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Economic History of Malaysia

John H. Drabble, University of Sydney, Australia

General Background

The Federation of Malaysia (see map), formed in 1963, originally consisted of Malaya, Singapore, Sarawak and Sabah. Due to internal political tensions Singapore was obliged to leave in 1965. Malaya is now known as Peninsular Malaysia, and the two other territories on the island of Borneo as East Malaysia. Prior to 1963 these territories were under British rule for varying periods from the late eighteenth century. Malaya gained independence in 1957, Sarawak and Sabah (the latter known previously as British North Borneo) in 1963, and Singapore full independence in 1965. These territories lie between 2 and 6 degrees north of the equator. The terrain consists of extensive coastal plains backed by mountainous interiors. The soils are not naturally fertile but the humid tropical climate subject to monsoonal weather patterns creates good conditions for plant growth. Historically much of the region was covered in dense rainforest (jungle), though much of this has been removed for commercial purposes over the last century leading to extensive soil erosion and silting of the rivers which run from the interiors to the coast.

SINGAPORE

The present government is a parliamentary system at the federal level (located in Kuala Lumpur, Peninsular Malaysia) and at the state level, based on periodic general elections. Each Peninsular state (except Penang and Melaka) has a traditional Malay ruler, the Sultan, one of whom is elected as paramount ruler of Malaysia (Yang dipertuan Agung) for a five-year term.

The population at the end of the twentieth century approximated 22 million and is ethnically diverse, consisting of 57 percent Malays and other indigenous peoples (collectively known as bumiputera), 24 percent Chinese, 7 percent Indians and the balance “others” (including a high proportion of non-citizen Asians, e.g., Indonesians, Bangladeshis, Filipinos) (Andaya and Andaya, 2001, 3-4)

Significance as a Case Study in Economic Development

Malaysia is generally regarded as one of the most successful non-western countries to have achieved a relatively smooth transition to modern economic growth over the last century or so. Since the late nineteenth century it has been a major supplier of primary products to the industrialized countries; tin, rubber, palm oil, timber, oil, liquified natural gas, etc.

However, since about 1970 the leading sector in development has been a range of export-oriented manufacturing industries such as textiles, electrical and electronic goods, rubber products etc. Government policy has generally accorded a central role to foreign capital, while at the same time working towards more substantial participation for domestic, especially bumiputera, capital and enterprise. By 1990 the country had largely met the criteria for a Newly-Industrialized Country (NIC) status (30 percent of exports to consist of manufactured goods). While the Asian economic crisis of 1997-98 slowed growth temporarily, the current plan, titled Vision 2020, aims to achieve “a fully developed industrialized economy by that date. This will require an annual growth rate in real GDP of 7 percent” (Far Eastern Economic Review, Nov. 6, 2003). Malaysia is perhaps the best example of a country in which the economic roles and interests of various racial groups have been pragmatically managed in the long-term without significant loss of growth momentum, despite the ongoing presence of inter-ethnic tensions which have occasionally manifested in violence, notably in 1969 (see below).

The Premodern Economy

Malaysia has a long history of internationally valued exports, being known from the early centuries A.D. as a source of gold, tin and exotics such as birds’ feathers, edible birds’ nests, aromatic woods, tree resins etc. The commercial importance of the area was enhanced by its strategic position athwart the seaborne trade routes from the Indian Ocean to East Asia. Merchants from both these regions, Arabs, Indians and Chinese regularly visited. Some became domiciled in ports such as Melaka [formerly Malacca], the location of one of the earliest local sultanates (c.1402 A.D.) and a focal point for both local and international trade.

From the early sixteenth century the area was increasingly penetrated by European trading interests, first the Portuguese (from 1511), then the Dutch East India Company [VOC](1602) in competition with the English East India Company [EIC] (1600) for the trade in pepper and various spices. By the late eighteenth century the VOC was dominant in the Indonesian region while the EIC acquired bases in Malaysia, beginning with Penang (1786), Singapore (1819) and Melaka (1824). These were major staging posts in the growing trade with China and also served as footholds from which to expand British control into the Malay Peninsula (from 1870), and northwest Borneo (Sarawak from 1841 and North Borneo from 1882). Over these centuries there was an increasing inflow of migrants from China attracted by the opportunities in trade and as a wage labor force for the burgeoning production of export commodities such as gold and tin. The indigenous people also engaged in commercial production (rice, tin), but remained basically within a subsistence economy and were reluctant to offer themselves as permanent wage labor. Overall, production in the premodern economy was relatively small in volume and technologically undeveloped. The capitalist sector, already foreign dominated, was still in its infancy (Drabble, 2000).

The Transition to Capitalist Production

The nineteenth century witnessed an enormous expansion in world trade which, between 1815 and 1914, grew on average at 4-5 percent a year compared to 1 percent in the preceding hundred years. The driving force came from the Industrial Revolution in the West which saw the innovation of large scale factory production of manufactured goods made possible by technological advances, accompanied by more efficient communications (e.g., railways, cars, trucks, steamships, international canals [Suez 1869, Panama 1914], telegraphs) which speeded up and greatly lowered the cost of long distance trade. Industrializing countries required ever-larger supplies of raw materials as well as foodstuffs for their growing populations. Regions such as Malaysia with ample supplies of virgin land and relative proximity to trade routes were well placed to respond to this demand. What was lacking was an adequate supply of capital and wage labor. In both aspects, the deficiency was supplied largely from foreign sources.

As expanding British power brought stability to the region, Chinese migrants started to arrive in large numbers with Singapore quickly becoming the major point of entry. Most arrived with few funds but those able to amass profits from trade (including opium) used these to finance ventures in agriculture and mining, especially in the neighboring Malay Peninsula. Crops such as pepper, gambier, tapioca, sugar and coffee were produced for export to markets in Asia (e.g. China), and later to the West after 1850 when Britain moved toward a policy of free trade. These crops were labor, not capital, intensive and in some cases quickly exhausted soil fertility and required periodic movement to virgin land (Jackson, 1968).

Tin

Besides ample land, the Malay Peninsula also contained substantial deposits of tin. International demand for tin rose progressively in the nineteenth century due to the discovery of a more efficient method for producing tinplate (for canned food). At the same time deposits in major suppliers such as Cornwall (England) had been largely worked out, thus opening an opportunity for new producers. Traditionally tin had been mined by Malays from ore deposits close to the surface. Difficulties with flooding limited the depth of mining; furthermore their activity was seasonal. From the 1840s the discovery of large deposits in the Peninsula states of Perak and Selangor attracted large numbers of Chinese migrants who dominated the industry in the nineteenth century bringing new technology which improved ore recovery and water control, facilitating mining to greater depths. By the end of the century Malayan tin exports (at approximately 52,000 metric tons) supplied just over half the world output. Singapore was a major center for smelting (refining) the ore into ingots. Tin mining also attracted attention from European, mainly British, investors who again introduced new technology – such as high-pressure hoses to wash out the ore, the steam pump and, from 1912, the bucket dredge floating in its own pond, which could operate to even deeper levels. These innovations required substantial capital for which the chosen vehicle was the public joint stock company, usually registered in Britain. Since no major new ore deposits were found, the emphasis was on increased efficiency in production. European operators, again employing mostly Chinese wage labor, enjoyed a technical advantage here and by 1929 accounted for 61 percent of Malayan output (Wong Lin Ken, 1965; Yip Yat Hoong, 1969).

Rubber

While tin mining brought considerable prosperity, it was a non-renewable resource. In the early twentieth century it was the agricultural sector which came to the forefront. The crops mentioned previously had boomed briefly but were hard pressed to survive severe price swings and the pests and diseases that were endemic in tropical agriculture. The cultivation of rubber-yielding trees became commercially attractive as a raw material for new industries in the West, notably for tires for the booming automobile industry especially in the U.S. Previously rubber had come from scattered trees growing wild in the jungles of South America with production only expandable at rising marginal costs. Cultivation on estates generated economies of scale. In the 1870s the British government organized the transport of specimens of the tree Hevea Brasiliensis from Brazil to colonies in the East, notably Ceylon and Singapore. There the trees flourished and after initial hesitancy over the five years needed for the trees to reach productive age, planters Chinese and European rushed to invest. The boom reached vast proportions as the rubber price reached record heights in 1910 (see Fig.1). Average values fell thereafter but investors were heavily committed and planting continued (also in the neighboring Netherlands Indies [Indonesia]). By 1921 the rubber acreage in Malaysia (mostly in the Peninsula) had reached 935 000 hectares (about 1.34 million acres) or some 55 percent of the total in South and Southeast Asia while output stood at 50 percent of world production.

Fig.1. Average London Rubber Prices, 1905-41 (current values)

As a result of this boom, rubber quickly surpassed tin as Malaysia’s main export product, a position that it was to hold until 1980. A distinctive feature of the industry was that the technology of extracting the rubber latex from the trees (called tapping) by an incision with a special knife, and its manufacture into various grades of sheet known as raw or plantation rubber, was easily adopted by a wide range of producers. The larger estates, mainly British-owned, were financed (as in the case of tin mining) through British-registered public joint stock companies. For example, between 1903 and 1912 some 260 companies were registered to operate in Malaya. Chinese planters for the most part preferred to form private partnerships to operate estates which were on average smaller. Finally, there were the smallholdings (under 40 hectares or 100 acres) of which those at the lower end of the range (2 hectares/5 acres or less) were predominantly owned by indigenous Malays who found growing and selling rubber more profitable than subsistence (rice) farming. These smallholders did not need much capital since their equipment was rudimentary and labor came either from within their family or in the form of share-tappers who received a proportion (say 50 percent) of the output. In Malaya in 1921 roughly 60 percent of the planted area was estates (75 percent European-owned) and 40 percent smallholdings (Drabble, 1991, 1).

The workforce for the estates consisted of migrants. British estates depended mainly on migrants from India, brought in under government auspices with fares paid and accommodation provided. Chinese business looked to the “coolie trade” from South China, with expenses advanced that migrants had subsequently to pay off. The flow of immigration was directly related to economic conditions in Malaysia. For example arrivals of Indians averaged 61 000 a year between 1900 and 1920. Substantial numbers also came from the Netherlands Indies.

Thus far, most capitalist enterprise was located in Malaya. Sarawak and British North Borneo had a similar range of mining and agricultural industries in the 19th century. However, their geographical location slightly away from the main trade route (see map) and the rugged internal terrain costly for transport made them less attractive to foreign investment. However, the discovery of oil by a subsidiary of Royal Dutch-Shell starting production from 1907 put Sarawak more prominently in the business of exports. As in Malaya, the labor force came largely from immigrants from China and to a lesser extent Java.

The growth in production for export in Malaysia was facilitated by development of an infrastructure of roads, railways, ports (e.g. Penang, Singapore) and telecommunications under the auspices of the colonial governments, though again this was considerably more advanced in Malaya (Amarjit Kaur, 1985, 1998)

The Creation of a Plural Society

By the 1920s the large inflows of migrants had created a multi-ethnic population of the type which the British scholar, J.S. Furnivall (1948) described as a plural society in which the different racial groups live side by side under a single political administration but, apart from economic transactions, do not interact with each other either socially or culturally. Though the original intention of many migrants was to come for only a limited period (say 3-5 years), save money and then return home, a growing number were staying longer, having children and becoming permanently domiciled in Malaysia. The economic developments described in the previous section were unevenly located, for example, in Malaya the bulk of the tin mines and rubber estates were located along the west coast of the Peninsula. In the boom-times, such was the size of the immigrant inflows that in certain areas they far outnumbered the indigenous Malays. In social and cultural terms Indians and Chinese recreated the institutions, hierarchies and linguistic usage of their countries of origin. This was particularly so in the case of the Chinese. Not only did they predominate in major commercial centers such as Penang, Singapore, and Kuching, but they controlled local trade in the smaller towns and villages through a network of small shops (kedai) and dealerships that served as a pipeline along which export goods like rubber went out and in return imported manufactured goods were brought in for sale. In addition Chinese owned considerable mining and agricultural land. This created a distribution of wealth and division of labor in which economic power and function were directly related to race. In this situation lay the seeds of growing discontent among bumiputera that they were losing their ancestral inheritance (land) and becoming economically marginalized. As long as British colonial rule continued the various ethnic groups looked primarily to government to protect their interests and maintain peaceable relations. An example of colonial paternalism was the designation from 1913 of certain lands in Malaya as Malay Reservations in which only indigenous people could own and deal in property (Lim Teck Ghee, 1977).

Benefits and Drawbacks of an Export Economy

Prior to World War II the international economy was divided very broadly into the northern and southern hemispheres. The former contained most of the industrialized manufacturing countries and the latter the principal sources of foodstuffs and raw materials. The commodity exchange between the spheres was known as the Old International Division of Labor (OIDL). Malaysia’s place in this system was as a leading exporter of raw materials (tin, rubber, timber, oil, etc.) and an importer of manufactures. Since relatively little processing was done on the former prior to export, most of the value-added component in the final product accrued to foreign manufacturers, e.g. rubber tire manufacturers in the U.S.

It is clear from this situation that Malaysia depended heavily on earnings from exports of primary commodities to maintain the standard of living. Rice had to be imported (mainly from Burma and Thailand) because domestic production supplied on average only 40 percent of total needs. As long as export prices were high (for example during the rubber boom previously mentioned), the volume of imports remained ample. Profits to capital and good smallholder incomes supported an expanding economy. There are no official data for Malaysian national income prior to World War II, but some comparative estimates are given in Table 1 which indicate that Malayan Gross Domestic Product (GDP) per person was easily the leader in the Southeast and East Asian region by the late 1920s.

Table 1
GDP per Capita: Selected Asian Countries, 1900-1990
(in 1985 international dollars)

1900 1929 1950 1973 1990
Malaya/Malaysia1 6002 1910 1828 3088 5775
Singapore - - 22763 5372 14441
Burma 523 651 304 446 562
Thailand 594 623 652 1559 3694
Indonesia 617 1009 727 1253 2118
Philippines 735 1106 943 1629 1934
South Korea 568 945 565 1782 6012
Japan 724 1192 1208 7133 13197

Notes: Malaya to 19731; Guesstimate2; 19603

Source: van der Eng (1994).

However, the international economy was subject to strong fluctuations. The levels of activity in the industrialized countries, especially the U.S., were the determining factors here. Almost immediately following World War I there was a depression from 1919-22. Strong growth in the mid and late-1920s was followed by the Great Depression (1929-32). As industrial output slumped, primary product prices fell even more heavily. For example, in 1932 rubber sold on the London market for about one one-hundredth of the peak price in 1910 (Fig.1). The effects on export earnings were very severe; in Malaysia’s case between 1929 and 1932 these dropped by 73 percent (Malaya), 60 percent (Sarawak) and 50 percent (North Borneo). The aggregate value of imports fell on average by 60 percent. Estates dismissed labor and since there was no social security, many workers had to return to their country of origin. Smallholder incomes dropped heavily and many who had taken out high-interest secured loans in more prosperous times were unable to service these and faced the loss of their land.

The colonial government attempted to counteract this vulnerability to economic swings by instituting schemes to restore commodity prices to profitable levels. For the rubber industry this involved two periods of mandatory restriction of exports to reduce world stocks and thus exert upward pressure on market prices. The first of these (named the Stevenson scheme after its originator) lasted from 1 October 1922- 1 November 1928, and the second (the International Rubber Regulation Agreement) from 1 June 1934-1941. Tin exports were similarly restricted from 1931-41. While these measures did succeed in raising world prices, the inequitable treatment of Asian as against European producers in both industries has been debated. The protective policy has also been blamed for “freezing” the structure of the Malaysian economy and hindering further development, for instance into manufacturing industry (Lim Teck Ghee, 1977; Drabble, 1991).

Why No Industrialization?

Malaysia had very few secondary industries before World War II. The little that did appear was connected mainly with the processing of the primary exports, rubber and tin, together with limited production of manufactured goods for the domestic market (e.g. bread, biscuits, beverages, cigarettes and various building materials). Much of this activity was Chinese-owned and located in Singapore (Huff, 1994). Among the reasons advanced are; the small size of the domestic market, the relatively high wage levels in Singapore which made products uncompetitive as exports, and a culture dominated by British trading firms which favored commerce over industry. Overshadowing all these was the dominance of primary production. When commodity prices were high, there was little incentive for investors, European or Asian, to move into other sectors. Conversely, when these prices fell capital and credit dried up, while incomes contracted, thus lessening effective demand for manufactures. W.G. Huff (2002) has argued that, prior to World War II, “there was, in fact, never a good time to embark on industrialization in Malaya.”

War Time 1942-45: The Japanese Occupation

During the Japanese occupation years of World War II, the export of primary products was limited to the relatively small amounts required for the Japanese economy. This led to the abandonment of large areas of rubber and the closure of many mines, the latter progressively affected by a shortage of spare parts for machinery. Businesses, especially those Chinese-owned, were taken over and reassigned to Japanese interests. Rice imports fell heavily and thus the population devoted a large part of their efforts to producing enough food to stay alive. Large numbers of laborers (many of whom died) were conscripted to work on military projects such as construction of the Thai-Burma railroad. Overall the war period saw the dislocation of the export economy, widespread destruction of the infrastructure (roads, bridges etc.) and a decline in standards of public health. It also saw a rise in inter-ethnic tensions due to the harsh treatment meted out by the Japanese to some groups, notably the Chinese, compared to a more favorable attitude towards the indigenous peoples among whom (Malays particularly) there was a growing sense of ethnic nationalism (Drabble, 2000).

Postwar Reconstruction and Independence

The returning British colonial rulers had two priorities after 1945; to rebuild the export economy as it had been under the OIDL (see above), and to rationalize the fragmented administrative structure (see General Background). The first was accomplished by the late 1940s with estates and mines refurbished, production restarted once the labor force had been brought back and adequate rice imports regained. The second was a complex and delicate political process which resulted in the formation of the Federation of Malaya (1948) from which Singapore, with its predominantly Chinese population (about 75%), was kept separate. In Borneo in 1946 the state of Sarawak, which had been a private kingdom of the English Brooke family (so-called “White Rajas”) since 1841, and North Borneo, administered by the British North Borneo Company from 1881, were both transferred to direct rule from Britain. However, independence was clearly on the horizon and in Malaya tensions continued with the guerrilla campaign (called the “Emergency”) waged by the Malayan Communist Party (membership largely Chinese) from 1948-60 to force out the British and set up a Malayan Peoples’ Republic. This failed and in 1957 the Malayan Federation gained independence (Merdeka) under a “bargain” by which the Malays would hold political paramountcy while others, notably Chinese and Indians, were given citizenship and the freedom to pursue their economic interests. The bargain was institutionalized as the Alliance, later renamed the National Front (Barisan Nasional) which remains the dominant political grouping. In 1963 the Federation of Malaysia was formed in which the bumiputera population was sufficient in total to offset the high proportion of Chinese arising from the short-lived inclusion of Singapore (Andaya and Andaya, 2001).

Towards the Formation of a National Economy

Postwar two long-term problems came to the forefront. These were (a) the political fragmentation (see above) which had long prevented a centralized approach to economic development, coupled with control from Britain which gave primacy to imperial as opposed to local interests and (b) excessive dependence on a small range of primary products (notably rubber and tin) which prewar experience had shown to be an unstable basis for the economy.

The first of these was addressed partly through the political rearrangements outlined in the previous section, with the economic aspects buttressed by a report from a mission to Malaya from the International Bank for Reconstruction and Development (IBRD) in 1954. The report argued that Malaya “is now a distinct national economy.” A further mission in 1963 urged “closer economic cooperation between the prospective Malaysia[n] territories” (cited in Drabble, 2000, 161, 176). The rationale for the Federation was that Singapore would serve as the initial center of industrialization, with Malaya, Sabah and Sarawak following at a pace determined by local conditions.

The second problem centered on economic diversification. The IBRD reports just noted advocated building up a range of secondary industries to meet a larger portion of the domestic demand for manufactures, i.e. import-substitution industrialization (ISI). In the interim dependence on primary products would perforce continue.

The Adoption of Planning

In the postwar world the development plan (usually a Five-Year Plan) was widely adopted by Less-Developed Countries (LDCs) to set directions, targets and estimated costs. Each of the Malaysian territories had plans during the 1950s. Malaya was the first to get industrialization of the ISI type under way. The Pioneer Industries Ordinance (1958) offered inducements such as five-year tax holidays, guarantees (to foreign investors) of freedom to repatriate profits and capital etc. A modest degree of tariff protection was granted. The main types of goods produced were consumer items such as batteries, paints, tires, and pharmaceuticals. Just over half the capital invested came from abroad, with neighboring Singapore in the lead. When Singapore exited the federation in 1965, Malaysia’s fledgling industrialization plans assumed greater significance although foreign investors complained of stifling bureaucracy retarding their projects.

Primary production, however, was still the major economic activity and here the problem was rejuvenation of the leading industries, rubber in particular. New capital investment in rubber had slowed since the 1920s, and the bulk of the existing trees were nearing the end of their economic life. The best prospect for rejuvenation lay in cutting down the old trees and replanting the land with new varieties capable of raising output per acre/hectare by a factor of three or four. However, the new trees required seven years to mature. Corporately owned estates could replant progressively, but smallholders could not face such a prolonged loss of income without support. To encourage replanting, the government offered grants to owners, financed by a special duty on rubber exports. The process was a lengthy one and it was the 1980s before replanting was substantially complete. Moreover, many estates elected to switch over to a new crop, oil palms (a product used primarily in foodstuffs), which offered quicker returns. Progress was swift and by the 1960s Malaysia was supplying 20 percent of world demand for this commodity.

Another priority at this time consisted of programs to improve the standard of living of the indigenous peoples, most of whom lived in the rural areas. The main instrument was land development, with schemes to open up large areas (say 100,000 acres or 40 000 hectares) which were then subdivided into 10 acre/4 hectare blocks for distribution to small farmers from overcrowded regions who were either short of land or had none at all. Financial assistance (repayable) was provided to cover housing and living costs until the holdings became productive. Rubber and oil palms were the main commercial crops planted. Steps were also taken to increase the domestic production of rice to lessen the historical dependence on imports.

In the primary sector Malaysia’s range of products was increased from the 1960s by a rapid increase in the export of hardwood timber, mostly in the form of (unprocessed) saw-logs. The markets were mainly in East Asia and Australasia. Here the largely untapped resources of Sabah and Sarawak came to the fore, but the rapid rate of exploitation led by the late twentieth century to damaging effects on both the environment (extensive deforestation, soil-loss, silting, changed weather patterns), and the traditional hunter-gatherer way of life of forest-dwellers (decrease in wild-life, fish, etc.). Other development projects such as the building of dams for hydroelectric power also had adverse consequences in all these respects (Amarjit Kaur, 1998; Drabble, 2000; Hong, 1987).

A further major addition to primary exports came from the discovery of large deposits of oil and natural gas in East Malaysia, and off the east coast of the Peninsula from the 1970s. Gas was exported in liquified form (LNG), and was also used domestically as a substitute for oil. At peak values in 1982, petroleum and LNG provided around 29 percent of Malaysian export earnings but had declined to 18 percent by 1988.

Industrialization and the New Economic Policy 1970-90

The program of industrialization aimed primarily at the domestic market (ISI) lost impetus in the late 1960s as foreign investors, particularly from Britain switched attention elsewhere. An important factor here was the outbreak of civil disturbances in May 1969, following a federal election in which political parties in the Peninsula (largely non-bumiputera in membership) opposed to the Alliance did unexpectedly well. This brought to a head tensions, which had been rising during the 1960s over issues such as the use of the national language, Malay (Bahasa Malaysia) as the main instructional medium in education. There was also discontent among Peninsular Malays that the economic fruits since independence had gone mostly to non-Malays, notably the Chinese. The outcome was severe inter-ethnic rioting centered in the federal capital, Kuala Lumpur, which led to the suspension of parliamentary government for two years and the implementation of the New Economic Policy (NEP).

The main aim of the NEP was a restructuring of the Malaysian economy over two decades, 1970-90 with the following aims:

  1. to redistribute corporate equity so that the bumiputera share would rise from around 2 percent to 30 percent. The share of other Malaysians would increase marginally from 35 to 40 percent, while that of foreigners would fall from 63 percent to 30 percent.
  2. to eliminate the close link between race and economic function (a legacy of the colonial era) and restructure employment so that that the bumiputera share in each sector would reflect more accurately their proportion of the total population (roughly 55 percent). In 1970 this group had about two-thirds of jobs in the primary sector where incomes were generally lowest, but only 30 percent in the secondary sector. In high-income middle class occupations (e.g. professions, management) the share was only 13 percent.
  3. To eradicate poverty irrespective of race. In 1970 just under half of all households in Peninsular Malaysia had incomes below the official poverty line. Malays accounted for about 75 percent of these.

