Asset Prices, Banks and
Financial Market Integration in
the British Industrial Revolution
Liam Brunt[1] & Edmund Cannon[2]
Abstract[3]
Using a large panel of weekly wheat prices, we infer the annual rate of return on capital in each county in England and Wales in the period 1770-1820. Throughout this period markets were efficient in the sense that weekly returns were serially uncorrelated. We show that the interest rate differential between London and each county can be explained by the density of bank coverage in that county. The explosion in provincial banking in England and Wales during the industrial revolution significantly reduced regional differentials in interest rates. This is direct evidence that the depth of financial intermediation determines the degree of capital market integration.
Keywords: banks, financial integration, industrial revolution.
JEL Classification: O16, N13, G21.
Introduction.Britain was distinguished from other economies during the Industrial Revolution by the sophistication of her financial markets (Neal, 1990). This is often invoked as an important cause of her industrial success in the eighteenth and nineteenth centuries (see, for example, Cameron, 1967). The importance of efficient capital markets, the difficulty of achieving them and their rôle in generating economic growth has also received considerable attention from development economists (Ikhide, 1996; Sial & Carter, 1996; MacKinnon, 1976; King & Levine, 1993). The growth of commercial banking in Britain was truly spectacular, rising from 120 banks in 1784 to 660 banks in 1814 (Pressnell, 1956). So if banking does indeed have a positive effect on the real economy then we should certainly be able to observe it in action in the British Industrial Revolution. In fact, there is very little direct evidence linking financial market integration to changes in the cost of capital during the Industrial Revolution; and a link between the cost of capital and the rate of investment during the Industrial Revolution has never been established empirically. Without these two links in the chain it is difficult to estimate the effect of financial market integration on British economic growth.
The purpose of this paper is to quantify the effect of commercial banking on financial market integration in Britain during the Industrial Revolution. The fundamental problem in analysing financial markets in this period is that we have very little information on the cost of capital. Hence it is difficult to estimate the effect of any changes that might take place on the demand or supply side of the market, or any change in the nature of financial intermediation. The recent analysis by Buchinsky and Polack was based on two series of deeds on property transactions, one for Yorkshire and the other for Middlesex, from which they inferred regional building, presumed to be determined partly by the cost of capital. Whilst their results are suggestive, one would not want to place too much weight on them alone.
Our departure point is to estimate the rate of return on capital in each county. We can do this by looking at the appreciation of a real asset through the year. The only asset that is sufficiently well documented through the period is grain. Bearing in mind that agriculture was the largest sector in the British economy until 1840 (Crafts, 1986) - and that grain was the single most important output - the rate of return on holding grain is probably the single best indicator of the cost of capital in the economy. McCloskey & Nash (1984) and Taub (1987) show how the seasonal variation in grain prices is related to the interest rate: grain is an asset, and in equilibrium the holders of grain must be compensated for storage and interest costs. We use the appreciation of grain prices through the harvest year to estimate the rate of interest prevailing in each county from 1770 onwards. We have previously used this technique successfully on data from earlier periods (Brunt & Cannon, 1999). Our estimates are based on a large panel of weekly grain prices collected by the British Government between 1770 and 1820; this enables us to estimate year-specific county-specific rates of return on capital. We compare the movement of our interest rate series over time to that of the Consol rate, and find a positive relationship.
We then explain the geographical and temporal variation in interest rates with reference to the spread of banks outside London (the so-called ‘country banks’). At this time the Bank of England enjoyed great privileges in the commercial banking market. As a result, other banks were restricted to being partnerships (as opposed to joint stock companies) with a maximum of six partners all of whom had unlimited liability. Hence the size of individual banks was greatly circumscribed and the geographical reach of each bank was inevitably very limited. We take advantage of this fact by using the number of banks as a measure of the availability of banking services within each geographical area. There is county-level data available for country banks from 1800 onwards. We show that the density of country banks has a significant effect on narrowing the differential between the rates of return on grain traded in London and each county outside London.
