Summary of JOIE article (17(3), June 2021) by Geoffrey M. Hodgson, Institute for International Management, Loughborough University London. The complete article is available on the JOIE website.
This is a summary of an article that addresses the role of financial institutions in empowering the British Industrial Revolution. Prominent economic historians have argued that investment was largely funded out of savings or profits, or by borrowing from family or friends: hence financial institutions played a minor role. But this claim sits uneasily with later evidence from other countries that effective financial institutions have mattered a great deal for economic development.
The conventional wisdom
Among economic historians, the conventional wisdom has it that entrepreneurs could draw on their savings or borrow from family and friends if needed (Postan, 1935; Heaton, 1937; Habakkuk, 1962; Pollard, 1964; Crouzet, 1965; Hartwell, 1965; Khanna, 1978). Larry Neal (1994: 152) called this the ‘Postan-Pollard story’.
Although this article does not overturn this conventional wisdom, it does note some doubts. Alex Trew (2010: 988) remarked that the conventional wisdom ‘runs against the large body of empirical evidence … that suggests that financial development is strongly correlated with, and perhaps leads, the level of economic growth.’ Ross Levine (2005) and Peter Rousseau (2003) provided a part of that body of evidence. The importance of finance in the modern era was also underlined by Joseph Schumpeter (1934).
The role of finance can be crucial because it no longer limits economic growth to the flows of savings and profits. With finance, entrepreneurs can expand more rapidly. Was Britain an exception? Did it manage to take off industrially without the extensive help of financial institutions?
There is at least one way of reconciling the conventional wisdom with evidence on the importance of finance. Borrowing from family and others might have been prevalent partly because of the underdevelopment of financial institutions and their inability to supply adequate loans. Despite the Financial Revolution of 1660-1720, the relatively immature and precarious state of financial institutions and financial markets may have acted as a hindrance on economic development during the eighteenth century (Cottrell, 1980; Williamson, 1984; Hoppit, 1987; Neal, 1994). This may be described as the Schumpeterian hypothesis, after Schumpeter’s (1934) emphasis on the role of finance in supporting innovation.
As yet, we have insufficient data to test this hypothesis. This scoping paper provides no new empirical evidence, and it does not resolve the foremost issues of dispute. Instead it frames the argument and points to some key areas and empirical resources where research is needed.
The Schumpeterian hypothesis in perspective
The Schumpeterian hypothesis might help to explain that, despite growing innovation and industrialization, from 1760 to 1820 Britain’s rate of growth of industrial output per capita increased by an average of only 0.7 per cent per annum. In the following 50 years growth picked up significantly.
Growth was held back for several reasons. The Bubble Act of 1720 put severe restriction on the formation of joint stock companies. It was not repealed until 1825. From 1714 to well into the nineteenth century, the highest legal rate that could be charged for a loan was 5 per cent. Progress with land registration was belated and slow, thus inhibiting the use of landed wealth as collateral. Patenting inventions was cumbersome and expensive. The development of financial institutions depends on detailed knowledge and experimentation, which is often painstakingly slow.
The Schumpeterian emphasis on financial institutions largely concerns the conditions and enablers of innovation, not its drivers. The hypothesis is compatible, for example, with the stress by Joel Mokyr (2009) on the energizing role and innovative potential of Enlightenment science and culture. It can also be dovetailed with the emphasis on the roles of ideas and innovations in the work of Deirdre McCloskey (2016a, 2016b).
The Industrial Revolution has been a foremost topic in economic history for well over a century, but our detailed knowledge of seventeenth- and eighteenth-century financial activities is still patchy. Peter Temin and Hans-Joachim Voth (2013: 4) noted that ‘banks and other forms of intermediation are hardly ever mentioned in modern treatments of the Industrial Revolution.’
Was there ‘no shortage of capital’?
The demand for finance should not be confused with its need. An economic demand for finance cannot be expressed without the legal and institutional machinery of property, collateral and contract. This institutional machinery was partly and crucially dependent on a series of legislative acts, which were neither easy nor automatic.
Sidney Pollard (1964) claimed that greater deployments of fixed capital goods would require greater tranches of long-term finance. Pollard (1964: 313) concluded: ‘the need for fresh capital, especially for fixed assets, has been less than is often supposed, since much capital could be generated from within the existing domestic manufacturing and associated credit systems.’ Fixed capital goods of lower value were taken to imply a lesser need for long-term finance.
Similarly, Sushil Khanna (1978: 1889-92) wrote that ‘the requirements of fixed investment were very modest and the threshold of entry into factory production quite low … there was no “capital scarcity” in 18th century England.’ Khanna (1978: 1897) noted that ‘Boulton and Watt, who had the monopoly of steam engines for 25 years, launched their firm in 1775 with a capital of only £3370.’