The principle underlying these aims was that the redistribution would not result in any one group losing in absolute terms. Rather it would be achieved through the process of economic growth, i.e. the economy would get bigger (more investment, more jobs, etc.). While the primary sector would continue to receive developmental aid under the successive Five Year Plans, the main emphasis was a switch to export-oriented industrialization (EOI) with Malaysia seeking a share in global markets for manufactured goods. Free Trade Zones (FTZs) were set up in places such as Penang where production was carried on with the undertaking that the output would be exported. Firms locating there received concessions such as duty-free imports of raw materials and capital goods, and tax concessions, aimed at primarily at foreign investors who were also attracted by Malaysia’s good facilities, relatively low wages and docile trade unions. A range of industries grew up; textiles, rubber and food products, chemicals, telecommunications equipment, electrical and electronic machinery/appliances, car assembly and some heavy industries, iron and steel. As with ISI, much of the capital and technology was foreign, for example the Japanese firm Mitsubishi was a partner in a venture to set up a plant to assemble a Malaysian national car, the Proton, from mostly imported components (Drabble, 2000).

Results of the NEP

Table 2 below shows the outcome of the NEP in the categories outlined above.

Table 2
Restructuring under the NEP, 1970-90

1970 1990
Wealth Ownership (%) Bumiputera 2.0 20.3
Other Malaysians 34.6 54.6
Foreigners 63.4 25.1
Employment
(%) of total
workers
in each
sector
Primary sector (agriculture, mineral
extraction, forest products and fishing)
Bumiputera 67.6 [61.0]* 71.2 [36.7]*
Others 32.4 28.8
Secondary sector
(manufacturing and construction)
Bumiputera 30.8 [14.6]* 48.0 [26.3]*
Others 69.2 52.0
Tertiary sector (services) Bumiputera 37.9 [24.4]* 51.0 [36.9]*
Others 62.1 49.0

Note: [ ]* is the proportion of the ethnic group thus employed. The “others” category has not been disaggregated by race to avoid undue complexity.
Source: Drabble, 2000, Table 10.9.

Section (a) shows that, overall, foreign ownership fell substantially more than planned, while that of “Other Malaysians” rose well above the target. Bumiputera ownership appears to have stopped well short of the 30 percent mark. However, other evidence suggests that in certain sectors such as agriculture/mining (35.7%) and banking/insurance (49.7%) bumiputera ownership of shares in publicly listed companies had already attained a level well beyond the target. Section (b) indicates that while bumiputera employment share in primary production increased slightly (due mainly to the land schemes), as a proportion of that ethnic group it declined sharply, while rising markedly in both the secondary and tertiary sectors. In middle class employment the share rose to 27 percent.

As regards the proportion of households below the poverty line, in broad terms the incidence in Malaysia fell from approximately 49 percent in 1970 to 17 percent in 1990, but with large regional variations between the Peninsula (15%), Sarawak (21 %) and Sabah (34%) (Drabble, 2000, Table 13.5). All ethnic groups registered big falls, but on average the non-bumiputera still enjoyed the lowest incidence of poverty. By 2002 the overall level had fallen to only 4 percent.

The restructuring of the Malaysian economy under the NEP is very clear when we look at the changes in composition of the Gross Domestic Product (GDP) in Table 3 below.

Table 3
Structural Change in GDP 1970-90 (% shares)

Year Primary Secondary Tertiary
1970 44.3 18.3 37.4
1990 28.1 30.2 41.7

Source: Malaysian Government, 1991, Table 3-2.

Over these three decades Malaysia accomplished a transition from a primary product-dependent economy to one in which manufacturing industry had emerged as the leading growth sector. Rubber and tin, which accounted for 54.3 percent of Malaysian export value in 1970, declined sharply in relative terms to a mere 4.9 percent in 1990 (Crouch, 1996, 222).

Factors in the structural shift

The post-independence state played a leading role in the transformation. The transition from British rule was smooth. Apart from the disturbances in 1969 government maintained a firm control over the administrative machinery. Malaysia’s Five Year Development plans were a model for the developing world. Foreign capital was accorded a central role, though subject to the requirements of the NEP. At the same time these requirements discouraged domestic investors, the Chinese especially, to some extent (Jesudason, 1989).

Development was helped by major improvements in education and health. Enrolments at the primary school level reached approximately 90 percent by the 1970s, and at the secondary level 59 percent of potential by 1987. Increased female enrolments, up from 39 percent to 58 percent of potential from 1975 to 1991, were a notable feature, as was the participation of women in the workforce which rose to just over 45 percent of total employment by 1986/7. In the tertiary sector the number of universities increased from one to seven between 1969 and 1990 and numerous technical and vocational colleges opened. Bumiputera enrolments soared as a result of the NEP policy of redistribution (which included ethnic quotas and government scholarships). However, tertiary enrolments totaled only 7 percent of the age group by 1987. There was an “educational-occupation mismatch,” with graduates (bumiputera especially) preferring jobs in government, and consequent shortfalls against strong demand for engineers, research scientists, technicians and the like. Better living conditions (more homes with piped water and more rural clinics, for example) led to substantial falls in infant mortality, improved public health and longer life-expectancy, especially in Peninsular Malaysia (Drabble, 2000, 248, 284-6).

The quality of national leadership was a crucial factor. This was particularly so during the NEP. The leading figure here was Dr Mahathir Mohamad, Malaysian Prime Minister from 1981-2003. While supporting the NEP aim through positive discrimination to give bumiputera an economic stake in the country commensurate with their indigenous status and share in the population, he nevertheless emphasized that this should ultimately lead them to a more modern outlook and ability to compete with the other races in the country, the Chinese especially (see Khoo Boo Teik, 1995). There were, however, some paradoxes here. Mahathir was a meritocrat in principle, but in practice this period saw the spread of “money politics” (another expression for patronage) in Malaysia. In common with many other countries Malaysia embarked on a policy of privatization of public assets, notably in transportation (e.g. Malaysian Airlines), utilities (e.g. electricity supply) and communications (e.g. television). This was done not through an open process of competitive tendering but rather by a “nebulous ‘first come, first served’ principle” (Jomo, 1995, 8) which saw ownership pass directly to politically well-connected businessmen, mainly bumiputera, at relatively low valuations.

The New Development Policy

Positive action to promote bumiputera interests did not end with the NEP in 1990, this was followed in 1991 by the New Development Policy (NDP), which emphasized assistance only to “Bumiputera with potential, commitment and good track records” (Malaysian Government, 1991, 17) rather than the previous blanket measures to redistribute wealth and employment. In turn the NDP was part of a longer-term program known as Vision 2020. The aim here is to turn Malaysia into a fully industrialized country and to quadruple per capita income by the year 2020. This will require the country to continue ascending the technological “ladder” from low- to high-tech types of industrial production, with a corresponding increase in the intensity of capital investment and greater retention of value-added (i.e. the value added to raw materials in the production process) by Malaysian producers.

The Malaysian economy continued to boom at historically unprecedented rates of 8-9 percent a year for much of the 1990s (see next section). There was heavy expenditure on infrastructure, for example extensive building in Kuala Lumpur such as the Twin Towers (currently the highest buildings in the world). The volume of manufactured exports, notably electronic goods and electronic components increased rapidly.

Asian Financial Crisis, 1997-98

The Asian financial crisis originated in heavy international currency speculation leading to major slumps in exchange rates beginning with the Thai baht in May 1997, spreading rapidly throughout East and Southeast Asia and severely affecting the banking and finance sectors. The Malaysian ringgit exchange rate fell from RM 2.42 to 4.88 to the U.S. dollar by January 1998. There was a heavy outflow of foreign capital. To counter the crisis the International Monetary Fund (IMF) recommended austerity changes to fiscal and monetary policies. Some countries (Thailand, South Korea, and Indonesia) reluctantly adopted these. The Malaysian government refused and implemented independent measures; the ringgitbecame non-convertible externally and was pegged at RM 3.80 to the US dollar, while foreign capital repatriated before staying at least twelve months was subject to substantial levies. Despite international criticism these actions stabilized the domestic situation quite effectively, restoring net growth (see next section) especially compared to neighboring Indonesia.

Rates of Economic Growth

Malaysia’s economic growth in comparative perspective from 1960-90 is set out in Table 4 below.

Table 4
Asia-Pacific Region: Growth of Real GDP (annual average percent)

1960-69 1971-80 1981-89
Japan 10.9 5.0 4.0
Asian “Tigers”
Hong Kong 10.0 9.5 7.2
South Korea 8.5 8.7 9.3
Singapore 8.9 9.0 6.9
Taiwan 11.6 9.7 8.1
ASEAN-4
Indonesia 3.5 7.9 5.2
Malaysia 6.5 8.0 5.4
Philippines 4.9 6.2 1.7
Thailand 8.3 9.9 7.1

Source: Drabble, 2000, Table 10.2; figures for Japan are for 1960-70, 1971-80, and 1981-90.

The data show that Japan, the dominant Asian economy for much of this period, progressively slowed by the 1990s (see below). The four leading Newly Industrialized Countries (Asian “Tigers” as they were called) followed EOF strategies and achieved very high rates of growth. Among the four ASEAN (Association of Southeast Asian Nations formed 1967) members, again all adopting EOI policies, Thailand stood out followed closely by Malaysia. Reference to Table 1 above shows that by 1990 Malaysia, while still among the leaders in GDP per head, had slipped relative to the “Tigers.”

These economies, joined by China, continued growth into the 1990s at such high rates (Malaysia averaged around 8 percent a year) that the term “Asian miracle” became a common method of description. The exception was Japan which encountered major problems with structural change and an over-extended banking system. Post-crisis the countries of the region have started recovery but at differing rates. The Malaysian economy contracted by nearly 7 percent in 1998, recovered to 8 percent growth in 2000, slipped again to under 1 percent in 2001 and has since stabilized at between 4 and 5 percent growth in 2002-04.

The new Malaysian Prime Minister (since October 2003), Abdullah Ahmad Badawi, plans to shift the emphasis in development to smaller, less-costly infrastructure projects and to break the previous dominance of “money politics.” Foreign direct investment will still be sought but priority will be given to nurturing the domestic manufacturing sector.

Further improvements in education will remain a key factor (Far Eastern Economic Review, Nov.6, 2003).

Overview

Malaysia owes its successful historical economic record to a number of factors. Geographically it lies close to major world trade routes bringing early exposure to the international economy. The sparse indigenous population and labor force has been supplemented by immigrants, mainly from neighboring Asian countries with many becoming permanently domiciled. The economy has always been exceptionally open to external influences such as globalization. Foreign capital has played a major role throughout. Governments, colonial and national, have aimed at managing the structure of the economy while maintaining inter-ethnic stability. Since about 1960 the economy has benefited from extensive restructuring with sustained growth of exports from both the primary and secondary sectors, thus gaining a double impetus.

However, on a less positive assessment, the country has so far exchanged dependence on a limited range of primary products (e.g. tin and rubber) for dependence on an equally limited range of manufactured goods, notably electronics and electronic components (59 percent of exports in 2002). These industries are facing increasing competition from lower-wage countries, especially India and China. Within Malaysia the distribution of secondary industry is unbalanced, currently heavily favoring the Peninsula. Sabah and Sarawak are still heavily dependent on primary products (timber, oil, LNG). There is an urgent need to continue the search for new industries in which Malaysia can enjoy a comparative advantage in world markets, not least because inter-ethnic harmony depends heavily on the continuance of economic prosperity.

Select Bibliography

General Studies

Amarjit Kaur. Economic Change in East Malaysia: Sabah and Sarawak since 1850. London: Macmillan, 1998.

Andaya, L.Y. and Andaya, B.W. A History of Malaysia, second edition. Basingstoke: Palgrave, 2001.

Crouch, Harold. Government and Society in Malaysia. Sydney: Allen and Unwin, 1996.

Drabble, J.H. An Economic History of Malaysia, c.1800-1990: The Transition to Modern Economic Growth. Basingstoke: Macmillan and New York: St. Martin’s Press, 2000.

Furnivall, J.S. Colonial Policy and Practice: A Comparative Study of Burma and Netherlands India. Cambridge (UK), 1948.

Huff, W.G. The Economic Growth of Singapore: Trade and Development in the Twentieth Century. Cambridge: Cambridge University Press, 1994.

Jomo, K.S. Growth and Structural Change in the Malaysian Economy. London: Macmillan, 1990.

Industries/Transport

Alavi, Rokiah. Industrialization in Malaysia: Import Substitution and Infant Industry Performance. London: Routledge, 1966.

Amarjit Kaur. Bridge and Barrier: Transport and Communications in Colonial Malaya 1870-1957. Kuala Lumpur: Oxford University Press, 1985.

Drabble, J.H. Rubber in Malaya 1876-1922: The Genesis of the Industry. Kuala Lumpur: Oxford University Press, 1973.

Drabble, J.H. Malayan Rubber: The Interwar Years. London: Macmillan, 1991.

Huff, W.G. “Boom or Bust Commodities and Industrialization in Pre-World War II Malaya.” Journal of Economic History 62, no. 4 (2002): 1074-1115.

Jackson, J.C. Planters and Speculators: European and Chinese Agricultural Enterprise in Malaya 1786-1921. Kuala Lumpur: University of Malaya Press, 1968.

Lim Teck Ghee. Peasants and Their Agricultural Economy in Colonial Malaya, 1874-1941. Kuala Lumpur: Oxford University Press, 1977.

Wong Lin Ken. The Malayan Tin Industry to 1914. Tucson: University of Arizona Press, 1965.

Yip Yat Hoong. The Development of the Tin Mining Industry of Malaya. Kuala Lumpur: University of Malaya Press, 1969.

New Economic Policy

Jesudason, J.V. Ethnicity and the Economy: The State, Chinese Business and Multinationals in Malaysia. Kuala Lumpur: Oxford University Press, 1989.

Jomo, K.S., editor. Privatizing Malaysia: Rents, Rhetoric, Realities. Boulder, CO: Westview Press, 1995.

Khoo Boo Teik. Paradoxes of Mahathirism: An Intellectual Biography of Mahathir Mohamad. Kuala Lumpur: Oxford University Press, 1995.

Vincent, J.R., R.M. Ali and Associates. Environment and Development in a Resource-Rich Economy: Malaysia under the New Economic Policy. Cambridge, MA: Harvard University Press, 1997

Ethnic Communities

Chew, Daniel. Chinese Pioneers on the Sarawak Frontier, 1841-1941. Kuala Lumpur: Oxford University Press, 1990.

Gullick, J.M. Malay Society in the Late Nineteenth Century. Kuala Lumpur: Oxford University Press, 1989.

Hong, Evelyne. Natives of Sarawak: Survival in Borneo’s Vanishing Forests. Penang: Institut Masyarakat Malaysia, 1987.

Shamsul, A.B. From British to Bumiputera Rule. Singapore: Institute of Southeast Asian Studies, 1986.

Economic Growth

Far Eastern Economic Review. Hong Kong. An excellent weekly overview of current regional affairs.

Malaysian Government. The Second Outline Perspective Plan, 1991-2000. Kuala Lumpur: Government Printer, 1991.

Van der Eng, Pierre. “Assessing Economic Growth and the Standard of Living in Asia 1870-1990.” Milan, Eleventh International Economic History Congress, 1994.

Citation: Drabble, John. “The Economic History of Malaysia”. EH.Net Encyclopedia, edited by Robert Whaples. July 31, 2004. URL http://eh.net/encyclopedia/economic-history-of-malaysia/

The Law of One Price

Karl Gunnar Persson, University of Copenhagen

Definitions and Explanation of the Law of One Price

The concept “Law of One Price” relates to the impact of market arbitrage and trade on the prices of identical commodities that are exchanged in two or more markets. In an efficient market there must be, in effect, only one price of such commodities regardless of where they are traded. The “law” can also be applied to factor markets, as is briefly noted in the concluding section.

The intellectual history of the concept can be traced back to economists active in France in the 1760-70’s, which applied the “law” to markets involved in international trade. Most of the modern literature also tends to discuss the “law” in that context.

However, since transport and transaction costs are positive the law of one price must be re-formulated when applied to spatial trade. Let us first look at a case with two markets which are trading, say, wheat but with wheat going in one direction only, from Chicago to Liverpool, as has been the case since the 1850’s.

In this case the price difference between Liverpool and Chicago markets of wheat of a particular quality, say, Red Winter no. 2, should be equal to the transport and transaction cost of shipping grain from Chicago to Liverpool. This is to say that the ratio of the Liverpool price to the price in Chicago plus transport and transaction costs should be equal to one. Tariffs are not explicitly discussed in the next paragraphs but can easily be introduced as a specific transaction cost at par with commissions and other trading costs.

If the price differential exceeds the transport and transaction costs, this means that the price ratio is greater than one, then self-interested and well-informed traders take the opportunity to make a profit by shipping wheat from Chicago to Liverpool. Such arbitrage closes the price gap because it increases supply and hence decreases price in Liverpool, while it increases demand, and hence price in Chicago. To be sure the operation of the law of one price is not only based on trade flows but inventory adjustments as well. In the example above traders in Liverpool might choose to release wheat from warehouses in Liverpool immediately since they anticipate shipments to Liverpool. This inventory release works to depress prices immediately. So the expectation of future shipments will have an impact on price immediately because of inventory adjustments.

If the price differential does not exceed the transport and transaction cost, this means that the price ratio is less than one, then self-interested and well informed traders take the opportunity to restrict the release of wheat from the warehouses in Liverpool and decrease the demand for shipments of wheat from Chicago. These reactions will trigger off an immediate price increase in Liverpool since supply falls in Liverpool and a price decrease in Chicago because demand falls.

Formal Presentation of the Law of One Price

Let PL and PC denote the prices in Liverpool and Chicago respectively. Furthermore, we also observe the transport and transactions costs, linked to shipping the commodity from Chicago to Liverpool, PTc. All prices are measured in the same currency and units, say, shillings per imperial quarter. What has been explained above verbally can be expressed formally. The law of one price adjusted for transport and transaction costs implies the following equilibrium, which henceforward will be referred to as the Fundamental Law of One Price Identity or FLOPI:

[Equation - Fundamental Law of One Price Identity]

In case the two markets both produce and can trade a commodity in either direction the law of one price states that the price difference should be smaller or equal to transport and transaction costs. FLOPI then is smaller or equal to one. If the price difference is larger than transport and transaction costs, trade will close the gap as suggested above. Occasionally domestic demand and supply conditions in two producing economies can be such that price differences are smaller than transport and transaction costs and there will not be any need for trade. In this particular case the two economies are both self-sufficient in wheat.

A case with many markets will necessitate a third elaboration of the concept of the law of one price. Let us look at it in a world of three markets, say Chicago, Liverpool and Copenhagen. Assume furthermore that both Chicago and Copenhagen supply Liverpool with the same commodity, say wheat. If so, the Liverpool-Copenhagen price differential must be equal to the transport and transaction costs between Copenhagen and Liverpool and the Chicago-London price differential will be equal to the transport and transaction costs between Chicago and Liverpool. But what about the price difference between Chicago and Copenhagen? It turns out that it will be determined by the difference between transport and transactions costs from Chicago to Liverpool and from Copenhagen to Liverpool. If it costs 7 cents to ship a bushel of grain from Chicago to Liverpool and 5 cents from Copenhagen to Liverpool, the law of price difference between Copenhagen and Chicago will be 2 cents that is 7 – 5 = 2. If price is 100 cents per bushel in Chicago it will be 107 in Liverpool and 102 in Copenhagen. So although the distance and transport cost between Chicago and Copenhagen is larger than between Chicago and Liverpool, the equilibrium price differential is smaller! This argument can be extended to many markets in the following sense: the price difference between two markets which do not trade with each other will be determined by the minimum difference in transport and transaction costs between these two markets to a market with which they both trade.

The argument in the preceding paragraph has important implications for the relationship between distance and price differences. It is often argued that the difference between prices of a commodity in two markets increases monotonically with distance. But this is true only if the two markets actually trade directly with each other. However, the likelihood that markets cease to trade directly with each other increases as the distance increases and long distance markets will therefore typically be only indirectly linked through a third common market. Hence the paradox illustrated above that the law of one price difference between Chicago and Copenhagen is smaller despite the larger geographical distance than that between Copenhagen and Liverpool or Chicago and Liverpool. In fact it is quite easy to imagine two markets at a distance of two units both exporting to a third market in between them at a distance of one unit from each of them and enjoying the same price despite the large distance.

Efficient Markets and the Law of One Price

In what follows we typically discuss the “law” in a context with trade of a particular commodity going in one direction only, that is FLOPI = 1.

In a market with arbitrage and trade, violations of the law of one price must be transitory. However, price differentials often differ from the law of one price equilibrium, that is FLOPI is larger or smaller than 1, so it is convenient to understand the law of one price as an “attractor equilibrium” rather than a permanent state in which prices and the ratio of prices rest. The concept “attractor equilibrium” can be understood with reference to the forces described in the preceding section. That is, there are forces which act to restore FLOPI when it has been subject to a shock.

A perfectly efficient set of markets will allow only very short violations of the law of one price. But this is too strong a condition to be of practical significance. There are always local shocks which will take time to get diffused to other markets and distortions of information will make global shocks affect local markets differently. How long violations can persist depends on the state of information technology, whether markets operate with inventories and how competitive markets are. Commodity markets with telegraphic or electronic information transmission, inventories and no barriers to entry for traders can be expected to tolerate only short and transitory violations of the law of one price. News about a price change in one major market will have immediate effects on prices elsewhere due to inventory adjustments.

A convenient econometric way of analyzing the nature of the law of one price as an “attractor equilibrium” is a so-called error correction model. In such a model an equilibrium law of one price is estimated. If markets are not well integrated one cannot establish or estimate FLOPI. Given the existence of a long-run or equilibrium price relationship between markets, a violation is a so called “innovation” or shock, which will be corrected for so that the equilibrium price difference is restored. Here is the intuition of the model described below: Assume first that Liverpool and Chicago prices are in a law of one price equilibrium. Then, for example, the price in Chicago is subject to a local shock or “innovation” so that price in Chicago plus transport and transaction costs now exceeds the price in Liverpool. That happens in period t-1, and then the price in Liverpool will increase in the next period, t, while the price in Chicago will fall. Prices will fall in Chicago because demand for shipments will fall and it will increase in Liverpool because of a fall in supply when traders in Liverpool stop releasing grain from the warehouses in expectation of higher prices in the future. Eventually the FLOPI = 1 condition will be restored but at higher prices in both Liverpool and Chicago.

To summarize, the logic behind the error correction model is that prices in Liverpool and Chicago will react if there is a dis-equilibrium, that is when the price differential is larger or smaller than transport and transaction costs. In this case the prices will adjust such that the deviation from equilibrium is decreasing. The error correction model is usually expressed in differences of log prices. Let. The error correction model in this version is given by:

[Equation - Error Correction Model]

whereare statistical error terms with are assumed to be normally distributed with mean zero and constant variances. Please, note that errors are not the “error” that figures in the term “error correction model.” A better name for the latter would be “shock correction model” or “innovation correction model” to evade misunderstanding.

and are so-called adjustment parameters which indicate the power of FLOPI as an “attractor equilibrium.” The expected sign of the parameter is negative and it is positive for. To see this, imagine a case where the expression in the parenthesis above is larger than one. Then price in Liverpool should fall and increase in Chicago.

The parameters and indicate the speed at which “innovations” are corrected, the larger the parameters are for a given magnitude of the “innovation,” the more transitory are the violations of the law of one price – in other words, the faster is the equilibrium restored. The magnitudes of the parameters are an indicator of the efficiency of the markets. The higher they are, the faster will the equilibrium law of one price (FLOPI) be restored and the more efficient markets are. (The absolute values of the sum of the parameters should not exceed one.) The magnitude of “innovations” also tends to fall as markets get more efficient as defined above.

It is convenient to express the parameters in terms of the half life of shocks. Half life of a shock measures the time it takes for an original deviation from the equilibrium law of one price (FLOPI) to be reduced to half. The half life of shocks has been reduced dramatically in the long-distance trade of bulky commodities like grain – that is distances above 1500 km. From the seventeenth to the late nineteenth centuries, the half life was reduced from up to two years to only two weeks in international wheat markets, as revealed by the increase in the adjustment parameters. The major reason for this dramatic change is the improvement in information transmission.

The adjustment parameters can also be illustrated graphically and Figure 1 displays the stylized characteristics of adjustment speed in long-distance wheat trade and indicates a spectacular increase in grain market efficiency, specifically in the nineteenth century.

Read Figure 1 in the following way. At time 0 the two markets are in a law of one price equilibrium (FLOPI), that is prices in the two markets are exactly equal (set here arbitrarily at 100), and the ratio of prices is one. In this particular graphical example we abstract from transport and transactions costs. Now imagine a shock to the price in one market by 10 percent to 110. That will be followed by a process of mutual adjustment to the law of one price equilibrium (FLOPI) but at higher prices in both markets compared to the situation before the shock. The new price level will not necessarily be halfway between the initial level and the level attained in the economy which was subject to a shock. Adjustments can be strong in some markets and weak in others. As can be seen in Figure 1, the adjustment is very slow in the case of the Pisa (Italy) to Ruremonde (Netherlands). In fact, a new law on price equilibrium is not attained within the time period, 24 months, allowed by the Figure. This indicates very low, but still significant, adjustment parameters. It is also worth noting the difference in adjustments speed between pre-telegraph Chicago-Liverpool trade in the 1850’s and post-telegraph trade in the 1880’s.

