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Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History

Author(s):Eichengreen, Barry
Reviewer(s):Rockoff, Hugh

Published by EH.Net (February 2016)

Barry Eichengreen, Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History. New York: Oxford University Press, 2015. vi + 512 pp. $30 (hardcover), ISBN: 978-0-19-939200-1.

Reviewed for EH.Net by Hugh Rockoff, Department of Economics, Rutgers University.
Barry Eichengreen knows as much or more about the financial history of the Great Depression as any living economic historian, and it shows in this splendid new book which compares the Great Recession with the Great Depression. The U.S. story, on which I will focus here, is the centerpiece, but as might be expected from Eichengreen, what happened in the rest of the world is also explored in detail. Eichengreen’s thesis is straightforward. In 2008 the United States, and with it the rest of the world, was headed for another Great Depression. Thanks to strong doses of monetary and fiscal stimulus, and lender-of-last-resort operations, especially in the United States, a second Great Depression was averted. Ideas were important: Much of the success can be attributed to John Maynard Keynes, Milton Friedman, and Anna Schwartz, and the lessons they drew from the Great Depression. But there was a downside to success. Because of the severity of the crisis in the 1930s the financial system underwent a massive reform that put it in a tough but effective straightjacket. The Great Recession was milder; politicians and lobbyists who opposed strict regulation regrouped, and the reforms were moderate at best. The Great Depression and the Great Recession were separated by eighty years, a long period of financial stability produced, according to Eichengreen, by New Deal financial reforms. But, he concludes, because the damage done by deregulation was only partly undone, “we are likely to see another such crisis in less than eighty years (p. 387).”

The analysis in the book is rigorous. Nevertheless, Eichengreen has written a book that can be read by policy makers, journalists, and the famous, and hopefully numerous, intelligent layperson. There are no charts, tables, or equations. Indeed, it would make a good textbook for an undergraduate course on the financial crisis. Eichengreen writes clearly. And he has sprinkled the text with biographical snippets that both inform and entertain. We meet William Jennings Bryan in the 1920s when he is using his oratorical skills to sell real estate in Florida; and we meet Charles Dawes, prominent banker, Vice President, Nobel Peace Prize winner (for his work on German Reparations), and composer of the melody for “It’s All in the Game.”

To make his case that the two crises were similar except for actions taken by governments, Eichengreen recounts both crises and identifies one parallel after another. The 1920s had Charles Ponzi; we had Bernie Madoff. In the 1920s the head of the Bank of England, Montagu Norman, was given, perhaps unconsciously, to “constructive ambiguity” (p. 23); we had Alan Greenspan. The 1920s witnessed the Florida land boom; we had subprime mortgages. Charles Dawes’s bank got needed assistance from the Reconstruction Finance Corporation, but the Guardian Group in Detroit was allowed to fail; we had Bear Stearns and Lehman Brothers. And this is just a taste. Eichengreen adds many, many more. Indeed, the parallels come so thick and fast that one is reminded of the phrase Albert Einstein used to describe two distant particles that were thought to be entangled: “spooky action at a distance.”

The book is divided into four parts. Part I, “The Best of Times,” consists of six chapters that cover the 1920s and the first decade of our century.  Here we learn (without attempting to be exhaustive) about real estate booms in the twenties, the attempt after World War I to reconstruct the gold standard, the repeated attempts to solve the German reparations problem, the Smoot-Hawley tariff, and the U.S. Stock market bubble. Then Eichengreen turns to our era and describes financial deregulation, the subprime mortgage boom, the expansion of the shadow banking sector, and the spread of this type of banking to Europe. Eichengreen doesn’t present new, controversial interpretations of events. Rather he presents conclusions based on careful readings of the available literature including the latest work by economic historians. What is new is the web of parallels he draws between the two crises. Others, of course, have noted the similarities, not the least Ben Bernanke as he wrestled with the crisis; but no one has created such a large catalog of parallels.

In Part II, “The Worst of Times,” nine chapters in all, we learn first about the stock market crash in 1929, the banking crises of 1930-33, and the spread of the Great Depression to Europe. Then he turns to the Great Recession: Bear Stearns, Lehman Brothers, AIG and all that, and the spread of the crisis to Europe.

In the seven chapters of Part III, “Toward Better Times,” we learn about Roosevelt’s attempts to revive the economy: the National Industrial Recovery Act, the Reconstruction Finance Corporation, Federal Reserve Policy in the 1930s, and Roosevelt’s conflicted ideas about budget deficits. European responses to the crisis are also discussed at length, and Japan’s Korekiyo Takahashi is celebrated as the finance minister who got it right. Takahashi, aided it must be said by costly Japanese military adventures, authorized a heavy dose of money-financed deficit spending and the result was the best economic performance among the industrial nations. Eichengreen then turns to our crisis: zero interest rates, quantitative easing, bailouts, and the fiscal stimulus. The argument is usually that what the government did helped, but more should have been done.

In Part IV, “Avoiding the Next Time,” Eichengreen focusses particularly on Dodd-Frank and the Euro. His main efforts are directed at explaining why so little was done to prevent another crisis. A number of potential reforms get favorable mentions: consolidation of regulatory agencies, higher capital requirements for financial institutions, and regulations that limit risk taking. But Eichengreen doesn’t rank possible reforms or explain in detail how they would work. Here I wanted Eichengreen to go on a bit, and tell us more about his ideas on what should have and presumably still can be done to prevent another crisis. His approach to Glass-Steagall is an example of his above the fray stance toward regulation. Eichengreen mentions Glass-Steagall, and the separation of commercial from investment banking many times — one chapter is titled “Shattered Glass.” He rejects the argument made mostly forcefully by Andrew Ross Sorkin (2012) — although it is one that must have occurred to many observers — that ending the separation of commercial and investment banking didn’t have much to do with causing the crisis. After all, Merrill Lynch, Bear Stearns, and Lehman brothers were not branches of commercial banks when they went off the rails. And AIG was an insurance company. Eichengreen tells us that ending Glass Steagall was “indicative of a trend” (p. 424), which it surely was, but he seems to feel that it was more than that. Here I would have liked to learn more about Eichengreen’s ideas about how ending Glass-Steagall undermined the system. Did it create moral hazard, because firms knew they could merge with a bank if they got in trouble? Or was it some other mechanism? And more urgently, I would have liked to have read more about Eichengreen’s views on how high a priority restoring Glass-Steagall should be, and where the lines should be drawn.

Comment and Conclusion

Eichengreen’s book is a synthesis. It pulls together an enormous body of studies by economic historians, policy makers, and journalists. Specialists in financial history will be familiar with many parts of the story. But I doubt there are any who will not learn a great deal from reading Eichengreen’s account. While I was persuaded by most of Eichengreen’s arguments I did have a recurring concern about how far we can go as social scientists, as opposed to policy advocates, in making assertions about what would have happened if alternative policies had been followed on the basis of two observations. It is one thing to claim that without aggressive monetary and fiscal actions and bailouts we might have ended up in another Great Depression.  And for me, as I suspect for most of us, that possibility justifies much of what was done. Even, say, a one-third chance of another Great Depression makes pulling out the stops worthwhile. But that claim is very different from the claim that we would have ended up in a Great Depression if less had been done. The truth is that we can’t be sure what path the economy would have followed if less had been done, or where we would be today.

Consider the following table which shows unemployment after four financial panics. When you compare 2008 only with 1930, it seems clear that we did a lot a better after the panic of 2008, and the things we did in 2008 “worked” at least up to a point: We avoided a Great Depression. On the other hand, we did, arguably, worse after 2008 than after the panic of 1907 when help for the economy was provided mainly through the circumscribed lender-of last-resort actions undertaken by J.P. Morgan.  And we did almost exactly the same as after the crisis of 1893, when only some limited stimulus came well after the crisis in the form of gold inflows and spending on the Spanish-American War. In fact, the 2008 and 1893 unemployment rates are so similar that it looks like another case of “spooky action at a distance.”

2008 1930 1907 1893
-1 4.6 2.9 2.5 4.3
0 5.8 8.9 3.1 6.8
1 9.3 15.7 7.5 9.3
2 9.6 22.9 5.7 8.5
3 8.9 20.9 5.9 9.3
4 8.1 16.2 7.0 8.5
5 7.4 14.4 5.9 7.8
6 6.2 10.0 5.7 5.9
7 5.3 9.2 8.5 5.0

Source: Historical Statistics of the United States, Millennial Edition: Volume 2, Work and Welfare, series Ba475 for 1893, 1907, and 1930 (pp. 2-82 and 2-83), and the standard Bureau of Labor Statistics series for 2008.

My point is not that 1893 is necessarily a better analog than 1930. One could argue the point, but I don’t think we know. Constructing a counterfactual macroeconomic history of a financial crisis and recession is essentially an exercise in forecasting, and we economists are just not very good at macroeconomic forecasting. We are in the position, I believe, of physicians in days gone by: we have some drugs that experience tells us sometimes relieve pain and suffering. But how they work and why they work in some cases and not in others, and what the long-run side effects are – we have some ideas we can discuss, or more likely debate, but the bottom line is that we don’t know.

(If we were entangled with the Depression of 1890s, we would want to know what happened in 1901 the year that corresponds to 2016. Among other things, 1901 began with a slide on the stock market of about 9%. Sound familiar?! Despite a spring rally the market finished the year off by about the same percentage. By the way, this is just an observation; I am not giving investment advice.)

Many excellent books and articles have been written about the financial crisis of 2008 and there will undoubtedly be many more. Gary Gorton’s papers and books and Ben Bernanke’s memoir immediately spring to mind, but the list of good books and articles is already a long one. There is nothing like a financial crisis to concentrate the minds of economists. However, if financial history is not your thing, and you want to read just one book about the financial crisis, you couldn’t do better than Hall of Mirrors.

Reference:

Andrew Ross Sorkin, “Reinstating an Old Rule Is Not a Cure for Crisis” New York Times, May 21, 2012. http://dealbook.nytimes.com/2012/05/21/reinstating-an-old-rule-is-not-a-cure-for-crisis/?_r=0.

Hugh Rockoff is Distinguished Professor of Economics at Rutgers University and a Research Associate with the National Bureau of Economic Research.

Copyright (c) 2016 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (February 2016). All EH.Net reviews are archived at http://eh.net/book-reviews/

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Macroeconomics and Fluctuations
Geographic Area(s):General, International, or Comparative
Europe
North America
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

Making the Modern American Fiscal State: Law, Politics, and the Rise of Progressive Taxation, 1877-1929

Author(s):Mehrotra, Ajay K.
Reviewer(s):Magness, Phillip W.

Published by EH.Net (November 2014)

Ajay K. Mehrotra, Making the Modern American Fiscal State: Law, Politics, and the Rise of Progressive Taxation, 1877-1929. New York: Cambridge University Press, 2014. xvi + 429 pp. $90 (cloth), ISBN: 978-1-107-04392-3.

Reviewed by Phillip W. Magness, Institute for Humane Studies, George Mason University.

In 1918, only five years removed from the ratification of the federal income tax amendment, economist Edwin R.A. Seligman (“The War Revenue Act,” Political Science Quarterly) summarized its consequences this way: “Never before, in the annals of civilization, has an attempt been made to take as much as two thirds of a man’s income by taxation.”  His observation reflected the rapid pace by which an initial top marginal rate of 7 percent had ballooned to upwards of 67 percent on the highest earners, its growth fueled almost entirely by the revenue demands of the First World War. Coming from a primary intellectual architect of the income tax movement, Seligman’s astonishment also conveyed hints of unease, or at least awareness that the trajectory of the policy had exceeded his original case for a new revenue device at an astronomical pace. Perhaps more telling is a near-contemporaneous assessment by Joseph Weldon Bailey, the former senator from Texas who set the Sixteenth Amendment into legislative motion in April 1909 and a man whom no less than Cordell Hull credited with forcing the income tax onto the national stage (see Cordell Hull, Memoirs of Cordell Hull, 1948, Vol. 1, p. 60 and Roy G. Blakey and Gladys C. Blakey, The Federal Income Tax, 1940, p. 30).  “While I have always favored an income tax,” Bailey reflected, “no intelligent and sincere student of the question could approve of a law such as we have today. Its rates are so high as to compel the conclusion that it was framed to encourage extravagance or to penalize prosperity” (speech reprinted in the Mexia Weekly Herald, April 23, 1920).

There can be no doubt that the Sixteenth Amendment induced a transformative shift in the fiscal order of the United States, though not always as anticipated. In Making the Modern American Fiscal State, legal historian Ajay K. Mehrotra takes up the task of tracing the intellectual origins of the events that brought the income tax into being and supplanted a previous tariff and excise-based tax system as the dominant fiscal mechanism of the federal government. Mehrotra’s argument follows the progressive disposition that typifies income tax historiography, although with a new twist that places intellectual rather than political figures at the center of the story.

Briefly summarized, the income tax movement traces to an emergent cohort of academic economists typified by Seligman, Richard Ely, and Henry Carter Adams who spent almost four decades mounting a sustained challenge to the prevailing “benefits theory” of taxation — the notion that revenue should be extracted according to a low, limited, and reciprocal provision of government services to the taxpayer. These intellectuals offered an alternative theory of taxation premised upon the “ability to pay” and the civic obligation implicit therein, providing an intellectual basis for redistributive direct taxation unchained from tangible benefits received. Their legacy continues in the expansive fiscal state of the present day.

In providing a guide to the normative justifications of progressive tax theory, Mehrotra has done historians a great service. He capably navigates these discussions through an impressive assemblage of archival and print sources and illustrates the dissemination of progressive academic influence into the policy sphere. Yet he also shares a pronounced enthusiasm for the results of this effort, which at times limits his ability to dispassionately assess unfolding historical events.

The book’s treatment of Pollock v. Farmer’s Loan & Trust (1895), invalidating the 1894 income tax, is illustrative. The author’s recounting of the case is at times difficult to differentiate from what he describes as Seligman’s own “neutral” brand of academic suasion as an “expert” consultant and critic. This pits Mehrotra and Seligman alike against anti-tax adversaries who invariably offer “selective” examinations of constitutional intent and “legal fictions” to reverse a century of precedent that “consistently interpreted” the Constitution’s limitations on direct taxes in ways that would not preclude the income tax (131, 135-36). While Pollock is a complex decision of mixed historical legacy, its core contention actually derived from a dearth of direct judicial consideration of the tax power since the founding era’s disjointed Seriatim decision in Hylton v. United States (1796), the “consistent” interregnum actually being a handful of obscure cases that only indirectly touched the relevant tax powers. A more measured assessment might turn to the open ambiguities of the income tax’s resemblance to acknowledged founding era direct taxes as opposed to teasing out favored claimants to originalist “truth,” or turn to the explicit primacy that the Constitution’s framers placed upon revenue derived from excises and tariffs as a point of contrast for a “new” revenue system that entered constitutionally uncharted territory save for a brief Civil War era experiment.

Mehrotra begins his inquiry with the older tariff system — the dominant federal revenue source of the nineteenth century — and thoroughly documents its role as a source of economic agitation. After the Civil War, tariff policy settled into a stable pattern of entrenched trade protectionism in the political service of predominantly northeastern industrial interests. This gave direct credence to the charge that the tariff-based tax system imposed its burdens upon consumers, agricultural exporters, and the poor while delivering massive benefits to wealthy industrialists by insulating them from international price competition. Thus a formative precept of “ability to pay” theory grew out of frustration with the tangible rent-seeking enterprise of the fiscal system’s status quo. It warrants mention that this assessment of the tariff system presents an under-acknowledged tension with the aforementioned repudiation of “benefits theory.” It is not difficult to see how the protectionist cronyism is far removed from an exemplar of benefits-based taxation — it is if anything an inversion of benefits reciprocity coupled with heavy, proactive government price manipulation — and yet the reader finds the tariff somewhat carelessly summarized as an extension of a vague benefits-enveloped laissez-faire status quo.

Far more curious though is the continuous diminishing of the tariff issue as the book progresses from the formative intellectual debates of the 1880s to the successful introduction of an income tax amendment in 1909. The amendment’s legislative adoption receives only four scant pages in which the tariff issue lightly appears. This oversight is substantial, as the amendment was actually an outgrowth of a heated public debate over protectionist logrolling that captured the ongoing Payne-Aldrich Tariff revision of that year. Indeed, derailing this tariff was the original objective of the income tax rider proposed by Bailey and so favorably referenced years later by Cordell Hull as the public turning point in the income tax debate. As the argument went, an income tax would flank the tariff interests by decoupling the trade policy from its revenue function and allow the country to “divorce this alliance” between revenue and trade protectionism, to borrow a phrase from MIT’s Davis R. Dewey (“Would a Federal Income Tax Be Fair to New England?” Boston Globe, January 16, 1910).

The tariff story is both crucial to understanding the complex political dynamics that produced the amendment and in many ways a complementary pattern of the academy’s diffusion into the political mainstream. Bailey’s strategy was a direct descendant of a briefly-referenced (p. 65) proposal three decades prior by Yale’s William Graham Sumner, a classical liberal free trader whom Mehrotra somewhat carelessly paints with the same “conservative” moniker that he elsewhere attaches to the 1909 tariff’s arch-protectionist and anti-income tax namesake, Senator Nelson Aldrich. Anti-tariff backers of the income tax similarly enlisted the trade theory work of Harvard’s Frank Taussig in the Senate floor debate, prompting Aldrich’s denunciation of this “dean of the free traders” for bringing university influence to bear upon congressional processes (Congressional Record, Vol. 44, p. 1537).  These and other free trade academic forebears of the income tax movement present an unaccounted complexity to Mehrotra’s story, which is dominated by such figures as Seligman and Ely, both progeny of German Historical School influences and far from free trade purists. Instead of this fuller and more complex story of academic diffusion into policy, we find only a more detailed and intellectually focused retelling of redistributive ideological conventions wherein the complex events of 1909 are almost wholly explained through vague appeals to the progressive tropes of “heightened social anxieties surrounding the power of Big Business and increasing economic inequality” (p. 264).

In fairness, Mehrotra openly identifies his objective in telling the progressive intellectual history of the income tax and the resulting work succeeds on that count. As a work of constitutional law and distinctively progressive political economy it functions well and will likely be a source guide for many years to come. Yet, with a few exceptions, it also does not venture far from these progressive precepts. Thus a full accounting of the consequences of the income tax movement, and particularly its constitutional political economy, are similarly partial toward its redistributive consequences and “professionalized” administrative implementation. Other consequences go all but unnoticed, such as the political windfall the Sixteenth Amendment provided to the Eighteenth wherein the supplanting of federal tax dependency on alcohol tariffs and excises also inadvertently removed a fiscal obstacle to Prohibition (see Donald J. Boudreaux and A.C. Pritchard, “The Price of Prohibition,” Arizona Law Review, 1994).  The amendment’s influence on trade — highly touted at its adoption, as we have seen — also goes unnoticed after an initial liberalization tied to the new income tax in 1913 succumbed to the resurgent protectionism of the Fordney-McCumber Tariff in 1922. In dismissing this latter event as a “vain effort to restore the ancien regime” (p. 395) and omitting its more notorious and consequential successor, the Smoot-Hawley Tariff, Mehrotra misses another important income tax legacy insofar as the “new” fiscal order had misdiagnosed the political economy of the “old” leading not to its replacement but rather the simultaneous coexistence of high tariffs, high progressive taxation, and all that it entailed. It stands to reason that the intellectual wisdom or folly of each policy was not the determinative factor, but rather the political interests they cultivated and advanced.

A final note may be offered, reflecting on the wartime source of the extraordinary marginal rates that became Seligman’s later surprise and Bailey’s disgust. As Mehrotra amply documents, it was not the peacetime reordering of 1913 but the revenue demands of American entry into the First World War that provided the lifeblood of the new income tax-based fiscal system and cemented its enduring and transformative permanence. More than its redistributive designs and its facilitation of a vast array of domestic expenditures and programs, the warfare state was the most direct font and beneficiary of the income tax’s prodigious revenue generation — a result that was entirely unexpected by many of its proponents. While acknowledging the Sixteenth Amendment’s other transformative effects on our constitutional political economy, we should be prepared to accept this product as the original and arguably most consequential outgrowth of the income tax era’s fiscal upheaval.

Phillip Magness is a policy historian, focusing on trade, taxation, and slavery in the nineteenth-century United States. His work on the constitutional history of tariffs and taxation has appeared in Constitutional Political Economy, the Journal of the Early Republic, and multiple popular outlets.  pmagness@ihs.gmu.edu

Copyright (c) 2014 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (November 2014). All EH.Net reviews are archived at http://www.eh.net/BookReview

Subject(s):Government, Law and Regulation, Public Finance
Geographic Area(s):North America
Time Period(s):19th Century
20th Century: Pre WWII

Smart Globalization: The Canadian Business and Economic History Experience

Editor(s):Smith, Andrew
Anastakis, Dimitry
Reviewer(s):McInnis, Marvin

Published by EH.Net (September 2014)

Andrew Smith and Dimitry Anastakis, editors, Smart Globalization: The Canadian Business and Economic History Experience. Toronto: University of Toronto Press, 2014. xi + 239 pp.  $28 (paperback), ISBN: 978-1-4426-1612-7.

Reviewed for EH.Net by Marvin McInnis, Professor of Economics, Queen’s University.

This is a collection of studies presented at a conference held at the University of Waterloo in January 2010. The editors offer them as exemplifications of the positive results of selective or “smart” globalization. They build especially on the writing of Dani Rodrik (e.g., Rodrik 2011). The proposition is that nations facing the integration of their economies with the rest of the world may be best advised to pursue a selective policy of some openness and some protective measures. Smith and Anastakis claim that Canadian economic history offers good examples of just such a policy stance. Economists and historians who have mostly looked upon the Canadian response to late nineteenth century globalization as essentially protectionist will be surprised by this point of view.

The inherent nature of the Canadian economy meant that from the initial time of European settlement of the country it was closely integrated into a wider world economy. Much of Canadian economic policy was based upon the desire to benefit from its international trading relationships. The dominant fact, however, facing Canadians was that their closest and most promising trading partner, the United States, had taken a steep step in a protectionist direction. The Canadian response was essentially defensive. Canada, too, became protectionist. Was this “smart” or merely a matter of just jumping onto the protectionist wagon? Wherein lay the selectivity? The usual view of the Canadian tariff is that, in a blanket fashion, protection was offered to anyone who wanted it, and even some (like the agricultural implement manufacturers) who said that they did not need it. There is little in the studies presented here that would point to clever design in the implementation of the tariff.

If one really wanted to assess whether the Canadian case exemplifies a strategic or selective use of protectionist measures within a broader accommodation to exposure to the rest of the world, one would need to carry out a carefully structured investigation. Picking and choosing studies by scholars who had other objectives in mind does not make a convincing case. Too often we are left wondering what might have been the alternative outcome. That said, the individual studies in the collection are interesting and useful contributions to our understanding of Canadian economic history. They are worth reading in their own right.

Andrew Dilley shows how the province of Ontario was able to develop hydroelectric power production and distribution as a state enterprise despite severe opposition from financiers in London. It is not shown that this was accomplished with impunity. For the editors’ purposes it would be useful to learn how the experience of the neighboring province of Quebec, acquiescing on private enterprise, contrasted with the experience of Ontario. In his chapter, Mark Kuhlberg shows how the much vaunted “manufacturing condition” imposed on pulpwood was in fact subverted by other policy aims of the province of Ontario. The requirement that pulpwood cut on crown land in Ontario be manufactured in the province, a patently protectionist measure, is shown to have had little actual effect given the exemptions offered to encourage settlement in the northern forest area. Daryl White explains how, under the stress of national emergency during World War I, Canada effectively forced the International Nickel company to refine nickel in Canada, rather than in the then non-combatant United States, to assure that Canadian nickel would not be supplied to the enemy. It is an interesting incident in Canadian development but hardly contributes to the editors’ line of argument.

Livio Di Matteo, Herbert Emery and Martin Shanahan contrast the broader developmental effects of natural resource based development in South Australia with the experience of the much more limited and differently situated area of northwestern Ontario. That certainly relates to globalization but it is not at all clear that it has much to do with protectionism, selective or not. Michael Hinton examines the widely claimed assertion that the Canadian cotton textile manufacturing industry is an outstanding example of the failure of infant industry protection. Not so, declares Hinton. Rather it was the reverse. Behind substantial tariff protection cotton textile manufacturing grew rapidly in Canada and it became a relatively efficient industry, as gauged by total factor productivity. It was not, however, the much-touted National Policy tariff of 1879 that brought this about but the enactment of a protective tariff twenty years earlier. It is less clear that this earlier protective measure was selective nor that it was the leading cause of the development of the industry. Nevertheless, Hinton’s chapter is closest to providing support for the general claim of the editors. It calls for close attention and evaluation.

Greig Mordue looks at the development of Canada’s automobile manufacturing industry. It is a subject worthy of study but can hardly be dealt with adequately in a short article or book chapter. Mordue is particularly skimpy on the early years of the development of the industry. In the 1920s Canada was a prominent exporter of automobiles. How much that had to do with a protective environment, how much to do with shrewd entrepreneurship, and how much to do with the exploitation of privileged status within the British Empire is not sorted out. As much as anything, the chapter is intended to provide some background to the more recent and innovative development of integration of the North American automotive industry. It provides a starting point, but only that.

