Domestic Responses to Capital Market Internationalization Under the Gold Standard,1870-1914 Daniel Verdier The internationalization of finance in recent years has brought the world economy to the level it had reached in 1913.With this has come a political debate about the vices and virtues of globalization and an analytic debate about its causes.This article presents an analysis of the earlier period that highlights the importance of political choices in bringing about the internationalization of finance and stresses the variabil- ity of choice among countries experiencing the same global phenomenon. One can hardly open a news magazine nowadays that does not feature an editorial warning against,or urging some kind of adjustment to,capital market globalization. Underlying this"global talk"are the beliefs that capital market internationalization is inevitable,uniform,and irreversible.The scientific debate shows more nuances, focusing mainly on the respective roles played by political and nonpolitical factors. One group of scholars see capital internationalization originating in changes in tech- nology or the international power system or both.They trace its distortionary impact on existing wealth distribution,with the relative immiseration of unskilled labor in the West and,more generally,of holders of immobile factors of production or sectors using these factors intensively.2 Some of them see internationalization as resulting in a weakening of state bureaucracies.3 Another group of scholars place the emphasis instead on state-borrowing preferences as the primary vehicle for global finance,4 on coordination among states as a facilitating mechanism,5 and on the mediating role of state institutions and resulting divergent policy responses. I am pleased to acknowledge the invaluable research assistance of Elizabeth Paulet.I thank John Odell, Louis Pauly,Jonathan Zeitlin,Peter Gourevitch,David Lake,and two anonymous reviewers for valuable suggestions.The research on which this article is based was financed by a grant from the Research Council of the European University Institute.An earlier draft was presented at the annual meeting of the Interna- tional Studies Association,Toronto,in March 1997,and published as an EUI Working Paper,RSC No.97. 1.See Loriaux 1991;Goodman and Pauly 1993:Andrews 1994;and Frieden and Rogowski 1996. 2.See Bates and Lien 1985;and Frieden and Rogowski 1996. 3. See Strange 1986:Webb 1991:Andrews 1994;and Cerny 1995. 4.Haggard and Maxfield 1996. 5.Helleiner 1994.16. 6.See Garrett and Lange 1995;and Garrett 1995. International Organization 52,1.Winter 1998.pp.1-34 1998 by The IO Foundation and the Massachusetts Institute of Technology
Domestic Responses to Capital Market Internationalization Under the Gold Standard, 1870–1914 Daniel Verdier The internationalization of nance in recent years has brought the world economy to the level it had reached in 1913. With this has come a political debate about the vices and virtues of globalization and an analytic debate about its causes. This article presents an analysis of the earlier period that highlights the importance of political choices in bringing about the internationalization of nance and stresses the variability of choice among countries experiencing the same global phenomenon. One can hardly open a news magazine nowadays that does not feature an editorial warning against, or urging some kind of adjustment to, capital market globalization. Underlying this ‘‘global talk’’ are the beliefs that capital market internationalization is inevitable, uniform, and irreversible. The scienti c debate shows more nuances, focusing mainly on the respective roles played by political and nonpolitical factors. One group of scholars see capital internationalization originating in changes in tech- nology or the international power system or both.1 They trace its distortionary impact on existing wealth distribution, with the relative immiseration of unskilled labor in the West and, more generally, of holders of immobile factors of production or sectors using these factors intensively.2 Some of them see internationalization as resulting in a weakening of state bureaucracies.3 Another group of scholars place the emphasis instead on state-borrowing preferences as the primary vehicle for global nance,4 on coordination among states as a facilitating mechanism,5 and on the mediating role of state institutions and resulting divergent policy responses.6 I am pleased to acknowledge the invaluable research assistance of Elizabeth Paulet. I thank John Odell, Louis Pauly, Jonathan Zeitlin, Peter Gourevitch, David Lake, and two anonymous reviewers for valuable suggestions. The research on which this article is based was nanced by a grant from the Research Council of the European University Institute. An earlier draft was presented at the annual meeting of the International Studies Association, Toronto, in March 1997, and published as an EUI Working Paper, RSC No. 97. 1. See Loriaux 1991; Goodman and Pauly 1993; Andrews 1994; and Frieden and Rogowski 1996. 2. See Bates and Lien 1985; and Frieden and Rogowski 1996. 3. See Strange 1986; Webb 1991; Andrews 1994; and Cerny 1995. 4. Haggard and Max eld 1996. 5. Helleiner 1994, 16. 6. See Garrett and Lange 1995; and Garrett 1995. International Organization 52, 1, Winter 1998, pp. 1–34 r 1998 by The IO Foundation and the Massachusetts Institute of Technology
