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Money in the American Colonies

Ron Michener, University of Virginia

“There certainly can’t be a greater Grievance to a Traveller, from one Colony to another, than the different values their Paper Money bears.” An English visitor, circa 1742 (Kimber, 1998, p. 52).

The monetary arrangements in use in America before the Revolution were extremely varied. Each colony had its own conventions, tender laws, and coin ratings, and each issued its own paper money. The monetary system within each colony evolved over time, sometimes dramatically, as when Massachusetts abolished the use of paper money within her borders in 1750 and returned to a specie standard. Any encyclopedia-length overview of the subject will, unavoidably, need to generalize, and few generalizations about the colonial monetary system are immune to criticism because counterexamples can usually be found somewhere in the historical record. Those readers who find their interest piqued by this article would be well advised to continue their study of the subject by consulting the more detailed discussions available in Brock (1956, 1975, 1992), Ernst (1973), and McCusker (1978).

Units of Account

In the colonial era the unit of account and the medium of exchange were distinct in ways that now seem strange. An example from modern times suggests how the ancient system worked. Nowadays race horses are auctioned in England using guineas as the unit of account, although the guinea coin has long since disappeared. It is understood by all who participate in these auctions that payment is made according to the rule that one guinea equals 21s. Guineas are the unit of account, but the medium of exchange accepted in payment is something else entirely. The unit of account and medium of exchange were similarly disconnected in colonial times (Adler, 1900).

The units of account in colonial times were pounds, shillings, and pence (1£ = 20s., 1s. = 12d.).1 These pounds, shillings, and pence, however, were local units, such as New York money, Pennsylvania money, Massachusetts money, or South Carolina money and should not be confused with sterling. To do so is comparable to treating modern Canadian dollars and American dollars as interchangeable simply because they are both called “dollars.” All the local currencies were less valuable than sterling.2 A Spanish piece of eight, for instance, was worth 4 s. 6 d. sterling at the British mint. The same piece of eight, on the eve of the Revolution, would have been treated as 6 s. in New England, as 8 s. in New York, as 7 s. 6 d. in Philadelphia, and as 32 s. 6 d. in Charleston (McCusker, 1978).

Colonists assigned local currency values to foreign specie coins circulating there in these pounds, shillings and pence. The same foreign specie coins (most notably the Spanish dollar) continued to be legal tender in the United States in the first half of the nineteenth century as well as a considerable portion of the circulating specie (Andrews, 1904, pp. 327-28; Michener and Wright, 2005, p. 695). Because the decimal divisions of the dollar so familiar to us today were a newfangled innovation in the early Republic and because the same coins continued to circulate the traditional units of account were only gradually abandoned. Lucius Elmer, in his account of the early settlement of Cumberland County, New Jersey, describes how “Accounts were generally kept in this State in pounds, shillings, and pence, of the 7 s. 6 d. standard, until after 1799, in which year a law was passed requiring all accounts to be kept in dollars or units, dimes or tenths, cents or hundredths, and mills or thousandths. For several years, however, aged persons inquiring the price of an article in West Jersey or Philadelphia, required to told the value in shillings and pence, they not being able to keep in mind the newly-created cents or their relative value . . . So lately as 1820 some traders and tavern keepers in East Jersey kept their accounts in [New] York currency.”3 About 1820, John Quincy Adams (1822) surveyed the progress that had been made in familiarizing the public with the new units:

“It is now nearly thirty years since our new monies of account, our coins, and our mint, have been established. The dollar, under its new stamp, has preserved its name and circulation. The cent has become tolerably familiarized to the tongue, wherever it has been made by circulation familiar to the hand. But the dime having been seldom, and the mille never presented in their material images to the people, have remained . . . utterly unknown. . . . Even now, at the end of thirty years, ask a tradesman, or shopkeeper, in any of our cities, what is a dime or mille, and the chances are four in five that he will not understand your question. But go to New York and offer in payment the Spanish coin, the unit of the Spanish piece of eight [one reale], and the shop or market-man will take it for a shilling. Carry it to Boston or Richmond, and you shall be told it is not a shilling, but nine pence. Bring it to Philadelphia, Baltimore, or the City of Washington, and you shall find it recognized for an eleven-penny bit; and if you ask how that can be, you shall learn that, the dollar being of ninety-pence, the eight part of it is nearer to eleven than to any other number . . .4 And thus we have English denominations most absurdly and diversely applied to Spanish coins; while our own lawfully established dime and mille remain, to the great mass of the people, among the hidden mysteries of political economy – state secrets.”5

It took many more decades for the colonial unit of account to disappear completely. Elmer’s account (Elmer, 1869, p. 137) reported that “Even now, in New York, and in East Jersey, where the eighth of a dollar, so long the common coin in use, corresponded with the shilling of account, it is common to state the price of articles, not above two or three dollars, in shillings, as for instance, ten shillings rather than a dollar and a quarter.”

Not only were the unit of account and medium of exchange disconnected in an unfamiliar manner, but terms such as money and currency did not mean precisely the same thing in colonial times that they do today. In colonial times, “money” and “currency” were practically synonymous and signified whatever was conventionally used as a medium of exchange. The word “currency” today refers narrowly to paper money, but that wasn’t so in colonial times. “The Word, Currency,” Hugh Vance wrote in 1740, “is in common Use in the Plantations . . . and signifies Silver passing current either by Weight or Tale. The same Name is also applicable as well to Tobacco in Virginia, Sugars in the West Indies &c. Every thing at the Market-Rate may be called a Currency; more especially that most general Commodity, for which Contracts are usually made. And according to that Rule, Paper-Currency must signify certain Pieces of Paper, passing current in the Market as Money” (Vance, 1740, CCR III, pp. 396, 431).

Failure to appreciate that the unit of account and medium of exchange were quite distinct in colonial times, and that a familiar term like “currency” had a subtly different meaning, can lead unsuspecting historians astray. They often assume that a phrase such as “£100 New York money” or “£100 New York currency” necessarily refers to £100 of the bills of credit issued by New York. In fact, it simply means £100 of whatever was accepted as money in New York, according to the valuations prevailing in New York.6 Such subtle misunderstandings have led some historians to overestimate the ubiquity of paper money in colonial America.

Means of Payment – Book Credit

While simple “cash-and-carry” transactions sometimes occurred most purchases involved at least short-term book credit; Henry Laurens wrote that before the Revolution it had been “the practice to give credit for one and more years for 7/8th of the whole traffic” (Burnet, 1923, vol. 2, pp. 490-1). The buyer would receive goods and be debited on the seller’s books for an agreed amount in the local money of account. The debt would be extinguished when the buyer paid the seller either in the local medium of exchange or in equally valued goods or services acceptable to the seller. When it was mutually agreeable the debt could be and often was paid in ways that nowadays seem very unorthodox – with the delivery of chickens, or a week’s work fixing fences on land owned by the seller. The debt might be paid at one remove, by the buyer fixing fences on land owned by someone to whom the seller was himself indebted. Accounts would then be settled among the individuals involved. Account books testify to the pervasiveness of this system, termed “bookkeeping barter” by Baxter. Baxter examined the accounts of John Hancock and his father Thomas Hancock, both prominent Boston merchants, whose business dealings naturally involved an atypically large amount of cash. Even these gentlemen managed most of their transactions in such a way that no cash ever changed hands (Baxter, 1965; Plummer, 1942; Soltow, 1965, pp. 124-55; Forman, 1969).

An astonishing array of goods and services therefore served by mutual consent at some time or other to extinguish debt. Whether these goods ought all to be classified as “money” is doubtful; they certainly lacked the liquidity and universal acceptability in exchange that ordinarily defines money. At certain times and in certain colonies, however, specific commodities came to be so widely used in transactions that they might appropriately be termed money. Specie, of course, was such a commodity, but its worldwide acceptance as money made it special, so it is convenient to set it aside for a moment and focus on the others.

Means of Payment – Commodity Money

At various times and places in the colonies such items as tobacco, rice, sugar, beaver skins, wampum, and country pay all served as money. These items were generally accorded a special monetary status by various acts of colonial legislatures. Whether the legislative fiat was essential in monetizing these commodities or whether it simply acknowledged the existing state of affairs is open to question. Sugar was used in the British Caribbean, tobacco was used in the Chesapeake, and rice in South Carolina, each being the central product of their respective plantation economies. Wampum signifies the stringed shells used by the Indians as money before the arrival of European settlers. Wampum and beaver skins were commonly used as money in the northern colonies in the early stages of settlement when the fur trade and Indian trade were still mainstays of the local economy (Nettels, 1928, 1934; Fernow, 1893; Massey, 1976; Brock, 1975, pp. 9-18).

Country pay is more complicated. Where it was used, country pay consisted of a hodgepodge of locally produced agricultural commodities that had been monetized by the colonial legislature. A list of commodities, such as Indian corn, beef, pork, etc. were assigned specific monetary values (so many s. per bushel or barrel), and debtors were permitted by statute to pay certain debts with their choice of these commodities at nominal values set by the colonial legislature.7 In some instances country pay was declared a legal tender for all private debts although contracts explicitly requiring another form of payment might be exempted (Gottfried, 1936; Judd, 1905, pp. 94-96). Sometimes country pay was only a legal tender in payment of obligations to the colonial or town governments. Even where country pay was a legal tender only in payment of taxes it was often used in private transactions and even served as a unit of account. Probate inventories from colonial Connecticut, where country pay was widely used, are generally denominated in country pay (Main and Main, 1988).8

There were predictable difficulties where commodity money was used. A pound in “country pay” was simply not worth a pound in cash even as that cash was valued locally. The legislature sometimes overvalued agricultural commodities in setting their nominal prices. Even when the legislature’s prices were not biased in favor of debtors the debtor still had the power to select the particular commodity tendered and had some discretion over the quality of that commodity. In late 17th century Massachusetts the rule of thumb used to convert country pay to cash was that three pounds in country pay were worth two pounds cash (Republicæ, 1731, pp. 376, 390).9 Even this formula seems to have overvalued country pay. When a group of men seeking to rent a farm in Connecticut offered Boston merchant Thomas Bannister £22 of country pay in 1700, Bannister hesitated. It appears Bannister wanted to be paid £15 per annum in cash. Country pay was “a very uncertain thing,” he wrote. Some years £22 in country pay might be worth £10, some years £12, but he did not expect to see a day when it would fetch fifteen.10 Savvy merchants such as Bannister paid careful attention to the terms of payment. An unwary trader could easily be cheated. Just such an incident occurs in the comic satirical poem “The Sotweed Factor.” Sotweed is slang for tobacco, and a factor was a person in America representing a British merchant. Set in late seventeenth-century Maryland, the poem is a first-person account of the tribulations and humiliations a newly-arrived Briton suffers while seeking to enter the tobacco trade. The Briton agrees with a Quaker merchant to exchange his trade goods for ten thousand weight of oronoco tobacco in cask and ready to ship. When the Quaker fails to deliver any tobacco, the aggrieved factor sues him at the Annapolis court, only to discover that his attorney is a quack who divides his time between pretending to be a lawyer and pretending to be a doctor and that the judges have to be called away from their Punch and Rum at the tavern to hear his case. The verdict?

The Byast Court without delay,
Adjudg’d my Debt in Country Pay:
In Pipe staves, Corn, or Flesh of Boar,
Rare Cargo for the English Shoar.

Thus ruined the poor factor sails away never to return. A footnote to the reader explains “There is a Law in this Country, the Plaintiff may pay his Debt in Country pay, which consists in the produce of the Plantation” (Cooke, 1708).

By the middle of the eighteenth century commodity money had essentially disappeared in northern port cities, but still lingered in the hinterlands and plantation colonies. A pamphlet written in Boston in 1740 observed “Look into our British Plantations, and you’ll see [commodity] Money still in Use, As, Tobacco in Virginia, Rice in South Carolina, and Sugars in the Islands; they are the chief Commodities, used as the general Money, Contracts are made for them, Salaries and Fees of Office are paid in them, and sometimes they are made a lawful Tender at a yearly assigned Rate by publick Authority, even when Silver was promised” (Vance, 1740, CCR III, p. 396). North Carolina was an extreme case. Country pay there continued as a legal tender even in private debts. The system was amended in 1754 and 1764 to require rated commodities to be delivered to government warehouses and be judged of acceptable quality at which point warehouse certificates were issued to the value of the goods (at mandated, not market prices): these certificates were a legal tender (Bullock, 1969, pp. 126-7, 157).

Means of Payment – Bills of Credit

Cash came in two forms: full-bodied specie coins (usually Spanish or Portuguese) and paper money known as “bills of credit.” Bills of credit were notes issued by provincial governments that were similar in many ways to modern paper money: they were issued in convenient denominations, were often a legal tender in the payment of debts, and routinely passed from man to man in transactions.11 Bills of credit were ordinarily put into circulation in one of two ways. The most common method was for the colony to issue bills to pay its debts. Bills of credit were originally designed as a kind of tax-anticipation scrip, similar to that used by many localities in the United States during the Great Depression (Harper, 1948). Therefore when bills of credit were issued to pay for current expenditures a colony would ordinarily levy taxes over the next several years sufficient to call the bills in so they might be destroyed.12 A second method was for the colony to lend newly printed bills on land security at attractive interest rates. The agency established to make these loans was known as a “land bank” (Thayer, 1953).13 Bills of credit were denominated in the £., s., and d. of the colony of issue, and therefore were usually the only form of money in circulation that was actually denominated in the local unit of account.14

Sometimes even the bills of credit issued in a colony were not denominated in the local unit of account. In 1764 Maryland redeemed its Maryland-pound-denominated bills of credit and in 1767 issued new dollar-denominated bills of credit. Nonetheless Maryland pounds, not dollars, remained the predominant unit of account in Maryland up to the Revolution (Michener and Wright, 2006a, p. 34; Grubb; 2006a, pp. 66-67; Michener and Wright, 2006c, p. 264). The most striking example occurred in New England. Massachusetts, Connecticut, New Hampshire, and Rhode Island all had, long before the 1730s, emitted paper money in bills of credit known as “old tenor” bills of credit, and “old tenor” had become the most commonly-used unit of account in New England. The old tenor bills of all four colonies passed interchangeably and at par with one another throughout New England.

Beginning in 1737, Massachusetts introduced a new kind of paper money known as “new tenor.” New tenor can be thought of as a monetary reform that ultimately failed to address underlying issues. It also served as a way of evading a restriction the Board of Trade had placed on the Governor of Massachusetts that limited him to emissions of not more than £30,000. The Massachusetts assembly declared each pound of the new tenor bills to be worth £3 in old tenor bills. What actually happened is that old tenor (abbreviated in records of the time as “O.T.”) continued to be the unit of account in New England, and so long as the old bills continued to circulate, a decreasing portion of the medium of exchange. Each new tenor bill was reckoned at three times its face value in old tenor terms. This was just the beginning of the confusion, for yet newer Massachusetts “new tenor” emissions were created, and the original “new tenor” emission became known as the “middle tenor.”15 The new “new tenor” bills emitted by Massachusetts were accounted in old tenor terms at four times their face value. These bills, like the old ones, circulated across colony borders throughout New England. As if this were not complicated enough, New Hampshire, Rhode Island, and Connecticut all created new tenor emission of their own, and the factors used to convert these new tenor bills into old tenor terms varied across colonies (Davis, 1970; Brock, 1975; McCusker, pp. 131-137). Connecticut, for instance, had a new tenor emission such that each new tenor bill was worth 3½ times its face value in old tenor (Connecticut, vol. 8, pp. 359-60; Brock, 1975, pp. 45-6). “They have a variety of paper currencies in the [New England] provinces; viz., that of New Hampshire, the Massachusetts, Rhode Island, and Connecticut,” bemoaned an English visitor, “all of different value, divided and subdivided into old and new tenors, so that it is a science to know the nature and value of their moneys, and what will cost a stranger some study and application” (Hamilton, 1907, p. 179). Throughout New England, however, Old Tenor remained the unit of account. “The Price of [provisions sold at Market],” a contemporary pamphlet noted, “has been constantly computed in Bills of the old Tenor, ever since the Emission of the middle and new Tenor Bills, just as it was before their Emission, and with no more Regard to or Consideration of either the middle or new Tenor Bills, than if they had never been emitted” (Enquiry, 1744, CCR IV, p. 174). This occurred despite the fact that by 1750 only an inconsiderable portion of the bills of credit in circulation were denominated in old tenor.16

For the most part, bills of credit were fiat money. Although a colony’s treasurer would often consent to exchange these bills for other forms of cash in the treasury, there was rarely a provision in the law stating that holders of bills of credit had a legally binding claim on the government for a fixed sum in specie, and treasurers were sometimes unable to accommodate people who wished to exchange money (Nicholas, 1912, p. 257; The New York Mercury, January 27, 1759, November 24, 1760).17 The form of the bills themselves was sometimes misleading in this respect. It was not uncommon for the bills to be inscribed with an explicit statement that the bill was worth a certain sum in silver. This was often no more than an expression of the assembly’s hope, at the time of issuance, of how the bills would circulate.18 Colonial courts sometimes allowed inhabitants to pay less to royal officials and proprietors by valuing bills of credit used to pay fees, dues, and quit rents according to their “official” rather than actual specie values. (Michener and Wright, 2006c, p. 258, fn. 5; Hart, 2005, pp. 269-71).

Maryland’s paper money was unique. Maryland’s paper money – unlike that of other colonies – gave the possessor an explicit legal claim on a valuable asset. Maryland had levied a tax and invested the proceeds of the tax in London. It issued bills of credit promising a fixed sum in sterling bills of exchange at predetermined dates, to be drawn on the colony’s balance in London. The colony’s accrued balances in London were adequate to fund the redemption, and when redemption dates arrived in 1748 and 1764 the sums due were paid in full so the colony’s pledge was considered credible.

Maryland’s paper money was unique in other ways as well. Its first emission was put into circulation in a novel fashion. Of the £90,000 emitted in 1733, £42,000 was lent to inhabitants, while the other £48,000 was simply given away, at the rate of £1.5 per taxable (McCusker, 1978, pp. 190-196; Brock, 1975, chapter 8; Lester, 1970, chapter 5). Maryland’s paper money was so peculiar that it is unrepresentative of the colonial experience. This was recognized even by contemporaries. Hugh Vance, in the Postscript to his Inquiry into the Nature and Uses of Money, dismissed Maryland as “intirely out of the Question; their Bills being on the Foot of promissory Notes” Vance, 1740, CCR III, p. 462).

In 1690, Massachusetts was the first colony to issue bills of credit (Felt, 1839, pp. 49-52; Davis, 1970, vol. 1, chapter 1; Goldberg, 2009).19 The bills were issued to pay soldiers returning from a failed military expedition against Quebec. Over time, the rest of the colonies followed suit. The last holdout was Virginia, which issued its first bills of credit in 1755 to defray expenses associated with its entry into the French and Indian War (Brock, 1975, chapter 9). The common denominator here is wartime finance, and it is worthwhile to recognize that the vast majority of the bills of credit issued in the colonies were issued during wartime to pay for pressing military expenditures. Peacetime issues did occur and are in some respects quite interesting as they seem to have been motivated in part by a desire to stimulate the economy (Lester, 1970). However, peacetime emissions are dwarfed by those that occurred in war.20 Some historians enamored of the land bank system, whereby newly emitted bills were lent to landowners in order to promote economic development, have stressed the economic development aspect of colonial emissions – particularly those of Pennsylvania – while minimizing the military finance aspect (Schweitzer, 1989, pp. 313-4). The following graph, however, illustrates the fundamental importance of war finance; the dramatic spike marks the French and Indian War (Brock, 1992, Tables 4, 6).

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That bills in circulation peaked in 1760 reflects the fact that Quebec fell in 1759 and Montreal in 1760, so that the land war in North America was effectively over by 1760.

Because bills were disproportionally emitted for wartime finance it is not surprising that the colonies whose currencies depreciated due to over-issue were those who shared a border with a hostile neighbor – the New England colonies bordering French Canada and the Carolinas bordering Spanish Florida.21 The colonies from New York to Virginia were buffered by their neighbors and therefore issued no more than modest amounts of paper money until they were drawn into the French and Indian War, by which time their economies were large enough to temporarily absorb the issues.

It is important not to confuse the bills of credit issued by a colony with the bills of credit circulating in that colony. “Under the circumstances of America before the war,” a Maryland resident wrote in 1787, “there was a mutual tacit consent that the paper of each colony should be received by its neighbours” (Hanson, 1787, p. 24).22 Between 1710 and 1750, the currencies of Massachusetts, Connecticut, New Hampshire, and Rhode Island passed indiscriminately and at par with one another in everyday transactions throughout New England (Brock, 1975, pp. 35-6). Although not quite so integrated a currency area as New England the colonies of New York, Pennsylvania, New Jersey, and Delaware each had bills of credit circulating within its neighbors’ borders (McCusker, 1978, pp. 169-70, 181-182). In the early 1760s, Pennsylvania money was the primary medium of exchange in Maryland (Maryland Gazette, September 15, 1763; Hazard, 1852, Eighth Series, vol. VII, p. 5826; McCusker, 1978, p. 193). In 1764 one quarter of South Carolina’s bills of credit circulated in North Carolina and Georgia (Ernst, 1973, p. 106). Where the currencies of neighboring colonies were of equal value, as was the case in New England between 1710 and 1750, bills of credit of neighboring colonies could be credited and debited in book accounts at face value. When this was not the case, as when Pennsylvania, Connecticut, or New Jersey bills of credit were used to pay a debt in New York, an adjustment had to be made to convert these sums to New York money. The conversion was usually based on the par values assigned to Spanish dollars by each colony. Indeed, this was also how merchants generally handled intercolonial exchange transactions (McCusker, 1978, p. 123). For example, on the eve of the Revolution a Spanish dollar was rated at 7 s. 6 d. in Pennsylvania money and at 8 s. in New York money. The ratio of eight to seven and a half being equal to 1.06666, Pennsylvania bills of credit were accepted in New York at a 6 and 1/3% advance (Stevens, 1867, pp. 10-11, 18). Connecticut rated the Spanish dollar at 6 s., and because the ratio of eight to six is 1.333, Connecticut bills of credit were accepted at a one third advance in New York (New York Journal, July 13, 1775). New Jersey’s paper money was a peculiar exception to this rule. By the custom of New York’s merchants, New Jersey bills of credit were accepted for thirty years or more at an advance of one pence in the shilling, or 8 and 1/3%, even though New Jersey rated the Spanish dollar at 7 s, 6 d., just as Pennsylvania did. The practice was controversial in New York, and the advance was finally reduced to the “logical” 6 and 2/3% advance by an act of the New York assembly in 1774.23

Means of Payment – Foreign Specie Coins

Specie coins were the other kind of cash that commonly circulated in the colonies. Few specie coins were minted in the colonies. Massachusetts coined silver “pine tree shillings” between 1652 and the closing of the mint in the early 1680s. This was the only mint of any size or duration in the colonies, although minting of small copper coins and tokens did occur at a number of locations (Jordan, 2002; Mossman, 1993). Colonial coinage is interesting numismatically, but economically it was too slight to be of consequence. Most circulating specie was minted abroad. The gold and silver coins circulating in the colonies were generally of Spanish or Portuguese origin. Among the most important of these coins were the Portuguese Johannes and moidore (more formally, the moeda d’ouro) and the Spanish dollar and pistole. The Johanneses were gold coins, 8 escudos (12,800 reis) in denomination; their name derived from the obverse of the coin, which bore the bust of Johannes V. Minted in Portugal and Brazil they were commonly known in the colonies as “joes.” The fractional denominations were 4 escudo and 2 escudo coins of the same origin. The 4 escudo (6,400 reis) coin, or “half joe,” was one of the most commonly used coins in the late colonial period. The moidore was another Portuguese gold coin, 4,000 reis in denomination. That these coins were being used as a medium of exchange in the colonies is not so peculiar as it might appear. Raphael Solomon (1976, p. 37) noted that these coins “played a very active part in international commerce, flowing in and out of the major seaports in both the Eastern and Western Hemispheres.” In the late colonial period the mid-Atlantic colonies began selling wheat and flour to Spain and Portugal “for which in return, they get hard cash” (Lydon, 1965; Virginia Gazette, January 12, 1769; Brodhead, 1853, vol. 8, p. 448).

The Spanish dollar and its fractional parts were, in McCusker’s (1978, p. 7) words, “the premier coin of the Atlantic world in the seventeenth and eighteenth centuries.” Well known and widely circulated throughout the world, its preeminence in colonial North America accounts for the fact that the United States uses dollars, rather than pounds, as its unit of account. The Spanish pistole was the Spanish gold coin most often encountered in America. While these coins were the most common, many others also circulated there (Solomon, 1976; McCusker, 1978, pp. 3-12).

Alongside the well-known gold and silver coins were various copper coins, most notably the English half-pence, that served as small change in the colonies. Fractional parts of the Spanish dollar and the pistareen, a small silver coin of base alloy, were also commonly used as change.24

None of these foreign specie coins were denominated in local currency units, however. One needed a rule to determine what a particular coin, such as a Spanish dollar, was worth in the £., s., and d. of local currency. Because foreign specie coins were in circulation long before any of the colonies issued paper money setting a rating on these coins amounted to picking a numeraire for the economy; that is, it defined what one meant by a pound of local currency. The ratings attached to individual coins were not haphazard: They were designed to reflect the relative weight and purity of the bullion in each coin as well as the ratio of gold to silver prices prevailing in the wider world.

In the early years of colonization these coin values were set by the colonial assemblies (Nettels, 1934, chap. 9; Solomon, 1976, pp. 28-29; John Hemphill, 1964, chapter 3). In 1700 Pennsylvania passed an act raising the rated value of its coins, causing the Governor of Maryland to complain to the Board of Trade of the difficulties this created in Maryland. He sought the Board’s permission for Maryland to follow suit. When the Board investigated the matter it concluded that the “liberty taken in many of your Majesty’s Plantations, to alter the rates of their coins as often as they think fit, does encourage an indirect practice of drawing the money from one Plantation to another, to the undermining of each other’s trade.” In response they arranged for the disallowance of the Pennsylvania act and a royal proclamation to put an end to the practice.25

Queen Anne’s proclamation, issued in 1704, prohibited a Spanish dollar of 17½ dwt. from passing for more than 6 s. in the colonies. Other current foreign silver coins were rated proportionately and similarly prohibited from circulating at a higher value. This particular rating of coins became known as “proclamation money.”26 It might seem peculiar that the// proclamation did not dictate that the colonies adopt the same ratings as prevailed in England. The Privy Council, however, had incautiously approved a Massachusetts act passed in 1697 rating Spanish dollars at 6 s., and attorney general Edward Northey felt the act could not be nullified by proclamation. This induced the Board of Trade to adopt the rating of the Massachusetts act.27

Had the proclamation been put into operation its effects would have been extremely deflationary because in most colonies coins were already passing at higher rates. When the proclamation reached America only Barbados attempted to enforce it. In New York Governor Lord Cornbury suspended its operation and wrote the Board of Trade that he could not enforce it in New York while it was being ignored in neighboring colonies as New York would be “ruined beyond recovery” if he did so (Brodhead, 1853, vol. 4, pp. 1131-1133; Brock, 1975, chapter 4). A chorus of such responses led the Board of Trade to take the matter to Parliament in hopes of enforcing a uniform compliance throughout America (House of Lords, 1921, pp. 302-3). On April 1, 1708, Parliament passed “An Act for ascertaining the Rates of foreign Coins in her Majesty’s Plantations in America” (Ruffhead, vol. 4, pp. 324-5). The act reiterated the restrictions embodied in Queen Anne’s Proclamation, and declared that anyone “accounting, receiving, taking, or paying the same contrary to the Directions therein contained, shall suffer six Months Imprisonment . . . and shall likewise forfeit the Sum of ten Pounds for every such Offence . . .”

The “Act for ascertaining the Rates of foreign Coins” never achieved its desired aim. In the colonies it was largely ignored, and business continued to be conducted just as if the act had never been passed. Pennsylvania, it was true, went though a show of complying but even that lapsed after a while (Brock, 1975, chapter 4). What the act did do, however, was push the process of coin rating into the shadows because it was no longer possible to address it in an open way by legislative enactment. Laws that passed through colonial legislatures (certain charter and proprietary colonies excepted) were routinely reviewed by the Privy Council, and if found to be inconsistent with British law, were declared null and void.

Two avenues remained open to alter coin ratings – private agreements among merchants that would not be subject to review in London, and a legislative enactment so stealthy as to slip through review unnoticed. New York was the first to succeed using stealth. In November 1709 it emitted bills of credit “for Tenn thousand Ounces of Plate or fourteen Thousand Five hundred & fourty five Lyon Dollars” (Lincoln, 1894, vol. 1, chap. 207, pp. 695-7). The Lyon dollar was an obscure silver coin that had escaped being explicitly mentioned in the enumeration of allowable values that had accompanied Queen Anne’s proclamation. Since 15 years previously New York had rated the Lyon dollar at 5 s. 6 d., it was generally supposed that that rating was still in force (Solomon, 1976, p. 30). The value of silver implied in the law’s title is 8 s. an ounce – a value higher than allowed by Parliament. Until 1723, New York’s emission acts contained clauses designed to rate an ounce of silver at 8 s. The act in 1714, for instance, tediously enumerated the denominations of the bills to be printed, in language such as “Five Hundred Sixty-eight Bills, of Twenty-five Ounces of Plate, or Ten Pounds value each” (Lincoln, 1894, vol. 1, chap. 280, pp. 819). When the Board of Trade finally realized what New York was up to it was too late: the earlier laws had already been confirmed. When the Board wrote Governor Hunter to complain, he replied, in part, “Tis not in the power of men or angels to beat the people of this Continent out of a silly notion of their being gainers by the Augmentation of the value of Plate” (Brodhead, vol. 5, p. 476). These colony laws were still thought to be in force in the late colonial period. Gaine’s New York Pocket Almanack for 1760 states that “Spanish Silver . . . here ‘tis fixed by Law at 8 s. per Ounce, but is often sold and bought from 9 s. to 9 s. and 3 d.”

In 1753 Maryland also succeeded using stealth, including revised coin ratings inconsistent with Queen Anne’s proclamation in “An Act for Amending the Staple of Tobacco, for Preventing Fraud in His Majesty’s Customs, and for the Limitation of Officer’s Fees” (McCusker, 1978, p. 192).

The most common subterfuge was for a colony’s merchants to meet and agree on coin ratings. Once the merchants agreed on such ratings, the colonial courts appear to have deferred to them, which is not surprising in light of the fact that many judges and legislators were drawn from the merchants’ ranks (e.g. Horle, 1991). These private agreements effectively nullified not only the act of Parliament but also local statutes, such as those rating silver in New York at 8 s. an ounce. Records of many such agreements have survived.28 There is also testimony that these agreements were commonplace. Lewis Morris remarked that “It is a common practice … [for] the merchants to put what value they think fit upon Gold and Silver coynes current in the Plantations.” When the Philadelphia merchants published a notice in the Pennsylvania Gazette of September 16, 1742 enumerating the values they had agreed to put on foreign gold and silver coins, only the brazenness of the act came as a surprise to Morris. “Tho’ I believe by the merchants private Agreements amongst themselves they have allwaies done the same thing since the Existence of A paper currency, yet I do not remember so publick an instance of defying an act of parliament” (Morris, 1993, vol. 3, pp. 260-262, 273). These agreements, when backed by a strong consensus among merchants, seem to have been effective. Decades later, Benjamin Franklin (1959, vol. 14, p. 232) recollected how the agreement that had offended Morris “had a great Effect in fixing the Value and Rates of our Gold and Silver.”

After the New York Chamber of Commerce was founded in 1768, merchant deliberations on these agreements were recorded. During this period, the coin ratings in effect in New York were routinely published in almanacs, particularly Gaine’s New-York pocket almanac. When the New York Chamber of Commerce resolved to change the rating of coins and the minimum allowable weight for guineas the almanac values changed immediately to reflect those adopted by the Chamber (Stevens, 1867, pp. 56-7. 69).29

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The coin rating table above, reproduced from The New-York Pocket Almanack for the Year 1771 shows how coin-rating worked in practice in the late colonial period. (Note the reference to the deliberations of the Chamber of Commerce.) It shows, for instance, that if you tendered a half joe in payment of debt in Pennsylvania, you would be credited with having paid £3 Pennsylvania money. If the same half joe were tendered in payment of a debt in New York you would be credited with having paid £ 3 4 s. New York money. In Connecticut it would have been £2 8 s. Connecticut money.30

The colonists possessed no central bank and colonial treasurers, however willing they might have been to exchange paper for specie, sometimes found themselves without the means to do so. That these coin ratings were successfully maintained for decades on end was a testament to the public’s faith in the bills of credit, which made them willing to voluntarily exchange them for specie at the established rate. Writing in 1786 and attempting to explain why New Jersey’s colonial bills of credit had retained their value, “Eugenio” attributed their success to the fact that it possessed what he called “the means of instant realization at value.” This awkward phrase signified the bills were instantly convertible at par. “Eugenio” went on to explain why:

“It is true that government did not raise a sum of coin and deposit the same in the treasury to exchange the bills on demand; but the faith of the government, the opinion of the people, and the security of the fund formerly by a well-timed and steady policy, went so hand in hand and so concurred to support each other, that the people voluntarily and without the least compulsion threw all their gold and silver, not locking up a shilling, into circulation concurrently with the bills; whereby the whole coin of the government became forthwith upon an emission of paper, a bank of deposit at every man’s door for the instant realization or immediate exchange of his bill into gold or silver. This had a benign and equitable, a persuasive, a satisfactory, and an extensive influence. If any one doubted the validity or price of his bill, his neighbor immediately removed his doubts by exchanging it without loss into gold or silver. If any one for a particular purpose needed the precious metals, his bill procured them at the next door, without a moment’s delay or a penny’s diminution. So high was the opinion of the people raised, that often an advance was given for paper on account of the convenience of carriage. In the market as well as in the payment of debts, the paper and the coin possessed a voluntary, equal, and concurrent circulation, and no special contract was made which should be paid or whether they should be received at a difference. By this instant realization and immediate exchange, the government had all the gold and silver in the community as effectually in their hands as if those precious metals had all been locked up in their treasury. By this realization and exchange they could extend credit to any degree it was required. The people could not be induced to entertain a doubt of their paper, because the government had never failed them in a single instance, either in war or in peace (New Jersey Gazette, January 30, 1786).”

Insofar as colonial bills of credit were convertible on demand into specie at the rated specie value of coins, there is no mystery as to why those bills of credit maintained their value. How merchants maintained and enforced such accords, however, is relatively inscrutable. Some economists are incredulous that private associations of merchants could accomplish the feat. The best evidence on this question can be found in a pamphlet by a disgruntled inhabitant complaining of the actions of a merchants’ association in Antigua (Anon., 1740), which provides a tantalizing glimpse of the methods merchants used.

Means of Payment – Private debt instruments

This leaves private debt instruments, such as bank notes, bills of exchange, notes of hand, and shop notes. It is sometimes asserted that there were no banks in colonial America, but this is something of an overstatement. There were several experiments made and several embryonic private banks actually got notes into circulation. Andrew McFarland Davis devoted an entire volume to banking in colonial New England (Davis, 1970, vol. 2; Perkins 1991 ). Perhaps the most successful bank of the era was established in South Carolina in 1731. It apparently issued notes totaling £50,000 South Carolina money and operated successfully for a decade.31 However, the banks that did exist did not last long enough or succeed in putting enough notes in circulation for us to be especially concerned about them.

Bills of exchange were similar to checks. A hypothetical example will illustrate how they functioned. The process of creating a bill of exchange began when someone obtained a balance on account overseas (in the case of the colonies, that place was often London). Suppose a Virginia tobacco producer consigned his tobacco to be sold in England, with the sterling proceeds to remain temporarily in the hands of a London merchant. The Virginia planter could then draw on those funds, by writing a bill of exchange payable in London. Suppose further that the planter drew a bill of exchange on his London correspondent, and sold it to a Virginia merchant, who then transmitted it to London to pay a balance due on imported dry goods. When the bill of exchange reached London, the dry goods wholesaler who received it would call on the London merchant holding the funds in order to receive the payment specified in the bill of exchange.

Bills of exchange were widely used in foreign trade, and were the preferred and most common method for paying debts due overseas. Because of the nature of the trade they financed, bills of exchange were usually in large denominations. Also, because bills of exchange were drawn on particular people or institutions overseas, there was an element of risk involved. Perhaps the person drawing the bill was writing a bad check, or perhaps the person on whom the bill was drawn was himself a deadbeat. One needed to be confident of the reputations of the parties involved when purchasing a bill of exchange. Perhaps because of their large denominations and the asymmetric information problems involved, bills of exchange played a limited role as a medium of exchange in the inland economy (McCusker, 1978, especially pp. 20-21).

Small denomination IOUs, called “notes of hand” were widespread, and these were typically denominated in local currency units. For the most part, these were not designed to circulate as a medium of exchange. When someone purchased goods from a shopkeeper on credit, the shopkeeper would generally get a “note of hand” as a receipt. In the court records in the Connecticut archives, one can find the case files for countless colonial-era cases where an individual was sued for nonpayment of a small debt.32 The court records generally include a note of hand entered as evidence to prove the debt. Notes of hand sometimes were proffered to third parties in payment of debt, however, particularly if the issuer was a person of acknowledged creditworthiness (Mather, 1691, p. 191). Some individuals of modest means created notes of hand in small denominations and attempted to circulate them as a medium of exchange; in Pennsylvania in 1768, a newspaper account stated that 10% of the cash offered in the retail trade consisted of such notes (Pennsylvania Chronicle, October 12, 1768; Kimber, 1998, p. 53). Indeed, many private banking schemes, such as the Massachusetts merchants’ bank, the New Hampshire merchants’ bank, the New London Society, and the Land Bank of 1740 were modeled on private notes of hand, and each consisted of an association designed to circulate such notes on a large scale. For the most part, however, notes of hand lacked the universal acceptability that would have unambiguously qualified them as money.

Shop notes were “notes of hand” of a particular type and seem to have been especially widespread in colonial New England. The twentieth-century analogue to shop notes would be scrip issued by an employer that could be used for purchases at the company store.33 Shop notes were I.O.U.s of local shopkeepers, redeemable through the shopkeeper. Such an I.O.U. might promise, for example, £6 in local currency value, half in money and half in goods (Weeden, 1891, vol. 2, p. 589; Ernst, 1990). Hugh Vance described the origins of shop notes in a 1740 pamphlet:

“… by the best Information I can have from Men of Credit then living, the Fact is truly this, viz. about the Year 1700, Silver-Money became exceedingly scarce, and the Trade so embarassed, that we begun to go into the Use of Shop-Goods, as the Money. The Shopkeepers told the Tradesmen, who had Draughts upon them from the Merchants for all Money, that they could not pay all in Money (and very truly) and so by Degrees brought the Tradesmen into the Use of taking Part in Shop-Goods; and likewise the Merchants, who must always follow the natural Course of Trade, were forced into the Way of agreeing with Tradesmen, Fishermen, and others; and also with the Shopkeepers, to draw Bills for Part and sometimes for all Shop-Goods (Vance, 1740, CCR III, pp. 390-91).”

Vance’s account seems accurate in all respects save one. Merchants played an active role in introducing shop notes into circulation. By the 1740s shop notes had been much abused, and it was disingenuous of Vance (himself a merchant) to suggest that merchants had had the system thrust upon them by shopkeepers. Merchants used shop notes to expedite sales and returns. The merchant might contact a shopkeeper and a shipbuilder. The shipbuilder would build a ship for the merchant, the ship to be sent to England and sold as a way of making returns. In exchange the merchant would provide the builder with shop notes and the shopkeeper with imported goods. The builder used the shop notes to pay his workers. The shop notes, in turn, were redeemed at the shop of the shopkeeper when presented to him by workers (Boston Weekly Postboy, December 8, 1740). Thomas Fitch tried to interest an English partner in just such a scheme in 1710:

“Realy it’s extream difficult to raise money here, for goods are generally Sold to take 1/2 money & 1/2 goods again out of the buyers Shops to pay builders of Ships [etc?] which is a great advantage in the readier if not higher sale of goods, as well as that it procures the Return; Wherefore if we sell goods to be paid in money we must give long time or they will not medle (Fitch, 1711, to Edward Warner, November 22, 1710).”

Like other substitutes for cash, shop notes were seldom worth their stated values. A 1736 pamphlet, for instance, reported wages to be 6s in bills of credit, or 7s if paid in shop notes (Anonymous, 1736, p. 143). One reason shop notes failed to remain at par with cash is that shopkeepers often refused to redeem them except with merchandise of their own choosing. Another abuse was to interpret money to mean British goods; half money, half goods often meant no money at all.34

Controversies

Colonial bills of credit were controversial when they were first issued, and have remained controversial to this day. Those who have wanted to highlight the evils of inflation have focused narrowly on the colonies where the bills of credit depreciated most dramatically – those colonies being New England and the Carolinas, with New England being a special focus because of the wealth of material that exists concerning New England history. When Hillsborough drafted a report for the Board of Trade intended to support the abolition of legal tender paper money in the colonies he rested his argument on the inflationary experiences of these colonies (printed in Whitehead, 1885, vol. IX, pp. 405-414). Those who have wanted to defend the use of bills of credit in the colonies have focused on the Middle colonies, where inflation was practically nonexistent. This tradition dates back at least to Benjamin Franklin (1959, vol. 14, pp. 77-87), who drafted a reply to the Board of Trade’s report in an effort to persuade Parliament to repeal of the Currency Act of 1764. Nineteenth-century authors, such as Bullock (1969) and Davis (1970), tended to follow Hillsborough’s lead whereas twentieth-century authors, such as Ferguson (1953) and Schweitzer (1987), followed Franklin’s.

Changing popular attitudes towards inflation have helped to rehabilitate the colonists. Whereas inflation in earlier centuries was rare, and even the mild inflation suffered in England between 1797 and 1815 was sufficient to stir a political uproar, the twentieth century has become inured to inflation. Even in colonial New England between 1711 and 1749, which was thought to have done a disgraceful job in managing its bills of credit, peacetime inflation was only about 5% per annum. Inflation during King George’s War was about 35% per annum.35

Nineteenth-century economists were guilty of overgeneralizing based on the unrepresentative inflationary experiences and associated debtor-creditor conflicts that occurred in a few colonies. Some twentieth-century economists, however, have swung too far in the other direction by generalizing on the basis of the success of the system in the Middle colonies and by attributing the benign outcomes there to the fundamental soundness of the system and its sagacious management. It would be closer to the truth, I believe, to note that the virtuous restraint exhibited by the Middle colonies was imposed upon them. Emissions in these colonies were sometimes vetoed by royal authorities and frequently stymied by instructions issued to royal or proprietary governors. The success of the Middle colonies owes much to the simple fact that they did not exert themselves in war to the extent that their New England neighbors did and that they were not permitted to freely issue bills of credit in peacetime.

