The Evolution of Capital Markets in the 19 th Century

1. The Evolution of Capital Markets in the 19th Century

2. Success and Dominance of British Finance • By 1820 • Parliamentary control of budget, annual audits • Salaried Tax Collectors • Tax Smoothing and Time Consistency • Short-Term Debt: treasury, army, and navy bills • Long-Term Debt: consols. • Consequence---cheapest borrowing and lowest inflation. Matched with dominance in manufacturing, trade and military power.

3. Other Countries Desire to Emulate • But, there is an absence of political stability and the institutions---such as North and Weingast describe---that ensure governments will follow credibly time-consistent policies. • France post-1815, strong monarchy, weak legislature, revolutions, 1830, 1848, 1871. Dominance of legislature only begins in 1871. But, never again default after 1797 • Belgium—formed from Kingdom of the Netherlands in 1830, strong monarchy, weak legislature, and revolution 1848 • Revolutions across Europe in 1848 • Can this result as seen in capital markets?

6. Two Features • Trend---downward trend in yields on government bonds • Convergence of rates between bonds issued by different governments. • What drives these two phenomenon? • HINT! Is it supply or demand?

7. What drives down the trend? Interest Rate S1 S2 ir1 ir2 I2 I1 G1 G2 Savings, Investment

8. Huge Rise in European Savings:Domestic and Overseas Investment

9. Where Does the Money Go?“Mary Poppins?”

10. Overseas Investment Central to World Economic Development • Many developing countries in the 19th century, including the U.S. and Canada, required vast investments in infrastructure----railroads, canals, ports, etc. and machinery and equipment. • They have trade deficits---U.S. has a trade deficit for the whole of the 19th century until 1914. • The capital investments---railroads, ports, bridges, factories---help to cover the huge trade deficits—so that these countries are not depleted of gold.

11. Great Age of Victorian Financehttp://www.youtube.com/watch?v=jt9JpYRulSkhttp://www.youtube.com/watch?v=C6DGs3qjRwQ&feature=related • “Mary Poppins-----the Fidelity Fiduciary Bank song • Mr. Dawes Sr, Mr. Banks and Bankers:If you invest your tuppenceWisely in the bankSafe and soundSoon that tuppence, Safely invested in the bank,Will compoundAnd you'll achieve that sense of conquestAs your affluence expandsIn the hands of the directorsWho invest as propriety demandsYou see, Michael, you'll be part ofRailways through AfricaDams across the NileFleets of ocean greyhoundsMajestic, self-amortizing canalsPlantations of ripening tea……………………

12. The First Era of Globalization • Integration of Labor Markets---Emigration of labor form Europe, where there are low wages to frontier economies where it is high (High Land to Labor ratio---low relative price of land) • Integration of Capital Markets----Migration of Capital from the European core to the European periphery (Eastern and Southern Europe) and the Rest of the World. High returns to newly industrializing countries and frontier economies. • Land does not move • Integration of Markets for Goods (Remember O’Rourke!). • Result---strong tendency for goods and factor price equalization.

13. Global Market for Goods • Reduction in Transportation Costs---shipping changes from wind to steam. Collapse of transport costs for goods and for labor • Reduction in Barriers to Trade—Tariffs • Corn Laws overturned 1841. Britain takes lead in lowering tariffs. Does not ask for reciprocity. • 1860 Cobden-Chevalier Anglo-French trade treaty. Resisted by many French industries, but political considerations for a rapprochment overwhelm the economic considerations. Tariffs now average 15% on British goods in France—a moderate tariff. Treaty introduces “most favored nation clause.” If one party to a treaty negotiates a treaty with a third and the new tariffs are more beneficial, they are automatically given to the other country. A spur to lowering tariff barriers. • France negotiates treaties with the Zollverein, Belgium, Italy, Switzerland and the Scandinavian countries---tariffs tumble.

