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SPRINGER BRIEFS IN FINANCE

Henry Schäfer

On Values in
Finance and
Ethics
Forgotten Trails
and Promising
Pathways
123
SpringerBriefs in Finance
More information about this series at http://www.springer.com/series/10282
Henry Schäfer

On Values in Finance
and Ethics
Forgotten Trails and Promising Pathways
Henry Schäfer
Institute of Business Administration
University of Stuttgart
Stuttgart, Germany

ISSN 2193-1720 ISSN 2193-1739 (electronic)

SpringerBriefs in Finance
ISBN 978-3-030-04683-5 ISBN 978-3-030-04684-2 (eBook)
https://doi.org/10.1007/978-3-030-04684-2

Library of Congress Control Number: 2018965162

© The Author(s), under exclusive licence to Springer Nature Switzerland AG 2019, corrected publication
2019
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Preface

Sustainable investments, socially responsible investments, impact investings, green

finance, blended finance, and many other buzzwords that are resounding throughout
the world suggest that financial matters have undergone a welcome reform into a
brave new world. But has the financial sector really recalled old virtues and
rediscovered forgotten trails of ethics and morality? Do global challenges like
climate change and other violations of a sustainable global development offer
promising pathways for an ethical renaissance within the financial sector?
The book at hand is intended to shed more light on such issues. It opens with the
building blocks of modern capital market theory as the starting point for the analysis
of a hidden ethical content, or even the foundations of current capital market and
finance theory. Later the long-standing struggle between ethics and economics is
demonstrated, which illustrates how the alienation between the financial and the real
side of economies and economic relationships can be explained. A brief introduction
into the basic pillars of ethics and morality is presented and linked with selected
standard models of modern capital market theory and finance theory. The sustain-
ability development approach is demonstrated as having the potential to initiate a
scientific revolution in finance according to Kuhn’s methodological approach.
Furthermore, a roadmap of modern value thinking, i.e., sustainability, corporate
social responsibility, and the theory of external effects, is elaborated. The book then
proceeds with the crucial role of stakeholders and nongovernmental organizations in
coping with firm behavior combatting sustainability and responsibility. Contractual
relationships between these groups and the role of the “license to operate” in a
de facto borderless global world are also discussed. The book ends with a
critical reflection of selected issues for a sustainability-linked finance that demon-
strate the still nascent state of ethics and finance.

Stuttgart, Germany Henry Schäfer

v
Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 A “Selfie” of Finance and Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 The Building Blocks of the Modern House of Finance:
Capital Market Theory and Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.2 Crisis, What Crisis? The House of Finance
in a Seismic Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.3 Rigor Versus Relevance: The Potential of Sustainability
to Promote a Scientific Revolution Program in Finance
in the Sense of Kuhn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.3.1 Stakeholder Versus Shareholder . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.3.2 The Paradox of Social Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3 On Values: The (Hidden) Ethical Framework in Capital Market
Theory (An Outline of Ethics in Economics and Finance) . . . . . . . . . . . . 27
3.1 The Classical Links Between Values, Money, and Finance:
Religions and Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.2 Ethics and Finance: The Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.2.1 Building Blocks of Ethics with Respect to Economics
and Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.2.2 Ethics in the Neoclassical Paradigm and in the Theory
of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2.3 Overcoming the Separation Principle in Finance . . . . . . . . . . 37
4 Key Points of Sustainability and CSR: Stakeholder Theory
and the Theory of External Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.1 Starting from the “Interior of the Earth”: Neoclassical Paradigm
and the Problem of External Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.1.1 A Tax for Good . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.1.2 A Market for “Bads” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.2 The Concept of Sustainable Development
and Its Links to Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
vii
viii Contents

4.3 Corporate Social Responsibility (CSR):

A Twin to Sustainability? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
5 Understanding How Stakeholders Are Affecting Sustainability
and Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
5.1 Why Should Firms Care About CSR, Stakeholders,
and NGOs? A Knowledge-Based View . . . . . . . . . . . . . . . . . . . . . . . . . 63
5.2 Stakeholder Theory, Firm Behavior, and the Link to Finance . . . . . . 65
5.3 Interactions Between Firms, Stakeholder,
and Nongovernmental Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
6 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
6.1 Only the Bad Counts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
6.2 Inside Out and Outside In . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
6.3 Shades of Gray . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
6.4 Bringing Home the Bacon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
6.5 Setting a Fox to Keep the Geese . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
6.6 It Is Always Good to Be Good . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
6.7 Power to the People . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
6.8 “Brain Salad Surgery” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
6.9 Information Overflow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
6.10 A Wolf in Sheep’s Clothing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
7 Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

Correction to: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C1

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Abbreviations

ADM Arrow, Debreu and McKenzie

APT Arbitrage pricing theory
bn Billion
CAPM Capital asset pricing model
CF(s) Cash flow(s)
CFP Corporate financial performance
CIC Codex Iuris Canonici
COP Conference of the parties
CSP Corporate social performance
CSR Corporate social responsibility
EC European Commission
ESG Environmental, social, governance
EU European Union
EU-ETS Emission Trading scheme of the European Union
EURIBOR Euro Interbank Offered Rate
GRI Global Reporting Initiative
IPCC Intergovernmental Panel on Climate Change
LIBOR London Interbank Offered Rate
m Million
MEH Market efficiency hypothesis
MIT Massachusetts Institute of Technology
MM Modigliani and Miller
MNC Multinational Company
MU Monetary unit
NGO Nongovernmental organization
OECD Organisation for Economic Co-operation and Development
Ph.D. Philosophiae Doctor ¼ Doctor of Philosophy
PRI Principles for Responsible Investments
R&D Research and development
REH Rational expectation hypothesis

ix
x Abbreviations

SDG Sustainable development goals

SocGen Société Générale
SRI Socially responsible investments
TCFD Task Force on Climate-Related Financial Disclosures
TOC Transnational Organized Crime
trn Trillion
UBS Union Bank of Switzerland
UK United Kingdom
UN United Nations
UNCED United Nations Conference on Environment and Development
UNEP FI UN Environment Programme for the Finance Initiative
USD US-Dollar
WACC Weighted average cost of capital
WBCSD World Business Council of Sustainable Development
WCED World Commission of Environment and Development
Notations

a A set of possible actions a ¼ (1,2,. . .,A)

c (a,s) A set of consequences resulting from the interaction of activities and the
state of the world
DC Damage cost
DU Damage unit
E (.) Expectation operator
I Investment
i Asset
MC Marginal cost
MD Marginal damage
θ(s) Probability distribution function
Pi,t Market price of an asset i
p0 Initial price of a good
p* Price of a good due to internalized negative external effects
qi Weight of an asset i
r Rate of return
s Set of future states of the environment s ¼ (1,2,. . .,S)
tx Pigou tax
t Time
u(c) Utility function
V Money value
W Market value
x Quantity of goods
Zi Present value of a cash flow of an asset i
€ Euro
ϕ Information vector

xi
List of Figures

Fig. 2.1 A look back at the “old-fashioned world”: finance and investment
and its auxiliary role in the production model of Erich Gutenberg . . . . 6
Fig. 2.2 Traditional corporate financial theory had a close link to business
and the real sector . .. . .. . .. . .. . . .. . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . .. . . .. . .. . 7
Fig. 2.3 The neoclassical paradigm in financial theory—still alive . . . . . . . . . . . 10
Fig. 2.4 The crucial role of Irving Fisher in finance theory: men’s actions are
driven by satisfying the appetite and permanent search
for happiness ............................................................... 11
Fig. 2.5 Financial management according to the neoclassical approach . . . . . . 13
Fig. 2.6 Why capital markets matter in modern finance . . . . . . . . . . . . . . . . . . . . . . . 16
Fig. 2.7 Milestones in financial economics from a
historical point of view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Fig. 2.8 The capital market paradigm is changing—and leaves space for
new paths . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Fig. 2.9 Kuhn’s model of scientific revolutions . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . 24
Fig. 3.1 Interest taking from the point of view of the world religions . . . . . . . . 28
Fig. 3.2 Interest taking as a century-old controversy—the Catholic
Church’s point of view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Fig. 3.3 A view into the present: socially responsible investments were
first known as “ethical investments” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Fig. 3.4 Ethics as a benchmark for finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Fig. 3.5 Overview of the ethical framework in
finance (Soppe 2000, p. 24) . . .. . . . . . .. . . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . 33
Fig. 3.6 Aristotle: economic value separated into use value and exchange
value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Fig. 3.7 The link between the market efficiency hypothesis (MEH)
and the rational expectations hypothesis (REH) . . . . . . . . . . . . . . . . . . . . . . 39
Fig. 4.1 Positive (+) and negative () externalities throughout a value
chain—an illustrative example (KPMG 2014, p. 13) . . . . . . . . . . . . . . . . . 44
Fig. 4.2 Illustration of the economics of a negative external effect . . . . . . . . . . . 45
Fig. 4.3 Sustainable development: application of an evolutionary concept . . . . . 50
xiii
xiv List of Figures

Fig. 4.4 Sustainability resulting from efficiency, sufficiency, and consistency

and their roles for the competiveness of an economic system . . . . . . . 52
Fig. 4.5 Sustainability myopia . . . .. . . .. . .. . . .. . . .. . . .. . .. . . .. . . .. . . .. . . .. . .. . . .. . . 54
Fig. 4.6 The ethical groundings of CSR (Küpper 2006, p. 170) . . . . . . . . . . . . . . 56
Fig. 4.7 CSR and related concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Fig. 4.8 CSR issues according to surveys—an example (Globescan and BSR
2012, p. 13) .. . .. .. . .. . .. .. . .. .. . .. . .. .. . .. .. . .. . .. .. . .. .. . .. . .. .. . .. .. . .. . 59
Fig. 5.1 Objectives, instruments, and benefits of a sustainability-related
stakeholder management (Maaß et al. 2014, p. 22) . . . . . . . . . . . . . . . . . . . 63
Fig. 5.2 The missing link between value creation and strategic resources
as a driver for a firm’s acceptance of CSR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Fig. 5.3 Stakeholder relationships in the context of the contract theory . . . . . . 65
Fig. 5.4 CSR as a response to stakeholder demands in order to maintain a
firm’s license to operate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Fig. 6.1 The challenge for stakeholder in consumption
(Bonini et al. 2008, p. 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Chapter 1
Introduction

Abstract Over the last four decades, finance and capital markets have experienced
tremendous progress in producing theoretical models and their applications in
practice. At the beginning of this process, financial innovations served as very
helpful tools for coping with risks and earning sound money. Lately, due to the
banking and subprime crisis, doubts have arisen about the capability of finance and
capital markets to serve as enablers for easing economic transactions in the real part
of the economy, contributing to the welfare of societies, and, last but not least, to
being legitimized as an integral part of a capitalistic system. Deep ethical concerns
about the shortcomings and necessary improvements to financial systems and their
participants have occupied not only regulators but also media, politicians, and
stakeholders. What we are still missing is a broad reflection of ethics in finance
and capital market theory. The following chapter introduces the structure of this
book and the major topics that it tackles.

