How Important Historically Were Financial Systems for
Growth in the U.K., U.S., Germany, and Japan?
Franklin Allen, Forrest Capie, Caroline Fohlin, Hideaki Miyajima,
Richard Sylla, Geoffrey Wood, and Yishay Yafeh*
October 25, 2010
Abstract
The case studies for each country survey the literature on the role of their
financial systems in their development. The sources of finance for industrial
development include (i) banks, (ii) securities markets, (iii) internal finance, (iv)
alternative sources of finance such as angel finance, trade credit, families, and friends,
and (v) governments. All four countries had sophisticated financial systems and all four
grew successfully. The fact that they had different financial systems suggests that if there
is an optimal financial structure for a country it does not lead to a significantly greater
level of growth than other possible structures. The experiences of the four countries
considered suggest that a variety of financial structures can lead to high rates of growth in
real per capita GDP.
*
Allen is at University of Pennsylvania, Capie and Wood are at City University London, Fohlin is at Johns
Hopkins University, Miyajima is at Waseda University, Sylla is at New York University and Yafeh is at the
Hebrew University. Allen is the corresponding author, allenf@wharton.upenn.edu. Prepared for the World
Bank Project on Financial Structure.
1. Introduction
(Franklin Allen)
The relationship between the growth rate of an economy and its financial structure
is a long-debated issue. On the one hand, Bagehot (1873) and Hicks (1969) argue that the
UK's financial system played an important role in the Industrial Revolution. On the other
hand, Robinson (1952) suggests that the causation goes the other way and that the
financial system developed as a result of economic growth. Levine (1997) provides an
excellent overview of the literature on economic growth and financial development.
In a pioneering study using cross-country data, Goldsmith (1969) found a
relationship between growth and financial development. However, his study was based
on limited data and did not control in a satisfactory way for other factors affecting growth.
In a series of studies King and Levine (1993a, b, c) consider data for 80 countries over
the period 1960-1989 and carefully control for other factors affecting growth. They find a
strong relationship between growth and financial development and also find evidence that
the level of financial development is a good predictor of future economic growth. In an
innovative study Rajan and Zingales (1998) use data from the US to find which industries
rely on external finance and investigate whether these industries grow faster in countries
with better developed financial systems. They find a positive correlation between growth
rates and financial development, suggesting that finance is important for growth.
Demirguç-Kunt and Maksimovic (1996) consider firm-level data from 30 countries and
argue that access to stock markets leads to faster growth. In an influential contribution,
McKinnon (1973) did case studies of Argentina, Brazil, Chile, Germany, Korea,
Indonesia and Taiwan in the period after the Second World War. His conclusion from
these cases is that better financial systems support faster economic growth. Taken
together these studies provide considerable support for a relationship between finance
and growth.
A large number of theoretical studies consider the growth-finance relationship.
Hicks (1969) and Bencivenga, Smith and Starr (1995) argue that the liquidity provided by
capital markets was key in allowing growth in the UK Industrial Revolution. Many of the
products produced early in the Industrial Revolution had been invented some time before
but lack of long-term finance delayed their manufacture. Liquid capital markets allowed
1
the projects to be financed by savers with short time horizons and/or uncertain liquidity
needs. Similarly, Bencivenga and Smith (1991) argue that intermediaries may be able to
enhance liquidity, while at the same time funding long-lived projects. Greenwood and
Jovanovic (1990) point out that intermediaries that can effectively process information
about entrepreneurs and projects can induce a higher rate of growth. King and Levine
(1993c) suggest that intermediaries can also do a better job of choosing innovations.
Another avenue for increasing growth is the higher expected returns that can be achieved
if risk is reduced through diversification (Saint-Paul (1982)). Boyd and Smith (1996,
1998) suggest that banks are important at low levels of development while markets
become more important as income rises. Rajan and Zingales (2001) suggest that banks
are less dependent than markets on the legal system. Hence, banks can do better when the
legal system is weak and markets do better when the legal system is more developed.
In this paper we consider the importance of financial structure for economic
growth by considering the historical experience of the United Kingdom, the United States,
Germany and Japan. The first part of this issue is how important was the overall
development of the financial system for growth in these four countries? The second is
that there are a number of sources of finance for industrial development and how
important is the mix of these. These sources include: (i) banks; (ii) securities markets;
(iii) internal finance; (iv) alternative sources of finance such as angel finance, trade credit,
families, and friends; and (v) governments. In particular, is there an optimal financial
structure for growth?
Forrest Capie and Geoffrey Wood explain in Section 2 that the United Kingdom
is a complex example of the importance of finance for growth. There was a financial
revolution from 1690 to 1720 that preceded the start of the Industrial Revolution that can
be dated to around 1740. Among other things, this financial revolution involved the
foundation of the Bank of England, the adoption of sound government finance and the
development of the stock market in London. On the face of it this would seem to support
the importance of finance to growth. The weakness of this argument is that by a number
of measures, the extent of financial intermediation was limited.
Better support for the theory of the importance of finance is provided by the
U.K.’s experience in the 19th century. In this case the intermediation provided by the
2
banking system expanded significantly as the Bank of England started to act as lender of
last resort. This development was subsequently followed by a jump in the growth rate in
the real economy.
The finance provided by the banking system came in the form of overdrafts that
were often rolled over so that they were essentially medium or long term in nature. The
underwriting of trade bills was also important. The London Stock Exchange was
important as a venue for issuing and trading the debt of the British and various other
governments rather than company shares. However, a significant amount of capital was
raised through the issue of shares in regional and local stock markets all over the country.
The stock exchanges were particularly important for raising finance for the railways.
Perhaps the most important source of funds was internal finance in the form of
retained earnings. The authors provide an estimate that around 70 percent of funds came
from this source. There is anecdotal evidence that angel finance was significant. The
U.K. government did not in the general course of affairs provide funds for industry.
In Section 3, Richard Sylla argues that the United States is the leading historical
example of a country where the financial system developed before a significant increase
in the rate of economic growth. The change in the financial system arguably played an
important part in enabling the jump in the growth rate. Alexander Hamilton, the
Secretary of the Treasury from 1789-1795, played a significant role in the modernization
of the financial system. The creation of the First Bank of the United States (1791-1811)
helped the banking system to develop. The bank acted as the government’s fiscal agent
but also undertook normal commercial bank activities and opened branches across the
nation. It provided a model for other banks to follow and as a result the U.S. started to
develop a sophisticated banking system. Hamilton also reformed the government’s
finances and ensured the issue of sound public debt. This helped the foundation of
securities markets and stock exchanges to trade these and other security issues. By the
middle of the 1790’s the U.S. had all the elements of a modern financial system in place.
This allowed the economy to grow at a real per capita growth rate of 1-2 percent year
from then until modern times.
All the sources of finance played an important role in this growth. The banking
system developed significantly throughout this period. This growth continued even after
3
the failure to renew the charter of the Second Bank of the United States in 1836 led to its
demise and the country had no central bank until the Federal Reserve began operations in
1914. By then the U.S. banking system had a third of total world deposits and these were
more than those of the banking systems of Germany, Great Britain and France put
together. The securities markets and stock exchanges also facilitated a number of
investment booms that fostered economic growth. These included state-government debt
issues to fund infrastructure and the development of cities, stock and bond issues to fund
the railroads in the middle and late 19th century and large scale industrial enterprises in
the 20th century.
Banks and markets were not substitutes but rather were complements. Funds
were collected by banks around the country and placed on deposit in New York. These
deposits funded call loans to buy stocks on the New York Stock Exchange and this
considerably helped large scale corporate finance.
The Federal government issued debt to raise money to fight wars and a variety of
other purposes such as funding the Louisiana Purchase. During peace time these debts
were paid down and state governments borrowed in their place to fund infrastructure
projects. Internal finance in the form of retained earnings is not well documented but
appears to have been important. The use of trade credit was greatly eased by the
development of credit reports by the two firms Dunn and Bradstreet that were later to
merge. Angel finance also appears to be important but again was not systematically
reported.
Japan went through the industrial revolution later than the U.K. and U.S.
Caroline Fohlin recounts in Section 4 that in Germany industrialization began in the early
decades of the 19th century but that economic growth took off in the third quarter of that
century.
The heavy financing needs for railroads led to new financial institutions and
reinvigorated the securities markets. There is some statistical evidence of a causative
relationship between the level of joint-stock banking assets and output growth in the
railroad sector during the 1850s through 1870s. However, there is no general statistical
relationship between banking assets and aggregate output.
With regard to the role of different types of finance the universal banks are
usually given most of the credit for providing commercial and industrial finance. The
4
savings banks (Sparkassen) also played a significant role and in fact actually mobilized
more capital than the large nationwide universal banks. In the first two thirds of the 19th
century tight restrictions on incorporation and the granting of limited liability meant that
securities markets could only play a limited role. Once the government liberalized
incorporation, particularly in the 1870 Company Law, existing stock markets rapidly
expanded their business and new ones opened. However, a large proportion of the
finance raised in new issues allowed owners to diversify their wealth rather than raise
new funds for investment.
Internal finance was very important for joint-stock companies. We know this
from the accounts that they were required to submit. There is no reliable data on angel
finance but anecdotal evidence suggests that this was important. Also firms partly used
trade credit to finance their operations as they were allowed to roll it over continually.
Government at both the state and federal levels played an important role in
funding development. They nationalized the railroads and funded large amounts of
military and industrial infrastructure. State and local governments also owned parts of
the banking system, for example, the regional Landesbanken. They also intervened in the
financial system in a number of other ways such as taxing stock market transactions.
In Section 5, Hideaki Miyajima and Yishay Yafeh recount the Japanese
experience. They consider the subperiods from the Meiji Restoration up to the start of
World War I and the interwar period separately. Not only did Japan’s financial and
economic development occur much later than in the other three countries considered, but
the whole process was more compressed in terms of time. During the first subperiod the
Bank of Japan was founded, networks of commercial banks were created, and stock
exchanges were set up. Financing of businesses depended on their size and industry,.
Family controlled business groups (Zaibatsu) depended primarily on retained earnings to
finance their growth. Other modern firms relied heavily on equity finance. Often this
would take the form of indirect bank lending when small shareholders would borrow to
buy shares and use them as collateral for the loan. From 1902-1915 manufacturing firms’
internal funds’ accounted for 16 percent of funds while equity accounted for 50 percent.
Trade credit granted by wholesalers and banks also played an important role in traditional
sectors such as raw silk, cotton weaving and pottery.
5
During the period 1914-1940, the use of each type of finance by different sectors
became even more distinct. Small and medium sized firms borrowed from banks, electric
utilities raised money with bonds, and large corporations used equity. Prior to the
financial crisis of 1927, many Zaibatsu raised money through closely related “organ
banks” that they set up. However, many of these firms and banks failed as a result of the
crisis. Particularly after the crisis, stock exchanges played an important role in the raising
of equity finance. The heavy use of equity finance occurred despite very little formal
investor protection. It seems that informal mechanisms provided trust and confidence in
this form of financing.
