prior probability

Thus far this week (see here and here), we have seen Adam Smith’s tedious and painstaking reconstruction of the rising fortunes of the East India Company. To sum up, although this mercantilist company had accumulated massive amounts of debts, it had also generated tons of revenue, and by 1773 — the year its five-year bribe payoffs to the British government were set to expire (see my previous post) — the firm was so flush with cash that it was poised to clear its massive debts. Instead, the company’s debts began to spiral out of control! Smith writes (sentence #47):

“In 1773, however, their debts, instead of being reduced, were augmented by an arrear to the treasury in the payment of the four hundred thousand pounds, by another to the custom-house for duties unpaid, by a large debt to the bank for money borrowed, and by a fourth for bills drawn upon them from India, and wantonly accepted, to the amount of upwards of twelve hundred thousand pounds.” (Smith 1784, p. 70)

The East India Company was now forced to take drastic measures. Among other things (sentence #48), the company had to take out a loan, beg the government for a moratorium on its bribe payments (again, see my previous post), and slash its dividend payments in half:

“The distress which these accumulated claims brought upon them, obliged them not only to reduce all at once their dividend to six per cent, but to throw themselves upon the mercy of government, and to supplicate, first, a release from further payment of the stipulated four hundred thousand pounds a year; and, secondly, a loan of fourteen hundred thousand, to save them from immediate bankruptcy.” (Smith 1784, pp. 70-71)

At the same time, Smith informs us in the very next sentence of this very long paragraph (sentence #49), the employees of the East India Company engaged in shady business practices in order to enrich themselves before the company’s imminent collapse:

The great increase of their fortune had, it seems, only served to furnish their servants with a pretext for greater profusion, and a cover for greater malversation, than in proportion even to that increase of fortune. (Smith 1784, p. 71)

The situation got so out of hand that the Parliament conducted a formal inquiry and made “several very important alterations” to the company’s corporate governance. In the immortal words of Adam Smith (sentence #50):

“The conduct of their servants in India, and the general state of their affairs both in India and in Europe, became the subject of a Parliamentary inquiry, in consequence of which several very important alterations were made in the constitution of their government, both at home and abroad.” (Smith 1784, p. 71)

What were these “alterations” or changes to the company’s constitution? First off, the operations of the company in India would now be subject to strict government oversight. Smith writes (sentences ##51-54):

“In India their principal settlements of Madras, Bombay, and Calcutta, which had before been altogether independent of one another, were subjected to a governor-general, assisted by a council of four assessors, Parliament assuming to itself the first nomination of this governor and council who were to reside at Calcutta; that city having now become, what Madras was before, the most important of the English settlements in India. The Court of the Mayor of Calcutta, originally instituted for the trial of mercantile causes which arose in city and neighbourhood, had gradually extended its jurisdiction with the extension of the empire. It was now reduced and confined to the original purpose of its institution. Instead of it a new supreme court of judicature was established, consisting of a chief justice and three judges to be appointed by the crown.” (Smith 1784, p. 71)

In addition to subjecting the operations of the company in India to government oversight, Smith describes two major changes to the internal corporate governance of the East India Company. One major change, Smith says (sentences #55 & #56), was to reduce the number of shareholders with voting rights:

“In Europe, the qualification necessary to entitle a proprietor to vote at their general courts was raised from five hundred pounds, the original price of a share in the stock of the company, to a thousand pounds. In order to vote upon this qualification too, it was declared necessary that he should have possessed it, if acquired by his own purchase, and not by inheritance, for at least one year, instead of six months, the term requisite before.” (Smith 1784, p. 71)

The other major change (sentences #57 & #58) was to increase and rotate the terms of the members of the company’s board of directors:

“The court of twenty-four directors had before been chosen annually; but it was now enacted that each director should, for the future, be chosen for four years; six of them, however, to go out of office by rotation every year, and not to be capable of being re-chosen at the election of the six new directors for the ensuing year. In consequence of these alterations, the courts, both of the proprietors and directors, it was expected, would be likely to act with more dignity and steadiness than they had usually done before.” (Smith 1784, pp. 71-72)

For Smith, however, these changes in the company’s corporate governance were merely cosmetic. They do not align the private incentives of corporate officers with the common good. Smith writes (sentence #59):

“But it seems impossible, by any alterations, to render those courts [i.e. boards of directors of joint stock companies doing business overseas], in any respect, fit to govern, or even to share in the government of a great empire; because the greater part of their members must always have too little interest in the prosperity of that empire to give any serious attention to what may promote it.” (Smith 1784, p. 72, my emphasis)

Adam Smith doesn’t hold back, for he does not limit this criticism to the board of directors of the East India Company. He extends his damning critique to the company’s shareholders. Smith writes (sentences ##60-63):