Keywords Financial crisis · Financial innovation · Unethical behavior · Ignorance ·

Ethics · Morality

You can check-out any time you like. But you can never leave!1

These are the last two sentences of the title track of the album Hotel California
released in February 1976 by the world-famous Californian country pop band The
Eagles. As one of the text writers later explained, the whole song is about the
underbelly of the American dream and about excessive ways of living in industri-
alized countries. Since the song’s fantastic career as a shooting star in the top ten
charts in many countries, tremendous innovations in technologies and ways of living
have been established, revolutionizing economies, societies, and nature. It is

The original version of this chapter was revised. A correction to this chapter is available at
https://doi.org/10.1007/978-3-030-04684-2_8.
1
https://www.azlyrics.com/lyrics/eagles/hotelcalifornia.html

© The Author(s), under exclusive licence to Springer Nature Switzerland AG 2019 1

H. Schäfer, On Values in Finance and Ethics, SpringerBriefs in Finance,
https://doi.org/10.1007/978-3-030-04684-2_1
2 1 Introduction

remarkable that some of the most important drivers of these ongoing developments
can also be dated back to the mid-1970s. For instance, Steve Jobs, Steve Wozniak,
and Ronald Wayne founded Apple Inc., and Bill Gates together with Paul Allen laid
the foundations of the terrific career of Microsoft Inc. Both ventures earmark the
beginning of fundamental technological and business innovations that has dramat-
ically changed the world over the last nearly four decades—even in the world of
finance, banking, and capital markets.
What has happened in the world of finance in the 1970s? It can best be illustrated
by some selected innovation highlights like the Black/Scholes formula (Black and
Scholes 1973) which began a revolution in capital markets. It was accompanied by
extensions of option pricing modellings like the Cox/Ross/Rubinstein binominal
model (Cox et al. 1979) and not to forget the arbitrage pricing theory published by
Ross (1976) as an alternative valuation model to the capital asset pricing model. That
means that parallel to the innovations within the real sectors of the economy, the
financial sector also initiated groundbreaking innovations. At the time only few
people will have been aware of the dramatic potential in the level playing field in
nearly every part of life and that finance was standing at the dawn of a historically
outstanding career.
Finance became the enabler of technical innovations, start-ups, and fitness pro-
grams for frozen firm conglomerates. But in many countries, the financial industry
also created financial innovations for their own. Intransparent financial vehicles like
conduits, rocket science-based investment products and risk tools, ultrahigh-speed
tradings in securities exchanges, etc. are only the tip of an iceberg of dynamic forces
in the financial sector that frequently only a few agents have understood. These
innovation processes came to an abrupt end with the subprime and the following
banking crisis shortly after the start of the millennium. Questions were raised about
how excess speculation, selfish capital market participants, and untamed profit
seeking in the financial industry could arise and loosen the former close ties to the
real sector and society. Among its audience and in finance in general, the crisis also
caused concern about the loss of any ethical or moral barriers in capital markets.
In the movie Wall Street 2, the mature investment banker Gordon Gekko
explained to his career-obsessed young partner that the financial crisis had demon-
strated that “money is a bitch,” i.e., finance is an unethical and amoral affair. In those
times the media, nongovernmental organizations (e.g., Occupy), and politicians
condemned the financial sector for its unethical behavior, its sangfroid, and its
irresponsibility. The financial industry itself and its academic servants had deigned
to accept criticism concerning violations of ethics and morality. An illustrative
example is an event at the annual meeting of Nobel laureates at Lake Constance in
Germany. The holder of the Nobel Prize for economics 1997, Robert C. Merton, was
asked by a young researcher from the central bank of Indonesia what role Nobel
laureates in economics played in the last financial crises. Merton himself wondered
whether he had understood the question correctly, i.e., that it is his personal
responsibility for the financial crisis. After uttering a big “Wow” on this “very
complicated question,” Merton elaborated on technical aspects of models in
1 Introduction 3

finance—not on ethical considerations what the asker might have meant.2 Maybe the
asker might have expected a comment in the sense of the following citation of a
Swiss professor in banking and finance to a similar subject: “This crisis is a moral
crisis. Instruments and techniques can be used for the good or for its opposite. The
mathematical models of finance we have developed do not include the human
implications they lead to” (Cossin 2009, p. 19).
Let us return to that song citation from the beginning. Following the past years of
excess financial activities, the song citation should remind us that finance sometimes
checks out from the common “house of ethics and morality,” which is enveloping
societies and economies as well as the human species. Ethics and morality guard
against systems and institutions collapsing, as almost happened in the aftermath of
the global financial crises. The crisis demonstrated that unethical behavior in capital
markets can be a severe threat to societies and economies and the whole modern way
of life.3
This is not a book about the subprime and banking crisis, although it starts with
the most dramatic shortcomings of the financial industry over the past decades and
continues with the necessity for ethical considerations in finance. The pivotal idea of
the book is that, despite the “check-out hypothesis,” finance, financial activities, and
financial agents will sooner or later be grounded in ethical virtue. In other words,
financial intermediaries cannot, in reality, leave the “house of ethics and morality.”
The reasons for this are addressed in this book. The core idea is that the former close
ties between finance and ethics have been forgotten, ignored, or abolished —along
with them the successful auxiliary role of the financial sector for the society,
economy, and nature. However the rehabilitation of the link between finance and
ethics is still possible and promises new pathways for a sustainable finance in general
and capital markets in particular.
The book is organized as follows: it starts with the building blocks of finance and
modern capital market theory (including behavioral finance) as the initial point for
the analysis of the hidden ethical content or even the foundations of current capital
market theory. A subsequent part demonstrates the long-standing struggle between
ethics and economics of which finance is a part. It illustrates how these discussions
can explain the alienation between the financial and the real side of economies and
economic relationships. A brief introduction into the basic pillars of ethics and
morality from a philosopher’s point of view is presented, linked with the dominating
standard models of modern capital markets and finance. It will be demonstrated that
the sustainable development approach has the potential to initiate a scientific
revolution in finance according to Kuhn’s methodological approach.

2
The original answer in full length is documented in a video available on https://www.mediatheque.
lindau-nobel.org/videos/33985/2014-useful-economics/laureate-merton.
3
When focusing on the relationship between ethics and finance in the following chapters of the
book, one should not underestimate the very fundamental challenges of ethics in economics as
Taylor (2014, p. 34) asked: “Does the study of economics itself discourage moral behavior?”.
4 1 Introduction

Furthermore a road map of modern ethical value thinking, i.e., sustainability,

corporate social responsibility, and stakeholder theory, is elaborated. It proceeds
with the crucial role of nongovernmental organizations in trying to cope with pitfalls
of firm behavior that violates sustainability and responsibility. Contractual relation-
ships between firms, capital market participants, and stakeholders and the role of the
license to operate are discussed. The book finishes with a sketch of the next
generation of a value-linked financial and capital market thinking—and their
challenges.
Chapter 2
A “Selfie” of Finance and Ethics

Abstract Historically, finance and capital market theory have passed remarkable
milestones. They have developed from a very practically minded tool box for the
requirements of a firm’s financial management to a highly sophisticated scientific
discipline. The focus on mathematics, statistics, and physics has encouraged ground-
breaking research in modern capital market theories. Without exaggeration it can be
claimed that, for years, the research output of finance has outshone other research
fields in economics and business administration. Financial economics have emerged
in tandem with natural sciences, just as Irving Fisher and his followers have been
sincerely wishing for. With the success of well-known capital market models in both
practice and academia, the neoclassically based dichotomies between the real and the
monetary sector have become fact. However, repeated crises in financial markets
augmented a growing distrust for stakeholders, politicians, regulators, and media
concerning the stability and efficiency of the financial sector. A growing awareness
of and the demand for ethics and morality in financial markets has increased over the
past decade. It has inspired new research that questions long-standing positions in
finance but has still been unable to lay the groundwork for a new paradigm in finance
and capital market theory that integrates ethics and morality within finance. Never-
theless the need to think and elaborate on finance and ethics remains.