Figure 1

Adjustment Speed in Markets after a Local Shock in Long-distance Wheat Markets
Cases from 1700-1900.

[Figure 1 - Speed in Markets after a Local Shock in Long-distance Wheat  Markets]

Note: The data underlying the construction are from Persson (1988) and Ejrnæs and Persson (2006).

It is worth noting that the fast speed of adjustment back to the law of one price recorded for single goods in the nineteenth century contrasts strongly with the sluggish adjustment in price indices (prices for bundles of goods) across economies (Giovanini 1998). However, some of these surprising results may depend on misspecifications of the tests (Taylor 2001).

Law of One Price and Convergence

The relationship between the convergence of prices on identical goods and the law of one price is not as straightforward as often believed. As was highlighted above, the law of one price can exist as an “equilibrium attractor,” despite large price differentials between markets, as long as the price differential reflects transport and transaction costs and if they are not prohibitively high. So in principle the adjustment parameters can be high, despite large price differentials. For example, the Chicago to Liverpool trade in the nineteenth century was based on highly efficient markets, but transport and transaction costs remained at about 20-25 percent of the Chicago price of wheat. However, historically the convergence in price levels in the nineteenth century was associated with an improvement in market efficiency as revealed by higher adjustment parameters. Convergence seems to be a nineteenth-century phenomenon. Figure 2 below indicates that there is not a long-run convergence in wheat markets. Convergence is here expressed as the UK price relative to the U.S. price. Falling transport costs, falling tariffs and increased market efficiency, which reduced risk premiums for traders, compressed price levels in the nineteenth century. Falling transport costs were particularly important for the landlocked producers when they penetrated foreign long-distance markets, as displayed by the dramatic convergence of Chicago to UK price levels. When the U.S. Midwest started to export grain to UK, the UK price level was 2.5 times the Chicago price. However, the figure exaggerates the true convergence significantly because the prices used do not refer to identical quality goods. As much as a third of the convergence shown in the graph has to do with improved quality of Chicago wheat relative to UK wheat, a factor often neglected in the convergence literature.

However, after the convergence forces had been exploited, trade policy was reversed. European farmers had little land relative to farmers in the New World economies, such as Argentina, Canada and U.S. and the former faced strong competition from imported grain. A protectionist backlash in continental Europe emerged in the 1880’s, continued during the Great Depression and after 1960, which contributed to price divergence. The trends discussed above are applicable to agricultural commodities but not necessarily to other commodities because protectionism is commodity specific. However, it is important to note that long-distance ocean shipping costs have not been subject to a long-run declining trend despite the widespread belief that this has been the case and therefore the convergence/divergence outcome is mostly a matter of trade policy.

Figure 2
Price Convergence, United States to United Kingdom, 1800-2000

(UK price relative to Chicago or New York price of wheat)

[Figure 3 - Price Convergence, United States to United Kingdom, 1800-2000]

Source: Federico and Persson (2006).

Note: Kernel regression is a convenient way of smoothing a time series.

The Law of One Price, Trade Restrictions and Barriers to Factor Mobility

Tariffs affect the equilibrium price differential very much like transport and transaction costs, but will tariffs also affect adjustment speed and market efficiency as defined above? The answer to that question depends on the level of tariffs. If tariffs are prohibitively high, then the domestic market will be cut off from the world market and the law of one price as an “equilibrium attractor” will cease to operate.

The law of one price can also, of course, be applied to factor markets – that is markets for capital and labor. For capital markets the law of one price would be such that interest rate or return differentials on identical assets traded in different locations or nations converge to zero or close to zero – that is the ratio of interest rates should converge to 1. If there are significant differences in interest rates between economies, capital will flow into the economy with high yields and contribute to leveling the differentials. It is clear that international capital market restrictions affect interest rate spreads. Periods of open capital markets, such as the Gold Standard period from 1870 to 1914, were periods of small and falling interest rate differentials. But the disintegration of the international capital markets and the introduction of capital market controls in the aftermath of the Great Depression in the 1930s witnessed an increase in interest rate spreads which remained substantial also under the Bretton Woods System c.1945 to 1971(73), in which capital mobility was restricted. It was not until the capital market liberalization of the 1980s and 1990s that interest rate differences again reached levels as low as a century earlier. Periods of war, when capital markets cease to function, are also periods when interest rates spreads increase.

The labor market is, however, the market that displays the most persistent violations of the law of price. We need to be careful, however, in spotting violations, in that we need to compare wages of identically skilled laborers and take differences in costs of living into consideration. Even so, huge real wage differences persist. A major reason for that is that labor markets in high income nations are shielded from international migration by a multitude of barriers.

The law of one price does not thrive under restrictions to trade or factor mobility.

References:

Ejrnæs, Mette, and Karl Gunnar Persson. “The Gains from Improved Market Efficiency: Trade before and after the Transatlantic Telegraph,” Working paper, Department of Economics, University of Copenhagen, 2006.

Federico. Giovanni and Karl Gunnar Persson. “Market Integration and Convergence in the World Wheat Market, 1800-2000.” In New Comparative Economic History, Essays in Honor of Jeffrey G. Williamson, edited by Timothy Hatton, Kevin O’Rourke and Alan Taylor. Cambridge, MA.:MIT Press, 2006.

Giovanini, Alberto. “Exchange Rates and Traded Goods Prices.” Journal of International Economics 24 (1988): 45-68.

Persson. Karl Gunnar. Grain Markets in Europe, 1500-1900: Integration and Deregulation. Cambridge: Cambridge University Press, 1998.

Taylor, Alan M. “Potential Pitfalls for the Purchasing Power Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price,” Econometrica 69, no. 2 (2001): 473-98.

Citation: Persson, Karl. “Law of One Price”. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/the-law-of-one-price/

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/

Ireland’s Great Famine

Ireland’s Great Famine

Cormac Ó Gráda, University College Dublin

The proximate cause of the Great Irish Famine (1846-52) was the fungus phythophtera infestans (or potato blight), which reached Ireland in the fall of 1845. The fungus destroyed about one-third of that year’s crop, and nearly all that of 1846. After a season’s remission, it also ruined most of the 1848 harvest. These repeated attacks made the Irish famine more protracted than most. Partial failures of the potato crop were nothing new in Ireland before 1845, but damage on the scale wrought by the ecological shock of potato blight was utterly unprecedented (Solar 1989; Clarkson and Crawford 2001). However, the famine would not have been so lethal had dependence on the potato been less. Poverty had reduced the bottom one-third or so of the population to almost exclusive dependence on the potato for sustenance. For those in this category, the daily intake was enormous: 4 to 5 kilos (9 to 11 pounds) daily per adult male equivalent for most of the year. That, coupled with an inadequate policy response from the authorities, made the consequences of repeated failures devastating (Bourke 1993).

Ireland was a poor country in 1845, income per head being about half that in the rest of the United Kingdom. The half-century or so before the famine was a period of increasing impoverishment for the landless poor. With impoverishment came rising inequality. Increasing population pressure was only partly relieved by an increase in the emigration rate and a fall in the birth rate (Boyle and Ó Gráda 1986). Moreover, demographic adjustment was weakest in the western and southern areas most at risk. The nutritional content of the potato and widespread access to heating fuel in the form of turf eased somewhat the poverty of Ireland’s three million ‘potato people.’ They were healthier and lived longer than the poor in other parts of Europe at the time. However, their poverty meant that when the potato failed, there was no trading down to a cheap alternative food (Ó Gráda 1994). Nowhere else in Europe had the potato, like tobacco a gift from the New World, made such inroads into the diet of the poor. It bears noting that the potato also failed throughout Europe in the 1840s. This brought hardship in many places, and excess mortality in the Low Countries and in parts of Germany. Yet nowhere was Ireland’s cataclysm repeated (Solar 1997).

The first attack of potato blight inflicted considerable hardship on rural Ireland, though no significant excess mortality. The catastrophe of the Great Famine really dates from the fall of 1846, when the first deaths from starvation were recorded. At first there were food riots and protests, but they subsided as hope and anger gave way to despair (Eiriksson 1997). During the winter and spring of 1846-7 the carnage reached its peak, but the famine continued for another three years. Like all major famines, the Irish potato famine produced many instances of roadside deaths, of neglect of the very young and the elderly, of heroism and of anti-social behavior, of evictions, and of a rise in crimes against property. It was widely reported in the contemporary press at first, both in Ireland and abroad. It elicited a massive response in terms of private donations for a time, especially through the Catholic Church worldwide and the Society of Friends. Philanthropists in Britain were also moved by Irish suffering. That was before compassion fatigue set in. For narrative accounts of the tragedy see Edwards and Williams (1956), Woodham-Smith (1962), Ó Gráda (1999), and Donnelly (2001).

Public Action

The debate about relief measures for Ireland in the press and in parliament in the 1840s has quite a modern resonance (compare Drèze and Sen 1989). At first the government opted for reliance on the provision of employment through public works schemes, the cost of which was to be split between local taxpayers and the central government. At their height in the spring of 1847 the works employed seven hundred thousand people or one-in-twelve of the entire population. The works did not contain the famine, partly because they did not target the neediest, partly because the average wage paid was too low, and partly because they entailed exposing malnourished and poorly clothed people (mostly men) to the elements during the worst months of the year.

The publicly-financed soup kitchens which replaced the public works reached three million people daily at their peak in early 1847. Mortality seemed to fall while they operated, though doubts remain about the effectiveness of a diet of thin meal-based gruel on weakened stomachs. The drop in food prices during the summer of 1847 prompted the authorities to treat the famine henceforth as a manageable, local problem. The main burden of relieving the poor henceforth was placed on the workhouses established under the Irish Poor Law of 1838. In principal those requiring relief were supposed to pass ‘the workhouse test,’ i.e. refusal to enter the workhouse was deemed evidence of being able to support one’s self. In practice, most of the workhouses were ill-equipped to meet the demands placed upon them, and in the event about one-quarter of all excess famine mortality occurred within their walls. Local histories highlight mismanagement and the impossible burden placed on local taxpayers; and the high overall proportion of workhouse deaths due to contagious diseases is an indictment of this form of relief. The very high mortality in some workhouses in 1850 and 1851 is evidence of the long-lasting character of the famine in some western areas (Guinnane and Ó Gráda 2002; Ó Murchadha 1998).

Traditional accounts of the famine pit the more humane policies of Sir Robert Peel’s Tories against the dogmatic stance of Sir John Russell’s Whig administration, which succeeded them. Peel was forced out of office in July 1846 when his party split on the issue of the Corn Laws. The contrast between Peel and Russell oversimplifies. Though Peel was more familiar with Ireland’s problems of economic backwardness than Whig ideologues such as Charles Wood, the crisis confronting him in 1845-6 was mild compared to what was to follow. Moreover, Peel broadly supported the Whig line in opposition, and it was left to his former Tory colleagues to mount a parliamentary challenge against Russell and Wood. Assessment of the public policy response cannot ignore the apocalyptic character of the crisis that it faced. Nonetheless, the government’s obsession with parsimony and its determination to make the Irish pay for ‘their’ crisis cannot but have increased the death rate. The same goes for the insistence on linking relief with structural reform (e.g. by making the surrender of all landholdings over a quarter of an acre in size a strict condition for relief). At the height of the crisis the policy stance adopted by the Whigs was influenced by Malthusian providentialism, i.e. the conviction that the potato blight was a divinely ordained remedy for Irish overpopulation. Compassion on the part of the British elite was in short supply. The fear that too much kindness would entail a Malthusian lesson not learnt also conditioned both the nature and extent of intervention (Gray 1999).

The Irish famine killed about one million people, or one-eighth of the entire population. This made it a major famine, relatively speaking, by world-historical standards. In pre-1845 Ireland famines were by no means unknown — that caused by arctic weather conditions in 1740-41 killed a higher share of a much smaller population (Dickson 1998) — but those that struck during the half-century or so before the Great Famine were mini-famines by comparison. The excess death toll of one million is an informed guess, since in the absence of civil registration excess mortality cannot be calculated directly (Mokyr 1985; Boyle and Ó Gráda 1986). The record of deaths in the workhouses and other public institutions is nearly complete, but the recording of other deaths depended on the memory of survivors in households where deaths had taken place. In many homes, of course, death and emigration meant that there were no survivors. The estimate does not include averted births, nor does it allow for famine-related deaths in Britain and further afield (Neal 1997).

Mortality was regionally very uneven. No part of Ireland escaped entirely, but the toll ranged from one-quarter of the population of some western counties to negligible fractions in counties Down and Wexford on the east coast. The timing of mortality varied too, even in some of the worst hit areas. In west Cork, a notorious problem area, the worst was over by late 1847, but the deadly effects of the famine ranged in county Clare until 1850 or even 1851. Infectious diseases — especially typhoid fever, typhus and dysentery/diarrhea — rather than literal starvation were responsible for the bulk of mortality. While Karl Marx was almost right to claim that the Irish famine killed ‘poor devils only,’ many who were not abjectly poor and starving died of famine-related diseases. Medical progress, by shielding the rich from infection, has made subsequent famines even more class-specific. By and large, the higher the death toll, the higher the proportion of starvation deaths (Mokyr and Ó Gráda 2002). As in most famines, the elderly and the young were most likely to succumb, but women proved marginally more resilient than men.

The famine also resulted in migration on a massive scale. Again precise estimates are impossible. Though these migrants were also victims of the famine, their departure improved not only their own survival chances, but also those of the majority who remained in Ireland. True, the Atlantic crossing produced its own carnage, particularly in Quebec’s Grosse-Isle, but most of those who fled made it safely to the other side. There thus is a sense in which migration was a crude form of disaster relief, and that more spending on subsidized emigration would have reduced the aggregate famine death toll (Ó Gráda and O’Rourke 1997). Most of those who emigrated relied on their own resources; some landlords helped through direct subsidies or by relieving those who left of their unpaid rent bills. The landless poor simply could not afford to leave.

A Hierarchy of Suffering

Like all famines, the Irish famine produced its hierarchy of suffering. The rural poor, landless or near-landless, were most likely to perish, and the earliest victims were in that category. Farmers found their effective land endowment reduced, since their holdings could no longer yield the same quantity of potatoes as before. They also faced increased labor costs, forcing them to reduce their concentration on tillage. Landlords’ rental income plummeted by as much a third. Many clergymen, medical practitioners, and poor law officials died of infectious diseases. Pawnbrokers found their pledges being unredeemed as the crisis worsened. Least affected were those businesses and their work forces who relied on foreign markets for their raw materials and their sales. The relative impact of the famine on different occupational groups may be inferred from the 1841 and 1851 censuses. The overall decline in the labor force was 19.1 percent. There were 14.4 percent fewer farmers, and 24.2 percent fewer farm laborers. Not surprisingly, given their vulnerability, the number of physicians and surgeons dropped by 25.3 percent. The small number of coffin makers (eight in 1841, twenty-two in 1851) is a reminder that during the famine most coffins were not made by specialist coffin makers. It is difficult to identify any significant class of ‘winners’ in the 1840s, though the census indicates increases in the numbers of millers and bakers, of barristers and attorneys, and of bailiffs and rate collectors. The huge fall in the numbers of spinners and weavers was partly a consequence of the famine, partly due to other causes (Ó Gráda 1999: chapter 4; 2001).

Post-Famine Adjustment

The Great Irish Famine was not just a watershed in Irish history, but also a major event in global history, with far-reaching and enduring economic and political consequences. Individual memories of the famine, coupled with ‘collective memory’ of the event in later years, influenced the political culture of both Ireland and Irish-America — and probably still do (Cullen 1997; Donnelly 2000; Ó Gráda 2001). The famine brought the era of famines in Ireland to a brutal end. Serious failures of the potato in the early 1860s and late 1870s, also due to potato blight, brought privation in the west of the country, but no significant excess mortality. The famine also resulted in higher living standards for survivors. The bargaining power of labor was greater. Any negative impact on landlords’ income from a declining population was more than compensated for by the relative increase in the prices of land-intensive output and the prompter payment of rents due. Higher emigration was another by-product of the famine, as the huge outflow of the crisis years generated its own ‘friends and neighbors’ dynamic. Only in a few remote and tiny pockets in the west did population fill the vacuum left by the ‘Great Hunger,’ and then only very briefly (Guinnane 1997).

Whether or not the famine led to the decline of certain native industries by reducing the domestic market remains a moot point, worthy of further research (Whelan 1999). The long-run impact of the famine on the health of affected survivors is another unresearched topic (compare Lumey 1998). Finally, though the introduction of new potato varieties offered some respite against phythophtera infestans thereafter, no reliable defense would be found against it until the 1890s.

Note: This essay builds on my entry on the Great Irish Famine in Paul Demeny and Geoffrey McNicoll, editors, Encyclopedia of Population (New York: Macmillan, 2003).

Further Reading

Bourke, Austin. The Visitation of God? The Potato and the Great Irish Famine. Dublin: Lilliput, 1993.

Boyle, P.P. and C. Ó Gráda. “Fertility Trends, Excess Mortality, and the Great Irish Famine.” Demography 23 (1986): 543-62.

Clarkson, L.E. and E.M. Crawford. Feast and Famine: Food and Nutrition in Ireland 1500-1920. Oxford: Oxford University Press, 2001.

Cullen, L.M. ‘The Politics of the Famine and Famine Historiography,” Comhdháil an Chraoibhín 1996 (Roscommon, Ireland) 1997: 9-31.

Dickson, David. Arctic Ireland. Belfast: White Row Press, 1998.

Donnelly, James S. The Irish Potato Famine. London: Sutton Publishing, 2000.

Drèze, Jean and Amartya Sen. Hunger and Public Action, Oxford: Oxford University Press, 1989.

Edwards, R.D. and T.D. Williams. The Great Famine: Studies in Irish History, 1845-52. Dublin; Browne & Nolan, 1956 [new edition published by Lilliput Press, 1994].

Eiriksson, Andrés. “Food Supply and Food Riots.” In Famine 150: The Teagasc/UCD Lectures, edited by Cormac Ó Gráda, 67-93. Dublin: Teagasc, 1997.

Gray, Peter. Famine, Land, and Politics: British Government and Irish Society, 1843-50, Dublin: Irish Academic Press, 1999.

Guinnane, Timothy W. The Vanishing Irish: Households, Migration and the Rural Economy in Ireland, 1850-1914. Princeton: Princeton University Press, 1997.

Guinnane, Timothy W. and Cormac Ó Gráda. “Workhouse Mortality and the Great Irish Famine.” In Famine Demography, edited by Tim Dyson and Cormac Ó Gráda, 44-64. Oxford: Oxford University Press, 2002.

Lumey, L.H. “Reproductive Outcomes in Women Prenatally Exposed to Undernutrition from the Dutch Famine Birth Cohort.” Proceedings of the Nutrition Society 57 (1998): 129-35.

Mokyr, Joel. Why Ireland Starved: An Analytical and Quantitative History of the Irish Economy, 1800-1850. London: Allen & Unwin, 1985.

Mokyr, Joel and Cormac Ó Gráda. “What Do People Die of during Famines? The Great Irish Famine in Comparative Perspective.” European Review of Economic History 6, no. 3 (2002): 339-64.

Neal, Frank. Black ’47: Britain and the Famine Irish. London: Macmillan, 1998.

Ó Gráda, Cormac. Ireland: A New Economic History, 1780-1939. Oxford: Oxford University Press, 1994.

Ó Gráda, Cormac. Black ’47 and Beyond: The Great Irish Famine in History, Economy, and Memory. Princeton: Princeton University Press, 1999.

Ó Gráda, Cormac. “Famine, Trauma, and Memory. ” Béaloideas 69 (2001): 121-43.

Ó Gráda, Cormac and Kevin H. O’Rourke. “Mass Migration as Disaster Relief: Lessons from the Great Irish Famine.” European Review of Economic History 1, no. 1 (1997): 3-25.

Ó Murchadha, Ciarán. Sable Wings over the Sand: Ennis, County Clare, and Its Wider Community during the Great Famine. Ennis: Clasp Press, 1998.

Solar, Peter M. “The Great Famine Was No Ordinary Subsistence Crisis.” In Famine: The Irish Experience, 900-1900, edited by E.M. Crawford. Edinburgh: John Donald, 1989.

Solar, Peter M. 1997. “The Potato Famine in Europe.” In Famine 150: The Teagasc/UCD Lectures, edited by Cormac Ó Gráda, 113-27. Dublin: Teagasc, 1997.

Whelan, Karl. “Economic Geography and the Long-run Effects of the Great Irish Famine.” Economic and Social Review 30, no. 1 (1999): 1-20.

Woodham-Smith, Cecil. The Great Hunger: Ireland, 1845-49, London: Hamish Hamilton, 1962.

Citation: O Grada, Cormac. “Ireland’s Great Famine”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/irelands-great-famine/

The Economic History of Indonesia

Jeroen Touwen, Leiden University, Netherlands

Introduction

In recent decades, Indonesia has been viewed as one of Southeast Asia’s successful highly performing and newly industrializing economies, following the trail of the Asian tigers (Hong Kong, Singapore, South Korea, and Taiwan) (see Table 1). Although Indonesia’s economy grew with impressive speed during the 1980s and 1990s, it experienced considerable trouble after the financial crisis of 1997, which led to significant political reforms. Today Indonesia’s economy is recovering but it is difficult to say when all its problems will be solved. Even though Indonesia can still be considered part of the developing world, it has a rich and versatile past, in the economic as well as the cultural and political sense.

Basic Facts

Indonesia is situated in Southeastern Asia and consists of a large archipelago between the Indian Ocean and the Pacific Ocean, with more than 13.000 islands. The largest islands are Java, Kalimantan (the southern part of the island Borneo), Sumatra, Sulawesi, and Papua (formerly Irian Jaya, which is the western part of New Guinea). Indonesia’s total land area measures 1.9 million square kilometers (750,000 square miles). This is three times the area of Texas, almost eight times the area of the United Kingdom and roughly fifty times the area of the Netherlands. Indonesia has a tropical climate, but since there are large stretches of lowland and numerous mountainous areas, the climate varies from hot and humid to more moderate in the highlands. Apart from fertile land suitable for agriculture, Indonesia is rich in a range of natural resources, varying from petroleum, natural gas, and coal, to metals such as tin, bauxite, nickel, copper, gold, and silver. The size of Indonesia’s population is about 230 million (2002), of which the largest share (roughly 60%) live in Java.

Table 1

Indonesia’s Gross Domestic Product per Capita

Compared with Several Other Asian Countries (in 1990 dollars)

Indonesia Philippines Thailand Japan
1900 745 1 033 812 1 180
1913 904 1 066 835 1 385
1950 840 1 070 817 1 926
1973 1 504 1 959 1 874 11 439
1990 2 516 2 199 4 645 18 789
2000 3 041 2 385 6 335 20 084

Source: Angus Maddison, The World Economy: A Millennial Perspective, Paris: OECD Development Centre Studies 2001, 206, 214-215. For year 2000: University of Groningen and the Conference Board, GGDC Total Economy Database, 2003, http://www.eco.rug.nl/ggdc.

Important Aspects of Indonesian Economic History

“Missed Opportunities”

Anne Booth has characterized the economic history of Indonesia with the somewhat melancholy phrase “a history of missed opportunities” (Booth 1998). One may compare this with J. Pluvier’s history of Southeast Asia in the twentieth century, which is entitled A Century of Unfulfilled Expectations (Breda 1999). The missed opportunities refer to the fact that despite its rich natural resources and great variety of cultural traditions, the Indonesian economy has been underperforming for large periods of its history. A more cyclical view would lead one to speak of several ‘reversals of fortune.’ Several times the Indonesian economy seemed to promise a continuation of favorable economic development and ongoing modernization (for example, Java in the late nineteenth century, Indonesia in the late 1930s or in the early 1990s). But for various reasons Indonesia time and again suffered from severe incidents that prohibited further expansion. These incidents often originated in the internal institutional or political spheres (either after independence or in colonial times), although external influences such as the 1930s Depression also had their ill-fated impact on the vulnerable export-economy.

“Unity in Diversity”

In addition, one often reads about “unity in diversity.” This is not only a political slogan repeated at various times by the Indonesian government itself, but it also can be applied to the heterogeneity in the national features of this very large and diverse country. Logically, the political problems that arise from such a heterogeneous nation state have had their (negative) effects on the development of the national economy. The most striking difference is between densely populated Java, which has a long tradition of politically and economically dominating the sparsely populated Outer Islands. But also within Java and within the various Outer Islands, one encounters a rich cultural diversity. Economic differences between the islands persist. Nevertheless, for centuries, the flourishing and enterprising interregional trade has benefited regional integration within the archipelago.

