Growth and Business Cycles in the 19th century

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Growth and Business Cycles in the 19th century

• The Role of Financial Markets Part I

2
Overview

• Organisation of the Course
• Introduction into the Course
• What we want to explain
• How Financial Systems Can be Compared
• The Financial System of the UK
• The Financial System of the US
• The Financial System of France
• The Financial System of Germany
• Summary

3
Outline

• First two sessions of introduction (today and
  next week)
• Then everyone chooses a subject, signs for the
  course, and decides on a date for the
  presentation
• Seminar papers will be due at the end of
  September
• Attendants of Part II of the course will write
  about an empirical/theoretical topic and present
  it at a block seminar around mid-September

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Grading

• Oral weight 1/3
• Participation in discussions will be graded every
  lesson (1/4 of oral grade)
• Presentation will be graded (1/4)
• Non-attendance or being late frequently will
  lower the grade (1/4)
• Compulsory reading will be graded (1/4)

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Grading

• Compulsory reading I want you to read one
  article/book chapter every week (15-50 pages)
• To enforce it, I offer you two possibilities, to
  be decided now
• Either hand in a summary of one A4-page every
  week, where you additionally pose a question
  about the text
• Or you write a 5-minutes test in class every
  week, where you also ask a question about the
  article
• Each student can gain a point if the test/summary
  is ok. The overall grade accounts for 1/4 of the
  oral grade

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Grading

• Attendance A certificate of disability will be
  needed only in the case of long-term sickness. In
  this case, we should talk about an extra homework
  to compensate for the missed classes
• After each class, I will assign points for
  attendance, participation and reading

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Grading

• Seminar paper (weight 2/3 of total grade)
• 12-15 pages of plain text
• Max. 5 pages of appendix
• Subject to be chosen in 2 weeks time
• Literature should be discussed with me
• Formal criteria account for 1/3 of the written
  grade
• Structure accounts for another 1/3
• 1/3 goes to contents
• A handout will be provided about the formal
  criteria

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Grading

• Presentation
• It takes 15-20 minutes
• Optimally, questions should be allowed at any
  time
• A handout of 1-3 pages has to be handed in on
  Wednesday before the presentation
• Powerpoint or slides are strongly recommended
• Most important is if the audience listens and
  understands

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Organisation

• Schedule after subjects have been chosen, I will
  write a schedule for the rest of the semester
• No class on Fri, May 14 because of the
  Humboldt-Forum Wirtschaft
• We will try to get along without an extra session

10
Organisation

• Questions?

11
Overview

• About the Course ?
• Introduction into the Course
• What we want to explain
• How Financial Systems Can be Compared
• The Financial System of the UK
• The Financial System of the US
• The Financial System of France
• The Financial System of Germany
• Summary

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What we want to explain

• Why are growth and the business cycle different
  in industrialized nations?
• e.g. UK developed first in the 18th century,
  biggest economy worldwide at that time
• Other nations began to grow later, like Germany
  and the US
• The nations had booms and downturns at different
  times, although there was also a considerable
  amount of parallel cycles

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What we want to explain

• How are economic development in the 19th century
  and the financial sector related?
• Did industrialization in each country cause a
  certain financial system to evolve?
• Or were there already financial structures that
  enforced a certain economic development?
• Or can we explain growth and business cycles
  without regarding financial systems at all? (RBC
  theory)

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What we want to explain

• In this course, we assume that financial systems
  matter for the real economy
• How can we describe that relationship? This is
  subject of the course

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How can we approach that question?

• We will deal with the subject in a historical way
• That means we begin with describing the financial
  systems of major industrial nations up to World
  War I
• We will also use economic theory and see if it
  fits historical evidence
• In Part II of the seminar historical data will be
  used to test different hypotheses (alternatively
  theory can be covered in more detail)

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Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared
• The Financial System of the UK
• The Financial System of the US
• The Financial System of France
• The Financial System of Germany
• Summary

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How Financial Systems Can be Compared

• A common approach ist to differentiate between
  bank and capital market dominated systems (Allen
  and Gale (2001))
• Countries therefore can be ordered by their share
  of capital that is financed by capital markets or
  banks

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Ordering by the Share of Capital Financed by
Capital Markets
US
UK
France
Japan
Germany
Capital-Market Financed
Bank Financed
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How Financial Systems Can be Compared

• Other dimensions are
• External corporate governance (From hostile
  takeovers to Hausbank-system)
• Concentration of banks (Nationwide systems or
  not)
• The role of government (How much intervention?)
• The stability of the system (bubbles, bank runs)

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Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared ?
• The Financial System of the UK
• The Financial System of the US
• The Financial System of France
• The Financial System of Germany
• Summary