A recent controversy has developed over the correct answer to the question – Why did some bills of credit depreciate, while others did not? Many early writers took it for granted that the price level in a colony would vary proportionally with the number of bills of credit the colony issued. This assumption was mocked by Ernst (1973, chapter 1) and devastated by West (1978). West performed simple regressions relating the quantity of bills of credit outstanding to price indices where such data exist. For most colonies he found no correlation between these variables. This was particularly striking because in the Middle colonies there was a dramatic increase in the quantity of bills of credit outstanding during the French and Indian War, and a dramatic decrease afterwards. Yet this large fluctuation seemed to have little effect on the purchasing power of those bills of credit as measured by prices of bills of exchange and the imperfect commodity price indices we possess. Only in New England in the first half of the eighteenth century did there seem to be a strong correlation between bills of credit outstanding and prices and exchange rates. Officer (2005) examined the New England episode and concluded that the quantity theory provides an adequate explanation in this instance, making the contrast with many other colonies (most notably, the Middle colonies) even more remarkable.

Seizing on West’s results Bruce Smith suggested that they disproved the quantity theory of money and provided evidence in favor of an alternative theory of money based on theoretical models of Wallace and Sargent, which Smith characterized as the “backing theory.”36 According to Smith (1985a, p. 534), the redemption provisions enacted when bills of credit were introduced into circulation on tax and loan funds were what prevented them from depreciating. “Just as the value of privately issued liabilities depends on the issuers’ balance sheet,” he wrote, “the same is true for government liabilities. Thus issues of money which are accompanied by increases in the (expected) discounted present value of the government’s revenues need not be inflationary.” One obvious problem with this theory is that the New England bills of credit which did depreciate were issued in exactly the same way. Smith’s answer was that the New England colonies administered their tax and loan funds poorly and New England’s poor administration accounted for the inflation experienced there.

Others who did not wholly agree with Smith – especially his sweeping refutation of the quantity theory – nonetheless pointed to the redemption provisions in explaining why bills of credit often retained their value (Wicker, 1985; Bernholz, 1988; Calomiris, 1988; Sumner, 1993; Rousseau, 2007). Of those who assigned credit to the redemption provisions, however, only Smith grappled with the key question; namely, why essentially identical redemption provisions failed to prevent inflation elsewhere.

Crediting careful administration of tax and loan funds for the steady value of some colonial currencies, and haphazard administration for the depreciation of others looks superficially appealing. The experiences of Pennsylvania and Rhode Island, generally thought to be the most and least successful issuers of colonial bills of credit, fit the hypothesis nicely. However, when one examines other cases, the hypothesis breaks down. Connecticut was generally credited with administering her bills of credit very carefully, yet they depreciated in lockstep with those of her New England neighbors for forty years (Brock, 1975, pp. 43-47). Virginia’s bills of credit retained their value even though Virginia’s colonial treasurer was discovered to have embezzled a sum equal to nearly half of Virginia’s total outstanding bills of credit and returned them to circulation (Michener, 1987, p. 247). North Carolina’s bills of credit held their value well in the late colonial period despite tax administration so notoriously corrupt it led to an armed revolt (Michener, 1987, pp. 248-9, Ernst, 1973, p. 221).

A competing explanation has been offered by Michener (1987, 1988), Brock (1992), McCallum (1992), and Michener and Wright (2006b). According to this explanation, the coin rating system operating in the colonies meant they were effectively on a specie standard with a de facto fixed par of exchange. Provided emissions of paper money did not exceed the amount needed for domestic purposes (“normal real balances,” in McCallum’s terminology) some specie would remain in circulation, prices would remain stable, and the fixed par could be maintained. Where emissions exceeded this bound specie would disappear from circulation and exchange rates would float freely, no longer tethered to the fixed par. Further emissions would cause inflation.37 This was said to account for inflation in New England after 1712, where specie did, in fact, completely disappear from circulation (Hutchinson, 1936, vol. 2, p. 154; Michener, 1987, pp. 288-94). If this explanation is correct, it would suggest that emissions of bills of credit ought to be offset by specie outflows, ceteris paribus.

Critics of the “specie circulated at rated values” explanation have frequently disregarded the ceteris paribus qualification and maintained that the theory implies specie flows always ought to be highly negatively correlated with changes in the quantity of bills of credit. This amounts to assuming the quantity of money demanded per capita in colonial America was nearly constant. If this were a valid test of the theory, one would be forced to reject it, because the specie stock fell little, if at all, in the Middle colonies in 1755-1760 as bills of credit increased, and when bills of credit began to decrease after 1760, specie became scarcer.

The flaw in critics’ reasoning, in my opinion, is that it assumes three unwarranted facts. First, that the demand for money, narrowly defined to mean bills of credit plus specie, was very stable despite the widespread use of bookkeeping barter; Second, that the absence of evidence of large interest rate fluctuations is evidence of the absence of large interest rate fluctuations (Smith, 1985b, pp. 1193, 1198; Letwin, 1982, p. 466); Third, that the opportunity cost of holding money is adequately measured by the nominal interest rate.38

With respect to the first point, colonial wars significantly influenced the demand for money. During peacetime, most transactions were handled by means of book credit. During major wars, however, many men served in the militia. Men in military service were paid in cash and taken far from the community in which their creditworthiness was commonly known, reducing both their need for book credit and their ability to obtain it. Moreover, it would have to give a shopkeeper pause and discourage him from advancing book credit to consider the real possibility that even his civilian customers might find themselves in the militia in the near future and gone from the local community, possibly forever. In each of the major colonial wars there is evidence suggesting an increase in cash real balances that could be attributed to the war’s impact on the book credit system. The increase in real money balances during the French and Indian War and the subsequent decrease can be largely accounted for in this way. With respect to the second point, fluctuations in the money supply are even compatible with a stable demand for money if periods when money is scarce are also periods when interest rates are high, as is also suggested by the historical record.39 It is true that the maximum interest rates specified in colonial usury laws are stable, generally in the range of 6%-8% per annum, often a bit lower late in the colonial era than at its beginning. This has been taken as evidence that colonial interest rates were stable. However, we know that these usury laws were commonly evaded and that market rates were often much higher (Wright, 2002, pp. 19-26). Some indication of how much higher became evident in the summer of 1768 when the Privy Council unexpectedly struck down New Hampshire’s usury law.40 News of the disallowance did not reach New Hampshire until the end of the year, at which time New Hampshire, having sunk the bills of credit issued to finance the French and Indian War during the 5 year interval permitted by the Currency Act of 1751, was in the throes of a liquidity crisis.41 Governor Wentworth reported to the Lords of Trade, that “Interest arose to 30 p. Ct. within six days of the repeal of the late Act.”42 By contrast, when cash was plentiful in Pennsylvania at the height of the French and Indian War, Pennsylvania’s “wealthy people were catching at every opportunity of letting out their money on good security, on common interest [that is, seven per cent].”43 With respect to the third point, the received theory that the nominal interest rate measures the opportunity cost of holding real money balances is derived from models in which individuals are free to borrow and lend at the nominal interest rate. Insofar as lenders respected the usury ceilings, borrowers were unable to borrow freely at the nominal interest rate. Recent work on moral hazard and adverse selection suggest that even private unregulated lenders forced to make loans in an environment characterized by seriously asymmetric information would be wise to ration loans by charging less than market clearing rates and limiting allowed borrowing. The creditworthiness of individuals was more difficult to determine in colonial times than today, and asymmetric information problems were rife. Under such circumstances, even an unregulated market rate of interest (if we had such data, which we don’t) would understate the opportunity cost of holding money for constrained borrowers.

The debate over why some colonial bills of credit depreciated, while others did not has spilled over into another related question: how much cash [i.e., paper money plus specie] circulated in the American colonies, and how much was in bills of credit, and how much was in specie? Clearly, if there was hardly any specie anywhere in colonial America, the concomitant circulation of specie at fixed rates could scarcely account for the stable purchasing power of bills of credit.

Determining how much cash circulated in the colonies is no easy matter, because the amount of specie in circulation is so hard to determine. The issue is further complicated by the fact that the total amount of cash in circulation fluctuated considerably from year to year, depending on such things as the demand for colonial staples and the magnitude of British military expenditure in the colonies (Sachs, 1957; Hemphill, 1964). The mix of bills of credit and specie in circulation was also highly variable. In the Middle colonies – and much of the most contentious debate involves the Middle colonies – the quantity of bills of credit in circulation was very modest (both absolutely and in per-capita terms) before the French and Indian War. The quantity exploded to cover military expenditures during the French and Indian War, and then fell again following 1760, until by the late colonial period, the quantity outstanding was once again very modest. Pennsylvania’s experience is not atypical of the Middle colonies. In 1754, on the eve of the French and Indian War, only £81,500 in Pennsylvania bills of credit were in circulation. At the height of the conflict, in 1760, this had increased to £446,158, but by 1773 the sum had been reduced to only £135,006 (Brock, 1992, Table 6). Any conclusion about the importance of bills of credit in the colonial money supply has to be carefully qualified because it will depend on the year in question.

Traditionally, economic historians have focused their attention on the eve of the Revolution, with a special focus on 1774, because of Alice Hanson Jones’s extensive study of 1774 probate records. Even with the inquiry dramatically narrowed, estimates have varied widely. McCusker and Menard (1985, p. 338), citing Alexander Hamilton for authority, estimated that just before the Revolution the “current cash” totaled 30 million dollars. Of the 30 million dollars, Hamilton said 8 million consisted of specie (27%). On the basis of this authority, Smith (1985a, p. 538; 1988, p. 22) has maintained that specie was a comparatively minor component in the colonial money supply.

Hamilton was arguing in favor of banks when he made this oft-cited estimate, and his purpose in presenting it was to show that the circulation was capable of absorbing a great deal of paper money, which ought to make us wonder whether his estimate might have been biased by his political agenda. Whether biased, or simply misinformed, Hamilton clearly got his facts wrong.

All estimates of the quantity of colonial bills of credit in circulation – including those of Brock (1975, 1992) that have been relied on by recent authors of all sides of the debate – lead inescapably to the conclusion that in 1774 there were very few bills of credit left outstanding, nowhere near the 22 million dollars implied by Hamilton. Calculations along these lines were first performed by Ratchford. Ratchford (1941, pp. 24-25) estimated the total quantity of bills of credit outstanding in each colony on the eve of the Revolution, and then added the local £., s., and d. of all the colonies (a true case of adding apples and oranges), converted to dollars by valuing dollars at 6 s. each, and concluded that the total was equal to about $5.16 million.

Ratchford’s method of summing local pounds and then converting to dollars is incorrect because local pounds did not have a uniform value across colonies. Since dollars were commonly rated at more than 6 s., his procedure resulted in an inflated estimate. We can correct this error by using McCusker’s (1978) data on 1774 exchange rates to convert local currency to sterling for each colony, obtain a sum in pounds sterling, and then convert to dollars using the rated value of the dollar in pounds sterling, 4½ s. Four and a half s. was very near the dollar’s value in London bullion markets in 1774, so no appreciable error arises from using the rated value. Doing so reduces Ratchford’s estimate to $3.42 million. Replacing Ratchford’s estimates of currency outstanding in New York, New Jersey, Pennsylvania, Virginia, and South Carolina with apparently superior data published by Brock (1975, 1992) reduces the total to $2.93 million. Even allowing for some imprecision in the data, this simply can’t be reconciled with Hamilton’s apparently mythical $22 million in paper money!

How much current cash was there in the colonies in 1774? Alice Hanson Jones’s extensive research into probate records gives an independent estimate of the money supply. Jones (1980, table 5.2) estimated that per capita cash-holding in the Middle colonies in 1774 was £1.8 sterling, and that the entire money supply of the thirteen colonies was slightly more than 12 million dollars.44 McCallum (1992) proposed another way to estimate total money balances in the colonies. McCallum started with the few episodes where historians generally agree paper money entirely displaced specie, making the total money supply measurable. He used money balances in these episodes as a basis for estimating money balances in other colonies by deriving approximate measures of the variability of money holdings over colonies and over time. Given the starkly different methodologies, it is remarkable that McCallum’s approach yields an answer practically indistinguishable from Jones’s.45

Various contemporary estimates, including estimates by Pelatiah Webster, Noah Webster, and Lord Sheffield, also suggest the total colonial money supply in 1774 was ten to twelve million dollars, mostly in specie (Michener 1988, p. 687; Elliot, 1845, p. 938). If we tentatively accept that the total money supply in the American colonies in 1774 was about twelve million dollars, and that only three million dollars worth of bills of credit remained outstanding, then fully 75% of the prewar money supply must have been in specie.

Even this may be an underestimate. Colonial probate inventories are notoriously incomplete, and the usual presumption is that Jones’s estimates are likely to be downwardly biased. Two examples not involving money illustrate the general problem. In Jones’s collection of inventories, over 20% of the estates did not include any clothes (Lindert, 1981, p. 657). In an independent survey of Surry County, Virginia probate records, Anna Hawley (1987, pp. 27-8) noted that only 34% of the estates listed hoes despite the fact that the region’s staple crops, corn and tobacco, had to be hoed several times a year.

In Jones’s 1774 database an amazing 70% of all estates were devoid of money. While the widespread use of credit made it possible to do without money in most transactions it is likely some estates contained cash that does not appear in probate inventories. Peter Lindert (1981, p. 658) surmised “cash was simply allocated informally among survivors even before probate took place.” McCusker and Menard (1985, p. 338, fn. 14) concurred noting “cash would have been one of the things most likely to have been distributed outside the usual probate proceedings.” If Jones actually underestimated cash holdings in 1774 the implication would be that more than 75% of the prewar money supply must have been specie.

That most of the cash circulating in the colonies in 1774 must have been specie seems like an inescapable conclusion. The issue has been clouded, however, by the existence of many contradictory and internally inconsistent estimates in the literature. By using them to defend his contention that specie was relatively unimportant, Smith (1988, p. 22) drew attention to these estimates.

The first such estimate was made by Roger Weiss (1970, p. 779), who computed the ratio of paper money to total money in the Middle colonies, using Jones’s probate data to estimate total money balances as has been done here; he arrived at a considerably smaller fraction of specie in the money supply. There is a simple explanation for this puzzling result: Weiss, whose article was published in 1970, based his analysis on Jones’s 1968 dissertation rather than her 1980 book. In her dissertation, Jones (1968, Tables 3 and 4, pp. 50-51) estimated the money supply in the three Middle colonies at £2.0 local currency per free white capita. Since £1 local currency was worth about £0.6 sterling, Weiss began with an estimated total money supply of £1.2 sterling per free white capita (equal to £1.13 per capita), rather than Jones’s more recent estimate of £1.8 sterling per capita.

Another authority is Letwin (1982, p. 467), who estimated that more than 60% of the money supply of Pennsylvania in 1775 was paper. Letwin used the Historical Statistics of the United States for his money supply data, and a casual back-of-the-envelope estimate that nominal balances in Pennsylvania were £700,000 in 1775 to conclude that 63% of Pennsylvania’s money supply was paper money. However, the data in Historical Statistics of the United States are known to be incorrect: Using Letwin’s back-of-the-envelope estimate, but redoing the calculation using Brock’s estimates of paper money in circulation, gives the result that in 1775 only 45.5% of Pennsylvania’s money supply was paper money; for 1774 the figure is 31%.46

That good faith attempts to estimate the stock of specie in the colonies in 1774 have given rise to such wildly varying and inconsistent estimates gives some indication of the task that remains to be accomplished.47 Many hints about how the specie stock varied over time in colonial America can be found in newspapers, legislative records, pamphlets and correspondence. Organizing those fragments of evidence and interpreting them is going to require great skill and will probably have to be done colony by colony. In addition, if the key to the purchasing power of colonial currency lies in the ratings attached to coins as I personally believe it does, then more effort is going to have to be paid in the future to tracking how those ratings evolved over time. Our knowledge at the moment is very fragmentary, probably because the politics of paper money has so engrossed the attention of historians that few people have attached much significance to coin ratings.

Economic historian Farley Grubb has proposed (2003, 2004, 2007) that the composition of the medium of exchange in colonial America and the early Republic can be determined from the unit of account used in arm’s length transactions, such as rewards offered in runaway ads and prices recorded in indentured servant contract registrations. If, for instance, a runaway reward is offered in pounds, shillings and pence, it means (Grubb argues) that colonial or state bills of credit were the medium of exchange used, while dollar rewards in such ads would imply silver. Grubb then uses contract registrations in the early Republic (2003, 2007) and runaway ads in colonial Pennsylvania (2004) to develop time series for hitherto unmeasurable components of the money supply and draws many striking conclusions from them. I believe Grubb is proceeding on a mistaken premise. Reversing Grubb’s procedure and using runaway ads in the early Republic and contract registrations in colonial Pennsylvania yields dramatically different results, which suggests the method is not useful. I have participated in this contentious published debate (see Michener and Wright 2005, 2006a, 2006c and Grubb 2003, 2004, 2006a, 2006b, 2007) and will leave it to the reader to draw his or her own conclusions.

Notes:

1. Beginning in 1767, Maryland issued bills of credit denominated in dollars (McCusker, 1978, p. 194).

2. For a number of years, Georgia money was an exception to this rule (McCusker, 1978, pp. 227-8).

3. Elmer (1869, p. 137). Similarly, historian Robert Shalhope (Shalhope, 2003, pp. 140, 142, 147, 290) documents a Vermont farmer who continued to reckon, at least some of the time, in New York currency (i.e. 8 shillings = $1) well into the 1820s.

4. To clarify: In New York, a dollar was rated at eight shillings, hence one reale, an eighth of a dollar, was one shilling. In Richmond and Boston, the dollar was rated at six shillings, or 72 pence, one eighth of which is 9 pence. In Philadelphia and Baltimore, the dollar was rated at seven shillings six pence, or ninety pence, and an eighth of a dollar would be 11.25 pence.

5. In 1822, for example, P. T. Barnum, then a young man from Connecticut making his first visit to New York, paid too much for a brace of oranges because of confusion over the unit of account. “I was told,” he later related, “[the oranges] were four pence apiece [as Barnum failed to realise, in New York there were 96 pence to the dollar], and as four pence in Connecticut was six cents, I offered ten cents for two oranges, which was of course readily taken; and thus, instead of saving two cents, as I thought, I actually paid two cents more than the price demanded” (Barnum, 1886, p. 18).

6. One way to see the truth of this statement is to examine colonial records predating the emission of colonial bills of credit. Virginia pounds are referred to long before Virginia issued its first bills of credit in 1755. See, for example, Pennsylvania Gazette, September 20, 1736, quoting Votes of the House of Burgesses in Virginia, August 30, 1736 or the Pennsylvania Gazette, May 29, 1746, quoting a runaway ad that mentions “a bond from a certain Fielding Turner to William Williams, for 42 pounds Virginia currency.” Advertisements in the Philadelphia newspapers in 1720 promise rewards for the return of runaway servants and slaves in Pennsylvania pounds, even though Pennsylvania did not issue its first bills of credit until 1723. The contemporary meaning of “currency” sheds light on otherwise confusing statements, such as an ad in the Pennsylvania Gazette, May 12, 1763, where the advertiser offered a reward for the recovery of £460 “New York currency” that was stolen from him and then parenthetically noted “the greatest part of said Money was in Jersey Bills.”

7. For an example of a complete list, see Felt (1839, pp. 82-83).

8. Further discussion of country pay in Connecticut can be found in Bronson (1865, pp. 23-4).

9. Weiss (1974, pp. 580-85) cites a passage from an 1684 court case that appears to contradict this discount. However, inspecting the court records shows that the initial debt consisted of 34s. 5d. in money to which the court added 17s. 3d. to cover the difference between money and country pay, a ratio of pay to money of exactly 3 to 2 (Massachusetts, 1961, pp. 303-4). Other good illustrations of the divergence of cash and country pay prices can be found in Knight (1935, pp. 40-1) and Judd (1905, pp. 95-6). The multiple price system was not limited to Massachusetts and Connecticut (Coulter, 1944, p. 107).

10. Thomas Bannister to Mr. Joseph Thomson, March 8, 1699/1700 in (Bannister, 1708).

11. In New York, for instance, early issues were legal tender, but the Currency Act of 1764 put a halt to new issues of legal tender paper money; the legal tender status of practically all existing issues expired in 1768. After prolonged and contentious negotiation with imperial authorities, the Currency Act of 1770 permitted New York to issue paper money that was a legal tender in payments to the colonial government, but not in private transactions. New York made its first issue under the terms of the Currency Act of 1770 in early 1771 (Ernst, 1973).

12. Ordinarily, but not always. For instance, in 1731 South Carolina reissued £106,500 in bills of credit without creating any tax fund with which to redeem them (Nettels, 1934, pp. 261-2; Brock, 1975, p. 123). The Board of Trade repeatedly pressured the colony to create a tax fund for this purpose, but without success. That no tax funds had been earmarked to redeem these bills was common knowledge, but it did not make the bills less acceptable as a medium of exchange, or adversely affect their value. The episode contradicts the common supposition that the promise of future redemption played a key role in determining the value of colonial currencies.

13. Once the bills of credit were placed in circulation, no distinction was made between them based on how they were originally issued. It is not as if one could only pay taxes with bills of the first sort, or repay mortgages with bills of the second sort. Many colonies, to save the cost of printing, would reuse worn but serviceable notes. A bill originally issued on loan, upon returning to the colonial treasury, might be reissued on tax funds; often it would have been impossible, even in principle, for an individual to examine the bills in his possession and deduce the funds ostensibly backing them.

14. Late in the seventeenth century Massachusetts briefly operated a mint that issued silver coins denominated in the local unit of account (Jordon, 2002). On the eve of the Revolution, Virginia obtained official permission to have copper coins minted for use in Virginia (Davis, 1970, vol. 1, chapter 2; Newman, 1956).

15. The Massachusetts government, unable to honor redemption promises made when the first new tenor emission was first created, decided in 1742 to revalue these bills from three to one to four to one with old tenor as compensation. When Massachusetts returned to a specie standard, the remaining middle tenor bills were redeemed at four to one (Davis, 1970; McCusker, 1978, p. 133).

16. New and old tenors have led to much confusion. In the Boston Weekly News Letter, July 1, 1742, there is an ad pertaining to someone who mistakenly passed Rhode Island New Tenor in Boston at three to one, when it was supposed to be valued at four to one. Modern day historians have also occasionally been misled. An excellent example can be found in Patterson (1961, p. 27). Patterson believed he had unearthed evidence of outrageous fraud during the Massachusetts currency reform, whereas he had, in fact, simply failed to convert a sum in an official document stated in new tenor terms into appropriate old tenor terms. Sufro (1976, p. 247) following Patterson, made similar accusations based on a similar misunderstanding of New England’s monetary units.

17. That colonial treasurers did not unfailingly provide this service is implicit in statements found in merchant letters complaining of how difficult it sometimes became to convert paper money to specie (Beekman to Evan and Francis Malbone, March 10, 1769, White, 1956, p. 522).

18. Nathaniel Appleton (1748) preached a sermon excoriating the province of Massachusetts Bay for flagrantly failing to keep the promises inscribed on the face of its bills of credit.

19. Goldberg (2009) uses circumstantial evidence to suggest that Massachusetts was engaged in a “monetary ploy to fool the king” when it made its first emissions. In Goldberg’s telling of the tale, the king had been furious about the Massachusetts mint and officially issuing paper money that was a full legal tender would have been a “colossal mistake” because it would have endangered the colony’s effort to obtain a new charter, which was essential to confirm the land grants the colony had already made. The alleged ploy Goldberg discovered was a provision passed shortly afterwards: “Ordered that all country pay with one third abated shall pass as current money to pay all country’s debts at the same prices set by this court.” Since those with a claim on the Treasury were going to be tendered either paper money or country pay, and since Goldberg interprets this as requiring those creditors to accept either 3 pounds in paper money or 2 pounds in country pay, the provision was, in Goldberg’s estimation, a way of forcing the paper money on the populace at a one third discount. The shortchanging of the public creditors, through some mechanism not adequately explained to my understanding, was sufficient to make the new paper money a defacto legal tender.

There are several problems with Goldberg’s analysis. Jordan (2002, pp. 36-45) has recently written the definitive history of the Massachusetts mint, and he minutely reviews the evidence pertaining to the Massachusetts mint and British reaction to it. He concludes that “there was no concerted effort by the king and his ministers to crush the Massachusetts mint.” In 1692 Massachusetts obtained a new charter and passed a law making the bills of credit a legal tender. The new charter required Massachusetts to submit all its laws to London for review, yet the imperial authorities quietly ratified the legal tender law, even though they were fully empowered to veto it, which seems very peculiar if the legal tender status of the bills was as unpopular with the King and his ministers as Goldberg maintains. The smoking gun Goldberg cites appears to me to be no more than a statement of the “three pounds of country pay equals two pounds cash” rule that prevailed in Massachusetts in the late seventeenth century. In his argument, Goldberg tacitly assumes that a pound of country pay was equal in value to a pound of hard money; he observes that the new bills of credit initially circulated at a one third discount (with respect to specie) and that this might have arisen because recipients (according to his interpretation) were offered only two pounds of country pay in lieu of three pounds of bills of credit (Goldberg, p. 1102). However, because country pay itself was worth, at most, two thirds of its nominal value in specie, by Goldberg’s reasoning paper money should have been at a discount of at least five ninths with respect to specie.

The paper money era in Massachusetts brought forth approximately fifty pamphlets and hundreds of newspaper articles and public debates in the Assembly, none of which confirm Goldberg’s inference.

20. The role bills of credit played as a means of financing government expenditures is discussed in Ferguson (1953).

21. Georgia was not founded until 1733, and one reason for its founding was to create a military buffer to protect the Carolinas from the Spanish in Florida.

22. Grubb (2004, 2006a, 2006b) argues that bills of credit did not commonly circulate across colony borders. Michener and Wright (2006a, 2006c) dispute Grubb’s analysis and provide (Michener and Wright 2006a, pp. 12-13, 24-30) additional evidence of the phenomenon.

23. Poor Thomas Improved: Being More’s Country Almanack for … 1768 gives as a rule that “To reduce New-Jersey Bills into York Currency, only add one penny to every shilling, and the Sum is determined.” (McCusker, 1978, pp. 170-71; Stevens, 1867, pp. 151-3, 160-1, 168, 185-6, 296; Lincoln, 1894, vol. 5, Chapter 1654, pp. 638-9.)

24. In two articles, John R. Hanson (1979, 1980) argued that bills of credit were important to the colonial economy because they provided much-needed small denomination money. His analysis, however, completely ignores the presence of half-pence, pistareens, and fractional denominations of the Spanish dollar. The Spanish minted halves, quarters, eighths, and sixteenths of the dollar, which circulated in the colonies (Solomon, 1976, pp. 31-32). For a good introduction to small change in the colonies, see Andrews (1886), Newman (1976), Mossman (1993, pp. 105-142), and Kays (2001).

25. Council of Trade and Plantations to the Queen, November 23, 1703, in Calendar of State Papers, 1702-1703, entry #1299. Brock, 1975, chap. 4.

26. This, it should be noted, is what British authorities meant by “proclamation money.” Since salaries of royal officials, fees, quit rents, etc. were often denominated in proclamation money, colonial courts often found a rationale to attach their own interpretation to “proclamation money” so as to reduce the real value of such salaries and fees. In New York, for example, eight shillings in New York’s bills of credit were ostensibly worth one ounce of silver although by the late colonial period they were actually worth less. This valuation of bills of credit made each seven pounds of New York bills of credit in principle worth six pounds in proclamation money. The New York courts used that fact to establish the rule that seven pounds in New York currency could pay a debt of six pounds proclamation money. This rule allowed New Yorkers to pay less in real terms than was contemplated by the British (Hart, 2005, pp. 269-71).

27. Brock (1975). The text of the proclamation can be found in the Boston New-Letter, December 11, 1704. To be precise, the Proclamation rate was actually in slight contradiction to that in the Massachusetts law, which had rated a piece of eight weighing 17 dwt. at 6 s. See Brock (1975, p. 133, fn. 7).

28. This contention has engendered considerable controversy, but the evidence for it seems to me both considerable and compelling. Apart from evidence cited in the text, see for Massachusetts, Michener (1987, p. 291, fn. 54), Waite Winthrop to Samuel Reade, March 5, 1708 and Wait Winthrop to Samuel Reade, October 22, 1709 in Winthrop (1892, pp. 165, 201); For South Carolina see South Carolina Gazette, May 14, 1753; August 13, 1744; and Manigualt (1969, p. 188); For Pennsylvania see Pennsylvania Gazette, April 2, 1730, December 3, 1767, February 15, 1775, March 8, 1775; For St. Kitts see Roberdeau to Hyndman & Thomas, October 16, 1766, in Roberdeau (1771); For Antigua, see Anonymous (1740).

29. The Chamber of Commerce adopted its measure in October 1769, apparently too late in the year to appear in the “1770” almanacs, which were printed and sold in late 1769. The 1771 almanacs, printed in 1770, include the revised coin ratings.

30. Note that the relative ratings of the half joe are aligned with the ratings of the dollar. For example, the ratio of the New York value of the half joe to the Pennsylvania value is 64 s./60 s. = 1.066666, and the ratio of the New York value of the half joe to the Connecticut value is 64 s./48 s. = 1.3333.

31. This bank has been largely overlooked, but is well documented. Letter of a Merchant in South Carolina to Alexander Cumings, Charlestown, May 23, 1730, South Carolina Public Records, Vol XIV, pp. 117-20; Anonymous (1734); Easterby (1951, [March 5, 1736/37] vol. 1, pp. 309-10); Governor Johnson to the Board of Trade in Calendar of State Papers, 1731, entry 488, p. 342; Whitaker (1741, p. 25); and Vance (1740, p. 463).

32.I base this on my own experience reviewing the contents of RG3 Litchfield County Court Files, Box 1 at the Connecticut State Library.

33. Though best documented in New England, Benjamin Franklin (1729, CCR II, p. 340) mentions their use in Pennsylvania.

34. See Douglass (1740, CCR III, pp. 328-329) and Vance (1740, CCR III, pp. 328-329). Douglass and Vance disagreed on all the substantive issues, so that their agreement on this point is especially noteworthy. See also Boston Weekly Newsletter, Feb. 12-19, 1741.

35. Data on New England prices during this period are very limited, but annual data exist for wheat prices and silver prices. Regressing the log of these prices on time yields an annual growth rate of prices approximately that mentioned in the text. The price data leave much to be desired, and the inflation estimates should be understood as simply a crude characterization. However, it does show that New England’s peacetime inflation during this era was not so extreme as to shock modern sensibilities.

36. Smith (1985a, 1985b). The quantity theory holds that the price level is determined by the supply and demand for money – loosely, how much money is chasing how many goods. Smith’s version of the backing theory is summarized by the passage quoted from his article.

37. John Adams explained this very clearly in a letter written June 22, 1780 to Vergennes (Wharton, vol. 3, p. 811). Adams’s “certain sum” and McCallum’s “normal real balances” are essentially the same, although Adams is speaking in nominal and McCallum in real terms.

A certain sum of money is necessary to circulate among the society in order to carry on their business. This precise sum is discoverable by calculation and reducible to certainty. You may emit paper or any other currency for this purpose until you reach this rule, and it will not depreciate. After you exceed this rule it will depreciate, and no power or act of legislation hitherto invented will prevent it. In the case of paper, if you go on emitting forever, the whole mass will be worth no more than that was which was emitted within the rule.

38. One of the principle observations Smith (1985b, p. 1198) makes in dismissing the possible importance of interest rate fluctuations is “it is known that sterling bills of exchange did not circulate at a discount.” Sterling bills were payable at a future date, and Smith presumably means that sterling bills should have been discounted if interest made an appreciable difference in their market value. Sterling bills, however, were discounted. These bills were not payable at a particular fixed date, but rather on a certain number of days after they were first presented for payment. For example, a bill might be payable “on sixty days sight,” meaning that once the bill was presented (in London, for example, to the person upon whom it was drawn) the person would have sixty days in which to make payment. Not all bills were drawn at the same sight, and sight periods of 30, 60, and 90 days were all common. Bills payable sooner sold at higher prices, and bills could be and sometimes were discounted in London to obtain quicker payment (McCusker, 1978, p. 21, especially fn. 25; David Vanhorne to Nicholas Browne and Co., October 3, 1766. Brown Papers, P-V2, John Carter Brown Library). In the early Federal period many newspapers published extensive prices current that included prices of bills drawn on 30, 60, and 90 days’ sight.

39. Franklin (1729) wrote a tract on colonial currency, in which he maintained as one of his propositions that “A great Want of Money in any Trading Country, occasions Interest to be at a very high Rate.” An anonymous referee warned that when colonists complained of a “want of money” that they were not complaining of a lack of a circulating medium per se, but were expressing a desire for more credit at lower interest rates. I do not entirely agree with the referee. I believe many colonists, like Franklin, reasoned like modern-day Keynesians, and believed high interest rates and scarce credit were caused by an inadequate money supply. For more on this subject, see Wright (2002, chapter 1).

40. Public Record Office, CO 5/ 947, August 13, 1768, pp. 18-23.

41. New Hampshire Gazette and Historical Chronicle, January 13, 1769.

42. Public Record Office, Wentworth to Hillsborough, CO 5/ 936, July 3, 1769.

43. Pennsylvania Chronicle, and Universal Advertiser, 28 December 1767.

44. This should be understood to be paper money and specie equal in value to 12 million dollars, not 12 million Spanish dollars. The fraction of specie in the money supply can’t be directly estimated from probate records. Jones (1980, p. 132) found that “whether the cash was in coin or paper was rarely stated.”

45. McCallum deflated money balances by the free white population rather than the total population. Using population estimates to put the numbers on a comparable basis reveals how close McCallum’s estimates are to those of Jones. For example, McCallum’s estimate for the Middle colonies, converted to a per-capita basis, is approximately £1.88 sterling.

46. This incident illustrates how mistakes about colonial currency are propagated and seem never to die out. Henry Phillips 1865 book presented data on Pennsylvania bills of credit outstanding. One of his major “findings” was that Pennsylvania retired only £25,000 between 1760 and 1769. This was a mistake: Brock (1992, table 6) found £225,247 had been retired over the same period. Because of the retirements Phillips missed, he overestimated the quantity of Pennsylvania bills of credit in circulation in the late colonial period by 50 to 100%. Lester (1939, pp. 88, 108) used Phillips’s series; Ratchford (1941) obtained his data from Lester. Through Ratchford, Phillips’s series found its way into Historical Statistics of the United States.

47. Benjamin Allen Hicklin (2007) maintains that generations of historians have exaggerated the scarcity of specie in seventeenth and early eighteenth century Massachusetts. Hicklin’s analysis illustrates the unsettled state of our knowledge about colonial specie stocks.

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Citation: Michener, Ron. “Money in the American Colonies”. EH.Net Encyclopedia, edited by Robert Whaples. June 8, 2003, revised January 13, 2011. URL http://eh.net/encyclopedia/money-in-the-american-colonies/

Japanese Industrialization and Economic Growth

Carl Mosk, University of Victoria

Japan achieved sustained growth in per capita income between the 1880s and 1970 through industrialization. Moving along an income growth trajectory through expansion of manufacturing is hardly unique. Indeed Western Europe, Canada, Australia and the United States all attained high levels of income per capita by shifting from agrarian-based production to manufacturing and technologically sophisticated service sector activity.

Still, there are four distinctive features of Japan’s development through industrialization that merit discussion:

The proto-industrial base

Japan’s agricultural productivity was high enough to sustain substantial craft (proto-industrial) production in both rural and urban areas of the country prior to industrialization.

Investment-led growth

Domestic investment in industry and infrastructure was the driving force behind growth in Japanese output. Both private and public sectors invested in infrastructure, national and local governments serving as coordinating agents for infrastructure build-up.

  • Investment in manufacturing capacity was largely left to the private sector.
  • Rising domestic savings made increasing capital accumulation possible.
  • Japanese growth was investment-led, not export-led.

Total factor productivity growth — achieving more output per unit of input — was rapid.

On the supply side, total factor productivity growth was extremely important. Scale economies — the reduction in per unit costs due to increased levels of output — contributed to total factor productivity growth. Scale economies existed due to geographic concentration, to growth of the national economy, and to growth in the output of individual companies. In addition, companies moved down the “learning curve,” reducing unit costs as their cumulative output rose and demand for their product soared.

The social capacity for importing and adapting foreign technology improved and this contributed to total factor productivity growth:

  • At the household level, investing in education of children improved social capability.
  • At the firm level, creating internalized labor markets that bound firms to workers and workers to firms, thereby giving workers a strong incentive to flexibly adapt to new technology, improved social capability.
  • At the government level, industrial policy that reduced the cost to private firms of securing foreign technology enhanced social capacity.

Shifting out of low-productivity agriculture into high productivity manufacturing, mining, and construction contributed to total factor productivity growth.

Dualism

Sharply segmented labor and capital markets emerged in Japan after the 1910s. The capital intensive sector enjoying high ratios of capital to labor paid relatively high wages, and the labor intensive sector paid relatively low wages.

Dualism contributed to income inequality and therefore to domestic social unrest. After 1945 a series of public policy reforms addressed inequality and erased much of the social bitterness around dualism that ravaged Japan prior to World War II.

The remainder of this article will expand on a number of the themes mentioned above. The appendix reviews quantitative evidence concerning these points. The conclusion of the article lists references that provide a wealth of detailed evidence supporting the points above, which this article can only begin to explore.

The Legacy of Autarky and the Proto-Industrial Economy: Achievements of Tokugawa Japan (1600-1868)

Why Japan?

Given the relatively poor record of countries outside the European cultural area — few achieving the kind of “catch-up” growth Japan managed between 1880 and 1970 – the question naturally arises: why Japan? After all, when the United States forcibly “opened Japan” in the 1850s and Japan was forced to cede extra-territorial rights to a number of Western nations as had China earlier in the 1840s, many Westerners and Japanese alike thought Japan’s prospects seemed dim indeed.

Tokugawa achievements: urbanization, road networks, rice cultivation, craft production

In answering this question, Mosk (2001), Minami (1994) and Ohkawa and Rosovsky (1973) emphasize the achievements of Tokugawa Japan (1600-1868) during a long period of “closed country” autarky between the mid-seventeenth century and the 1850s: a high level of urbanization; well developed road networks; the channeling of river water flow with embankments and the extensive elaboration of irrigation ditches that supported and encouraged the refinement of rice cultivation based upon improving seed varieties, fertilizers and planting methods especially in the Southwest with its relatively long growing season; the development of proto-industrial (craft) production by merchant houses in the major cities like Osaka and Edo (now called Tokyo) and its diffusion to rural areas after 1700; and the promotion of education and population control among both the military elite (the samurai) and the well-to-do peasantry in the eighteenth and early nineteenth centuries.

Tokugawa political economy: daimyo and shogun

These developments were inseparable from the political economy of Japan. The system of confederation government introduced at the end of the fifteenth century placed certain powers in the hands of feudal warlords, daimyo, and certain powers in the hands of the shogun, the most powerful of the warlords. Each daimyo — and the shogun — was assigned a geographic region, a domain, being given taxation authority over the peasants residing in the villages of the domain. Intercourse with foreign powers was monopolized by the shogun, thereby preventing daimyo from cementing alliances with other countries in an effort to overthrow the central government. The samurai military retainers of the daimyo were forced to abandon rice farming and reside in the castle town headquarters of their daimyo overlord. In exchange, samurai received rice stipends from the rice taxes collected from the villages of their domain. By removing samurai from the countryside — by demilitarizing rural areas — conflicts over local water rights were largely made a thing of the past. As a result irrigation ditches were extended throughout the valleys, and riverbanks were shored up with stone embankments, facilitating transport and preventing flooding.

The sustained growth of proto-industrialization in urban Japan, and its widespread diffusion to villages after 1700 was also inseparable from the productivity growth in paddy rice production and the growing of industrial crops like tea, fruit, mulberry plant growing (that sustained the raising of silk cocoons) and cotton. Indeed, Smith (1988) has given pride of place to these “domestic sources” of Japan’s future industrial success.

Readiness to emulate the West

As a result of these domestic advances, Japan was well positioned to take up the Western challenge. It harnessed its infrastructure, its high level of literacy, and its proto-industrial distribution networks to the task of emulating Western organizational forms and Western techniques in energy production, first and foremost enlisting inorganic energy sources like coal and the other fossil fuels to generate steam power. Having intensively developed the organic economy depending upon natural energy flows like wind, water and fire, Japanese were quite prepared to master inorganic production after the Black Ships of the Americans forced Japan to jettison its long-standing autarky.

From Balanced to Dualistic Growth, 1887-1938: Infrastructure and Manufacturing Expand

Fukoku Kyohei

After the Tokugawa government collapsed in 1868, a new Meiji government committed to the twin policies of fukoku kyohei (wealthy country/strong military) took up the challenge of renegotiating its treaties with the Western powers. It created infrastructure that facilitated industrialization. It built a modern navy and army that could keep the Western powers at bay and establish a protective buffer zone in North East Asia that eventually formed the basis for a burgeoning Japanese empire in Asia and the Pacific.

Central government reforms in education, finance and transportation

Jettisoning the confederation style government of the Tokugawa era, the new leaders of the new Meiji government fashioned a unitary state with powerful ministries consolidating authority in the capital, Tokyo. The freshly minted Ministry of Education promoted compulsory primary schooling for the masses and elite university education aimed at deepening engineering and scientific knowledge. The Ministry of Finance created the Bank of Japan in 1882, laying the foundations for a private banking system backed up a lender of last resort. The government began building a steam railroad trunk line girding the four major islands, encouraging private companies to participate in the project. In particular, the national government committed itself to constructing a Tokaido line connecting the Tokyo/Yokohama region to the Osaka/Kobe conurbation along the Pacific coastline of the main island of Honshu, and to creating deepwater harbors at Yokohama and Kobe that could accommodate deep-hulled steamships.

Not surprisingly, the merchants in Osaka, the merchant capital of Tokugawa Japan, already well versed in proto-industrial production, turned to harnessing steam and coal, investing heavily in integrated spinning and weaving steam-driven textile mills during the 1880s.

Diffusion of best-practice agriculture

At the same time, the abolition of the three hundred or so feudal fiefs that were the backbone of confederation style-Tokugawa rule and their consolidation into politically weak prefectures, under a strong national government that virtually monopolized taxation authority, gave a strong push to the diffusion of best practice agricultural technique. The nationwide diffusion of seed varieties developed in the Southwest fiefs of Tokugawa Japan spearheaded a substantial improvement in agricultural productivity especially in the Northeast. Simultaneously, expansion of agriculture using traditional Japanese technology agriculture and manufacturing using imported Western technology resulted.

Balanced growth

Growth at the close of the nineteenth century was balanced in the sense that traditional and modern technology using sectors grew at roughly equal rates, and labor — especially young girls recruited out of farm households to labor in the steam using textile mills — flowed back and forth between rural and urban Japan at wages that were roughly equal in industrial and agricultural pursuits.

