Chapter 1 A Short History of Capitalism The Dawn of Capitalism Capitalism happens when people make things and sell them for money. Or if they don't make things, they provide services for money. For much of human history, capitalism was an alien concept, because the bulk of the world's population never got their hands on money. Over thousands of years, the average person lived out his or her life without buying a single item. People worked as serfs, slaves, or servants, for masters who owned the land and everything on it. In return, the workers were given free room in a hut and a tiny plot of ground where they could grow their own vegetables. But they didn't get a paycheck. Nobody complained about working for zero pay, because there was no place to spend it. Once in a while, a pack of traveling salesmen would come through town and set up a market, but a market was an isolated event. The kings, queens, princes, princesses, dukes, earls, and so forth, who owned all the property -- buildings, furniture, animals, ox carts, everything from gold jewelry to pots and pans -- kept it in the family. It wouldn't have occurred to them to sell off a piece of land, even if they could make a big profit and have less grass to mow. There were no "for sale" signs in front of castles. The only ways to acquire real estate were to inherit it or to take it by force. In many parts of the world, since the earliest days of Judaism and continuing with Christianity, business for profit was an X-rated activity and lending money and charging interest could get you kicked out of the church or the synagogue and guarantee you an eternal spot in hell. Bankers had an unsavory reputation, and people had to sneak around and visit them on the sly. The idea of benefiting from a transaction, or getting ahead in life, was regarded as selfish, immoral, and counter to God's plan for an orderly universe. Today, everybody wants to improve his or her lot, but if you had lived in the Midge Ages and you said your goal was to "get ahead" or to "better yourself," your friends would have given you blank looks. The concept of getting ahead didn't exit. If you want more details about what life was like before there were markets and before people worked for a paycheck and had the freedom to spend it, read the first chapter of Robert Heilbroner's classic book The Worldly Philosophers. It's a lot more fun than it sounds. By the late 1700s, the world had opened up for business with brisk trade between nations, and markets were cropping up everywhere. Enough money was in circulation and enough people could buy things that merchants were making a nice living. This new merchant class of shopkeepers, peddlers, shippers, and traders was becoming richer and more powerful than princes and dukes with all their real estate and their armies. Bankers came out of the closet, to make loans. Our Pioneer Investors The history books give many reasons for America's great success -- the favorable climate, the rich soil, the wide-open spaces, the Bill of Rights, the ingenious political system, the nonstop flow of hardworking immigrants, the oceans on each side that protect us from invaders. Backyard inventors, dreamers and schemers, banks, money, and investors also deserve a place on this list. In the opening chapter of our story as a nation, we read about native Indians, French trappers, Spanish conquistadores, sailors who sailed in the wrong direction, soldiers of fortune, explorers in coonskin caps, and Pilgrims at the first Thanksgiving dinner. But behind the scenes, somebody had to pay the bills for the ships, the food, and all the expenses for these adventures. Most of this money came out of the pockets of English, Dutch, and French investors. Without them, the colonies never would have gotten colonized. At the time Jamestown got started and the Pilgrims landed at Plymouth Rock, there were millions of acres of wilderness land along the eastern seaboard, but you couldn't just sail there, pick your spot, clear a space out of the forest, and start growing tobacco or trading with the Indians. You had to have permission from a king or a queen. In those days, the kings and queens ran the whole show. If you wanted to go into business in the royal lands, which was most of the land on earth, you had to get a royal license, called a "charter of incorporation." These licenses were the forerunners of the modern corporation, and business people couldn't operate without a charter or a piece of somebody else's charter. Religious groups such as the Quakers in Pennsylvania got charters. So did groups of merchants, such as the ones that founded Jamestown. And once you had the royal permit to settle the land and start a colony, then you had to look for the financing. That's where the earliest stock market comes into play. As far back as 1602, Dutch people were buying shares in the United Dutch East India company. This was the world's first popular stock, sold on the world's first popular stock exchange, which operated from a bridge over the Amstel River in Amsterdam. Crowds of eager investors gathered there, trying to get the attention of a stockbroker, and when their pushing and shoving got out of hand, police were called in to restore the peace. The Dutch spent