The Evolution of Capital Markets
in the 19th Century
Success and Dominance
of British Finance
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•
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By 1820
Parliamentary control of budget, annual audits
Salaried Tax Collectors
Tax Smoothing and Time Consistency
Short-Term Debt: treasury, army, and navy bills
Long-Term Debt: consols.
Consequence---cheapest borrowing and lowest
inflation. Matched with dominance in
manufacturing, trade and military power.
Other Countries Desire to Emulate
• But, there is an absence of political stability and
the institutions---such as North and Weingast
describe---that ensure governments will follow
credibly time-consistent policies.
• France post-1815, strong monarchy, weak
legislature, revolutions, 1830, 1848, 1871.
Dominance of legislature only begins in 1871.
But, never again default after 1797
• Belgium—formed from Kingdom of the
Netherlands in 1830, strong monarchy, weak
legislature, and revolution 1848
• Revolutions across Europe in 1848
• Can this result as seen in capital markets?
Two Features
• Trend---downward trend in yields on
government bonds
• Convergence of rates between bonds
issued by different governments.
• What drives these two phenomenon?
• HINT! Is it supply or demand?
What drives down the trend?
Interest
Rate
S1
S2
ir1
ir2
I2
I1
G1
G2
Savings, Investment
Huge Rise in European Savings:
Domestic and Overseas
Investment
Where
Does the
Money Go?
“Mary
Poppins?”
Overseas Investment Central to
World Economic Development
• Many developing countries in the 19th century,
including the U.S. and Canada, required vast
investments in infrastructure----railroads, canals,
ports, etc. and machinery and equipment.
• They have trade deficits---U.S. has a trade
deficit for the whole of the 19th century until
1914.
• The capital investments---railroads, ports,
bridges, factories---help to cover the huge trade
deficits—so that these countries are not
depleted of gold.
Great Age of Victorian Finance
http://www.youtube.com/watch?v=jt9JpYRulSk
http://www.youtube.com/watch?v=C6DGs3qjRwQ&feature=related
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•
“Mary Poppins-----the Fidelity Fiduciary Bank song
Mr. Dawes Sr, Mr. Banks and Bankers:
If you invest your tuppence
Wisely in the bank
Safe and sound
Soon that tuppence,
Safely invested in the bank,
Will compound
And you'll achieve that sense of conquest
As your affluence expands
In the hands of the directors
Who invest as propriety demands
You see, Michael, you'll be part of
Railways through Africa
Dams across the Nile
Fleets of ocean greyhounds
Majestic, self-amortizing canals
Plantations of ripening tea
……………………
The First Era of Globalization
• Integration of Labor Markets---Emigration of
labor form Europe, where there are low wages
to frontier economies where it is high (High Land
to Labor ratio---low relative price of land)
• Integration of Capital Markets----Migration of
Capital from the European core to the European
periphery (Eastern and Southern Europe) and
the Rest of the World. High returns to newly
industrializing countries and frontier economies.
• Land does not move
• Integration of Markets for Goods (Remember
O’Rourke!).
• Result---strong tendency for goods and factor
price equalization.
Global Market for Goods
• Reduction in Transportation Costs---shipping changes
from wind to steam. Collapse of transport costs for
goods and for labor
• Reduction in Barriers to Trade—Tariffs
– Corn Laws overturned 1841. Britain takes lead in lowering
tariffs. Does not ask for reciprocity.
– 1860 Cobden-Chevalier Anglo-French trade treaty. Resisted
by many French industries, but political considerations for a
rapprochment overwhelm the economic considerations.
Tariffs now average 15% on British goods in France—a
moderate tariff. Treaty introduces “most favored nation
clause.” If one party to a treaty negotiates a treaty with a
third and the new tariffs are more beneficial, they are
automatically given to the other country. A spur to lowering
tariff barriers.
– France negotiates treaties with the Zollverein, Belgium, Italy,
Switzerland and the Scandinavian countries---tariffs tumble.