Economic Development and State Formation

State formation can be viewed as a condition for an emerging national economy. This process essentially started in Indonesia in the nineteenth century, when the Dutch colonized an area largely similar to present-day Indonesia. Colonial Indonesia was called ‘the Netherlands Indies.’ The term ‘(Dutch) East Indies’ was mainly used in the seventeenth and eighteenth centuries and included trading posts outside the Indonesian archipelago.

Although Indonesian national historiography sometimes refers to a presumed 350 years of colonial domination, it is exaggerated to interpret the arrival of the Dutch in Bantam in 1596 as the starting point of Dutch colonization. It is more reasonable to say that colonization started in 1830, when the Java War (1825-1830) was ended and the Dutch initiated a bureaucratic, centralizing polity in Java without further restraint. From the mid-nineteenth century onward, Dutch colonization did shape the borders of the Indonesian nation state, even though it also incorporated weaknesses in the state: ethnic segmentation of economic roles, unequal spatial distribution of power, and a political system that was largely based on oppression and violence. This, among other things, repeatedly led to political trouble, before and after independence. Indonesia ceased being a colony on 17 August 1945 when Sukarno and Hatta proclaimed independence, although full independence was acknowledged by the Netherlands only after four years of violent conflict, on 27 December 1949.

The Evolution of Methodological Approaches to Indonesian Economic History

The economic history of Indonesia analyzes a range of topics, varying from the characteristics of the dynamic exports of raw materials, the dualist economy in which both Western and Indonesian entrepreneurs participated, and the strong measure of regional variation in the economy. While in the past Dutch historians traditionally focused on the colonial era (inspired by the rich colonial archives), from the 1960s and 1970s onward an increasing number of scholars (among which also many Indonesians, but also Australian and American scholars) started to study post-war Indonesian events in connection with the colonial past. In the course of the 1990s attention gradually shifted from the identification and exploration of new research themes towards synthesis and attempts to link economic development with broader historical issues. In 1998 the excellent first book-length survey of Indonesia’s modern economic history was published (Booth 1998). The stress on synthesis and lessons is also present in a new textbook on the modern economic history of Indonesia (Dick et al 2002). This highly recommended textbook aims at a juxtaposition of three themes: globalization, economic integration and state formation. Globalization affected the Indonesian archipelago even before the arrival of the Dutch. The period of the centralized, military-bureaucratic state of Soeharto’s New Order (1966-1998) was only the most recent wave of globalization. A national economy emerged gradually from the 1930s as the Outer Islands (a collective name which refers to all islands outside Java and Madura) reoriented towards industrializing Java.

Two research traditions have become especially important in the study of Indonesian economic history during the past decade. One is a highly quantitative approach, culminating in reconstructions of Indonesia’s national income and national accounts over a long period of time, from the late nineteenth century up to today (Van der Eng 1992, 2001). The other research tradition highlights the institutional framework of economic development in Indonesia, both as a colonial legacy and as it has evolved since independence. There is a growing appreciation among scholars that these two approaches complement each other.

A Chronological Survey of Indonesian Economic History

The precolonial economy

There were several influential kingdoms in the Indonesian archipelago during the pre-colonial era (e.g. Srivijaya, Mataram, Majapahit) (see further Reid 1988,1993; Ricklefs 1993). Much debate centers on whether this heyday of indigenous Asian trade was effectively disrupted by the arrival of western traders in the late fifteenth century

Sixteenth and seventeenth century

Present-day research by scholars in pre-colonial economic history focuses on the dynamics of early-modern trade and pays specific attention to the role of different ethnic groups such as the Arabs, the Chinese and the various indigenous groups of traders and entrepreneurs. During the sixteenth to the nineteenth century the western colonizers only had little grip on a limited number of spots in the Indonesian archipelago. As a consequence much of the economic history of these islands escapes the attention of the economic historian. Most data on economic matters is handed down by western observers with their limited view. A large part of the area remained engaged in its own economic activities, including subsistence agriculture (of which the results were not necessarily very meager) and local and regional trade.

An older research literature has extensively covered the role of the Dutch in the Indonesian archipelago, which began in 1596 when the first expedition of Dutch sailing ships arrived in Bantam. In the seventeenth and eighteenth centuries the Dutch overseas trade in the Far East, which focused on high-value goods, was in the hands of the powerful Dutch East India Company (in full: the United East Indies Trading Company, or Vereenigde Oost-Indische Compagnie [VOC], 1602-1795). However, the region was still fragmented and Dutch presence was only concentrated in a limited number of trading posts.

During the eighteenth century, coffee and sugar became the most important products and Java became the most important area. The VOC gradually took over power from the Javanese rulers and held a firm grip on the productive parts of Java. The VOC was also actively engaged in the intra-Asian trade. For example, cotton from Bengal was sold in the pepper growing areas. The VOC was a successful enterprise and made large dividend payments to its shareholders. Corruption, lack of investment capital, and increasing competition from England led to its demise and in 1799 the VOC came to an end (Gaastra 2002, Jacobs 2000).

The nineteenth century

In the nineteenth century a process of more intensive colonization started, predominantly in Java, where the Cultivation System (1830-1870) was based (Elson 1994; Fasseur 1975).

During the Napoleonic era the VOC trading posts in the archipelago had been under British rule, but in 1814 they came under Dutch authority again. During the Java War (1825-1830), Dutch rule on Java was challenged by an uprising led by Javanese prince Diponegoro. To repress this revolt and establish firm rule in Java, colonial expenses increased, which in turn led to a stronger emphasis on economic exploitation of the colony. The Cultivation System, initiated by Johannes van den Bosch, was a state-governed system for the production of agricultural products such as sugar and coffee. In return for a fixed compensation (planting wage), the Javanese were forced to cultivate export crops. Supervisors, such as civil servants and Javanese district heads, were paid generous ‘cultivation percentages’ in order to stimulate production. The exports of the products were consigned to a Dutch state-owned trading firm (the Nederlandsche Handel-Maatschappij, NHM, established in 1824) and sold profitably abroad.

Although the profits (‘batig slot’) for the Dutch state of the period 1830-1870 were considerable, various reasons can be mentioned for the change to a liberal system: (a) the emergence of new liberal political ideology; (b) the gradual demise of the Cultivation System during the 1840s and 1850s because internal reforms were necessary; and (c) growth of private (European) entrepreneurship with know-how and interest in the exploitation of natural resources, which took away the need for government management (Van Zanden and Van Riel 2000: 226).

Table 2

Financial Results of Government Cultivation, 1840-1849 (‘Cultivation System’) (in thousands of guilders in current values)

1840-1844 1845-1849
Coffee 40 278 24 549
Sugar 8 218 4 136
Indigo, 7 836 7 726
Pepper, Tea 647 1 725
Total net profits 39 341 35 057

Source: Fasseur 1975: 20.

Table 3

Estimates of Total Profits (‘batig slot’) during the Cultivation System,

1831/40 – 1861/70 (in millions of guilders)

1831/40 1841/50 1851/60 1861/70
Gross revenues of sale of colonial products 227.0 473.9 652.7 641.8
Costs of transport etc (NHM) 88.0 165.4 138.7 114.7
Sum of expenses 59.2 175.1 275.3 276.6
Total net profits* 150.6 215.6 289.4 276.7

Source: Van Zanden and Van Riel 2000: 223.

* Recalculated by Van Zanden and Van Riel to include subsidies for the NHM and other costs that in fact benefited the Dutch economy.

The heyday of the colonial export economy (1900-1942)

After 1870, private enterprise was promoted but the exports of raw materials gained decisive momentum after 1900. Sugar, coffee, pepper and tobacco, the old export products, were increasingly supplemented with highly profitable exports of petroleum, rubber, copra, palm oil and fibers. The Outer Islands supplied an increasing share in these foreign exports, which were accompanied by an intensifying internal trade within the archipelago and generated an increasing flow of foreign imports. Agricultural exports were cultivated both in large-scale European agricultural plantations (usually called agricultural estates) and by indigenous smallholders. When the exploitation of oil became profitable in the late nineteenth century, petroleum earned a respectable position in the total export package. In the early twentieth century, the production of oil was increasingly concentrated in the hands of the Koninklijke/Shell Group.


Figure 1

Foreign Exports from the Netherlands-Indies, 1870-1940

(in millions of guilders, current values)

Source: Trade statistics

The momentum of profitable exports led to a broad expansion of economic activity in the Indonesian archipelago. Integration with the world market also led to internal economic integration when the road system, railroad system (in Java and Sumatra) and port system were improved. In shipping lines, an important contribution was made by the KPM (Koninklijke Paketvaart-Maatschappij, Royal Packet boat Company) that served economic integration as well as imperialist expansion. Subsidized shipping lines into remote corners of the vast archipelago carried off export goods (forest products), supplied import goods and transported civil servants and military.

The Depression of the 1930s hit the export economy severely. The sugar industry in Java collapsed and could not really recover from the crisis. In some products, such as rubber and copra, production was stepped up to compensate for lower prices. In the rubber exports indigenous producers for this reason evaded the international restriction agreements. The Depression precipitated the introduction of protectionist measures, which ended the liberal period that had started in 1870. Various import restrictions were launched, making the economy more self-sufficient, as for example in the production of rice, and stimulating domestic integration. Due to the strong Dutch guilder (the Netherlands adhered to the gold standard until 1936), it took relatively long before economic recovery took place. The outbreak of World War II disrupted international trade, and the Japanese occupation (1942-1945) seriously disturbed and dislocated the economic order.

Table 4

Annual Average Growth in Economic Key Aggregates 1830-1990

GDP per capita Export volume Export

Prices

Government Expenditure
Cultivation System 1830-1840 n.a. 13.5 5.0 8.5
Cultivation System 1840-1848 n.a. 1.5 - 4.5 [very low]
Cultivation System 1849-1873 n.a. 1.5 1.5 2.6
Liberal Period 1874-1900 [very low] 3.1 - 1.9 2.3
Ethical Period 1901-1928 1.7 5.8 17.4 4.1
Great Depression 1929-1934 -3.4 -3.9 -19.7 0.4
Prewar Recovery 1934-1940 2.5 2.2 7.8 3.4
Old Order 1950-1965 1.0 0.8 - 2.1 1.8
New Order 1966-1990 4.4 5.4 11.6 10.6

Source: Booth 1998: 18.

Note: These average annual growth percentages were calculated by Booth by fitting an exponential curve to the data for the years indicated. Up to 1873 data refer only to Java.

The post-1945 period

After independence, the Indonesian economy had to recover from the hardships of the Japanese occupation and the war for independence (1945-1949), on top of the slow recovery from the 1930s Depression. During the period 1949-1965, there was little economic growth, predominantly in the years from 1950 to 1957. In 1958-1965, growth rates dwindled, largely due to political instability and inappropriate economic policy measures. The hesitant start of democracy was characterized by a power struggle between the president, the army, the communist party and other political groups. Exchange rate problems and absence of foreign capital were detrimental to economic development, after the government had eliminated all foreign economic control in the private sector in 1957/58. Sukarno aimed at self-sufficiency and import substitution and estranged the suppliers of western capital even more when he developed communist sympathies.

After 1966, the second president, general Soeharto, restored the inflow of western capital, brought back political stability with a strong role for the army, and led Indonesia into a period of economic expansion under his authoritarian New Order (Orde Baru) regime which lasted until 1997 (see below for the three phases in New Order). In this period industrial output quickly increased, including steel, aluminum, and cement but also products such as food, textiles and cigarettes. From the 1970s onward the increased oil price on the world market provided Indonesia with a massive income from oil and gas exports. Wood exports shifted from logs to plywood, pulp, and paper, at the price of large stretches of environmentally valuable rainforest.

Soeharto managed to apply part of these revenues to the development of technologically advanced manufacturing industry. Referring to this period of stable economic growth, the World Bank Report of 1993 speaks of an ‘East Asian Miracle’ emphasizing the macroeconomic stability and the investments in human capital (World Bank 1993: vi).

The financial crisis in 1997 revealed a number of hidden weaknesses in the economy such as a feeble financial system (with a lack of transparency), unprofitable investments in real estate, and shortcomings in the legal system. The burgeoning corruption at all levels of the government bureaucracy became widely known as KKN (korupsi, kolusi, nepotisme). These practices characterize the coming-of-age of the 32-year old, strongly centralized, autocratic Soeharto regime.

From 1998 until present

Today, the Indonesian economy still suffers from severe economic development problems following the financial crisis of 1997 and the subsequent political reforms after Soeharto stepped down in 1998. Secessionist movements and the low level of security in the provincial regions, as well as relatively unstable political policies, form some of its present-day problems. Additional problems include the lack of reliable legal recourse in contract disputes, corruption, weaknesses in the banking system, and strained relations with the International Monetary Fund. The confidence of investors remains low, and in order to achieve future growth, internal reform will be essential to build up confidence of international donors and investors.

An important issue on the reform agenda is regional autonomy, bringing a larger share of export profits to the areas of production instead of to metropolitan Java. However, decentralization policies do not necessarily improve national coherence or increase efficiency in governance.

A strong comeback in the global economy may be at hand, but has not as yet fully taken place by the summer of 2003 when this was written.

Additional Themes in the Indonesian Historiography

Indonesia is such a large and multi-faceted country that many different aspects have been the focus of research (for example, ethnic groups, trade networks, shipping, colonialism and imperialism). One can focus on smaller regions (provinces, islands), as well as on larger regions (the western archipelago, the eastern archipelago, the Outer Islands as a whole, or Indonesia within Southeast Asia). Without trying to be exhaustive, eleven themes which have been subject of debate in Indonesian economic history are examined here (on other debates see also Houben 2002: 53-55; Lindblad 2002b: 145-152; Dick 2002: 191-193; Thee 2002: 242-243).

The indigenous economy and the dualist economy

Although western entrepreneurs had an advantage in technological know-how and supply of investment capital during the late-colonial period, there has been a traditionally strong and dynamic class of entrepreneurs (traders and peasants) in many regions of Indonesia. Resilient in times of economic malaise, cunning in symbiosis with traders of other Asian nationalities (particularly Chinese), the Indonesian entrepreneur has been rehabilitated after the relatively disparaging manner in which he was often pictured in the pre-1945 literature. One of these early writers, J.H. Boeke, initiated a school of thought centering on the idea of ‘economic dualism’ (referring to a modern western and a stagnant eastern sector). As a consequence, the term ‘dualism’ was often used to indicate western superiority. From the 1960s onward such ideas have been replaced by a more objective analysis of the dualist economy that is not so judgmental about the characteristics of economic development in the Asian sector. Some focused on technological dualism (such as B. Higgins) others on ethnic specialization in different branches of production (see also Lindblad 2002b: 148, Touwen 2001: 316-317).

The characteristics of Dutch imperialism

Another vigorous debate concerns the character of and the motives for Dutch colonial expansion. Dutch imperialism can be viewed as having a rather complex mix of political, economic and military motives which influenced decisions about colonial borders, establishing political control in order to exploit oil and other natural resources, and preventing local uprisings. Three imperialist phases can be distinguished (Lindblad 2002a: 95-99). The first phase of imperialist expansion was from 1825-1870. During this phase interference with economic matters outside Java increased slowly but military intervention was occasional. The second phase started with the outbreak of the Aceh War in 1873 and lasted until 1896. During this phase initiatives in trade and foreign investment taken by the colonial government and by private businessmen were accompanied by extension of colonial (military) control in the regions concerned. The third and final phase was characterized by full-scale aggressive imperialism (often known as ‘pacification’) and lasted from 1896 until 1907.

The impact of the cultivation system on the indigenous economy

The thesis of ‘agricultural involution’ was advocated by Clifford Geertz (1963) and states that a process of stagnation characterized the rural economy of Java in the nineteenth century. After extensive research, this view has generally been discarded. Colonial economic growth was stimulated first by the Cultivation System, later by the promotion of private enterprise. Non-farm employment and purchasing power increased in the indigenous economy, although there was much regional inequality (Lindblad 2002a: 80; 2002b:149-150).

Regional diversity in export-led economic expansion

The contrast between densely populated Java, which had been dominant in economic and political regard for a long time, and the Outer Islands, which were a large, sparsely populated area, is obvious. Among the Outer Islands we can distinguish between areas which were propelled forward by export trade, either from Indonesian or European origin (examples are Palembang, East Sumatra, Southeast Kalimantan) and areas which stayed behind and only slowly picked the fruits of the modernization that took place elsewhere (as for example Benkulu, Timor, Maluku) (Touwen 2001).

The development of the colonial state and the role of Ethical Policy

Well into the second half of the nineteenth century, the official Dutch policy was to abstain from interference with local affairs. The scarce resources of the Dutch colonial administrators should be reserved for Java. When the Aceh War initiated a period of imperialist expansion and consolidation of colonial power, a call for more concern with indigenous affairs was heard in Dutch politics, which resulted in the official Ethical Policy which was launched in 1901 and had the threefold aim of improving indigenous welfare, expanding the educational system, and allowing for some indigenous participation in the government (resulting in the People’s Council (Volksraad) that was installed in 1918 but only had an advisory role). The results of the Ethical Policy, as for example measured in improvements in agricultural technology, education, or welfare services, are still subject to debate (Lindblad 2002b: 149).

Living conditions of coolies at the agricultural estates

The plantation economy, which developed in the sparsely populated Outer Islands (predominantly in Sumatra) between 1870 and 1942, was in bad need of labor. The labor shortage was solved by recruiting contract laborers (coolies) in China, and later in Java. The Coolie Ordinance was a government regulation that included the penal clause (which allowed for punishment by plantation owners). In response to reported abuse, the colonial government established the Labor Inspectorate (1908), which aimed at preventing abuse of coolies on the estates. The living circumstances and treatment of the coolies has been subject of debate, particularly regarding the question whether the government put enough effort in protecting the interests of the workers or allowed abuse to persist (Lindblad 2002b: 150).

Colonial drain

How large of a proportion of economic profits was drained away from the colony to the mother country? The detrimental effects of the drain of capital, in return for which European entrepreneurial initiatives were received, have been debated, as well as the exact methods of its measurement. There was also a second drain to the home countries of other immigrant ethnic groups, mainly to China (Van der Eng 1998; Lindblad 2002b: 151).

The position of the Chinese in the Indonesian economy

In the colonial economy, the Chinese intermediary trader or middleman played a vital role in supplying credit and stimulating the cultivation of export crops such as rattan, rubber and copra. The colonial legal system made an explicit distinction between Europeans, Chinese and Indonesians. This formed the roots of later ethnic problems, since the Chinese minority population in Indonesia has gained an important (and sometimes envied) position as capital owners and entrepreneurs. When threatened by political and social turmoil, Chinese business networks may have sometimes channel capital funds to overseas deposits.

Economic chaos during the ‘Old Order’

The ‘Old Order’-period, 1945-1965, was characterized by economic (and political) chaos although some economic growth undeniably did take place during these years. However, macroeconomic instability, lack of foreign investment and structural rigidity formed economic problems that were closely connected with the political power struggle. Sukarno, the first president of the Indonesian republic, had an outspoken dislike of colonialism. His efforts to eliminate foreign economic control were not always supportive of the struggling economy of the new sovereign state. The ‘Old Order’ has for long been a ‘lost area’ in Indonesian economic history, but the establishment of the unitary state and the settlement of major political issues, including some degree of territorial consolidation (as well as the consolidation of the role of the army) were essential for the development of a national economy (Dick 2002: 190; Mackie 1967).

Development policy and economic planning during the ‘New Order’ period

The ‘New Order’ (Orde Baru) of Soeharto rejected political mobilization and socialist ideology, and established a tightly controlled regime that discouraged intellectual enquiry, but did put Indonesia’s economy back on the rails. New flows of foreign investment and foreign aid programs were attracted, the unbridled population growth was reduced due to family planning programs, and a transformation took place from a predominantly agricultural economy to an industrializing economy. Thee Kian Wie distinguishes three phases within this period, each of which deserve further study:

(a) 1966-1973: stabilization, rehabilitation, partial liberalization and economic recovery;

(b) 1974-1982: oil booms, rapid economic growth, and increasing government intervention;

(c) 1983-1996: post-oil boom, deregulation, renewed liberalization (in reaction to falling oil-prices), and rapid export-led growth. During this last phase, commentators (including academic economists) were increasingly concerned about the thriving corruption at all levels of the government bureaucracy: KKN (korupsi, kolusi, nepotisme) practices, as they later became known (Thee 2002: 203-215).

Financial, economic and political crisis: KRISMON, KRISTAL

The financial crisis of 1997 started with a crisis of confidence following the depreciation of the Thai baht in July 1997. Core factors causing the ensuing economic crisis in Indonesia were the quasi-fixed exchange rate of the rupiah, quickly rising short-term foreign debt and the weak financial system. Its severity had to be attributed to political factors as well: the monetary crisis (KRISMON) led to a total crisis (KRISTAL) because of the failing policy response of the Soeharto regime. Soeharto had been in power for 32 years and his government had become heavily centralized and corrupt and was not able to cope with the crisis in a credible manner. The origins, economic consequences, and socio-economic impact of the crisis are still under discussion. (Thee 2003: 231-237; Arndt and Hill 1999).

(Note: I want to thank Dr. F. Colombijn and Dr. J.Th Lindblad at Leiden University for their useful comments on the draft version of this article.)

Selected Bibliography

In addition to the works cited in the text above, a small selection of recent books is mentioned here, which will allow the reader to quickly grasp the most recent insights and find useful further references.

General textbooks or periodicals on Indonesia’s (economic) history:

Booth, Anne. The Indonesian Economy in the Nineteenth and Twentieth Centuries: A History of Missed Opportunities. London: Macmillan, 1998.

Bulletin of Indonesian Economic Studies.

Dick, H.W., V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie. The Emergence of a National Economy in Indonesia, 1800-2000. Sydney: Allen & Unwin, 2002.

Itinerario “Economic Growth and Institutional Change in Indonesia in the 19th and 20th centuries” [special issue] 26 no. 3-4 (2002).

Reid, Anthony. Southeast Asia in the Age of Commerce, 1450-1680, Vol. I: The Lands below the Winds. New Haven: Yale University Press, 1988.

Reid, Anthony. Southeast Asia in the Age of Commerce, 1450-1680, Vol. II: Expansion and Crisis. New Haven: Yale University Press, 1993.

Ricklefs, M.C. A History of Modern Indonesia since ca. 1300. Basingstoke/Londen: Macmillan, 1993.

On the VOC:

Gaastra, F.S. De Geschiedenis van de VOC. Zutphen: Walburg Pers, 1991 (1st edition), 2002 (4th edition).

Jacobs, Els M. Koopman in Azië: de Handel van de Verenigde Oost-Indische Compagnie tijdens de 18de Eeuw. Zutphen: Walburg Pers, 2000.

Nagtegaal, Lucas. Riding the Dutch Tiger: The Dutch East Indies Company and the Northeast Coast of Java 1680-1743. Leiden: KITLV Press, 1996.

On the Cultivation System:

Elson, R.E. Village Java under the Cultivation System, 1830-1870. Sydney: Allen and Unwin, 1994.

Fasseur, C. Kultuurstelsel en Koloniale Baten. De Nederlandse Exploitatie van Java, 1840-1860. Leiden, Universitaire Pers, 1975. (Translated as: The Politics of Colonial Exploitation: Java, the Dutch and the Cultivation System. Ithaca, NY: Southeast Asia Program, Cornell University Press 1992.)

Geertz, Clifford. Agricultural Involution: The Processes of Ecological Change in Indonesia. Berkeley: University of California Press, 1963.

Houben, V.J.H. “Java in the Nineteenth Century: Consolidation of a Territorial State.” In The Emergence of a National Economy in Indonesia, 1800-2000, edited by H.W. Dick, V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie, 56-81. Sydney: Allen & Unwin, 2002.

On the Late-Colonial Period:

Dick, H.W. “Formation of the Nation-state, 1930s-1966.” In The Emergence of a National Economy in Indonesia, 1800-2000, edited by H.W. Dick, V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie, 153-193. Sydney: Allen & Unwin, 2002.

Lembaran Sejarah, “Crisis and Continuity: Indonesian Economy in the Twentieth Century” [special issue] 3 no. 1 (2000).

Lindblad, J.Th., editor. New Challenges in the Modern Economic History of Indonesia. Leiden: PRIS, 1993. Translated as: Sejarah Ekonomi Modern Indonesia. Berbagai Tantangan Baru. Jakarta: LP3ES, 2002.

Lindblad, J.Th., editor. The Historical Foundations of a National Economy in Indonesia, 1890s-1990s. Amsterdam: North-Holland, 1996.

Lindblad, J.Th. “The Outer Islands in the Nineteenthh Century: Contest for the Periphery.” In The Emergence of a National Economy in Indonesia, 1800-2000, edited by H.W. Dick, V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie, 82-110. Sydney: Allen & Unwin, 2002a.