Section 6 draws conclusions from the experience of the four countries concerning
the relationship between financial structure and growth. First, for the U.K. and the U.S.
there is significant evidence that an improved financial structure led to a higher growth
rate. In Germany there is some evidence of this, while in Japan the process of both
financial and industrial development was much more compressed and makes causation
more difficult to establish.
Perhaps the most important conclusion, however, concerns the different types of
finance that were used in each country. Banks played an important role in all countries.
In the U.K. this took the form of rollover of overdrafts. In the U.S. the banking system
was particularly effective in mobilizing deposits and funding firms. In Germany the
universal and other banks played an important role in funding industry. In Japan banks
funded certain parts of industry, particularly small and medium enterprises. There was a
significant difference in the use of equity in the four countries. In the U.K. it was
important for a wide range of firms including firms listed on regional and local exchanges
as well as for the railways. In the U.S. it was important for the railroads in the 19th
century and large industrial corporations particularly in the early 20th century. In
Germany the importance varied over time, with equity becoming more widely used after
it became easier for firms to incorporate in 1870. In Japan significant amounts of equity
finance were used by large industrial corporations throughout the period from the Meiji
Restoration up until World War II.
Angel finance seems to have been important in all four countries. Unfortunately
there is little in the way of hard evidence to support this. Trade credit is also important in
6
each country but seems to have been particularly important in Japan. The role of
government in providing finance differs significantly across the four countries. In the
U.K. the government was very little involved while at the other extreme in Germany the
federal and state governments were involved in a number of wayssuch as nationalizing
the railways.
All four countries had sophisticated financial systems and all four grew
successfully. The fact that their financial systems were so different in a number of ways
suggests that if there is an optimal financial structure for a country it does not lead to a
significantly greater level of growth than other possible structures. The experiences of
the four countries considered suggest that a variety of financial structures can lead to high
rates of growth in real per capita GDP.
2. The United Kingdom
(Forrest Capie and Geoffrey Wood)
Introduction. Modern economic growth was defined by Simon Kuznets ‘as a sustained
increase in per capita or per worker product …’.(Kuznets, p.1) The beginnings of this
sustained rise can be found in the 18th century in England/northwest Europe. There had
been periods of progress and prosperity before in world history but they had been
relatively short-lived and stagnation or decline inevitably followed. What was different
after the 18th century was that growth was permanently sustained. The causes of this
continue to keep economists and historians busy, and within all the explanations the role
of finance has long featured.
Study of the relationship between finance and economic development goes back a
long way; certainly to the 19th century, and it was touched on in The Wealth of Nations.
After a time when the focus was elsewhere, study of the role of finance in growth reemerged in recent times. A major contributor to the research was Ross Levine. In a
summarizing statement he wrote, ‘Although conclusions must be stated hesitantly and
with ample qualifications, the preponderance of theoretical reasoning and empirical
evidence suggests a positive, first order relationship between financial development and
economic growth. … There is even evidence that the level of financial development is a
good predictor of future rates of economic growth.’ (JEL 1997 pp. 688,9) How to
7
measure the “level of financial development” is not immediately obvious, of course; we
set out various measures below.
Emphasis on the importance of finance has been widely endorsed by both
economists and economic historians in the last decade or so. In his American Economic
History Association Presidential Address Richard Sylla made a strong case for this being
so for the United States. Rousseau provided econometric back-up for the four major
economies of the Netherlands, England, the U.S. and Japan (Federal Reserve Bank of St
Louis Review July/August 2003 pp. 81-106).
England. The case for the role of finance in economic growth in England (Britain?1)
does, at least at first glance, also look compelling. The story would be of the following
kind.
The industrial revolution is commonly thought of as beginning in the 18th century.
It was initially precisely dated by Ashton as being a process which started in 1760 and
continued to about 1830. That timing was later revised by Rostow, with his equally
precise dating of the ‘take-off’ being 1786. More recent work seems to have been intent
on taking the beginnings back further, so that years such as 1740 or even earlier have
become more acceptable. Be all that as it may, by that reckoning the British industrial
revolution was essentially a mid-eighteenth century phenomenon. But irrespective of all
the differences of views over dating, however, it is widely accepted that there was in
England a financial revolution which preceded the industrial one. It occurred at the end
of the 17th century, in the 1690s, or stretching from 1690 to 1720.
What did this financial revolution comprise, and why is it dated as it is? A long
list of innovations and changes can be given, from the establishment of the Bank of
England in 1694 and the prospering of commercial fractional reserve banking following
its beginnings in the 1670s (and particularly from the 1690s onwards), through the reform
of the coinage in 1696, and the establishment of credible government debt, credible in the
sense that there was by then widespread acceptance that government would honor its
pledges and was free from the irresponsible spending and revenue-raising of monarchies
1
Which is discussed depends to an extent on the availability of data; there exists the possibility that the
timing of developments differed slightly in the two countries.
8
(see Dickson (1967) and Neal (1990)). There was also the appearance of a stock market,
recognizable as such to modern eyes, in the 1690s. While elements of this financial
revolution may have contributed to the South Sea bubble and panic of 1720, other aspects
provided for its resolution, and indeed English financial markets quickly settled down
after the crisis, unlike, for example, those of Paris following the near contemporaneous
Mississippi Bubble. There was thus clearly a financial revolution ahead of the industrial
revolution, and on the surface there would therefore seem to be a good case for saying
that British experience fitted the general story that is increasingly being told of financial
development preceding growth in the real economy.
Banking and other measures. But some further things need to be said. While it is true
that fractional reserve banking became established in the late 17th century the extent of
financial intermediation was quite limited. The size of the banking multiplier, one term
for the amount by which the monetary base is multiplied to produce the money stock,2
(one measure of financial intermediation) remained small throughout the 18th century.
The multiplier was probably no more than 1.5 at the beginning of the 18th century and
seems not to have changed much by the end. There was of course a great growth in
banking in that century. The number of banks rose rapidly, particularly in the second half
of the century, so that by the end there were around 800. They were spread across most of
the country and engaged in all manner of enterprises. But the scale of intermediation as
captured by the banking multiplier seems not to have changed much (Capie (2004)). The
substantial growth in financial intermediation as measured by the multiplier came in the
19th century, when the multiplier grew to around 4 and then stayed at that level for
another hundred years. This increase in the multiplier was to an extent associated with the
emergence of the doctrine that the central bank should act as lender of last resort to the
banking system. First suggested by Francis Baring in 1796, it was fully developed by
Henry Thornton in 1803, popularized in the numerous writings of Walter Bagehot, and
fully adopted by the Bank of England by the 1870s. The central bank’s being willing to
act thus in a crisis of course made fractional reserve banking safer – for both the bankers
and their customers.
2
Various ways of calculating this number are set out in Capie and Webber (1985).
9
Another measure of financial intermediation, additional and complementary to the
banking multiplier, was proposed by Mancur Olson and colleagues. They were looking
for a monetary measure which captured the ‘enforceability and the security of property
rights’. They called this ‘contract intensive money’ (CIM). The idea was that when
lending took place in the expectation of later returns the parties involved needed to be
confident that the contract would be honored, and if not honored then enforceable, and
predictably so, at law. Where confidence was high there would be a lot of commercial
and economic activity, and the measure would be high. CIM was the ratio of noncurrency money to total money supply. A high CIM indicates a developed banking
system and capital markets. And the higher CIM is, the greater are the gains from
specialization in production, and so the higher is the capital stock, productivity and per
capita income. Developed capital markets allow firms to be bigger, and to also, should
they wish, to be more specialized. The former comes from the increased availability of
capital, the latter from the capacity to ride out transitory adverse shocks by borrowing –
this latter being particularly facilitated by the invention of the overdraft. The overdraft is
generally regarded as a Scottish invention, appearing first in the Scottish banks in the 18th
century and then rapidly being adopted in England. (The banking systems of the two
countries were separate in essential ways until the second half of the 20th century.)
Consistent with the data from the banking sector (the banking multiplier) the best
estimates of CIM for the British economy in the 18th century show no rise across the
period, but start to rise with the banking multiplier. It may be that, as recent work has been showing, the rate of growth of the real
economy in the 18th century was in fact quite low. It was sustained growth, but, according
to Crafts and Harley (1992), for the fifty years or so after 1740 it was probably no more
than 1 per cent per annum. So if there was little to get excited about on the growth front it
should not be surprising that the growth of financial intermediation was less exciting than
some have suggested (for these measures see Goldsmith (1985)). But the story still holds.
The real spurt in the growth of the economy (to something closer to 3 per cent per
annum) comes when we are closer to the middle decades of the 19th century, as did the
important rise in financial intermediation; and indeed, the latter preceded the former.
These were the years when the “6 partner rule” was abolished, allowing banks to expand
10
geographically and of course in size. Between the abolishing of that rule (1825) and when
the Midland Bank (the amalgamation of numerous small banks) was the biggest bank in
the world were only some 60 years. The nature of bank finance did, however, change
little over the period – it comprised overdrafts (usually unsecured) and the underwriting
of trade bills. Overdrafts were said to be in the main for working capital but they could
be, and were, rolled over for many years and so in effect provided medium to long-term
finance.
If finance was not intermediated by the banking system on any significant scale in
the early part of Britain’s industrialization, where then did finance come from? How did
funds get from savers to investors? We consider in turn internal finance, “alternative”
means (family and so forth), securities markets (including in particular local, regionalized,
securities markets), and the role of government. We consider these in that order.
Internal finance. Investment finance from retained profits is an important source of
finance in the twenty-first century, and has been so in the U.K. since the very beginning
of industrialization. The practice of reinvesting profits developed from the earliest times,
and as late as the 19th century it was still an important piece in the pattern, with
something of the order of 70 per cent of funds coming from this source. (That kind of
proportion also happened to be what has been seen for many other developed countries.)
“Alternative finance”. As with internal finance from retained profits, the data are not
abundant for “alternative” finance either. But the narrative that is found in the texts is that
in the early stages of industrialization funds were most commonly sought and obtained
from within family and a close circle of friends or acquaintances.
Securities markets. These developed in Britain at a comparatively early date – by the
early 18th century they were well established. But these markets were dominated for
many years, indeed, until well into the 19th century, by government securities. Debt
financed wars had left a large stock of government debt, and this debt was both the
largest part of the market and the part most actively traded. The market was used to raise
new capital, but here a major role, perhaps the major role, was played not by the London
11
Stock Exchange but by the regional exchanges. There were stock exchanges scattered
over the country. For example, there were exchanges in Birmingham, Manchester,
Liverpool, Newcastle, Edinburgh, and Glasgow; and these were only the major regional
exchanges – there were also numerous smaller ones. These exchanges specialized in
firms located in their respective regions, and funds for these firms were raised on them
and the shares, once issued, were traded on them. This specialization of course reflected
the concentration of information about these firms in their local areas. Figures for the
amounts of capital raised are not readily or reliably available, and nor are figures for
turnover.
All these exchanges, for the informational reasons that led to local exchanges
dealing with local firms, were, of course, primarily sources of funds for established firms.
Start ups then as now resorted to family, friends, bank, or other sources of finance.
