What Bound Prometheus?
British Finance and the Industrial Revolution
Revolutions aren’t cheap. It’s why the modern economy relies heavily on venture capital and investment banks, which take risks to help new firms get access to short-term finance and long-term backing. So why was the British Industrial Revolution so capital-light? Unlike many subsequent industrialization efforts, Britain’s had been characterized by a low and slowly-growing rate of investment, such that accumulation barely kept up with population growth. Capital-labor ratios probably did not increase substantially before 1830, dampening output per capita and worker productivity. Yet rates of return were exceptionally high in the leading sectors of the Industrial Revolution, thanks to the spread of technological change after the middle of the eighteenth century. Theoretically, such opportunities should have induced British investors, chasing profitable investments, to throw their savings into manufacturing, increasing the size of the capital stock and expanding output. But the macro-evidence suggests that they did not, and the output data shows incontrovertibly that the British economy—despite rampant industrial innovation—grew sluggishly until the middle of the nineteenth century. Britain wasn’t post-unification Germany or Gilded Age, replete with large-scale production and investment banking; indeed, it wasn’t even Meiji Japan—renowned for its special labor-intensive growth.
This is especially odd given that eighteenth-century Britain had been transfixed by a “Financial Revolution,” characterized by unprecedented mobilization of savings by the British government and banking sector. From 1688 to 1750, Dutch techniques were imported en masse, from the bill of exchange to transferable shares in public companies. But the vast majority of textile, iron, coal, and steam producers ignored them. As Neal (1994) wrote, “the industrial revolution had taken place… without any interaction with the preceding financial revolution.” Why didn’t the slew of innovations in debt instruments and banking lead to greater mobility of capital into the private sector? The tools for resolving the capital market fragmentation that so evidently characterized industrializing Britain were ready to be used. Why weren’t they?
The classic explanation, advanced by Michael Postan (1935) and completed by Sidney Pollard (1964), was that the capital wasn’t needed. Since the costs of fixed capital—plants, machinery, infrastructure—required to set up the innovations of the Industrial Revolution were relatively small, firms could make the necessary investments out of the high profits being earned and borrow from friendly and family when these funds fell short. In 1830, only cotton mills had fixed capital as a major asset, and even in this case the share was little more than half. A jenny cost £5, a mule £30, and a powerful steam engine £500-£800. In this story, the scale of enterprise determines the investment requirements, and since the former were small, so were the latter. This common-sense narrative has remained almost an orthodoxy for three-quarters of a century, leading scholars to habitually remark in passing that “the capital needs of early industrialization were modest” (the word ‘modest’ crops up often) or that “capital equivalent to about four months’ wages was enough to start a firm.” Myriad case studies of individual inventors and entrepreneurs provide the empirical backdrop, such as that of Boulton and Watt, who started their steam-engine enterprise in 1775 with just £3370.
Was there really no capital scarcity in British industry? After all, interest rates were low and falling throughout the eighteenth century, suggesting minimal pressure from investment demand. A deeper look, however, suggests otherwise. The Boulton and Watt example is actually a powerful counterpoint. Part of the reason why their capital requirements were so “modest” is that, until 1795, the pair weren’t building many steam engines at all. Instead, they patented designs and allowed others to produce under license, acting as consulting engineers when needed, because they lacked the capital to set up an engineering works for themselves. To stave off disaster, Boulton sunk his whole fortune into the firm, took donations from his wife and friends, and mortgaged off massive chunks of his father’s property. Evidently the pair would gladly have invested more capital into the firm, both to expand operations and to ensure its basic survival. The question is not why they wouldn’t, but why they couldn’t.
I recently considered the possibility that capital was made scarce by the British government’s massive borrowing for military finance. What I did not discuss, however, was the possibility that the entire mechanism for channeling private savings into industry was flawed. The evidence of the eighteenth century suggests that the innovations of the Financial Revolution were geared toward two specific tasks—making payments and the provision of public credit—that were not directly useful for the accumulation of industrial capital. We have already noted the prodigious increase in government debt, which reached 200 percent of GDP by the beginning of the nineteenth century. The establishment of the Bank of England led to the use of its banknotes as a secure means of payment for nearly all large transactions in the City of London and created a safe haven for depositors. A system of bill brokers and private banks, meanwhile, arose as an effective mechanism for moving funds between the metropolis and the surrounding country. Transferring cash and government borrowing could be done at unprecedentedly low cost during the nineteenth century. “The Financial Revolution almost exclusively benefited the Hanoverian military state and members of the elite closely associated with it,” write Temin and Voth (2013). “[A] different kind of revolution might have benefited England’s industrial transformation.”
But British banks did not participate effectively in the finance of industry. The goldsmiths did not evolve into modern commercial institutions for transmitting deposits to needy enterprises, and the Bank of England focused primarily on public finance. In 1780, three-quarters of the Bank’s assets were government securities, and this disproportion was characteristic of the City at large. Only one cadre in the financial sector attempted to channel capital to manufacturing concerns: the country banks, minor institutions founded by ordinary bourgeois to issue notes and convey savings back to London. But they were almost uniformly too small for the purpose, hamstrung by a 1707 regulation that prohibited the issuance of promissory notes by any firm with more than six partners. Though the number of country banks rose from less than a dozen in 1750 to over 300 in 1800, their average capitalization was less than £10,000 in the late eighteenth century—a far cry from the German universal banks, the Belgian Societe Generale, or the French Credit Mobilier. Even in 1825, their total capital combined was less than half that of the Bank of England. Suggestions that the country banks were like modern-day venture capitalists fall flat, not least because their frequent bankruptcies helped to take nascent industrialists down with them. 334 failed between 1790 and 1826, including 60 in the final year of that period. There was no institution standing ready to play a Gerschenkronian role in the promotion and scaling-up of manufacturing industry.
