts of Central Asia. Ethnic and religious minorities had a lowly status within the Russian Empire. Russian Jews had residence restrictions and could not move freely, apart from some Jewish merchants, professionals and artisans (Ferguson, 2006: 59). The same applied to the Ottoman Empire, where minorities were engaged in commerce and banking and had lowly positions. The descent of the Ottoman Empire led to political fragmentation at the end of the nineteenth century. Serbia, Montenegro and Romania ceded from the declining Ottoman Empire and were granted independence after the Russo-Turkish War of 1877–78. The new Balkan states were based on principles of ethnicity and wanted to expand their territory to Albania, Macedonia and Thrace to include their ethnic kin. Greeks were expelled from Thrace and Macedonia during World War I. Mass migration occurred at the end of the war, when Greeks. Turks and Bulgarians moved to their newly established nation-states (ibid.: 76). Serbia wanted to take over Bosnia, which was annexed by Austria-Hungary in 1908. The Serbs used terrorism in their attempt to cede Bosnia from the Austrian-Hungarian Empire. Serb terror groups like the Black Hand planned to kill the Archduke Franz Ferdinand, heir to the Austro-Hungarian throne. They succeeded in their mission on June 28 1914, when Gavrilo Princip fired his gun at the open carriage in which the Archduke and his wife were traveling. Austria declared war on Serbia on July 28 after Serbia had failed to comply with an ultimatum to cooperate with an Austrian inquiry into the Sarajevo assassinations. Actually, until this time the London financial market had not expected the coming of war, as is borne out by the fact that prices of government bonds (consoles) did not decline before July 22 (Ferguson, 2006: 85). Russia, Germany, France, the Ottoman Empire and a host of other nations subsequently joined the war. Germany and the Ottoman Empire supported Austria/Hungary; Russia started to mobilize on July 31 in defense of Serbia. Germany declared war on Russia and France on August 1 and 3. Britain entered the fray on August 4. Formal and informal alliances drew the world into an initially localized conflict and transformed it into a world war. The Russian support of Serbia was inspired by a wish to restore its reputation as an imperial power, which had been blemished by the Japan-Russo war and the Austrian annexation of Bosnia (ibid.: 104). The British were drawn into the war because the Germans violated Belgian neutrality which was guaranteed by international law. The French were drawn into the war, because the Germans considered them to be Russian allies. The globalization of the conflict was inevitable due to Britain’s position as an empire with a small European army, which prompted it to wage a global war (ibid.: 109). An impasse emerged, when the Germans won in the East, but were unable to win on the Western Front. The central powers (Austria, Germany and

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the Ottoman Empire) defeated Russia, Serbia and Romania. They concluded a peace treaty with the new Soviet state in 1918 at Brest-Litovsk. The treaty foresaw the ceding of Poland, Finland, the Baltic States, Belarus and the Ukraine to Germany. All territories Russia had captured from the Ottoman Empire were returned. Russia had to pay six million marks to Germany as reparation payments. However, the Treaty of Brest-Litovsk lasted only eight and a half months as German defeat on the Western Front annulled the treaty. The German inability to win in Belgium and Northern France meant their ultimate defeat and entailed the collapse of the Austro-Hungarian, German, Russian and Ottoman empires. A terrorist attack thus proved fatal to four empires, which collapsed due to a few shots from a suicide killer, whose suicide, however, failed. Britain, France and the United States emerged on the winning side of the war, although they were not involved in the initial conflict between Serbia and Austria-Hungary. An armistice was concluded in November 1918 between Germany and the Allied forces. Peace negotiations went on in Versailles between Britain, France and the Unites States for many months. Germany was not part of the negotiations and could only either accept or reject the conditions put forward by the Allies. In the end, Germany had to accept liability for the war; had to cede 15 percent of its territories and pay reparations to France. Poland and the Baltic states emerged as independent nations, which lasted unti1 1939, when Poland was split between the Soviet Union and Germany and the Soviet Union occupied the Baltic States. The European empires at the beginning of the twentieth century were all connected by marriage. However, the weakness of their powers was demonstrated by the fact that emperors gave in to generals and foreign ministers who were eager to begin war (ibid.: 105). Both the Russian tsar and the German emperor were reluctant to start a war, but were overruled by the generals. The Germans had for some years contemplated the invasion of northern France. The German general Moltke wanted to seize the opportunity and start a pre-emptive war against both Russia and France, before these two nations had built up their military capabilities. Democracy, which was installed in several European nations like Russia, Germany, France and Austria at the turn of the century, had eroded the stability of the nineteenth-century imperial age. Declining monarchic authority weakened the diplomatic channels between the European, imperial dynasties. Emperors were pushed aside by generals and prime ministers, who became de facto commanders-in-chief. The war was initially welcomed by the German people who expected the German Army to achieve an easy victory akin to nineteenth-century wars in which Germany had been victorious. The ultimate German defeat remained inexplicable to many Germans and was ascribed to internal enemies like Communists, Jews and labor leaders who were said to have organized strikes in the arms industry in 1917 at a crucial moment of the war.

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Rising empires New empires grew out of the nation-states that were born out of the defeated empires. Twentieth-century empires differed from their predecessors by their short duration. The Soviet and Nazi empires that emerged after the collapse of the Ottoman, Hohenzollern, Habsburg and Romanov empires did not make it to the end of the century. Their short duration differs sharply from former empires that often lasted for millennia. This might indicate that empire has become an unsustainable form of governance. The inherent inequality of empire met increasing resistance in the nineteenth century. Resentment of empire seemed to beckon a new age of democracy. But the new nation-states that arose out of the defeated European land-based empires in the twentieth century were based on notions of exclusivity that drew much deeper lines between ethnic and political groups than had prevailed in empires. Traditional barriers between people were replaced by ethnic and ideological barriers. We can argue that social hierarchies based on race are immutable and do not allow emancipation. It is paradoxical that the hereditary principle gained weight to explain a person’s intelligence, aptitude and character in times when the hereditary power of monarchs was treated with suspicion. Former economic elites were devalued in both Nazi Germany and the Soviet Union. This applied to German Jewry, which had gained prominence in both business and the professions. It also applied to the descendants of class enemies in the Soviet Union, who could not join party associations or attend higher education (Overy, 2004: 234). Hence, heredity was put on his head; the former successful strata were now excluded from social ascent. Arguably the new dictatorships rejected the old rules of the game as unjust and therewith condemned the winners who had emerged from it, whose manifest success was ascribed to exploitation and ‘foul play’. Both Nazi Germany and the Soviet Union rejected the capitalist rules of the game and defaulted on their foreign debts. Both Hitler and Stalin rejected capitalism as a fair system of allocation and income distribution and replaced it by command economies (ibid.: 398). Both regimes reversed the occupational hierarchy. Intellectuals were distrusted and manual work was regarded in both regimes as intrinsically rewarding and morally validating (ibid.: 235). Democracy was abolished in both empires. The Soviets closed the Russian Assembly in 1918. The German parliament was wound up in 1933 and a one-party state was established by plebiscite. Both dictators defined democracy as the absence of political division and the ‘true’ representation of popular interests (ibid.: 58). Hitler rose to power as leader of the National Socialist Party, which obtained 44 percent of the votes in March 1933; the last multi-party election in the Weimar Republic (ibid.: 47). His government adopted emergency powers in 1933 and the authority to make new laws. Rivals to Hitler like

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Rohm were eliminated, based on allegations of planning a coup. His murder made it clear to anyone that opposition to Hitler’s authority was not going to be accepted. Stalin’s road to power was based on his alleged position as Lenin’s heir, although Lenin had warned Russia against Stalin. All other members of the Politburo like Bukharin, Trotsky, Zinoviev and Kamonev were removed from the Party’s top rank in the years 1924–30 (ibid.: 23). Stalin used his position as General Secretary of the Communist Party to appoint his favorites. His control of the Secretariat provided him with information on Party members, which he used to concoct accusations and demolish reputations, if necessary, to enhance his position. Friends were turned into foes and enemies of the communist state overnight, if they were considered a threat to his position. The Party was central to both autocracies. Party members controlled factories, neighborhoods and other organizations and reported on people’s behavior. People could be persecuted for criticizing the regime. People’s opinions were dictated by the party leadership and ultimately by the leaders themselves. Hitler and Stalin were the ultimate arbiters on issues of ideology (ibid.: 126). We can ask, whether twentieth-century dictatorships can be compared to their predecessors. One difference involves that both regimes were supported by large parts of the population. This makes them similar to direct democracy and not autocracy. Another similarity involves the promise of victory and a better life. However, both Hitler and Stalin based their powers on the perceived threats of internal enemies – either of a racial or bourgeois nature – to the state. This differed from single leaders in direct democracies like Venice whose tenure depended on their military success. The two twentieth-century dictators also differed from the early Venetian doges, since they did not rise from the military and also did not lead the troops in the field. The era of state leaders who led the troops in the field seems to have ended with Napoleon. Yet, both Hitler and Stalin were commandersin-chief and decided on military strategy. Hitler took over as commander-inchief after Hindenburg’s death in August 1934. Stalin took over supreme command of the military in June 1941. ‘They dominated the process of military and strategic decision making and prevented others from doing so’ (ibid.: 444). Soviet military leadership was removed and the most senior officers were shot in 1937, based on allegations of a plot to overthrow Stalin. Hitler also had his crises with generals, when two generals were sacked, based on allegations of moral turpitude. Generals who considered Hitler’s war plans too risky were forced to resign. Hence, the expression of ideas had become superfluous, since one man’s ideas prevailed. These ideas could not be easily falsified, since failure was ascribed to ‘hidden’ enemies. Unmasking and persecuting internal enemies became the main disciplinary mechanism in both empires. Hitler launched his war of aggression against the Soviet Union in 1941 to eradicate communism, which he considered a lethal threat to the German people. The war between the two ideologies, in Hitler’s words, could only be

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settled by the complete destruction of one side or the other (ibid.: 484). However, Hitler had signed a non-aggression pact with Stalin in 1939. Stalin turned from friend to foe, when the 1939 pact and the other pacts that were signed in 1940 and 1941 were broken by Hitler. Stalin had appropriated parts of Poland, Finland and Romania and the Baltic States under the non-aggression pact. Soviet, German and Japanese soldiers fought a war to the death. This can be explained by the harsh discipline imposed on soldiers of the imperial armies, who were forced to move forward or be shot. The Wehrmacht executed between 15,000 and 20,000 of its own men. Only a small minority of the 11 million German soldiers surrendered before the official surrender on May 7 1945. Japanese soldiers even fought more tenaciously; for the eight Japanese soldiers who died in battle, there was only one captured. Japanese soldiers had developed a Spartan code of honor, which dismissed surrender as an option (Ferguson, 2006: 539). The same attitude prevailed among German soldiers. However, more important was the idea that captured soldiers would be killed by the enemy anyway. This had been the German policy towards Russian prisoners, which was reversed after the victory of the Red Army (ibid.: 544). Managing Stalin’s Soviet Union and Hitler’s Germany Both twentieth-century empires were illiberal, formal land empires. Stalin wanted to pursue an intensive growth policy. Industrialization would raise productivity and national income. However, workers first had to sacrifice consumption in order to reach the higher growth path. Hitler pursued extensive growth by territorial expansion. ‘Hitler’s economic vision considered the world’s wealth as finite, which led to a struggle for survival through expropriation’ (Overy, 2004: 402). Hitler held the view that British wealth was based on the exploitation of 350 million Indian slaves. Hence, he considered exploitation the only route to wealth. Expropriation of private property was common under both regimes. Expropriation was part of Soviet ideology, but was also directed towards enemies of the regime in Hitler Germany (ibid.: 438). Both economies were command economies that strove for autarky. They were both preoccupied with the control of natural resources and the exploitation of subjugated labor and not with innovation. International trade was completely planned by both regimes. Macro-economic planning was facilitated by a lack of attention to consumer goods and a rapid rise of producer goods production, particularly for rearmament in both countries. The consequence of the drastic reallocation from consumer to producer goods industries was that real wages stagnated or fell. Both dictators – in spite of their rhetoric – lowered the living standards of their population. Hourly wage rates in Germany were frozen at Depression levels. Soviet real wage rates declined continuously in the 1930s (ibid.: 427). Bread was rationed

