Karl Gunnar Persson An Economic

History of Europe
Reading Notes

Table of Contents
Chapter 5 Institutions and Growth ................................................................................. 3
5.1 Institutions and efficiency....................................................................................................... 3
5.2 The peculiarity of institutional explanations........................................................................... 3
5.3 The characteristics of a modern economy .............................................................................. 3
5.4 Market performance in history ............................................................................................... 4
5.5 The evolution of labour markets: the rise and decline of serfdom ......................................... 4
5.6 Firms and farms ...................................................................................................................... 4
5.7 Co-operatives and hold-up...................................................................................................... 5
5.8 Contracts, risks and contract enforcement ............................................................................. 6
5.9 Asymmetric information, reputation and self-enforcing contracts ......................................... 6
Chapter 6 Knowledge, Technology Transfer, and Convergence ....................................... 7
6.1 Industrial Revolution, Industrious Revolution and Industrial Enlightenment ......................... 7
6.3 The impact of new knowledge: brains replace muscles .......................................................... 8
6.4 The lasting impact of nineteenth-century discoveries and twentieth-century
accomplishments ........................................................................................................................ 10
6.5 Technology transfer and catch-up......................................................................................... 10
6.5.1 Why was Germany a late industrial nation and why did it grow faster than Britain once
it started to grow? ........................................................................................................................ 11
6.5.2 Human and capital investment ........................................................................................... 11
6.5.3 Research and Development ................................................................................................ 12
6.5.4 Industrial relations .............................................................................................................. 12
6.6 Convergence in the long run: three stories ........................................................................... 12
Chapter 7 Money, Credit and Banking .......................................................................... 14
7.1 The origins of money ............................................................................................................ 14
7.2 The revival of the monetary system in Europe: coins and bills of exchange ......................... 14
7.3 Usury and interest rates in the long run ............................................................................... 15
7.4 The emergence of paper money ........................................................................................... 15
7.6 The impact of banks on economic growth ............................................................................ 16
7.7 Banks versus stock markets .................................................................................................. 17
Chapter 8 Trade, Tariffs and Growth ............................................................................ 18
8.1 The comparative advantage argument for free trade and its consequences ........................ 18
8.2 Trade patterns in history: the difference between nineteenth and twentieth-century trade
................................................................................................................................................... 18
8.3 Trade policy and growth ....................................................................................................... 19
8.4.1 From mercantilism to free trade ......................................................................................... 19
8.4.2 The disintegration of international trade in the interwar period ....................................... 20
8.4.3 The restoration of the free-trade regime after the Second World War ............................. 21
8.4.4 Empirical investigations....................................................................................................... 21
Chapter 9 International Monetary Regimes in History .................................................. 21

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 9.1 Why is an international monetary system necessary? .......................................................... 21
9.2 How do policymakers choose the international monetary regime?...................................... 21
9.3.1 The International Gold Standard c. 18701914 .................................................................. 22
9.3.2 The interwar years .............................................................................................................. 23
9.3.3 The Bretton Woods System................................................................................................. 23
9.3.4 The world of floating exchange rates .................................................................................. 24
Chapter 10 The Era of Political Economy: from the minimal state to the Welfare State in
the Twentieth Century.................................................................................................... 24
10.1 Economy and politics at the close of the nineteenth century ............................................. 24
10.2 The long farewell to economic orthodoxy: the response to the Great Depression ............. 25
10.3 Successes and failures of macroeconomic management in the second half of the twentieth
century..................................................................................................................................... 25
10.4 Karl Marxs trap: the rise and fall of the socialist economies in Europe .............................. 26
10.5 A market failure theory of the Welfare State...................................................................... 27
Chapter 12 Globalisation and its Challenge to Europe ................................................... 28
12.1 Globalization and the law of one price ............................................................................... 28
12.2 What drives globalization? ................................................................................................. 28
12.3 The phases of globalization................................................................................................. 29
12.3.1 Capital markets ................................................................................................................. 29
12.3.2 Commodity markets .......................................................................................................... 30
12.3.3 Labour markets ................................................................................................................. 30
12.4.2 The retreat from the world economy ............................................................................... 31

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Chapter 5 Institutions and Growth

5.1 Institutions and efficiency

The development of institutions is mainly explained by their efficiency-enhancing

effects. Examples of such institutions are money and banking, the Welfare State, and private
property rights. Here, we take an efficiency-enhancing institutional change to mean any
change which confers a net increase in welfare.
On the other hand, the persistency of an institution does not imply that it is efficient:
take serfdom and slavery as examples. More ambiguous were craft guilds, since they might
have improved efficiency due to market thinness and the presence of agents with undue
market or political power. Equally dubious was the German Hansa, which brought a potential
efficiency gain, since it defended the rights of members against violations of rights in foreign
cities.

5.2 The peculiarity of institutional explanations

Explanations of institutions which invoke their efficiency-enhancing effects are based

on a consequence explanation: what one wants to explain is explained by its beneficial
consequences at a later stage. One such example in the natural sciences is Darwins theory of
natural selection. However, in History and in social sciences, we need to ascertain the
existence of mechanisms that guarantee that the efficiency-improving institutions are
selected and survive. As will be made clear and already has been noted, while the competitive
selection of markets is a legitimate mechanism for our purposes, persistence is emphatically
not. Furthermore, not all institutions developed spontaneously.

5.3 The characteristics of a modern economy

High income levels and growth rates across pre-industrial Europe are associated with
(1) slack resource constraints, (2) high population density, (3) regular commodity markets
with diversified demand, (4) efficient factor markets. Particularly for the Netherlands, there
was already by this time free access to efficiently functioning markets, an advanced division
of labour and a government that respected and enforced property rights (including patents).
Additionally, status was linked to effort and not to rights obtained by birth, feudal aristocracy
never dominated the rural economy as elsewhere, and a tolerant mentality welcomed
talented immigrants. However, this proved to be insufficient: by the early 19th century, Britain
had taken the leadership of the world economy.
On hindsight, both countries had already set constraints on the political executive by
the 17th century: The Glorious Revolution (1688) in Britain established a constitutional
monarchy, an unique setting within Europe. Indeed, government can have a long-lasting
effect on growth. When the Low Countries split, the northern part, the Netherlands, was
supported by merchants and rose to pre-eminence. The southern part, however, stayed
under the oppressive Spanish rule, which caused labour to migrate to the North. Hence, the
Early Modern period teaches that sustained economic growth is not compatible with
predatory kleptocratic government.

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5.4 Market performance in history

As markets grow more complex, they increasingly need a solid legal structure and
contract-enforcement mechanisms. Thus, markets other than spot markets, which have the
simplest structures, may not be as efficient as prescribed by standard economic theory in the
absence of institutions. Specifically, market frictions will often arise due to lack of
information; the introduction of the telegraph and the commercial press by the middle of the
19th century thus fostered price convergence in international markets, thereby increasing
efficiency.
Throughout most of History, markets have been thin, meaning that participants were
few and widely scattered, and information was hard to get and travelled slowly. Merchants
and manufacturers addressed the problem by gathering at yearly or seasonal fairs. For
instance, the fairs held in the Champagne area from the middle of the 12th century were pan-
European and served such a purpose.

5.5 The evolution of labour markets: the rise and decline of serfdom

As has been noted, persistency does not imply efficiency, and serfdom and slavery
serve as important testimonies. Serfdom rose in order to halt labour mobility in a time of
labour short, the decline of the Roman Empire. Had it been allowed, and the land rent
extracted by landowners would have been null, since there was unowned land right at the
frontier on which workers would have the same productivity. Under this system, peasants
often had a small plot on which they could grow a subsistence output, and also performed
labour services on their lords estate. Naturally, their incentive to work in the subsistence-
devoted plot was much higher than do work on the lords estate. This then involved high
monitoring costs, since landowners could not credibly threaten serfs with eviction, as there
was widespread labour shortage.
At the dawn of the second millennium, population growth led to decreasing marginal
productivity of labour in land, which implied that the opportunity cost of working by the
feudal lord decreased to the level of the wage he paid. This led to the possibility of negotiation
with free peasants, who then started gaining customary rights to the land they tilled. After
the Black Death, however, renewed labour shortage led to a wave of second serfdom in
some countries.
While emancipation came in the Early Modern period for most of Western Europe, it
came later in many countries: Denmark and Bohemia at the end of the 18th century, Prussia
in the first quarter of the 19th century, and Russia at the end of the 19th century. This illustrates
the process of imitation: while the end of serfdom was a spontaneous market-led
development, the late emancipations were initiated by reform-minded elites inspired by
liberal ideology they started imitating institutions that were judged to function well in other,
more successful economies.
Furthermore, emancipation freed labour for industry and increased the proportion of
self-monitoring owner-occupied agricultural units, thus enhancing efficiency.

5.6 Firms and farms

The relative importance of household-based farms increased as that of big estates fell
back, even though it was probably already 75% even in the Medieval period, but during the

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18th and 19th century, the phenomenon of consolidation emerged1. On the contrary,
manufacturing firms broke away from small-scale production. This raises two questions:
1. Why are workers salaried while peasants are the residual claimants? In agriculture, it
is difficult to disentangle the effects of labour effort and of nature; thus, agricultural
workers will neither be fully rewarded for their effort nor fully punished for shirking.
This leads to high monitoring costs, as has been said, and leasing or selling simply
decreases those to zero.; leasing or selling simply decreases those to zero. In industry,
on the other hand, malpractice can be detected fairly easily, because it is not
constrained by nature. Additionally, capital markets were still poorly developed,
which made it difficult for workers to own the companies (in any case, these are found
to face tighter credit constraints). Finally, the rich can endure risk better than the poor,
and a firm is a risky investment. Commented [MS1]: Risk-aversion doesnt seem valid. Isnt
2. Why did agriculture move from large-scale to small-scale production, while in industry agriculture as risky?

the reverse happened? Economies of scale seem to be largest for industry, as it

required a critical mass of fixed investments (such as textile mills).