Keywords Monetary theory · Capital market theory · Finance theory · Crisis ·

Stakeholder · Neoclassic · Financial crisis · Uncertainty · Irving Fisher

Capital market and finance theory have not simply arisen from nowhere. They have
emerged historically along different paths of economic thought. Before modern
capital market theory evolved in the 1920s with Fisher’s paradigm of value addi-
tivity and the separation theorem (as described in the following Sect. 2.1), finance
and capital markets were closely tied together. Financial transactions served as an
auxiliary mean to enable the frictionless flow of goods and inventory piling. The
basic reference model of a firm was the manufacturing entity, which combines
productive factors (resources) as inputs to create outputs of marketable goods.
Such a paradigm was widespread in the 1950s, and one of the well-known examples,

© The Author(s), under exclusive licence to Springer Nature Switzerland AG 2019 5

H. Schäfer, On Values in Finance and Ethics, SpringerBriefs in Finance,
https://doi.org/10.1007/978-3-030-04684-2_2
6 2 A “Selfie” of Finance and Ethics

A firm is an entity that consists of three elementary processes:

(1) manufacturing (2) marketing (3) financing

System of
combined productive factors (resources)

Elementary Planning
factors factors

Materials Management
Working and (real) capital equipment Business development
Manpower Organisation

A firm as a process of value creating

combinations
Business administration conducting
Result: output of operating factors the value creation process in a firm
Focus: productivity measurement
Corporate finance mainly understood as Theory of Cost
cash flow calculations and financial Production Theory
planning

Fig. 2.1 A look back at the “old-fashioned world”: finance and investment and its auxiliary role in
the production model of Erich Gutenberg

not only in Germany, was Gutenberg’s production theory and cost theory of the firm
(Gutenberg 1958). The dominating view of a firm as a manufacturing entity oper-
ating in order to supply markets with goods that satisfy the urgent needs of
demanding market participants emerged with the beginning of the industrial revo-
lution in the nineteenth century. This concept can still be witnessed in modern
thought as it describes most family-owned firms in many industrialized countries
very well (Schäfer and Goldschmidt 2010, pp. 285–286).
According to such a real economy-driven paradigm (see Fig. 2.1), the main
objectives of finance in practice as well as in academics were devoted to practical
questions. Most often tackled subjects have been how to organize a firm’s funding
with short- and long-term capital, to ensuring the financial equilibrium of a firm (i.e.,
remaining solvent) and to managing special or stressful situations within firms such
as the threat of a default, mergers, etc. For such purposes, finance had a very limited,
special role to play and was reduced to financial management and closely linked to
accounting and controlling. Academic representatives of such views were, among
others, Schmalenbach (1922) in Germany and, in Anglo-Saxon countries,
researchers like Dewing (1920), Williams (1938), and Hoagland (1933). Although
such approaches were much closer to accounting than to microeconomics (see
Fig. 2.2), Solomon’s statement is intriguing: “The theory of financial management
can be viewed as an extension of the theory of the firm. But whereas the traditional
emphasis in microeconomics is on the relationship between profits and the volume of
2 A “Selfie” of Finance and Ethics 7

Traditional view of finance

Commodity driven view of the firm.

A firm is represented by one or more entrepreneurs and seen as a homogenous
decision-making entity with non-financial objectives.
The focus of a firm is on production and sales (Gutenberg tradition), which determine
capital requirements and financing transactions.
Investing and financing have auxiliary functions to enable a firm’s value creation process
(mainly consisting of procurement, manufacturing, marketing)
To ensure a financial equilibrium (i.e. short-term liquidity) is the main priority for financial
management.
Investment and finance are understood as stock and flow operations, that change the
capital endowment of a firm.

Finance and investment understood as a descriptive science

The academic focus is on taxonomies and financial contracts. Special references are
given to the management of a firm’s financial crisis.
Cash flow financing and working capital management are of paramount importance.
Strong ties exist with accounting and controlling (the treasurer`s view).

Fig. 2.2 Traditional corporate financial theory had a close link to business and the real sector

output—with the amount of capital input taken as fixed—the theory of financial

management is expressly concerned with the relationship between profitability and
the volume of capital used” (Solomon 1963, p. 12). In such a paradigm, capital
markets in general were only of minor importance, also partly due to their nascent
stages at the time.
After World War II, the needs of practitioners in finance dominated the research
agendas of academics in the finance arena. The focus was on the managerial
approach to finance, stressing the organizational requirements of planning and
monitoring financial transactions inside a firm and the relationship with its share-
and debtholders. The treasury department became the most important organizational
home base of finance, responsible for the management of a firm’s flow of funds and
its capital structure. In large capitalized firms, the treasury department was headed or
supervised by the controlling department. It developed new and powerful instru-
ments for managing the flow of information and installing innovative planning and
controlling tools and systems (Dauten 1948; Howard and Upton 1953). At the same
time, the so-called decision approach of finance and investing emerged in order to
rationalize investment decisions in firms. At first, the focus was again on real
investment projects (Lutz and Lutz 1951; Dean 1951; Weston 1966). During the
early post-World War II period, times were beginning to change as capital market
theory emerged from the neoclassical paradigm of perfect markets, total equilibrium
models, and contingent claims analysis.
8 2 A “Selfie” of Finance and Ethics

2.1 The Building Blocks of the Modern House of Finance:

Capital Market Theory and Finance

State-of-the-art finance and capital market theory as it exists nowadays in textbooks,

academic thinking and practice is implicitly grounded on the assumption of a
monetary market economy. Although financing processes such as saving and lending
can be exercised in purely barter economies, the use of money eases economic
transactions and reduces transaction costs (Alchian 1977; Hirshleifer 1973). In its
research program the microfoundation of money, monetary theory constitutes the
three classical roles of money in a market economy: as the means of exchange, the
unit of account (“measure of value”), and store of value (Clower 1977). Arrow,
Debreu, and McKenzie (ADM) demonstrated in their pioneering neoclassical total
equilibrium models that the role of money has to be reduced to a numéraire (Arrow
1964; Debreu 1959; McKenzie 1959). It then can work like “grease” to facilitate
frictionless economic transactions between agents and solve the problem of double
coincidence of wants. For the allocations of goods and resources, the functioning of
the pricing process, and the derivations of the equilibrium solutions in markets and
the total economy, money is then neutral. In a complete and perfect market system of
the ADM-type, money is like a veil and traded on a residual market (the money
market) and is solely required to make the system of mathematical equations
solvable.
With the neutrality of money, financial intermediaries like banks, insurance
companies, etc. specialized in facilitating financial processes by the use of special
monetary contracts are superfluous. As the later following work of, e.g., Benston and
Smith (1976), Diamond (1984), Greenbaum et al. (1981), and others demonstrated,
such financial middlemen are only needed in a capital market system if special
information asymmetries and agency problems occur. As practice demonstrates, this
is not an exception but in fact the rule, and therefore financial intermediaries play an
important role for the functioning of a monetary and market economy alongside
money and financial contracts.
The special role of money in neoclassical equilibrium models is much more
fundamental, as it allows the quantitative and the qualitative dichotomy of the total
economic system into two subsystems (Samuelson 1968, p. 3). The real sector encom-
passes the allocation and the price formation of nonmonetary goods. In the monetary
sector (money and capital markets) and the microeconomic setting, the relative prices
of financial contracts are fixed, and on a macroeconomic basis, the overall price level is
determined. This describes the quantitative dichotomy (Modigliani 1963, pp. 83–84).
From a technical point of view for modeling economic systems by mathematical
equations, such a distinction seems appropriate as it eases the handling of the com-
plexity, interaction, and interdependency of all components of an economic system (the
so-called Cournot problem, Hoover 1984, pp. 64–65). However, the former sketched
quantitative dichotomy worked well for economic modelings and equilibrium solutions
and implicitly pervades financial models, e.g., option pricing models.
2.1 The Building Blocks of the Modern House of Finance: Capital Market. . . 9

What is underestimated so far is the relevance of the qualitative dichotomy. To

assume the neutrality of money might help for finding smart solutions that often help
a lot in solving problems in daily economic life. On the other hand, operating in an
environment of a quantitative dichotomy obscures the effects of money and the
monetary sector on the allocation processes in the real sector. As the
microeconomic-based monetary theory has proven (e.g., Brunner and Meltzer
1971; Alchian 1977), the introduction of money in a nonmonetary economy is
justified by a welfare argument. Money ideally reduces transactions costs, eases
economic transactions, avoids uncertainties in nonmonetary economies (e.g., the due
to the problem of double coincidence of wants), and is a precondition for economic
growth and welfare. With such a function, money and monetary contracts are neither
neutral nor an isolated sector. Due to its focal role for the functioning of an economic
system money, capital markets and financial intermediaries require a special atten-
tion (e.g., of regulators which define the rules and institutions for a workable
financial system). However, the qualitative dichotomy in the neoclassical paradigm
might support a separated thinking and acting in economic sectors which indeed are
closely tied together. If such actually close ties loose, negative spillovers from the
monetary and financial sector to the real sector might occur and disturb the efficiency
of an entire economic system.
It is necessary to recapitulate the role of money, financial contracts, and financial
markets to make aware of the implicit foundations of modern theories of capital
markets and finance. They are based on the neoclassical total equilibrium paradigm
and the related understanding of the role of money and financial contracts. A further
summing up of the hidden neoclassical roots of modern finance leads to the marginal
utility school (represented by Carl Menger) which will also be of significance in the
following sections. Financial assets in the total equilibrium modeling have to be
understood as coming from money-derived contracts that transform money over time
(through the rate of interest) and handle risk. As derivatives of money, financial
assets should also be neutral with reference to the equilibrium in a real market
economy (see Fig. 2.3).
Finance theory and capital market theory can then be interpreted as a layer below
the total equilibrium approach. They refer to the microeconomic spheres. Here most
of the fundamental ideas refer to the early and groundbreaking works of Irving
Fisher on interest rates and investment decision-making (Fisher 1930). Fisher could
be understood as the predecessor of an equilibrium oriented, neoclassical-grounded
capital market theory as it evolved in the late 1950s. In fact he implicitly operated in
the manner of the neutral money paradigm by introducing of the separation and the
value additivity theorem. Following on from there, investment decisions are made,
neglecting the financing conditions and individual utility functions of agents. As
today’s textbooks state in nearly the same manner, the entire decision-making
process for investments is then solely based on the marginal productivity of capital
(i.e., the internal rate of return or marginal efficiency of capital) (e.g., Brealey et al.
2011). In addition, as Fisher explained: “The Principle of Maximum Present Value:
Out of all options, that one is selected which has the maximum present value
reckoned at the market rate of interest” (Fisher 1930, p.12). His sole focus on cash
10 2 A “Selfie” of Finance and Ethics

Neoclassical (capital market driven) paradigm

Separation theorem: Liquidity risk of a Type of financial contract matters:

firm depends on financial
management, has to ensure the
survival of the firm, and the profit risk is
determined by a firm’s procurement,
production, marketing.
Corporate finance is understood as a
process of optimal participation in a
firm‘s financial success: Net cash
inflows of a firm‘s investment projects
have to be distributed among capital
providers according to their role as
share- and debtholders.
Determined by the selected rule of future
and uncertain cash flow distributions of
financed investments (debt or equity or
both).
Future and uncertain cash inflows should
be vested into such specific contracts so
that they can be placed in the capital
markets according to individual risk and
return preferences of different types of
investors.
The sale of such contracts allows capital
inflows into the firm.