Geographic economies of scale in the Tokaido belt

Concentration of industrial production first in Osaka and subsequently throughout the Tokaido belt fostered powerful geographic scale economies (the ability to reduce per unit costs as output levels increase), reducing the costs of securing energy, raw materials and access to global markets for enterprises located in the great harbor metropolises stretching from the massive Osaka/Kobe complex northward to the teeming Tokyo/Yokohama conurbation. Between 1904 and 1911, electrification mainly due to the proliferation of intercity electrical railroads created economies of scale in the nascent industrial belt facing outward onto the Pacific. The consolidation of two huge hydroelectric power grids during the 1920s — one servicing Tokyo/Yokohama, the other Osaka and Kobe — further solidified the comparative advantage of the Tokaido industrial belt in factory production. Finally, the widening and paving during the 1920s of roads that could handle buses and trucks was also pioneered by the great metropolises of the Tokaido, which further bolstered their relative advantage in per capita infrastructure.

Organizational economies of scale — zaibatsu

In addition to geographic scale economies, organizational scale economies also became increasingly important in the late nineteenth centuries. The formation of the zaibatsu (“financial cliques”), which gradually evolved into diversified industrial combines tied together through central holding companies, is a case in point. By the 1910s these had evolved into highly diversified combines, binding together enterprises in banking and insurance, trading companies, mining concerns, textiles, iron and steel plants, and machinery manufactures. By channeling profits from older industries into new lines of activity like electrical machinery manufacturing, the zaibatsu form of organization generated scale economies in finance, trade and manufacturing, drastically reducing information-gathering and transactions costs. By attracting relatively scare managerial and entrepreneurial talent, the zaibatsu format economized on human resources.

Electrification

The push into electrical machinery production during the 1920s had a revolutionary impact on manufacturing. Effective exploitation of steam power required the use of large central steam engines simultaneously driving a large number of machines — power looms and mules in a spinning/weaving plant for instance – throughout a factory. Small enterprises did not mechanize in the steam era. But with electrification the “unit drive” system of mechanization spread. Each machine could be powered up independently of one another. Mechanization spread rapidly to the smallest factory.

Emergence of the dualistic economy

With the drive into heavy industries — chemicals, iron and steel, machinery — the demand for skilled labor that would flexibly respond to rapid changes in technique soared. Large firms in these industries began offering premium wages and guarantees of employment in good times and bad as a way of motivating and holding onto valuable workers. A dualistic economy emerged during the 1910s. Small firms, light industry and agriculture offered relatively low wages. Large enterprises in the heavy industries offered much more favorable remuneration, extending paternalistic benefits like company housing and company welfare programs to their “internal labor markets.” As a result a widening gulf opened up between the great metropolitan centers of the Tokaido and rural Japan. Income per head was far higher in the great industrial centers than in the hinterland.

Clashing urban/rural and landlord/tenant interests

The economic strains of emergent dualism were amplified by the slowing down of technological progress in the agricultural sector, which had exhaustively reaped the benefits due to regional diffusion from the Southwest to the Northeast of best practice Tokugawa rice cultivation. Landlords — around 45% of the cultivable rice paddy land in Japan was held in some form of tenancy at the beginning of the twentieth century — who had played a crucial role in promoting the diffusion of traditional best practice techniques now lost interest in rural affairs and turned their attention to industrial activities. Tenants also found their interests disregarded by the national authorities in Tokyo, who were increasingly focused on supplying cheap foodstuffs to the burgeoning industrial belt by promoting agricultural production within the empire that it was assembling through military victories. Japan secured Taiwan from China in 1895, and formally brought Korea under its imperial rule in 1910 upon the heels of its successful war against Russia in 1904-05. Tenant unions reacted to this callous disrespect of their needs through violence. Landlord/tenant disputes broke out in the early 1920s, and continued to plague Japan politically throughout the 1930s, calls for land reform and bureaucratic proposals for reform being rejected by a Diet (Japan’s legislature) politically dominated by landlords.

Japan’s military expansion

Japan’s thrust to imperial expansion was inflamed by the growing instability of the geopolitical and international trade regime of the later 1920s and early 1930s. The relative decline of the United Kingdom as an economic power doomed a gold standard regime tied to the British pound. The United States was becoming a potential contender to the United Kingdom as the backer of a gold standard regime but its long history of high tariffs and isolationism deterred it from taking over leadership in promoting global trade openness. Germany and the Soviet Union were increasingly becoming industrial and military giants on the Eurasian land mass committed to ideologies hostile to the liberal democracy championed by the United Kingdom and the United States. It was against this international backdrop that Japan began aggressively staking out its claim to being the dominant military power in East Asia and the Pacific, thereby bringing it into conflict with the United States and the United Kingdom in the Asian and Pacific theaters after the world slipped into global warfare in 1939.

Reform and Reconstruction in a New International Economic Order, Japan after World War II

Postwar occupation: economic and institutional restructuring

Surrendering to the United States and its allies in 1945, Japan’s economy and infrastructure was revamped under the S.C.A.P (Supreme Commander of the Allied Powers) Occupation lasting through 1951. As Nakamura (1995) points out, a variety of Occupation-sponsored reforms transformed the institutional environment conditioning economic performance in Japan. The major zaibatsu were liquidated by the Holding Company Liquidation Commission set up under the Occupation (they were revamped as keiretsu corporate groups mainly tied together through cross-shareholding of stock in the aftermath of the Occupation); land reform wiped out landlordism and gave a strong push to agricultural productivity through mechanization of rice cultivation; and collective bargaining, largely illegal under the Peace Preservation Act that was used to suppress union organizing during the interwar period, was given the imprimatur of constitutional legality. Finally, education was opened up, partly through making middle school compulsory, partly through the creation of national universities in each of Japan’s forty-six prefectures.

Improvement in the social capability for economic growth

In short, from a domestic point of view, the social capability for importing and adapting foreign technology was improved with the reforms in education and the fillip to competition given by the dissolution of the zaibatsu. Resolving tension between rural and urban Japan through land reform and the establishment of a rice price support program — that guaranteed farmers incomes comparable to blue collar industrial workers — also contributed to the social capacity to absorb foreign technology by suppressing the political divisions between metropolitan and hinterland Japan that plagued the nation during the interwar years.

Japan and the postwar international order

The revamped international economic order contributed to the social capability of importing and adapting foreign technology. The instability of the 1920s and 1930s was replaced with replaced with a relatively predictable bipolar world in which the United States and the Soviet Union opposed each other in both geopolitical and ideological arenas. The United States became an architect of multilateral architecture designed to encourage trade through its sponsorship of the United Nations, the World Bank, the International Monetary Fund and the General Agreement on Tariffs and Trade (the predecessor to the World Trade Organization). Under the logic of building military alliances to contain Eurasian Communism, the United States brought Japan under its “nuclear umbrella” with a bilateral security treaty. American companies were encouraged to license technology to Japanese companies in the new international environment. Japan redirected its trade away from the areas that had been incorporated into the Japanese Empire before 1945, and towards the huge and expanding American market.

Miracle Growth: Soaring Domestic Investment and Export Growth, 1953-1970

Its infrastructure revitalized through the Occupation period reforms, its capacity to import and export enhanced by the new international economic order, and its access to American technology bolstered through its security pact with the United States, Japan experienced the dramatic “Miracle Growth” between 1953 and the early 1970s whose sources have been cogently analyzed by Denison and Chung (1976). Especially striking in the Miracle Growth period was the remarkable increase in the rate of domestic fixed capital formation, the rise in the investment proportion being matched by a rising savings rate whose secular increase — especially that of private household savings – has been well documented and analyzed by Horioka (1991). While Japan continued to close the gap in income per capita between itself and the United States after the early 1970s, most scholars believe that large Japanese manufacturing enterprises had by and large become internationally competitive by the early 1970s. In this sense it can be said that Japan had completed its nine decade long convergence to international competitiveness through industrialization by the early 1970s.

MITI

There is little doubt that the social capacity to import and adapt foreign technology was vastly improved in the aftermath of the Pacific War. Creating social consensus with Land Reform and agricultural subsidies reduced political divisiveness, extending compulsory education and breaking up the zaibatsu had a positive impact. Fashioning the Ministry of International Trade and Industry (M.I.T.I.) that took responsibility for overseeing industrial policy is also viewed as facilitating Japan’s social capability. There is no doubt that M.I.T.I. drove down the cost of securing foreign technology. By intervening between Japanese firms and foreign companies, it acted as a single buyer of technology, playing off competing American and European enterprises in order to reduce the royalties Japanese concerns had to pay on technology licenses. By keeping domestic patent periods short, M.I.T.I. encouraged rapid diffusion of technology. And in some cases — the experience of International Business Machines (I.B.M.), enjoying a virtual monopoly in global mainframe computer markets during the 1950s and early 1960s, is a classical case — M.I.T.I. made it a condition of entry into the Japanese market (through the creation of a subsidiary Japan I.B.M. in the case of I.B.M.) that foreign companies share many of their technological secrets with potential Japanese competitors.

How important industrial policy was for Miracle Growth remains controversial, however. The view of Johnson (1982), who hails industrial policy as a pillar of the Japanese Development State (government promoting economic growth through state policies) has been criticized and revised by subsequent scholars. The book by Uriu (1996) is a case in point.

Internal labor markets, just-in-time inventory and quality control circles

Furthering the internalization of labor markets — the premium wages and long-term employment guarantees largely restricted to white collar workers were extended to blue collar workers with the legalization of unions and collective bargaining after 1945 — also raised the social capability of adapting foreign technology. Internalizing labor created a highly flexible labor force in post-1950 Japan. As a result, Japanese workers embraced many of the key ideas of Just-in-Time inventory control and Quality Control circles in assembly industries, learning how to do rapid machine setups as part and parcel of an effort to produce components “just-in-time” and without defect. Ironically, the concepts of just-in-time and quality control were originally developed in the United States, just-in-time methods being pioneered by supermarkets and quality control by efficiency experts like W. Edwards Deming. Yet it was in Japan that these concepts were relentlessly pursued to revolutionize assembly line industries during the 1950s and 1960s.

Ultimate causes of the Japanese economic “miracle”

Miracle Growth was the completion of a protracted historical process involving enhancing human capital, massive accumulation of physical capital including infrastructure and private manufacturing capacity, the importation and adaptation of foreign technology, and the creation of scale economies, which took decades and decades to realize. Dubbed a miracle, it is best seen as the reaping of a bountiful harvest whose seeds were painstakingly planted in the six decades between 1880 and 1938. In the course of the nine decades between the 1880s and 1970, Japan amassed and lost a sprawling empire, reorienting its trade and geopolitical stance through the twists and turns of history. While the ultimate sources of growth can be ferreted out through some form of statistical accounting, the specific way these sources were marshaled in practice is inseparable from the history of Japan itself and of the global environment within which it has realized its industrial destiny.

Appendix: Sources of Growth Accounting and Quantitative Aspects of Japan’s Modern Economic Development

One of the attractions of studying Japan’s post-1880 economic development is the abundance of quantitative data documenting Japan’s growth. Estimates of Japanese income and output by sector, capital stock and labor force extend back to the 1880s, a period when Japanese income per capita was low. Consequently statistical probing of Japan’s long-run growth from relative poverty to abundance is possible.

The remainder of this appendix is devoted to introducing the reader to the vast literature on quantitative analysis of Japan’s economic development from the 1880s until 1970, a nine decade period during which Japanese income per capita converged towards income per capita levels in Western Europe. As the reader will see, this discussion confirms the importance of factors discussed at the outset of this article.

Our initial touchstone is the excellent “sources of growth” accounting analysis carried out by Denison and Chung (1976) on Japan’s growth between 1953 and 1971. Attributing growth in national income in growth of inputs, the factors of production — capital and labor — and growth in output per unit of the two inputs combined (total factor productivity) along the following lines:

G(Y) = { a G(K) + [1-a] G(L) } + G (A)

where G(Y) is the (annual) growth of national output, g(K) is the growth rate of capital services, G(L) is the growth rate of labor services, a is capital’s share in national income (the share of income accruing to owners of capital), and G(A) is the growth of total factor productivity, is a standard approach used to approximate the sources of growth of income.

Using a variant of this type of decomposition that takes into account improvements in the quality of capital and labor, estimates of scale economies and adjustments for structural change (shifting labor out of agriculture helps explain why total factor productivity grows), Denison and Chung (1976) generate a useful set of estimates for Japan’s Miracle Growth era.

Operating with this “sources of growth” approach and proceeding under a variety of plausible assumptions, Denison and Chung (1976) estimate that of Japan’s average annual real national income growth of 8.77 % over 1953-71, input growth accounted for 3.95% (accounting for 45% of total growth) and growth in output per unit of input contributed 4.82% (accounting for 55% of total growth). To be sure, the precise assumptions and techniques they use can be criticized. The precise numerical results they arrive at can be argued over. Still, their general point — that Japan’s growth was the result of improvements in the quality of factor inputs — health and education for workers, for instance — and improvements in the way these inputs are utilized in production — due to technological and organizational change, reallocation of resources from agriculture to non-agriculture, and scale economies, is defensible.

With this in mind consider Table 1.

Table 1: Industrialization and Economic Growth in Japan, 1880-1970:
Selected Quantitative Characteristics

Panel A: Income and Structure of National Output

Real Income per Capita [a] Share of National Output (of Net Domestic Product) and Relative Labor Productivity (Ratio of Output per Worker in Agriculture to Output per Worker in the N Sector) [b]
Years Absolute Relative to U.S. level Year Agriculture Manufacturing & Mining

(Ma)

Manufacturing,

Construction & Facilitating Sectors [b]

Relative Labor Productivity

A/N

1881-90 893 26.7% 1887 42.5% 13.6% 20.0% 68.3
1891-1900 1,049 28.5 1904 37.8 17.4 25.8 44.3
1900-10 1,195 25.3 1911 35.5 20.3 31.1 37.6
1911-20 1,479 27.9 1919 29.9 26.2 38.3 32.5
1921-30 1,812 29.1 1930 20.0 25.8 43.3 27.4
1930-38 2,197 37.7 1938 18.5 35.3 51.7 20.8
1951-60 2,842 26.2 1953 22.0 26.3 39.7 22.6
1961-70 6,434 47.3 1969 8.7 30.5 45.9 19.1

Panel B: Domestic and External Sources of Aggregate Supply and Demand Growth: Manufacturing and Mining (Ma), Gross Domestic Fixed Capital Formation (GDFCF), and Trade (TR)

Percentage Contribution to Growth due to: Trade Openness and Trade Growth [c]
Years Ma to Output Growth GDFCF to Effective

Demand Growth

Years Openness Growth in Trade
1888-1900 19.3% 17.9% 1885-89 6.9% 11.4%
1900-10 29.2 30.5 1890-1913 16.4 8.0
1910-20 26.5 27.9 1919-29 32.4 4.6
1920-30 42.4 7.5 1930-38 43.3 8.1
1930-38 50.5 45.3 1954-59 19.3 12.0
1955-60 28.1 35.0 1960-69 18.5 10.3
1960-70 33.5 38.5

Panel C: Infrastructure and Human Development

Human Development Index (HDI) [d] Electricity Generation and National Broadcasting (NHK) per 100 Persons [e]
Year Educational Attainment Infant Mortality Rate (IMR) Overall HDI

Index

Year Electricity NHK Radio Subscribers
1900 0.57 155 0.57 1914 0.28 n.a.
1910 0.69 161 0.61 1920 0.68 n.a.
1920 0.71 166 0.64 1930 2.46 1.2
1930 0.73 124 0.65 1938 4.51 7.8
1950 0.81 63 0.69 1950 5.54 11.0
1960 0.87 34 0.75 1960 12.28 12.6
1970 0.95 14 0.83 1970 34.46 21.9

Notes: [a] Maddison (2000) provides estimates of real income that take into account the purchasing power of national currencies.

[b] Ohkawa (1979) gives estimates for the “N” sector that is defined as manufacturing and mining (Ma) plus construction plus facilitating industry (transport, communications and utilities). It should be noted that the concept of an “N” sector is not standard in the field of economics.

[c] The estimates of trade are obtained by adding merchandise imports to merchandise exports. Trade openness is estimated by taking the ratio of total (merchandise) trade to national output, the latter defined as Gross Domestic Product (G.D.P.). The trade figures include trade with Japan’s empire (Korea, Taiwan, Manchuria, etc.); the income figures for Japan exclude income generated in the empire.

[d] The Human Development Index is a composite variable formed by adding together indices for educational attainment, for health (using life expectancy that is inversely related to the level of the infant mortality rate, the IMR), and for real per capita income. For a detailed discussion of this index see United Nations Development Programme (2000).

[e] Electrical generation is measured in million kilowatts generated and supplied. For 1970, the figures on NHK subscribers are for television subscribers. The symbol n.a. = not available.

Sources: The figures in this table are taken from various pages and tables in Japan Statistical Association (1987), Maddison (2000), Minami (1994), and Ohkawa (1979).

Flowing from this table are a number of points that bear lessons of the Denison and Chung (1976) decomposition. One cluster of points bears upon the timing of Japan’s income per capita growth and the relationship of manufacturing expansion to income growth. Another highlights improvements in the quality of the labor input. Yet another points to the overriding importance of domestic investment in manufacturing and the lesser significance of trade demand. A fourth group suggests that infrastructure has been important to economic growth and industrial expansion in Japan, as exemplified by the figures on electricity generating capacity and the mass diffusion of communications in the form of radio and television broadcasting.

Several parts of Table 1 point to industrialization, defined as an increase in the proportion of output (and labor force) attributable to manufacturing and mining, as the driving force in explaining Japan’s income per capita growth. Notable in Panels A and B of the table is that the gap between Japanese and American income per capita closed most decisively during the 1910s, the 1930s, and the 1960s, precisely the periods when manufacturing expansion was the most vigorous.

Equally noteworthy of the spurts of the 1910s, 1930s and the 1960s is the overriding importance of gross domestic fixed capital formation, that is investment, for growth in demand. By contrast, trade seems much less important to growth in demand during these critical decades, a point emphasized by both Minami (1994) and by Ohkawa and Rosovsky (1973). The notion that Japanese growth was “export led” during the nine decades between 1880 and 1970 when Japan caught up technologically with the leading Western nations is not defensible. Rather, domestic capital investment seems to be the driving force behind aggregate demand expansion. The periods of especially intense capital formation were also the periods when manufacturing production soared. Capital formation in manufacturing, or in infrastructure supporting manufacturing expansion, is the main agent pushing long-run income per capita growth.

Why? As Ohkawa and Rosovsky (1973) argue, spurts in manufacturing capital formation were associated with the import and adaptation of foreign technology, especially from the United States These investment spurts were also associated with shifts of labor force out of agriculture and into manufacturing, construction and facilitating sectors where labor productivity was far higher than it was in labor-intensive farming centered around labor-intensive rice cultivation. The logic of productivity gain due to more efficient allocation of labor resources is apparent from the right hand column of Panel A in Table 1.

Finally, Panel C of Table 1 suggests that infrastructure investment that facilitated health and educational attainment (combined public and private expenditure on sanitation, schools and research laboratories), and public/private investment in physical infrastructure including dams and hydroelectric power grids helped fuel the expansion of manufacturing by improving human capital and by reducing the costs of transportation, communications and energy supply faced by private factories. Mosk (2001) argues that investments in human-capital-enhancing (medicine, public health and education), financial (banking) and physical infrastructure (harbors, roads, power grids, railroads and communications) laid the groundwork for industrial expansions. Indeed, the “social capability for importing and adapting foreign technology” emphasized by Ohkawa and Rosovsky (1973) can be largely explained by an infrastructure-driven growth hypothesis like that given by Mosk (2001).

In sum, Denison and Chung (1976) argue that a combination of input factor improvement and growth in output per combined factor inputs account for Japan’s most rapid spurt of economic growth. Table 1 suggests that labor quality improved because health was enhanced and educational attainment increased; that investment in manufacturing was important not only because it increased capital stock itself but also because it reduced dependence on agriculture and went hand in glove with improvements in knowledge; and that the social capacity to absorb and adapt Western technology that fueled improvements in knowledge was associated with infrastructure investment.

References

Denison, Edward and William Chung. “Economic Growth and Its Sources.” In Asia’s Next Giant: How the Japanese Economy Works, edited by Hugh Patrick and Henry Rosovsky, 63-151. Washington, DC: Brookings Institution, 1976.

Horioka, Charles Y. “Future Trends in Japan’s Savings Rate and the Implications Thereof for Japan’s External Imbalance.” Japan and the World Economy 3 (1991): 307-330.

Japan Statistical Association. Historical Statistics of Japan [Five Volumes]. Tokyo: Japan Statistical Association, 1987.

Johnson, Chalmers. MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975. Stanford: Stanford University Press, 1982.

Maddison, Angus. Monitoring the World Economy, 1820-1992. Paris: Organization for Economic Co-operation and Development, 2000.

Minami, Ryoshin. Economic Development of Japan: A Quantitative Study. [Second edition]. Houndmills, Basingstoke, Hampshire: Macmillan Press, 1994.

Mitchell, Brian. International Historical Statistics: Africa and Asia. New York: New York University Press, 1982.

Mosk, Carl. Japanese Industrial History: Technology, Urbanization, and Economic Growth. Armonk, New York: M.E. Sharpe, 2001.

Nakamura, Takafusa. The Postwar Japanese Economy: Its Development and Structure, 1937-1994. Tokyo: University of Tokyo Press, 1995.

Ohkawa, Kazushi. “Production Structure.” In Patterns of Japanese Economic Development: A Quantitative Appraisal, edited by Kazushi Ohkawa and Miyohei Shinohara with Larry Meissner, 34-58. New Haven: Yale University Press, 1979.

Ohkawa, Kazushi and Henry Rosovsky. Japanese Economic Growth: Trend Acceleration in the Twentieth Century. Stanford, CA: Stanford University Press, 1973.

Smith, Thomas. Native Sources of Japanese Industrialization, 1750-1920. Berkeley: University of California Press, 1988.

Uriu, Robert. Troubled Industries: Confronting Economic Challenge in Japan. Ithaca: Cornell University Press, 1996.

United Nations Development Programme. Human Development Report, 2000. New York: Oxford University Press, 2000.

Citation: Mosk, Carl. “Japan, Industrialization and Economic Growth”. EH.Net Encyclopedia, edited by Robert Whaples. January 18, 2004. URL http://eh.net/encyclopedia/japanese-industrialization-and-economic-growth/

Islamic Economics: What It Is and How It Developed

M. Umer Chapra, Islamic Research and Training Institute

Islamic economics has been having a revival over the last few decades. However, it is still in a preliminary stage of development. In contrast with this, conventional economics has become a well-developed and sophisticated discipline after going through a long and rigorous process of development over more than a century. Is a new discipline in economics needed? If so, what is Islamic economics, how does it differ from conventional economics, and what contributions has it made over the centuries? This article tries to briefly answer these questions.

It is universally recognized that resources are scarce compared with the claims on them. However, it is also simultaneously recognized by practically all civilizations that the well-being of all human beings needs to be ensured. Given the scarcity of resources, the well-being of all may remain an unrealized dream if the scarce resources are not utilized efficiently and equitably. For this purpose, every society needs to develop an effective strategy, which is consciously or unconsciously conditioned by its worldview. If the worldview is flawed, the strategy may not be able to help the society actualize the well-being of all. Prevailing worldviews may be classified for the sake of ease into two board theoretical constructs (1) secular and materialist, and (2) spiritual and humanitarian.

The Role of the Worldview

Secular and materialist worldviews attach maximum importance to the material aspect of human well-being and tend generally to ignore the importance of the spiritual aspect. They often argue that maximum material well-being can be best realized if individuals are given unhindered freedom to pursue their self-interest and to maximize their want satisfaction in keeping with their own tastes and preferences.[1] In their extreme form they do not recognize any role for Divine guidance in human life and place full trust in the ability of human beings to chalk out a proper strategy with the help of their reason. In such a worldview there is little role for values or government intervention in the efficient and equitable allocation and distribution of resources. When asked about how social interest would be served when everyone has unlimited freedom to pursue his/her self-interest, the reply is that market forces will themselves ensure this because competition will keep self-interest under check.

In contrast with this, religious worldviews give attention to both the material as well as the spiritual aspects of human well-being. They do not necessarily reject the role of reason in human development. They, however, recognize the limitations of reason and wish to complement it by revelation. They do not also reject the need for individual freedom or the role that the serving of self-interest can play in human development They, however, emphasize that both freedom and the pursuit of self-interest need to be toned down by moral values and good governance to ensure that everyone’s well-being is realized and that social harmony and family integrity are not hurt in the process of everyone serving his/her self-interest.

Material and Spiritual Needs

Even though none of the major worldviews prevailing around the world is totally materialist and hedonist, there are, nevertheless, significant differences among them in terms of the emphasis they place on material or spiritual goals and the role of moral values and government intervention in ordering human affairs. While material goals concentrate primarily on goods and services that contribute to physical comfort and well-being, spiritual goals include nearness to God, peace of mind, inner happiness, honesty, justice, mutual care and cooperation, family and social harmony, and the absence of crime and anomie. These may not be quantifiable, but are, nevertheless, crucial for realizing human well-being. Resources being limited, excessive emphasis on the material ingredients of well-being may lead to a neglect of spiritual ingredients. The greater the difference in emphasis, the greater may be the difference in the economic disciplines of these societies. Feyerabend (1993) frankly recognized this in the introduction to the Chinese edition of his thought-provoking book, Against Method, by stating that “First world science is only one science among many; by claiming to be more it ceases to be an instrument of research and turns into a (political) pressure group” (p.3, parentheses are in the original).

The Enlightenment Worldview and Conventional Economics

There is a great deal that is common between the worldviews of most major religions, particularly those of Judaism, Christianity and Islam. This is because, according to Islam, there is a continuity and similarity in the value systems of all Revealed religions to the extent to which the Message has not been lost or distorted over the ages. The Qur’an clearly states that: “Nothing has been said to you [Muhammad] that was not said to the Messengers before you” (Al-Qur’an, 41:43). If conventional economics had continued to develop in the image of the Judeo-Christian worldview, as it did before the Enlightenment Movement of the seventeenth and eighteenth centuries, there may not have been any significant difference between conventional and Islamic economics. However, after the Enlightenment Movement, all intellectual disciplines in Europe became influenced by its secular, value-neutral, materialist and social-Darwinist worldview, even though this did not succeed fully. All economists did not necessarily become materialist or social-Darwinist in their individual lives and many of them continued to be attached to their religious worldviews. Koopmans (1969) has rightly observed that “scratch an economist and you will find a moralist underneath.” Therefore, while theoretically conventional economics adopted the secular and value neutral orientation of the Enlightenment worldview and failed to recognize the role of value judgments and good governance in the efficient and equitable allocation and distribution of resources, in practice this did not take place fully. The pre-Enlightenment tradition never disappeared completely (see Baeck, 1994, p. 11).

There is no doubt that, in spite of its secular and materialist worldview, the market system led to a long period of prosperity in the Western market-oriented economies. However, this unprecedented prosperity did not lead to the elimination of poverty or the fulfillment of everyone’s needs in conformity with the Judeo-Christian value system even in the wealthiest countries. Inequalities of income and wealth have also continued to persist and there has also been a substantial degree of economic instability and unemployment which have added to the miseries of the poor. This indicates that both efficiency and equity have remained elusive in spite of rapid development and phenomenal rise in wealth.

Consequently there has been persistent criticism of economics by a number of well-meaning scholars, including Thomas Carlyle (Past and Present, 1843), John Ruskin (Unto this Last, 1862) and Charles Dickens (Hard Times, 1854-55) in England, and Henry George (Progress and Poverty, 1879) in America. They ridiculed the dominant doctrine of laissez-faire with its emphasis on self-interest. Thomas Carlyle called economics a “dismal science” and rejected the idea that free and uncontrolled private interests will work in harmony and further the public welfare (see Jay and Jay, 1986). Henry George condemned the resulting contrast between wealth and poverty and wrote: “So long as all the increased wealth which modern progress brings goes but to build great fortunes, to increase luxury and make sharper the contrast between the House of Have and the House of Want, progress is not real and cannot be permanent” (1955, p. 10).

In addition to failing to fulfill the basic needs of a large number of people and increasing inequalities of income and wealth, modern economic development has been associated with the disintegration of the family and a failure to bring peace of mind and inner happiness (Easterlin 2001, 1995 and 1974; Oswald, 1997; Blanchflower and Oswald, 2000; Diener and Oshi, 2000; and Kenny, 1999). Due to these problems and others the laissez-faire approach lost ground, particularly after the Great Depression of the 1930s as a result of the Keynesian revolution and the socialist onslaught. However, most observers have concluded that government intervention alone cannot by itself remove all socio-economic ills. It is also necessary to motivate individuals to do what is right and abstain from doing what is wrong. This is where the moral uplift of society can be helpful. Without it, more and more difficult and costly regulations are needed. Nobel-laureate Amartya Sen has, therefore, rightly argued that “the distancing of economics from ethics has impoverished welfare economics and also weakened the basis of a good deal of descriptive and predictive economics” and that economics “can be made more productive by paying greater and more explicit attention to ethical considerations that shaped human behaviour and judgment” (1987, pp. 78-79). Hausman and McPherson also conclude in their survey article “Economics and Contemporary Moral Philosophy” that “An economy that is engaged actively and self-critically with the moral aspects of its subject matter cannot help but be more interesting, more illuminating and, ultimately, more useful than the one that tries not to be” (1993, p. 723).

Islamic Economics – and How It Differs from Conventional Economics

While conventional economics is now in the process of returning to its pre-Enlightenment roots, Islamic economics never got entangled in a secular and materialist worldview. It is based on a religious worldview which strikes at the roots of secularism and value neutrality. To ensure the true well-being of all individuals, irrespective of their sex, age, race, religion or wealth, Islamic economics does not seek to abolish private property, as was done by communism, nor does it prevent individuals from serving their self-interest. It recognizes the role of the market in the efficient allocation of resources, but does not find competition to be sufficient to safeguard social interest. It tries to promote human brotherhood, socio-economic justice and the well-being of all through an integrated role of moral values, market mechanism, families, society, and ‘good governance.’ This is because of the great emphasis in Islam on human brotherhood and socio-economic justice.

The Integrated Role of the Market, Families, Society, and Government

The market is not the only institution where people interact in human society. They also interact in the family, the society and the government and their interaction in all these institutions is closely interrelated. There is no doubt that the serving of self-interest does help raise efficiency in the market place. However, if self-interest is overemphasized and there are no moral restraints on individual behavior, other institutions may not work effectively – families may disintegrate, the society may be uncaring, and the government may be corrupt, partisan, and self-centered. Mutual sacrifice is necessary for keeping the families glued together. Since the human being is the most important input of not only the market, but also of the family, the society and the government, and the family is the source of this input, nothing may work if families disintegrate and are unable to provide loving care to children. This is likely to happen if both the husband and wife try to serve just their own self-interest and are not attuned to the making of sacrifices that the proper care and upbringing of children demands. Lack of willingness to make such sacrifice can lead to a decline in the quality of the human input to all other institutions, including the market, the society and the government. It may also lead to a fall in fertility rates below the replacement level, making it difficult for society not only to sustain its development but also its social security system.

The Role of Moral Values

While conventional economics generally considers the behavior and tastes and preferences of individuals as given, Islamic economics does not do so. It places great emphasis on individual and social reform through moral uplift. This is the purpose for which all God’s messengers, including Abraham, Moses, Jesus, and Muhammad, came to this world. Moral uplift aims at the change in human behavior, tastes and preferences and, thereby, it complements the price mechanism in promoting general well-being. Before even entering the market place and being exposed to the price filter, consumers are expected to pass their claims through the moral filter. This will help filter out conspicuous consumption and all wasteful and unnecessary claims on resources. The price mechanism can then take over and reduce the claims on resources even further to lead to the market equilibrium. The two filters can together make it possible to have optimum economy in the use of resources, which is necessary to satisfy the material as well as spiritual needs of all human beings, to reduce the concentration of wealth in a few hands, and to raise savings, which are needed to promote greater investment and employment. Without complementing the market system with morally-based value judgments, we may end up perpetuating inequities in spite of our good intentions through what Solo calls inaction, non-choice and drifting (Solo, 1981, p. 38)

From the above discussion, one may easily notice the similarities and differences between the two disciplines. While the subject matter of both is the allocation and distribution of resources and both emphasize the fulfillment of material needs, there is an equal emphasis in Islamic economics on the fulfillment of spiritual needs. While both recognize the important role of market mechanism in the allocation and distribution of resources, Islamic economics argues that the market may not by itself be able to fulfill even the material needs of all human beings. This is because it can promote excessive use of scarce resources by the rich at the expense of the poor if there is undue emphasis on the serving of self-interest. Sacrifice is involved in fulfilling our obligations towards others and excessive emphasis on the serving of self-interest does not have the potential of motivating people to make the needed sacrifice. This, however, raises the crucial question of why a rational person would sacrifice his self-interest for the sake of others?

The Importance of the Hereafter

This is where the concepts of the innate goodness of human beings and of the Hereafter come in – concepts which conventional economics ignores but on which Islam and other major religions place a great deal of emphasis. Because of their innate goodness, human beings do not necessarily always try to serve their self-interest. They are also altruistic and are willing to make sacrifices for the well-being of others. In addition, the concept of the Hereafter does not confine self-interest to just this world. It rather extends it beyond this world to life after death. We may be able to serve our self-interest in this world by being selfish, dishonest, uncaring, and negligent of our obligations towards our families, other human beings, animals, and the environment. However, we cannot serve our self-interest in the Hereafter except by fulfilling all these obligations.

Thus, the serving of self-interest receives a long-run perspective in Islam and other religions by taking into account both this world and the next. This serves to provide a motivating mechanism for sacrifice for the well-being of others that conventional economics fails to provide. The innate goodness of human beings along with the long-run perspective given to self-interest has the potential of inducing a person to be not only efficient but also equitable and caring. Consequently, the three crucial concepts of conventional economics – rational economic man, positivism, and laissez-faire – were not able to gain intellectual blessing in their conventional economics sense from any of the outstanding scholars who represent the mainstream of Islamic thought.

Rational Economic Man

While there is hardly anyone opposed to the need for rationality in human behavior, there are differences of opinion in defining rationality (Sen, 1987, pp. 11-14). However, once rationality has been defined in terms of overall individual as well as social well-being, then rational behavior could only be that which helps us realize this goal. Conventional economics does not define rationality in this way. It equates rationality with the serving of self-interest through the maximization of wealth and want satisfaction, The drive of self-interest is considered to be the “moral equivalent of the force of gravity in nature” (Myers, 1983, p. 4). Within this framework society is conceptualized as a mere collection of individuals united through ties of self-interest.

The concept of ‘rational economic man’ in this social-Darwinist, utilitarian, and material sense of serving self–interest could not find a foothold in Islamic economics. ‘Rationality’ in Islamic economics does not get confined to the serving of one’s self-interest in this world alone; it also gets extended to the Hereafter through the faithful compliance with moral values that help rein self-interest to promote social interest. Al-Mawardi (d. 1058) considered it necessary, like all other Muslim scholars, to rein individual tastes and preferences through moral values (1955, pp. 118-20). Ibn Khaldun (d.1406) emphasized that moral orientation helps remove mutual rivalry and envy, strengthens social solidarity, and creates an inclination towards righteousness (n.d., p.158).

Positivism

Similarly, positivism in the conventional economics sense of being “entirely neutral between ends” (Robbins, 1935, p. 240) or “independent of any particular ethical position or normative judgment” (Friedman, 1953) did not find a place in Muslim intellectual thinking. Since all resources at the disposal of human beings are a trust from God, and human beings are accountable before Him, there is no other option but to use them in keeping with the terms of trust. These terms are defined by beliefs and moral values. Human brotherhood, one of the central objectives of Islam, would be a meaningless jargon if it were not reinforced by justice in the allocation and distribution of resources.

Pareto Optimum

Without justice, it would be difficult to realize even development. Muslim scholars have emphasized this throughout history. Development Economics has also started emphasizing its importance, more so in the last few decades.[2] Abu Yusuf (d. 798) argued that: “Rendering justice to those wronged and eradicating injustice, raises tax revenue, accelerates development of the country, and brings blessings in addition to reward in the Hereafter” (1933/34, p. 111: see also pp. 3-17). Al-Mawardi argued that comprehensive justice “inculcates mutual love and affection, obedience to the law, development of the country, expansion of wealth, growth of progeny, and security of the sovereign” (1955, p. 27). Ibn Taymiyyah (d. 1328) emphasized that “justice towards everything and everyone is an imperative for everyone, and injustice is prohibited to everything and everyone. Injustice is absolutely not permissible irrespective of whether it is to a Muslim or a non-Muslim or even to an unjust person” (1961-63, Vol. 18, p. 166).

Justice and the well-being of all may be difficult to realize without a sacrifice on the part of the well-to-do. The concept of Pareto optimum does not, therefore, fit into the paradigm of Islamic economics. This is because Pareto optimum does not recognize any solution as optimum if it requires a sacrifice on the part of a few (rich) for raising the well-being of the many (poor). Such a position is in clear conflict with moral values, the raison d’être of which is the well-being of all. Hence, this concept did not arise in Islamic economics. In fact, Islam makes it a religious obligation of Muslims to make a sacrifice for the poor and the needy, by paying Zakat at the rate of 2.5 percent of their net worth. This is in addition to the taxes that they pay to the governments as in other countries.

The Role of State

Moral values may not be effective if they are not observed by all. They need to be enforced. It is the duty of the state to restrain all socially harmful behavior[3] including injustice, fraud, cheating, transgression against other people’s person, honor and property, and the non-fulfillment of contracts and other obligations through proper upbringing, incentives and deterrents, appropriate regulations, and an effective and impartial judiciary. The Qur’an can only provide norms. It cannot by itself enforce them. The state has to ensure this. That is why the Prophet Muhammad said: “God restrains through the sovereign more than what He restrains through the Qur’an” (cited by al-Mawardi, 1955, p. 121). This emphasis on the role of the state has been reflected in the writings of all leading Muslim scholars throughout history.[4] Al-Mawardi emphasized that an effective government (Sultan Qahir) is indispensable for preventing injustice and wrongdoing (1960, p. 5). Say’s Law could not, therefore, become a meaningful proposition in Islamic economics.

How far is the state expected to go in the fulfillment of its role? What is it that the state is expected to do? This has been spelled out by a number of scholars in the literature on what has come to be termed as “Mirrors for Princes.”[5] None of them visualized regimentation or the owning and operating of a substantial part of the economy by the state. Several classical Muslim scholars, including al-Dimashqi (d. after 1175) and Ibn Khaldun, clearly expressed their disapproval of the state becoming directly involved in the economy (Al-Dimashqi, 1977, pp. 12 and 61; Ibn Khaldun, pp. 281-83). According to Ibn Khaldun, the state should not acquire the character of a monolithic or despotic state resorting to a high degree of regimentation (ibid., p. 188). It should not feel that, because it has authority, it can do anything it likes (ibid, p. 306). It should be welfare-oriented, moderate in its spending, respect the property rights of the people, and avoid onerous taxation (ibid, p. 296). This implies that what these scholars visualized as the role of government is what has now been generally referred to as ‘good governance’.

Some of the Contributions Made by Islamic Economics

The above discussion should not lead one to an impression that the two disciplines are entirely different. One of the reasons for this is that the subject matter of both disciplines is the same, allocation and distribution of scarce resources. Another reason is that all conventional economists have never been value neutral. They have made value judgments in conformity with their beliefs. As indicated earlier, even the paradigm of conventional economics has been changing – the role of good governance has now become well recognized and the injection of a moral dimension has also become emphasized by a number of prominent economists. Moreover, Islamic economists have benefited a great deal from the tools of analysis developed by neoclassical, Keynesian, social, humanistic and institutional economics as well as other social sciences, and will continue to do so in the future.

The Fallacy of the ‘Great Gap’ Theory

A number of economic concepts developed in Islamic economics long before they did in conventional economics. These cover a number of areas including interdisciplinary approach; property rights; division of labor and specialization; the importance of saving and investment for development; the role that both demand and supply play in the determination of prices and the factors that influence demand and supply; the roles of money, exchange, and the market mechanism; characteristics of money, counterfeiting, currency debasement, and Gresham’s law; the development of checks, letters of credit and banking; labor supply and population; the role of the state, justice, peace, and stability in development; and principles of taxation.I t is not possible to provide comprehensive coverage of all the contributions Muslim scholars have made to economics. Only some of their contributions will be highlighted below to remove the concept of the “Great Gap” of “over 500 years” that exists in the history of conventional economic thought as a result of the incorrect conclusion by Joseph Schumpeter in History of Economic Analysis (1954), that the intervening period between the Greeks and the Scholastics was sterile and unproductive.[6] This concept has become well embedded in the conventional economics literature as may be seen from the reference to this even by the Nobel-laureate, Douglass North, in his December 1993 Nobel lecture (1994, p. 365). Consequently, as Todd Lowry has rightly observed, “the character and sophistication of Arabian writings has been ignored” (See his ‘Foreword’ in Ghazanfar, 2003, p. xi).

The reality, however, is that the Muslim civilization, which benefited greatly from the Chinese, Indian, Sassanian and Byzantine civilizations, itself made rich contributions to intellectual activity, including socio-economic thought, during the ‘Great Gap’ period, and thereby played a part in kindling the flame of the European Enlightenment Movement. Even the Scholastics themselves were greatly influenced by the contributions made by Muslim scholars. The names of Ibn Sina (Avicenna, d. 1037), Ibn Rushd (Averroes, d. 1198) and Maimonides (d. 1204, a Jewish philosopher, scientist, and physician who flourished in Muslim Spain) appear on almost every page of the thirteenth-century summa (treatises written by scholastic philosophers) (Pifer, 1978, p. 356).

Multidisciplinary Approach for Development

One of the most important contributions of Islamic economics, in addition to the above paradigm discussion, was the adoption of a multidisciplinary dynamic approach. Muslim scholars did not focus their attention primarily on economic variables. They considered overall human well-being to be the end product of interaction over a long period of time between a number of economic, moral, social, political, demographic and historical factors in such a way that none of them is able to make an optimum contribution without the support of the others. Justice occupied a pivotal place in this whole framework because of its crucial importance in the Islamic worldview There was an acute realization that justice is indispensable for development and that, in the absence of justice, there will be decline and disintegration.

The contributions made by different scholars over the centuries seem to have reached their consummation in Ibn Khaldun’s Maquddimah, which literally means ‘introduction,’ and constitutes the first volume of a seven-volume history, briefly called Kitab al-‘Ibar or the Book of Lessons [of History].[7] Ibn Khaldun lived at a time (1332-1406) when the Muslim civilization was in the process of decline. He wished to see a reversal of this tide, and, as a social scientist, he was well aware that such a reversal could not be envisaged without first drawing lessons (‘ibar) from history to determine the factors that had led the Muslim civilization to bloom out of humble beginnings and to decline thereafter. He was, therefore, not interested in knowing just what happened. He wanted to know the how and why of what happened. He wanted to introduce a cause and effect relationship into the discussion of historical phenomena. The Muqaddimah is the result of this desire. It tries to derive the principles that govern the rise and fall of a ruling dynasty, state (dawlah) or civilization (‘umran).