millions of guilders (their version of the dollar) for the privilege of owning shares in United Dutch East India, which today, with so many companies known by their abbreviations, might well be called UDEI. In any event, the Dutch company took these millions of guilders raised in the stock sale and used the money to outfit a few ships. These ships were sent off to India and points east to bring back the latest Far Eastern merchandise, which was the rage in Europe at the time. While optimists paid higher and higher prices for the shares of United Dutch East India, figuring the company would make them a fortune, the pessimists bet against the stock through a clever maneuver called "shorting," which was invented in the 1600s and is still being used by the pessimists of today. In the case of United Dutch East India, the optimists turned out to be right, because the stock price doubled in the first years of trading, and the shareholders got a regular bonus, known as the dividend. The company managed to stay in business for two centuries, until it ran out of steam and was dissolved in 1799. No doubt you've heard how Henry Hudson sailed his ship, the Half Moon, up the Hudson River in what is now New York, looking for a passage to India, thus repeating the navigational mistake made by Christopher Columbus. Have you ever wondered who paid for this wild goose chase? Columbus, we all know, got his financing from King Ferdinand and Queen Isabella of Spain, while Hudson got his from the aforementioned United Dutch East India Company. Another Dutch enterprise, the Dutch West India Company, sent the first Europeans to settle on Manhattan Island. So when Peter Minuit made the most famous real estate deal in history, buying Manhattan for a small pile of trinkets worth sixty guilders (twenty-four dollars in our money), he was acting on behalf of the Dutch West India shareholders. Too bad for them the company didn't stay in business long enough to get the benefit from owning all that expensive downtown New York office space. Seeing how the Dutch financed their New World adventures, the English followed their example. The Virginia Company of London had exclusive rights to a huge area that extended from the Carolinas through present-day Virginia and up into part of today's New York State. That company footed the bill for the first expedition to Jamestown, where Pocahontas saved Captain John Smith from having his head bashed in by her angry relatives. The settlers at Jamestown worked there but didn't own the place, a sticking point from the beginning. They were hired to clear the land, plant the crops, and build the houses, but all the property, the improvements, and the businesses belonged to the shareholders back in London. If Jamestown made a profit, the actual residents would never see a penny of it. After seven years of nasty disputes and complaints from the settlers at Jamestown, the rules were changed so they could own their own private property. It turned out not to matter at the time, because the original colony went bankrupt. But there was a great lesson to be learned from Jamestown: A person who owns property and has a stake in the enterprise is likely to work harder and feel happier and do a better job than a person who doesn't. The exclusive right to do business along the rest of the coastline from Maryland into Maine was awarded to yet another English company: the Virginia Company of Plymouth. The way the map was drawn in those days, most of New England was part of northern Virginia. When the Pilgrims landed at Plymouth Rock and stumbled onto shore, they were trespassing on property belonging to the Plymouth Company. Every schoolchild learns how the Pilgrims risked their lives to find religious freedom, how they crossed the cruel ocean in a tiny ship, the Mayflower, how they suffered through cold New England winters, how they made friends with the Indians and got their squash and pumpkin recipes, but nothing about the remarkable story of how they got their money. Let's back up for a minute to review this story. The Pilgrims had left England and taken up residence in the Netherlands, where the first stock market got its start -- not that the Pilgrims cared about stocks. After several years in the Netherlands, the Pilgrims got fed up and decided to move. They had three possible destinations in mind: the Orinoco River in South America; a section of New York controlled by the Dutch; or a parcel of land offered them by the Virginia Company of London. The one thing holding them back was a lack of cash. They needed supplies and a ship, and could afford neither. Without financial help, they would have been stuck in Europe forever, and we might never have heard of them. This is when Thomas Weston entered the picture. Weston was a wealthy London hardware dealer, or ironmonger, as they were called in those days. He had access to property in New England and he had access to plenty of cash, and he and his pals thought the Pilgrims would make an excellent investment: So they made an offer they hoped the Pilgrims wouldn't refuse. Weston's group, who nicknamed themselves "The Adventurers" even though they weren't the ones going on the adventure, agreed to put up the money to send the Pilgrims to America. In