Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865-1914

Published by EH.NET (May 2002)

Lance E. Davis and Robert E. Gallman, Evolving Financial Markets and

International Capital Flows: Britain, the Americas, and Australia,

1865-1914. Cambridge: Cambridge University Press, 2001. vii + 986 pp.

$100.00 (cloth), ISBN: 0-521-55352-0.

Reviewed for EH.NET by Alan M. Taylor, Department of Economics, University of

California, Davis.

Lance Davis and the late Robert Gallman have produced a monumental book. The

authors’ aim is to understand financial markets in five countries in the late

nineteenth century, their evolution, and their interaction with the growth of

global financial markets. Why should we care? With a new era of globalization

now upon us the potential for an instructive history lesson is clear.

The authors make the locus for their study the world capital market in the

1865-1914 era and its major players. For their sample they select the one major

capital exporter, Britain, and four major capital importing countries, the four

settler economies of the United States, Canada, Australia and Argentina. The

book proceeds from an introductory chapter, laying out the major hypotheses to

a study of each country in turn, in the order noted. Some closing chapters sum

up and ponder the lessons.

Knowing the lifetime achievements of the two distinguished authors will permit

some potential readers to guess, if not the entire story, at least some of the

tools and approaches employed. Work on the United Kingdom’s capital exports

naturally draws on Davis’s prior work with Huttenback, and their databases of

capital called and securities performance in London prior to 1914, supplemented

by national income and growth data and married to a dense coverage of the

country’s financial history. On the United States, national income and growth

rest on Gallman’s seminal contributions in that field, meshing with Davis’s own

landmark works on financial development. The other settler economies represent

more of a “frontier” for the authors too, but an encyclopedic coverage of each,

born of deep digging in the primary data sources and a comprehensive sweep of

the secondary literature, leaves the reader convinced that the authors, far

from speculatively squatting in such an historical outback, have staked out a

firm claim on the relevant scholarly territory.

The central thesis, again perhaps no surprise, is that although capital

accumulation matters for economic growth (a widely held, if not uncontested,

claim, in light of the “A versus k” debate), such a process does not occur in a

vacuum. Specifically, one needs to understand the transaction costs associated

with capital mobilization to understand the process fully, for the capital

market is unlike the market for goods, and is beset by unique problems (moral

hazard, adverse selection, risk, uncertainty, asymmetric and imperfect

information, time inconsistency) whose solution depends on the design of

particular mechanisms. And, of course, those mechanisms are embedded in an

institutional structure: the financial sector itself. Thus the book largely

sidesteps questions of saving supply and investment demand, to focus on the

financial frictions that exist in systems of intermediation. Nonetheless, some

attention to supply and demand fundamentals is necessary for correct inference

from quantity and price data, so the authors have to keep that set of tools on

one side, but always at the ready. This is a big set of tasks.

Financial evolution and growth can be understood at one level by a cliometric

study of stocks, banks, deposits, leverage, financial ratios, returns, and so

on; but the Davis-Gallman thesis is that such a picture would be incomplete

without an understanding of how the system is shaped by shocks that are

exogenous (for example, wars and globalization, to pick the big ones) and

shocks that are endogenous (crises, government policy, learning, market power,

network externalities, or other sources of lock-in that might generate a “path

dependent” outcome). Hence, the book aspires to that modern marriage which

marks the very best of scholarship in economic history today. On the one hand

it is a book of quantitative rigor that seeks to document changing financial

markets. On the other hand it is a book of modern-day institutional economic

history explaining how the market outcomes shape, and are shaped by, the

broader political economy setting. Or maybe it is two books.