The remainder of the paper is organised as follows. Section 1 discusses the merits and problems of using grain prices to infer the cost of capital. Section 2 discusses our data set in more detail and illustrates the seasonal pattern of prices more closely. Section 3 begins with a discussion of market efficiency in the sense used in the finance literature - namely that returns should be serially uncorrelated and prices follow a martingale process (weak market efficiency). This is important because it influences our interpretation of the price data. We then estimate the gross rate of return on grain for each county-year. Section 4 outlines the institutional structure of British banking in the period 1770 to 1820, which informs our model of financial market integration. Section 5 uses the county-level interest rate estimates to analyse the level of financial market integration, and shows how this was influenced by the spread of banks. Section 6 concludes.
1. Inferring the cost of capital from grain prices. There are several conceptual and practical difficulties with inferring the cost of capital from the appreciation of grain prices. This has generated considerable scepticism amongst economic historians about the value of the approach. In this section we address these issues and explain why this is the most practical and effective method of estimating the cost of capital. In the following section we discuss the technical details of our estimation procedure and implement it.
There are two lines of argument which we can adopt to defend grain prices as a data source for inferring the cost of capital. First, the grain price approach has the advantage that it is based upon a considerable body of data and provides high frequency data which is at least available on a consistent basis and is as good quality as anything else available. Second, there is qualitative evidence that markets behaved in the way assumed by the grain price approach and that thus it gives us an accurate and representative estimate of the cost of capital. Hence it is perfectly reasonable to use grain prices, whether or not there are other sources. We now consider each of these arguments in turn.
1.1 Options for measuring the cost of capital. The usual approach to measuring the cost of capital is to look at the rate of return on a riskless asset or, if that is unavailable, to use widely traded assets whose risk can be quantified easily. The usual asset in these circumstances would be short-dated treasury bills or government bonds, since such government-backed securities are free of firm- or individual-specific risks. However, if we want to measure interest rate variation within a country that has poorly integrated financial markets then our task becomes more difficult, since government bonds are generally issued and traded only in the capital city. The best that we can hope to do is to find an asset which is widely traded and is equally risky in each place; this would then allow us to measure genuine variations in the cost of capital, rather than variations in risk across the country. The second best would be to look at assets in each place which have different but known levels of risk, which would allow us, in principle, to infer risk-adjusted rates of return.
When dealing with historical economies, there are three data sources that offer a reasonable chance of allowing us to estimate the local cost of (riskless) capital.
The first source is bank records. James (1978) has used this source for the United States in the late nineteenth century. Unfortunately, it is exceedingly difficult to get good data for earlier time periods and other countries. Moreover, there is a huge limitation with this approach. If we want to examine the effect of banks entering a local capital market ab initio, then we need to observe the cost of capital both before and after the banks exist. But it is clearly impossible to use the records of non-existent banks to measure the local cost of capital, and hence we can never observe the cost of capital prior to the advent of banks. This is highly likely to be a binding constraint; when we are dealing with any economy of the nineteenth century (and many developing economies today), particular localities will have no banks during at least some of the period of analysis.
The second source of data on the cost of capital is mortgages on land, which is both widely traded and relatively low risk. Allen (1988) has used this source for England in the early modern period. Unfortunately, it is difficult to get a large and geographically dispersed sample of mortgages. Moreover, there may be severe sample selection problems. For example, we have often been left mortgage documents from the largest landowners, who may have had peculiar risk characteristics. Also, the large landowners may well have had exceptionally easy access to the largest financial markets. So the mortgage rate recorded for a piece of land in the north of England may actually reflect the cost of capital in London (where the landowner raised his loan), rather than the cost of capital in the north of England.
The third data source on the cost of capital is grain prices. The grain production process results in grain being harvested once per annum (generally in August in England) and then stored through the next 12 months. Whilst it was stored, the grain had to appreciate enough to offset the physical cost of storage, the physical losses in storage, and the cost of the capital invested in the purchase of the grain. Otherwise, rational economic agents would not have stored the grain, instead finding some other investment opportunity for their savings. Following the work of McCloskey & Nash (1984) and Brunt & Cannon (1998), we can use this price appreciation to estimate the local cost of capital. Grain prices offer several advantages over other sources. First, before the Second World War every locality produced and traded grain for local consumption. Second, governments keenly monitored the price of grain in every locality because they were worried about the possibility of excessive price rises causing social unrest. This has left us with a huge amount of price data, usually with weekly observations (or sometimes even higher frequency). Third, holding grain was roughly equally risky in every locality, so we do not have to worry about the risk premium when looking at regional variations.