Since the centre of Ibn Khaldun’s analysis is the human being, he sees the rise and fall of dynasties or civilizations to be closely dependent on the well-being or misery of the people. The well-being of the people is in turn not dependent just on economic variables, as conventional economics has emphasized until recently, but also on the closely interrelated role of moral, psychological, social, economic, political, demographic and historical factors. One of these factors acts as the trigger mechanism. The others may, or may not, react in the same way. If the others do not react in the same direction, then the decay in one sector may not spread to the others and either the decaying sector may be reformed or the decline of the civilization may be much slower. If, however, the other sectors react in the same direction as the trigger mechanism, the decay will gain momentum through an interrelated chain reaction such that it becomes difficult over time to identify the cause from the effect. He, thus, seems to have had a clear vision of how all the different factors operate in an interrelated and dynamic manner over a long period to promote the development or decline of a society.

He did not, thus, adopt the neoclassical economist’s simplification of confining himself to primarily short-term static analysis of only markets by assuming unrealistically that all other factors remain constant. Even in the short-run, everything may be in a state of flux through a chain reaction to the various changes constantly taking place in human society, even though these may be so small as to be imperceptible. Therefore, even though economists may adopt the ceteris paribus assumption for ease of analysis, Ibn Khaldun’s multidisciplinary dynamics can be more helpful in formulating socio-economic policies that help improve the overall performance of a society. Neoclassical economics is unable to do this because, as North has rightly asked, “How can one prescribe policies when one does not understand how economies develop?” He, therefore, considers neoclassical economics to be “an inappropriate tool to analyze and prescribe policies that will induce development” (North, 1994, p. 549).

However, this is not all that Islamic economics has done. Muslim scholars, including Abu Yusuf (d. 798), al-Mawardi (d. 1058), Ibn Hazm (d. 1064), al-Sarakhsi (d. 1090), al-Tusi (d. 1093), al-Ghazali (d. 1111), al-Dimashqi (d. after 1175), Ibn Rushd (d. 1187), Ibn Taymiyyah (d.1328), Ibn al-Ukhuwwah (d. 1329), Ibn al-Qayyim (d. 1350), al-Shatibi (d. 1388), Ibn Khaldun (d. 1406), al-Maqrizi (d. 1442), al-Dawwani (d. 1501), and Shah Waliyullah (d. 1762) made a number of valuable contributions to economic theory. Their insight into some economic concepts was so deep that a number of the theories propounded by them could undoubtedly be considered the forerunners of some more sophisticated modern formulations of these theories.[8]

Division of Labor, Specialization, Trade, Exchange and Money and Banking

A number of scholars emphasized the necessity of division of labor for economic development long before this happened in conventional economics. For example, al-Sarakhsi (d. 1090) said: “the farmer needs the work of the weaver to get clothing for himself, and the weaver needs the work of the farmer to get his food and the cotton from which the cloth is made …, and thus everyone of them helps the other by his work…” (1978, Vol. 30, p. 264). Al-Dimashqi, writing about a century later, elaborates further by saying: “No individual can, because of the shortness of his life span, burden himself with all industries. If he does, he may not be able to master the skills of all of them from the first to the last. Industries are all interdependent. Construction needs the carpenter and the carpenter needs the ironsmith and the ironsmith needs the miner, and all these industries need premises. People are, therefore, necessitated by force of circumstances to be clustered in cities to help each other in fulfilling their mutual needs” (1977, p. 20-21).

Ibn Khaldun ruled out the feasibility or desirability of self-sufficiency, and emphasized the need for division of labor and specialization by indicating that: “It is well-known and well-established that individual human beings are not by themselves capable of satisfying all their individual economic needs. They must all cooperate for this purpose. The needs that can be satisfied by a group of them through mutual cooperation are many times greater than what individuals are capable of satisfying by themselves” (p. 360). In this respect he was perhaps the forerunner of the theory of comparative advantage, the credit for which is generally given in conventional economics to David Ricardo who formulated it in 1817.

The discussion of division of labor and specialization, in turn, led to an emphasis on trade and exchange, the existence of well-regulated and properly functioning markets through their effective regulation and supervision (hisbah), and money as a stable and reliable measure, medium of exchange and store of value. However, because of bimetallism (gold and silver coins circulating together) which then prevailed, and the different supply and demand conditions that the two metals faced, the rate of exchange between the two full-bodied coins fluctuated. This was further complicated by debasement of currencies by governments in the later centuries to tide over their fiscal problems. This had, according to Ibn Taymiyyah (d. 1328) (1961-63, Vol. 29, p. 649), and later on al-Maqrizi (d. 1442) and al-Asadi (d. 1450), the effect of bad coins driving good coins out of circulation (al-Misri, 1981, pp. 54 and 66), a phenomenon which was recognized and referred to in the West in the sixteenth century as Gresham’s Law. Since debasement of currencies is in sheer violation of the Islamic emphasis on honesty and integrity in all measures of value, fraudulent practices in the issue of coins in the fourteenth century and afterwards elicited a great deal of literature on monetary theory and policy. The Muslims, according to Baeck, should, therefore, be considered forerunners and critical incubators of the debasement literature of the fourteenth and fifteenth centuries (Baeck, 1994, p. 114).

To finance their expanding domestic and international trade, the Muslim world also developed a financial system, which was able to mobilize the “entire reservoir of monetary resources of the mediaeval Islamic world” for financing agriculture, crafts, manufacturing and long-distance trade (Udovitch, 1970, pp. 180 and 261). Financiers were known as sarrafs. By the time of Abbasid Caliph al-Muqtadir (908-32), they had started performing most of the basic functions of modern banks (Fischel, 1992). They had their markets, something akin to the Wall Street in New York and Lombard Street in London, and fulfilled all the banking needs of commerce, agriculture and industry (Duri, 1986, p. 898). This promoted the use of checks (sakk) and letters of credit (hawala). The English word check comes from the Arabic term sakk.

Demand and Supply

A number of Muslim scholars seem to have clearly understood the role of both demand and supply in the determination of prices. For example, Ibn Taymiyyah (d. 1328) wrote: “The rise or fall of prices may not necessarily be due to injustice by some people. They may also be due to the shortage of output or the import of commodities in demand. If the demand for a commodity increases and the supply of what is demanded declines, the price rises. If, however, the demand falls and the supply increases, the price falls” (1961-3, Vol. 8, p. 523).

Even before Ibn Taymiyyah, al-Jahiz (d. 869) wrote nearly five centuries earlier that: “Anything available in the market is cheap because of its availability [supply] and dear by its lack of availability if there is need [demand] for it” (1983, p. 13), and that “anything the supply of which increases, becomes cheap except intelligence, which becomes dearer when it increases” (ibid., p. 13).

Ibn Khaldun went even further by emphasizing that both an increase in demand or a fall in supply leads to a rise in prices, while a decline in demand or a rise in supply contributes to a fall in prices (pp. 393 and 396). He believed that while continuation of ‘excessively low’ prices hurts the craftsmen and traders and drives them out of the market, the continuation of ‘excessively high’ prices hurts the consumers. ‘Moderate’ prices in between the two extremes were, therefore, desirable, because they would not only allow the traders a socially-acceptable level of return but also lead to the clearance of the markets by promoting sales and thereby generating a given turnover and prosperity (ibid, p. 398). Nevertheless, low prices were desirable for necessities because they provide relief to the poor who constitute the majority of the population (ibid, p. 398). If one were to use modem terminology, one could say that Ibn Khaldun found a stable price level with a relatively low cost of living to be preferable, from the point of view of both growth and equity in comparison with bouts of inflation and deflation. The former hurts equity while the latter reduces incentive and efficiency. Low prices for necessities should not, however, be attained through the fixing of prices by the state; this destroys the incentive for production (ibid, pp. 279-83).

The factors which determined demand were, according to Ibn Khaldun, income, price level, the size of the population, government spending, the habits and customs of the people, and the general development and prosperity of the society (ibid, pp.398-404). The factors which determined supply were demand (ibid, pp. 400 and 403), order and stability (pp. 306-08), the relative rate of profit (ibid, pp. 395 and 398), the extent of human effort (p. 381), the size of the labor force as well as their knowledge and skill (pp. 363 and 399-400), peace and security (pp. 394-95 and 396), and the technical background and development of the whole society (pp. 399-403). All these constituted important elements of his theory of production. If the price falls and leads to a loss, capital is eroded, the incentive to supply declines, leading to a recession. Trade and crafts also consequently suffer (p. 398).

This is highly significant because the role of both demand and supply in the determination of value was not well understood in the West until the late nineteenth and the early twentieth centuries. Pre-classical English economists like William Petty (1623-87), Richard Cantillon (1680-1734), James Steuart (1712-80), and even Adam Smith (1723-90), the founder of the Classical School, generally stressed only the role of the cost of production, and particularly of labor, in the determination of value. The first use in English writings of the notions of both demand and supply was perhaps in 1767 (Thweatt, 1983). Nevertheless, it was not until the second decade of the nineteenth century that the role of both demand and supply in the determination of market prices began to be fully appreciated (Groenewegen, 1973). While Ibn Khaldun had been way ahead of conventional economists, he probably did not have any idea of demand and supply schedules, elasticities of demand and supply and most important of all, equilibrium price, which plays a crucial role in modern economic discussions.

Public Finance

Taxation

Long before Adam Smith (d. 1790), who is famous, among other things, for his canons of taxation (equality, certainty, convenience of payment, and economy in collection) (see Smith, 1937, pp. 777-79), the development of these canons can be traced in the writings of pre-Islamic as well as Muslim scholars, particularly the need for the tax system to be just and not oppressive. Caliphs Umar (d. 644), Ali (d. 661) and Umar ibn Abd al-Aziz (d. 720), stressed that taxes should be collected with justice and leniency and should not be beyond the ability of the people to bear. Tax collectors should not under any circumstances deprive the people of the necessities of life (Abu Yusuf, 1933/34, pp. 14, 16 and 86). Abu Yusuf, adviser to Caliph Harun al-Rashid (786-809), argued that a just tax system would lead not only to an increase in revenues but also to the development of the country (Abu Yusuf, 1933/34, p. 111; see also pp. 14, 16, 60, 85, 105-19 and 125). Al-Mawardi also argued that the tax system should do justice to both the taxpayer and the treasury – “taking more was iniquitous with respect to the rights of the people, while taking less was unfair with respect to the right of the public treasury” (1960, p. 209; see also pp. 142-56 and 215).[9]

Ibn Khaldun stressed the principles of taxation very forcefully in the Muqaddimah. He quoted from a letter written by Tahir ibn al-Husayn, Caliph al-Ma’mun’s general, advising his son, ‘Abdullah ibn Tahir, Governor of al-Raqqah (Syria): “So distribute [taxes] among all people making them general, not exempting anyone because of his nobility or wealth and not exempting even your own officials or courtiers or followers. And do not levy on anyone a tax which is beyond his capacity to pay” (p. 308).[10] In this particular passage, he stressed the principles of equity and neutrality, while in other places he also stressed the principles of convenience and productivity.

The effect of taxation on incentives and productivity was so clearly visualized by Ibn Khaldun that he seems to have grasped the concept of optimum taxation. He anticipated the gist of the Laffer Curve, nearly six hundred years before Arthur Laffer, in two full chapters of the Muqaddimah.[11] At the end of the first chapter, he concluded that “the most important factor making for business prosperity is to lighten as much as possible the burden of taxation on businessmen, in order to encourage enterprise by ensuring greater profits [after taxes]” (p. 280). This he explained by stating that “when taxes and imposts are light, the people have the incentive to be more active. Business therefore expands, bringing greater satisfaction to the people because of low taxes …, and tax revenues also rise, being the sum total of all assessments” (p. 279). He went on to say that as time passes the needs of the state increase and rates of taxation rise to increase the yield. If this rise is gradual people become accustomed to it, but ultimately there is an adverse impact on incentives. Business activity is discouraged and declines, and so does the yield of taxation (pp. 280-81). A prosperous economy at the beginning of the dynasty, thus, yields higher tax revenue from lower tax rates while a depressed economy at the end of the dynasty, yields smaller tax revenue from higher rates (p. 279). He explained the reasons for this by stating: “Know that acting unjustly with respect to people’s wealth, reduces their will to earn and acquire wealth … and if the will to earn goes, they stop working. The greater the oppression, the greater the effect on their effort to earn … and, if people abstain from earning and stop working, the markets will stagnate and the condition of people will worsen” (pp. 286-87); tax revenues will also decline (p. 362). He, therefore, advocated justice in taxation (p. 308).

Public Expenditure

For Ibn Khaldun the state was also an important factor of production. By its spending it promotes production and by its taxation it discourages production (pp. 279-81). Since the government constitutes the greatest market for goods and services, and is a major source of all development (pp. 286 and 403), a decrease in its spending leads to not only a slackening of business activity and a decline in profits but also a decline in tax revenue (p. 286). The more the government spends, the better it may be for the economy (p. 286).[12] Higher spending enables the government to do the things that are needed to support the population and to ensure law and order and political stability (pp. 306 and 308). Without order and political stability, the producers have no incentive to produce. He stated that “the only reason [for the accelerated development of cities] is that the government is near them and pours its money into them, like the water [of a river] that makes green everything around it, and irrigates the soil adjacent to it, while in the distance everything remains dry” (p. 369).

Ibn Khaldun also analyzed the effect of government expenditure on the economy and is, in this respect, a forerunner of Keynes. He stated: “A decrease in government spending leads to a decline in tax revenues. The reason for this is that the state represents the greatest market for the world and the source of civilization. If the ruler hoards tax revenues, or if these are lost, and he does not spend them as they should be, the amount available with his courtiers and supporters would decrease, as would also the amount that reaches through them to their employees and dependents [the multiplier effect]. Their total spending would, therefore, decline. Since they constitute a significant part of the population and their spending constitutes a substantial part of the market, business will slacken and the profits of businessmen will decline, leading also to a decline in tax revenues … Wealth tends to circulate between the people and the ruler, from him to them and from them to him. Therefore, if the ruler withholds it from spending, the people would become deprived of it” (p. 286).

Economic Mismanagement and Famine

Ibn Khaldun established the causal link between bad government and high grain prices by indicating that in the later stage of the dynasty, when public administration becomes corrupt and inefficient, and resorts to coercion and oppressive taxation, incentive is adversely affected and the farmers refrain from cultivating the land. Grain production and reserves fail to keep pace with the rising population. The absence of reserves causes supply shortages in the event of a famine and leads to price escalation (pp. 301-02).

Al-Maqrizi (d. 1442) who, as muhtasib (market supervisor), had intimate knowledge of the economic conditions during his times, applied Ibn Khaldun’s analysis in his book (1956) to determine the reasons for the economic crisis of Egypt during the period 1403-06. He identified that the political administration had become very weak and corrupt during the Circassian period. Public officials were appointed on the basis of bribery rather than ability.[13] To recover the bribes, officials resorted to oppressive taxation. The incentive to work and produce was adversely affected and output declined. The crisis was further intensified by debasement of the currency through the excessive issue of copper fulus, or fiat money, to cover state budgetary deficits. All these factors joined hands with the famine to lead to a high degree of inflation, misery of the poor, and impoverishment of the country.

Hence, al-Maqrizi laid bare the socio-political determinants of the prevailing ‘system crisis’ by taking into account a number of variables like corruption, bad government policies, and weak administration. All of these together played a role in worsening the impact of the famine, which could otherwise have been handled effectively without a significant adverse impact on the population. This is clearly a forerunner of Sen’s entitlement theory, which holds the economic mismanagement of illegitimate governments to be responsible for the poor people’s misery during famines and other natural disasters (Sen, 1981). What al-Maqrizi wrote of the Circassian Mamluks was also true of the later Ottoman period (See Meyer, 1989).

Stages of Development

Ibn Khaldun stated the stages of development through which every society passes, moving from the primitive Bedouin stage to the rise of village, towns and urban centers with an effective government, development of agriculture, industry and sciences, and the impact of values and environment on this development ( Muqaddimah, pp. 35, 41-44, 87-95, 120-48, 172-76). Walliyullah[14] (d. 1762) later analyzed the development of society through four different stages from primitive existence to a well-developed community with khilafah (morally-based welfare state), which tries to ensure the spiritual as well as material well-being of the people. Like Ibn Khaldun, he considered political authority to be indispensable for human well-being. To be able to serve as a source of well-being for all and not of burden and decay, it must have the characteristics of the khilafah. He applied this analysis in various writings to the conditions prevailing during his life-time. He found that the luxurious life style of the rulers, along with their exhausting military campaigns, the increasing corruption and inefficiency of the civil service, and huge stipends to a vast retinue of unproductive courtiers, led them to the imposition of oppressive taxes on farmers, traders and craftsmen, who constituted the main productive section of the population. These people had, therefore, lost interest in their occupations, output had slowed down, state financial resources had declined, and the country had become impoverished (Waliyullah, 1992, Vol. I, pp. 119-52). Thus, in step with Ibn Khaldun and other Muslim scholars, al-Maqrizi and Waliyullah combined moral, political, social and economic factors to explain the economic phenomena of their times and the rise and fall of their societies.

Muslim Intellectual Decline

Unfortunately, the rich theoretical contribution made by Muslim scholars up until Ibn Khaldun did not get fertilized and irrigated by later scholars to lead to the development of Islamic economics, except by a few isolated scholars like al-Maqrizi, al-Dawwani (d. 1501), and Waliyullah. Their contributions were, however, only in specific areas and did not lead to a further development of Ibn Khaldun’s model of socio-economic and political dynamics. Islamic economics did not, therefore, develop as a separate intellectual discipline in conformity with the Islamic paradigm along the theoretical foundations and method laid down by Ibn Khaldun and his predecessors. It continued to remain an integral part of the social and moral philosophy of Islam.

One may ask here why the rich intellectual contributions made by Muslim scholars did not continue after Ibn Khaldun. The reason may be that, as indicated earlier, Ibn Khaldun lived at a time when the political and socio-economic decline of the Muslim world was underway.[15] He was perhaps “the sole point of light in his quarter of the firmament” (Toynbee, 1935, Vol. 3, p. 321). According to Ibn Khaldun himself, sciences progress only when a society is itself progressing (p. 434). This theory is clearly upheld by Muslim history. Sciences progressed rapidly in the Muslim world for four centuries from the middle of the eighth century to the middle of the twelfth century and continued to do so at a substantially decelerated pace for at least two more centuries, tapering off gradually thereafter (Sarton 1927, Vol. 1 and Book 1 of Vol. 2). Once in a while there did appear a brilliant star on an otherwise unexciting firmament. Economics was no exception. It also continued to be in a state of limbo in the Muslim world. No worthwhile contributions were made after Ibn Khaldun.

The trigger mechanism for this decline was, according to Ibn Khaldun, the failure of political authority to provide good governance. Political illegitimacy, which started after the end of khilafah in 661 gradually led to increased corruption and the use of state resources for private benefit at the neglect of education and other nation-building functions of the state. This gradually triggered the decline of all other sectors of the society and economy.[16]

The rapidly rising Western civilization took over the torch of knowledge from the declining Muslim world and has kept it burning with even greater brightness. All sciences, including the social sciences, have made phenomenal progress. Conventional economics became a separate academic discipline after the publication of Alfred Marshall’s great treatise, Principles of Economics, in 1890 (Schumpeter, 1954, p.21),[17] and has continued to develop since then at a remarkable speed. With such a great achievement to its credit, there is no psychological need to allow the ‘Great Gap’ thesis to persist. It would help promote better understanding of Muslim civilization in the West if textbooks started giving credit to Muslim scholars. They were “the torchbearers of ancient learning during the medieval period” and “it was from them that the Renaissance was sparked and the Enlightenment kindled” (Todd Lowry in his ‘Foreword’ in Ghazanfar, 2003, p. xi). Watt has been frank enough to admit that, “the influence of Islam on Western Christendom is greater than is usually realized” and that, “an important task for Western Europeans, as we move into the era of the one world, is … to acknowledge fully our debt to the Arab and Islamic world” (Watt, 1972, p. 84).

Conventional economics, however, took a wrong turn after the Enlightenment Movement by stripping itself of the moral basis of society emphasized by Aristotelian and Judeo-Christian philosophies. This deprived it of the role that moral values and good governance can play in helping society raise both efficiency and equity in the allocation and distribution of scarce resources needed for promoting the well-being of all. However, this has been changing. The role of good governance has already been recognized and that of moral values is gradually penetrating the economics orthodoxy. Islamic economics is also reviving now after the independence of Muslim countries from foreign domination. It is likely that the two disciplines will converge and become one after a period of time. This will be in keeping with the teachings of the Qur’an, which clearly states that mankind was created as one but became divided as a result of their differences and transgression against each other (10:19, 2:213 and 3: 19). This reunification [globalization, as it is new called], if reinforced by justice and mutual care, should help promote peaceful coexistence and enable mankind to realize the well-being of all, a goal the realization of which we are all anxiously looking forward to.

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[1] This is the liberal version of the secular and materialist worldviews. There is also the totalitarian version which does not have faith in the individuals’ ability to manage private property in a way that would ensure social well-being. Hence its prescription is to curb individual freedom and to transfer all means of production and decision making to a totalitarian state. Since this form of the secular and materialist worldview failed to realize human well-being and has been overthrown practically everywhere, it is not discussed in this paper.

[2] The literature on economic development is full of assertions that improvement in income distribution is in direct conflict with economic growth. For a summary of these views, see Cline, 1973, Chapter 2. This has, however, changed and there is hardly any development economist now who argues that injustice can help promote development.

[3] North has used the term ‘nasty’ for all such behavior. See the chapter “Ideology and Free Rider,” in North, 1981.

[4] Some of these scholars include Abu Yusuf (d. 798), al-Mawardi (d. 1058), Abu Ya’la (d. 1065), Nazam al-Mulk (d.1092), al-Ghazali (d. 1111), Ibn Taymiyyah (d. 1328), Ibn Khaldun (d. 1406), Shah Walliyullah (d. 1762), Jamaluddin al-Afghani (d. 1897), Muhammad ‘Abduh (d. 1905), Muhammad Iqbal (d. 1938), Hasan al-Banna (d. 1949), Sayyid Mawdudi (d. 1979), and Baqir al-Sadr (d. 1980).

[5] Some of these authors include al-Katib (d. 749), Ibn al-Muqaffa (d. 756) al-Nu‘man (d. 974), al-Mawardi (d. 1058), Kai Ka’us (d. 1082), Nizam al-Mulk (d. 1092), al-Ghazali (d. 1111), al-Turtushi (d. 1127). (For details, see Essid, 1995, pp.19-41.)

[6] For the fallacy of the Great Gap thesis, see Mirakhor (1987) and Ghazanfar (2003), particularly the “Foreword” by Todd Lowry and the “Introduction” by Ghazanfar.

[7] The full name of the book (given in the bibliography) may be freely translated as “The Book of Lessons and the Record of Cause and Effect in the History of Arabs, Persians and Berbers and their Powerful Contemporaries.” Several different editions of the Muqaddimah are now available in Arabic. The one I have used is that published in Cairo by al-Maktabah al-Tijarriyah al-Kubra without any indication of the year of publication. It has the advantage of showing all vowel marks, which makes the reading relatively easier. The Muqaddimah was translated into English in three volumes by Franz Rosenthal. Its first edition was published in 1958 and the second edition in 1967. Selections from the Muqaddimah by Charles Issawi were published in 1950 under the title, An Arab Philosophy of History: Selections from the Prolegomena of Ibn Khaldun of Tunis (1332-1406).

A considerable volume of literature is now available on Ibn Khaldun. This includes Spengler, 1964; Boulakia, 1971; Mirakhor, 1987; and Chapra, 2000.

[8] For some of these contributions, see Spengler, 1964; DeSmogyi, 1965; Mirakhor, 1987; Siddiqi, 1992; Essid, 1995; Islahi, 1996; Chapra, 2000; and Ghazanfar, 2003.

[9] For a more detailed discussion of taxation by various Muslim scholars, see the section on “Literature on Mirrors for Princes” in Essid, 1995, pp. 19-41.

[10] This letter is a significant development over the letter of Abu Yusuf to Caliph Harun al-Rashid (1933/34, pp. 3-17). It is more comprehensive and covers a larger number of topics.

[11] These are “On tax revenues and the reason for their being low and high” (pp. 279-80) and “Injustice ruins development” (pp. 286-410).

[12] Bear in mind the fact that this was stated at the time when commodity money, which it is not possible for the government to ‘create,’ was used, and fiduciary money, had not become the rule of the day.

[13] This was during the Slave (Mamluk) Dynasty in Egypt, which is divided into two periods. The first period was that of the Bahri (or Turkish) Mamluks (1250-1382), who have generally received praise in the chronicles of their contemporaries. The second period was that of the Burji Mamluks (Circassians, 1382-1517). This period was beset by a series of severe economic crises. (For details see Allouche, 1994.)

[14] Shah Walliyullah al-Dihlawi, popularly known as Walliyullah, was born in 1703, four years before the death of the Mughal Emperor, Aurangzeb (1658-1707). Aurangzeb’s rule, spanning a period of forty-nine years, was followed by a great deal of political instability – ten different changes in rulers during Walliyullah’s life-span of 59 years – leading ultimately to the weakening and decline of the Mughal Empire.

[15] For a brief account of the general decline and disintegration of the Muslim world during the fourteenth century, see Muhsin Mahdi, 1964, pp. 17-26.

[16] For a discussion of the causes of Muslim decline, see Chapra, 2000, pp. 173-252.

[17] According to Blaug (1985), economics became an academic discipline in the 1880s (p. 3).

Citation: Chapra, M. “Islamic Economics: What It Is and How It Developed”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/islamic-economics-what-it-is-and-how-it-developed/

Gold Standard

Lawrence H. Officer, University of Illinois at Chicago

The gold standard is the most famous monetary system that ever existed. The periods in which the gold standard flourished, the groupings of countries under the gold standard, and the dates during which individual countries adhered to this standard are delineated in the first section. Then characteristics of the gold standard (what elements make for a gold standard), the various types of the standard (domestic versus international, coin versus other, legal versus effective), and implications for the money supply of a country on the standard are outlined. The longest section is devoted to the “classical” gold standard, the predominant monetary system that ended in 1914 (when World War I began), followed by a section on the “interwar” gold standard, which operated between the two World Wars (the 1920s and 1930s).

Countries and Dates on the Gold Standard

Countries on the gold standard and the periods (or beginning and ending dates) during which they were on gold are listed in Tables 1 and 2 for the classical and interwar gold standards. Types of gold standard, ambiguities of dates, and individual-country cases are considered in later sections. The country groupings reflect the importance of countries to establishment and maintenance of the standard. Center countries — Britain in the classical standard, the United Kingdom (Britain’s legal name since 1922) and the United States in the interwar period — were indispensable to the spread and functioning of the gold standard. Along with the other core countries — France and Germany, and the United States in the classical period — they attracted other countries to adopt the gold standard, in particular, British colonies and dominions, Western European countries, and Scandinavia. Other countries — and, for some purposes, also British colonies and dominions — were in the periphery: acted on, rather than actors, in the gold-standard eras, and generally not as committed to the gold standard.

Table 1Countries on Classical Gold Standard
Country Type of Gold Standard Period
Center Country
Britaina Coin 1774-1797b, 1821-1914
Other Core Countries
United Statesc Coin 1879-1917d
Francee Coin 1878-1914
Germany Coin 1871-1914
British Colonies and Dominions
Australia Coin 1852-1915
Canadaf Coin 1854-1914
Ceylon Coin 1901-1914
Indiag Exchange (British pound) 1898-1914
Western Europe
Austria-Hungaryh Coin 1892-1914
Belgiumi Coin 1878-1914
Italy Coin 1884-1894
Liechtenstein Coin 1898-1914
Netherlandsj Coin 1875-1914
Portugalk Coin 1854-1891
Switzerland Coin 1878-1914
Scandinavia
Denmarkl Coin 1872-1914
Finland Coin 1877-1914
Norway Coin 1875-1914
Sweden Coin 1873-1914
Eastern Europe
Bulgaria Coin 1906-1914
Greece Coin 1885, 1910-1914
Montenegro Coin 1911-1914
Romania Coin 1890-1914
Russia Coin 1897-1914
Middle East
Egypt Coin 1885-1914
Turkey (Ottoman Empire) Coin 1881m-1914
Asia
Japann Coin 1897-1917
Philippines Exchange (U.S. dollar) 1903-1914
Siam Exchange (British pound) 1908-1914
Straits Settlementso Exchange (British pound) 1906-1914
Mexico and Central America
Costa Rica Coin 1896-1914
Mexico Coin 1905-1913
South America
Argentina Coin 1867-1876, 1883-1885, 1900-1914
Bolivia Coin 1908-1914
Brazil Coin 1888-1889, 1906-1914
Chile Coin 1895-1898
Ecuador Coin 1898-1914
Peru Coin 1901-1914
Uruguay Coin 1876-1914
Africa
Eritrea Exchange (Italian lira) 1890-1914
German East Africa Exchange (German mark) 1885p-1914
Italian Somaliland Exchange (Italian lira) 1889p-1914

a Including colonies (except British Honduras) and possessions without a national currency: New Zealand and certain other Oceanic colonies, South Africa, Guernsey, Jersey, Malta, Gibraltar, Cyprus, Bermuda, British West Indies, British Guiana, British Somaliland, Falkland Islands, other South and West African colonies.
b Or perhaps 1798.
c Including countries and territories with U.S. dollar as exclusive or predominant currency: British Honduras (from 1894), Cuba (from 1898), Dominican Republic (from 1901), Panama (from 1904), Puerto Rico (from 1900), Alaska, Aleutian Islands, Hawaii, Midway Islands (from 1898), Wake Island, Guam, and American Samoa.
d Except August – October 1914.
e Including Tunisia (from 1891) and all other colonies except Indochina.
f Including Newfoundland (from 1895).
g Including British East Africa, Uganda, Zanzibar, Mauritius, and Ceylon (to 1901).
h Including Montenegro (to 1911).
I Including Belgian Congo.
j Including Netherlands East Indies.
k Including colonies, except Portuguese India.
l Including Greenland and Iceland.
m Or perhaps 1883.
n Including Korea and Taiwan.
o Including Borneo.
p Approximate beginning date.

Sources: Bloomfield (1959, pp. 13, 15; 1963), Bordo and Kydland (1995), Bordo and Schwartz (1996), Brown (1940, pp.15-16), Bureau of the Mint (1929), de Cecco (1984, p. 59), Ding (1967, pp. 6- 7), Director of the Mint (1913, 1917), Ford (1985, p. 153), Gallarotti (1995, pp. 272 75), Gunasekera (1962), Hawtrey (1950, p. 361), Hershlag (1980, p. 62), Ingram (1971, p. 153), Kemmerer (1916; 1940, pp. 9-10; 1944, p. 39), Kindleberger (1984, pp. 59-60), Lampe (1986, p. 34), MacKay (1946, p. 64), MacLeod (1994, p. 13), Norman (1892, pp. 83-84), Officer (1996, chs. 3 4), Pamuk (2000, p. 217), Powell (1999, p. 14), Rifaat (1935, pp. 47, 54), Shinjo (1962, pp. 81-83), Spalding (1928), Wallich (1950, pp. 32-36), Yeager (1976, p. 298), Young (1925).

Table 2Countries on Interwar Gold Standard
Country Type ofGold Standard Ending Date
Exchange-RateStabilization CurrencyConvertibilitya
United Kingdomb 1925 1931
Coin 1922e Other Core Countries
Bullion 1928 Germany 1924 1931
Australiag 1925 1930
Exchange 1925 Canadai 1925 1929
Exchange 1925 Indiaj 1925 1931
Coin 1929k South Africa 1925 1933
Austria 1922 1931
Exchange 1926 Danzig 1925 1935
Coin 1925 Italym 1927 1934
Coin 1925 Portugalo 1929 1931
Coin 1925 Scandinavia
Bullion 1927 Finland 1925 1931
Bullion 1928 Sweden 1922 1931
Albania 1922 1939
Exchange 1927 Czechoslovakia 1923 1931
Exchange 1928 Greece 1927 1932
Exchange 1925 Latvia 1922 1931
Coin 1922 Poland 1926 1936
Exchange 1929 Yugoslavia 1925 1932
Egypt 1925 1931
Exchange 1925 Palestine 1927 1931
Exchange 1928 Asia
Coin 1930 Malayat 1925 1931
Coin 1925 Philippines 1922 1933
Exchange 1928 Mexico and Central America
Exchange 1922 Guatemala 1925 1933
Exchange 1922 Honduras 1923 1933
Coin 1925 Nicaragua 1915 1932
Coin 1920 South America
Coin 1927 Bolivia 1926 1931
Exchange 1928 Chile 1925 1931
Coin 1923 Ecuador 1927 1932
Exchange 1927 Peru 1928 1932
Exchange 1928 Venezuela 1923 1930

a And freedom of gold export and import.
b Including colonies (except British Honduras) and possessions without a national currency: Guernsey, Jersey, Malta, Gibraltar, Cyprus, Bermuda, British West Indies, British Guiana, British Somaliland, Falkland Islands, British West African and certain South African colonies, certain Oceanic colonies.
cIncluding countries and territories with U.S. dollar as exclusive or predominant currency: British Honduras, Cuba, Dominican Republic, Panama, Puerto Rico, Alaska, Aleutian Islands, Hawaii, Midway Islands, Wake Island, Guam, and American Samoa.
dNot applicable; “the United States dollar…constituted the central point of reference in the whole post-war stabilization effort and was throughout the period of stabilization at par with gold.” — Brown (1940, p. 394)
e1919 for freedom of gold export.
f Including colonies and possessions, except Indochina and Syria.
g Including Papua (New Guinea) and adjoining islands.
h Kenya, Uganda, and Tanganyika.
I Including Newfoundland.
j Including Bhutan, Nepal, British Swaziland, Mauritius, Pemba Island, and Zanzibar.
k 1925 for freedom of gold export.
l Including Luxemburg and Belgian Congo.
m Including Italian Somaliland and Tripoli.
n Including Dutch Guiana and Curacao (Netherlands Antilles).
o Including territories, except Portuguese India.
p Including Liechtenstein.
q Including Greenland and Iceland.
r Including Greater Lebanon.
s Including Korea and Taiwan.
t Including Straits Settlements, Sarawak, Labuan, and Borneo.

Sources: Bett (1957, p. 36), Brown (1940), Bureau of the Mint (1929), Ding (1967, pp. 6-7), Director of the Mint (1917), dos Santos (1996, pp. 191-92), Eichengreen (1992, p. 299), Federal Reserve Bulletin (1928, pp. 562, 847; 1929, pp. 201, 265, 549; 1930, pp. 72, 440; 1931, p. 554; 1935, p. 290; 1936, pp. 322, 760), Gunasekera (1962), Jonung (1984, p. 361), Kemmerer (1954, pp. 301 302), League of Nations (1926, pp. 7, 15; 1927, pp. 165-69; 1929, pp. 208-13; 1931, pp. 265-69; 1937/38, p. 107; 1946, p. 2), Moggridge (1989, p. 305), Officer (1996, chs. 3-4), Powell (1999, pp. 23-24), Spalding (1928), Wallich (1950, pp. 32-37), Yeager (1976, pp. 330, 344, 359); Young (1925, p. 76).

Characteristics of Gold Standards

Types of Gold Standards

Pure Coin and Mixed Standards

In theory, “domestic” gold standards — those that do not depend on interaction with other countries — are of two types: “pure coin” standard and “mixed” (meaning coin and paper, but also called simply “coin”) standard. The two systems share several properties. (1) There is a well-defined and fixed gold content of the domestic monetary unit. For example, the dollar is defined as a specified weight of pure gold. (2) Gold coin circulates as money with unlimited legal-tender power (meaning it is a compulsorily acceptable means of payment of any amount in any transaction or obligation). (3) Privately owned bullion (gold in mass, foreign coin considered as mass, or gold in the form of bars) is convertible into gold coin in unlimited amounts at the government mint or at the central bank, and at the “mint price” (of gold, the inverse of the gold content of the monetary unit). (4) Private parties have no restriction on their holding or use of gold (except possibly that privately created coined money may be prohibited); in particular, they may melt coin into bullion. The effect is as if coin were sold to the monetary authority (central bank or Treasury acting as a central bank) for bullion. It would make sense for the authority to sell gold bars directly for coin, even though not legally required, thus saving the cost of coining. Conditions (3) and (4) commit the monetary authority in effect to transact in coin and bullion in each direction such that the mint price, or gold content of the monetary unit, governs in the marketplace.

Under a pure coin standard, gold is the only money. Under a mixed standard, there are also paper currency (notes) — issued by the government, central bank, or commercial banks — and demand-deposit liabilities of banks. Government or central-bank notes (and central-bank deposit liabilities) are directly convertible into gold coin at the fixed established price on demand. Commercial-bank notes and demand deposits might be converted not directly into gold but rather into gold-convertible government or central-bank currency. This indirect convertibility of commercial-bank liabilities would apply certainly if the government or central- bank currency were legal tender but also generally even if it were not. As legal tender, gold coin is always exchangeable for paper currency or deposits at the mint price, and usually the monetary authority would provide gold bars for its coin. Again, two-way transactions in unlimited amounts fix the currency price of gold at the mint price. The credibility of the monetary-authority commitment to a fixed price of gold is the essence of a successful, ongoing gold-standard regime.

A pure coin standard did not exist in any country during the gold-standard periods. Indeed, over time, gold coin declined from about one-fifth of the world money supply in 1800 (2/3 for gold and silver coin together, as silver was then the predominant monetary standard) to 17 percent in 1885 (1/3 for gold and silver, for an eleven-major-country aggregate), 10 percent in 1913 (15 percent for gold and silver, for the major-country aggregate), and essentially zero in 1928 for the major-country aggregate (Triffin, 1964, pp. 15, 56). See Table 3. The zero figure means not that gold coin did not exist, rather that its main use was as reserves for Treasuries, central banks, and (generally to a lesser extent) commercial banks.

Table 3Structure of Money: Major-Countries Aggregatea(end of year)
1885 1928
8 50
33 0d
18 21
33 99

a Core countries: Britain, United States, France, Germany. Western Europe: Belgium, Italy, Netherlands, Switzerland. Other countries: Canada, Japan, Sweden.
b Metallic money, minor coin, paper currency, and demand deposits.
c 1885: Gold and silver coin; overestimate, as includes commercial-bank holdings that could not be isolated from coin held outside banks by the public. 1913: Gold and silver coin. 1928: Gold coin.
d Less than 0.5 percent.
e 1885 and 1913: Gold, silver, and foreign exchange. 1928: Gold and foreign exchange.
f Official gold: Gold in official reserves. Money gold: Gold-coin component of money supply.

Sources: Triffin (1964, p. 62), Sayers (1976, pp. 348, 352) for 1928 Bank of England dollar reserves (dated January 2, 1929).

An “international” gold standard, which naturally requires that more than one country be on gold, requires in addition freedom both of international gold flows (private parties are permitted to import or export gold without restriction) and of foreign-exchange transactions (an absence of exchange control). Then the fixed mint prices of any two countries on the gold standard imply a fixed exchange rate (“mint parity”) between the countries’ currencies. For example, the dollar- sterling mint parity was $4.8665635 per pound sterling (the British pound).

Gold-Bullion and Gold-Exchange Standards

In principle, a country can choose among four kinds of international gold standards — the pure coin and mixed standards, already mentioned, a gold-bullion standard, and a gold- exchange standard. Under a gold-bullion standard, gold coin neither circulates as money nor is it used as commercial-bank reserves, and the government does not coin gold. The monetary authority (Treasury or central bank) stands ready to transact with private parties, buying or selling gold bars (usable only for import or export, not as domestic currency) for its notes, and generally a minimum size of transaction is specified. For example, in 1925 1931 the Bank of England was on the bullion standard and would sell gold bars only in the minimum amount of 400 fine (pure) ounces, approximately £1699 or $8269. Finally, the monetary authority of a country on a gold-exchange standard buys and sells not gold in any form but rather gold- convertible foreign exchange, that is, the currency of a country that itself is on the gold coin or bullion standard.

Gold Points and Gold Export/Import

A fixed exchange rate (the mint parity) for two countries on the gold standard is an oversimplification that is often made but is misleading. There are costs of importing or exporting gold. These costs include freight, insurance, handling (packing and cartage), interest on money committed to the transaction, risk premium (compensation for risk), normal profit, any deviation of purchase or sale price from the mint price, possibly mint charges, and possibly abrasion (wearing out or removal of gold content of coin — should the coin be sold abroad by weight or as bullion). Expressing the exporting costs as the percent of the amount invested (or, equivalently, as percent of parity), the product of 1/100th of these costs and mint parity (the number of units of domestic currency per unit of foreign currency) is added to mint parity to obtain the gold-export point — the exchange rate at which gold is exported. To obtain the gold-import point, the product of 1/100th of the importing costs and mint parity is subtracted from mint parity.

If the exchange rate is greater than the gold-export point, private-sector “gold-point arbitrageurs” export gold, thereby obtaining foreign currency. Conversely, for the exchange rate less than the gold-import point, gold is imported and foreign currency relinquished. Usually the gold is, directly or indirectly, purchased from the monetary authority of the one country and sold to the monetary authority in the other. The domestic-currency cost of the transaction per unit of foreign currency obtained is the gold-export point. That per unit of foreign currency sold is the gold-import point. Also, foreign currency is sold, or purchased, at the exchange rate. Therefore arbitrageurs receive a profit proportional to the exchange-rate/gold-point divergence.

Gold-Point Arbitrage

However, the arbitrageurs’ supply of foreign currency eliminates profit by returning the exchange rate to below the gold-export point. Therefore perfect “gold-point arbitrage” would ensure that the exchange rate has upper limit of the gold-export point. Similarly, the arbitrageurs’ demand for foreign currency returns the exchange rate to above the gold-import point, and perfect arbitrage ensures that the exchange rate has that point as a lower limit. It is important to note what induces the private sector to engage in gold-point arbitrage: (1) the profit motive; and (2) the credibility of the commitment to (a) the fixed gold price and (b) freedom of foreign exchange and gold transactions, on the part of the monetary authorities of both countries.

Gold-Point Spread

The difference between the gold points is called the (gold-point) spread. The gold points and the spread may be expressed as percentages of parity. Estimates of gold points and spreads involving center countries are provided for the classical and interwar gold standards in Tables 4 and 5. Noteworthy is that the spread for a given country pair generally declines over time both over the classical gold standard (evidenced by the dollar-sterling figures) and for the interwar compared to the classical period.