Lindblad, J.Th. “The Late Colonial State and Economic Expansion, 1900-1930s.” In The Emergence of a National Economy in Indonesia, 1800-2000, edited by H.W. Dick, V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie, 111-152. Sydney: Allen & Unwin, 2002b.

Touwen, L.J. Extremes in the Archipelago: Trade and Economic Development in the Outer Islands of Indonesia, 1900‑1942. Leiden: KITLV Press, 2001.

Van der Eng, Pierre. “Exploring Exploitation: The Netherlands and Colonial Indonesia, 1870-1940.” Revista de Historia Económica 16 (1998): 291-321.

Zanden, J.L. van, and A. van Riel. Nederland, 1780-1914: Staat, instituties en economische ontwikkeling. Amsterdam: Balans, 2000. (On the Netherlands in the nineteenth century.)

Independent Indonesia:

Arndt, H.W. and Hal Hill, editors. Southeast Asia’s Economic Crisis: Origins, Lessons and the Way forward. Singapore: Institute of Southeast Asian Studies, 1999.

Cribb, R. and C. Brown. Modern Indonesia: A History since 1945. Londen/New York: Longman, 1995.

Feith, H. The Decline of Constitutional Democracy in Indonesia. Ithaca, New York: Cornell University Press, 1962.

Hill, Hal. The Indonesian Economy. Cambridge: Cambridge University Press, 2000. (This is the extended second edition of Hill, H., The Indonesian Economy since 1966. Southeast Asia’s Emerging Giant. Cambridge: Cambridge University Press, 1996.)

Hill, Hal, editor. Unity and Diversity: Regional Economic Development in Indonesia since 1970. Singapore: Oxford University Press, 1989.

Mackie, J.A.C. “The Indonesian Economy, 1950-1960.” In The Economy of Indonesia: Selected Readings, edited by B. Glassburner, 16-69. Ithaca NY: Cornell University Press 1967.

Robison, Richard. Indonesia: The Rise of Capital. Sydney: Allen and Unwin, 1986.

Thee Kian Wie. “The Soeharto Era and After: Stability, Development and Crisis, 1966-2000.” In The Emergence of a National Economy in Indonesia, 1800-2000, edited by H.W. Dick, V.J.H. Houben, J.Th. Lindblad and Thee Kian Wie, 194-243. Sydney: Allen & Unwin, 2002.

World Bank. The East Asian Miracle: Economic Growth and Public Policy. Oxford: World Bank /Oxford University Press, 1993.

On economic growth:

Booth, Anne. The Indonesian Economy in the Nineteenth and Twentieth Centuries. A History of Missed Opportunities. London: Macmillan, 1998.

Van der Eng, Pierre. “The Real Domestic Product of Indonesia, 1880-1989.” Explorations in Economic History 39 (1992): 343-373.

Van der Eng, Pierre. “Indonesia’s Growth Performance in the Twentieth Century.” In The Asian Economies in the Twentieth Century, edited by Angus Maddison, D.S. Prasada Rao and W. Shepherd, 143-179. Cheltenham: Edward Elgar, 2002.

Van der Eng, Pierre. “Indonesia’s Economy and Standard of Living in the Twentieth Century.” In Indonesia Today: Challenges of History, edited by G. Lloyd and S. Smith, 181-199. Singapore: Institute of Southeast Asian Studies, 2001.

Citation: Touwen, Jeroen. “The Economic History of Indonesia”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/the-economic-history-of-indonesia/

Medieval Guilds

Gary Richardson, University of California, Irvine

Guilds existed throughout Europe during the Middle Ages. Guilds were groups of individuals with common goals. The term guild probably derives from the Anglo-Saxon root geld which meant ‘to pay, contribute.’ The noun form of geld meant an association of persons contributing money for some common purpose. The root also meant ‘to sacrifice, worship.’ The dual definitions probably reflected guilds’ origins as both secular and religious organizations.

The term guild had many synonyms in the Middle Ages. These included association, brotherhood, college, company, confraternity, corporation, craft, fellowship, fraternity, livery, society, and equivalents of these terms in Latin, Germanic, Scandinavian, and Romance languages such as ambach, arte, collegium, corporatio, fraternitas, gilda, innung, corps de métier, societas, and zunft. In the late nineteenth century, as a professional lexicon evolved among historians, the term guild became the universal reference for these groups of merchants, artisans, and other individuals from the ordinary (non-priestly and non-aristocratic) classes of society which were not part of the established religious, military, or governmental hierarchies.

Much of the academic debate about guilds stems from confusion caused by incomplete lexicographical standardization. Scholars study guilds in one time and place and then assume that their findings apply to guilds everywhere and at all times or assert that the organizations that they studied were the one type of true guild, while other organizations deserved neither the distinction nor serious study. To avoid this mistake, this encyclopedia entry begins with the recognition that guilds were groups whose activities, characteristics, and composition varied greatly across centuries, regions, and industries.

Guild Activities and Taxonomy

Guilds filled many niches in medieval economy and society. Typical taxonomies divide urban occupational guilds into two types: merchant and craft.

Merchant guilds were organizations of merchants who were involved in long-distance commerce and local wholesale trade, and may also have been retail sellers of commodities in their home cities and distant venues where they possessed rights to set up shop. The largest and most influential merchant guilds participated in international commerce and politics and established colonies in foreign cities. In many cases, they evolved into or became inextricably intertwined with the governments of their home towns.

Merchant guilds enforced contracts among members and between members and outsiders. Guilds policed members’ behavior because medieval commerce operated according to the community responsibility system. If a merchant from a particular town failed to fulfill his part of a bargain or pay his debts, all members of his guild could be held liable. When they were in a foreign port, their goods could be seized and sold to alleviate the bad debt. They would then return to their hometown, where they would seek compensation from the original defaulter.

Merchant guilds also protected members against predation by rulers. Rulers seeking revenue had an incentive to seize money and merchandise from foreign merchants. Guilds threatened to boycott the realms of rulers who did this, a practice known as withernam in medieval England. Since boycotts impoverished both kingdoms which depended on commerce and governments for whom tariffs were the principal source of revenue, the threat of retaliation deterred medieval potentates from excessive expropriations.

Merchant guilds tended to be wealthier and of higher social status than craft guilds. Merchants’ organizations usually possessed privileged positions in religious and secular ceremonies and inordinately influenced local governments.

Craft guilds were organized along lines of particular trades. Members of these guilds typically owned and operated small businesses or family workshops. Craft guilds operated in many sectors of the economy. Guilds of victuallers bought agricultural commodities, converted them to consumables, and sold finished foodstuffs. Examples included bakers, brewers, and butchers. Guilds of manufacturers made durable goods, and when profitable, exported them from their towns to consumers in distant markets. Examples include makers of textiles, military equipment, and metal ware. Guilds of a third type sold skills and services. Examples include clerks, teamsters, and entertainers.

These occupational organizations engaged in a wide array of economic activities. Some manipulated input and output markets to their own advantage. Others established reputations for quality, fostering the expansion of anonymous exchange and making everyone better off. Because of the underlying economic realities, victualling guilds tended towards the former. Manufacturing guilds tended towards the latter. Guilds of service providers fell somewhere in between. All three types of guilds managed labor markets, lowered wages, and advanced their own interests at their subordinates’ expense. These undertakings had a common theme. Merchant and craft guilds acted to increase and stabilize members’ incomes.

Non-occupational guilds also operated in medieval towns and cities. These organizations had both secular and religious functions. Historians refer to these organizations as social, religious, or parish guilds as well as fraternities and confraternities. The secular activities of these organizations included providing members with mutual insurance, extending credit to members in times of need, aiding members in courts of law, and helping the children of members afford apprenticeships and dowries.

The principal pious objective was the salvation of the soul and escape from Purgatory. The doctrine of Purgatory was the belief that there lay between Heaven and Hell an intermediate place, by passing though which the souls of the dead might cleanse themselves of guilt attached to the sins committed during their lifetime by submitting to a graduated scale of divine punishment. The suffering through which they were cleansed might be abbreviated by the prayers of the living, and most especially by masses. Praying devoutly, sponsoring masses, and giving alms were three of the most effective methods of redeeming one’s soul. These works of atonement could be performed by the penitent on their own or by someone else on their behalf.

Guilds served as mechanisms for organizing, managing, and financing the collective quest for eternal salvation. Efforts centered on three types of tasks. The first were routine and participatory religious services. Members of guilds gathered at church on Sundays and often also on other days of the week. Members marked ceremonial occasions, such as the day of their patron saint or Good Friday, with prayers, processions, banquets, masses, the singing of psalms, the illumination of holy symbols, and the distribution of alms to the poor. Some guilds kept chaplains on call. Others hired priests when the need arose. These clerics hosted regular religious services, such as vespers each evening or mass on Sunday morning, and prayed for the souls of members living and deceased.

The second category consisted of actions performed on members’ behalf after their deaths and for the benefit of their souls. Postmortem services began with funerals and burials, which guilds arranged for the recently departed. The services were elaborate and extensive. On the day before internment, members gathered around the corpse, lit candles, and sung a placebo and a dirge, which were the vespers and matins from the Office of the Dead. On the day of internment, a procession marched from churchyard to graveyard, buried the body, distributed alms, and attended mass. Additional masses numbering one to forty occurred later that day and sometimes for months thereafter. Postmortem prayers continued even further into the future and in theory into perpetuity. All guilds prayed for the souls of deceased members. These prayers were a prominent part of all guild events. Many guilds also hired priests to pray for the souls of the deceased. A few guilds built chantries where priests said those prayers.

The third category involved indoctrination and monitoring to maintain the piety of members. The Christian catechism of the era contained clear commandments. Rest on the Sabbath and religious holidays. Be truthful. Do not deceive others. Be chaste. Do not commit adultery. Be faithful to your family. Obey authorities. Be modest. Do not covet thy neighbors’ possessions. Do not steal. Do not gamble. Work hard. Support the church. Guild ordinances echoed these exhortations. Members should neither gamble nor lie nor steal nor drink to excess. They should restrain their gluttony, lust, avarice, and corporal impulses. They should pray to the Lord, live like His son, and give alms to the poor.

Righteous living was important because members’ fates were linked together. The more pious one’s brethren, the more helpful their prayers, and the quicker one escaped from purgatory. The worse one’s brethren, the less salutary their supplications and the longer one suffered during the afterlife. So, in hopes of minimizing purgatorial pain and maximizing eternal happiness, guilds beseeched members to restrain physical desires and forgo worldly pleasures.

Guilds also operated in villages and the countryside. Rural guilds performed the same tasks as social and religious guilds in towns and cities. Recent research on medieval England indicates that guilds operated in most, if not all, villages. Villages often possessed multiple guilds. Most rural residents belonged to a guild. Some may have joined more than one organization.

Guilds often spanned multiple dimensions of this taxonomy. Members of craft guilds participated in wholesale commerce. Members of merchant guilds opened retail shops. Social and religious guilds evolved into occupational associations. All merchant and craft guilds possessed religious and fraternal features.

In sum, guild members sought prosperity in this life and providence in the next. Members wanted high and stable incomes, quick passage through Purgatory, and eternity in Heaven. Guilds helped them coordinate their collective efforts to attain these goals.

Guild Structure and Organization

To attain their collective goals, guild members had to cooperate. If some members slacked off, all would suffer. Guilds that wished to lower the costs of labor had to get all masters to reduce wages. Guilds that wished to raise the prices of products had to get all members to restrict output. Guilds that wished to develop respected reputations had to get all members to sell superior merchandise. Guild members contributed money – to pay priests and purchase pious paraphernalia – and contributed time, emotion, and personal energy, as well. Members participated in frequent religious services, attended funerals, and prayed for the souls of the brethren. Members had to live piously, abstaining both from the pleasures of the flesh and the material temptations of secular life. Members also had to administer their associations. The need for coordination was a common denominator.

To convince members to cooperate and advance their common interests, guilds formed stable, self-enforcing associations that possessed structures for making and implementing collective decisions.

A guild’s members met at least once a year (and in most cases more often) to elect officers, audit accounts, induct new members, debate policies, and amend ordinances. Officers such as aldermen, stewards, deans, and clerks managed the guild’s day to day affairs. Aldermen directed guild activities and supervised lower-ranking officers. Stewards kept guild funds, and their accounts were periodically audited. Deans summoned members to meetings, feasts, and funerals, and in many cases, policed members’ behavior. Clerks kept records. Decisions were usually made by majority vote among the master craftsmen.

These officers administered a nexus of agreements among a guild’s members. Details of these agreements varied greatly from guild to guild, but the issues addressed were similar in all cases. Members agreed to contribute certain resources and/or take certain actions that furthered the guild’s occupational and spiritual endeavors. Officers of the guild monitored members’ contributions. Manufacturing guilds, for example, employed officers known as searchers who scrutinized members’ merchandise to make sure it met guild standards and inspected members’ shops and homes seeking evidence of attempts to circumvent the rules. Members who failed to fulfill their obligations faced punishments of various sorts.

Punishments varied across transgressions, guilds, time, and space, but a pattern existed. First time offenders were punished lightly, perhaps suffering public scolding and paying small monetary fines, and repeat offenders punished harshly. The ultimate threat was expulsion. Guilds could do nothing harsher because laws protected persons and property from arbitrary expropriations and physical abuse. The legal system set the rights of individuals above the interests of organizations. Guilds were voluntary associations. Members facing harsh punishments could quit the guild and walk away. The most the guild could extract was the value of membership. Abundant evidence indicates that guilds enforced agreements in this manner.

Other game-theoretic options existed, of course. Guilds could have punished uncooperative members by taking actions with wider consequences. Members of a manufacturing guild who caught one of their own passing off shoddy merchandise under the guilds’ good name could have punished the offender by collectively lowering the quality of their products for a prolonged period. That would lower the offender’s income, albeit at the cost of lowering the income of all other members as well. Similarly, members of a guild that caught one of their brethren shirking on prayers and sinning incessantly could have punished the offender by collectively forsaking the Lord and descending into debauchery. Then, no one would or could pray for the soul of the offender, and his period in Purgatory would be extended significantly. In broader terms, cheaters could have been punished by any action that reduced the average incomes of all guild members or increased the pain that all members expected to endure in Purgatory. In theory, such threats could have convinced even the most recalcitrant members to contribute to the common good.

But, no evidence exists that craft guilds ever operated in such a manner. None of the hundreds of surviving guild ordinances contains threats of such a kind. No surviving guild documents describe punishing the innocent along with the guilty. Guilds appear to have eschewed indiscriminant retaliation for several salient reasons. First, monitoring members’ behavior was costly and imperfect. Time and risk preferences varied across individuals. Uncertainty of many kinds influenced craftsmen’s decisions. Some members would have attempted to cheat regardless of the threatened punishment. Punishments, in other words, would have occurred in equilibrium. The cost of carrying out an equilibrium-sustaining threat of expulsion would have been lower than the cost of carrying out an equilibrium-sustaining threat that reduced average income. Thus, expelling members caught violating the rules was an efficient method of enforcing the rules. Second, punishing free riders by indiscriminately harming all guild members may not have been a convincing threat. Individuals may not have believed that threats of mutual assured destruction would be carried out. The incentive to renegotiate was strong. Third, skepticism probably existed about threats to do onto others as they had done onto you. That concept contradicted a fundamental teaching of the church, to do onto others as you would have them do onto you. It also contradicted Jesus’ admonition to turn the other cheek. Thus, indiscriminant retaliation based upon hair-trigger strategies was not an organizing principle likely to be adopted by guilds whose members hoped to speed passage through Purgatory.

A hierarchy existed in large guilds. Masters were full members who usually owned their own workshops, retail outlets, or trading vessels. Masters employed journeymen, who were laborers who worked for wages on short term contracts or a daily basis (hence the term journeyman, from the French word for day). Journeymen hoped to one day advance to the level of master. To do this, journeymen usually had to save enough money to open a workshop and pay for admittance, or if they were lucky, receive a workshop through marriage or inheritance.

Masters also supervised apprentices, who were usually boys in their teens who worked for room, board, and perhaps a small stipend in exchange for a vocational education. Both guilds and government regulated apprenticeships, usually to ensure that masters fulfilled their part of the apprenticeship agreement. Terms of apprenticeships varied, usually lasting from five to nine years.

The internal structure of guilds varied widely across Europe. Little is known for certain about the structure of smaller guilds, since they left few written documents. Most of the evidence comes from large, successful associations whose internal records survive to the present day. The description above is based on such documents. It seems likely that smaller organizations fulfilled many of the same functions, but their structure was probably less formal and more horizontal.

Relationships between guilds and governments also varied across Europe. Most guilds aspired to attain recognition as a self-governing association with the right to possess property and other legal privileges. Guilds often purchased these rights from municipal and national authorities. In England, for example, a guild which wished to possess property had to purchase from the royal government a writ allowing it to do so. But, most guilds operated without formal sanction from the government. Guilds were spontaneous, voluntary, and self-enforcing associations.

Guild Chronology and Impact

Reconstructing the history of guilds poses several problems. Few written records survive from the twelfth century and earlier. Surviving documents consist principally of the records of rulers – kings, princes, churches – that taxed, chartered, and granted privileges to organizations. Some evidence also exists in the records of notaries and courts, which recorded and enforced contracts between guild masters and outsiders, such as the parents of apprentices. From the fourteenth and fifteenth centuries, records survive in larger numbers. Surviving records include statute books and other documents describing the internal organization and operation of guilds. The evidence at hand links the rise and decline of guilds to several important events in the history of Western Europe.

In the late Roman Empire, organizations resembling guilds existed in most towns and cities. These voluntary associations of artisans, known as collegia, were occasionally regulated by the state but largely left alone. They were organized along trade lines and possessed a strong social base, since their members shared religious observances and fraternal dinners. Most of these organizations disappeared during the Dark Ages, when the Western Roman Empire disintegrated and urban life collapsed. In the Eastern Empire, some collegia appear to have survived from antiquity into the Middle Ages, particularly in Constantinople, where Leo the Wise codified laws concerning commerce and crafts at the beginning of the tenth century and sources reveal an unbroken tradition of state management of guilds from ancient times. Some scholars suspect that in the West, a few of the most resilient collegia in the surviving urban areas may have evolved in an unbroken descent into medieval guilds, but the absence of documentary evidence makes it appear unlikely and unprovable.

In the centuries following the Germanic invasions, evidence indicates that numerous guild-like associations existed in towns and rural areas. These organizations functioned as modern burial and benefit societies, whose objectives included prayers for the souls of deceased members, payments of weregilds in cases of justifiable homicide, and supporting members involved in legal disputes. These rural guilds were descendents of Germanic social organizations known as gilda which the Roman historian Tacitus referred to as convivium.

During the eleventh through thirteenth centuries, considerable economic development occurred. The sources of development were increases in the productivity of medieval agriculture, the abatement of external raiding by Scandinavian and Muslim brigands, and population increases. The revival of long-distance trade coincided with the expansion of urban areas. Merchant guilds formed an institutional foundation for this commercial revolution. Merchant guilds flourished in towns throughout Europe, and in many places, rose to prominence in urban political structures. In many towns in England, for example, the merchant guild became synonymous with the body of burgesses and evolved into the municipal government. In Genoa and Venice, the merchant aristocracy controlled the city government, which promoted their interests so well as to preclude the need for a formal guild.

Merchant guilds’ principal accomplishment was establishing the institutional foundations for long-distance commerce. Italian sources provide the best picture of guilds’ rise to prominence as an economic and social institution. Merchant guilds appear in many Italian cities in the twelfth century. Craft guilds became ubiquitous during the succeeding century.

In northern Europe, merchant guilds rose to prominence a few generations later. In the twelfth and early thirteenth centuries, local merchant guilds in trading cities such as Lubeck and Bremen formed alliances with merchants throughout the Baltic region. The alliance system grew into the Hanseatic League which dominated trade around the Baltic and North Seas and in Northern Germany.

Social and religious guilds existed at this time, but few records survive. Small numbers of craft guilds developed, principally in prosperous industries such as cloth manufacturing, but records are also rare, and numbers appear to have been small.

As economic expansion continued in the thirteenth and fourteenth centuries, the influence of the Catholic Church grew, and the doctrine of Purgatory developed. The doctrine inspired the creation of countless religious guilds, since the doctrine provided members with strong incentives to want to belong to a group whose prayers would help one enter heaven and it provided guilds with mechanisms to induce members to exert effort on behalf of the organization. Many of these religious associations evolved into occupational guilds. Most of the Livery Companies of London, for example, began as intercessory societies around this time.

The number of guilds continued to grow after the Black Death. There are several potential explanations. The decline in population raised per-capita incomes, which encouraged the expansion of consumption and commerce, which in turn necessitated the formation of institutions to satisfy this demand. Repeated epidemics decreased family sizes, particularly in cities, where the typical adult had on average perhaps 1.5 surviving children, few surviving siblings, and only a small extended family, if any. Guilds replaced extended families in a form of fictive kinship. The decline in family size and impoverishment of the church also forced individuals to rely on their guild more in times of trouble, since they no longer could rely on relatives and priests to sustain them through periods of crisis. All of these changes bound individuals more closely to guilds, discouraged free riding, and encouraged the expansion of collective institutions.

For nearly two centuries after the Black Death, guilds dominated life in medieval towns. Any town resident of consequence belonged to a guild. Most urban residents thought guild membership to be indispensable. Guilds dominated manufacturing, marketing, and commerce. Guilds dominated local politics and influenced national and international affairs. Guilds were the center of social and spiritual life.

The heyday of guilds lasted into the sixteenth century. The Reformation weakened guilds in most newly Protestant nations. In England, for example, the royal government suppressed thousands of guilds in the 1530s and 1540s. The king and his ministers dispatched auditors to every guild in the realm. The auditors seized spiritual paraphernalia and funds retained for religious purposes, disbanded guilds which existed for purely pious purposes, and forced craft and merchant guilds to pay large sums for the right to remain in operation. Those guilds that did still lost the ability to provide members with spiritual services.

In Protestant nations after the Reformation, the influence of guilds waned. Many turned to governments for assistance. They requested monopolies on manufacturing and commerce and asked courts to force members to live up to their obligations. Guilds lingered where governments provided such assistance. Guilds faded where governments did not. By the seventeenth century, the power of guilds had withered in England. Guilds retained strength in nations which remained Catholic. France abolished its guilds during the French Revolution in 1791, and Napoleon’s armies disbanded guilds in most of the continental nations which they occupied during the next two decades.

References

Basing, Patricia. Trades and Crafts in Medieval Manuscripts. London: British Library, 1990.

Cooper, R.C.H. The Archives of the City of London Livery Companies and Related Organizations. London: Guildhall Library, 1985.

Davidson, Clifford. Technology, Guilds, and Early English Drama. Early Drama, Art, and Music Monograph Series, 23. Kalamazoo, MI: Medieval Institute Publications, Western Michigan University, 1996

Epstein, S. R. “Craft Guilds, Apprenticeships, and Technological Change in Pre-Industrial Europe.” Journal of Economic History 58 (1998): 684-713.

Epstein, Steven. Wage and Labor Guilds in Medieval Europe. Chapel Hill, NC: University of North Carolina Press, 1991.

Gross, Charles. The Gild Merchant; A Contribution to British Municipal History. Oxford: Clarendon Press, 1890.

Gustafsson, Bo. “The Rise and Economic Behavior of Medieval Craft Guilds: An Economic-Theoretical Interpretation.” Scandinavian Journal of Economics 35, no. 1 (1987): 1-40.

Hanawalt, Barbara. “Keepers of the Lights: Late Medieval English Parish Gilds.” Journal of Medieval and Renaissance Studies 14 (1984).

Hatcher, John and Edward Miller. Medieval England: Towns, Commerce and Crafts, 1086 – 1348. London: Longman, 1995.

Hickson, Charles R. and Earl A. Thompson. “A New Theory of Guilds and European Economic Development.” Explorations in Economic History. 28 (1991): 127-68.

Lopez, Robert. The Commercial Revolution of the Middle Ages, 950-1350. Englewood Cliffs, NJ: Prentice-Hall, 1971.

Mokyr, Joel. The Lever of Riches: Technological Creativity and Economic Progress. Oxford: Oxford University Press, 1990

Pirenne, Henri. Medieval Cities: Their Origins and the Revival of Trade. Frank Halsey (translator). Princeton: Princeton University Press, 1952.

Richardson, Gary. “A Tale of Two Theories: Monopolies and Craft Guilds in Medieval England and Modern Imagination.” Journal of the History of Economic Thought (2001).

Richardson, Gary. “Brand Names Before the Industrial Revolution.” UC Irvine Working Paper, 2000.

Richardson, Gary. “Guilds, Laws, and Markets for Manufactured Merchandise in Late-Medieval England,” Explorations in Economic History 41 (2004): 1–25.

Richardson, Gary. “Christianity and Craft Guilds in Late Medieval England: A Rational Choice Analysis” Rationality and Society 17 (2005): 139-89

Richardson, Gary. “The Prudent Village: Risk Pooling Institutions in Medieval English Agriculture,” Journal of Economic History 65, no. 2 (2005): 386–413.