return, the Pilgrims had to agree to work four days a week for seven straight years to make the colony profitable. At the end of seven years, the partnership would dissolve and both sides would split the profits, after which the Pilgrims would be free to go their own way. The Pilgrims accepted these terms, because they lacked an alternative, and began packing their bags. Then at the last minute, Weston turned the tables on them and changed the contract. Now, instead of having to work four days a week for the good of the business, they were required to work six. This would give them no free time to plant a home garden, or mend their clothes, or practice their religion, other than on Sundays. After arguing with Weston and getting nowhere, the Pilgrims decided to set sail without a signed agreement and without any travel money, because although Weston had paid for everything so far, he refused to advance them another cent. They had to sell some of the butter they'd made for the trip so they could pay the port charges and leave the harbor in the Speedwell, the ship they had outfitted in Holland. The Speedwell leaked, so they were forced to return to port, suspecting all along that the captain and sailors were in cahoots with Weston and had deliberately sprung the leak. Most of them crowded into a second ship that was smaller and slower than the Speedwell -- the Mayflower. They were crammed into the Mayflower, on their way to their promised land in Virginia, when they drifted off course and overshot their destination. Realizing their mistake, they tried to turn south, but the rocks and shoals of Cape Cod blocked their passage. Rather than risk a shipwreck in these unfamiliar, rough waters, they dropped anchor in Provincetown harbor. From there, they moved to Plymouth, where they built their shelters and planted their crops. With Weston having cut off the money flow, the Pilgrims needed a new source of cash. They worked out a new deal between another group of investors (headed by John Peirce) and the Plymouth Company, which owned the land. The Pilgrims would get one hundred acres apiece to use as they pleased. Peirce would get one hundred acres per Pilgrim. On top of that, he and the other investors would get fifteen hundred acres apiece for paying the rest of the Pilgrims' moving expenses and for bankrolling the settlement. Among their many other worries, how to survive the winter, how to get along with the natives, and so forth, the Pilgrims had to worry about how to pay back the two groups of investors, Peirce's and Weston's, who had put up considerable sums to carry them this far. As much as we like to think of the Pilgrims as focusing only on God, they had the same problems as the rest of us: bills. After one year of the Plymouth colony's being in business, the Mayflower sailed back to England on a visit with an empty cargo hold: no furs, no gems, no crops, nothing the investors could sell. Plymouth was losing money and continued to lose money season after season, or as they say on Wall Street, quarter after quarter. This made the investors very upset, as investors always are when they get zero return on their money. Worse than that, they had to send more supplies back to the colony, so the costs were going up. By 1622, Weston was fed up with Pymouth and supporting the high-cost Pilgrims with nothing to show for it, so he gave away his share of the business to his fellow "Adventurers." Meanwhile, John Peirce was sneaking around the other investors' backs, trying to get control of Plymouth for himself so he could become the "Lord Proprietor of Plymouth Plantation." He didn't get away with it. For five years, Pilgrims and investors carried on their money dispute: the Pilgrims complaining about a lack of support and the investors complaining about a lack of profits. Then in 1627, the partnership was dissolved, with the exasperated investors selling the entire operation to the Pilgrims for the modest sum of eighteen hundred British pounds. Since the Pilgrims didn't have eighteen hundred pounds, they had to buy the colony on the installment plan: two hundred pounds per year. This was the first "leveraged buyout" in American history, a forerunner of the famous RJR Nabisco deal of the 1980s that became the book and the movie Barbarians at the Gate. (In a leveraged buyout, a company is purchased with borrowed money by people who can't really afford it.) The Pilgrims' leveraged buyout was the first time in our history that workers took over the company business. Now comes the most interesting part of the story. As soon as they had established themselves, the Pilgrims decided to live in a communistic way: They pooled their resources and no individual was allowed to own any private property. Governor William Bradford, the Pilgrim leader at the time, saw right away that the communist arrangement would fail. He realized that without private property, the people would have no incentive to work very hard. Why should they bother, when all the inhabitants of the colony got the same benefits (food, housing, and so forth) whether they worked or sat around doing nothing? A few farsighted residents of the colony petitioned Governor Bradford to set things up so farmers and fishermen were allowed to own