How Important Historically Were Financial Systems for Growth in

the UK, US, Germany and Japan?

Franklin Allen, Forrest Capie, Caroline Fohlin, Hideaki Miyajima, Richard Sylla, Geoffrey Wood and Yishay Yafeh

Financial Structure and Economic DevelopmentWorld Bank

June 16, 2011

Historical Financial Revolutions:Key Components

• Strong Public Finances and Debt Management• Stable Money• Effective Central Bank

• Innovative, Growing Banking System• Vibrant Securities Markets• Increasing Number of Corporations

UK and US Financial Revolutions

• Parliamentary control of revenues, spending, debt, 1690s

• Coinage reform, 1696• Bank of England, 1694

• Banking established in late 17th century, but “quite limited” through 18th century

• Securities markets, 1690s—but mostly government debt markets until early to mid 19th century

• Corporations—a few, but not many, until late 1850s. Ditto joint-stock companies until 1820s.

• Hamilton’s implementation of federal revenue system, 1789ff, and US debt restructuring, 1790

• Specie-based dollar, 1791-1792• Bank of the United States, 1791

• Banking--4 banks in 1790, rapid growth of corporate banking thereafter: 600-700 banks by 1830s and 1,500-1,600 banks by 1860

• Securities markets in major cities in 1790s; exchanges in Phila. (1790) and NYC (1792)

• Corporations—about 300 new ones in 1790s, growing to 20,000 or so by 1860.

Comparing and Contrasting the two Financial Revolutions

• UK’s was protracted and incomplete until mid 19th century.

• Bank of England does not become a central bank until mid 19th c.

• Bank of England’s monopoly of joint-stock/corporate banking until 1825 slowed banking growth.

• UK securities markets were mostly national debt markets until 1830s, when regional stock exchanges began to serve business firms.

• Joint-stock companies until 1820s and corporations until 1850s were slow to develop in England.

• US’s a century later was quick and complete, in early 1790s.

• Bank(s) of the US (1790s-1830s) were more modern banks and central banks than Bank of England.

• US banking expanded rapidly, especially in Northeast where corporate bank entry was relatively free.

• US, with a much smaller national debt, had a greater balance of equity and debt financing.

• US led the world in chartering business corporations with thousands by the early 19th c. and tens of thousands by 1860.

Some Results of the Differing UK and US Financial Revolutions

• UK real growth was slow in 18th century, perhaps 1%/yr, not much above population growth, and did not reach 3%/yr until second quarter of 19th century, when modern rates of per capita real growth of 1+%/yr. took hold.

• Based on its first industrial revolution, international trade prowess, and empire, UK becomes the workshop of the world by mid 19th century, and reforms its financial system to become a world leader.

• In the 19th and 20th centuries, the US, Germany, and Japan catch up, and sometimes surpass, the UK on some financial and economic metrics.

• US real growth was 3+% in 18th c., not much above population growth, but rose after 1790 to overall rates of 4-5%/yr and modern per capita real rates of more than 1%/yr.

• US quickly catches up with UK in early 19th century, with parity of real per capita income by 1830s or 1840s.

• Based mostly on internal economic development, US surpasses UK in total and per capita product by 1870s or 1880s, and becomes the largest national economy and industrial leader.

• By the early 20th century, the US has more than a third of world bank deposits, and more deposits than the UK, France, and Germany combined.

Further Comparisons• Business enterprises in both the 19th-century UK and the US relied heavily on retained

profits as a source of finance, but possibly less so in the US because of easier access to bank and equity financing and less initial wealth accumulation than the UK.

• Banks and securities markets in both countries were linked and complementary, not alternative, sources of finance. In both countries, for example, it seems that investors borrowed from banks to buy stock.

• Government was a more important source of finance in the US than in the “laissez faire” UK. The US government often paid down its debts, returning funds to the capital markets, and it “spent” its land resources through grants of land to states and railroad corporations. US state and local governments accessed capital markets to raise money for banks and “internal improvements” (canals, RRs, urban infrastructure).

• By getting rid of its central bank in the 1830s for political reasons, the US weakened its financial system just when the UK was strengthening its system by abandoning earlier draconian regulations and turning the Bank of England into a modern central bank. In the US, a central bank would not reappear until 1913, after a period of more frequent financial crises than in the UK.