Fig. 2.3 The neoclassical paradigm in financial theory—still alive

flows stemmed from the crucial assumption that investors’ only economic driver is
the maximization of their individual utility functions (to satisfy their “hunger for
experience”; see Fisher 1930, pp. 10–12) by increasing monetary income outflows
from investment projects. Needless to say, such a paradigm makes no obvious
reference to ethics or morals. It is a strictly hedonistic understanding.
However, what makes the Fisher’s assumption so relevant to ethical consider-
ations are his (and his followers’) fundamental convictions. In order to become a
respected science, finance theory and capital market theory ought to lean on natural
sciences, especially on physics. “In all of these areas (price formation, the monetary
system, interest) Fisher proceeded by translating problems that had been understood
in terms of differentiated social actors and goods into the terms of a mechanical
system equilibrating a homogeneous substance” (Breslau 2003, p. 399). Under these
circumstances, an intensive analysis of utility functions is superfluous as it is
substituted by axiomatic conditions. “To fix the idea of utility the economist should
go no farther than is serviceable in explaining economic facts. It is not his province
to build a theory of psychology” (Fisher 1892, p. 11). Fisher refused to go any
further into psychological, sociological, and even ethical foundations of utility
functions. It was merely for the sake of being accepted as a well-respected scientist
keeping up with natural scientists—as he stated very pronouncedly: “But the
economist need not envelope his own science in the hazes of ethics, psychology,
biology and metaphysics” (Fisher 1892, p. 23). This basic conviction spread among
academics in the years following Fisher’s statement and has lasted among the
majority of capital market theorists until today, as we will see later on.1

1
Fisher’s point of view and self-understanding is very reminiscent of the later so-called debate on
positivism that underwent an intensive programmatic discussion in economics under the umbrella of
the monetarism debate between the two Nobel laureates Milton Friedman and James Tobin.
2.1 The Building Blocks of the Modern House of Finance: Capital Market. . . 11

Individuals‘ one and only driver for action and choice:

the wish to get a mental thrill (Irving Fisher: „Hunger for Experience“)

Instrument

Mental income

Consumption

Non-durable goods Real income Durable goods

Money income dimensions

Size [MU/period] Degree of certainty Time horizon

(„Money for nothing“) („No risk, no fun“) („Live today, pay tomorrow“)
distribution of wealth pricing risks interest rate theory

Fig. 2.4 The crucial role of Irving Fisher in finance theory: men’s actions are driven by satisfying
the appetite and permanent search for happiness

Fisher’s fundamental point of view highlights the reasons responsible for ignor-
ing individual utility functions and the differences between them with respect to the
preferred money amount (amount preference), the degree of certainty (risk prefer-
ence), and the date of availability (time preference) of cash flows. Utility as a very
subjective term for the psychological state of individual agents hinders interpersonal
comparisons in economic transactions. With the substitution of utility by a market-
priced cash flow from investment opportunities, the measurement of utility is no
longer required. Instead, utility is expressed by a universal monetary value and in
terms of monetary units. Differences in individual utilities can be matched in
principle by individual lending and borrowing transactions on perfect capital mar-
kets. A risk-free interest rate expresses the time value of money and the overall price
for the allocation of capital and related financial income streams (Fisher 1930,
pp. 130–147). From a very particular ethical point of view, namely, the Christian
Church, Fisher’s underlining of the interest rate as the crucial economic regulator of
different time preferences was completely in opposition to the right of people to take
interest per se. Figure 2.4 demonstrates the basic ideas of Irving Fisher’s concept.

Friedman defended the research community of positivism. He argued that sound research can be
based solely on axiomatic grounds and the resulting explanations are valid although they have not
been verified through prior realistic circumstances (Friedman 1953, p. 4). Tobin criticized Friedman
and his proponents for causing the so-called “post hoc ergo propter hoc” problem, i.e., missing a
causal model as the underlying rational for empirical validity (Tobin 1970).
12 2 A “Selfie” of Finance and Ethics

Fisher’s idea of substituting the individual and complex utility function and,
implicitly, the individual values of monetary cash flows with monetary market
values and prices, together with the principle of separating finance and investment
transactions, had tremendous impacts on his successors in capital market theory. The
following fundamental issues reflect Fisher’s overwhelming contribution even for
the current state of capital market theory—and its resistance to addressing the
matters of ethics and morality. Etzioni’s statement that the neoclassical understand-
ing has no moral dimension seems obvious, as the following explanations will
demonstrate (Etzioni 1991, p. 355):
– The assumption of a perfect capital market is one of the implicit cornerstones of
Fisher’s paradigm. It is remarkable that the initial idea to formulate a perfect
capital market served as a model (the ADM total equilibrium models) but over the
following decades gained normative power. The most crucial outcomes of such a
paradigm were deregulations of capital markets in many industrialized countries
at the beginning of the new millennium.
– By substituting the individual utility function with a universal market-priced
cash flow income stream, it became possible to generalize investment decisions
for individual investors, based on derived parameters such as the net present value
or the internal rate of return. Investors who took additional parameters into
account like for instance social or ecological ones or any other ingredients outside
the setting of the capital market theory when making investment decisions would
be condemned to earning a return below market returns or suffer from extraordi-
nary risky positions.
– Nobody, operating as a rational investor, would voluntarily incur a loss by
investing outside Fisher’s basic principles. Investors should stick to the idea of
man as a homo oeconomicus. This rational, selfish yet highly knowledgeable
agent would not operate within his individual utility function but instead with
monetary cash flow-based market values. Any ethical or moral considerations
would be anachronistic to him. Deviations from the principle of the maximization
of individual income streams, such as altruism, and of getting individual satis-
faction by anything else than spending income for the consumption of goods
would not be in line with Fisher’s way of satisfying a person’s hunger for
experience.
– The separation principle and the independence of investments from financing
conditions opened the door for huge innovations in marketable financial contracts
and were escorted by immense research dynamics in capital market theory. And
so the development separating the financial and the real side of an economy was
laid—a shortcoming that peaked in the subprime and banking crises 2008 and
which is in sharp contrast to the need for an integration of the financial and real
sides of an economy.
Figure 2.5 repeats the basic components of the modern view of finance coming up
from Fisher’s basic ideas. His separation theorem was refined by enriching the
investment decision process with additional components like tax shields and other
financial side effects. It was up to Modigliani and Miller (MM) to prove that, under
2.1 The Building Blocks of the Modern House of Finance: Capital Market. . . 13

Modern finance (in the tradition of Irving Fisher)

Monetary view of the firm, i.e., it is a source to generate different types of income
streams (dividends, interest, taxes, salaries etc.) for different stakeholder groups.
Target of the firm: Maximizing its market value (in a narrow sense its shareholder value)
as a prerequisite to fulfill the different income expectations of the stakeholder groups.
Only monetary cash flows matter.
Finance and investment are decision problems for shareholders and bondholders to
optimize their individual income preferences (with respect to time, amount and risk
preferences).
Consumption preferences are the main sources that constitute differences in individual
income preferences of investors.
A perfect and complete world of capital markets is the most important ingredient of this
paradigm as it allows the transformation of investors’ individual and often different time
preferences.

Fig. 2.5 Financial management according to the neoclassical approach

the assumption of perfect capital markets, financing and investment processes are
separable from each other (Modigliani and Miller 1958). Again, individual utility
functions were of no concern. Debt financing could enlarge the capacity of a firm to
invest, prompting many financial institutions like private equity investors and hedge
funds to take advantage of Modigliani and Miller’s academic insights. With the
introduction of the arbitrage equilibrium principle, even an investor’s risk prefer-
ence became obsolete. At that time the separation theorem and the neutrality of
money was also inspired by the work of Markowitz on portfolio selection (Marko-
witz 1952).
As mathematics and statistics became the dominating analytical methods in
capital market theory-related research in the second part of the twentieth century,
his work also marked a new stage in the progress of capital market theorists’ efforts
to keep up with natural sciences. Instructive is the following citation at Markowitz’
defense of his doctoral thesis when his opponent, Noble laureate Milton Friedman,
said: “Harry, I don’t see anything wrong with the math here, but I have a problem.
This isn’t a dissertation in economics and we can’t give you a Ph.D. in economics for
a dissertation that’s not economics” (Bernstein 1992, p. 60). However, with his
dissertation Markowitz opened the door for a new generation of “quants” in finance
and economics. The new economics tackled uncertainty and risk not as an
intransparent and cloudy issue. By making future events and their consequences
for economic transactions calculable and computable, they unveiled the curtain of
mystic and miracle that surrounded uncertainty and future in economics for a long
time (Bernstein 1996, p. 217).
Markowitz’ work was the beginning of a research program that extended his basic
ideas of a general equilibrium concept. Its most prominent outcome was the capital
asset pricing model (CAPM) as Sharpe (1964), Mossin (1966), Lintner (1965), and
Ross (1976), independently from each other, have all formulated it. Financial
14 2 A “Selfie” of Finance and Ethics

decisions under uncertainty were reduced to a smart model, based on assumptions

about a generalized optimization behavior. Individual utility functions (preferences)
again became irrelevant for asset valuation due to the separation and value additivity
theorems: individual preferences were independent among agents, and a market-
related valuation is assumed to be always possible. The structure of a portfolio of
assets does not matter as Tobin proved in his two-fund principle (another kind of
separation theorem) (Tobin 1958). And if the unique market portfolio is held among
all agents, investment decisions are then independent from underlying individual
decisions concerning consumption and investment (i.e., saving) and are also not
influenced by finance decisions (i.e., the capital structure). In such thinking, the
value of a risk-bearing asset is reduced to a monetary value and independent of the
underlying individual utility function of the cash flow stream itself (not of the risk
preference)—and of any ethical values.2
The ADM total equilibrium model delivered a very important ingredient for the
extension of the Fisherian separation principle in cases of uncertainty. By introduc-
ing a particular good, described by its anticipated state-dependent future outcome,
the so-called contingent claim, a complete set of spot and future markets could be
designed in general equilibrium models. The money values of assets were then
dependent on their expected returns and related risks. The method of evaluating
the asset is grounded in the theory of expected utility. A restricted system purely
based on financial terms and goals ties together the three Fisherian dimensions
driving economic behavior in financial matters—amount and time preferences were
completed by the risk preference in the individual utility function.
The introduction of such a substantive uncertainty results from an incomplete
information vector and is the traditional view of the axiomatic theory of choice under
uncertainty.3 Hirshleifer and Riley (1979, pp. 1377–1379) defined decision-making
under uncertainty as a problem of choice described by the following relationships:
– A set of future states of the environment s ¼ (1,2,. . .,S)
– A set of possible actions a ¼ (1,2,. . .,A)
– A set of consequences resulting from the interactions and states of the environ-
ment c(a, s)
– A preference scaling or utility function defined over consequences u(c)
– A probability distribution function θ(s) expressing the decision-maker’s beliefs as
to possible environmental states

