British capital outows, 1870-1914: a global saving need perspective

Alex Armand June 2006

Contents
1 Introduction 2 The development of Capital exports 2.1 Development, destinations and structure 3 The 3.1 3.2 3.3 . . . . . . . . . . . . . 3 3 3 4 4 6 8 9 11

nature of asset demand and supply Saving rates, investments: the global saving need . . . . . . . . Returns and Diversication . . . . . . . . . . . . . . . . . . . . . Supply side and preferences . . . . . . . . . . . . . . . . . . . . .

4 Trade or Capital Markets? 5 Conclusion

Introduction

A massive amount of capital outows from Great Britain characterized the period between 1870 and 1913 and shaped deep economic consequences all over the world. This persistent trend directly inuenced the British economy by generating an astonishing increase in its share of overseas income. As we can observe in Figure 1, this share passed from around 2% of GDP in 1870 to more than 6% at the turning of the century and then, after a small down-turning, again above 6% in 1913. Why such an important ow of capital was leaking Britain toward overseas countries? Which were the main forces driving such a phenomenon? In order to understand the reason for such a gigantic outow of capital from Britain, it is necessary to understand the dynamics of its course and the main force that were determining the asset demand and supply, then to recognize if capital markets were the main force driving such phenomenon and contrast it with trade related factors. Figure 1 Share of overseas income as a percentage of GDP, 1870-1913 (Feinstein, 1972). Moreover, it is important to understand that the period during the which British capital outows consistently coincides with a larger and global phenomenon, known by historians as the First Wave of Globalization. The decades between 1870 and World War I have been determined by free capital mobility, free trade, mass migration ows, the Gold Standard and an international system mainly ruled by British hegemonic power. Under the perspective developed in the paper, this global phenomenon has to be xed as central, since the deep changes in the international system could explain the magnitude of capital mobility from Great Britain in the way they allowed for exchanges between countries with saving-investment surpluses and countries characterized by decits.

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2.1

The development of Capital exports

Development, destinations and structure1

From 1865 to 1914, Britain totally raised around 4.1 billion for investments overseas, but capital already began to outows forcefully after 1855, rising at an average rate of 4% GDP per year. This tendency resulted in an increase of the share of net stock of overseas assets over the total wealth stock, from 8% in 1855 to 33% in 19132 . Following Stone (1999), we can focus on the period of the major increasing trend in capital exports and divide it in six sub-periods, from 1870-1913. As it can be observed from the gure 2, the course has been characterized by dierent series of increases and down-turnings: in general two increase-decrease patterns characterized the rst three period, resulting in a relatively small dierence between 1870 and 1893. From fourth to sixth period,
1 Stone 2 Edelstein

(1999), Edelstein (1994). (1994).

the trend recorded instead a strong increase, reaching the peak just before World War I in 1914, with a ow of around 9.5 times higher than the ow in 1870. The main characteristic of British capital exports was the concentration, in the sense of country destination, investment channel and nancial instruments. Even if Britain was exporting capital toward 150 countries in the world, almost half of the total exports during 1865-1914 was concentrated in United States, Canada, Argentina, Australia and India, while around 90% owed to around 25 countries (among which British colonies or possessions). In some senses, it is surprising that the majority of ows were designated to countries outside the Empire. In fact, only 40% of the total capital exports went to the Empire, where investments in raw materials were preferred. In both destinations, private industry investments were predominant. Government bonds (mainly in Australia, South Africa, India and Brazil) and railroad securities (prevalent in Northern America and Argentina) were the main channels of capital exports and were representing around two thirds of the aggregate value. In term of nancial instruments, British capital exports were mainly concentrated on xed-interest obligations: in fact, debentures and preference shares were composing around three fourths of total ows, while equities were representing 23% and notes just 3%. Then, assuming a risk rationale in investment decisions, capital ows were more related to portfolio investments, instead of direct investments, in which the risk for large scale projects (such as railways) is relevantly higher.