The exchanges were, however, particularly important in the finance of the
railways. This important element of infrastructure, which had replaced canals as the main
method of transport of goods by around the middle of the 19th century, had very large
financing requirements. The heyday of railway investment was the Victorian era.
Between the 1830s and the 1860s some hundreds of railway companies were floated, and
huge amounts of capital were raised for them. Although the demands of the railways for
capital declined from the 1870s on, the stock exchanges, perhaps having been prompted
by the railways to a more important role than heretofore, continued to be important in the
late 19th century for the large companies, and particularly in some sectors such as
brewing.
Government as a source of finance. Government can never be a source of finance in the
sense that individuals can be. Governments can, however, transfer funds, having raised
them by either taxation or borrowing (money creation as a source of revenue being out of
the question under the gold standard). But throughout the years of Britain’s economic
development the British government had a policy of laissez faire. Either by deliberate,
philosophy-based choice, or by accident, government was small and non-interventionist.
Where industry was assisted it was by tariff, not by subsidy or loan (and tariffs were low).
Indeed, it is notable that Britain’s growth rate accelerated – whichever date one chooses
12
for its acceleration – without any change in the size, scope, or activities of government.
Government remained small until the First World War.
Concluding remarks. The recently emerging view is that financial development is an
essential precondition for economic growth. Study of British experience reinforces this.
There can be no growth without the prior development of finance.
3. The United States
(Richard Sylla)
Financial development and economic growth. The U.S. provides perhaps the leading
historical example of finance-led economic growth. During the long colonial period, the
War of Independence, and the postwar confederation, 1607-1789, Americans were
relatively well off economically compared to others in the world. But that was mostly the
result of a limited, if rapidly growing population enjoying an abundance of new-world
resources. Defining modern economic growth as sustained increases of per capita
income and product of 1 percent per year or more, the consensus of economic historians
is that in these nearly two centuries there was little if any economic growth. Then,
beginning around 1790, growth became modern. The U.S. economy experienced
sustained and gradually accelerating real per capita growth rates of 1-2 percent per year
for the next two centuries, right up to our own time. Industrial production, a key
component of modern growth, appears to have increased at a sustained rate of about 5
percent per year from 1790 into the early 20th century, no doubt contributing to the
gradual acceleration of the modern economic growth rate of broader GDP.3
What makes the 1790s break from pre-modern to modern growth interesting is
that it occurred at the very time the U.S. was having a financial revolution, that is, the
emergence of a modern, articulated financial system involving the installation of sound
public finances and debt management, a stable dollar currency, a central bank, a banking
system, securities markets and stock exchanges, and a regime of easy incorporation for
business enterprises. None of these key institutional components of a modern financial
3
Johnston and Williamson (2009) provide the best current estimates of nominal and real U.S. GDP, total
and per capita, annually from 1790 to the present; Davis (2004) gives annual industrial production from
1790 to 1915.
13
system was present in the 1780s. All were present by the mid 1790s, and they continued
to develop thereafter, albeit with occasional setbacks. The guiding hand of the financial
revolution was that of Alexander Hamilton, secretary of the treasury from 1789 to 1795.
In the execution of his grand plan for financial modernization Hamilton, of course, had
the help of Congress, the president, state legislatures, and the nascent business and
financial communities. Implementation of the plan also provoked a vigorous opposition
and the emergence of political parties. From that time to the present, financial
developments, regulations, and reforms have been among the staples of U.S. politics and
the country’s historiography.4
Economic historians in recent decades have shifted attention away from the
politics of U.S. financial development and toward the role of finance in the country’s
steady growth. Half a century ago, not much was known about growth in the early
decades, but it was assumed that modern growth must have begun as a result of the
transportation, communications, and industrial revolutions of the early to mid-19th
century. These brought to the country improved roads, navigation with steamboats,
canals, railroads, telegraphs, textile factories, and a variety of other light industries. Later
in the century, innovations such as telephony and electric power, and the emergence of
heavy industries and large corporations in many industries sustained, even increased,
growth rates.
Today we have a better, if still imperfect, grasp of when growth accelerated,
earlier than previously suspected. We also are now more aware than that when the
transportation, communications, and industrial revolutions arose in the early to mid 19th
century, they were financed by a banking system and securities markets that had emerged
earlier, in the last decade of the 18th century. Even the country’s vast geographic
expansion, which tripled its size during the half century between 1803 and 1853,
depended on the prior financial system. A famous example was the Louisiana Purchase
of 1803, financed by issuing federal government bonds denominated in U.S. dollars and
sending them to Napoleon’s France, which in turn sold them to European private
4
For comparative perspectives on the U.S. financial revolution and evidence that it did indeed jump-start
U.S. economic growth, see Rousseau and Sylla (2003, 2005). For details of the financial revolution, its
first crisis in 1792, and how it played out in the early decades of U.S. history, see Bodenhorn (2010), Sylla
(1998, 2005, 2008, 2009, 2010), Wright (2002, 2008, 2010), Sylla, Wilson, and Wright (2006), and Sylla,
Wright, and Cowen (2009).
14
investors. By 1803, the securities of what fifteen years before had been a bankrupt
government in default on its debts enjoyed a prime credit rating in international financial
markets. Encouraged by the presence of modern financial institutions and markets in the
U.S., foreign investors beginning in the 1790s and continuing for decades, even centuries,
would transfer large amounts of capital to the U.S. by purchasing the securities of
governments, railroads, and industrial firms, and by directly investing in the country.5
Growth of the banking system. In 1790, there were but three local, corporate banks in
the U.S., all founded in the previous decade, with a combined capital of $3 million.
When Congress in 1791 authorized Hamilton’s Bank of the United States (BUS), its
twenty-year charter provided a model for those of other banks and its presence acted as a
catalyst to stimulate banking development at the state level. The first BUS was a much
larger corporation than any of the local banks, with $10 million of capital, 20 percent of
which was subscribed by the federal government. In addition to being the government’s
fiscal agent, the BUS would carry on an ordinary commercial banking business, and it
was given the authority to open branches nationwide. The second BUS, a similar but
larger institution with $35 million in capital and more nationwide branches, operated
from 1816 to 1836.
Both BUSs for the most part were well-managed institutions. By virtue of their
interstate branching privileges, they provided the country with an efficient interstate,
interregional payments system. They also developed central-bank regulatory powers by
virtue of their special relationship with the federal government, which made them
recipients of the monetary liabilities of state banks as Americans made tax and other
payments. The powers and privileges of the two BUSs, however, became political
liabilities in the context of the U.S. federal system, leading to non-renewal of their
charters in 1811 and 1836. The U.S. would not again have a central bank until 1914,
when the Federal Reserve System began its long run. In the interim, 1836 to 1914, the
domestic payments system, relying on note brokers and correspondent banking, was less
5
See Sylla, Wilson, and Wright (2006) and Wilkins (1989) for the origins and development of foreign
investment in the U.S.
15
efficient than it had been. And banking crises were more frequent when the central bank
was absent. Those were major reasons for reinstituting a central bank in 1914.
Starting in 1791, states responded to the federal BUS initiative by granting more
corporate banking charters: there were 20 state banks by 1795, more than a hundred by
1810, nearly 600 by the mid 1830s, and some 1,600 by 1860. These were banks of
discount, deposit, and note issue. Some were large banks in leading cities, while many
more were small country banks, or what today would be called community banks.
State banking systems expanded rapidly for two main reasons. First, the rapid
growth of the economy increased demands for credit, making banking quite a profitable
business. In fact, many banks in New England states were established by entrepreneurs
who used them as funding agencies—insider lending—for their industrial and
commercial ventures.6 Second, in an example of incentive compatibility, states quickly
discovered that banks could be made to share their profits with state governments via
partial or total state ownership of bank stock, via taxation of bank capital, via the
charging of “bonus” fees to banks for the grants of corporate charters, and via statedirected lending requirements.
State-chartered banks were supplemented by private unincorporated banks and
brokers, probably numbering in the hundreds by the 1850s, which could carry on a
discount and deposit business but were prohibited from issuing bank notes. A number of
the private bankers became investment bankers, underwriting securities issues and
mediating the flow of capital from Europe to the United States. By the middle of the 19th
century the U.S. was probably as “well banked” as any country in the world, and its
banking system served to mobilize and allocate capital throughout the country with
seeming efficiency.7
Nonetheless, from a later perspective that was just a start. During the Civil War
(1861-1865) the federal government re-entered the activity of bank chartering by
establishing the National Banking System, a system that granted federal charters to old
state banks and newly established national banks. National banks had to buy government
bonds, which aided the Treasury’s war financing. National banks could use the bonds as
6
7
Lamoreaux (1994).
Bodenhorn (2000); Wright (2002).
16
collateral for national bank note issues. State-bank note issues were taxed out of existence
in 1866, with the result that the U.S. at long last had a fairly uniform paper currency that
was, de jure or de facto, a liability of the federal government. State banks, however,
survived the loss of note-issuing privileges; they continued and even thrived as banks of
discount and deposit, as did private bankers. Thus, in 1914 on the eve of World War I,
the U.S. commercial banking system featured no fewer than 27,213 independent banks,
of which 7,518 were national and 19,718 were state-chartered institutions.8 A few of
these banks in New York and other major cities were among the largest in the world. But
most were small, one-office (or unit, as opposed to branch) banks because most state
banking laws disallowed anything else. State preferences were allowed to dictate even
what national banks could do in the state of their domicile.
Industrialist Andrew Carnegie titled an address to the Economic Club of New
York in 1908, shortly after the bank panic of 1907, “The Worst Banking System in the
World.” He referred, of course, to the U.S. banking system. Since the 1830s it lacked a
central bank to act as a lender of last resort in crises. It based its bank note currency on
an inelastic supply of U.S. government bonds. Its unit banks lacked the safety of
diversified loan portfolios that larger branch-bank systems might have conferred. In
1914, the advent of the Federal Reserve System would alleviate the first two weaknesses
of U.S. banking, and in the following decades of the 20th century restrictions on branch
banking would gradually disappear.9
But not all was negative in the pre-1914 U.S. banking scene. “The worst
commercial banking system in the world” was also by a good measure the world’s
largest, with well over a third of total world deposits, greater than the combined deposits
of the banks of Germany, Britain, and France.10 Whatever were the problems of U.S.
banking, a comparatively limited access of Americans to bank credit was not one of
them.
Securities markets. Active securities markets arose in a number of U.S. cities starting in
the early 1790s, when Philadelphia (in 1790) and New York (in 1792) even opened stock
8
Federal Reserve System (1959).
White (1983).
10
Michie (2003).
9
17
exchanges. The impetus was the sudden appearance of three new issues of U.S.
government bonds with a par value of some $63 million, and $10 million par value of
shares of the Bank of the United States. These new issues, with a par value that
approximated 40 percent of US GDP, were a part of Hamilton’s debt-restructuring and
national-bank initiatives. Because government revenues were uncertain, one of the new
issues was a zero-coupon bond for ten years, and very likely the world’s first “zero.”