2
The development of new classes of mathematical formulated valuation models with exact solutions
has fascinated practitioners in capital markets until recently. With such tools, every skilled agent
was able to calculate asset prices with his pocket calculator and later on with Microsoft Excel
program and other claculation software. More complex calculations were eased by preprogrammed
spreadsheets that could be retrieved by the F9 button. In a heretical article in the Financial Times,
such agents therefore have been called F9 monkeys (Tett 2005) as they rely solely on mathematical
operations without any deeper understanding of assumptions and model causalities that lie behind.
3
Uncertainty can have two origins: lack of information (which is substantive uncertainty) and
limited cognitive capabilities of decision-makers to consistently pursue their objectives with given
information (represented by procedural uncertainty) (Dosi and Egidi 1991, p. 145).
2.1 The Building Blocks of the Modern House of Finance: Capital Market. . . 15

Within the concept of substantive uncertainty, certainty presumes a cognitively

competent decision-maker having perfect knowledge of relevant future states of
environment. A future environmental state occurring with certainty can be attributed
by a probability of one. In contrast, the concept of risk is characterized by the
attribution of different probabilities to all possible future environmental states.
Risk in the Knightian sense (Knight 1921) presumes that the probability of each
future environmental state can be described by an objective probability distribution
function, which refers to a mathematical or statistical probability (Kyläheiko et al.
2002, p. 74). Under those circumstances, it is assumed that behavioral risks do not
occur. Systemic uncertainty, fat tails, and other deviations from the bell-shaped
normal distribution function of the Gaussian curve are irrelevant in these models
(Bernstein 1996, p. 6).4
However, decision-making under uncertainty is tricky as nominal amounts of
future cash flows are state dependent so that the timing and the degree of uncertainty
of individual cash flows may differ among investments. It is at this point that a
deeper understanding of the concept of utility becomes important. Utility is the
perceived degree of satisfied individual wants and is therefore intangible (how,
e.g., is the “mental income” in the Fisherian sense defined?). But if Fisher was
right, we can only explain economic behavior by knowing each other’s utilities and
preferences independent of the good serving as a means of achieving “experience
and happiness.” Such a situation is best represented by a barter economy. But a pure
barter economy burdens on economic transactions high (sometimes prohibitive)
costs, markets reduce transaction costs, and money goes one step further: as financial
assets stem from money-derived contracts to transform money over time (via the
interest rate) and to handle risk with contingent claims, they extend the money
market of the ADM model to the capital market.
Along with this approach, the valuation and comparison of uncertain future cash
flows might differ between agents. The optimal link would be the certainty equiv-
alent according to the individual’s expected utility, which might be subjective
following differences in individual agents’ perceptions. Both shortcomings require
a common denominator for state-dependent future cash flows evaluated to the
present (i.e., discounting). As a simplified approach, the monetary value was intro-
duced as a proxy for the individual value in a utility function. Moreover, inside such
a function, the risk premium substitutes the individual certainty equivalent. The
replacement is more than a technical matter. The substitute is established in (effi-
cient) capital markets and represents a kind of a public good as it can be derived for
every rational market participant with low transaction costs by studying the risk-
adjusted asset prices in capital markets. Figure 2.6 illustrates the structure of such a
causality.
The integration of uncertainty, risk aversion, diversification, market pricing of
assets, ambitious assumptions of expectation formation, and the information effi-
ciency of capital markets became crucial for what Haugen (1995) later on called New

4
So-called Black Swans as Taleb (2007) has discussed it.
16 2 A “Selfie” of Finance and Ethics

Decision making under uncertainty: valuation &

comparison of cash uncertain future cash flows

Individual utility function?

Problem: nominal amount, date, degree of uncertainty (often unknown)
of CFs differ amongst investments comparison
requires a common denominator CF stream (objective?)

Utility is intangible, value

„Solution“: simplified approach by means of
can be measured in
(monetary) values as a proxy for individual utility
monetary terms

Linking perceived single values with market values, Information efficiency as

resp. market prices. Best linkage of utility and capital a consequence of perfect
market theory: certainty equivalents. Second Best: markets
assume perfect capital markets and the risk premium

Outcomes of the perfect capital market world: e.g.

Portfolio Selection Theory, Separation theorem,
Modiglian/Miller theorem etc.

Fig. 2.6 Why capital markets matter in modern finance

Finance. Profit and related income maximization became the sole drivers for eco-
nomic decisions and transactions. Economic agents were assumed to have homog-
enous and rational expectations.5 As stated by the underlying state preference
theory: “The individual subjective beliefs concerning the probabilities of the future
state of nature” (Copeland et al. 2005, p. 103). Agents have access to objective
information, i.e., information assumed to be complete, real-time, correct, costless,
and public. The underlying rational expectation hypothesis (REH) and the hypoth-
esis of information-efficient capital markets (MEH) allow agents independent and
rational behavior. This stated the so-called joint hypothesis. It has, until today, also
delivered the two fundamental pillars of modern capital market theory. According to
Fama’s work, it guarantees the no-arbitrage principle that has become the corner-
stone of the equilibrium paradigm in modern capital markets, as, in the short term,
rational speculators and arbitrageurs eliminate the failures of other market partici-
pants and hold the price formation process, more or less, at an equilibrium (Fama
1970, 1991). Individuals can make errors but sooner or later they are eliminated from
capital markets according to the law of large numbers.
It was up to Black, Scholes, and Merton to extend the logic of probability theory
in order to elicit the fair value of derivatives, namely, “options” (Black and Scholes
1973). The Black/Scholes formula demonstrated that spot market transactions and

5
“Expectations, since they are informed predictions of future events, are essentially the same as the
predictions of the relevant economic theory” (Muth 1961, p. 316).
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no related content on Scribd:
much public attention that the article which has since proved to be
the real wealth of the island was heedlessly overlooked, so that it is
not too much to say that the present high position of Ceylon as a tea-
producing country has been to a great extent entirely due to
accident, it being only after the outbreak of the coffee-pest in 1870
that tea was first looked upon as a possible source of profit. When
utter ruin seemed the only fate of the planters, it was suggested that
they turn their attention to the cultivation of tea. A commission was
duly appointed to visit the tea districts of India, and report upon the
desirability of introducing the tea-plant into Ceylon. Very tardily,
indeed, at first did the planters come to regard the experiment in the
light of a paying speculation, for old habits and prejudices were
strong, inducing them to cling with persistency to the hope that the
coffee-plague would ultimately disappear, and it was only as a last
resource that they decided to turn their attention to tea-culture on
that island. The first plantation was started with plants received from
China; the result, however, proved a financial failure, the first tea
produced therefrom costing $25 per pound. Other spasmodic efforts
were made later, until it was finally admitted that tea-culture could be
made a success on the island, when a rush was made for estates for
tea-growing purposes. The progress made was small at the
beginning, many of those who planted tea doing so under the
conviction that the industry would not pay, abandoning the scheme
almost at the outset.
Ceylon eventually began its career as a tea-growing country under
the most favorable circumstances; all the mythical hallucinations
about tea cultivation having been removed, the disastrous
experience of India saving Ceylon from falling into any serious error
at the outset. Several India planters settled on the island, bringing
with them a knowledge of its proper cultivation and preparation, so
that when these facts are taken into consideration, the success
which has attended its cultivation in Ceylon is not so much to be
wondered at. The island also possessed other advantages over India
in that it suffers less from drought, the rains are more regular and
equable, there being scarcely a month in the year without at least
some rain, and apart from the adaptability of its soil and climate, it
has cheaper labor and superior facilities for forwarding the tea to the
shipping ports, all important factors in its cultivation for profit. The
tea-producing districts of the island are very compact, having Kandy
as its chief centre and extending well into the southwestern
provinces touching the coast toward the west. The southwestern
section of the island is considered a perfect tea-growing district, soil
is good, the climate hot and moist, and the plant can be cultivated at
almost any elevation, several plantations there being situated as
high as 6,000 feet above sea-level. But although the crops are fairly
healthy at this altitude, it is admitted that the plantations lower down
are best adapted for the production of the finer grades. The first
successful garden was established in 1870 in the now celebrated
Loocandura estate, with plants brought from Calcutta, and coolies
skilled in its cultivation and manipulation. Tea of particularly good
quality was produced from the beginning, samples of which were
sent to London and highly spoken of by dealers there. Since that
time tea cultivation in Ceylon has made steady progress if not rapid
strides.
The plant chiefly grown in Ceylon is a hybrid—the Manipur or
indigenous tea of Manipari (India)—is also extensively planted there,
being equally hardy and suitable to the soil of the island, which is of
a light, sandy nature, thickly intermixed with iron-sandstone, this
mineral being peculiarly attractive to the tea-plant. The methods of
cultivation and preparation are similar in every respect to those in
vogue in India. The land is carefully drained and weeded, the trees
are not allowed to grow too high, being reduced to a bushy form and
picked when they are from two to three years old, according to site
and elevation, and the tea prepared from the tender shoots only,
caution being exercised not to injure the plants or future flushes
checked.
Picking the leaf is carried on all the year round in Ceylon, except
during pruning time, when the plants do not “flush” for two months,
with which exception they flush every week, from each shoot of
which the two top-leaves with the young shoot and half the third or
coarser leaf are only plucked at a time. At 4 o’clock each evening the
day’s “picking” is carried to the factory and the leaves laid out on the
“withering” mats, which are stretched one above the other from poles
or racks until the next morning, when the leaf is sufficiently
evaporated, being rendered soft, pliable, and easy to roll by that
time. The next process, that of “Rolling,” is one to which special
attention is paid, as it is mainly to this system that the quality of the
tea depends. The previously withered leaves are put into the roller,
which is operated by hand or steam power, 100 pounds at a time
placed in an upper box of the machine and pressed down with
weights on the table or lower portion of the machine. The box
containing the pressed tea travels with a circular motion round the
table, by which the leaves are pressed, twisted and rolled as they
come in contact with the small battens fitted into the centre of the
table. After an hour the pressure is increased until at the finish it is
from four to five hundred pounds on the leaves, the juice thus
expressed being carefully collected and poured back into the roller
every now and again until it is all absorbed by the crushed and
twisted mass of leaves. When the rolling process is finished, the
leaves are then placed on trays holding from 20 to 25 pounds,
covered with a wet cloth and allowed to ferment from two to four
hours according to the weather, or until they become a bright-copper
color, when they are again rolled from a half to an hour according to
fancy, after which they are ready for firing.
The “Sirocco machine” for firing tea-leaves by hot air has also
superseded the pan or “Charcoal process” in Ceylon. The leaves
having been laid out on wire-gauze trays, they are passed through
this “hot-air” machine, in which they become thoroughly fired Tea in
from twenty to twenty-five minutes, after which it is placed in sieves,
which are worked either in a lateral or revolving direction by the aid
of steam or manual power, and the different grades are sifted out,
the larger and coarser leaves which do not pass through the sieves
falling into a “cutter,” where they are cut to a uniform size. On estates
where they bulk the Tea, in Ceylon, the result of the day’s work is
placed in enormous air-tight lead-lined chests, where it remains until
a sufficient quantity to form a “Break” or “Chop” is accumulated,
which is generally once per week. The chest is then opened from the
bottom and the tea bulked, after which it is lightly fired again and
packed into the teak-wood chests for shipment. Light iron chests,
coated inside and out with lead, and a lid to screw on, are now being
extensively used by many estates for the better shipment of teas in
both India and Ceylon.
Ceylon teas derive their trade names from the estates or plantations
on which they are grown, being classed commercially as
“Loocanduris,” “Matagalas,” “Ruan-wallas,” “Kanda-loyas,” “Semba-
watties,” “Windsor Forests,” “Narangallas,” “Rakuwana,”
“Madulsuma” and “Kandapole,” the finest being produced in the
districts of Dunbula and Dolosbagie. Like India teas, they are
principally converted into Pekoes, Souchongs, Pekoe-Souchongs,
Congous, Broken-leaf, and Fannings. Their strength and flavor, like
those of their India prototypes, varying greatly in quality in
accordance with the elevation at which they are grown, their
uniformity also varying from year to year as in the India districts.
Some of the better grades resemble Cachars and Darjeelings, being
full and strong in liquor, but frequently “toasty” or burnt in flavor, while
the lower grades are decidedly inferior to the corresponding China
grades in flavor and fragrance. A feature about the later shipments
most to be regretted is that the planters appear to be making the
same mistake that the Chinese and Japanese have made, that of
sacrificing quality to quantity in their eagerness to get rich too fast.