We can spell out in more detail the methodological structures employed in the

book. The chapters on each country proceed in a similar fashion, almost

following a template. Whilst some might see this as mechanical, it is to be

applauded as it clearly facilitates the comparative analysis for which the

authors are striving. Typically, discussion begins with a broad overview of the

economic history of the country in question, often going back decades or even

centuries, to spell out the major developments at the macroeconomic level and

the micro-level changes in the financial sector. The formal quantitative

analysis of the macroeconomy then follows, to motivate a study of the ups and

downs of the financial sector in light of growth and fluctuations in the

broader economy. The quantitative and descriptive guns then turn on the

financial sector for the rest of the chapter, seeking to document its size,

growth, performance and external linkages, and to explain the rise and fall of

the whole sector and its constituent parts, such as banks, primary and

secondary securities markets, nonbank financial intermediaries (building

societies, insurance companies) and so on. As that story unfolds, the reader is

gradually weaned off the early barrage of tables containing the data and the

hard-sought documentary evidence is gradually piled up. The approach is

balanced. It isn’t heavily “cliometric,” since the quantitative base is heavy,

but not dominant, and the methods are certainly not econometrically high-tech.

But it is not exactly an “analytic narrative” either, since formal theory is

eschewed. With its textual layers filled by a dense flow of historiographic

information the style is, perhaps, more like economic history as “thick

description.”

And at 986 pages, the description is thick indeed. The sheer size of the book

poses problems for the reader (as it no doubt did for the author and the

press). The reader has to try to keep all the balls in the air at once. The

mobilization hypothesis, though rather intractable, needs to be always in the

back of the mind. In addition, when moving between the chapters it is tricky to

keep all of the relevant quantitative detail at hand so as to make the relevant

comparisons. And even within a chapter, the connection between the early

quantitative results and the later narrative needs keen attention. In some

sense, such problems are simply the occupational hazard of anyone engaged in so

vast an enterprise, but one is always desirous of devices that can ease the

management of the tasks at hand. Sometimes, for example, very useful comparison

tables appear that link data across all the countries. (The best of these is

Table 7:3-1, which lays out major differences in the environment in each

country; it is a shame that we have to wait until p. 778 for this nugget).

Sometimes, the national narratives make connections with one another. Still,

the reader will need some reserves of energy to make it to the last page and

still have everything in order.

Overall, what is the bottom line? Invoking North (p. 753) as they start to tell

the lessons from the past, the authors quote as a dictum that “the economies of

scope, complementarities, and network externalities of an institutional matrix

make institutional change overwhelmingly incremental and path dependent” and

that since ” the static structure of economic theory ill fits us to understand

that process we need to construct a theoretical framework that models economic

change.” The authors do not claim to supply such a framework for the episode

they study (nor does anyone else, yet) but their aim is to develop a

“taxonomy,” which they think is an important first step towards developing a

theory. For this review, a sample of events in each country can illustrate the

various taxonomic forms on display, revealing the links these authors make to

other parts of the literature whilst pursuing their own unique comparative

approach.

Learning matters. In the United Kingdom, financial history is linked back to

early modern times, and the notion of “educating” the British saver is

discussed, that is, how agents learned that pieces of paper can represent real

wealth, and how the risk associated with such instruments can be evaluated,

managed, and diversified, and this despite periodic hiccups such as the South

Sea Bubble. As the Industrial Revolution happened first in England, the need

for “impersonal” capital in such ventures as the early railroads again widened

the market.

Wars matter. As Britain refined its strong fiscal state to develop and maintain

military strength in the seventeenth and eighteenth centuries, the flotation of

public debt set the foundation for future financial markets. Similarly,

Hamilton’s innovations in the United States set the stage for a later period of

“saver education” there in the nineteenth century.

Broad political choices matter. In countries like Australia, where government

managed much more of the economy (significantly, railroads) there was less need

to float private capital issues, so such markets remained thin.

The external environment matters. Even Australian public issues could be

largely floated in Britain, again denting the need to develop domestic markets,

and a similar story can be told of Argentina, which, of all the countries,

satisfied the largest share of capital formation (about two thirds) via import.

Banking regulation matters. In Canada, banks could not take demand deposits and

lend long. This, and branching, kept banks safer, but left a niche in the

market unfilled. The unique Canadian bond house sprang up to fill it. In the

U.S. branching was not permitted, so the market for commercial paper expanded

to fill the niche left by the inability of banks to intermediate between

surplus and deficit regions.

