Download Export Capital and Inflows

Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
“Export of capital itself was probably not harmful to the British economy after 1870, but the inflows of
income thus generated did have detrimental consequences. Discuss.”
After a century of supremacy, the end of the Victorian era brought with it an end to Britain’s
dominance in the global league table. More precisely, the relative decline of the British economy occurred
during a specific period, from 1870 to 1914, when Britain lost ground on both relative and absolute
economic growth, and lost its cherished position as the technological and industrial engine of the world.
As with any historical “incident” of this magnitude, many academics avidly search for its causes
and assume that if they can pinpoint a reasonable causal relationship that survives basic statistical analysis,
there is no doubt that they have found the causal explanation. In economics however, unlike many other
sciences, the simplest solution is rarely the best. The obvious causation for the contemporaries of the period
was a case in point. The second half of the 19th century saw a substantial growth of capital exports that was
not matched by imports. The argument was that “too much” capital was leaving the country, benefiting
Britain’s rival nations rather than beneficially increasing Britain’s stock of housing, for example, and
funding for other social projects. At first sight, this assertion seems to fit in with common sense; if there is
a net export of capital, the immediate and short-term effect is that this capital is not being used
domestically. More recently though, the causes of Britain’s slowdown have been thrown into contention as
more complete theories and fresh empirical evidence are invalidating the assertion. One such theory is that
the social benefits of capital exports outweighed its costs, but the flow of income generated by foreign
investments had detrimental effects and could of helped caused Britain’s fall from grace.
I will start by painting a broad picture of Britain’s economic situation at the beginning of the
1870’s before explaining both why there was such an increase in capital exports and why this was not
necessarily a bad thing. I will then be able to explain the theory behind the damaging effects of foreign
income inflows and attempt to balance these against the benefits of capital exports.
To determine the effects of the impressive growth in capital exports, the first questions needing to
be answered are what prompted Britain to export so much and what the nature and scope of foreign
investment was. Over the period 1870 to 1913, capital exports averaged around 5% of GNP, but this rate
increased to 7% from 1905-1913 and 9% in 1911-1913. Particularly interesting figures are international
comparisons of saving rates and domestic investment. Savings rates were similar in Britain, Germany and
the USA, standing around 11% to 15%, but domestic investment was a paltry 7% of GNP for Britain and
12% in Germany and the USA over the same period. We can immediately see that Britain exported much
more than the other two countries; the difference between the domestic saving rate and domestic
investment assumed as being the savings exported from the country. The third equally impressive figure to
bare in mind is the amount of wealth Britain had accumulated abroad. Net overseas assets grew from
around 7% of net national wealth in 1850 to around 14% in 1870, and around 32% in 1913 or a total of
around £4 billion.
Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
The target of British foreign investment shifted from being mainly directed to Europe in the early
1850’s to targeting the Empire, the USA and Latin America from the late 1860’s onwards. Of the
proportion of the £4 billion spend on securities for overseas investment, North America received 34%,
South America 17%, Asia, Europe, Australia and Africa each received between 11-14% of the rest. The
type of investment being financed in these countries was predominantly investments in railways, attracting
a stable 40% of all investment. Other public works and utilities attracted around 23% of British capital and,
although still minority investments, the portion of investments going to agriculture, mining and
manufacturing rose over the period.
Before answering the subjective question of whether or not Britain exported too much capital, we
must ask ourselves why there was such an exodus of capital. Was it based on rational behaviour, as would
predict the neo-classicists, or was it the “herd” effect to which investors so often fail to distance themselves
from? The theoretical neo-classical interpretation of the scale of foreign investment is based on the
assumption that investors, as rational beings, seek to maximise their returns on any investments they
undertake. By choosing to invest overseas rather than domestically, benefits accrue to society from the
higher returns, thereby raising national income. Had the flow of overseas investment being curtailed and
switched to domestic use, it was argued that returns would have been severely reduced. As Russel Rea
stated in the House of Commons in 1909, “We have built a vast and profitable system of railways in
Argentina. Would my hon. Friend have preferred to duplicate the Great Western System? In the one case
we a get a good return for our money, in the other we should simply have destroyed a good property.” On
the other side of the argument, many pragmatists at the time argued that there was no rationale behind
investors’ preference for foreign investment. The City, edged on by its own profit maximising appetite,
would channel as many funds through to foreign investments, as these would create further business for
them in the form of insurance and shipping operations. In this way, with the City sending over 70 % of all
funds abroad, it was argued there was a bias towards capital export in financial markets. Moreover, as the
larger outflows of capital exports came in short bursts, the image of many small investors dumbly and
suddenly following the herd can easily be envisioned.