Shares of banks, insurance companies, and other corporations chartered by states also
appeared in newspaper listings of securities traded. As of 1790, there were fewer than 30
business corporations in the U.S. A decade later there would be 300. By 1860 the states
had chartered some 25-30,000 corporations, and that impressive total would rise ten-fold
by the early 20th century. The comparative ease of forming corporations was a distinctive
feature of U.S. financial and economic development. Then, as now, the number of listed
and actively traded corporations was small in relation to the total number of them. But
even unlisted and inactively traded corporations raised funds through stock issues, kept
money in banks, and relied on bank loans.
From the 1790s into the 20th century, securities markets and stock exchanges were
allowed to develop with minimal public oversight and regulation. These markets and the
investment banking industry that developed along with them facilitated a number of
investment booms that fostered economic growth. These included large-scale state
government debt issues incurred for transportation and banking enterprises during the
internal-improvement boom of the 1820s and 1830s, the corporate securities that financed
railroad expansion from the 1830s into the 20th century, the local government debt issues
to finance city growth in an increasingly urbanized society, and the securities issues of
large industrial enterprises that emerged in the late 19th and early 20th centuries. Public
stock markets grew rapidly from the 1880s to the 1930s to make liquid the securities of
increasing numbers of large, capital-intensive enterprises. Trading also became more
concentrated as firms shifted their listings from regional markets to the larger exchanges
and markets of New York.11
Since a modern financial system emerged so early and then grew so rapidly in the
U.S., foreign banks had a minimal presence. They simply were not needed. But foreign
11
O’Sullivan (2007)
18
help was welcome in two areas, the financing of international trade and the export of
American securities or, in other words, the import of foreign capital. European financial
houses excelled at trade finance, and would not be challenged by Americans until the 20th
century. Securities exports might be considered a joint venture with foreign financiers,
since American private bankers established European affiliates, and immigrants from
Europe became private bankers in the U.S., relying on their old-world connections to
place American securities abroad.
Links of the banking system and the securities markets. Financial systems are often
described as being either bank- or market-oriented, and these are considered to be
alternatives to one another. U.S. financial history, however, suggests that banks and
markets can be complementary. In the early 19th century, country and city banks kept
some of their reserves in the form of deposits at banks in major cities. This was done to
facilitate long-distance payments and note clearing. Large city banks began to compete
for these bankers’ balances by paying interest on them. They could afford to do that
because the interbank balances could be lent out on call to finance securities markets.
New York, as the leading port and the city with the largest securities markets, became a
magnet for bankers’ balances, especially after the 1860s when the National Banking
System institutionalized the practice of counting interbank balances as a part of banks’
required reserves. The bankers’ balance-call loan system became a powerful mechanism
for mobilizing and concentrating bank funds from all over the U.S. in large banks,
especially those of New York. Concentration of interbank balances in New York banks
facilitated the operations of the city’s primary and secondary securities markets. This was
a boon to large-scale corporate finance.12 Thus in the U.S. case, the banking system and
the securities markets worked in tandem to finance high rates of capital formation and
economic growth.
Governments as demanders and suppliers of finance. The federal government in the
long 19th century, 1789-1914, practiced tax smoothing by borrowing heavily to finance
wars, and then paying down its debts in peacetime to return funds to the capital markets.
12
Sylla (1975); James (1978).
19
That is what happened after the quasi-war with France (1798-1800), the War of 1812
(1812-15), the Mexican War (1846-48), the Civil War (1861-65), and the SpanishAmerican War (1898). Since the wartime borrowing often took place when interest rates
were elevated and prices inflated, and the debt reductions occurred when prices and
interest rates were lower, tax smoothing in practice likely made a net contribution to
capital formation and economic growth. Clearly that was the case when, as sometimes
happened, the government paid more than par value to repurchase its debt.
The government also promoted capital formation by “spending” a portion of its
considerable land resources to promote transportation improvements (e.g., land grants to
railroad corporations, which sold the land to finance construction) and human capital
(land grants to states, which sold the land to finance schools and land-grant colleges).
Before 1820, recognizing that private financial facilities were lacking on the expanding
western frontier, the federal government even acted as a financial intermediary by
granting credit to settlers for land purchases. It also provided credit to import merchants
by allowing them to pay import duties, a principal source of federal revenue, several
months after the tax liabilities were incurred.
In the aftermath of wars, as the federal government returned funds to the capital
markets by paying down its debt, state and local governments increased their borrowing
to finance transportation and other infrastructural improvements. A notable example
came after the War of 1812, when the federal government totally extinguished a national
debt of $127 million between 1816 and 1836, while state governments, to finance
transportation and banking investments, ran up debts of $200 million by 1840. Similarly,
after the Civil War the federal government ran budget surpluses every year from 1866 to
1893, substantially reducing its debt while state and local governments increased their
debts.13 Money made available by federal debt repayments also found its way into
corporate securities. It was frequently observed that Treasury announcements of
imminent debt redemptions led to rises in the market prices of stocks and bonds.
Internal finance. Both corporations, of which there were many in the U.S., and
unincorporated enterprises, of which there were even more, plowed back portions of their
13
Ibid.
20
profits into expansion of their businesses. For the 19th century, how internal finance
compared with external finance has not been a topic much investigated. For
corporations, we do know that dividend payouts were a greater proportion of earnings
than they became in the 20th century. Stock investment returns before the 20th century
were weighted more toward dividends and less to price appreciation, in part because in
that era of limited transparency and corporate reporting dividends were an investor’s
primary signal of how well a company was performing.14
Internal finance, the plowing back of retained earnings into firm expansion, is
often viewed as a substitute for external finance, and no doubt in many cases it was. But
in some cases it may have been a complement. In the dynamic context of an articulated
financial system, external finance facilitated internal finance: business enterprises having
access to banks and/or capital markets for working capital needs could channel more of
their profits into fixed investments. Without such access, the enterprises would have to
look after their working capital needs on their own. Rapid growth of the U.S. banking
system meant that many enterprises could rely on bank loans for working capital. By the
1830s a commercial paper market also emerged, and in the late 19th and early 20th
centuries it became an important source of short-term financing for many companies. The
availability of bank and market financing for working capital needs thus freed up more of
a firm’s internally generated funds for fixed capital investment.15
Trade credit and angel finance. Trade credit is as old as the hills, but until the modern
era it was pretty much confined to traders who had a personal knowledge of one another,
either familial or as part of social group or network. For the U.S. to take advantage of its
geographically extensive free-trade area, it was necessary to find a way to grant trade
credit impersonally. Beginning in the 1830s, a unique American solution to the problem
was the credit reporting firm. These firms hired third-party agents in the various
communities of the U.S. to report on the character and creditworthiness of local
businessmen and companies, and then sold the information gathered to other firms that
were asked to grant trade credit. By the 1850s, two firms, Dun and Bradstreet (which
14
15
Baskin (1988).
James (1978, 1995).
21
later would merge to become Dun & Bradstreet) were publishing reference books rating
the creditworthiness of tens of thousands of firms in the U.S. and Canada. In the 20th
century the business model developed by the early credit reporting firms would be
extended from trade to consumer credit, as well as to the business of credit rating
agencies. Credit reporting and credit rating agencies expanded the scope of finance by
reducing informational asymmetries between lenders and borrowers.16
As with internal and external finance, trade credit in the context of the U.S.
financial system should be viewed more as a complement of than a substitute for bank
and market finance. Many firms granting trade credit could do so because they had
access to bank and market funding even if the firms asking for trade credit did not enjoy
such access. The same argument applies also to angel and venture capital financing. For
entrepreneurs seeking funds to implement their ideas, such as Robert Fulton in steam
navigation or Thomas Edison in electricity and electric lighting, such angel financing
might have been their only option. But Fulton’s partner and angel financier in
developing the first commercially successful steamboat was Robert Livingston, a wealthy
man who had access to the formal financial system, as did Edison’s early financiers such
as J. P. Morgan and his partners. A holistic view of a modern financial system often
reveals that what might at first glance appear to be alternative or substitute forms of
financing are in fact complements.
Concluding comments. The U.S. almost from its inception was blessed with a modern,
dynamic financial system. Since it began its modern economic growth trajectory at
virtually the same time, one can make a strong case that modern financial arrangements
led to economic growth. Hamilton, a student of financial history, drew amply on
European precedents in his plan for U.S. financial modernization. He also introduced
some novel concepts, and others would emerge as the system developed. It was an
innovative system, and one that exhibited positive network externalities as one or another
of its components generated value for other components. These externalities along with
efficient resource allocation and risk management facilitation are at the heart of finance’s
contributions to economic growth. Modern financial systems, of course, can also
16
Olegario (2006); Sylla (2002).
22
generate negative externalities, more commonly known as financial crises. Few blessings
are unmixed.
4. Germany
(Caroline Fohlin)
Introduction. Germany spent most of the 19th century as a fragmented group of
sovereign states. Starting out that century with backward agrarian institutions, low
agricultural productivity, multiple and seigniorage-heavy monetary systems, and a near
landlocked position in central Europe, the states that later comprised the German empire
did not possess a lot of what economic historians would call “preconditions” for
industrialization. The German states differed considerably in their levels of economic
and financial development, as well as in their fiscal and monetary policy, hindering
coherent conclusions about German economic growth and its causes before unification
under the Second Reich, the Kaiserreich, in 1871. This difficulty has not prevented
economic historians from attempting to estimate growth rates over the 17th through 19th
centuries, and heated debate has often arisen over exactly when Germany’s economic
growth “took off” into sustained, modern-style rates. As a general rule, economic
historians identify a structural shift in growth rates over the third quarter of the 19th
century, with slow but positive growth for the century and a half prior—albeit interrupted
by major shocks in the form of revolution and the Napoleonic Wars—and much higher
growth rates during and following this key early industrialization phase.17
At the start of the 19th century, on the order of 80 percent of the German
population engaged in agriculture, mostly at subsistence levels and many shackled by low
productivity, serfdom and restrictive agrarian laws and practices. Agrarian reforms in the
first two decades of that century, paved the way for protoindustrialization, allowing labor
to move into production in handicrafts, textiles and metal-working.18 The German
customs union in 1834 reduced tariff barriers among the states and gave impetus for
increased production as well as for transportation networks, drawing more labor out of
agriculture and into industry.
17
Pfister (2008).
Pierenkemper and Tilly (2004) provide extensive details of both the agrarian reforms and the customs
union and their impact on the industrialization process.
18
23
Germany passed through similar stages of industrial development as other
European countries in the 19th century, beginning with textiles, light manufacturing, and
basic metal working in the early-middle century, moving on to chemicals, large-scale
mining, steel works, and railroads in the several decades after the 1840s, all the while
developing new modes of transportation that integrated its previously very fragmented
markets and allowed productive factors to move about. Heavy industry, using refined
steel-making techniques, larger scale production methods, engineering-based technology,
and electrification, took hold in the last quarter of the 19th century, especially in the 1890s,
and grew rapidly for several decades to follow.