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3.1

The nature of asset demand and supply

Saving rates, investments: the global saving need 3

This perspective is basically related to the concept of investment-saving behavior and to the notion that in a closed economy, national investments and savings must be equal in every period. However, in an open economy, this identity doesnt necessarily have to be equal in every period. In fact, if the national savings exceed national investments, the excess can be lent by savers abroad: this dierence can then be considered a major force driving capital outows if the net amount of British net foreign lending equals the imbalance. Since the period 1870-1914 (known as the rst wave of globalization) has been characterized by unprecedentedly high degree of openness, an explanation of capital ows cannot avoid to focus on international equilibria and dynamics, i.e. the relation between national savings and investments. A global saving need, which generated exchanges in capital between countries with saving-investment surpluses and countries with decits, could then explain the quick increase in capital outows from Great Britain toward overseas countries.
3 As

Bernanke emphasized on U.S. current account decit in 1990s.

In the years between 1870 and 1913, Britain economy was running an excess of national savings relatively to national investments, but what was generating this disequilibrium? In its famous critique to Imperialism in 1902, Hobson claimed that Britain had a bad distribution of income, which was generating in the period an excess of savings relatively to national investments. This must have been the main reason for such an important capital outow in the history of Britain, driving down the domestic returns and reducing domestic consumption. Other evidence comes from Edelstein (1994), who found that British investments were lower than the level of savings, reaching two peaks in 1877 and 1901; he found surprising that following these two peaks, a rapid expansion in overseas investments recorded in 1879 and 1904. Evidence suggests then that in the last part of the XIXth century, Britain was generating an excess on national savings in relation to domestic investments: the characteristic of income distribution, which generated a higher level of savings relatively to investments, can then be assumed as a central characteristic of British Victorian economy. It is not surprising that that the sharp increase of capital outows from Britain coincide with the most important emigration ows in XIXth century. A demographic analysis is then necessary to understand the global need for capital and then the role of Britain. In the period between 1870 and 1914 around 60 million people emigrated from resource-scarce and labor-abundant Europe to resource-abundant countries overseas. The destinations were mainly represented by Argentina, Australia, Brazil, Canada, New Zealand and United States, not surprisingly even the main destinations of British capital. Moreover, the need for savings came as well from the composition of emigrants: more than three quarters of immigrants, who went to the United States, were from 16 to 40 years old, namely their composition were skewed toward younger generations. This characteristic, generating higher propensities to consume, tied to the low income of the high majority of immigrants can explain the strong need for foreign savings. The growing number of immigrants, the high fertility and the low infant mortality generated fast population and labor force growth in the overseas regions, which in turn created a strong need for investments in capital4 . High dependency rates could then be the reason for high requirements for foreign savings in order to exploit investment possibilities, creating a strong link with British excess of savings. Moreover, dierences in income and in population distribution can clarify the capital outows in 1870-1914 toward overseas countries especially from United Kingdom. Observing Figure 3 and the data for GDP per capita, in 1870 Great Britain disposed of a relatively higher income. In this year, Great Britain generated a GDP per capita of 3.263 US$5 , while some overseas countries were signicantly poorer, than returns to capital would be higher and demand for savings stronger: in the same year, United States recorded 2.457 US$, while Canada and Argentina produced less than half relatively to Great Britain, with respectively 1.620 US$ and 1.311 US$. Moreover,
4 Green 5 Expressed

and Urquhart (1976), Edelstein (1982). in constant terms, US$ 1990.

comparing GDP per capita in 1870 and 1913, we can have a dimension of the dierences in growth and of the convergence: overseas country grew much faster than Great Britain, underlining the growth potential of such countries in 1870. While GDP per capita in Great Britain along the period 1870-1913 grew on average by 1.01% per annum, growth in overseas countries evolved much faster (e.g. Argentina grew by 2.50% p.a., while United States by 1.81% p.a.). Following this rationale, Taylor and Williamson (1994) analyzed the dependency ratio eect over the savings in the New World economies. Observing Argentina, Australia, Canada and United States, they found that the reduction of dependency rates generated a reduction in the capacity of generate capital. A distribution of population strongly characterized by a high number of people in young age and with lower propensity to consume, as the one created in overseas countries by the emigration waves in 1870-1913, must be a central force in attracting capital from abroad. Moreover, Taylor and Williamson estimated that about of the British overseas investments could be explained by high demand for capital in regions where the massive population movements generated high dependency rates, then low saving rates.