This is a path-dependence explanation: a particular institution need not be the most

efficient; it only needs to be sufficiently efficient to become established. Once it has done so
(perhaps by unique, even accidental, historical conditions), it will breed its own success and
even exclude alternatives that are more efficient. Here, the capitalist firm seems to have been
brought about by capital market imperfections and risk-aversion. The path dependence then
constrained alternatives as soon as owners of capital had acquired management skills and
entrepreneurial ideals which they passed on from generation to generation. Unity of aims
and flexibility of labour finally gave capitalist firms higher resilience to the competitive
selection of the market.

5.7 Co-operatives and hold-up

Co-operative firms, which were managed by representatives of the suppliers of a

major input processed by firms, crowded out already established capitalist firms by the end
of the 19th century in Scandinavia. These prevailed in sawmills and paper producers, meat
producers, dairies and wineries, but not in car manufacturing or steel production. Milk
suppliers had a bit bargaining power that allowed them to hold-up deliveries because quality
assessment was difficult. Hence, once they had established a commercial relationship,
farmers that used milk products as inputs could not credibly threaten to end the contract,
since they had great difficulty in finding a partner who they could trust. Furthermore, there is
a difference in time-horizons between firms and dairies. Nowadays, this problem is solved
through vertical integration, as in car manufacturing. This, however, was not an option in the
19th century, since farmers were not willing to become salaried workers farming is a way of
living. Therefore, the system became on of de facto vertical integration, with cooperatives

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Before that, the system was one of open fields, according to which a household owned or leased land scattered
in a large number of narrow strips around the village. This allowed or forced farmer to co-operate in ploughing,
sowing, weeding and harvesting, which was seemingly impractical. Why did the open fields then endure? There
are three possible reasons: (1) minimisation of risk through diversification, (2) some small communities were
built on mutual assistance and thus receptive to this type of system and (3) the state of the art in technology
could not provide a single family with the means to plough an entire land.

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facing both attitudes of opportunism by suppliers and commitment by firms, as well as the
risk of having a residual claim.

5.8 Contracts, risks and contract enforcement

Contracts more often than not developed spontaneously. They tend to reduce risk and
constrain the opportunistic behaviour of contracting parties. The limited liability company, in
particular, emerged as an efficiency enhancing institution. In a simple partnership contract,
an investor provided funds to a merchant, and the contract stipulates a return to the investor.
Now, every contract is incomplete and needs trust, which is itself a self-enforcing unwritten
contract for what in modern jargon is called social capital. However, with unlimited liability it
is the only enforcing mechanism, and this restricted the amount of capital that could be
raised, since business relationships were then restricted to family and friends. In a limited
liability company, however, the investors are not personally liable for the damage or debts
accumulated by the company they owned shares in.
In agriculture, peasants often leased land by surrendering a share of the output. This
reduced labour effort and incentives for production: a constant fraction of the marginal
product must be paid to the landowner, while with a fixed rent there is a point where the
worker gains the entire marginal product, assuming equal marginal productivities. Are there
any efficiency gains with this contract? Albeit not at the aggregate level, there might be for
the counterparties through:
1. risk reduction with a bad harvest, the payment decreases. However, there were
fixed rent contracts that allowed postponement.
2. Mitigation of the tragedy of the commons if farmers had a short-term contract, they
would have an incentive to over-exploit the plot in a short period of time in order to
extract the most they could. This argument is only valid, however, with short-term
contracts; indeed, often tenants even obtained hereditary contracts.

5.9 Asymmetric information, reputation and self-enforcing contracts

Long-distance trade, which involved merchants and their local agents, was subject to
the principal-agent problem. This was solved through the creation of incentive-compatibility
constraints: merchants often joined and traded information about agents, reducing moral
hazard by increasing credibility and reputation. Indeed, ethnic groups operated throughout
Europe under close and exclusive networks possibly because ethnicity facilitated the
dissemination of information about members conduct, since an ethnic group shared
common beliefs and language.

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Chapter 6 Knowledge, Technology Transfer, and Convergence

6.1 Industrial Revolution, Industrious Revolution and Industrial Enlightenment

The British Industrial Revolution was not exactly based on a scientific understanding
of production processes decisive steps were taken in that period (and before) towards a
more profound understanding of nature, but these accomplishments had little immediate
impact on production technologies. The exception is the steam engine developed by Thomas
Newcomen, which drew on results from inquiries by Galilei, Torricelli, Huygens and von
Guericke. Systematic experiments became more common before and during the Industrial
Revolution, but the massive breakthrough of technologies did not arrive until the 1850s, and
mostly towards the end of that century; even later in the 19th century, many innovators were
more skilled and original as entrepreneurs than as researchers, e.g., Alfred Nobel
(commercialisation of dynamite) and Guglielmo Marconi (commercialisation of wireless
communication). Indeed, Crafts and Harley have noted that the revolution was more of a
transition. For instance, the first steam engine was used to pump water from coal mines, and
needed to be near those mines because it was extremely energy inefficient and needed cheap
fossil fuel. Efficiency increased throughout the 19th century (coal consumption per
horsepower-hour fell by a factor of almost 45 from the early 18th century to the end of the
19th), but it only had an impact on transport in the middle of the century, and sail was the
dominant mode of long-distance sea transport even in the early decades of the 20th century.
Indeed, the Industrial Revolution was only revolutionary in the spinning and weaving of
cotton cloth; however, even this had been developed continuously since the medieval age,
the innovators being skilled craftsmen rather than scientists.
De Vries points out that the Industrial Revolution was indeed preceded and triggered
off by an Industrious Revolution, which consists in a fundamental change in consumer
behaviour: all household members started getting involved in the market either as producers
or as workers during the century before, and the consequent increase in income spilled over
into increased demand for new commodities. This confounds the traditional view that the
Industrial Revolution was solely a supply-side phenomenon.
A modern revision of the Industrial Revolution would stress that:
1. The rate of technological progress was much slower than previously thought. There
was not much difference between pre-industrial growth and the early phase of the
Industrial Revolution, output growth per head being only slightly higher than in the
pre-industrial period, and TFP growth being roughly the same as in medieval and Early
Modern agriculture. We can thus conclude there was no revolution in per capita
growth rates. Modern growth rates prevailed in Britain from around the 1850s and
only did so at the end of the century in the rest of industrialising Europe.
2. Most of the technologies were sector-specific rather than general-purpose, with the
exception of the steam engine.

Mokyr, however, emphasizes that a pan-European industrial enlightenment,

concealed by slow growth, was taking place; there was a pan-European movement towards
having a scientific approach to nature and production. Contributors to the steam engine were
not only British, but also Italian, French and Danish; oxygen was independently discovered by
the Swede Carl Wilhelm Scheele and the Englishman Joseph Priestly; Antoine Lavoisier made
important contributions to chemistry.

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 As scientific societies were formed, the cost of accessing new knowledge fell, as these
served to present new results and to popularise and diffuse them. Furthermore, the German
technical universities started supplying industry with professionals working in research
departments. This enlightenment was uniquely European, and took place at a time when
technological stagnation characterised the rest of the world, notably the Middle East and
China. Why, then, was the Industrial Revolution British? It is not implausible that it was
accidental to some extent. Mokyr even asserts that it would have taken place elsewhere, but
certainly in Europe, where institutions were especially adequate for gainful accumulation of
useful knowledge. One of these were patents. Their contribution to growth is inconclusive
during the early stages of industrialisation, but during the second half of the 19th century they
were extensively used, as many ground-breaking innovations were developed simultaneously
and independently. Theoretical results, however, were seldom, if at all, patented. Data on
patent applications show that the Iberian Peninsula completely missed out on the Industrial
Enlightenment, and that the general upward trend was only reversed by the First World War.

Three characteristics of the new era of sustained and higher economic growth stand
out: (1) from the 1850s onwards, science-based knowledge became a major factor in
economic growth, which led to an increase in TFP; (2) the flow of inventions increased the
capital-labour ratio, which in its turn increased labour productivity; (3) increasingly
sophisticated technologies and production processes increased the demand for education
and human capital investment, and new occupations emerged: engineers, teachers,
accountants and university-trained scientists. An increased pace in the generation of new
ideas and an increase in human and physical capital per employee are thus the major vehicles
in the era of modern economic growth.

6.3 The impact of new knowledge: brains replace muscles

A rough overview of production processes during the 19th century reveals that in
paper, the process of separating cellulose and other pernicious elements became
predominantly chemical and that in the iron industry, pig or cast iron, which was made by
heating iron ore with charcoal and blowing air over it (in a blast furnace), was now liable to
be decarburised, so as to make it more resistant, and turned into steel or other metals.
However, the single most important new technology was electricity, which is a general-
purpose technology.