More recently, it has become evident that these types of expositions are not sufficiently developed
to warrant any accurate conclusion. The analysis of British capital exports must be based on a complete
cost benefit analysis backed by factual evidence.
First, we need to answer what caused investors to favour foreign investments to domestic ones.
The neo-classical theory underpinning rational investor behaviour is that, once risk is taken into account, he
will always favour the highest rate of return. The evidence from the period points to a substantial
differential between expected rates of return, foreign ones generally beating domestic rates, even once risk
is taken into account. Edelstein’s analysis of the average risk-discounted returns of British and foreign
securities between 1870 and 1913 seems to confirm the neo-classical theory, as foreign ones consistently
beat domestic ones. Using this analysis, the conclusion was postulated that there never was too much
capital exported, but the averages used by Edelstein mask the real process that was going on. In fact, not
only does the technique of averaging over 43 years lose much of its significance, but it also does nothing to
explain the large, so called “Kuznets” swings in investment targeting foreign or domestic securities.
Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
Moreover, the technique does not take behavioural risks or similar components into answering the
questions as to why there was so much foreign investment or if the level was excessive.
The Kuznets swings from 1870 to 1913 show overseas returns dominating domestic returns in the
periods 1877-96 and 1897-1909. The actual investments rates remain fairly closely correlated, with net
foreign investment as a proportion of GNP (NFI/GDP) increasing over the two aforementioned periods of
higher overseas return rates. However, there is still some divergence such as the rise of NFI/GNP from
1862 to 1871, suggesting other factors not included in the rational neo-classical model. The bursts in
British investment seem to be explained by the lumpiness of these investments, notably the large social
overhead projects needed to be undertaken in regions with virtually no savings resources and inappropriate
capital markets. These types of investments, although typically portfolio investments with limited control
over management, provided great opportunities in which returns were sometimes guaranteed by
governments. In the case of railways for example, they would also bring favourable returns in the long
term, as the region would come to rely on this infrastructure as an engine for its growth.
Two other elements leading to the attractiveness of overseas investment should be noted. The first
is that foreign investment offered a good form of portfolio diversification. It allowed investors to diversify
into completely new markets where technology was radically altering the economies of the regions, with
consequences on trade, and hence, the components of the world economy. The second important element to
bear in mind is that other constraints not modelled by the risk premiums arguably existed more in domestic
investments that in the overseas ones. The most notable constraints on domestic investments were the
difficulties associated with gathering accurate company information and the type of domestic investments
competing with foreign ones. Unlike Germany and the US, Britain did not have the big investment banks
that nurtured companies from their birth and helped manage their accounts and investments. Also, domestic
demands for capital were sometimes of the type needed to bail out ailing companies or prevent bankruptcy,
clearly less inspiring to the investor that a foreign large-scale railway construction for example. Most
worryingly, laws surrounding the accurate disclosure of company information were so lax that investors
were frightened to invest domestically, especially after many incidents where deceitful or fraudulent
information was given to investors, thereby denting the credibility of genuinely sound companies and their
ability to raise capital. Due to this and the fact that foreign investments generated healthy secondary
businesses in shipping and insurance, the accusation that the city was biased to overseas markets is
probably accurate. At least in the sense that it was easier to orchestrate investments where the costs and
returns of social overhead projects where beginning to be well known, rather than have to rely on the
misleading accounts held by directors of domestic companies.
Having discredited the neo-classical model for the period and determined the nature and scope of
overseas investments in relation to domestic ones, it is now possible to approach the certainly more
subjective question of whether or not capital exports had a beneficial impact on the UK economy.
Much emphasis by historians on this question is linked to the idea of push and pull effects
operating to support capital exports. Was capital being “pushed” out of the country by excess savings and
fading home returns, or was it simply being “pulled” out of the country by higher foreign returns. The
econometric evidence suggests that the pull force overrode the push force for the 1860’s and early 1870’s.
Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
The gap, mentioned earlier on, between overseas and home risk-adjusted returns could be seen as a
disequilibrium, as investors reacted to the new opportunities abroad. Later on, it appears that the push
forces had a slight dominance over the pull forces, through a combination of diminishing returns at home
and an increasing saving rate by the agents most likely to invest. If such push forces were prevalent and
dominated the pull effects for some time during that period, we can ask ourselves if these caused a
divergence between the private costs and benefits of overseas investments and the social costs and benefits.
If this was the case, we need to look at significant costs and benefits of capital exports and separate the
social and private portions.
First, a popular social cost argument was that the risk of defaulting or bankruptcy by foreign
debtors was higher and had greater consequences than defaults by domestic debtors. It was argued that if
there were a domestic default or bankruptcy, at least the capital would stay in the UK rather than disappear
abroad. However, if the capital had not been profitable, it is not always obvious that it could or would have
a better use elsewhere. Moreover, overseas capital would still belong to British investors and used again if
there was a need to do so. Ultimately though, it is not possible to conclude on this argument without
calculating the approximate monetary costs of such situations, both domestically and overseas. In fact, the
total actually lost overseas, approximately £500 million, is short of the £640 million which would have
been necessary to equilibrate the risks of domestic and foreign investments. 1 We can conclude that there
certainly was no extra social cost from foreign defaults and that foreign debts or bankruptcy would either
happen to a lesser extent than domestically, or that the capital had a greater chance of being recoverable.
Second, the argument that capital should have been put to domestic use, even if this meant
forgoing higher foreign returns was popular at the time. This is a difficult argument to disprove because the
outcome of such a shift can only be hypothesised. It is however clear that the investor will usually only be
worried with the private consequences of his investment and not the social ones. It is also clear that there is
a much potential for social costs and benefits to diverge from private ones in capital investments, such as
housing and education. However, one flaw in the argument was that it was almost an assumption that
capital could simply be shifted from foreign to domestic investment, without taking into account such
elements as elasticities. It is very probable that if capital exports had been restricted, the UK’s total level of
investment would have fallen and the rate of return on domestic investments would have fallen further. The
counter-argument for this is the so-called “Hayek effect” and the failure to look at dynamic effects of
investment. Hayek showed that investments, such as repairs and infrastructure improvements, could often
raise the returns of capital already in place. Had funds been diverted to domestic use, it was argued that
diminishing returns would not necessarily step in because of the “Hayek effect”, but also because of
technological improvements. As technology changed, implementing it as new capital was seen as crucial to
sustaining economic growth and diversifying into new industries. Some estimates of the effect of diverting
funds to domestic use, even without altering the state of technology, would have raised British GDP by
38.8% by the outbreak of the war2. This is however a very unlikely outcome as a reduction in capital
exports would have lead to higher import prices, especially food prices, no interest payments or dividends
and a fall in the secondary industries assimilated with high levels of capital exports. It is therefore probably
1
2
The economic history of Britain since 1700. P192.
Capital Exports, 1870-1914. Sydney Pollard. P503
Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
more likely that the extra investment would have gone into agriculture or consumption rather than
manufacturing.
As for the benefits of capital exports, they come in three main flavours. The benefit of being able
to import cheaper food and primary produce, the benefit of generating further secondary services in the
City with insurance and shipping, and the benefit of increasing the demand for British exports in the longer
term. The first of these, cheaper import prices, came about due to the important use of capital investments
in transport and the extractive industries. By increasing the productive potential of foreign economies and
reducing the costs of using more productive resources, the total cost and hence the import prices of these
produce fell. The terms of trade, the ratio of British export prices to import prices, therefore increased
consistently by 0.1% per year (Imlah 1958). The second positive aspect of capital exports was that it
sustained and boosted the British shipping industry. Two-thirds of incomes from services came from
shipping and, between 1860 and 1910, Dean and Cole estimate shipping contributed 4% to 5% to national
income. The British fleet was the largest in the world, transporting more than half of Britain’s trade and a
large proportion of other country’s trade. This was in turn insured by British insurers and Lloyds was said
to insure almost every ship in the world. Capital exports therefore boosted international trade, which in turn
boosted British shipping and insurance companies. Lastly, capital exports are likely to have had long term
effects on Britain’s exports to these countries. The countries in question were lifted to a higher level of
wealth, allowing them to import more finished goods from developed countries including Britain. The only
problem with this “benefit” being that other developed countries, having improved their export industry
rather than finance foreign capital formation, were, in a sense, free-riders at the expense of Britain.