Does the launch of the celebrated steam engine partnership of Matthew Boulton and James Watt with ‘only £3370’ confirm that finance was adequate for their industrial ambitions? No. When they started in 1775, Boulton and Watt did not themselves manufacture many steam engines. Instead, they generally patented their designs and allowed others to manufacture the engines on licence.
According to Eric Roll (1930: 24-6), the ‘most important’ reason for this arrangement ‘was undoubtedly the lack of sufficient capital’ to finance a works themselves. It was not until 1795 that they focused on manufacturing steam engines for sale. The early decades of their business were fraught with financial difficulties. Roll (1930: 38) noted their ‘serious lack of capital which … hampered the growth of the business and more than once presented the partners with the prospect of immediate collapse.’
The example of Boulton and Watt shows clearly that the ratio of fixed to circulating capital is at best a weak indicator of the need for finance. Contrary to H. J. Habakkuk (1962: 175), financial institutions did not spring up quickly to rescue entrepreneurs in dire need. There is a tendency among some economic historians to confuse capital goods with finance capital. The two have to be rigorously distinguished (Hodgson, 2014, 2015, 2021).
The institutional foundations of modern finance
Modern banking systems depend on central banks and markets for debt. Larry Neal (1994: 180-1) described the Bank of England (created in 1694) as helping to develop a ‘web of credit … anchored securely in the City of London’. The number of banks increased. Country banks played an important and growing role, but they were often insecure, and their numbers fluctuated, due to failures and amalgamations.
Crucial was the emergence of institutions making debt itself saleable or ‘negotiable.’ Exchanges of promissory notes involve the purchase of a promise, and originally this was not recognized as a valid contract in law. Repeated statutory legislation and experiences of case law up to the 1750s were required to consolidate negotiability.
Fractional reserve banking has a cumulative effect on money creation by commercial banks as it expands the money supply beyond the scale of the deposits alone. Any debt is funded by current assets, or by claims owed by a third party. The purchaser of debt receives the right to an asset that itself can be used as collateral to borrow. Credit money thus feeds on itself. But this all depends on a legal structure of enforceability, a fractional reserve system backed by private and state assurances, and sufficient confidence that debt can be redeemed.
The Bank of England did not become the institutional lender of last resort until about 1760, after a series of financial panics. ‘On the eve of the industrial revolution it took its first step towards the assumption of the powers and responsibilities of central banking … the lender of last resort [was] a function of much greater significance than its former role as a fiscal arm of the crown’ (Lovell, 1957: 15-17).
Security or collateral are the foundations of credit. The main store of wealth was land. Institutions to establish land as collateral for loans were limited in the UK until well into the eighteenth century. Economists previously have paid insufficient attention to the institutional conditions required to mortgage assets or use them as security for loans.
Land alienability and mortgageability in England before 1700
If land cannot be sold or its use-rights transferred, then it cannot be used as security for loans. Much English land was bought and sold, at least from the twelfth century. But the studies in the book edited by Chris Briggs and Jaco Zuijderduijn (2018) confirm that mortgaging in medieval England was rare.
In the seventeenth century the mortgaging of inheritable copyhold lands became more common. The lord of the manor owned the land but passed lifetime or inheritable usus and usus fructus rights to a copyholding tenant, who paid a nominal rent. If the copyhold were inheritable, then it could be sold on or mortgaged, under the jurisdiction of the manorial court.
Juliet Gayton (2018) found no evidence of a copyhold mortgage before the seventeenth century. She saw this absence as due to the unreformed usury laws. Using a sample of manorial records, she found a pronounced rise in the number of copyhold mortgages from 1606 to the 1660s.
There were enduring restrictions on selling landed property, known as entails. Many entails enforced primogeniture. But even when the courts limited the scope of entails in 1614, these were replaced by voluntary and widespread ‘strict settlements’ that had similar effects and prevailed until the nineteenth century (North et al. 2009: 89-9; Allen, 2012: 65). Strict settlements stubbornly endured, largely because the wealthy elite wanted them. Owners were disinclined to sell or mortgage buildings or land that had been in their family for generations.
Also much land was set aside as commons. This land could not be sold or mortgaged. Dan Bogart and Gary Richardson (2011: 249-50) showed that legislative reform of landed property rights took off rapidly after 1750. Further research into land sales and mortgaging in this period would be helpful to confirm or deny the dramatic picture suggested by the legislative data.
