Odd Lots - This Explains Why Modern Markets Developed Where They Did

Episode Date: January 15, 2018

For centuries, markets were highly-personalized things, often controlled by select groups of people who traded based on long-established and closely-knit relationships. Closed networks -- such as merchant guilds in 16th century Europe -- could ensure trust between buyers and sellers by pushing out bad actors. But then, something happened that would eventually become the foundation of all modern markets. In the 1500s, new trade routes and the arrival of the printing press helped erode the power of merchant guilds and give way to a much more open system of trading where strangers could interact with each other.  On this edition of the Odd Lots podcast, Prateek Raj gives his theory about why modern markets first took hold in Northern Europe, and what this 500-year-old period of disruption can tell us about the world today.  See omnystudio.com/listener for privacy information.

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Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio. and wherever you get your podcasts. Hello and welcome to another edition of the Odd Lots podcast. I'm Tracy Allaway.

And I'm Joe Weizenthal. So Joe, we obviously talk a lot about markets on the show and we talk a lot about stock markets. But do we ever stop and consider how stock markets came into being? We really don't talk about the origins of these markets all that much. why the stock market was created. We sort of take it for granted. I'm very interested in this subject because I often wonder, you know, if you were to go around to market participants and ask them, why do we have a stock market in the first place? Why did we invent this thing? I'm always curious what the answers would be because I still don't think I have a solid grip on why they exist.

Yeah. And if you think about it, like if you think real hard about it, it's kind of a weird construction, right? The idea that a bunch of strangers are going to get together and share or sell each other shares in particular companies or things. Like, why do we do that and why do we trust the other participants involved? Totally. Like, every time there's an IPO or something, and it's like, wait, if you're selling and you know more about the company, you think if the insiders in a company are selling, why should I be buying? I guess that that a bad. signed. And of course, there's various mechanisms that we've built to learn about companies, mandatory regulatory disclosures, quarterly reports, earnings calls, presentations, outside auditors.

But we're still essentially buying into companies that, at best, we only have partial information of what's really going on. Right. So that's the other side of the story, right? There's two things. There's trust and there's information involved. So we are going to take a journey back in time for this particular edition of Odd Lots and figure out how those two things kind of came together at a particular moment in time to create some of the first modern markets, really. I can't wait because as hard as it is right now to really have a grip on what's going on with the companies we invest in, you know, you think back to hundreds of years ago and how much worse disclosure would have been and auditing and standards of

data reporting. Right now, we all basically all... Accounting. Think about accounting in like the 1600s. Yeah, accounting and P&L statements and balance sheets. We have the, we have machines that can parse this in very standard ways of reporting this stuff. But at the beginning, how did anyone believe anything? Exactly. All right. So I'm glad you're on board. So to discuss all of this, we have Pateek Raj for our guest. He is a PhD student over at the University College London. He's also a research fellow at the Stickler Center for the study of the economy and the state at the University of Chicago Booth School of Business. And he is also the author of a paper called The Origins of Impersonal Markets in Commercial and Communication Revolutions of Europe. And it's

going to be really interesting, I promise. Let's bring him on. All right, Prateek. Thanks for joining us today. Hi, Tracy and Joe. Great to be here. So, uh, did we get the intro right, were trust and information kind of the two pillars of importance when it came to creating the first modern market? So when you think about trust, trust is generally a much more complicated construct, right? Because you can have trust in your family members and you can have trust in strangers. So I think trust gets created when you have one, some incentives to really trust strangers. So if you don't have any incentive to go out and do business with people who you don't know, why would you need to trust them? So incentives really matter. And then on the other hand, of course,

you need to know about something about them, something about the markets they work in. You need to have certain trust in the markets and so forth. So yes, trust is really important. But then the key question is, how do you create that trust? So in your paper and before we talk, about how impersonal markets or stock markets were created. You talk about the pre-existing structures that were in place to essentially solve the trust problem or to partially solve it. And you talk about the role of, I think, trade guilds in this. So can you explain what these guilds were, what they did and their importance to commerce? So not just in Europe, but around the world, traditionally business has happened through

networks. So you have cabalas in Arabic world, you have jatis in India, you have Guanjis or clans in China, and you have had guilds in Europe. And the central role that they play is that, one, you generally are interacting with people you know, or at least people you know who know other people. So what it does is that it creates a repeated interaction and that kind of creates trust. So that's the simplest reason why you can have, you want to do business in networks. Can you give an example to really help us understand it of an industry, you know, a lot of your writing is in Europe, an industry that would have been dominated by a guild and how specifically it would have facilitated trade within that area? Basically all sorts of trading industries

would be dominated by guilds or networks. I think an example in the more, world is like these taxi associations. These are associations where basically entering is rather difficult. You need to have a high license fee to pay if you wanted to enter these taxi associations. And one of the reasons you had these was because you wanted reliable people to enter the taxi industry because who knows if you have a taxi driver who is not very reliable. So taxi associations are an example of a good modern-day guilt. And then you have something like Uber or Lyft disrupting that.