Table 4Gold-Point Estimates: Classical Gold Standard
Countries Period Gold Pointsa(percent) Spreadd(percent) Method of Computation
Exportb Importc
U.S./Britain 1881-1890 0.6585 0.7141 1.3726 PA
U.S./Britain 1891-1900 0.6550 0.6274 1.2824 PA
U.S./Britain 1901-1910 0.4993 0.5999 1.0992 PA
U.S./Britain 1911-1914 0.5025 0.5915 1.0940 PA
France/U.S. 1877-1913 0.6888 0.6290 1.3178 MED
Germany/U.S. 1894-1913 0.4907 0.7123 1.2030 MED
France/Britain 1877-1913 0.4063 0.3964 0.8027 MED
Germany/Britain 1877-1913 0.3671 0.4405 0.8076 MED
Germany/France 1877-1913 0.4321 0.5556 0.9877 MED
Austria/Britain 1912 0.6453 0.6037 1.2490 SE
Netherlands/Britain 1912 0.5534 0.3552 0.9086 SE
Scandinaviae /Britain 1912 0.3294 0.6067 0.9361 SE

a For numerator country.
b Gold-import point for denominator country.
c Gold-export point for denominator country.
d Gold-export point plus gold-import point.
e Denmark, Sweden, and Norway.

Method of Computation: PA = period average. MED = median exchange rate form estimate of various authorities for various dates, converted to percent deviation from parity. SE = single exchange-rate- form estimate, converted to percent deviation from parity.

Sources: U.S./Britain — Officer (1996, p. 174). France/U.S., Germany/U.S., France/Britain, Germany/Britain, Germany/France — Morgenstern (1959, pp. 178-81). Austria/Britain, Netherlands/Britain, Scandinavia/Britain — Easton (1912, pp. 358-63).

Table 5Gold-Point Estimates: Interwar Gold Standard
Countries Period Gold Pointsa(percent) Spreadd(percent) Method of Computation
Exportb Importc
U.S./Britain 1925-1931 0.6287 0.4466 1.0753 PA
U.S./France 1926-1928e 0.4793 0.5067 0.9860 PA
U.S./France 1928-1933f 0.5743 0.3267 0.9010 PA
U.S./Germany 1926-1931 0.8295 0.3402 1.1697 PA
France/Britain 1926 0.2042 0.4302 0.6344 SE
France/Britain 1929-1933 0.2710 0.3216 0.5926 MED
Germany/Britain 1925-1933 0.3505 0.2676 0.6181 MED
Canada/Britain 1929 0.3521 0.3465 0.6986 SE
Netherlands/Britain 1929 0.2858 0.5146 0.8004 SE
Denmark/Britain 1926 0.4432 0.4930 0.9362 SE
Norway/Britain 1926 0.6084 0.3828 0.9912 SE
Sweden/Britain 1926 0.3881 0.3828 0.7709 SE

a For numerator country.
b Gold-import point for denominator country.
c Gold-export point for denominator country.
d Gold-export point plus gold-import point.
e To end of June 1928. French-franc exchange-rate stabilization, but absence of currency convertibility; see Table 2.
f Beginning July 1928. French-franc convertibility; see Table 2.

Method of Computation: PA = period average. MED = median exchange rate form estimate of various authorities for various dates, converted to percent deviation from parity. SE = single exchange-rate- form estimate, converted to percent deviation from parity.

Sources: U.S./Britain — Officer (1996, p. 174). U.S./France, U.S./Germany, France/Britain 1929- 1933, Germany/Britain — Morgenstern (1959, pp. 185-87). Canada/Britain, Netherlands/Britain — Einzig (1929, pp. 98-101) [Netherlands/Britain currencies’ mint parity from Spalding (1928, p. 135). France/Britain 1926, Denmark/Britain, Norway/Britain, Sweden/Britain — Spalding (1926, pp. 429-30, 436).

The effective monetary standard of a country is distinguishable from its legal standard. For example, a country legally on bimetallism usually is effectively on either a gold or silver monometallic standard, depending on whether its “mint-price ratio” (the ratio of its mint price of gold to mint price of silver) is greater or less than the world price ratio. In contrast, a country might be legally on a gold standard but its banks (and government) have “suspended specie (gold) payments” (refusing to convert their notes into gold), so that the country is in fact on a “paper standard.” The criterion adopted here is that a country is deemed on the gold standard if (1) gold is the predominant effective metallic money, or is the monetary bullion, (2) specie payments are in force, and (3) there is a limitation on the coinage and/or the legal-tender status of silver (the only practical and historical competitor to gold), thus providing institutional or legal support for the effective gold standard emanating from (1) and (2).

Implications for Money Supply

Consider first the domestic gold standard. Under a pure coin standard, the gold in circulation, monetary base, and money supply are all one. With a mixed standard, the money supply is the product of the money multiplier (dependent on the commercial-banks’ reserves/deposit and the nonbank-public’s currency/deposit ratios) and the monetary base (the actual and potential reserves of the commercial banking system, with potential reserves held by the nonbank public). The monetary authority alters the monetary base by changing its gold holdings and its loans, discounts, and securities portfolio (non gold assets, called its “domestic assets”). However, the level of its domestic assets is dependent on its gold reserves, because the authority generates demand liabilities (notes and deposits) by increasing its assets, and convertibility of these liabilities must be supported by a gold reserve, if the gold standard is to be maintained. Therefore the gold standard provides a constraint on the level (or growth) of the money supply.

The international gold standard involves balance-of-payments surpluses settled by gold imports at the gold-import point, and deficits financed by gold exports at the gold-export point. (Within the spread, there are no gold flows and the balance of payments is in equilibrium.) The change in the money supply is then the product of the money multiplier and the gold flow, providing the monetary authority does not change its domestic assets. For a country on a gold- exchange standard, holdings of “foreign exchange” (the reserve currency) take the place of gold. In general, the “international assets” of a monetary authority may consist of both gold and foreign exchange.

The Classical Gold Standard

Dates of Countries Joining the Gold Standard

Table 1 (above) lists all countries that were on the classical gold standard, the gold- standard type to which each adhered, and the period(s) on the standard. Discussion here concentrates on the four core countries. For centuries, Britain was on an effective silver standard under legal bimetallism. The country switched to an effective gold standard early in the eighteenth century, solidified by the (mistakenly) gold-overvalued mint-price ratio established by Isaac Newton, Master of the Mint, in 1717. In 1774 the legal-tender property of silver was restricted, and Britain entered the gold standard in the full sense on that date. In 1798 coining of silver was suspended, and in 1816 the gold standard was formally adopted, ironically during a paper-standard regime (the “Bank Restriction Period,” of 1797-1821), with the gold standard effectively resuming in 1821.

The United States was on an effective silver standard dating back to colonial times, legally bimetallic from 1786, and on an effective gold standard from 1834. The legal gold standard began in 1873-1874, when Acts ended silver-dollar coinage and limited legal tender of existing silver coins. Ironically, again the move from formal bimetallism to a legal gold standard occurred during a paper standard (the “greenback period,” of 1861-1878), with a dual legal and effective gold standard from 1879.

International Shift to the Gold Standard

The rush to the gold standard occurred in the 1870s, with the adherence of Germany, the Scandinavian countries, France, and other European countries. Legal bimetallism shifted from effective silver to effective gold monometallism around 1850, as gold discoveries in the United States and Australia resulted in overvalued gold at the mints. The gold/silver market situation subsequently reversed itself, and, to avoid a huge inflow of silver, many European countries suspended the coinage of silver and limited its legal-tender property. Some countries (France, Belgium, Switzerland) adopted a “limping” gold standard, in which existing former-standard silver coin retained full legal tender, permitting the monetary authority to redeem its notes in silver as well as gold.

As Table 1 shows, most countries were on a gold-coin (always meaning mixed) standard. The gold-bullion standard did not exist in the classical period (although in Britain that standard was embedded in legislation of 1819 that established a transition to restoration of the gold standard). A number of countries in the periphery were on a gold-exchange standard, usually because they were colonies or territories of a country on a gold-coin standard. In situations in which the periphery country lacked its own (even-coined) currency, the gold-exchange standard existed almost by default. Some countries — China, Persia, parts of Latin America — never joined the classical gold standard, instead retaining their silver or bimetallic standards.

Sources of Instability of the Classical Gold Standard

There were three elements making for instability of the classical gold standard. First, the use of foreign exchange as reserves increased as the gold standard progressed. Available end-of- year data indicate that, worldwide, foreign exchange in official reserves (the international assets of the monetary authority) increased by 36 percent from 1880 to 1899 and by 356 percent from 1899 to 1913. In comparison, gold in official reserves increased by 160 percent from 1880 to 1903 but only by 88 percent from 1903 to 1913. (Lindert, 1969, pp. 22, 25) While in 1913 only Germany among the center countries held any measurable amount of foreign exchange — 15 percent of total reserves excluding silver (which was of limited use) — the percentage for the rest of the world was double that for Germany (Table 6). If there were a rush to cash in foreign exchange for gold, reduction or depletion of the gold of reserve-currency countries could place the gold standard in jeopardy.

Table 6Share of Foreign Exchange in Official Reserves(end of year, percent)
Country 1928b
Excluding Silverb
0 10
0 0c
0d 51
13 16
27 32

a Official reserves: gold, silver, and foreign exchange.
b Official reserves: gold and foreign exchange.
c Less than 0.05 percent.
d Less than 0.5 percent.

Sources: 1913 — Lindert (1969, pp. 10-11). 1928 — Britain: Board of Governors of the Federal Reserve System [cited as BG] (1943, p. 551), Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929). United States: BG (1943, pp. 331, 544), foreign exchange consisting of Federal Reserve Banks holdings of foreign-currency bills. France and Germany: Nurkse (1944, p. 234). Rest of world [computed as residual]: gold, BG (1943, pp. 544-51); foreign exchange, from “total” (Triffin, 1964, p. 66), France, and Germany.

Second, Britain — the predominant reserve-currency country — was in a particularly sensitive situation. Again considering end-of 1913 data, almost half of world foreign-exchange reserves were in sterling, but the Bank of England had only three percent of world gold reserves (Tables 7-8). Defining the “reserve ratio” of the reserve-currency-country monetary authority as the ratio of (i) official reserves to (ii) liabilities to foreign monetary authorities held in financial institutions in the country, in 1913 this ratio was only 31 percent for the Bank of England, far lower than those of the monetary authorities of the other core countries (Table 9). An official run on sterling could easily force Britain off the gold standard. Because sterling was an international currency, private foreigners also held considerable liquid assets in London, and could themselves initiate a run on sterling.

Table 7Composition of World Official Foreign-Exchange Reserves(end of year, percent)
1913a British pounds 77
2 French francs }2}

}

16
5b

a Excluding holdings for which currency unspecified.
b Primarily Dutch guilders and Scandinavian kroner.

Sources: 1913 — Lindert (1969, pp. 18-19). 1928 — Components of world total: Triffin (1964, pp. 22, 66), Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929), Board of Governors of the Federal Reserve System [cited as BG] (1943, p. 331) for Federal Reserve Banks holdings of foreign-currency bills.

Table 8Official-Reserves Components: Percent of World Total(end of year)
Country 1928
Gold Foreign Exchange
0 7 United States 27 0a
0b 13 Germany 6 4
95 36 Table 9Reserve Ratiosa of Reserve-Currency Countries

(end of year)

Country 1928c
Excluding Silverc
0.31 0.33
90.55 5.45
2.38 not available
2.11 not available

a Ratio of official reserves to official liquid liabilities (that is, liabilities to foreign governments and central banks).
b Official reserves: gold, silver, and foreign exchange.
c Official reserves: gold and foreign exchange.

Sources : 1913 — Lindert (1969, pp. 10-11, 19). Foreign-currency holdings for which currency unspecified allocated proportionately to the four currencies based on known distribution. 1928 — Gold reserves: Board of Governors of the Federal Reserve System [cited as BG] (1943, pp. 544, 551). Foreign- exchange reserves: Sayers (1976, pp. 348, 352) for Bank of England dollar reserves (dated January 2, 1929); BG (1943, p. 331) for Federal Reserve Banks holdings of foreign-currency bills. Official liquid liabilities: Triffin (1964, p. 22), Sayers (1976, pp. 348, 352).

Third, the United States, though a center country, was a great source of instability to the gold standard. Its Treasury held a high percentage of world gold reserves (more than that of the three other core countries combined in 1913), resulting in an absurdly high reserve ratio — Tables 7-9). With no central bank and a decentralized banking system, financial crises were frequent. Far from the United States assisting Britain, gold often flowed from the Bank of England to the United States to satisfy increases in U.S. demand for money. Though in economic size the United States was the largest of the core countries, in many years it was a net importer rather than exporter of capital to the rest of the world — the opposite of the other core countries. The political power of silver interests and recurrent financial panics led to imperfect credibility in the U.S. commitment to the gold standard. Runs on banks and runs on the Treasury gold reserve placed the U.S. gold standard near collapse in the early and mid-1890s. During that period, the credibility of the Treasury’s commitment to the gold standard was shaken. Indeed, the gold standard was saved in 1895 (and again in 1896) only by cooperative action of the Treasury and a bankers’ syndicate that stemmed gold exports.

Rules of the Game

According to the “rules of the [gold-standard] game,” central banks were supposed to reinforce, rather than “sterilize” (moderate or eliminate) or ignore, the effect of gold flows on the monetary supply. A gold outflow typically decreases the international assets of the central bank and thence the monetary base and money supply. The central-bank’s proper response is: (1) raise its “discount rate,” the central-bank interest rate for rediscounting securities (cashing, at a further deduction from face value, a short-term security from a financial institution that previously discounted the security), thereby inducing commercial banks to adopt a higher reserves/deposit ratio and therefore decreasing the money multiplier; and (2) decrease lending and sell securities, thereby decreasing domestic assets and thence the monetary base. On both counts the money supply is further decreased. Should the central bank rather increase its domestic assets when it loses gold, it engages in “sterilization” of the gold flow and is decidedly not following the “rules of the game.” The converse argument (involving gold inflow and increases in the money supply) also holds, with sterilization involving the central bank decreasing its domestic assets when it gains gold.

Price Specie-Flow Mechanism

A country experiencing a balance-of-payments deficit loses gold and its money supply decreases, both automatically and by policy in accordance with the “rules of the game.” Money income contracts and the price level falls, thereby increasing exports and decreasing imports. Similarly, a surplus country gains gold, the money supply increases, money income expands, the price level rises, exports decrease and imports increase. In each case, balance-of-payments equilibrium is restored via the current account. This is called the “price specie-flow mechanism.” To the extent that wages and prices are inflexible, movements of real income in the same direction as money income occur; in particular, the deficit country suffers unemployment but the payments imbalance is nevertheless corrected.

The capital account also acts to restore balance, via interest-rate increases in the deficit country inducing a net inflow of capital. The interest-rate increases also reduce real investment and thence real income and imports. Similarly, interest-rate decreases in the surplus country elicit capital outflow and increase real investment, income, and imports. This process enhances the current-account correction of the imbalance.

One problem with the “rules of the game” is that, on “global-monetarist” theoretical grounds, they were inconsequential. Under fixed exchange rates, gold flows simply adjust money supply to money demand; the money supply is not determined by policy. Also, prices, interest rates, and incomes are determined worldwide. Even core countries can influence these variables domestically only to the extent that they help determine them in the global marketplace. Therefore the price-specie-flow and like mechanisms cannot occur. Historical data support this conclusion: gold flows were too small to be suggestive of these mechanisms; and prices, incomes, and interest rates moved closely in correspondence (rather than in the opposite directions predicted by the adjustment mechanisms induced by the “rules of the game”) — at least among non-periphery countries, especially the core group.

Discount Rate Rule and the Bank of England

However, the Bank of England did, in effect, manage its discount rate (“Bank Rate”) in accordance with rule (1). The Bank’s primary objective was to maintain convertibility of its notes into gold, that is, to preserve the gold standard, and its principal policy tool was Bank Rate. When its “liquidity ratio” of gold reserves to outstanding note liabilities decreased, it would usually increase Bank Rate. The increase in Bank Rate carried with it market short-term increase rates, inducing a short-term capital inflow and thereby moving the exchange rate away from the gold-export point by increasing the exchange value of the pound. The converse also held, with a rise in the liquidity ratio involving a Bank Rate decrease, capital outflow, and movement of the exchange rate away from the gold import point. The Bank was constantly monitoring its liquidity ratio, and in response altered Bank Rate almost 200 times over 1880- 1913.

While the Reichsbank (the German central bank), like the Bank of England, generally moved its discount rate inversely to its liquidity ratio, most other central banks often violated the rule, with changes in their discount rates of inappropriate direction, or of insufficient amount or frequency. The Bank of France, in particular, kept its discount rate stable. Unlike the Bank of England, it chose to have large gold reserves (see Table 8), with payments imbalances accommodated by fluctuations in its gold rather than financed by short-term capital flows. The United States, lacking a central bank, had no discount rate to use as a policy instrument.

Sterilization Was Dominant

As for rule (2), that the central-bank’s domestic and international assets move in the same direction; in fact the opposite behavior, sterilization, was dominant, as shown in Table 10. The Bank of England followed the rule more than any other central bank, but even so violated it more often than not! How then did the classical gold standard cope with payments imbalances? Why was it a stable system?

Table 10Annual Changes in Internationala and Domesticb Assets of Central BankPercent of Changes in the Same Directionc
1880-1913d Britain 33
__ France 33
31 British Dominionse 13
32 Scandinaviag 25
33 South Americai 23

a 1880-1913: Gold, silver and foreign exchange. 1922-1936: Gold and foreign exchange.
b Domestic income-earning assets: discounts, loans, securities.
c Implying country is following “rules of the game.” Observations with zero or negligible changes in either class of assets excluded.
d Years when country is off gold standard excluded. See Tables 1 and 2.
e Australia and South Africa.
f1880-1913: Austria-Hungary, Belgium, and Netherlands. 1922-1936: Austria, Italy, Netherlands, and Switzerland.
g Denmark, Finland, Norway, and Sweden.
h1880-1913: Russia. 1922-1936: Bulgaria, Czechoslovakia, Greece, Hungary, Poland, Romania, and Yugoslavia.
I Chile, Colombia, Peru, and Uruguay.

Sources: Bloomfield (1959, p. 49), Nurkse (1944, p. 69).

The Stability of the Classical Gold Standard

The fundamental reason for the stability of the classical gold standard is that there was always absolute private-sector credibility in the commitment to the fixed domestic-currency price of gold on the part of the center country (Britain), two (France and Germany) of the three remaining core countries, and certain other European countries (Belgium, Netherlands, Switzerland, and Scandinavia). Certainly, that was true from the late-1870s onward. (For the United States, this absolute credibility applied from about 1900.) In earlier periods, that commitment had a contingency aspect: it was recognized that convertibility could be suspended in the event of dire emergency (such as war); but, after normal conditions were restored, convertibility would be re-established at the pre-existing mint price and gold contracts would again be honored. The Bank Restriction Period is an example of the proper application of the contingency, as is the greenback period (even though the United States, effectively on the gold standard, was legally on bimetallism).

Absolute Credibility Meant Zero Convertibility and Exchange Risk

The absolute credibility in countries’ commitment to convertiblity at the existing mint price implied that there was extremely low, essentially zero, convertibility risk (the probability that Treasury or central-bank notes would not be redeemed in gold at the established mint price) and exchange risk (the probability that the mint parity between two currencies would be altered, or that exchange control or prohibition of gold export would be instituted).

Reasons Why Commitment to Convertibility Was So Credible

There were many reasons why the commitment to convertibility was so credible. (1) Contracts were expressed in gold; if convertibility were abandoned, contracts would inevitably be violated — an undesirable outcome for the monetary authority. (2) Shocks to the domestic and world economies were infrequent and generally mild. There was basically international peace and domestic calm.

(3) The London capital market was the largest, most open, most diversified in the world, and its gold market was also dominant. A high proportion of world trade was financed in sterling, London was the most important reserve-currency center, and balances of payments were often settled by transferring sterling assets rather than gold. Therefore sterling was an international currency — not merely supplemental to gold but perhaps better: a boon to non- center countries, because sterling involved positive, not zero, interest return and its transfer costs were much less than those of gold. Advantages to Britain were the charges for services as an international banker, differential interest returns on its financial intermediation, and the practice of countries on a sterling (gold-exchange) standard of financing payments surpluses with Britain by piling up short-term sterling assets rather than demanding Bank of England gold.

(4) There was widespread ideology — and practice — of “orthodox metallism,” involving authorities’ commitment to an anti-inflation, balanced-budget, stable-money policy. In particular, the ideology implied low government spending and taxes and limited monetization of government debt (financing of budget deficits by printing money). Therefore it was not expected that a country’s price level or inflation would get out of line with that of other countries, with resulting pressure on the country’s adherence to the gold standard. (5) This ideology was mirrored in, and supported by, domestic politics. Gold had won over silver and paper, and stable-money interests (bankers, industrialists, manufacturers, merchants, professionals, creditors, urban groups) over inflationary interests (farmers, landowners, miners, debtors, rural groups).

(6) There was freedom from government regulation and a competitive environment, domestically and internationally. Therefore prices and wages were more flexible than in other periods of human history (before and after). The core countries had virtually no capital controls; the center country (Britain) had adopted free trade, and the other core countries had moderate tariffs. Balance-of-payments financing and adjustment could proceed without serious impediments.

(7) Internal balance (domestic macroeconomic stability, at a high level of real income and employment) was an unimportant goal of policy. Preservation of convertibility of paper currency into gold would not be superseded as the primary policy objective. While sterilization of gold flows was frequent (see above), the purpose was more “meeting the needs of trade” (passive monetary policy) than fighting unemployment (active monetary policy).

(8) The gradual establishment of mint prices over time ensured that the implied mint parities (exchange rates) were in line with relative price levels; so countries joined the gold standard with exchange rates in equilibrium. (9) Current-account and capital-account imbalances tended to be offsetting for the core countries, especially for Britain. A trade deficit induced a gold loss and a higher interest rate, attracting a capital inflow and reducing capital outflow. Indeed, the capital- exporting core countries — Britain, France, and Germany — could eliminate a gold loss simply by reducing lending abroad.

Rareness of Violations of Gold Points

Many of the above reasons not only enhanced credibility in existing mint prices and parities but also kept international-payments imbalances, and hence necessary adjustment, of small magnitude. Responding to the essentially zero convertibility and exchange risks implied by the credible commitment, private agents further reduced the need for balance-of-payments adjustment via gold-point arbitrage (discussed above) and also via a specific kind of speculation. When the exchange rate moved beyond a gold point, arbitrage acted to return it to the spread. So it is not surprising that “violations of the gold points” were rare on a monthly average basis, as demonstrated in Table 11 for the dollar, franc, and mark exchange rate versus sterling. Certainly, gold-point violations did occur; but they rarely persisted sufficiently to be counted on monthly average data. Such measured violations were generally associated with financial crises. (The number of dollar-sterling violations for 1890-1906 exceeding that for 1889-1908 is due to the results emanating from different researchers using different data. Nevertheless, the important common finding is the low percent of months encompassed by violations.)

Table 11Violations of Gold Points
Exchange Rate Time Period Number of Months Number dollar-sterling 240 0.4
1890-1906 3 dollar-sterling 76 0
1889-1908 12b mark-sterling 240 7.5

a May 1925 – August 1931: full months during which both United States and Britain on gold standard.
b Approximate number, deciphered from graph.

Sources: Dollar-sterling, 1890-1906 and 1925-1931 — Officer (1996, p. 235). All other — Giovannini (1993, pp. 130-31).

Stabilizing Speculation

The perceived extremely low convertibility and exchange risks gave private agents profitable opportunities not only outside the spread (gold-point arbitrage) but also within the spread (exchange-rate speculation). As the exchange value of a country’s currency weakened, the exchange rate approaching the gold-export point, speculators had an ever greater incentive to purchase domestic currency with foreign currency (a capital inflow); for they had good reason to believe that the exchange rate would move in the opposite direction, whereupon they would reverse their transaction at a profit. Similarly, a strengthened currency, with the exchange rate approaching the gold-import point, involved speculators selling the domestic currency for foreign currency (a capital outflow). Clearly, the exchange rate would either not go beyond the gold point (via the actions of other speculators of the same ilk) or would quickly return to the spread (via gold-point arbitrage). Also, the further the exchange rate moved toward the gold point, the greater the potential profit opportunity; for there was a decreased distance to that gold point and an increased distance from the other point.

This “stabilizing speculation” enhanced the exchange value of depreciating currencies that were about to lose gold; and thus the gold loss could be prevented. The speculation was all the more powerful, because the absence of controls on capital movements meant private capital flows were highly responsive to exchange-rate changes. Dollar-sterling data, in Table 12, show that this speculation was extremely efficient in keeping the exchange rate away from the gold points — and increasingly effective over time. Interestingly, these statements hold even for the 1890s, during which at times U.S. maintenance of currency convertibility was precarious. The average deviation of the exchange rate from the midpoint of the spread fell decade-by-decade from about 1/3 of one percent of parity in 1881-1890 (23 percent of the gold-point spread) to only 12/100th of one percent of parity in 1911-1914 (11 percent of the spread).

Table 12Average Deviation of Dollar-Sterling Exchange Rate from Gold-Point-Spread Midpoint
Percent of Parity Quarterly observations
0.32 1891-1900 19
0.15 1911-1914a 11
0.28 Monthly observations
0.24 1925-1931c 26

a Ending with second quarter of 1914.
b Third quarter 1925 – second quarter 1931: full quarters during which both United States and Britain on gold standard.
c May 1925 – August 1931: full months during which both United States and Britain on gold standard.

Source: Officer (1996, pp. 182, 191, 272).

Government Policies That Enhanced Gold-Standard Stability

Government policies also enhanced gold-standard stability. First, by the turn of the century South Africa — the main world gold producer — sold all its gold in London, either to private parties or actively to the Bank of England, with the Bank serving also as residual purchaser of the gold. Thus the Bank had the means to replenish its gold reserves. Second, the orthodox- metallism ideology and the leadership of the Bank of England — other central banks would often gear their monetary policy to that of the Bank — kept monetary policies harmonized. Monetary discipline was maintained.

Third, countries used “gold devices,” primarily the manipulation of gold points, to affect gold flows. For example, the Bank of England would foster gold imports by lowering the foreign gold-export point (number of units of foreign currency per pound, the British gold-import point) through interest-free loans to gold importers or raising its purchase price for bars and foreign coin. The Bank would discourage gold exports by lowering the foreign gold-import point (the British gold-export point) via increasing its selling prices for gold bars and foreign coin, refusing to sell bars, or redeeming its notes in underweight domestic gold coin. These policies were alternative to increasing Bank Rate.

The Bank of France and Reichsbank employed gold devices relative to discount-rate changes more than Britain did. Some additional policies included converting notes into gold only in Paris or Berlin rather than at branches elsewhere in the country, the Bank of France converting its notes in silver rather than gold (permitted under its “limping” gold standard), and the Reichsbank using moral suasion to discourage the export of gold. The U.S. Treasury followed similar policies at times. In addition to providing interest-free loans to gold importers and changing the premium at which it would sell bars (or refusing to sell bars outright), the Treasury condoned banking syndicates to put pressure on gold arbitrageurs to desist from gold export in 1895 and 1896, a time when the U.S. adherence to the gold standard was under stress.

Fourth, the monetary system was adept at conserving gold, as evidenced in Table 3. This was important, because the increased gold required for a growing world economy could be obtained only from mining or from nonmonetary hoards. While the money supply for the eleven- major-country aggregate more than tripled from 1885 to 1913, the percent of the money supply in the form of metallic money (gold and silver) more than halved. This process did not make the gold standard unstable, because gold moved into commercial-bank and central-bank (or Treasury) reserves: the ratio of gold in official reserves to official plus money gold increased from 33 to 54 percent. The relative influence of the public versus private sector in reducing the proportion of metallic money in the money supply is an issue warranting exploration by monetary historians.

Fifth, while not regular, central-bank cooperation was not generally required in the stable environment in which the gold standard operated. Yet this cooperation was forthcoming when needed, that is, during financial crises. Although Britain was the center country, the precarious liquidity position of the Bank of England meant that it was more often the recipient than the provider of financial assistance. In crises, it would obtain loans from the Bank of France (also on occasion from other central banks), and the Bank of France would sometimes purchase sterling to push up that currency’s exchange value. Assistance also went from the Bank of England to other central banks, as needed. Further, the credible commitment was so strong that private bankers did not hesitate to make loans to central banks in difficulty.

In sum, “virtuous” two-way interactions were responsible for the stability of the gold standard. The credible commitment to convertibility of paper money at the established mint price, and therefore the fixed mint parities, were both a cause and a result of (1) the stable environment in which the gold standard operated, (2) the stabilizing behavior of arbitrageurs and speculators, and (3) the responsible policies of the authorities — and (1), (2), and (3), and their individual elements, also interacted positively among themselves.

Experience of Periphery

An important reason for periphery countries to join and maintain the gold standard was the access to the capital markets of the core countries thereby fostered. Adherence to the gold standard connoted that the peripheral country would follow responsible monetary, fiscal, and debt-management policies — and, in particular, faithfully repay the interest on and principal of debt. This “good housekeeping seal of approval” (the term coined by Bordo and Rockoff, 1996), by reducing the risk premium, involved a lower interest rate on the country’s bonds sold abroad, and very likely a higher volume of borrowing. The favorable terms and greater borrowing enhanced the country’s economic development.

However, periphery countries bore the brunt of the burden of adjustment of payments imbalances with the core (and other Western European) countries, for three reasons. First, some of the periphery countries were on a gold-exchange standard. When they ran a surplus, they typically increased — and with a deficit, decreased — their liquid balances in London (or other reserve-currency country) rather than withdraw gold from the reserve-currency country. The monetary base of the periphery country would increase, or decrease, but that of the reserve-currency country would remain unchanged. This meant that such changes in domestic variables — prices, incomes, interest rates, portfolios, etc.–that occurred to correct the surplus or deficit, were primarily in the periphery country. The periphery, rather than the core, “bore the burden of adjustment.”

Second, when Bank Rate increased, London drew funds from France and Germany, that attracted funds from other Western European and Scandinavian countries, that drew capital from the periphery. Also, it was easy for a core country to correct a deficit by reducing lending to, or bringing capital home from, the periphery. Third, the periphery countries were underdeveloped; their exports were largely primary products (agriculture and mining), which inherently were extremely sensitive to world market conditions. This feature made adjustment in the periphery compared to the core take the form more of real than financial correction. This conclusion also follows from the fact that capital obtained from core countries for the purpose of economic development was subject to interruption and even reversal. While the periphery was probably better off with access to the capital than in isolation, its welfare gain was reduced by the instability of capital import.

The experience on adherence to the gold standard differed among periphery groups. The important British dominions and colonies — Australia, New Zealand, Canada, and India — successfully maintained the gold standard. They were politically stable and, of course, heavily influenced by Britain. They paid the price of serving as an economic cushion to the Bank of England’s financial situation; but, compared to the rest of the periphery, gained a relatively stable long-term capital inflow. In undeveloped Latin American and Asia, adherence to the gold standard was fragile, with lack of complete credibility in the commitment to convertibility. Many of the reasons for credible commitment that applied to the core countries were absent — for example, there were powerful inflationary interests, strong balance-of-payments shocks, and rudimentary banking sectors. For Latin America and Asia, the cost of adhering to the gold standard was very apparent: loss of the ability to depreciate the currency to counter reductions in exports. Yet the gain, in terms of a steady capital inflow from the core countries, was not as stable or reliable as for the British dominions and colonies.

The Breakdown of the Classical Gold Standard

The classical gold standard was at its height at the end of 1913, ironically just before it came to an end. The proximate cause of the breakdown of the classical gold standard was political: the advent of World War I in August 1914. However, it was the Bank of England’s precarious liquidity position and the gold-exchange standard that were the underlying cause. With the outbreak of war, a run on sterling led Britain to impose extreme exchange control — a postponement of both domestic and international payments — that made the international gold standard non-operational. Convertibility was not legally suspended; but moral suasion, legalistic action, and regulation had the same effect. Gold exports were restricted by extralegal means (and by Trading with the Enemy legislation), with the Bank of England commandeering all gold imports and applying moral suasion to bankers and bullion brokers.

Almost all other gold-standard countries undertook similar policies in 1914 and 1915. The United States entered the war and ended its gold standard late, adopting extralegal restrictions on convertibility in 1917 (although in 1914 New York banks had temporarily imposed an informal embargo on gold exports). An effect of the universal removal of currency convertibility was the ineffectiveness of mint parities and inapplicability of gold points: floating exchange rates resulted.

Interwar Gold Standard

Return to the Gold Standard

In spite of the tremendous disruption to domestic economies and the worldwide economy caused by World War I, a general return to gold took place. However, the resulting interwar gold standard differed institutionally from the classical gold standard in several respects. First, the new gold standard was led not by Britain but rather by the United States. The U.S. embargo on gold exports (imposed in 1917) was removed in 1919, and currency convertibility at the prewar mint price was restored in 1922. The gold value of the dollar rather than of the pound sterling would typically serve as the reference point around which other currencies would be aligned and stabilized. Second, it follows that the core would now have two center countries, the United Kingdom and the United States.

Third, for many countries there was a time lag between stabilizing a country’s currency in the foreign-exchange market (fixing the exchange rate or mint parity) and resuming currency convertibility. Given a lag, the former typically occurred first, currency stabilization operating via central-bank intervention in the foreign-exchange market (transacting in the domestic currency and a reserve currency, generally sterling or the dollar). Table 2 presents the dates of exchange- rate stabilization and currency convertibility resumption for the countries on the interwar gold standard. It is fair to say that the interwar gold standard was at its height at the end of 1928, after all core countries were fully on the standard and before the Great Depression began.

Fourth, the contingency aspect of convertibility conversion, that required restoration of convertibility at the mint price that existed prior to the emergency (World War I), was broken by various countries — even core countries. Some countries (including the United States, United Kingdom, Denmark, Norway, Netherlands, Sweden, Switzerland, Australia, Canada, Japan, Argentina) stabilized their currencies at the prewar mint price. However, other countries (France, Belgium, Italy, Portugal, Finland, Bulgaria, Romania, Greece, Chile) established a gold content of their currency that was a fraction of the prewar level: the currency was devalued in terms of gold, the mint price was higher than prewar. A third group of countries (Germany, Austria, Hungary) stabilized new currencies adopted after hyperinflation. A fourth group (Czechoslovakia, Danzig, Poland, Estonia, Latvia, Lithuania) consisted of countries that became independent or were created following the war and that joined the interwar gold standard. A fifth group (some Latin American countries) had been on silver or paper standards during the classical period but went on the interwar gold standard. A sixth country group (Russia) had been on the classical gold standard, but did not join the interwar gold standard. A seventh group (Spain, China, Iran) joined neither gold standard.

The fifth way in which the interwar gold standard diverged from the classical experience was the mix of gold-standard types. As Table 2 shows, the gold coin standard, dominant in the classical period, was far less prevalent in the interwar period. In particular, all four core countries had been on coin in the classical gold standard; but, of them, only the United States was on coin interwar. The gold-bullion standard, nonexistent prewar, was adopted by two core countries (United Kingdom and France) as well as by two Scandinavian countries (Denmark and Norway). Most countries were on a gold-exchange standard. The central banks of countries on the gold-exchange standard would convert their currencies not into gold but rather into “gold-exchange” currencies (currencies themselves convertible into gold), in practice often sterling, sometimes the dollar (the reserve currencies).

Instability of the Interwar Gold Standard

The features that fostered stability of the classical gold standard did not apply to the interwar standard; instead, many forces made for instability. (1) The process of establishing fixed exchange rates was piecemeal and haphazard, resulting in disequilibrium exchange rates. The United Kingdom restored convertibility at the prewar mint price without sufficient deflation, resulting in an overvalued currency of about ten percent. (Expressed in a common currency at mint parity, the British price level was ten percent higher than that of its trading partners and competitors). A depressed export sector and chronic balance-of-payments difficulties were to result. Other overvalued currencies (in terms of mint parity) were those of Denmark, Italy, and Norway. In contrast, France, Germany, and Belgium had undervalued currencies. (2) Wages and prices were less flexible than in the prewar period. In particular, powerful unions kept wages and unemployment high in British export industries, hindering balance-of-payments correction.

(3) Higher trade barriers than prewar also restrained adjustment.

(4) The gold-exchange standard economized on total world gold via the gold of reserve- currency countries backing their currencies in their reserves role for countries on that standard and also for countries on a coin or bullion standard that elected to hold part of their reserves in London or New York. (Another economizing element was continuation of the move of gold out of the money supply and into banking and official reserves that began in the classical period: for the eleven-major-country aggregate, gold declined to less than œ of one percent of the money supply in 1928, and the ratio of official gold to official-plus-money gold reached 99 percent — Table 3). The gold-exchange standard was inherently unstable, because of the conflict between (a) the expansion of sterling and dollar liabilities to foreign central banks to expand world liquidity, and (b) the resulting deterioration in the reserve ratio of the Bank of England, and U.S. Treasury and Federal Reserve Banks.

This instability was particularly severe in the interwar period, for several reasons. First, France was now a large official holder of sterling, with over half the official reserves of the Bank of France in foreign exchange in 1928, versus essentially none in 1913 (Table 6); and France was resentful that the United Kingdom had used its influence in the League of Nations to induce financially reconstructed countries in Europe to adopt the gold-exchange (sterling) standard. Second, many more countries were on the gold-exchange standard than prewar. Cooperation in restraining a run on sterling or the dollar would be difficult to achieve. Third, the gold-exchange standard, associated with colonies in the classical period, was viewed as a system inferior to a coin standard.

(5) In the classical period, London was the one dominant financial center; in the interwar period it was joined by New York and, in the late 1920s, Paris. Both private and official holdings of foreign currency could shift among the two or three centers, as interest-rate differentials and confidence levels changed.

(6) The problem with gold was not overall scarcity but rather maldistribution. In 1928, official reserve-currency liabilities were much more concentrated than in 1913: the United Kingdom accounted for 77 percent of world foreign-exchange reserves and France less than two percent (versus 47 and 30 percent in 1913 — Table 7). Yet the United Kingdom held only seven percent of world official gold and France 13 percent (Table 8). Reflecting its undervalued currency, France also possessed 39 percent of world official foreign exchange. Incredibly, the United States held 37 percent of world official gold — more than all the non-core countries together.

(7) Britain’s financial position was even more precarious than in the classical period. In 1928, the gold and dollar reserves of the Bank of England covered only one third of London’s liquid liabilities to official foreigners, a ratio hardly greater than in 1913 (and compared to a U.S. ratio of almost 5œ — Table 9). Various elements made the financial position difficult compared to prewar. First, U.K. liquid liabilities were concentrated on stronger countries (France, United States), whereas its liquid assets were predominantly in weaker countries (such as Germany). Second, there was ongoing tension with France, that resented the sterling-dominated gold- exchange standard and desired to cash in its sterling holding for gold to aid its objective of achieving first-class financial status for Paris.

(8) Internal balance was an important goal of policy, which hindered balance-of-payments adjustment, and monetary policy was affected greatly by domestic politics rather than geared to preservation of currency convertibility. (9) Especially because of (8), the credibility in authorities’ commitment to the gold standard was not absolute. Convertibility risk and exchange risk could be well above zero, and currency speculation could be destabilizing rather than stabilizing; so that when a country’s currency approached or reached its gold-export point, speculators might anticipate that currency convertibility would not be maintained and the currency devalued. Hence they would sell rather than buy the currency, which, of course, would help bring about the very outcome anticipated.

(10) The “rules of the game” were infrequently followed and, for most countries, violated even more often than in the classical gold standard — Table 10. Sterilization of gold inflows by the Bank of England can be viewed as an attempt to correct the overvalued pound by means of deflation. However, the U.S. and French sterilization of their persistent gold inflows reflected exclusive concern for the domestic economy and placed the burden of adjustment on other countries in the form of deflation.

(11) The Bank of England did not provide a leadership role in any important way, and central-bank cooperation was insufficient to establish credibility in the commitment to currency convertibility.

Breakdown of the Interwar Gold Standard

Although Canada effectively abandoned the gold standard early in 1929, this was a special case in two respects. First, the action was an early drastic reaction to high U.S. interest rates established to fight the stock-market boom but that carried the threat of unsustainable capital outflow and gold loss for other countries. Second, use of gold devices was the technique used to restrict gold exports and informally terminate the Canadian gold standard.

The beginning of the end of the interwar gold standard occurred with the Great Depression. The depression began in the periphery, with low prices for exports and debt-service requirements leading to insurmountable balance-of-payments difficulties while on the gold standard. However, U.S. monetary policy was an important catalyst. In the second half of 1927 the Federal Reserve pursued an easy-money policy, which supported foreign currencies but also fed the boom in the New York stock market. Reversing policy to fight the Wall Street boom, higher interest rates attracted monies to New York, which weakened sterling in particular. The stock market crash in October 1929, while helpful to sterling, was followed by a passive monetary policy that did not prevent the U.S. depression that started shortly thereafter and that spread to the rest of the world via declines in U.S. trade and lending. In 1929 and 1930 a number of periphery countries either formally suspended currency convertibility or restricted it so that their currencies went beyond the gold-export point.

It was destabilizing speculation, emanating from lack of confidence in authorities’ commitment to currency convertibility that ended the interwar gold standard. In May 1931 there was a run on Austria’s largest commercial bank, and the bank failed. The run spread to Germany, where an important bank also collapsed. The countries’ central banks lost substantial reserves; international financial assistance was too late; and in July 1931 Germany adopted exchange control, followed by Austria in October. These countries were definitively off the gold standard.

The Austrian and German experiences, as well as British budgetary and political difficulties, were among the factors that destroyed confidence in sterling, which occurred in mid-July 1931. Runs on sterling ensued, and the Bank of England lost much of its reserves. Loans from abroad were insufficient, and in any event taken as a sign of weakness. The gold standard was abandoned in September, and the pound quickly and sharply depreciated on the foreign- exchange market, as overvaluation of the pound would imply.

Amazingly, there were no violations of the dollar-sterling gold points on a monthly average basis to the very end of August 1931 (Table 11). In contrast, the average deviation of the dollar-sterling exchange rate from the midpoint of the gold-point spread in 1925-1931 was more than double that in 1911-1914, by either of two measures (Table 12), suggesting less- dominant stabilizing speculation compared to the prewar period. Yet the 1925-1931 average deviation was not much more (in one case, even less) than in earlier decades of the classical gold standard. The trust in the Bank of England had a long tradition, and the shock to confidence in sterling that occurred in July 1931 was unexpected by the British authorities.