Graham Taylor provides an account of the success of Samuel Bronfman’s Seagram Corporation in becoming whiskey distributor to the world. As much as anything this is a story of careful tip-toeing around other countries’ protectionism. This is entrepreneurial history, including the ultimate “decline of empire.” It makes a good read. Almost as if for balance Matthew Bellamy tells about beer. The issue is why Canada’s oldest and in many ways most successful of North America’s brewing industries did not establish a world presence. It might have been expected to do that. Molson, Labatt, and Carling were, at least for a time, big names in beer. The U.S. market was difficult to penetrate and Carling did it only under unusual circumstances and by Americanizing, but ultimately was unable to sustain its presence. What Bellamy does not point out is that at the beginning of the twentieth century Anheuser-Busch’s Budweiser was more of a national brand in Canada than Molson (a much older company). How is it that Foster’s of Australia may have been more successful in gaining an international presence than Labatt of Canada? The particularized European market was a tough challenge to penetrate, but what about the third world? If Canadians were able to do so well in electrical utilities and banking in third world countries, why not in beer? A lot of questions remain to be answered. The great consolidation of brewing internationally is a very recent phenomenon.

In short, the individual chapters of this book make interesting and useful contributions to our understanding of Canadian economic history. From that point of view they are well worth examining. The editors of the volume are, however, unsuccessful in using these individual studies to make a case for the cogency of selective protectionism. There is too little attention to what might have been the course of development in the absence of protectionist measures. A structured analysis of the selective protection issue is lacking.

Reference:
Dani Rodrik, 2011, The Globalization Paradox: Democracy and the Future of the World Economy, New York: Norton.

Marvin McInnis is professor of economics emeritus at Queen’s University, Canada. He is currently assembling a few of his previously unpublished papers into a book on Canadian economic development in the nineteenth and early twentieth centuries.

Copyright (c) 2014 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (September 2014). All EH.Net reviews are archived at http://www.eh.net/BookReview

Subject(s):Business History
Economic Planning and Policy
International and Domestic Trade and Relations
Geographic Area(s):North America
Time Period(s):19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII

Bertola.Uruguay.final

An Overview of the Economic History of Uruguay
since the 1870s

Luis Bértola, Universidad de la República — Uruguay

Uruguay’s Early History

Without silver or gold, without valuable species, scarcely peopled by gatherers and fishers, the Eastern Strand of the Uruguay River (Banda Oriental was the colonial name; República Oriental del Uruguay is the official name today) was, in the sixteenth and seventeenth centuries, distant and unattractive to the European nations that conquered the region. The major export product was the leather of wild descendants of cattle introduced in the early 1600s by the Spaniards. As cattle preceded humans, the state preceded society: Uruguay’s first settlement was Colonia del Sacramento, a Portuguese military fortress founded in 1680, placed precisely across from Buenos Aires, Argentina. Montevideo, also a fortress, was founded by the Spaniards in 1724. Uruguay was on the border between the Spanish and Portuguese empires, a feature which would be decisive for the creation, with strong British involvement, in 1828-1830, of an independent state.

Montevideo had the best natural harbor in the region, and rapidly became the end-point of the trans-Atlantic routes into the region, the base for a strong commercial elite, and for the Spanish navy in the region. During the first decades after independence, however, Uruguay was plagued by political instability, precarious institution building and economic retardation. Recurrent civil wars with intensive involvement by Britain, France, Portugal-Brazil and Argentina, made Uruguay a center for international conflicts, the most important being the Great War (Guerra Grande), which lasted from 1839 to 1851. At its end Uruguay had only about 130,000 inhabitants.

“Around the middle of the nineteenth century, Uruguay was dominated by the latifundium, with its ill-defined boundaries and enormous herds of native cattle, from which only the hides were exported to Great Britain and part of the meat, as jerky, to Brazil and Cuba. There was a shifting rural population that worked on the large estates and lived largely on the parts of beef carcasses that could not be marketed abroad. Often the landowners were also the caudillos of the Blanco or Colorado political parties, the protagonists of civil wars that a weak government was unable to prevent” (Barrán and Nahum, 1984, 655). This picture still holds, even if it has been excessively stylized, neglecting the importance of subsistence or domestic-market oriented peasant production.

Economic Performance in the Long Run

Despite its precarious beginnings, Uruguay’s per capita gross domestic product (GDP) growth from 1870 to 2002 shows an amazing persistence, with the long-run rate averaging around one percent per year. However, this apparent stability hides some important shifts. As shown in Figure 1, both GDP and population grew much faster before the 1930s; from 1930 to 1960 immigration vanished and population grew much more slowly, while decades of GDP stagnation and fast growth alternated; after the 1960s Uruguay became a net-emigration country, with low natural growth rates and a still spasmodic GDP growth.

GDP growth shows a pattern featured by Kuznets-like swings (Bértola and Lorenzo 2004), with extremely destructive downward phases, as shown in Table 1. This cyclical pattern is correlated with movements of the terms of trade (the relative price of exports versus imports), world demand and international capital flows. In the expansive phases exports performed well, due to increased demand and/or positive terms of trade shocks (1880s, 1900s, 1920s, 1940s and even during the Mercosur years from 1991 to 1998). Capital flows would sometimes follow these booms and prolong the cycle, or even be a decisive force to set the cycle up, as were financial flows in the 1970s and 1990s. The usual outcome, however, has been an overvalued currency, which blurred the debt problem and threatened the balance of trade by overpricing exports. Crises have been the result of a combination of changing trade conditions, devaluation and over-indebtedness, as in the 1880s, early 1910s, late 1920s, 1950s, early 1980s and late 1990s.

Population and per capita GDP of Uruguay, 1870-2002 (1913=100)

Table 1: Swings in the Uruguayan Economy, 1870-2003

Per capita GDP fall (%) Length of recession (years) Time to pre-crisis levels (years) Time to next crisis (years)
1872-1875 26 3 15 16
1888-1890 21 2 19 25
1912-1915 30 3 15 19
1930-1933 36 3 17 24-27
1954/57-59 9 2-5 18-21 27-24
1981-1984 17 3 11 17
1998-2003 21 5

Sources: See Figure 1.

Besides its cyclical movement, the terms of trade showed a sharp positive trend in 1870-1913, a strongly fluctuating pattern around similar levels in 1913-1960 and a deteriorating trend since then. While the volume of exports grew quickly up to the 1920s, it stagnated in 1930-1960 and started to grow again after 1970. As a result, the purchasing power of exports grew fourfold in 1870-1913, fluctuated along with the terms of trade in 1930-1960, and exhibited a moderate growth in 1970-2002.

The Uruguayan economy was very open to trade in the period up to 1913, featuring high export shares, which naturally declined as the rapidly growing population filled in rather empty areas. In 1930-1960 the economy was increasingly and markedly closed to international trade, but since the 1970s the economy opened up to trade again. Nevertheless, exports, which earlier were mainly directed to Europe (beef, wool, leather, linseed, etc.), were increasingly oriented to Argentina and Brazil, in the context of bilateral trade agreements in the 1970s and 1980s and of Mercosur (the trading zone encompassing Argentina, Brazil, Paraguay and Uruguay) in the 1990s.

While industrial output kept pace with agrarian export-led growth during the first globalization boom before World War I, the industrial share in GDP increased in 1930-54, and was mainly domestic-market orientated. Deindustrialization has been profound since the mid-1980s. The service sector was always large: focusing on commerce, transport and traditional state bureaucracy during the first globalization boom; focusing on health care, education and social services, during the import-substituting industrialization (ISI) period in the middle of the twentieth century; and focusing on military expenditure, tourism and finance since the 1970s.

The income distribution changed markedly over time. During the first globalization boom before World War I, an already uneven distribution of income and wealth seems to have worsened, due to massive immigration and increasing demand for land, both rural and urban. However, by the 1920s the relative prices of land and labor changed their previous trend, reducing income inequality. The trend later favored industrialization policies, democratization, introduction of wage councils, and the expansion of the welfare state based on an egalitarian ideology. Inequality diminished in many respects: between sectors, within sectors, between genders and between workers and pensioners. While the military dictatorship and the liberal economic policy implemented since the 1970s initiated a drastic reversal of the trend toward economic equality, the globalizing movements of the 1980s and 1990s under democratic rule didn’t increase equality. Thus, inequality remains at the higher levels reached during the period of dictatorship (1973-85).

Comparative Long-run Performance

If the stable long-run rate of Uruguayan per capita GDP growth hides important internal transformations, Uruguay’s changing position in the international scene is even more remarkable. During the first globalization boom the world became more unequal: the United States forged ahead as the world leader (nearly followed by other settler economies); Asia and Africa lagged far behind. Latin America showed a confusing map, in which countries as Argentina and Uruguay performed rather well, and others, such as the Andean region, lagged far behind (Bértola and Williamson 2003). Uruguay’s strong initial position tended to deteriorate in relation to the successful core countries during the late 1800s, as shown in Figure 2. This trend of negative relative growth was somewhat weak during the first half of the twentieth century, improved significantly during the 1960s, as the import-substituting industrialization model got exhausted, and has continued since the 1970s, despite policies favoring increased integration into the global economy.

 Per capita GDP of Uruguay relative to four core countries, 1870-2002

If school enrollment and literacy rates are reasonable proxies for human capital, in late 1800s both Argentina and Uruguay had a great handicap in relation to the United States, as shown in Table 2. The gap in literacy rates tended to disappear — as well as this proxy’s ability to measure comparative levels of human capital. Nevertheless, school enrollment, which includes college-level and technical education, showed a catching-up trend until the 1960’s, but reverted afterwards.

The gap in life-expectancy at birth has always been much smaller than the other development indicators. Nevertheless, some trends are noticeable: the gap increased in 1900-1930; decreased in 1930-1950; and increased again after the 1970s.

Table 2: Uruguayan Performance in Comparative Perspective, 1870-2000 (US = 100)

1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
GDP per capita

Uruguay

101 65 63 27 32 27 33 27 26 24 19 18 15 16

Argentina

63 34 38 31 32 29 25 25 24 21 15 16

Brazil

23 8 8 8 8 8 7 9 9 13 11 10
Latin America 13 12 13 10 9 9 9 6 6

USA

100 100 100 100 100 100 100 100 100 100 100 100 100 100
Literacy rates

Uruguay

57 65 72 79 85 91 92 94 95 97 99

Argentina

57 65 72 79 85 91 93 94 94 96 98

Brazil

39 38 37 42 46 51 61 69 76 81 86

Latin America

28 30 34 37 42 47 56 65 71 77 83

USA

100 100 100 100 100 100 100 100 100 100 100
School enrollment

Uruguay

23 31 31 30 34 42 52 46 43

Argentina

28 41 42 36 39 43 55 44 45

Brazil

12 11 12 14 18 22 30 42

Latin America

USA

100 100 100 100 100 100 100 100 100
Life expectancy at birth

Uruguay

102 100 91 85 91 97 97 97 95 96 96

Argentina

81 85 86 90 88 90 93 94 95 96 95
Brazil 60 60 56 58 58 63 79 83 85 88 88
Latin America 65 63 58 58 59 63 71 77 81 88 87
USA 100 100 100 100 100 100 100 100 100 100 100

Sources: Per capita GDP: Maddison (2001) and Astorga, Bergés and FitzGerald (2003). Literacy rates and life expectancy; Astorga, Bergés and FitzGerald (2003). School enrollment; Bértola and Bertoni (1998).

Uruguay during the First Globalization Boom: Challenge and Response

During the post-Great-War reconstruction after 1851, Uruguayan population grew rapidly (fueled by high natural rates and immigration) and so did per capita output. Productivity grew due to several causes including: the steam ship revolution, which critically reduced the price spread between Europe and America and eased access to the European market; railways, which contributed to the unification of domestic markets and reduced domestic transport costs; the diffusion and adaptation to domestic conditions of innovations in cattle-breeding and services; a significant reduction in transaction costs, related to a fluctuating but noticeable process of institutional building and strengthening of the coercive power of the state.

Wool and woolen products, hides and leather were exported mainly to Europe; salted beef (tasajo) to Brazil and Cuba. Livestock-breeding (both cattle and sheep) was intensive in natural resources and dominated by large estates. By the 1880s, the agrarian frontier was exhausted, land properties were fenced and property rights strengthened. Labor became abundant and concentrated in urban areas, especially around Montevideo’s harbor, which played an important role as a regional (supranational) commercial center. By 1908, it contained 40 percent of the nation’s population, which had risen to more than a million inhabitants, and provided the main part of Uruguay’s services, civil servants and the weak and handicraft-dominated manufacturing sector.

By the 1910s, Uruguayan competitiveness started to weaken. As the benefits of the old technological paradigm were eroding, the new one was not particularly beneficial for resource-intensive countries such as Uruguay. International demand shifted away from primary consumption, the population of Europe grew slowly and European countries struggled for self-sufficiency in primary production in a context of soaring world supply. Beginning in the 1920s, the cattle-breeding sector showed a very poor performance, due to lack of innovation away from natural pastures. In the 1930’s, its performance deteriorated mainly due to unfavorable international conditions. Export volumes stagnated until the 1970s, while purchasing power fluctuated strongly following the terms of trade.

Inward-looking Growth and Structural Change

The Uruguayan economy grew inwards until the 1950s. The multiple exchange rate system was the main economic policy tool. Agrarian production was re-oriented towards wool, crops, dairy products and other industrial inputs, away from beef. The manufacturing industry grew rapidly and diversified significantly, with the help of protectionist tariffs. It was light, and lacked capital goods or technology-intensive sectors. Productivity growth hinged upon technology transfers embodied in imported capital goods and an intensive domestic adaptation process of mature technologies. Domestic demand grew also through an expanding public sector and the expansion of a corporate welfare state. The terms of trade substantially impacted protectionism, productivity growth and domestic demand — the government raised money by manipulating exchange rates, so that when export prices rose the state had a greater capacity to protect the manufacturing sector through low exchange rates for capital goods, raw material and fuel imports and to spur productivity increases by imports of capital, while protection allowed industry to pay higher wages and thus expand domestic demand.

However, rent-seeking industries searching for protectionism and a weak clienteslist state, crowded by civil servants recruited in exchange for political favors to the political parties, directed structural change towards a closed economy and inefficient management. The obvious limits to inward looking growth of a country peopled by only about two million inhabitants were exacerbated in the late 1950s as terms of trade deteriorated. The clientelist political system, which was created by both traditional parties while the state was expanding at the national and local level, was now not able to absorb the increasing social conflicts, dyed by stringent ideological confrontation, in a context of stagnation and huge fiscal deficits.

Re-globalization and Regional Integration

The dictatorship (1973-1985) started a period of increasing openness to trade and deregulation which has persisted until the present. Dynamic integration into the world market is still incomplete, however. An attempt to return to cattle-breeding exports, as the engine of growth, was hindered by the oil crises and the ensuing European response, which restricted meat exports to that destination. The export sector was re-orientated towards “non-traditional exports” — i.e., exports of industrial goods made of traditional raw materials, to which low-quality and low-wage labor was added. Exports were also stimulated by means of strong fiscal exemptions and negative real interest rates and were re-orientated to the regional market (Argentina and Brazil) and to other developing regions. At the end of the 1970s, this policy was replaced by the monetarist approach to the balance of payments. The main goal was to defeat inflation (which had continued above 50% since the 1960s) through deregulation of foreign trade and a pre-announced exchange rate, the “tablita.” A strong wave of capital inflows led to a transitory success, but the Uruguayan peso became more and more overvalued, thus limiting exports, encouraging imports and deepening the chronic balance of trade deficit. The “tablita” remained dependent on increasing capital inflows and obviously collapsed when the risk of a huge devaluation became real. Recession and the debt crisis dominated the scene of the early 1980s.

Democratic regimes since 1985 have combined natural resource intensive exports to the region and other emergent markets, with a modest intra-industrial trade mainly with Argentina. In the 1990s, once again, Uruguay was overexposed to financial capital inflows which fueled a rather volatile growth period. However, by the year 2000, Uruguay had a much worse position in relation to the leaders of the world economy as measured by per capita GDP, real wages, equity and education coverage, than it had fifty years earlier.

Medium-run Prospects

In the 1990s Mercosur as a whole and each of its member countries exhibited a strong trade deficit with non-Mercosur countries. This was the result of a growth pattern fueled by and highly dependent on foreign capital inflows, combined with the traditional specialization in commodities. The whole Mercosur project is still mainly oriented toward price competitiveness. Nevertheless, the strongly divergent macroeconomic policies within Mercosur during the deep Argentine and Uruguayan crisis of the beginning of the twenty-first century, seem to have given place to increased coordination between Argentina and Brazil, thus making of the region a more stable environment.

The big question is whether the ongoing political revival of Mercosur will be able to achieve convergent macroeconomic policies, success in international trade negotiations, and, above all, achievements in developing productive networks which may allow Mercosur to compete outside its home market with knowledge-intensive goods and services. Over that hangs Uruguay’s chance to break away from its long-run divergent siesta.

References

Astorga, Pablo, Ame R. Bergés and Valpy FitzGerald. “The Standard of Living in Latin America during the Twentieth Century.” University of Oxford Discussion Papers in Economic and Social History 54 (2004).

Barrán, José P. and Benjamín Nahum. “Uruguayan Rural History.” Latin American Historical Review, 1985.

Bértola, Luis. The Manufacturing Industry of Uruguay, 1913-1961: A Sectoral Approach to Growth, Fluctuations and Crisis. Publications of the Department of Economic History, University of Göteborg, 61; Institute of Latin American Studies of Stockholm University, Monograph No. 20, 1990.

Bértola, Luis and Reto Bertoni. “Educación y aprendizaje en escenarios de convergencia y divergencia.” Documento de Trabajo, no. 46, Unidad Multidisciplinaria, Facultad de Ciencias Sociales, Universidad de la República, 1998.

Bértola, Luis and Fernando Lorenzo. “Witches in the South: Kuznets-like Swings in Argentina, Brazil and Uruguay since the 1870s.” In The Experience of Economic Growth, edited by J.L. van Zanden and S. Heikenen. Amsterdam: Aksant, 2004.

Bértola, Luis and Gabriel Porcile. “Argentina, Brasil, Uruguay y la Economía Mundial: una aproximación a diferentes regímenes de convergencia y divergencia.” In Ensayos de Historia Económica by Luis Bertola. Montevideo: Uruguay en la región y el mundo, 2000.

Bértola, Luis and Jeffrey Williamson. “Globalization in Latin America before 1940.” National Bureau of Economic Research Working Paper, no. 9687 (2003).

Bértola, Luis and others. El PBI uruguayo 1870-1936 y otras estimaciones. Montevideo, 1998.

Maddison, A. Monitoring the World Economy, 1820-1992. Paris: OECD, 1995.

Maddison, A. The World Economy: A Millennial Perspective. Paris: OECD, 2001.

An Overview of the Economic History of Uruguay since the 1870s

Luis Bértola, Universidad de la República — Uruguay

Uruguay’s Early History

Without silver or gold, without valuable species, scarcely peopled by gatherers and fishers, the Eastern Strand of the Uruguay River (Banda Oriental was the colonial name; República Oriental del Uruguay is the official name today) was, in the sixteenth and seventeenth centuries, distant and unattractive to the European nations that conquered the region. The major export product was the leather of wild descendants of cattle introduced in the early 1600s by the Spaniards. As cattle preceded humans, the state preceded society: Uruguay’s first settlement was Colonia del Sacramento, a Portuguese military fortress founded in 1680, placed precisely across from Buenos Aires, Argentina. Montevideo, also a fortress, was founded by the Spaniards in 1724. Uruguay was on the border between the Spanish and Portuguese empires, a feature which would be decisive for the creation, with strong British involvement, in 1828-1830, of an independent state.

Montevideo had the best natural harbor in the region, and rapidly became the end-point of the trans-Atlantic routes into the region, the base for a strong commercial elite, and for the Spanish navy in the region. During the first decades after independence, however, Uruguay was plagued by political instability, precarious institution building and economic retardation. Recurrent civil wars with intensive involvement by Britain, France, Portugal-Brazil and Argentina, made Uruguay a center for international conflicts, the most important being the Great War (Guerra Grande), which lasted from 1839 to 1851. At its end Uruguay had only about 130,000 inhabitants.

“Around the middle of the nineteenth century, Uruguay was dominated by the latifundium, with its ill-defined boundaries and enormous herds of native cattle, from which only the hides were exported to Great Britain and part of the meat, as jerky, to Brazil and Cuba. There was a shifting rural population that worked on the large estates and lived largely on the parts of beef carcasses that could not be marketed abroad. Often the landowners were also the caudillos of the Blanco or Colorado political parties, the protagonists of civil wars that a weak government was unable to prevent” (Barrán and Nahum, 1984, 655). This picture still holds, even if it has been excessively stylized, neglecting the importance of subsistence or domestic-market oriented peasant production.

Economic Performance in the Long Run

Despite its precarious beginnings, Uruguay’s per capita gross domestic product (GDP) growth from 1870 to 2002 shows an amazing persistence, with the long-run rate averaging around one percent per year. However, this apparent stability hides some important shifts. As shown in Figure 1, both GDP and population grew much faster before the 1930s; from 1930 to 1960 immigration vanished and population grew much more slowly, while decades of GDP stagnation and fast growth alternated; after the 1960s Uruguay became a net-emigration country, with low natural growth rates and a still spasmodic GDP growth.

GDP growth shows a pattern featured by Kuznets-like swings (Bértola and Lorenzo 2004), with extremely destructive downward phases, as shown in Table 1. This cyclical pattern is correlated with movements of the terms of trade (the relative price of exports versus imports), world demand and international capital flows. In the expansive phases exports performed well, due to increased demand and/or positive terms of trade shocks (1880s, 1900s, 1920s, 1940s and even during the Mercosur years from 1991 to 1998). Capital flows would sometimes follow these booms and prolong the cycle, or even be a decisive force to set the cycle up, as were financial flows in the 1970s and 1990s. The usual outcome, however, has been an overvalued currency, which blurred the debt problem and threatened the balance of trade by overpricing exports. Crises have been the result of a combination of changing trade conditions, devaluation and over-indebtedness, as in the 1880s, early 1910s, late 1920s, 1950s, early 1980s and late 1990s.

Population and per capita GDP of Uruguay, 1870-2002 (1913=100)

Table 1: Swings in the Uruguayan Economy, 1870-2003

Per capita GDP fall (%) Length of recession (years) Time to pre-crisis levels (years) Time to next crisis (years)
1872-1875 26 3 15 16
1888-1890 21 2 19 25
1912-1915 30 3 15 19
1930-1933 36 3 17 24-27
1954/57-59 9 2-5 18-21 27-24
1981-1984 17 3 11 17
1998-2003 21 5

Sources: See Figure 1.

Besides its cyclical movement, the terms of trade showed a sharp positive trend in 1870-1913, a strongly fluctuating pattern around similar levels in 1913-1960 and a deteriorating trend since then. While the volume of exports grew quickly up to the 1920s, it stagnated in 1930-1960 and started to grow again after 1970. As a result, the purchasing power of exports grew fourfold in 1870-1913, fluctuated along with the terms of trade in 1930-1960, and exhibited a moderate growth in 1970-2002.

The Uruguayan economy was very open to trade in the period up to 1913, featuring high export shares, which naturally declined as the rapidly growing population filled in rather empty areas. In 1930-1960 the economy was increasingly and markedly closed to international trade, but since the 1970s the economy opened up to trade again. Nevertheless, exports, which earlier were mainly directed to Europe (beef, wool, leather, linseed, etc.), were increasingly oriented to Argentina and Brazil, in the context of bilateral trade agreements in the 1970s and 1980s and of Mercosur (the trading zone encompassing Argentina, Brazil, Paraguay and Uruguay) in the 1990s.

While industrial output kept pace with agrarian export-led growth during the first globalization boom before World War I, the industrial share in GDP increased in 1930-54, and was mainly domestic-market orientated. Deindustrialization has been profound since the mid-1980s. The service sector was always large: focusing on commerce, transport and traditional state bureaucracy during the first globalization boom; focusing on health care, education and social services, during the import-substituting industrialization (ISI) period in the middle of the twentieth century; and focusing on military expenditure, tourism and finance since the 1970s.

The income distribution changed markedly over time. During the first globalization boom before World War I, an already uneven distribution of income and wealth seems to have worsened, due to massive immigration and increasing demand for land, both rural and urban. However, by the 1920s the relative prices of land and labor changed their previous trend, reducing income inequality. The trend later favored industrialization policies, democratization, introduction of wage councils, and the expansion of the welfare state based on an egalitarian ideology. Inequality diminished in many respects: between sectors, within sectors, between genders and between workers and pensioners. While the military dictatorship and the liberal economic policy implemented since the 1970s initiated a drastic reversal of the trend toward economic equality, the globalizing movements of the 1980s and 1990s under democratic rule didn’t increase equality. Thus, inequality remains at the higher levels reached during the period of dictatorship (1973-85).