Technological progress had five general characteristics:

1) Resource saving;
2) Lessened the constraints of nature, in particular reliance on human and animal
energy;
3) Improved the quality of commodities: the industrial age saw both quality
improvements and quality differentiation. Indeed, Nordhaus estimated that a quality-
adjusted price index for light would decrease at a 3 to 4% yearly rate since the 1850s,
the point where it starts to diverge from the conventional price index.
4) Developed new products and services;
a. For the construction industry, the increased supply of cheap steel allowed a
viable usage of reinforced concrete concrete with a steel structure inside.
This is much more resilient to shocks (like earthquakes) than plain concrete.

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 b. The internal combustion engine (the first was the Otto-cycle) led to the
development of the automotive industry and laid the foundations for the jet
engine;
c. The industrial production of nitrates through ammonia was a precondition for
the spectacular increase in agricultural yields in the 20th century and allowed
the production of a new commodity, the artificial fertiliser. This also widened
the resource base.
5) Widened the resource base for industrial use.
a. In the paper-making process, wood became a possible resource from the
1850s on. Indeed, major contributors to this process from that point on were
from countries abundant in wood: the US, Germany and Sweden.
b. The Gilchrist method (at the end of the 1870s) made possible the use of
phosphorous-rich iron ores, common in the continent but inexistent in Britain
(hence the inability of the Bessemer converter to deal with it). This incidentally
provided a fertiliser for agriculture, since the phosphorous that was reclaimed
as slag in the process could serve as such a fertiliser.

(i)(ii) Saving resources and lessening natural constraints

Bob Allen notes that in the early years of the Industrial Revolution, Britain was unique
in that it was a high-wage economy with cheap energy resources. This led primarily to labour-
saving inventions in the textile industry, whose inventors were primarily English: Samuel
Crompton, Thomas Highs, James Hargreaves all worked towards the mechanisation spinning,
and Edmund Cartwright invented the power loom, which introduced mechanisation of
weaving. In 1801, the Jacquard loom could already provide a pre-programmed control of the
production process.
In steel making, the Bessemer converter - which blew cold air through molten pig iron
to reduce impurities and decarburise the iron - and the Siemens-Martin process - which
reused the hot gases to warm a brick chamber through which the fresh air needed for
combustion was fed - were indeed not only labour-saving but also relaxed the resource
constraint, as they reduced the need for coal.
The electric motor, introduced in the 1890s, was superior to steam as a prime mover
in industry because of the high proportion of electricity it converted to kinetic energy and its
flexibility. In the early 20th century, it loosened a location constraint imposed by earlier energy
sources: mills needed water, and steam engines needed a critical size and cheap coal. With
electricity, each machine can be driven by its own electric motor given an electricity grid.
Initially, it was produced with kinetic energy from steam engines and later by the steam
turbine (still the major producer of electricity). Drawing on Michael Faraday, the transformer
(1890s) turned low-voltage electricity at the point of production into high-voltage for
transmission (which involves lower transmission losses) and then back to low voltage at the
point of consumption (which is more convenient for both production and consumption);
kinetic energy generated by water could now be used again. Generally speaking, the,
electricity replaced animate power supplied by the muscles of men and animals with
inanimate power produced by fossil fuels like coal and oil.

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6.4 The lasting impact of nineteenth-century discoveries and twentieth-century
accomplishments

Many products conceived during the second half of the 19th century were further
developed during the 20th century: the internal combustion engine, the bicycle, the
gramophone and sound recording. Particularly significant was the transformation of the
Bessemer converter with the so-called Linz-Donawits method, which used pure oxygen
instead of air.
By the second half of the 19th century, the USAs manufacturing sector had achieved
a substantial productivity advantage, and such was maintained due to:
- The pioneering rationalisation of production processes (Fordism): this was based on
the principle of division of labour in which each worker did a limited number of tasks
repeatedly. Furthermore, a huge domestic market with rather homogeneous
preferences was accommodating to standardised production in the US.
- The efforts devoted to innovative research and development.
It differed from Europes flexible and customised production in that while American
production used purpose-built machinery for long production runs, European production
used skilled labour to meet customers diversified needs. Mass production was only widely
transferred to Europe after the Second World War, and in some countries this was fiercely
resisted by trade unions.

The most important general-purpose technology of the 20th century is electronic

computing, but this had its origin in the mechanical calculators developed by Leibniz and
Pascal. However, if mechanical calculators increased the speed of computations by a factor
of 6 relative to manual calculation, modern computers led to a cost reduction of 7.3 x 1013.

6.5 Technology transfer and catch-up

Europe had the necessary institutional requirements for technology transfer (albeit in
varying degrees): part of the public was literate in matters scientific and technical; there was
a critical minimum level of education; the banking system supported innovative
entrepreneurs; and the general institutional characteristics of a modern economy were in
place. Accordingly, we wish to test the (beta) convergence hypothesis: relatively poor
economies can be expected to grow faster than the most advanced economies once they get
started. This is appropriate because it is plausible to assume that European economies had
the same economic fundamentals, but started from different initial conditions at the
beginning of the 19th century. Hence, can find three reasons for the advantage of
backwardness:
1. Technology transfer;
2. Structural change: labour moves from less efficient to more efficient sectors, and the
less efficient become more efficient in the process;
3. Different capital-labour ratios (Solow model) or different share of scientists (Romer
model).

Analysing the periods 1870-1913, 1913-1950 and 1950-1973, we see that during the
40 years before the First World War, growth in Europe was between 1 and 2%. During the
interwar period it decreased, but after the 1950s it increased to 3-5%, only to fall back to 2-

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3% in recent decades. As a rule of thumb, about half of the growth can be attributed to factor
inputs (education, capital and labour), and the other half to TFP.
The correlation between growth rates and initial GDP level is found to be positive only
during the interwar period, where the conditions for technology transfer were absent.
Furthermore, initially rich economies relied less on technology transfer because they had
already established research departments in their largest firms as well as centre of research
in universities. Some comments on particular countries or groups or countries are relevant:
- The United Kingdom is an under-performer from 1950 to 1975, but it was in the
regression line in 1870-1913. From 1870 to 1975 as a whole, however, growth was 2%
in France, Germany and the Scandinavian nations, but only 1,2% in the United
Kingdom.
- The Scandinavian economies did better than expected in all periods. This was so
because they had a dynamic Germany in their vicinity, their educational system had a
comparatively high quality, and they were the most open economies in all periods.
- Ireland was absent from the scientific breakthrough at the end of the 19th century,
and was the last Western European nation to catch up with the technological leads.
This was so because it had a declining Britain in its vicinity, its most talented
inhabitants headed to the US or to the UK, it was the only advanced country to
experience population decline well into the Golden Age, the share of investment did
not reach the European average until the 1970s, and the protectionism of the Great
Depression remained until the late 1950s.

6.5.1 Why was Germany a late industrial nation and why did it grow faster than Britain once
it started to grow?

Germany did not have efficiently functioning markets well into the 19th century. The
Stein-Hardernberg land reforms, imposed in 1807-1821, introduced well-defined property
rights in land and freed labour from the control of the landlords, while depriving working
people of customary rights to common land. Thus, a new landless proletariat sought work in
rural areas and in growing cities, while farmers with ownership of land hired workers; this
increased productivity in agriculture and changed the income distribution in favour of the
property-owning classes, which stimulated savings and investment towards industry.
The Prussian Customs Union of 1818 triggered off subsequent economic integration,
a process which culminated in the so-called Zollverein in 1833, thus providing a stimulus to
trade. Furthermore, a common currency was instituted, so that by the middle of the 19th
century Germany was ready for modern economic growth. Once it started, per capita GDP
growth was higher than that of the UK and the US, and by 1873 it had closed the income gap
relative to the UK. In 1914 labour productivity was higher in chemicals and metallurgy, even
though Britain kept its lead in financial services and retailing.
In the periods 1870-1913 and 1950-1973, German growth was approximately double
that of the UK, and in both periods it started from a relatively low initial income.

6.5.2 Human and capital investment

The British investment ratio was exceptionally low, about half of the US and lower
than in most industrialising European nations until after the Second World War. Possible
reasons for this are that British investors had inadequate information about domestic

11
conditions, or simply that there was a shortage of high-yielding investment opportunities at
home and a preference for foreign investments.
How can we explain Britains relatively sluggish growth? The most promising path is
through an institutions-based rationale: inadequate financial institutions were unable to seek
out promising investment opportunities. Britains role as the worlds principal banker in the
late 19th century potentially caused British to neglect inward investments. Kennedy points out
that British financial institutions, unlike in the continent, were not picking the right
investment objects, and were in fact missing a number of promising opportunities. Germany,
on the other hand, had its specialist banks serving firms, which has been credited with
fostering the ability of Germany to form a strong presence in frontier technology.
Furthermore, this foreign bias in Britain reflected the fact that, until the final quarter of the
19th century, profits were higher on foreign assets. What is not valid is to pose that foreign
investment was caused by a high capital-labour ratio; compared to the US, where labour was
scarce, it was about one third in 1913 and 60% in 1950.
British investment remained in traditional sectors which had low growth potential due
to sluggish growth in world trade: British export dominance was in industries such as textiles,
soon to be under tough competition, and industry was unable to diversify out of these types
of investments. After 1950, the domestic investment ratio converged to the European norm,
but in any case, remained rather below that of Japan.

6.5.3 Research and Development

The big American firms were the first to set up R&D departments in the end of the
19th century, and spending on research has been consistently higher there since. Germany
also emerged as a leading nation in pure and applied science until the rise of Hitler. Private
research spending was probably stimulated due to the possibility of cartelisation, for cartel
pricing enables firms to recover the outlay on research. At the end of the 20 th century it was
possibly around 3% of GDP, a ratio in line with the remaining leading nations.