their own farms and boats and to make a profit from their efforts. In return, they supported the community by paying a tax on their profits. This free-enterprise system that Bradford put in place was basically the same as the one we have today. Being independent did not solve the Pilgrims' money problems. In spite of their hard work, the debt of the colony increased from eighteen hundred pounds to six thousand. More Pilgrims were brought over from Holland to expand the fishing fleet. Their hope was to pay off part of the debt with the profits from fishing, but they never caught enough fish. For ten years, negotiations dragged on between the, colony and its lenders, until the dispute was settled once and for all in 1642. The Pilgrims helped build the social, political, religious, and economic foundation of modern America, but to the investors, they were nothing but a bust. Weston, Peirce, and friends were the big losers in this venture, and they were no dummies, either, which goes to show that; investing is a tricky business, where the best-laid plans can often go awry. Or maybe they deserved what they got, for being so sneaky and underhanded, and for trying to renege on the original deal. This is one instance in which the general population could be happy it didn't have a chance to buy shares: The Pilgrims were not a public company, the way the Dutch West and East India companies had been. But there were other opportunities for the European masses to get in on the New World bonanza, and with equally disastrous results. There was the ill-fated Mississippi Company and the South Sea Company, both of which appeared on the scene in the early 1700s, selling shares to tens of thousands of gullible customers in the stock markets of Paris and London. The Mississippi Company was the pet project of a flashy wheelerdealer named John Law, one of the most interesting characters of his century. Law left his native Scotland, after he'd killed a man in a duel over a failed business venture, and moved to France. He wangled an introduction to the king; Louis XV, who was underage and left the royal decisions to a regent, the Duke of Orleans. Knowing a royal family was the only way to get ahead in those days, and Law convinced the regent that he, Law, could solve the problem of France's huge national debt. Law's plan was for France to hire a printing press and print paper money, which it could use to pay offthe debt. Paper money was a relatively new idea in the world, and the regent was very impressed. So impressed, in fact, that he gave the immigrant from Scotland complete control over the Royal Bank of France, along with the royal printing press. Soon, Law's paper money was circulating everywhere. Almost overnight, he went from being a stranger in the country to being the king of French finance and the wealthiest inhabitant of Paris next to Louis XV himself. With his popularity riding high in the opinion polls, or however they measured it in those days, Law announced his second big project: the Mississippi Company. Its purpose was to bring back fantastic treasures from the vicinity of the Mississippi River. The Mississippi flowed through Louisiana territory, first visited by French explorers (Colbert, Joliet, Marquette) and later claimed by the French. The French people back home thought Louisiana was another Mexico, rich in silver and gold deposits just waiting to be carried away. Law himself had never been to Mississippi, or anyplace else in the New World for that matter, but he did a convincing sales job to make the public believe that the fantastic stories they'd heard were true. Like fans at a rock concert, hysterical Parisians rushed into the maze of narrow streets near Law's mansion. They had to apply to buy shares. Waving their new French money, they fell over themselves trying to get Law's representatives to accept their applications. The price of the shares rose and rose, until Law's company was worth more, on paper, than all the gold in circulation. And still the buyers kept coming. There was hardly a person alive in France who didn't catch the Mississippi fever and dream of Mississippi gold that didn't really exist. They had no information whatsoever about Law's company, other than what Law himself said about it, and there was no Wall Street Journal or Nightly Business News to tell them that Law's scheme had no chance of success. In fact, whenever people questioned him or his company, they were shipped out of town, to distant prisons. Whenever crowds of people bet their life savings on a hopeless proposition, it's called a "mania" or a "bubble." The pattern is always the same. Frantic investors pay ridiculous prices in order to get in on a spurious opportunity, and sooner or later, the prices come crashing down. After the Mississippi "bubble" burst, and people realized Law's company was a sham and Law himself was nothing more than a financial Wizard of Oz, investors tried to unload their shares and found no buyers. They lost their life savings, the French economy collapsed, and the banking system collapsed along with it. As quickly as Law had become a French hero, he became a French goat. England had its own version of the Mississippi Company, the South Sea Company, founded in 1711. The