3.2

Returns and Diversication

The classical explanation for the British capital outows is concerning with the fact that overseas investments were providing higher returns than domestic returns. Evidence of this explanation comes from Edelstein (1994), who looked at year-end market value, annual dividends or interest paid and capital gains and losses, deriving realized rate of returns and comparing results for domestic and overseas investments. He found that the preference for overseas securities was generated by an average return of 5.7%, rather than 4.6% for domestic securities. Following Edelstein, British investors were then rationally choosing overseas assets because of their higher expected return. However, other studies obtained dierent results concerning returns. In fact, in the opposite direction of Edelstein went Davis and Huttemback (1986), who analyzed data from rms accounting records and included other dimensions inuencing returns, such scal burden related to imperial defence. Davis and Huttemback found signicant dierences between sectors and periods, but, overall in the period 1885-1904, domestic activities generated higher returns than investments overseas and in the Empire. Observing Figure 5, we can remark that the highest returns on equities between rms in United Kingdom, in foreign countries and in the Empire for each period is quite volatile along the period 1860-1912. Foreign rms were supplying higher rates of return in the rst period (1860-1869) and in the last (1905-1912), while in other periods were supplying inferior returns or almost equivalent (in the years between 1870 and 1904, the returns in the United Kingdom were superior, excluding 1885-1889). Moreover, enforcing the thesis

of bad distribution of income, the study of Davis and Huttemback argued that the majority of investments overseas and to the Empire were made by the two richest categories of the population. In fact, the elites and the middle class collected around 79.4% of overseas investments and around 70.4% in the empire.

At least intuitively, it is then questionable that overseas assets were not supplying higher returns. Even if real investments and activities related to assets were not furnishing higher returns because of higher marginal returns from capital, it is feasible that a country risk premium could have enhanced the returns. British investors were not only facing the risk related of the failure of the rm, but they were only facing challenging the possibility of a breakdown of the international system, i.e. a war that would wipe out international trade and capital ows. However, an analysis based on the simple comparison between return possibilities is not complete and could lead to mistaken conclusions and to errors related to sample selection. As Oer (1993) noted the results of Davis and Huttemback can be questioned: some data exclusion could lead to mistakes in the estimated returns and, in addition, the procedure based on rms accounting records is indirectly assuming that rms were following rules that could be equally evaluated to contemporary accounting practices. Observing rates of returns in order to understand the asset demand in Victorian Britain can then be questioned. We could claim that investors were rational and they were attracted by higher returns or we can assume irrationality among operators, but we need to look at the return-risk interaction in order to understand the demand. In this sense, British demand for assets were also driven by high possibilities of diversication. Investments overseas were able to supply nancial assets which provided the possibility of investing in high returns-medium risk prospects (e.g. US railway bonds). In other words, overseas activities provided a higher ability to generate nancial assets that could have improved the returns of domestic investors through small correlation coecients. Analyzing the effects of international diversication by observing prices, shares and dividends of securities traded in London and in United States, Chabot and Kurz (2005) found that overseas investments supplied in the period 1866-1885 a wide possibility of portfolio diversication, increasing returns and reducing the risk. In other word, investing overseas was providing to Victorians investors the possibility of expanding the mean-variance frontier, resulting in notably increases in wealth. Observing Figure 5, it is clear that for the same level of risk, including in the portfolio a larger share of foreign assets would have increased the return signicantly comparing it with the level of return that only British securities could have generated.

