British capital outflows, 1870-1914: a globalsaving need perspective

Alex Armand

June 2006

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Contents1 Introduction 3

2 The development of Capital exports 32.1 Development, destinations and structure . . . . . . . . . . . . . 3

3 The nature of asset demand and supply 43.1 Saving rates, investments: the global saving need . . . . . . . . 43.2 Returns and Diversification . . . . . . . . . . . . . . . . . . . . . 63.3 Supply side and preferences . . . . . . . . . . . . . . . . . . . . . 8

4 Trade or Capital Markets? 9

5 Conclusion 11

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1 IntroductionA massive amount of capital outflows from Great Britain characterized theperiod between 1870 and 1913 and shaped deep economic consequences all overthe world. This persistent trend directly influenced the British economy bygenerating an astonishing increase in its share of overseas income. As we canobserve in Figure 1, this share passed from around 2% of GDP in 1870 to morethan 6% at the turning of the century and then, after a small down-turning,again above 6% in 1913. Why such an important flow of capital was leakingBritain toward overseas countries? Which were the main forces driving such aphenomenon? In order to understand the reason for such a gigantic outflow ofcapital from Britain, it is necessary to understand the dynamics of its courseand the main force that were determining the asset demand and supply, then torecognize if capital markets were the main force driving such phenomenon andcontrast it with trade related factors. Figure 1 Share of overseas income as apercentage of GDP, 1870-1913 (Feinstein, 1972).

Moreover, it is important to understand that the period during the which Britishcapital outflows consistently coincides with a larger and global phenomenon,known by historians as the First Wave of Globalization. The decades between1870 and World War I have been determined by free capital mobility, free trade,mass migration flows, the Gold Standard and an international system mainlyruled by British hegemonic power. Under the perspective developed in thepaper, this global phenomenon has to be fixed as central, since the deep changesin the international system could explain the magnitude of capital mobility fromGreat Britain in the way they allowed for exchanges between countries withsaving-investment surpluses and countries characterized by deficits.

2 The development of Capital exports

2.1 Development, destinations and structure1

From 1865 to 1914, Britain totally raised around 4.1 billion for investmentsoverseas, but capital already began to outflows forcefully after 1855, rising atan average rate of 4% GDP per year. This tendency resulted in an increase ofthe share of net stock of overseas assets over the total wealth stock, from 8% in1855 to 33% in 19132 . Following Stone (1999), we can focus on the period ofthe major increasing trend in capital exports and divide it in six sub-periods,from 1870-1913. As it can be observed from the figure 2, the course has beencharacterized by different series of increases and down-turnings: in general twoincrease-decrease patterns characterized the first three period, resulting in arelatively small difference between 1870 and 1893. From fourth to sixth period,

1Stone (1999), Edelstein (1994).2Edelstein (1994).

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the trend recorded instead a strong increase, reaching the peak just before WorldWar I in 1914, with a flow of around 9.5 times higher than the flow in 1870.

The main characteristic of British capital exports was the concentration, inthe sense of country destination, investment channel and financial instruments.Even if Britain was exporting capital toward 150 countries in the world, almosthalf of the total exports during 1865-1914 was concentrated in United States,Canada, Argentina, Australia and India, while around 90% flowed to around25 countries (among which British colonies or possessions). In some senses,it is surprising that the majority of flows were designated to countries outsidethe Empire. In fact, only 40% of the total capital exports went to the Empire,where investments in raw materials were preferred. In both destinations, privateindustry investments were predominant.

Government bonds (mainly in Australia, South Africa, India and Brazil) andrailroad securities (prevalent in Northern America and Argentina) were the mainchannels of capital exports and were representing around two thirds of the ag-gregate value. In term of financial instruments, British capital exports weremainly concentrated on fixed-interest obligations: in fact, debentures and pref-erence shares were composing around three fourths of total flows, while equitieswere representing 23% and notes just 3%. Then, assuming a risk rationale ininvestment decisions, capital flows were more related to portfolio investments,instead of direct investments, in which the risk for large scale projects (such asrailways) is relevantly higher.

3 The nature of asset demand and supply

3.1 Saving rates, investments: the global saving need3

This perspective is basically related to the concept of investment-saving behaviorand to the notion that in a closed economy, national investments and savingsmust be equal in every period. However, in an open economy, this identitydoesnt necessarily have to be equal in every period. In fact, if the national sav-ings exceed national investments, the excess can be lent by savers abroad: thisdifference can then be considered a major force driving capital outflows if thenet amount of British net foreign lending equals the imbalance. Since the period1870-1914 (known as the first wave of globalization) has been characterized byunprecedentedly high degree of openness, an explanation of capital flows cannotavoid to focus on international equilibria and dynamics, i.e. the relation be-tween national savings and investments. A global saving need, which generatedexchanges in capital between countries with saving-investment surpluses andcountries with deficits, could then explain the quick increase in capital outflowsfrom Great Britain toward overseas countries.