organizers copied all their moves from Law. They promised to pay off England's huge military debt if the English monarch would grant them a monopoly on trade with countries in the "south seas" -- particularly Mexico and Peru. In 1720, the South Sea Company announced a new plan to lend the British government enough money to wipe out its entire national debt, military and otherwise, if the government would agree to pay 5 percent interest on the loan. At the same time, the company began to sell more shares of its stock. Half of London headed for Exchange Alley, the hometown stock market, in their horse-drawn carriages, determined to buy shares. This caused a nasty carriage jam, and the streets were blocked for weeks. There was so much demand for these South Sea shares that the price tripled overnight, before the British Parliament had approved the debt deal. A British statesman even issued a warnlng: People should keep their money in their pockets. But during bubbles such as this one, nobody listens to a lone voice of reason. When the word got out that the organizers of the South Sea Company had gotten very rich by selling shares, other companies were quickly created by people who also wanted to get rich. There was a company for every wild scheme you could think of: a perpetual motion machine, salt farms in the Holy Land, importing walnut trees from Virginia, drying malt in hot air, making lumber from sawdust, inventing a new kind of soap. One company refused to tell investors what it planned to do with their money. It described its purpose as follows: "carrying out an undertaking of great advantage, but nobody can know what it is." Lords and laymen, merchants and menials, people from every profession and every rank in society got drawn into the London stock market expecting to strike it rich. When the bubble finally burst, the English suffered the same fate as the French. The price of South Sea shares took a nosedive, crowds of people lost their life savings, and the British financial system was on the brink of collapse. One by one, the directors of the South Sea Company were brought to trial, had their estates confiscated, and were sent to prison, some in the infamous Tower of London. Sir Isaac Newton was caught in the bubble and lost a lot of money. "I can calculate the motions of heavenly bodies," he said, "but not the madness of people." The South Sea fiasco gave the stock market such a bad name that Parliament passed a law making it illegal to buy or sell shares in any company, no matter what business it was in. The stock exchange was abolished and all trading, which back then was called "jobbing," was brought to a halt. The stockbroker went from being the most popular person in town to an outcast with a worse reputation than any pickpocket, highway robber, or prostitute. This was a sad beginning for stocks, but matters have greatly improved since then, especially in recent decades. Early Entrepreneurs On our side of the Atlantic, residents of the colonies who had come here as part of somebody else's business began to go into business on their own. Companies of many types were established in the early 1700s. Merchants who went into business for themselves, or with partners, soon discovered the advantages of forming corporations. Later on, after we got our independence, Americans took to the idea of incorporation far more readily than the Europeans had. None of the other major industrial nations -- Great Britain, France, Germany, or Japan -- produced as many corporations as we did. In fact, a few of the companies that opened their doors nearly three hundred years ago are still operating today! This is an amazing feat, when you think of all the wars, panics, depressions, and other calamities the country has been subjected to. Generations have come and gone, products drifted in and out of fashion, cities burned, forests deforested, neighborhoods destroyed -- hardly anything has lasted since the 1700s. But J.E. Rhoads & Sons has been around since 1702, when it manufactured buggy whips. Rhoads & Sons would have disappeared long ago, if it hadn't been for its clever managers from the 1860s, who saw the railroads coming and realized there was no future in making buggy whips in a world without buggies. They retooled the factory to make conveyor belts. The Dexter Company got its start as a gristmill in Windsor Locks, Connecticut, in 1767 -- two and a quarter centuries later, it's still in business, but not in the gristmill business. Like Rhoads, it was kept alive by quick-witted managers who knew how to change with the times. Milling was a dying industry, so Dexter got out of its mills and started to produce stationery. From statiortery, it switched to tea bags, and from tea bags to glue. Today, it makes high-tech coatings and adhesives for airplanes. A Baltimore firm, D. Landreth Seed, has survived since 1784 -- on vegetable seeds. It sold seeds to Thomas Jefferson at his Virginia estate, and more than two hundred years later, it's still selling seeds to Jefferson's estate. If a company makes a good product that's never out of date, it can stay in business forever. Since none of these early companies was a public company, people couldn't own shares in them. (Dexter went public on its 