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in Stalin’s Russia. Millions of Soviets died of starvation due to harvest failures, poor food distribution and war, in the 1920s and 1930s. Rationing was introduced in Germany and the German-occupied territories during the war. Germans were expropriated from their personal belongings like clothes. Men could keep no more than two pair of shoes or two sets of suits of clothes (ibid.: 429). Surplus income was taxed away or seized by means of involuntary saving schemes. Both regimes thus attempted to lower wages to subsistence levels and to appropriate the remainder for military build-up and other public investments. The increasing discrepancy between ideal and reality was masked by eliminating criticism and critics. Both dictators immunized themselves against failure by pointing at disloyal minorities and dissenters who were held responsible for setbacks and failure; the masked enemy of Stalinism was hidden away within the party apparatus; for Hitler, it was the Jew (ibid.: 641). These enemies were considered lethal; their victory would cause the loss of the German race or the reappearance of the bourgeoisie and the fall of the Soviet state. The violence ascribed to the enemy justified the violence that was meted out by the two regimes towards imaginary enemies. This struggle cost the lives of millions of people and uprooted the lives of many more millions. Uncertainty about a person’s status was deliberately maintained to terrorize the population. This applied to Stalinism, where friends could turn into enemies overnight. It also applied to Hitler’s prosecution of the Jews. His hatred of Jewry was no secret. The Germans wavered between pursuing a policy of exploitation or extinction towards the Jews in the first years of the war (Ferguson, 2006: 401). But, policies towards the Jews changed from emigration to elimination, when the odds of war turned against Hitler. Seventy percent of German Jews left in the 1930s, when voluntary departure was still possible (ibid.: 269). Departing Jews had to pay high taxes. Remaining Jews were expropriated and their businesses confiscated or burnt down in 1938. People in German-occupied territories were categorized into those who were worthy of life like the Dutch and French, who were considered ethnically close to Germans. These people were economically exploited, but could survive, if they complied with the regime. This did not apply to Poles and Slavs, which were considered inferior races. The Polish elite should be eliminated and the little people would be reduced to slave status (ibid.: 397). But loopholes existed, since Poles who were considered racially close to Germans could be Germanized (ibid.: 468). The distinction between favored and non-favored people was thus not clear-cut and changed over time. Both Hitler and Stalin depicted the states of their nations as one of continuous crisis. The state was under siege from either internal and/or external enemies, which prompted the use of special powers. Groups were set against each other. Old were pitted against young; bourgeois were set up against revolutionaries; Aryans were pitted against other races. Stalin’s great purge

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of 1937–38 that killed millions was directed towards class enemies and saboteurs, who were held responsible for bad economic performance. This applied to managers and skilled technical workers, who were removed by the thousands and replaced by unskilled young people (ibid.: 238–9). The new recruits were rewarded on the basis of ideological loyalty rather than performance. Only party members were eligible for office or license. Communist Party membership needed be renewed on a regular basis by a purge committee. People whose behavior was criticized or who failed to pass the exam on Marxism/Leninism were purged. Party membership was easily withdrawn as transpires from the huge numbers who lost Party membership. The result of the purge policy was to remove large numbers of ‘old Bolsheviks’ who had joined the Party before 1917 (ibid.: 140). Party members could thus lose their privileges at any moment. Uncertainty about a person’s worth was used to trigger conformity in both dictatorships. Demise and promotion were not based on objective norms, but on subjective evaluations and anonymous accusations. The concept of economic sabotage was built into the Soviet Criminal Code of 1926. Every act of negligence in the process of production and distribution was considered a counter-revolutionary crime, with penalties ranging from one year in jail to execution by shooting (the highest measure of social defense) (ibid.: 435). Individuals were held accountable for failures beyond their responsibility in both the Soviet Union and Nazi Germany. A law against economic sabotage was published in Germany in 1936. Both Stalin and Hitler used performance pay schemes to compensate workers. The majority of workers were paid by piece rates that were set by time and motion studies (ibid.: 320). Soviet workers could earn bonuses as shock workers. In 1935, individual targets were set, so that workers were pitted against each other (ibid.: 319). Hitler’s Germany applied identical processes of individualization and fragmentation of the workforce. Norm fixing was a difficult task in both regimes. The authorities wanted to raise norms in order to increase productivity. However, in the Soviet Union, it offered endless opportunities for malingering or returning false records of achievement. Both systems of labor organization within plants were based on physical norms, but were executed in a subjective manner. Experts could be dismissed at will and workers were promoted or dismissed on political grounds in both the Soviet and German system of worker appraisal and reward (ibid.: 324).

The age of alliance European alliances The first half of the twentieth century was characterized by emerging empires and by unstable alliances. The Germans and the Soviet Union concluded a non-aggression pact in 1939, which was revoked in 1941, after

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which the Soviets allied with the British and the Americans. The French allied with the Russians in World War I, but not in World War II. The Italians fought the Germans in World War I, but were allies in World War II. The volatility of alliances undermined their capacity as a deterrent. Hitler’s annexation of Austria and of the Czech Sudetenland in 1938 was neither opposed by the British nor French military. Ferguson argues that a war between Germany and Britain was inevitable and that a preemptive move against Hitler in 1938 could have prevented worse (Ferguson, 2006: 372). After 1938, Britain lacked credibility and the guarantees it gave to Poland, Romania and Greece needed to be tested in the field. However, both Sudetenland and the free city of Danzig were largely populated by Germans, who had expressed a preference for joining Germany in a plebiscite. The principle of self-determination thus clashed with the status of these political entities as protectorates. They were not British protectorates, but were protected by the League of Nations that was founded after World War I. However, the protection of the League of Nations proved to be non-existent. The European map of the 1990s closely resembled that of 1918 after the collapse of the old empires. The new nation-states of central Europe that emerged out of the collapse of the Soviet Union have joined new alliances like the European Union and NATO. The EU wants to promote trade among its members. It is an alliance with democratic rules of procedure. The original treaty represented all members equally, irrespective of their size. We can argue that this represented the larger stake small countries have in international trade. The expansion of the European Union with new member states prompted them to revise their decision rules. However, the dominance of large member states would reduce equality and make the Union less attractive to small members, who might opt out of regulations that were decided by a majority. The European Union accepted only democracies as members, but could not prevent civil wars on its territories. Northern Ireland and the Basque country are cases in point. Former British colonies could join the Commonwealth of Nations after gaining independence. The Commonwealth is a voluntary association of nations that were under British administration and as such is the successor of the British Empire. The first members, Canada, Australia and New Zealand, entered in 1931 after the Statute of Westminster. The Commonwealth is not a military or political alliance, but wants to promote economic and cultural exchange between its members. Commonwealth members have certain privileges with respect to trade and migration and can also join the British Army. We could compare the Commonwealth with the European Union, which is also not a military alliance. The Commonwealth also could not prevent civil wars and coups in several former colonies like Sierra Leone, Uganda and Nigeria. Some Commonwealth members adopted policies that curbed international trade and favored domestic production; thereby annulling the benefits they could have obtained from trade. Lately,

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some Commonwealth members have had their membership suspended after they turned to policies of expropriation of foreign and domestic investments. Zimbabwe and Nigeria are cases in point. Military alliances A descent of dictatorship and rise of democracy around the world would tend to decrease empire and promote military alliance. Alliances are most worthwhile, if they deter war. This implies that the composition of alliances is known and that guarantees are considered binding. Alliances have little deterrent effect, if states swiftly change allegiance and enter a (formerly) hostile military alliance. The most powerful member of a military alliance is sometimes dubbed a ‘hegemon’, a primus inter pares among free nations (Ferguson, 2004: 8). Hegemony results after the defeat of contenders. Britain became the military world leader after Napoleon’s defeat. Britain did not need an alliance at the time, because it was not contested. However, Britain could not have been victorious in the twentieth century without its allies. In this sense, the British Empire had become an alliance at that time. Nations that cannot protect themselves either need to join an alliance or become a protectorate. The choice largely depends on the military power of the nation. Countries with a military capacity can join an alliance, whereas countries that lack such capacity can opt for protectorate status. Protectorates can stick to their own culture as long as the host government is friendly to the military power as is demonstrated by the deployment of US troops in the Middle East. US protectorates are often autocracies, but have open economies. The US is the largest partner of NATO (North Atlantic Treaty Organization), a military alliance that was founded in 1949. The US also has nonNATO allies around the globe, like Australia. We can argue that NATO is not an alliance due to the predominant position of the US. US hegemony could weaken the alliance as it undermines democratic decisionmaking. Each of the 26 NATO members has a representative in both the North Atlantic Council and the Military Committee. The Secretary General presides over the Council meetings. There is no voting or decision by majority in the Council. The Military Committee is also cast in an advisory role. The Defense Planning Committee (military committee minus France) consists of each nation’s chief military commander. The US supplies NATO chief commanders. NATO command is located in Stuttgart, Germany, and Norfolk, Virginia. Arguably, the US features elements of both empire and alliance. France opted out of NATO command structure, although it upheld political membership. All NATO forces were removed from French soil in 1966, while France built an independent defense force. France re-entered the NATO Military Committee in 1995, but is not on the Defence Planning

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Committee. (Wikipedia). France wanted to be on an equal footing with the US and the UK in NATO command structure at the time and asked for a tripartite directorate. Moreover, French President de Gaulle wanted NATO assistance in fighting Algerian insurgents. However, the US refused NATO assistance to protect colonial possessions. This had become manifest during the Suez Crisis of 1956. The Netherlands was also refused assistance in its conflict with Indonesia over Dutch Papua New Guinea. NATO as an alliance of democracies did not want to be involved in warfare to protect imperial possessions. The Soviet Union, which wanted to enter NATO in 1956 (supported by France), was refused membership as this would have turned the Cold War into an inter-alliance affair. US forces are deployed in NATO member countries, but the reverse does not apply. US army bases in Kuwait and Djibouti are also home to military from NATO countries. Kyrgyzstan has raised problems and US bases in Uzbekistan were vacated in 2006. Both Russia and China try to obtain military bases in Central Asia. NATO is an alliance of democracies, but not all its members were democratic. Portugal was not a democracy when it entered in 1949. Moreover, Greece could remain within NATO after the generals seized power in 1967. NATO does not intervene in a country’s internal affairs. This kept it from intervening in wars of liberation in former colonies and also from intervening in civil wars in both Spain and Northern Ireland. NATO as a stable alliance has preserved peace in the Northern hemisphere during the Cold War through deterrence.