2 International Organization It is not the first time that cross-border capital flows grow out of ordinary propor- tions.A century ago,during the period of the gold standard,the world experienced levels of capital internationalization comparable,if not higher,than current ones.Yet hardly any of the most extreme predictions associated with today's occurrence were realized:internationalization was neither inevitable,uniform,nor notably successful- Britain and France,who embraced internationalization,grew more slowly than Ger- many and the United States,who accepted lower levels of capital market interdepen- dence.And,of course,internationalization was reversed. Two lessons can be drawn from the nineteenth-century stab at capital internation- alization.First,internationalization was a political choice informed by redistribu- tional considerations between rival domestic interests and decided by coalitions on which governments were dependent for support.The choice in favor of openness re- flected the economic preferences of large commercial banks,in alliance with savers in creditor countries,and large firms in debtor countries,all of whom expected to benefit from openness.In contrast,the choice in favor of lesser capital interdepen- dence reflected the preferences of sectors that were expected to lose from openness, including agriculture and sectors with a high density of small-and medium-sized firms. Second,the domestic institutional structure in each country determined the iden- tity of the politically dominant coalition.Decentralized structures allowed potential losers to curb public policies favorable to capital market internationalization,whereas centralized structures allowed expected winners to promote such policies.As a re- sult,economies with centralized states ended up being the most dependent on the international capital market,whereas economies with decentralized states took a less active part in the globalization of finance. This inquiry into the functioning of turn-of-the-century capital markets innovates on two further counts.First,unlike most studies of internationalization,this study parts with comparative statics.7 As generally recognized,internationalization is a process that feeds on itself,calling for a dynamic model.Second,this study modifies the standard approach to the redistributional effects of capital flows.8 Economic in its inspiration,the standard approach points to the cleavage between savers and non- savers,two politically inept groupings on account of size and diffusion.Yet concerns over the wealth effects of financial fows have not remained uniformly unvoiced. They were articulated in a majority of countries along another line of cleavage-the center-periphery cleavage-pitting each central government against its respective local governments. The first part of the article presents the theoretical framework,the second part the argument,and the third part the evidence.The conclusion will summarize the find- ings and amplify the themes of this introduction. 7.See Andrews 1994;and Frieden and Rogowski 1996. 8.Frieden 1991
It is not the rst time that cross-border capital ows grow out of ordinary proportions. A century ago, during the period of the gold standard, the world experienced levels of capital internationalization comparable, if not higher, than current ones. Yet hardly any of the most extreme predictions associated with today’s occurrence were realized: internationalization was neither inevitable, uniform, nor notably successful— Britain and France, who embraced internationalization, grew more slowly than Ger- many and the United States, who accepted lower levels of capital market interdepen- dence. And, of course, internationalization was reversed. Two lessons can be drawn from the nineteenth-century stab at capital internation- alization. First, internationalization was a political choice informed by redistributional considerations between rival domestic interests and decided by coalitions on which governments were dependent for support. The choice in favor of openness re- ected the economic preferences of large commercial banks, in alliance with savers in creditor countries, and large rms in debtor countries, all of whom expected to bene t from openness. In contrast, the choice in favor of lesser capital interdepen- dence re ected the preferences of sectors that were expected to lose from openness, including agriculture and sectors with a high density of small- and medium-sized rms. Second, the domestic institutional structure in each country determined the identity of the politically dominant coalition. Decentralized structures allowed potential losersto curb public policies favorable to capital market internationalization, whereas centralized structures allowed expected winners to promote such policies. As a re- sult, economies with centralized states ended up