Making the market

Vice-Chancellor Professor Paul JohnsonVice-Chancellor Professor Paul Johnson


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Matt Smith:

Welcome to a La Trobe University podcast with myself, Matt Smith and sitting across from me today is Professor Paul Johnson, Vice Chancellor of La Trobe University. Thank you for joining me, Professor Johnson.

Paul Johnson:

My pleasure, Matt.

Matt Smith:

And apparently, we've got quite a few listeners in the Vatican City as well, so I'd like to give a big shout out to the Pope if he's listening. It's good to finally get the vice chancellor here so we can hear his thoughts because he's not only a very good Vice-Chancellor, but he's also a respected academic.

You previously worked at the London School of Economics and now you've written a book called ‘Making the Market’ about the Victorian origins of corporate capitalism. Can you tell us about the experience of writing this book and juggling what I'm sure has been a very busy career with finding time to write?

Paul Johnson:

This is a book that began… I think I should say… probably ashamed to say over 10 years ago when I was given a two-year fellowship in the U.K. from the British Academy to go away and start some research on how the structures of the modern capitalist world were put into place in the 19th century. And I worked on that full-time for two years. I then went back to my job at the London School of Economics and became heavily involved in administration.

So I've written the book piecemeal over time. But actually, that has been quite good for me because in this book, which looks at the structures of the market, things like where limited liability and incorporation and bankruptcy rules and the stock exchange and financial press, where all these things came from. They were essentially all invented in the 19th century or gained their current form in the 19th century.

So I've been able to observe some of the developments in the modern corporate economy. So I've seen parallels between many of the concerns that existed 150 years ago about dodgy companies being set up or directors extracting huge remuneration payments from companies or false information being distributed a bank shares on the stock exchange. Many of the things that we are familiar with today, but I've seen them in the past.

And over the more than decade on which I've slowly worked on this book, there've been lots of little modern case studies that in a sense have given me new insight into what happened in the past. So it's been an interesting exercise writing this book. It's been difficult, I have to say, to fit academic research in with a career that's been increasingly administrative because to undertake good research, I think most researchers would say they need quite a lot of time to engage in the research.

And if you're doing an administrative job, if you're running a university, then you may have 15 minutes here or 15 minutes there, but you seldom have even half a day to focus on other things. So, managing time, which is always difficult, has been particularly difficult. But I've finished the book and I hope people find it of interest.

Matt Smith:

Now, you started writing this 10 years ago. If you finished it 10 years ago, how different would it have been to how it is now?

Paul Johnson:

I think if I'd finished it 10 years ago… so before Enron, before the Dotcom boom and bust, before the global financial crisis, I would have been looking at some of the developments in the 19th century as being interesting, but perhaps things that happen then with much less modern and continuing relevance. But this series of events in the corporate economy, which you might say have, in a sense, culminated with the global financial crisis and the collapse of most of the investment banks on Wall Street, has I think given me an opportunity to see some elements of the developmental history which have been particularly important for today.

Let me give you an example. In 1811, there was a discussion amongst a number of writers about how life insurance should be sold. One set of writers argued that it was immoral for commission payments to be related to the sale of life insurance because they said, “Anyone who gets commission for selling a life insurance policy will clearly put their own interest before the interest of the person buying the policy.”

But in fact, commission-based selling was the norm for most life insurance companies; has continued to be the norm for most commercial or retail products in the financial services industry. There was a campaign to have commission-based selling rendered illegal. It didn't succeed. But let's just imagine, if commission-based selling of financial products had been banned in the 19th century and if that ban had continued, we wouldn't have had the fundamental underlying cause of the global financial crisis, which was a selling by commission agents of sub-prime mortgages to people whom they knew would never be able to repay those mortgages. But the commission agents, the selling agents didn't care. They just wanted to get the contracts signed and take their commission. So you can see that there was a debate that took place almost 200 years ago that has direct relevance to the underlying cause of the global financial crisis.

Matt Smith:

One decision back then. You say that the market and all its elements were invented. What is it about that time period that necessitated this sort of system?

Paul Johnson:

At the beginning of the 19th century and 1800, this is in the United Kingdom which was the leading economy at that period, there was no stock exchange. There was no capacity for companies to automatically become incorporated; so to become public companies. There was no ability for companies generally to take a limited liability form, there was no formalized bankruptcy proceeding, there were no standards for company accounts and company reporting and there was no financial press.