US hegemony? Using empire to promote democracy The countries of Europe were liberated from German occupation by Allied forces in 1945. Asian countries were liberated from Japanese occupation. The idea of a liberation war largely fought by foreign troops to (re)install democracy as happened in World Wars I and II is a new phenomenon. The (re)installation of democracy by military force seems to contradict the idea of empire. We can argue that an invasion to install democracy should lead to the admission of the invaded country in an alliance as happened, when Germany joined NATO in 1955. But the conquered countries also fit the definition of protectorate. The US had a considerable military presence in Japan and Germany after World War II. These countries were not allowed to build their own military, which fits a protectorate definition. These occupations were voluntary, since new regimes had denounced the former dictatorships. US troops were also deployed in South Korea in the aftermath of the Korean War. Small numbers of US military were stationed in Singapore, Thailand and the Philippines in 2007. These countries all adhere to the capitalist rules of the game. However, they are not immune to coups

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and insurgencies as demonstrated by Thailand and the Philippines. The US military, however, does not interfere in these countries’ internal affairs. Democracy was re-installed in the Philippines in 1986, when Marcos, who had extended his democratic mandate as president, went into exile. Democracy would promote a country from protectorate to ally status, but also makes its allegiance less reliable. US troops were withdrawn from the Philippines in 1992, but returned in 2001 after the terrorist attacks of 9/11. The Philippines participated in the Iraq invasion, but withdrew in 2004 after a Philippine truck driver was kidnapped. Alliance does not allow interference in the domestic affairs of a member, but only protects against a foreign enemy. Empire, by contrast, fights insurgents as was demonstrated by several insurrections that were put down by the British in India, the Sudan, South Africa and elsewhere. The present US mission of bringing democracy to the world seems to rule out empire and to promote alliance. But this would make local forces responsible for quelling domestic violence. The only possible way for a democracy to become a protectorate is by parliamentary request. After the Cold War The US avoided the role of empire at the end of both world wars and installed world leagues to keep the peace. The League of Nations was established at the end of World War I and the United Nations at the end of World War II. The UN is not a military alliance, since this presumes the existence of an enemy. However, the UN has no external enemies, since all nations are UN members. But the Cold War split the world into two opposing alliances, the US and the Soviet Union, whose huge military capabilities deterred direct warfare between the two blocs, while proxy wars were fought in Asia, Africa and Latin America. The collapse of the Soviet Union at the end of the twentieth century created a new political situation. The US had to formulate a new approach to non-allied nations. The US invaded Kuwait in 1991 and ended Iraqi occupation. The war was fought with the authorization of the UN Security Council by a broad alliance of Arab, NATO and other forces. This was a coalition of the willing, since NATO members were not obliged to participate in this mission outside treaty territory. Kuwait built defense relations with a broad array of countries, ranging from Russia, to the UK, France and Arab members of the Gulf War Coalition after the war was ended. Kuwait was used as a launching base for US troops in the Iraq War of 2003. Arguably, Kuwait was a protectorate and not a US ally, as it has relationships with all members of the UN Security Council. The US took a humanitarian stance, when it interfered in Somalia in 1992 as it wanted to relieve the plight of starving Somalis. The US led a UN mission and installed UN peacekeepers to look after the rebuilding of Somali government. The UN has peacekeepers in many former conflict areas

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like Israel (since 1948) and the Indian-Pakistan border, where they have been deployed since 1949. These nations can be called UN protectorates. However, UN protection is often absent, since UN peacekeepers are forbidden to participate in warfare. The UN mission in Somalia was withdrawn, when it became part of a civil war between rival clans. The UN’s ban on intervention in internal affairs created problems when a humanitarian disaster emerged in former Yugoslavia, when Serbia wanted to annex other parts of the Federation after 1990. The members of the Security Council were divided over the UN’s right to interfere in the Yugoslav war. NATO air strikes helped to bring the Bosnian War to an end. NATO forces took over from UN peacekeepers UNPROFOR, who were unable to prevent the Srebrenica massacre. Diplomatic efforts led to the Dayton Agreement of 1995, which entailed the independence of Bosnia/Herzegovina. The Dayton Agreement was implemented by NATO-led IFOR and later SFOR troops. This makes Bosnia/Herzegovina a NATO protectorate. A US-led NATO force ended the civil war between Serbs and Albanian Kosovars in 1999. The NATO-led air strikes were carried out without prior authorization of the UN Security Council. An armistice was concluded, which implied the withdrawal of Serbian troops from Kosovo. The future status of Kosovo remained inconclusive. Kosovo became a UN protectorate, when Russian troops (unexpectedly) rolled into Pristina within four days of the end of the war and the UN Security Council accepted Resolution 1244, which laid the administration of Kosovo in UN hands (Kirkpatrick, 2007: 264). NATO troops take care of the military in Kosovo. We might conclude that secession was backed by NATO troops in cases of ethnic cleansing on European territory. The newly founded states, however, depend on foreign protection. The terrorist attacks on the US of 9/11 2001 were considered an attack on a NATO member and prompted action in Afghanistan. A US-led coalition of the willing invaded Afghanistan in October 2001. An ISAF force under UN Security Council authorization was charged with securing Kabul and the Afghan Transitional Administration headed by Hamid Karzai in December 2001. NATO took full control of the ISAF forces in Afghanistan in 2006. This was the first NATO mission outside the North Atlantic area. The missions in both Kosovo and Afghanistan were carried out without prior approval of the UN Security Council, but the implementation forces obtained UN authorization. These courses of events differed from operation Desert Storm in Kuwait, where UN Security Council authorization was obtained before the operation began. Arguably, UN authorization either at the start or after the success of a US-led military operation eliminates the possibility of making these territories either US protectorates or allies. The UN as an alliance encompassing all nations allows nations to make other choices. The US-led invasion of Iraq lacked UN authorization both before and after the old regime was toppled. The invasion was also a coalition of the

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willing involving both NATO and non-NATO members. A number of coalition partners withdrew their troops from Iraq, when their term of duty had ended. The UN had a mission in Iraq, which was attacked in the aftermath of the invasion, killing the UN representative in Iraq. It seems that the mission of bringing democracy to Afghanistan and Iraq prevents the possibility of installing US protectorates there. In this vein, Ferguson’s plea for a long-term military commitment of the US in these countries is curbed by their democratic mission. Iraq could become a US ally, although it seems unlikely that the Iraqis would choose such a course. Secession of some parts of Iraq could make these into US protectorates; as was the de facto situation for the Kurdish region before the invasion. It could be argued that democracy implies that military command should be handed to the Iraqis with the US military in a supporting role. The problems the US face in Iraq (and Afghanistan) undermine the idea that toppling dictatorships makes countries ripe for democracy. Democracy has a better chance, when it emerges by peaceful means. Al-Qaeda features as a new enemy of the US after the end of the Cold War. Al-Qaeda wants to get rid of Western influence in the Middle East and establish an Islamic empire. Their aim is to overthrow ‘corrupt’ Muslim governments like Saudi Arabia and allies of the West such as Egypt, as stated by Al Qaeda’s deputy leader, Al Zawahri, in a video message that was released in early July 2007. He stated that the ‘Islamic state of Iraq’ was crucial in reviving an Islamic Caliphate. Corrupt regimes should be overthrown by popular uprising, military coups or civil disobedience. Al Zawahri predicted that the fall of the West is imminent. Their policy against Western powers involves terrorist attacks on US allies like Britain to compel them to withdraw their forces from Iraq. Moreover, terrorist attacks foment anxiety among different ethnic groups in Western countries and preclude their integration. Ultimately, this two-pronged strategy could put globalization on halt if immigration is curbed and new alliances curbing trade are built.

Conclusion The US would not need an alliance, if it is the only superpower, whose rule is uncontested. However, the US cannot easily win guerilla wars and quell insurgencies as demonstrated by the wars in Vietnam, Afghanistan and Iraq. The collapse of the Soviet Union was not due to military force but to economic superiority. Arguably, the US is an economic but not a military hegemon and has to resort to alliance policies. Most Americans agree that spreading American ideas around the globe is a good thing. But this should be achieved through leading by example and not by military force (Ferguson, 2004: 7). The US does not need to impose its economic institutions on other countries. Their manifest success will trigger voluntarily adoption. Venice did not need to seize Amsterdam to make the Dutch adopt double

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entry book-keeping. American corporations are, therefore, the best organizations to disseminate American institutions and culture. A new empire of the willing would consist of all nations that want to play according to liberal rules. Such a liberal empire of the willing seems more likely than the restoration of a British type of empire. An empire of the willing also implies that different nations can occupy first place at different times. The leading economic role has changed several times in the past centuries. Italy was the richest country in the world in the sixteenth century. It was succeeded by Holland, which held the lead for almost 300 years (1564–1836). It was replaced by the United Kingdom, and around 1904 by the United States (Maddison, 2004). But such changes in leadership do not need to change the rules of the game. It is only natural that the first position changes hands in economic competition. However, nothing is irreversible in the economic game. Companies can rebound as can nations. The game is never over.

Notes

2 Entrepreneurship and economic development 1 The Protestant Ethic was the translation of the first part of Weber’s Gesammelte Aufsatze zur Religionssoziologie (1920) and contained the revised version of the articles that were published in the Archiv fu¨r Sozialwissenschaften und Sozialpolitik in 1904 and 1905. 5 Valuation and authority in failing firms 1 Statistical Abstract of the United States (2000), no. 879, giving data for the 1985–99 period. 2 Two-thirds of reorganization petitions were withdrawn. Liquidation was the cause of withdrawal in 90 percent of Dutch withdrawal cases (Boot and Ligterink, 2000). 3 Bris et al. (2004) removed dismissals, pre-packs and subsidiaries from their sample. 7 Executive pay and tenure 1 The 15 companies involved were ABN/AMRO, Aegon, Ahold, Akzo Nobel, Buhrmann, Fortis, Hagemeyer, Heineken, ING, Koninklijke Olie, Numico, Philips, Reed Elsevier, Unilever and Wolters Kluwer. 8 Decision agents in corporate and political democracies 1 The youngest member of the Signoria went to pray in St Mark’s.On leaving the Basilica; he was to stop the first boy he met and take him to the Doge’s palace, where the Great Council minus those members, who were under 30, was to be in full session. The boy known as the ballatino would have the duty of picking the slips of paper from the urn during the drawing of lots. By the first of these draws the council chose 30 of their own members. The second was used to reduce the 30 to 9. And the 9 would then vote for 40, each was to receive at least 7 nominations. The 40 would then again by lot be reduced to 12, whose task was to choose for 25, of whom each required 9 votes. The 25 were in turn reduced to another 9; the 9 voted for 45 with a minimum of 7 votes each, and from these the ballatino picked out the names of 11. The 11 now voted for 41 – 9 or more votes each – and it was these 41 who were to elect the doge. They first attended mass and individually swore an oath that they would act honestly and uprightly, for the good of the republic. They were then locked in secret conclave in the Palace, cut off from all contact or communication with the outside world and guarded by a special force of sailors day and night, until their work was done.

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2 Machiavelli wrote The Prince to obtain Medici favour. The same applies to Florentine Histories, which was dedicated to the Medici pope Clement VII. This differs from Discourses, which was dedicated to Zanobi Buondelmonti and Cosimo Rucellai (Florentine merchants). He states: ‘ I have chosen to dedicate this work not to those, who are princes, but those who, on account of their innumerable good qualities, deserve to be so’, which expresses his disappointment with the lack of interest the Medicis had shown in his services.