“Frequently a man of great, sometimes even a man of small fortune, is willing to purchase a thousand pounds’ share in India stock merely for the influence which he expects to acquire by a vote in the court of proprietors. It gives him a share, though not in the plunder, yet in the appointment of the plunderers of India; the court of directors, though they make that appointment, being necessarily more or less under the influence of the proprietors, who not only elect those directors, but sometimes overrule the appointments of their servants in India. Provided he can enjoy this influence for a few years, and thereby provide for a certain number of his friends, he frequently cares little about the dividend, or even about the value of the stock upon which his vote is founded. About the prosperity of the great empire, in the government of which that vote gives him a share, he seldom cares at all.” (Smith 1784, p. 72, my emphases)

Then, in what has to be one of the most strongly-worded and damning passages Smith would ever write (sentence #64), Smith makes the following indictment:

“No other sovereigns ever were, or, from the nature of things, ever could be, so perfectly indifferent about the happiness or misery of their subjects, the improvement or waste of their dominions, the glory or disgrace of their administration, as, from irresistible moral causes, the greater part of the proprietors of such a mercantile company are, and necessarily must be.” (Smith 1784, p. 72, my emphasis)

Worse yet, according to Smith (sentences ##65-67), the British government only made matters (this lack of alignment between the company and the common good) worse :

“This indifference, too, was more likely to be increased than diminished by some of the new regulations which were made in consequence of the Parliamentary inquiry. By a resolution of the House of Commons, for example, it was declared, that when the fourteen hundred thousand pounds lent to the company by government should be paid, and their bond-debts be reduced to fifteen hundred thousand pounds, they might then, and not till then, divide eight per cent upon their capital; and that whatever remained of their revenues and net profits at home should be divided into four parts; three of them to be paid into the exchequer for the use of the public, and the fourth to be reserved as a fund either for the further reduction of their bond-debts, or for the discharge of other contingent exigencies which the company might labour under. But if the company were bad stewards, and bad sovereigns, when the whole of their net revenue and profits belonged to themselves, and were at their own disposal, they were surely not likely to be better when three-fourths of them were to belong to other people, and the other fourth, though to be laid out for the benefit of the company, yet to be so under the inspection and with the approbation of other people.” (Smith 1784, pp. 72-73, my emphases)

I will conclude my survey of Smith’s stinging critique of the East India Company in my next post. (To be continued …)

Picking up where we last left off (see my previous post), Adam Smith next describes two great external events — the War of Austrian Succession (1740-48) and the Seven Years’ War (1756-63) — that improved the fortunes of the East India Company. Smith writes (sentences ##32-36):

“During the French war, which began in 1741, the ambition of Mr. Dupleix, the French governor of Pondicherry, involved them in the wars of the Carnatic, and in the politics of the Indian princes. After many signal successes, and equally signal losses, they at last lost Madras, at that time their principal settlement in India. It was restored to them by the Treaty of Aix-la-Chapelle; and about this time the spirit of war and conquest seems to have taken possession of their 
servants in India, and never since to have left them. During the French war, which began in 1755, their arms partook of the general good fortune of those of Great Britain. They defended Madras, took Pondicherry, recovered Calcutta, and acquired the revenues of a rich and extensive territory, amounting, it was then said, to upwards of three millions a year.” (Smith 1784, pp. 68-69)

What did the East India Company do with these riches? They ended up having to bribe the British government 400,000 pounds per year. Smith matter-of-factly states (sentence #37):

“They remained for several years in quiet possession of this revenue: but in 1767, administration laid claim to their territorial acquisitions, and the revenue arising from them, as of right belonging to the crown; and the company, in compensation for this claim, agreed to pay the government four hundred thousand pounds a year.” (Smith 1784, p. 69)

According to Smith (sentences #38 & #39), this bribe was equal to the amount to be paid in annual dividends to the shareholders of the East India Company:

“They [the board of directors of the East India Co.] had before this gradually augmented their dividend from about six to ten per cent; that is, upon their capital of three millions two hundred thousand pounds they had increased it by a hundred and twenty-eight thousand pounds, or had raised it from one hundred and ninety-two thousand to three hundred and twenty thousand pounds a year. They were attempting about this time to raise it still further, to twelve and a half per cent, which would have made their annual payments to their proprietors equal to what they had agreed to pay annually to government, or to four hundred thousand pounds a year.” (Smith 1784, p. 69)

But it was not to be. According to Smith (sentence #40), the East India Company was saddled with massive amounts of debts — “upwards of six or seven millions sterling”! — so it was prohibited from increasing the dividend payments to its shareholders by two successive acts of Parliament in 1767 and 1768:

“But during the two years in which their agreement with government was to take place, they were restrained from any further increase of dividend by two successive Acts of Parliament, of which the object was to enable them to make a speedier progress in the payment of their debts, which were at this time estimated at upwards of six or seven millions sterling.” (Smith 1784, p. 69)

Next, the government and the East India Co. cut a deal: the company agreed to continue its bribe payments to the British government for five more years; in exchange, the government would allow the company to increases its dividend payments by one percent per year. Smith writes (sentences #41 & #42):

“In 1769, they [the members of the board of directors of the East India Co.] renewed their agreement with government for five years more, and stipulated that during the course of that period they should be allowed gradually to increase their dividend to twelve and a half per cent; never increasing it, however, more than one per cent in one year. This increase of dividend, therefore, when it had risen to its utmost height, could augment their annual payments, to their proprietors and government together, but by six hundred and eight thousand pounds beyond what they had been before their late territorial acquisitions.” (Smith 1784, pp. 69-70)

