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The Effluent Society
The Flight of Capital from Late Victorian Britain
During the late nineteenth century, Britain quietly experienced a transformation almost as significant as the Industrial Revolution of a century before. As the Belle Epoque faded and the clouds of war gathered, Britain metamorphosed from an industrial to a financial power—from workshop of to banker for the world. “During the latter half of the nineteenth century,” wrote John Maynard Keynes, “the influence of London on credit conditions throughout the world was so predominant that the Bank of England could almost have claimed to be the conductor of the international orchestra.” A golden torrent of British capital flowed abroad from 1870 to 1914, averaging annually about a third of the nation’s investment. In 1913, 32 percent of Britain’s wealth (a total of £4,000 million) was vested in overseas assets—a proportion never surpassed before or since by any nation. If you were a government or firm in the developing world and needed cash, you listed bonds on the London market.
“Before 1914, in the era of Edwardian high finance, London’s leading role was generally acknowledged,” writes Adam Tooze. But was that pre-eminence a sign of economic strength? Foreign investment implies that rates of return abroad exceeded those at home; was this because of new demand for capital in emerging markets, or of flagging demand in Britain? Moreover, was the export of domestic savings desirable? It came, as we noted last week, amid a drastic slowdown in British productivity growth—the late Victorian climacteric. If real foreign returns were actually higher, then the repatriation of capital would not directly have raised British incomes, and would have diverted funds from the infrastructure projects that made cheap raw materials available for import. On the other hand, each pound mailed overseas was one unavailable for increasing the stock of social overhead capital or investment in new branches of industry that so spectacularly failed to take off in the late nineteenth century. And the chief question: why was it all happening?
During first half of the nineteenth century, Britain was a minor creditor nation. Net foreign investment averaged 1-1.5 percent of GNP from 1811 to 1850. Around mid-century, this situation changed dramatically, rising from 2 percent during the 1850s to 3 percent in the subsequent decade, and then jumping up to 4.67 percent in 1865-74. From 1870 to 1914, the net foreign investment rate averaged 4.3 percent, reaching a staggering climax of 6.51 percent in the decade before the First World War. Over one-third of the £4,079 million went to North America, 16.8 percent to South America, 14 percent to Asia, and 10.6 percent to Africa. Nearly two-thirds of the funds were allocated to European settler colonies—regions where demand for “lumpy social overhead capital,” especially railroads, was high—and a quarter to the tropics. Unlike in prior and subsequent periods, most lending (70-80 percent) consisted of portfolio investment, or the purchases of government and private bonds or equity. Almost none of this was spent on building up industry; over 80 percent was allocated to constructing infrastructure—railways, docks, telegraphs, power—and extracting raw materials. The United States was a case in point: two-thirds of the £836.4 million raised by Americans in Britain went to building railroads and 10 percent to urban public utilities.
What was the cost to Britain? In direct terms, there were positive wealth effects as British savings found their most productive uses in chasing the highest-possible rates of return. Indirectly, social overhead and extractive industry capital formation probably increased Britain’s terms of trade by making it easier to export raw materials. In Canada and Argentina, which lacked adequate internal water transport, developing railway systems significantly lowered the cost of delivering exportable goods from the interior to the coast. British funds were almost irreplaceable in the growth of these countries (unlike in the US, where marginally higher returns might have attracted investment in Britain’s absence). British consumers and firms gained access to prairie wheat fields, remote mineral mines, and mountainous timber reserves by dint of their countrymen’s investments, which made cheap grain, meat, and industrial raw materials widely available. Foreign investment drove commodity price convergence. There were likely negative growth effects, however. Capital markets could not have priced in the true social rate of return in the new industries of the Belle Epoque, especially if learning-by-doing and increasing returns put a premium on early, infant investment. Money shipped out to build foreign railroads, even if well-spend, may accidentally have deprived automakers, chemical firms, and electricity suppliers of capital at an essential stage for becoming internationally competitive. Simultaneously, that same foreign investment was increasing the demand for the old export sectors of the first Industrial Revolution, imparting specialization down a structural dead end.
