Debt Into Growth: How Sovereign Debt Accelerated the Industrial Revolution
1. Debt Into Growth: How Sovereign Debt Accelerated
the Industrial Revolution
Jaume Ventura (CREi, UPF and Barcelona GSE)
Hans-Joachim Voth (University of Zurich)
September 2-3, 2016
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2. Debt and Expenditure in the UK, 1692-1860
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3. Growth of Output in Britain, 1700-1860
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4. Estimates of Productivity Growth in England, 1770-1860
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5. Real Wages in England, 1700-1850
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6. The Question
Why did the country that borrowed the most industrialized …rst?
Answer 1: Debt accumulation was detrimental to industrialization by
crowding out investment and slowing down growth (Williamson 1984)
But crowding-out should work through interest rates, and these did not
increase (Mirowski 1981; Clark 2001, Quinn, 2001, Sussman and Yafeh 2004,
Heim and Mirowski 1987)
Answer 2: Debt accumulation was neutral to industrialization, since it raised
total savings and did not crowd out investment (Barro 1987)
Our answer: Debt accumulation accelerated industrialization!
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7. Building blocks of our argument
The Industrial Revolution is the arrival of a new class of capitalists with
better technologies, but few savings
I Hansen and Prescott (2001)
The …nancial system cannot channel funds from nobles to capitalists, and the
latter …nance investment with reinvested pro…ts
I Temin and Voth (2013)
In this setting, sovereign debt accelerates structural change and growth:
I Nobles buy the debt and reduce their low-return investments
I This lowers the demand for labor and wages
I This raises pro…ts and the high-return investments of capitalists
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8. Documenting …nancial frictions
Private credit markets worked poorly (Goldsmith banks for the nobles,
Merchant banks for trade, Bubble Act restricts equity)
I One book by two prominent economic historians: Temin and Voth (2013)
I One quote from a prominent historian of the period: “the reservoirs of savings
were full enough, but conduits to connect them with the wheels of industry
were few and meagre ... surprisingly little of [Britain’s] wealth found its way
into the new industrial enterprises ...” (Postan 1935)
About 74% of the wealth was in land and buildings
I Limited trading (leaseholds, perpetual trusts)
Dynamic ine¢ ciency?
I 117 out of 160 years: growth rate > return to government bonds
I Agricultural investments 1770-1810: I = £ 138m. >> rK= £ 43m.
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9. Yield on Government Bonds and Returns to Enclosure,
1692-1860
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10. UK Debt Dynamics, 1700-1913
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11. The pre-industrial economy
Technology and factor markets:
I Production function: yt = A lλ
t kα
t n1 λ α
t
I Land and labor in …xed supply: lt = nt = 1
I To produce one unit of capital, one unit of goods is needed
I All factors are paid their marginal products
The pre-industrial economy contains nobles, masses and the crown:
I The nobles own land and capital, and they save a fraction β of their income
I The masses own the labor, and they do not save
I The crown raises taxes to …ghts foreign wars that cost a fraction x of output
Dynamics: kt+1 = β (λ + α) (1 x) A kα
t
Steady state: k = [β (λ + α) (1 x) A]
1
1 α
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12. A stylized model of the Industrial Revolution
Assume a new class of capitalists arrive:
I Like capitalists, they save a fraction β of their income
I Unlike capitalists, ...
F ... to produce one unit of capital, they need 1/π units of goods
F ... they have no land and start with a small share of the capital stock: s0 0
The impact of these capitalists depends crucially on the credit market. We
consider two extreme cases:
I Frictionless credit market
I No credit market
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13. Frictionless credit market
Assume there is a competitive private credit market:
I Capitalists …nance their investments with savings of the nobles
I Competition equalizes the interest rate to the return to investment
Dynamics:
kt+1 = π β (λ + α) (1 x) A kα
t
st+1 =
α st
λ + α
Steady-state:
k = [π β (λ + α) (1 x) A]
1
1 α
s = 0
The Industrial Revolution brings fast economic growth, little social change
and large gains in the living standards of the masses
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14. The capital stock and the share owned by capitalists
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15. Consumptions of the di¤erent groups
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16. No credit market
There is no private credit market due to some unspeci…ed friction
Dynamics:
kt+1 = β [λ + α (1 + (π 1) st )] (1 x) A kα
t
st+1 =
π α st
λ + α (1 + (π 1) st )
I Successful Industrial Revolution if π > 1 +
λ
α
Steady state:
k = (π β α (1 x) A)
1
1 α
s = 1
λ
α (π 1)
The Industrial Revolution brings slow economic growth, fast social change
and small gains in the living standards of the masses
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17. The capital stock and the share owned by capitalists
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18. Consumptions of the di¤erent groups
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19. The role of sovereign debt
Assume now that the arrival of the capitalists coincides with a shift from
taxes to debt:
I Foreign wars without raising taxes: dt+1 = Rt dt + x A kα
t
I Nobles willing to buy debt: Rt = α A kα 1
t
I Capitalists not willing to buy debt: π α kα 1
t > Rt
Isn’t sovereign debt just a means to postpone taxes? Yes, but you can
postpone them forever if:
I π β > 1 (noble investments are dynamically ine¢ cient)
I x
π β 1
π 1
λ (the debt does not exceed the savings of the nobles)
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20. The role of sovereign debt
Dynamics:
kt+1 = β f[λ + α (1 + (π 1) st )] kα
t + Rt dt g dt+1
st+1 =
π β α st kα
t
β f[λ + α (1 + (π 1) st )] kα
t + Rt dt g dt+1
Steady state:
k = (π β α)
1
1 α
s = 1
λ
α (π 1)
+
x
α (π β 1)
Debt accumulation slows down the Industrial Revolution initially, but then
accelerates it afterwards and takes it to a higher steady state
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21. The capital stock and the share owned by capitalists
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22. Consumptions of the di¤erent groups
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23. A numerical exercise
Is it possible to use such a simple framework to obtain a sense of the
quantitative importance of the mechanism that we highlight here? The
answer is yes, if you add depreciation!
With reasonable parameter values we …nd that:
I With debt it takes about 170 years to travel half the way towards the new
steady state, while in the absence of debt it takes 225 years
I With debt it takes 125 years for capitalists to take over 70% of the capital,
while in the absence of debt it takes 278 years
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27. Financial frictions and the Industrial Revolution
Why was growth slow at the start of the Industrial Revolution?
I Lots of inventions and innovations appeared rather quickly
I Financial frictions limited investment by capitalists
Why did the Industrial Revolution generate massive social change?
I Nobles held all wealth and power in 1700, but had lost most of it by 1900
I Financial frictions kept the gains of industrialization in the hands of capitalists
Why did the Industrial Revolution not raise the living standards of workers?
I Real wages did not grow much during the core phase of industrialization
I Sovereign debt crowded-out nobles’investment and kept wages low
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28. Lessons for today
Is sovereign debt always growth enhancing? No, of course, just look at the
seminal work of Reinhart and Rogo¤!
This model does not have much to say, for instance, about the recent
sovereign debt crisis in the periphery of Europe (Broner et al. 2014)
But this model might have something interesting to say about Chinese
growth with the following role assignments:
I The “crown”: USA and, to some extent, Europe
I The “nobles”: China’s government (state-owned banks and enterprises)
I The “capitalists”: China’s new entrepreneurial class
I The “masses”: China´s workers
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