14. Williamson (JEP, 1998)When does convergence begin?

16. Globalization, Inequality and Backlash

17. The Backlash • Anti-Immigration Legislation • U.S. 1917 literacy test—vetoed by President Wilson • U.S. Emergency Quota Act 1921 • Barriers raised in Argentina, Australia, Brazil and Canada • Tariffs • 1879 German tariff • Tariffs in France, Sweden and other countries.

18. The First Era of Globalization1860/1870-1913 • Markets are highly integrated---labor, capital, goods • Spread of European (British) institutions for managing monetary and fiscal operations of the government. • Rapid growth around the world with rapidly rising per capita incomes. • Blown Apart by World War I.

19. The Two Major Concerns of Monetary Policyin all Periods and all Places • Fiscal Policy “Time Consistent Policy:” WarsDeficits financed by selling bonds. Raise taxes just enough to run peacetime surplus to cover the interest cost and slowly pay down debt. 2. Monetary Policy Price Stability: 19th CGold Standard Financial Stability

20. Key to Development of Price Stability: The Adoption of the Gold Standard in the 19thC • Gold Standard ensures long-term price stability • The price level remains stable in the long-run, although there will be year-to-year price increases and declines. On average the price level will be stable. • Commitment to Gold Standard is one way that a government can promise that it will not manipulate the money supply---”time consistency”---it must be easily verifiable by the public. • Money and capital markets are thus assured. Can borrow cheaply---not defrauded by surprise inflation

21. Bordo (1981) How would a time series graph of this look?

22. Cheating? Counterfeiting? • Gold: Durable and High Value to Weight • The Public Cheats: Counterfeiting • The Government Cheats: Debasement • If done widely---result would be inflationary

23. A Simple Closed Economy Model of the Gold Standard • Autarky---no trade---closed economy • Government accepts gold ore for a fixed price per ounce (U.S. 1 oz = $20.67), called here Pg • Government mint produces gold coins (for a small fee that is revenue to the government) • All money is in the form of gold coins • Stock of Gold = monetary gold plus non-monetary gold

24. What if big increase in Stock of Gold? Relative Price of Gold Stock of Gold Price Level Aggregate Supply (Pg /P1) P1 Aggregate Demand Non-monetary demand for gold 0 A B Gold Q1 Non-Mon G=0A, Monetary G = AB Output or GDP

25. Basic Idea of Gold Standard • Gold mining is very expensive---very small additions to the total stock in any one year—1 to 3% of total. • How fast does the economy increase? 1 to 3% per year. [growth of aggregate supply] • ΔM/M + ΔV/V = ΔP/P + ΔQ/Q • If Velocity change approx = 0 • ΔP/P = ΔM/M - ΔQ/Q, roughly cancel each other out. • Long-Term Price Stability is the result

26. What if? • What if ΔM/M >> ΔQ/Q • Then ΔP/P = ΔM/M - ΔQ/Q = ?? • ΔM/M << ΔQ/Q • Then ΔP/P = ΔM/M - ΔQ/Q = ?? • When would either event happen????

27. Is the economy doomed to inflation or deflation? • No, there is an equilibrating factor • In an inflation, the relative price of gold (Pg /P) will fall • Mining will decline and rate of growth of gold stock will fall • Increase in non-monetary use of gold • Both of which will gradually reverse inflation • In an deflation, the relative price of gold (Pg /P) will rise • Mining will increase and the rate of growth of gold stock will rise • Decrease in non-monetary use of gold • Both of which will gradually reverse deflation • Result is that there will be long-term price stability under the gold standard

28. Simple Open Economy Gold Standard • Two countries—U.S. and U.K. • US sets price of one ounce of gold = $20.67 • UK sets price of one ounce of gold = £4.247 • Result £1 = $4.867, the exchange rate

29. The Open Economyunder a simple gold coin standard • The open economy: IM = imports, EX= exports, EX - IM = the trade balance • If EX - IM > 0, trade surplus, country is paid in gold • If EX – IM < 0, trade deficit, country pays difference in gold • So EX - IM = ΔM or change in money stock