3As Bernanke emphasized on U.S. current account deficit in 1990s.

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In the years between 1870 and 1913, Britain economy was running an excess ofnational savings relatively to national investments, but what was generating thisdisequilibrium? In its famous critique to Imperialism in 1902, Hobson claimedthat Britain had a bad distribution of income, which was generating in theperiod an excess of savings relatively to national investments. This must havebeen the main reason for such an important capital outflow in the history ofBritain, driving down the domestic returns and reducing domestic consumption.Other evidence comes from Edelstein (1994), who found that British investmentswere lower than the level of savings, reaching two peaks in 1877 and 1901; hefound surprising that following these two peaks, a rapid expansion in overseasinvestments recorded in 1879 and 1904. Evidence suggests then that in the lastpart of the XIXth century, Britain was generating an excess on national savingsin relation to domestic investments: the characteristic of income distribution,which generated a higher level of savings relatively to investments, can then beassumed as a central characteristic of British Victorian economy.

It is not surprising that that the sharp increase of capital outflows from Britaincoincide with the most important emigration flows in XIXth century. A de-mographic analysis is then necessary to understand the global need for capitaland then the role of Britain. In the period between 1870 and 1914 around 60million people emigrated from resource-scarce and labor-abundant Europe toresource-abundant countries overseas. The destinations were mainly representedby Argentina, Australia, Brazil, Canada, New Zealand and United States, notsurprisingly even the main destinations of British capital. Moreover, the needfor savings came as well from the composition of emigrants: more than threequarters of immigrants, who went to the United States, were from 16 to 40years old, namely their composition were skewed toward younger generations.This characteristic, generating higher propensities to consume, tied to the lowincome of the high majority of immigrants can explain the strong need for for-eign savings. The growing number of immigrants, the high fertility and the lowinfant mortality generated fast population and labor force growth in the over-seas regions, which in turn created a strong need for investments in capital4 .High dependency rates could then be the reason for high requirements for for-eign savings in order to exploit investment possibilities, creating a strong linkwith British excess of savings. Moreover, differences in income and in popula-tion distribution can clarify the capital outflows in 1870-1914 toward overseascountries especially from United Kingdom. Observing Figure 3 and the data forGDP per capita, in 1870 Great Britain disposed of a relatively higher income.In this year, Great Britain generated a GDP per capita of 3.263 US$5 , whilesome overseas countries were significantly poorer, than returns to capital wouldbe higher and demand for savings stronger: in the same year, United Statesrecorded 2.457 US$, while Canada and Argentina produced less than half rela-tively to Great Britain, with respectively 1.620 US$ and 1.311 US$. Moreover,

4Green and Urquhart (1976), Edelstein (1982).5Expressed in constant terms, US$ 1990.

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comparing GDP per capita in 1870 and 1913, we can have a dimension of thedifferences in growth and of the convergence: overseas country grew much fasterthan Great Britain, underlining the growth potential of such countries in 1870.While GDP per capita in Great Britain along the period 1870-1913 grew onaverage by 1.01% per annum, growth in overseas countries evolved much faster(e.g. Argentina grew by 2.50% p.a., while United States by 1.81% p.a.).

Following this rationale, Taylor and Williamson (1994) analyzed the depen-dency ratio effect over the savings in the New World economies. ObservingArgentina, Australia, Canada and United States, they found that the reductionof dependency rates generated a reduction in the capacity of generate capital. Adistribution of population strongly characterized by a high number of people inyoung age and with lower propensity to consume, as the one created in overseascountries by the emigration waves in 1870-1913, must be a central force in at-tracting capital from abroad. Moreover, Taylor and Williamson estimated thatabout of the British overseas investments could be explained by high demandfor capital in regions where the massive population movements generated highdependency rates, then low saving rates.

3.2 Returns and DiversificationThe classical explanation for the British capital outflows is concerning withthe fact that overseas investments were providing higher returns than domesticreturns. Evidence of this explanation comes from Edelstein (1994), who lookedat year-end market value, annual dividends or interest paid and capital gainsand losses, deriving realized rate of returns and comparing results for domesticand overseas investments. He found that the preference for overseas securitieswas generated by an average return of 5.7%, rather than 4.6% for domesticsecurities.