Comparative Long-run Performance

If the stable long-run rate of Uruguayan per capita GDP growth hides important internal transformations, Uruguay’s changing position in the international scene is even more remarkable. During the first globalization boom the world became more unequal: the United States forged ahead as the world leader (nearly followed by other settler economies); Asia and Africa lagged far behind. Latin America showed a confusing map, in which countries as Argentina and Uruguay performed rather well, and others, such as the Andean region, lagged far behind (Bértola and Williamson 2003). Uruguay’s strong initial position tended to deteriorate in relation to the successful core countries during the late 1800s, as shown in Figure 2. This trend of negative relative growth was somewhat weak during the first half of the twentieth century, improved significantly during the 1960s, as the import-substituting industrialization model got exhausted, and has continued since the 1970s, despite policies favoring increased integration into the global economy.

 Per capita GDP of Uruguay relative to four core countries,  1870-2002

If school enrollment and literacy rates are reasonable proxies for human capital, in late 1800s both Argentina and Uruguay had a great handicap in relation to the United States, as shown in Table 2. The gap in literacy rates tended to disappear — as well as this proxy’s ability to measure comparative levels of human capital. Nevertheless, school enrollment, which includes college-level and technical education, showed a catching-up trend until the 1960’s, but reverted afterwards.

The gap in life-expectancy at birth has always been much smaller than the other development indicators. Nevertheless, some trends are noticeable: the gap increased in 1900-1930; decreased in 1930-1950; and increased again after the 1970s.

Table 2: Uruguayan Performance in Comparative Perspective, 1870-2000 (US = 100)

1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
GDP per capita

Uruguay

101 65 63 27 32 27 33 27 26 24 19 18 15 16

Argentina

63 34 38 31 32 29 25 25 24 21 15 16

Brazil

23 8 8 8 8 8 7 9 9 13 11 10
Latin America 13 12 13 10 9 9 9 6 6

USA

100 100 100 100 100 100 100 100 100 100 100 100 100 100
Literacy rates

Uruguay

57 65 72 79 85 91 92 94 95 97 99

Argentina

57 65 72 79 85 91 93 94 94 96 98

Brazil

39 38 37 42 46 51 61 69 76 81 86

Latin America

28 30 34 37 42 47 56 65 71 77 83

USA

100 100 100 100 100 100 100 100 100 100 100
School enrollment

Uruguay

23 31 31 30 34 42 52 46 43

Argentina

28 41 42 36 39 43 55 44 45

Brazil

12 11 12 14 18 22 30 42

Latin America

USA

100 100 100 100 100 100 100 100 100
Life expectancy at birth

Uruguay

102 100 91 85 91 97 97 97 95 96 96

Argentina

81 85 86 90 88 90 93 94 95 96 95
Brazil 60 60 56 58 58 63 79 83 85 88 88
Latin America 65 63 58 58 59 63 71 77 81 88 87
USA 100 100 100 100 100 100 100 100 100 100 100

Sources: Per capita GDP: Maddison (2001) and Astorga, Bergés and FitzGerald (2003). Literacy rates and life expectancy; Astorga, Bergés and FitzGerald (2003). School enrollment; Bértola and Bertoni (1998).

Uruguay during the First Globalization Boom: Challenge and Response

During the post-Great-War reconstruction after 1851, Uruguayan population grew rapidly (fueled by high natural rates and immigration) and so did per capita output. Productivity grew due to several causes including: the steam ship revolution, which critically reduced the price spread between Europe and America and eased access to the European market; railways, which contributed to the unification of domestic markets and reduced domestic transport costs; the diffusion and adaptation to domestic conditions of innovations in cattle-breeding and services; a significant reduction in transaction costs, related to a fluctuating but noticeable process of institutional building and strengthening of the coercive power of the state.

Wool and woolen products, hides and leather were exported mainly to Europe; salted beef (tasajo) to Brazil and Cuba. Livestock-breeding (both cattle and sheep) was intensive in natural resources and dominated by large estates. By the 1880s, the agrarian frontier was exhausted, land properties were fenced and property rights strengthened. Labor became abundant and concentrated in urban areas, especially around Montevideo’s harbor, which played an important role as a regional (supranational) commercial center. By 1908, it contained 40 percent of the nation’s population, which had risen to more than a million inhabitants, and provided the main part of Uruguay’s services, civil servants and the weak and handicraft-dominated manufacturing sector.

By the 1910s, Uruguayan competitiveness started to weaken. As the benefits of the old technological paradigm were eroding, the new one was not particularly beneficial for resource-intensive countries such as Uruguay. International demand shifted away from primary consumption, the population of Europe grew slowly and European countries struggled for self-sufficiency in primary production in a context of soaring world supply. Beginning in the 1920s, the cattle-breeding sector showed a very poor performance, due to lack of innovation away from natural pastures. In the 1930’s, its performance deteriorated mainly due to unfavorable international conditions. Export volumes stagnated until the 1970s, while purchasing power fluctuated strongly following the terms of trade.

Inward-looking Growth and Structural Change

The Uruguayan economy grew inwards until the 1950s. The multiple exchange rate system was the main economic policy tool. Agrarian production was re-oriented towards wool, crops, dairy products and other industrial inputs, away from beef. The manufacturing industry grew rapidly and diversified significantly, with the help of protectionist tariffs. It was light, and lacked capital goods or technology-intensive sectors. Productivity growth hinged upon technology transfers embodied in imported capital goods and an intensive domestic adaptation process of mature technologies. Domestic demand grew also through an expanding public sector and the expansion of a corporate welfare state. The terms of trade substantially impacted protectionism, productivity growth and domestic demand — the government raised money by manipulating exchange rates, so that when export prices rose the state had a greater capacity to protect the manufacturing sector through low exchange rates for capital goods, raw material and fuel imports and to spur productivity increases by imports of capital, while protection allowed industry to pay higher wages and thus expand domestic demand.

However, rent-seeking industries searching for protectionism and a weak clienteslist state, crowded by civil servants recruited in exchange for political favors to the political parties, directed structural change towards a closed economy and inefficient management. The obvious limits to inward looking growth of a country peopled by only about two million inhabitants were exacerbated in the late 1950s as terms of trade deteriorated. The clientelist political system, which was created by both traditional parties while the state was expanding at the national and local level, was now not able to absorb the increasing social conflicts, dyed by stringent ideological confrontation, in a context of stagnation and huge fiscal deficits.

Re-globalization and Regional Integration

The dictatorship (1973-1985) started a period of increasing openness to trade and deregulation which has persisted until the present. Dynamic integration into the world market is still incomplete, however. An attempt to return to cattle-breeding exports, as the engine of growth, was hindered by the oil crises and the ensuing European response, which restricted meat exports to that destination. The export sector was re-orientated towards “non-traditional exports” — i.e., exports of industrial goods made of traditional raw materials, to which low-quality and low-wage labor was added. Exports were also stimulated by means of strong fiscal exemptions and negative real interest rates and were re-orientated to the regional market (Argentina and Brazil) and to other developing regions. At the end of the 1970s, this policy was replaced by the monetarist approach to the balance of payments. The main goal was to defeat inflation (which had continued above 50% since the 1960s) through deregulation of foreign trade and a pre-announced exchange rate, the “tablita.” A strong wave of capital inflows led to a transitory success, but the Uruguayan peso became more and more overvalued, thus limiting exports, encouraging imports and deepening the chronic balance of trade deficit. The “tablita” remained dependent on increasing capital inflows and obviously collapsed when the risk of a huge devaluation became real. Recession and the debt crisis dominated the scene of the early 1980s.

Democratic regimes since 1985 have combined natural resource intensive exports to the region and other emergent markets, with a modest intra-industrial trade mainly with Argentina. In the 1990s, once again, Uruguay was overexposed to financial capital inflows which fueled a rather volatile growth period. However, by the year 2000, Uruguay had a much worse position in relation to the leaders of the world economy as measured by per capita GDP, real wages, equity and education coverage, than it had fifty years earlier.

Medium-run Prospects

In the 1990s Mercosur as a whole and each of its member countries exhibited a strong trade deficit with non-Mercosur countries. This was the result of a growth pattern fueled by and highly dependent on foreign capital inflows, combined with the traditional specialization in commodities. The whole Mercosur project is still mainly oriented toward price competitiveness. Nevertheless, the strongly divergent macroeconomic policies within Mercosur during the deep Argentine and Uruguayan crisis of the beginning of the twenty-first century, seem to have given place to increased coordination between Argentina and Brazil, thus making of the region a more stable environment.

The big question is whether the ongoing political revival of Mercosur will be able to achieve convergent macroeconomic policies, success in international trade negotiations, and, above all, achievements in developing productive networks which may allow Mercosur to compete outside its home market with knowledge-intensive goods and services. Over that hangs Uruguay’s chance to break away from its long-run divergent siesta.

References

Astorga, Pablo, Ame R. Bergés and Valpy FitzGerald. “The Standard of Living in Latin America during the Twentieth Century.” University of Oxford Discussion Papers in Economic and Social History 54 (2004).

Barrán, José P. and Benjamín Nahum. “Uruguayan Rural History.” Latin American Historical Review, 1985.

Bértola, Luis. The Manufacturing Industry of Uruguay, 1913-1961: A Sectoral Approach to Growth, Fluctuations and Crisis. Publications of the Department of Economic History, University of Göteborg, 61; Institute of Latin American Studies of Stockholm University, Monograph No. 20, 1990.

Bértola, Luis and Reto Bertoni. “Educación y aprendizaje en escenarios de convergencia y divergencia.” Documento de Trabajo, no. 46, Unidad Multidisciplinaria, Facultad de Ciencias Sociales, Universidad de la República, 1998.

Bértola, Luis and Fernando Lorenzo. “Witches in the South: Kuznets-like Swings in Argentina, Brazil and Uruguay since the 1870s.” In The Experience of Economic Growth, edited by J.L. van Zanden and S. Heikenen. Amsterdam: Aksant, 2004.

Bértola, Luis and Gabriel Porcile. “Argentina, Brasil, Uruguay y la Economía Mundial: una aproximación a diferentes regímenes de convergencia y divergencia.” In Ensayos de Historia Económica by Luis Bertola. Montevideo: Uruguay en la región y el mundo, 2000.

Bértola, Luis and Jeffrey Williamson. “Globalization in Latin America before 1940.” National Bureau of Economic Research Working Paper, no. 9687 (2003).

Bértola, Luis and others. El PBI uruguayo 1870-1936 y otras estimaciones. Montevideo, 1998.

Maddison, A. Monitoring the World Economy, 1820-1992. Paris: OECD, 1995.

Maddison, A. The World Economy: A Millennial

Citation: Bertola, Luis. “An Overview of the Economic History of Uruguay since the 1870s”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/article/Bertola.Uruguay.final

The 1929 Stock Market Crash

Harold Bierman, Jr., Cornell University

Overview

The 1929 stock market crash is conventionally said to have occurred on Thursday the 24th and Tuesday the 29th of October. These two dates have been dubbed “Black Thursday” and “Black Tuesday,” respectively. On September 3, 1929, the Dow Jones Industrial Average reached a record high of 381.2. At the end of the market day on Thursday, October 24, the market was at 299.5 — a 21 percent decline from the high. On this day the market fell 33 points — a drop of 9 percent — on trading that was approximately three times the normal daily volume for the first nine months of the year. By all accounts, there was a selling panic. By November 13, 1929, the market had fallen to 199. By the time the crash was completed in 1932, following an unprecedentedly large economic depression, stocks had lost nearly 90 percent of their value.

The events of Black Thursday are normally defined to be the start of the stock market crash of 1929-1932, but the series of events leading to the crash started before that date. This article examines the causes of the 1929 stock market crash. While no consensus exists about its precise causes, the article will critique some arguments and support a preferred set of conclusions. It argues that one of the primary causes was the attempt by important people and the media to stop market speculators. A second probable cause was the great expansion of investment trusts, public utility holding companies, and the amount of margin buying, all of which fueled the purchase of public utility stocks, and drove up their prices. Public utilities, utility holding companies, and investment trusts were all highly levered using large amounts of debt and preferred stock. These factors seem to have set the stage for the triggering event. This sector was vulnerable to the arrival of bad news regarding utility regulation. In October 1929, the bad news arrived and utility stocks fell dramatically. After the utilities decreased in price, margin buyers had to sell and there was then panic selling of all stocks.

The Conventional View

The crash helped bring on the depression of the thirties and the depression helped to extend the period of low stock prices, thus “proving” to many that the prices had been too high.

Laying the blame for the “boom” on speculators was common in 1929. Thus, immediately upon learning of the crash of October 24 John Maynard Keynes (Moggridge, 1981, p. 2 of Vol. XX) wrote in the New York Evening Post (25 October 1929) that “The extraordinary speculation on Wall Street in past months has driven up the rate of interest to an unprecedented level.” And the Economist when stock prices reached their low for the year repeated the theme that the U.S. stock market had been too high (November 2, 1929, p. 806): “there is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world.” The key phrases in these quotations are “exaggerated balloon of American stock values” and “extraordinary speculation on Wall Street.” Likewise, President Herbert Hoover saw increasing stock market prices leading up to the crash as a speculative bubble manufactured by the mistakes of the Federal Reserve Board. “One of these clouds was an American wave of optimism, born of continued progress over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississippi Bubble” (Hoover, 1952). Thus, the common viewpoint was that stock prices were too high.

There is much to criticize in conventional interpretations of the 1929 stock market crash, however. (Even the name is inexact. The largest losses to the market did not come in October 1929 but rather in the following two years.) In December 1929, many expert economists, including Keynes and Irving Fisher, felt that the financial crisis had ended and by April 1930 the Standard and Poor 500 composite index was at 25.92, compared to a 1929 close of 21.45. There are good reasons for thinking that the stock market was not obviously overvalued in 1929 and that it was sensible to hold most stocks in the fall of 1929 and to buy stocks in December 1929 (admittedly this investment strategy would have been terribly unsuccessful).

Were Stocks Obviously Overpriced in October 1929?
Debatable — Economic Indicators Were Strong

From 1925 to the third quarter of 1929, common stocks increased in value by 120 percent in four years, a compound annual growth of 21.8%. While this is a large rate of appreciation, it is not obvious proof of an “orgy of speculation.” The decade of the 1920s was extremely prosperous and the stock market with its rising prices reflected this prosperity as well as the expectation that the prosperity would continue.

The fact that the stock market lost 90 percent of its value from 1929 to 1932 indicates that the market, at least using one criterion (actual performance of the market), was overvalued in 1929. John Kenneth Galbraith (1961) implies that there was a speculative orgy and that the crash was predictable: “Early in 1928, the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.” Galbraith had no difficulty in 1961 identifying the end of the boom in 1929: “On the first of January of 1929, as a matter of probability, it was most likely that the boom would end before the year was out.”

Compare this position with the fact that Irving Fisher, one of the leading economists in the U.S. at the time, was heavily invested in stocks and was bullish before and after the October sell offs; he lost his entire wealth (including his house) before stocks started to recover. In England, John Maynard Keynes, possibly the world’s leading economist during the first half of the twentieth century, and an acknowledged master of practical finance, also lost heavily. Paul Samuelson (1979) quotes P. Sergeant Florence (another leading economist): “Keynes may have made his own fortune and that of King’s College, but the investment trust of Keynes and Dennis Robertson managed to lose my fortune in 1929.”

Galbraith’s ability to ‘forecast’ the market turn is not shared by all. Samuelson (1979) admits that: “playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught by the 1929 debacle.” For many, the collapse from 1929 to 1933 was neither foreseeable nor inevitable.

The stock price increases leading to October 1929, were not driven solely by fools or speculators. There were also intelligent, knowledgeable investors who were buying or holding stocks in September and October 1929. Also, leading economists, both then and now, could neither anticipate nor explain the October 1929 decline of the market. Thus, the conviction that stocks were obviously overpriced is somewhat of a myth.

The nation’s total real income rose from 1921 to 1923 by 10.5% per year, and from 1923 to 1929, it rose 3.4% per year. The 1920s were, in fact, a period of real growth and prosperity. For the period of 1923-1929, wholesale prices went down 0.9% per year, reflecting moderate stable growth in the money supply during a period of healthy real growth.

Examining the manufacturing situation in the United States prior to the crash is also informative. Irving Fisher’s Stock Market Crash and After (1930) offers much data indicating that there was real growth in the manufacturing sector. The evidence presented goes a long way to explain Fisher’s optimism regarding the level of stock prices. What Fisher saw was manufacturing efficiency rapidly increasing (output per worker) as was manufacturing output and the use of electricity.

The financial fundamentals of the markets were also strong. During 1928, the price-earnings ratio for 45 industrial stocks increased from approximately 12 to approximately 14. It was over 15 in 1929 for industrials and then decreased to approximately 10 by the end of 1929. While not low, these price-earnings (P/E) ratios were by no means out of line historically. Values in this range would be considered reasonable by most market analysts today. For example, the P/E ratio of the S & P 500 in July 2003 reached a high of 33 and in May 2004 the high was 23.

The rise in stock prices was not uniform across all industries. The stocks that went up the most were in industries where the economic fundamentals indicated there was cause for large amounts of optimism. They included airplanes, agricultural implements, chemicals, department stores, steel, utilities, telephone and telegraph, electrical equipment, oil, paper, and radio. These were reasonable choices for expectations of growth.

To put the P/E ratios of 10 to 15 in perspective, note that government bonds in 1929 yielded 3.4%. Industrial bonds of investment grade were yielding 5.1%. Consider that an interest rate of 5.1% represents a 1/(0.051) = 19.6 price-earnings ratio for debt.

In 1930, the Federal Reserve Bulletin reported production in 1920 at an index of 87.1 The index went down to 67 in 1921, then climbed steadily (except for 1924) until it reached 125 in 1929. This is an annual growth rate in production of 3.1%. During the period commodity prices actually decreased. The production record for the ten-year period was exceptionally good.

Factory payrolls in September were at an index of 111 (an all-time high). In October the index dropped to 110, which beat all previous months and years except for September 1929. The factory employment measures were consistent with the payroll index.

The September unadjusted measure of freight car loadings was at 121 — also an all-time record.2 In October the loadings dropped to 118, which was a performance second only to September’s record measure.

J.W. Kendrick (1961) shows that the period 1919-1929 had an unusually high rate of change in total factor productivity. The annual rate of change of 5.3% for 1919-1929 for the manufacturing sector was more than twice the 2.5% rate of the second best period (1948-1953). Farming productivity change for 1919-1929 was second only to the period 1929-1937. Overall, the period 1919-1929 easily took first place for productivity increases, handily beating the six other time periods studied by Kendrick (all the periods studies were prior to 1961) with an annual productivity change measure of 3.7%. This was outstanding economic performance — performance which normally would justify stock market optimism.

In the first nine months of 1929, 1,436 firms announced increased dividends. In 1928, the number was only 955 and in 1927, it was 755. In September 1929 dividend increased were announced by 193 firms compared with 135 the year before. The financial news from corporations was very positive in September and October 1929.

The May issue of the National City Bank of New York Newsletter indicated the earnings statements for the first quarter of surveyed firms showed a 31% increase compared to the first quarter of 1928. The August issue showed that for 650 firms the increase for the first six months of 1929 compared to 1928 was 24.4%. In September, the results were expanded to 916 firms with a 27.4% increase. The earnings for the third quarter for 638 firms were calculated to be 14.1% larger than for 1928. This is evidence that the general level of business activity and reported profits were excellent at the end of September 1929 and the middle of October 1929.

Barrie Wigmore (1985) researched 1929 financial data for 135 firms. The market price as a percentage of year-end book value was 420% using the high prices and 181% using the low prices. However, the return on equity for the firms (using the year-end book value) was a high 16.5%. The dividend yield was 2.96% using the high stock prices and 5.9% using the low stock prices.

Article after article from January to October in business magazines carried news of outstanding economic performance. E.K. Berger and A.M. Leinbach, two staff writers of the Magazine of Wall Street, wrote in June 1929: “Business so far this year has astonished even the perennial optimists.”

To summarize: There was little hint of a severe weakness in the real economy in the months prior to October 1929. There is a great deal of evidence that in 1929 stock prices were not out of line with the real economics of the firms that had issued the stock. Leading economists were betting that common stocks in the fall of 1929 were a good buy. Conventional financial reports of corporations gave cause for optimism relative to the 1929 earnings of corporations. Price-earnings ratios, dividend amounts and changes in dividends, and earnings and changes in earnings all gave cause for stock price optimism.

Table 1 shows the average of the highs and lows of the Dow Jones Industrial Index for 1922 to 1932.

Table 1
Dow-Jones Industrials Index Average
of Lows and Highs for the Year
1922 91.0
1923 95.6
1924 104.4
1925 137.2
1926 150.9
1927 177.6
1928 245.6
1929 290.0
1930 225.8
1931 134.1
1932 79.4

Sources: 1922-1929 measures are from the Stock Market Study, U.S. Senate, 1955, pp. 40, 49, 110, and 111; 1930-1932 Wigmore, 1985, pp. 637-639.

Using the information of Table 1, from 1922 to 1929 stocks rose in value by 218.7%. This is equivalent to an 18% annual growth rate in value for the seven years. From 1929 to 1932 stocks lost 73% of their value (different indices measured at different time would give different measures of the increase and decrease). The price increases were large, but not beyond comprehension. The price decreases taken to 1932 were consistent with the fact that by 1932 there was a worldwide depression.

If we take the 386 high of September 1929 and the 1929-year end value of 248.5, the market lost 36% of its value during that four-month period. Most of us, if we held stock in September 1929 would not have sold early in October. In fact, if I had money to invest, I would have purchased after the major break on Black Thursday, October 24. (I would have been sorry.)

Events Precipitating the Crash

Although it can be argued that the stock market was not overvalued, there is evidence that many feared that it was overvalued — including the Federal Reserve Board and the United States Senate. By 1929, there were many who felt the market price of equity securities had increased too much, and this feeling was reinforced daily by the media and statements by influential government officials.

What precipitated the October 1929 crash?

My research minimizes several candidates that are frequently cited by others (see Bierman 1991, 1998, 1999, and 2001).

  • The market did not fall just because it was too high — as argued above it is not obvious that it was too high.
  • The actions of the Federal Reserve, while not always wise, cannot be directly identified with the October stock market crashes in an important way.
  • The Smoot-Hawley tariff, while looming on the horizon, was not cited by the news sources in 1929 as a factor, and was probably not important to the October 1929 market.
  • The Hatry Affair in England was not material for the New York Stock Exchange and the timing did not coincide with the October crashes.
  • Business activity news in October was generally good and there were very few hints of a coming depression.
  • Short selling and bear raids were not large enough to move the entire market.
  • Fraud and other illegal or immoral acts were not material, despite the attention they have received.

Barsky and DeLong (1990, p. 280) stress the importance of fundamentals rather than fads or fashions. “Our conclusion is that major decade-to-decade stock market movements arise predominantly from careful re-evaluation of fundamentals and less so from fads or fashions.” The argument below is consistent with their conclusion, but there will be one major exception. In September 1929, the market value of one segment of the market, the public utility sector, should be based on existing fundamentals, and fundamentals seem to have changed considerably in October 1929.

A Look at the Financial Press

Thursday, October 3, 1929, the Washington Post with a page 1 headline exclaimed “Stock Prices Crash in Frantic Selling.” the New York Times of October 4 headed a page 1 article with “Year’s Worst Break Hits Stock Market.” The article on the first page of the Times cited three contributing factors:

  • A large broker loan increase was expected (the article stated that the loans increased, but the increase was not as large as expected).
  • The statement by Philip Snowden, England’s Chancellor of the Exchequer that described America’s stock market as a “speculative orgy.”
  • Weakening of margin accounts making it necessary to sell, which further depressed prices.

While the 1928 and 1929 financial press focused extensively and excessively on broker loans and margin account activity, the statement by Snowden is the only unique relevant news event on October 3. The October 4 (p. 20) issue of the Wall Street Journal also reported the remark by Snowden that there was “a perfect orgy of speculation.” Also, on October 4, the New York Times made another editorial reference to Snowden’s American speculation orgy. It added that “Wall Street had come to recognize its truth.” The editorial also quoted Secretary of the Treasury Mellon that investors “acted as if the price of securities would infinitely advance.” The Times editor obviously thought there was excessive speculation, and agreed with Snowden.

The stock market went down on October 3 and October 4, but almost all reported business news was very optimistic. The primary negative news item was the statement by Snowden regarding the amount of speculation in the American stock market. The market had been subjected to a barrage of statements throughout the year that there was excessive speculation and that the level of stock prices was too high. There is a possibility that the Snowden comment reported on October 3 was the push that started the boulder down the hill, but there were other events that also jeopardized the level of the market.