6.5.4 Industrial relations

In Britain, trade unions were organised by skills, which is found to have a negative
impact on productivity growth a union representing a key skill in a firm can gain much by
fighting for its own interests at the expense of others. Unlike in Germany, trade unions in
Britain did not co-operate closely with employers, and they were not receptive to new,
labour-saving technologies. However, employers were also at fault for lack of technological
innovation: the British-owned car industry was virtually wiped out after 1950, while at the
same time Britain has remained a major producer of Japanese cars.
Another contributor to sluggish growth was the comparatively large nationalised steel
and coal sectors, where TFP was exceptionally low.

6.6 Convergence in the long run: three stories

Roughly speaking, there has been income (sigma) convergence since the 1870s, but
the timing and pace vary. This type of convergence is something we expect to happen when
less rich economies introduce growth-promoting institutions and exploit best-practice
technology borrowed from the leading economies. Generally, Americans lead is persistent,

12
except during the 1930s, and there is convergence only during the Golden Age, after which a
smaller income differential stabilises. The large income differential right after the Second
World War represented a potential for Scandinavian catch-up, and this was exploited. We
next analyse specific countries with some more detail:
Argentina: Until the Golden Age, its income level was roughly at par with that of
Scandinavian countries. Afterwards, the income gap widened, and in the 1930s it
embarked on an import substitution industrialisation programme, which was a
response to the severe downturn it experienced as a primarily food and raw-material-
producing nation. With populist governments that created debts too large to manage
without repeated default, Argentinas dismal performance is seen largely as a political
failure.
Germany and Italy: These countries were initially divergent, but around 1900 Italy
starts to converge. This process is halted by the interwar period and wartime
destruction, but during the Golden Age, both had spectacular growth due to the war-
inflicted low level of income. This spurred investment, but followed a typical Solow
model path: both countries settled down after the Golden Age.
Ireland: Starting from a similar income level to that of Italy in 1950, it lagged behind
until the late 20th century. It had a sheltered home market, so none of the gains from
scale economies could be exploited. The Golden Age was thus a period of lost
opportunities. This experience teaches that openness seems to be a prerequisite for
growth for small economies.
Czechoslovakia: albeit relatively advanced, it traced Irelands dismal performance
until the middle of the 1970s and beyond.
France: There was long-term convergence with respect to Britain, and France
overtook it by the end of the Golden Age. After the Second World War, France
regained its long-term trend in less than five years; despite war-time destruction, both
social and human capital and institutions remained.
Spain: There is no trace of convergence until well into the Golden Age. It took 88 years
to double income with the growth of the period 1850-1950, but only 13 with that of
the Golden Age, mainly due to the TFP growth in the latter. Spain was disgraced by a
Civil War and a nationalist government, and only opened up gradually from the 1950s
onwards. Under Franco, inequality also increased. In 1950, Spain and Portugal had
almost 50% of the labour force in agriculture, against 20% in Sweden and 5% in the
UK. Openness to new technologies forces labour out of agriculture, and leads to a
structural convergence effect; the time at which an economy starts to catch up is
linked to the start of its agricultural transformation.

13
Chapter 7 Money, Credit and Banking

7.1 The origins of money

Pre-industrial economies have grown mainly due to exploitation of regional and

national comparative advantages. Money accordingly developed alongside the occupation
and regional division of labour, and was first introduced some 5 or 6 thousand years ago, not
with stamped coins (which began to be in use only in the Chinese and Greek civilisations) but
with standardised ingots of metal.
Barter involves a time-consuming process of matching wants, and forces trade to be
below optimal level (it must always be balanced). Furthermore, indivisibility makes the short
side of the market to be the dominant one, and there is no universal unit of account. The
invention of money is efficiency-enhancing in that it solves the problem of non-coincidence
of wants. A good can serve as a means of payment if someone demands it, e.g. wheat. If that
means of payment is not easily perishable, it serves also as a store of value, and because there
is someone who wishes it on its own, it can be a unit of account.

7.2 The revival of the monetary system in Europe: coins and bills of exchange

Grain is an example of a commodity money (used in Ancient Egypt), i.e., a commodity

is used as money that has alternative, often ornamental, uses and an intrinsic value. What
goods can be used as money?
Perishable goods and commodities subject to high price volatility cannot serve as store
of value;
To be accepted as a means of payment, it must be easily recognisable (so as to foster
trust);
It must have a high value-to-weight ratio. This eliminated copper, and favoured silver
and gold. In the 19th century, technologies were developed to create counterfeit-proof
coins (with full-bodied coins).

With the fall of the Roman Empire, an orderly monetary system ceased to exist, and
only resurged with the Carolingian Empire. This introduced the principle of the hierarchy of
denominations, which survived in Britain into the 1970s, when the decimal system was
introduced. One pound of silver was divided into 240 pennies (denarii), and later a dozen
pennies were called a shilling (solidus); 20 shillings consequently made a pound (libra). The
mint levied a fee of 5-10% of the face value of the coin, the so-called seigniorage fee. This was
also a way to raise income for the government. However, governments found it tempting to
fund expenditure by lowering the gold or silver fineness of the coin, which would drive full-
bodied coins out of circulation and start an inflationary process.
After the Carolingian Empire, cities and monasteries assumed the right to mint coins.
This gave moneychangers the job of assessing the exchange rate, which in turn converged to
the ratios of the metal content of the coins. From the 13th or 14th century, the bill of exchange
emerged as an instrument to minimise the actual transfer of coins or bullions between trading
parties; it is a promise from the debtor to pay the creditor at a specified point in the future.
Institutions then developed so that these debts and credits could be offset between accounts
held by merchants through simple bookkeeping transfers in the ledges of banks. These

14
operations depended on moneychangers and banks having opened up for deposits and
clearing between different accountholders. Increasingly, the bill of exchange became a
financial credit instrument and a substitute for money, even for inland transactions. It
spread throughout Europe due to the Italian merchants, and was adopted by the Hanseatic
League. Most trading cities had legal procedures to force debtors to honour their obligations;
there were branch offices and correspondents of identical ethnic origin to minimise the risk
of default.
During the 15th and 16th centuries, transferability of a bill was facilitated: each person
who took part in the chain of transfers of a bill had to be responsible for ensuring that the
promise to pay the debt was honoured when the bill matured. Thus, it became a liquid asset
for many banks.
In Italy, during the 14th century, fractional reserve banking was born. In the early
times, there were frequent bankruptcies and bank runs. Financially sophisticated cities such
as Venice and Amsterdam, authorities could react by prohibiting fractional reserve banking
for a period and setting up public clearing banks. The discounting of bills was introduced in
16th century Antwerp, and the practice spread to London due to religious persecution in the
Low Countries.
Commercial centres established public deposit banks which were required to hold
adequate reserves or refrain from fractional reserve banking. The Amsterdamshe Wisselbank,
for instance, performed clearinghouse functions, and became the most important bank in the
17th century. Gradually, the bill of exchange lost its pre-eminence as a means of payments
and credit as banks with international reach managed international payments and provided
traders and firms with overdraft facilities. This was possible due to the advancement of
information technologies in the 19th centuries.

7.3 Usury and interest rates in the long run

The Church considered any positive interest rate as usury and as such incompatible
with Christian faith; it became more flexible only as demand for credit increased. One sensible
explanation for this was the common practice of exploitation by charging 50-100% interest.
The Church thus set pawnshops, which had a philanthropic aim, and could be found in
medieval Italy and northwest Europe from the late Middle Ages. They were mainly used by
the common people for short-term credit to ease temporary economic hardship. There were,
however, several grounds for setting an interest rate that were considered legitimate, such
as the opportunity cost of money lent. By the 16th century, a much greater tolerance of loans
at interest was gaining ground. This was not linked to Reformation, but Reformed churches
indeed retreated from the role of arbiter and accepted that secular authorities should be
given the role of regulating interest rate.
The prohibition of usury had as possible effects that (1) borrowers were at the mercy
of non-Christian loan sharks and (2) that interest rates increased due to constrained lending,
as there was uncertainty on what constituted usury. Over time, interest rates tended to
decline to single digits.

7.4 The emergence of paper money

Paper money is not commodity money; however, in its first two centuries it was
redeemable to full-bodied coins. This did not disappear until the interwar period of the 20th

15
century, by which time the public central banks took for themselves the monopoly of money.
The banknote had a major advantage over the bill of exchange: it did not require the chain of
liabilities created by the assignment process necessary to make the bill transferable; what
mattered was only the reputation of the bank that issued the note.
Initially, paper money developed spontaneously; it was just the deposit receipt at the
goldsmith or moneychanger. The first bank to issue banknotes was the Swedish Stockholms
Banco led by Johan Palmstruch, of Dutch origin the diffusion of financial as well as industrial
innovations was fostered by migration. However, a run on the bank ended its short history
(1657-68). England then became the pioneer in note-issuing banks during the 1690s and into
the 18th century. These practised fractional reserve banking, thereby increasing the money
supply. This process spread to the continent from the early to the middle of the 19th century.
By the end of the century, the state and its central bank had monopolised the issuing of notes
in most European nations.
The introduction of fiat money was delayed with varying degrees in Europe due to
traumatic experiences caused by bank runs. During wars, fiat money was often used, but it
permanently emerged after the break-up of the gold standard in the 1930s, by which time
banks did not issue notes. Fiat money has at least two advantages over coins: (1) the
production cost is much smaller and (2) holding large reserves implies losing the interest they
do not bear. Why, then, did it take so long to be widely implemented?
Fiat money requires trust on the part of the public that the issuers will not be tempted
to issue too many notes, which would fuel inflation and erode the purchasing power of
money. Convertibility to gold would tame that. Furthermore, free banking was mostly in
place, which has severe moral hazard problems: if banks managed to improve the collective
reputation of the banking system, a single bank might be tempted to exploit it. An agency
with a lender of last resort mechanism would thus contribute to credibility and would mitigate
the contagious effects of defaults. Central banks were mainly transformed private banks, like
the Bank of England and the Banque de France in mid-19th century. The possibility of
monetary financing, however, remained a problem in gaining credibility.
Two major changes contributed to public acceptance of fiat money: an accountable
government, and an independent central bank. After monetary reforms of the mid-1920s,
nations with an inflationary history granted national banks greater independence, so that this
worked together with greater accountability of governments. In the UK and Sweden, this step
was only given in the early 1990s, after the inflationary experiences of the 70s and 80s.