Following Edelstein, British investors were then rationally choosing overseas as-sets because of their higher expected return. However, other studies obtaineddifferent results concerning returns. In fact, in the opposite direction of Edel-stein went Davis and Huttemback (1986), who analyzed data from firms ac-counting records and included other dimensions influencing returns, such fiscalburden related to imperial defence. Davis and Huttemback found significantdifferences between sectors and periods, but, overall in the period 1885-1904,domestic activities generated higher returns than investments overseas and inthe Empire. Observing Figure 5, we can remark that the highest returns onequities between firms in United Kingdom, in foreign countries and in the Em-pire for each period is quite volatile along the period 1860-1912. Foreign firmswere supplying higher rates of return in the first period (1860-1869) and in thelast (1905-1912), while in other periods were supplying inferior returns or al-most equivalent (in the years between 1870 and 1904, the returns in the UnitedKingdom were superior, excluding 1885-1889). Moreover, enforcing the thesis

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of bad distribution of income, the study of Davis and Huttemback argued thatthe majority of investments overseas and to the Empire were made by the tworichest categories of the population. In fact, the elites and the middle classcollected around 79.4% of overseas investments and around 70.4% in the empire.

At least intuitively, it is then questionable that overseas assets were not supply-ing higher returns. Even if real investments and activities related to assets werenot furnishing higher returns because of higher marginal returns from capital,it is feasible that a country risk premium could have enhanced the returns.British investors were not only facing the risk related of the failure of the firm,but they were only facing challenging the possibility of a breakdown of the inter-national system, i.e. a war that would wipe out international trade and capitalflows.

However, an analysis based on the simple comparison between return possibili-ties is not complete and could lead to mistaken conclusions and to errors relatedto sample selection. As Offer (1993) noted the results of Davis and Huttembackcan be questioned: some data exclusion could lead to mistakes in the estimatedreturns and, in addition, the procedure based on firms accounting records is in-directly assuming that firms were following rules that could be equally evaluatedto contemporary accounting practices.

Observing rates of returns in order to understand the asset demand in VictorianBritain can then be questioned. We could claim that investors were rational andthey were attracted by higher returns or we can assume irrationality among op-erators, but we need to look at the return-risk interaction in order to understandthe demand. In this sense, British demand for assets were also driven by highpossibilities of diversification. Investments overseas were able to supply financialassets which provided the possibility of investing in high returns-medium riskprospects (e.g. US railway bonds). In other words, overseas activities provideda higher ability to generate financial assets that could have improved the returnsof domestic investors through small correlation coefficients. Analyzing the ef-fects of international diversification by observing prices, shares and dividendsof securities traded in London and in United States, Chabot and Kurz (2005)found that overseas investments supplied in the period 1866-1885 a wide pos-sibility of portfolio diversification, increasing returns and reducing the risk. Inother word, investing overseas was providing to Victorians investors the possi-bility of expanding the mean-variance frontier, resulting in notably increases inwealth. Observing Figure 5, it is clear that for the same level of risk, includingin the portfolio a larger share of foreign assets would have increased the returnsignificantly comparing it with the level of return that only British securitiescould have generated.

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In a similar analysis, Goetzmann and Ukhov (2004) showed that British in-vestors had access to securities and to information concerning political andeconomic details from all over the world. They showed that, even by assum-ing that expected returns on overseas investments (for equal asset classes) wereequal to domestic returns, it was profitable for British investors to send a shareof their capital to finance overseas activities. It is then necessary to concludethat British investors were driven, even if in a less sophisticated way than today,by a diversification motive and they were then rationally acting. In order togrowth Britain required investments in capital and many economists at the endof XIXth century believed that British investors were biased toward overseasassets and then were the responsible for the worsening of the British industry.However, evidence demonstrates that investors were not irrational, but werebehaving in a risk-return rationale. Moreover, there is little evidence that littleevidence that British firms suffered from a lack of capital as a result of UKoverseas investment: in fact, since financial market were enough developed inBritain, established firms or industries found it easy to gain more funds, e.g. byissuing equities6.