Smith, Toulmin. English Gilds. London: N. Trübner & Co., 1870.

Swanson, Heather. 1983. Building Craftsmen in Late Medieval York. York: University of York, 1983.

Thrupp, Sylvia. The Merchant Class of Medieval London 1300-1500. Chicago: University of Chicago Press, 1989.

Unwin, George. The Guilds and Companies of London. London: Methuen & Company, 1904.

Ward, Joseph. Metropolitan Communities: Trade Guilds, Identity, and Change in Early Modern London. Palo Alto: Stanford University Press, 1997.

Westlake, H. F. The Parish Gilds of Mediaeval England. London: Society for Promotion of Christian Knowledge, 1919.

Citation: Richardson, Gary. “Medieval Guilds”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/medieval-guilds/

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 Economic History of the Fur Trade: 1670 to 1870

Ann M. Carlos, University of Colorado
Frank D. Lewis, Queen’s University

Introduction

A commercial fur trade in North America grew out of the early contact between Indians and European fisherman who were netting cod on the Grand Banks off Newfoundland and on the Bay of Gaspé near Quebec. Indians would trade the pelts of small animals, such as mink, for knives and other iron-based products, or for textiles. Exchange at first was haphazard and it was only in the late sixteenth century, when the wearing of beaver hats became fashionable, that firms were established who dealt exclusively in furs. High quality pelts are available only where winters are severe, so the trade took place predominantly in the regions we now know as Canada, although some activity took place further south along the Mississippi River and in the Rocky Mountains. There was also a market in deer skins that predominated in the Appalachians.

The first firms to participate in the fur trade were French, and under French rule the trade spread along the St. Lawrence and Ottawa Rivers, and down the Mississippi. In the seventeenth century, following the Dutch, the English developed a trade through Albany. Then in 1670, a charter was granted by the British crown to the Hudson’s Bay Company, which began operating from posts along the coast of Hudson Bay (see Figure 1). For roughly the next hundred years, this northern region saw competition of varying intensity between the French and the English. With the conquest of New France in 1763, the French trade shifted to Scottish merchants operating out of Montreal. After the negotiation of Jay’s Treaty (1794), the northern border was defined and trade along the Mississippi passed to the American Fur Company under John Jacob Astor. In 1821, the northern participants merged under the name of the Hudson’s Bay Company, and for many decades this merged company continued to trade in furs. Finally, in the 1990s, under pressure from animal rights groups, the Hudson’s Bay Company, which in the twentieth century had become a large Canadian retailer, ended the fur component of its operation.

Figure 1
Hudson’s Bay Company Hinterlands
 Hudson's Bay Company Hinterlands (map)

Source: Ray (1987, plate 60)

The fur trade was based on pelts destined either for the luxury clothing market or for the felting industries, of which hatting was the most important. This was a transatlantic trade. The animals were trapped and exchanged for goods in North America, and the pelts were transported to Europe for processing and final sale. As a result, forces operating on the demand side of the market in Europe and on the supply side in North America determined prices and volumes; while intermediaries, who linked the two geographically separated areas, determined how the trade was conducted.

The Demand for Fur: Hats, Pelts and Prices

However much hats may be considered an accessory today, they were for centuries a mandatory part of everyday dress, for both men and women. Of course styles changed, and, in response to the vagaries of fashion and politics, hats took on various forms and shapes, from the high-crowned, broad-brimmed hat of the first two Stuarts to the conically-shaped, plainer hat of the Puritans. The Restoration of Charles II of England in 1660 and the Glorious Revolution in 1689 brought their own changes in style (Clarke, 1982, chapter 1). What remained a constant was the material from which hats were made – wool felt. The wool came from various animals, but towards the end of the fifteenth century beaver wool began to be predominate. Over time, beaver hats became increasingly popular eventually dominating the market. Only in the nineteenth century did silk replace beaver in high-fashion men’s hats.

Wool Felt

Furs have long been classified as either fancy or staple. Fancy furs are those demanded for the beauty and luster of their pelt. These furs – mink, fox, otter – are fashioned by furriers into garments or robes. Staple furs are sought for their wool. All staple furs have a double coating of hair with long, stiff, smooth hairs called guard hairs which protect the shorter, softer hair, called wool, that grows next to the animal skin. Only the wool can be felted. Each of the shorter hairs is barbed and once the barbs at the ends of the hair are open, the wool can be compressed into a solid piece of material called felt. The prime staple fur has been beaver, although muskrat and rabbit have also been used.

Wool felt was used for over two centuries to make high-fashion hats. Felt is stronger than a woven material. It will not tear or unravel in a straight line; it is more resistant to water, and it will hold its shape even if it gets wet. These characteristics made felt the prime material for hatters especially when fashion called for hats with large brims. The highest quality hats would be made fully from beaver wool, whereas lower quality hats included inferior wool, such as rabbit.

Felt Making

The transformation of beaver skins into felt and then hats was a highly skilled activity. The process required first that the beaver wool be separated from the guard hairs and the skin, and that some of the wool have open barbs, since felt required some open-barbed wool in the mixture. Felt dates back to the nomads of Central Asia, who are said to have invented the process of felting and made their tents from this light but durable material. Although the art of felting disappeared from much of western Europe during the first millennium, felt-making survived in Russia, Sweden, and Asia Minor. As a result of the Medieval Crusades, felting was reintroduced through the Mediterranean into France (Crean, 1962).

In Russia, the felting industry was based on the European beaver (castor fiber). Given their long tradition of working with beaver pelts, the Russians had perfected the art of combing out the short barbed hairs from among the longer guard hairs, a technology that they safeguarded. As a consequence, the early felting trades in England and France had to rely on beaver wool imported from Russia, although they also used domestic supplies of wool from other animals, such rabbit, sheep and goat. But by the end of the seventeenth century, Russian supplies were drying up, reflecting the serious depletion of the European beaver population.

Coincident with the decline in European beaver stocks was the emergence of a North American trade. North American beaver (castor canadensis) was imported through agents in the English, French and Dutch colonies. Although many of the pelts were shipped to Russia for initial processing, the growth of the beaver market in England and France led to the development of local technologies, and more knowledge of the art of combing. Separating the beaver wool from the felt was only the first step in the felting process. It was also necessary that some of the barbs on the short hairs be raised or open. On the animal these hairs were naturally covered with keratin to prevent the barbs from opening, thus to make felt, the keratin had to be stripped from at least some of the hairs. The process was difficult to refine and entailed considerable experimentation by felt-makers. For instance, one felt maker “bundled [the skins] in a sack of linen and boiled [them] for twelve hours in water containing several fatty substances and nitric acid” (Crean, 1962, p. 381). Although such processes removed the keratin, they did so at the price of a lower quality wool.

The opening of the North American trade not only increased the supply of skins for the felting industry, it also provided a subset of skins whose guard hairs had already been removed and the keratin broken down. Beaver pelts imported from North America were classified as either parchment beaver (castor sec – dry beaver), or coat beaver (castor gras – greasy beaver). Parchment beaver were from freshly caught animals, whose skins were simply dried before being presented for trade. Coat beaver were skins that had been worn by the Indians for a year or more. With wear, the guard hairs fell out and the pelt became oily and more pliable. In addition, the keratin covering the shorter hairs broke down. By the middle of the seventeenth century, hatters and felt-makers came to learn that parchment and coat beaver could be combined to produce a strong, smooth, pliable, top-quality waterproof material.

Until the 1720s, beaver felt was produced with relatively fixed proportions of coat and parchment skins, which led to periodic shortages of one or the other type of pelt. The constraint was relaxed when carotting was developed, a chemical process by which parchment skins were transformed into a type of coat beaver. The original carrotting formula consisted of salts of mercury diluted in nitric acid, which was brushed on the pelts. The use of mercury was a big advance, but it also had serious health consequences for hatters and felters, who were forced to breathe the mercury vapor for extended periods. The expression “mad as a hatter” dates from this period, as the vapor attacked the nervous systems of these workers.

The Prices of Parchment and Coat Beaver

Drawn from the accounts of the Hudson’s Bay Company, Table 1 presents some eighteenth century prices of parchment and coat beaver pelts. From 1713 to 1726, before the carotting process had become established, coat beaver generally fetched a higher price than parchment beaver, averaging 6.6 shillings per pelt as compared to 5.5 shillings. Once carotting was widely used, however, the prices were reversed, and from 1730 to 1770 parchment exceeded coat in almost every year. The same general pattern is seen in the Paris data, although there the reversal was delayed, suggesting slower diffusion in France of the carotting technology. As Crean (1962, p. 382) notes, Nollet’s L’Art de faire des chapeaux included the exact formula, but it was not published until 1765.

A weighted average of parchment and coat prices in London reveals three episodes. From 1713 to 1722 prices were quite stable, fluctuating within the narrow band of 5.0 and 5.5 shillings per pelt. During the period, 1723 to 1745, prices moved sharply higher and remained in the range of 7 to 9 shillings. The years 1746 to 1763 saw another big increase to over 12 shillings per pelt. There are far fewer prices available for Paris, but we do know that in the period 1739 to 1753 the trend was also sharply higher with prices more than doubling.

Table 1
Price of Beaver Pelts in Britain: 1713-1763
(shillings per skin)

Year Parchment Coat Averagea Year Parchment Coat Averagea
1713 5.21 4.62 5.03 1739 8.51 7.11 8.05
1714 5.24 7.86 5.66 1740 8.44 6.66 7.88
1715 4.88 5.49 1741 8.30 6.83 7.84
1716 4.68 8.81 5.16 1742 7.72 6.41 7.36
1717 5.29 8.37 5.65 1743 8.98 6.74 8.27
1718 4.77 7.81 5.22 1744 9.18 6.61 8.52
1719 5.30 6.86 5.51 1745 9.76 6.08 8.76
1720 5.31 6.05 5.38 1746 12.73 7.18 10.88
1721 5.27 5.79 5.29 1747 10.68 6.99 9.50
1722 4.55 4.97 4.55 1748 9.27 6.22 8.44
1723 8.54 5.56 7.84 1749 11.27 6.49 9.77
1724 7.47 5.97 7.17 1750 17.11 8.42 14.00
1725 5.82 6.62 5.88 1751 14.31 10.42 12.90
1726 5.41 7.49 5.83 1752 12.94 10.18 11.84
1727 7.22 1753 10.71 11.97 10.87
1728 8.13 1754 12.19 12.68 12.08
1729 9.56 1755 12.05 12.04 11.99
1730 8.71 1756 13.46 12.02 12.84
1731 6.27 1757 12.59 11.60 12.17
1732 7.12 1758 13.07 11.32 12.49
1733 8.07 1759 15.99 14.68
1734 7.39 1760 13.37 13.06 13.22
1735 8.33 1761 10.94 13.03 11.36
1736 8.72 7.07 8.38 1762 13.17 16.33 13.83
1737 7.94 6.46 7.50 1763 16.33 17.56 16.34
1738 8.95 6.47 8.32

a A weighted average of the prices of parchment, coat and half parchment beaver pelts. Weights are based on the trade in these types of furs at Fort Albany. Prices of the individual types of pelts are not available for the years, 1727 to 1735.

Source: Carlos and Lewis, 1999.

The Demand for Beaver Hats

The main cause of the rising beaver pelt prices in England and France was the increasing demand for beaver hats, which included hats made exclusively with beaver wool and referred to as “beaver hats,” and those hats containing a combination of beaver and a lower cost wool, such as rabbit. These were called “felt hats.” Unfortunately, aggregate consumption series for the eighteenth century Europe are not available. We do, however, have Gregory King’s contemporary work for England which provides a good starting point. In a table entitled “Annual Consumption of Apparell, anno 1688,” King calculated that consumption of all types of hats was about 3.3 million, or nearly one hat per person. King also included a second category, caps of all sorts, for which he estimated consumption at 1.6 million (Harte, 1991, p. 293). This means that as early as 1700, the potential market for hats in England alone was nearly 5 million per year. Over the next century, the rising demand for beaver pelts was a result of a number factors including population growth, a greater export market, a shift toward beaver hats from hats made of other materials, and a shift from caps to hats.

The British export data indicate that demand for beaver hats was growing not just in England, but in Europe as well. In 1700 a modest 69,500 beaver hats were exported from England and almost the same number of felt hats; but by 1760, slightly over 500,000 beaver hats and 370,000 felt halts were shipped from English ports (Lawson, 1943, app. I). In total, over the seventy years to 1770, 21 million beaver and felt hats were exported from England. In addition to the final product, England exported the raw material, beaver pelts. In 1760, £15,000 in beaver pelts were exported along with a range of other furs. The hats and the pelts tended to go to different parts of Europe. Raw pelts were shipped mainly to northern Europe, including Germany, Flanders, Holland and Russia; whereas hats went to the southern European markets of Spain and Portugal. In 1750, Germany imported 16,500 beaver hats, while Spain imported 110,000 and Portugal 175,000 (Lawson, 1943, appendices F & G). Over the first six decades of the eighteenth century, these markets grew dramatically, such that the value of beaver hat sales to Portugal alone was £89,000 in 1756-1760, representing about 300,000 hats or two-thirds of the entire export trade.

European Intermediaries in the Fur Trade

By the eighteenth century, the demand for furs in Europe was being met mainly by exports from North America with intermediaries playing an essential role. The American trade, which moved along the main water systems, was organized largely through chartered companies. At the far north, operating out of Hudson Bay, was the Hudson’s Bay Company, chartered in 1670. The Compagnie d’Occident, founded in 1718, was the most successful of a series of monopoly French companies. It operated through the St. Lawrence River and in the region of the eastern Great Lakes. There was also an English trade through Albany and New York, and a French trade down the Mississippi.

The Hudson’s Bay Company and the Compagnie d’Occident, although similar in title, had very different internal structures. The English trade was organized along hierarchical lines with salaried managers, whereas the French monopoly issued licenses (congés) or leased out the use of its posts. The structure of the English company allowed for more control from the London head office, but required systems that could monitor the managers of the trading posts (Carlos and Nicholas, 1990). The leasing and licensing arrangements of the French made monitoring unnecessary, but led to a system where the center had little influence over the conduct of the trade.

The French and English were distinguished as well by how they interacted with the Natives. The Hudson’s Bay Company established posts around the Bay and waited for the Indians, often middlemen, to come to them. The French, by contrast, moved into the interior, directly trading with the Indians who harvested the furs. The French arrangement was more conducive to expansion, and by the end of the seventeenth century, they had moved beyond the St. Lawrence and Ottawa rivers into the western Great Lakes region (see Figure 1). Later they established posts in the heart of the Hudson Bay hinterland. In addition, the French explored the river systems to the south, setting up a post at the mouth of the Mississippi. As noted earlier, after Jay’s Treaty was signed, the French were replaced in the Mississippi region by U.S. interests which later formed the American Fur Company (Haeger, 1991).

The English takeover of New France at the end of the French and Indian Wars in 1763 did not, at first, fundamentally change the structure of the trade. Rather, French management was replaced by Scottish and English merchants operating in Montreal. But, within a decade, the Montreal trade was reorganized into partnerships between merchants in Montreal and traders who wintered in the interior. The most important of these arrangements led to the formation of the Northwest Company, which for the first two decades of the nineteenth century, competed with the Hudson’s Bay Company (Carlos and Hoffman, 1986). By the early decades of the nineteenth century, the Hudson’s Bay Company, the Northwest Company, and the American Fur Company had, combined, a system of trading posts across North America, including posts in Oregon and British Columbia and on the Mackenzie River. In 1821, the Northwest Company and the Hudson’s Bay Company merged under the name of the Hudson’s Bay Company. The Hudson’s Bay Company then ran the trade as a monopsony until the late 1840s when it began facing serious competition from trappers to the south. The Company’s role in the northwest changed again with the Canadian Confederation in 1867. Over the next decades treaties were signed with many of the northern tribes forever changing the old fur trade order in Canada.

The Supply of Furs: The Harvesting of Beaver and Depletion

During the eighteenth century, the changing technology of felt production and the growing demand for felt hats were met by attempts to increase the supply of furs, especially the supply of beaver pelts. Any permanent increase, however, was ultimately dependent on the animal resource base. How that base changed over time must be a matter of speculation since no animal counts exist from that period; nevertheless, the evidence we do have points to a scenario in which over-harvesting, at least in some years, gave rise to serious depletion of the beaver and possibly other animals such as marten that were also being traded. Why the beaver were over-harvested was closely related to the prices Natives were receiving, but important as well was the nature of Native property rights to the resource.

Harvests in the Fort Albany and York Factory Regions

That beaver populations along the Eastern seaboard regions of North America were depleted as the fur trade advanced is widely accepted. In fact the search for new sources of supply further west, including the region of Hudson Bay, has been attributed in part to dwindling beaver stocks in areas where the fur trade had been long established. Although there has been little discussion of the impact that the Hudson’s Bay Company and the French, who traded in the region of Hudson Bay, were having on the beaver stock, the remarkably complete records of the Hudson’s Bay Company provide the basis for reasonable inferences about depletion. From 1700 there is an uninterrupted annual series of fur returns at Fort Albany; the fur returns from York Factory begin in 1716 (see Figure 1).

The beaver returns at Fort Albany and York Factory for the period 1700 to 1770 are described in Figure 2. At Fort Albany the number of beaver skins over the period 1700 to 1720 averaged roughly 19,000, with wide year-to-year fluctuations; the range was about 15,000 to 30,000. After 1720 and until the late 1740s average returns declined by about 5,000 skins, and remained within the somewhat narrower range of roughly 10,000 to 20,000 skins. The period of relative stability was broken in the final years of the 1740s. In 1748 and 1749, returns increased to an average of nearly 23,000. Following these unusually strong years, the trade fell precipitously so that in 1756 fewer than 6,000 beaver pelts were received. There was a brief recovery in the early 1760s but by the end decade trade had fallen below even the mid-1750s levels. In 1770, Fort Albany took in just 3,600 beaver pelts. This pattern – unusually large returns in the late 1740s and low returns thereafter – indicates that the beaver in the Fort Albany region were being seriously depleted.

Figure 2
Beaver Traded at Fort Albany and York Factory 1700 – 1770

Source: Carlos and Lewis, 1993.

The beaver returns at York Factory from 1716 to 1770, also described in Figure 2, have some of the key features of the Fort Albany data. After some low returns early on (from 1716 to 1720), the number of beaver pelts increased to an average of 35,000. There were extraordinary returns in 1730 and 1731, when the average was 55,600 skins, but beaver receipts then stabilized at about 31,000 over the remainder of the decade. The first break in the pattern came in the early 1740s shortly after the French established several trading posts in the area. Surprisingly perhaps, given the increased competition, trade in beaver pelts at the Hudson’s Bay Company post increased to an average of 34,300, this over the period 1740 to 1743. Indeed, the 1742 return of 38,791 skins was the largest since the French had established any posts in the region. The returns in 1745 were also strong, but after that year the trade in beaver pelts began a decline that continued through to 1770. Average returns over the rest of the decade were 25,000; the average during the 1750s was 18,000, and just 15,500 in the 1760s. The pattern of beaver returns at York Factory – high returns in the early 1740s followed by a large decline – strongly suggests that, as in the Fort Albany hinterland, the beaver population had been greatly reduced.

The overall carrying capacity of any region, or the size of the animal stock, depends on the nature of the terrain and the underlying biological determinants such as birth and death rates. A standard relationship between the annual harvest and the animal population is the Lotka-Volterra logistic, commonly used in natural resource models to relate the natural growth of a population to the size of that population:
F(X) = aX – bX2, a, b > 0 (1)

where X is the population, F(X) is the natural growth in the population, a is the maximum proportional growth rate of the population, and b = a/X, where X is the upper limit to population size. The population dynamics of the species exploited depends on the harvest each period:

DX = aX – bX2- H (2)

where DX is the annual change in the population and H is the harvest. The choice of parameter a and maximum population X is central to the population estimates and have been based largely on estimates from the beaver ecology literature and Ontario provincial field reports of beaver densities (Carlos and Lewis, 1993).

Simulations based on equation 2 suggest that, until the 1730s, beaver populations remained at levels roughly consistent with maximum sustained yield management, sometimes referred to as the biological optimum. But after the 1730s there was a decline in beaver stocks to about half the maximum sustained yield levels. The cause of the depletion was closely related to what was happening in Europe. There, buoyant demand for felt hats and dwindling local fur supplies resulted in much higher prices for beaver pelts. These higher prices, in conjunction with the resulting competition from the French in the Hudson Bay region, led the Hudson’s Bay Company to offer much better terms to Natives who came to their trading posts (Carlos and Lewis, 1999).

Figure 3 reports a price index for furs at Fort Albany and at York Factory. The index represents a measure of what Natives received in European goods for their furs. At Fort Albany, fur prices were close to 70 from 1713 to 1731, but in 1732, in response to higher European fur prices and the entry of la Vérendrye, an important French trader, the price jumped to 81. After that year, prices continued to rise. The pattern at York Factory was similar. Although prices were high in the early years when the post was being established, beginning in 1724 the price settled down to about 70. At York Factory, the jump in price came in 1738, which was the year la Vérendrye set up a trading post in the York Factory hinterland. Prices then continued to increase. It was these higher fur prices that led to over-harvesting and, ultimately, a decline in beaver stocks.

Figure 3
Price Index for Furs: Fort Albany and York Factory, 1713 – 1770

Source: Carlos and Lewis, 2001.

Property Rights Regimes

An increase in price paid to Native hunters did not have to lead to a decline in the animal stocks, because Indians could have chosen to limit their harvesting. Why they did not was closely related their system of property rights. One can classify property rights along a spectrum with, at one end, open access, where anyone can hunt or fish, and at the other, complete private property, where a sole owner has full control over the resource. Between, there are a range of property rights regimes with access controlled by a community or a government, and where individual members of the group do not necessarily have private property rights. Open access creates a situation where there is less incentive to conserve, because animals not harvested by a particular hunter will be available to other hunters in the future. Thus the closer is a system to open access the more likely it is that the resource will be depleted.

Across aboriginal societies in North America, one finds a range of property rights regimes. Native Americans did have a concept of trespass and of property, but individual and family rights to resources were not absolute. Sometimes referred to as the Good Samaritan principle (McManus, 1972), outsiders were not permitted to harvest furs on another’s territory for trade, but they were allowed to hunt game and even beaver for food. Combined with this limitation to private property was an Ethic of Generosity that included liberal gift-giving where any visitor to one’s encampment was to be supplied with food and shelter.

Why a social norm such as gift-giving or the related Good Samaritan principle emerged was due to the nature of the aboriginal environment. The primary objective of aboriginal societies was survival. Hunting was risky, and so rules were put in place that would reduce the risk of starvation. As Berkes et al.(1989, p. 153) notes, for such societies: “all resources are subject to the overriding principle that no one can prevent a person from obtaining what he needs for his family’s survival.” Such actions were reciprocal and especially in the sub-arctic world were an insurance mechanism. These norms, however, also reduced the incentive to conserve the beaver and other animals that were part of the fur trade. The combination of these norms and the increasing price paid to Native traders led to the large harvests in the 1740s and ultimately depletion of the animal stock.

The Trade in European Goods

Indians were the primary agents in the North American commercial fur trade. It was they who hunted the animals, and transported and traded the pelts or skins to European intermediaries. The exchange was a voluntary. In return for their furs, Indians obtained both access to an iron technology to improve production and access to a wide range of new consumer goods. It is important to recognize, however, that although the European goods were new to aboriginals, the concept of exchange was not. The archaeological evidence indicates an extensive trade between Native tribes in the north and south of North America prior to European contact.

The extraordinary records of the Hudson’s Bay Company allow us to form a clear picture of what Indians were buying. Table 2 lists the goods received by Natives at York Factory, which was by far the largest of the Hudson’s Bay Company trading posts. As is evident from the table, the commercial trade was more than in beads and baubles or even guns and alcohol; rather Native traders were receiving a wide range of products that improved their ability to meet their subsistence requirements and allowed them to raise their living standards. The items have been grouped by use. The producer goods category was dominated by firearms, including guns, shot and powder, but also includes knives, awls and twine. The Natives traded for guns of different lengths. The 3-foot gun was used mainly for waterfowl and in heavily forested areas where game could be shot at close range. The 4-foot gun was more accurate and suitable for open spaces. In addition, the 4-foot gun could play a role in warfare. Maintaining guns in the harsh sub-arctic environment was a serious problem, and ultimately, the Hudson’s Bay Company was forced to send gunsmiths to its trading posts to assess quality and help with repairs. Kettles and blankets were the main items in the “household goods” category. These goods probably became necessities to the Natives who adopted them. Then there were the luxury goods, which have been divided into two broad categories: “tobacco and alcohol,” and “other luxuries,” dominated by cloth of various kinds (Carlos and Lewis, 2001; 2002).