7.6 The impact of banks on economic growth

Banks affect economic growth through:

The impact on the savings ratio: the proliferation of banks outside metropolitan areas
increased the savings ratio by increasing the opportunity cost of holding money. If in
the pre-industrial era the ratio was about 5% of national income, in the second half
of the 19th century it had increased to 10-20%.
The increase of efficiency of the use to which savings are channelled and
The effect of increased monetisation of the economy: From 1730 to 1850, it is
estimated that a 1% increase in monetisation led to a 2% increase in industrial output
after 5 years.

16
 Bank failures were not infrequent during the late 18th and early 19th centuries. Given
the fragility of trust, savings banks initially had to pursue a very conservative asset strategy,
only investing in government debt in many countries. Later, lending constraints were relaxed
and real estate and land were accepted as collateral. This was especially important for the
consolidation process.
Savings banks were originally designed for low and middle-income earners, but also
had an important role in providing finance for infrastructure investments, and over time their
portfolios became more and more like those of the other banks. During the 19th century, the
joint-stock bank also emerged. These were not constrained by depositors preference for
liquidity and were urged by their owners to adopt a less conservative loan strategy. Typically,
they were more involved in the financing of commerce and industry than savings banks.
Through the 20th century, joint-stock banks often competed with savings banks, or became
investment banks, servicing industrial firms and helping in M&A processes.
There is empirical evidence that both bank depth and stock market depth are
positively linked to investment and productivity growth. This is natural, since both select the
most promising technologies and monitor firms. Gerschenkron argued that the backwardness
in the continent prompted banks to play a more active role in fostering industrial
development by establishing close links between themselves and the industry, being better
suited to solve the agency problems inherent in banking. Indeed, there is a controversial
argument stating that Victorian Britain (1850-1900) failued due to the failure of financial
intermediaries to direct savings towards the most profitable investment opportunities in
industry. Furthermore, Kennedy showed that British merchant bankers were risk-averse and
thus made life hard for evolving, but riskier, technologies. Furthermore, Britains pre-eminent
role in international finance was a hindrance rather than a help because a much too high
proportion of savings was invested in overseas assets.
Traditionally, the British system is denominated as transaction banking for its
excellence in commercial banking, which included the discounting of bills and the provision
of short-term credit. The French and German systems, on the other hand, are called
relationship banking, for they also provided mortgages for houses and investment banking
services. When they did so, they were called universal banks. Some of these preferred to take
a long-term stake or provide varieties of corporate finance to particular firms: banks typically
followed a firm from its start to its maturity.
In the early 19th century only Britain had a well-developed banking system, consisting
of a wide network of country banks and a strong centre in London; it provided mostly short-
term credit to industry and commerce, bill discounting and deposit banking.
Germanys rapid catch-up has been attributed to relationship banking. However, the
historical record does not support the traditional view that it eased the cash constraint which
transaction-type banks imposed on their customers, and British banks seem to have been
able to establish highly efficient routines for scrutinising borrows. Short-term loans were
routinely rolled over to the next period, effectively making them less short-term than they
appear at first sight, and British banks were more resilient to industry-wide shocks. On the
whole, then, evidence is inconclusive. Nonetheless there is some proof that British banks held
assets which were not optimal at the end of the 19th century.

7.7 Banks versus stock markets

17
 The information needed and the costs involved in obtaining information about firms
have precluded the vast majority of the public from investing directly in the stock market.
However, mutual funds exploit economies of scale in gathering information, and an increasing
share of total savings was diverted to these institutions, especially in the last third of the 20th
century.
Stock markets in Europe developed as modern banking emerged in the second half of
the 19th century, which suggests they are complementary services. Stock markets trade
marketable assets, while banks deal with non-marketed assets; hence they need greater
monitoring. Furthermore, before the middle of the 19th century, very few firms could offer
marketable assets. All this made the banking system become sophisticated before the same
process ensued in the stock markets. Why did they then co-exist? There are at least two
possible explanations. The first, advanced by Gerschenkron, relies on path dependence: large
banks in Germany were particularly well suited for the conditions in Germany, and that
stymied further development in stock markets. The second notes that the inefficiencies of the
two markets do not occur at the same time. On one hand, stock markets continue to function
even in periods of widespread banking crises. On the other, in stock markets, insufficient
information can lead to bubbles, since a particular agents information is revealed by his
actions, and is believed to be based on solid knowledge. Relationship banking is more able to
keep the information private, even though this can lead to undue market power over one
firm. Thus, an economy in which firms are neither totally dependent on banks nor totally
dependent on stock markets may be the best solution.

Chapter 8 Trade, Tariffs and Growth

8.1 The comparative advantage argument for free trade and its consequences

With respect to the Heckscher-Ohlin model, the factor price-equalisation theorem has
found little empirical evidence. Rybczinskis theorem, on the other hand, can be observed in
times of mass migration or population growth: there is usually a tendency for countries to
produce more labour-intensive goods, such as industrial goods, after such events. Indeed, the
extension of the frontier in 19th century America made it become a world leader in the
production and export of agricultural goods.

8.2 Trade patterns in history: the difference between nineteenth and twentieth-century
trade

The Stolper-Samuelson theorem provides a justification for strife within nations due
to inequality, as well as across nations due to the protectionism that possibly ensues.
19th-century international trade was largely inter-sectoral: over 80% of UKs exports
were manufactures, and over 80% of her imports were primary products. In northwest Europe
trade volumes were, roughly speaking, equally divided, and elsewhere it was the reverse. The
patter of trade of the USA and Canada is thus in line with the Hecksher-Ohlin Theorem, for
these are land-abundant countries. However, manufactured goods represented only a third
of total imports due to protectionism.
From the 20th century on, trade became increasingly intra-sectoral, since larger
markets provide more opportunities for monopolistically competitive firms. However, trade

18
between the industrialised and the less developed countries is still primarily inter-sectoral.
Furthermore, aggregation can mask comparative advantage within the industry.
The income elasticity of demand for industrial goods is larger than for agricultural
products, which means that as incomes have increased around the world, there has been a
general shift towards industrial goods in world production and trade.

8.3 Trade policy and growth

Trade theory posits nothing about growth; it only implies a one-off increase in welfare.
In new growth theory, however, trade enables technological knowledge to travel across
borders, assuming it to be non-rival. However, competition, fostered by trade, can lead to a
decrease in the R&D share. International patent laws thus attempt to mitigate this effect.
One common argument for protectionism is the infant industry, as was the case of
American protection of the manufacturing industry. If technological progress is aided by
learning-by-doing and dynamic economies of scale, this might justify protectionism: when
average costs are decreasing and permanently lower than those of the established producer,
protection can give the infant industry a boost and be set into a path according to which
comparative advantage is eventually reached. Note, however, that this argument requires the
presence of market failures; without them, investors would nevertheless be attracted by the
new firm. All in all, theory cannot offer us a unified view on the effects of trade on growth.

8.4.1 From mercantilism to free trade

The Corn Laws, under Ricardos spell, were repealed in 1846, but there is evidence
that tariffs in Britain were falling even before. This led to the first era of free trade, from 1850
to 1875. Tariff revenue was 10-50% of total revenue before this period, and remained high in
the US during the 19th century.
16th-century mercantilism protected home industries so as to generate current
account surpluses. This could only effectively come into being without retaliation, which was
evidently not the case. During this era (until the 18th century), Europes trade increased at 1%
per year, mostly due to the empires. This was done with goods which were not easily
produced at home, such as cotton and sugar. The privileged access to America by Britain may
have helped her ensure the continuance of the Industrial Revolution by guaranteeing markets
for its expanding industries. However, only with the dismantling of mercantilist barriers did
world trade really take off, and not without its hurdles due to instituted rights; the interests
of the losers can have an impact on trade policy disproportionate to their size. Take the EUs
CAP: this ensures protection to the meagre agricultural labour share at the expense of the
consumers as a whole. Nonetheless, the impact of the repeal of the Corn Laws was softened
due to the increase in trade, which increase state revenue above plans and allowed higher
spending.
The Cobden-Chevalier Treaty of 1860 marked a milestone due to its use of the Most
Favoured Nation Clause. Data for volumes of treaties and trade are shown below.