Ceylon-Pekoes—Are of three kinds, “Plain,” “Silver,” and “Golden-

tip” Pekoes. The former is a small, plain black-leaf tea, lightly
“tipped” and finely made. The liquor is bright and fairly heavy in body
and fragrant so far as this term applies to this variety, but is not
adapted to the American taste.

Silver-tip Pekoe—Is a long, whitish-downy leaf almost “satiny” in

texture, with silvery tips at the ends. The liquor is dark-yellow or
golden, bright and sparkling in the cup, delicate and fragrant in
flavor, but very much overrated in commercial value and intrinsic
merit.

Golden-tip Pekoe—Is smaller in make, darker in color, “silky” in

texture, and literally ablaze with rich yellow or orange tips. The
infusion is much darker and heavier in body, of a deep wine color,
fresh and piquant in taste, and much appreciated by those who
prefer this variety.

Ceylon Souchong—Is rather large and bold in style for this “make”
of tea, but is nevertheless heavy and round in body, rich and mellow
in flavor, and, taken altogether, a pleasing and palatable tea for all
practical purposes.

Pekoe-Souchong—Is chiefly composed of the larger and coarser

leaves that will not pass through the sieves, but which, falling into the
“cutter” in sifting, are cut up into an even and uniform size. It is
medium in size, “choppy” in appearance, ripe and rich in liquor, fairly
brisk and “malty” in flavor.

Ceylon Congous—Are open, rough and coarse in style, dark in

liquor, heavy in body, but fairly brisk and pungent in flavor, making,
on the whole, a serviceable tea for blending with Chinese Congous
or Oolongs of the lower grades.

“Bhud” Tea—Is a term applied to a small golden-yellow leaf Ceylon

Tea, claimed to be composed of the buds of the plant just expanding,
but is in reality prepared from the smallest and yellowest leaves of
the ordinary “Golden-tip Pekoe,” and though sometimes
commanding a fabulously high and inflated price, out of all reason
with its intrinsic value as a tea, and which is only done for advertising
purposes—being in reality no better in either drawing or drinking
qualities.

Broken Leaf—Like those of the India variety, are composed of the

large, old and mutilated leaves separated in sifting from all or either
of the foregoing kinds, drawing and drinking in ratio to the variety
obtained from.

Fannings—Also, like their Indian prototype, are prepared from the

screenings and refuse of leaves of the respective kinds, but are poor
teas to handle as a rule.
As late as 1873 there were only 255 acres under tea cultivation in
Ceylon, the total area at present time reaching as high as 150,000
acres, with an average yield of 1,000 pounds per acre, figures which
go to show the marvelous strides the island has made in the industry
in a comparatively few years, large tracts being still taken up for the
purpose. The total product in 1888 was 23,000,000 pounds, as
against 13,000,000 pounds for the previous year, an increase of
10,000,000 pounds in a single year, a record never even approached
in the history of the tea trade. And, when it is taken into
consideration that it is only a few years since tea cultivation was
practically commenced on that island, it is obvious that the future of
its product must be very bright indeed. It is already predicted by
planters and others interested that the tea export of Ceylon will
eventually rival, if not exceed, that of India itself. The average cost of
Tea to the Ceylon producers is about 6½ pence (13 cents) per
pound, some of the lowland estates putting their teas f. o. b. in
Colombo at even less than this figure.
Nearly all the India and Ceylon teas go into consumption in England
and her possessions, the bulk of her China purchases being re-
exported. The English merchants invariably favoring the products of
their own colonies to the prejudice of those of other countries,
discriminating against them, irrespective of merit or value, in this
particular instance compelling their customers, in a measure, to use
these dubious varieties of the genus tea. But for presumption and
audacity in their claims of superiority the India and Ceylon tea
growers and dealers are far and away ahead of all competition. The
so-called great favor with which India and Ceylon teas are said to be
regarded by British consumers being due in a great measure to the
energy and persistency with which the trade has been pushed, the
teas being literally forced on the public by the Government as well as
by the English growers and dealers, in addition to the strong ties of
relationship connecting the planters with the mother country. There is
not the slightest doubt but that the check which the consumption of
China teas appears to have sustained in England is entirely due to
these causes. But already there is a growing and positive revulsion
of taste in many sections of that country in favor of the purer China
teas, owing to their truer character, greater delicacy and richness of
flavor.
The chief and only advantages that India and Ceylon teas possess
over those of China and Japan are their great strength and thickness
in the cup, which are due mainly to the modern methods of
fermentation and firing by steam and machinery. China and Japan
teas excel them in flavor and aroma, occupying in regard to them a
position analogous to that of French wines, in comparison with those
of other countries. The product of the latter may be stronger and
heavier in body, but for richness of flavor and delicacy of aroma—
essential qualities in both wine and tea—the French grape and
China tea-leaf stand alone and unrivalled for their intrinsic merits, as
well as for their being the only true teas, in all that constitutes tea.
Broadly stated, the predominant features of India and Ceylon teas
are body and strength, those of China and Japan flavor and aroma.
There is also this difference between them, that while a given
quantity of India and Ceylon teas will yield a larger amount of a
darker-colored liquor and stronger in flavor than that of a similar
quantity of China and Japan, they still lack the richness and delicacy
of the latter, if not indeed the properties of a true tea altogether.
Again, as to how much liquor an equal quantity of the former will
yield in comparison with a similar weight of the latter, is another
mooted question. As far as quantity, color and body are concerned, it
must be admitted that India and Ceylon teas are once and a half
greater. But in flavor and aroma, the essential qualities that
constitute and are most appreciated in tea, China and Japan teas far
excel them. Thus if one pound of China or Japan teas yields five
gallons of extract of a certain weight, strength and color, one pound
of India or Ceylon will produce seven and a half gallons of a similar
beverage, but will be devoid of that fragrant flavor and rich aroma so
characteristic of the China and Japan product. The value of tea,
intrinsically and commercially, depending principally upon the
character and flavor of the infusion, as well as the aroma imparted to
it by the volatile oil.
Ceylon, like India teas, will not keep as long or as well as either
China or Japan, becoming sour and rancid by exposure in a few
months, defects attributed to the method of curing, but in reality
inherent in them. Again the latter contain a larger percentage of the
active principle (theine) and less of the astringent property (tannin),
and are consequently less injurious and more refreshing. The great
excess of the latter property in both India and Ceylon teas
accounting for their dark color, and harsh, pungent taste in the
infusion, as well as being the unsuspected cause of the indigestion
and nervousness among those who use them to any extent. So that
in view of the strenuous efforts now made to introduce India and
Ceylon teas into the American market, it may be well to here caution
consumers against their injurious and deleterious effects on the
human system, such injury being caused, not alone by the excess of
tannin, but also by the sap or juice of the natural leaf not being
sufficiently expressed before the leaves are fired by proper
fermentation. It being claimed by physicians and others that to the
fixed and general use of these teas in England is attributable the
great increase of heart-burn, flatulency, nervousness and dyspepsia
among the people of that country.
Against the dubious and questionable advantages of body and
strength so loudly vaunted in India and Ceylon teas, China and
Japan possess others—greater and more important ones—among
which are that the tea-grower in the latter countries working his own
land in smaller quantities brings greater care and more industry to
the task. Again in the methods of curing and firing the leaf, the latter
have also the advantage of superiority, as it is now generally
admitted by experts and others interested in the business that
though the “Sirocco” or hot-air process may be more rapid in its work
and certain not to taint the leaves in any way, it is yet open to doubt
whether the older, slower, and more natural method of firing in pans
over charcoal fires is not the better, more thorough and effective in
its results than the new and artificial one. The Chinese and
Japanese have been curing and firing teas by that method for
centuries, and they surely ought to be the best judges by this time.
To sum up, India and Ceylon may produce stronger and more
powerful teas if that can be called a recommendation, but for
smoothness of liquor, richness and delicacy of flavor, such as are
essential to every-day, universal consumption, the China tea-leaf
and French grape stand and will continue to stand unrivalled. India
and Ceylon may claim to be the teas of to-day, but it remains to be
seen whether that day be long or short, as in my humble opinion,
without laying any claim to the prophetic, the teas of the future as in
the past will be China and Japan teas.