By the end of the 19th century, by 1900, all those things were in place. In 1800, though there wasn't a formal stock exchange, there was trading of stocks but it was regarded largely as gambling and is morally dubious. By the end of the 19th century, the stock exchange in London was at the center of global financial transactions particularly around the British Empire but also taking on board the North Atlantic.

Those global financial transactions were regarded as being fundamental to the workings of modern economy. So it's in the 19th century that you see the transition from I suppose a traditional economy where most of the economic interactions were done on a face-to-face basis by people who were the owners of companies, or the owners of businesses to by the end of the 19th century, a world in which most businesses were limited liability public corporations, where the shares of most companies were traded on exchanges and where people got information about what was happening not from their face to face contact with whoever was running the business, but from the financial press.

So it's in that period, which is of course a period of huge growth, huge economic growth and development that we see also the development of the associated financial institutions. But the way those institutions developed was not because of any plan. And we've not ended up with a set of institutions that were or are in any obvious sense optimal or ideal. The development path… and in the book what I do is trace the development path, there were lots of dead ends. People went in particular byways of trying this organization form and that organization form. And what we ended up with by the end of the 19th century in the U.K., and true of many other countries too, was a set of institutions that had sort of evolved by a mixture of deliberate design and chance. But it's those institutions that still form the bedrock of the modern corporate economy.

It's quite important to understand that the foundations of the modern corporate economy have not been put in place either because it'd been designed to work well, nor have they evolved in a manner that guarantees absolute efficiency. And that is important because a lot of the governance of the modern corporate economy has been premised upon the idea that markets work and that markets of which they do work, they send good pricing goals and that markets evolve in a manner that will reject inefficiency and promote efficiency.

But what I argue in this book is that in fact the market has evolved in a much more disorderly way. So we have a set of market institutions which aren't necessarily likely to generate optimal or efficient outcomes. But regulators and economists have typically viewed markets as naturally evolving to produce efficient and optimal outcomes.

I think that is simply a misreading of history, but it's a misreading of history that has cost us dear because too many people have believed that markets will evolve in an optimal manner and therefore will always perform in an optimal manner. We know from the global financial crisis that that simply isn't true.

Matt Smith:

Yes, definitely. Was there a better understanding of the way that the market works, well, 150 years ago, did society understand the way the markets work better than they do now?

Paul Johnson:

No, I think in the 19th century it was a voyage of discovery for everyone about the way in which markets worked. Adam Smith, who produced the I suppose the founding study of economics in his book, “The Wealth of Nations,” published in 1774 then influenced a whole load of economists through the 19th century with their view of how the market worked. But people were trying to understand this new world in which they were operating in.

It was a world where there were huge transformations in terms of international transportation with the opening up of international trade routes in a much more aggressive manner. In the end, the opening up of… by the end of the 19th century, the telegraph which gave instant communication or almost instant communication trans-Atlantically and within national economies.

But the market was always changing. The market will always change. Technology always advances. So people were trying to understand and comprehend this. And so the institutional changes and innovations in part took account of the way in which the market was developing.

But also, the structure that the institutions ended up with was in part determined by things like party politics and parliament and what bit of legislation would be passed and what bit of legislation would be resisted. So it was a somewhat sort of not quite a random process of development, but certainly as I said a disorderly one.

Throughout the 19th century, there were many financial crises. There was, on average, a crisis once every decade. So, the cycle of boom and bust, which we now think of as exceptional, the global financial crisis was the biggest shock to the international economy since the 1929 Great Depression and clearly has been a very big shock.

Generally, we've come to think of the economy as being relatively benign, relatively ordered, relatively stable. In the 19th century, people didn't really think about it in that way because there was at least one crisis every decade with the boom and bust. And so, part of the reason why the institutions developed was to try to get control of this leviathan that seemed to be growing; this large set of market and financial institutions which almost had a life of their own. So it was always being constrained by institutional change.

Matt Smith:

Do you think we should still be surprised whenever there's a crash or a bust? Are they inevitable?