In a similar analysis, Goetzmann and Ukhov (2004) showed that British investors had access to securities and to information concerning political and economic details from all over the world. They showed that, even by assuming that expected returns on overseas investments (for equal asset classes) were equal to domestic returns, it was protable for British investors to send a share of their capital to nance overseas activities. It is then necessary to conclude that British investors were driven, even if in a less sophisticated way than today, by a diversication motive and they were then rationally acting. In order to growth Britain required investments in capital and many economists at the end of XIXth century believed that British investors were biased toward overseas assets and then were the responsible for the worsening of the British industry. However, evidence demonstrates that investors were not irrational, but were behaving in a risk-return rationale. Moreover, there is little evidence that little evidence that British rms suered from a lack of capital as a result of UK overseas investment: in fact, since nancial market were enough developed in Britain, established rms or industries found it easy to gain more funds, e.g. by issuing equities6 .

3.3

Supply side and preferences

Why the ows of capital kept on growing all over the period 1870-1913 without any correction to reduce such a surplus? From the supply side, it is central to understand that the period was characterized by the Pax-Britannica, by London as the world nancial centre and by the British pound as the dominant currency in the context of International Gold Standard. Investors were then able to access to a large number of investment possibilities directly investing at the London stock exchange. As we can observe from Figure 6, already in 1873 British operators could have invested in Indian, Colonial and foreign corporation stocks, in dominion and colonial government securities and in foreign bonds and stocks; moreover, these investment possibilities kept on growing in the period. Focusing on such lens, as Temin (1987) proposed, such a persistent ow of capital without could be explained by a change in investors preferences. After having assumed that investors were rational, it seems constructive, in order to understand the capital ows determinant, to concentrate not on market imperfections, but on imperfect substitutability between domestic and overseas assets. In the last decades of XIXth century, since the relevant markets for investors were equities in domestic rms and foreign bonds and since the market for domestic equities were quite insignicant century, the main trade-o faced was the following: illiquid domestic equities versus liquid foreign bonds. Assuming then imperfect substitutability between assets, we could explain capital outows by arguing a change of investors preferences toward more liquid assets. Moreover, this argument enforces the income distribution reason by Hob son explaining the high investment rates in Britain. If fact, if we assume a change in prefer6 Williams

et al. (1983).

ences of investors, we would be able to explain not only the high level of capital exports, but even the lower investments rates in Britain and then the necessity of looking for new uses for excess savings. Moreover, following Caballero et al. (2006), we can claim that all the British capital outows could have been explained not only by dierentials of growth potentials through regions in the world, but even for their heterogeneous capacity to generate nancial assets from real investments. It is then clear that a capital investment in the New World could have been more productive, given the higher returns to capital for low income countries, and then could have attracted investors looking for higher returns. But in the same way, the capital could have been attracted as well by a dierent ability to generate nancial assets; as I have already argued, investors looking for assets with higher returns and medium risk had to invest in nancial assets that could have been generated only outside Britain. A clear example are U.S. railways: if we compare the London Stock Exchange composition in 1873 and in 1913, we can observe that the share of American Railways passed from around 3.6% of the total nominal value to around 15.3% (see Figure 6). Such an increase could be explained by a change in investors preferences or by dierences in potential risk-return possibilities.

Trade or Capital Markets?

Observing the British balance of trades course along the period 1870-1913, it is clear that the pattern uctuate strongly and that the long run trend showed negative. From 3.2 % in 1872, the balance of trade decreased to 0.9 % in 1913, reaching a peak of almost 5% at the turning of the century. After analyzing the intense capital outows from Britain during 1870-1913 and its socio-economic determinant, we can observe that such deviations must derive exclusively from the saving-investment global behaviors and from the capital markets. But what drove the British current account deterioration if capital were highly out-owing from Britain? The examination of the British current account deterioration can be ruled following two alternative perspectives of the same identity: the rst consider the trade pattern and the second focus on investments, savings and international capital ows. It is important to consider and analyze here the trade perspectives in order to understand if related force could have explained such worsening. In literature, the microeconomic explanation by Matthews et al. (1982) followed this perspective and argued that the worsening of British current account along the period 1870-1914 was mainly due to exogenous trends in the British economy. The avoidance of innovation and diversication at the maturity stage of the product life-cycle of important export goods (e.g. cotton textiles), tied to the long-term decline in productivity, could explain the reduction of exports. Losses in productivity could have raised the convenience to buy British goods 9