With this now deal in place, Smith explains (sentences ##43-46) why the company should have been able to finance a “sinking fund” to pay off its massive debts over time:

“What the gross revenue of those territorial acquisitions was supposed to amount to has already been mentioned [i.e. “upwards of three millions a year”]; and by an account brought by the Cruttenden East Indiaman in 1768, the net revenue [of the East India Co.], clear of all deductions and military charges, was stated at two millions forty-eight thousand seven hundred and forty-seven pounds. They [the East India Co.] were said at the same time to possess another revenue, arising partly from lands, but chiefly from the customs established at their different settlements, amounting to four hundred and thirty-nine thousand pounds. The profits of their trade too, according to the evidence of their chairman before the House of Commons, amounted at this time to at least four hundred thousand pounds a year, according to that of their accountant, to at least five hundred thousand; according to the lowest account, at least equal to the highest dividend that was to be paid to their proprietors. So great a revenue might certainly have afforded an augmentation of six hundred and eight thousand pounds in their annual payments, and at the same time have left a large sinking fund sufficient for the speedy reduction of their debts.” (Smith 1784, p. 70, my emphasis)

So, what could go wrong? I will proceed into the last part of this very long paragraph in my next post. (To be continued …)

Last week (see here, here, here, and here), we retraced Adam Smith’s survey of three historic overseas trading firms — the Royal African, Hudson’s Bay, and South Sea companies — and saw a pattern began to emerge: Adam Smith is no friend of joint stock companies, especially those with large numbers of shareholders. With this background in mind, we now turn to the last part of Smith’s digression on joint stock companies: his lengthy survey of the English East India Company, the private company that conquered and ruled what would become the “jewel in the crown” of the British Empire, the Indian subcontinent.

Of the four firms in his survey of joint stock companies, Smith devotes the most ink to this one: five paragraphs (paras. 26-30) of varying lengths spread across 12 pages (pp. 65-76) of the last part of his 1784 pamphlet (Smith 1784, Part #13). And of these five paragraphs, the first one (para. 26 of Part #13) is by far the longest. This one Jocycean paragraph alone contains over 2700 words and 67 sentences and spans a full nine pages of his 79-page pamphlet! So, what does Smith say about the East India Co.? First off (sentences ##1-4 of para. 26), the Scottish scholar retraces the history of this storied company:

“The old English East India Company was established in 1600 by a charter from Queen Elizabeth. In the first twelve voyages which they fitted out for India, they appear to have traded as a regulated company, with separate stocks, though only in the general ships of the company. In 1612, they united into a joint stock. Their charter was exclusive, and though not confirmed by Act of Parliament, was in those days supposed to convey a real exclusive privilege. For many years, therefore, they were not much disturbed by interlopers.” (Smith 1784, pp. 65-66, my emphasis)

Next (sentences #5 & #6 of para. 26), Smith describes the structure of its capital and internal corporate governance:

“Their capital, which never exceeded seven hundred and forty-four thousand pounds, and of which fifty pounds was a share, was not so exorbitant, nor their dealings so extensive, as to afford either a pretext for gross negligence and profusion, or a cover to gross malversation. Notwithstanding some extraordinary losses, occasioned partly by the malice of the Dutch East India Company, and partly by other accidents, they carried on for many years a successful trade.” (Smith 1784, at p. 66, my emphasis)

But there is always a “but”! Smith writes (sentences ##7-9):

“But in process of time, when the principles of liberty were better understood, it became every day more and more doubtful how far a Royal Charter, not confirmed by Act of Parliament, could convey an exclusive privilege. Upon this question the decisions of the courts of justice were not uniform, but varied with the authority of government and the humours of the times. Interlopers multiplied upon them, and towards the end of the reign of Charles II, through the whole of that of James II and during a part of that of William III, reduced them to great distress.” (Smith 1784, my emphasis)

So, what happened next? Smith informs us (sentences ##10-12) that a proposal was made to Parliament in 1698 in which the East India Co. would loan two million pounds to the government presumably in exchange for the exclusive right to trade in India:

“In 1698, a proposal was made to Parliament of advancing two millions to government at eight per cent, provided the subscribers were erected into a new East India Company with exclusive privileges. The old East India Company offered seven hundred thousand pounds, nearly the amount of their capital, at four per cent upon the same conditions. But such was at that time the state of public credit, that it was more convenient for government to borrow two millions at eight per cent than seven hundred thousand pounds at four.” (Smith 1784, my emphasis)

Who made this patently absurd proposal, and why was it ever accepted? Smith does not say. Instead, he describes (sentences ##13-18) what happened next — an “every man for himself” situation inadvertently caused by a legal loophole when this proposal was approved:

“The proposal of the new subscribers was accepted, and a new East India Company established in consequence. The old East India Company, however, had a right to continue their trade till 1701. They had, at the same time, in the name of their treasurer, subscribed, very artfully, three hundred and fifteen thousand pounds into the stock of the new. By a negligence in the expression of the Act of Parliament which vested the East India trade in the subscribers to this loan of two millions, it did not appear evident that they were all obliged to unite into a joint stock. A few private traders, whose subscriptions amounted only to seven thousand two hundred pounds, insisted upon the privilege of trading separately upon their own stocks and at their own risk. The old East India Company had a right to a separate trade upon their old stock till 1701; and they had likewise, both before and after that period, a right, like that of other private traders, to a separate trade upon the three hundred and fifteen thousand pounds which they had subscribed into the stock of the new company. The competition of the two companies with the private traders, and with one another, is said to have well-nigh ruined both.” (Smith 1784, pp. 66-67, my emphases)

In other words, this legal loophole not only led to the temporary creation of two separate East India companies; it also allowed investors in the new company as well as the “old” East India Company itself to compete against the new East India Co.! This situation of market cannibalization apparently got so out of hand that yet another proposal was made to Parliament in 1730 that would have effectively converted the East India Co. into a “regulated company”, i.e. an exclusive guild-like entity that could apply and enforce the same set of rules on all its members. According to Smith (sentences #19 & #20):

“Upon a subsequent occasion, in 1730, when a proposal was made to Parliament for putting the trade under the management of a regulated company, and thereby laying it in some measure open, the East India Company, in opposition to this proposal, represented in very strong terms what had been, at this time, the miserable effects, as they thought them, of this competition. In India, they said, it raised the price of goods so high that they were not worth the buying; and in England, by overstocking the market, it sunk their price so low that no profit could be made by them.” (Smith 1784, p. 67)

The “new” East India Co., however, opposed this proposal for two reasons. The company claimed that this proposal would produce a decrease in the prices of the goods they imported into England and an increase in the prices of goods they exported into India. But Smith (sentences ##21-24) is totally skeptical of this second claim:

“That by a more plentiful supply, to the great advantage and conveniency of the public, it must have reduced, very much, the price of Indian goods in the English market, cannot well be doubted; but that it should have raised very much their price in the Indian market seems not very probable, as all the extraordinary demand which that competition could occasion must have been but as a drop of water in the immense ocean of Indian Commerce. The increase of demand, besides, though in the beginning it may sometimes raise the price of goods, never fails to lower it in the run. It encourages production, and thereby increases the competition of the producers, who, in order to undersell one another, have recourse to new divisions of labour and new improvements of art which might never otherwise have been thought of. The miserable effects of which the company complained were the cheapness of consumption and the encouragement given to production, precisely the two effects which it is the great business of political economy to promote.” (Smith 1784, pp. 67-68, my emphasis)

In any case, as Smith goes on to explain (sentences ##25-27), the two East India companies were officially merged into a single business entity in 1702 and that entity was converted 100% into a joint stock company in 1708 with the exclusive right to trade in India:

“The competition, however, of which they gave this doleful account, had not been allowed to be of long continuance. In 1702, the two companies were, in some measure, united by an indenture tripartite, to which the queen was the third party; and in 1708, they were, by act of parliament, perfectly consolidated into one company by their present name of the The United Company of Merchants trading to the East Indies. Into this act it was thought worth while to insert a clause allowing the separate traders to continue their trade till Michaelmas 1711, but at the same time empowering the directors, upon three years’ notice, to redeem their little capital of seven thousand two hundred pounds, and thereby to convert the whole stock of the company into a joint stock.” (Smith 1784, p. 68, my emphasis)

And according to Smith (sentence #31), this consolidation worked: “From 1708, or at least from 1711, this company, being delivered from all competitors, and fully established in the monopoly of the English commerce to the East Indies, carried on a successful trade, and from their profits made annually a moderate dividend to their proprietors.” (Smith 1784, p. 68) In fact, it must have worked so well that the new East India Co. continued to loan substantial sums of money to the government. According to Smith (sentences ##28-30):

“By the same act, the capital of the company, in consequence of a new loan to government, was augmented from two millions to three millions two hundred thousand pounds. In 1743, the company advanced another million to government. But this million being raised, not by a call upon the proprietors, but by selling annuities and contracting bond-debts, it did not augment the stock upon which the proprietors could claim a dividend. It augmented, however, their trading stock, it being equally liable with the other three millions two hundred thousand pounds to the losses sustained, and debts contracted, by the company in prosecution of their mercantile projects.” (Smith 1784, p. 68)

As it happened, the company’s wealth would only continue to rise. In my next post, we shall see how two great external events — the War of Austrian Succession (1740-48) and the Seven Years’ War (1756-63) — improved the fortunes of the famed East India Company. (To be continued …)

Also, on this day (9 August) in 1974, Richard Nixon resigned from office in disgrace and, ten years ago (2016), my wife and I closed on the purchase of our current home in the College Park neighborhood of Orlando, Florida!