On August 8, the Federal Reserve Bank of New York had increased the rediscount rate from 5 to 6%. On September 26 the Bank of England raised its discount rate from 5.5 to 6.5%. England was losing gold as a result of investment in the New York Stock Exchange and wanted to decrease this investment. The Hatry Case also happened in September. It was first reported on September 29, 1929. Both the collapse of the Hatry industrial empire and the increase in the investment returns available in England resulted in shrinkage of English investment (especially the financing of broker loans) in the United States, adding to the market instability in the beginning of October.

Wednesday, October 16, 1929

On Wednesday, October 16, stock prices again declined. the Washington Post (October 17, p. 1) reported “Crushing Blow Again Dealt Stock Market.” Remember, the start of the stock market crash is conventionally identified with Black Thursday, October 24, but there were price declines on October 3, 4, and 16.

The news reports of the Post on October 17 and subsequent days are important since they were Associated Press (AP) releases, thus broadly read throughout the country. The Associated Press reported (p. 1) “The index of 20 leading public utilities computed for the Associated Press by the Standard Statistics Co. dropped 19.7 points to 302.4 which contrasts with the year’s high established less than a month ago.” This index had also dropped 18.7 points on October 3 and 4.3 points on October 4. The Times (October 17, p. 38) reported, “The utility stocks suffered most as a group in the day’s break.”

The economic news after the price drops of October 3 and October 4 had been good. But the deluge of bad news regarding public utility regulation seems to have truly upset the market. On Saturday, October 19, the Washington Post headlined (p. 13) “20 Utility Stocks Hit New Low Mark” and (Associated Press) “The utility shares again broke wide open and the general list came tumbling down almost half as far.” The October 20 issue of the Post had another relevant AP article (p. 12) “The selling again concentrated today on the utilities, which were in general depressed to the lowest levels since early July.”

An evaluation of the October 16 break in the New York Times on Sunday, October 20 (pp. 1 and 29) gave the following favorable factors:

  • stable business condition
  • low money rates (5%)
  • good retail trade
  • revival of the bond market
  • buying power of investment trusts
  • largest short interest in history (this is the total dollar value of stock sold where the investors do not own the stock they sold)

The following negative factors were described:

  • undigested investment trusts and new common stock shares
  • increase in broker loans
  • some high stock prices
  • agricultural prices lower
  • nervous market

The negative factors were not very upsetting to an investor if one was optimistic that the real economic boom (business prosperity) would continue. The Times failed to consider the impact on the market of the news concerning the regulation of public utilities.

Monday, October 21, 1929

On Monday, October 21, the market went down again. The Times (October 22) identified the causes to be

  • margin sellers (buyers on margin being forced to sell)
  • foreign money liquidating
  • skillful short selling

The same newspaper carried an article about a talk by Irving Fisher (p. 24) “Fisher says prices of stocks are low.” Fisher also defended investment trusts as offering investors diversification, thus reduced risk. He was reminded by a person attending the talk that in May he had “pointed out that predicting the human behavior of the market was quite different from analyzing its economic soundness.” Fisher was better with fundamentals than market psychology.

Wednesday, October 23, 1929

On Wednesday, October 23 the market tumbled. The Times headlines (October 24, p.1) said “Prices of Stocks Crash in Heavy Liquidation.” The Washington Post (p. 1) had “Huge Selling Wave Creates Near-Panic as Stocks Collapse.” In a total market value of $87 billion the market declined $4 billion — a 4.6% drop. If the events of the next day (Black Thursday) had not occurred, October 23 would have gone down in history as a major stock market event. But October 24 was to make the “Crash” of October 23 become merely a “Dip.”

The Times lamented October 24, (p. 38) “There was hardly a single item of news which might be construed as bearish.”

Thursday, October 24, 1929

Thursday, October 24 (Black Thursday) was a 12,894,650 share day (the previous record was 8,246,742 shares on March 26, 1929) on the NYSE. The headline on page one of the Times (October 25) was “Treasury Officials Blame Speculation.”

The Times (p. 41) moaned that the cost of call money had been 20% in March and the price break in March was understandable. (A call loan is a loan payable on demand of the lender.) Call money on October 24 cost only 5%. There should not have been a crash. The Friday Wall Street Journal (October 25) gave New York bankers credit for stopping the price decline with $1 billion of support.

the Washington Post (October 26, p. 1) reported “Market Drop Fails to Alarm Officials.” The “officials” were all in Washington. The rest of the country seemed alarmed. On October 25, the market gained. President Hoover made a statement on Friday regarding the excellent state of business, but then added how building and construction had been adversely “affected by the high interest rates induced by stock speculation” (New York Times, October 26, p. 1). A Times editorial (p. 16) quoted Snowden’s “orgy of speculation” again.

Tuesday, October 29, 1929

The Sunday, October 27 edition of the Times had a two-column article “Bay State Utilities Face Investigation.” It implied that regulation in Massachusetts was going to be less friendly towards utilities. Stocks again went down on Monday, October 28. There were 9,212,800 shares traded (3,000,000 in the final hour). The Times on Tuesday, October 29 again carried an article on the New York public utility investigating committee being critical of the rate making process. October 29 was “Black Tuesday.” The headline the next day was “Stocks Collapse in 16,410,030 Share Day” (October 30, p. 1). Stocks lost nearly $16 billion in the month of October or 18% of the beginning of the month value. Twenty-nine public utilities (tabulated by the New York Times) lost $5.1 billion in the month, by far the largest loss of any of the industries listed by the Times. The value of the stocks of all public utilities went down by more than $5.1 billion.

An Interpretive Overview of Events and Issues

My interpretation of these events is that the statement by Snowden, Chancellor of the Exchequer, indicating the presence of a speculative orgy in America is likely to have triggered the October 3 break. Public utility stocks had been driven up by an explosion of investment trust formation and investing. The trusts, to a large extent, bought stock on margin with funds loaned not by banks but by “others.” These funds were very sensitive to any market weakness. Public utility regulation was being reviewed by the Federal Trade Commission, New York City, New York State, and Massachusetts, and these reviews were watched by the other regulatory commissions and by investors. The sell-off of utility stocks from October 16 to October 23 weakened prices and created “margin selling” and withdrawal of capital by the nervous “other” money. Then on October 24, the selling panic happened.

There are three topics that require expansion. First, there is the setting of the climate concerning speculation that may have led to the possibility of relatively specific issues being able to trigger a general market decline. Second, there are investment trusts, utility holding companies, and margin buying that seem to have resulted in one sector being very over-levered and overvalued. Third, there are the public utility stocks that appear to be the best candidate as the actual trigger of the crash.

Contemporary Worries of Excessive Speculation

During 1929, the public was bombarded with statements of outrage by public officials regarding the speculative orgy taking place on the New York Stock Exchange. If the media say something often enough, a large percentage of the public may come to believe it. By October 29 the overall opinion was that there had been excessive speculation and the market had been too high. Galbraith (1961), Kindleberger (1978), and Malkiel (1996) all clearly accept this assumption. the Federal Reserve Bulletin of February 1929 states that the Federal Reserve would restrain the use of “credit facilities in aid of the growth of speculative credit.”

In the spring of 1929, the U.S. Senate adopted a resolution stating that the Senate would support legislation “necessary to correct the evil complained of and prevent illegitimate and harmful speculation” (Bierman, 1991).

The President of the Investment Bankers Association of America, Trowbridge Callaway, gave a talk in which he spoke of “the orgy of speculation which clouded the country’s vision.”

Adolph Casper Miller, an outspoken member of the Federal Reserve Board from its beginning described 1929 as “this period of optimism gone wild and cupidity gone drunk.”

Myron C. Taylor, head of U.S. Steel described “the folly of the speculative frenzy that lifted securities to levels far beyond any warrant of supporting profits.”

Herbert Hoover becoming president in March 1929 was a very significant event. He was a good friend and neighbor of Adolph Miller (see above) and Miller reinforced Hoover’s fears. Hoover was an aggressive foe of speculation. For example, he wrote, “I sent individually for the editors and publishers of major newspapers and magazine and requested them systematically to warn the country against speculation and the unduly high price of stocks.” Hoover then pressured Secretary of the Treasury Andrew Mellon and Governor of the Federal Reserve Board Roy Young “to strangle the speculative movement.” In his memoirs (1952) he titled his Chapter 2 “We Attempt to Stop the Orgy of Speculation” reflecting Snowden’s influence.

Buying on Margin

Margin buying during the 1920’s was not controlled by the government. It was controlled by brokers interested in their own well-being. The average margin requirement was 50% of the stock price prior to October 1929. On selected stocks, it was as high as 75%. When the crash came, no major brokerage firm was bankrupted, because the brokers managed their finances in a conservative manner. At the end of October, margins were lowered to 25%.

Brokers’ loans received a lot of attention in England, as they did in the United States. The Financial Times reported the level and the changes in the amount regularly. For example, the October 4 issue indicated that on October 3 broker loans reached a record high as money rates dropped from 7.5% to 6%. By October 9, money rates had dropped further to below .06. Thus, investors prior to October 24 had relatively easy access to funds at the lowest rate since July 1928.

The Financial Times (October 7, 1929, p. 3) reported that the President of the American Bankers Association was concerned about the level of credit for securities and had given a talk in which he stated, “Bankers are gravely alarmed over the mounting volume of credit being employed in carrying security loans, both by brokers and by individuals.” The Financial Times was also concerned with the buying of investment trusts on margin and the lack of credit to support the bull market.

My conclusion is that the margin buying was a likely factor in causing stock prices to go up, but there is no reason to conclude that margin buying triggered the October crash. Once the selling rush began, however, the calling of margin loans probably exacerbated the price declines. (A calling of margin loans requires the stock buyer to contribute more cash to the broker or the broker sells the stock to get the cash.)

Investment Trusts

By 1929, investment trusts were very popular with investors. These trusts were the 1929 version of closed-end mutual funds. In recent years seasoned closed-end mutual funds sell at a discount to their fundamental value. The fundamental value is the sum of the market values of the fund’s components (securities in the portfolio). In 1929, the investment trusts sold at a premium — i.e. higher than the value of the underlying stocks. Malkiel concludes (p. 51) that this “provides clinching evidence of wide-scale stock-market irrationality during the 1920s.” However, Malkiel also notes (p. 442) “as of the mid-1990’s, Berkshire Hathaway shares were selling at a hefty premium over the value of assets it owned.” Warren Buffett is the guiding force behind Berkshire Hathaway’s great success as an investor. If we were to conclude that rational investors would currently pay a premium for Warren Buffet’s expertise, then we should reject a conclusion that the 1929 market was obviously irrational. We have current evidence that rational investors will pay a premium for what they consider to be superior money management skills.

There were $1 billion of investment trusts sold to investors in the first eight months of 1929 compared to $400 million in the entire 1928. the Economist reported that this was important (October 12, 1929, p. 665). “Much of the recent increase is to be accounted for by the extraordinary burst of investment trust financing.” In September alone $643 million was invested in investment trusts (Financial Times, October 21, p. 3). While the two sets of numbers (from the Economist and the Financial Times) are not exactly comparable, both sets of numbers indicate that investment trusts had become very popular by October 1929.

The common stocks of trusts that had used debt or preferred stock leverage were particularly vulnerable to the stock price declines. For example, the Goldman Sachs Trading Corporation was highly levered with preferred stock and the value of its common stock fell from $104 a share to less than $3 in 1933. Many of the trusts were levered, but the leverage of choice was not debt but rather preferred stock.

In concept, investment trusts were sensible. They offered expert management and diversification. Unfortunately, in 1929 a diversification of stocks was not going to be a big help given the universal price declines. Irving Fisher on September 6, 1929 was quoted in the New York Herald Tribune as stating: “The present high levels of stock prices and corresponding low levels of dividend returns are due largely to two factors. One, the anticipation of large dividend returns in the immediate future; and two, reduction of risk to investors largely brought about through investment diversification made possible for the investor by investment trusts.”

If a researcher could find out the composition of the portfolio of a couple of dozen of the largest investment trusts as of September-October 1929 this would be extremely helpful. Seven important types of information that are not readily available but would be of interest are:

  • The percentage of the portfolio that was public utilities.
  • The extent of diversification.
  • The percentage of the portfolios that was NYSE firms.
  • The investment turnover.
  • The ratio of market price to net asset value at various points in time.
  • The amount of debt and preferred stock leverage used.
  • Who bought the trusts and how long they held.

The ideal information to establish whether market prices are excessively high compared to intrinsic values is to have both the prices and well-defined intrinsic values at the same moment in time. For the normal financial security, this is impossible since the intrinsic values are not objectively well defined. There are two exceptions. DeLong and Schleifer (1991) followed one path, very cleverly choosing to study closed-end mutual funds. Some of these funds were traded on the stock market and the market values of the securities in the funds’ portfolios are a very reasonable estimate of the intrinsic value. DeLong and Schleifer state (1991, p. 675):

“We use the difference between prices and net asset values of closed-end mutual funds at the end of the 1920s to estimate the degree to which the stock market was overvalued on the eve of the 1929 crash. We conclude that the stocks making up the S&P composite were priced at least 30 percent above fundamentals in late summer, 1929.”

Unfortunately (p. 682) “portfolios were rarely published and net asset values rarely calculated.” It was only after the crash that investment trusts started to reveal routinely their net asset value. In the third quarter of 1929 (p. 682), “three types of event seemed to trigger a closed-end fund’s publication of its portfolio.” The three events were (1) listing on the New York Stock Exchange (most of the trusts were not listed), (2) start up of a new closed-end fund (this stock price reflects selling pressure), and (3) shares selling at a discount from net asset value (in September 1929 most trusts were not selling at a discount, the inclusion of any that were introduces a bias). After 1929, some trusts revealed 1929 net asset values. Thus, DeLong and Schleifer lacked the amount and quality of information that would have allowed definite conclusions. In fact, if investors also lacked the information regarding the portfolio composition we would have to place investment trusts in a unique investment category where investment decisions were made without reliable financial statements. If investors in the third quarter of 1929 did not know the current net asset value of investment trusts, this fact is significant.

The closed-end funds were an attractive vehicle to study since the market for investment trusts in 1929 was large and growing rapidly. In August and September alone over $1 billion of new funds were launched. DeLong and Schleifer found the premiums of price over value to be large — the median was about 50% in the third quarter of 1929) (p. 678). But they worried about the validity of their study because funds were not selected randomly.

DeLong and Schleifer had limited data (pp. 698-699). For example, for September 1929 there were two observations, for August 1929 there were five, and for July there were nine. The nine funds observed in July 1929 had the following premia: 277%, 152%, 48%, 22%, 18% (2 times), 8% (3 times). Given that closed-end funds tend to sell at a discount, the positive premiums are interesting. Given the conventional perspective in 1929 that financial experts could manager money better than the person not plugged into the street, it is not surprising that some investors were willing to pay for expertise and to buy shares in investment trusts. Thus, a premium for investment trusts does not imply the same premium for other stocks.

The Public Utility Sector

In addition to investment trusts, intrinsic values are usually well defined for regulated public utilities. The general rule applied by regulatory authorities is to allow utilities to earn a “fair return” on an allowed rate base. The fair return is defined to be equal to a utility’s weighted average cost of capital. There are several reasons why a public utility can earn more or less than a fair return, but the target set by the regulatory authority is the weighted average cost of capital.

Thus, if a utility has an allowed rate equity base of $X and is allowed to earn a return of r, (rX in terms of dollars) after one year the firm’s equity will be worth X + rX or (1 + r)X with a present value of X. (This assumes that r is the return required by the market as well as the return allowed by regulators.) Thus, the present value of the equity is equal to the present rate base, and the stock price should be equal to the rate base per share. Given the nature of public utility accounting, the book value of a utility’s stock is approximately equal to the rate base.

There can be time periods where the utility can earn more (or less) than the allowed return. The reasons for this include regulatory lag, changes in efficiency, changes in the weather, and changes in the mix and number of customers. Also, the cost of equity may be different than the allowed return because of inaccurate (or incorrect) or changing capital market conditions. Thus, the stock price may differ from the book value, but one would not expect the stock price to be very much different than the book value per share for very long. There should be a tendency for the stock price to revert to the book value for a public utility supplying an essential service where there is no effective competition, and the rate commission is effectively allowing a fair return to be earned.

In 1929, public utility stock prices were in excess of three times their book values. Consider, for example, the following measures (Wigmore, 1985, p. 39) for five operating utilities.

border=”1″ cellspacing=”0″ cellpadding=”2″ class=”encyclopedia” width=”580″>

1929 Price-earnings Ratio

High Price for Year

Market Price/Book Value

Commonwealth Edison

35

3.31

Consolidated Gas of New York

39

3.34

Detroit Edison

35

3.06

Pacific Gas & Electric

28

3.30

Public Service of New Jersey

35

3.14

Sooner or later this price bubble had to break unless the regulatory authorities were to decide to allow the utilities to earn more than a fair return, or an infinite stream of greater fools existed. The decision made by the Massachusetts Public Utility Commission in October 1929 applicable to the Edison Electric Illuminating Company of Boston made clear that neither of these improbable events were going to happen (see below).

The utilities bubble did burst. Between the end of September and the end of November 1929, industrial stocks fell by 48%, railroads by 32% and utilities by 55% — thus utilities dropped the furthest from the highs. A comparison of the beginning of the year prices and the highest prices is also of interest: industrials rose by 20%, railroads by 19%, and utilities by 48%. The growth in value for utilities during the first nine months of 1929 was more than twice that of the other two groups.

The following high and low prices for 1929 for a typical set of public utilities and holding companies illustrate how severely public utility prices were hit by the crash (New York Times, 1 January 1930 quotations.)

1929
Firm High Price Low Price Low Price DividedBy High Price
American Power & Light 1753/8 641/4 .37
American Superpower 711/8 15 .21
Brooklyn Gas 2481/2 99 .44
Buffalo, Niagara & Eastern Power 128 611/8 .48
Cities Service 681/8 20 .29
Consolidated Gas Co. of N.Y. 1831/4 801/8 .44
Electric Bond and Share 189 50 .26
Long Island Lighting 91 40 .44
Niagara Hudson Power 303/4 111/4 .37
Transamerica 673/8 201/4 .30

Picking on one segment of the market as the cause of a general break in the market is not obviously correct. But the combination of an overpriced utility segment and investment trusts with a portion of the market that had purchased on margin appears to be a viable explanation. In addition, as of September 1, 1929 utilities industry represented $14.8 billion of value or 18% of the value of the outstanding shares on the NYSE. Thus, they were a large sector, capable of exerting a powerful influence on the overall market. Moreover, many contemporaries pointed to the utility sector as an important force in triggering the market decline.

The October 19, 1929 issue of the Commercial and Financial Chronicle identified the main depressing influences on the market to be the indications of a recession in steel and the refusal of the Massachusetts Department of Public Utilities to allow Edison Electric Illuminating Company of Boston to split its stock. The explanations offered by the Department — that the stock was not worth its price and the company’s dividend would have to be reduced — made the situation worse.

the Washington Post (October 17, p. 1) in explaining the October 16 market declines (an Associated Press release) reported, “Professional traders also were obviously distressed at the printed remarks regarding inflation of power and light securities by the Massachusetts Public Utility Commission in its recent decision.”

Straws That Broke the Camel’s Back?

Edison Electric of Boston

On August 2, 1929, the New York Times reported that the Directors of the Edison Electric Illuminating Company of Boston had called a meeting of stockholders to obtain authorization for a stock split. The stock went up to a high of $440. Its book value was $164 (the ratio of price to book value was 2.6, which was less than many other utilities).

On Saturday (October 12, p. 27) the Times reported that on Friday the Massachusetts Department of Public Utilities has rejected the stock split. The heading said “Bars Stock Split by Boston Edison. Criticizes Dividend Policy. Holds Rates Should Not Be Raised Until Company Can Reduce Charge for Electricity.” Boston Edison lost 15 points for the day even though the decision was released after the Friday closing. The high for the year was $440 and the stock closed at $360 on Friday.

The Massachusetts Department of Public Utilities (New York Times, October 12, p. 27) did not want to imply to investors that this was the “forerunner of substantial increases in dividends.” They stated that the expectation of increased dividends was not justified, offered “scathing criticisms of the company” (October 16, p. 42) and concluded “the public will take over such utilities as try to gobble up all profits available.”

On October 15, the Boston City Council advised the mayor to initiate legislation for public ownership of Edison, on October 16, the Department announced it would investigate the level of rates being charged by Edison, and on October 19, it set the dates for the inquiry. On Tuesday, October 15 (p. 41), there was a discussion in the Times of the Massachusetts decision in the column “Topic in Wall Street.” It “excited intense interest in public utility circles yesterday and undoubtedly had effect in depressing the issues of this group. The decision is a far-reaching one and Wall Street expressed the greatest interest in what effect it will have, if any, upon commissions in other States.”

Boston Edison had closed at 360 on Friday, October 11, before the announcement was released. It dropped 61 points at its low on Monday, (October 14) but closed at 328, a loss of 32 points.

On October 16 (p. 42), the Times reported that Governor Allen of Massachusetts was launching a full investigation of Boston Edison including “dividends, depreciation, and surplus.”

One major factor that can be identified leading to the price break for public utilities was the ruling by the Massachusetts Public Utility Commission. The only specific action was that it refused to permit Edison Electric Illuminating Company of Boston to split its stock. Standard financial theory predicts that the primary effect of a stock split would be to reduce the stock price by 50% and would leave the total value unchanged, thus the denial of the split was not economically significant, and the stock split should have been easy to grant. But the Commission made it clear it had additional messages to communicate. For example, the Financial Times (October 16, 1929, p. 7) reported that the Commission advised the company to “reduce the selling price to the consumer.” Boston was paying $.085 per kilowatt-hour and Cambridge only $.055. There were also rumors of public ownership and a shifting of control. The next day (October 17), the Times reported (p. 3) “The worst pressure was against Public Utility shares” and the headline read “Electric Issue Hard Hit.”

Public Utility Regulation in New York

Massachusetts was not alone in challenging the profit levels of utilities. The Federal Trade Commission, New York City, and New York State were all challenging the status of public utility regulation. New York Governor (Franklin D. Roosevelt) appointed a committee on October 8 to investigate the regulation of public utilities in the state. The Committee stated, “this inquiry is likely to have far-reaching effects and may lead to similar action in other States.” Both the October 17 and October 19 issues of the Times carried articles regarding the New York investigative committee. Professor Bonbright, a Roosevelt appointee, described the regulatory process as a “vicious system” (October 19, p. 21), which ignored consumers. The Chairman of the Public Service Commission, testifying before the Committee wanted more control over utility holding companies, especially management fees and other transfers.

The New York State Committee also noted the increasing importance of investment trusts: “mention of the influence of the investment trust on utility securities is too important for this committee to ignore” (New York Times, October 17, p. 18). They conjectured that the trusts had $3.5 billion to invest, and “their influence has become very important” (p. 18).

In New York City Mayor Jimmy Walker was fighting the accusation of graft charges with statements that his administration would fight aggressively against rate increases, thus proving that he had not accepted bribes (New York Times, October 23). It is reasonable to conclude that the October 16 break was related to the news from Massachusetts and New York.

On October 17, the New York Times (p. 18) reported that the Committee on Public Service Securities of the Investment Banking Association warned against “speculative and uniformed buying.” The Committee published a report in which it asked for care in buying shares in utilities.

On Black Thursday, October 24, the market panic began. The market dropped from 305.87 to 272.32 (a 34 point drop, or 9%) and closed at 299.47. The declines were led by the motor stocks and public utilities.

The Public Utility Multipliers and Leverage

Public utilities were a very important segment of the stock market, and even more importantly, any change in public utility stock values resulted in larger changes in equity wealth. In 1929, there were three potentially important multipliers that meant that any change in a public utility’s underlying value would result in a larger value change in the market and in the investor’s value.

Consider the following hypothetical values for a public utility:

Book value per share for a utility $50

Market price per share 162.502

Market price of investment trust holding stock (assuming a 100% 325.00

premium over market value)

Eliminating the utility’s $112.50 market price premium over book value, the market price of the investment trust would be $50 without a premium. The loss in market value of the stock of the investment trust and the utility would be $387.50 (with no premium). The $387.50 is equal to the $112.50 loss in underlying stock value and the $275 reduction in investment trust stock value. The public utility holding companies, in fact, were even more vulnerable to a stock price change since their ratio of price to book value averaged 4.44 (Wigmore, p. 43). The $387.50 loss in market value implies investments in both the firm’s stock and the investment trust.

For simplicity, this discussion has assumed the trust held all the holding company stock. The effects shown would be reduced if the trust held only a fraction of the stock. However, this discussion has also assumed that no debt or margin was used to finance the investment. Assume the individual investors invested only $162.50 of their money and borrowed $162.50 to buy the investment trust stock costing $325. If the utility stock went down from $162.50 to $50 and the trust still sold at a 100% premium, the trust would sell at $100 and the investors would have lost 100% of their investment since the investors owe $162.50. The vulnerability of the margin investor buying a trust stock that has invested in a utility is obvious.

These highly levered non-operating utilities offered an opportunity for speculation. The holding company typically owned 100% of the operating companies’ stock and both entities were levered (there could be more than two levels of leverage). There were also holding companies that owned holding companies (e.g., Ebasco). Wigmore (p. 43) lists nine of the largest public utility holding companies. The ratio of the low 1929 price to the high price (average) was 33%. These stocks were even more volatile than the publicly owned utilities.