Why did it happen? The first step to answering this question would seem to be find out whether capital was pushed or pulled abroad. Michael Edelstein identifies two competing hypotheses for push factors that may have forced British savings overseas. On the one hand, investment in British industry may have been running into diminishing returns amid the late Victorian “climacteric.” With productivity growth falling by at least half prior to the First World War, rates of return in transportation, agriculture, and manufacturing were unlikely to be high. On the other, John A. Hobson famously argued that British inequality meant that too high a proportion of the national income went to property owners with a high propensity to save, glutting the country with funds that had to be placed in foreign countries. But the initial wave of overseas investment in the 1850s and 1860s appeared to have been pulled. Developing countries such as Australia, India, and the United States needed money to build railroads, but lacked domestic savings and sophisticated capital markets, forcing them to call upon Britain, the world leader in both respects. Edelstein notes that since Britain was also expanding her railroads at the time, it appears that increased foreign demand for capital (not a domestic shortfall) changed the balance. Moreover, rates of return abroad were higher: 5.72 percent per annum versus 4.6 percent at home, even adjusted for risk.
There is some evidence for the Hobson thesis, too. Econometric tests show that Britain tended to generate more-than-predicted levels of saving during boom years, suggesting that over-accumulation sparked foreign investment after the peak of a business cycle. The age structure of the population was also changing, with a rising proportion of Britons reaching their prime saving years (45-64) and the fraction of dependents (under 14) falling dramatically. But this isn’t the inequality-based over-saving postulated by the original theory, and in any event, the size of these effects remains indeterminate and subordinate to whatever pull forces dragged investment funds abroad. A final area of interest lies in the institutional structure of the British capital market. As we’ve noted before, British lenders had few vehicles for transferring their funds to new enterprises for long-term investments; in the meantime, it was comparatively easy for foreign firms and governments to list debentures on London capital markets. While Britain’s older industries were increasingly able to raise external funding through bond and equity issues, or by just ploughing back profits, some of the new industries lacked these options. Electricity suppliers, for example, struggled to raise capital after the 1880s, with consequences for backward-linked equipment suppliers and for the scaling-up of this critical industry. The absence of dedicated investment banks, like in Germany, France, and the United States, meant that shady “company promoters” filled this role, and not well. Goetzmann and Uhkov (2006) may have been right that British investors’ selection of foreign assets was merely proper diversification given the choices at hand, but the contorted banking sector meant that these choices weren’t too favorable to British industry.
Were British investors biased against investing at home? Keynes thought so; in the 1931 Macmillan Report, he and his colleagues concluded that “our financial machinery is definitely weak in that it fails to give clear guidance to the investor when appeals are made to him on the behalf of home industry.” Sidney Pollard, writing in 1987, added that “that there was virtually total ignorance among financial institutions and advisors about investment opportunities in home industry, and that banks and other institutional lenders operated with traditional and irrational prejudices as to which type of investments they should support and which they should not.” But conservatism and myopia look unlikely. Edelstein’s data, as we’ve discussed, show that foreign returns were generally higher abroad—which would mean that Britons were underinvesting overseas. Recent studies, such as that of Goetzmann and Uhkov (2006) and Chabot and Kurz (2012), have suggested (following Hobson, actually) that foreign investment was rational diversification of savers’ portfolios. The latter write that “The real benefit of international investing was the diversification benefit of holding foreign assets that had a low correlation with their domestic counterparts,” though they agree that savings also went abroad because “that is where the returns were.”
Nevertheless, these look like second-order effects of the deep problem: British growth was slowing down, while it was speeding up in Europe and the regions of recent settlement. There were a variety of reasons for this, and I’ve only begun to explore them; nevertheless, they relate more closely to the conditions of production in Britain and the demands of technology than to institutional inhibitions or the supply of capital. The new technologies of the Second Industrial Revolution—which tended to substitute high levels of raw material input for workers and plant—were poorly-suited for British factor prices and resource endowments, while the small size of the British market curtailed possibilities for economies of scale. Tariff protection, especially among the European powers aiming to protect infant industries, reduced the ability of British firms to compensate for this by accessing export markets. Williamson and O’Rourke (1999) document a fall in rates of return in Britain across the Belle Epoque. They also suggest that the demographic effects of overseas migration to the New World was to increase the dependency burden there, such that foreign investment by the comparatively older British population was an intergenerational transfer. This, they claim, explains fully two-thirds of the capital flows. Migration, of course, was the concomitant of the increased economic opportunities available in the industrializing settler colonies.
Britain’s shift from manufacturing titan to leading lender was, in short, a damaging symptom of a deeper syndrome: the struggle to adapt to the economic conditions of the Second Industrial Revolution. Capital outflows reflected that opportunities were growing abroad and stunted at home, and tended to widen that gap through a destructive feedback process. One hesitates to invoke the tired metaphors of economic maturity and senescence, but Britain was literally an aging society, and that had consequences for her saving decisions and relative factor prices. Younger countries needed the capital, and the British had it.