19
 Britain remained a free trader until the interwar period, but other nations that initially
followed eventually reversed their policies in the last two decades of the 19th century,
motivated by the menace of cheap American grain. In Germany, industry and agriculture were
protected alike, but tariff revenue even became lower than before.
Labour was scarce in the US, which implied high wages in manufacturing. This implied
that manufacturers wanted protection from cheap imports, in opposition to the landowners.
Why, then were the US protectionism? First, there was a need for government revenue at the
dawn of independence. Then, it became a deliberate act towards protecting the domestic
industry. Roughly speaking, tariffs increased after independence, decrease in the 1850s, but
after the Civil War the victorious northern states and their emerging industries were more
inclined towards protection.

8.4.2 The disintegration of international trade in the interwar period

Only some nations, notably the UK, Denmark and the Netherlands, remained free
traders until after the war. During the war, most countries reduced food tariffs, but after the
1920s there was a radical return to a virtually mercantilist attitude of viewing trade as a zero-
sum game. In 1930, the US notably passed the Smoot-Hawley Act, increasing tariffs
considerably, and thus generating retaliation. Trade-to-income ratios did not recover their
pre-1913 rates until the 1960s. The Great Depression decreased American demand for
imports, which decreased income elsewhere and thus also decreased demand for imports
elsewhere. This decreased both prices and quantities, which led to a reduction in export
revenues. Food and raw material producers were hardest hit because their terms of trade
deteriorated. They had to borrow on the international capital market but the main lenders,
the American institutions, were unwilling to lend. Since they were unable to finance their
imports, these countries imposed restrictions on the trade balance to restore current account
sustainability, instead of leaving the gold standard and allowing their currencies to
depreciate. The world became divided into trade blocs: the British Commonwealth; Germany,

20
Western Europe and the USA; and Germany and Eastern and Central Europe with a forced
balance of trade due to payment in a non-convertible aski mark.

8.4.3 The restoration of the free-trade regime after the Second World War

After the war, it was realised that lack of co-ordination in liberalisation during the
interwar period had aggravated the Depression. However, countries had many current
account constraints, so liberalisation could not be immediate.
Tariff reductions were agreed in the first GATT in Genova in 1947, and a major
breakthrough came during the 1960s with the Kennedy Round. Alongside, the EEC was
created, but this consisted in a Customs Union. Both the EU and the US have continued to
protect their agriculture heavily, at the expense of many poorer countries. Other industries
had a reduction to tariff levels akin to those of the 19th century. In 1987, the Uruguay Round
established the WTO, with 153 countries (against 23 for the first GATT), and some advances
have been made regarding agriculture and intellectual property rights. Since 1986, trade has
growth twice as much as word output, and tariffs have fallen from 26 to 8,8% in 2007. The
financial crisis, however, stymied progress in the WTO.

8.4.4 Empirical investigations

In the late 19th century, protection and growth do not seem to have a negative
correlation. Indeed, the reverse seems to be the case look at the cases of Germany and the
US against that of the UK. Clemens and Williamson, however, note that the correlation is
positive for the rich countries and negative for the poor ones: is the structure of protection
rather than protection itself that matters? Lehmann and ORourke found, for the period 1875-
1913 that industrial tariffs were positively correlated with growth but agriculture tariffs
negatively so.
Using an index of openness for the period 1970-89, Sachs and Warner find growth to
be negatively correlated to being closed, and Estevadeordal and Taylor find liberalisation of
trade, from 1970 to the present, to lead to faster growth if applied to capital and intermediate
goods, but this is not so clear for other goods.

Chapter 9 International Monetary Regimes in History

9.1 Why is an international monetary system necessary?

International monetary systems solve the problem of no-coincidence of wants at the

world level, and allow imbalances in the trade balance. This opens the possibility for
investment to be financed with foreign debt, instead of doing so exclusively with domestic
savings.

9.2 How do policymakers choose the international monetary regime?

Countries that had commodity money with the same underlying commodities also
had, by implication, a fixed exchange rate regime. Today, however, floating exchange rates
dominate. Fixed exchange rates have the advantage that international traders are not subject

21
to unexpected changes in exchange rates and therefore do not need to factor this uncertainty
into the price they demand for their goods. A strong disadvantage, however, is the implied
loss of monetary autonomy, reflected by the classic open economy trilemma.
From the second half of the 19th century until the First World War, the International
Gold Standard had fixed exchange rates and capital mobility at the expense of monetary
autonomy; after the Second World War until 1973, the Bretton Woods System had fixed
exchange rates and monetary autonomy at the expense of capital mobility; after 1973, the
world has predominantly been one of monetary autonomy and capital mobility, at the
expense of fixed exchange rates.

9.3.1 The International Gold Standard c. 18701914

In a sense, the gold standard emerged by accident: many countries fixed their
currencies against the gold, incidentally creating a fixed exchange rate regime. However, the
institutional building blocks of the system were two. First, Britains Resumption Act of 1819,
which resumed and institutionalised the practice of exchanging currency notes for gold on
demand at a fixed rate; second, restrictions on the export of gold were repealed.
Due to divisibility and golds high value, many countries had practised bimetallism.
Nevertheless, Britain led the way in basing her currency on gold alone, and her success led
other countries to follow her lead, although with some conflicts in the United States, which
remained bimetallic until 1873.
The US and Germany formed their own monetary unions; internationalism led to the
creation of the Scandinavian Monetary Union in 1875 and the Latin Monetary Union in 1865
with France, Belgium, Italy, Switzerland, Spain and others as members. France saw the LMU
as a way to create a system based on the franc and Paris; it was thus bimetallic. Nevertheless,
despite the political significance of monetary unions, they become largely irrelevant in a world
of fixed exchange rates.
The rules of the game, a set of rules based on the law and practice of individual
countries and not formally institutionalised, made the gold standard a de facto fixed exchange
rate regime. They were three:
1. The currency should be freely convertible to gold at a set price or mint parity (small
deviations in the exchange rate were possible due to transport and transaction costs);
2. There should be no barriers to the flow of capital, i.e. gold, between countries;
3. Money should be convertible on request to gold, and thus backed by gold reserves.

Governments took, on the whole, a laissez-faire attitude towards economic policy,

partly due to the existence of the price-specie-flow mechanism, whereby the gold standard
should automatically ensure balance of payments equilibrium: When Britain has a trade
surplus, gold flows into Britain, which causes British prices to rise and terms of trade to
decrease. That leads to an increase in demand for foreign goods and a decrease in foreign
demand for domestic goods, propelling an outflow of gold, thereby restoring equilibrium.
Often, however, central banks were more worried about gold losses than gold gains, and thus
practised sterilisation of gold inflows by intervening in the foreign exchange market, through
open market operations, or by increasing the minimum reserve ratio.
There are three main reasons for the longevity of the gold standard:
Commitment: Deviations from the gold standard would be followed by a return to the
original parity;

22
 Confidence: People believed that exchange rates would remain fixed, so all
speculation went in that direction;
Symmetry: No country had an overwhelming influence on price levels. In fact, all
national price levels were dictated by gold demand and supply, which created uniform
rates of inflation or deflation across countries, potentially causing economic distress.
This is somewhat irrelevant in a laissez-faire world, but towards the end of the 19th
century there was already political unrest in the US due to deflation.

9.3.2 The interwar years

The interwar years saw the end of the gold standard: government expenditure was
financed by bonds and seigniorage. After the war, some governments financed reconstruction
by printing even more money, which led to hyperinflation in Germany (3.25 million percent
per month).
The US returned to the gold standard in 1919. All countries should have returned at
pre-war parities according to the rules of the game, but this would require deflation,
sometimes to an unrealistic extent, because due to wage rigidity, deflation causes labour to
become relatively expensive and, consequently, output declines. The UK returned to the old
parity in 1925 so as to recover the leading role it had; this caused unemployment to soar. On
the other hand, a more pragmatic France returned to the standard at 20% of the pre-war
parity.
By 1929, sterilisation by the US and France led them to hold 70% of the global supply
of gold, which in turn necessitated a reduction of the other countries money supply. This,
together with the Wall Street Crash, led to the Great Depression of the 1930s. The gold
standard prolonged and worsened the Depression, according to Eichengreen: countries
needed to protect their gold reserves and thus refused to provide liquidity to banks; countries
that relied on American loans had to put currency controls and this, coupled with low capital
mobility, led to the decline of world trade during the 1930s. In 1931, the UK left the gold
standard; in 1933, the US did. They devalued their currencies to roughly 60% of their 1929
parity and were able to recover relatively faster from the Great Depression, since (1) over-
valued currencies were restored to normal levels, (2) inflation increased, thus decreasing real
wages and real interest rates and (3) monetary autonomy was then possible. France was the
last major country to leave the gold standard in 1936, and this caused the French to miss the
revival of the international economy in the mid-1930s.

9.3.3 The Bretton Woods System

The Depression led countries to virtual autarky, and fascism emerged. In July 1944, 44
countries signed the Bretton Woods agreement. This was an attempt to preserve fixed
exchange rates and free trade without having to withhold monetary autonomy. Their belief
in fixed exchange rates was the result of the interwar chaos, and the feeling that floating
exchange rates had been a cause of instability and harmful to trade. Its characteristics were
the following:
The dollar was fixed against the price of gold: $35 an ounce;
Member countries held reserves in gold or dollar assets, with the right to sell dollars
to the US Federal Reserve for gold at the official price. These reserves served to guard

23
 against short-term swings in exchange rates, without a link to the monetary supply as
they had had under the gold standard;
All currencies were fixed in value against the dollar, giving N-1 exchange rates.