being the most dependent on the international capital market, whereas economies with decentralized states took a less active part in the globalization of nance. This inquiry into the functioning of turn-of-the-century capital markets innovates on two further counts. First, unlike most studies of internationalization, this study parts with comparative statics.7 As generally recognized, internationalization is a process that feeds on itself, calling for a dynamic model. Second, this study modi es the standard approach to the redistributional effects of capital ows.8 Economic in its inspiration, the standard approach points to the cleavage between savers and non- savers, two politically inept groupings on account of size and diffusion. Yet concerns over the wealth effects of nancial ows have not remained uniformly unvoiced. They were articulated in a majority of countries along another line of cleavage—the center–periphery cleavage—pitting each central government against its respective local governments. The rst part of the article presents the theoretical framework, the second part the argument, and the third part the evidence. The conclusion will summarize the ndings and amplify the themes of this introduction. 7. See Andrews 1994; and Frieden and Rogowski 1996. 8. Frieden 1991. 2 International Organization
Capital Market Internationalization 3 The Model Internationalization has a dynamic,historical character:it feeds on itself.Although all studies of internationalization acknowledge this feature,they fail to draw the appropriate methodological consequence. When inquiring into the origins of internationalization,all authors concur in listing two sets of determining factors:(1)technological innovations yielding reduc- tions in cross-border transaction costs,and (2)government policies easing cross- border capital flows.Although technological innovations may,in some circum- stances,be viewed as exogenous shocks,government policies are unequivocally endogenous to the mechanism of internationalization.Causal models of the compara- tive-statics type cannot supply the proper explanation;internationalization would be serving both as independent and dependent variable-an axiomatic non sequitur for this kind of model.That circularity must instead be explicitly tackled through a dynamic model. The need for a dynamic approach is far from being universally shared.Studies of internationalization that seek to explain internationalization,instead,try to fit it into the Procrustean bed of comparative statics,with circularity being avoided in one of two ways:(1)technological determinism,which makes technological innovation exogenous and uses it to determine the model:10 and(2)structural determinism, which sees internationalization as the suboptimal outcome of states'competitive bidding for international capital.Technological determinism,however,goes against recent developments in "new growth"theory,making innovation a process that is endogenous to firms'profit-maximizing strategies,which states can influence through diverse policies.2 With respect to the second claim only the future will tell whether the deregulatory race between states for capital is structural or contingent on revers- ible domestic changes.The fact that the same countries already went through a simi- lar race under the gold standard weakens considerably the claim that today's compe- tition is here to stay. A simple dynamic model features a two-period decision process,allowing for a change in the state of nature in between.In the first period,the government is con- fronted with a technological innovation that promises to ease internationalization in the second period if the regulatory status quo is left unchanged and if the innovation is allowed to move down its learning curve,that is,be adopted,diffused,and im- proved through learning by doing.The government decides on the basis of expected return and opportunity cost,taking into account what other countries might do,whether to check the innovation by means of countervailing policies or let it mature.If the 9.See Goodman and Pauly 1993;Andrews 1994;Frieden and Rogowski 1996;and Haggard and Maxfield 1996. 10.Frieden and Rogowski 1996. 11.Andrews 1994. 12.Roemer 1994
The Model Internationalization has a dynamic, historical character: it feeds on itself. Although all studies of internationalization acknowledge this feature, they fail to draw the appropriate methodological consequence. When inquiring into the origins of internationalization, all authors concur in listing two sets of determining factors: (1) technological innovations yielding reductions in cross-border transaction costs, and (2) government policies easing cross- border capital ows.9 Although technological innovations may, in some circumstances, be viewed as exogenous shocks, government policies are unequivocally endogenous to the mechanism of internationalization. Causal models of the comparative-statics type cannot supply the proper explanation; internationalization would be serving both as independent and dependent variable—an axiomatic non sequitur for this kind of model. That circularity must instead