As the succeeding sections explain in detail, and like most economies that
reached high levels of industrial development by the start of the 20th century, Germany
built up a sophisticated financial system over the latter half of the 19th century. While
private bankers and securities markets appeared centuries earlier, the first great wave of
financial development came in the 1850s. This financial ‘revolution’ coincided with (and
was facilitated by) major reforms of currency and monetary policy as well as with rapid
developments in industry and transportation, most notably the railroads. Railroads
accelerated the movement of inputs and outputs made feasible by previous institutional
developments (agrarian reform and customs union), but also demanded massive
quantities of raw materials and labor to produce rails, rolling stock, engines, and the fuel
to make them go.
The finance-growth nexus in Germany therefore begins with the financing of
the railroads. The railroads’ large-scale production and operations required financing
beyond the means of any one individual, and thereby stimulated the accumulation and
mobilization of financial capital on unprecedented scale. Throughout the third quarter of
the 19th century, German railroad finance helped engender new financial institutions and
instruments, both private and public, and gave new life to securities markets as a means
of financing private debt and equity.
Clearly, the German financial system played an important role in economic
growth during this period. It is hard to imagine the industrialization process absent the
institutions and markets that funneled capital toward productive enterprise. The
financial and real sectors both developed rapidly from the 1850s to World War I, and
24
beyond. And one study has been able to pin down a statistically causal relationship
between development of joint-stock banking assets and output growth in (primarily) the
railroad sector during the 1850s through 1870s.19 We cannot, however, find a robust
causal relationship between financial and real growth after the 1880s or over the full
period from the 1850s to World War I.20
In this purely statistical sense, we can say that German growth was not “finance
led.” But that’s probably not the most interesting or useful question to ask about
financial systems and growth. Even if we could pin down a robust statistical relationship
at the aggregate level, the results would not explain whether a certain type of financial
system, or a particular structure of financial institutions, caused economic growth.21
These questions are more helpful but naturally a lot harder to answer. More interesting
than these statistical analyses is a more finely-tuned study of the evolving shape of
institutions and systems, and of the surrounding laws and regulation, and how they
actually worked in channeling capital to productive uses. With that goal in mind, we turn
to an examination of the various components of the German financial system and their
roles in promoting economic growth historically.22
Banks and other financial institutions. Despite its late start in financial and industrial
development relative to Great Britain, German financiers had created a large range of
financial institutions by the mid-19th century: everything from large, universal banks to
small, regional (but also publicly traded) banks, private bankers, savings banks, rural
(mostly) credit cooperatives, public and private mortgage banks, and various forms of
insurance companies (important for their extensive investment portfolios and industrial
involvement).
In thinking about industrial finance in Germany, the ‘universal’ banks get the
lion’s share of the credit. These publicly-traded banks initially evolved out of the private
banking houses and first appeared in the form of the A. Schaaffhausen’scher Bankverein
during, and as a result of, the crisis of 1848. Joint-stock banks—of which large,
19
Burhop (2006).
Fohlin (1999) and Burhop (2006).
21
For a more extensive discussion of comparative financial system design and industrial development, see
Fohlin (2011, forthcoming).
22
Most of the following is based on Fohlin (2007a).
20
25
nationwide universal banks comprised a subset—grew rapidly in the 1850s but made up
less than 10 percent of financial institution assets during the first great wave of
industrialization (around 1860 and even 1880), but their share rose to nearly a quarter
after the industrialization process had taken its course, by the start of World War I.23
Nationwide branching began with the formation of the Deutsche Bank in 1870.24 Partly
via buyouts of smaller banks, particularly myriad local private bankers and provincial
joint-stock banks, the large banks created national networks and began taking time
deposits and eventually demand deposits. But the expansion of branching networks
developed rather slowly during industrialization and only really accelerated after World
War I.25
Perhaps more important to economic growth are the uses toward which these
institutions put their capital. The universal banks mainly financed commercial and
industrial clients, and the largest among them dominated the national scene by the late
19th century. These institutions provided the full range of corporate lending services,
from very short term lending, to credits on current account and commercial paper. The
banks probably played a more direct and more critical part in capital mobilization during
the earlier phase of industrialization prior to free incorporation (1850-70), due to the
relatively small scale of industrial firms and of the industrial sector as a whole. After the
liberalization of incorporation, the universal banks served as the primary conduit to
capital markets for industrial issues and also for brokerage transactions. The largest
banks played a key role in organizing the new issues of large corporate enterprises, often
taking over the new issue and selling the shares off to clients and later on the stock
exchanges.26 Major pre-WWI new issues booms took place in the early 1870s and the
latter half of the 1890s.
23
Goldsmith, 1985, tabulated in Fohlin, 2007a.
Notably, Riesser (1911) claims that the Cologne-based Schaaffhausen’sche Bankverein proposed the
creation of a branch in Berlin in 1851, but their petition to do so (such matters were still tightly controlled
at this time) was refused by the government.
25
Fohlin (2002, 2007a).
26
Fohlin (2007a) analyzes the role of the large banks in-depth. Fohlin (2010) and included references
analyze the new issues markets and the role of asymmetric information and market power among the large
universal bank-underwriters during the 1880s. Burhop (forthcoming) and Lehmann (2010) look at new
issues markets during early and later time periods.
24
26
Smaller joint-stock banks and private bankers participated to some extent in
underwriting consortia usually led by larger, Berlin-based ‘great banks.’ These smaller
banks also developed commercial banking relationships with larger banks, which could
evolve into equity stakes by the latter in the former and eventually mergers or
acquisitions. By maintaining local management, the smaller banks in the provinces could
continue their local ties to the community, and the attendant information and marketing
benefits of those ties, but the smaller partners did face growing demands and limitations
on their decision-making from the central administration.
Though the joint-stock banks played the most direct role in industrial finance,
the savings banks (Sparkassen), as a group, also deserve their due: in the latter half of the
19th century, they actually mobilized more capital than the large nationwide universal
banks, providing government guaranteed and liquid repositories for individuals’ savings
that could then be channeled into diverse investments throughout the economy. They
maintained a local orientation and financed low-risk needs, but they also tied into the
commercial banking networks and thereby indirectly helped mobilize smaller deposits
towards high-growth sectors.
Germany’s late industrial development meant that a large portion of the
population remained in rural areas long into the 19th century, and yet the financial
revolution reached into these areas as well. Credit cooperatives, among them the
Raiffeisen banks, dotted the rural landscape over the second half of the 19th century.
Tiny in size, but profuse in numbers, they offered long-term lending on the basis of shortterm deposits. Geographical constraints focused coops narrowly on their communities
and allowed them to lend on soft information about borrowers and their projects.27
Mortgage banks (Hypothekenbanken) focused narrowly on lending collateralized
by real estate. These banks issued mortgage-backed bonds (Pfandbriefe) that were an
important source of credit for infrastructure development in 19th and early 20th century.28
These banks operated in a more arms-length manner, due to hypothecation and
securitization of their assets. The mortgage banks’ securities transactions were
27
Guinanne (2004).
Orazio Mastroeni (2001) for information on modern Pfandbrief markets in Europe
http://www.bis.org/publ/bppdf/bispap05b.pdf
28
27
considered safe and remained on their balance sheets. Another set of institutions, the
Landschaften, also provided mortgage credit, mainly on rural land.
While the large, nationwide banks gained an advantage in capital mobilization
and redistribution in the pre-war era, all of the smaller-scale institutions contributed. The
credit cooperatives, for example, formed “Centrals” to gather funds from surplus regions
and employ them in deficit regions. They thereby simultaneously helped improve
portfolio diversification and systemic stability. The savings banks used Landesbanken to
serve a similar role. The latter, along with the Postbank system, eventually developed an
extensive branching system like those of the commercial banks, but that process took
place primarily after industrialization and even after World War II.29
The German banking system enjoyed substantial stability toward the end of the
19th century, but not for the entirety of its industrialization period. Indeed, the financial
revolution of the 1850s (and the second wave of the early 1870s) was fraught with
failures. A large number of joint-stock banks were formed, and a large proportion of
them failed. Crises in the 1850s and 1870s in particular weeded out the weakest banks.
The overhaul of the monetary system and creation in 1876 of a strong central bank that
provided unified note issuance and LOLR facilities, created a solid foundation for
subsequent banking development. Adding to these factors, the specialization of financial
functions among a range of institutions, as well as the increasingly national scope of
branching, the stability of the system improved significantly even by the 1880s.30
Periodic financial crises still erupted in the early 1890s, 1900-01, and 1907-08, but fewer
institutions outright failed, and the largest institutions weathered the storms well.
As the large banks grasped opportunities to expand via absorption of private
banking houses and smaller joint-stock banks, the joint-stock banking sector increased its
concentration over the industrialization period and beyond.31 Growing concentration
raised concerns about the power of the great banks and their domination over industry,
but modern studies have found mixed evidence on those claims. In the commercial loan
market, the German universal banks behaved in line with active competition, and at least
29
Fohlin (2007a, chapter 8) surveys the development of the German financial system after World War I.
Holtfrerich (1989). The last section here discusses more of the government’s role in development.
31
Fohlin (2002) looks at the role of changing regulation and stock market taxation on the growth and
concentration of the universal banking sector.
30
28
large industrial enterprises maintained relationships with multiple banks.32 The
investment banking side of the universal banks was likely less competitive, since the
largest banks held a significant advantage in ensuring that large issues succeeded.
Universal banks earned large fees on new issues, and those fees increased with the
market share of the bank.33 Yet Feldman (1998) shows via diary entries of the famous
industrialist Hugo Stinnes that even the largest banks ‘squabbled’ over their shares in
underwriting consortia for large, important new issues.34
Securities markets. New stock and bond issues became big business for the largest
universal banks as early as the 1871 ‘Gründerboom’ that followed the German victory in
the Franco-Prussian war. Financial markets had appeared in important commercial
centers early on—Cologne in 1553, Hamburg in 1558, and Frankfurt in 1585—but they
remained focused on commercial paper and only sporadically active until growing needs
from industry and government arrived in the 19th century.35 Increases in agricultural
productivity spurred demand for commodities markets. Government debt issues created a
parallel need for bond markets, while increasing industrial and trading activities drove
markets in commercial paper. In principle, these functions must have mobilized capital
in the early industrialization phase by creating a ready market for commodities and debt
securities, but so far there has been little quantitative research on the subject. At the same
time, given the tight restrictions on incorporation and limited liability in the first twothirds of the 19th century, the markets could play only a limited role in the financing of
industry during the first phase of industrialization.
Once the government liberalized incorporation, most notably in the 1870
company law (Aktiengesetz), existing stock markets dramatically expanded their business
32
Fohlin (2007a) shows concentration ratios compared to the U.K. and U.S. (which was not really
comparable due to its limits on branching and interstate banking). Both Germany and the U.S. demonstrate
a high degree of competitiveness from the 1880s to 1918, based on price markup models. See Fohlin
(2008) on competition in U.S. commercial banking markets. Wellhöner’s (1989) archival evidence
demonstrates that the large corporate clients of the universal banks were not dominated by those banks, as
the traditional (cf Hilferding) ‘Bankenmacht’ story goes.