30. US [V = constant] ΔM/M + ΔV/V = ΔP/P + ΔQ/Q EX - IM = 0 Trade is in balance ------------------------- UK [V = constant] ΔM/M + ΔV/V = ΔP/P + ΔQ/Q EX - IM = 0 Trade is in balance ------------------------ Now UK has productivity growth and output increases, prices (P) of its good fall Initially

31. US [V = constant] EX - IM < 0 Trade is in deficit EX – IM = ΔM <0 ΔP/P = ΔM/M - ΔQ/Q, so ΔP < 0 Deflation and US gains some competitive advantage and trade deficit dissipates UK [V = constant] EX - IM > 0 Trade is in surplus EX – IM = ΔM >0 ΔP/P = ΔM/M - ΔQ/Q, so ΔP > 0 Inflation and Britain loses some competitive advantage and trade surplus dissipates UK has productivity growth and output increases, and prices of its good (P) falls

32. Equilibrium is restored! • This is the 18th century philosopher/economist David Hume’s Price-Specie-Flow mechanism. • BUT----to remember how it works, say it backwards: Flow-Specie-Price. • The equilibrating mechanism for a simple “gold coin standard” • Basics---now to add more realistic features

33. ASSETS --------------------- Gold £10,000 LIABILITIES ----------------------- Deposits £10,000 But, gold is very expensive to use, even for domestic purposes—the Goldsmiths of London 17th CenturyA GOLDSMITH’S BALANCE SHEET Sir Richard Hoare---opened a goldsmith business in 1672 on Cheapside. He held gold on deposit for customers and eventually moved into banking. In 1690 he moved his business to Fleet Street and called his business C. Hoare & Company---it is today, England’s oldest private bank.

34. ASSETS --------------------- Gold £10,000 Loans £5,000 The Bank can tolerate some withdrawals. Liabilities --------------------- Deposits £15,000 (10,000 were deposits of gold and 5,000 are deposits created for the borrowers) But why not earn something on the gold---lend it out, the birth of fractional reserve banking!!A GOLDSMITH’S BALANCE SHEET

35. ASSETS --------------------- Gold £35,000 Loans £65,000 --------------------- Total £100,000 LIABILITIES --------------------- Capital £20,000 Deposits £40,000 Banknotes £40,000 ------------------ Total £100,000 A COMPLETE BANKBANK’S BALANCE SHEET

36. What If? • What happens if there are random inflows and outflows of deposits and return of banknotes? • What happens if the public finds out if a business loan of £1,000 is bad? • What happens if public finds out that business loans of £25,000 are bad? • What is a run on the bank? • When does a panic happen? • Can the system melt down? What is a liquidity crisis or scramble for liquidity? What are the consequences for the economy?

37. Central Banking • Bank of England established 1694. A private bank that acts as banker to the government. It has a monopoly of banknote issue in London in exchange to loan to government. • Becomes by far the largest bank in Britain and it has the largest gold reserve! • When other banks are in trouble it lends [“discounts”] to them---stop a crisis that might engulf it. LOLR • Becomes a bankers’ bank, freed from forced loans to govt. • Key feature is that this “central bank” is independent of the government---hence it has greater credibility.

38. Banque de France • Banque de France is founded 1800 • A private bank, but the governor is appointed by the government. Yet it is independent of the government. • A conservative institution devoted to ensuring the gold standard. A large gold reserve to back its banknotes. • After 1815, prices in France are relatively stable in 1914. • Lender of last resort to French institutions.

39. Reichsbank • Reichsbank founded in 1870. • Germany moves from bimetallism to the gold standard. • Part of economic integration of German Empire. A center if the Prussian State Bank. • A private institution subject to some government control. • Helps to establish a uniform national coinage. • Monopoly of note issue • In charge of price stability and financial responsibility.

40. Banca d’Italia • Established by amalgamating the remaining state banks in 1893. • Italy on the gold standard intermittently—but Bank “shadows” the gold standard. Lira stays close to parity. • Discount rate not a discretionary tool of the bank but of the government.

41. Central Bank Policies • Policies to provide Price Stability • Under Gold Standard----operate under the rules of the game • Under Fiat Money Standard---control growth of money or interest rates. • Lender of Last Resort---policy to provide financial stability. Aim is to prevent banking panics from getting out of control and affecting the broader economy.