Overall though, we can safely conclude that capital exports did not harm the British economy and
a total cost-benefit analysis would most certainly point to the fact that they were beneficial both privately
and socially. Their effect on the Balance of Payments (BOP) and in particular, the reverse flows of Interest
Payments and Dividends (IPD) rewarding investors for their capital exports, is, however, one of the areas
which could have had detrimental consequences to the UK economy.
From 1856 to 1875, as the level of capital exports grew at unprecedented rates, more capital was
flowing abroad than interest flowing back. Income from services made up the balance. After about 1875,
the level of IPD overtook the value of all British foreign investments. Overseas income as a proportion of
GDP rose from 2.0 per cent in 1872 to around 7 per cent in 1913 3. To explain why this income may have
had detrimental effects, it is important to dissect Britain’s Balance of Payments (BoP) over the period.
The trade balance over the period followed a volatile, but overall downward trend, with a large
deficit between 1890 and 1906. This was as a result of many transformations to the economy, particularly
following the decline of once important industries such as the cotton industry and the rapid industrialisation
of the US and Germany, taking a share of the export market. One crucial part of this process could have
been nourished by the effect of overseas income on the BOP. Breaking the current account of the Balance
of Payments down, the balance of trade was generally in deficit, whilst the balance on invisible trade,
spurred by shipping and insurance, was in surplus. The rapid rise of the level of IPD further improved
Britain’s balance of payments position, increasing British prices and national income and thereby denting
3
Rowthorn and Solomou. Economic History Review. 1991. P 654
Andrew Nutter
[email protected]
Economics
Sara Horrell
16/04/99
the competitiveness of British exports. Two effects are thought to have deteriorated the balance of trade;
the so-called “Dutch disease” and the “absorption” effects.
The Dutch disease explanation states that, as overseas incomes increase and exports become
uncompetitive, the price of exports fall relative to the GDP deflator, and rise relative to the price of imports.
The absorption effect on the other hand, rather than focusing on relative price changes, predicts that
changes in overseas income have a direct effect on national consumption patterns. In times of rising
overseas income, a rise in consumption is then most likely, which, if domestic production is unable to cope
with, leads to a worsening of the trade balance. The consequence of these effects is that a country with high
and growing levels of overseas investment will find its trade balance worsening, and the UK seems to be a
good country on which to test the theory. As overseas income grew rapidly from 1870 to 1913, the trade
balance deteriorated in a systematic way. Rowthorn and Solomou have attempted to quantify the extent to
which the Dutch disease and absorption effect deteriorated the trade balance. The result of their analysis
shows that the Dutch disease effect had little significant effect on the long-run trend of the deteriorating
trade balance. The evidence to discredit the Dutch disease effect hinging on the lack of any notable
correlation between the real exchange rate movements and trade balance movements, except in a short
period during the Edwardian period. The absorption effect, on the other hand, did have a notable effect on
the trade balance. They calculated that the marginal propensity to consume out of overseas income was
0.53, a reassuringly similar value to the consumption propensity out of domestic income. They then
conclude that with a high correlation between the rise in overseas income and the worsening trade balance,
it is possible to causally link the effect on the trade balance to the absorption effect.
Nevertheless, such arguments can be as easily discredited as they can be supported. The trade
process is almost too complicated to fully understand, and I believe it is impossible to draw such a direct
causation. It is not justifiable to attribute the deterioration of the trade balance solely on the absorption or
Dutch disease effects of overseas income. There is no doubt there were many other causes of the worsening
trade deficit, not least the advance of other developed industries in once “monopolised” industries and the
fact that imports mainly constituted of food and primary produce, not the type of goods that the absorption
effect would predict. The only firm conclusion we can draw is that the growth of overseas income did have
some detrimental consequences on the UK economy, but is not all to blame for the worsening trade deficit.
As for capital exports, they appear to have had tangible and beneficial consequences to the UK
economy. The net benefit or cost between the consequences of capital exports and overseas income is
almost impossible to measure. One would however assume that internationally at least, the long term
benefits of Britain’s capital investment, to the target countries and other countries involved in subsequent
trade, largely surpass its costs, such as debt repayment. The far more subjective questions of whether or not
it was “fair” for Britain to “subsidise” other countries benefits from lower import prices at the expense of
its domestic industries, and whether it is desirable to live as a rentier nation, should then be answered.
Interesting questions unfortunately outside the scope of this essay.