Thus far this week (see here and here), we have seen Adam Smith’s survey of two historic overseas trading firms organized as joint-stock companies: the Royal African and Hudson’s Bay companies. Today, we turn to Smith’s survey of the ill-fated South Sea Company. Smith devotes four paragraphs to this infamous chapter in the history of mercantilism: paragraphs 22 to 25 of the last part of his 1784 pamphlet (Part #13).

Smith begins his survey of the South Sea Co. (para. 22) by telling us what he is not going to do — he is not going to rehash the ignominious “knavery and extravagance” that led to the infamous South Sea bubble of mercantilist lore: “The knavery and extravagance of their stock-jobbing projects are sufficiently known, and the explication of them would be foreign to the present subject.” (Smith 1784, p. 63) Instead, the Scottish scholar is going to provide what he thinks was the root cause of the collapse of the South Sea Company:

“The South Sea Company never had any forts or garrisons to maintain, and therefore were entirely exempted from one great expense to which other joint stock companies for foreign trade are subject. But they had an immense capital divided among an immense number of proprietors. It was naturally to be expected, therefore, that folly, negligence, and profusion should prevail in the whole management of their affairs.” (Id. at p. 63, my emphasis)

Simply put, it was not just “[t]he knavery and extravagance of [the South Sea Company’s] stock-jobbing projects” that led to its ultimate demise. It was destined to fail because of the structure of its business model. Unlike the Hudson’s Bay Company (see my previous post), which had a “moderate” amount of capital “divided among a very small number of proprietors” (id. at p. 62), the South Sea Company had an “immense” amount of capital “divided among an immense number of proprietors.” (Id. at p. 63)

In addition to its bad business model, the South Sea Company also made bad business deals. A case in point is the South Sea Company’s first business deal: the Asiento de Negros (see here), a 30-year monopoly contract granted by the Spanish Crown in 1713 via the Treaty of Utrecht, which gave the South Sea Company the exclusive right to transport enslaved Africans to the colonies in the Spanish Americas. Here is how Adam Smith describes this sordid chapter in this history of mercantilism:

“Their [the South Sea Company’s] mercantile projects were not much better conducted. The first trade which they engaged in was that of supplying the Spanish West Indies with negroes, of which (in consequence of what was called the Assiento contract granted them by the Treaty of Utrecht) they had the exclusive privilege. But as it was not expected that much profit could be made by this trade, both the Portuguese and French companies, who had enjoyed it upon the same terms before them, having been ruined by it, they were allowed, as compensation, to send annually a ship of a certain burden to trade directly to the Spanish West Indies. Of the ten voyages which this annual ship was allowed to make, they are said to have gained considerably by one, that of the Royal Caroline in 1731, and to have been losers, more or less, by almost all the rest.” (Smith 1784, p. 63, my emphasis)

Why did the South Sea Company lose money on nine out of ten slave shipments? Smith speculates that it was internal corruption and bad management that led to this state of affairs:

“Their ill success was imputed, by their factors and agents, to the extortion and oppression of the Spanish government; but was, perhaps, principally owing to the profusion and depredations of those very factors and agents, some of whom are said to have acquired great fortunes even in one year.” (Id. at pp. 63-64, my emphasis)

According to Smith, the South Sea Company lost so much money on these slave shipments that it petitioned the British king to let the firm sell off its rights under the Asiento: “In 1734, the company petitioned the king that they might be allowed to dispose of the trade and tonnage of their annual ship, on account of the little profit which they made by it, and to accept such equivalent as they could obtain from the of Spain.” (Id. at p. 64)

In the next paragraph (para. 23), Smith cites another example of the South Sea Company’s bad management:

“In 1724, this company had undertaken the whale-fishery. Of this, indeed, they had no monopoly; but as long as they carried it on, no other British subjects appear to have engaged in it. Of the eight voyages which their ships made to Greenland, they were gainers by one, and losers by all the rest. After their eighth and last voyage, when they had sold their ships, stores, and utensils, they found that their whole loss, upon this branch, capital and interest included, amounted to upwards of two hundred and thirty-seven thousand pounds.” (Id. at p. 64, my emphasis)

But while the South Sea Company was losing money on its Asiento contract and whale-fishery business, it was also lobbying the government for special favors. Smith writes (para. 24):

“In 1722, this company petitioned the Parliament to be allowed to divide their immense capital of more than thirty-three millions eight hundred thousand pounds, the whole of which had been lent to government, into two equal parts: The one half, or upwards of sixteen millions nine hundred thousand pounds, to be put upon the same footing with other government annuities, and not to be subject to the debts contracted, or losses incurred, by the directors of the company in the prosecution of their mercantile projects; the other half to remain, as before, a trading stock, and to be subject to those debts and losses. The petition was too reasonable not to be granted. In 1733, they again petitioned the Parliament that three-fourths of their trading stock might be turned into annuity stock, and only one-fourth remain as trading stock, or exposed to the hazards arising from the bad management of their directors.” (Id.)