201st birthday, in 1968.) At the time of the Revolution there was not one home-grown public company in the country. The earliest to appear on the scene after the Revolution was a bank -- the Bank of North America, founded in 1781. The Bank of New York (1784) was the first stock ever to trade on the New York Stock Exchange. It still trades there today. The Bank of Boston followed New York's lead and sold shares, as did the Bank of the United States, whose main purpose in life was to figure out how to pay off the debts from the Revolutionary War. In colonial America there had been no banks, because the British didn't allow them. We corrected this problem after the Revolution, but even so, there was a lot of fuss about the federal government sponsoring a bank. Some of the Founding Fathers, particularly Jefferson, distrusted bankers and their paper money. Taking their cue from their European ancestors, our earliest shareholders paid too much for their bank stocks, and they knew very little about what they were buying. The bidding went higher and higher until it got to the level of ridiculous prices, and on Wall Street, whatever goes up that high must always come down. Bank stocks landed with a thud in the Crash of 1792, the first crash in Wall Street history. As soon as the dust settled, the New York State Legislature passed a law, similar to the laws passed earlier in London, making it a crime to traffic in stocks. Stock trading went underground. This was a good lesson to investors in a young country, and it is a good lesson for young investors today. When you are an owner of a company, you only make money if the company succeeds. A lot of them don't. This is the risk of buying stocks: The company you own may turn out to be worthless. It is for taldng this risk that people are rewarded so handsomely if they pick the right companies to invest in. Investors were very happy to own shares in the company that built the bridge over the Charles River in Massachusetts. John Hancock was one of the founders. The sale of the Charles River Bridge stock was held on the eleventh anniversary of Bunker Hill Day, in 1786. There was a parade across the bridge, complete with the firing of cannons, followed by a party at which eighty-three original investors were treated to a banquet. It was a joyous occasion, followed by many joyous years in which investors were paid a dividend. These steady dividends came from the tolls collected from the people who used the bridge to get across the river. The customers of the bridge weren't nearly as happy as the investors in the bridge. Eventually, a second bridge, the Warren Bridge, was built across the Charles River to compete with the first. Once enough tolls were collected to pay off the costs of building this second bridge, the plan was to abolish the toll so people could cross the river for free. The owners of the original bridge objected to this plan, and filed a lawsuit that went all the way to the Supreme Court. They lost the case, and that was the end of their profitable monopoly. Another successful company modeled along the lines of the Charles River Bridge was the Lancaster Turnpike in Pennsylvania. The Lancaster Turnpike sold shares (through a lottery, as it turns out) and also paid a nice dividend. Again, the money came from tolls collected along this sixty-mile road from Philadelphia to Lancaster. The customers of this road didn't like the tolls any more than the customers of the Charles River Bridge did, but they preferred paying them to driving their buggies through fields.and woods. Turnpike, bridge, and canal companies were the forerunners of the trolley, railroad, and subway companies that came along a bit later. The Father of the Financial System We all recognize George Washington as the father of our country, but Alexander Hamilton was the father of the financial system. That part gets lost in the history books, but without the financial system, the political system never would have worked. Hamilton deserves the credit for this. He's more famous for being a lousy shot and losing a duel to Aaron Burr, but he was also an astute economic planner and one of the founders of the Bank of New York. Hamilton realized that the country couldn't get along without money, and to have money, it needed banks. It seems obvious today, but back then, banking was a controversial subject. George Washington agreed with Hamilton about the banks, and even invested in one himself. Washington was a shareholder in the Bank of Alexandria, which opened near his home at Mount Vernon. But a lot of important people were opposed to Hamilton's ideas, and foremost among them was Thomas Jefferson. Jefferson was a gentleman farmer who believed there was virtue in tilling the soil and living off the land. He hated factories and the cities that grew up around the factories. To Jefferson, banks were the root of all evil, especially the government's bank. As it turns out, Jefferson was no expert on personal finance. He ran through a large fortune and died virtually bankrupt in 1826. He was a big spender, parti Excerpted from Learn to Earn: A Beginner's Guide to the Basics of Investing and Business by Peter Lynch, John Rothchild All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.
