William N. Goetzmann Yale School of Management Financial Innovation William N. Goetzmann Yale School of Management

A Puzzle Why didn’t the industrial revolution begin in China? Song dynasty (960-1127) Superior Eastern science Organized central government Wide rule of law Meritocratic society Unprecedented literacy Answer: Finance

Overview Background and Motivation Foundations of Capital Markets Historical Development

Foundations Time Chance Market Company

Time Loan Stocks Pension Institutions Exchange of value through time Buying future dividends Pension Invest now for future reward Institutions Family, Bank, Fund, Government, Non-profit

Chance Future is Uncertain Options Insurance Structured products Contract on outcomes Fire, market drop, catastrophe Options Insurance Structured products Probability theory and stochsastic processes

Market Transferability Assets as close economic substitutes Paper and electronic symbols of contracts Complex network of equivalencies

Company Non-human entity Corporate capitalism Urban government Church or order Private corporation Corporate capitalism

Historical Thesis Europe’s advancement in financial technology was sparked in the late Middle Ages by deficit financing of municipal governments. Corporate finance drew directly on existing government securities markets. China never indigenously developed bonds or markets. Lack of indigenous foundations led to conflict.

Elements of Financial Technology Time is Money Contracts and instruments that move money through time. Present value comparison of cash flows in time. Contingent Claims Insurance Contracting on economic outcomes. Negotiability Creating transferable claims and a market. Corporate Capitalism Separating financing from investment decision.

Roots of Finance: China Contracts (bi-partite) 750 B.C. Loans 750 B.C. Financial institutions (pawnshops) 700 A.D. Legal systems for international finance, 700 A.D.

Property Rights: 1000 B.C.

Securitized Lending 700 A.D.

Roman Equity Shares 200 B.C.

Iraq: Legal Contracts 1600 B.C.

Ptolemaic & Roman Egypt Giro banks Checking Annuities Shares Mortgages Chirographs

Feudal Foundations Assignment of property yields Medieval fiefs Fief-rente Census contracts Bailiwicks Bearer-rentes in Low Counties Chirographs in Catalonia

Chirographs and Sticks

The Great Divergence 1100 – 1400 A.D. China at war with steppe peoples. Europe at war with Islam. Both need money.

Map page 74

Finance in Song China

Europe: First Bonds & Shares Adapted from Feudal “Census” loans. Venice Wartime finance Rialto market Genoa Bank of St. George Florence Civic taxation and savings institutions. See Pezzolo

First Bond Market, Rialto, Venice

Monte di Pieta Florentine Bond

Financial Economics 1200 A.D. Leonardo of Pisa, Liber Abaci, 1202 A.D. A business textbook Trading problems Exchange rates Banks and loans Analyzes a fief-rente as a present-value problem Comparing flows using the time-value of money

First Business School? Palazzo Mazzanti, Verona, School of Nicolò Tartaglia

A Perpetuity

Corporate Finance: 1600 Used liquid markets developed for government finance. Used demand for savings and instruments by a new investor class.

Amsterdam: First Corporate Shares and Bonds

The London Exchange and Capitalism

Chinese Enterprise Family Based Proto-capitalism Encounter with the West.

China learns to Borrow Railroad Finance

Western Finance Created an investor class Created a capital market. Diversification of personal risk. Substituting financial security for family security. Created a capital market. Turning technological ideas into economic growth. Financed the growth of global infrastructure. Railroads, electrification and more.

Economic Lessons Financial development depends upon political needs, context. An organic, time-dependent process. Can it be transplanted? clash of financial technologies in Russia and China.

Conclusions Financial capitalism became the polarizing phenomenon of the 20th Century. The roots of that polarity lay deep in the diverging historical development of the nation-state. Finance is an inter-connected set of mathematical, legal and social tools.