After Parliament granted both of these favors, only one-fourth of the company’s stock remained exposed to active trade and potential losses. But the company was so poorly run and so riddled with corruption that it finally ceased to exist in 1748. It was in that year, Smith tells us, that “[a]n end was put to their trade with the Spanish West Indies” and that “the remainder of their trading stock was turned into an annuity stock.” (Id. at pp. 64-65) In short, “the company ceased in every respect to be a trading company.” (Id. at p. 65)

Next (para. 25), Smith concludes his postmortem of the South Sea Company with the following observation:

“It ought to be observed that in the trade which the South Sea Company carried on by means of their annual ship [under the Asiento contract], the only trade by which it ever was expected that they could make any considerable profit, they were not without competitors, either in the foreign or in the home market. At Carthagena, Porto Bello, and La Vera Cruz, they had to encounter the competition of the Spanish merchants, who brought from Cadiz, to those markets, European goods of the same kind with the outward cargo of their ship; and in England they had to encounter that of the English merchants, who imported from Cadiz goods of the Spanish West Indies of the same kind with the inward cargo. The goods both of the Spanish and English merchants, indeed, were, perhaps, subject to higher duties.” (Smith 1784, p. 65, my emphasis)

In other words, the South Sea Company faced some stiff competition from Spanish and English merchants, but it (the South Sea Co.) enjoyed a comparative advantage over them because its competitors had to pay higher duties on the goods and slaves they transported. But in the eloquent and immortal words of Adam Smith: “… the loss occasioned by the negligence, profusion, and malversation of the servants of the company had probably been a tax much heavier than all those duties.” (Id.) Smith then concludes his survey of the South Company with the following sweeping generalization about joint stock companies writ large:

“That a joint stock company should be able to carry on successfully any branch of foreign trade, when private adventurers can come into any sort of open and fair competition with them, seems contrary to all experience.” (Id., my emphasis)

Between the lines, Smith is making a deeper point here: the South Sea Co. was destined to fail not because of external factors but because of its internal business structure: it was a joint stock company with too many shareholders. And why are too many shareholders bad? Because no one shareholder has the incentive to monitor the day-to-day micro-conduct of the company’s agents or the big macro-decisions of the board of directors.

Nota bene: Three down: the Royal African, Hudson’s Bay, and South Sea companies. One to go: the East India Co. We will turn to the East India Company and then wrap up my Adam Smith series next week. (To be continued …)

Nota bene: Today’s post contains another installment of my multi-part review of Adam Smith’s “digression on joint stock companies” in his 1784 pamphlet Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations.

We revisited Adam Smith’s brief history of the Royal African Company in my previous post. Today, we will review Smith’s survey of the Hudson’s Bay Company, which appears in paragraph 21 of the last part of his 1784 pamphlet (Smith 1784, pp. 62-63).

Adam Smith begins by comparing and contrasting the general good fortune of the Hudson’s Bay Company (HBC) with the absolute and abysmal failure of Royal African Company (RAC): “The Hudson’s Bay Company, before their misfortunes in the late war [i.e. the Seven Years’ War of 1756–1763], had been much more fortunate than the Royal African Company.” (Smith 1784, p. 62) But why was the HBC “much more fortunate” than the RAC? Smith provides several reasons for their divergent fortunes. One was the HBC’s lower operating costs (the HBC had just 120 men on its payroll); the other was the HBC’s greater efficiency:

“Their [the HBC’s] necessary expense is much smaller. The whole number of people whom they maintain in their different settlements and habitations, which they have honoured with the name of forts, is said not to exceed a hundred and twenty persons. This number, however, is sufficient to prepare beforehand the cargo of furs and other goods necessary for loading their ships, which, on account of the ice, can seldom remain above six or eight weeks in those seas. This advantage of having a cargo ready prepared could not for several years be acquired by private adventurers, and without it there seems to be no possibility of trading to Hudson’s Bay.” (Id. at p. 62)

Next, Smith drills down on what I consider to be the real reason why the HBC’s business model succeeded. In a word (or three words), the HBC enjoyed a de facto monopoly over its overseas markets, or in Smith’s own words:

“The moderate capital of the company, which, it is said, does not exceed one hundred and ten thousand pounds, may besides be sufficient to enable them to engross the whole, or almost the whole, trade and surplus produce of the miserable, though extensive country, comprehended within their charter. No private adventurers, accordingly, have ever attempted to trade to that country in competition with them. This company, therefore, have always enjoyed an exclusive trade in fact, though they may have no right to it in law.” (Id. at p. 62, my emphasis)

But wait, there’s more! Smith then provides another possible reason — a structural one — for the HBC’s success. Simply put, the HBC was owned by a small number of stockholders (only 18 in all, according to this source), which led to better corporate governance, or in the immortal words of Adam Smith:

“Over and above all this, the moderate capital of this company is said to be divided among a very small number of proprietors. But a joint stock company, consisting of a small number of proprietors, with a moderate capital, approaches very nearly to the nature of a private copartnery, and may be capable of nearly the same degree of vigilance and attention. It is not to be wondered at, therefore, if, in consequence of these different advantages, the Hudson’s Bay Company had, before the late war, been able to carry on their trade with a considerable degree of success.” (Id., my emphasis)

What Smith is saying here is that a joint stock company with a small number of shareholders resembles a general partnership, which will generally have a small number of partners, because in both of these business models, the owners will have a strong incentive to monitor the affairs and management of their firm.