We lack information on how much land was alienable in the seventeenth century. But we do know that even if it could be sold, obtaining a mortgage on freehold land was prohibitively risky and expensive before 1670. Robert Allen (1992: 102-3) explained:
It was possible to mortgage freehold land, but the arrangements were so unsatisfactory that money was raised by a mortgage only in dire circumstances. In such mortgages the freehold in the property was conveyed to the mortgagee, who advanced all the money. Repayment was normally to be made in six months. If default occurred by even so much as one day, the title remained permanently with the mortgagee. Moreover, the mortgagor was still indebted to the mortgagee for the repayment of the loan.
The seventeenth century saw the first steps in developing modern mortgage law. Landowners petitioned the courts for more favourable legislation. But mortgage law ‘remained confused at least into the 1670s’. Allen (1992: 104) continued:
It was not until the end of the [seventeenth] century that mortgages became automatically and indefinitely extendable, as long as the mortgagor regularly paid interest. Only then did the mortgage become a routine device for using land to raise long-term finance.
Empirical research by Peter Grajzl and Peter Murrell (2021a, 2021b) into English case law shows that the rules of mortgaging became under greater court dispute from about 1640 and deliberation upon them rose until 1690. Subsequently, disputes remained at around that level, to begin to fall after about 1720. This indicates that mortgage law became substantially settled before the middle of the eighteenth century.
It took several decades to build up financial institutions under which alienable land could be readily mortgaged. Further changes in land ownership and land registration were necessary, and these were slow in coming.
Contrary to Douglass North and Barry Weingast (1989) and Daron Acemoglu et al. (2005), property was relatively secure for centuries before the Glorious Revolution of 1688 (Hodgson, 2017). What were needed to bolster entrepreneurship in the eighteenth century were increased opportunities for land alienability combined with other institutional arrangements to facilitate the use of land to obtain credit.
Raising mortgages in the eighteenth century
As Benito Arruñada (2012) explained, there need to be safeguards to ensure that the mortgagor has genuine title to the land, and that its boundaries are not under dispute. A partial solution is the formation of land registries, as Hernando de Soto (2000) has pursued in contemporary Peru. But as Arruñada (2017) elaborated, an operable system of land registration requires trustworthy financial intermediaries plus legal and administrative institutions that are efficient and relatively free of corruption. Even today, only a minority of countries fulfil these conditions.
By 1663 the Bedford Level land registry was in operation in Fenlands. Registers of conveyances and mortgages were established in the West Riding of Yorkshire in 1704, the East Riding of Yorkshire in 1707, Middlesex in 1708 and the North Riding of Yorkshire in 1735. By comparison, the Low Countries had a more extensive and much better organised system of land registration as early as the seventeenth century (Van Bochove et al., 2015). In the UK, land registration took centuries to develop. Progress was patchy. But from the end of the seventeenth century there is even some evidence of mortgaging in parts of England that lacked land registries.
By using the records of attorneys, B. L. Anderson (1969) established that mortgaging occurred in Lancashire throughout the eighteenth century, and M. Miles (1981) and Pat Hudson (1986) found significant evidence post-1750 of borrowing and mortgaging in the West Riding of Yorkshire. More land could be mortgaged as enclosures of common lands progressed. But mortgage risks were high.
The conventional wisdom, laid down by Postan (1935), developed by Pollard (1964) and endorsed by many others, is that most finance came from savings, or by borrowing from family and friends, and that financial institutions otherwise played a minor role. This jars against widespread international evidence of the importance of financial institutions in economic development. The nascent state of British financial institutions may have restricted borrowing, thus helping to account for the remarkably slow rate of growth of industrial output from 1760 to 1820. This is the Schumpeterian hypothesis.
This hypothesis raises a number of questions for which we do not yet have adequate answers. There was a significant amount of mortgaging activity after 1670, but the overall extent cannot yet be gauged. Future empirical research should attempt to estimate the following:
- The extent to which finance for entrepreneurship was provided out of savings or by borrowing from family or friends.
- The extent to which finance for entrepreneurship was provided through peer-to-peer lending intermediaries, banks or other financial institutions, where measures were typically in place to minimize and rectify default on the loans.
- In particular, concerning (2), we need to gauge the extent to which landed and other property could or was used as collateral to obtain loans.
- The overall degree to which the underdeveloped state of financial institutions acted as a constraint on industrial growth.
Note that (1) is logically independent of (3) and (4). If the conventional wisdom concerning (1) were confirmed, or disconfirmed, then this would not determine the answer to (3) or (4).
Multiple legal changes were required to develop a modern financial system. Institutional advances were neither automatic nor always responsive to business demands. This stress on financial institutions does not rule out other factors such as the influence of Enlightenment ideas (McCloskey, 2010, 2016a, 2016b; Mokyr, 2009). We need to look more closely at key institutional developments in the eighteenth and nineteenth centuries. There is much empirical research still to be done to determine the role of financial institutions in the British Industrial Revolution.
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