3.3 Supply side and preferencesWhy the flows of capital kept on growing all over the period 1870-1913 withoutany correction to reduce such a surplus? From the supply side, it is centralto understand that the period was characterized by the Pax-Britannica, byLondon as the world financial centre and by the British pound as the dominantcurrency in the context of International Gold Standard. Investors were thenable to access to a large number of investment possibilities directly investing atthe London stock exchange. As we can observe from Figure 6, already in 1873British operators could have invested in Indian, Colonial and foreign corporationstocks, in dominion and colonial government securities and in foreign bonds andstocks; moreover, these investment possibilities kept on growing in the period.

Focusing on such lens, as Temin (1987) proposed, such a persistent flow of cap-ital without could be explained by a change in investors preferences. Afterhaving assumed that investors were rational, it seems constructive, in order tounderstand the capital flows determinant, to concentrate not on market imper-fections, but on imperfect substitutability between domestic and overseas assets.In the last decades of XIXth century, since the relevant markets for investorswere equities in domestic firms and foreign bonds and since the market for do-mestic equities were quite insignificant century, the main trade-off faced was thefollowing: illiquid domestic equities versus liquid foreign bonds. Assuming thenimperfect substitutability between assets, we could explain capital outflows byarguing a change of investors preferences toward more liquid assets. Moreover,this argument enforces the income distribution reason by Hob son explainingthe high investment rates in Britain. If fact, if we assume a change in prefer-

6Williams et al. (1983).

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ences of investors, we would be able to explain not only the high level of capitalexports, but even the lower investments rates in Britain and then the necessityof looking for new uses for excess savings.

Moreover, following Caballero et al. (2006), we can claim that all the Britishcapital outflows could have been explained not only by differentials of growthpotentials through regions in the world, but even for their heterogeneous ca-pacity to generate financial assets from real investments. It is then clear thata capital investment in the New World could have been more productive, giventhe higher returns to capital for low income countries, and then could have at-tracted investors looking for higher returns. But in the same way, the capitalcould have been attracted as well by a different ability to generate financialassets; as I have already argued, investors looking for assets with higher returnsand medium risk had to invest in financial assets that could have been gener-ated only outside Britain. A clear example are U.S. railways: if we comparethe London Stock Exchange composition in 1873 and in 1913, we can observethat the share of American Railways passed from around 3.6% of the total nom-inal value to around 15.3% (see Figure 6). Such an increase could be explainedby a change in investors preferences or by differences in potential risk-returnpossibilities.

4 Trade or Capital Markets?Observing the British balance of trades course along the period 1870-1913, itis clear that the pattern fluctuate strongly and that the long run trend showednegative. From 3.2 % in 1872, the balance of trade decreased to 0.9 % in 1913,reaching a peak of almost 5% at the turning of the century. After analyzing theintense capital outflows from Britain during 1870-1913 and its socio-economicdeterminant, we can observe that such deviations must derive exclusively fromthe saving-investment global behaviors and from the capital markets. But whatdrove the British current account deterioration if capital were highly out-flowingfrom Britain?

The examination of the British current account deterioration can be ruled fol-lowing two alternative perspectives of the same identity: the first consider thetrade pattern and the second focus on investments, savings and internationalcapital flows. It is important to consider and analyze here the trade perspectivesin order to understand if related force could have explained such worsening. Inliterature, the microeconomic explanation by Matthews et al. (1982) followedthis perspective and argued that the worsening of British current account alongthe period 1870-1914 was mainly due to exogenous trends in the British econ-omy. The avoidance of innovation and diversification at the maturity stage ofthe product life-cycle of important export goods (e.g. cotton textiles), tied tothe long-term decline in productivity, could explain the reduction of exports.Losses in productivity could have raised the convenience to buy British goods

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in other countries, then worsening the balance of trade not relating the problemto increased imports, but to reduced exports.

A second stream of thought in this perspective focused on International Compet-itiveness7 . The rapid industrialization overseas and increases in competitivenessin other countries (such Germany) reduced the desirability of British productsabroad because of expensiveness. As a result total world share of British ex-ports reduced significantly and concentrate in imperial possessions, especiallyin Africa and Asia. As we can observe from Figure 8, the changes in total pro-ductivity in Britain relative to United States and Germany are not extremelyhigh in the last decades of XIXth century. However, if we focus on the industry,the relative worse productivity position of United Kingdom to United States isquite relevant, as well as the losses in relation to Germany from 1891 to 1911.

Another explanation, advanced by Matthews et al. (1982) and Pollard (1985),is instead related to macroeconomic effect of overseas income. The rapid growthof overseas income improved the balance of payments, raising domestic pricesand national income and resulting in a overall loss of competitiveness; moreover,this effect has been developed along with speedily increasing coal imports. Thisexplanation has been tied to the Dutch Disease8 argument. However, thislast argument has been thwarted by Rowthorn and Solomou (1991), who foundthat the importance of such effect must be limited to short period effects overconsumption and investments and only for the Edwardian period, 1900-1913.