To sum up, although the HBC and RAC had two things in common — both firms were formed under a royal charter by King Charles II, and both firms lost their monopoly rights after the the Glorious Revolution of 1688-89, when Charles II’s brother, James II, was deposed from power — the HBC was able to succeed because of its de facto monopoly and because it was owned by a small number of shareholders.

But after explaining why the HBC was “much more fortunate” than the RAC, Smith appears to hedge. He puts on his accountant’s cap (see here, for example) by taking a closer look at the HBC’s accounts, making “proper allowances” for the HBC’s “extraordinary risk and expense” and then concluding as follows:

It does not seem probable, however, that their profits ever approached to what the late Mr. Dobbs imagined them. A much more sober and judicious writer, Mr. Anderson, author of The Historical and Chronological Deduction of Commerce, very justly observes that, upon examining the accounts of which Mr. Dobbs himself was given for several years together of their exports and imports, and upon making proper allowances for their extraordinary risk and expense, it does not appear that their profits deserve to be envied, or that they can much, if at all, exceed the ordinary profits of trade.” (Id. at pp. 62-63, my emphasis)

What about the other two joint stock companies in Smith’s survey of overseas trading companies, the South Sea and East India companies? We will turn to the South Sea Company in my next post. (To be continued …)

Nota bene: Today’s post contains the next installment of my multi-part review of Adam Smith’s “digression on joint stock companies” in his 1784 pamphlet Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations.

Adam Smith traces the sordid history of the Royal African Company in paragraph 20 of the last part of his 1784 pamphlet (Part #13). But what is most revealing about Smith’s little history lesson is what he leaves out. For me, the following two omissions stand out:

1. Omission #1: The Royal African Company (RAC) was first led by James Stuart, Duke of York (see here, for example), who later became King James II in 1685 (pictured below).
2. Omission #2: The RAC shipped more enslaved African men, women, and children to the Americas than any other single institution during the entire period of the transatlantic slave trade (see here and here)

Instead, Smith begins his history of the RAC not with its royal pedigree or its sordid slave trading but with the RAC’s inability to maintain its royal monopoly rights:

“The Royal African Company soon found that they could not maintain the competition against private adventurers, whom, notwithstanding the Declaration of Rights, they continued for some time to call interlopers, and to persecute as such.” (Smith 1784, p. 60)

As I mentioned in my previous post (see here), the reference to “the Declaration of Rights” in the above passage refers to the 1689 Declaration of Rights of 1689, after James II was overthrown in the Glorious Revolution of 1688. Both of these political developments not only shifted the center of political power in Britain from the monarchy to Parliament; they also ended up undermining the RAC’s attempt to monopolize the slave trade. Since the RAC’s erstwhile royal monopoly was never ratified by Parliament, independent slave traders (or “interlopers” in the eyes of the RAC) were now free to compete with the RAC.

Next, Smith describes how, in 1698, these “private adventurers [i.e. the independent slave traders or interlopers described above] were subjected to a duty of ten per cent upon almost all the different branches of their trade [sound familiar?], to be employed by the company in the maintenance of their forts and garrisons.” (Id. at p. 61) Alas, Smith reports that “notwithstanding this heavy tax, the company [RAC] were still unable to maintain the competition” and that “[t]heir stock and credit gradually declined.” (Id.) In fact, the RAC’s finances became so dire that Parliament had to intervene on many occasions:

“In 1712, their debts had become so great that a particular Act of Parliament was thought necessary, both for their security and for that of their creditors. It was enacted that the resolution of two-thirds of these creditors in number and value should bind the rest, both with regard to the time which should be allowed to the company for the payment of their debts, and with regard to any other agreement which it might be thought proper to make with them concerning those debts. In 1730, their affairs were in so great disorder that they were altogether incapable of maintaining their forts and garrisons, the sole purpose and pretext of their institution. From that year, till their final dissolution [in 1750], the Parliament judged it necessary to allow the annual sum of ten thousand pounds for that purpose.” (Smith 1784, p. 61)

The Royal African Company eventually decided to get out of the slave trading business altogether in 1732:

“In 1732, after having been for many years losers by the trade of carrying negroes to the West Indies, they at last resolved to give it up altogether; to sell to the private traders to America the negroes which they purchased upon the coast; and to employ their servants in a trade to the inland parts of Africa for gold dust, elephants’ teeth, dyeing drugs, etc.” (Id.)

The RAC, however, was unable to recover it finances and was eventually dissolved by Parliament in 1750:

“But their success in this more confined trade was not greater than in their former extensive one. Their affairs continued to go gradually to decline, till at last, being in every respect a bankrupt company, they were dissolved by Act of Parliament, and their forts and garrisons vested in the present regulated company of merchants trading to Africa.” (Id.)