The amount of leverage (both debt and preferred stock) used in the utility sector may have been enormous, but we cannot tell for certain. Assume that a utility purchases an asset that costs $1,000,000 and that asset is financed with 40% stock ($400,000). A utility holding company owns the utility stock and is also financed with 40% stock ($160,000). A second utility holding company owns the first and it is financed with 40% stock ($64,000). An investment trust owns the second holding company’s stock and is financed with 40% stock ($25,600). An investor buys the investment trust’s common stock using 50% margin and investing $12,800 in the stock. Thus, the $1,000,000 utility asset is financed with $12,800 of equity capital.

When the large amount of leverage is combined with the inflated prices of the public utility stock, both holding company stocks, and the investment trust the problem is even more dramatic. Continuing the above example, assume the $1,000,000 asset again financed with $600,000 of debt and $400,000 common stock, but the common stock has a $1,200,000 market value. The first utility holding company has $720,000 of debt and $480,000 of common. The second holding company has $288,000 of debt and $192,000 of stock. The investment trust has $115,200 of debt and $76,800 of stock. The investor uses $38,400 of margin debt. The $1,000,000 asset is supporting $1,761,600 of debt. The investor’s $38,400 of equity is very much in jeopardy.

Conclusions and Lessons

Although no consensus has been reached on the causes of the 1929 stock market crash, the evidence cited above suggests that it may have been that the fear of speculation helped push the stock market to the brink of collapse. It is possible that Hoover’s aggressive campaign against speculation, helped by the overpriced public utilities hit by the Massachusetts Public Utility Commission decision and statements and the vulnerable margin investors, triggered the October selling panic and the consequences that followed.

An important first event may have been Lord Snowden’s reference to the speculative orgy in America. The resulting decline in stock prices weakened margin positions. When several governmental bodies indicated that public utilities in the future were not going to be able to justify their market prices, the decreases in utility stock prices resulted in margin positions being further weakened resulting in general selling. At some stage, the selling panic started and the crash resulted.

What can we learn from the 1929 crash? There are many lessons, but a handful seem to be most applicable to today’s stock market.

  • There is a delicate balance between optimism and pessimism regarding the stock market. Statements and actions by government officials can affect the sensitivity of stock prices to events. Call a market overpriced often enough, and investors may begin to believe it.
  • The fact that stocks can lose 40% of their value in a month and 90% over three years suggests the desirability of diversification (including assets other than stocks). Remember, some investors lose all of their investment when the market falls 40%.
  • A levered investment portfolio amplifies the swings of the stock market. Some investment securities have leverage built into them (e.g., stocks of highly levered firms, options, and stock index futures).
  • A series of presumably undramatic events may establish a setting for a wide price decline.
  • A segment of the market can experience bad news and a price decline that infects the broader market. In 1929, it seems to have been public utilities. In 2000, high technology firms were candidates.
  • Interpreting events and assigning blame is unreliable if there has not been an adequate passage of time and opportunity for reflection and analysis — and is difficult even with decades of hindsight.
  • It is difficult to predict a major market turn with any degree of reliability. It is impressive that in September 1929, Roger Babson predicted the collapse of the stock market, but he had been predicting a collapse for many years. Also, even Babson recommended diversification and was against complete liquidation of stock investments (Financial Chronicle, September 7, 1929, p. 1505).
  • Even a market that is not excessively high can collapse. Both market psychology and the underlying economics are relevant.

References

Barsky, Robert B. and J. Bradford DeLong. “Bull and Bear Markets in the Twentieth Century,” Journal of Economic History 50, no. 2 (1990): 265-281.

Bierman, Harold, Jr. The Great Myths of 1929 and the Lessons to be Learned. Westport, CT: Greenwood Press, 1991.

Bierman, Harold, Jr. The Causes of the 1929 Stock Market Crash. Westport, CT, Greenwood Press, 1998.

Bierman, Harold, Jr. “The Reasons Stock Crashed in 1929.” Journal of Investing (1999): 11-18.

Bierman, Harold, Jr. “Bad Market Days,” World Economics (2001) 177-191.

Commercial and Financial Chronicle, 1929 issues.

Committee on Banking and Currency. Hearings on Performance of the National and Federal Reserve Banking System. Washington, 1931.

DeLong, J. Bradford and Andrei Schleifer, “The Stock Market Bubble of 1929: Evidence from Closed-end Mutual Funds.” Journal of Economic History 51, no. 3 (1991): 675-700.

Federal Reserve Bulletin, February, 1929.

Fisher, Irving. The Stock Market Crash and After. New York: Macmillan, 1930.

Galbraith, John K. The Great Crash, 1929. Boston, Houghton Mifflin, 1961.

Hoover, Herbert. The Memoirs of Herbert Hoover. New York, Macmillan, 1952.

Kendrick, John W. Productivity Trends in the United States. Princeton University Press, 1961.

Kindleberger, Charles P. Manias, Panics, and Crashes. New York, Basic Books, 1978.

Malkiel, Burton G., A Random Walk Down Wall Street. New York, Norton, 1975 and 1996.

Moggridge, Donald. The Collected Writings of John Maynard Keynes, Volume XX. New York: Macmillan, 1981.

New York Times, 1929 and 1930.

Rappoport, Peter and Eugene N. White, “Was There a Bubble in the 1929 Stock Market?” Journal of Economic History 53, no. 3 (1993): 549-574.

Samuelson, Paul A. “Myths and Realities about the Crash and Depression.” Journal of Portfolio Management (1979): 9.

Senate Committee on Banking and Currency. Stock Exchange Practices. Washington, 1928.

Siegel, Jeremy J. “The Equity Premium: Stock and Bond Returns since 1802,”

Financial Analysts Journal 48, no. 1 (1992): 28-46.

Wall Street Journal, October 1929.

Washington Post, October 1929.

Wigmore, Barry A. The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933. Greenwood Press, Westport, 1985.

1 1923-25 average = 100.

2 Based a price to book value ratio of 3.25 (Wigmore, p. 39).

Citation: Bierman, Harold. “The 1929 Stock Market Crash”. EH.Net Encyclopedia, edited by Robert Whaples. March 26, 2008. URL http://eh.net/encyclopedia/the-1929-stock-market-crash/

An Economic History of Patent Institutions

B. Zorina Khan, Bowdoin College

Introduction

Such scholars as Max Weber and Douglass North have suggested that intellectual property systems had an important impact on the course of economic development. However, questions from other eras are still current today, ranging from whether patents and copyrights constitute optimal policies toward intellectual inventions and their philosophical rationale to the growing concerns of international political economy. Throughout their history, patent and copyright regimes have confronted and accommodated technological innovations that were no less significant and contentious for their time than those of the twenty-first century. An economist from the nineteenth century would have been equally familiar with considerations about whether uniformity in intellectual property rights across countries harmed or benefited global welfare and whether piracy might be to the advantage of developing countries. The nineteenth and early twentieth centuries in particular witnessed considerable variation in the intellectual property policies that individual countries implemented, and this allows economic historians to determine the consequences of different rules and standards.

This article outlines crucial developments in the patent policies of Europe, the United States, and follower countries. The final section discusses the harmonization of international patent laws that occurred after the middle of the nineteenth century.

Europe

The British Patent System

The grant of exclusive property rights vested in patents developed from medieval guild practices in Europe. Britain in particular is noted for the establishment of a patent system which has been in continuous operation for a longer period than any other in the world. English monarchs frequently used patents to reward favorites with privileges, such as monopolies over trade that increased the retail prices of commodities. It was not until the seventeenth century that patents were associated entirely with awards to inventors, when Section 6 of the Statute of Monopolies (21 Jac. I. C. 3, 1623, implemented in 1624) repealed the practice of royal monopoly grants to all except patentees of inventions. The Statute of Monopolies allowed patent rights of fourteen years for “the sole making or working of any manner of new manufacture within this realm to the first and true inventor…” Importers of foreign discoveries were allowed to obtain domestic patent protection in their own right.

The British patent system established significant barriers in the form of prohibitively high costs that limited access to property rights in invention to a privileged few. Patent fees for England alone amounted to £100-£120 ($585) or approximately four times per capita income in 1860. The fee for a patent that also covered Scotland and Ireland could cost as much as £350 pounds ($1,680). Adding a co-inventor was likely to increase the costs by another £24. Patents could be extended only by a private Act of Parliament, which required political influence, and extensions could cost as much as £700. These constraints favored the elite class of those with wealth, political connections or exceptional technical qualifications, and consciously created disincentives for inventors from humble backgrounds. Patent fees provided an important source of revenues for the Crown and its employees, and created a class of administrators who had strong incentives to block proposed reforms.

In addition to the monetary costs, complicated administrative procedures that inventors had to follow implied that transactions costs were also high. Patent applications for England alone had to pass through seven offices, from the Home Secretary to the Lord Chancellor, and twice required the signature of the Sovereign. If the patent were extended to Scotland and Ireland it was necessary to negotiate another five offices in each country. The cumbersome process of patent applications (variously described as “mediaeval” and “fantastical”) afforded ample material for satire, but obviously imposed severe constraints on the ordinary inventor who wished to obtain protection for his discovery. These features testify to the much higher monetary and transactions costs, in both absolute and relative terms, of obtaining property rights to inventions in England in comparison to the United States. Such costs essentially restricted the use of the patent system to inventions of high value and to applicants who already possessed or could raise sufficient capital to apply for the patent. The complicated system also inhibited the diffusion of information and made it difficult, if not impossible, for inventors outside of London to readily conduct patent searches. Patent specifications were open to public inspection on payment of a fee, but until 1852 they were not officially printed, published or indexed. Since the patent could be filed in any of three offices in Chancery, searches of the prior art involved much time and inconvenience. Potential patentees were well advised to obtain the help of a patent agent to aid in negotiating the numerous steps and offices that were required for pursuit of the application in London.

In the second half of the eighteenth century, nation-wide lobbies of manufacturers and patentees expressed dissatisfaction with the operation of the British patent system. However, it was not until after the Crystal Palace Exhibition in 1851 that their concerns were finally addressed, in an effort to meet the burgeoning competition from the United States. In 1852 the efforts of numerous societies and of individual engineers, inventors and manufacturers over many decades were finally rewarded. Parliament approved the Patent Law Amendment Act, which authorized the first major adjustment of the system in two centuries. The new patent statutes incorporated features that drew on testimonials to the superior functioning of the American patent regime. Significant changes in the direction of the American system included lower fees and costs, and the application procedures were rationalized into a single Office of the Commissioners of Patents for Inventions, or “Great Seal Patent Office.”

The 1852 patent reform bills included calls for a U.S.-style examination system but this was amended in the House of Commons and the measure was not included in the final version. Opponents were reluctant to vest examiners with the necessary discretionary power, and pragmatic observers pointed to the shortage of a cadre of officials with the required expertise. The law established a renewal system that required the payment of fees in installments if the patentee wished to maintain the patent for the full term. Patentees initially paid £25 and later installments of £50 (after three years) and £100 (after seven years) to maintain the patent for a full term of fourteen years. Despite the relatively low number of patents granted in England, between 1852 and 1880 the patent office still made a profit of over £2 million. Provision was made for the printing and publication of the patent records. The 1852 reforms undoubtedly instituted improvements over the former opaque procedures, and the lower fees had an immediate impact. Nevertheless, the system retained many of the former features that had implied that patents were in effect viewed as privileges rather than merited rights, and only temporarily abated expressions of dissatisfaction.

One source of dissatisfaction that endured until the end of the nineteenth century was the state of the common law regarding patents. At least partially in reaction to a history of abuse of patent privileges, patents were widely viewed as monopolies that restricted community rights, and thus to be carefully monitored and narrowly construed. Second, British patents were granted “by the grace of the Crown” and therefore were subject to any restrictions that the government cared to impose. According to the statutes, as a matter of national expediency, patents were to be granted if “they be not contrary to the law, nor mischievous to the State, by raising prices of commodities at home, or to the hurt of trade, or generally inconvenient.” The Crown possessed the ability to revoke any patents that were deemed inconvenient or contrary to public policy. After 1855, the government could also appeal to a need for official secrecy to prohibit the publication of patent specifications in order to protect national security and welfare. Moreover, the state could commandeer a patentee’s invention without compensation or consent, although in some cases the patentee was paid a royalty.

Policies towards patent assignments and trade in intellectual property rights also constrained the market for inventions. Ever vigilant to protect an unsuspecting public from fraudulent financial schemes on the scale of the South Sea Bubble, ownership of patent rights was limited to five investors (later extended to twelve). Nevertheless, the law did not offer any relief to the purchaser of an invalid or worthless patent, so potential purchasers were well advised to engage in extensive searches before entering into contracts. When coupled with the lack of assurance inherent in a registration system, the purchase of a patent right involved a substantive amount of risk and high transactions costs — all indicative of a speculative instrument. It is therefore not surprising that the market for assignments and licenses seems to have been quite limited, and even in the year after the 1852 reforms only 273 assignments were recorded.

In 1883 new legislation introduced procedures that were somewhat simpler, with fewer steps. The fees fell to £4 for the initial term of four years, and the remaining £150 could be paid in annual increments. For the first time, applications could be forwarded to the Patent Office through the post office. This statute introduced opposition proceedings, which enabled interested parties to contest the proposed patent within two months of the filing of the patent specifications. Compulsory licenses were introduced in 1883 (and strengthened in 1919 as “licenses of right”) for fear that foreign inventors might injure British industry by refusing to grant other manufacturers the right to use their patent. The 1883 act provided for the employment of “examiners” but their activity was limited to ensuring that the material was patentable and properly described. Indeed, it was not until 1902 that the British system included an examination for novelty, and even then the process was not regarded as stringent as in other countries. Many new provisions were designed to thwart foreign competition. Until 1907 patentees who manufactured abroad were required to also make the patented product in Britain. Between 1919 and 1949 chemical products were excluded from patent protection to counter the threat posed by the superior German chemical industry. Licenses of right enabled British manufacturers to compel foreign patentees to permit the use of their patents on pharmaceuticals and food products.

In sum, changes in the British patent system were initially unforthcoming despite numerous calls for change. Ultimately, the realization that England’s early industrial and technological supremacy was threatened by the United States and other nations in Europe led to a slow process of revisions that lasted well into the twentieth century. One commentator summed up the series of developments by declaring that the British patent system at the time of writing (1967) remained essentially “a modified version of a pre-industrial economic institution.”

The French Patent System

Early French policies towards inventions and innovations in the eighteenth century were based on an extensive but somewhat arbitrary array of rewards and incentives. During this period inventors or introducers of inventions could benefit from titles, pensions that sometimes extended to spouses and offspring, loans (some interest-free), lump-sum grants, bounties or subsidies for production, exemptions from taxes, or monopoly grants in the form of exclusive privileges. This complex network of state policies towards inventors and their inventions was revised but not revoked after the outbreak of the French Revolution.

The modern French patent system was established according to the laws of 1791 (amended in 1800) and 1844. Patentees filed through a simple registration system without any need to specify what was new about their claim, and could persist in obtaining the grant even if warned that the patent was likely to be legally invalid. On each patent document the following caveat was printed: “The government, in granting a patent without prior examination, does not in any manner guarantee either the priority, merit or success of an invention.” The inventor decided whether to obtain a patent for a period of five, ten or fifteen years, and the term could only be extended through legislative action. Protection extended to all methods and manufactured articles, but excluded theoretical or scientific discoveries without practical application, financial methods, medicines, and items that could be covered by copyright.

The 1791 statute stipulated patent fees that were costly, ranging from 300 livres through 1500 livres, based on the declared term of the patent. The 1844 statute maintained this policy since fees were set at 500 francs ($100) for a five year patent, 1000 francs for a 10 year patent and 1500 for a patent of fifteen years, payable in annual installments. In an obvious attempt to limit international diffusion of French discoveries, until 1844 patents were voided if the inventor attempted to obtain a patent overseas on the same invention. On the other hand, the first introducer of an invention covered by a foreign patent would enjoy the same “natural rights” as the patentee of an original invention or improvement. Patentees had to put the invention into practice within two years from the initial grant, or face a tribunal which had the power to repeal the patent, unless the patentee could point to unforeseen events which had prevented his complying with the provisions of the law. The rights of patentees were also restricted if the invention related to items that were controlled by the French government, such as printing presses and firearms.

In return for the limited monopoly right, the patentee was expected to describe the invention in such terms that a workman skilled in the arts could replicate the invention and this information was expected to be made public. However, no provision was made for the publication or diffusion of these descriptions. At least until the law of April 7 1902, specifications were only available in manuscript form in the office in which they had originally been lodged, and printed information was limited to brief titles in patent indexes. The attempt to obtain information on the prior art was also inhibited by restrictions placed on access: viewers had to state their motives; foreigners had to be assisted by French attorneys; and no extract from the manuscript could be copied until the patent had expired.

The state remained involved in the discretionary promotion of invention and innovation through policies beyond the granting of patents. In the first place, the patent statutes did not limit their offer of potential appropriation of returns only to property rights vested in patents. The inventor of a discovery of proven utility could choose between a patent or making a gift of the invention to the nation in exchange for an award from funds that were set aside for the encouragement of industry. Second, institutions such as the Société d’encouragement pour l’industrie nationale awarded a number of medals each year to stimulate new discoveries in areas they considered to be worth pursuing, and also to reward deserving inventors and manufacturers. Third, the award of assistance and pensions to inventors and their families continued well into the nineteenth century. Fourth, at times the Society purchased patent rights and turned the invention over into the public domain.

The basic principles of the modern French patent system were evident in the early French statutes and were retained in later revisions. Since France during the ancien régime was likely the first country to introduce systematic examinations of applications for privileges, it is somewhat ironic that commentators point to the retention of registration without prior examination as the defining feature of the “French system” until 1978. In 1910 fees remained high, although somewhat lower in real terms, at one hundred francs per year. Working requirements were still in place, and patentees were not allowed to satisfy the requirement by importing the article even if the patentee had manufactured it in another European country. However, the requirement was waived if the patentee could persuade the tribunal that the patent was not worked because of unavoidable circumstances.

Similar problems were evident in the market for patent rights. Contracts for patent assignments were filed in the office of the Prefect for the district, but since there was no central source of information it was difficult to trace the records for specific inventions. The annual fees for the entire term of the patent had to be paid in advance if the patent was assigned to a second party. Like patents themselves, assignments and licenses were issued with a caveat emptor clause. This was partially due to the nature of patent property under a registration system, and partially to the uncertainties of legal jurisprudence in this area. For both buyer and seller, the uncertainties associated with the exchange likely reduced the net expected value of trade.

The Spanish Patent System

French patent laws were adopted in its colonies, but also diffused to other countries through its influence on Spain’s system following the Spanish Decree of 1811. The Spanish experience during the nineteenth century is instructive since this country experienced lower rates and levels of economic development than the early industrializers. Like its European neighbors, early Spanish rules and institutions were vested in privileges which had lasting effects that could be detected even in the later period. The per capita rate of patenting in Spain was lower than other major European countries, and foreigners filed the majority of patented inventions. Between 1759 and 1878, roughly one half of all grants were to citizens of other countries, notably France and (to a lesser extent) Britain. Thus, the transfer of foreign technology was a major concern in the political economy of Spain.

This dependence on foreign technologies was reflected in the structure of the Spanish patent system, which permitted patents of introduction as well as patents for invention. Patents of introduction were granted to entrepreneurs who wished to produce foreign technologies that were new to Spain, with no requirement of claims to being the true inventor. Thus, the sole objective of these instruments was to enhance innovation and production in Spain. Since the owners of introduction patents could not prevent third parties from importing similar machines from abroad, they also had an incentive to maintain reasonable pricing structures. Introduction patents had a term of only five years, with a cost of 3000 reales, whereas the fees of patents for invention varied from 1000 reales for five years, 3000 reales for ten years, and 6000 reales for a term of fifteen years. Patentees were required to work the patent within one year, and about a quarter of patents granted between 1826 and 1878 were actually implemented. Since patents of introduction had a brief term, they encouraged the production of items with high expected profits and a quick payback period, after which monopoly rights expired, and the country could benefit from its diffusion.

The German Patent System

The German patent system was influenced by developments in the United States, and itself influenced legislation in Argentina, Austria, Brazil, Denmark, Finland, Holland, Norway, Poland, Russia and Sweden. The German Empire was founded in 1871, and in the first six years each state adopted its own policies. Alsace-Lorraine favored a French-style system, whereas others such as Hamburg and Bremen did not offer patent protection. However, after strong lobbying by supporters of both sides of the debate regarding the merits of patent regimes, Germany passed a unified national Patent Act of 1877.

The 1877 statute created a centralized administration for the grant of a federal patent for original inventions. Industrial entrepreneurs succeeded in their objective of creating a “first to file” system, so patents were granted to the first applicant rather than to the “first and true inventor,” but in 1936 the National Socialists introduced a first to invent system. Applications were examined by examiners in the Patent Office who were expert in their field. During the eight weeks before the grant, patent applications were open to the public and an opposition could be filed denying the validity of the patent. German patent fees were deliberately high to eliminate protection for trivial inventions, with a renewal system that required payment of 30 marks for the first year, 50 marks for the second year, 100 marks for the third, and 50 marks annually after the third year. In 1923 the patent term was extended from fifteen years to eighteen years.

German patent policies encouraged diffusion, innovation and growth in specific industries with a view to fostering economic development. Patents could not be obtained for food products, pharmaceuticals or chemical products, although the process through which such items were produced could be protected. It has been argued that the lack of restrictions on the use of innovations and the incentives to patent around existing processes spurred productivity and diffusion in these industries. The authorities further ensured the diffusion of patent information by publishing claims and specification before they were granted. The German patent system also facilitated the use of inventions by firms, with the early application of a “work for hire” doctrine that allowed enterprises access to the rights and benefits of inventions of employees.

Although the German system was close to the American patent system, it was in other ways more stringent, resulting in patent grants that were lower in number, but likely higher in average value. The patent examination process required that the patent should be new, nonobvious, and also capable of producing greater efficiency. As in the United States, once granted, the courts adopted an extremely liberal attitude in interpreting and enforcing existing patent rights. Penalties for willful infringement included not only fines, but also the possibility of imprisonment. The grant of a patent could be revoked after the first three years if the patent was not worked, if the owner refused to grant licenses for the use of an invention that was deemed in the public interest, or if the invention was primarily being exploited outside of Germany. However, in most cases, a compulsory license was regarded as adequate.

After 1891 a parallel and weaker version of patent protection could be obtained through a gebrauchsmuster or utility patent (sometimes called a petty patent), which was granted through a registration system. Patent protection was available for inventions that could be represented by drawings or models with only a slight degree of novelty, and for a limited term of three years (renewable once for a total life of six years). About twice as many utility patents as examined patents were granted early in the 1930s. Patent protection based on co-existing systems of registration and examination appears to have served distinct but complementary purposes. Remedies for infringement of utility patents also included fines and imprisonment.

Other European Patent Systems

Very few developed countries would now seriously consider eliminating statutory protection for inventions, but in the second half of the nineteenth century the “patent controversy” in Europe pitted advocates of patent rights against an effective abolitionist movement. For a short period, the abolitionists were strong enough to obtain support for dismantling patent systems in a number of European countries. In 1863 the Congress of German Economists declared “patents of invention are injurious to common welfare;” and the movement achieved its greatest victory in Holland, which repealed its patent legislation in 1869. The Swiss cantons did not adopt patent protection until 1888, with an extension in the scope of coverage in 1907. The abolitionists based their arguments on the benefits of free trade and competition, and viewed patents as part of an anticompetitive and protectionist strategy analogous to tariffs on imports. Instead of state-sponsored monopoly awards, they argued, inventors could be rewarded by alternative policies, such as stipends from the government, payments from private industry or associations formed for that purpose, or simply through the lead time that the first inventor acquired over competitors by virtue of his prior knowledge.

According to one authority, the Netherlands eventually reinstated its patent system in 1912 and Switzerland introduced patent laws in 1888 largely because of a keen sense of morality, national pride and international pressure to do so. The appeal to “morality” as an explanatory factor is incapable of explaining the timing and nature of changes in strategies. Nineteenth-century institutions were not exogenous and their introduction or revisions generally reflected the outcome of a self-interested balancing of costs and benefits. The Netherlands and Switzerland were initially able to benefit from their ability to free-ride on the investments that other countries had made in technological advances. As for the cost of lower incentives for discoveries by domestic inventors, the Netherlands was never vaunted as a leader in technological innovation, and this is reflected in their low per capita patenting rates both before and after the period without patent laws. They recorded a total of only 4561 patents in the entire period from 1800 to 1869 and, even after adjusting for population, the Dutch patenting rate in 1869 was a mere 13.4 percent of the U.S. patenting rate. Moreover, between 1851 and 1865 88.6 percent of patents in the Netherlands had been granted to foreigners. After the patent laws were reintroduced in 1912, the major beneficiaries were again foreign inventors, who obtained 79.3 of the patents issued in the Netherlands. Thus, the Netherlands had little reason to adopt patent protection, except for external political pressures and the possibility that some types of foreign investment might be deterred.