Rowthorn and Solomou enforced the argument that the main reason for balanceof trade deterioration have to be linked to the main phenomenon in 1870-1913,i.e. the huge amount of overseas investments. In fact, we have to complement theDutch Disease explanation with the absorption effect explanation in order toobtain a complete understanding. The relevant increase of the capital exportsof the United Kingdom toward overseas countries generated a rapid growthof overseas income, while the wealth accumulation overseas shifted to Britishinvestors. The higher availability of wealth increased the national consumptionand, given the domestic production, increased the net demand for imports.Rowthorn and Solomou decomposed the trade balance course into the domesticinvestment effect, the consumption propensity effect and overseas income effect:they found that the over the long run, the consequences of the absorption effectare evidence for the deteriorating of the balance of trade through changes inconsumption behavior.

Comparing the fact that Britain was mainly capital abundant and that over-seas countries were land abundant, it is clear that the New World had a rele-

7See Sayers, R.S. (1965), A history of economic change in England, 1880-1939, Oxford;Kindleberger, C.P. (1978), Economic response: comparative studies in trade, finance andgrowth, Cambridge, Mass.; Lewis, W.A. (1978), Growth and fluctuations, 1870-1913.

8When overseas income is growing, reduction of price of exports relative to GDP deflatorand increase in export prices relative to competitors.

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vant comparative advantage in agriculture. The free trade could then explainwhy Britain concentrate on capital: differences in relative advantages make forBritish convenient to shift toward capital, instead of loosing the struggle withoverseas countries in the production of food. In addition, it could be claimedthat the huge flows of emigrants generated improvements in international trade,by reducing transportation and communication costs, but evidence shows thatall the effects generated by the trade side of the economy could be mainly drivenby savings requirements and then to capital exchanges through world regions.Trade related argument cannot explain neither the magnitude of such a hugeamount of capital outflows, nor the deterioration of the trade balance.

5 ConclusionCapital flows cannot be tied to just one rationale, but the phenomenon recordedin Britain in 1870-1913 must be the fruit of several factors co-operating in theBritish and the world macro-environment environment. Firstly, the political en-vironment and the demographic and economic situation in Europe allowed forhuge movements of people, generating a change in the global equilibrium for thesaving-investment relationship. Secondly, British excess of saving found its waythrough global saving requirements and capital began to outstrip from Britaintoward overseas countries, where the population structure and the high possi-bilities to exploit capital-intensive activities were generating a strong demandfor savings.

The astonishing flow of capital streaming from Britain in the period 1870-1913must be related to the global imbalances and to exchanges that an highly openinternational system could generate. Evidence suggests that capital flows weredue to a change in the international system, which in turn generated the demandfor British excess savings. British investors found then a higher profitable wayto employ their savings and diversification provided the rationale. All traderelated arguments can just be seen as a consequence of higher forces in theinternational system.

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count Deficit, Sandridge Lecture, Virginia Association of Economics, Rich-mond, Virginia, Federal Reserve Board.

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[3] Chabot, B. and C. Kurz (2005), "That is where the money was: ForeignBias and English Investment Abroad, 1866-1885", unpublished manuscript.

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[17] Temin, P. (1987), Capital Exports, 1870-1914: An Alternative Model,Economic History Review 40, pp. 453-58.

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Figure 1: Share of overseas income as a percentage of GDP, 1870-1913 (Feinstein,1972)

Figure 2: Total capital outflows, UK, thousand of pounds (Stone, 1999).

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Figure 3: Living standards and productivity (ORourke and Williamson, 2000).

Figure 4: Rates of return on equities (Davis and Huttemback, 1982).

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Figure 5: Mean variance frontier for different compositions (Chabot and Kurz,2005). Benchmark 1 include only British securities (British government bondportfolio, British corporate bond portfolio, and British corporate stock portfo-lio). Benchmark 2 consider BM1 and Foreign Government Bonds. Benchmark3 includes BM1 and Foreign corporate bonds and Foreign corporate stocks.

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Figure 6: Nominal value (million pounds) of securities quoted at London StockExchange (Goetzmann and Ukhov, 2004).

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Figure 7: UK trade balance as a percentage of GDP, 1870-1913 (Feinstein, 1972).

Figure 8: Comparative total factor productivity, UK=100 (Broadberry, 1997).

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