be explicitly tackled through a dynamic model. The need for a dynamic approach is far from being universally shared. Studies of internationalization that seek to explain internationalization, instead, try to t it into the Procrustean bed of comparative statics, with circularity being avoided in one of two ways: (1) technological determinism, which makes technological innovation exogenous and uses it to determine the model;10 and (2) structural determinism, which sees internationalization as the suboptimal outcome of states’ competitive bidding for international capital.11 Technological determinism, however, goes against recent developments in ‘‘new growth’’ theory, making innovation a process that is endogenousto rms’ pro t-maximizing strategies, which states can in uence through diverse policies.12 With respect to the second claim only the future will tell whether the deregulatory race between states for capital is structural or contingent on reversible domestic changes. The fact that the same countries already went through a similar race under the gold standard weakens considerably the claim that today’s competition is here to stay. A simple dynamic model features a two-period decision process, allowing for a change in the state of nature in between. In the rst period, the government is confronted with a technological innovation that promises to ease internationalization in the second period if the regulatory status quo is left unchanged and if the innovation is allowed to move down its learning curve, that is, be adopted, diffused, and im- proved through learning by doing. The government decides on the basis of expected return and opportunity cost, taking into account what other countries might do, whether to check the innovation by means of countervailing policies or let it mature. If the 9. See Goodman and Pauly 1993; Andrews 1994; Frieden and Rogowski 1996; and Haggard and Max eld 1996. 10. Frieden and Rogowski 1996. 11. Andrews 1994. 12. Roemer 1994. Capital Market Internationalization 3
4 International Organization innovation is aborted,then internationalization will not ensue,and the degree of openness will remain unchanged in the second period.If,instead,the innovation is allowed to mature,internationalization will proceed,and the degree of openness of the capital market will be higher in the second period than in the first. I now amend the story to make space for coalitions and institutions.Assume that the government decision is the outcome of a policy process in which the most orga- nized interests get to impose their policy preferences.Private interests in the first period anticipate the future distributional effects of the initial innovation were it to run its course in the second period.Anticipated losers will try to nip the innovation in the bud if they can politically organize.Whether or not they can organize depends on the nature of extant domestic institutions (or a subset thereof).To the extent that countries have different institutions,the degree of internationalization chosen by each government will differ,reflecting institutional variation. One advantage of setting up the problem this way is not to confuse the outcome- the degree of openness to capital flows achieved by each country-with the cause-an exogenous innovation promising gains and losses tomorrow to interests that can anticipate its wealth effects and act accordingly now.Internationalization is not or- dained in the present formulation,but unlikely to proceed very far if potential losers enjoy political power.Another advantage is to differentiate the initial technological innovation,which may be treated as exogenous to politics,from the price shock that will result from the widespread adoption of the innovation,which is endogenous.3A possible drawback of the present formulation comes from its perhaps excessive sim- plicity;the process is reduced to only two periods,with actors graced with the gift of perfect foresight.Reality may afford many more periods,with individuals and gov- ernments exhibiting a present foresight limited to the next period alone and a present latitude constrained by decisions made in the prior period.The two-stage set-up, however,with its perfect foresight implication,makes the presentation of the mate- rial clearer. Applying this model to the case of capital market internationalization under the gold standard will require completing three successive steps:(1)extract from the late-nineteenth-century historical reality the exogenous technological changes that had the potential to increase cross-border investment in all countries;(2)derive the potential domestic losers from this innovation,assess their nonmarket options in light of their institutional power,and then derive each country's policy response;and (3)derive the predicted degree of openness to international capital flows that each country should have eventually reached according to the model.The next part of the article presents the three-step argument,and the third part confronts it with the his- torical record. 13.The price shock is taken as exogenous in Rogowski's 1989 setup and also in Frieden and Rogowski 1996.In Rogowski's story the exogenous price shock increases the wealth and power of the supporters of internationalization,thereby leading to greater policy openness.In the present story,the price shock comes too late,if at all,to help the partisans of internationalization prevail over their opponents