The case was somewhat different for Switzerland, which was noted for being innovative, but in a narrow range of pursuits. Since the scale of output and markets were quite limited, much of Swiss industry generated few incentives for invention. A number of the industries in which the Swiss excelled, such as hand-made watches, chocolates and food products, were less susceptible to invention that warranted patent protection. For instance, despite the much larger consumer market in the United States, during the entire nineteenth century fewer than 300 U.S. patents related to chocolate composition or production. Improvements in pursuits such as watch-making could be readily protected by trade secrecy as long as the industry remained artisanal. However, with increased mechanization and worker mobility, secrecy would ultimately prove to be ineffective, and innovators would be unable to appropriate returns without more formal means of exclusion.

According to contemporary observers, the Swiss resolved to introduce patent legislation not because of a sudden newfound sense of morality, but because they feared that American manufacturers were surpassing them as a result of patented innovations in the mass production of products such as boots, shoes and watches. Indeed, before 1890, American inventors obtained more than 2068 patents on watches, and the U.S. watch making industry benefited from mechanization and strong economies of scale that led to rapidly falling prices of output, making them more competitive internationally. The implications are that the rates of industrial and technical progress in the United States were more rapid, and technological change was rendering artisanal methods obsolete in products with mass markets. Thus, the Swiss endogenously adopted patent laws because of falling competitiveness in their key industrial sectors.

What was the impact of the introduction of patent protection in Switzerland? Foreign inventors could obtain patents in the United States regardless of their domestic legislation, so we can approach this question tangentially by examining the patterns of patenting in the United States by Swiss residents before and after the 1888 reforms. Between 1836 and 1888, Swiss residents obtained a grand total of 585 patents in the United States. Fully a third of these patents were for watches and music boxes, and only six were for textiles or dyeing, industries in which Switzerland was regarded as competitive early on. Swiss patentees were more oriented to the international market, rather than the small and unprotected domestic market where they could not hope to gain as much from their inventions. For instance, in 1872 Jean-Jacques Mullerpack of Basel collaborated with Leon Jarossonl of Lille, France to invent an improvement in dyeing black with aniline colors, which they assigned to William Morgan Brown of London, England. Another Basel inventor, Alfred Kern, assigned his 1883 patent for violet aniline dyes to the Badische Anilin and Soda Fabrik of Mannheim, Germany.

After the patent reforms, the rate of Swiss patenting in the United States immediately increased. Swiss patentees obtained an annual average of 32.8 patents in the United States in the decade before the patent law was enacted in Switzerland. After the Swiss allowed patenting, this figure increased to an average of 111 each year in the following six years, and in the period from 1895 to 1900 a total of 821 Swiss patents were filed in the United States. The decadal rate of patenting per million residents increased from 111.8 for the ten years up to the reforms, to 451 per million residents in the 1890s, 513 in the 1900s, 458 in the 1910s and 684 in the 1920s. U.S. statutes required worldwide novelty, and patents could not be granted for discoveries that had been in prior use, so the increase was not due to a backlog of trade secrets that were now patented.

Moreover, the introduction of Swiss patent laws also affected the direction of inventions that Swiss residents patented in the United States. After the passage of the law, such patents covered a much broader range of inventions, including gas generators, textile machines, explosives, turbines, paints and dyes, and drawing instruments and lamps. The relative importance of watches and music boxes immediately fell from about a third before the reforms to 6.2 percent and 2.1 percent respectively in the 1890s and even further to 3.8 percent and 0.3 percent between 1900 and 1909. Another indication that international patenting was not entirely unconnected to domestic Swiss inventions can be discerned from the fraction of Swiss patents (filed in the U.S.) that related to process innovations. Before 1888, 21 percent of the patent specifications mentioned a process. Between 1888 and 1907, the Swiss statutes included the requirement that patents should include mechanical models, which precluded patenting of pure processes. The fraction of specifications that mentioned a process fell during the period between 1888 and 1907, but returned to 22 percent when the restriction was modified in 1907.

In short, although the Swiss experience is often cited as proof of the redundancy of patent protection, the limitations of this special case should be taken into account. The domestic market was quite small and offered minimal opportunity or inducements for inventors to take advantage of economies of scale or cost-reducing innovations. Manufacturing tended to cluster in a few industries where innovation was largely irrelevant, such as premium chocolates, or in artisanal production that was susceptible to trade secrecy, such as watches and music boxes. In other areas, notably chemicals, dyes and pharmaceuticals, Swiss industries were export-oriented, but even today their output tends to be quite specialized and high-valued rather than mass-produced. Export-oriented inventors were likely to have been more concerned about patent protection in the important overseas markets, rather than in the home market. Thus, between 1888 and 1907, although Swiss laws excluded patents for chemicals, pharmaceuticals and dyes, 20.7 percent of the Swiss patents filed in the United States were for just these types of inventions. The scanty evidence on Switzerland suggests that the introduction of patent rights was accompanied by changes in the rate and direction of inventive activity. In any event, both the Netherlands and Switzerland featured unique circumstances that seem to hold few lessons for developing countries today.

The Patent System in the United States

The United States stands out as having established one of the most successful patent systems in the world. Over six million patents have been issued since 1790, and American industrial supremacy has frequently been credited to its favorable treatment of inventors and the inducements held out for inventive activity. The first Article of the U.S. Constitution included a clause to “promote the Progress of Science and the useful Arts by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.” Congress complied by passing a patent statute in April 1790. The United States created in 1836 the first modern patent institution in the world, a system whose features differed in significant respects from those of other major countries. The historical record indicates that the legislature’s creation of a uniquely American system was a deliberate and conscious process of promoting open access to the benefits of private property rights in inventions. The laws were enforced by a judiciary which was willing to grapple with difficult questions such as the extent to which a democratic and market-oriented political economy was consistent with exclusive rights. Courts explicitly attempted to implement decisions that promoted economic growth and social welfare.

The primary feature of the “American system” is that all applications are subject to an examination for conformity with the laws and for novelty. An examination system was set in place in 1790, when a select committee consisting of the Secretary of State (Thomas Jefferson), the Attorney General and the Secretary of War scrutinized the applications. These duties proved to be too time-consuming for highly ranked officials who had other onerous duties, so three years later it was replaced by a registration system. The validity of patents was left up to the district courts, which had the power to set in motion a process that could end in the repeal of the patent. However by the 1830s this process was viewed as cumbersome and the statute that was passed in 1836 set in place the essential structure of the current patent system. In particular, the 1836 Patent Law established the Patent Office, whose trained and technically qualified employees were authorized to examine applications. Employees of the Patent Office were not permitted to obtain patent rights. In order to constrain the ability of examiners to engage in arbitrary actions, the applicant was given the right to file a bill in equity to contest the decisions of the Patent Office with the further right of appeal to the Supreme Court of the United States.

American patent policy likewise stands out in its insistence on affordable fees. The legislature debated the question of appropriate fees, and the first patent law in 1790 set the rate at the minimal sum of $3.70 plus copy costs. In 1793 the fees were increased to $30, and were maintained at this level until 1861. In that year, they were raised to $35, and the term of the patent was changed from fourteen years (with the possibility of an extension) to seventeen years (with no extensions.) The 1869 Report of the Commissioner of Patents compared the $35 fee for a US patent to the significantly higher charges in European countries such as Britain, France, Russia ($450), Belgium ($420) and Austria ($350). The Commissioner speculated that both the private and social costs of patenting were lower in a system of impartial specialized examiners, than under a system where similar services were performed on a fee-per-service basis by private solicitors. He pointed out that in the U.S. the fees were not intended to exact a price for the patent privilege or to raise revenues for the state – the disclosure of information was the sole price for the patent property right – rather, they were imposed merely to cover the administrative expenses of the Office.

The basic parameters of the U.S. patent system were transparent and predictable, in itself an aid to those who wished to obtain patent rights. In addition, American legislators were concerned with ensuring that information about the stock of patented knowledge was readily available and diffused rapidly. As early as 1805 Congress stipulated that the Secretary of State should publish an annual list of patents granted the preceding year, and after 1832 also required the publication in newspapers of notices regarding expired patents. The Patent Office itself was a source of centralized information on the state of the arts. However, Congress was also concerned with the question of providing for decentralized access to patent materials. The Patent Office maintained repositories throughout the country, where inventors could forward their patent models at the expense of the Patent Office. Rural inventors could apply for patents without significant obstacles, because applications could be submitted by mail free of postage.

American laws employed the language of the English statute in granting patents to “the first and true inventor.” Nevertheless, unlike in England, the phrase was used literally, to grant patents for inventions that were original in the world, not simply within U.S. borders. American patent laws provided strong protection for citizens of the United States, but varied over time in its treatment of foreign inventors. Americans could not obtain patents for imported discoveries, but the earliest statutes of 1793, 1800 and 1832, restricted patent property to citizens or to residents who declared that they intended to become citizens. As such, while an American could not appropriate patent rights to a foreign invention, he could freely use the idea without any need to bear licensing or similar costs that would otherwise have been due if the inventor had been able to obtain a patent in this country. In 1836, the stipulations on citizenship or residency were removed, but were replaced with discriminatory patent fees: foreigners could obtain a patent in the U.S. for a fee of three hundred dollars, or five hundred if they were British. After 1861 patent rights (with the exception of caveats) were available to all applicants on the same basis without regard to nationality.

The American patent system was based on the presumption that social welfare coincided with the individual welfare of inventors. Accordingly, legislators rejected restrictions on the rights of American inventors. However, the 1832 and 1836 laws stipulated that foreigners had to exploit their patented invention within eighteen months. These clauses seem to have been interpreted by the courts in a fairly liberal fashion, since alien patentees “need not prove that they hawked the patented improvement to obtain a market for it, or that they endeavored to sell it to any person, but that it rested upon those who sought to defeat the patent to prove that the plaintiffs neglected or refused to sell the patented invention for reasonable prices when application was made to them to purchase.” Such provisions proved to be temporary aberrations and were not included in subsequent legislation. Working requirements or compulsory licenses were regarded as unwarranted infringements of the rights of “meritorious inventors,” and incompatible with the philosophy of U.S. patent grants. Patentees were not required to pay annuities to maintain their property, there were no opposition proceedings, and once granted a patent could not be revoked unless there was proven evidence of fraud.

One of the advantages of a system that secures property rights is that it facilitates contracts and trade. Assignments provide a straightforward index of the effectiveness of the American system, since trade in inventions would hardly proliferate if patent rights were uncertain or worthless. An extensive national network of licensing and assignments developed early on, aided by legal rulings that overturned contracts for useless or fraudulent patents. In 1845 the Patent Office recorded 2,108 assignments, which can be compared to the cumulative stock of 7188 patents that were still in force in that year. By the 1870s the number of assignments averaged over 9000 assignments per year, and this increased in the next decade to over 12,000 transactions recorded annually. This flourishing market for patented inventions provided an incentive for further inventive activity for inventors who were able to appropriate the returns from their efforts, and also linked patents and productivity growth.

Property rights are worth little unless they can be legally enforced in a consistent, certain, and predictable manner. A significant part of the explanation for the success of the American intellectual property system relates to the efficiency with which the laws were interpreted and implemented. United States federal courts from their inception attempted to establish a store of doctrine that fulfilled the intent of the Constitution to secure the rights of intellectual property owners. The judiciary acknowledged that inventive efforts varied with the extent to which inventors could appropriate the returns on their discoveries, and attempted to ensure that patentees were not unjustly deprived of the benefits from their inventions. Numerous reported decisions before the early courts declared that, rather than unwarranted monopolies, patent rights were “sacred” and to be regarded as the just recompense to inventive ingenuity. Early courts had to grapple with a number of difficult issues, such as the appropriate measure of damages, disputes between owners of conflicting patents, and how to protect the integrity of contracts when the law altered. Changes inevitably occurred when litigants and judiciary both adapted to a more complex inventive and economic environment. However, the system remained true to the Constitution in the belief that the defense of rights in patented invention was important in fostering industrial and economic development.

Economists such as Joseph Schumpeter have linked market concentration and innovation, and patent rights are often felt to encourage the establishment of monopoly enterprises. Thus, an important aspect of the enforcement of patents and intellectual property in general depends on competition or antitrust policies. The attitudes of the judiciary towards patent conflicts are primarily shaped by their interpretation of the monopoly aspect of the patent grant. The American judiciary in the early nineteenth century did not recognize patents as monopolies, arguing that patentees added to social welfare through innovations which had never existed before, whereas monopolists secured to themselves rights that already belong to the public. Ultimately, the judiciary came to openly recognize that the enforcement and protection of all property rights involved trade-offs between individual monopoly benefits and social welfare.

The passage of the Sherman Act in 1890 was associated with a populist emphasis on the need to protect the public from corporate monopolies, including those based on patent protection, and raised the prospect of conflicts between patent policies and the promotion of social welfare through industrial competition. Firms have rarely been charged directly with antitrust violations based on patent issues. At the same time, a number of landmark restraint of trade lawsuits have involved technological innovators. In the early decades of the 20th century these included innovative enterprises such as John Deere & Co., American Can and International Harvester, through to the numerous cases since 1970 against IBM, Xerox, Eastman Kodak and, most recently, Intel and Microsoft. The evidence suggests that, holding other factors constant, more innovative firms and those with larger patent stocks are more likely to be charged with antitrust violations. A growing fraction of cases involve firms jointly charged with antitrust violations that are linked to patent based market power and to concerns about “innovation markets.”

The Japanese Patent System

Japan emerged from the Meiji era as a follower nation which deliberately designed institutions to try to emulate those of the most advanced industrial countries. Accordingly, in 1886 Takahashi Korekiyo was sent on a mission to examine patent systems in Europe and the United States. The Japanese envoy was not favorably impressed with the European countries in this regard. Instead, he reported: ” … we have looked about us to see what nations are the greatest, so that we could be like them; … and we said, `What is it that makes the United States such a great nation?’ and we investigated and we found it was patents, and we will have patents.” The first national patent statute in Japan was passed in 1888, and copied many features of the U.S. system, including the examination procedures.

However, even in the first statute, differences existed that reflected Japanese priorities and the “wise eclecticism of Japanese legislators.” For instance, patents were not granted to foreigners, protection could not be obtained for fashion, food products, or medicines, patents that were not worked within three years could be revoked, and severe remedies were imposed for infringement, including penal servitude. After Japan became a signatory of the Paris Convention a new law was passed in 1899, which amended existing legislation to accord with the agreements of the Convention, and extended protection to foreigners. The influence of the German laws were evident in subsequent reforms in 1909 (petty or utility patents were protected) and 1921 (protection was removed from chemical products, work for hire doctrines were adopted, and an opposition procedure was introduced). The Act of 1921 also permitted the state to revoke a patent grant on payment of appropriate compensation if it was deemed in the public interest. Medicines, food and chemical products could not be patented, but protection could be obtained for processes relating to their manufacture.

The modern Japanese patent system is an interesting amalgam of features drawn from the major patent institutions in the world. Patent applications are filed, and the applicants then have seven years within which they can request an examination. Before 1996 examined patents were published prior to the actual grant, and could be opposed before the final grant; but at present, opposition can only occur in the first six months after the initial grant. Patents are also given for utility models or incremental inventions which are required to satisfy a lower standard of novelty and nonobviousness and can be more quickly commercialized. It has been claimed that the Japanese system favors the filing of a plethora of narrowly defined claims for utility models that build on the more substantive contributions of patent grants, leading to the prospect of an anti-commons through “patent flooding.” Others argue that utility models aid diffusion and innovation in the early stages of the patent term, and that the pre-grant publication of patent specifications also promotes diffusion.

Harmonization of International Patent Laws

Today very few developed countries would seriously consider eliminating statutory protection for intellectual property, but in the second half of the nineteenth century the “patent controversy” pitted advocates of patent rights against an effective abolitionist movement. For a short period the latter group was strong enough to obtain support in favor of dismantling the patent systems in countries such as England, and in 1863 the Congress of German Economists declared “patents of invention are injurious to common welfare.” The movement achieved its greatest victory in Holland, which repealed its patent legislation in 1869. The abolitionists based their arguments on the benefits of free trade and competition and viewed patents as part of a protectionist strategy analogous to tariffs. Instead of monopoly awards to inventors, their efforts could be rewarded by alternative policies, such as stipends from the government, payments from private industry or associations formed for that purpose, or simply through the lead time that the first inventor acquired over competitors by virtue of his prior knowledge.

The decisive victory of the patent proponents shifted the focus of interest to the other extreme, and led to efforts to attain uniformity in intellectual property rights regimes across countries. Part of the impetus for change occurred because the costs of discordant national rules became more burdensome as the volume of international trade in industrial products grew over time. Americans were also concerned about the lack of protection accorded to their exhibits in the increasingly more prominent World’s Fairs. Indeed, the first international patent convention was held in Austria in 1873, at the suggestion of U.S. policy makers, who wanted to be certain that their inventors would be adequately protected at the International Exposition in Vienna that year. It also yielded an opportunity to protest the provisions in Austrian law which discriminated against foreigners, including a requirement that patents had to be worked within one year or risk invalidation. The Vienna Convention adopted several resolutions, including a recommendation that the United States opposed, in favor of compulsory licenses if they were deemed in the public interest. However, the convention followed U.S. lead and did not approve compulsory working requirements.

International conventions proliferated in subsequent years, and their tenor tended to reflect the opinions of the conveners. Their objective was not to reach compromise solutions that would reflect the needs and wishes of all participants, but rather to promote preconceived ideas. The overarching goal was to pursue uniform international patent laws, although there was little agreement about the finer points of these laws. It became clear that the goal of complete uniformity was not practicable, given the different objectives, ideologies and economic circumstances of participants. Nevertheless, in 1884 the International Union for the Protection of Industrial Property was signed by Belgium, Portugal, France, Guatemala, Italy, the Netherlands, San Salvador, Serbia, Spain and Switzerland. The United States became a member in 1887, and a significant number of developing countries followed suit, including Brazil, Bulgaria, Cuba, the Dominican Republic, Ceylon, Mexico, Trinidad and Tobago and Indonesia, among others.

The United States was the most prolific patenting nation in the world, many of the major American enterprises owed their success to patents and were expanding into international markets, and the U.S. patent system was recognized as the most successful. It is therefore not surprising that patent harmonization implied convergence towards the American model despite resistance from other nations. Countries such as Germany were initially averse to extending equal protection to foreigners because they feared that their domestic industry would be overwhelmed by American patents. Ironically, because its patent laws were the most liberal towards patentees, the United States found itself with weaker bargaining abilities than nations who could make concessions by changing their provisions. The U.S. pressed for the adoption of reciprocity (which would ensure that American patentees were treated as favorably abroad as in the United States) but this principle was rejected in favor of “national treatment” (American patentees were to be granted the same rights as nationals of the foreign country). This likely influenced the U.S. tendency to use bilateral trade sanctions rather than multilateral conventions to obtain reforms in international patent policies.

It was commonplace in the nineteenth century to rationalize and advocate close links between trade policies, protection, and international laws regarding intellectual property. These links were evident at the most general philosophical level, and at the most specific, especially in terms of compulsory working requirements and provisions to allow imports by the patentee. For instance, the 1880 Paris Convention considered the question of imports of the patented product by the patentee. According to the laws of France, Mexico and Tunisia, such importation would result in the repeal of the patent grant. The Convention inserted an article that explicitly ruled out forfeiture of the patent under these circumstances, which led some French commentators to argue that “the laws on industrial property… will be truly disastrous if they do not have a counterweight in tariff legislation.” The movement to create an international patent system elucidated the fact that intellectual property laws do not exist in a vacuum, but are part of a bundle of rights that are affected by other laws and policies.

Conclusion

Appropriate institutions to promote creations in the material and intellectual sphere are especially critical because ideas and information are public goods that are characterized by nonrivalry and nonexclusion. Once the initial costs are incurred, ideas can be reproduced at zero marginal cost and it may be difficult to exclude others from their use. Thus, in a competitive market, public goods may suffer from underprovision or may never be created because of a lack of incentive on the part of the original provider who bears the initial costs but may not be able to appropriate the benefits. Market failure can be ameliorated in several ways, for instance through government provision, rewards or subsidies to original creators, private patronage, and through the creation of intellectual property rights.

Patents allow the initial producers a limited period during which they are able to benefit from a right of exclusion. If creativity is a function of expected profits, these grants to inventors have the potential to increase social production possibilities at lower cost. Disclosure requirements promote diffusion, and the expiration of the temporary monopoly right ultimately adds to the public domain. Overall welfare is enhanced if the social benefits of diffusion outweigh the deadweight and social costs of temporary exclusion. This period of exclusion may be costly for society, especially if future improvements are deterred, and if rent-seeking such as redistributive litigation results in wasted resources. Much attention has also been accorded to theoretical features of the optimal system, including the breadth, longevity, and height of patent and copyright grants.

However, strongly enforced rights do not always benefit the producers and owners of intellectual property rights, especially if there is a prospect of cumulative invention where follow-on inventors build on the first discovery. Thus, more nuanced models are ambivalent about the net welfare benefits of strong exclusive rights to inventions. Indeed, network models imply that the social welfare of even producers may increase from weak enforcement if more extensive use of the product increases the value to all users. Under these circumstances, the patent owner may benefit from the positive externalities created by piracy. In the absence of royalties, producers may appropriate returns through ancillary means, such as the sale of complementary items or improved reputation. In a variant of the durable-goods monopoly problem, it has been shown that piracy can theoretically increase the demand for products by ensuring that producers can credibly commit to uniform prices over time. Also in this vein, price and/or quality discrimination of non-private goods across pirates and legitimate users can result in net welfare benefits for society and for the individual firm. If the cost of imitation increases with quality, infringement can also benefit society if it causes firms to adopt a strategy of producing higher quality commodities.

Economic theorists who are troubled by the imperfections of intellectual property grants have proposed alternative mechanisms that lead to more satisfactory mathematical solutions. Theoretical analyses have advanced our understanding in this area, but such models by their nature cannot capture many complexities. They tend to overlook such factors as the potential for greater corruption or arbitrariness in the administration of alternatives to patents. Similarly, they fail to appreciate the role of private property rights in conveying information and facilitating markets, and their value in reducing risk and uncertainty for independent inventors with few private resources. The analysis becomes even less satisfactory when producers belong to different countries than consumers. Thus, despite the flurry of academic research on the economics of intellectual property, we have not progressed far beyond Fritz Machlup’s declaration that our state of knowledge does not allow to us to either recommend the introduction or the removal of such systems. Existing studies leave a wide area of ambiguity about the causes and consequences of institutional structures in general, and their evolution across time and region.

In the realm of intellectual property, questions from four centuries ago are still current, ranging from its philosophical underpinnings, to whether patents and copyrights constitute optimal policies towards intellectual inventions, to the growing concerns of international political economy. A number of scholars are so impressed with technological advances in the twenty-first century that they argue we have reached a critical juncture where we need completely new institutions. Throughout their history, patent and copyright regimes have confronted and accommodated technological innovations that were no less significant and contentious for their time. An economist from the nineteenth century would have been equally familiar with considerations about whether uniformity in intellectual property rights across countries harmed or benefited global welfare, and whether piracy might be to the advantage of developing countries. Similarly, the link between trade and intellectual property rights that informs the TRIPS (trade-related aspects of intellectual property rights) agreement was quite standard two centuries ago.

Today the majority of patents are filed in developed countries by the residents of developed countries, most notably those of Japan and the United States. The developing countries of the twenty-first century are under significant political pressure to adopt stronger patent laws and enforcement, even though few patents are filed by residents of the developing countries. Critics of intellectual property rights point to costs, such as monopoly rents and higher barriers to entry, administrative costs, outflows of royalty payments to foreign entities, and a lack of indigenous innovation. Other studies, however, have more optimistic findings regarding the role of patents in economic and social development. They suggest that stronger protection can encourage more foreign direct investment, greater access to technology, and increased benefits from trade openness. Moreover, both economic history and modern empirical research indicate that stronger patent rights and more effective markets in invention can, by encouraging and enabling the inventiveness of ordinary citizens of developing countries, help to increase social and economic welfare.