42. Central Banks, the Gold Standard, and the Rules of the Game • The gold standard was an automatic equilibrating mechanism. • But---long time delays and costly if relies on actual shipment of gold. • Instead Central Bank policy as begun by Bank of England was to enhance operation of gold standard by following the “Rules of the Game”

43. Central Bank Reserves • Key currencies are a feature of the gold standard era. • When a country runs a trade surplus, it will first accumulate the trade deficit countries’ currency. Banks sell and Central Banks accumulate this “foreign exchange.” Then, the central banks may convert the currencies---pounds, FF or RMs into gold. But it is not required. An incentive to do so as assets in these currencies earn interest while gold does not. • Result, substantial accumulation

44. By 1913, Foreign Exchange as a Percentage of Total Reserves • Bank of England 0% • Bank of France ½ % • Reichsbank 15% • Average of Other European Central Bank • 26% • Average of Africa Asia and Australia • 67%

45. Role Key Currencies and Sterling (and FF and RM) balances • THUS, when trade surpluses occur or interest rates are high. • Most of these are sterling balances in London---as London is the center of the world trade and • World Financial Capital in the 19th century. • Changes in the Bank of England’s discount rate are thus highly effective in the central bank’s operation. • Bank of England is often referred to as the “conductor of the orchestra”----the orchestra of the gold standard with central banks following the rules of the game.

46. The “Rules of the Game” • Bank of England set its “discount rate” which was rate at which banks and others could borrow. • EX – IM < 0, trade deficit, country pays difference in gold---but as gold flows out and the Bank of England loses reserves, so it raises the discount rateinvestment, inventories and consumption fallaggregate demand declines and Price level fall, speeding the adjustment • EX – IM > 0, trade surplus, country gains difference in gold----but as gold flows in, the Bank of England will gain reserves, so it lowers the discount rateinvestment, inventories and consumption riseaggregate demand rises and Price level rises, speeding the adjustment • Central Bank may not follow rules as there is an asymmetry, trade deficits force a bank to raise discount rate, trade surpluses do not force a bank to lower the discount rate. If it does not follow the rule, there will be a slower adjustment.

47. How shocks cause bank runs and panics: Asymmetric Information • A run begins when some depositors observe negative information about a bank, e.g. a company it lends to has failed or an industry it lends to has suffered a decline---this is a natural part of the business cycle. • Is it enough to make the bank fail? (Insolvent) or Does it not have enough cash to pay out immediately (Illiquid) Don’t know asymmetric information. • A Customer will want to withdraw his/her deposits because they fear the bank will be unable to pay out all deposits. • Depositors “run” because they believe that others will run on the bank. There is sequential payment, induces fear they will not get money out. • If Depositors cannot discriminate between sound and unsound banks and they observing others “running” , there will be “contagion,” runs will multiply producing a “panic.”

48. Is a bank in trouble “Illiquid” or “Insolvent”? • “Illiquid” banks do not have enough reserves and cannot sell enough assets quickly enough to satisfy demand for withdrawals • “Insolvent” bank’s assets are worth less than its liabilities. It is not a matter of time. Impossible to pay out all deposits

49. ASSETS Reserves $ 5,000 Bonds $ 5,000 Loans $90,000 ----------------------- Total $100,000 LIABILITIES Capital $20,000 Deposits $80,000 --------------------------- Total $100,000 Illiquid v. Insolvent—a loss from bad loans of $15,000 versus $30,000 If customers don’t know the size of the loss, they will run. Both types of banks will have trouble. But do we want both to be in trouble? Should both fail? What are the consequences for the economy and the recession if the illiquid banks closes its doors?

50. To Trace out the effects on the economyMoney Supply under the Gold Standard • M = [(1 + C/D)/(C/D + RR/D + ER/D)]H • C/D = coins/deposits + banknotes • RR/D = required bank reserves in coin/deposits + banknotes • ER/D = excess reserves/deposits + banknotes • H = gold and silver coins