33
Based on data from the 1880s (Fohlin (2010)).
34
See Feldman’s (1998) biography of Stinnes.
35
Fohlin (2007a), chapter 7, as well as Fohlin (2007b), provide extensive details and references to the
literature. Founding dates come from websites of the Hamburg and Frankfurt exchanges and of the city of
Cologne.
29
and new ones sprang up in most areas of Germany by the end of the 19th century. The
Berlin Stock Exchange became Germany’s premier stock market, drawing hundreds of
companies to list their shares there in the early 1870s. But the bust that followed that
boom led to a drop-off in new issues for several years. The IPO cycle rose and fell, but
the new issues market increasingly became a way for founding entrepreneurs to diversify
their assets and for large firms to grow larger by building new facilities and by taking
over existing ones.
Thus, even during the later stages of industrialization, only a small portion of
stock market business funneled capital into truly new enterprises, and it is therefore
difficult to assess the impact of securities markets on economic growth simply by
measuring the volume of IPOs or other offerings. Surely, the indirect effects of highlyfunctioning securities markets aided economic growth. We know that the Berlin Stock
Exchange operated with relatively high liquidity and low transactions costs, and with
substantial efficiency.36 We can surmise that the availability of such liquid and efficient
markets made it more likely that investors would invest in new ventures, given their
greater confidence that they could later sell those stakes to gain liquidity when needed.
And companies that listed their shares on the stock exchanges, and thereby opened
themselves up to closer scrutiny and the oversight of shareholders, outperformed those
that remained (most likely) more closely held and perhaps more capital constrained.37
Internal finance and alternative sources of finance. While banks and stock markets
mobilized vast amounts of capital for industry over the industrialization period, industrial
firms financed a substantial portion of their investments out of retained earnings. We
know the most about the financing of joint-stock corporations after 1870, by virtue of
their legally-mandated public reporting of financial accounts in an annual report. These
joint-stock corporations, many of which were closely held and not listed on a stock
36
See Fohlin and Reinhold (2010) on the cross-section of common stock returns; Burhop and Gelman
(2008) for market efficiency tests; and Gehrig and Fohlin (2006) on liquidity measures.
37
Fohlin (2007a), chapter 6, analyzes company balance sheet data to study the impact of both banking
relationships (board seats) and stock market listings and finds the latter much more important to firm
performance.
30
exchange, held financial assets—primarily cash and receivables—averaging 20-30
percent of total assets in the period 1895-1912.38
We have much less widespread historical evidence and research on the alternative
sources of finance available to German firms over the industrialization period. Angel
finance must have played some role, but its extent is not known and, by its nature, may
not be knowable. As in most places, entrepreneurial firms started out as family
businesses. Even some that became extremely large—such as Krupp—remained family
businesses for several generations. Although these firms reached out for external
financing, their own wealth and that of family members comprised the foundation of the
firms’ capital. Once a firm had gone public, and especially once it had gained listing on a
stock exchange, family and friends diminished in importance. Still, German corporations
often remained closely held even after issuing stock, though decreasingly so over the late
19th century. As company founders aged, and securities markets expanded, many
families sought the diversification benefits of selling off stakes to a wider range of
shareholders.39 The largest firms, especially the large, universal banks and insurance
companies, were the most likely to become widely held. Little evidence remains on
ownership structure of German firms, because the system used bearer shares, whose
ownership is not registered as a rule.40
We can quantify trade credit a bit better, at least among firms that left archival
records or published balance sheets. Based on the balance sheets of corporations, it
appears that firms partly financed operations via trade credit. Since the German
universal banks and private bankers offered current account services, allowing firms to
roll over credits for longer periods, trade credits may have served as auxiliary sources.
Government’s role. German governments (both state and federal levels) potentially
influenced the rate and direction of economic growth in a range of ways, both direct and
indirect, but the government role is too complex and variable to permit strong
generalizations. Most directly, government financed industrial development via the
38
Fohlin (2007a), p. 171.
Fohlin (2005, 2007a). James (2006) argues that the family firm remained key to the German system.
40
Franks, Mayer, and Wagner (2006) pull together some scattered archival evidence, but we still cannot
draw general patterns.
39
31
nationalization of railroads and enormous financing of military and industrial
infrastructure. The nationalization of the railways began with partial participation by the
State, for example, in the Cologne-Minden Railway in 1843. The state could guarantee a
basic level of dividends to outside shareholders in return for a greater share of profits in
good years. State owned railways increased from 56 percent in 1870 to 82 percent in
1880.41 Prussia-Hesse purchased 8,400 miles of road between 1879 and 1885, and
Saxony purchased over 780 miles between 1871 and 1907.42 While the government
clearly poured enormous resources into the railroads, and the railroads obviously spurred
economic growth, the nationalization approach did not necessarily increase growth over
the alternative approach of leaving the railroads in the hands of private investors.43
Likewise, government spending on military and infrastructure may have spurred growth,
or it may have simply redirected capital to alternate uses.44 The broad-scale
nationalization of the railroads took place despite the development of active financial
markets and institutions. Government backing and ownership of banks and industrial
enterprise became more prevalent after industrialization—to some extent in the 1930s
(notably with the bail-out of large universal banks in the 1931 crisis) and then more
prevalently during the post-WWII reconstruction.
Governments played another key role, through creation and backing of certain
types of financial institutions and of central banks—first at the state level, such as in
Bavaria, Saxony, Prussia, and elsewhere, then with the Reichsbank as of 1876. Along
with credit facilities, the Reichsbank set interest rates and issued the new currency, which
unified the former plethora of monetary systems into one—itself significantly reducing
transactions costs in trade and finance. Provincial governments operated Landesbanken,
which provided local finance and served as regional central banks for the savings banks.45
41
Wessel (1982).
Bogart (2007), p. 47 (Table 1).
43
On the one hand, nationalization may have accelerated the completion of the German rail network and
lessened volatility of railroad investment (Field (1980)), but it may have also skewed the allocation of
capital in such a way as to reduce investment efficiency (Fremdling (1980)). Dunlavy (1994) argues that
Prussia’s “hands-off” approach to early railroads encouraged the creation of a complete railroad system, in
contrast to the more fragmented but active government involvement that she argues impeded railroad
development in the United States.
44
For example, the shipbuilding race against Britain in the run-up to World War I, funneled massive
resources into that one industry. (Maurer, 1997).
45
Fohlin (2007a), p. 24.
42
32
Postal savings banks appeared in 1909 and evolved into an important part of the financial
system, primarily along the lines of private savings banks.
The German government regulated a range of areas impacting the financing of
industrial development in the 19th and early 20th centuries. The most obvious is the
regulation of bank note issue that unified the currency, the conservative monetary policy
under the Reichsbank, and the laissez faire regulation on universal banks that had
relinquished the right to issue notes and therefore shifted fully into commercial and
investment banking. Regulation also encouraged development of other forms of credit
institutions at regional levels, such as the savings banks, postal banks, and Landesbanken
already discussed.
German law worked to protect shareholders, creating rights and obligations under
the shareholder law of 1870 (Aktiengesetz) and attempting to strengthen corporate
governance provisions with the 1884 revision to that law.46 At the same time, the
government took what we might consider misguided regulatory steps in the imposition of
stock exchange taxes starting in the 1880s and with certain provisions of the stock
exchange law (Börsengesetz) of 1896, including the infamous ban on trading in many
futures. These regulations perhaps affected economic growth around the edges, but the
rapid and relatively stable growth of the German economy over the period in question
suggests on the face of it that regulation did not impede growth.
Concluding remarks. A long tradition of German economic history has credited the
universal banks with near-heroic feats in propelling industrialization from their
beginnings in 1848 until World War I. The joint-stock banks did channel funds to large
enterprises throughout the period from 1850 to 1913.47 These banks must have helped
promote growth by expanding capital supply, but their organizational form and business
model did not in itself promote higher rates of growth.
The universal banks were also just one part of a complex, evolving financial
system that included—especially after 1870—a variety of financial institutions to serve
46
Fohlin (2002, 2007b) and Fear and Kobrak (2006). Also Burhop and Gelman (2008).
As I argued in Fohlin (2007a), they developed most of what have become their characteristic features—
interlocking directorates, proxy-voting, equity stakes, for example—during and after the later stages of
industrialization.
47
33
disparate clientele at all levels of the population; active capital markets that worked in
concert with joint-stock banks; and a unified monetary policy, solid LOLR, and
supporting financial and corporate regulations.
The German case also highlights the feedback mechanism, or mutual
reinforcement, between financial and real sector growth. The long-standing existence of
banking firms and securities markets prior to industrialization demonstrates that simply
putting financial institutions in place did not create economic growth. But having those
institutions and markets ready to go, and having the ability to quickly create new ones
when the need finally arose, helped emergent industry grow more rapidly.
Finally, it is important to appreciate that the effectiveness of the German financial
system as a whole has varied over time. Financial institutions historically emerged and
adapted to meet the changing needs of industry within the constraints of technology,
imagination, and government regulation. But as the system and its institutions matured,
it often became less flexible and adaptable. Some institutions outlived their usefulness or
failed to adapt quickly enough, while some potentially useful institutions emerged late or
not at all. Thus, the finance-growth connection has almost certainly varied more over
time within Germany than it has differed between Germany and other countries with
similarly high levels of economic development.48
5. Japan
(Hideaki Miyajima and Yishay Yafeh)
Introduction. The early financial history of modern Japan can be divided into two subperiods: the period from the Meiji Restoration (1868) to the outbreak of World War I, and
the interwar period (here we do not discuss the post World War II era).
The first period was characterized primarily by the establishment of modern
institutions such as the Bank of Japan, networks of commercial banks, property rights,
stock exchanges, and corporate law. This period was also characterized by the integration
of Japan into the international financial system primarily through debt issuances in
London by the Japanese government and subsequently also by some non-government
48
See the discussion in Fohlin (2011, forthcoming), evaluating the cross-country evidence on political,
economic, and legal factors in the relationship between financial development and growth.
34
entities. In the financial system, corporate growth during the Meiji period was financed in
various ways: While family firms and family-controlled business groups depended
primarily on internal funds (as is often the case elsewhere) modern industry was financed
to a surprising extent by equity. Small and medium-sized firms were financially backed
by merchant credit combined with local bank lending.
The second (interwar) period, from World War I to 1940, was characterized
primarily by changes in the industrial organization and corporate control aspects of the
Japanese economy. These changes were primarily related to the fast growth of familycontrolled pyramidal groups, the zaibatsu, whose origins date back to the late 19th century,
but whose rate of diversification and expansion increased significantly during this period.
The increased influence of several large groups affected not only the economic (and
political) structure of Japan, but also its financial system. The growth of the zaibatsu in
the first half of this period (1914-1927) was accompanied by the emergence, and failure,
of “organ banks,” an early version of what is now called “related lending,” whereby some
large firms depended heavily on bank finance, establishing exclusive relationships with
their “organ” bank, and often ending in failure during the crisis of 1927. In the second
half of this period (1927-1940), after the 1927 crisis, stock markets played an important
role as a source of funds despite the absence of formal mechanisms of investor protection
and the dominance of (tunneling-prone?) family-controlled pyramidal groups. In fact,
investors seem to have been eager to invest in the equity of zaibatsu-affiliated firms,
perhaps because they were considered low risk or because they were regarded as
entrepreneurial and successful, as well as closely connected to the government.