Patents Statistics for France, Britain, the United States and Germany, 1790-1960
YEAR FRANCE BRITAIN U.S. GERMANY
1790 . 68 3 .
1791 34 57 33 .
1792 29 85 11 .
1793 4 43 20 .
1794 0 55 22 .
1795 1 51 12 .
1796 8 75 44 .
1797 4 54 51 .
1798 10 77 28 .
1799 22 82 44 .
1800 16 96 41 .
1801 34 104 44 .
1802 29 107 65 .
1803 45 73 97 .
1804 44 60 84 .
1805 63 95 57 .
1806 101 99 63 .
1807 66 94 99 .
1808 61 95 158 .
1809 52 101 203 .
1810 93 108 223 .
1811 66 115 215 0
1812 96 119 238 2
1813 88 142 181 2
1814 53 96 210 1
1815 77 102 173 10
1816 115 118 206 10
1817 162 103 174 16
1818 153 132 222 18
1819 138 101 156 10
1820 151 97 155 10
1821 180 109 168 11
1822 175 113 200 8
1823 187 138 173 22
1824 217 180 228 25
1825 321 250 304 17
1826 281 131 323 67
1827 333 150 331 69
1828 388 154 368 87
1829 452 130 447 59
1830 366 180 544 57
1831 220 150 573 34
1832 287 147 474 46
1833 431 180 586 76
1834 576 207 630 66
1835 556 231 752 73
1836 582 296 702 65
1837 872 256 426 46
1838 1312 394 514 104
1839 730 411 404 125
1840 947 440 458 156
1841 925 440 490 162
1842 1594 371 488 153
1843 1397 420 493 160
1844 1863 450 478 158
1845 2666 572 473 256
1846 2750 493 566 252
1847 2937 493 495 329
1848 1191 388 583 256
1849 1953 514 984 253
1850 2272 523 883 308
1851 2462 455 752 274
1852 3279 1384 885 272
1853 4065 2187 844 287
1854 4563 1878 1755 276
1855 5398 2046 1881 287
1856 5761 1094 2302 393
1857 6110 2028 2674 414
1858 5828 1954 3455 375
1859 5439 1977 4160 384
1860 6122 2063 4357 550
1861 5941 2047 3020 551
1862 5859 2191 3214 630
1863 5890 2094 3773 633
1864 5653 2024 4630 557
1865 5472 2186 6088 609
1866 5671 2124 8863 549
1867 6098 2284 12277 714
1868 6103 2490 12526 828
1869 5906 2407 12931 616
1870 3850 2180 12137 648
1871 2782 2376 11659 458
1872 4875 2771 12180 958
1873 5074 2974 11616 1130
1874 5746 3162 12230 1245
1875 6007 3112 13291 1382
1876 6736 3435 14169 1947
1877 7101 3317 12920 1604
1878 7981 3509 12345 4200
1879 7828 3524 12165 4410
1880 7660 3741 12902 3960
1881 7813 3950 15500 4339
1882 7724 4337 18091 4131
1883 8087 3962 21162 4848
1884 8253 9983 19118 4459
1885 8696 8775 23285 4018
1886 9011 9099 21767 4008
1887 8863 9226 20403 3882
1888 8669 9309 19551 3923
1889 9287 10081 23324 4406
1890 9009 10646 25313 4680
1891 9292 10643 22312 5550
1892 9902 11164 22647 5900
1893 9860 11600 22750 6430
1894 10433 11699 19855 6280
1895 10257 12191 20856 5720
1896 11430 12473 21822 5410
1897 12550 14210 22067 5440
1898 12421 14167 20377 5570
1899 12713 14160 23278 7430
1900 12399 13710 24644 8784
1901 12103 13062 25546 10508
1902 12026 13764 27119 10610
1903 12469 15718 31029 9964
1904 12574 15089 30258 9189
1905 12953 14786 29775 9600
1906 13097 14707 31170 13430
1907 13170 16272 35859 13250
1908 13807 16284 32735 11610
1909 13466 15065 36561 11995
1910 16064 15269 35141 12100
1911 15593 17164 32856 12640
1912 15737 15814 36198 13080
1913 15967 16599 33917 13520
1914 12161 15036 39892 12350
1915 5056 11457 43118 8190
1916 3250 8424 43892 6271
1917 4100 9347 40935 7399
1918 4400 10809 38452 7340
1919 10500 12301 36797 7766
1920 18950 14191 37060 14452
1921 17700 17697 37798 15642
1922 18300 17366 38369 20715
1923 19200 17073 38616 20526
1924 19200 16839 42584 18189
1925 18000 17199 46432 15877
1926 18200 17333 44733 15500
1927 17500 17624 41717 15265
1928 22000 17695 42357 15598
1929 24000 18937 45267 20202
1930 24000 20888 45226 26737
1931 24000 21949 51761 25846
1932 21850 21150 53504 26201
1933 20000 17228 48807 21755
1934 19100 16890 44452 17011
1935 18000 17675 40663 16139
1936 16700 17819 39831 16750
1937 16750 17614 37738 14526
1938 14000 19314 38102 15068
1939 15550 17605 43118 16525
1940 10100 11453 42323 14647
1941 8150 11179 41171 14809
1942 10000 7962 38514 14648
1943 12250 7945 31101 14883
1944 11650 7712 28091 .
1945 7360 7465 25712 .
1946 11050 8971 21859 .
1947 13500 11727 20191 .
1948 13700 15558 24007 .
1949 16700 20703 35224 .
1950 17800 13509 43219 .
1951 25200 13761 44384 27767
1952 20400 21380 43717 37179
1953 43000 17882 40546 37113
1954 34000 17985 33910 19140
1955 23000 20630 30535 14760
1956 21900 19938 46918 18150
1957 23000 25205 42873 20467
1958 24950 18531 48450 19837
1959 41600 18157 52509 22556
1960 35000 26775 47286 19666

Additional Reading

Khan, B. Zorina. The Democratization of Invention: Patents and Copyrights in American Economic Development. New York: Cambridge University Press, 2005.

Khan, B. Zorina, and Kenneth L. Sokoloff. “Institutions and Technological Innovation during Early Economic Growth, 1790-1930.” NBER Working Paper No. 10966. Cambridge, MA: December 2004. (Available at www.nber.org.)

Bibliography

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Bugbee, Bruce. The Genesis of American Patent and Copyright Law. Washington, DC: Public Affairs Press, 1967.

Coulter, Moureen. Property in Ideas: The Patent Question in Mid-Victorian England. Kirksville, MO: Thomas Jefferson Press, 1991

Dutton, H. I. The Patent System and Inventive Activity during the Industrial Revolution, 1750-1852, Manchester, UK: Manchester University Press, 1984.

Epstein, R. “Industrial Inventions: Heroic or Systematic?” Quarterly Journal of Economics 40 (1926): 232-72.

Gallini, Nancy T. “The Economics of Patents: Lessons from Recent U.S. Patent Reform.” Journal of Economic Perspectives 16, no. 2 (2002): 131–54.

Gilbert, Richard and Carl Shapiro. “Optimal Patent Length and Breadth.” Rand Journal of Economics 21 (1990): 106-12.

Gilfillan, S. Colum. The Sociology of Invention. Cambridge, MA: Follett, 1935.

Gomme, A. A. Patents of Invention: Origin and Growth of the Patent System in Britain, London: Longmans Green, 1946.

Harding, Herbert. Patent Office Centenary, London: Her Majesty’s Stationery Office, 1953.

Hilaire-Pérez, Liliane. Inventions et Inventeurs en France et en Angleterre au XVIIIe siècle. Lille: Université de Lille, 1994.

Hilaire-Pérez, Liliane. L’invention technique au siècle des Lumières. Paris: Albin Michel, 2000.

Jeremy, David J., Transatlantic Industrial Revolution: The Diffusion of Textile Technologies between Britain and America, 1790-1830s. Cambridge, MA: MIT Press, 1981.

Khan, B. Zorina. “Property Rights and Patent Litigation in Early Nineteenth-Century America.” Journal of Economic History 55, no. 1 (1995): 58-97.

Khan, B. Zorina. “Married Women’s Property Right Laws and Female Commercial Activity.” Journal of Economic History 56, no. 2 (1996): 356-88.

Khan, B. Zorina. “Federal Antitrust Agencies and Public Policy towards Patents and Innovation.” Cornell Journal of Law and Public Policy 9 (1999): 133-69.

Khan, B. Zorina, “`Not for Ornament’: Patenting Activity by Women Inventors.” Journal of Interdisciplinary History 33, no. 2 (2000): 159-95.

Khan, B. Zorina. “Technological Innovations and Endogenous Changes in U.S. Legal Institutions, 1790-1920.” NBER Working Paper No. 10346. Cambridge, MA: March 2004. (available at www.nber.org)

Khan, B. Zorina, and Kenneth L. Sokoloff. “‘Schemes of Practical Utility’: Entrepreneurship and Innovation among ‘Great Inventors’ in the United States, 1790-1865.” Journal of Economic History 53, no. 2 (1993): 289-307.

Khan, B. Zorina, and Kenneth L. Sokoloff. “Entrepreneurship and Technological Change in Historical Perspective.” Advances in the Study of Entrepreneurship, Innovation, and Economic Growth 6 (1993): 37-66.

Khan, B. Zorina, and Kenneth L. Sokoloff. “Two Paths to Industrial Development and Technological Change.” In Technological Revolutions in Europe, 1760-1860, edited by Maxine Berg and Kristine Bruland. London: Edward Elgar, London, 1997.

Khan, B. Zorina, and Kenneth L. Sokoloff. “The Early Development of Intellectual Property Institutions in the United States.” Journal of Economic Perspectives 15, no. 3 (2001): 233-46.

Khan, B. Zorina, and Kenneth L. Sokoloff. “Innovation of Patent Systems in the Nineteenth Century: A Comparative Perspective.” Unpublished manuscript (2001).

Khan, B. Zorina, and Kenneth L. Sokoloff. “Institutions and Democratic Invention in Nineteenth-century America.” American Economic Review Papers and Proceedings 94 (2004): 395-401.

Khan, B. Zorina, and Kenneth L. Sokoloff. “Institutions and Technological Innovation during Early Economic Growth: Evidence from the Great Inventors of the United States, 1790-1930.” In Institutions and Economic Growth, edited by Theo Eicher and Cecilia Garcia-Penalosa. Cambridge, MA: MIT Press, 2006.

Lamoreaux, Naomi R. and Kenneth L. Sokoloff. “Long-Term Change in the Organization of Inventive Activity.” Science, Technology and the Economy 93 (1996): 1286-92.

Lamoreaux, Naomi R. and Kenneth L. Sokoloff. “The Geography of Invention in the American Glass Industry, 1870-1925.” Journal of Economic History 60, no. 3 (2000): 700-29.

Lamoreaux, Naomi R. and Kenneth L. Sokoloff. “Market Trade in Patents and the Rise of a Class of Specialized Inventors in the Nineteenth-century United States.” American Economic Review 91, no. 2 (2001): 39-44.

Landes, David S. Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. Cambridge: Cambridge University Press, 1969.

Lerner, Josh. “Patent Protection and Innovation over 150 Years.” NBER Working Paper No. 8977. Cambridge, MA: June 2002.

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Machlup, Fritz. An Economic Review of the Patent System. Washington, DC: U.S. Government Printing Office, 1958.

Machlup, Fritz. “The Supply of Inventors and Inventions.” In The Rate and Direction of Inventive Activity, edited by R. Nelson. Princeton: Princeton University Press, 1962.

Machlup, Fritz, and Edith Penrose. “The Patent Controversy in the Nineteenth Century.” Journal of Economic History 10, no. 1 (1950): 1-29.

Macleod, Christine. Inventing the Industrial Revolution. Cambridge: Cambridge University Press, 1988.

McCloy, Shelby T. French Inventions of the Eighteenth Century. Lexington: University of Kentucky Press, 1952.

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Schmookler, Jacob. Invention and Economic Growth. Cambridge, MA: Harvard University Press, 1966.

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Sokoloff, Kenneth L. “Invention, Innovation, and Manufacturing Productivity Growth in the Antebellum Northeast.” In American Economic Growth and Standards of Living before the Civil War, edited by Robert E. Gallman and John Joseph Wallis, 345-78. Chicago: University of Chicago Press, 1992.

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Citation: Khan, B. “An Economic History of Patent Institutions”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/an-economic-history-of-patent-institutions/

An Economic History of New Zealand in the Nineteenth and Twentieth Centuries

John Singleton, Victoria University of Wellington, New Zealand

Living standards in New Zealand were among the highest in the world between the late nineteenth century and the 1960s. But New Zealand’s economic growth was very sluggish between 1950 and the early 1990s, and most Western European countries, as well as several in East Asia, overtook New Zealand in terms of real per capita income. By the early 2000s, New Zealand’s GDP per capita was in the bottom half of the developed world.

Table 1:
Per capita GDP in New Zealand
compared with the United States and Australia
(in 1990 international dollars)

US Australia New Zealand NZ as
% of US
NZ as % of
Austrialia
1840 1588 1374 400 25 29
1900 4091 4013 4298 105 107
1950 9561 7412 8456 88 114
2000 28129 21540 16010 57 74

Source: Angus Maddison, The World Economy: Historical Statistics. Paris: OECD, 2003, pp. 85-7.

Over the second half of the twentieth century, argue Greasley and Oxley (1999), New Zealand seemed in some respects to have more in common with Latin American countries than with other advanced western nations. As well as a snail-like growth rate, New Zealand followed highly protectionist economic policies between 1938 and the 1980s. (In absolute terms, however, New Zealanders continued to be much better off than their Latin American counterparts.) Maddison (1991) put New Zealand in a middle-income group of countries, including the former Czechoslovakia, Hungary, Portugal, and Spain.

Origins and Development to 1914

When Europeans (mainly Britons) started to arrive in Aotearoa (New Zealand) in the early nineteenth century, they encountered a tribal society. Maori tribes made a living from agriculture, fishing, and hunting. Internal trade was conducted on the basis of gift exchange. Maori did not hold to the Western concept of exclusive property rights in land. The idea that land could be bought and sold was alien to them. Most early European residents were not permanent settlers. They were short-term male visitors involved in extractive activities such as sealing, whaling, and forestry. They traded with Maori for food, sexual services, and other supplies.

Growing contact between Maori and the British was difficult to manage. In 1840 the British Crown and some Maori signed the Treaty of Waitangi. The treaty, though subject to various interpretations, to some extent regularized the relationship between Maori and Europeans (or Pakeha). At roughly the same time, the first wave of settlers arrived from England to set up colonies including Wellington and Christchurch. Settlers were looking for a better life than they could obtain in overcrowded and class-ridden England. They wished to build a rural and largely self-sufficient society.

For some time, only the Crown was permitted to purchase land from Maori. This land was then either resold or leased to settlers. Many Maori felt – and many still feel – that they were forced to give up land, effectively at gunpoint, in return for a pittance. Perhaps they did not always grasp that land, once sold, was lost forever. Conflict over land led to intermittent warfare between Maori and settlers, especially in the 1860s. There was brutality on both sides, but the Europeans on the whole showed more restraint in New Zealand than in North America, Australia, or Southern Africa.

Maori actually required less land in the nineteenth century because their numbers were falling, possibly by half between the late eighteenth and late nineteenth centuries. By the 1860s, Maori were outnumbered by British settlers. The introduction of European diseases, alcohol, and guns contributed to the decline in population. Increased mobility and contact between tribes may also have spread disease. The Maori population did not begin to recover until the twentieth century.

Gold was discovered in several parts of New Zealand (including Thames and Otago) in the mid-nineteenth century, but the introduction of sheep farming in the 1850s gave a more enduring boost to the economy. Australian and New Zealand wool was in high demand in the textile mills of Yorkshire. Sheep farming necessitated the clearing of native forests and the planting of grasslands, which changed the appearance of large tracts of New Zealand. This work was expensive, and easy access to the London capital market was critical. Economic relations between New Zealand and Britain were strong, and remained so until the 1970s.

Between the mid-1870s and mid-1890s, New Zealand was adversely affected by weak export prices, and in some years there was net emigration. But wool prices recovered in the 1890s, just as new exports – meat and dairy produce – were coming to prominence. Until the advent of refrigeration in the early 1880s, New Zealand did not export meat and dairy produce. After the introduction of refrigeration, however, New Zealand foodstuffs found their way on to the dinner tables of working class families in Britain, but not the tables of the middle and upper classes, as they could afford fresh produce.

In comparative terms, the New Zealand economy was in its heyday in the two decades before 1914. New Zealand (though not its Maori shadow, Aotearoa) was a wealthy, dynamic, and egalitarian society. The total population in 1914 was slightly above one million. Exports consisted almost entirely of land-intensive pastoral commodities. Manufactures loomed large in New Zealand’s imports. High labor costs, and the absence of scale economies in the tiny domestic market, hindered industrialization, though there was some processing of export commodities and imports.

War, Depression and Recovery, 1914-38

World War One disrupted agricultural production in Europe, and created a robust demand for New Zealand’s primary exports. Encouraged by high export prices, New Zealand farmers borrowed and invested heavily between 1914 and 1920. Land exchanged hands at very high prices. Unfortunately, the early twenties brought the start of a prolonged slump in international commodity markets. Many farmers struggled to service and repay their debts.

The global economic downturn, beginning in 1929-30, was transmitted to New Zealand by the collapse in commodity prices on the London market. Farmers bore the brunt of the depression. At the trough, in 1931-32, net farm income was negative. Declining commodity prices increased the already onerous burden of servicing and repaying farm mortgages. Meat freezing works, woolen mills, and dairy factories were caught in the spiral of decline. Farmers had less to spend in the towns. Unemployment rose, and some of the urban jobless drifted back to the family farm. The burden of external debt, the bulk of which was in sterling, rose dramatically relative to export receipts. But a protracted balance of payments crisis was avoided, since the demand for imports fell sharply in response to the drop in incomes. The depression was not as serious in New Zealand as in many industrial countries. Prices were more flexible in the primary sector and in small business than in modern, capital-intensive industry. Nevertheless, the experience of depression profoundly affected New Zealanders’ attitudes towards the international economy for decades to come.

At first, there was no reason to expect that the downturn in 1929-30 was the prelude to the worst slump in history. As tax and customs revenue fell, the government trimmed expenditure in an attempt to balance the budget. Only in 1931 was the severity of the crisis realized. Further cuts were made in public spending. The government intervened in the labor market, securing an order for an all-round reduction in wages. It pressured and then forced the banks to reduce interest rates. The government sought to maintain confidence and restore prosperity by helping farms and other businesses to lower costs. But these policies did not lead to recovery.

Several factors contributed to the recovery that commenced in 1933-34. The New Zealand pound was devalued by 14 percent against sterling in January 1933. As most exports were sold for sterling, which was then converted into New Zealand pounds, the income of farmers was boosted at a stroke of the pen. Devaluation increased the money supply. Once economic actors, including the banks, were convinced that the devaluation was permanent, there was an increase in confidence and in lending. Other developments played their part. World commodity prices stabilized, and then began to pick up. Pastoral output and productivity continued to rise. The 1932 Ottawa Agreements on imperial trade strengthened New Zealand’s position in the British market at the expense of non-empire competitors such as Argentina, and prefigured an increase in the New Zealand tariff on non-empire manufactures. As was the case elsewhere, the recovery in New Zealand was not the product of a coherent economic strategy. When beneficial policies were adopted it was as much by accident as by design.

Once underway, however, New Zealand’s recovery was comparatively rapid and persisted over the second half of the thirties. A Labour government, elected towards the end of 1935, nationalized the central bank (the Reserve Bank of New Zealand). The government instructed the Reserve Bank to create advances in support of its agricultural marketing and state housing schemes. It became easier to obtain borrowed funds.

An Insulated Economy, 1938-1984

A balance of payments crisis in 1938-39 was met by the introduction of administrative restrictions on imports. Labour had not been prepared to deflate or devalue – the former would have increased unemployment, while the latter would have raised working class living costs. Although intended as a temporary expedient, the direct control of imports became a distinctive feature of New Zealand economic policy until the mid-1980s.

The doctrine of “insulationism” was expounded during the 1940s. Full employment was now the main priority. In the light of disappointing interwar experience, there were doubts about the ability of the pastoral sector to provide sufficient work for New Zealand’s growing population. There was a desire to create more industrial jobs, even though there seemed no prospect of achieving scale economies within such a small country. Uncertainty about export receipts, the need to maintain a high level of domestic demand, and the competitive weakness of the manufacturing sector, appeared to justify the retention of quantitative import controls.

After 1945, many Western countries retained controls over current account transactions for several years. When these controls were relaxed and then abolished in the fifties and early sixties, the anomalous nature of New Zealand’s position became more visible. Although successive governments intended to liberalize, in practice they achieved little, except with respect to trade with Australia.

The collapse of the Korean War commodity boom, in the early 1950s, marked an unfortunate turning point in New Zealand’s economic history. International conditions were unpropitious for the pastoral sector in the second half of the twentieth century. Despite the aspirations of GATT, the United States, Western Europe and Japan restricted agricultural imports, especially of temperate foodstuffs, subsidized their own farmers and, in the case of the Americans and the Europeans, dumped their surpluses in third markets. The British market, which remained open until 1973, when the United Kingdom was absorbed into the EEC, was too small to satisfy New Zealand. Moreover, even the British resorted to agricultural subsidies. Compared with the price of industrial goods, the price of agricultural produce tended to weaken over the long term.

Insulation was a boon to manufacturers, and New Zealand developed a highly diversified industrial structure. But competition was ineffectual, and firms were able to pass cost increases on to the consumer. Import barriers induced many British, American, and Australian multinationals to establish plants in New Zealand. The protected industrial economy did have some benefits. It created jobs – there was full employment until the 1970s – and it increased the stock of technical and managerial skills. But consumers and farmers were deprived of access to cheaper – and often better quality – imported goods. Their interests and welfare were neglected. Competing demand from protected industries also raised the costs of farm inputs, including labor power, and thus reduced the competitiveness of New Zealand’s key export sector.

By the early 1960s, policy makers had realized that New Zealand was falling behind in the race for greater prosperity. The British food market was under threat, as the Macmillan government began a lengthy campaign to enter the protectionist EEC. New Zealand began to look for other economic partners, and the most obvious candidate was Australia. In 1901, New Zealand had declined to join the new federation of Australian colonies. Thus it had been excluded from the Australian common market. After lengthy negotiations, a partial New Zealand-Australia Free Trade Agreement (NAFTA) was signed in 1965. Despite initial misgivings, many New Zealand firms found that they could compete in the Australian market, where tariffs against imports from the rest of the world remained quite high. But this had little bearing on their ability to compete with European, Asian, and North American firms. NAFTA was given renewed impetus by the Closer Economic Relations (CER) agreement of 1983.

Between 1973 and 1984, New Zealand governments were overwhelmed by a group of inter-related economic crises, including two serious supply shocks (the oil crises), rising inflation, and increasing unemployment. Robert Muldoon, the National Party (conservative) prime minister between 1975 and 1984, pursued increasingly erratic macroeconomic policies. He tightened government control over the economy in the early eighties. There were dramatic fluctuations in inflation and in economic growth. In desperation, Muldoon imposed a wage and price freeze in 1982-84. He also mounted a program of large-scale investments, including the expansion of a steel works, and the construction of chemical plants and an oil refinery. By means of these investments, he hoped to reduce the import bill and secure a durable improvement in the balance of payments. But the “Think Big” strategy failed – the projects were inadequately costed, and inherently risky. Although Muldoon’s intention had been to stabilize the economy, his policies had the opposite effect.

Economic Reform, 1984-2000

Muldoon’s policies were discredited, and in 1984 the Labour Party came to power. All other economic strategies having failed, Labour resolved to deregulate and restore the market process. (This seemed very odd at the time.) Within a week of the election, virtually all controls over interest rates had been abolished. Financial markets were deregulated, and, in March 1985, the New Zealand dollar was floated. Other changes followed, including the sale of public sector trading organizations, the reduction of tariffs and the elimination of import licensing. However, reform of the labor market was not completed until the early 1990s, by which time National (this time without Muldoon or his policies) was back in office.

Once credit was no longer rationed, there was a large increase in private sector borrowing, and a boom in asset prices. Numerous speculative investment and property companies were set up in the mid-eighties. New Zealand’s banks, which were not used to managing risk in a deregulated environment, scrambled to lend to speculators in an effort not to miss out on big profits. Many of these ventures turned sour, especially after the 1987 share market crash. Banks were forced to reduce their lending, to the detriment of sound as well as unsound borrowers.

Tight monetary policy and financial deregulation led to rising interest rates after 1984. The New Zealand dollar appreciated strongly. Farmers bore the initial brunt of high borrowing costs and a rising real exchange rate. Manufactured imports also became more competitive, and many inefficient firms were forced to close. Unemployment rose in the late eighties and early nineties. The early 1990s were marked by an international recession, which was particularly painful in New Zealand, not least because of the high hopes raised by the post-1984 reforms.

An economic recovery began towards the end of 1991. With a brief interlude in 1998, strong growth persisted for the remainder of the decade. Confidence was gradually restored to the business sector. Unemployment began to recede. After a lengthy time lag, the economic reforms seemed to be paying off for the majority of the population.

Large structural changes took place after 1984. Factors of production switched out of the protected manufacturing sector, and were drawn into services. Tourism boomed as the relative cost of international travel fell. The face of the primary sector also changed, and the wine industry began to penetrate world markets. But not all manufacturers struggled. Some firms adapted to the new environment and became more export-oriented. For instance, a small engineering company, Scott Technology, became a world leader in the provision of equipment for the manufacture of refrigerators and washing machines.