The regulatory environment in which British banking arose explains the abstinence of the large firms from corporate finance and the fragility of their smaller counterparts. Three key restrictions proved especially debilitating. We have already discussed the six-partner rule, which prevented the formation of the stable, well-capitalized institutions that would prove crucial to the industrialization of the Continent. The second was the existence of usury laws, which put a legal maximum on interest rate charges for loans. Fines for violators could reach three times the principal involved in the transaction, and the effectiveness of the English judicial system ensured that enforcement was vigorous and binding. In 1714, to placate landowners indebted during the War of the Spanish Succession, the government reduced the maximum rate from 6 to 5 percent. The move had the additional benefit—for the state—of making it easier to borrow on the capital market, but the consequences for the private sector were dramatic. Interest rates are the price that bring capital markets into equilibrium, bringing investment demand level with supply. A usury law is a price ceiling, creating a wedge between supply and demand—savers will not provide sufficient capital to satiate investors seeking mandated-cheap funds. Lenders are also unable to properly price risk by charging suspect borrowers higher interest rates. Faced with these challenges, British banks were forced to ration credit. Hoare’s, for example, either lent at 5 percent or not at all—and the loans that did go out went to safe, elite borrowers. The top 20 customers took in 69 percent of all money lent, each of whom received six times the average volume. The banking system as a whole backed into the corner of collateralized lending, restricting credit to a small cadre of elites and cutting out parvenus. This was exceedingly detrimental to nascent industrialists, who generally lacked access to City connections and struggled to offer up land assets as collateral.
The usury laws not only made the major London banks more conservative; they also crippled the country banks in their efforts to extend manufacturing credit. Venture capitalists can earn up to 1,000 percent returns, which compensates for the perils of investing in unknown startups. Country banks, by contrast, could take in no more than 5 percent (frequently less)—so they were forced either to be overly conservative, restricting their lending to owners and friends, or to take balance sheet risks that contributed to their perpetual failures. Operation as industrial financiers under the usury laws was a tempting but unviable business model. The situation deteriorated after 1720 with the passage of the Bubble Act, which prohibited the formation of joint-stock companies without a government charter. Commonly (but wrongly) assumed to be a protective response to the collapse of the South Sea Bubble, the Act was a piece of special-interest legislation designed to secure the financing of the South Sea Company itself, which hoped to prevent the formation of other bubbles because that “traffic obstructed the rise of the South Sea stock.” Banks and firms were rendered incapable of securing capital by issuing new shares, and were even blocked from entering any kind of business not explicitly laid out in the state charter. The severity of the Act was made immediately clear by the wave of incorporations that followed its repeal in 1826; by 1833, 33 joint-stock banks had been founded. There had been practically no incorporations in the intervening century. Many of the country banks that survived the repeated crises immediately ditched their old business models. Even so, limited liability was only granted to shareholders from 1856 to 1862.
A counterfactual for British development in the absence of banking restrictions is the contemporary United States. In the first two decades after independence, which liberated the country from usury laws and the Bubble Act, there were 323 new incorporations; from 1800 to 1830, there were 3,500. Bank capital exceeded Britain’s almost immediately and was three times as large after 1800. American failure rates were actually lower, because higher capitalization provided security and removed the incentive to abandon a distressed firm. By 1830, both bank capital and the number of corporations per per head were 6 times British levels. US banks were actually venture-capitalistic, lending to traders and manufacturers, and even the First and Second Banks of the United States financed capital formation. As the British system became increasingly insular, focusing primarily on bills of exchange and government debt, the American became more expansive, keeping pace with surging industrialization in the early decades of the nineteenth century. It was in America, not Britain (where the partnership prevailed), that the massive joint-stock corporation—boasting laboratories and research teams—emerged as the apotheosis of business operation and capital investment during the Second Industrial Revolution. The Chandlerian and Fordist form demanded equity structures and financing unavailable in early industrial Britain, but plentiful in Germany and the United States.
Between crowding-out and financial underdevelopment, then, capital was clearly difficult to come by in early industrial Britain. Savings wasn’t the problem; as Williamson pointed out, while domestic investment was 11.4 percent of national income from 1760 to 1820, the gross private saving rate (including public debt) was 18.1 percent. Instead, as Postan (1935) observed, “the reservoirs of savings were full enough, but conduits to connect them with the wheels of industry were few and meagre... [so] surprisingly little of [Britain’s] wealth found its way into the new industrial enterprises.” Usury laws stopped banks from investing in risky industrial ventures, keeping them in the “boring” business of discounting commercial bills of exchange and trading in the safest government debt. Since the state could offer higher rates of interest than private borrowers, it faced little competition for capital and siphoned off what it needed. All the considerable skill in deposit collection, bookkeeping, and risk management went into government lending and greasing mercantile trade, skirting the perilous waters of industrial promotion. For that, Britain paid a heavy price: slow initial growth, a dysfunctional financial system, and a corporate structure and scale poorly suited for trans-Atlantic industrial competition during the nineteenth century. Her rivals quickly internalized those harsh lessons.