in other countries, then worsening the balance of trade not relating the problem to increased imports, but to reduced exports. A second stream of thought in this perspective focused on International Competitiveness7 . The rapid industrialization overseas and increases in competitiveness in other countries (such Germany) reduced the desirability of British products abroad because of expensiveness. As a result total world share of British exports reduced signicantly and concentrate in imperial possessions, especially in Africa and Asia. As we can observe from Figure 8, the changes in total productivity in Britain relative to United States and Germany are not extremely high in the last decades of XIXth century. However, if we focus on the industry, the relative worse productivity position of United Kingdom to United States is quite relevant, as well as the losses in relation to Germany from 1891 to 1911. Another explanation, advanced by Matthews et al. (1982) and Pollard (1985), is instead related to macroeconomic eect of overseas income. The rapid growth of overseas income improved the balance of payments, raising domestic prices and national income and resulting in a overall loss of competitiveness; moreover, this eect has been developed along with speedily increasing coal imports. This explanation has been tied to the Dutch Disease 8 argument. However, this last argument has been thwarted by Rowthorn and Solomou (1991), who found that the importance of such eect must be limited to short period eects over consumption and investments and only for the Edwardian period, 1900-1913. Rowthorn and Solomou enforced the argument that the main reason for balance of trade deterioration have to be linked to the main phenomenon in 1870-1913, i.e. the huge amount of overseas investments. In fact, we have to complement the Dutch Disease explanation with the absorption eect explanation in order to obtain a complete understanding. The relevant increase of the capital exports of the United Kingdom toward overseas countries generated a rapid growth of overseas income, while the wealth accumulation overseas shifted to British investors. The higher availability of wealth increased the national consumption and, given the domestic production, increased the net demand for imports. Rowthorn and Solomou decomposed the trade balance course into the domestic investment eect, the consumption propensity eect and overseas income eect: they found that the over the long run, the consequences of the absorption eect are evidence for the deteriorating of the balance of trade through changes in consumption behavior. Comparing the fact that Britain was mainly capital abundant and that overseas countries were land abundant, it is clear that the New World had a rele7 See Sayers, R.S. (1965), A history of economic change in England, 1880-1939, Oxford; Kindleberger, C.P. (1978), Economic response: comparative studies in trade, nance and growth, Cambridge, Mass.; Lewis, W.A. (1978), Growth and uctuations, 1870-1913. 8 When overseas income is growing, reduction of price of exports relative to GDP deator and increase in export prices relative to competitors.

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vant comparative advantage in agriculture. The free trade could then explain why Britain concentrate on capital: dierences in relative advantages make for British convenient to shift toward capital, instead of loosing the struggle with overseas countries in the production of food. In addition, it could be claimed that the huge ows of emigrants generated improvements in international trade, by reducing transportation and communication costs, but evidence shows that all the eects generated by the trade side of the economy could be mainly driven by savings requirements and then to capital exchanges through world regions. Trade related argument cannot explain neither the magnitude of such a huge amount of capital outows, nor the deterioration of the trade balance.

Conclusion

Capital ows cannot be tied to just one rationale, but the phenomenon recorded in Britain in 1870-1913 must be the fruit of several factors co-operating in the British and the world macro-environment environment. Firstly, the political environment and the demographic and economic situation in Europe allowed for huge movements of people, generating a change in the global equilibrium for the saving-investment relationship. Secondly, British excess of saving found its way through global saving requirements and capital began to outstrip from Britain toward overseas countries, where the population structure and the high possibilities to exploit capital-intensive activities were generating a strong demand for savings. The astonishing ow of capital streaming from Britain in the period 1870-1913 must be related to the global imbalances and to exchanges that an highly open international system could generate. Evidence suggests that capital ows were due to a change in the international system, which in turn generated the demand for British excess savings. British investors found then a higher protable way to employ their savings and diversication provided the rationale. All trade related arguments can just be seen as a consequence of higher forces in the international system.