Table 2
Value of Goods Received at York Factory in 1740 (made beaver)

We have much less information about the French trade. The French are reported to have exchanged similar items, although given their higher transport costs, both the furs received and the goods traded tended to be higher in value relative to weight. The Europeans, it might be noted, supplied no food to the trade in the eighteenth century. In fact, Indians helped provision the posts with fish and fowl. This role of food purveyor grew in the nineteenth century as groups known as the “home guard Cree” came to live around the posts; as well, pemmican, supplied by Natives, became an important source of nourishment for Europeans involved in the buffalo hunts.

The value of the goods listed in Table 2 is expressed in terms of the unit of account, the made beaver, which the Hudson’s Bay Company used to record its transactions and determine the rate of exchange between furs and European goods. The price of a prime beaver pelt was 1 made beaver, and every other type of fur and good was assigned a price based on that unit. For example, a marten (a type of mink) was a made beaver, a blanket was 7 made beaver, a gallon of brandy, 4 made beaver, and a yard of cloth, 3? made beaver. These were the official prices at York Factory. Thus Indians, who traded at these prices, received, for example, a gallon of brandy for four prime beaver pelts, two yards of cloth for seven beaver pelts, and a blanket for 21 marten pelts. This was barter trade in that no currency was used; and although the official prices implied certain rates of exchange between furs and goods, Hudson’s Bay Company factors were encouraged to trade at rates more favorable to the Company. The actual rates, however, depended on market conditions in Europe and, most importantly, the extent of French competition in Canada. Figure 3 illustrates the rise in the price of furs at York Factory and Fort Albany in response to higher beaver prices in London and Paris, as well as to a greater French presence in the region (Carlos and Lewis, 1999). The increase in price also reflects the bargaining ability of Native traders during periods of direct competition between the English and French and later the Hudson’s Bay Company and the Northwest Company. At such times, the Native traders would play both parties off against each other (Ray and Freeman, 1978).

The records of the Hudson’s Bay Company provide us with a unique window to the trading process, including the bargaining ability of Native traders, which is evident in the range of commodities received. Natives only bought goods they wanted. Clear from the Company records is that it was the Natives who largely determined the nature and quality of those goods. As well the records tell us how income from the trade was being allocated. The breakdown differed by post and varied over time; but, for example, in 1740 at York Factory, the distribution was: producer goods – 44 percent; household goods – 9 percent; alcohol and tobacco – 24 percent; and other luxuries – 23 percent. An important implication of the trade data is that, like many Europeans and most American colonists, Native Americans were taking part in the consumer revolution of the eighteenth century (de Vries, 1993; Shammas, 1993). In addition to necessities, they were consuming a remarkable variety of luxury products. Cloth, including baize, duffel, flannel, and gartering, was by far the largest class, but they also purchased beads, combs, looking glasses, rings, shirts, and vermillion among a much longer list. Because these items were heterogeneous in nature, the Hudson’s Bay Company’s head office went to great lengths to satisfy the specific tastes of Native consumers. Attempts were also made, not always successfully, to introduce new products (Carlos and Lewis, 2002).

Perhaps surprising, given the emphasis that has been placed on it in the historical literature, was the comparatively small role of alcohol in the trade. At York Factory, Native traders received in 1740 a total of 494 gallons of brandy and “strong water,” which had a value of 1,976 made beaver. More than twice this amount was spent on tobacco in that year, nearly five times was spent on firearms, twice was spent on cloth, and more was spent on blankets and kettles than on alcohol. Thus, brandy, although a significant item of trade, was by no means a dominant one. In addition, alcohol could hardly have created serious social problems during this period. The amount received would have allowed for no more than ten two-ounce drinks per year for the adult Native population living in the region.

The Labor Supply of Natives

Another important question can be addressed using the trade data. Were Natives “lazy and improvident” as they have been described by some contemporaries, or were they “industrious” like the American colonists and many Europeans? Central to answering this question is how Native groups responded to the price of furs, which began rising in the 1730s. Much of the literature argues that Indian trappers reduced their effort in response to higher fur prices; that is, they had backward-bending supply curves of labor. The view is that Natives had a fixed demand for European goods that, at higher fur prices, could be met with fewer furs, and hence less effort. Although widely cited, this argument does not stand up. Not only were higher fur prices accompanied by larger total harvests of furs in the region, but the pattern of Native expenditure also points to a scenario of greater effort. From the late 1730s to the 1760s, as the price of furs rose, the share of expenditure on luxury goods increased dramatically (see Figure 4). Thus Natives were not content simply to accept their good fortune by working less; rather they seized the opportunity provided to them by the strong fur market by increasing their effort in the commercial sector, thereby dramatically augmenting the purchases of those goods, namely the luxuries, that could raise their living standards.

Figure 4
Native Expenditure Shares at York Factory 1716 – 1770

Source: Carlos and Lewis, 2001.

A Note on the Non-commercial Sector

As important as the fur trade was to Native Americans in the sub-arctic regions of Canada, commerce with the Europeans comprised just one, relatively small, part of their overall economy. Exact figures are not available, but the traditional sectors; hunting, gathering, food preparation and, to some extent, agriculture must have accounted for at least 75 to 80 percent of Native labor during these decades. Nevertheless, despite the limited time spent in commercial activity, the fur trade had a profound effect on the nature of the Native economy and Native society. The introduction of European producer goods, such as guns, and household goods, mainly kettles and blankets, changed the way Native Americans achieved subsistence; and the European luxury goods expanded the range of products that allowed them to move beyond subsistence. Most importantly, the fur trade connected Natives to Europeans in ways that affected how and how much they chose to work, where they chose to live, and how they exploited the resources on which the trade and their survival was based.

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Ray, Arthur J. Indians in the Fur Trade: Their Role as Hunters, Trappers and Middlemen in the Lands Southwest of Hudson Bay, 1660-1870. Toronto: University of Toronto Press, 1974.

Ray, Arthur J. and Donald Freeman. “Give Us Good Measure”: An Economic Analysis of Relations between the Indians and the Hudson’s Bay Company before 1763. Toronto: University of Toronto Press, 1978.

Ray, Arthur J. “Bayside Trade, 1720-1780.” In Historical Atlas of Canada 1, edited by R. Cole Harris, plate 60. Toronto: University of Toronto Press, 1987.

Rich, E. E. Hudson’s Bay Company, 1670 – 1870. 2 vols. Toronto: McClelland and Stewart, 1960.

Rich, E.E. “Trade Habits and Economic Motivation among the Indians of North America.” Canadian Journal of Economics and Political Science 26, no. 1 (1960): 35-53.

Shammas, Carole. “Changes in English and Anglo-American Consumption from 1550-1800.” In Consumption and the World of Goods, edited by John Brewer and Roy Porter, 177-205. London: Routledge, 1993.

Wien, Thomas. “Selling Beaver Skins in North America and Europe, 1720-1760: The Uses of Fur-Trade Imperialism.” Journal of the Canadian Historical Association, New Series 1 (1990): 293-317.

Citation: Carlos, Ann and Frank Lewis. “Fur Trade (1670-1870)”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/the-economic-history-of-the-fur-trade-1670-to-1870/

An Economic History of Finland

Riitta Hjerppe, University of Helsinki

Finland in the early 2000s is a small industrialized country with a standard of living ranked among the top twenty in the world. At the beginning of the twentieth century it was a poor agrarian country with a gross domestic product per capita less than half of that of the United Kingdom and the United States, world leaders at the time in this respect. Finland was part of Sweden until 1809, and a Grand Duchy of Russia from 1809 to 1917, with relatively broad autonomy in its economic and many internal affairs. It became an independent republic in 1917. While not directly involved in the fighting in World War I, the country went through a civil war during the years of early independence in 1918, and fought against the Soviet Union during World War II. Participation in Western trade liberalization and bilateral trade with the Soviet Union required careful balancing of foreign policy, but also enhanced the welfare of the population. Finland has been a member of the European Union since 1995, and has belonged to the European Economic and Monetary Union since 1999, when it adopted the euro as its currency.

Gross Domestic Product per capita in Finland and in EU 15, 1860-2004, index 2004 = 100

Sources: Eurostat (2001–2005)

Finland has large forest areas of coniferous trees, and forests have been and still are an important natural resource in its economic development. Other natural resources are scarce: there is no coal or oil, and relatively few minerals. Outokumpu, the biggest copper mine in Europe in its time, was depleted in the 1980s. Even water power is scarce, despite the large number of lakes, because of the small height differences. The country is among the larger ones in Europe in area, but it is sparsely populated with 44 people per square mile, 5.3 million people altogether. The population is very homogeneous. There are a small number of people of foreign origin, about two percent, and for historical reasons there are two official language groups, the Finnish-speaking majority and a Swedish-speaking minority. In recent years population has grown at about 0.3 percent per year.

The Beginnings of Industrialization and Accelerating Growth

Finland was an agrarian country in the 1800s, despite poor climatic conditions for efficient grain growing. Seventy percent of the population was engaged in agriculture and forestry, and half of the value of production came from these primary industries in 1900. Slash and burn cultivation finally gave way to field cultivation during the nineteenth century, even in the eastern parts of the country.

Some iron works were founded in the southwestern part of the country in order to process Swedish iron ore as early as in the seventeenth century. Significant tar burning, sawmilling and fur trading brought cash with which to buy a few imported items such as salt, and some luxuries – coffee, sugar, wines and fine cloths. The small towns in the coastal areas flourished through the shipping of these items, even if restrictive legislation in the eighteenth century required transport via Stockholm. The income from tar and timber shipping accumulated capital for the first industrial plants.

The nineteenth century saw the modest beginnings of industrialization, clearly later than in Western Europe. The first modern cotton factories started up in the 1830s and 1840s, as did the first machine shops. The first steam machines were introduced in the cotton factories and the first rag paper machine in the 1840s. The first steam sawmills were allowed to start only in 1860. The first railroad shortened the traveling time from the inland towns to the coast in 1862, and the first telegraphs came at around the same time. Some new inventions, such as electrical power and the telephone, came into use early in the 1880s, but generally the diffusion of new technology to everyday use took a long time.

The export of various industrial and artisan products to Russia from the 1840s on, as well as the opening up of British markets to Finnish sawmill products in the 1860s were important triggers of industrial development. From the 1870s on pulp and paper based on wood fiber became major export items to the Russian market, and before World War I one-third of the demand of the vast Russian empire was satisfied with Finnish paper. Finland became a very open economy after the 1860s and 1870s, with an export share equaling one-fifth of GDP and an import share of one-fourth. A happy coincidence was the considerable improvement in the terms of trade (export prices/import prices) from the late 1860s to 1900, when timber and other export prices improved in relation to the international prices of grain and industrial products.

Openness of the economies (exports+imports of goods/GDP, percent) in Finland and EU 15, 1960-2005

Sources: Heikkinen and van Zanden 2004; Hjerppe 1989.

Finland participated fully in the global economy of the first gold-standard era, importing much of its grain tariff-free and a lot of other foodstuffs. Half of the imports consisted of food, beverages and tobacco. Agriculture turned to dairy farming, as in Denmark, but with poorer results. The Finnish currency, the markka from 1865, was tied to gold in 1878 and the Finnish Senate borrowed money from Western banking houses in order to build railways and schools.

GDP grew at a slightly accelerating average rate of 2.6 percent per annum, and GDP per capita rose 1.5 percent per year on average between 1860 and 1913. The population was also growing rapidly, and from two million in the 1860s it reached three million on the eve of World War I. Only about ten percent of the population lived in towns. The investment rate was a little over 10 percent of GDP between the 1860s and 1913 and labor productivity was low compared to the leading nations. Accordingly, economic growth depended mostly on added labor inputs, as well as a growing cultivated area.

Catching up in the Interwar Years

The revolution of 1917 in Russia and Finland’s independence cut off Russian trade, which was devastating for Finland’s economy. The food situation was particularly difficult as 60 percent of grain required had been imported.

Postwar reconstruction in Europe and the consequent demand for timber soon put the economy on a swift growth path. The gap between the Finnish economy and Western economies narrowed dramatically in the interwar period, although it remained the same among the Scandinavian countries, which also experienced fast growth: GDP grew by 4.7 percent per annum and GDP per capita by 3.8 percent in 1920–1938. The investment rate rose to new heights, which also improved labor productivity. The 1930s depression was milder than in many other European countries because of the continued demand for pulp and paper. On the other hand, Finnish industries went into depression at different times, which made the downturn milder than it would have been if all the industries had experienced their troughs simultaneously. The Depression, however, had serious and long-drawn-out consequences for poor people.

The land reform of 1918 secured land for tenant farmers and farm workers. A large number of new, small farms were established, which could only support families if they had extra income from forest work. The country remained largely agrarian. On the eve of World War II, almost half of the labor force and one-third of the production were still in the primary industries. Small-scale agriculture used horses and horse-drawn machines, lumberjacks went into the forest with axes and saws, and logs were transported from the forest by horses or by floating. Tariff protection and other policy measures helped to raise the domestic grain production to 80–90 percent of consumption by 1939.

Soon after the end of World War I, Finnish sawmill products, pulp and paper found old and new markets in the Western world. The structure of exports became more one-sided, however. Textiles and metal products found no markets in the West and had to compete hard with imports on the domestic market. More than four-fifths of exports were based on wood, and one-third of industrial production was in sawmilling, other wood products, pulp and paper. Other growing industries included mining, basic metal industries and machine production, but they operated on the domestic market, protected by the customs barriers that were typical of Europe at that time.

The Postwar Boom until the 1970s

Finland came out of World War II crippled by the loss of a full tenth of its territory, and with 400.000 evacuees from Karelia. Productive units were dilapidated and the raw material situation was poor. The huge war reparations to the Soviet Union were the priority problem of the decision makers. The favorable development of the domestic machinery and shipbuilding industries, which was based on domestic demand during the interwar period and arms deliveries to the army during the War made war-reparations deliveries possible. They were paid on time and according to the agreements. At the same time, timber exports to the West started again. Gradually the productive capacity was modernized and the whole industry was reformed. Evacuees and soldiers were given land on which to settle, and this contributed to the decrease in farm size.

Finland became part of the Western European trade-liberalization movement by joining the World Bank, the International Monetary Fund (IMF) and the Bretton Woods agreement in 1948, becoming a member of the General Agreement on Tariffs and Trade (GATT) two years later, and joining Finnefta (an agreement between the European Free Trade Area (EFTA) and Finland) in 1961. The government chose not to receive Marshall Aid because of the world political situation. Bilateral trade agreements with the Soviet Union started in 1947 and continued until 1991. Tariffs were eased and imports from market economies liberated from 1957. Exports and imports, which had stayed at internationally high levels during the interwar years, only slowly returned to the earlier relative levels.

The investment rate climbed to new levels soon after War World II under a government policy favoring investments and it remained on this very high level until the end of the 1980s. The labor-force growth stopped in the early 1960s, and economic growth has since depended on increases in productivity rather than increased labor inputs. GDP growth was 4.9 percent and GDP per capita 4.3 percent in 1950–1973 – matching the rapid pace of many other European countries.

Exports and, accordingly, the structure of the manufacturing industry were diversified by Soviet and, later, on Western orders for machinery products including paper machines, cranes, elevators, and special ships such as icebreakers. The vast Soviet Union provided good markets for clothing and footwear, while Finnish wool and cotton factories slowly disappeared because of competition from low-wage countries. The modern chemical industry started to develop in the early twentieth century, often led by foreign entrepreneurs, and the first small oil refinery was built by the government in the 1950s. The government became actively involved in industrial activities in the early twentieth century, with investments in mining, basic industries, energy production and transmission, and the construction of infrastructure, and this continued in the postwar period.

The new agricultural policy, the aim of which was to secure reasonable incomes and favorable loans to the farmers and the availability of domestic agricultural products for the population, soon led to overproduction in several product groups, and further to government-subsidized dumping on the international markets. The first limitations on agricultural production were introduced at the end of the 1960s.

The population reached four million in 1950, and the postwar baby boom put extra pressure on the educational system. The educational level of the Finnish population was low in Western European terms in the 1950s, even if everybody could read and write. The underdeveloped educational system was expanded and renewed as new universities and vocational schools were founded, and the number of years of basic, compulsory education increased. Education has been government run since the 1960s and 1970s, and is free at all levels. Finland started to follow the so-called Nordic welfare model, and similar improvements in health and social care have been introduced, normally somewhat later than in the other Nordic countries. Public child-health centers, cash allowances for children, and maternity leave were established in the 1940s, and pension plans have covered the whole population since the 1950s. National unemployment programs had their beginnings in the 1930s and were gradually expanded. A public health-care system was introduced in 1970, and national health insurance also covers some of the cost of private health care. During the 1980s the income distribution became one of the most even in the world.

Slower Growth from the 1970s

The oil crises of the 1970s put the Finnish economy under pressure. Although the oil reserves of the main supplier, the Soviet Union, showed no signs of running out, the price increased in line with world market prices. This was a source of devastating inflation in Finland. On the other hand, it was possible to increase exports under the terms of the bilateral trade agreement with the Soviet Union. This boosted export demand and helped Finland to avoid the high and sustained unemployment that plagued Western Europe.

Economic growth in the 1980s was somewhat better than in most Western economies, and at the end of the 1980s Finland caught up with the sluggishly-growing Swedish GDP per capita for the first time. In the early 1990s the collapse of the Soviet trade, Western European recession and problems in adjusting to the new liberal order of international capital movement led the Finnish economy into a depression that was worse than that of the 1930s. GDP fell by over 10 percent in three years, and unemployment rose to 18 percent. The banking crisis triggered a profound structural change in the Finnish financial sector. The economy revived again to a brisk growth rate of 3.6 percent in 1994-2005: GDP growth was 2.5 percent and GDP per capita 2.1 percent between 1973 and 2005.

Electronics started its spectacular rise in the 1980s and it is now the largest single manufacturing industry with a 25 percent share of all manufacturing. Nokia is the world’s largest producer of mobile phones and a major transmission-station constructor. Connected to this development was the increase in the research-and- development outlay to three percent of GDP, one of the highest in the world. The Finnish paper companies UPM-Kymmene and M-real and the Finnish-Swedish Stora-Enso are among the largest paper producers in the world, although paper production now accounts for only 10 percent of manufacturing output. The recent discussion on the future of the industry is alarming, however. The position of the Nordic paper industry, which is based on expensive, slowly-growing timber, is threatened by new paper factories founded near the expanding consumption areas in Asia and South America, which use local, fast-growing tropical timber. The formerly significant sawmilling operations now constitute a very small percentage of the activities, although the production volumes have been growing. The textile and clothing industries have shrunk into insignificance.

What has typified the last couple of decades is the globalization that has spread to all areas. Exports and imports have increased as a result of export-favoring policies. Some 80 percent of the stocks of Finnish public companies are now in foreign hands: foreign ownership was limited and controlled until the early 1990s. A quarter of the companies operating in Finland are foreign-owned, and Finnish companies have even bigger investments abroad. Most big companies are truly international nowadays. Migration to Finland has increased, and since the collapse of the eastern bloc Russian immigrants have become the largest single foreign group. The number of foreigners is still lower than in many other countries – there are about 120.000 people with foreign background out of a population of 5.3 million.

The directions of foreign trade have been changing because trade with the rising Asian economies has been gaining in importance and Russian trade has fluctuated. Otherwise, almost the same country distribution prevails as has been common for over a century. Western Europe has a share of three-fifths, which has been typical. The United Kingdom was for long Finland’s biggest trading partner, with a share of one-third, but this started to diminish in the 1960s. Russia accounted for one-third of Finnish foreign trade in the early 1900s, but the Soviet Union had minimal trade with the West at first, and its share of the Finnish foreign trade was just a few percentage points. After World War II Soviet-Finnish trade increased gradually until it reached 25 percent of Finnish foreign trade in the 1970s and early 1980s. Trade with Russia is now gradually gaining ground again from the low point of the early 1990s, and had risen to about ten percent in 2006. This makes Russia one of Finland’s three biggest trading partners, Sweden and Germany being the other two with a ten percent share each.

The balance of payments was a continuing problem in the Finnish economy until the 1990s. Particularly in the post-World War II period inflation repeatedly eroded the competitive capacity of the economy and led to numerous devaluations of the currency. An economic policy favoring exports helped the country out of the depression of the 1990s and improved the balance of payments.

Agriculture continued its problematic development of overproduction and high subsidies, which finally became very unpopular. The number of farms has shrunk since the 1960s and the average size has recently risen to average European levels. The share of agricultural production and labor are also on the Western European levels nowadays. Finnish agriculture is incorporated into the Common Agricultural Policy of the European Union and shares its problems, even if Finnish overproduction has been virtually eliminated.

The share of forestry is equally low, even if it supplies four-fifths of the wood used in Finnish sawmills and paper factories: the remaining fifth is imported mainly from the northwestern parts of Russia. The share of manufacturing is somewhat above Western European levels and, accordingly, that of services is high but slightly lower than in the old industrialized countries.

Recent discussion on the state of the economy mainly focuses on two issues. The very open economy of Finland is very much influenced by the rather sluggish economic development of the European Union. Accordingly, not very high growth rates are to be expected in Finland either. Since the 1990s depression, the investment rate has remained at a lower level than was common in the postwar period, and this is cause for concern.

The other issue concerns the prominent role of the public sector in the economy. The Nordic welfare model is basically approved of, but the costs create tensions. High taxation is one consequence of this and political parties discuss whether or not the high public-sector share slows down economic growth.

The aging population, high unemployment and the decreasing numbers of taxpayers in the rural areas of eastern and central Finland place a burden on the local governments. There is also continuing discussion about tax competition inside the European Union: how does the high taxation in some member countries affect the location decisions of companies?

Development of Finland’s exports by commodity group 1900-2005, percent

Source: Finnish National Board of Customs, Statistics Unit

Note on classification: Metal industry products SITC 28, 67, 68, 7, 87; Chemical products SITC 27, 32, 33, 34, 5, 66; Textiles SITC 26, 61, 65, 84, 85; Wood, paper and printed products SITC 24, 25, 63, 64, 82; Food, beverages, tobacco SITC 0, 1, 4.

Development of Finland’s imports by commodity group 1900-2005, percent

Source: Finnish National Board of Customs, Statistics Unit

Note on classification: Metal industry products SITC 28, 67, 68, 7, 87; Chemical products SITC 27, 32, 33, 34, 5, 66; Textiles SITC 26, 61, 65, 84, 85; Wood, paper and printed products SITC 24, 25, 63, 64, 82; Food, beverages, tobacco SITC 0, 1, 4.

References:

Heikkinen, S. and J.L van Zanden, eds. Explorations in Economic Growth. Amsterdam: Aksant, 2004.

Heikkinen, S. Labour and the Market: Workers, Wages and Living Standards in Finland, 1850–1913. Commentationes Scientiarum Socialium 51 (1997).

Hjerppe, R. The Finnish Economy 1860–1985: Growth and Structural Change. Studies on Finland’s Economic Growth XIII. Helsinki: Bank of Finland Publications, 1989.

Jalava, J., S. Heikkinen and R. Hjerppe. “Technology and Structural Change: Productivity in the Finnish Manufacturing Industries, 1925-2000.” Transformation, Integration and Globalization Economic Research (TIGER), Working Paper No. 34, December 2002.

Kaukiainen, Yrjö. A History of Finnish Shipping. London: Routledge, 1993.

Myllyntaus, Timo. Electrification of Finland: The Transfer of a New Technology into a Late Industrializing Economy. Worcester, MA: Macmillan, Worcester, 1991.

Ojala, J., J. Eloranta and J. Jalava, editors. The Road to Prosperity: An Economic History of Finland. Helsinki: Suomalaisen Kirjallisuuden Seura, 2006.

Pekkarinen, J. and J. Vartiainen. Finlands ekonomiska politik: den långa linjen 1918–2000, Stockholm: Stiftelsen Fackföreningsrörelsens institut för ekonomisk forskning FIEF, 2001.

Citation: Hjerppe, Riitta. “An Economic History of Finland”. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/an-economic-history-of-finland/

The Euro and Its Antecedents

Jerry Mushin, Victoria University of Wellington

The establishment, in 1999, of the euro was not an isolated event. It was the latest installment in the continuing story of attempts to move towards economic and monetary integration in western Europe. Its relationship with developments since 1972, when the Bretton Woods system of fixed (but adjustable) exchange rates in terms of the United States dollar was collapsing, is of particular interest.

Political moves towards monetary cooperation in western Europe began at the end of the Second World War, but events before 1972 are beyond the scope of this article. Coffey and Presley (1971) have described and analyzed relevant events between 1945 and 1971.

The Snake

In May 1972, at the end of the Bretton Woods (adjustable-peg) system, many countries in western Europe attempted to stabilize their currencies in relation to each other’s currencies. The arrangements known as the Snake in the Tunnel (or, more frequently, as the Snake), which were set up by members of the European Economic Community (EEC), one of the forerunners of the European Union, lasted until 1979. Each member agreed to limit, by market intervention, the fluctuations of its currency’s exchange rate in terms of other members’ currencies. The maximum divergence between the strongest and the weakest currencies was 2.25%. The agreement meant that the French government, for example, would ensure that the value of the French franc would show very limited fluctuation in terms of the Italian lira or the Netherlands guilder, but that there would be no commitment to stabilize its fluctuations against the United States dollar, the Japanese yen, or other currencies outside the agreement.