The section illustrates three interesting points. First, we provide a historical
example of a shift in the nature of a financial system over time. Second, we describe the
concurrent emergence and growth of the zaibatsu business groups and stock market
finance in an environment where formal investor protection is less than fully developed.
Finally, we suggest that equity finance may have been supported by “informal”
institutions which provided trust and confidence.
The rest of the section is organized as follows. The next subsection provides an
overview of the establishment of economic institutions in Meiji Japan and its integration
into the global financial system of the pre-World War I era. The following subsection
35
focuses on the emergence and growth of the zaibatsu groups and the relation between this
phenomenon and the “division of labor” between different intermediaries within the
financial system. The evolution of Japan’s financial system in the interwar period is
discussed next. The final subsection concludes.
The emergence of Japan’s financial system institutions. Following the turmoil of the
1870s, the decade immediately after the Meiji Restoration, Japan embarked upon a series
of reforms designed to set up the institutions of a modern economy and financial system.
Table 1 lists some of the events and institutional changes of that period; the Meiji period
reforms included setting up the foundations of modern banking starting with the
amendment of the National Bank Act in 1876, which was followed by the establishment
of a central bank, the Bank of Japan, in 1882. In 1890, the banking law was amended, and
the government introduced a banking licensing system. Initially, bank capital was based
on equity and on borrowing from the Bank of Japan; deposits did not account for much
until the early 20th century. The banking system consisted of many small and local banks
which competed intensively, especially in offering loans to households (landowners,
merchants) which were indirectly channeled to commercial activities. In addition to many
small privately-owned domestic banks, the banking system included also governmentestablished banks (e.g. the Industrial Bank of Japan) with specific developmental goals.
Foreign banks did not play a role in the Japanese financial system of the time. Stock
markets were established in Tokyo and Osaka in 1878; apparently, these were not a major
source of capital in the pre-World War I era, although by some estimates market
capitalization in Japan of the early 20th century was already quite high.49
Beside specific measures to establish a financial system, Japan of the Meiji period
took considerable steps to set up the institutions of a modern market economy and, in
particular, to explicitly define and protect property rights, both in the promulgation of the
Meiji Constitution (1889) and in the subsequent enactment of the corporate law (1890).
Another fundamental economic change of the Meiji period was the privatization program
of the early 1880s in which the government sold “model factories” it had set up earlier to
49
See Rajan and Zingales (2003a). However, measuring the extent to which equity finance was used in
Japan during this period is not straightforward so these estimates should be treated with caution, see below.
36
private hands; some of the entrepreneurs involved in buying these government assets (e.g.
Iwasaki, a former low ranking samurai) ended up controlling the main pyramidal groups
which would dominate the economic scene of Japan in later decades (Mitsubishi in this
case), thus providing the earliest documented historical evidence on the link between
mass privatization and the formation of business groups.
Also during the Meiji period, in 1897, Japan adopted the Gold Standard, the
policy tool used by contemporary developed economies to signal commitment to a stable
macroeconomic environment. This reform was part of Japan’s attempt to become
integrated in the global financial system of the time with London at its core (indeed, one
of the explicit objectives of adopting the Gold Standard was to raise capital in London).
In the decade following the adoption of the Gold Standard, Japan became one of the
largest borrowers on the London market, the spreads (risk premium relative to British
government debt) on Japanese bonds declined significantly, and non-government entities
began to tap the London market for capital. This trend became especially pronounced
following Japan’s surprising military victory over Russia in 1904-1905 which was
interpreted as a very credible signal of economic development and good macro
management by investors in London.50
By the end of the Meiji period (1912) Japan was a stable, open economy with a
set of institutions which could be considered comparable to the standard of contemporary
continental Europe. In conjunction with the institutional changes of the Meiji period, this
era witnessed the emergence of a preliminary “division of labor” between financial
intermediaries whereby different funding sources were used to finance different types of
firms: bank loans were primarily used by small and medium-size family-owned firms;
equity finance was primarily used by large corporations.
The early industrialization and financial division of labor. In this section we discuss
the emergence of business groups and the continued development of a “division of labor”
(specialization) between financial intermediaries.
50
See Sussman and Yafeh (2000) and Hoshi and Kashap (2001), chapter 2, for more information on the
institutional changes of the Meiji period.
37
Family-controlled Business Groups Initially Relied on Retained Earnings: Familycontrolled pyramidal groups, called zaibatsu (“financial cliques”) played an important
role in Japanese industrialization. Their emergence was initially related to the sale of
government-owned assets to, and the signing of government procurement contracts with,
a small number of wealthy and trusted individuals, as is typical in the emergence process
of business groups in many countries. The major zaibatsu groups originally diversified
into mining, shipbuilding, international trade, financial services and more with
government support and encouragement. Although there were some occasions in which a
business group (e.g. Mitsui) used bank loans to finance growth for a limited time, major
business groups depended, for the most part on internal finance, allocating high profits
from their core businesses (normally mining) to other growing sectors.
It is possible to argue that in Japan’s early stages of economic and financial
development, these groups made up for “missing institutions” (in capital, labor and other
markets) and contributed to economic development and possibly also to a “big push.” By
1914 (the earliest available figure), the major zaibatsu groups accounted for about 40% of
all assets held by all industrial firms in Japan.51
Other Modern Firms Relied on Equity Finance and on Indirect Bank Lending:
In contrast with family businesses and groups, standalone firms in the modern industries
(e.g. railways, electric utility, cotton spinning, flour mills, paper, breweries, etc.) were not
financed by retained earnings, presumably because profits were relatively low and growth
opportunities high. One estimate suggests that internal resources accounted for only 16%
of funds used by manufacturing firms in Japan between 1902 and 1915 whereas equity
finance accounted for about 50%. These estimates are very crude and subject to
methodological problems (see below) but they do indicate that firms managed to raise
money from external sources.52
It is interesting to note that firms in modern sectors were established as joint-stock
companies from the beginning. For example, cotton spinning firms were started by
51
See Miyajima and Kawamoto (2010) for a recent evaluation of the emergence and growth of the
zaibatsu, and Khanna and Yafeh (2007) for international comparisons of the emergence of business groups
across countries and time periods. Morck and Nakamura (2007) describe the contribution of business
groups in Japan to economic development and present the idea of a group-orchestrated “big push.”
52
Teranishi (2005), p. 51.
38
several merchants who hired technicians, imported cotton spinning machinery and raised
money from small investors, from other local merchants and from wealthy landowners
and farmers. The phenomenon of dispersedly owned joint stock companies in early stages
of modernization raises the question how was it possible for firms to raise money from
small outside investors when investor protection was still rudimentary.
One explanation relates this phenomenon to the presence of “alternative”
institutions such as “business coordinators” who played an important role in the process
of issuing shares in the beginning of the 20th century. The coordinators (zaikai-sewanin)
were outside investors (“venture capitalists”) who took an equity stake in companies and
marketed their shares to outside shareholders. They were businessmen who were often
senior members of the business community or held director positions in multiple firms.
Due to their business success in the early stages of industrialization, they were highly
respected members of society. One of the functions of these coordinators was to monitor
newly established firms in the face of a large number of cases of fraud. They were also
expected to provide general business advice and to promote business relations with other
firms. This institution could explain why, during the process of modernization in Japan,
companies in major industries took the form of joint stock companies from very early
stages, with a relatively dispersed ownership structure.53
Once modern firms were established, the process of raising equity finance in
Japan at the time was somewhat unusual. Companies sold shares to investors in
“installments” at a price which was lower than the share’s face value (often as low as one
fourth of the face value), but with a commitment from investors to invest more (up to the
face value of their equity) when more funds were needed. When companies required
more capital, they typically did not issue new shares but “rights” (allotments to existing
shareholders) below the market price. Small investors, who received dividends on a
regular basis, were expected to respond on these occasions (i.e. inject capital when rights
were issued).
53
See Miwa and Ramseyer (2002) for further information on business coordinators. One of most famous
coordinators was Eiichi Shibusawa, who founded the Dai-Ichi Kokuritsu Bank, and headed the company
for forty three years. He participated in the establishment of over five hundred firms and held a board
position on forty nine of them.
39
When accumulated dividends and capital injections from existing shareholders
were insufficient, banks played an important role even though bank debt did not finance
firms in modern industries directly. Banks, which did not have enough information on
newly established companies and hesitated to lend to them, offered instead loans to
households (landowners and merchants) taking equity in companies owned by borrowers
as collateral. The use of equity as collateral became quite popular both in financing new
firms and in funding new investments of existing firms; indeed, in 1893-1897, nearly half
of the value of all collateral for bank loans took the form of stocks (equity) in firms
owned by borrowing individuals. These procedures make it very difficult to derive
precise quantitative estimates of the sources of finance used by Japanese firms.
Trade Credit Played an Important Role in More Traditional Sectors: Japanese
economic growth included also the development of indigenous industries such as raw silk,
cotton weaving, pottery, and even green tea in rural areas. These sectors were major
export industries which required capital for their operations. In the early phases of
industrialization (before 1910), credit from merchants and traders (rather than bank loans)
played an important role in providing financing to these sectors. As noted above, banks
were reluctant to lend to small firms directly and therefore local merchants became
intermediaries between banks and small firms or farmers, utilizing their reputation with
the banks and information networks with small firms.
As an illustration, silk producers borrowed mostly from raw silk wholesalers, but
obtained some loans from regional banks or branch offices of large city banks.
Wholesalers borrowed from large banks in Yokohama where silk was exported. Direct
lending to silk producers by banks in Yokohama was almost impossible because of the
lack of information on geographically dispersed, small borrowers (there were 91,751 silkreeling factories in 1926). By contrast, wholesalers had a vast network of information
sources on silk producers. It is reported that even regional banks made their lending
decisions on the basis of the lending behavior of wholesalers.54
54
This paragraph draws on Teranishi (2005). 40
The evolution of the Japanese financial system in the interwar period. World War I
generated a boom in the Japanese economy with business opportunities for Japanese
firms in trading, shipping and textiles. Corporate finance during the war and the
immediate postwar period was largely based on the high wartime profits; at the same time,
bank loans as well as equity finance began to play a role in funding corporations, offering
capital at low interest rates. The post-World War I boom ended in 1920, and the Japanese
economy entered into a recession which lasted over a decade. The changes in the
financial system during the 1920s and 1930s took place against the backdrop of
fundamental changes in the Japanese economy as a whole. The Great Depression in Japan
ended with fiscal and monetary expansion, increased military spending, the Manchurian
incident, and the abolition of the Gold Standard (1931).
During this period, the financial system experienced significant developments.