Williamson (JEP, 1998)
When does convergence begin?
Globalization, Inequality and Backlash
The Backlash
• Anti-Immigration Legislation
– U.S. 1917 literacy test—vetoed by President
Wilson
– U.S. Emergency Quota Act 1921
– Barriers raised in Argentina, Australia, Brazil
and Canada
• Tariffs
– 1879 German tariff
– Tariffs in France, Sweden and other countries.
The First Era of Globalization
1860/1870-1913
• Markets are highly integrated---labor,
capital, goods
• Spread of European (British) institutions
for managing monetary and fiscal
operations of the government.
• Rapid growth around the world with rapidly
rising per capita incomes.
• Blown Apart by World War I.
The Two Major Concerns of
Monetary Policy
in all Periods and all Places
1. Fiscal Policy
“Time Consistent Policy:” WarsDeficits
financed by selling bonds. Raise taxes just
enough to run peacetime surplus to cover
the interest cost and slowly pay down debt.
2. Monetary Policy
Price Stability: 19th CGold Standard
Financial Stability
Key to Development of Price Stability:
The Adoption of the Gold Standard in the 19thC
• Gold Standard ensures long-term price stability
– The price level remains stable in the long-run,
although there will be year-to-year price increases
and declines. On average the price level will be
stable.
• Commitment to Gold Standard is one way that a
government can promise that it will not
manipulate the money supply---”time
consistency”---it must be easily verifiable by the
public.
• Money and capital markets are thus assured.
Can borrow cheaply---not defrauded by surprise
inflation
Bordo (1981)
How would a time series graph of this look?
Cheating? Counterfeiting?
• Gold: Durable and
High Value to Weight
• The Public Cheats:
Counterfeiting
• The Government
Cheats: Debasement
• If done widely---result
would be inflationary
A Simple Closed Economy Model
of the Gold Standard
• Autarky---no trade---closed economy
• Government accepts gold ore for a fixed price
per ounce (U.S. 1 oz = $20.67), called here Pg
• Government mint produces gold coins (for a
small fee that is revenue to the government)
• All money is in the form of gold coins
• Stock of Gold = monetary gold plus nonmonetary gold
What if big increase in Stock of Gold?
Relative
Price of
Gold
Stock of Gold
Price
Level
Aggregate
Supply
(Pg /P1)
P1
Aggregate
Demand
Non-monetary
demand for gold
0
A
B
Gold
Q1
Non-Mon G=0A, Monetary G = AB
Output or GDP
Basic Idea of Gold Standard
• Gold mining is very expensive---very small
additions to the total stock in any one
year—1 to 3% of total.
• How fast does the economy increase? 1 to
3% per year. [growth of aggregate supply]
• ΔM/M + ΔV/V = ΔP/P + ΔQ/Q
• If Velocity change approx = 0
• ΔP/P = ΔM/M - ΔQ/Q, roughly cancel
each other out.
• Long-Term Price Stability is the result
What if?
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•
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What if ΔM/M >> ΔQ/Q
Then ΔP/P = ΔM/M - ΔQ/Q = ??
ΔM/M << ΔQ/Q
Then ΔP/P = ΔM/M - ΔQ/Q = ??
• When would either event happen????
Is the economy doomed to inflation or deflation?
• No, there is an equilibrating factor
• In an inflation, the relative price of gold (Pg /P)
will fall
– Mining will decline and rate of growth of gold stock
will fall
– Increase in non-monetary use of gold
– Both of which will gradually reverse inflation
• In an deflation, the relative price of gold (Pg /P)
will rise
– Mining will increase and the rate of growth of gold
stock will rise
– Decrease in non-monetary use of gold
– Both of which will gradually reverse deflation
• Result is that there will be long-term price
stability under the gold standard
Simple Open Economy Gold Standard
• Two countries—U.S. and U.K.