Paul Johnson:

I think they are inevitable because I think there will always be a degree of enthusiasm for the quick win. And in the 19th century, there was a lot of criticism particularly from religious groups about the stock market, arguing that it was immoral, that it was nothing other than gambling and that it corrupted people's moral sensibilities by making them look for the quick win and the quick gain rather than accepting that you get, as it were an honest day’s pay for an honest day's toil. And some people would still hold those views about the stock market. But certainly, the view that people had in the 19th century that there will always be a degree of over enthusiasm for investment opportunities that people will tend to rush in, there will be a bit of a boom and then a bust, I think people appreciated that.

Matt Smith:

Is that something that something that we maybe need, though, because while a bust is bad, a boom is good so we need that sort of cycle?

Paul Johnson:

The cycle will always be there. It's a degree of sort of in a sense you run too fast and then you overshoot.

Matt Smith:

Of course, but is it a good thing?

Paul Johnson:

I think you can see in the 19th century that there were some very good things that came out of the boom and bust cycles. Certainly, there was a lot of physical capital development. In the United Kingdom, the railways, for instance, grew enormously in the 1840s because of a huge amount of invested capital that went into them even though investors lost a lot of that money because there was a huge crash in the 1840s in terms of railway shares. But nonetheless, they put the money in so that many of the railway lines were built. And though the investors may have lost out, the traveling public gained a lot from the fact that those railway lines were there.

And you see the same in the modern world. I mean, sometimes people invest heavily in certain telecommunications ventures, for instance. Sometimes, the investors will make a lot of money out of those, sometimes they won't. But if the network is set up, then the users will benefit from it. So, yes, there are advantages.

Matt Smith:

Do you think that there's something that the modern market can learn that they've maybe forgotten about the way things used to work?

Paul Johnson:

Yes, I think there are things that can be learned. I should say, I don't think history ever repeats itself. It stutters; history stutters, perhaps. So there are certain similarities but never direct repetition.

But there are some things that can be learned. We can, for instance, learn that regulation attempts to counter a boom bust cycle through regulation have consistently failed. The market actors will always out-maneuver the regulation. It may take them 5 or 10 or 15 years, but they will out-maneuver it. The market will change because of technology and changes in people's mindset. And the regulation, which is fit for a purpose at one point in time becomes essentially redundant and then you will move into the next cycle.

So one lesson I would say we might learn form that is that one of the most effective ways to regulate the market is to use market pressures itself or themselves to regulate the market. By which, I mean, if you can use for instance a key market signal like price to regulate the market rather than having a police force to regulate the market… a police force in terms of commercial regulatory structures… then, you may be more effective.

So, let me give an example on that. People knew that in the 19th century as we know today that when companies go bankrupt, right up to the point of which they go bankrupt, there is little public information about their true financial state and indeed it's not uncommon for auditors to have signed off their annual accounts quite recently to say this company is in good shape, then it goes bust. And so, there is a problem in the audit system because the people who were paid to do the audit are paid by the company that wants a good audit result.

Now, it's clear that auditors work very hard to make sure they're not unduly influenced. But nonetheless, in the end, they can only get access to what the company will make available to them and companies, it is clear sometimes, have not made available key information about their true financial state. So, I think there's a problem with the audit system.

One of the suggestions coming out of the global financial crisis in the collapse of Enron and so on is that we need much, much tougher audit and reporting requirements. But a lesson that you might learn from history is that actually, companies will always try to conceal things, if they can, from regulators. But you could take a different approach.

For instance, you could say that directors of companies cannot have limited liability. That is, every director of every company will be personally liable to their last cent for the debts of the company. If you did that, initially no one would want to become a director of a company. But, you can see that you would necessarily need to create a secondary insurance market for directors' liability.

But the companies that then sold liability insurance to directors would have a commercial need to know what the real financial state of the company would be. Whereas auditors have no commercial need to know what the real financial state of a company is because they don't carry any downside liability. Whereas an insurer, who is ensuring the liability of directors, would be carrying a downside financial liability. So you could use a pricing system to get I believe much better oversight of a company's true financial position.

Matt Smith:

Professor Johnson, your book is ‘Making the Market’ and it's out in May.

Paul Johnson:

That's right. Published by Cambridge University Press and I'm sure it can be got through any good bookstores on the high streets or online.

Matt Smith:

OK. Well, thank you for your time today.

Paul Johnson:

My pleasure.