Given the relative merits of the three sources for estimating the local cost of capital (bank loans, mortgages and grain prices), the grain price approach is a clear winner. The potential pitfalls in using grain data are no greater than the potential pitfalls with the other sources; and grain prices are the only source which are likely to give a wide and consistent spatial and temporal coverage.
1.2 Accuracy and representativeness of cost of capital estimates based on grain prices. If our estimates of the cost of capital are to be both accurate and representative of the wider economy, then certain conditions need to be met at the micro level and the macro level. First, at the micro level the appreciation of wheat stocks can be interpreted as a return on investment – that is, a rate of interest – only if the grain price is determined by the activities of homo economicus. Economic agents must be (at least approximately) rational, far-sighted, self-interested and operating in a market economy. If agents are pursuing some other kind of behaviour or maximand then grain prices will clearly not exhibit a return on investment. Komlos & Landes (1991) have argued strongly that agents in the grain market cannot be assumed to be homo economicus. This criticism focussed on the medieval economy (rather than the eighteenth century) but many economic historians will have similar reservations about farmers in the later period and we need to address their fears. Second, suppose that we can answer the first question in the affirmative and treat the appreciation of grain prices as a rate of interest. Can we then go further and interpret this return on investment as the rate of interest? This depends on the extent to which product and financial markets were integrated; and the extent to which agriculture, industry and services were integrated.
We begin by noting that the conditions required for the appreciation of grain stocks to reflect a rate of interest are actually quite mild. We do not require everyone in the economy to be a rational, far-sighted, self-interested optimising agent. It could be the case that many people held grain irrespective of whether they were expecting to receive a return on the money that they had invested. But as long as agents at the margin required a market rate of return, then the price of grain would exhibit a cycle that ensured a rate of return for everyone. That is to say, the existence of people who are willing to arbitrage between grain markets and other markets (especially financial markets) is sufficient to ensure that grain holdings earn the market rate of return. However, it would obviously strengthen our case if we could show that most or all participants in the grain market were likely to seek a market return on their stocks of grain. So we now consider each type of agent operating in the grain market. We show that in each case they acted as rational economic agents and were well-integrated with financial markets, arbitraging between the grain and financial markets as necessary.
Let us start with the farmer. English agriculture in the late eighteenth century was very commercialised. The standard pattern was for large landowners to rent out substantial farms (say, 200 acres) to tenant farmers on long term contracts (usually lasting 10 years and sometimes 20 years). These tenant farmers provided all the movable capital (animals, tools, seed, etc.) and hired workers as required from an active labour market (both on annual contracts and on a daily basis). The tenant farmers were geographically mobile and often moved from one locality to another between tenancies. They were used to evaluating investment opportunities and calculating rates of return; and generally they were not capital constrained. In fact, agricultural profits were very high in the late eighteenth century and the investment funds for industry came from the agricultural sector. It is therefore no surprise to find in 1796 that farmers were well aware of the wheat price cycle, and they arranged their grain disposals accordingly.
[T]here are a set of wealthy farmers who have it in their power to retain a part of their growth in those natural and best of granaries, their ricks. Was it otherwise, as the Corn Laws now stand, we might often, even with a most plentiful harvest, be in the utmost danger of famine.
The argument made use of is, that the little farmer is, through necessity, obliged to thresh out his corn and bring it to market; but that the opulent man will not produce his, until it comes to a certain price. (Arbuthnot, 1796, vol.27, pp.21-22)
We have evidence also from the testimony of farmers and merchants appearing in the Parliamentary enquiry of 1828 (British Parliamentary Papers, 1928, vol.18, pp.284-9). The witnesses to the committee discuss both ‘normal’ trade conditions and those pertaining during the agricultural depression of the 1820s. We can see that farmers commonly financed the storage of grain through bank lending, in anticipation of higher prices later in the year.
During the war, the landlords easily raised money at the banks on discount, and consequently were not under the necessity of opposing the speculations of the farmers; since however, the failure of so many banks in the south of Ireland, the landlords, generally, have been unable to continue this indulgence. We find accordingly, by the notes of the different markets, that the delivery of crops is every where, not only quite unreserved, but much earlier than during the war.
And again,
The want of money has obliged them generally to bring their Corn to market as early as possible of late years, and but few of the more wealthy have seen sufficient prospect of advance to induce them to hold [Corn].