• US sets price of one ounce of gold =
$20.67
• UK sets price of one ounce of gold =
£4.247
• Result £1 = $4.867, the exchange rate
The Open Economy
under a simple gold coin standard
• The open economy: IM = imports, EX=
exports, EX - IM = the trade balance
• If EX - IM > 0, trade surplus, country is paid
in gold
• If EX – IM < 0, trade deficit, country pays
difference in gold
• So EX - IM = ΔM or change in money stock
Initially
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• US
[V = constant]
ΔM/M + ΔV/V = ΔP/P
+ ΔQ/Q
EX - IM = 0
Trade is in balance
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• UK
[V = constant]
ΔM/M + ΔV/V = ΔP/P
+ ΔQ/Q
EX - IM = 0
Trade is in balance
-----------------------Now UK has
productivity growth
and output increases,
prices (P) of its good
fall
UK has productivity growth and output
increases, and prices of its good (P) falls
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•
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•
•
US [V = constant]
EX - IM < 0
Trade is in deficit
EX – IM = ΔM <0
ΔP/P = ΔM/M - ΔQ/Q,
so
• ΔP < 0
• Deflation and US
gains some
competitive
advantage and trade
deficit dissipates
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UK [V = constant]
EX - IM > 0
Trade is in surplus
EX – IM = ΔM >0
ΔP/P = ΔM/M - ΔQ/Q,
so
• ΔP > 0
• Inflation and Britain
loses some
competitive
advantage and trade
surplus dissipates
Equilibrium is restored!
• This is the 18th century
philosopher/economist David Hume’s
Price-Specie-Flow mechanism.
• BUT----to remember how it works, say it
backwards: Flow-Specie-Price.
• The equilibrating mechanism for a simple
“gold coin standard”
• Basics---now to add more realistic features
But, gold is very expensive to use, even for domestic
purposes—the Goldsmiths of London 17th Century
A GOLDSMITH’S BALANCE SHEET
• ASSETS
• --------------------• Gold £10,000
• LIABILITIES
• ----------------------• Deposits £10,000
Sir Richard Hoare---opened a
goldsmith business in 1672 on
Cheapside. He held gold on deposit
for customers and eventually moved
into banking. In 1690 he moved his
business to Fleet Street and called
his business C. Hoare & Company--it is today, England’s oldest private
bank.
But why not earn something on the gold---lend it
out, the birth of fractional reserve banking!!
A GOLDSMITH’S BALANCE SHEET
•
•
•
•
ASSETS
--------------------Gold £10,000
Loans £5,000
• The Bank can tolerate
some withdrawals.
• Liabilities
• --------------------• Deposits £15,000
(10,000 were deposits
of gold and 5,000 are
deposits created for
the borrowers)
A COMPLETE BANK
BANK’S BALANCE SHEET
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•
•
•
ASSETS
--------------------Gold £35,000
Loans £65,000
• --------------------• Total £100,000
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•
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•
•
LIABILITIES
--------------------Capital £20,000
Deposits £40,000
Banknotes £40,000
• -----------------• Total £100,000
What If?
• What happens if there are random inflows and
outflows of deposits and return of banknotes?
• What happens if the public finds out if a business
loan of £1,000 is bad?
• What happens if public finds out that business
loans of £25,000 are bad?
• What is a run on the bank?
• When does a panic happen?
• Can the system melt down? What is a liquidity
crisis or scramble for liquidity? What are the
consequences for the economy?
• Bank of England established 1694. A private bank that acts as
banker to the government. It has a monopoly of banknote issue
in London in exchange to loan to government.
• Becomes by far the largest bank in Britain and it has the largest
gold reserve!
• When other banks are in trouble it lends [“discounts”] to them--stop a crisis that might engulf it. LOLR
• Becomes a bankers’ bank, freed from forced loans to govt.
• Key feature is that this “central bank” is independent of the
government---hence it has greater credibility.