21
The Financial System of the United Kingdom The
Bank of England 1694

• No formal markets had been developed before 1700
• When Nine Years War (1688-1697) against France
  had to be fought, the government wanted to borrow
  money
• The Bank of England (BoE) was created in 1694 to
  help the government doing so
• It was a privately owned and profit-oriented
  institution and provided a 1,2 mio loan to the
  government for 100,000 annual interest
• It was allowed to issue bank notes as a
  substitute for gold in large transactions

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The Bubble Act 1720

• One of the first speculative bubbles ocurred in
  1720, urging the Parliament to pass an Act that
  restricted the founding of stock joint companies
  (company with pooled capital of its members and
  tradeable shares)
• The reason was that the shares of the South Sea
  Company had risen so high that similar companies
  were founded trying to get a piece of the cake
• The Parliament wanted to prevent that, because
  the South Sea Company funded a part of its debt,
  and the Parliament did not want capital owners to
  invest in other companies
• The price of the stocks fell, while the Act was
  passed

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London Stock Exchange 1802

• The formal institution was founded in 1802
• After the Bubble Act was abolished in 1824, and
  full freedoom to found companies was granted in
  1856, the number of publicly listed firms
  expanded significantly
• Before 1802, the capital market in London served
  first of all as an important instrument to trade
  government debt
• There was large demand for capital through
  economic growth, which spurred the Exchange

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Private Banks

• In 1742, the BoE was granted the monopoly for its
  right to issue bank notes, excepting private
  banks
• Before that, it had competed with other
  institutions
• London became Englands clearing center, so the
  private banks were divided into London banks
  and country banks
• At the beginning of the 20th century, five major
  nationwide networks had developed

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Industry Finance

• An important feature of the British banking
  system was that private banks did not engage in
  long-term lending
• One reason might have been the fear of bank runs
  in the 19th century
• Industry finance therefore was done by markets
• Small firms used family and friends to fund their
  financial needs

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Stability of the Banking System

• Last banking run 1866 (Overend, Guerney and
  Company crisis)
• Then, the BoE made clear that it always would
  provide sufficient liquidity to banks in a
  crisis, and systematic runs were avoided

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Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared ?
• The Financial System of the UK ?
• The Financial System of the US
• The Financial System of France
• The Financial System of Germany
• Summary

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The Financial System of the US

• Important steps of development between ca. 1850
  and ca. 1950
• Developed a market-oriented system
• Political history can explain much

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US Banks General Distrust Against Nationwide
Systems

• Due to the federal organisation of the US, there
  always existed a distrust against powerful
  institutions
• Nevertheless, with the BoE as an example, the
  First Bank of the United States was founded in
  1791 for a 20 years period, later the Second
  Bank of the United States was set up for 20 years
  from 1816 on
• After 1836, the Second Bank was not rechartered
• Foundation of banks was left to the states, which
  mainly did not regulate the banks (free entry)

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The Setup of a Federal Bank 1863

• The Civil War (1861-65) first led to
  reconsideration of the role of banks, because the
  federal government needed a bank to trade its
  debt
• The National Bank Acts 1863 and 1864 installed a
  national banking system
• However, could banks hold equity? (Important for
  industrial lending)
• Supreme Court decided no, which limited the banks
  importance

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Instability of the Banking System

• Since there was no powerful nationwide bank and
  state banks were not regulated effectively, the
  system was unstable
• Panics ocurred until approximately until 1933,
  when the Glass-Steagull Act insured deposits and
  prohibited commercial banking and investment
  banking in one house
• The Banking Act of 1935 extended the Federal
  Reserve Systems power, leading to stability
• Panics happened e.g. in 1837, 1857, 1873, 1884,
  1893, 1907, and 1933. Often, they lead to
  economic downturns and depressions

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New York Capital Market Spurred by Wars and Weak
Banks

• The NY capital market helped to finance Civil War
  needs and provided WW I-parties with funds
• The regulations of banks made them unattractive
  for industrial lending, thus letting companies
  going public and raising capital on the market

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The New York Stock Exchange

• The NY Stock Exchange (NYSE) is at the heart of
  NY capital markets
• First agreement of 24 brokers in 1792
  (Buttonwood Agreement)
• In 1817 the New York Stock Exchange Board was
  founded
• The name NYSE stems from 1863

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Capital Market Crashs With Paradox Effects

• Other than banks, capital markets still are
  likely to crash
• The crashs of 1929 at the NYSE caused the
  foundation of the Securities and Exchange
  Commisssion (SEC), and the regulation of capital
  markets
• Banks were even more restricted, the importance
  of capital markets apparently was increased (SEC
  might has increased the integrity of the market)
• The crash of 1987