innovation is aborted, then internationalization will not ensue, and the degree of openness will remain unchanged in the second period. If, instead, the innovation is allowed to mature, internationalization will proceed, and the degree of openness of the capital market will be higher in the second period than in the rst. I now amend the story to make space for coalitions and institutions. Assume that the government decision is the outcome of a policy process in which the most orga- nized interests get to impose their policy preferences. Private interests in the rst period anticipate the future distributional effects of the initial innovation were it to run its course in the second period. Anticipated losers will try to nip the innovation in the bud if they can politically organize. Whether or not they can organize depends on the nature of extant domestic institutions (or a subset thereof). To the extent that countries have different institutions, the degree of internationalization chosen by each government will differ, re ecting institutional variation. One advantage of setting up the problem this way is not to confuse the outcome— the degree of opennessto capital ows achieved by each country—with the cause—an exogenous innovation promising gains and losses tomorrow to interests that can anticipate its wealth effects and act accordingly now. Internationalization is not or- dained in the present formulation, but unlikely to proceed very far if potential losers enjoy political power. Another advantage is to differentiate the initial technological innovation, which may be treated as exogenous to politics, from the price shock that will result from the widespread adoption of the innovation, which is endogenous.13 A possible drawback of the present formulation comes from its perhaps excessive sim- plicity; the process is reduced to only two periods, with actors graced with the gift of perfect foresight. Reality may afford many more periods, with individuals and gov- ernments exhibiting a present foresight limited to the next period alone and a present latitude constrained by decisions made in the prior period. The two-stage set-up, however, with its perfect foresight implication, makes the presentation of the material clearer. Applying this model to the case of capital market internationalization under the gold standard will require completing three successive steps: (1) extract from the late-nineteenth-century historical reality the exogenous technological changes that had the potential to increase cross-border investment in all countries; (2) derive the potential domestic losers from this innovation, assess their nonmarket options in light of their institutional power, and then derive each country’s policy response; and (3) derive the predicted degree of openness to international capital ows that each country should have eventually reached according to the model. The next part of the article presents the three-step argument, and the third part confronts it with the historical record. 13. The price shock is taken as exogenousin Rogowski’s 1989 setup and also in Frieden and Rogowski 1996. In Rogowski’s story the exogenous price shock increases the wealth and power of the supporters of internationalization, thereby leading to greater policy openness. In the present story, the price shock comes too late, if at all, to help the partisans of internationalization prevail over their opponents. 4 International Organization
Capital Market Internationalization 5 The Argument Changes in Banking Technology and the Demand for Short Assets14 The surge in capital flows witnessed under the gold standard,I argue in this and the next two sections,originated in a demand for foreign investments,not merely long, as usually noted,but more importantly short.Banks in the late-nineteenth century had a need for short assets,which the international capital market could supply.In this and the next sections I focus on the demand and supply side of short-term assets. Banking until the mid-nineteenth century relied on personal connections.Bankers would borrow from and lend to individuals whom they knew well,either because they lived in the same towns or because borrowers and bank shareholders were often the same people-a relation that Naomi Lamoreaux has appropriately dubbed"in- sider lending."15 Philip Cottrell wrote of the English country banks: Until the 1880s English country banks were products of the localities and regions that they served;customers and shareholders were frequently the same people. The bank's constituencies both owned the banks and did business with them. Directors and managers knew their customers well and with prudence and local knowledge were prepared to go beyond the bounds of short-term lending.16 Where local,personal connections were unavailing,banks would simply not