Central
Banking
Banque de France
• Banque de France is founded 1800
• A private bank, but the governor is appointed by
the government. Yet it is independent of the
government.
• A conservative institution devoted to ensuring
the gold standard. A large gold reserve to back
its banknotes.
• After 1815, prices in France are relatively stable
in 1914.
• Lender of last resort to French institutions.
Reichsbank
• Reichsbank founded in 1870.
• Germany moves from bimetallism to the gold
standard.
• Part of economic integration of German Empire.
A center if the Prussian State Bank.
• A private institution subject to some government
control.
• Helps to establish a uniform national coinage.
• Monopoly of note issue
• In charge of price stability and financial
responsibility.
Banca d’Italia
• Established by amalgamating the
remaining state banks in 1893.
• Italy on the gold standard intermittently—
but Bank “shadows” the gold standard.
Lira stays close to parity.
• Discount rate not a discretionary tool of
the bank but of the government.
Central Bank Policies
• Policies to provide Price Stability
– Under Gold Standard----operate under the
rules of the game
– Under Fiat Money Standard---control growth
of money or interest rates.
• Lender of Last Resort---policy to provide
financial stability. Aim is to prevent
banking panics from getting out of control
and affecting the broader economy.
Central Banks, the Gold Standard,
and the Rules of the Game
• The gold standard was an automatic
equilibrating mechanism.
• But---long time delays and costly if relies
on actual shipment of gold.
• Instead Central Bank policy as begun by
Bank of England was to enhance
operation of gold standard by following the
“Rules of the Game”
Central Bank Reserves
• Key currencies are a feature of the gold
standard era.
• When a country runs a trade surplus, it will first
accumulate the trade deficit countries’ currency.
Banks sell and Central Banks accumulate this
“foreign exchange.” Then, the central banks
may convert the currencies---pounds, FF or RMs
into gold. But it is not required. An incentive to
do so as assets in these currencies earn interest
while gold does not.
• Result, substantial accumulation
By 1913, Foreign Exchange as a
Percentage of Total Reserves
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•
Bank of England
0%
Bank of France
½%
Reichsbank
15%
Average of Other European Central Bank
26%
Average of Africa Asia and Australia
67%
Role Key Currencies and Sterling
(and FF and RM) balances
• THUS, when trade surpluses occur or interest
rates are high.
• Most of these are sterling balances in London--as London is the center of the world trade and
• World Financial Capital in the 19th century.
• Changes in the Bank of England’s discount rate
are thus highly effective in the central bank’s
operation.
• Bank of England is often referred to as the
“conductor of the orchestra”----the orchestra of
the gold standard with central banks following
the rules of the game.
The “Rules of the Game”
• Bank of England set its “discount rate” which was rate at
which banks and others could borrow.
• EX – IM < 0, trade deficit, country pays difference in gold--but as gold flows out and the Bank of England loses
reserves, so it raises the discount rateinvestment,
inventories and consumption fallaggregate demand
declines and Price level fall, speeding the adjustment
• EX – IM > 0, trade surplus, country gains difference in gold---but as gold flows in, the Bank of England will gain
reserves, so it lowers the discount rateinvestment,
inventories and consumption riseaggregate demand rises
and Price level rises, speeding the adjustment
• Central Bank may not follow rules as there is an
asymmetry, trade deficits force a bank to raise discount
rate, trade surpluses do not force a bank to lower the
discount rate. If it does not follow the rule, there will be a
slower adjustment.
How shocks cause bank runs and panics:
Asymmetric Information
• A run begins when some depositors observe negative
information about a bank, e.g. a company it lends to has
failed or an industry it lends to has suffered a decline--this is a natural part of the business cycle.
• Is it enough to make the bank fail? (Insolvent) or Does it
not have enough cash to pay out immediately (Illiquid)
Don’t know asymmetric information.