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Index

Abana 150 Abbasid Caliphate 5, 12 Abjuration, Oath of (1581) 156–57 ABN-AMRO 126–27, 131, 133 absolute priority rule 89–90, 95, 97, 99 absolutism, political autonomy and 41, 142 Acemoglu, D. and Robinson, J.A. 9–10 Acemoglu, D. et al. 8, 86 AEGON 131, 132 Afghanistan 17, 18, 213, 214 Africa 4, 14, 17, 20, 50, 69, 187, 188, 190, 192; European colonization of 190–91; North Africa 46; slavery in 170; South Africa 194, 200, 212; Sub-Saharan 9, 187–88, 197; West Africa 69 agency theory: executive pay, tenure and 121, 136–37; performance pay 101, 103–5, 118 AHOLD 130, 131, 133 Al-Qaeda 18, 214 Alaska 190 Alba, Ferdinand Alvarez, Duke of 156 Albania 201, 202 Allahabad, Treaty of (1757) 182 Allgood, S. and Ferrer, K.A. 132 alliances: age of 208–11; and empires 190–92, 208–11; in Europe 208–10; military alliances 210–11 America, colonization of 186; see also Canada; United States Amritsar, massacre at (1917) 193 Amsterdam 5, 25, 26, 65, 156, 214; futures market for shares in VOC 66–68; Stock Exchange (Bourse) 66–69, 130–33 Anatolia 5 Anglo-Saxon countries 79, 82, 124

Anjou, Hercule-Franc¸ois, Duke of 156 Antwerp 5, 156, 157 Apple 60, 123 Aqua, King of West Cameroon 187 Arab Empire 5 Arabi Pasha 186 Argentina 8, 12, 17, 75, 76, 125, 188; civil law system of 83 Armenians 15, 16 ASA (Attraction-Selection-Attrition) model 109–10, 112 Asia 14, 17, 20, 69, 162, 173, 186, 188, 190, 194, 196, 212; Central Asia 202, 211; see also China; Japan; India ASML 133 Athens 3, 4, 8, 122, 162, 163, 191, 194; Athenian Council 143, 145; maritime empire of 185, 191, 192 Augello, Massimo M. 27 Augsburg, Peace of (1555) 25 Augustus, Emperor of Rome 196 Aurungzeb, Mogul Emperor of India 181–82 Australia 13, 76, 77, 186, 189, 193, 209; civil law system of 83; Gold Standard, adoption of 74 Austria 22, 76, 77, 79, 124, 125, 155, 201, 202; Austria-Hungary 203 autarky (beggar your neighbor) 64, 77–79, 166, 170, 206 authority: in bankruptcy law 81; charismatic authority 37–39; between investor and entrepreneur, demarcation of 63–64; ownership and 121–22; shareholders, authority of 124–25 autocracy: autocratic stability 165; autocratic Sultanates of Islam 176, 179; decision agents in 142–43;

230

Index

government, international trade and 176–80; hold-up problem in autocracies 176; subjective selection in 174; tradition of, growth and 172 Axelrod, R. 163 Babylon 4 Baird, D.G. and Rasmussen, R.K. 88, 90, 91 Baird, Douglas G. 89, 90–91, 92, 93 Baker, G. et al. 104–5, 109 Baker, George 103 Baker, G.P. and Hall, B.G. 109 Balia (reform committee) in Florence 153–54, 160 Banda Islands 65, 66 Bank of America 127 Bank of England 69 bankruptcy law: absolute priority rule 89–90, 95, 97, 99; authority 81; British law 98; Chapter 11 proceedings (US) 87, 88, 89, 90, 91, 92, 95, 96; consequences of legal origins 82–83; convergence, pressure in European law for 92–94; creditors 81, 82; creditors, protection for 85; creditors, rights of 84–86; debt, default on 81; debt, predominance over equity finance 83–84; European law, evolution of 92–98, 99; evolution in England of 98; financial development 83–84; French law 97; German law 96–97; goals of 87–88; inflation 81; involuntary bankruptcy 89, 93; judiciary, role of 99; labor contracts, acquittal of 93; legal origins 82–83, 83–87; limited liability 81; liquidation 81; losses, restriction of 81; Netherlands law 94–96; optimal law 93; reorganization 81, 93; reorganization, EU and US rates explained 91–92, 99; reorganization, incidence of 88–89; review and revision 83, 86–87; robustness of 86–87; US law, rationale and practice 89–91, 99; valuation perspective 88 Banque Royale 71 Barbarigo, Andrea 49, 50 Barbarossa, Frederick 151 Barksdale, Jim 59–60 Barro, Robert 164, 165 Bartlett, C.A. and Mohammed, A. 114 Baskin, Jonathan B. 50, 73 Batavia 67

Baumol, William J. 21 Bebchuk, Lucian 143–44 Beck, T. and Levine, R. 83, 84 Belgium 15, 76, 77, 79, 125, 155, 189, 197; civil law system of 83 Bell, King of West Cameroon 187 Bengal 18, 182, 189 Beranek, W. et al. 90 Berger, P.G. and Ofek, E. 126 Berle, Adolf 48–49 Bhattacharjee, A. et al. 88 bi-metallic system in France 74 Biedermeier Bank 22 Bihar 182, 189 Block-Lieb, S. 89 boards and board members 120–21, 122–23, 138 Boehm-Bawerk, Eugen von 24, 28, 39 bond market in Brazil 86–87, 98–99 bonus schemes 106 Boot, A. and Ligterink, J. 88, 92, 216n2 Booz Allen Hamilton Inc 129 Bosnia 202, 213 Brabant 157 Bratton, William W. 126 Brazil 17, 69, 75, 76, 77, 188; bond market in 86–87, 98–99 Breda, Treaty of (1667) 158 Bretton Woods Agreement 79 Bris, A. et al. 88, 92, 216n3 Britain (and England) 5, 6, 14, 25, 26, 27, 36, 41, 45, 77, 78, 175–76, 200, 201, 203, 215; Bank of England 69; bankruptcy law, evolution of 98; Bubble Act (1720) 72–73, 86; Cadbury Code 129, 134–35; colonial institutions 75; common law system of 82, 83; Companies Act (1985) 98; Company Voluntary Arrangement (CVA) 98; Corn Laws (1848) 182; creditors’ rights 84–86; financial development 83–84; financial institutions 69–70; Gold Standard, adoption of 74; imperialism and international trade 181–83; Insolvency Act (1986) 98; investments, waves of 73–75; joint stock companies 50; Joint Stock Company Act (1844) 74; liberal empire of 187–89, 196–97; limited liability in 50; London Stock Exchange 76; maritime empire of 12, 13, 18–19, 185–86, 187, 190–91, 197; mission of empire 192–93; Pax

Index Britannica 182, 188; rentier empire of 19; rise as global power 181; South Sea Company 70–71, 72; Statute of Monopolies in 35; Trade and Industry, Department of 98 British East India Company 66, 181–82, 189, 192–93; Dutch East India Company (VOC) and 69–70 Brouwer, M. and Hendrix, B. 58 Brouwer, Maria 31–32 Bruges 156 Brussels 155, 156 Bubble Act (1720) 72–73, 86 Buetter, Michael 82 Buhrman 131 Bukharin, Nikolay Ivanovich 205 Bulgaria 201 Buondelmonti, Zanobi 217n2 bureaucracy: capitalism and 21; performance pay 115; uncertainty, organizations and 51 Burgelman, R.A. and Grove, A.S. 114 Burgelman, Robert 111, 112, 114 Business Cycles (Schumpeter, J.A.) 22, 39 Buys, Paulus 158 Byzantine Empire 5, 12, 13, 65, 147, 167, 176, 177 Cadbury Code 129, 134–35 Calcutta 181 Caliphate of Islam 176, 214 Cambodia 17, 173, 176 Cambrai, League of 192 Canada 13, 189, 190, 193, 209; civil law system of 83; Gold Standard, adoption of 74 Canal, Nicolo` 150 Candiano Doges of Venice 147 Cantillon, Richard 20 Cape of Good Hope 67 capitalism: adventurous and rational 49–50; capital markets, imperfection in 61; capital movements, control of 79; entrepreneurship, economic development and 20, 21; rationality of capitalist enterprise 41–42 Capitalism, Socialism and Democracy (Schumpeter, J.A.) 22, 40 Carmagnola, Francesco Bussone da 150–51 Carolingian Empire 5 Castro, Fidel 10 Catherine the Great 39

231

Central Asia 202, 211 Central Europe 209 CEO (chief executive officer): changing role of 127–29; duality in 143; Dutch demographics 130–31; external hiring of 131; past and present in large Dutch companies 132–34; remuneration in large Dutch companies 129–30; turnovers in Europe 121, 129, 130 Ceylon 65, 66, 67 change: change agency 37–39; corporate governance, and change in 120–21; Dutch East India Company (VOC), governance change 68–69; institutional change 1–2, 36, 62, 66, 161–62; management of 114–17; regulatory change, pay and tenure 134–36; TOC (Total Organizational Change) 115; transformational change 116; uncertainty and institutional change 1–2 Chapter 11 proceedings (US) 87, 88, 89, 90, 91, 92, 95, 96 charismatic authority 37–39 Charles, Duke of Calabria 152 Charles V 24, 155, 156 Chicago School 30 Chile 17, 75, 76, 77; Gold Standard, adoption of 74 China 4, 12, 13, 14, 29, 33, 37, 42, 71, 74, 162, 169, 175, 176, 178, 187, 188, 194, 196, 201; civil law system of 83; empire of 165, 166–67, 172, 173, 176, 177, 179–80, 182; imperialism and international trade 181–83; Manchu contest for 196; Mongol invasion of 196; recent rise of 183; US/China R&D facilitation 183 Christensen, C.M. and Bower, J.L. 113 Christiensen, A.E. 50 Ciompi Revolution (1378) 152–53 city republics, governance in 146–59 city-states of Italy 36, 142, 146–47, 162, 176, 178, 181, 198, 199 Civil Law of Germany (1896) 82–83 Clark, Jim 59, 60 Clive, Robert 182 co-determination, employees and 144–45 Coase, Ronald 105, 164 Code Napoleon 82, 86 Coen, Jan Pietersz 67 Cold War 8, 211, 212, 214; and after, governance, prosperity and 17–19

232

Index

collective action theory 9–10, 164 collective responsibility 122, 132, 133 collective welfare 164, 198 Collegantia of Venice 47, 49 Collins, J.C. and Porras, J.I. 114 Cologne 158 Cologne War (1582–83) 25 colonial institutions 75 colonies (podestas) of Venice 151, 199 commenda organization in Italy 46–48; commenda ventures 121–22; spread of 49–50 common good 163–65 common law system of England 82, 83 Commonwealth of Nations 209–10 communication, decision-making and 117 Communism 8 Companies Act (1985) 98 Company Voluntary Arrangement (CVA) 98 compensation under uncertainty, models of 105–8 competition 2, 40, 51, 65, 75, 102–3, 122, 125, 161; absence of 12; among employers 105; among financiers 42, 78; among investors 57, 174–75; economic competition 7, 103, 142, 195, 197, 215; entrepreneurship, state and 64; foreign competition 69, 72, 74, 102; global competition 103, 168–69; guild protection against 35; of ideas 64, 176; international competition 169, 176; market competition 7, 128; monopoly and 170–71; perfect competition 28, 167, 169 condottieri warfare 151 conformism 24, 64, 110, 113, 174, 208; non-conformism 27, 174 Confucian bureaucracy 177 Confucius 173 Congo 189 Constantinople 15, 65, 177, 181 Continental Europe 9, 76–77, 129, 200 control rights 136–38 convergence, pressure in European law for 92–94 Corfu 191 Corinth 3 Corn Laws (1848) 182 corporate democracy 143–44, 145 corporate governance: and changes in executive pay 120–21; executive and