Smith then concludes his paragraph on the RAC (para. 20 of Part #13 of his 1784 pamphlet) with the following observation:

“Before the erection of the Royal African Company, there had been three other joint stock companies successively established, one after another, for the African trade. They were all equally unsuccessful. They all, however, had exclusive charters, which, though not confirmed by Act of Parliament, were in those days supposed to convey a real exclusive privilege.” (Id. at pp. 61-62)

But this observation begs an important question: why were all these slave trading companies “all equally unsuccessful” in the first place? Was it because they were organized as joint stock companies, or was it because the slave trade itself was not an economically productive, let alone profitable, activity? I will turn to the Hudson’s Bay Company in my next post. (To be continued …)

And now, back to our regularly scheduled programming: Adam Smith’s 1784 pamphlet Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations. Last week, we surveyed the first 18 paragraphs of the last part (Part #13) of Smith’s pamphlet, where Smith compares and contrasts two different types of overseas trading companies: regulated companies and joint stock companies. For reference, below are the relevant links:

1. Adam Smith’s second dire warning (paras. 1 to 5 on pp. 47-49 of Part #13)
2. Adam Smith and the economics of corporate governance (paras. 6 to 15 on pp. 49-58)
3. Adam Smith’s rebuke of corporate boards (paras. 16 to 18 on pp. 58-60)

In the next ten paragraphs (19 to 28) of Part #13 of his pamphlet, Smith surveys four specific overseas trading companies that were organized as joint stock companies: (i) the Royal African Company, (ii) the Hudson’s Bay Company, (iii) the ill-fated South Sea Company, and (iv) the “old” English East India Company. (Before proceeding, please note that these particular four joint stock companies are not to be confused with the “regulated companies” (see here, for example) that Smith had previously surveyed in paragraphs 8 to 14 on pages 50-58 of his pamphlet, including the Hamburgh Company (see para. 9), the Russian Company (para. 9), the Turkey Company (para. 10), and the Africa Company (paras. 12 to 14), the successor of the Royal African Company.)

First off (para. 19), Smith cites a pivotal turning point in British political history — the Glorious Revolution of 1688 and the Declaration of Rights of 1689 — to compare and contrast the corporate charters of these four specific joint stock companies:

“The Royal African Company, the predecessors of the present African Company, had an exclusive privilege by charter, but as that charter had not been confirmed by Act of Parliament, the trade, in consequence of the Declaration of Rights, was, soon after the revolution, laid open to all his Majesty’s subjects. The Hudson’s Bay Company are, as to their legal rights, in the same situation as the Royal African Company. Their exclusive charter has not been confirmed by Act of Parliament. The South Sea Company, as long as they continued to be a trading company, had an exclusive privilege confirmed by Act of Parliament; as have likewise the present United Company of Merchants trading to the East Indies.” (Smith 1784, p. 60)

In other words, the Glorious Revolution and the Declaration of Rights not only shifted the center of political power in Britain from the monarchy to Parliament; these historic events also ended up producing a “natural experiment” of sorts by removing overnight the previously-established legal monopolies of the Royal African Company (RAC) and the Hudson’s Bay Company (HBC). Although the RAC and HBC had been awarded royal monopolies in their respective overseas markets, both of these companies lost their monopoly rights in the aftermath of the Glorious Revolution of 1688. After 1688, a trading company’s charter would have to be approved by an official act of Parliament in order to obtain the exclusive right to an overseas market, and of the four companies listed above, only the last two — the South Sea Company and the English East India Company — were able to obtain this official approval.

So, how did these four joint stock companies fare? More specifically, did the firms with exclusive trading rights outperform the ones without such legal rights? Or was it the other way around? Did the companies without the exclusive rights outperform the monopolies? As it happens, Smith will survey all four joint stock companies in great detail in the next nine paragraphs of Part #13 (paragraphs 20 to 29 on pp. 60-74 of Part #13) as follows:

• The Royal African Company (para. 20 on pp. 60-62)
• The Hudson’s Bay Company (para. 21 on pp. 62-63)
• The South Sea Company (paras. 22-25 on pp. 63-65)
• And last but not least, the English East India Company (paras. 26-30 on pp. 65-76)

For my part, I will follow Smith’s sequence, beginning with the Royal African Company, in my next post. (To be continued …)

Due to my travels, I will resume my ongoing series on Adam Smith in my next post; in the meantime, I can vouch for the substance of this tweet (or see below) as I was one of Rob Harrison’s students at the Yale Law School back in the day!

Is it possible to use ChatGPT and other large language models to promote critical thinking in higher education? As it happens, I am a member of a five-person team of college professors who have experimented with new ways of using GenAI in the fields of tax law and tax accounting. (Two special shout outs go to our department chair, Jay Thibodeau, who motivated our team to study this question, and to our lead authors, Keri White and Rachel Detert, both of whom will be presenting our findings this afternoon (Monday, August 3) at the annual meeting of the American Accounting Association (AAA) in Las Vegas, Nevada.) In the meantime, here is a direct link to our paper, “Depreciating rollercoasters and rhinoceroses: capital asset classification, client tax advice, and the use of GenAI to develop critical thinking“, which will be published in the prestigious Journal of Accounting Education this fall.