GermanyFinancial and Economic Development

• Until 1871: fragmented group of sovereign states– Highly variable rates of (proto)industrialization across German states

in 1st half of 19c – Spotty financial development– Variety of monetary systems

• Unification in 1871 and thereafter– Unified monetary systems– Created central bank and monetary policy– Promulgated national corporate law

Germany During Heavy Industrialization Period

Financial and Economic Development

• When did Germany start growing?– Slow but positive growth already in 18th and early

19th centuries• interrupted by revolution and Napoleonic Wars

– Structural shift to higher growth rates circa 1850• Early industrialization 1850-early 1870s• Later industrialization 1870s-1913

– Significant variation in growth across regions

Banks and Other Financial Institutions

• Many types of financial institutions by mid-19th century– Tiny to large– Private to incorporated– Agrarian to corporate– Personal savings to investment banking

• Universal banks get most of the credit– Combined investment and commercial banking starting 1850s

• Big growth after liberalization of incorporation and industrial development spurt of early 1870s

• Strong ties to securities market activity• Corporate governance role connected with proxy voting system

Securities Markets

• Markets developed early and often– First ones founded very early (mid-16c)

• Primarily commercial and government paper for first 300 years– Stocks took off in early 1870s

• Most issues for pre-existing firms, not new enterprise

• Helped existing firms grow and merge– Performed well (high market quality)

• Helped funnel resources into high return areas– Listed companies performed better than unlisted ones

• Very likely selection bias• Selection is helpful for targeting investment

Internal Finance and Alternative Sources of Finance

• Internal finance key factor in corporate finance– Liquid assets averaged 20-30 percent of total assets in the

period 1895-1912• Prevalence of family firms, closely held– Even some quite large ones (Krupp)

• Trade credits and financing via other non-financial firms

Government’s Role

• Direct finance– Nationalization of railroads – Financing of military and industrial infrastructure– Creation of banking institutions

• Indirect role– Regulating and shaping financial and monetary system– Early shareholder protections– Stock exchange taxes and ban on futures (1897-1908)

Conclusions

• Germany possessed complex financial system by the later stages of industrialization– Banks of many kinds– Active, high-quality markets– Legal protection of shareholders– Strong LOLR– High capitalization and liquidity of banks and corporate firms

• Structure and organization less important than functions

Conclusions

• Feedback mechanism between financial development and growth – Cannot draw causal inferences about direction– Financial institutions couldn’t create growth without industrial base

• Finance-growth relationship varies a lot over time & place– Cannot say that this type of system was best for all periods– Or that it would have worked as well in other places

JapanThree Main Features of its Financial History

• Japan as an example of a shift in the nature of the financial system over time (not always “bank-based” or “market-based)

• The growth of the Japanese zaibatsu in the inter-war period as an example of co-existence of limited formal investor protection, pyramidal business groups and equity finance

• Japanese financial history offers examples of trust-generating “informal” institutions

System Evolution over Time

• Pre-World War I: sources of finance included internal funds for family firms, some use of equity in modern industry, some merchant/trade and bank credit in small/mid-sized firms.

• Interwar period: Rise of the Zaibatsu pyramidal groups and changes in the financial system – “organ” (group) banks and “related lending” emerge, as well as (in the 1930s) equity markets as a major source of funding for the fast growing groups

Co-existence of Business Groups and Active Equity Markets

• Japan of the 1930s illustrates something that would be regarded as an anomaly in the Law & Finance literature:

• Pyramidal business groups raising funding on equity markets without much fear of minority shareholder expropriation and without modern formal mechanisms of investor protection (but with well-defined property rights)

• Explanations: Reputation? Gov’t support of the groups? Tunneling less pervasive than commonly portrayed in the literature?

Informal Institutions and Trust

• Early in its development (pre-World War I) Japan illustrates the importance of alternative, informal institutions for raising capital (similar to evidence from other countries)

• Example: “business coordinators” (zaikai-sewanin) of the early 20th century - outside investors (“venture capitalists”) who took an equity stake in companies and also marketed their shares to outside investors. Often senior/respectable members of the business community, who would monitor newly established firms in the face of a large number of cases of fraud and also provided general business advice

• This institution as an explanation for the phenomenon of companies taking the form of joint stock companies with a relatively dispersed ownership structure even at very early stages of economic and financial development

Comparison of Germany and Japan

• Despite the fact that today both Germany and Japan are regarded as “bank-based” systems equity markets were important at an earlier stage in both countries

• Trust mechanisms were important in both countries, in Germany it was the relationships between banks and firms and in Japan it was agents such as “business coordinators”

Overall Conclusions• 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.