121–24; and legislation for executive pay 120; lessons from political governance? 138–40; political and 142–46; public governance and 146–47; see also governance, prosperity and corporatism 142, 143, 145 Corsica 46 Couwenberg, O. 91 craft guilds 2, 32–36, 144–45, 152–53, 155 creditors 81, 82; protection for 85; rights of 84–86 Crete 65 Crotonville Corporate University 117 Crusades 10 Cuba 76, 190 culture: corporate culture 108–10, 118; cultural homogeneity 109, 110 Czechoslovakia 16, 209 Dahya, J. and Travlos, N.G. 136–37 Dahya, J. et al. 129 Dandolo, Enrico 148 Danet, Didier 82 Danzig 209 Dawson, John P. 83 Day, Christian 62 de Gaulle, Charles 211 de Jong, A. et al. 134, 136 de Jong, Linda 130 de-layering 116 de Long, B. and Shleifer, A. 142, 178 de Witt, Johan 158 debt: default on 81; government debt, conversion of 72; predominance over equity finance 83–84; see also bankruptcy law decision agents 141–60; absolutism, political autonomy and 142; autocracy 142–43; CEO, duality in 143; city republics, governance in 146–59; co-determination, employees and 144–45; corporate democracy 143–44, 145; corporatism 142; delegation 141; direct democracy 141; duality 141–42, 143; Florence, corporate democracy and Medici rule in 151–55, 159–60; freedom of expression 145–46; limited liability 143; models of decision making 122–23; Netherlands and Low Countries, governance in 155–59, 159–60; party democracy 142;

Index political and corporate governance 142–46; political autonomy, absolutism and 142; representative democracy 141, 142, 143, 145; shareholder democracy 141, 144; Venice, governance in 147–51, 159–60; see also corporate governance; Florence; Netherlands; Venice decision power 11, 91, 120, 121, 124, 137 decision rights 81, 91, 136–38 Del Guercio, D. et al. 125 delegation 122, 127, 132, 139, 141 Delft 66 Delian League 191–92 Demirgue-Kunt, A. and Maksimovic, V. 75 democracy: centralized democracy 10–11; dictatorship and 8–9, 161–84; direct democracy 141; dispute resolution and 9; liberal democracy 7, 8, 9; nation-building and 200–201; oligarchy and 10–12; party democracy 139, 141, 142, 144, 146; promotion of, empires and 211–12; prosperity and 8; representative democracy 141, 142, 143, 145; stability of 8–10; taxation and democracy 180–81 democracy and dictatorship 161–84; autocratic government, international trade and 176–80; autocratic stability 165; autocratic subjective selection 174; autocratic tradition, growth and 172; collective action theory 164; common good 163–65; dictatorship, autocratic appropriation and static efficiency within stable dictatorships 167–71; dictatorship, dynamic efficiency in 171–75; dictatorship, economic progress and 161; domestic labor, autocratic appropriation by exploitation of 169–70; dynamic efficiency, dictatorial (dis)incentives for 171–75; education 7, 10, 109, 162, 175–76, 187, 193, 198, 204; feudalism 5, 10, 24, 25, 29, 33–34, 36, 70, 151, 173–74, 178–79, 181; foreign labor, autocratic appropriation by exploitation of 170–71; foreign markets, monopolistic appropriation in 169; game theory 163; hold-up problem in autocracies 176; human capital, investments in 175–76;

233

human capital as source of growth 162; ideological servitude 174; imperialism, international trade and 181–83; innovation, favoritism in dictatorships and 172–75; innovation, gains in dictatorships from 171–72; institutions, emergence and change in 161–62; institutions, growth and 161–63, 183–84; institutions, political theory of institution-building 164; international trade and autocratic government 176–80, 184; international trade and imperialism 181–83; local markets, monopolistic appropriation in 167–69; maximum welfare (collective good) 164; military protection of trade routes 181, 182, 183; neo-classical economics 162–63; organizations, rules of 162–63; property rights, security in 161, 183; socialism 17, 21, 32, 174, 175; stability and growth 165, 166–67; stable status hierarchies 173–74; taxation and democracy 180–81; trade, role in institutional development 162, 183–84; voluntary association 15, 50, 178, 209 Denmark 15, 138 Dickson, P.G.M. 71 dictatorship: autocratic appropriation and static efficiency within 167–71; dynamic efficiency in 171–75; economic progress and 161; entrepreneurship, state and 78; see also democracy and dictatorship Digital Equipment Corporation (DEC) 113, 114, 115 diversification: diversified corporations 122; entrepreneurship, state and 63; uncertainty, organizations and 49 diversity 7, 110; organizational diversity 101, 115; religious diversity 157; stimulation of 57, 62, 64, 105 Djakarta (formerly Batavia) 67 Djankov, S. et al. 79, 125, 161 Dolfuss, Engelbert 201 Dollar, D. and Kraay, A. 162 domestic labor, exploitation of 169–70 Dominican Republic 162 Dosi, G. and Marengo, L. 111 Drenthe 155 duality 141–42, 143, 149; CEO duality 137, 143

234

Index

Dutch East India Company (VOC) 35–36, 50, 65–68, 69–70, 72, 73, 120, 157, 180, 189; decentralization of 72; development of 64–69; governance changes 68, 69; see also Netherlands Dutch West India Company (WIC) 68–69 dynamic efficiency 171–75 Easterly, W. and Levine, R. 161 Eastern Europe 34, 175, 197, 201 economics: economic competition 7, 103, 142, 195, 197, 215; economic power 194–95; financial development, political economy of 70, 75–79; neo-classical economics 20, 21, 162–63; progress 44; progress, dictatorship and 161; progress, liberal empires and 13–14 education 7, 10, 109, 162, 175–76, 187, 193, 198, 204 Egypt 13, 36, 76, 77, 186–87; ancient Egyptian civilization 3, 4, 33, 176, 189; Gold Standard, adoption of 74 Elizabeth I 156 Ellison, Larry 60 empires 12–14, 185–215; age of alliance 208–11; alliances and 190–92, 208–11; alliances in Europe 208–10; aspirations of 185; concept of, importance of 187; decline, costs of 197–98; democracy, promotion through 211–12; economic power 194–95; European (20th century) 201–8; formal empire, concept of 185–86; formal empire, voluntary nature of 187; imperial rise and decline 194–98; imperialism, forms of 186; inequality, centrality of 185; innovation, organizational and institutional 198–200; investment and 186–87; liberal empire, benefits of 187–90; liberal empire, concept of 186; military alliances 210–11; military power 194–95; mission of empire 192–94; nation-building and democracy 200–201; Nazi Germany, management of 206–8; post-Cold War situation 212–14; stability, costs of 196–97; Stalin’s Soviet Union, management of 206–8; US hegemony? 211–14; victory, costs of 195–96; of the willing 214–15

England 158; democracy and taxation in 180; Glorious Revolution (1688) 158–59; Latin American plantations 170–71; Royal monopolies in 169; see also Britain (and England) Enkhuizen 66 Enron 134 entrepreneurship: bureaucracy and capitalism 21; Calvinism and economic development, Weber on 23–27, 42; capitalism 20, 21; capitalist enterprise, rationality of 41–42; change agency 37–39; charismatic authority, Weber on 37–39; economic development and 20–43; economic growth 20; extensive growth 20; history of organizations, Weber on 32–37; investment and entrepreneurship, Knight on 30–32, 43; later work of Schumpeter 39–41; life and work of Knight 22–23; life and work of Schumpeter 22; life and work of Weber 22, 23, 42; neo-classical economics 20, 21; productivity growth 20; Schumpeter’s Theory of Economic Development 27–29; scientific knowledge 20; theories of entrepreneurship 20–21; uncertainty, organizations and 44, 45 entrepreneurship and state 61–80; authority between investor and entrepreneur, demarcation of 63–64; capital markets, imperfection in 61; capital movements, control of 79; competition 64; conformism 64; decentralization of VOC 72; development of VOC 64–69; dictatorship 78; disequilibrium 61; diversification 63; diversity, stimulation of 62; entrepreneurs, valuation of 62; expectational intertemporal equilibrium 61; financial development, political economy of 70, 75–79; financial markets 61; financial markets, ‘weeding out’ function of 63; financial sources 63; freedom of incorporation 74; governance, unpredictable shifts in 63; governance changes in VOC 68–69; government approval, requirement for ex ante approval 72–73; government debt, conversion of 72;

Index inflation 78; investment waves 73–75; investor confidence 62–63; investorentrepreneur relationships 61–62, 63–64; limited liability 64; monopolies 63, 74–75; political decisions and investor confidence 62–63; political economy of financial development 75–79; private enterprise 70–71; productivity 61; risk absorption, state and 69–72; shareholding 64; shipping and merchantile activities in Low Countries 64–69; social welfare 61; state and risk absorption 69–72; stock market crisis (2000) 80; twenty-first century empire? 79–80; uncertainty 61; unemployment 61; welfare states 78–79 Estates General of France 179, 180 Estonia 201 The Ethics of Competition (Knight, F. H.) 22 ethnicity as organizational principle 14–17 Europe: autonomous free cities in 5; bankruptcy law in, evolution of 92–98, 99; Bretton Woods system in 79; Central Europe 209; CEO turnovers in 121, 129, 130; city growth in pre-industrial Europe 142; colonization of Africa 190–91; Continental Europe 9, 76–77, 129, 200; cultural assimilation in 16; democratic nation-states in, rise of 198; Eastern Europe 34, 175, 197, 201; empires of (20th century) 201–8; financial development in 76; immigration from 17; liberation from Nazi occupation 211; Middle Ages in 18, 45, 47, 49–50, 170, 177; Mongol invasion of 194; Nazi invasion of 201; organizational and institutional innovation in 198–200; peace in, post-1815 188; political associations in 11; segregation and self-organization in 15; wars between nation-states in 196; Western Europe 16, 20, 21, 33–34, 36, 69, 73, 170 European Union (EU) 19, 129, 209; bankruptcy law, evolution of 92–98, 98–99; reorganization, incidence of 91–92 executive pay, tenure and 120–40; activist shareholders 126, 138; agency

235

theory 121, 136–37; authority and ownership 121–22; boards and board members 120–21, 122–23, 138; CEO, Dutch demographics 130–31; CEO, past and present in large Dutch companies 132–34; changing role of CEO 127–29; collective responsibility 122; commenda ventures 121–22; control rights 136–38; controlling shareholders 125; corporate governance, and changes in 120–21; corporate governance, and legislation for 120; corporate governance, executive and 121–24; corporate governance, lessons from political governance? 138–40; decision making, models of 122–23; decision power 121; decision rights 136–38; delegation 122, 127, 132, 139, 141; diversified corporations 122; external hiring of CEO 131; failure, dealing with 122–23; family blocks 125–26; fixed pay 120, 122; hedge funds 126; hierarchical delegation 132, 139; independence of directors 138; in large Dutch companies 129–34; legislation on shareholder initiatives 126–27; managerial autonomy 120; open corporations 136–37; performance pay 101, 103, 104, 106, 109, 116, 121, 208; public governance, models of 139; regulations, changes in 134–36; remuneration of CEO in large Dutch companies 129–30; residual control model 137; shareholders 120; shareholders, authority of 124–25; shareholders, decision power of 124–27; shareholders, external directors and 137; state controlled corporations 125–26 expectational intertemporal equilibrium 61 extensive growth 20 failure, dealing with 122–23 Fairchild Semiconductors 59 Fama, E.F. and Jensen, M.C. 136–37 fascism in Italy 201 favoritism 102, 108–10, 118–19 Ferguson, Niall: alliances and empire 190–91; British bureaucracy, social ascent and 173; collapsing empires 202; democracy and taxation 180–81;