JAVA TEAS.
Tea culture was introduced to the Island of Java in 1826, the seeds
and plants being obtained from Japan for the purpose. The plants
having thrived beyond expectation, a plantation of 800 trees was
formed the following year in the residency of Buitenzorg, although
samples of tea grown elsewhere on the island were shown at an
exhibition held in Amsterdam in 1828. Another plantation was
subsequently established in the district of Carvet in Preanger, from
which its cultivation later extended to Krawang and other residencies
in the island. So successful was the progress made that in 1833 the
number of trees in the latter residency was returned at more than
500,000. Up to 1842 tea was cultivated in Java exclusively for
Government account and under the immediate supervision of its own
officials, nearly 14,000,000 trees being in bearing there that year. But
the number of laborers required for its cultivation and manipulation
becoming so large, the supervision so difficult, and the results so
unsatisfactory, the Government was eventually compelled to
relinquish many of its plantations to private parties, contracting at the
same time to purchase their product at a fixed price. This change
proved beneficial, resulting in a still further extension and
improvement in its culture; the contracts with the Government being
entirely annulled after seven years’ trial, and the industry being left to
private energy and capital, without control or interference, it soon
developed to large proportions.
In Java the best teas are grown at an elevation ranging from 3,000 to
4,000 feet above sea-level, the finest being produced on the
mountain slopes, in the residencies of Preanger, Bagelen and
Banjœmas. Nothing could be more attractive than the plantations
situated on these ranges, each containing from 70,000 to 100,000
plants in perennial bloom and giving employment to from twenty-five
to thirty families of native laborers. The methods of cultivation and
preparation are much the same as in Japan, though latterly the India
system is being largely adopted, both Black and Green teas being
prepared at will from the leaf of the same plants. The seeds are first
sown in nurseries, from which the young plants, when old enough,
are set out in line, at a uniform distance of four feet from each other.
The trees are never allowed to exceed two and a half feet in height,
and are much more prolific than either the China or India species,
the leaves being picked from them all the year round. They are
known to commerce under the appellations of “Preangers,”
“Krawangs,” “Cheribons,” “Bagelens” and “Banjœmas” teas, and
usually converted into Pekoe, Souchong, Pekoe-Souchong,
Congous, Oolongs and Imperials, Broken-leaf and Siftings after the
India and Ceylon manner. The leaves for the different “makes” are
sorted during picking and graded according to size, the smallest and
tenderest being converted into Pekoe, the medium size into
Souchongs, and the largest and oldest into Congous, Oolongs,
Imperials and Broken-leaf teas.

Java Pekoe—Is a small, jet-black leaf, lightly tipped with yellowish

ends. The liquor is extremely dark, almost black in color, heavy and
thick in body, bitter and astringent in flavor, and entirely unsuited to
the average taste.

Java Souchongs—Are composed of the older and coarser leaves of

the tea-plant. They are bold in style, black in color, dark in draw, thick
in body, and exceedingly strong in flavor, too much so to use alone.

Pekoe-Souchongs—Comprise the older and coarser leaves of the

respective pickings, considered too large for conversion into Pekoe
and too small for Souchong, possessing the same characteristics in
draw and drink of both the latter varieties.
Java Congous—Are large, rough, loosely made teas, dark in liquor,
heavy in body, and strong to rankness in flavor, on the whole a most
undesirable sort for any purpose, becoming rancid and sour when
kept too long.

Java Oolongs—Are Java tea pure and simple, made in imitation of

China Oolongs, but possessing nothing of the properties or
characteristics of the latter, only the name.

Java Green Teas—Include Imperial Hysons and Young Hysons, but

are only so in name, as they still possess all the peculiarities of Java
tea in draw and drinking qualities.
Java teas in general are particularly small in leaf, dull-black in color,
but exceedingly well made and handsome in appearance, almost
perfect in style, approximating more to Indias in make, color and
character, but do not keep well, becoming rank and sour on brief
exposure to the atmosphere. The liquor of all of them is also
deficient in strength and flavor, being devoid of any pronounced
fragrance or distinctive aroma, defects attributable in a great
measure to faulty and imperfect manufacture, as well as to the fact
that they are picked from the plants the year round and allowed no
resting or recuperating period. The annual product averages about
15,000,000 pounds, packed in large wooden cases weighing from
100 to 120 pounds, and shipped principally to Holland, Germany and
England, only small lots occasionally being received in this country.
At the present time the cultivation of tea is mainly confined to the
province of Preanger, in the western part of the island, the industry
being in the hands of experienced planters, who spare no pains to
increase the product and quality of the article. Notwithstanding their
care, however, they cannot congratulate themselves on the profits
resulting therefrom, the price continuing to fall, the planters being
forced to expend their utmost energies to save their plantations from
ruin, this being not only the case with recent enterprises, but also
with the older plantations that have been flourishing for many years.
In addition to decline in price, the Java tea plantations have been
ravaged by an insect known as the Theluis (tea louse), which each
year destroys in value hundreds of thousands of florins, but at the
same time there is noticeable a distinct improvement in the quality of
the tea produced there. Until very recently they were only used in
Europe when mixed with China teas on account of the excessive
quantity of tannin which they contain, and known tendency to rapid
decay, the improvement in quality now rendering that process
needless, the introduction of Assam plants enabling the planters to
compete with India and Ceylon.

OTHER VARIETIES OF TEA.

African Teas—It is expected that both India and Ceylon will
doubtless have in the near future a formidable rival to their tea
industry in South Africa, where promising tea gardens have been
extensively laid out by planters from India, with seeds and plants
obtained from Ceylon. The soil and climate of the region around
Natal particularly are very similar to those of Southern India, and
especially favorable to the successful and profitable production of
the tea plant. Recent reports pronounce the venture a complete
success, the product in 1892 amounting to over 20,000 pounds of
tea, although introduced only three years prior and grading in quality
with the average teas of Ceylon and India. It is predicted that in a
few years South Africa will not only rival but excel the latter countries
not only in the quantity but also in the quality of their product.

Singapore Tea—Tea plantations have been recently formed in the

districts of Johore and Seragoon, from seeds and plants imported
from India, but as yet are only in an experimental stage. Samples
already received are large in leaf, coarse in make, coal black in
color, an effort being made to imitate Oolongs in style. The infusion
is dark red, heavy, strong and somewhat astringent in flavor.

Perak Tea—Recently an invoice consisting of some eighty half

chests of tea grown in the Straits settlements was shipped to
London. The general quality was so favorably commented on by the
brokers and dealers there that it found a ready sale at full prices for
its kind.

Fiji Tea—Is another new addition to the constantly increasing teas of

commerce. It is produced from plants imported from India and
assorted into Pekoes, Congous and Souchongs, grading with and
approximating to Java teas in style, color and character.

Caravan Tea—Is simply a fine Lapsing or Padrae Souchong, put up

in Hankow for the Russian market, and transported overland by
caravan through Bokhara and Central Asia to Moscow and
Petersburg.

Russian Tea—Grown in the district of Transcaucasia, consists

largely of the leaves of a shrub possessing the botanical name of
Vacinium staphylos, which when infused yields a decoction having
some resemblance to the ordinary teas of commerce, but is acrid
and nauseating in flavor. They are generally prepared for the
express purpose of mixing with inferior China tea, and also with
exhausted leaves, that is, tea once used, dried and rolled again.

American Tea—Samples of tea grown in South Carolina have lately

been received in the New York market and tested there by experts,
who pronounce them only fair in quality, and ranking them with the
India, Ceylon and teas of that character.

Hop Tea—Is a species of tea now being prepared from common

hops in the Kent district in England, prepared and cured by the
“Sirocco” process, after the manner of India tea, and used chiefly to
blend with the ordinary teas of commerce, the combination
resembling a mixture of Virginia smoking tobacco and a rough-
leaved Assam tea. It is claimed to be healthy and wholesome, from
the fact that the lapulin of the hops counteracts or neutralizes the
excess of tannin contained in the India teas, but nearly doubles it in
price.