References
[1] Bernanke, B. (2005), The Global Saving Glut and the U.S. Current Account Decit, Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, Federal Reserve Board. [2] Blanchard, O., F. Giavazzi and F. Sa (2005), International Investors, the U.S. Current Account, and the Dollar in Brookings Papers on Economic Activity. Broadberry, S.N. (1997), The Productivity Race: British Manufacturing in International Pespective, 1850-1990, Cambridge University Press, Cambridge.

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[3] Chabot, B. and C. Kurz (2005), "That is where the money was: Foreign Bias and English Investment Abroad, 1866-1885", unpublished manuscript. [4] Davis, L. and R. Huttenback (1982), The Political Economy of British Imperialism: Measures of Benets and Support, Journal of Economic History. [5] Davis, L. and R. Huttenback (1982), Mammon on the Pursuit of empire: The Political Economy of British Imperialism, 1860-1912, Cambridge. [6] Edelstein, M. (1982), Overseas Investment in the age of High Imperialism: the United Kingdom, 1850-1914, New York, Columbia University press. [7] Edelstein, M. (1994) Foreign Investment and Accumulation, 1860-1914 in R.C. Floud and D. McCloskey (eds.), The Economic History of Britain Since 1700, Vol. 2, 1860-1939. [8] Edelstein, M. (1994), Imperialism: Cost and Benet in The Economic History of Britain Since 1700, vol. 2, edited by R. Floud and D. McCloskey. 2nd ed. 2 vols. Cambridge: Cambridge University Press. [9] Goetzmann, W.N. and A.D. Ukhov (2004), British Investment Overseas 1870-1913: A Modern Portfolio Theory Approach, Yale ICF Working Paper No. 05-03. [10] Green A., and M.C. Urquhart (1972), Factor and Commodity Flows in the International Economy of m1870-1914. A Multi-country view, Journal of Economic History 36, 217-52. Matthews, R.C.O., C.H. [11] Feinstein and J.C. Odling-Smee (1982), British Economic Growth 18561973, Oxford. Oer, A. (1993), The British Empire, 1870-1914: A Waste of Money?, EcHR 46, 21539. [12] ORourke, K. and J. Williamson (2000), Globalization and History. The Evolution of a Nineteenth-Century Economy, The MIT Press. [13] Pollard, S. (1985), Capital exports, 1870-1914, Economic History Review, 2nd ser., pp.489-514. [14] Rowthorn, R. and S. Solomou (1991), The Macroeconomic Eects of Overseas Investment on the UK Balance of Trade, 1870-1913, Economic History Review 44, pp. 654-64. [15] Stone, I. (1999), The Global Export of Capital from Great Britain, 18651914, St. Martins Press, New York. [16] Taylor, A. and J. Williamson (1994), Capital Flows to the New World as an Intergenerational Transfer, Journal of Political Economy 102, pp. 348-71.

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[17] Temin, P. (1987), Capital Exports, 1870-1914: An Alternative Model, Economic History Review 40, pp. 453-58. [18] Williams, K., Williams, J. and Thomas, D. (1983), Why are the British Bad at Manufacturing?

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Figure 1: Share of overseas income as a percentage of GDP, 1870-1913 (Feinstein, 1972)

Figure 2: Total capital outows, UK, thousand of pounds (Stone, 1999).

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Figure 3: Living standards and productivity (ORourke and Williamson, 2000).

Figure 4: Rates of return on equities (Davis and Huttemback, 1982).

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Figure 5: Mean variance frontier for dierent compositions (Chabot and Kurz, 2005). Benchmark 1 include only British securities (British government bond portfolio, British corporate bond portfolio, and British corporate stock portfolio). Benchmark 2 consider BM1 and Foreign Government Bonds. Benchmark 3 includes BM1 and Foreign corporate bonds and Foreign corporate stocks.

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Figure 6: Nominal value (million pounds) of securities quoted at London Stock Exchange (Goetzmann and Ukhov, 2004).

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Figure 7: UK trade balance as a percentage of GDP, 1870-1913 (Feinstein, 1972).

Figure 8: Comparative total factor productivity, UK=100 (Broadberry, 1997).

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