236

Index

empire, advocation of return of 12–14; ethnicity as organization principle 15–16; financial development, political economy of 76, 77; formal empire, migration and 186; ideas, spread of 215; imperial rise and decline 194–97; imperialism and international trade 181–82; investment waves 73, 74–75; Japanese honor code 206; liberal empire, benefits of 187–90; military alliances 210; military commitment in Iraq 214; mission of empire 192–93; monopoly strategies 171; nation-building and democracy 200–201; Nazi Germany 207, 209; post Cold War scene 17–18; risk absorption and the state 69–70, 71 feudalism 5, 10, 24, 25, 29, 33–34, 36, 70, 151, 173–74, 178–79, 181 Filo, David 60 financial development 83–84; political economy of 70, 75–79 financial markets 61; ‘weeding out’ function of 63 financial sources 63 Finland 125 firm, theory of 102–5 fixed pay 120, 122 Flanders 157 Florence 5, 8, 34, 142, 159, 178, 181, 192, 199; Balia (reform committee) in 153–54, 160; Ciompi Revolution (1378) 152–53; constitutional conflict in 146–47; corporate democracy and Medici rule in 151–55, 159–60; corporatism in medieval 144–45; Florentine Signoria 143, 144–45, 152, 153, 154, 155; Gonfaliniere of Justice 152–53, 154, 155 Ford 125 foreign labor, exploitation of 170–71 formal empire: concept of 185–86; voluntary nature of 187 Forrester, V. 3 Fortis 131, 132 Foss, Nicolai J. 112, 113 France 16, 25, 36, 41, 42, 71, 74, 76, 77, 79, 158, 176, 192, 200, 202, 203; bankruptcy law, evolution of 97; Banque Royale 71; bi-metallic system in 74; civil law system of 82–83, 87, 124–25; Code Napoleon 82, 86; creditors’ rights 84–86;

decolonization by 197; democracy and taxation in 181; empire of 13, 170–71; Estates General of 179, 180; financial development 83–84; Franco-Prussian War 195; French Revolution 6, 8, 10–11, 82, 200; Latin American plantations 170–71; Louisiana trade 70, 71; Mississippi Company 70, 71, 72; Napoleonic rule in 82, 86, 195; Royal monopolies in 169; trading monopolies of 71 Franco, Francisco 201 Franco-Prussian War 195 Franks, J.R. and Torous, W.N. 92 Franks, J.R. et al. 92, 93, 96–97 Franz Ferdinand, Archduke 202 Frederick the Great 195 Frederick Wilhelm II of Prussia 158–59 freedom: of association 11–12; of expression 145–46; of incorporation 74 Freedom and Economic Reform (Knight, F.H.) 22 French Revolution 6, 8, 10–11, 82, 200 Frentorp, Paul 65–66, 67–69, 70–72, 73–74 Frey, B.S. and Benz, M. 121, 139, 142, 143, 144, 145–46 Friedman, Milton 61 Friesland 155, 158 Fukuyama, Francis 6–8 Gabriel, Satya J. 169 game theory 163 Gandhi, Mohandas K. (Mahatma) 193 Gates, Bill 32 Gelderblom, O. 50 General Economic History (Weber, M.) 23, 32, 33–37, 41 General Electric (GE) 116–17 Genghis Khan 4, 196 Genoa 8, 46–48, 65, 70, 148, 181; maritime empire of 191 Germany 9, 14, 15–16, 24–25, 34, 35, 36, 77, 78, 79, 124, 129, 138, 155, 202, 203, 211; bankruptcy law, evolution of 96–97; Civil Law (1896) 82–83; creditors’ rights 84–86; debt finance, importance of 83; defeat of Nazi regime (1945) 198; employee democracy in 144; financial development 83–84; Franco-Prussian War 195; Hanseatic Union 50; Insolvency Code (1994) 96–97; Nazi

Index Germany 14–15, 16, 17, 80, 185, 204–6, 209; Nazi Germany, management in 206–8 Getronics 133 Ghana (formerly Gold Coast) 69, 190 Ghoshal, S. and Moran, P. 199 Gilson, Stuart 88 Gladstone, William Ewart 187 Glaeser, E. et al. 161, 162, 163, 164, 175, 182 globalization 2–6, 12, 78, 80, 202, 214 Glorious Revolution (1688) 158–59 Gold Standard 12, 74–75, 76, 78, 182 Goldsmith, R.W. 196 Gompers, P.A. 58 Gonfaliniere of Justice in Florence 152–53, 154, 155 Google 7, 195 governance: centralized democracy 10–11; city republics, governance in 146–59; Cold War and after 17–19; democracy, dictatorship and 8–9; democracy, dispute resolution and 9; democracy, prosperity and 8; democracy, stability of 8–10, 9; economic success and liberal empires 13–14; empires, questions concerning 12–14; ethnicity as organizational principle 14–17; feudal system 5; Florence, corporate democracy and Medici rule 151–55, 159–60; freedom of association 11–12; globalization, ebb and flow of 2–6; government approval, requirement for ex ante approval 72–73; government debt, conversion of 72; history, Soviet collapse and end of ? 6–8; illiberal empires 12–13; institutional innovation 1–2; institutional instability, growth and 12–13; institutions, trade and 5; integration, collapse of empire and new forms of 18–19; investment decisions, markets and 7; liability problems 1; liberal democracy 7, 9; liberal empires 12–14; limited liability, concept of 10; in Low Countries 155–59, 159–60; market competition 7; minorities and self-determination 16–17; oligarchy and democracy 10–12; political and corporate 142–46; political associations 11–12; prosperity and 1–19; revolution and leadership 9–10; trade, rise and fall of 3, 5–6;

237

uncertainty and institutional change 1–2; unpredictable shifts in 63; in Venice 147–51, 159–60 Grant, R.M. 111 Greece 17, 201, 209; ancient civilization in 3, 33, 36, 46, 188, 197; city-states of ancient Greece 197; creditors’ rights 85; polis (city) in ancient Greece 198 Grimani, Antonio 149, 159 Groningen 68, 155, 158 Guam 190 Guatemala 17 Guelders 158 guilds see craft guilds Guinea 71 Guyana 69 Habsburg Empire 25, 66, 155–56, 181, 197 Hagemeyer 130, 131 Hahn, David 85 Hammurabi Code 37 Hammurabi of Babylon 4, 175 Hanseatic Union 50 Hardt, M. and Negri, A. 2 Hawaii 190 He´bert, R.F. and Link, A.N. 21 hedge funds 62, 126–27, 133, 138 Heijn, Albert 130 Heineken, Alfred 130 Heineken Corporation 130, 131 Helots 166 Hewlett Packard (HP) 113, 114 Hibbert, Christopher 152, 153, 154, 198 hierarchical decision-making 113–14 hierarchical delegation 132, 139 History of Economic Analysis (Schumpeter, J.A.) 27–28, 39, 40–41, 42 History of Venice (Norwich, J.J.) 147 Hitler, Adolf 15, 204–6, 206–8 Hohenzollern Empire 197 hold-up problem in autocracies 176 Holland see Netherlands Holy Roman Empire 6, 18, 25, 192, 197 Hoorn 66, 68 Hoover, C.B. 46 Hopt, K.J. and Leyens, P.C. 138 Houtman, Cornelis de 65 human capital: as growth source 162; investments in 175–76; valuation of 101–2, 111–12, 118 Hungary 16, 41, 201

238

Index

Hunt, Bishop Charleston 73 Hussein, Saddam 17–18 IBM 125, 195 ideological servitude 174 illiberal empires 12–13, 185–86, 206 IMF (International Monetary Fund) 13, 188 imperialism: forms of 186; international trade and 181–83; rise and decline of 194–98; see also empires incentive contracts 57 incentive pay 102–5 India 13, 14, 29, 34, 76, 77, 162, 172, 173, 178, 186, 187, 188, 192, 212; Amritsar, massacre at (1917) 193; British bureaucracy in 173; civil law system of 83; Dutch trading posts in 67; imperialism and international trade 181–83; Indian Army 193; Indian Mutiny (1857) 193; Mogul Empire in 169, 181–82, 187; recent rise of 183 Indian Mutiny (1857) 193 Indonesia 170, 186, 193 inequality of empire 185, 189, 191, 193, 204 inflation: bankruptcy law 81; entrepreneurship, state and 78 ING Group 131 innovation: favoritism in dictatorships and 172–75; gains in dictatorships from 171–72; organizational and institutional in empires 198–200; uncertainty, organizations and 44 Insolvency Act (UK, 1986) 98 Insolvency Code (Germany, 1994) 96–97 institutions: emergence and change in 161–62; growth and 12–13, 161–63, 183–84; instability of, growth and 12–13; institutional innovation 1–2; political theory of institutionbuilding 164; trade and 5; see also governance integration, new forms of 18–19 Intel 114 international trade: autocratic government and 176–80, 184; imperialism and 181–83 intrinsic motivation 108–10 investment: decisions on, markets and 7; different perceptions, investor and entrepreneur with 53; empires and 186–87; entrepreneurship, state and

investor-entrepreneur relationships 61–62, 63–64; identical perceptions, investor and entrepreneur with 51–53; investor confidence 62–63; models of investor-entrepreneur relationships 51–56; reason why investors’ perceptions should differ 53–55, 62; share of profit contracts 55–56; uncertainty and 56–58; waves of 73–75 involuntary bankruptcy 89, 93 IPOs (Initial Public Offerings) 43, 45 Iran (formerly Persia) 74, 185; Islamic Republic of 17, 18; Persian Empire 4–5, 191 Iraq 213–14 Ireland 18, 201 Islam 5, 18, 175; autocratic Sultanates of 176, 179; Caliphate of 176, 214; Muslim ascendancy in seventh century 194 Israel 17, 18, 124, 125 Italy 24–25, 27, 34, 124, 155; city-states of 36, 142, 146–47, 162, 176, 178, 181, 198, 199; civil law system of 83; commenda organisation in 46–48, 49; empire of 17; fascism in 201; inter-imperial fighting in 192; maritime ventures in Medieval Italy 45–51, 60, 61–62; societas maris 47, 59, 60; societas terra 49 James II 158 Japan 14, 21, 76, 77, 79, 174, 175, 211; civil law system of 83; debt finance, importance of 83; Dutch trading posts in 67; empire of 165, 166–67; imperialism and international trade 181–83; Japan-Russo War 202; Japanese Empire 17; Tokugawa Shoguns in 177 Java 74, 193 Jensen, M.C. and Meckling, W. 57, 164 Jensen, M.C. and Murphy, K.J. 127–28 Jensen, M.C. et al. 120, 127, 128–30, 134 Jews 15, 16, 26, 177, 200, 202, 203, 207 Jobs, Steve 60 Johnston, James 131, 132 joint stock companies 35, 36, 50, 73; Joint Stock Company Act (1844) 74 Jordan, M. et al. 110 judiciary, role in bankruptcy law 99