This was a narrower objective than the aim of the adjustable-peg system, which was intended to stabilize the value of each currency in terms of the values of all other major currencies, but for which the amount of reserves held by governments had proved to be insufficient. It was felt that this limited objective could be achieved with the amount of reserves available to member governments.

The agreement also had a political dimension. Stable exchange rates are likely to encourage international trade, and it was hoped that the new exchange-rate regime would stimulate members’ trade within western Europe at the expense of their trade with the rest of the world. This was one of the objectives of the EEC from its inception.

Exchange rates within the group of currencies were to be managed by market intervention; member governments undertook to buy and sell their currencies in sufficiently large quantities to influence their exchange rates. There was an agreed maximum divergence between the strongest and weakest currencies. Exchange rates of the whole group of currencies fluctuated together against external denominators such as the United States dollar.

The Snake is generally regarded as a failure. Membership was very unstable; the United Kingdom and the Irish Republic withdrew after less than one month, and only the German Federal Republic remained a member for the whole of its existence. Other members withdrew and rejoined, and some did this several times. In addition, the political context of the Snake was not clearly defined. Sweden and Norway participated in the Snake although, at that time, neither of these countries was a member of the EEC and Sweden was not a candidate for admission.

The curious name of the Snake in the Tunnel comes from the appearance of exchange-rate graphs. In terms of a non-member currency, the value of each currency in the system could fluctuate but only within a narrow band that was also fluctuating. The trend of each exchange rate showed some resemblance to a snake inside the narrow confines of a tunnel.

European Monetary System

The Snake came to an end in 1979 and was replaced with the European Monetary System (EMS). The exchange-rate mechanism of the EMS had the same objectives as the Snake, but the procedure for allocating intervention responsibilities among member governments was more precisely specified.

The details of the EMS arrangements have been explained by Adams (1990). Membership of the EMS involved an obligation on each EMS-member government to undertake to stabilize its currency value with respect to the value of a basket of EMS-member currencies called the European Currency Unit (ECU). Each country’s currency had a weight in the ECU that was related to the importance of that country’s trade within the EEC. An autonomous shift in the external value of any EMS-member currency changed the value of the ECU and therefore imposed exchange-rate adjustment obligations on all members of the system. The magnitude of each of these obligations was related to the weight allocated to the currency experiencing the initial disturbance.

The effects of the EMS requirements on each individual member depended upon that country’s weight in the ECU. The system ensured that major members delegated to their smaller partners a greater proportion of their exchange-rate adjustment responsibilities than the less important members imposed on the dominant countries. The explanation for this lack of symmetry depends on the fact that a particular percentage shift in the external value of the currency of a major member of the EMS (with a high weight in the ECU) had a greater effect on the external value of the ECU than had the same percentage disturbance to the external value of the currency of a less important member. It therefore imposed greater exchange-rate adjustment responsibilities on the remaining members than did the same percentage shift applied to the external value of the less important currency. While each of the major members of the EMS could delegate to the remaining members a high proportion of its adjustment obligations, the same is not true for the smaller countries in the system. This burden was, however, seen by the smaller nations (including Denmark, Belgium, and Netherlands) as an acceptable price for exchange-rate stability with their main trading partners (including France and the German Federal Republic).

The position of the Irish Republic, which joined the EMS in 1979 despite both the very low weight of its currency in the ECU and the absence of the UK, its dominant trading partner, appears to be anomalous. The explanation of this decision is that it was principally concerned about the significant problem of imported inflation that was derived from the rising price level of its British imports. This was based on the assumption that, once the rigid link between the two currencies was broken, inflation in the UK would lead to a fall in the value of the British pound relative to the value of the Irish Republic pound. However, purchasing power is not the only determinant of exchange rates, and the value of the British pound increased sharply in 1979 causing increased imported inflation in the Irish Republic. The appreciation of the British pound was probably caused principally by developments in the UK oil industry and by the monetarist style of UK macroeconomic policy.

Partly because it had different rules for different countries, the EMS had a more stable membership than had the Snake. The standard maximum exchange-rate fluctuation from its reference value that was permitted for each EMS currency was ±2.25%. However, there were wider bands (±6%) for weaker members (Italy from 1979, Spain from 1989, and the UK from 1990) and the Netherlands observed a band of ±1%. The system was also subject to frequent realignments of the parity grid. The Irish Republic joined the EMS in 1979 but the UK did not, thus ending the link between the British pound and the Irish Republic pound. The UK joined in 1990 but, as a result of substantial international capital flows, left in 1992. The bands were increased in width to ±15% in 1992.

Incentives to join the EMS were comparable to those that applied to the Snake and included the desire for stable exchange rates with a country’s principal trading partners and the desire to encourage trade within the group of EMS members rather than with countries in the rest of the world. Cohen (2003), in his analysis of monetary unions, has explained the advantages and disadvantages of trans-national monetary integration.

The UK decided not to participate in the exchange-rate mechanism of the EMS at its inception. It was influenced by the fact that the weight allocated to the British pound (0.13) in the definition of the ECU was insufficient to allow the UK government to delegate to other EMS members a large proportion of the exchange-rate stabilization responsibilities that it would acquire under EMS rules. The outcome of EMS membership for the UK in 1979 would have been, therefore, in marked contrast to the outcome for France (with an ECU-weight of 0.20) and, especially, for the German Federal Republic (with an ECU-weight of 0.33). The proportion of the UK’s exports that, at that time, was sold in EMS countries was low relative to the proportion of any other EMS-member’s exports, and this was reflected in its ECU weight. The relationship between the weight assigned to an individual EMS-member’s currency in the definition of the ECU and the ability of that country to delegate adjustment responsibilities was that a particular percentage shift in the external value of the currency of a major member of the EMS had a greater effect on the value of the ECU than the same percentage disturbance to the external value of the currency of a less important member, and it therefore imposed greater exchange-rate adjustment responsibilities on the remaining EMS members than did the same percentage shift applied to the external value of the less important EMS-member currency.

A second reason for the refusal of the UK to join the EMS in 1979 was that membership would not have led to greater stability of its exchange rates with respect to the currencies of its major trading partners, which were, at that time, outside the EMS group of countries.

An important reason for the British government’s continued refusal, for more than eleven years, to participate in the EMS was its concern about the loss of sovereignty that membership would imply. A floating exchange rate (even a managed floating exchange rate such as was operated by the UK government from 1972 to 1990) permits an independent monetary policy, but EMS obligations make this impossible. Monetarist views on the efficacy of restraining the rate of inflation by controlling the rate of growth of the money supply were dominant during the early years of the EMS, and an independent monetary policy was seen as being particularly significant.

By 1990, when the UK government decided to join the EMS, a number of economic conditions had changed. It is significant that the proportion of UK exports sold in EMS countries had risen markedly. Following substantial speculative selling of British currency in September 1992, however, the UK withdrew from the EMS. One of the causes of this was the substantial flow of short-term capital from the UK, where interest rates were relatively low, to Germany, which was implementing a very tight monetary policy and hence had very high interest rates. This illustrates that a common monetary policy is one of the necessary conditions for the operation of agreements, such as the EMS, that are intended to limit exchange-rate fluctuations.

The Euro

Despite the partial collapse of the EMS in 1992, a common currency, the euro, was introduced in 1999 by eleven of the fifteen members of the European Union, and a twelfth country joined the euro zone in 2001. From 1999, each national currency in this group had a rigidly fixed exchange rate with the euro (and, hence, with each other). Fixed exchange rates, in national currency units per euro, are listed in Table 1. In 2002, euro notes and coins replaced national currencies in these countries. The intention of the new currency arrangement is to reduce transactions costs and encourage economic integration. The Snake and the EMS can perhaps be regarded as transitional structures leading to the introduction of the euro, which is the single currency of a single integrated economy.

Table 1
Value of the Euro (in terms of national currencies)

Austria 13.7603
Belgium 40.3399
Finland 5.94573
France 6.55957
Germany 1.95583
Greece 340.750
Irish Republic 0.787564
Italy 1936.27
Luxembourg 40.3399
Netherlands 2.20371
Portugal 200.482
Spain 166.386

Source: European Central Bank

Of the members of the European Union, to which participation in this innovation was restricted, Denmark, Sweden, and the UK chose not to introduce the euro in place of their existing currencies. The countries that adopted the euro in 1999 were Austria, Belgium, France, Finland, Germany, Irish Republic, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Greece, which adopted the euro in 2001, was initially excluded from the new currency arrangement because it had failed to satisfy the conditions described in the Treaty of Maastricht, 1991. The maximum value for each of five variables for each country that was specified in the Treaty is listed in Table 2.

Table 2
Conditions for Euro Introduction (Treaty of Maastricht, 1991)

Inflation rate 1.5 percentage points above the average of the three euro countries with the lowest rates
Long-term interest rates 2.0 percentage points above the average of the three euro countries with the lowest rates
Exchange-rate stability fluctuations within the EMS band for at least two years
Budget deficit/GDP ratio 3%
Government debt/GDP ratio 60%

Source: The Economist, May 31, 1997.

The euro is also used in countries that, before 1999, used currencies that it has replaced: Andorra (French franc and Spanish peseta), Kosovo (German mark), Monaco (French franc), Montenegro (German mark), San Marino (Italian lira), and Vatican (Italian lira). The euro is also the currency of French Guiana, Guadeloupe, Martinique, Mayotte, Réunion, and St Pierre-Miquelon that, as départements d’outre-mer, are constitutionally part of France.

The euro was adopted by Slovenia in 2007, by Cyprus (South) and Malta in 2008, by Slovakia in 2009, by Estonia in 2011,  by Latvia in 2014, and by Lithuania in 2015. Table 3 shows the exchange rates between the euro and the currencies of these countries.

Table 3 Value of the Euro (in terms of national currencies)

         Cyprus (South) 0.585274
         Estonia 15.6466
         Latvia 0.702804
         Lithuania 3.4528
         Malta 0.4293
         Slovakia 30.126
         Slovenia 239.64

Source: European Central Bank

Currencies whose exchange rates were, in 1998, pegged to currencies that have been replaced by the euro have had exchange rates defined in terms of the euro since its inception. The Communauté Financière Africaine (CFA) franc, which is used by Benin, Burkina Faso, Cameroon, Central African Republic, Chad, Congo Republic, Côte d’Ivoire, Equatorial Guinea, Gabon, Guinea-Bissau, Mali, Niger, Sénégal, and Togo was defined in terms of the French franc until 1998, and is now pegged to the euro. The Comptoirs Français du Pacifique (CFP) franc, which is used in the three French territories in the south Pacific (Wallis and Futuna Islands, French Polynesia, and New Caledonia), was also defined in terms of the French franc and is now pegged to the euro. The Comoros franc has similarly moved from a French-franc peg to a euro peg. The Cape Verde escudo, which was pegged to the Portuguese escudo, is also now pegged to the euro. Bosnia-Herzegovina, and Bulgaria, which previously operated currency-board arrangements with respect to the German mark, now fix the exchange rates of their currencies in terms of the euro. Botswana, Croatia, Czech Republic, Denmark, Macedonia, and São Tomé-Príncipe also peg their currencies to the euro. Additional countries that peg their currencies to a basket that includes the euro are Algeria, Belarus, Fiji, Iran, Kuwait, Libya, Morocco, Samoa (Western), Singapore, Syria, Tunisia, and Vanuatu. Romania, and Switzerland, which do not operate fixed exchange-rate systems, occasionally intervene to smooth extreme fluctuations, in terms of the euro, of their exchange rates (European Central Bank, 2016).

The group of countries that use the euro or that have linked the values of their currencies to the euro might be called the “greater euro zone.” It is interesting that membership of this group of countries has been determined largely by historical accident. Its members exhibit a marked absence of macroeconomic commonality. Within this bloc, macroeconomic indicators, including the values of GDP and of GDP per person, have a wide range of values. The degree of financial integration with international markets also varies substantially in these countries. Countries that stabilize their exchange rates with respect to a basket of currencies that includes the euro have adjustment systems that are less closely related to its value. This weaker connection means that these countries should not be regarded as part of the greater euro zone.

The establishment of the euro is a remarkable development whose economic effects, especially in the long term, are uncertain. This type of exercise, involving the rigid fixing of certain exchange rates and then the replacement of a group of existing currencies, has rarely been undertaken in the recent past. Other than the introduction of the euro, and the much less significant case of the merger in 1990 of the former People’s Democratic Republic of Yemen (Aden) and the former Arab Republic of Yemen (Sana’a), the monetary union that accompanied the expansion of the German Federal Republic to incorporate the former German Democratic Republic in 1990 is the sole recent example. However, the very distinctive political situation of post-1945 Germany (and its economic consequences) make it difficult to draw relevant conclusions from this experience. The creation of the euro is especially noteworthy at a time when the majority, and an increasing proportion, of countries have chosen floating (or managed floating) exchange rates for their currencies. With the important exception of China, this includes most major economies. This statement should be treated with caution, however, because countries that claim to operate a managed floating exchange rate frequently aim, as described by Calvo and Reinhart (2002), to stabilize their currencies with respect to the United States dollar.

When the euro was established, it replaced national currencies. However, this is not the same as the process known as dollarization, in which a country adopts another country’s currency. For example, the United States dollar is the sole legal tender in Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama, Timor-Leste, and Zimbabwe. It is also the sole legal tender in the overseas possessions of the United States (American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and U.S. Virgin Islands), in two British territories (Turks and Caicos Islands and British Virgin Islands) and in the Caribbean Netherlands. Like the countries that use the euro, a dollarized country cannot operate an independent monetary policy. A euro-using country will, however, have some input into the formation of monetary policy, whereas dollarized countries have none. In addition, unlike euro-using countries, dollarized countries probably receive none of the seigniorage that is derived from the issue of currency.

Prospects for the Euro

The expansion of the greater euro zone, which is likely to continue with the economic integration of the new members of the European Union, and with the probable admission of additional new members, has enhanced the importance of the euro. However, this expansion is unlikely to make the greater euro zone into a major currency bloc comparable to, for example, the Sterling Area even at the time of its collapse in 1972.  Mushin (2012) has described the nature and role of the Sterling Area

Mundell (2003) has predicted that the establishment of the euro will be the model for a new currency bloc in Asia. However, there is no evidence yet of any significant movement in this direction. Eichengreen et al (1995) have argued that monetary unification in the emerging industrial economies of Asia is unlikely to occur. A feature of Mundell’s paper is that he assumes that the benefits of joining a currency area almost necessarily exceed the costs, but this remains unproven.

The creation of the euro will have, and might already have had, macroeconomic consequences for the countries that comprise the greater euro zone. Since 1999, the influences on the import prices and export prices of these countries have included the effects of monetary policy run by the European Central Bank (www.ecb.int), a non-elected supra-national institution that is directly accountable neither to individual national governments nor to individual national parliaments, and developments, including capital flows, in world financial markets. Neither of these can be relied upon to ensure stable prices at an acceptable level in price-taking economies. The consequences of the introduction of the euro might be severe in some parts of the greater euro zone, especially in the low-GDP economies. For example, unemployment might increase if exports cease to have competitive prices. Further, domestic macroeconomic policy is not independent of exchange-rate policy. One of the costs of joining a monetary union is the loss of monetary-policy independence.

Data on Exchange-rate Policies

The best source of data on exchange-rate policies is probably the International Monetary Fund (IMF) (see www.imf.org). Almost all countries of significant size are members of the IMF; notable exceptions are Cuba (since 1964), the Republic of China (Taiwan) (since 1981), and the People’s Democratic Republic of Korea (North Korea). The most significant IMF publications that contain exchange-rate data are International Financial Statistics and the Annual Report on Exchange Arrangements and Exchange Restrictions.

Since 2009, the IMF has allocated each country’s exchange rate policy to one of ten categories. Unfortunately, the definitions of these mean that the members of the greater euro zone are not easy to identify. In this taxonomy, the exchange rate systems of countries that are part of a monetary union are classified according to the arrangements that govern the joint currency. The exchange rate policies of the eleven countries that introduced the euro in 1999, Cyprus (South), Estonia, Greece, Latvia, Lithuania, Malta, Slovakia, and Slovenia are classified as “Free floating.” Kosovo, Montenegro, and San Marino have “No separate legal tender.” Bosnia-Herzegovina, and Bulgaria have “Currency boards.” Cape Verde, Comoros, Denmark, São Tomé and Príncipe, and the fourteen African countries that use the CFA franc have “Conventional pegs.” Macedonia has a “Stabilized arrangement.” Croatia has a “Crawl-like arrangement.” Andorra, Monaco, Vatican, and the three territories in the south Pacific that use the CFP franc are not IMF members. Anderson, Habermeier, Kokenyne, and Veyrune (2009) explain and discuss the definitions of these categories and compare them to the definitions that were used by the International Monetary Fund until 2010. Information on the exchange-rate policy of each of its members is published by the International Monetary Fund (2016).

Other Monetary Unions in Europe

The establishment of the Snake, the EMS, and the euro have affected some of the other monetary unions in Europe. The monetary unions of Belgium-Luxembourg, of France-Monaco, and of Italy-Vatican-San Marino predate the Snake, survived within the EMS, and have now been absorbed into the euro zone. Unchanged by the introduction of the euro are the UK-Gibraltar-Guernsey-Isle of Man-Jersey monetary union (which is the remnant of the Sterling Area that also includes Falkland Islands and St. Helena), the Switzerland-Liechtenstein monetary union, and the use of the Turkish lira in Northern Cyprus.

The relationship between the currencies of the Irish Republic (previously the Irish Free State) and the UK is an interesting case study of the interaction of political and economic forces on the development of macroeconomic (including exchange-rate) policy. Despite the non-participation of the UK, the Irish Republic was a foundation member of the EMS. This ended the link between the British pound and the Irish Republic pound (also called the punt) that had existed since the establishment of the Irish currency following the partition of Ireland (1922), so that a step towards one monetary union destroyed another. Until 1979, the Irish Republic pound had a rigidly fixed exchange rate with the British pound, and each of the two banking systems cleared the other’s checks as if denominated in its own currency. These very close financial links meant that every policy decision of monetary importance in the UK coincided with an identical change in the Irish Republic, including the currency reforms of 1939 (US-dollar peg), 1949 (devaluation), 1967 (devaluation), 1971 (decimalization), 1972 (floating exchange rate), and 1972 (brief membership of the Snake). From 1979 until 1999, when the Irish Republic adopted the euro, there was a floating exchange rate between the British pound and the Irish Republic pound. South of the Irish border, the dominant political mood in the 1920s was the need to develop a distinct non-British national identity, but there were perceived to be good economic grounds for retaining a very close link with the British pound. By 1979, although political rhetoric still referred to the desire for a united Ireland, the economic situation had changed, and the decision to join the EMS without the membership of the UK meant that, for the first time, different currencies were used on each side of the Irish border. In both of these cases, political objectives were tempered by economic pressures.

Effects of the Global Financial Crisis

One of the ways of analyzing the significance of a new system is to observe the effects of circumstances that have not been predicted. The global financial crisis [GFC] that began in 2007 provides such an opportunity. In the UK and in the Irish Republic, whose business cycles are usually comparable, the problems that followed the GFC were similar in nature and in severity. In both of these countries, major banks (and therefore their depositors) were rescued from collapse by their governments. However, the macroeconomic outcomes have been different. The increase in the unemployment rate has been much greater in the Irish Republic than in the UK. The explanation for this is that an independent monetary policy is not possible in the Irish Republic, which is part of the euro zone. The UK, which does not use the euro, responded to the GFC by operating a very loose monetary policy (with a very low discount rate and large scale “quantitative easing”). The effects of this have been compounded by depreciation of the British pound. Although, partly because of the common language, labor is mobile between the UK and the Irish Republic, the unemployment rate in the Irish Republic remains high because its real exchange rate is high and its real interest rates are high. The effect of the GFC is that the Irish Republic now has an overvalued currency, which has made an inefficient economy more inefficient. Simultaneously, the more efficient economies in the euro zone (and some countries that are outside the euro zone, including the UK, whose currencies have depreciated) now have undervalued currencies, which have encouraged their economies to expand. This illustrates one of the consequences of membership of the euro zone. Had the GFC been predicted, the estimation of the economic benefits for the Irish Republic (and for Greece, Italy, Portugal, Spain, and other countries) would probably have been different. The political consequences for the more efficient countries in the euro zone, including Germany, might also be significant. At great cost, these countries have provided financial assistance to the weaker members of the euro zone, especially Greece.

Conclusion

The future role of the euro is uncertain. Especially in view of the British decision to withdraw from the European Union, even its survival is not guaranteed. It is clear, however, that the outcome will depend on both political and economic forces.

References:

Adams, J. J. “The Exchange-Rate Mechanism in the European Monetary System.” Bank of England Quarterly Bulletin 30, no. 4 (1990): 479-81.

Anderson, Harald, Karl Habermeier, Annamaria Kokenyne, and Romain Veyrune. Revised System for the Classification of Exchange Rate Arrangements, Washington DC: International Monetary Fund, 2009.

Calvo, Guillermo and Carmen Reinhart. “Fear of Floating.” Quarterly Journal of Economics 117, no 2 (2002): 379-408.

Coffey, Peter and John Presley. European Monetary Integration. London: Macmillan Press, 1971.

Cohen, Benjamin. “Monetary Unions.” In Encyclopedia of Economic and Business History, edited by Robert Whaples, 2003. http://eh.net/encyclopedia/monetary-unions/

Eichengreen, Barry, James Tobin, and Charles Wyplosz. “Two Cases for Sand in the Wheels of International Finance.” Economic Journal 105, no. 1 (1995): 162-72.

European Central Bank.  The International Role of the Euro.  2016.

International Monetary Fund. Annual Report of the Executive Board, 2016.

Mundell, Robert. “Prospects for an Asian Currency Area.” Journal of Asian Economics 14, no. 1 (2003): 1-10.

Mushin, Jerry. “The Sterling Area.” In Encyclopedia of Economic and Business History, edited by Robert Whaples, 2012.  http://eh.net/encyclopedia/the-sterling-area/

Endnote:

Jerry Mushin can be reached at  jerry.mushin1@outlook.com.  This article includes material from some of the author’s publications:

Mushin, Jerry. “A Simulation of the European Monetary System.” Computer Education 35 (1980): 8-19.

Mushin, Jerry. “The Irish Pound: Recent Developments.” Atlantic Economic Journal 8, no, 4 (1980): 100-10.

Mushin, Jerry. “Exchange-Rate Adjustment in a Multi-Currency Monetary System.” Simulation 36, no 5 (1981): 157-63.

Mushin, Jerry. “Non-Symmetry in the European Monetary System.” British Review of Economic Issues 8, no 2 (1986): 85-89.

Mushin, Jerry. “Exchange-Rate Stability and the Euro.” New Zealand Banker 11, no. 4 (1999): 27-32.

Mushin, Jerry. “A Taxonomy of Fixed Exchange Rates.” Australian Stock Exchange Perspective 7, no. 2 (2001): 28-32.

Mushin, Jerry. “Exchange-Rate Policy and the Efficacy of Aggregate Demand Management.” The Business Economist 33, no. 2 (2002): 16-24.

Mushin, Jerry. Output and the Role of Money. New York, London and Singapore: World Scientific Publishing Company, 2002.

Mushin, Jerry. “The Deceptive Resilience of Fixed Exchange Rates.” Journal of Economics, Business and Law 6, no. 1 (2004): 1-27.

Mushin, Jerry. “The Uncertain Prospect of Asian Monetary Integration.” International Economics and Finance Journal 1, no. 1 (2006): 89-94.

Mushin, Jerry. “Increasing Stability in the Mix of Exchange Rate Policies.” Studies in Business and Economics 14, no. 1 (2008): 17-30.

Mushin, Jerry. “Predicting Monetary Unions.” International Journal of Economic Research 5, no. 1 (2008): 27-33.

Mushin, Jerry. Interest Rates, Prices, and the Economy. Jodhpur: Scientific Publishers (India), 2009.

Mushin, Jerry. “Infrequently Asked Questions on the Monetary Union of the Countries of the Gulf Cooperation Council.” Economics and Business Journal: Inquiries and Perspectives, 3, no. 1, (2010): 1-12.

Mushin, Jerry. “Common Currencies: Economic and Political Causes and Consequences.” The Business Economist 42, no. 2, (2011): 19-26.

Mushin, Jerry. “Exchange Rates, Monetary Aggregates, and Inflation,” Bulletin of Political Economy 7, no. 1 (2013): 69-88.

Citation: Mushin, Jerry. “The Euro and Its Antecedents”. EH.Net Encyclopedia, edited by Robert Whaples. October 12, 2016. URL http://eh.net/encyclopedia/the-euro-and-its-antecedents/