A major crash matters. Events in 1890 in Australia scarred the financial system

for over a decade and the economy sat in slump. Savers who were burned were

nervous of putting their money in the bank (or in any private enterprise) and

private financial development was slowed.

(On the impact of a crash, I would read Argentine financial history after the

Baring Crash in the same way, only as more disastrous; but the authors put a

slightly more positive spin on the Argentine case. Yet the major banks were

wiped out or suspended there, the major national bank was the only source of

growth in the system, large swathes of the pampas were no longer served after

the provincial bank collapsed and closed all its rural branches, and external

capital flows were turned off for a decade. Under the circumstances the

Argentine recovery in the late 1890s was remarkable, but it took place despite,

rather than because of, the resilience of the financial system.)

On the other hand, some institutions receive little attention, though maybe

they also mattered. For example, the settler economies had high shares of

activity in agriculture, and in many cases land was sharecropped, usually

fifty-fifty. This clearly changed investment incentives for each party, and

hence the derived demand for intermediation. Even in the Argentine case, where

the literature has argued that such problems were potentially severe, we are

still poorly placed to know how much they mattered.

It is fair to say that the book’s taxonomy is very complete. Is it too

complete? Or rather, could it be faulted for not discriminating enough among

the different shocks that are said to matter? And what does “matter” mean? This

is nothing more than the old “how big is big?” problem.

One is not necessarily, or only, asking here for a hypothesis test, for by just

listening to the siren songs of statistical significance we will surely run our

ship onto the rocks — as we are occasionally reminded. The question is really

quantitative significance, and the “big” threshold is then potentially more

subjective (personally, my rule of thumb is 15 percent; just don’t ask me why).

To take an example from the book, the very attentive reader, arriving at p.

691, will note that the Argentine insurance industry was not a “major player”

and didn’t contribute in a significant way to capital formation or the

financial markets; a key empirical fact here is that the sector “only” held 1.5

percent or less of Argentine tangible wealth. As our extremely attentive reader

will recall, this is in contrast to the British case discussed four to five

hundred pages earlier, where the insurance firms were “major players” in the

formal securities markets (p. 150); in the British case, insurance sector

assets (503 million pounds, p. 142) were about 5 percent of total British

tangible wealth (11,750 million pounds, p. 63). Now, some of the difference (5

versus 1.5) is no surprise, since financially backward Argentina’s ratio of

financial assets to GNP was about half that of Britain (even without a list of

tables, our clairvoyant reader has just sprinted forward to check Goldsmith’s

ratios on p. 770). So the ratio of insurance assets to total financial assets

in the two countries differs even less. Implicitly, in between the two ratios,

the authors have in mind a threshold for this sector to be a “major player”;

but they do not tell us what that threshold is and why it takes that value. Of

course, this is a contrived example. And it is a little unfair; as the authors’

surrounding discussion makes clear, size matters, but so does much else, such

as sectoral innovation and activity in certain markets. But I think those

caveats do not make the problem go away, they only complicate it further, and

it is an issue that hovers just under the surface throughout the book.

We strive to keep our theories parsimonious, and careful empirical work remains

our principal bulwark against kitchen-sink models. The taxonomy proposed by

Davis and Gallman leads to many hypotheses, some testable, and the empirical

challenge of substantiating these will likely keep future generations of

cliometricians quite busy. There are many hypotheses on offer in the book, and

all are plausible, and probably mattered to some degree. Although there is a

wealth of data, the book finds little space for formal empirical testing,

having much else to keep the reader occupied.

Still, there are some intriguing pieces of evidence here and there. The finding

that capital calls in the four settler economies are largely uncorrelated at an

annual frequency (p. 35) makes a powerful case for the idea that

(country-specific) investment demand shocks on the periphery were dominant, and

(common, British) savings supply shocks were unimportant in driving the

cyclical flow of capital overseas, though one might wish for a more

comprehensive model of trends and cycles in capital exports based on

“fundamentals.” The finding that risk and return were correlated for overseas

securities in the London market fits the prescriptions of finance theory, but

the data are there to test a full-blown international CAPM model, and we could

learn much from that kind of empirical exercise (p. 219 et seq.).

Future researchers have been set many challenges by this book, and they will

have plenty of hypotheses to attack. Undoubtedly they will be assisted by the

public release of the underlying data from this book. Some data originate in

the earlier Davis-Huttenback study, such as the London securities prices,

balance sheets, profit and loss data, and the capital call data. It is highly

desirable that future scholars have access via the web to a readable version of

these and other data, to sustain work on this topic. I encourage Lance Davis in

his ongoing efforts to get the timeworn tapes decoded and uploaded in a modern

workable form.

Style matters. In a book of this size, efficient design is paramount to keep

things manageable. Some technical problems do crop up, where the authors,

copyeditors, typesetters, and editors might have made different choices. The

citation style is cumbersome, and a move to author-date might have been

economical. There is no list of tables and figures. Given that the book is, in

places, just a wall of tables and figures, this may be understandable, but it

makes navigation difficult. Even the table placement is hard on the reader —

in the U.K. chapter there are sections of uninterrupted tables running twelve

pages (even, once, twenty pages) in a row, and these are not the only cases of

information overload. Perhaps the strategic use of appendices or a different

layout could have helped maintain the flow. The book really needed one more

spell check. Still, one cannot complain too much — the mere fact that a press

was willing to run a 986-page academic book should be cause for some rejoicing

in these days of hard-nosed publishing, notwithstanding the generous subsidy of

this series by the Sanwa Bank.

Moving from style to substance, the one thing I would have added to the overall

comparative study is more discussion of the role of the gold standard, a

critical macro-institution that is almost sidelined in the discussion of the

micro-financial nexus. As recent research has conclusively shown, the gold

standard (at least pre-1914) had important implications for country risk, the

spread between local government bond yields and London consol yields. It

therefore deeply affected countries’ access to the London market. Going on or

off the gold standard was a major regime change, and the constraints on

monetary policy so implied had even deeper implications for how financial

markets, especially banks, could operate. On the periphery, to take Argentina

as an example (and the lesson is still obviously relevant today), it is clear

that you cannot have a credible gold standard commitment and have

lender-of-last-resort options. The precise choice of monetary policy, note

issue laws, bank regulation, and so on, all interact with this larger regime

choice. It is impossible to understand the larger money-banking story without

that key ingredient, and policy makers and private agents obviously had this

variable in their sights.

It again seems like carping, however, to point out omissions in a book of

roughly one thousand pages, and the strengths should be recognized. The

chapters on the United Kingdom and United States offer very fine treatments of

their subjects, as one would expect, and could almost stand as books in their

own right. In the other chapters, especially a short one on Argentina (“only”

eighty pages), the material is well organized even if the interpretations are

more hedged and depend more on secondary literature. Yet the point of such a

comparative study is surely that the whole be greater than the sum of the

parts, and in this respect the book succeeds. The volume embodies the vast

human capital accumulation of its authors — and that capital, now mobilized

(at some cost) for our benefit, will be a reference for years to come.

Alan M. Taylor writes on economic history and international economics. He has

a special interest in Argentina. His recent works include Straining at the

Anchor: The Argentine Currency Board and the Search for Macroeconomic

Stability, 1880-1935 with Gerardo della Paolera (University of Chicago

Press, 2001); “A Century of Missing Trade?” (with Antoni Estevadeordal)

American Economic Review, 2002; “A Century of Purchasing Power Parity,”

Review of Economics and Statistics, 2002; and “Globalization and Capital

Markets” (with Maurice Obstfeld), in Globalization in Historical

Perspective, edited by Michael D. Bordo, Alan M. Taylor, and Jeffrey G.

Williamson (University of Chicago Press, forthcoming).