Following the U.K. abandonment of the gold standard, many countries followed, some to maintain their competitiveness via currency devaluation, others in response to destabilizing capital flows. The United States held on until 1933, when both domestic and foreign demands for gold, manifested in runs on U.S. commercial banks, became intolerable. The “gold bloc” countries (France, Belgium, Netherlands, Switzerland, Italy, Poland) and Danzig lasted even longer; but, with their currencies now overvalued and susceptible to destabilizing speculation, these countries succumbed to the inevitable by the end of 1936. Albania stayed on gold until occupied by Italy in 1939. As much as a cause, the Great Depression was a consequence of the gold standard; for gold-standard countries hesitated to inflate their economies for fear of weakening the balance of payments, suffering loss of gold and foreign-exchange reserves, and being forced to abandon convertibility or the gold parity. So the gold standard involved “golden fetters” (the title of the classic work of Eichengreen, 1992) that inhibited monetary and fiscal policy to fight the depression. Therefore, some have argued, these fetters seriously exacerbated the severity of the Great Depression within countries (because expansionary policy to fight unemployment was not adopted) and fostered the international transmission of the Depression (because as a country’s output decreased, its imports fell, thus reducing exports and income of other countries).

The “international gold standard,” defined as the period of time during which all four core countries were on the gold standard, existed from 1879 to 1914 (36 years) in the classical period and from 1926 or 1928 to 1931 (four or six years) in the interwar period. The interwar gold standard was a dismal failure in longevity, as well as in its association with the greatest depression the world has known.

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The Economics of American Farm Unrest, 1865-1900

James I. Stewart, Reed College

American farmers have often expressed dissatisfaction with their lot but the decades after the Civil War were extraordinary in this regard. The period was one of persistent and acute political unrest. The specific concerns of farmers were varied, but at their core was what farmers perceived to be their deteriorating political and economic status.

The defining feature of farm unrest was the efforts of farmers to join together for mutual gain. Farmers formed cooperatives, interest groups, and political parties to protest their declining fortunes and to increase their political and economic power. The first such group to appear was The Grange or Patrons of Husbandry, founded in the 1860s to address farmers’ grievances against the railroads and desire for greater cooperation in business matters. The agrarian-dominated Greenback Party followed in the 1870s. Its main goal was to increase the amount of money in circulation and thus to lower the costs of credit to farmers. The Farmers’ Alliance appeared in the 1880s. Its members practiced cooperative marketing and lobbied the government for various kinds of business and banking regulation. In the 1890s, aggrieved farmers took their most ambitious steps yet, forming the independent People’s or Populist Party to challenge the dominance of the unsympathetic Republican and Democratic parties.

Although farmers in every region of the country had cause for agitation, unrest was probably greatest in the northern prairie and Plains states. A series of droughts there between 1870 and 1900 created recurring hardships, and Midwestern grain farmers faced growing price competition from producers abroad. Farmers in the South also revolted, but their protests were muted by racism. Black farmers were excluded from most farm groups, and many white farmers were reluctant to join the attack on established politics and business for fear of undermining the system of social control that kept blacks inferior to whites (Goodwyn, 1978).

The Debate about the Causes of Farm Unrest

For a long time, a debate raged about the causes of farm unrest. Historians could not reconcile the complaints of farmers with evidence about the agricultural terms of trade— the prices farmers received for their output, especially relative to the prices of other goods and services farmers purchased such as transportation, credit, and manufactures. Now, however, there appears to be some consensus. Before exploring the basis for this consensus, it will be useful to examine briefly the complaints of farmers. What were farmers so upset about? Why did they feel so threatened?

The Complaints of Farmers

The complaints of farmers are well documented (Buck, 1913; Hicks, 1931) and relatively uncontroversial. They concerned farmers’ declining incomes and fractious business relationships primarily. First, farmers claimed that farm prices were falling and, as a consequence, so were their incomes. They generally blamed low prices on over-production. Second, farmers alleged that monopolistic railroads and grain elevators charged unfair prices for their services. Government regulation was the farmers’ solution to the problem of monopoly. Third, there was a perceived shortage of credit and money. Farmers believed that interest rates were too high because of monopolistic lenders, and the money supply was inadequate, producing deflation. A falling price level increased the real burden of debt, as farmers repaid loans with dollars worth significantly more than those they had borrowed. Farmers demanded ceilings on interest rates, public boards to mediate foreclosure proceedings, and the U.S. Treasury to coin silver freely to increase the money supply. Finally, farmers complained about the political influence of the railroads, big business, and money lenders. These interests had undue influence over policy making in the state legislatures and U.S. Congress. In short, farmers felt their economic and political interests were being shortchanged by a gang of greedy railroads, creditors, and industrialists.

The Puzzle of Farm Unrest

Economic historians have subjected the complaints of farmers to rigorous statistical testing. Each claim has been found inconsistent to some extent with the available evidence about the terms of trade.

First, consider farmers’ complaints about prices. Farm prices were falling, along with the prices of most other goods during this period. This does not imply, however, that farm incomes were also falling. First, real prices (farm prices relative to the general price level) are a better measure of the value that farmers were receiving for their output. When real prices over the post-Civil War period are examined, there is an approximately horizontal trend (North, 1974). Moreover, even if real farm prices had been falling, farmers were not necessarily worse off (Fogel and Rutner, 1972). Rising farm productivity could have offset the negative effects of falling real prices on incomes. Finally, direct evidence about the incomes of farmers is scarce, but estimates suggest that farm incomes were not falling (Bowman, 1965). Some regions experienced periods of distress—Iowa and Illinois in the 1870s and Kansas and Nebraska in the 1890s, for instance—but there was no general agricultural depression. If anything, data on wages, land rents, and returns to capital suggest that land in the West was opened to settlement too slowly (Fogel and Rutner, 1972).

Next, consider farmers’ claims about interest rates and mortgage debt. It is true that interest rates on the frontier were high, averaging two to three percentage points more than those in the Northeast. Naturally, frontier farmers complained bitterly about paying so much for credit. Lenders, however, may have been well justified in the rates they charged. The susceptibility of the frontier to drought and the financial insecurity of many settlers created above average lending risks for which creditors had to be compensated (Bogue, 1955). For instance, borrowers often defaulted, leaving land worth only a fraction of the loan as security. This story casts doubt on the exploitation hypothesis. Furthermore, when the claims of farmers were subjected to rigorous statistical testing, there was little evidence to substantiate the monopoly hypothesis (Eichengreen, 1984). Instead, consistent with the unique features of the frontier mortgage market, high rates of interest appear to have been compensation for the inherent risks of lending to frontier farmers. Finally, regarding the burden on borrowers of a falling price level, deflation may have been not as onerous as farmers alleged. The typical mortgage had a short term, less than five years, implying that lenders and borrowers could often anticipate changes in the price level (North, 1974).

Last, consider farmers’ complaints about the railroads. These appear to have the most merit. Nevertheless, for a long time, most historians dismissed farmers’ grievances, assuming that the real cost to farmers of shipping their produce to market must have been steadily falling because of productivity improvements in the railroad sector. As Robert Higgs (1970) shows, however, gains in productivity in rail shipping did not necessarily translate into lower rates for farmers and thus higher farm gate prices. Real rates (railroad rates relative to the prices farmers received for their output) were highly variable between 1865 and 1900. More important, over the whole period, there was little decrease in rail rates relative to farm prices. Only in the 1890s did the terms of trade begin to improve in farmers’ favor. Employing different data, Aldrich (1985) finds a downward trend in railroad rates before 1880 but then no trend or an increasing trend thereafter.

The Causes of Farm Unrest

Many of the complaints of farmers are weakly supported or even contradicted by the available evidence, leaving questions about the true causes of farm unrest. If the monopoly power of the railroads and creditors was not responsible for farmers’ woes, what or who was?

Most economic historians now believe that agrarian unrest reflected the growing risks and uncertainties of agriculture after the Civil War. Uncertainty or risk can be thought of as an economic force that reduces welfare. Today, farmers use sophisticated production technologies and agricultural futures markets to reduce their exposure to environmental and economic uncertainty at little cost. In the late 1800s, the avoidance of risk was much more costly. As a result, increases in risk and uncertainty made farmers worse off. These uncertainties and risks appear to have been particularly severe for farmers on the frontier.

What were the sources of risk? First, agriculture had become more commercial after the Civil War (Mayhew, 1972). Formerly self-sufficient farmers were now dependent on creditors, merchants, and railroads for their livelihoods. These relationships created opportunities for economic gain but also obligations, hardships, and risks that many farmers did not welcome. Second, world grain markets were becoming ever more integrated, creating competition in markets abroad once dominated by U.S. producers and greater price uncertainty (North, 1974). Third, agriculture was now occurring in the semi-arid region of the United States. In Kansas, Nebraska, and the Dakotas, farmers encountered unfamiliar and adverse growing conditions. Recurring but unpredictable droughts caused economic hardship for many Plains farmers. Their plights were made worse because of the greater price elasticity (responsiveness) of world agricultural supply (North, 1974). Drought-stricken farmers with diminished harvests could no longer count on higher domestic prices for their crops.

A growing body of research now supports the hypothesis that discontent was caused by increasing risks and uncertainties in U.S. agriculture. First, there are strong correlations between different measures of economic risk and uncertainty and the geographic distribution of unrest in fourteen northern states between 1866 and 1909 (McGuire, 1981; 1982). Farm unrest was closely tied to the variability in farm prices, yields, and incomes across the northern states. Second, unrest was highest in states with high rates of farm foreclosures (Stock, 1986). On the frontier, the typical farmer would have had a neighbor whose farm was seized by creditors and thus cause to worry about his own future financial security. Third, Populist agitation in Kansas in the 1890s coincided with unexpected variability in crop prices that resulted in lost profits and lower incomes (DeCanio, 1980). Finally, as mentioned already, high interest rates were not a sign of monopoly but rather compensation to creditors for the greater risks of frontier lending (Eichengreen, 1984).

The Historical Significance of Farm Unrest

Farm unrest had profound and lasting consequences for American economic development. Above all, it ushered in fundamental and lasting institutional change (Hughes, 1991; Libecap, 1992).

The change began in the 1870s. In response to the complaints of farmers, Midwestern state legislatures enacted a series of laws regulating the prices and practices of railroads, grain elevators, and warehouses. The “Grange” laws were a turning point because they reversed a longstanding trend of decreasing government regulation of the private sector. They also prompted a series of landmark court rulings affirming the regulatory prerogatives of government (Hughes, 1991). In Munn v. Illinois (1877), the U.S. Supreme Court rejected a challenge to the legality of the Granger laws, famously ruling that government had the legal right to regulate any commerce “affected with the public interest.”

Farmers also sought redress of their grievances at the federal level. In 1886, the U.S. Supreme Court had ruled in Wabash, St. Louis, and Pacific Railway v. Illinois that only the federal government had the right to regulate commerce between the states. This meant the states could not regulate many matters of concern to farmers. In 1887, Congress passed the Interstate Commerce Act, which gave the Interstate Commerce Commission regulatory oversight over long distance rail shipping. This legislation was followed by the Sherman Antitrust Act of 1890, which prohibited monopolies and certain conspiracies, combinations, and restraints of trade. Midwestern cattle farmers urged the passage of an antitrust law, alleging that the notorious Chicago meat packers had conspired to keep cattle prices artificially low (Libecap, 1992). Both laws marked the beginning of growing federal involvement in private economic activity (Hughes, 1991; Ulen, 1987).

Not all agrarian proposals were acted upon, but even demands that fell on deaf ears in Congress and the state legislatures had lasting impacts (Hicks, 1931). For instance, many Alliance and Populist demands such as the graduated income tax and the direct election of U.S. Senators became law during the Progressive Era.

Historians disagree about the legacy of the late nineteenth century farm movements. Some view their contributions to U.S. institutional development positively (Hicks, 1931), while others do not (Hughes, 1991). Nonetheless, few would dispute their impact. In fact, it is possible to see much institutional change in the U.S. over the last century as the logical consequence of political and legal developments initiated by farmers during the late 1800s (Hughes, 1991).

The Sources of Cooperation in the Farm Protest Movement

Nineteenth century farmers were remarkably successful at joining together to increase their economic and political power. Nevertheless, one aspect of farm unrest that has largely been neglected by scholars is the sources of cooperation in promoting agrarian interests. According to Olson (1965), large lobbying or interest groups like the Grange and the Farmers’ Alliance should have been plagued by free-riding: the incentives for individuals not to contribute to the collective production of public goods—those goods for which it is impossible or very costly to exclude others from enjoying. A rational and self-interested farmer would not join a lobbying group because he could enjoy the benefits of its work without incurring any of the costs.

Judging by their political power, most farm interest groups were, however, able to curb free-riding. Stewart (2006) studies how the Dakota Farmers’ Alliance did this between 1885 and 1890. First, the Dakota Farmers’ Alliance provided valuable goods and services to its members that were not available to outsiders, creating economic incentives for membership. These goods and services included better terms of trade through cooperative marketing and the sharing of productivity-enhancing information about agriculture. Second, the structure of the Dakota Farmers’ Alliance as a federation of township chapters enabled the group to monitor and sanction free-riders. Within townships, Alliance members were able to pressure others to join the group. This strategy appears to have succeeded among German and Norwegian immigrants, who were much more likely than others to join the Dakota Farmers’ Alliance and whose probability of joining was increasing in the share of their nativity group in the township population. This is consistent with long-standing social norms of cooperation in Germany and Norway and economic theory about the use of social norms to elicit cooperation in collective action.

References

Aldrich, Mark. “A Note on Railroad Rates and the Populist Uprising.” Agricultural History 41 (1985): 835-52.

Bogue, Allan G. Money at Interest: The Farm Mortgage on the Middle Border. Ithaca, NY: Cornell University Press, 1955.

Bowman, John. “An Economic Analysis of Midwestern Farm Values and Farm Land Income, 1860-1900.” Yale Economic Essays 5 (1965): 317-52.

Buck, Solon J. The Granger Movement: A Study of Agricultural Organization and Its Political, Economic, and Social Manifestations, 1870-1880. Cambridge: Harvard University Press. 1913.

DeCanio, Stephen J. “Economic Losses from Forecasting Error in Agriculture.” Journal of Political Economy 88 (1980): 234-57.

Eichengreen, Barry. “Mortgage Interest Rates in the Populist Era.” American Economic Review 74 (1984): 995-1015.

Fogel, Robert W. and Jack L. Rutner. “The Efficiency Effects of Federal Land Policy, 1850-1900: A Report of Some Provisional Findings.” In The Dimensions of Quantitative Research in History, edited by Wayne O. Aydelotte, Allan G. Bogue and Robert W. Fogel. Princeton, N.: Princeton University Press, 1972.

Goodwyn, Lawrence. The Populist Moment: A Short History of the Agrarian Revolt in America. New York: Oxford University Press, 1978.

Hicks, John D. The Populist Revolt: A History of the Farmers’ Alliance and the People’s Party. Minneapolis: University of Minnesota Press, 1931.

Higgs, Robert. “Railroad Rates and the Populist Uprising.” Agricultural History 44 (1970): 291-97.

Hughes, Jonathan T. The Government Habit Redux: Economic Controls from Colonial Times to the Present. Princeton, NJ: Princeton University Press, 1991.

Libecap, Gary D. “The Rise of the Chicago Packers and the Origins of Meat Inspection and Antitrust.” Economic Inquiry 30 (1992): 242-62.

Mayhew, Anne. “A Reappraisal of the Causes of the Farm Protest Movement in the United States, 1870-1900.” Journal of Economic History 32 (1972): 464-75.

McGuire, Robert A. “Economic Causes of Late Nineteenth Century Agrarian Unrest: New Evidence.” Journal of Economic History 41 (1981): 835-52.

McGuire, Robert A. “Economic Causes of Late Nineteenth Century Agrarian Unrest: Reply.” Journal of Economic History 42 (1981): 697-99.

North, Douglass. Growth and Welfare in the American Past: A New Economic History. Englewood Cliffs, NJ: Prentice Hall, 1974.

Olson, Mancur. The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge, MA: Harvard University Press, 1965.

Stewart, James I. “Free-riding, Collective Action, and Farm Interest Group Membership.” Reed College Working Paper, 2006. Available at http://www.reed.edu/~stewartj.

Stock, James H. “Real Estate Mortgages, Foreclosures, and Midwestern Agrarian Unrest, 1865-1920.” Journal of Economic History 44 (1983): 89-105.

Ulen, Thomas C. “The Market for Regulation: The ICC from 1887 to 1920.” American Economic Review 70 (1980): 306-10.

Citation: Stewart, James. “The Economics of American Farm Unrest, 1865-1900″. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/the-economics-of-american-farm-unrest-1865-1900/

Education and Economic Growth in Historical Perspective

David Mitch, University of Maryland Baltimore County

In his introduction to the Wealth of Nations, Adam Smith (1776, p. 1) states that the proportion between the annual produce of a nation and the number of people who are to consume that produce depends on “the skill, dexterity, and judgment with which its labour is generally applied.” In recent decades, analysts of economic productivity in the United States during the twentieth century have made allowance for Smith’s “skill, dexterity, and judgment” of the labor force under the rubric of labor force quality (Ho and Jorgenson 1999; Aaronson and Sullivan 2001; DeLong, Goldin, and Katz 2003). These studies have found that a variety of factors have influenced labor force quality in the U.S., including age structure and workforce experience, female labor force participation, and immigration. One of the most important determinants of labor force quality has been years of schooling completed by the labor force.

Data limitations complicate generalizing these findings to periods before the twentieth century and to geographical areas beyond the United States. However, the rise of modern economic growth over the last few centuries seems to roughly coincide with the rise of mass schooling throughout the world. The sustained growth in income per capita evidenced in much of the world over the past two to two and a half centuries is a marked divergence from previous tendencies. Kuznets (1966) used the phrase “modern economic growth” to describe this divergence and he placed its onset in the mid-eighteenth century. More recently, Maddison (2001) has placed the start of sustained economic growth in the early nineteenth century. Maddison (1995) estimates that per capita income between 1520 and 1992 increased some eight times for the world as a whole and up to seventeen times for certain regions. Popular schooling was not widespread anywhere in the world before 1600. By 1800, most of North America, Scandinavia, and Germany had achieved literacy rates well in excess of fifty percent. In France and England literacy rates were closer to fifty percent and school attendance before the age of ten was certainly widespread, if not yet the rule. It was not until later in the nineteenth century and the early twentieth century that Southern and Eastern Europe were to catch up with Western Europe and it was only the first half of the twentieth century that saw schooling become widespread through much of Asia and Latin America. Only later in the twentieth century did schooling begin to spread throughout Africa. The twentieth century has seen the spread of secondary and university education to much of the adult population in the United States and to a lesser extent in other developed countries.[2] However, correlation is not causation; rising income per capita may have contributed to rising levels of schooling, as well as schooling to income levels. Thus, the contribution of rising schooling to economic growth should be examined more directly.

Estimating the Contribution of the Rise of Mass Schooling to Economic Growth: A Growth Accounting Perspective

Growth accounting can be used to estimate the general bounds of the contribution the rise of schooling has made to economic growth over the past few centuries.[3] A key assumption of growth accounting is that factors of production are paid their social marginal products. Growth accounting starts with estimates of the growth of individual factors of production, as well as the shares of these factors in total output and estimates of the growth of total product. It then apportions the growth in output into that attributable to growth in each factor of production specified in the analysis and into that due to a residual that cannot otherwise be explained. Estimates of how much schooling has increased the productivity of individual workers, combined with estimates of the increase in schooling completed by the labor force, yield estimates of how much the increase in schooling has contributed to increasing output. A growth accounting approach offers the advantage that with basic estimates (or at least possible ranges) for trends in output, labor force, schooling attainment, and preferably capital stock and factor shares, it yields estimates of schooling’s contribution to economic growth. An important disadvantage is that it relies on indirect estimates at the micro level for how schooling influences productivity at the aggregate level, rather than on direct empirical evidence.[4]

Back-of-the-envelope estimates of increases in income per capita attributable to rising levels of education over a period of a few centuries can be obtained by considering possible ranges of levels of schooling increases as measured in average years of schooling along with possible ranges of rates of return per year of schooling, in terms of the percentage by which a year of schooling raises earnings and common ranges for labor’s share in national income. By using a Cobb-Douglas specification of the aggregate production function with two factors of production, labor and physical capital, one can arrive at the following equation for the ratio between final and initial national income per worker due to increases in average school years completed between the two time periods:

1) (Y/L)1/ (Y/L)0 = ( (1 + r )S1 - S0 )α

Where Y = output, L = the labor force, r = the percent by which a year of schooling increases labor productivity, S is the average years of schooling completed by the labor force in each time period, α is labor’s share in national income, and the subscripts 0 and 1 denote the initial and final time period over which the schooling changes occur.[5] This formulation is a partial equilibrium one, holding constant the level of physical capital. However, the level of physical capital should be expected to increase in response to improved labor force quality due to more schooling. A common specification of a growth model that allows for such responses of physical capital implies the following ratio between final and initial national income per worker (see Lord 2001, 99-100):

2) (Y/L)1/ (Y/L)0 = ( (1 + r )S1 - S0 )

The bounds on increases in years of schooling can be placed at between zero and 16, that is, between a completely unschooled and presumably illiterate population to one in which a college education is universal. As bounds on returns to increasing earnings per year of schooling, one can employ Krueger and Lindahl’s (2001) survey of results from recent estimates of earnings functions, which finds that returns range from 5 percent to 15 percent. The implications of varying these two parameters are reported in Tables 1A and 1B. Table 1A reports estimates based on the partial equilibrium specification holding constant the level of physical capital in equation 1). Table 1B reports estimates allowing for a changing level of physical capital as in equation 2). Labor’s share of income has been set at a commonly used value of 0.7 (see DeLong, Goldin and Katz 2003, 29; Maddison 1995, 255).

Table 1A
Increase in per Capita Income over a Base Level of 1 Attributable to Hypothetical Increases in Average Schooling Levels — Holding the Physical Capital Stock Constant

Percent Increase in Earnings per Extra Year of Schooling
Increase in Average
Years of Schooling
5% 10% 15%
1 1.035 1.07 1.10
3 1.11 1.22 1.34
6 – illiteracy to
universal grammar school
.23 1.49 1.80
12 – illiteracy to
universal high school
1.51 2.23 3.23
16 – illiteracy to
universal college
1.73 2.91 4.78

Table 1B
Increase in per Capita Income over a Base Level of 1 Attributable to Hypothetical Increases in Average Schooling Levels — Allowing for Steady-state Changes in the Physical Capital Stock

Percent Increase in Earnings per Extra Year of Schooling
Increase in Average
Years of Schooling
5% 10% 15%
1 1.05 1.10 1.15
3 1.16 1.33 1.52
6 – illiteracy to
universal grammar school
1.34 1.77 2.31
12 – illiteracy to
universal high school
1.79 3.14 5.35
16 – illiteracy to
universal college
2.18 4.59 9.36

The back-of-the-envelope calculations in Tables 1A and 1B make two simple points. First, schooling increases have the potential to explain a good deal of estimated long-term increases in per capita income. With the average member of an economy’s labor force embodying investments of twelve years of schooling and a moderate ten-percent rate of return per year of schooling and no increase in the capital stock, at least 17 percent of Maddison’s eight-fold increase in per capita income can be accounted for (i.e. 1.23/7) by rising schooling. Indeed, a 16 year schooling increase allowing for steady-state capital stock increases and at 15 percent per year return overexplains Maddison’s eight-fold increase (8.36/7). After all, if schooling has had substantial effects on the productivity of individual workers, if a sizable share of the labor force has experienced improvements in schooling completed and with labor’s share of output greater than half, then the contribution of rising schooling to increasing output should be large.

Second, the contribution of schooling increases that have actually occurred historically to per capita income increases is more modest accounting for at best about one fifth of Maddison’s one-fold increase. Thus an increase in average years of schooling completed by the labor force of 6 years, roughly that entailed by the spread of universal grammar schooling, would account for 19 percent (1.31/7) of an eight-fold per capita output increase at a high 15 percent rate of return allowing for steady state changes in the physical capital stock (Table 1B). And at a low 5 percent return per year of schooling, the contribution would be only 5 percent of the increase (0.34/7). Making lower-level elementary education universal would entail increasing average years of schooling completed by the labor force by 1 to 3 years; in most circumstances this is not a trivial accomplishment as measured by the societal resources required. However, even at a high 15 percent per year return and allowing for steady state changes in the capital stock (Table 1B), the contribution of a 3 year increase in average years of schooling would only account for 7 percent (0.52/7) of Maddison’s eight-fold increase.

How do the above proposed bounds on schooling increases compare with possible increases in the physical capital stock? Kendrick (1993, 143) finds a somewhat larger growth rate in his estimated human capital stock than in the stock of non-human capital for the U.S. between 1929 and 1969, though for the sub-period 1929-48, he estimates a slightly higher growth rate for the non-human capital stock. In contrast, Maddison (1995, 35-37) estimates larger increases in the value of non-residential structures per worker and in the value of machinery and equipment per worker than in years of schooling per adult for the U.S. and the U.K. between 1820 and 1992. For the U.S., he estimates that the value of non-residential structures per worker rose by 21 times and the value of machinery and equipment per worker rose by 141 times in comparison with a ten-fold increase in the years of schooling per adult between 1820 and 1992. For the U.K., his estimates indicate a 15 fold increase in the value of structures per worker and a 97 fold increase in value of machinery and equipment per worker in contrast with a seven-fold increase in average years of schooling between 1820 and 1992. It should be noted that these estimates are based on cumulated investments in schooling to estimate human capital; that is, they are based on the costs incurred to produce human capital. Davies and Whalley (1991, 188-189) argue that estimates based on the alternative approach of calculating the present value of future earnings premiums attributable to schooling and other forms of human capital yield substantially higher estimates of human capital due to capturing inframarginal returns above costs accruing to human capital investments. For the growth accounting approach employed here, the cumulated investment or cost approach would seem the appropriate one. Are there more inherent bounds on the accumulation of human capital over time than non-human capital? One limit on the accumulation of human capital is set by how much of one’s potential working life a worker is willing to sacrifice for purposes of improving education and future productivity. This can be compared with the corresponding limit on the willingness to sacrifice current consumption for wealth accumulation.

However, this discussion makes no explicit allowance for changes over time in the quality of schooling. Improvements in teacher training and teacher recruitment along with ongoing curriculum developments among other factors could lead to ongoing improvements over time in how much a year of school attendance would improve the underlying future productivity of the student. Woessmann (2002) and Hanushek and Kimcoe (2000) have recently argued for the importance of allowing for variation in school quality in estimating the impact of cross national variation in human capital levels on economic growth. Woessmann (2002) makes the suggestion that allowing for improvements in the quality of schooling can remove the upper bounds on schooling investment that would be present if this was simply a matter of increasing the percentage of the population enrolled in school at given levels of quality. While there would seem to be inherent bounds on the proportion of one’s life that one is willing to spend in school, such bounds would not apply to increases in expenditures and other means of improving school quality.

Expenditures per pupil appear to have risen markedly over long periods of time. Thus, in the United States, expenditure per pupil in public elementary and secondary schools in constant 1989-90 dollars rose by over 6 times between 1923-24 and 1973-74 (National Center for Educational Statistics, 60). And in Victorian England, nominal expenditures per pupil in state subsidized schools more than doubled between 1870 and 1900, despite falling prices (Mitch 1982, 204). These figures do not control for the rising percentage of students enrolled in higher grade levels (presumably at higher expenditure per student), general rises in living standards affecting teachers’ salaries and other factors influencing the abilities of those recruited into teaching. Nevertheless, they suggest the possibility of sizable improvements over time in school quality.

It can be argued that implicitly allowance is made for improvements in school quality in the rate of return imputed per year of schooling completed on average by the labor force. Insofar as schools became more effective over time in transmitting knowledge and skills, the economic return per year of schooling should have increased correspondingly. Thus any attempt to allow for school quality in a growth accounting analysis should be careful to avoid double counting school quality in both school inputs and in returns per year of schooling.

The benchmark for the impact of increases in average levels of schooling completed in Table 1 are Maddison’s estimates of changes in output per capita over the last two centuries. In fact, major increases in schooling levels have most commonly been compressed into intervals of several decades or less, rather than periods of a century or more. This would imply that the contribution to output growth of improvements in labor force quality due to increases in schooling levels would have been concentrated primarily in periods of marked improvement in schooling levels and would have been far more modest during periods of more sluggish increase in educational attainment. In order to gauge the impact of the time interval over which changes in schooling occur on growth rates of output, Table 2 provides the change in average years of schooling implied by some of the hypothetical changes in average levels of schooling attainment reported in Table 1 for various time periods.

Table 2

Annual Change in Average Years of Schooling per Adult per Year Implied by Hypothetical Figures in Table 1

Time period over which increase occurred
Total Increase in
Average Years of
Schooling per Adult
5 years 10 years 30 years 50 years 100 years
1 0.2 0.1 0.033 0.02 0.01
3 0.6 0.3 0.1 0.06 0.03
6 1.2 0.6 0.2 0.12 0.06
9 1.8 0.9 0.3 0.18 0.09

Table 3 translates these rates of schooling growth into output growth rates using the partial equilibrium framework of equation 1) using a value for the share of labor of 0.7 as above. The contribution of schooling to growth rates of output and output per capita can be calculated as labor’s share times the percentage return per year of schooling on earnings times the annual increase in average years of schooling.

Table 3A
Contribution of Schooling for Large Increases in Schooling to Annual Growth Rates of Output

Length of time for schooling increase 6 year rise in average years of schooling 6 year rise in average years of schooling 9 year rise in average years of schooling 9 year rise in average years of schooling
5% return 10 % return 5 % return 10% return
30 years 0.7% 1.4% 1.05% 2.1%
50 years 0.42% 0.84% 0.63% 1.26%

Table 3B
Contribution of Schooling for Small to Modest Increases in Schooling to Annual Growth Rates of Output

Length of time for schooling increase 1 year rise in average years of schooling 1 year rise in average years of schooling 3 year rise in average years of schooling 3 year rise in average years of schooling
5 % return 10 % return 5% return 10% return
5 years 0.7% 1.4% 2.1% 4.2%
10 years 0.35% 0.7% 1.05% 2.1%
20 years 0.175% 0.35% 0.525% 1.05%
30 years 0.12% 0.23% 0.35% 0.7%
50 years 0.07% 0.14% 0.21% 0.42%
100 years 0.035% 0.07% 0.105% 0.21%

The case of the U.S. in the twentieth century as analyzed in DeLong, Goldin and Katz (2003) offers an example of how apparent limits or at least resistance to ongoing expansion of schooling have lowered the contribution of schooling to growth. They find that between World War I and the end of the century, improvements in labor quality attributable to schooling can account for about a quarter of the growth of output per capita in the U.S. during this period; this is similar in magnitude to Denison’s (1962) estimates for the first part of this period. This era saw the mean years of schooling completed by age 35 increased from 7.4 years for an American born in 1875 to 14.1 years for an American born in 1975 (DeLong, Goldin and Katz 2003, 22). However, in the last two decades of the twentieth century the rate of increase of mean years of schooling completed leveled off and correspondingly the contribution of schooling to labor quality improvements fell almost in half.

Maddison (1995) has compiled estimates of the average years of schooling completed for a number of countries going back to 1820. It is indicative of the sparseness of schooling completed by adult population estimates that Maddison reports estimates for only 3 countries, the U.S., the U.K., and Japan, all the way back to 1820. Maddison’s figures come from other studies and their reliability warrants further critical scrutiny than can be accorded them here. Since systematic census evidence on adult educational attainment did not begin until the mid-twentieth century, estimates of labor force educational attainment prior to 1900 should be treated with some skepticism. Nevertheless, Maddison’s estimates can be used to give a sense of plausible changes in levels of schooling completed over the last century and a half. The average increases in years of schooling per year for various time periods implied by Maddison’s figures are reported in Table 4. Maddison constructed his figures by giving primary education a weight of 1, secondary education a weight of 1.4, and tertiary, a weight of 2 based on evidence on relative earnings for each level of education.

Table 4
Estimates of the Annual Change in Average Years of Schooling per Person aged 15-64 for Selected Countries and Time Periods

Country 1913-1973 1870-1973 1870-1913
U.S. 0 .112 0.107 0.092
France 0.0783
Germany 0.053
Netherlands 0.064
U.K. 0.0473 0.0722 0.102
Japan 0.112 0.106 0.090

Source: Maddison (1995), 37, Table 2-3

Table 5
Annual Growth Rates in GDP per Capita

Region 1820-70 1870-1913 1913-50 1950-73 1973-92
12 West European Countries 0.9 1.3 1.2 3.8 1.8
4 Western Offshoots 1.4 1.5 1.3 2.4 1.2
5 South European Countries n.a. 0.9 0.7 4.8 2.2
7 East European Countries n.a. 1.2 1.0 4.0 -0.8
7 Latin American Countries n.a. 1.5 1.9 2.4 0.4
11 Asian Countries 0.1 0.7 -0.2 3.1 3.5
10 African countries n.a. n.a. 1.0 1.8 -0.4

Source: Maddison (1995), 62-63, Table 3-2.

In comparing Tables 2 and 4 it can be observed that the estimated actual changes in years of schooling compiled by Maddison (as well as the average over 55 countries reported by Lichtenberg (1994) for the third quarter of the twentieth century) fall within a lower bound set in the hypothetical ranges of a 3 year increase in average schooling spread over a century and an upper bound set by a 6 year increase in average schooling spread over 50 years.

Equations 1) and 2) above assume that each year of schooling of a worker has the same impact on productivity. In fact it has been common to find that the impact of schooling on productivity varies according to level of education. While the rate of return as a percentage of costs tends to be higher for primary than secondary schooling, which is in turn higher than tertiary education, this reflects the far lower costs, especially lower foregone earnings, of primary schooling (Psacharopolous and Patrinos 2004). The earnings premium per year of schooling tends to be higher for higher levels of education and this earnings premium, rather than the rate of return as a percentage costs, is the appropriate measure for assessing the contribution of rising schooling to growth (OECD 2001). Accordingly growth accounting analyses commonly construct schooling indexes weighting years of schooling according to estimates of each year’s impact on earnings (see for example Maddison 1995; Denison 1962). DeLong, Goldin and Katz (2003) use chain weighted indexes of returns according to each level of schooling. A rough approximation of the effect of allowing for variation in economic impact by level of schooling in the analysis in Table 1 is simply to focus on the mid-range 10 percent rate of return as an approximate average of high, low, and medium level returns.[6]

The U.S. is notable for rapid expansion in schooling attainment over the twentieth century at both the secondary and tertiary level, while in Europe widespread expansion has tended to focus on the primary and lower secondary level. These differences are evident in Denison’s estimates of the actual differences in educational distribution between the United States and a number of Western European countries in the mid-twentieth century (see Table 6).

Table 6

Percentage Distributions of the Male Labor Force by Years of Schooling Completed

Years of School Completed United States 1957 France 1954 United Kingdom 1951 Italy 1961
0 1.4 0.3 0.2 13.7
1-4 5.7 2.4 0.2 26.1
5-6 6.3 19.2 0.8 38.0
7 5.8 21.1 4.0 4.2
8 17.2 27.8 27.2 8.1
9 6.3 4.6 45.1 0.7
10 7.3 4.1 8.4 0.7
11 6.0 6.5 7.3 0.6
12 26.2 5.4 2.5 1.8
13-15 8.3 5.4 2.2 3.0
16 or more 9.5 3.2 2.1 3.1

Source: Denison (1967), 80, Table 8-1.

Some segments of the population are likely to have much greater enhancements of productivity from additional years of schooling than others. Insofar as the more able benefit from schooling compared to the rest of the ability distribution, putting substantially greater relative emphasis on expansion of higher levels of schooling could considerably augment growth rates over a more egalitarian strategy. This result would follow from a substantially greater premium assigned to higher levels of education. However, some studies of education in developing countries have found that they allocate a disproportionate share of resources to tertiary schooling at the expense of primary schooling, reflecting efforts of elites to benefit their offspring. How this has impeded economic growth would depend on the disparity in rates of return among levels of education, a point of some controversy in the economics of education literature (Birdsall 1996; Psacharopoulos 1996).

While allocating schooling disproportionately towards the more able in a society may have promoted growth, there would have been corresponding losses stemming from groups that have been systematically excluded or at least restricted in their access to education due to discrimination by factors such as race, gender and religion (Margo 1990). These losses could be attributed in part to the presence of individuals of high ability in groups experiencing discrimination due to failure to provide them with sufficient education to properly utilize their talents. However, historians such as Ashton (1948, 15) have argued that the exclusion of non-Anglicans from English universities prior to the mid-nineteenth century resulted in the channeling of their talents into manufacturing and commerce.

Even if returns have been higher at some levels of education than others, a sustained and substantial increase in labor force quality would seem to entail an egalitarian strategy of widespread increase in access to schooling. The contrast between the rapid increase in access to secondary and tertiary schooling in the U.S. and the much more limited increase in access in Europe during the twentieth century with the correspondingly much greater role for schooling in accounting for economic growth in the U.S. than in Europe (see Denison 1967) points to the importance of an egalitarian strategy in sustaining ongoing increases in aggregate labor force quality.

One would expect on increase in the relative supply of more schooled labor to lead to a decline in the premium to schooling, other things equal. Some recent analyses of the contribution of schooling to growth have allowed for this by specifying a parametric relationship between the distribution of schooling in an economy’s labor force and its impact on output or on a hypothesized intermediary human capital factor (Bils and Klenow 2000).[7]

Direct empirical evidence on trends in the premium to schooling is helpful both to obviate reliance on a theoretical specification and to allow for factors such as technical change that may have offset the impact of the increasing supply of schooling. Goldin and Katz (2001) have developed evidence on trends in the premium to schooling over the twentieth century that have allowed them to adjust for these trends in estimating the contribution of schooling to economic growth (DeLong, Goldin and Katz 2003). They find a marked fall in the premium to schooling, roughly falling in half between 1910 and 1950. However, they also find that this decline in the schooling premium was more than offset by their estimated increase over this same period in years of schooling completed by the average worker of 2.9 years and hence that on net schooling increases contributed to improved productivity of the U.S. workforce. They estimate increases of 0.5 percent per year in labor productivity due to increased educational attainment between 1910 and 1950 relative to the average total annual increase in labor productivity of 1.62 percent over the entire period 1915 to 2000. For the period since 1960, DeLong, Goldin and Katz find that the premium to education has increased while the increase in educational attainment at first increased and then declined. During this latter period, the increase in labor force quality has declined, as noted above, despite a widening premium to education, due to the slowing down in the increase in educational attainment.

Classifying the Range of Possible Relationships between Schooling and Economic Growth

In generalizing beyond the twentieth-century U.S. experience, allowance should be made both for the role of influences other than education on economic growth and for the possibility that the impact of education on growth can vary considerably according to the historical situation. In fact to understand why and how education might contribute to economic growth over the range of historical experience, it is important to investigate the variation in the impact of education on growth that has occurred historically. In relating education to economic growth, one can distinguish four basic possibilities.

The first is one of stagnation in both educational attainment and in output per head. Arguably, this was the most common situation throughout the world until 1750 and even after that date characterized Southern and Eastern Europe through the late nineteenth century, as well as most of Africa, Asia, and Latin American through the mid-twentieth century. The qualifier “arguably” is inserted here, because this view of the matter almost surely makes inadequate allowance for the improvements in informal acquisition of skills through family transmission and direct experience as well as through more formal non-schooling channels such as guild-sponsored apprenticeships, an aspect to be taken up further below. It also makes no allowance for the possible long-term improvements in per capita income that took place prior to 1750 but have been inadequately documented. Still focusing on formal schooling as the source of improvement in labor force, there is reason to think that this may have been a pervasive situation throughout much of human history.

The second situation is one in which income per capita rose despite stagnating education levels; factors other than improvements in educational attainment were generating economic growth. England during its industrial revolution, 1750 to 1840 is a notable instance in which some historians have argued that this situation prevailed. During this period, English schooling and literacy rates rose only slightly if at all, while income per capita appears to have risen. Literacy and schooling appears to have been of little use in newly created manufacturing occupations such as in cotton spinning. Indeed, literacy rates and schooling actually appears to have declined in some of the most rapidly industrializing areas of England such as Lancashire (Sanderson 1972; Nicholas and Nicholas 1992). Not all have concurred with this interpretation of the role of education in the English industrial revolution and the result depends on how educational trends are measured and how education is specified as affecting output (see Laqueur; Crafts 1995; Mitch 1999). Moreover this makes no allowance for the role of informal acquisition of skills. Boot (1995) argues that in the case of cotton spinners, informal skill acquisition with experience was substantial.

The simplest interpretation of this situation is that other factors contributed to economic growth other than schooling or human capital more generally. The clearest non-human capital explanatory factor would perhaps be physical capital accumulation; another might be foreign trade. However, if one turns to technological advance as a driving force, then this gives rise to the possibility that human capital — at least broadly defined — was if not the underlying force at least a central contributing factor to the industrial revolution. The argument for this possibility is that the improvements in knowledge and skills associated with technological advance are embodied in human agents and hence are forms of human capital. Recent work by Mokyr (2002) would suggest this interpretation. Nevertheless, the British industrial revolution does remain as a prominent instance in which human capital conventionally defined as schooling stagnated in the presence of a notable upsurge in economic growth. A less extreme case is provided by the post-World War II European catch-up with the United States, as Denison’s (1967) growth accounting analysis indicates that this occurred despite slower European increases in educational attainment due to other factors offsetting this. Historical instances such as that of the British industrial revolution call into question the common assumption that education is a necessary prerequisite for economic growth (see Mitch 1990).

The third situation is one in which rising educational attainment corresponds with rising rates of economic growth. This is the situation one would expect to prevail if education contributes to economic productivity and if any negative factors are not sufficient to offset this influence. One sub-set of instances would be those in which very large and reasonably compressed increases in the educational attainment of the labor force occurred. One important example of this is the twentieth century U.S., with the high school movement followed by increases in college attendance, as noted above. Another would be those of certain East Asian economies since World War II, as documented in the growth accounting analysis by Young (1995) of the substantial contributions of their rising educational attainment to their rapid growth rates. Another sub-set of cases corresponding to more modest increases in schooling can be interpreted as applying either to countries experiencing schooling increases focussed at the elementary level, as in much of Western Europe over the nineteenth century. The so-called literacy campaigns, as in the Soviet Union and Cuba (see Arnove and Graff eds. 1987) in the early and mid-twentieth century with modest improvements in educational attainment over compressed time periods of just a few decades could also be viewed as fitting into this sub-category. However, whether there were increases in output per capita corresponding to these more modest increases in educational attainment remains to be established.

The fourth situation is one in which economic growth has stagnated despite the presence of marked improvements in educational attainment. Possible examples of this situation would include the early rise of literacy in some Northern European areas, such as Scotland and Scandinavia, in the seventeenth and eighteenth centuries (see Houston 1988; Sandberg 1979) and some regions of Africa and Asia in the later twentieth century (see Pritchett 2001). One explanation of this situation is that it reflects instances in which any positive impact of educational attainment is small relative to other influences having an adverse impact. But one can also interpret it as reflecting situations in which incentive structures direct educated people into destructive and transfer activities inimical to economic growth (see North 1990; Baumol 1990; Murphy, Shleifer, and Vishny 1991).