lend to enterprises.Gustav Mevissen,a co-director of the Bank of Darmstadt,made the point with utmost clarity in an instruction to the bank management written at midcentury: The task of our bank is not to attract the business of industrial and commercial enterprise in general.On the contrary,it will be our mission to establish contact with all government institutions,joint-stock companies,and wealthy private per- sons in the hope of obtaining as large a share of the business of governments,of princes and principates,as well as joint-stock companies and wealthy private persons as possible.17 By the middle of the century banking evolved into a more impersonal and profes- sional activity under the pressure of two circumstances.The first circumstance was the rise in individual deposits and the simultaneous decline of bank equity and note issuing.Until midcentury,there were only two main ways of procuring capital in 14.Assets are the left-hand side of a balance-sheet,and liabilities are the right-hand side.Assers are investments,which banks finance with resources or liabilities.Assets and liabilities are arranged ac- cording to maturity.Short assets typically include cash,loans to the stock market,short-term government debt.three-to-six-month credit advances (also called overdrafis),and commercial paper (bills of ex- change,acceptances).A bill of exchange is a buyer's promise to pay in three months:the seller can cash it immediately with a bank.An acceptance is an international bill of exchange.Long assets include long- term government debt,participations in other joint-stock companies,and all loans or advances with a maturity longer than six months.Short liabilities include deposits,positive current accounts.and,in some cases,notes.Long liabilities include equity (capital and reserves). 15.Lamoreaux 1994. 16.Cottrel11992.53 17.Tily1986,121
The Argument Changes in Banking Technology and the Demand for Short Assets 14 The surge in capital ows witnessed under the gold standard, I argue in this and the next two sections, originated in a demand for foreign investments, not merely long, as usually noted, but more importantly short. Banks in the late-nineteenth century had a need for short assets, which the international capital market could supply. In this and the next sections I focus on the demand and supply side of short-term assets. Banking until the mid-nineteenth century relied on personal connections. Bankers would borrow from and lend to individuals whom they knew well, either because they lived in the same towns or because borrowers and bank shareholders were often the same people—a relation that Naomi Lamoreaux has appropriately dubbed ‘‘insider lending.’’ 15 Philip Cottrell wrote of the English country banks: Until the 1880s English country banks were products of the localities and regions that they served; customers and shareholders were frequently the same people. The bank’s constituencies both owned the banks and did business with them. Directors and managers knew their customers well and with prudence and local knowledge were prepared to go beyond the bounds of short-term lending.16 Where local, personal connections were unavailing, banks would simply not lend to enterprises. Gustav Mevissen, a co-director of the Bank of Darmstadt, made the point with utmost clarity in an instruction to the bank management written at midcentury: The task of our bank is not to attract the business of industrial and commercial enterprise in general. On the contrary, it will be our mission to establish contact with all government institutions, joint-stock companies, and wealthy private per- sons in the hope of obtaining as large a share of the business of governments, of princes and principates, as well as joint-stock companies and wealthy private persons as possible.17 By the middle of the century banking evolved into a more impersonal and professional activity under the pressure of two circumstances. The rst circumstance was the rise in individual deposits and the simultaneous decline of bank equity and note issuing. Until midcentury, there were only two main ways of procuring capital in 14. Assets are the left-hand side of a balance-sheet , and liabilities are the right-hand side. Assets are investments, which banks nance with resources or liabilities. Assets and liabilities are arranged ac- cording to maturity. Short assets typically include cash, loans to the stock market, short-term government debt, three-to-six-month credit advances (also called overdrafts), and commercial paper (bills of ex- change, acceptances). A bill of exchange is a buyer’s promise to pay in three months; the seller can cash it immediately with a bank. An acceptance is an international bill of exchange. Long assets include longterm government debt, participations in other joint-stock companies, and all loans or advances with a maturity longer than six months. Short liabilities include deposits, positive current accounts, and, in some cases, notes. Long liabilities include equity (capital and reserves). 15. Lamoreaux 1994. 16. Cottrell 1992, 53. 17. Tilly 1986, 121. Capital Market Internationalization 5