Annual inflation was reduced to low single digits by the early nineties. Price stability was locked in through the 1989 Reserve Bank Act. This legislation gave the central bank operational autonomy, while compelling it to focus on the achievement and maintenance of price stability rather than other macroeconomic objectives. The Reserve Bank of New Zealand was the first central bank in the world to adopt a regime of inflation targeting. The 1994 Fiscal Responsibility Act committed governments to sound finance and the reduction of public debt.

By 2000, New Zealand’s population was approaching four million. Overall, the reforms of the eighties and nineties were responsible for creating a more competitive economy. New Zealand’s economic decline relative to the rest of the OECD was halted, though it was not reversed. In the nineties, New Zealand enjoyed faster economic growth than either Germany or Japan, an outcome that would have been inconceivable a few years earlier. But many New Zealanders were not satisfied. In particular, they were galled that their closest neighbor, Australia, was growing even faster. Australia, however, was an inherently much wealthier country with massive mineral deposits.

Assessment

Several explanations have been offered for New Zealand’s relatively poor economic performance during the twentieth century.

Wool, meat, and dairy produce were the foundations of New Zealand’s prosperity in Victorian and Edwardian times. After 1920, however, international market conditions were generally unfavorable to pastoral exports. New Zealand had the wrong comparative advantage to enjoy rapid growth in the twentieth century.

Attempts to diversify were only partially successful. High labor costs and the small size of the domestic market hindered the efficient production of standardized labor-intensive goods (e.g. garments) and standardized capital-intensive goods (e.g. autos). New Zealand might have specialized in customized and skill-intensive manufactures, but the policy environment was not conducive to the promotion of excellence in niche markets. Between 1938 and the 1980s, Latin American-style trade policies fostered the growth of a ramshackle manufacturing sector. Only in the late eighties did New Zealand decisively reject this regime.

Geographical and geological factors also worked to New Zealand’s disadvantage. Australia drew ahead of New Zealand in the 1960s, following the discovery of large mineral deposits for which there was a big market in Japan. Staple theory suggests that developing countries may industrialize successfully by processing their own primary products, instead of by exporting them in a raw state. Canada had coal and minerals, and became a significant industrial power. But New Zealand’s staples of wool, meat and dairy produce offered limited downstream potential.

Canada also took advantage of its proximity to the U.S. market, and access to U.S. capital and technology. American-style institutions in the labor market, business, education and government became popular in Canada. New Zealand and Australia relied on, arguably inferior, British-style institutions. New Zealand was a long way from the world’s economic powerhouses, and it was difficult for its firms to establish and maintain contact with potential customers and collaborators in Europe, North America, or Asia.

Clearly, New Zealand’s problems were not all of its own making. The elimination of agricultural protectionism in the northern hemisphere would have given a huge boost the New Zealand economy. On the other hand, in the period between the late 1930s and mid-1980s, New Zealand followed inward-looking economic policies that hindered economic efficiency and flexibility.

References

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Belich, James. Making Peoples: A History of the New Zealanders from Polynesian Settlement to the End of the Nineteenth Century, Auckland: Penguin, 1996.

Condliffe, John B. New Zealand in the Making. London: George Allen & Unwin, 1930.

Dalziel, Paul. “New Zealand’s Economic Reforms: An Assessment.” Review of Political Economy 14, no. 2 (2002): 31-46.

Dalziel, Paul and Ralph Lattimore. The New Zealand Macroeconomy: Striving for Sustainable Growth with Equity. Melbourne: Oxford University Press, fifth edition, 2004.

Easton, Brian. In Stormy Seas: The Post-War New Zealand Economy. Dunedin: University of Otago Press, 1997.

Endres, Tony and Ken Jackson. “Policy Responses to the Crisis: Australasia in the 1930s.” In Capitalism in Crisis: International Responses to the Great Depression, edited by Rick Garside, 148-65. London: Pinter, 1993.

Evans, Lewis, Arthur Grimes, and Bryce Wilkinson (with David Teece), “Economic Reform in New Zealand 1984-95: The Pursuit of Efficiency.” Journal of Economic Literature 34, no. 4 (1996): 1856-1902.

Gould, John D. The Rake’s Progress: the New Zealand Economy since 1945. Auckland: Hodder and Stoughton, 1982.

Greasley, David and Les Oxley. “A Tale of Two Dominions: Comparing the Macroeconomic Records of Australia and Canada since 1870.” Economic History Review 51, no. 2 (1998): 294-318.

Greasley, David and Les Oxley. “Outside the Club: New Zealand’s Economic Growth, 1870-1993.” International Review of Applied Economics 14, no. 2 (1999): 173-92.

Greasley, David and Les Oxley. “Regime Shift and Fast Recovery on the Periphery: New Zealand in the 1930s.” Economic History Review 55, no. 4 (2002): 697-720.

Hawke, Gary R. The Making of New Zealand: An Economic History. Cambridge: Cambridge University Press, 1985.

Jones, Steve R.H. “Government Policy and Industry Structure in New Zealand, 1900-1970.” Australian Economic History Review 39, no, 3 (1999): 191-212.

Mabbett, Deborah. Trade, Employment and Welfare: A Comparative Study of Trade and Labour Market Policies in Sweden and New Zealand, 1880-1980. Oxford: Clarendon Press, 1995.

Maddison, Angus. Dynamic Forces in Capitalist Development. Oxford: Oxford University Press, 1991.

Maddison, Angus. The World Economy: Historical Statistics. Paris: OECD, 2003.

McKinnon, Malcolm. Treasury: 160 Years of the New Zealand Treasury. Auckland: Auckland University Press in association with the Ministry for Culture and Heritage, 2003.

Schedvin, Boris. “Staples and Regions of the Pax Britannica.” Economic History Review 43, no. 4 (1990): 533-59.

Silverstone, Brian, Alan Bollard, and Ralph Lattimore, editors. A Study of Economic Reform: The Case of New Zealand. Amsterdam: Elsevier, 1996.

Singleton, John. “New Zealand: Devaluation without a Balance of Payments Crisis.” In The World Economy and National Economies in the Interwar Slump, edited by Theo Balderston, 172-90. Basingstoke: Palgrave, 2003.

Singleton, John and Paul L. Robertson. Economic Relations between Britain and Australasia, 1945-1970. Basingstoke: Palgrave, 2002.

Ville, Simon. The Rural Entrepreneurs: A History of the Stock and Station Agent Industry in Australia and New Zealand. Cambridge: Cambridge University Press, 2000.

Citation: Singleton, John. “New Zealand in the Nineteenth and Twentieth Centuries”. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. URL http://eh.net/encyclopedia/an-economic-history-of-new-zealand-in-the-nineteenth-and-twentieth-centuries/

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 Economic History of Korea

The Economic History of Korea

Myung Soo Cha, Yeungnam University

Three Periods

Two regime shifts divide the economic history of Korea during the past six centuries into three distinct periods: 1) the period of Malthusian stagnation up to 1910, when Japan annexed Korea; 2) the colonial period from 1910-45, when the country embarked upon modern economic growth; and 3) the post colonial decades, when living standards improved rapidly in South Korea, while North Korea returned to the world of disease and starvation. The dramatic history of living standards in Korea presents one of the most convincing pieces of evidence to show that institutions — particularly the government — matter for economic growth.

Dynastic Degeneration

The founders of the Chosôn dynasty (1392-1910) imposed a tribute system on a little-commercialized peasant economy, collecting taxes in the form of a wide variety of products and mobilizing labor to obtain the handicrafts and services it needed. From the late sixteenth to the early seventeenth century, invading armies from Japan and China shattered the command system and forced a transition to a market economy. The damaged bureaucracy started to receive taxes in money commodities — rice and cotton textiles — and eventually began to mint copper coins and lifted restrictions on trade. The wars also dealt a serious blow to slavery and the pre-war system of forced labor, allowing labor markets to emerge.

Markets were slow to develop: grain markets in agricultural regions of Korea appeared less integrated than those in comparable parts of China and Japan. Population and acreage, however, recovered quickly from the adverse impact of the wars. Population growth came to a halt around 1800, and a century of demographic stagnation followed due to a higher level of mortality. During the nineteenth century, living standards appeared to deteriorate. Both wages and rents fell, tax receipts shrank, and budget deficits expanded, forcing the government to resort to debasement. Peasant rebellions occurred more frequently, and poor peasants left Korea for northern China.

Given that both acreage and population remained stable during the nineteenth century, the worsening living standards imply that the aggregate output contracted, because land and labor were being used in an ever more inefficient way. The decline in efficiency appeared to have much to do with disintegrating system of water control, which included flood control and irrigation.

The water control problem had institutional roots, as in Q’ing China. Population growth caused rapid deforestation, as peasants were able to readily obtain farmlands by burning off forests, where property rights usually remained ill-defined. (This contrasts with Tokugawa Japan, where conflicts and litigation following competitive exploitation of forests led to forest regulation.) While the deforestation wrought havoc on reservoirs by increasing the incidence and intensity of flooding, private individuals had little incentives to repair the damages, as they expected others to free-ride on the benefits of their efforts. Keeping the system of water control in good condition required public initiatives, which the dynastic government could not undertake. During the nineteenth century, powerful landowning families took turns controlling minor or ailing kings, reducing the state to an instrument serving private interests. Failing to take measures to maintain irrigation, provincial officials accelerated its decay by taking bribes in return for conniving at the practice of farming on the rich soil alongside reservoirs. Peasants responded to the decaying irrigation by developing new rice seed varieties, which could better resist droughts but yielded less. They also tried to counter the increasingly unstable water supply by building waterways linking farmlands with rivers, which frequently met opposition from people farming further downstream. Not only did provincial administrators fail to settle the water disputes, but also some of them became central causes of clashes. In 1894 peasants protested against a local administrator’s attempts to generate private income by collecting fees for using waterways, which had been built by peasants. The uprising quickly developed into a nationwide peasant rebellion, which the crumbling government could suppress only by calling in military forces from China and Japan. An unforeseen consequence of the rebellion was the Sino-Japanese war fought on the Korean soil, where Japan defeated China, tipping the balance of power in Korea critically in her favor.

The water control problem affected primarily rice farming productivity: during the nineteenth century paddy land prices (as measured by the amount of rice) fell, while dry farm prices (as measured by the amount of dry farm products) rose. Peasants and landlords converted paddy lands into dry farms during the nineteenth century, and there occurred an exodus of workers out of agriculture into handicraft and commerce. Despite the proto-industrialization, late dynastic Korea remained less urbanized than Q’ing China, not to mention Tokugawa Japan. Seasonal fluctuations in rice prices in the main agricultural regions of Korea were far wider than those observed in Japan during the nineteenth century, implying a significantly higher interest rate, a lower level of capital per person, and therefore lower living standards for Korea. In the mid-nineteenth century paddy land productivity in Korea was about half of that in Japan.

Colonial Transition to Modern Economic Growth

Less than two decades after having been opened by Commodore Perry, Japan first made its ambitions about Korea known by forcing the country open to trade in 1876. Defeating Russia in the war of 1905, Japan virtually annexed Korea, which was made official five years later. What replaced the feeble and predatory bureaucracy of the ChosǑn dynasty was a developmental state. Drawing on the Meiji government’s experience, the colonial state introduced a set of expensive policy measures to modernize Korea. One important project was to improve infrastructure: railway lines were extended, and roads and harbors and communication networks were improved, which rapidly integrated goods and factor markets both nationally and internationally. Another project was a vigorous health campaign: the colonial government improved public hygiene, introduced modern medicine, and built hospitals, significantly accelerating the mortality decline set in motion around 1890, apparently by the introduction of the smallpox vaccination. The mortality transition resulted in a population expanding 1.4% per year during the colonial period. The third project was to revamp education. As modern teaching institutions quickly replaced traditional schools teaching Chinese classics, primary school enrollment ration rose from 1 percent in 1910 to 47 percent in 1943. Finally, the cadastral survey (1910-18) modernized and legalized property rights to land, which boosted not only the efficiency in land use, but also tax revenue from landowners. These modernization efforts generated sizable public deficits, which the colonial government could finance partly by floating bonds in Japan and partly by unilateral transfers from the Japanese government.

The colonial government implemented industrial policy as well. The Rice Production Development Program (1920-1933), a policy response to the Rice Riots in Japan in 1918, was aimed at increasing rice supply within the Japanese empire. In colonial Korea, the program placed particular emphasis upon reversing the decay in water control. The colonial government provided subsidies for irrigation projects, and set up institutions to lower information, negotiation, and enforcement costs in building new waterways and reservoirs. Improved irrigation made it possible for peasants to grow high yielding rice seed varieties. Completion of a chemical fertilizer factory in 1927 increased the use of fertilizer, further boosting the yields from the new type of rice seeds. Rice prices fell rapidly in the late 1920s and early 1930s in the wake of the world agricultural depression, leading to the suspension of the program in 1933.

Despite the Rice Program, the structure of the colonial economy has been shifting away from agriculture towards manufacturing ever since the beginning of the colonial rule at a consistent pace. From 1911-40 the share of manufacturing in GDP increased from 6 percent to 28 percent, and the share of agriculture fell from 76 percent to 41 percent. Major causes of the structural change included diffusion of modern manufacturing technology, the world agricultural depression shifting the terms of trade in favor of manufacturing, and Japan’s early recovery from the Great Depression generating an investment boom in the colony. Also Korea’s cheap labor and natural resources and the introduction of controls on output and investment in Japan to mitigate the impact of the Depression helped attract direct investment in the colony. Finally, subjugating party politicians and pushing Japan into the Second World War with the invasion of China in 1937, the Japanese military began to develop northern parts of Korea peninsula as an industrial base producing munitions.

The institutional modernization, technological diffusion, and the inflow of Japanese capital put an end to the Malthusian degeneration and pushed Korea onto the path of modern economic growth. Both rents and wages stopped falling and started to rise from the early twentieth century. As the population explosion made labor increasingly abundant vis-a-vis land, rents increased more rapidly than wages, suggesting that income distribution became less equal during the colonial period. Per capita output rose faster than one percent per year from 1911-38.

Per capita grain consumption declined during the colonial period, providing grounds for traditional criticism of the Japanese colonialism exploiting Korea. However, per capita real consumption increased, due to rising non-grain and non-good consumption, and Koreans were also getting better education and living longer. In the late 1920s, life expectancy at birth was 37 years, an estimate several years longer than in China and almost ten years shorter than in Japan. Life expectancy increased to 43 years at the end of the colonial period. Male mean stature was slightly higher than 160 centimeters at the end of the 1920s, a number not significantly different from the Chinese or Japanese height, and appeared to become shorter during the latter half of the colonial period.

South Korean Prosperity

With the end of the Second World War in 1945, two separate regimes emerged on the Korean peninsula to replace the colonial government. The U.S. military government took over the southern half, while communist Russia set up a Korean leadership in the northern half. The de-colonization and political division meant sudden disruption of trade both with Japan and within Korea, causing serious economic turmoil. Dealing with the post-colonial chaos with economic aid, the U.S. military government privatized properties previously owned by the Japanese government and civilians. The first South Korean government, established in 1948, carried out a land reform, making land distribution more egalitarian. Then the Korean War broke out in 1950, killing one and half million people and destroying about a quarter of capital stock during its three year duration.

After the war, South Korean policymakers set upon stimulating economic growth by promoting indigenous industrial firms, following the example of many other post-World War II developing countries. The government selected firms in targeted industries and gave them privileges to buy foreign currencies and to borrow funds from banks at preferential rates. It also erected tariff barriers and imposed a prohibition on manufacturing imports, hoping that the protection would give domestic firms a chance to improve productivity through learning-by-doing and importing advanced technologies. Under the policy, known as import-substitution industrialization (ISI), entrepreneurs seemed more interested in maximizing and perpetuating favors by bribing bureaucrats and politicians, however. This behavior, dubbed as directly unproductive profit-seeking activities (DUP), caused efficiency to falter and living standards to stagnate, providing a background to the collapse of the First Republic in April 1960.

The military coup led by General Park Chung Hee overthrew the short-lived Second Republic in May 1961, making a shift to a strategy of stimulating growth through export promotion (EP hereafter), although ISI was not altogether abandoned. Under EP, policymakers gave various types of favors — low interest loans being the most important — to exporting firms according to their export performance. As the qualification for the special treatment was quantifiable and objective, the room for DUP became significantly smaller. Another advantage of EP over ISI was that it accelerated productivity advances by placing firms under the discipline of export markets and by widening the contact with the developed world: efficiency growth was significantly faster in export industries than in the rest of the economy. In the decade following the shift to EP, per capita output doubled, and South Korea became an industrialized country: from 1960/62 to 1973/75 the share of agriculture in GDP fell from 45 percent to 25 percent, while the share of manufacturing rose from 9 percent to 27 percent. One important factor contributing to the achievement was that the authoritarian government could enjoy relative independence from and avoid capture by special interests.

The withdrawal of U.S. troops from Vietnam in the early 1970s and the subsequent conquest of the region by the communist regime alarmed the South Korean leadership, which has been coping with the threat of North Korea with the help of the U.S. military presence. Park Chung Hee’s reaction was to reduce the level of reliance on the U.S. armed support by expanding capability to produce munitions, which required returning to ISI to build heavy and chemical industries (HCI). The government intervened heavily in the financial markets, directing banks to provide low interest loans to chaebols — conglomerates of businesses owned by a single family — selected for the task of developing different sectors of HCI. Successfully expanding the capital-intensive industries more rapidly than the rest of the economy, the HCI drive generated multiple symptoms of distortion, including rapidly slowing growth, worsening inflation and accumulation of non-performing loans.

Again the ISI ended with a regime shift, triggered by Park Chung Hee’s assassination in 1979. In the 1980s, the succeeding leadership made systematic attempts to sort out the unwelcome legacy of the HCI drive by de-regulating trade and financial sectors. In the 1990s, liberalization of capital account followed, causing rapid accumulation of short-term external debts. This, together with a highly leveraged corporate sector and the banking sector destabilized by the financial repression, provided the background to the contagion of financial crisis from Southeast Asia in 1997. The crisis provided a strong momentum for corporate and financial sector reform.

In the quarter century following the policy shift in the early 1960s, the South Korean per capita output grew at an unusually rapid rate of 7 percent per year, a growth performance paralleled only by Taiwan and two city-states, Hong Kong and Singapore. The portion of South Koreans enjoying the benefits of the growth increased more rapidly from the end of 1970s, when the rising trend in the Gini coefficient (which measures the inequality of income distribution) since the colonial period was reversed. The growth was attributable far more to increased use of productive inputs — physical capital in particular — than to productivity advances. The rapid capital accumulation was driven by an increasingly high savings rate due to a falling dependency ratio, a lagged outcome of rapidly falling mortality during the colonial period. The high growth was also aided by accumulation of human capital, which started with the introduction of modern education under the Japanese rule. Finally, the South Korean developmental state, as symbolized by Park Chung Hee, a former officer of the Japanese Imperial army serving in wartime Manchuria, was closely modeled upon the colonial system of government. In short, South Korea grew on the shoulders of the colonial achievement, rather than emerging out of the ashes left by the Korean War, as is sometimes asserted.

North Korean Starvation

Neither did the North Korean economy emerge out of a void. Founders of the regime took over the system of command set up by the Japanese rulers to invade China. They also benefited from the colonial industrialization concentrated in the north, which had raised the standard of living in the north above that in the south at the end of the colonial rule. While the economic advantage led the North Korean leadership to feel confident enough to invade the South in 1950, it could not sustain the lead: North Korea started to lag behind the fast growing South from the late 1960s, and then suffered a tragic decline in living standards in the 1990s.

After the conclusion of the Korean War, the North Korean power elites adopted a strategy of driving growth through forced saving, which went quickly to the wall for several reasons. First, managers and workers in collective farms and state enterprises had little incentive to improve productivity to counter the falling marginal productivity of capital. Second, the country’s self-imposed isolation made it difficult for it to benefit from the advanced technologies of the developed world through trade and foreign investment. Finally, the despotic and militaristic rule diverted resources to unproductive purposes and disturbed the consistency of planning.

The economic stalemate forced the ruling elites to experiment with the introduction of material incentives and independent accounting of state enterprises. However, they could not push the institutional reform far enough, for fear that it might destabilize their totalitarian rule. Efforts were also made to attract foreign capital, which ended in failure too. Having spent the funds lent by western banks in the early 1970s largely for military purposes, North Korea defaulted on the loans. Laws introduced in the 1980s to draw foreign direct investment had little effect.

The collapse of centrally planned economies in the late 1980s virtually ended energy and capital goods imports at subsidized prices, dealing a serious blow to the wobbly regime. Desperate efforts to resolve chronic food shortages by expanding acreage through deforestation made the country vulnerable to climatic shocks in the 1990s. The end result was a disastrous subsistence crisis, to which the militarist regime responded by extorting concessions from the rest of the world through brinkmanship diplomacy.

Further Reading

Amsden, Alice. Asia’s Next Giant: South Korea and Late Industrialization. Oxford: Oxford University Press, 1989.

Ban, Sung Hwan. “Agricultural Growth in Korea.” In Agricultural Growth in Japan, Taiwan, Korea, and the Philippines, edited by Yujiro Hayami, Vernon W. Ruttan, and Herman M. Southworth, 96-116. Honolulu: University Press of Hawaii, 1979.

Cha, Myung Soo. “Imperial Policy or World Price Shocks? Explaining Interwar Korean Consumption Trend.” Journal of Economic History 58, no. 3 (1998): 731-754.

Cha, Myung Soo. “The Colonial Origins of Korea’s Market Economy.” In Asia-Pacific Dynamism, 1550-2000, edited by A.J.H. Latham and H. Kawakatsu, 86-103. London: Routledge, 2000.

Cha, Myung Soo. “Facts and Myths about Korea’s Economic Past.” Forthcoming in Australian Review of Economic History 44 (2004).

Cole, David C. and Yung Chul Park. Financial Development in Korea, 1945-1978. Cambridge: Harvard University Press, 1983.

Dollar, David and Kenneth Sokoloff. “Patterns of Productivity Growth in South Korean Manufacturing Industries, 1963-1979.” Journal of Development Economics 33, no. 2 (1990): 390-27.

Eckert, Carter J. Offspring of Empire: The Koch’ang Kims and the Colonial Origins of Korean Capitalism, 1876-1945. Seattle: Washington University Press, 1991.

Gill, Insong. “Stature, Consumption, and the Standard of Living in Colonial Korea.” In The Biological Standard of Living in Comparative Perspective, edited by John Komlos and Joerg Baten, 122-138. Stuttgart: Franz Steiner Verlag, 1998.

Gragert, Edwin H. Landownership under Colonial Rule: Korea’s Japanese Experience, 1900-1935. Honolulu: University Press of Hawaii, 1994.

Haggard, Stephan. The Political Economy of the Asian Financial Crisis. Washington: Institute of International Economics, 2000.

Haggard, Stephan, D. Kang and C. Moon. “Japanese Colonialism and Korean Development: A Critique.” World Development 25 (1997): 867-81.

Haggard, Stephan, Byung-kook Kim and Chung-in Moon. “The Transition to Export-led Growth in South Korea: 1954-1966.” Journal of Asian Studies 50, no. 4 (1991): 850-73.

Kang, Kenneth H. “Why Did Koreans Save So Little and Why Do They Now Save So Much?” International Economic Journal 8 (1994): 99-111.

Kang, Kenneth H, and Vijaya Ramachandran. “Economic Transformation in Korea: Rapid Growth without an Agricultural Revolution?” Economic Development and Cultural Change 47, no. 4 (1999): 783-801.

Kim, Kwang Suk and Michael Roemer. Growth and Structural Transformation. Cambridge, MA: Harvard University Press, 1979.

Kimura, Mitsuhiko. “From Fascism to Communism: Continuity and Development of Collectivist Economic Policy in North Korea.” Economic History Review 52, no.1 (1999): 69-86.

Kimura, Mitsuhiko. “Standards of Living in Colonial Korea: Did the Masses Become Worse Off or Better Off under Japanese Rule?” Journal of Economic History 53, no. 3 (1993): 629-652.

Kohli, Atul. “Where Do High Growth Political Economies Come From? The Japanese Lineage of Korea’s ‘Developmental State’.” World Development 9: 1269-93.

Krueger, Anne. The Developmental Role of the Foreign Sector and Aid. Cambridge: Harvard University Press, 1982.

Kwon, Tai Hwan. Demography of Korea: Population Change and Its Components, 1925-66. Seoul: Seoul National University Press, 1977.

Noland, Marcus. Avoiding the Apocalypse: The Future of the Two Koreas. Washington: Institute for International Economics, 2000.

Palais, James B. Politics and Policy in Traditional Korea. Cambridge: Harvard University Press, 1975.

Stern, Joseph J, Ji-hong Kim, Dwight H. Perkins and Jung-ho Yoo, editors. Industrialization and the State: The Korean Heavy and Chemical Industry Drive. Cambridge: Harvard University Press, 1995.

Woo, Jung-en. Race to the Swift: State and Finance in Korean Industrialization. New York: Columbia University Press, 1991.

Young, Alwyn. “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience.” Quarterly Journal of Economics 110, no. 3 (1995): 641-80.

Citation: Cha, Myung. “The Economic History of Korea”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/the-economic-history-of-korea/