Debt Into Growth: How Sovereign Debt Accelerated the Industrial Revolution

Debt Into Growth: How Sovereign Debt Acceleratedthe Industrial Revolution

Jaume Ventura (CREi, UPF and Barcelona GSE)

Hans-Joachim Voth (University of Zurich)

September 2-3, 2016

Ventura and Voth ( ) Cambridge-INET conference September 2-3, 2016 1 / 28

Debt and Expenditure in the UK, 1692-1860


Growth of Output in Britain, 1700-1860


Estimates of Productivity Growth in England, 1770-1860


Real Wages in England, 1700-1850


The Question

Why did the country that borrowed the most industrialized first?

Answer 1 : Debt accumulation was detrimental to industrialization bycrowding out investment and slowing down growth (Williamson 1984)

But crowding-out should work through interest rates, and these did notincrease (Mirowski 1981; Clark 2001, Quinn, 2001, Sussman and Yafeh 2004,Heim and Mirowski 1987)

Answer 2 : Debt accumulation was neutral to industrialization, since it raisedtotal savings and did not crowd out investment (Barro 1987)

Our answer : Debt accumulation accelerated industrialization!


Building blocks of our argument

The Industrial Revolution is the arrival of a new class of capitalists withbetter technologies, but few savings

I Hansen and Prescott (2001)

The financial system cannot channel funds from nobles to capitalists, and thelatter finance investment with reinvested profits

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 investmentsI This lowers the demand for labor and wagesI This raises profits and the high-return investments of capitalists


Documenting financial 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 savingswere full enough, but conduits to connect them with the wheels of industrywere few and meagre ... surprisingly little of [Britain’s] wealth found its wayinto the new industrial enterprises ...” (Postan 1935)

About 74% of the wealth was in land and buildings

I Limited trading (leaseholds, perpetual trusts)

Dynamic ineffi ciency?

I 117 out of 160 years: growth rate > return to government bondsI Agricultural investments 1770-1810: I = £ 138m. >> rK= £ 43m.


Yield on Government Bonds and Returns to Enclosure,1692-1860


UK Debt Dynamics, 1700-1913


The pre-industrial economy

Technology and factor markets:

I Production function: yt = A · lλt · kαt · n1−λ−α

t

I Land and labor in fixed supply: lt = nt = 1I To produce one unit of capital, one unit of goods is neededI 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 fights foreign wars that cost a fraction x of output

Dynamics: kt+1 = β · (λ+ α) · (1− x) · A · kαt

Steady state: k∗ = [β · (λ+ α) · (1− x) · A]11−α


A stylized model of the Industrial Revolution

Assume a new class of capitalists arrive:

I Like capitalists, they save a fraction β of their incomeI Unlike capitalists, ...

F ... to produce one unit of capital, they need 1/π units of goodsF ... 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. Weconsider two extreme cases:

I Frictionless credit marketI No credit market


Frictionless credit market

Assume there is a competitive private credit market:

I Capitalists finance their investments with savings of the noblesI 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 · stλ+ α

Steady-state:

k∗ = [π · β · (λ+ α) · (1− x) · A]11−α

s∗ = 0

The Industrial Revolution brings fast economic growth, little social changeand large gains in the living standards of the masses


The capital stock and the share owned by capitalists


Consumptions of the different groups


No credit market

There is no private credit market due to some unspecified friction

Dynamics:

kt+1 = β · [λ+ α · (1+ (π − 1) · st )] · (1− x) · A · kαt

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)11−α

s∗ = 1− λ

α · (π − 1)The Industrial Revolution brings slow economic growth, fast social changeand small gains in the living standards of the masses






The role of sovereign debt

Assume now that the arrival of the capitalists coincides with a shift fromtaxes to debt:

I Foreign wars without raising taxes: dt+1 = Rt · dt + x · A · kαt

I Nobles willing to buy debt: Rt = α · A · kα−1t

I Capitalists not willing to buy debt: π · α · kα−1t > Rt

Isn’t sovereign debt just a means to postpone taxes? Yes, but you canpostpone them forever if:

I π · β > 1 (noble investments are dynamically ineffi cient)

I x ≤ π · β− 1π − 1 · λ (the debt does not exceed the savings of the nobles)


The role of sovereign debt

Dynamics:

kt+1 = β · {[λ+ α · (1+ (π − 1) · st )] · kαt + Rt · dt} − dt+1

st+1 =π · β · α · st · kα

tβ · {[λ+ α · (1+ (π − 1) · st )] · kα

t + Rt · dt} − dt+1

Steady state:

k∗ = (π · β · α)11−α

s∗ = 1− λ

α · (π − 1) +x

α · (π · β− 1)

Debt accumulation slows down the Industrial Revolution initially, but thenaccelerates it afterwards and takes it to a higher steady state






A numerical exercise

Is it possible to use such a simple framework to obtain a sense of thequantitative importance of the mechanism that we highlight here? Theanswer is yes, if you add depreciation!

With reasonable parameter values we find that:

I With debt it takes about 170 years to travel half the way towards the newsteady 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


Debt-to-income ratio


Social change


Income per capita


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 quicklyI 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 1900I 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 industrializationI Sovereign debt crowded-out nobles’investment and kept wages low


Lessons for today

Is sovereign debt always growth enhancing? No, of course, just look at theseminal work of Reinhart and Rogoff!

This model does not have much to say, for instance, about the recentsovereign debt crisis in the periphery of Europe (Broner et al. 2014)

But this model might have something interesting to say about Chinesegrowth with the following role assignments:

I The “crown”: USA and, to some extent, EuropeI The “nobles”: China’s government (state-owned banks and enterprises)I The “capitalists”: China’s new entrepreneurial classI The “masses”: China´ s workers


Economy & Finance

Debt Into Growth: How Sovereign Debt Accelerated the Industrial Revolution