Hence, all but one of the member countries were responsible for maintaining the
exchange rate, with the USA simply responsible for maintaining the dollar price of gold.
Capital controls were performed by ensuring convertibility of currencies only on the trade
balance and not on the financial account. Flexibility for countries with current account deficits
was ensured by (1) the IMF, which controlled a pool of gold and currencies from member
countries which it could lend to members that were experiencing current account deficits,
but where contractionary policy would cause unemployment, under the condition of
supervision and (2) the possibility of devaluation against the dollar in case of fundamental
disequilibrium of the balance of payments (which was not defined).
Delaying payment for goods or lending by forwarding money in advance overcame
capital restrictions, and speculative pressures were thus able to emerge. This prompted
destabilising speculation: the UK devalued in 1967, and France in 1957, 1958 and 1969.
Asymmetry was a problem, since the dollar could obviously not devalue against itself,
and only the USA had the freedom to set its interest rate and use monetary policy. In the
1960s, welfare spending was expanded in the US and there was the Vietnam War, which led
to inflation and an over-valued dollar (because the dollar price of gold was constant). America
devalued against gold in 1971, and gold convertibility was abandoned in 1973. Thus,
commitment of central bankers to the fixed exchange rates, confidence in stable exchange
rates and symmetry were all absent in the system.

9.3.4 The world of floating exchange rates

Floating exchange rates thus emerged by accident, but they havent been replaced since due
to (1) the economic theories of Mundell on optimal currency areas, (2) divergence in price
levels and (3) compatibility of folating exchange rates with free capital flows and trade. The
new exchange rates, when fixed, were regional rather than international, as in the European
Monetary System in the 1980s and early 1990s. Countries linked their currencies to the
German mark, which had a reputation for low inflation; this disproved that inflation couldnt
be avoided without a gold standard. An historical analysis then shows that a monetary union
requires a supranational dimension, which all but the Euro Area lacked.

Chapter 10 The Era of Political Economy: from the minimal state to

the Welfare State in the Twentieth Century

10.1 Economy and politics at the close of the nineteenth century

The 19th century was the era of the minimal state. Government expenditure was
around 10% of GDP, and welfare was less than half of this. The role of the state was solely to
enact laws and regulation, such as on labour conditions.

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10.2 The long farewell to economic orthodoxy: the response to the Great Depression

The view of the economy as a self-regulating entity was the dominant one in the 19th
century: prices were assumed flexible. With the First World War, trade routes were disrupted,
the gold standard suspended, political systems changed, trade unions strengthened and
social-democrat parties gained a wide electoral base. Wage rigidities had played an important
role in the chaos of the interwar period, and indeed the different exchange rate choices
affected countries ability to resist the Great Depression. Scandinavia and Britain, where
orthodoxy dominated, was at a competitive disadvantage relative to more pragmatic
countries like France. As firms increased market power and trade unions emerged,
deflationary policies became less likely. On the whole, during the interwar gold standard very
little nominal price or wage-level adjustment occurred.

The consequences of the Great Depression were several:

The banking system went into a deep decline;
Industrial output declined sharply, but food production was only marginally affected;
Food and primary product prices fell dramatically, depriving these exports from the
income to pay for industrial imports from Europe once the USA ceased to lend
internationally in 1930;
America brought in protectionist policies and the rest of the world followed suit;
Between 1929 and 1933 world trade fell to a third of its value;
Nominal rates were low, but high deflation kept real interest rates very high, which
stymied investment.

In Continental Europe, economic orthodoxy was still in place, and results went from dismal,
in France, to disastrous, in Germany:
France: Remaining on gold forced deflation and stagnation.
Germany: Without the fetters of the gold standard on monetary autonomy, the
devaluation gave rise to inflation and thus to decreasing real wages and interest rates.
However, the new macroeconomic ideas had little practical impact for the
management of the Great Depression: austerity was put in place as revenues
decreased, and fiscal policy was too radical. To start with, tt had had short-lived
governments whose reckless spending exploded into hyperinflation in the 1920s, and
after re-joining the gold standard, the Reparation payments that it had to do were
more than offset by the inflow of foreign capital. With the shock to export earnings
caused by the Great Depression, foreign debt became unsustainable, and the German
government introduced austerity measures. Economic activity and imports were
reduced, and unemployment went up to 25%. Most importantly, Hitler rose to power.
According to some, however, Germany had no choice: as expansionary monetary
policy would have driven down interest rates and frightened away capital. But in 1931,
Germany introduced capital controls, and it is unclear why it did not follow Britain into
abandoning the gold standard.

10.3 Successes and failures of macroeconomic management in the second half of the
twentieth century

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 Keynesians contribution was in that they showed that an increase in government
spending worked legitimately through a spending multiplier. There was a dominance of
Keynesian ideas until the 1970s and 1980s, a period of slow growth, high unemployment and
inflation. This gave rise to the New Classical critique. Keynesians have admitted that they
previously neglected the problems of inflation when firms and trade unions anticipated
government demand management if they knew government would react to an increase in
unemployment due to an increase in wages by increasing government spending to decrease
unemployment, inflationary pressures would build up. Furthermore, the political economy
aspect encouraged governments not to raise taxes in good times, which led to accumulation
of public debt in the 1970s and 1980s.
Germany was initially reluctant to embrace the full-employment principle and France
experimented with a more comprehensive indicative planning. Elsewhere, it was indeed
embraced, and unemployment went well under 5%. After the 1980s, unemployment went up
again to between 5 to 10%.
Timing problems led many times to overheating, with an inadequate budgetary
process. In France and the UK, there were frequent balance-of-payments problems and trade
unions and employers failed to build the co-operative institutions present in Germany.
The relative success of demand management in the Golden Age (1950-73) depended
as much on the elastic supply of raw materials, such as oil, and labour from the dwindling
agricultural sector and from immigration. This caused low inflation and low unemployment.
The rapid economic growth of the Golden Age was seemingly due to high profits and
investment, technology transfer, increased openness to trade and high TFP. Furthermore, the
Welfare State introduced automatic stabilisers, which is a more efficient instrument than
active, ad hoc policy, since in the former case the government does not need to get the timing
right.
The wage restraint offered by trade unions broke down in the early 1970s because (1)
of import-price shocks from oil, (2) free lunches of technology transfer were not so easily
available and (3) the Welfare State costs were increasingly borne by the low to middle-income
earners. This gave rise to stagflation, which was accommodated (except in Germany) by
repeated devaluations. Sweden and the UK even entered into floating exchange rate regimes.
By the 1980s the main preoccupation of governments thus became to combat high, often
two-digit, inflation. Germany had a tradition of low inflation, so some economies, including
France, Italy and Denmark, pegged their currencies to the Deutsch Mark in the 1980s. In the
1990s, full employment was subordinated to price stability with independent central banks;
it is however possible that higher unemployment is caused, in the present, by generous
insurance schemes. European nations within the EU managed to bring down inflation rates
considerably in the 1990s, also due to the pressure from the low-wage developing nations.

10.4 Karl Marxs trap: the rise and fall of the socialist economies in Europe

Marx argued that social systems thrive and expand only if they can develop
technologies and sustain and increase material welfare, which explains, ironically, the demise
of the socialist experiment.
The social-democratic movement considered itself as Marxs legitimate heir,
especially during the formative years at the end of the 19th century. In contrast with socialist
economies, social democracy strove to balance the domain of markets and that of politics
the mixed economy and it turned out, in fact, to be the most endurable solution.

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 Marx, who posed that communism would have to use the processes developed by the
capitalist system, would be surprised to hear that Russia was predominantly agrarian. After
the Russian revolution, the government soon had to re-introduce market principles (with the
New Economic Plan). The return to tight central planning only arrived in the early 1930s with
the first five-year plan. The inspiration from central planning was not provided by Marx, and
one possible source was the administrative bureaucracies that developed in Germany, in
particular to sustain the war effort, and those that managed public enterprises like the
railways system. Early Soviet planning had four main characteristics: (1) abolition of private
ownership of resources and means of production, (2) very high investment ratios, (3) a strong
bias towards investment in capital goods industries and (4) neglect of consumer goods
production.
A transition towards a Soviet-style political and economic system was then imposed
after the Second World War in the Baltic states, Poland, East Germany, Czechoslovakia,
Romania, Bulgaria, Yugoslavia and Albania. About a third of the European population was
living in centrally planned economies by the mid-1950s. Private property survived longer in
East German industry, and Polish and Yugoslavia agriculture was spared collectivisation. The
new socialist economies, except East Germany and Czechoslovakia, were predominantly
agrarian with small industrial sectors. They thus had comparative advantage in agriculture,
but investment was high in industry. Thus, the productivity hap between industrial
occupations and jobs in agriculture was huge, which implied gains from the structural
relocation of the labour force. Structural change was one of the reasons why growth was
quite high in the Golden Age, but much worse than in Western Europe: compared to Portugal
and Spain, growth was 2 pp. lower, but investment ratios were 10-15 pp higher; this meant
investments were highly inefficient, which is understandable, since information about the
input-output matrix is very hard to gather in a centrally planned economy. Managers in the
industrial sectors, favoured by policymakers, had virtually free access to capital, which
explains the excessive investment ratios and neglect of consumers only excess demand for
consumer goods made consumers tolerate the poor quality.
Russias income relative to that of Western Europe fell from almost 70%in 1950 to
50% in 1990. Eastern Europe falls from earning half the Western European income in 1950 to
a third forty years later. Although saved from the perils of unemployment and intensification
of work experienced in the West, workers in the socialist economies were deprived of political
rights as well as the consumer goods available to people in Western Europe.