35
Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared ?
• The Financial System of the UK ?
• The Financial System of the US ?
• The Financial System of France
• The Financial System of Germany
• Summary

36
The Financial System of France

• As in the United Kingdom, a speculative bubble
  led the limitation of stock markets
• But unlike the UK it was not eased in the 19th
  century, but as late as 1980
• Instead, a powerful banking system developed

37
The Mississippi Bubble

• The story starts with a Scotsman, John Law, who
  travelled around Europe with a business plan a
  bank issuing notes without 100 gold coverage
• Finally, he convinced the French regent in 1716
  of his idea and set up the Banque Générale, to be
  reorganized 1718 as the Banque Royale
• It issued bank notes with a limit set by the
  regent
• It was merged with the Compagnie dOccident
  (Louisiana or Mississippi Company)
• The share prices rose spectactulary and then
  crashed

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The Role of the Stock Market

• After the Mississippi bubble had burst, a stock
  exchange (Bourse) was opened in order to regulate
  the trade of stocks
• The French Revolution lead to the closing of the
  Bourse and the suppression of public companies
• Even as the bourse was reopened, French railway
  shares first were traded in London (1842-1845)
• The stock markets never became as important as
  long term bank lending
• The role of the French press, which was known to
  be corrupt, might have discounted the markets
  importance in France

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French Industrial Banking Crédit Mobilier 1852

• After the failure of the Banque Royale, the term
  banque was omitted in France and credit
  institutions were rather named caisse, crédit,
  société or comptoire
• Industrial banking was introduced by Jacques
  Laffite with the Caisse Générale du Commerce et
  de LIndustrie which failed in 1848, but the idea
  was resurrected with Crédit Mobilier by the
  Pereire brothers
• It served as a prototype for European industrial
  banking, and was developed further in Germany
• Other bank networks were founded by the
  government to serve different financial needs as
  savings banks (Crédit Lyonannais) or agricultural
  banks (Société de Crédit Agricole)

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Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared ?
• The Financial System of the UK ?
• The Financial System of the US ?
• The Financial System of France ?
• The Financial System of Germany
• Summary

41
The Financial System of Germany

• Political fragmentation was the determinant of
  the financial system in Germany prior the
  unification of the Kaiserreich
• A formal stock market was not founded before
  1871, before that markets played a minor role in
  industrial finance and traded government debt,
  the share of capital never rose above 25 percent
• Banks developed close ties to industry by
  long-term lending

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The Upcoming of the Large Credit Banks

• At the beginning of the 19th century at least for
  financial centres existed and banks were
  family-dominated Rothschild in Frankfurt,
  Oppenheim in Cologn, Heine and Warburg in
  Hamburg, and Bleichröder in Berlin
• With the French Crédit Mobilier as an example,
  joint credit banks (Schaffhausen, Darmstädter)
  were founded around 1850
• They provided industrial loans and mobilized
  capital by issuing shares
• Other banks with same statutes were founded, such
  as the Dresdener Bank (1870) and the Deutsche
  Bank (1872)

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Universal Banking

• The important distinction of German major banks
  and e.g. american or english banks was that
  germans used retail deposits to finance the loans
  they gave
• That means they combined commercial and
  investment banking
• This was introduced by the Deutsche Bank that was
  the biggest German bank already at the end of the
  19th century
• Other major banks also developed retail banking
  and spread with their branches over the whole
  country, creating large nationwide networks
• Regional diversification enhanced the ability to
  engage in different industries and diversify
  regional risk

44
Overview

• About the Course ?
• Introduction to the Course
• What We Want to Explain ?
• How Financial Systems Can be Compared ?
• The Financial System of the UK ?
• The Financial System of the US ?
• The Financial System of France ?
• The Financial System of Germany ?
• Summary

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Summary

• The US and UK developed market-oriented systems,
  whereas France and Germany created bank-oriented
  systems
• In the US, no nationwide banking-system was
  created, unlike the UK
• The ties between industry and banks are closer in
  Germany than in France
• Germanies Hausbanken developed without government
  regulation, while in Japan (not covered in the
  slides) the state significantly influenced the
  main bank system

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Open question

• Which system is best?

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Next Week, April 23

• In case we did not finish The remainings of the
  descriptive part
• Theory about the relationship of real and nominal
  variables
• Readings Burda/Wyplosz (1997) (undergraduate
  level, 16 pages in total)
• Ch. 10.5 and 10.6
• Ch. 14.4, 14.5 and 14.6
• Literature is found in the faculty library or can
  be copied at our institute