Index Kaiser, Kevin M.J. 88–89, 92, 97, 98 Kamenev, Lev Borisovich 205 Kaplan, David A. 59 Kaplan, R.D. 3 Karzai, Hamid 213 Kaufman, D. and Kraay, A. 161, 178 Kennedy, Paul 194 Keynes, John Maynard 79 Khomeini, Ayatollah Ruhollah 18 Kirkpatrick, Jeanne J. 213 Kleiner & Perkins 59 KLM Airlines 133 Knight, Frank H. 21, 39–40, 42, 44–45; on investment and entrepreneurship 30–32, 43; life and work of 22–23 Kohn, Meir 50 Koogle, Tim 60 Kopinski, Thaddeus C. 132 Korean War 17 Kosovo 213 KPN 132 Krugman, P. 3 Kuwait 213 La Porta, R. et al. 83, 84–85, 124, 125, 174 labor: acquittal of labor contracts 93; domestic labor, exploitation of 169–70; foreign labor, exploitation of 170–71; management and, goals of 100 Lal, Deepak 173, 174, 182, 186, 187–89, 193, 194, 196, 197 Lando, Michele 153 Lando of Gubbio 152 Lane, Frederic C. 49, 50 Lasalle 127 Latin America 8, 13, 20, 75, 76, 77, 85, 170, 172, 188, 197, 212; Monetary Union of 74 Latvia 201 Law, John 70, 71 Lazear, E. and Rosen, S. 106 League of Nations 16, 209, 212 legislation: legal origins of bankruptcy law 82–83, 83–87; on shareholder initiatives 126–27 Lemaire, Isaac 67 Lenin, Vladimir I. 10, 205 Leontief, Wassily 29 liberal democracy 7, 8, 9 liberal empires: benefits of 187–90; concept of 186; governance, prosperity and 12–14

239

Liemandt, Joe 115 Light ‘N Easy Irons 116 limited liability: bankruptcy law 81; concept of 10; decision agents 143; entrepreneurship, state and 64 Lipset, Seymour M. 8, 162 liquidation 81, 87, 88, 89, 91, 92, 93, 94–95, 96, 98, 123 Lithuania 16, 201 Lombardy 148 London Stock Exchange 76 Louis Napoleon 68 Louis XIV 70–71 Louis XV 179 Louisiana purchase (1803) 189 Lucca 152 McCaw Cellular 59–60 Macedonia 202 McGregor, Douglas 110 McGuire, M.C. and Olson, M.C. 165, 168 Machiavell, Nicolo` 145, 146, 150–51, 152–54, 166, 199, 217n2 McNeill, W.H. 3, 4, 5, 24–25, 34, 41, 175, 177, 196, 198 Maddison, Angus 20, 73, 170, 172, 175, 179, 188, 215 Madras 181 Malaysia 162 management 59–60, 66, 83, 91, 92, 97, 98, 124, 126; autonomous management 45; corporate management 109, 125, 138–40, 144–46; creditors’ rights and 84–85; European management 93; failure of 99; incumbent management 67, 81, 85, 88, 89, 93, 127, 134, 136; interim management 192; labor and, goals of 100; lower and middle management 123, 124, 141, 160; management theory 100–101, 118; managerial autonomy 120; mismanagement 67–68; motivation of 104–5; risk management 135, 137; senior management 113, 114, 116, 117, 118, 121, 128–29, 133, 146 Manchu China 196 Mao Zedong 10, 168, 173, 176 Marcos, Ferdinand 212 Marcus Aurelius 196 Margaret of Parma 156 market competition 7, 128 Markkula, A.C. ‘Mike’ Jr. 60

240

Index

Marshall Aid 195 Maurice of Orange 157 Means, Gardiner 48–49 Medici, Alessandro 154–55 Medici, Cosimo de 142, 153, 155, 160 Medici, Giovanni di Bicci de 153 Medici, Lorenzo de 154 Medici, Piero de 154 medieval age see Middle Ages Meijer, G. and Meijer, S.Y.T. 82 Memmo, Tribuno 147 Menger, Carl 24 Mesopotamia 3, 4, 36, 37, 175, 182, 185, 194, 198 Mexico 77, 125, 170, 190; civil law system of 83 Michiel II, Doge of Venice 148 Microsoft 32, 38, 60, 125, 133, 195 Middelburg 66, 68 Middle Ages 3, 25, 32, 37, 46, 70, 142, 155, 178, 187; medieval banking 181 Midway 190 Milan 142, 150, 153 military alliances 210–11 military power 194–95 military protection of trade routes 181, 182, 183 Milkovich, G. and Newman, J. 104, 105 Ming dynasty 177, 196 Mississippi Company 70, 71, 72 Mogul Empire in India 169, 181–82, 187 Moltke, Helmuth, Graf von 203 Mongol Empire 185, 194, 196 monopolies: chartered monopolies 63, 65, 66, 67, 68, 69, 72, 74, 122, 169; entrepreneurship, state and 63, 74–75; foreign markets, monopolistic appropriation in 169; local markets, monopolistic appropriation in 167–69; monopoly rights 35, 70, 83; state monopolies 26, 41, 169 Montagu, Sir Edwin 193 Montenegro 202 moral hazard 2, 51, 57, 100, 104, 118, 134, 145, 174 Morosoni, Marin 149 motivation 11, 24, 110; cohesion in 102; employee motivation 100, 102, 103; entrepreneurial motivation 30, 39; extrinsic motivation 108, 139; intrinsic motivation 108–9, 111; in principal-agent model 108 Motorola 60

Mujahedin 17–18 Mumbai (formerly Bombay) 181 Munster (and Westphalia), Treaty of (1648) 158 Murphy, K.J. and Zabojnik, J. 128 Musacchio, Aldo 77, 86–87 Mussolini, Benito 201 Mycenaea 3, 6, 197 Myers, Stewart 105 Najemy, John M. 152 Naples 152, 154 Napoleon Buonaparte 8, 155, 187 Nasser, Gamal Abdel 186, 187 nation-building 14, 15, 16, 17, 24, 197, 200–201 NATO (North Atlantic Treaty Organization) 209, 210–11, 213–14 Nazi Germany 14–15, 16, 17, 80, 185, 204–6, 209; management in 206–8 Negroponte 150 neo-classical economics 20, 21, 162–63 Netherlands 5, 23, 25–26, 27, 41, 45, 77, 78, 79, 124, 125, 138, 159–60, 162, 176, 194, 200, 214–15; Abjuration, Oath of (1581) 156–57; bankruptcy law, evolution of 94–96; British East India Company and VOC 69–70; Civil Code 82; Code of Commerce 74; creditors’ rights 84–86; decision agents 155–59, 159–60; Dutch Culture Regime 190; Dutch East India Company (VOC) 35–36, 50, 65–68, 69–70, 72, 73, 120, 157, 180, 189; Dutch Medieval Republic 147; Dutch West India Company (WIC) 68–69; 80 Years War 156; executive compensation and tenure in large Dutch companies 129–34; financial development 83–84; Holland, province of 155, 156, 157, 158; imperialism and international trade 181–83; independence of 158; investments, waves of 73–75; Latin American plantations 170–71; maritime empire of 13, 185–86, 191, 197; mission of empire 192–93; monopoly charter of VOC 72; Nederlandse Handelsmaatschappij (NHM, Dutch Trading Company) 73–74; quasi-independent city states in 155–59; rederijen (shipping companies) 50, 64–69, 72; shipping and merchantile activities in Low

Index Countries 64–69; Stadthouders in 155; States General in 68, 156–58; Tabaksblat Code (corporate governance code) 126–27, 133, 134–36; Tulipmania 62; Utrecht Union 156; Wisselbank 69 Netherlands Antilles 69 Netscape 59–60 New York 69 New Zealand 85, 189, 209 Nigeria 209, 210; civil law system of 83 North, D.C. and Thomas, R.P. 36, 41 North, Douglas C. 1–2, 49, 70, 161 North Africa 46 North Korea 17 Norwich, John Julius 122, 147–50, 177 Numico 130, 131, 132 OECD (Organization for Economic Cooperation and Development) 21 oligarchy 3, 9, 10–12, 148 Olson, Mancur 161, 164–65, 166, 171 Olson, M.C. and McGuire, M.C. 168, 172 OPEC (Organization of Petroleum Exporting Countries) 169 open corporations 136–37 Oracle 60 organizations: conducive to entrepreneurship 45; organizational psychology 102, 108–9, 110, 118; rules of 162–63; see also, corporate governance; governance; uncertainty, organizations and Orissa 182, 189 Osterloh, M. and Frey, B.S. 101, 108, 111–12 Oticon 113 Ottoman Empire 5, 14, 16, 26, 33, 176, 177, 179–80, 197, 202 Overijsel 158 Overy, Richard 204–5, 206–7 Padgett, J.F. and Ansell, C.K. 153 Parsons, Talcott 23, 29 Parthia 5 party democracy 139, 141, 142, 144, 146 Pax Britannica 182, 188 Peloponnesian War 3, 166 performance pay 100–119; agency theory 101, 103–5, 118; bonus schemes 106; bureaucracy 115; change, management of 114–17;

241

communication, decision-making and 117; compensation under uncertainty, models of 105–8; corporate culture 108–10, 118; cultural homogeneity 109, 110; de-layering 116; discourse, role of 101; executive pay, tenure and 101, 103, 104, 106, 109, 116, 121, 208; favoritism 102, 108–10, 118–19; firm, theory of 102–5; hierarchical decision-making 113–14; incentive pay 102–5; intrinsic motivation 108–10; management theory 100–101, 118; motivation, cohesion in 102; organizational psychology 102, 108–9, 110, 118; personal relationships 111–12, 117; principle-agent theory 100; project evaluation, employee evaluation and 114; project selection 112–14; promotion policies, importance of 100–101; promotion premium, derivation under favoritism 118–19; remuneration policies, importance of 100–101; risk-sharing 101; strategy making 114; subjectivity in valuation of human capital 101–2; team spirit 111–12; tournaments 106–8; tradeable knowledge 112; transformational change 116; uncertainty and incentive pay 101, 102–5; uncertainty and risk-sharing 101, 118; uncertainty and strategy development 111–14; valuation of human capital 101–2, 111–12, 118 Pericles 191 Peron, Juan 8 Persia see Iran personal relationships 111–12, 117 Peru 170 Pfeffer, J. 109 Phelps, E. and Zoega, G. 61 Phelps, Edmund S. 61 Philip II 155–56, 157 Philip the Good 155 Philippines 9, 190, 212 Philips 130, 131 Phoenicia 3, 4 Piacenza 48 Pisa 46–48, 152 Pixar 123 Plato 3, 27–28, 166 Pochet, Christine 96, 97 Pol Pot 17, 173, 176

242

Index

Poland 15, 16, 41, 203, 209 politics: autonomy, absolutism and 142; corporate governance and 142–46; financial development and political economy 75–79; political associations 11–12; political decisions and investor confidence 62–63 Pope Clement VII 154, 217n2 Pope Julius II 192 Portugal 26, 65, 69, 125, 177, 201; civil law system of 83; decolonization by 197; Gold Standard, adoption of 74; maritime empire of 13, 185, 197; merchantile model 65, 66 Postan, M.M. 50 Powelson, J.P. 200 Preeg, Ernest H. 183 Prendergast, Canice 103–4 Princip, Gavrilo 202 principal-agent model 44, 45, 48, 50, 51, 108 principal-agent theory 50, 100, 103, 108, 110, 137, 149 private enterprise 70–71, 72, 180, 185 productivity 116, 117; growth in 20, 22, 28, 61, 182, 183, 208; labor productivity 169; national income and 206 profit shares 47, 55, 56, 57, 59, 60, 62, 103 property rights, security in 161, 183 The Protestant Ethic and the Spirit of Capitalism (Weber, M.) 23–24, 26, 44, 49 Protestantism and the Rise of Capital (Weber, M.) 22 Rajan, R.G. and Zingales, L. 75, 76, 77–78 Rajan, R.G. et al. 122 Rayton, P. 103 Recife 69 Reed Elsevier 131, 132 Renaissance 5, 37 reorganization in bankruptcy 81, 88–89, 91–92, 93, 99 representative democracy 141, 142, 143, 145 Republic (Plato) 3, 27–28, 166 residual control model 136–37 Riemersma, J.C. 50 risk: absorption of, state and 69–72; aversion to 101, 113, 118, 123, 127;

risk premiums 2, 12, 31, 188; risk-sharing 101, 106, 109, 118; see also uncertainty, organizations and Risk, Uncertainty and Profit (Knight, F.H.) 22, 30–31 Robert, J.J. 92 Robert, King of Naples 152 Rogers, Gregory C. 114 Roman Empire 3, 4, 5, 12, 13, 33, 38, 175, 185, 188, 189, 196; fall of 197; polis (city) in ancient Rome 198, 199 Roman Republic 142, 143, 163, 170; foenus nauticum (sea loan) 46; Roman Law 32, 37, 199 Romania 201, 202, 209 Roosevelt, Franklin D. 80 Rotterdam 66, 68 Royal Dutch Shell 131, 132, 133 Rucellai, Cosimo 217n2 Rudolf II 24 Russia 16, 18, 34, 38, 76, 195, 201, 202, 203; bi-metallic system in 74; Romanov Empire 201–2; Royal monopolies in 169; Russo-Japanese War 202; Tsarist Russia 16, 169 S & P 500 127–29 Sahlman, William A. 59 Samoa 190 Sarbanes-Oxley Act (2002) 62, 134, 137, 143 Sardinia 46 Saudi Arabia 18, 214 Savonarola 154 SBM Offshore 132 Scandinavia 41, 79; civil law of countries of 82–83 Schama, Simon 26 Schein, Edgar H. 108, 113 Schmoller, Gustav von 23 Schneider, B. et al. 110, 115 Schneider, Benjamin 109–10, 115 Schumpeter, Joseph A. 21, 30, 31, 37–38, 41–42, 42–43, 44, 45, 141, 199; later work of 39–41; life and work of 22–23; Theory of Economic Development 27–29 Science and Society (Weber, M.) 32–33 scientific knowledge 20 Senegal 71 Sequioa Capital 60 Serbia 202 Sforza, Ludovico 142 Shammas, C. 50

Index shareholders: activist shareholders 126, 138; authority of 124–25; controlling shareholders 125; decision power of 124–27; entrepreneurship, state and shareholding 64; executive pay, tenure and 120; external directors and 137; family blocks 125–26; shareholder democracy 141, 144 Shy, O. 52, 163 Siberia 38 Sicily 46 Sierra Leone 192, 209 Signoria of Florence 143, 144–45, 152, 153, 154, 155 Silicon Graphics 59 Silicon Valley 45, 60 Silver Standard 74 Singapore 161, 183 Slater, Robert 117 slavery 193, 200; abolition in North of US 192; in Africa 170 Smith, Adam 189 Social and Economic Organization (Weber, M.) 23, 37 socialism 17, 21, 32, 174, 175 societas maris 47, 59, 60 societas terra 49 Soderini, Piero 154 Sophism 3 South Africa 194, 200, 212 South Korea 14, 161, 174, 182, 183, 211 South Sea Bubble 62, 73 South Sea Company 70–71, 72 Soviet Union 3, 6, 8, 14–15, 16, 17, 18, 78, 80, 169, 173, 175, 178, 185, 187, 201, 203, 204–6; collapse of 6–8, 18, 209, 214; Stalin’s Soviet Union, management of 206–8 Spain 25, 26, 36, 41, 65, 70–71, 155, 176, 192, 200; civil law system of 83; decolonization by 197; democracy and taxation in 181; fascism in 201; Latin American plantations 170–71, 172; maritime empire of 185, 189; trade with Americas 50 Spanish American War 190 Sparta 3, 166, 175, 178, 191 Sri Lanka 85 stability: costs of stable empires 196–97; growth and, in democracy and dictatorship 165, 166–67; stable status hierarchies 173–74 Stadthouders in Netherlands 155

243

Stalin, Josef 16, 166, 204–6; management of Soviet Empire 206–8 state controlled corporations 125–26 States General in Netherlands 68, 156–58 Statute of Monopolies 35 stock market crisis (2000) 80 Stork 133 Stuart, Maria 158 Sub-Saharan Africa 9, 187–88, 197 Sudan 212 Suez Canal 13, 186 Sumatra 193 Sumeria 3 Surinam 69 Sweden 125, 201 Sweezy, Paul Marlor 29 Switzerland 77, 78, 201; civil law system of 83 Syria 46 Tabaksblat Code (corporate governance code) 126–27, 133, 134–36 Taiwan 161, 183 Tandem Corporation 59 taxation and democracy 180–81 TCI 126, 133 team spirit 111–12 technological progress 20, 44, 110, 113, 183 Thailand 212 Theory of Economic Development (Schumpeter, J.A.) 22, 27, 28–29, 39–40 Theory of Profits and Uncertainty (Knight, F.H.) 30 Thrace 202 3M Corporation 114 Tichy, N. and Sherman, S. 116–17 Tichy, Noel 115 Tilley, Allan 94, 96, 97 TNT 133 TOC (Total Organizational Change) 115 Tocqueville, Alexis de 10–12 Tokugawa Shoguns in Japan 177 Tom Tom 133 tournaments 106–8 trade: rise and fall of 3, 5–6; role in institutional development 162, 183–84 tradeable knowledge 112 Tradonico, Piero 147

244

Index

transformational change 116 Treviso 148 Tribuno, Piero 147 Trieste 149 Trilogy 115 Trotsky, Leo 205 Tsarist Russia 16, 169 Turkey 17 Tuscany 154, 155 Uganda 209 Ukraine 16 uncertainty, organizations and 44–60; bureaucracy 51; capitalism, adventurous and rational 49–50; commenda organization, spread of 49–50; competition among investors 57; diversification 49; economic progress 44; entrepreneurship 44, 45; incentive contracts 57; incentive pay and uncertainty 101, 102–5; innovation 44; institutional change and uncertainty 1–2; investments and uncertainty 56–58; investorentrepreneur relationships, models of 51–56; Italy, maritime adventures in medieval times 45–51, 60, 61–62; joint stock companies 50; maritime enterprise, Weber on evolution of 48–49; moral hazard 57; organizations conducive to entrepreneurship 45; principal-agent relationships, Weber on 44, 45, 48, 50–51; profit shares 57; progress and innovation 44; risk-sharing and uncertainty 101, 118; Silicon Valley 45, 60; strategy development and uncertainty 111–14; technological progress 44; uncertainty and entrepreneurship 44; uncertainty and technological progress 44; venture capital, comparison of old and new 58–60 unemployment 19, 61, 64, 79 Unilever 131 United Nations (UN) 212–14 United States 6, 10–11, 13, 14, 15, 16, 17–18, 19, 76, 77, 78, 79, 129, 137–38, 175–76, 189, 194, 195, 197, 203, 214–15; American Civil War 8; American Revolution 6, 8; bankruptcy law 87–89, 91–92, 98–99; bankruptcy law, rationale and practice 89–91, 99; civil law system

of 83; creditors’ rights 84–86; financial development 83–84; hegemony of ? 211–14; imperialism of 189–90; incorporation law 74; Louisiana purchase (1803) 189; Marshall Aid 195; New Deal and National Recovery Act 80; reorganization, incidence of 88–89, 89–90, 91–92; Sarbanes-Oxley Act (2002) 62, 134, 137, 143; slavery, abolition in North of 192; US/China R&D facilitation 183; venture capital firms 58–59 Uruguay 17 USSR see Soviet Union Utrecht 155, 156, 158; Treaty of 70–71; Utrecht Union 156 van der Moolen 132 van Heemskerck, Jacob 65 van Oldenbarneveldt, Johan 65–66, 67, 157 van Wassenaer Obdam, Jacob 158 van Waveren, Freek 133 Vargas, Getu´lio D. 77 VEB (Dutch Association of Security Owners) 127, 144 Vendex/KBB 133 Venice 5, 8, 15, 34, 46–48, 65, 66, 70, 122, 142–43, 154, 159–60, 177, 178, 181, 192, 194, 214; Collegantia of 47, 49; colonies (podestas) of 151, 199; condottieri warfare 151; Council of Ten 149–50; governance in 147–51, 159–60; Great Council of 46, 148–49; maritime empire of 185, 187, 191; Venetian Republic 143 venture capital 58–60 Verkleij, Roderik 129 Versailles 42; Conference at (1919) 15–16 Versatel 132 Vietnam 173; War in 17, 214 Vikings 12 Visconti, Gian Galeazzo 142, 150 VNU 133 voluntary association 15, 50, 178, 209 Walter, Duke of Athens 152 Weber, Max 21, 40; bureaucracy model 146; Calvinism and economic development 23–27, 42, 44; capitalism as rational calculation 41–42; charismatic authority 37–39;

Index favoritism and innovation 173–74; favoritism and privilege 102; feudal organization and ethics 5; financial authority 121; on Florentine commerce 160; globalization, ebb and flow of 3–4; history of organizations 32–37; human capital, investment in 175–76; institutional innovation 199–200; international trade and autocratic government 177–79; life and work of 22, 23, 42; maritime enterprise, evolution of 48–49; on maritime ventures in medieval Italy 47–48; marriage as stabilizing influence 155; on origins of kingdoms and nations 165; principal-agent relationships 44, 45–46, 48, 50–51; Protestant Ethic 23, 24, 44, 49, 216n1; tradition, resistance and 172; on venture capital 58, 59 Weinacht, Paul-Ludwig 82 Weisbach, M.S. 138 Weisberg, Robert 89 Welch, Jack 116 welfare: maximum welfare (collective good) 164; social welfare 61; welfare states 78–79 West Africa 69 Western Europe 16, 20, 21, 33–34, 36, 69, 73, 170

245

Westphalia, Peace of (1648) 25 Wilhelmina, Queen of the Netherlands 193 William I 73, 190 William II of Orange 69, 156–57, 158 William III of Orange 70, 158 William IV of Orange 158–59 William the Silent (William I of Orange) 73, 157–58, 160 Wilson, T. Woodrow 15–16 Wisselbank 69 Wolters Kluwer 130, 131 World Bank 13 World War I 3, 6, 77, 78, 193, 195, 202–3, 209, 211 World War II 3, 17, 77, 193, 194, 195, 205–6, 209, 211 Worldcom 134 Wozniack, Steve 60 Yahoo 60 Yang, Jerry 60 Yugoslavia 16, 17, 201, 213 Zakaria, Fareed 163 Al-Zawahiri, Ayman 214 Zeeland 65–66, 67, 155, 156, 157, 158 Zimbabwe 9, 210 Zingales, Luigi 105 Zinoviev, Grigoriy Yevseyevich 205