10.5 A market failure theory of the Welfare State

The modern Welfare State was born after the Second World War, and since the 1970s
has been between 25 and 35% of GDP, half allocated to transfer and the remaining to health
and education. Redistribution across classes is a minor effect of welfare spending and can be
explained by the extension of the franchise, which made it possible for the majority of low
and middle-income earners to tax the rich. The kernel of the system is the intertemporal
allocation of resources.
Let the net welfare state balance for the household denote the difference of its
contributions to and its benefits from the Welfare State. The Welfare State is a provider of
transfers and services which helps households to smooth consumption possibilities over their
life cycle. The typical household starts as a net receiver from the generations that have left
the family-formation and child-rearing phase behind. As children leave school, the household

27
starts becoming a net contributor until old age, when households become intensive public
health consumers as well as beneficiaries of publicly-funded pensions. Most European nations
have a mix of pay-as-you-go pensions and funded pension schemes.
Welfare institutions were preferred to markets because the latter were deemed
inferior for four distinct reasons:
1. Market solutions tend to have distributional effects which violate commonly help
preferences for equal access to some essential services. Although consumers are
found to have altruistic preferences, it has been shown that ethnic homogeneity is
usually positively associated with more redistribution, and that there is high
reluctance to provide foreign aid.
2. Externalities and co-ordination problems would make the market solution inefficient.
Usefulness of the knowledge is enhanced by everyone having corresponding
knowledge, so any private decision to invest in elementary schooling will depend on
what others are doing. Compulsory schooling solves that problem. Taxation and
redistribution suffers from the same issue, while health insurance suffers from
adverse selection.
3. Capital market imperfections are not compatible with universal access to
intertemporal smoothing of income. Banks will probably not grant loans to all people
alike.
4. Time-inconsistent preferences make most people underinvest in pension saving as
well as sick leave and unemployment insurance people still have a bias towards
immediate gratification, leading to underinvestment in pensions.

While Barro found a negative correlation between taxation and growth, Lidnert was
unable to do so. The explanation might be that nations with high welfare spending had
smarter tax systems, which raised more revenue from taxing consumption and less from
taxing income or corporate profits.

Chapter 12 Globalisation and its Challenge to Europe

12.1 Globalization and the law of one price

The first wave of globalisation started in the middle of the 19th century as barriers to
trade, migration and capital mobility were abolished or weakened, and as the speed of
information transmission increased. Indeed, labour mobility across borders was less
restricted before 1914 than it is now. Two World Wars and the Great Depression brought
about an anti-globalisation backlash, and late the 19th-century globalisation level was not
regained until the 1970s or 1980s, when the second globalisation period gained momentum.
The law of one price operated first within regions and nations, and later in clusters of
neighbouring nations as transport and information transmission improved. Such
improvement is primarily a 19th century phenomenon. By the middle of the century, all major
cities in Europe were linked by the telegraph, and if information was transmitted by telegraph,
the price difference would be known within hours.

12.2 What drives globalization?

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 What were the forces that drove market integration and globalisation? Mainly politics
and technology. Within the scope of the former, we can witness tariff reduction, financial
market deregulation and immigration policy. However, structural changes in liberalising
economies bring about winners and losers, and there have been free-trade backlashes.
Within the scope of the latter, we can witness the reduction in transport and transaction
costs. However, it is unclear whether transport costs have fallen since the beginning of the
20th century, and even before the only clear trend is a decrease in domestic freight rates.
Information transmission costs have fallen since the early 19th century while speed
has increased due to the telegraph by the early 1870s the whole world was wired and the
development of a commercial press LEcho des Halles, for instance. During the remainder
of that century, price differences which could not be explained by trade costs gradually
declined.

12.3 The phases of globalization

There are three characteristics associated with market integration: (1) price
convergence, (2) faster price adjustment in the domestic economy to world market events
and (3) an increase in the volume of trade, capital flows and migration flows.

12.3.1 Capital markets

Was arbitrage in capital markets efficient? Larry Neal found that for the London and
Amsterdam markets in the 17th and 18th centuries, not only were price movements highly
correlated, but furthermore there were no systematic unexplained price differences between
the two markets for identical assets. This might not have been representative, however, since
these were the leading financial centres in the 18th century, with frequent and efficient postal
services linking the two cities.
The advent of transcontinental telegraphs in the 1860s and 1870s created the pre-
conditions for global capital markets. Current account imbalances increased in the 19th
century until 1914 (to around 7% in some nations), only to decline in the interwar period.
They remained low for a long time after the Second World War, but increased again after
capital market deregulation in the 1980s. Domestic savings and domestic investment have
nonetheless remained strongly correlated, which may be explained by a home bias in the
collection of information. Investigating this home bias, we find that the world was more
globalised pre-1930, the Great Depression restoring a strong link between domestic
investment and domestic savings. In recent decades, 25% of additional savings head abroad,
again 40% during the first globalisation phase.
In the first globalisation period, nations were typically either debtors or creditors, with
the UK, France and Germany as the major creditors and Russia, Scandinavia, the British
Empire and Latin America as major debtors. Today, nations have both liabilities and assets in
foreign markets. The magnitude of capital flows is causing problems for developing
economies: Latin America and East Asia were troubled by large fluctuations in foreign
investments in the late 1990s the merits of liberalisation of capital markets have been
questioned since.
There were two periods of capital market integration: the first in the 50 years before
1914 (the International Gold Standard period), and the second starting with the break-up of

29
the Bretton Woods System in 1973. Indeed, the predictions generated by covered interest
rate parity conditions validate this description.
In the 19th century, the UK was the largest creditor (50% of the stock of foreign capital
in 1914), and was joined by France and Germany by the end of the century. During the 20th
century, the USA emerged as the major foreign investor (Britains stock fell to 15% of total).
In the early phase of the Industrial Revolution foreign investments were insignificant; after
1850 the stock of foreign capital increased to 20% of world GDP. It fell in the 1930s and
exploded in the 1980s. By the end of the 20th century it was about 100% of GDP.
In the first globalisation phase the developing world received one third of foreign
investments, but that had decreased to 10% at the end of the 20th century. Multinationals
tend to invest in middle to high-income nations, and these firms widely propagated during
this period. By contrast, investment in raw materials and infrastructure was more relevant in
the past.

12.3.2 Commodity markets

Price convergence was present in the Baltic area in the 18th century, and between the
Baltic ports and European ports on the Atlantic coast. The spice trade and trade in tropical
commodities also experienced this convergence as early as the 17th century.
Wheat price differentials between the UK and the US have decreased substantially
during the 19th century, fluctuated strongly during the interwar period and tended to increase
after the Second World War owing to higher freight rates and to the UKs membership in the
Common Market and the Common Agricultural Policy. For Continental Europe, tariffs against
grain imports from the USA in the 1880s and in the interwar period, as well as the later
Common Agricultural Policy, prevented long periods of price convergence.
The share of exports increased from 3-5% to 20-25% in small economies and in the
UK, and to 10-15% for larger economies. It fell in the interwar years and fully recovered only
by the 1970s or 1980s. Manufacturing as a share of GDP decreased at the same time, which
means exports per added value increased between 50 to 80% in this sector.
Speed of price adjustment decreased dramatically from almost 1 year to less than a
week through the 19th century. On modern commodity markets it is a matter of hours.

12.3.3 Labour markets

The convergence mechanism in labour markets is migration. However, there is a

home culture bias: workers are reluctant to move to nations where there are not many
previous immigrants from their own country. Furthermore, transport costs were very high
before 1850. Accordingly, there were substantial flows of forced migration mainly due to
religious persecution, and this included skilled workers. From 1650 to 1800 European
migration the the Americas was smaller than for a single year in the late 19th or early 20th
centuries, viz. slightly below 1 million. However, Africans emigrated forcefully to the Americas
(7 million until the first quarter of the 19th century).
Internal European migration was small relative to European migration to the Americas
before 1914. The majority was from the British Isles, Germany and Scandinavia. In 1900-1910
migrants from eastern and southern Europe became the majority of a total which consisted
in a million per year. Most of them went to North America, but South America was also
popular amongst South Europeans. This was facilitated by the steam boat and the decrease

30
in prices. During the interwar period, immigration barriers were erected in the New World,
and the numbers never recovered again: they are now similar or lower than those of the
1840s.
From 1870 to 1913 and after 1950 we see signs of wage convergence.

12.4.2 The retreat from the world economy

The New World has transformed policy priorities from protectionism and free
migration to free trade and constrained migration. Europe returned to its free trade tradition
after the Second World War, but also restricted immigration. Why was this so? If immigration
decreases output per capita of the receiving country, trade also decreases the wages of the
importing sector. Furthermore, open economies score high on both trade openness and the
labour compact index (a measure of working conditions and insurance coverage).
In the first globalisation era, there was a race to the top: the most advanced labour
protection standards were imitated and implemented by other economies as they became
more open. Furthermore, Rodrik found there was a positive relationship between openness
and welfare spending during the second wave of globalisation.
In the early phase of globalisation, exports of manufactured goods came from Europe,
while the rest of the world, including North America, primarily exported food and raw
materials. Countries with agricultural specialisation in the first globalisation period were met
with protectionism in North America and Europe in the 1930s, and these policies have been
strengthened since the 1950s. The developing world thus started import substitution
industrialisation, often with infant-industry protection. The long-run growth of Latin America
was disappointing in the 20th century. Infant industries tended not to grow up. Tariffs have
more than halved since 1975 in these countries, and import substitution industrialisation has
been abandoned.

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