PARAGUAYAN TEA.
Yerba Maté, or “Paraguayan tea,” which although not entering into
general use or commerce, is yet deserving of notice in this work from
its extensive consumption among the inhabitants of South America.
It is prepared from the leaves and stems of the Ilex, a species of
holly found growing in a wild state in that country. In size and
appearance it closely resembles an orange tree, having a whitish
bark and leafy, tufted boughs, with leaves four inches long when full
grown, dark-green in color, thick, glossy and crenate at the edges,
pale on the lower surface and containing the same active principle,
Theine, so characteristic of China tea. The flowers or blossoms are
small and white, hanging in clusters at the angles of the leaves, the
fruit or berries being red, smooth and similar to those of the common
holly. So closely does it approach the tea of China in effect, that
many authorities claim it to be a species of that plant, yielding a
liquor similar in many respects. But while not containing as much
volatile oil as the latter, owing to the primitive manner in which it is
prepared, it nevertheless yields a most agreeable and refreshing
beverage, enjoyed by many and forming the staple drink of millions
of the inhabitants of Paraguay and other South American countries.
Expeditions to collect and prepare it start annually from the capital to
the Yerbales or groves in the interior, taking extra mules and bullocks
to bring the dried leaves back. On reaching the forests Tatacuas or
camps are formed by clearing the ground and beating it down with
heavy mallets until it is sufficiently hard and level for the purpose.
The leaf in the natural state is from four to five inches long, thick,
leathery, glossy and serrated at the edges, and is prepared for use in
a network made from raw-hide straps stretched on posts,
underneath which wood fires are kindled. The leaves and stems, as
they are collected, are placed on these nets and scorched, care
being taken only that they do not ignite or burn too much—in which
state they closely resemble senna. When sufficiently scorched they
are ground, in some instances, into a coarse powder in a rude
wooden mill, weighed and packed for export in large bullock hides,
holding from 200 to 250 pounds each and left to dry and tighten in
the sun for a few days, becoming meanwhile as hard and impervious
as stone. This method of curing is very defective, as the stems and
other extraneous matter imparts a “woody” flavor to the infusion
which is otherwise very agreeable and refreshing. It is prepared for
use in a kind of filter or perforated bowl called Maté, from which it
derives its trade name. The infusion is yellowish in color, almost
syrupy in body, possessing an “herby” or weedy flavor, bitterish in
taste, much disliked at first by those unaccustomed to its use, but
nevertheless pleasant, wholesome and refreshing, pleasanter still
when cold, and while approaching in its chemical composition to the
regular teas of commerce it does not cause the wakefulness or
nervousness attributed to the latter.
In the smaller towns and rural districts of South America it is
regarded as a regular form of diet, and not, like ordinary tea, a mere
accompaniment to the meal, being looked upon as a necessary, as
well as a luxury, by the inhabitants, and is the first thing offered a
visitor when entering a house, the table being rarely without it. The
gaucho of the plains will travel for weeks asking no better fare than a
little dried beef, washed down with copious drafts of Maté, the Indian
carriers subsisting for days together on it alone, in short, being to
them what the tea of China is to its inhabitants, essential and
indispensable. The Government has a monopoly of its sale, a heavy
duty being imposed on its exportation, forming the principal source of
its revenue. The popular method of preparing it in Paraguay is to mix
large proportions of raw sugar with a decoction made from the
powder or leaves until a thick syrup is produced, when it is ready for
drinking, the nourishing properties attributed to the infusion by the
natives, it is contended, being due, in a great measure, to the excess
of saccharine matter. It ranges in price from four to eight cents per
pound in the prepared state, one pound yielding as much as twenty
quarts of the infusion of moderate strength. It is difficult to get at any
reliable returns for the entire traffic in this commodity, the production
being carried on in such a crude and desultory manner, extending,
as it does, over a vast area of wild country, the official returns
furnishing only an approximate estimate of its trade and
consumption. The total production may, however, be computed at
1,500,000 arobas, equivalent to about 40,000,000 pounds per
annum, the total consumption averaging thirteen pounds per capita
to the population, as against two pounds of coffee and one-fourth
pound of China tea. Its use is confined chiefly to Paraguay, Uruguay,
Argentine, Peru, Chili and Brazil. Its consumption in Paraguay and
Argentine alone is over 35,000,000 pounds per annum, as against
5,000,000 pounds of coffee. Surprising as this large quantity may
appear at first sight, it is explained by the fact that Maté constitutes
the only vegetable nourishment of many classes in these
communities, forming, as it does, the chief dietic beverage of over
20,000,000 of people in South America alone. Yet it is singular, to
say the least, that its consumption should be so great in such large
coffee-producing countries, and which export annually over half the
world’s supply of that commodity. Strong efforts are being made at
the present time to open up a trade in it in Europe, particularly in
France, where the cafés now advertise it among their regular
beverages, and shops devoted to its exclusive sale also recommend
it. But whether these efforts will succeed remains to be proven,
considering the enormous increase in the production of so many
other teas and their established consumption.

TRADE GRADINGS OF TEA.

A Standard Invoice of Green tea contains a number of “Lines,” made

up as follows: Gunpowder, No. 1 and 2 and 3; Imperial, No. 1, 2 and
3; Young Hyson, No. 1, 2 and 3. There being rarely more than two
lines of Hyson, and never more than one of Twankay.
A “Chop” of Oolongs comprises four, sometimes five, “Lines” termed
“Firsts,” “Seconds,” “Thirds,” “Fourths” and “Fifths,” when any, which
are again subdivided into “Brackets” or “Numbers,” ranging from one
to ten but similar in grade.
An Invoice of “English Breakfast teas” includes a quantity of Capers,
Pekoes, Congou and Souchong teas, graded and classed according
to the district of production, by which terms they are best known to
trade.
A Standard Invoice of Japans embrace some Pan-fired, Sun-dried
and Basket-fired teas with occasionally other makes, also ranking
according to the different districts.
A “Break” or “chop” of India or Ceylon include Pekoes, Congous,
Pekoe-Souchongs, Broken-leaf and Fannings, and are best known
to trade by their plantation names and district appellations.
The term “Muster” means Sample-package or chest, the name on
top of label the vessel, route or “chop,” the initials in centre those of
the importer. The names at bottom such as “Tong-mow,” “Tong-lee,”
grower or packer, and the Chinese character on inside of package.
“Chop mark,” denoting the “chop” or picking, which cannot always be
relied on, as shippers are apt to put on that which has the best
reputation, or which happens to be most in demand the season of
shipping.
 CHAPTER VI.

A D U LT E R AT I O N
AND

DETECTION.

The Teas of commerce are subject to four principal descriptions of

sophistication—“Facing” or Coloring with deleterious compounds, in
order to enhance their appearance;—Substituting with spent,
partially-used or exhausted leaves to increase their bulk and reduce
the cost;—Mixing or blending with spurious or foreign leaves, and—
Sanding or adulterating with a variety of mineral matter, chiefly iron
or steel filings, to add to the weight. Each trade has its own special
form of adulteration, and as in the milk business the most prevalent
sophistications are watering and skimming, so in the Tea-trade the
besetting malpractice is coloring and mixing with or substitution of
partially-exhausted tea leaves, so that the main efforts of experts
and tea-analysts should be directed more to this form of adulteration.
The other forms have received some attention from chemists and
others interested in the article, but not to the extent which the
importance of the subject merits. But it is against the two former
most common and dangerous forms of adulteration that the principal
efforts of tea-analysts and inspectors should more particularly be
directed; and, while considerable of this nefarious and positively
injurious work is done in the countries of importation, by far the
greater portion is perpetrated in the countries of production. For
consummate skill in the “tricks of trade,” the Chinese as a people
have long been proverbial. “They are a self-ended people,” says an
old writer, “having the same reputation in Asia that the Jews have in
Europe.” Yet there are strong reasons for stating that many dealers
in our own and other tea-drinking countries have become expert
imitators of their methods, especially in the minor forms of coloring,
mixing, repacking and refacing. The sophistications in our own
country being chiefly confined to the admixture of damaged, stained
and tainted teas with sound, pure or high-grade goods, with the
object of concealing or disguising their defects, and the substitution
of one variety for another by repacking and relabeling. The latter
form being practiced to a much greater extent than most people
imagine, giving rise to a special branch of business in nearly all of
the larger cities.

“FACED” OR COLORED TEAS.

Of the various forms of adulteration practiced in China and Japan
artificial coloring or “facing” is perhaps the most prevalent and
glaring. The material used for the purpose is usually composed of
Prussian blue, gypsum, indigo, turmeric, and more frequently, China
clay, a whitish iridescent powder, resembling mica, variously
composed, but generally consisting of kaolin (soapstone), and
sulphate of lime. While that in use in Japan is not known, its
composition being a secret, known only to the manufacturers, but is
evidently a preparation of gypsum and kaolin, the Japanese
contending that it is a vegetable compound pure and simple. That
kaolin is used in its preparation can hardly be denied, as kaolin
contains sulphur, and many of the lower grades of Japan teas are
found on infusion to possess a slightly sulphurous odor. It has been
proved, however, whatever its nature, to be less harmful and
injurious than the Chinese compound, and used only in the
manipulation and sophistication of the lower or commoner grades of
tea in that country.
The process of coloring or facing Green teas is performed by placing
a portion of Prussian blue in a porcelain bowl, not unlike a chemist’s
mortar, and pulverizing it into a fine powder, a small quantity of
gypsum being meanwhile burned over a charcoal fire, to soften it,
after which it is ground fine. The two substances are next mixed
together, in the proportions of one part blue to four parts gypsum,
both making in combination a light-blue preparation, in which state it
is applied to the leaves during the last process of firing, about five
minutes prior to removal from the pans, the time being regulated by
a burning joss stick. The Saihoo taking a handful of the compound,
scatters it over the leaves while in the pans, other operators tossing
and turning the leaves around rapidly with their hands meantime in
order that it may equally diffuse among them. One ounce of coloring-
matter will face fifteen pounds of leaves, imparting to them a dull
leaden-blue hue, and “glossy” or greasy appearance, readily
detected in the hand. In many districts, most notably in Ningpo and
Canton, turmeric, kaolin, and China clay are more extensively
employed for the purpose. This almost transparent form of
adulteration is readily detected in the following manner:—
(1) When the tea is heavily coated it may be easily recognized by its
dull leaden-blue color and greasy appearance in the hand, or by
placing a small quantity of the leaves on a piece of glass or smooth
table, on removing them the coloring-matter will be found adhering to
the hands, glass or table, and its nature, whether Prussian blue,
turmeric, kaolin or indigo, readily determined with the aid of a
microscope. (2) When only lightly colored or suspected, place a
sample of the leaves in a cup or wine-glass and pour on briskly
boiling water and stir well for two or three minutes, then strain well
through a thin muslin cloth. The coloring-matter, if any, will be found
adhering to the cloth, that passing through, sticking to the sides, or
forming a sediment at the bottom of the vessel into which it is
strained. If these deposits be treated with a preparation of chlorine,
or a solution of chloride of lime, and turn white, the coloring
substance used is indigo. But if treated with a little potash, and it
becomes brown, it will prove to be Prussian blue, the application of a
little sulphuric acid having the effect of turning it blue again.
What are known to trade as “Canton Green teas” are made from tea-
dust and exhausted leaves ground up fine and aglutinized with a