that I am studying. It will next survey the development of government bond markets in The Netherlands and England. It will then analyze the raising of capital by the EIC and VOC in the primary market, after that explain the emergency of secondary market in company shares in the Dutch Republic and the absence of such a market in England for another century, and finally conclude from the history, theory and policy viewpoints.
1. Theories of Law, Finance and Economic Development
Economic theory long assumed that stock market development allowed the transfer of capital from investors to entrepreneurs and contributed to economic growth. In the last two decades, empirical studies have provided clear support not only for the claim that stock market development and economic growth are correlated, but also for the direction of the causality, from stock market to growth. More recently, a rapidly growing body of literature has established the claim that stock market development results from a supporting legal and institutional framework.2 It is now asserted, on both theoretical and empirical grounds, that by designing the appropriate investor protection law and stock market institutions, developed countries achieved fast and sustainable growth in the past. Today, it is recommended that LDCs do the same, in order to achieve growth in the future.
The definition and protection of property rights by law is essential for investment and for economic development. Individuals are willing to invest more labor and capital in their property when they are sure that the increase in value and in revenues will be captured by them and not by the state or by third parties. Protection of property rights is also good for investment in the stock market. However, investors in the stock market have more particular concerns. The specific concerns of investors in government bonds are different from the concerns of investors in shares of business corporations.3 The main concern for investors in government bonds is that the State will suspend payment or even write off the debt. In other words, the risk is that the State will expropriate bondholders’ intangible property rights in the bonds. A greater obstacle to the development of a government bond market is that States, as absolute and unconstrained sovereigns, cannot credibly commit not to expropriate.
In investment in company shares, a misalignment of interests between insiders and outsiders creates significant agency problems. The main concern for these investors is that insiders will shirk and steal, leaving outsider equity holders with less than their share in the profits or even with a loss of the investment.4 Personal relationships between investors and insiders provide social and other non-legal mechanisms to moderate the problem; however, when the relationship between the insiders and the outsiders is impersonal, the problem is more acute. The law can reduce these concerns. Significant asymmetry in information between insiders and outsiders augments the agency problem. Outsiders need a law that will not only provide them with protective contractual rights but also with an institutional structure that enables them to get verifiable information that they are being defrauded.
The law and finance literature (La Porta, Lopez-de-Silanes et al. 1997; La Porta, Lopez-de-Silanes et al. 1998)finds that legal origins matter. Equity capitalization and GDP per capita are predicted by the legal origins of the current legal system of a state. To put it differently, the
2 For good surveys of this literature see: Beck, T. and R. Levine (2005). Legal Institutions and Financial Development. . C. Menard and M. M. Shirley. Dordrecht, Springer, Dam, K. (2006). . Washington, Brookings Institution Press.
3 I will focus here on equity investment in corporations, leaving aside corporate bonds.
4 There is also a secondary concern for expropriation by the State.