Cross-country studies of the relationship between changes in schooling and growth since 1960 have yielded conflicting results which in itself could be interpreted as supporting the presence of some mix of the four situations just surveyed. A number of studies have found at best a weak relationship between changes in schooling and growth (Pritchett 2001; Bils and Klenow 2000); others have found a stronger relationship (Topel 1999). Much seems to depend on issues of measurement and on how the relationship between schooling and output is specified (Temple 2001b; Woessmann 2002, 2003).

The Determinants of Schooling

Whether education contributes to economic growth can be seen as depending on two factors, the extent to which educational levels improve over time and the impact of education on economic productivity. The first factor is a topic for extended discussion in its own right and no attempt will be made to consider it in depth here. Factors commonly considered include rising income per capita, distribution of political power, and cultural influences (Goldin 2001, Lindert 2004, Mariscal and Sokoloff 2000, Easterlin 1981; Mitch 2004). The issue of endogeneity of determination has often been raised with respect to the determinants of schooling. Thus, it is plausible that rising income contributes to rising levels of schooling and that the spread of mass education can influence the distribution of political power as well as the reverse. While these are important considerations, they are sufficiently complex to warrant extended attention in their own right.[8]

Influences on the Economic Impact of Schooling

Insofar as schooling improves general human intellectual capacities, it could be seen as having a universal impact irrespective of context. However, Rosenzweig (1995; 1999) has noted that the even the general influence of education on individual productivity or adaptability depend on the complexity of the situation. He notes that for agricultural tasks primarily involving physical exertion, no difference in productivity is evident between workers according to education levels; however, in more complex allocative decisions, education does enhance performance. This could account for findings that literacy rates were low among cotton spinners in the British industrial revolution despite findings of substantial premiums to experience (Sanderson 1972; Boot 1995). However, other studies have found literacy to have a substantial positive impact on labor productivity in cotton textile manufacture in the U.S., Italy, and Japan (Bessen 2003; A’Hearn 1998, Saxonhouse 1977) and have suggested a connection between literacy and labor discipline.

A more macro influence is the changing sectoral composition of the economy. It is common to suggest that the service and manufacturing sector have more functional uses for educated labor than the agricultural sector and hence that the shift from agriculture to industry in particular will lead to greater use of educated labor and in turn to require more educated labor forces. However, there are no clear theoretical or empirical grounds for the claim that agriculture makes less use of educated labor than other sectors of the economy. In fact, farmers have often had relatively high literacy rates and there are more obvious functional uses for education in agriculture in keeping accounts and keeping up with technological developments than in manufacturing. Nilsson et al (1999) argue that the process of enclosure in nineteenth-century Sweden, with the increased demands for reading and writing land transfer documents that this entailed, increased the value of literacy in the Swedish agrarian economy. The findings noted above that those in cotton textile occupations associated with early industrialization in Britain had relatively low literacy rates is one indication of the lack of any clear cut ranking across broad economic sectors in the use of educated labor.

Changes in the organization of decision making within major sectors as well as changes in the composition of production within sectors are more likely to have had an impact on demands for educated labor. Thus, within agriculture the extent of centralization or decentralization of decision making, that is the extent to which farm work forces consisted of farmers and large numbers of hired workers or of large numbers of peasants each with scope for making allocative decisions, is likely to have affected the uses made of educated labor in agriculture. Within manufacturing, a given country’s endowment of skilled relative to unskilled labor has been seen as influencing the extent to which openness to trade increases skill premiums, though this entails endogenous determination (Wood 1995).

Technological advance would have tended to boost the demand for more skilled and educated labor if technological advance and skills are complementary, as is often asserted.

However, there is no theoretical reason why technology and skills need be complementary and indeed concepts of directed technological change or induced innovation would suggest that in the presence of relatively high skill premiums, technological advance would be skill saving rather than skill using. Goldin and Katz (1998) have argued that the shift from the factory to continuous processing and batch production associated with the shift of power sources from steam to electricity in the early twentieth century lead to rising technology skill complementarity in U.S. manufacturing. It remains to be established how general this trend has been. It could be related to the distinction made between the dominance in the United States of extensive growth in the nineteenth century due to the growth of factors of production such as labor and capital and the increasing importance of intensive growth in the twentieth century. Intensive growth is often associated with technological advance and a presumed enhanced value for education (Abramovitz and David 2000). Some analysts have emphasized the importance of capital-skill complementarity. For example, Galor and Moav (2003) point to the level of the physical capital stock as a key influence on the return to human capital investment; they suggest that once physical capital stock accumulation surpassed a certain level, the positive impact of human capital accumulation on the return to physical capital became large enough that owners of physical capital came to support the rise of mass schooling. They cite the case of schooling reform in early twentieth century Britain as an example.

Even sharp declines in the premiums to schooling do not preclude a significant impact of education on economic growth. DeLong, Goldin and Katz’s (2003) growth accounting analysis for the twentieth century U.S. makes the point that even at modest positive returns to schooling on the order of 5 percent per year of schooling, with large enough increases in educational attainment, the contribution to growth can be substantial.

Human Capital

Economists have generalized the impact of schooling on labor force quality into the concept of human capital. Human capital refers to the investments that human beings make in themselves to enhance their economic productivity. These investments can take on many forms and include not only schooling but also apprenticeship, a healthy diet, and exercise, among other possibilities. Some economists have even suggested that more amorphous societal factors such as trust, institutional tradition, technological know how and innovation can all be viewed as forms of human capital (Temple 2001a; Topel 1999; Mokyr 2002). Thus broadly defined, human capital would appear as a prime candidate for explaining much of the difference across nations and over time in output and economic growth. However, gaining much insight into the actual magnitudes and the channels of influence by which human capital might influence economic growth requires specification of both the nature and determinants of human capital and how human capital affects aggregate production of an economy.

Much of the literature on human capital and growth makes the implicit assumption that some sort of numerical scale exists for human capital, even if multidimensional and even if unobservable. This in turn implies that it is meaningful to relate levels and changes of human capital to levels of income per capita and rates of economic growth. Given the multiplicity of factors that influence human knowledge and skill and in turn how these influence labor productivity, difficulties would seem likely to arise with attempts to measure aggregate human capital similar to those that have arisen with attempts to specify and measure the nature of human intelligence. Woessmann (2002, 2003) provides useful surveys of some of the issues involved in attempting to specify human capital at the aggregate level appropriate for relating it to economic growth.

One can distinguish between approaches to the measurement of human capital that focus on schooling, as in the discussion above, and those that take a broader view. Broad view approaches try to capture all investments that may have improved human productivity from whatever source, including not just schooling but other productivity enhancing investments, such as on-the-job training. The basic premise of broad view approaches is that for an aggregate economy, the income going to labor over and above what that labor would earn if it were paid the income of an unskilled worker can be viewed as human capital. This measure can be constructed in various ways including as a ratio using unskilled labor earnings as the denominator as in Mulligan and Sala-I-Martin (1997) or using the share of labor income not going as compensation for unskilled labor as in Crafts (1995) and Mitch (2004). Mulligan and Sala-I-Martin (2000) point to some of the major index number problems that can arise in using this approach to aggregate heterogeneous workers.

Crafts and Mitch find that for Britain during its late eighteenth and early nineteenth century industrial revolution between one-sixth and one-fourth of income per capita can be attributed to human capital measured as the share of labor income not going as compensation for unskilled labor.

One approach that has been taken recently to estimate the role of human capital differences in explaining international differences in income per capita is to consider changes in immigrant earnings between origin and destination countries along with differences between immigrant and native workers in the destination country. Olson (1996) suggested that the large increase in earnings of immigrants commonly observed in moving from a low income to a high income country points to a small role for human capital in explaining the wide variation in per capita income across countries. Hendricks (2002) has used differences between immigrant and native earnings in the U.S. to estimate the contribution of otherwise unobserved skill differences to explaining differences in income per capita across countries and finds that they account for only a small part of the latter differences. Hendricks’ approach raises the issue of whether there could be long-term increases in otherwise unobserved skills that could have contributed to economic growth.

The Informal Acquisition of Human Capital

One possible source of such skills is through the informal acquisition of human capital through on-the-job experience. Insofar as work has been common from early adolescence onwards, the issue arises of why the aggregate stock of skills acquired through experience would vary over time and thus influence rates of economic growth. Some types of on-the-job experience which contribute to economic productivity, such as apprenticeship, may entail an opportunity cost and aggregate trends in skill accumulation will be influenced by societal willingness to incur such opportunity costs.

Insofar as schooling continues through adolescence, this can interfere with the accumulation of workforce experience. DeLong, Goldin and Katz (2003) note the tradeoff between rising average years of schooling completed and decreasing years of labor force experience in influencing labor force quality of the U.S. labor force in the last half of the twentieth century. Connolly (2004) has found that informal experience played a relatively greater role in Southern economic growth than for other regions of the United States.

Hansen (1997) has also distinguished the academically-oriented secondary schooling the United States developed in the late nineteenth and early twentieth century from the vocationally-oriented schooling and apprenticeship system that Germany developed over the same time period. Goldin (2001) argues that in the United States the educational system developed general abilities suitable for the greater opportunities for geographical and occupational mobility that prevailed there, while specific vocational training was more suitable for the more restricted mobility opportunities in Germany.

Little evidence exists on whether long-term trends in informal opportunities for skill acquisition have influenced growth rates. However, Smith’s (1776) view of the importance of the division of labor in influencing productivity would suggest that the impact of trends in these opportunities may well have been quite sizable.

Externalities from Education

Economists commonly claim that education yields benefits to society over and above the impact on labor market productivity perceived by the person receiving the education. These benefits can include impacts on economic productivity, such as impacts on technological advance. They can also include non-labor market benefits. Thus McMahon (2002, 11) in his assessment of the social benefits of education includes not only direct effects on economic productivity but also impacts on a) population growth rates and health b) democratization, political stability, and human rights, c) the environment, d) reduction of poverty and inequality, e) crime and drug use, and f) labor force participation. While these effects may appear to involve primarily non-market activity and thus would not be reflected in national output measures and growth rates, factors such as political stability, democratization, population growth, and health have obvious consequences for prospects for long-term growth. However, allowance should be made for the simultaneous influence of the distribution of political power and life expectancy on societal investments in schooling.

For the period since 1960, numerous studies have employed cross country variation in various estimates of human capital and income per capita to directly estimate the impact of human capital on levels of income per capita and growth. A central goal of many such estimates is to see if there are externalities to education on output over and above the private returns estimated from micro data. The results have been conflicting and this has been attributed not only to problems of measurement error but also to differences in specification of human capital and its impact on growth. There does not appear to be strong evidence of large positive externalities to human capital (Temple 2001a). Furthermore, McMahon (2004) reports some empirical specifications which yield substantial indirect long-run effects.

For the period before 1960, limits on the availability of data on schooling and income have limited the use of this empirical regression approach. Thus, any discussion of the impact of externalities of education on production is considerably more conjectural. The central role of government, religious, and philanthropic agencies in the provision of schooling suggests the presence of externalities. Politicians and educators more frequently justified government and philanthropic provision of schooling by its impacts on religious and moral behavior than by any market failure resulting in sub-optimal provision of schooling from the standpoint of maximizing labor productivity. Thus, Adam Smith in his discussion of mass schooling in The Wealth of Nations, places more emphasis on its value to the state in enhancing orderliness and decency while reducing the propensity to popular superstition than on its immediate value in enhancing the economic productivity of the individual worker.

The Impact of the Level of Human Capital on Rates of Economic Growth

The approaches considered thus far relate changes in educational attainment of the labor force to changes in output per worker. An alternative, though not mutually exclusive, approach is to relate the level of educational attainment of an economy’s labor force to its rate of economic growth. The argument for doing so is that a high but unchanging level of educational attainment should contribute to growth by facilitating creativity, innovation and adaptation to change as well as facilitating the ongoing maintenance and improvement of skill in the workforce. Topel (1999) has argued that there may not be any fundamental difference between the two types of approach insofar as ongoing sources of productivity advance and adaptation to change could be viewed as reflecting ongoing improvements in human capital. Nevertheless, some empirical studies based on international data for the late twentieth century have found that a country’s level of educational attainment has a much stronger impact on its rate of economic growth than its rate of improvement in educational attainment (Benhabib and Spiegel 1994).

The paucity of data on schooling attainment has limited the empirical examination of the relationship between levels of human capital and economic growth for periods before the late twentieth century. However, Sandberg (1982) has argued, based on a descriptive comparison of economies in various categories, that those with high levels of schooling in 1850 subsequently experienced faster rates of economic growth. Some studies, such as O’Rourke and Williamson (1997) and Foreman-Peck and Lains (1999), have found that high levels of schooling and literacy have contributed to more rapid rates of convergence for European countries in the late nineteenth century and at the state level for the U.S. over the twentieth century (Connolly 2004).

Bowman and Anderson (1963), a much earlier study based on international evidence for the mid-twentieth century, can be interpreted in the spirit of relating levels of education to subsequent levels of income growth. Their reading of the cross-country relationship between literacy rates and per capita income at mid-twentieth-century was that a threshold of 40 percent adult literacy was required for a country to have a per capita income above 300 1955 dollars. Some have ahistorically projected back this literacy threshold to earlier centuries although the Bowman and Anderson proposal was intended to apply to mid-twentieth century development patterns.

The mechanisms by which the level of schooling would influence the rate of economic growth are problematic to establish. One can distinguish two general possibilities. One would be that higher levels of educational attainment facilitate adaptation and responsiveness to change throughout the workforce. This would be especially important where a large percentage of workers are in decision making positions such as an economy composed largely of small farmers and other small enterprises. The finding of Foster and Rosenzweig (1996) for late twentieth century India that the rate of return to schooling is higher during periods of more rapid technological advance in agriculture would be consistent with this. Likewise, Nilsson et al (1999) find that literacy was important for nineteenth-century Swedish farmers in dealing with enclosure, an institutional change. The other possibility is that higher levels of educational attainment increase the potential pool from which an elite group responsible for innovation can be recruited. This could be viewed as applying specifically to scientific and technical innovation as in Mokyr (2002) and Jones (2002) — but also to technological and industrial leadership more generally (Nelson and Wright 1992) and to facilitating advancement in society by ability irrespective of social origins (Galor and Tsiddon 1997). Recently, Labuske and Baten (2004) have found that international rates of patenting are related to secondary enrollment rates.

Two issues have arisen in the recent theoretical literature regarding specifying relationships between the level of human capital and rates of economic growth. First, Lucas (1988) in an influential model of the impact of human capital on growth, specifies that the rate of growth of human capital formation depends on initial levels of human capital, in other words that parents’ and teachers’ human capital has a direct positive influence on the rate of growth of learners’ human capital. This specification of the impact of the initial level of human capital allows for ongoing and unbounded growth of human capital and through this its ongoing contribution to economic growth. Such ongoing growth of human capital could occur through improvements in the quality of schooling or through enhanced improvements in learning from parents and other informal settings. While it might be plausible to suppose that improved education of teachers will enhance their effectiveness with learners, it seems less plausible to suppose that this enhanced effectiveness will increase unbounded in proportion to initial levels of education (Lord 2001, 82).

A second issue is that insofar as higher levels of human capital contribute to economic growth through increases in research and development activity and innovative activity more generally, one would expect the presence of scale effects. Economies with larger populations holding constant their level of human capital per person should benefit from more overall innovative activity simply because they have more people engaged in innovative activity. Jones (1995) has pointed out that such scale effects seem implausible if one looks at the time series relationship between rates of economic growth and those engaged in innovative activity. In recent decades the growth of the number of scientists, engineers, and others engaged in innovative activity has far outstripped the actual growth of productivity and other indicators of direct impact on innovation. Thus, one should allow for diminishing returns in the relationship between levels of education and technological advance.

Thus, as with schooling externalities, considering the impact of levels of education on growth offers numerous channels of influence leaving the challenge for the historian of ascertaining their quantitative importance in the past.

Conclusion

This survey has considered some of the basic ways in which the rise of mass education has contributed to economic growth in recent centuries. Given their potential influence on labor productivity, levels and changes in schooling and of human capital more generally have the potential for explaining a large share of increases in per capita output over time. However, increases in mass schooling seem to explain a major share of economic growth only over relatively short periods of time, with a more modest impact over longer time horizons. In some situations, such as the United States in the twentieth century, it appears that improvements in the schooling of the labor force have made substantial contributions to economic growth. Yet schooling should not be seen as either a necessary or sufficient condition for generating economic growth. Factors other than education can contribute to economic growth and in their absence, it is not clear that schooling in itself can contribute to economic growth. Moreover, there are likely limits on the extent to which average years of schooling of the labor force can expand, although improvement in the quality of schooling is not so obviously bounded. Perhaps the most obvious avenue through which education has contributed to economic growth is by expanding the rate of technological change. But as has been noted, there are numerous other possible channels of influence ranging from political stability and property rights to life expectancy and fertility. The diversity of these channels point to both the challenges and the opportunities in examining the historical connections between education and economic growth.

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[1] I have received helpful comments on this essay from Mac Boot, Claudia Goldin, Bill Lord, Lant Pritchett, Robert Whaples, and an anonymous referee. At an earlier stage in working through some of this material, I benefited from a quite useful conversation with Nick Crafts. However, I bear sole responsibility for remaining errors and shortcomings.

[2] For a detailed survey of trends in schooling in the early modern and modern period see Graff (1987).

[3] See Barro (1998) for a brief intellectual history of growth accounting.

[4] Blaug (1970) provides an accessible, detailed critique of the assumptions behind Denison’s growth accounting approach and Topel (1999) provides a further discussion of the problems of using a growth accounting approach to measure the contribution of education, especially those due to omitting social externalities.

[5] By using a Cobb-Douglas specification of the aggregate production function, one can arrive at the following equation for the ratio between final and initial national income per worker due to increases in average school years completed between the two time periods, t = 0 and t =1:

Start with the aggregate production function specification:

Y = A K(1-α) [(1+r)S L]α

Y/L = A (K/L)(1-α) [(1+r)S L/L]α

Y/L = A (K/L)(1-α) [(1+r)S]α

Assume that the average years of schooling of the labor force is the only change between t = 0 and t =1; that is, assume no change in the ratio of capital to labor between time periods. Then the ratio of the income per worker in the later time period to the earlier time period will be:

(Y/L)1/ (Y/L)0 = ( (1 + r )S1- S0 )α

Where Y = output, A = a measure of the current state of technology, K = the physical capital stock, L = the labor force, r = the percent by which a year of schooling increases labor productivity, S is the average years of schooling completed by the labor force in each time period, α is labor’s share in national income, and the subscripts 0 and 1 denote initial and final time periods.

As noted above, the derivation above is for a partial equilibrium change in years of schooling of the labor force holding constant the physical capital stock. Allowing for physical capital stock accumulation in response to schooling increases in a Solow-type model implies that the ratio of final to initial output per worker will be

(Y/L)1/ (Y/L)0 = ( (1 + r )S1 - S0 ) .

For a derivation of this see Lord (2001, 99-100). Lord’s derivation differs from that here by specifying the technology parameter A as labor augmenting. Allowing for increases in A over time due to technical change would further increase the contribution to output per worker of additional years of schooling.

[6]To take a specific example, suppose that in the steady-state case of Table 1B, a 5 percent earnings premium per year of schooling is assigned to the first 6 years of schooling, i.e. primary schooling, a 10 percent earnings premium per year is assigned to the next 6 years of schooling, i.e. secondary schooling, and a 15 percent earnings premium per year is assigned to the final 4 years of schooling, that is college. In that case, the impact on steady state income per capita compared with no schooling at all would be (1.05)6x(1.10)6x(1.15)4 = 4.15, compared with the 4.59 in going from no schooling to universal college at a 10 percent rate of return for every year of school completed.

[7] Denison’s standard growth accounting approach assumes that education is labor augmenting and, in particular, that there is an infinite elasticity of substitution between skilled and unskilled labor. This specification is conventional in growth accounting analysis. But another common specification in entering education into aggregate production functions is to specify human capital as a third factor of production along with unskilled labor and physical capital. Insofar as this is done with a Cobb-Douglas production function specification, as is conventional, the implied elasticity of substitution between human capital and either unskilled labor or physical capital is unity. The complementarity between human capital and other inputs this implies will tend to increase the contribution of human capital increases to economic growth by decreasing the tendency for diminishing returns to set in. (For a fuller treatment of the considerations involved see Griliches 1970, Conlisk 1970, Broadberry 2003). For an application of this approach in a historical growth accounting exercise, see Crafts (1995), who finds a fairly substantial contribution of human capital during the English industrial revolution. For a critique of Crafts’ estimates see Mitch (1999).

[8] For an examination of long-run growth dynamics with schooling investments endogenously determined by transfer-constrained family decisions see Lord 2001, 209-213 and Rangazas 2000. Lord and Rangazas find that allowing for the fact that families are credit constrained in making schooling investment decisions is consistent with the time path of interest rates in the U.S. between 1870 and 1970.

Citation: Mitch, David. “Education and Economic Growth in Historical Perspective”. EH.Net Encyclopedia, edited by Robert Whaples. July 26, 2005. URL http://eh.net/encyclopedia/education-and-economic-growth-in-historical-perspective/

Economy of England at the Time of the Norman Conquest

John McDonald, Flinders University, Adelaide, Australia

The Domesday Survey of 1086 provides high quality and detailed information on the inputs, outputs and tax assessments of most English estates. This article describes how the data have been used to reconstruct the eleventh-century Domesday economy. By exploiting modern economic theory and statistical methods the reconstruction has led to a radically different assessment of the way in which the Domesday economy and fiscal system were organized. It appears that tax assessments were based on a capacity to pay principle subject to politically expedient concessions and we can discover who received lenient assessments and why. Penetrating questions can be asked about the economy. We can compare the efficiency of Domesday agricultural production with the efficiency of more modern economies, measure the productivity of inputs and assess the impact of feudalism and manorialism on economic activity. The emerging picture of a reasonably well organized economy and fair tax system contrasts with the assessment of earlier historians who saw the Normans as capable military and civil administrators but regarded the economy as haphazardly run and tax assessments as “artificial” or arbitrary. The next section describes the Survey, the contemporary institutional arrangements and the main features of Domesday agricultural production. Some key findings on the Domesday economy and tax system are then briefly discussed.

Domesday England and the Domesday Survey

William the Conqueror invaded England from France in 1066 and carried out the Domesday Survey twenty years later. By 1086, Norman rule had been largely consolidated, although only after rebellion and civil dissent had been harshly put down. The Conquest was achieved by an elite, and, although the Normans brought new institutions and practices, these were superimposed on the existing order. Most of the Anglo-Saxon aristocracy were eliminated, the lands of over 4,000 English lords passing to less than 200 Norman barons, with much of the land held by just a handful of magnates.

William ruled vigorously through the Great Council. England was divided into shires, or counties, which were subdivided into hundreds. There was a sophisticated and long established shire administration. The sheriff was the king’s agent in the county, royal orders could be transmitted through the county and hundred courts, and an effective taxation collection system was in place.

England was a feudal state. All land belonged to the king. He appointed tenants-in-chief, both lay and ecclesiastical, who usually held land in return for providing a quota of fully equipped knights. The tenants-in-chief might then grant the land to sub-tenants in return for rents or services, or work the estate themselves through a bailiff. Although the Survey records 112 boroughs, agriculture was the predominant economic activity, with stock rearing of greater importance in the south-west and arable farming more important in the east and midlands. Manorialism was a pervasive influence, although it existed in most parts of England in a modified form. On the manor the peasants worked the lord’s demesne in return for protection, housing, and the use of plots of land to cultivate their own crops. They were tied to the lord and the manor and provided a resident workforce. The demesne was also worked by slaves who were fed and housed by the lord.

The Domesday Survey was commissioned on Christmas day, 1085, and it is generally thought that work on summarizing the Survey was terminated with the death of William in September 1087. The task was facilitated by the availability of Anglo-Saxon hidage (tax) lists. The counties of England were grouped into (probably) seven circuits. Each circuit was visited by a team of commissioners, bishops, lawyers and lay barons who had no material interests in the area. The commissioners were responsible for circulating a list of questions to land holders, for subjecting the responses to a review in the county court by the hundred juries, often consisting of half Englishmen and half Frenchmen, and for supervising the compilation of county and circuit returns. The circuit returns were then sent to the Exchequer in Winchester where they were summarized, edited and compiled into Great Domesday Book.

Unlike modern surveys, individual questionnaire responses were not treated confidentially but became public knowledge, being verified in the courts by landholders with local knowledge. In such circumstances, the opportunities for giving false or misleading evidence were limited.

Domesday Book consists of two volumes, Great (or Exchequer) Domesday and Little Domesday. Little Domesday is a detailed original survey circuit return of circuit VII, Essex, Norfolk and Suffolk. Great Domesday is a summarized version of the other circuit returns sent to the King’s treasury in Winchester. (It is thought that the death of William occurred before Essex and East Anglia could be included in Great Domesday.) The two volumes contain information on the net incomes or outputs (referred to as the annual values), tax assessments and resources of most manors in England in 1086, some information for 1066, and sometimes also for an intermediate year. The information was used to revise tax assessments and document the feudal structure, “who held what, and owed what, to whom.”

Taxation

The Domesday tax assessments relate to a non-feudal tax, the geld, thought to be levied annually by the end of William’s reign. The tax can be traced back to the danegeld, and, although originally a land tax, by Norman times, it was more broadly based and a significant impost on landholders.

There is an extensive literature on the Norman tax system, much of it influenced by Round (1895), who considered the assessments to be “artificial,” in the sense that they were imposed from above via the county and hundred with little or no consideration of the capacity of an individual estate to pay the tax. Round largely based his argument on an unsystematic and subjective review of the distribution of the assessments across estates, vills and the hundreds of counties.

In (1985a) and (1986, Ch. 4), Graeme Snooks and I argued that, contrary to Round’s hypothesis, the tax assessments were based on a capacity to pay principle, subject to some politically expedient tax concessions. Similar tax systems operate in most modern societies and reflect an attempt to collect revenue in a politically acceptable way. We found empirical support for the hypothesis, using statistical methods. We showed, for example, that for Essex lay estates about 65 percent of variation in the tax assessments could be attributed to variations in manorial net incomes or manorial resources, two alternative ways of measuring capacity to pay. Similar results were obtained for other counties. Capacity to pay explains from 64 to 89 percent of variation in individual estate assessment data for the counties of Buckinghamshire, Cambridgeshire, Essex and Wiltshire, and from 72 to 81 percent for aggregate data for 29 counties (see McDonald and Snooks, 1987a). The estimated tax relationships capture the main features of the tax system.

Capacity to pay explains most variation in tax assessments, but some variation remains. Who and which estates were treated favorably? And what factors were associated with lenient taxation? These issues were investigated in McDonald (1998) where frontier methods were used to derive a measure of how favorable the tax assessments were for each Essex lay estate. (The frontier methods, also known as “data envelopment analysis,” use the tax and income observations to trace out an outer bound, or frontier, for the tax relationship.) Estates, tenants-in-chief and local areas (hundreds) of the county with lenient assessments were identified, and statistical methods used to discover factors associated with favorable assessments. Some significant factors were the tenant-in-chief holding the estate (assessments tended to be less beneficial for the tenants-in-chief holding a large number of estates in Essex), the hundred location (some hundreds receiving more favorable treatment than others), proximity to an urban center (estates remote from the urban centers being more favorably treated), economic size of the estate (larger estates being less favorably treated) and tenure (estates held as sub-tenancies having more lenient assessments). The results suggest a similarity with more modern tax systems, with some groups and activities receiving minor concessions and the administrative process inducing some unevenness in the assessments. Although many details of the tax system have been lost in the mists of time, careful analysis of the Survey data has enabled us to rediscover its main features.

Production

Since Victorian times historians have used Domesday Book to study the political, institutional and social structures and the geography of Domesday England. However, the early scholars tended to draw away from economic issues. They were unable to perceive that systematic economic relationships were present in the Domesday economy, and, in contrast to their view that the Normans displayed considerable ability in civil administration and military matters, economic production was regarded as poorly organized (see McDonald and Snooks, 1985a, 1985b and 1986, especially Ch 3). One explanation why the Domesday scholars were unable to discover consistent relationships in the economy lies in the empirical method they adopted. Rather than examining the data as a whole using statistical techniques, conclusions were drawn by generalizing from a few (often atypical) cases. It is not surprising that no consistent pattern was evident when data were restricted to a few unusual observations. It would also appear that the researchers often did not have a firm grasp of economic theory (for example, seemingly being perplexed that the same annual value, that is, net output, could be generated by estates with different input mixes, see McDonald and Snooks, 1986, Ch. 3).

In McDonald and Snooks (1986), using modern economic and statistical methods, Graeme Snooks and I reanalyzed manorial production relationships. The study shows that strong relationships existed linking estate net output to inputs. We estimated manorial production functions which indicate many interesting characteristics of Domesday production: returns to scale were close to constant, oxen plough teams and meadowland were prized inputs in production but horses contributed little, and villans, bordars and slaves (the less free workers) contributed far more than freemen and sokemen ( the more free) to the estate’s net output. The evidence suggested that in many ways Domesday landholders operated in a manner similar to modern entrepreneurs. Unresolved by this research was the question of how similar was the pattern of medieval and modern economic activity. In particular, how well organized was estate production?

Clearly, in an absolute sense Domesday estate production was inefficient. With modern technology, using, for example, motorized tractors, output could have been increased many-fold. A more interesting question is: Given the contemporary technology and institutions, how efficient was production?

In McDonald (1998) frontier methods were used to measure best practice, given the economic environment. We then measured how far, on average, estate production was below the best practice frontier. Providing some estates were effectively organized, so that best practice was good practice, this will be a useful measure. If many estates were run haphazardly and ineffectively, average efficiency will be low and efficiency dispersion measures large. Comparisons with average efficiency levels in similar production situations will give an indication of whether Domesday average efficiency was unusually low.

A large number of efficiency studies have been reported in the literature. Three case studies with characteristics similar to Domesday production are Hall’s (1975) study of agriculture after the Civil War in the American South, Hall and LeVeen’s (1978) analysis of small Californian farms and Byrnes, Färe, Grosskopf and Lovell’s (1988) study of American surface coalmines. For all three studies the individual establishment is the production unit, the economic activity is unsophisticated primary production and similar frontier methods are used to measure efficiency.

The comparison studies suggest that efficiency levels varied less across Domesday estates than they did among postbellum Southern farms and small Californian farms in the 1970s (and were very similar for Domesday estates and US surface coalmines). Certainly, the average Domesday estate efficiency level does not appear to be unusually low when compared with average efficiency levels in similar production situations.

In McDonald (1998) estate efficiency measures are also used to examine details of production on individual estates and statistical methods employed to find factors associated with efficiency. Some of these include the estate’s tenant-in-chief (some tenants-in-chief displayed more entrepreneurial flair than others), the size of the estate (larger estates, using inputs in different proportions to smaller estates, tended to be more efficient) and the kind of agriculture undertaken (estates specialized in grazing were more efficient).

Largely through the influences of feudalism and manorialism, Domesday agriculture suffered from poorly developed factor markets and considerable immobility of inputs. Although there were exceptions to the rule, as a first approximation, manorial production can be characterized in terms of estates worked by a residential labor force using the resources, which were available on the estate.

Input productivity depends on the mix of inputs used in production, and with estates endowed with widely different resource mixes, one might expect that input productivities would vary greatly across estates. The frontier analysis generates input productivity measures (shadow prices), and these confirm this expectation — indeed on many estates some inputs made very little contribution to production. The frontier analysis also allows us to estimate the economic cost of input rigidity induced by the feudal and manorial arrangements. The calculation indicates that if inputs had been mobile among estates an increase in total net output of 40.1 percent would have been possible. This potential loss in output is considerable. The frontier analysis indicates the loss in total net output resulting from estates not being fully efficient was 51.0 percent. The loss in output due to input rigidities is smaller, but of a similar order of magnitude.

Domesday Book is indeed a rich data source. It is remarkable that so much can be discovered about the English economy almost one thousand years ago.

Further reading

Background information on Domesday England is contained in McDonald and Snooks (1986, Ch. 1 and 2; 1985a, 1985b, 1987a and 1987b) and McDonald (1998). For more comprehensive accounts of the history of the period see Brown (1984), Clanchy (1983), Loyn (1962), (1965), (1983), Stenton (1943), and Stenton (1951). Other useful references include Ballard (1906), Darby (1952), (1977), Galbraith (1961), Hollister (1965), Lennard (1959), Maitland (1897), Miller and Hatcher (1978), Postan (1966), (1972), Round (1895), (1903), the articles in Williams (1987) and references cited in McDonald and Snooks (1986). The Survey is discussed in McDonald and Snooks (1986, sec. 2.2), the references cited there, and the articles in Williams (1987). The Domesday and modern surveys are compared in McDonald and Snooks (1985c).
The reconstruction of the Domesday economy is described in McDonald and Snooks (1986). Part 1 contains information on the basic tax and production relationships and Part 2 describes the methods used to estimate the relationships. The tax and production frontier analysis and efficiency comparisons are described in McDonald (1998). The book also explains the frontier methodology. A series of articles describe features of the research to different audiences: McDonald and Snooks (1985a, 1985b, 1987a, 1987b), economic historians; McDonald (2000), economists; McDonald (1997), management scientists; McDonald (2002), accounting historians (who recognize that Domesday Book possesses many attributes of an accounting record); and McDonald and Snooks (1985c), statisticians. Others who have made important contributions to our understanding of the Domesday economy include Miller and Hatcher (1978), Harvey (1983) and the contributors to the volumes edited by Aston (1987), Holt (1987), Hallam (1988) and Britnell and Campbell (1995).

References

Aston, T.H., editor. Landlords, Peasants and Politics in Medieval England. Cambridge: Cambridge University Press, 1987.
Ballard, Adolphus. The Domesday Inquest. London: Methuen, 1906.
Brittnell, Richard H. and Bruce M.S. Campbell, editors. A Commercialising Economy: England 1086 to c. 1300. Manchester: Manchester University Press, 1995.
Brown, R. Allen. The Normans. Woodbridge: Boydell Press, 1984.
Byrnes, P., R. Färe, S. Grosskopf and C.A. K. Lovell. “The Effect of Unions on Productivity: U.S. Surface Mining of Coal.” Management Science 34 (1988): 1037-53.
Clanchy, M.T. England and Its Rulers, 1066-1272. Glasgow: Fontana, 1983.
Darby, H.C. The Domesday Geography of Eastern England. Reprinted 1971. Cambridge: Cambridge University Press, 1952.
Darby, H.C. Domesday England. Reprinted 1979. Cambridge: Cambridge University Press, 1977.
Darby, H.C. and I.S. Maxwell, editor. The Domesday Geography of Northern England. Cambridge: Cambridge University Press, 1962.
Galbraith, V.H. The Making of Domesday Book. Oxford: Clarendon Press,1961.
Hall, A. R. “The Efficiency of Post-Bellum Southern Agriculture.” Ann Arbor, MI: University Microfilms International, 1975.
Hall, B. F. and E. P. LeVeen. “Farm Size and Economic Efficiency: The Case of California.” American Journal of Agricultural Economics 60 (1978): 589-600.
Hallam, H.E. Rural England, 1066-1348. Brighton: Fontana, 1981.
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Harvey, S.P.J. “The Extent and Profitability of Demesne Agriculture in the Latter Eleventh Century.” In Social Relations and Ideas: Essays in Honour of R.H. Hilton, edited by T.H. Ashton et al. Cambridge, Cambridge University Press, 1983.
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McDonald, John. and G. D. Snooks. “The Determinants of Manorial Income in Domesday England: Evidence from Essex.” Journal of Economic History 45 (1985b): 541-556.
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McDonald, John. and G. D. Snooks. “The Suitability of Domesday Book for Cliometric Analysis.” Economic History Review 40 (1987a): 252-261.
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Citation: McDonald, John. “Economy of England at the Time of the Norman Conquest”. EH.Net Encyclopedia, edited by Robert Whaples. September 9, 2004. URL http://eh.net/encyclopedia/economy-of-england-at-the-time-of-the-norman-conquest/

Savings and Loan Industry (U.S.)

David Mason, Young Harris College

The savings and loan industry is the leading source of institutional finance for residential home mortgages in America. From the appearance of the first thrift in Philadelphia in 1831, savings and loans (S&Ls) have been primarily local lenders focused on helping people of modest means to acquire homes. This mission was severely compromised by the financial scandals that enveloped the industry in the 1980s, and although the industry was severely tarnished by these events S&Ls continue to thrive.

Origins of the Thrift Industry

The thrift industry traces its origins to the British building society movement that emerged in the late eighteenth century. American thrifts (known then as “building and loans” or “B&Ls”) shared many of the same basic goals of their foreign counterparts — to help working-class men and women save for the future and purchase homes. A person became a thrift member by subscribing to shares in the organization, which were paid for over time in regular monthly installments. When enough monthly payments had accumulated, the members were allowed to borrow funds to buy homes. Because the amount each member could borrow was equal to the face value of the subscribed shares, these loans were actually advances on the unpaid shares. The member repaid the loan by continuing to make the regular monthly share payments as well as loan interest. This interest plus any other fees minus operating expenses (which typically accounted for only one to two percent of revenues) determined the profit of the thrift, which the members received as dividends.

For the first forty years following the formation of the first thrift in 1831, B&Ls were few in number and found in only a handful of Midwestern and Eastern states. This situation changed in the late nineteenth century as urban growth (and the demand for housing) related to the Second Industrial Revolution caused the number of thrifts to explode. By 1890, cities like Philadelphia, Chicago, and New York each had over three hundred thrifts, and B&Ls could be found in every state of the union, as well as the territory of Hawaii.

Differences between Thrifts and Commercial Banks

While industrialization gave a major boost to the growth of the thrift industry, there were other reasons why these associations could thrive along side larger commercial banks in the 19th and early 20th centuries. First, thrifts were not-for-profit cooperative organizations that were typically managed by the membership. Second, thrifts in the nineteenth century were very small; the average B&L held less than $90,000 in assets and had fewer than 200 members, which reflected the fact that these were local institutions that served well-defined groups of aspiring homeowners.

Another major difference was in the assets of these two institutions. Bank mortgages were short term (three to five years) and were repaid interest only with the entire principle due at maturity. In contrast, thrift mortgages were longer term (eight to twelve years) in which the borrower repaid both the principle and interest over time. This type of loan, known as the amortizing mortgage, was commonplace by the late nineteenth century, and was especially beneficial to borrowers with limited resources. Also, while banks offered a wide array of products to individuals and businesses, thrifts often made only home mortgages primarily to working-class men and women.

There was also a significant difference in the liabilities of banks and thrifts. Banks held primarily short-term deposits (like checking accounts) that could be withdrawn on demand by accountholders. In contrast, thrift deposits (called share accounts) were longer term, and because thrift members were also the owners of the association, B&Ls often had the legal right to take up to thirty days to honor any withdrawal request, and even charge penalties for early withdrawals. Offsetting this disadvantage was the fact that because profits were distributed as direct credits to member share balances, thrifts members earned compound interest on their savings.

A final distinction between thrifts and banks was that thrift leaders believed they were part of a broader social reform effort and not a financial industry. According to thrift leaders, B&Ls not only helped people become better citizens by making it easier to buy a home, they also taught the habits of systematic savings and mutual cooperation which strengthened personal morals. This attitude of social uplift was so pervasive that the official motto of the national thrift trade association was “The American Home. Safeguard of American Liberties” and its leaders consistently referred to their businesses as being part of a “movement” as late as the 1930s.

The “Nationals” Crisis

The early popularity of B&Ls led to the creation of a new type of thrift in the 1880s called the “national” B&L. While these associations employed the basic operating procedures used by traditional B&Ls, there were several critical differences. First, the “nationals” were often for-profit businesses formed by bankers or industrialists that employed promoters to form local branches to sell shares to prospective members. The members made their share payments at their local branch, and the money was sent to the home office where it was pooled with other funds members could borrow from to buy homes. The most significant difference between the “nationals” and traditional B&Ls was that the “nationals” promised to pay savings rates up to four times greater than any other financial institution. While the “nationals” also charged unusually high fees and late payment fines as well as higher rates on loans, the promise of high returns caused the number of “nationals” to surge. When the effects of the Depression of 1893 resulted in a decline in members, the “nationals” experienced a sudden reversal of fortunes. Because a steady stream of new members was critical for a “national” to pay both the interest on savings and the hefty salaries for the organizers, the falloff in payments caused dozens of “nationals” to fail, and by the end of the nineteenth century nearly all the “nationals” were out of business.

The “nationals” crisis had several important effects on the thrift industry, the first of which was the creation of the first state regulations governing B&Ls, designed both to prevent another “nationals” crisis and to make thrift operations more uniform. Significantly, thrift leaders were often responsible for securing these new guidelines. The second major change was the formation of a national trade association to not only protect B&L interests, but also promote business growth. These changes, combined with improved economic conditions, ushered in a period of prosperity for thrifts, as seen below:

Year Number of B&Ls
B&L
Assets (000,000)
1888 3,500 $300
1900 5,356 $571
1914 6,616 $1,357

Source: Carroll D. Wright, Ninth Annual Report of the Commissioner of Labor: Building and Loan Associations (Washington, D.C.: USGPO, 1894), 214; Josephine Hedges Ewalt, A Business Reborn: The Savings and Loan Story, 1930-1960 (Chicago: American Savings and Loan Institute Publishing Co., 1962), 391. (All monetary figures in this study are in current dollars.)

The Thrift Trade Association and Business Growth

The national trade association that emerged from the “nationals” crisis became a prominent force in shaping the thrift industry. Its leaders took an active role in unifying the thrift industry and modernizing not only its operations but also its image. The trade association led efforts to create more uniform accounting, appraisal, and lending procedures. It also spearheaded the drive to have all thrifts refer to themselves as “savings and loans” not B&Ls, and to convince managers of the need to assume more professional roles as financiers.

The consumerism of the 1920s fueled strong growth for the industry, so that by 1929 thrifts provided 22 percent of all mortgages. At the same time, the average thrift held $704,000 in assets, and more than one hundred thrifts had over $10 million in assets each. Similarly, the percentage of Americans belonging to B&Ls rose steadily so that by the end of the decade 10 percent of the population belonged to a thrift, up from just 4 percent in 1914. Significantly, many of these members were upper- and middle-class men and women who joined to invest money safely and earn good returns. These changes led to broad industry growth as seen below:

Year Number of B&Ls Assets (000,000)
1914 6,616 $1,357
1924 11,844 $4,766
1930 11,777 $8,829

Source: Ewalt, A Business Reborn, 391

The Depression and Federal Regulation

The success during the “Roaring Twenties” was tempered by the financial catastrophe of the Great Depression. Thrifts, like banks, suffered from loan losses, but in comparison to their larger counterparts, thrifts tended to survive the 1930s with greater success. Because banks held demand deposits, these institutions were more susceptible to “runs” by depositors, and as a result between 1931 and 1932 almost 20 percent of all banks went out of business while just over 2 percent of all thrifts met a similar fate. While the number of thrifts did fall by the late 1930s, the industry was able to quickly recover from the turmoil of the Great Depression as seen below:

Year Number of B&Ls Assets (000,000)
1930 11,777 $8,829
1937 9,225 $5,682
1945 6,149 $8,747

Source: Savings and Loan Fact Book, 1955 (Chicago: United States Savings and Loan League, 1955), 39.