So in a modern world, I think taxi associations are like a favorite example that I like to use. So in the 1600s in Europe, you have these powerful merchant guilds. And there's a lot of influence and a lot of money presumably tied to them because it's almost a monopoly, I suppose, that they have over particular areas of trade. in a similar way to the taxi medallions have a monopoly nowadays, with the exception of the disruptive forces that are Uber and Lyft. What happened in the 1600s to dislodge the power of the merchant guilds? So generally, when people think about guilds or any of such network institutions, there tends to be these two extreme views.

The one view is that, oh, guilds were really nice institutions, which were communities in which people would do business and rely on each other. And kind of capitalism came in and created this very atomist world. That's one way of looking at guilds. And then the other way of looking at gills is that, well, these gills were these networks of nepotism and monopoly. And basically, free market comes in and reigns in their power. And you have people who can come from anywhere, or any background who can enter a business and excel in it.

So when you want to understand why did Gilstip line, we have to identify the things that they were really good at, which is providing information to people or basically protecting people from a lot of risks because you were basically trading with people who, if they cheated on you, you could kind of ostracize them or make their reputation go bad.

So this kind of reliability and information helped Gil's survive for so long. So when you think about how would Gil's decline, you have to go back and look at situations where people had suddenly a new incentive to start to do business with new people because Gil's were not very good at providing you with new opportunities or situations where you could get new information. So you have to look at the interaction between incentives to go outside of Guilts. and the need to the ability to get information. And so in your paper, you identified two key factors that sort of demonstrate a grand unified theory.

And you look at where these impersonal networks took off. And the two factors seem to be, A, in the cities that had an opportunity to trade with the outside world. So key trading ports, geographic exposure to trade routes. And then the other thing is proximity to the town. where Gutenberg invented the printing press. And so the combination of places that sort of had access to printing press, the new vector of information and places that were on these trade routes, combining those two is where you see the first impersonal networks germinate.

Yes, exactly. So that's the story. The big question is that why is it that it's northwestern Europe where the first stock markets or the first joint stock companies emerged. Why not in Spain, or why not in Italy, or why not in Germany? And that's where you want to look at this combination of factors. For example, Spain had all the benefits of Atlantic trade. So when it comes to the incentive to go out of guilds and do business,

I think like Amsterdam, even in southern cities of Spain, you had such incentives. On the other hand, if you want to go after a theory that, oh, well, access to information made it easier for people to talk to each other and to talk to strangers, then you would have to ask, why did this not happen in Germany, where basically that's the hub for the printing press? And so it is the combination of these two things that, well, you need to have incentives to go out and do business with people you don't know, and you need to have information about the markets and the commodities you're trading and somewhat the... people you are working with, that's really important. So it's the two things when they come together that, at least in this paper, I argue, create the conditions that are favorable for the rise of such markets. Okay, so if I'm a trader in Antwerp or Amsterdam and I'm looking at all these opportunities taking place in the new world is the basic idea that in addition to having that exposure to new

types of trade or new potential businesses, I can now pick up a printed book or pamphlet and I can learn how to trade or I can learn more information about those particular businesses? Yes, so that's sort of the idea. So obviously when the printing press came in, all sorts of things were being printed. A lot of it was religious books and a small part of it was things like merchant manuals and books in economics, etc., etc. And what was happening is that when you happen to be at a place where trade is really desirable, the content that gets produced in these kind of places

are related to those which help traders out. For example, Amsterdam was emerging as a good hub where a lot of navigation-related books were being printed. Or, for example, in Antwerp, there was a lot of printing of economics books or it emerged as a hub for double-entry bookkeeping. So basically, the incentives to do trade was driving. Once you had the access to printing,

it was driving the content that was helpful for creation of information that would help with trade. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen. Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed.

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Get the reporting and the context from Bloomberg's 3,000 journalists and analysts. We're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. What happened to the merchant guilds in these areas in areas like Antwerp and Amsterdam? Did they try to fight the change? or was it just sort of a slow dissolving of the role that they played in facilitating trade? So it could differ from place to place. Like one of the interesting historical stories that I learned while doing this research

was this divergence between Hamburg and Lubick, and which kind of tells you how, for example, in Lubbock, Gills tried to push back on the idea of opening of impersonal markets, while in Hamburg, they were not able to have that kind of resistance. And the reason why I think that was the case is because these two cities happen to be at a very interesting geography. So they are on two sides of the Jutland Peninsula in the northern Germany. And Hamburg is on the Atlantic coast while Lubek is on the Baltic coast. So the basic idea is that because Hamburg was at the Atlantic coast,

So this site of the Jateland Peninsula had greater incentives to basically, or exposure to the Atlantic trade and its benefits. While Lubek, while it was a major city, it didn't get that kind of exposure because it was on the Baltic side of the sea. And these two cities were just 65 kilometers apart from each other. So in Lubek, you have a lot of resistance to new merchants coming in, and they start to prop up privileges, they start to fight against the Danish and the Dutch who are giving them competition. So yes, the gills in more established cities try to fight back, while in a place like Hamburg, they slowly basically dissolved away. You know, I noticed, we've kind of introduced this as talking about the origins of the stock market.

You've been very specific using this term impersonal markets. Can you talk just a little bit about what sort of the distinction is? I mean, I imagine that the early impersonal markets aren't really recognizably what we would call stock markets today. So what precisely was being traded here? So the first stock market was the Amsterdam Stock Exchange, which was specifically made to raise capital for the Dutch East India Company. So it was for this one giant company that essentially a stock market was created. Before that, there existed, for example, these commodity borses where, so for example, in Antwerp, where people would basically trade commodities in spot kind of situations.

So the reason why I like to use the term in personal markets is because, from a historical point of view, my view is that 16th century and thereafter was a major historical break in terms of how the world was doing business, which was that while until now you had relationships that drove how business was done. But now suddenly, at least an opportunity emerged, that somebody from some part of the world could just come in and start to do business in some other city. So basically, this kind of lowered the entry barriers for people who might not have been privileged enough in the prior centuries to do trade. So it is a major part of the story that,

how impersonal markets by making things more individualistic make it easier for people who are probably more motivated to come and do business. So for example, in case of Hamburg, it was a major hub for foreign merchants. But Lubek had this problem that they didn't want to have foreign merchants because they wanted to keep all their privileges for the locals. So that's why I like to use the term impersonal markets because the rise of stock market can be like a side effect of this broad change in history. But so for example, when you think about the Wall Street, people from all parts of the world just come in and then work at these banks. And it's not that you have to be, it's a pretty diverse place. And it's because your networks don't necessarily need to be so important as long as you are really good at making money. So how much of the rise of impersonal

markets had to have happened along with a strengthening of legal and governmental institutions. Because I imagine that that took care of part of the trust problem as well, right? Yes. So there is sort of a core evolution that is happening that you especially see in cities like Antwerp and Amsterdam and also Hamburg and London, where basically when you already have an incentive to attract new people whom you don't have any historical or, you know, familial ties with to your city. Then in order to attract these new merchants, you start to make your institutions better. You essentially say, well, okay, until now, our courts were so designed that you would only

allow for, you would only do, provide these legal services to a certain group of merchants, coming from a specific group places. so you will give out privileges. Now suddenly you started to build these institutions which were more generalized. What it means is that instead of giving legal services to a specific set of merchants,

all your laws would now apply to all merchants that come there, and there is no special privilege that exists to a few set of merchants. So there is this sort of a democratization of institutions where you could simply get the legal services

of that particular city, if you happen to be a merchant. So legal institutions start to evolve and obviously it takes a long time before they start to look the way they look now. But that's, in my view, a time when there's a kickstart of this legal evolution as well. So listening to all this, it's pretty obvious that the lessons that you drew out from this period, there are so many that apply to markets today and some of the changes that we're seeing. You already mentioned Uber and now. I could get in someone's car without knowing who they are, and I don't have to see that they're part of some taxi guild, and I could have a pretty good trust that they're going to get me to

where they are. So that's a big change. But it's funny, you mentioned Wall Street, which is, of course, highly relevant to us. And even though the stock market and all the markets we talk about are in some sense, impersonal markets, for a long time, even still, there's been this important personal element. And people on Wall Street, financial advisors, brokers, they're all talk about, oh, we bring you the personal element and we have a personal relationship with clients. And if there's one of the biggest tensions that we're seeing right now in finance, it's this question of whether that's overrated and will we still need financial advisors or whether it'll all be robo advisors. So it seems to me there's still this very big personal

element to it. And the same, you know, this buildup of new information is once again, you know, really threatening that. So I think relationships are always going to matter. That's just always going to be the case because there is always going to be some informational advantage that you're going to have with building relationships and building personal trust with people. But I think this issue becomes relevant when you want to build Wall Street kind of institutions in other parts of the world. So for example, there is an interesting paper by Ragaram Rajan and Luigi Zengalis about the Asian banking crisis in the late 90s, where they basically talk about how this relationship-based

nature of trade or business in Asian stock markets was responsible partly for the weakness of the financial institutions in that region. And what they need is better contractual institutions to make sure that the over-reliance on relationship kind of goes away. So it is a spectrum where certain societies kind of have too much of reliance on relationships versus some which have limited. So it would never be the case that they will all go away, but you could be in a world where relationships really, really matter and you could do nothing without having them. What about the information side of things? Because quite a few people have drawn an analogy between what we've seen recently with the power and rise of the internet and fake news and the ability

of basically everyone to disseminate information at will with the revolution that was the printing press. So if we have another big spurt in the democratization of information or the dissemination of information, what does that mean for the development of markets this time around? So when you think about the internet, it's obviously has already, and the mobile phone, it has already kind of democratized information for a lot of people. For example, in India, landline phones were available to like a very small fraction of people, but now about, like, a large majority of Indians have a mobile phone and with it access to basic internet facilities. So there's already this democratization of information happening. But one of the conclusions that I drew, especially after the last year of the way political economy has evolved, is that there is no such thing that information technology would have a blanket positive or a negative effect. And once again, it goes back to the question of incentives.

So what kind of content people develop once they have internet in their hands depends a lot on other things that is around them? So if in case you have economic opportunities, opportunities to do business, etc., etc., you will basically try to seek information that is financially relevant for you. But I guess if in case you are in a place which is economically not growing, the same information technology can be used for other stuff. For example, in 16th century Europe, most of the places were primarily printing stuff about old religious texts or analysis of something that was happening. in the past. So the incentives drive your content in the end. And the same is true today.

Was there fake news in Antwerp? So what I know is that there's this new book by Jared Rubin who talks about the fact that, for example, in the Ottoman Empire, they didn't really like the printing press a lot because they basically thought that printing would lead to a lot of fake religious books. would kind of corrupt the existing pristine religious material. So certainly there existed people who would have this concern for fake news in a different version. And there were rumors and there were things like that. And so, yeah, so that's something that I got really interested in the last year

because I honestly didn't really think that fake news and this kind of fraudulent information would be so relevant. But looking at the way things have moved over time, I think that's something, which is probably a topic of a future paper, that how do institutions deal with are people, people trust the media itself. So why did people trust the printing press and the books being printed in the first place?

That's an interesting research topic in itself in my view. We'll have to have you back on once you publish that paper, Patique. I'll be happy to come. All right, Prateek, Raj, a PhD student over at the University, University College London, thank you so much for joining us today. Thanks a lot. Thank you, Pertique. That was great. So, Joe, I thought that was a really fascinating conversation with so many modern parallels,

especially when it comes to the idea of trust, of course, and of course, disseminating information because the Internet has really revolutionized both those things and so has new technology. Absolutely. I mean, I think like intuitively, it's not a surprise that the right. of the internet and new communication technologies would have a profound effect on trade and disintermediation of trust networks and all that, that we sort of get. But I think that what's really interesting about Prateek's research is the sort of rigor with which he demonstrates

the mechanism between the new information technology and the evolution of trade. And if you look at this paper, you could see that there's sort of some very statistical meat on the bones, you could say, in terms of really establishing where these impersonal markets flourished and these towns and where they were in proximity to the printing press and trade. So it really sort of bolsters and really strengthens this sort of intuitive idea. Yeah. And there's a really nice map in it as well, where he sort of overlays a lot of these ideas on 17th century Europe. So it's well worth reading that paper when you have a chance. You know what I'm surprised about

that we didn't go over to the blockchain conversation because blockchain, of course, is both about trust and information. Yeah. You know what? I'm actually impressed. You say that you're surprised that we didn't go there. I'm actually impressed with us for not going there because so many conversations

do ultimately go back these days to something related to blockchain change or whatever. So we actually showed a little bit of restraint. But no, absolutely. I'm sorry. I ruined it. No, yeah, you did ruin it. No, but you're totally right. And thinking about the importance of bookkeeping and being able to actually believe what a network is doing, it seems like a lot of, these are the problems that a lot of people are still looking to solve. And a good reminder that for as impersonal as markets have gotten, as Pertique mentioned, there's still a pretty big personal relationship and a lot of these things. Yeah, absolutely. Okay. You know what? I'm going to say,

let's leave it there because otherwise we really are going to start doing a blockchain episode, and then I'll feel really bad. Yeah, we got it. We got to end it there. All right. This has been another edition of the Oddlots podcast. You can follow me on Twitter at Tracy Allaway. And you can follow me on Twitter at the stalwart. And you should follow Prateek on Twitter at critique Raj underscore. And I want to thank our producers, Tofor Forges. You can follow him on Twitter at Forges T. And the head of podcast at Bloomberg, Francesca Leib.

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