Trust banks were newly established in the 1920s and engaged in trustee business;
insurance companies were established and played a significant role as “institutional
investors” in the 1930s. More importantly, the “division of labor” between financial
intermediaries, which had started before World War I, became clearer: bank loans were
primarily used by small and medium, family-owned, firms; bonds were mainly used by
electric utilities (the only sector to thrive during the 1920s); and equity finance was
primarily used by large corporations, often group-affiliated.
The Rise and Fall of Organ Banks: Small and medium sized firms, including second tier
business groups tended to be family controlled. As Japanese households accumulated
financial assets in the form of deposits, city and local banks began to lend money to client
firms on the basis of these deposits. In contrast with the indirect methods of bank finance
used earlier, during World War I, investments of second tier family-controlled businesses
groups (whose business activities in trade, shipping, iron and steel had experienced a
boom during the war) were financed by bank debt assumed directly by the companies
rather than indirectly by their owners. The tendency of these family firms to use bank
debt may be related to phenomena described in the literature on present-day family firms,
which often hesitate to dilute their equity ownership and prefer instead to rely on bank
borrowing.
41
Typical examples of such second tier family-controlled groups are the Suzuki
group (which was focused on trade and depended on loans from a quasi-government bank,
the Taiwan Bank) and Kawasaki Shipyards which depended on a city bank (Number 15
Bank). The growth of such companies was often associated with an attempt by the firm
(or group) to establish its own bank. The Furukawa and Asano groups, for instance,
established their own banks during World War I, raising money from external deposits
(such practices were observed also among much smaller family firms and local
businesses). These banks, sometimes called organ banks, often faced financial distress
and in some cases brought about the demise of the entire group (e.g. Suzuki) in the 1920s.
Some authors describe these episodes as early examples of “related lending” and of the
risks associated with them. In the case of Suzuki, for example, group companies
apparently delayed their post-World War I restructuring and instead relied on continuous
borrowing from their group bank. This “soft budget constraint” combined with
continuously increasing leverage continued until both the borrowing firms and their
banks went bankrupt in the Financial Crisis of 1927.55
The Corporate Bond Market and Information generated by Large Banks: Another
important feature of corporate finance during the interwar period in Japan is the corporate
bond market, which was used primarily by electric utility giants in the 1920s and 1930s.
By some estimates, bond issuance accounted for 20% of total external finance in the
period 1928-1940. The development of the bond market was supported by the activities
of five large banks and one quasi-government bank (the Industrial Bank of Japan, IBJ).
They underwrote the issued bonds and offered brokerage services to households. It is
reported that the probability of default on corporate bonds underwritten by one of the
large five banks or IBJ was significantly lower the default probability on bonds
underwritten by other banks and securities houses56 However, as elsewhere, the default
55
See Morck and Nakamura (2005). The banking crisis, in part a legacy of the 1923 Kanto earthquake,
brought about significant consolidation to the Japanese banking system; the number of banks declined from
over 1200 in 1927 to 538 in 1932 (Hoshi and Kashyap, 2001, chapter 2).
56
See Konishi (2002).
42
rate increased during the Great Depression, and the government imposed new collateral
requirements in 1931; the corporate bond market subsequently declined.57
Large Business Groups Relied on Equity Finance: Finally, perhaps the most
noteworthy feature of the interwar period in terms of Japan’s financial development is the
simultaneous rapid rise of large family-controlled business groups and equity markets
during the 1930s. The value of business group-controlled assets increased nearly ten-fold
between the early 1920s and the early 1940s — the main zaibatsu groups were among the
major beneficiaries of the government-sponsored investment in heavy industry — and
equity finance became their primary source of capital.
Until the rapid financial development of Japanese equity markets in the 1930s, the
major three zaibatsu groups seem to have maintained an active internal capital market to
finance their investments. As diversified pyramidal entities (organized in the first and
second decades of the 20th century), the major groups had a holding company at the apex
of their pyramid (a partnership with limited liability) controlling lower tiers of firms
organized as joint stock companies. Within these pyramids, large investments and new
entry into “high technology” areas were supported by internal transfers of capital, which
seem to have been especially important in the early phases of development of new
industries. For example, during World War I, groups used their high profits in mining (a
“cash cow sector”) to channel funds into growing sectors such as chemical or electric
machinery.
In the 1930s, however, the zaibatsu shifted to raising equity finance by carving
out subsidiaries. For example, Mitsui Trading Co. sold 50% its holdings in Toyo Rayon
and used the proceeds to finance Toyo Rayon’s investment as well as the expansion of
other Mitsui firms. Nissan’s profitable affiliate, Hitachi, was partially sold out, and the
proceeds were invested in their new business activities such as automobiles. The use of
equity finance by business groups is puzzling; modern evidence suggests that reliance of
pyramidal business groups on equity finance is rare. The prevalence of this phenomenon
in interwar Japan is especially intriguing given the fact that modern (formal) mechanisms
57
See Rajan and Zingales (2003b).
43
of investor protection were, at the time, virtually non-existent (although property rights
were well defined).
A possible explanation could be the support of the government and the perception
of the groups as both safe and wielding monopoly power. In addition, the major groups
tried to establish a reputation for bailing out ailing subsidiaries and thus conveyed to
investors a sense of being low-risk combined with a sense that by investing in the shares
of a group-affiliated company an investor could receive part of the rents associated with
the operations of a large, entrepreneurial and government-favored group. Indeed, not only
did the presence of the zaibatsu not discourage small outside shareholders from investing
in new issues, it may actually have encouraged this activity to the extent that small
shareholders viewed the group structure as a trust mechanism rather than as a mechanism
for minority expropriation. Consequently, in the 1930s, when equity markets thrived,
internal capital markets within business groups were less dependent on retained earnings,
and instead reallocated within the group the funds raised on equity markets.58
Concluding remarks. The financial history of modern Japan is interesting in several
respects. First, Japan’s financial (and economic) history begins with the establishment of
an entire set of institutions which typically characterize developed economies (a central
bank, property rights, and so forth). In this sense, Meiji Japan offers potential lessons for
contemporary developing economies.
Second, the financial system of Japan played a significant role in financing
industrialization and economic growth, with a clear “division of labor” especially
between banks, which financed small family firms, and equity markets which financed
large-scale corporate groups. The Japanese financial system underwent significant
58
This paragraph draws primarily on Miyajima and Kawamoto (2010) and on Franks, Mayer and Miyajima
(2008). For further discussion of the question why minority shareholders may be willing to invest in the
shares of pyramidal business groups despite fear of “tunneling,” see Khanna and Yafeh (2007). Some
authors argue that the strict control exercised by holding companies over subsidiaries in the largest three
groups was associated with slow entry into new industries and “hesitation” to assume risk, whereas
younger and smaller groups expanded more aggressively (e.g. Morikawa, 1992). A mirror image of the
importance of equity finance as a source of capital for large firms in Japan in the 1930s can be found in the
composition of household assets in which “securities” accounted for about 50% starting in the early
twentieth century, see Hoshi and Kashyap (2001) chapter 2. Hoshi and Kashyap also emphasize that
corporate governance in interwar Japan was primarily driven by shareholder activities on boards, rather
than by bank (lender) monitoring, a common feature in postwar Japan. 44
transformation in the prewar era and relative importance of different financial
intermediaries was far from constant.
Third, prewar Japan provides an example of thriving equity markets combined
with low levels of investor protection, in contrast with what the “conventional wisdom”
in financial economics would suggest. Moreover, pyramidal business groups were major
players in these markets, and investors seem to have been willing to invest in their shares
despite the risk of minority shareholder expropriation. To some extent, these anomalies
may be explained by the existence of alternative institutions which helped allay investor
fears of “tunneling;” and in part, this may be due to the size, security and government
support associated with the largest business groups. The shift to a planned economy
towards and during World War II, as well as the postwar reforms and economic
transformation, brought about radical changes in the structure of the Japanese financial
system.
6. Conclusions
(Franklin Allen)
This paper considers the role of a country’s financial structure in determining its
economic growth using the historical experience of four of the most advanced economies
in the world. The U.K. was the first country to go through the industrial revolution in the
19th century. This was preceded by a financial revolution. However, the evidence from
the nineteenth century is perhaps more persuasive for the importance of finance for
growth. The U.S. provides the most clear cut example of a financial revolution preceding
an industrial revolution. In Germany there is some evidence of financing causing
economic growth, at least in the railroad industry. In Japan both processes were
compressed.
The role of different types of finance varied across the four countries. Since all
four countries were successful in terms of growth it is difficult to conclude that there is a
unique optimal financial structure for a country that should be widely adopted by other
countries going through the development process. Different types of finance can be used
to fund real economic growth. Bank loans and equity finance were important in all
countries but these operated in different ways.
45
One important aspect of a country’s financial structure that has not been discussed
in this paper, concerns its effect on industrial structure. Allen and Gale (1999, 2000)
have argued that a country’s financial structure is important in this respect, with equity
finance through stock exchanges supporting innovative industries and debt finance
through banks being better suited to existing industries. This remains an important topic
for future research.
46
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Table 1
Chronology of Financial Development in Japan, 1868-1940
Year
Event
1868
1876
1878
1881
1882
1889
1890
1890
1938
1939-45
1943
Meiji Restoration
Mitsui establishes banking business
Tokyo Stock Exchange established
Privatization begins
The establishment of the Bank of Japan
The Meiji Constitution
Company Law takes effect
Bank Code Revised, commercial banking system established; Mitsui Trading and
Mitsui Bank incorporated (another incorporation boom in 1890s
Listing requirements revised to encourage trading on stock markets
Sino-Japanese War
Mitsubishi and Sumitomo incorporate their banking divisions.
Revision of Commercial Code
Industrial Bank of Japan established
Russo-Japanese War; Tax reforms: introduction of income tax creates tax
advantages for corporations
Mitsui Partnership established
Commercial Code revised (under incorporation articles, representative director
appointed, fiduciary duties clarified, criminal liability defined.)
Stock Exchange Directive revised under Imperial Ordinance No. 229
Asano Family holding company established; Okura Limited Partnership
established
Tax reforms (advantages to holding companies).
Sumitomo unlimited partnership established; Furukawa Trading de facto
bankrupt, merged with Furukawa Mining; Suzuki Unlimited Partnership
established
Revised Stock Exchange Law promulgated, Stock Exchange Directive and Stock
Exchange Law Enforcement Regulations revised. Bankruptcy Law, Conciliation
Law enacted
Kanto Earthquake
Showa Financial Crisis; Suzuki and Kawasaki Shipbuilding go bankrupt
Banking Law amended
Showa Depression
Manchurian Incident; Furukawa Bank liquidated
May 15 Incident; Hitachi, Nihon Mining (Nissan Group) go public
Accounting guidelines adopted
February 26 Incident
Outbreak of war with China; Mitsubishi, Sumitomoto Holding Company
reorganized as joint stock companies
Commercial Code revised
Corporate Profit Dividend and Capital Distribution Directive promulgated.
Munitions Company Law
1945 (Aug)
Tokyo Stock Exchange closed
1894
1894-95
1895
1899
1902
1904-05
1909
1911
1918
1920
1921
1922
1923
1927
1928
1929
1931
1932
1934
1936
1937-
54