• A Customer will want to withdraw his/her deposits
because they fear the bank will be unable to pay out all
deposits.
• Depositors “run” because they believe that others will run
on the bank. There is sequential payment, induces fear
they will not get money out.
• If Depositors cannot discriminate between sound and
unsound banks and they observing others “running” ,
there will be “contagion,” runs will multiply producing a
“panic.”
Is a bank in trouble “Illiquid” or “Insolvent”?
• “Illiquid” banks do not have enough
reserves and cannot sell enough assets
quickly enough to satisfy demand for
withdrawals
• “Insolvent” bank’s assets are worth less
than its liabilities. It is not a matter of time.
Impossible to pay out all deposits
Illiquid v. Insolvent—a loss from bad loans of
$15,000 versus $30,000
•
•
•
•
•
•
ASSETS
Reserves $ 5,000
Bonds
$ 5,000
Loans
$90,000
----------------------Total
$100,000
• LIABILITIES
• Capital $20,000
• Deposits $80,000
• --------------------------• Total
$100,000
If customers don’t know the size of the loss, they will run.
Both types of banks will have trouble. But do we want both
to be in trouble? Should both fail? What are the
consequences for the economy and the recession if the
illiquid banks closes its doors?
To Trace out the effects on the economy
Money Supply under the Gold Standard
• M = [(1 + C/D)/(C/D + RR/D + ER/D)]H
• C/D = coins/deposits + banknotes
• RR/D = required bank reserves in
coin/deposits + banknotes
• ER/D = excess reserves/deposits +
banknotes
• H = gold and silver coins
Effects on a Recession
• In a recession, there is a rise in unemployment
C/D rises as deposits are withdrawn
• In a recession, there are loan losses.
• Fear that a bank is insolventrun
• What’s the effect on the Money Supply?
• C/D and ER/D rise  M to decline
• Result? Interest rates rise Investment and
Consumption decline
• Recession is amplified, possibility of vicious
downward cycle…………..what could be done??
Lender of Last Resort
• After disastrous panic of 1825,
Bank of England learns that it must
lend early to halt a panic.
• Walter Bagehot, editor of the
Economist, Lombard Street (1873)
• Bagehot’s Rule: “Lend Freely But
on Good Collateral” Only the
intrinsically solvent firms will be
able to borrow—high rate will limit
borrowing.
• Only the illiquid not the insolvent
will be saved.
• Last British banking panic was 1890
(the Barings crisis)---until 2008
“Northern Rock.”
19th C Orthodox Central Banking Policy
• FOR PRICE STABILITY:
– THE GOLD STANDARD---the Central will adhere to
the Gold Standard and stand ready to exchange its
currency for gold coin. It is a fixed exchange rate
system which ensures long-term (but not short-term
price stability) from the automatic the price specie
flow mechanism
– THE RULES OF THE GAME for the Central Bank---a
trade deficit/gold outflowraise interest rates; a trade
surplus/gold inflowlower interest rates. These
affect investment, consumption and capital flows and
speed up the automatic adjustment mechanism.
• FOR FINANCIAL STABILITY:
– Bagehot’s Rule. Prevent a panic from exacerbating a
recession. Ensure that only solvent banks are saved.
Avoid “moral hazard.”
The Success of the Gold Standard
• Long-term Price Stability
• Limited Financial Crises
• High rates of economic growth
Why is Price Stability Important?
• If behavior of price level or inflation were certain, then
there would be less risk for business and individuals.
They would know the real rates of interest.
• Real interest rate = Nominal interest rate - Rate of
Inflation
• But the more uncertain people are about the price level
or inflation, the more risk.
• The more RISK the higher the required yields the
lower investment and the lower economic growth
• There is a cost to the economy if a government does not
find some way to make the public believe that it is
committed controlling inflation.
• Can this be measured?
• Gold standard is a commitment mechanism, examine
interest rates under the gold standard.
Gold Standard Promotes Overseas
Investment