Even through fewer thrifts failed than banks, the industry still experienced significant foreclosures and problems attracting funds. As a result, some thrift leaders looked to the federal government for assistance. In 1932, the thrift trade association worked with Congress to create a federal home loan bank that would make loans to thrifts facing fund shortages. By 1934, the other two major elements of federal involvement in the thrift business, a system of federally-chartered thrifts, and a federal deposit insurance program, were in place.

The creation of federal regulation was the most significant accomplishment for the thrift industry in the 1930s. While thrift leaders initially resisted regulation, in part because they feared the loss of business independence, their attitudes changed when they saw the benefits regulation gave to commercial banks. As a result, the industry quickly assumed an active role in the design and implementation of thrift oversight. In the years that followed, relations between thrift leaders and federal regulators became so close that some critics alleged that the industry had effectively “captured” their regulatory agencies.

The Postwar “Glory Years”

By all measures, the two decades that followed the end of World War II were the most successful period in the history of the thrift industry. The return of millions of servicemen eager to take up their prewar lives led to a dramatic increase in new families, and this “baby boom” caused a surge in new (mostly suburban) home construction. By the 1940s S&Ls (the name change occurred in the late 1930s) provided the majority of the financing for this expansion. The result was strong industry expansion that lasted through the early 1960s. In addition to meeting the demand for mortgages, thrifts expanded their sources of revenue and achieved greater asset growth by entering into residential development and consumer lending areas. Finally, innovations like drive-up teller windows and the ubiquitous “time and temperature” signs helped solidify the image of S&Ls as consumer-friendly, community-oriented institutions.

By 1965, the industry bore little resemblance to the business that had existed in the 1940s. S&Ls controlled 26 percent of consumer savings and provided 46 percent of all single-family home loans (tremendous gains over the comparable figures of 7 percent and 23 percent, respectively, for 1945), and this increase in business led to a considerable increase size as seen below:

Year Number of S&Ls Assets (000,000)
1945 6,149 $8,747
1952 6,004 $22,585
1959 6,223 $63,401
1965 6,071 $129,442

Source:Savings and Loan Fact Book, 1966, (Chicago: United States Savings and Loan League, 1966)92-4.

This expansion, however, was not uniform. More than a third of all thrifts had fewer than $5 million in assets each, while the one hundred largest thrifts held an average of $340 million each; three S&Ls approached $5 billion in assets. While regional expansion in states like California, account for part of this disparity, there were other controversial actions that fueled individual thrift growth. Some thrifts attracted funds by issuing stock to the public and become publicly held corporations. Another important trend involved raising rates paid on savings to lure deposits, a practice that resulted in periodic “rate wars” between thrifts and even commercial banks. These wars became so severe that in 1966 Congress took the highly unusual move of setting limits on savings rates for both commercial banks and S&Ls. Although thrifts were given the ability to pay slightly higher rates than banks, the move signaled an end to the days of easy growth for the thrift industry.

Moving from Regulation to Deregulation

The thirteen years following the enactment of rate controls presented thrifts with a number of unprecedented challenges, chief of which was finding ways to continue to expand in an economy characterized by slow growth, high interest rates and inflation. These conditions, which came to be known as “stagflation,” wrecked havoc with thrift finances for a variety of reasons. Because regulators controlled the rates thrifts could pay on savings, when interest rates rose depositors often withdrew their funds and placed them in accounts that earned market rates, a process known as disintermediation. At the same time, rising rates and a slow growth economy made it harder for people to qualify for mortgages that in turn limited the ability to generate income.

In response to these complex economic conditions, thrift managers came up with several innovations, such as alternative mortgage instruments and interest-bearing checking accounts, as a way to retain funds and generate lending business. Such actions allowed the industry to continue to record steady asset growth and profitability during the 1970s even though the actual number of thrifts was falling, as seen below.

Year Number of S&Ls Assets (000,000)
1965 6,071 $129,442
1970 5,669 $176,183
1974 5,023 $295,545
1979 4,709 $579,307

Source: Savings and Loan Fact Book, 1980, (Chicago: United States Savings and Loan League, 1980)48-51.

Despite such growth, there were still clear signs that the industry was chafing under the constraints of regulation. This was especially true with the large S&Ls in the western United States that yearned for additional lending powers to ensure continued growth. At the same time, major changes in financial markets, including the emergence of new competitors and new technologies, fueled the need to revise federal regulations for thrifts. Despite several efforts to modernize these laws in the 1970s, few substantive changes were enacted.

The S&L Crisis of the 1980s

In 1979 the financial health of the thrift industry was again challenged by a return of high interest rates and inflation, sparked this time by a doubling of oil prices. Because the sudden nature of these changes threatened to cause hundreds of S&L failures, Congress finally acted on deregulating the thrift industry. It passed two laws (the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Act of 1982) that not only allowed thrifts to offer a wider array of savings products, but also significantly expanded their lending authority. These changes were intended to allow S&Ls to “grow” out of their problems, and as such represented the first time that the government explicitly sought to increase S&L profits as opposed to promoting housing and homeownership. Other changes in thrift oversight included authorizing the use of more lenient accounting rules to report their financial condition, and the elimination of restrictions on the minimum numbers of S&L stockholders. Such policies, combined with an overall decline in regulatory oversight (known as forbearance), would later be cited as factors in the later collapse of the thrift industry.

While thrift deregulation was intended to give S&Ls the ability to compete effectively with other financial institutions, it also contributed to the worst financial crisis since the Great Depression as seen below:

Year S&L Failures Assets (000,000) Year Total S&Ls Industry Assets (000,000)
1980-2 118 $43,101 1980 3,993 $603,777
1983-5 137 $39,136 1983 3,146 $813,770
1986-7 118 $32,248 1985 3,274 $1,109,789
1988 205 $100,705 1988 2,969 $1,368,843
1989 327 $135,245 1989 2,616 $1,186,906

Source: Statistics on failures: Norman Strunk and Fred Case, Where Deregulation Went Wrong (Chicago: United States League of Savings Institutions, 1988), 10; Lawrence White, The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation (New York: Oxford University Press, 1991), 150; Managing the Crisis: The FDIC and RTC Experience, 1980‑1994 (Washington, D.C.: Resolution Trust Corporation, 1998), 795, 798; Historical Statistics on Banking, Bank and Thrift Failures, FDIC web page http://www2.fdic.gov/hsob accessed 31 August 2000; Total industry statistics: 1999 Fact Book: A Statistical Profile on the United States Thrift Industry. (Washington, D.C.: Office of Thrift Supervision, June 2000), 1, 4.

The level of thrift failures at the start of the 1980s was the largest since the Great Depression, and the primary reason for these insolvencies was the result of losses incurred when interest rates rose suddenly. Even after interest rates had stabilized and economic growth returned by the mid-1980s, however, thrift failures continued to grow. One reason for this latest round of failures was because of lender misconduct and fraud. The first such failure tied directly to fraud was Empire Savings of Mesquite, TX in March 1984, an insolvency that eventually cost the taxpayers nearly $300 million. Another prominent fraud-related failure was Lincoln Savings and Loan headed by Charles Keating. When Lincoln came under regulatory scrutiny in 1987, Senators Dennis DeConcini, John McCain, Alan Cranston, John Glenn, and Donald Riegle (all of whom received campaign contributions from Keating and would become known as the “Keating Five”) questioned the appropriateness of the investigation. The subsequent Lincoln failure is estimated to have cost the taxpayers over $2 billion. By the end of the decade, government officials estimated that lender misconduct cost taxpayers more than $75 billion, and the taint of fraud severely tarnished the overall image of the savings and loan industry.

Because most S&Ls were insured by the Federal Savings & Loan Insurance Corporation (FSLIC), few depositors actually lost money when thrifts failed. This was not true for thrifts covered by state deposit insurance funds, and the fragility of these state systems became apparent during the S&L crisis. In 1985, the anticipated failure of Home State Savings Bank of Cincinnati, Ohio sparked a series of deposit runs that threatened to bankrupt that state’s insurance program, and eventually prompted the governor to close all S&Ls in the state. Maryland, which also operated a state insurance program, experienced a similar panic when reports of fraud surfaced at Old Court Savings and Loan in Baltimore. In theaftermath of the failures in these two states all other state deposit insurance funds were terminated and the thrifts placed under the FSLIC. Eventually, even the FSLIC began to run out of money, and in 1987 the General Accounting Office declared the fund insolvent. Although Congress recapitalized the FSLIC when it passed the Competitive Equality Banking Act, it also authorized regulators to delay closing technically insolvent S&Ls as a way to limit insurance payoffs. The unfortunate consequence of such a policy was that allowing troubled thrifts to remain open and grow eventually increased the losses when failure did occur.

In 1989, the federal government finally created a program to resolve the S&L crisis. In August, Congress passed the Financial Institutions Reform Recovery and Enforcement Act (FIRREA), a measure that both bailed out the industry and began the process of re-regulation. FIRREA abolished the Federal Home Loan Bank Board and switched S&L regulation to the newly created Office of Thrift Supervision. It also terminated the FSLIC and moved the deposit insurance function to the FDIC. Finally, the Resolution Trust Corporation was created to dispose of the assets held by failed thrifts, while S&Ls still in business were placed under stricter oversight. Among the new regulations thrifts had to meet were higher net worth standards and a “Qualified Thrift Lender Test” that forced them to hold at least 70 percent of assets in areas related to residential real estate.

By the time the S&L crisis was over by the early 1990s, it was by most measures the most expensive financial collapse in American history. Between 1980 and 1993, 1,307 S&Ls with more than $603 billion in assets went bankrupt, at a cost to taxpayers of nearly $500 billion. It should be noted that S&Ls were not the only institutions to suffer in the 1980s, as the decade also witnessed the failure of 1,530 commercial banks controlling more than $230 billion in assets.

Explaining the S&L Crisis

One reason why so many thrifts failed in the 1980s was in the nature of how thrifts were deregulated. S&Ls historically were specialized financial institutions that used relatively long-term deposits to fund long-term mortgages. When thrifts began to lose funds to accounts that paid higher interest rates, initial deregulation focused on loosening deposit restrictions so thrifts could also offer higher rates. Unfortunately, because thrifts still lacked the authority to make variable rate mortgages many S&Ls were unable to generate higher income to offset expenses. While the Garn-St. Germain Act tried to correct this problem, the changes authorized were exceptionally broad and included virtually every type of lending power.

The S&L crisis was magnified by the fact that deregulation was accompanied by an overall reduction in regulatory oversight. As a result, unscrupulous thrift managers were able to dodge regulatory scrutiny, or use an S&L for their own personal gain. This, in turn, related to another reasons why S&Ls failed — insider fraud and mismanagement. Because most thrifts were covered by federal deposit insurance, some lenders facing insolvency embarked on a “go for broke” lending strategy that involved making high risk loans as a way to recover from their problems. The rationale behind this was that if the risky loan worked the thrift would make money, and if the loan went bad insurance would cover the losses.

One of the most common causes of insolvency, however, was that many thrift managers lacked the experience or knowledge to evaluate properly the risks associated with lending in deregulated areas. This applied to any S&L that made secured or unsecured loans that were not traditional residential mortgages, since each type of financing entailed unique risks that required specific skills and expertise on how to identify and mitigate. Such factors meant that bad loans, and in turn thrift failures, could easily result from well-intentioned decisions based on incorrect information.

The S&L Industry in the 21st Century

Although the thrift crisis of the 1980s severely tarnished the S&L image, the industry survived the period and, now under greater government regulation, is once again growing. At the start of the twenty-first century, America’s 1,103 thrift institutions control more than $863 billion in assets, and remain the second-largest repository for consumer savings. While thrift products and services are virtually indistinguishable from those offered by commercial banks (thrifts can even call themselves banks), these institutions have achieved great success by marketing themselves as community-oriented home lending specialists. This strategy is intended to appeal to consumers disillusioned with the emergence of large multi-state banking conglomerates. Despite this rebound, the thrift industry (like the commercial banking industry) continues to face competitive challenges from nontraditional banking services, innovations in financial technology, and the potential for increased regulation.

References

Barth, James. The Great Savings and Loan Debacle. Washington, D.C.: AEI Press, 1991.

Bodfish, Morton. editor. History of Buildings & Loan in the United States. Chicago: United States Building and Loan League, 1932.

Ewalt, Josephine Hedges. A Business Reborn: The Savings and Loan Story, 1930‑1960. Chicago: American Savings and Loan Institute Press, 1964.

Lowy, Martin. High Rollers: Inside the Savings and Loan Debacle. New York: Praeger, 1991.

Mason, David L. “From Building and Loans to Bail-Outs: A History of the American Savings and Loan Industry, 1831-1989.”Ph.D dissertation, Ohio State University, 2001.

Riegel, Robert and J. Russell Doubman. The Building‑and‑Loan Association. New York: J. Wiley & Sons, Inc., 1927.

Rom, Mark Carl. Public Spirit in the Thrift Tragedy. Pittsburgh: University of Pittsburgh Press, 1996.

Strunk, Norman and Fred Case. Where Deregulation Went Wrong: A Look at the Causes Behind Savings and Loan Failures in the 1980s. Chicago: United States League of Savings Institutions, 1988.

White, Lawrence, J. The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991.

Citation: Mason, David. “Savings and Loan Industry, US”. EH.Net Encyclopedia, edited by Robert Whaples. June 10, 2003. URL http://eh.net/encyclopedia/savings-and-loan-industry-u-s/

African Americans in the Twentieth Century

Thomas N. Maloney, University of Utah

The nineteenth century was a time of radical transformation in the political and legal status of African Americans. Blacks were freed from slavery and began to enjoy greater rights as citizens (though full recognition of their rights remained a long way off). Despite these dramatic developments, many economic and demographic characteristics of African Americans at the end of the nineteenth century were not that different from what they had been in the mid-1800s. Tables 1 and 2 present characteristics of black and white Americans in 1900, as recorded in the Census for that year. (The 1900 Census did not record information on years of schooling or on income, so these important variables are left out of these tables, though they will be examined below.) According to the Census, ninety percent of African Americans still lived in the Southern US in 1900 — roughly the same percentage as lived in the South in 1870. Three-quarters of black households were located in rural places. Only about one-fifth of African American household heads owned their own homes (less than half the percentage among whites). About half of black men and about thirty-five percent of black women who reported an occupation to the Census said that they worked as a farmer or a farm laborer, as opposed to about one-third of white men and about eight percent of white women. Outside of farm work, African American men and women were greatly concentrated in unskilled labor and service jobs. Most black children had not attended school in the year before the Census, and white children were much more likely to have attended. So the members of a typical African American family at the start of the twentieth century lived and worked on a farm in the South and did not own their home. Children in these families were unlikely to be in school even at very young ages.

By 1990 (the most recent Census for which such statistics are available at the time of this writing), the economic conditions of African Americans had changed dramatically (see Tables 1 and 2). They had become much less concentrated in the South, in rural places, and in farming jobs and had entered better blue-collar jobs and the white-collar sector. They were nearly twice as likely to own their own homes at the end of the century as in 1900, and their rates of school attendance at all ages had risen sharply. Even after this century of change, though, African Americans were still relatively disadvantaged in terms of education, labor market success, and home ownership.

Table 1: Characteristics of Households in 1900 and 1990

1900 1990
Black White Black White
A. Region of Residence
South 90.1% 23.5% 53.0% 32.9%
Northeast 3.6% 31.8% 18.9% 20.9%
Midwest 5.8% 38.5% 18.9% 25.3%
West 0.5% 6.2% 9.2% 21.0%
B. Share Rural
75.8% 56.1% 11.9% 25.7%
C. Share of Homes Owner-Occupied
22.1% 49.2% 43.4% 67.3%

Based on household heads in Integrated Public Use Microdata Series Census samples for 1900 and 1990.

Table 2: Characteristics of Individuals in 1900 and 1990

1900 1990
Male Female Male Female
Black White Black White Black White Black White
A. Occupational Distribution
Professional/Technical 1.3% 3.8% 1.6% 10.7% 9.9% 17.2% 16.6% 21.9%
Proprietor/Manager/Official 0.8 6.9 0.2 2.6 6.5 14.7 5.4 10.0
Clerical 0.2 4.0 0.2 5.6 10.7 7.2 29.7 31.9
Sales 0.3 4.2 0.2 4.1 2.9 6.7 4.1 7.3
Craft 4.2 15.9 0 3.1 17.4 20.7 2.3 2.1
Operative 7.3 13.4 1.8 24.5 20.7 14.9 12.4 8.0
Laborer 25.5 14.0 6.5 1.5 12.2 7.2 2.0 1.5
Private Service 2.2 0.4 33.0 33.2 0.1 0 2.0 0.8
Other Service 4.8 2.4 20.6 6.6 18.5 9.0 25.3 15.8
Farmer 30.8 23.9 6.7 6.1 0.2 1.4 0.1 0.4
Farm Laborer 22.7 11.0 29.4 2.0 1.0 1.0 0.4 0.5
B. Percent Attending School by Age
Ages 6 to 13 37.8% 72.2% 41.9% 71.9% 94.5% 95.3% 94.2% 95.5
Ages 14 to 17 26.7 47.9 36.2 51.5 91.1 93.4 92.6 93.5
Ages 18 to 21 6.8 10.4 5.9 8.6 47.7 54.3 52.9 57.1

Based on Integrated Public Use Microdata Series Census samples for 1900 and 1990. Occupational distributions based on individuals aged 18 to 64 with recorded occupation. School attendance in 1900 refers to attendance at any time in the previous year. School attendance in 1990 refers to attendance since February 1 of that year.

These changes in the lives of African Americans did not occur continuously and steadily throughout the twentieth century. Rather, we can divide the century into three distinct eras: (1) the years from 1900 to 1915, prior to large-scale movement out of the South; (2) the years from 1916 to 1964, marked by migration and urbanization, but prior to the most important government efforts to reduce racial inequality; and (3) the years since 1965, characterized by government antidiscrimination efforts but also by economic shifts which have had a great impact on racial inequality and African American economic status.

1900-1915: Continuation of Nineteenth-Century Patterns

As was the case in the 1800s, African American economic life in the early 1900s centered on Southern cotton agriculture. African Americans grew cotton under a variety of contracts and institutional arrangements. Some were laborers hired for a short period for specific tasks. Many were tenant farmers, renting a piece of land and some of their tools and supplies, and paying the rent at the end of the growing season with a portion of their harvest. Records from Southern farms indicate that white and black farm laborers were paid similar wages, and that white and black tenant farmers worked under similar contracts for similar rental rates. Whites in general, however, were much more likely to own land. A similar pattern is found in Southern manufacturing in these years. Among the fairly small number of individuals employed in manufacturing in the South, white and black workers were often paid comparable wages if they worked at the same job for the same company. However, blacks were much less likely to hold better-paying skilled jobs, and they were more likely to work for lower-paying companies.

While the concentration of African Americans in cotton agriculture persisted, Southern black life changed in other ways in the early 1900s. Limitations on the legal rights of African Americans grew more severe in the South in this era. The 1896 Supreme Court decision in the case of Plessy v. Ferguson provided a legal basis for greater explicit segregation in American society. This decision allowed for the provision of separate facilities and services to blacks and whites as long as the facilities and services were equal. Through the early 1900s, many new laws, known as Jim Crow laws, were passed in Southern states creating legally segregated schools, transportation systems, and lodging. The requirement of equality was not generally enforced, however. Perhaps the most important and best-known example of separate and unequal facilities in the South was the system of public education. Through the first decades of the twentieth century, resources were funneled to white schools, raising teacher salaries and per-pupil funding while reducing class size. Black schools experienced no real improvements of this type. The result was a sharp decline in the relative quality of schooling available to African-American children.

1916-1964: Migration and Urbanization

The mid-1910s witnessed the first large-scale movement of African Americans out of the South. The share of African Americans living in the South fell by about four percentage points between 1910 and 1920 (with nearly all of this movement after 1915) and another six points between 1920 and 1930 (see Table 3). What caused this tremendous relocation of African Americans? The worsening political and social conditions in the South, noted above, certainly played a role. But the specific timing of the migration appears to be connected to economic factors. Northern employers in many industries faced strong demand for their products and so had a great need for labor. Their traditional source of cheap labor, European immigrants, dried up in the late 1910s as the coming of World War I interrupted international migration. After the end of the war, new laws limiting immigration to the US would keep the flow of European labor at a low level. Northern employers thus needed a new source of cheap labor, and they turned to Southern blacks. In some cases, employers would send recruiters to the South to find workers and to pay their way North. In addition to this pull from the North, economic events in the South served to push out many African Americans. Destruction of the cotton crop by the boll weevil, an insect that feeds on cotton plants, and poor weather in some places during these years made new opportunities in the North even more attractive.

Table 3: Share of African Americans Residing in the South

Year Share Living in South
1890 90%
1900 90%
1910 89%
1920 85%
1930 79%
1940 77%
1950 68%
1960 60%
1970 53%
1980 53%
1990 53%

Sources: 1890 to 1960: Historical Statistics of the United States, volume 1, pp. 22-23; 1970: Statistical Abstract of the United States, 1973, p. 27; 1980: Statistical Abstract of the United States, 1985, p. 31; 1990: Statistical Abstract of the United States, 1996, p. 31.

Pay was certainly better, and opportunities were wider, in the North. Nonetheless, the region was not entirely welcoming to these migrants. As the black population in the North grew in the 1910s and 1920s, residential segregation grew more pronounced, as did school segregation. In some cases, racial tensions boiled over into deadly violence. The late 1910s were scarred by severe race riots in a number of cities, including East St. Louis (1917) and Chicago (1919).

Access to Jobs in the North

Within the context of this broader turmoil, black migrants did gain entry to new jobs in Northern manufacturing. As in Southern manufacturing, pay differences between blacks and whites working the same job at the same plant were generally small. However, black workers had access to a limited set of jobs and remained heavily concentrated in unskilled laborer positions. Black workers gained admittance to only a limited set of firms, as well. For instance, in the auto industry, the Ford Motor Company hired a tremendous number of black workers, while other auto makers in Detroit typically excluded these workers. Because their alternatives were limited, black workers could be worked very intensely and could also be used in particularly unpleasant and dangerous settings, such as the killing and cutting areas of meat packing plants, foundry departments in auto plants, and blast furnaces in steel plants.

Unions

Through the 1910s and 1920s, relations between black workers and Northern labor unions were often antagonistic. Many unions in the North had explicit rules barring membership by black workers. When faced with a strike (or the threat of a strike), employers often hired in black workers, knowing that these workers were unlikely to become members of the union or to be sympathetic to its goals. Indeed, there is evidence that black workers were used as strike breakers in a great number of labor disputes in the North in the 1910s and 1920s. Beginning in the mid-1930s, African Americans gained greater inclusion in the union movement. By that point, it was clear that black workers were entrenched in manufacturing, and that any broad-based organizing effort would have to include them.

Conditions around 1940

As is apparent in Table 3, black migration slowed in the 1930s, due to the onset of the Great Depression and the resulting high level of unemployment in the North in the 1930s. Beginning in about 1940, preparations for war again created tight labor markets in Northern cities, though, and, as in the late 1910s, African Americans journeyed north to take advantage of new opportunities. In some ways, moving to the North in the 1940s may have appeared less risky than it had during the World War I era. By 1940, there were large black communities in a number of Northern cities. Newspapers produced by these communities circulated in the South, providing information about housing, jobs, and social conditions. Many Southern African Americans now had friends and relatives in the North to help with the transition.

In other ways, though, labor market conditions were less auspicious for black workers in 1940 than they had been during the World War I years. Unemployment remained high in 1940, with about fourteen percent of white workers either unemployed or participating in government work relief programs. Employers hired these unemployed whites before turning to African American labor. Even as labor markets tightened, black workers gained little access to war-related employment. The President issued orders in 1941 that companies doing war-related work had to hire in a non-discriminatory way, and the Fair Employment Practice Committee was created to monitor the hiring practices of these companies. Initially, few resources were devoted to this effort, but in 1943 the government began to enforce fair employment policies more aggressively. These efforts appear to have aided black employment, at least for the duration of the war.

Gains during the 1940s and 1950s

In 1940, the Census Bureau began to collect data on individual incomes, so we can track changes in black income levels and in black/white income ratios in more detail from this date forward. Table 4 provides annual earnings figures for black and white men and women from 1939 (recorded in the 1940 Census) to 1989 (recorded in the 1990 Census). The big gains of the 1940s, both in level of earnings and in the black/white income ratio, are very obvious. Often, we focus on the role of education in producing higher earnings, but the gap between average schooling levels for blacks and whites did not change much in the 1940s (particularly for men), so schooling levels could not have contributed too much to the relative income gains for blacks in the 1940s (see Table 5). Rather, much of the improvement in the black/white pay ratio in this decade simply reflects ongoing migration: blacks were leaving the South, a low-wage region, and entering the North, a high-wage region. Some of the improvement reflects access to new jobs and industries for black workers, due to the tight labor markets and antidiscrimination efforts of the war years.

Table 4: Mean Annual Earnings of Wage and Salary Workers

Aged 20 and Over

Male

Female

Black White Ratio Black White Ratio
1939 $537.45 $1234.41 .44 $331.32 $771.69 .43
1949 1761.06 2984.96 .59 992.35 1781.96 .56
1959 2848.67 5157.65 .55 1412.16 2371.80 .59
1969 5341.64 8442.37 .63 3205.12 3786.45 .85
1979 11404.46 16703.67 .68 7810.66 7893.76 .99
1989 19417.03 28894.69 .67 15319.29 16135.65 .95

Source: Integrated Public Use Microdata Series Census samples for 1940, 1950, 1960, 1970, 1980, and 1990. Includes only those with non-zero earnings who were not in school. All figures are in current (nominal) dollars.

Table 5: Years of School Attended for Individuals 20 and Over

Male

Female

Black White Difference Black White Difference
1940 5.9 9.1 3.2 6.9 10.5 3.6
1950 6.8 9.8 3 7.8 10.8 3
1960 7.9 10.5 2.6 8.8 11.0 2.2
1970 9.4 11.4 2.0 10.3 11.7 1.4
1980 11.2 12.5 1.3 11.8 12.4 0.6

Source: Integrated Public Use Microdata Series Census samples for 1940, 1950, 1960, 1970, and 1980. Based on highest grade attended by wage and salary workers aged 20 and over who had non-zero earnings in the previous year and who were not in school at the time of the census. Comparable figures are not available in the 1990 Census.

Black workers relative incomes were also increased by some general changes in labor demand and supply and in labor market policy in the 1940s. During the war, demand for labor was particularly strong in the blue-collar manufacturing sector. Workers were needed to build tanks, jeeps, and planes, and these jobs did not require a great deal of formal education or skill. In addition, the minimum wage was raised in 1945, and wartime regulations allowed greater pay increases for low-paid workers than for highly-paid workers. After the war, the supply of college-educated workers increased dramatically. The GI Bill, passed in 1944, provided large subsidies to help pay the expenses of World War II veterans who wanted to attend college. This policy helped a generation of men further their education and get a college degree. So strong labor demand, government policies that raised wages at the bottom, and a rising supply of well-educated workers meant that less-educated, less-skilled workers received particularly large wage increases in the 1940s. Because African Americans were concentrated among the less-educated, low-earning workers, these general economic forces were especially helpful to African Americans and served to raise their pay relative to that of whites.

The effect of these broader forces on racial inequality helps to explain the contrast between the 1940s and 1950s evident in Table 4. The black-white pay ratio may have actually fallen a bit for men in the 1950s, and it rose much more slowly in the 1950s than in the 1940s for women. Some of this slowdown in progress reflects weaker labor markets in general, which reduced black access to new jobs. In addition, the general narrowing of the wage distribution that occurred in the 1940s stopped in the 1950s. Less-educated, lower-paid workers were no longer getting particularly large pay increases. As a result, blacks did not gain ground on white workers. It is striking that pay gains for black workers slowed in the 1950s despite a more rapid decline in the black-white schooling gap during these years (Table 5).

Unemployment

On the whole, migration and entry to new industries played a large role in promoting black relative pay increases through the years from World War I to the late 1950s. However, these changes also had some negative effects on black labor market outcomes. As black workers left Southern agriculture, their relative rate of unemployment rose. For the nation as a whole, black and white unemployment rates were about equal as late as 1930. This equality was to a great extent the result of lower rates of unemployment for everyone in the rural South relative to the urban North. Farm owners and sharecroppers tended not to lose their work entirely during weak markets, whereas manufacturing employees might be laid off or fired during downturns. Still, while unemployment was greater for everyone in the urban North, it was disproportionately greater for black workers. Their unemployment rates in Northern cities were much higher than white unemployment rates in the same cities. One result of black migration, then, was a dramatic increase in the ratio of black unemployment to white unemployment. The black/white unemployment ratio rose from about 1 in 1930 (indicating equal unemployment rates for blacks and whites) to about 2 by 1960. The ratio remained at this high level through the end of the twentieth century.

1965-1999: Civil Rights and New Challenges

In the 1960s, black workers again began to experience more rapid increases in relative pay levels (see Table 4). These years also marked a new era in government involvement in the labor market, particularly with regard to racial inequality and discrimination. One of the most far-reaching changes in government policy regarding race actually occurred a bit earlier, in the 1954 Supreme Court decision in the case of Brown v. the Board of Education of Topeka, Kansas. In that case, the Supreme Court ruled that racial segregation of schools was unconstitutional. However, substantial desegregation of Southern schools (and some Northern schools) would not take place until the late 1960s and early 1970s.

School desegregation, therefore, was probably not a primary force in generating the relative pay gains of the 1960s and 1970s. Other anti-discrimination policies enacted in the mid-1960s did play a large role, however. The Civil Rights Act of 1964 outlawed discrimination in a broad set of social arenas. Title VII of this law banned discrimination in hiring, firing, pay, promotion, and working conditions and created the Equal Employment Opportunity Commission to investigate complaints of workplace discrimination. A second policy, Executive Order 11246 (issued by President Johnson in 1965), set up more stringent anti-discrimination rules for businesses working on government contracts. There has been much debate regarding the importance of these policies in promoting better jobs and wages for African Americans. There is now increasing agreement that these policies had positive effects on labor market outcomes for black workers at least through the mid-1970s. Several pieces of evidence point to this conclusion. First, the timing is right. Many indicators of employment and wage gains show marked improvement beginning in 1965, soon after the implementation of these policies. Second, job and wage gains for black workers in the 1960s were, for the first time, concentrated in the South. Enforcement of anti-discrimination policy was targeted on the South in this era. It is also worth noting that rates of black migration out of the South dropped substantially after 1965, perhaps reflecting a sense of greater opportunity there due to these policies. Finally, these gains for black workers occurred simultaneously in many industries and many places, under a variety of labor market conditions. Whatever generated these improvements had to come into effect broadly at one point in time. Federal antidiscrimination policy fits this description.

Return to Stagnation in Relative Income

The years from 1979 to 1989 saw the return of stagnation in black relative incomes. Part of this stagnation may reflect the reversal of the shifts in wage distribution that occurred during the 1940s. In the late 1970s and especially in the 1980s, the US wage distribution grew more unequal. Individuals with less education, particularly those with no college education, saw their pay decline relative to the better-educated. Workers in blue-collar manufacturing jobs were particularly hard hit. The concentration of black workers, especially black men, in these categories meant that their pay suffered relative to that of whites. Another possible factor in the stagnation of black relative pay in the 1980s was weakened enforcement of antidiscrimination policies at this time.

While black relative incomes stagnated on average, black residents of urban centers suffered particular hardships in the 1970s and 1980s. The loss of blue-collar manufacturing jobs was most severe in these areas. For a variety of reasons, including the introduction of new technologies that required larger plants, many firms relocated their production facilities outside of central cities, to suburbs and even more peripheral areas. Central cities increasingly became information-processing and financial centers. Jobs in these industries generally required a college degree or even more education. Despite decades of rising educational levels, African Americans were still barely half as likely as whites to have completed four years of college or more: in 1990, 11.3% of blacks over the age of 25 had four years of college or more, versus 22% of whites. As a result of these developments, many blacks in urban centers found themselves surrounded by jobs for which they were poorly qualified, and at some distance from the types of jobs for which they were qualified, the jobs their parents had moved to the city for in the first place. Their ability to relocate near these blue-collar jobs seems to have been limited both by ongoing discrimination in the housing market and by a lack of resources. Those African Americans with the resources to exit the central city often did so, leaving behind communities marked by extremely high rates of poverty and unemployment.

Over the fifty years from 1939 to 1989, through these episodes of gain and stagnation, the ratio of black mens average annual earnings to white mens average annual earnings rose about 23 points, from .44 to .67. The timing of improvement in the black female/ white female income ratio was similar. However, black women gained much more ground overall: the black-white income ratio for women rose 50 points over these fifty years and stood at .95 in 1989 (down from .99 in 1979). The education gap between black women and white women declined more than the education gap between black and white men, which contributed to the faster pace of improvement in black womens relative earnings. Furthermore, black female workers were more likely to be employed full-time than were white female workers, which raised their annual income. The reverse was true among men: white male workers were somewhat more likely to be employed full time than were black male workers.

Comparable data on annual incomes from the 2000 Census are not available at the time of this writing. Evidence from other labor market surveys suggests that the tight labor markets of the late 1990s may have brought renewed relative pay gains for black workers. Black workers also experienced sharp declines in unemployment during these years, though black unemployment remained about twice as great as white unemployment.

Beyond the Labor Market: Persistent Gaps in Wealth and Health

When we look beyond these basic measures of labor market success, we find more disturbingly large and persistent gaps between African Americans and white Americans. Wealth differences between blacks and whites continue to be very large. In the mid-1990s, black households held only about one-quarter the amount of wealth that white households held, on average. If we leave out equity in ones home and personal possessions and focus on more strictly financial, income-producing assets, black households held only about ten to fifteen percent as much wealth as white households. Big differences in wealth holding remain even if we compare black and white households with similar incomes.

Much of this wealth gap reflects the ongoing effects of the historical patterns described above. When freed from slavery, African Americans held no wealth, and their lower incomes prevented them from accumulating wealth at the rate whites did. African Americans found it particularly difficult to buy homes, traditionally a households most important asset, due to discrimination in real estate markets. Government housing policies in the 1930s and 1940s may have also reduced their rate of home-buying. While the federal government made low interest loans and loan insurance available through the Home Owners Loan Corporation and the Federal Housing Authority, these programs generally could not be used to acquire homes in black or mixed neighborhoods, usually the only neighborhoods in which blacks could buy, because these were considered to be areas of high-risk for loan default. Because wealth is passed on from parents to children, the wealth differences of the mid-twentieth century continue to have an important impact today.

Differences in life expectancy have also proven to be remarkably stubborn. Certainly, black and white mortality patterns are more similar today than they once were. In 1929, the first year for which national figures are available, white life expectancy at birth was 58.6 years and black life expectancy was 46.7 years (for men and women combined). By 2000, white life expectancy had risen to 77.4 years and black life expectancy was 71.8 years. Thus, the black-white gap had fallen from about twelve years to less than six. However, almost all of this reduction in the gap was completed by the early 1960s. In 1961, the black-white gap was 6.5 years. The past forty years have seen very little change in the gap, though life expectancy has risen for both groups.

Some of this remaining difference in life expectancy can be traced to income differences between blacks and whites. Black children face a particularly high risk of accidental death in the home, often due to dangerous conditions in low-quality housing. African Americans of all ages face a high risk of homicide, which is related in part to residence in poor neighborhoods. Among older people, African Americans face high risk of death due to heart disease, and the incidence of heart disease is correlated with income. Still, black-white mortality differences, especially those related to disease, are complex and are not yet fully understood.

Infant mortality is a particularly large and particularly troubling form of health difference between blacks and whites.

In 2000 the white infant mortality rate (5.7 per 1000 live births) was less than half the rate for African Americans (14.0 per 1000). Again, some of this mortality difference is related to the effect of lower incomes on the nutrition, medical care, and living conditions available to African American mothers and newborns. However, the full set of relevant factors is the subject of ongoing research.

Summary and Conclusions

It is undeniable that the economic fortunes of African Americans changed dramatically during the twentieth century. African Americans moved from tremendous concentration in Southern agriculture to much greater diversity in residence and occupation. Over the period in which income can be measured, there are large increases in black incomes in both relative and absolute terms. Schooling differentials between blacks and whites fell sharply, as well. When one looks beyond the starting and ending points, though, more complex realities present themselves. The progress that we observe grew out of periods of tremendous social upheaval, particularly during the world wars. It was shaped in part by conflict between black workers and white workers, and it coincided with growing residential segregation. It was not continuous and gradual. Rather, it was punctuated by periods of rapid gain and periods of stagnation. The rapid gains are attributable to actions on the part of black workers (especially migration), broad economic forces (especially tight labor markets and narrowing of the general wage distribution), and specific antidiscrimination policy initiatives (such as the Fair Employment Practice Committee in the 1940s and Title VII and contract compliance policy in the 1960s). Finally, we should note that this century of progress ended with considerable gaps remaining between African Americans and white Americans in terms of income, unemployment, wealth, and life expectancy.

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Citation: Maloney, Thomas. “African Americans in the Twentieth Century”. EH.Net Encyclopedia, edited by Robert Whaples. January 14, 2002. URL http://eh.net/encyclopedia/african-americans-in-the-twentieth-century/

Economic Development in the Americas since 1500: Endowments and Institutions

Author(s):Engerman, Stanley L.
Sokoloff, Kenneth L.
Reviewer(s):Nonnenmacher, Tomas

Published by EH.Net (September 2013)

Stanley L. Engerman and Kenneth L. Sokoloff, Economic Development in the Americas since 1500: Endowments and Institutions. New York: Cambridge University Press, 2012. xx + 417 pp. $99 (hardcover), ISBN: 978-1-107-00955-4.

Reviewed for EH.Net by Tomas Nonnenmacher, Department of Economics, Allegheny College.

Economic Development in the Americas since 1500: Endowments and Institutions brings together the works of Stanley Engerman and the late Kenneth Sokoloff ? along with coauthors Stephen Haber, Elisa Mariscal and Eric Zolt ? on the topic of geography, institutions, and economic development. Their thesis will be very familiar to economic historians: a causal chain links initial endowments in New World colonies to the organization of economic activity, economic power, political power, institutions, and long-run economic performance. Institutions, in Engerman and Sokoloff?s story, are endogenous, and knowing the resource allocation of a colony in 1500 explains much of its future economic performance. The book begins with three chapters that lay out the big picture and then turns to case studies on suffrage, schooling, taxation, land and immigration policies, and banking. The concluding chapters offer commentary on the use of institution-based explanations of growth and a comparison with alternative explanations of development.

The New World constituted a vast and heterogeneous set of opportunities for European nations. Engerman and Sokoloff group colonies into three categories: those with land most suitable for growing lucrative crops like sugar and tobacco, those with rich mineral resources and a substantial native population, and those with land most suitable for small-scale agriculture. Europeans exploited the natural resources in the first two categories of colonies by either importing slaves from Africa or using the Native American population. Doing so led to an uneven distribution of economic and political power that persisted via the adoption of institutions designed to protect that power. In contrast, in areas where the initial endowment of natural resources did not encourage the use of forced labor, a virtuous cycle of political competition generated pro-growth institutions. The long-run economic prosperity of the U.S. and Canada relative to their neighbors is not due to ?better? British institutions, but due to the British coming to the New World late to the game and acquiring colonies that did not possess the valuable natural endowments that made slavery so profitable. Indeed, the economic development of the British sugar colonies (Barbados, Jamaica, and Belize) is more similar to that of Spanish, Dutch, and French colonies in the Caribbean than to the U.S. and Canada. Even the Puritan work ethic has a counterexample in Providence Island off the coast of Nicaragua.

The middle chapters of the book are the heart of Engerman and Sokoloff?s analysis and provide compelling narratives and statistical evidence supporting their hypothesis of a link between inequality and institutional choice. The chapter on voting establishes the link between economic and political inequality. The original thirteen colonies had rules that linked property or wealth to the right to vote. While these restrictions were fairly strict, they still allowed a broad set of elites to participate in elections. In order to attract immigrants, new western states, which had lower population density and lower income inequality, restricted the franchise much less, using race, gender, age, and criminal record rather than wealth and property. The pattern of extending the franchise in areas with lower population density and lower income inequality is a central piece of Engerman and Sokoloff?s story. In Latin America, the right to vote was greatly limited via a literacy test. Racial boundaries were generally more porous in Latin America, making the implementation of an explicit racial criterion politically difficult. While generally rising over time, the proportion of the population voting in Latin America remained well below that in the United States and Canada through 1940. This pattern limited the access of the general population to the political process and led to rules being written for the elites.

Using literacy as a requirement for the franchise reduced the incentive to provide public school education. The schooling ratio was highest in cities (where inequality was lower), in countries with higher income, and in countries in which a higher percentage of the population voted. Political inequality and education are thus directly linked. Inequality is also linked to the tax structure, with more unequal countries relying on regressive sales and trade taxes and more equal countries relying on property and income taxes. Immigration and land policy was open in the United States and Canada and restrictive in Latin America. The cumulative effect led to enormous differences in land ownership rates by the early 1900s. In Mexico, the highest rural land ownership rate was 5.6% in the Pacific Northwest. The rural land ownership rate was 83.4% in the western United States and 87.1% in Canada. Finally, the chapter on the banking system (by Stephen Haber) draws links between elite power and banking regulation. A powerful Latin American elite manipulated the opaque regulatory process in their favor.

One measure of the importance of a research agenda is the number of scholars who build on it, and, by this measure, Engerman and Sokoloff have achieved great success. Many subsequent studies find support for their hypotheses or raise questions about the links between economic and political inequality and underdevelopment. The work of Engerman and Sokoloff is foundational to the literature on colonialism, institutions, and economic development and anyone interested in development or new institutional economics will need to read this book.

Tomas Nonnenmacher is a Professor of Economics at Allegheny College. His most recent article, ?Stability and Change on Henequen Haciendas in Revolutionary Yucat?n: Two Case Studies from the Henequen Zone? is coauthored with Shannan Mattiace and is forthcoming in Estudios Mexicanos/Mexican Studies. He is currently working on a project exploring entrepreneurship in the telegraph industry.

Copyright (c) 2013 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2013). All EH.Net reviews are archived at http://www.eh.net/BookReview

Subject(s):Economic Development, Growth, and Aggregate Productivity
Economywide Country Studies and Comparative History
Geographic Area(s):Latin America, incl. Mexico and the Caribbean
North America
Time Period(s):16th Century
17th Century
18th Century
19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII