Monday, 1 June 2015

when debt is beautiful

debt is awful, debt is bad, debt is too high for growth... sounds familiar? Well, you'll be forgiven if you thought this was about Herr Schäuble and the Greeks, or some such fun topic. Actually, it is much more boring. It's about a paper Jaume Ventura and I finally put into circulation. In it, we ask the simple question -- why did the country that piled up the biggest debt mountain in history manage to industrialize regardless?

Traditionally, thinking about this fell into two camps - those who thought that it happened despite all that debt, and those who thought that it didn't matter at all. The first school - let's call them crowding-outers - looked at lots of evidence showing that government borrowing slowed industrial growth and expansion. Peter Temin and I actually wrote a paper about it, which one seminar participant called the "most beautiful piece of evidence in favor of crowding out" (published in Explorations in Economic History, link here). The second school of thought argues for Ricardian equivalence - people know the debt has to be temporary, and hence they will undo its effects through savings decisions, etc. Robert Barro wrote a beautiful paper with these features.

What do we do? We argue that debt was good - under the (particular) circumstances of the British IR. Here is the abstract and the paper:

Why did the country that borrowed the most industrialize first? Earlier research has viewed the explosion of debt in 18th century Britain as either detrimental, or as neutral for economic growth. In this paper, we argue instead that Britain’s borrowing boom was beneficial. The massive issuance of liquidly traded bonds allowed the nobility to switch out of low-return investments such as agricultural improvements. This switch lowered factor demand by old sectors and increased profits in new, rising ones such as textiles and iron. Because external financing contributed little to the Industrial Revolution, this boost in profits in new industries accelerated structural change, making Britain more industrial more quickly. The absence of an effective transfer of financial resources from old to new sectors also helps to explain why the Industrial Revolution led to massive social change – because the rich nobility did not lend to or invest in the revolutionizing industries, it failed to capture the high returns to capital in these sectors, leading to relative economic decline.
I think the beauty here is that the paper offers a unified explanation for a number of features - painstakingly unearthed over the last 30 years by NFR Crafts, Bob Allen, Nick Harley, Charles Feinstein and others -- that are hard to reconcile otherwise in standard growth models:

  • growth was slow (despite rapid technological change)
  • over short horizons, there was crowding out - but Britain industrialized first regardless
  • structural change was rapid
  • wage growth lagged output growth; counting urban disamenties, workers probably shared none of the gains of industrialization for the first 70 years or so
  • financial intermediation played no role in financing the new industries
  • rates of return on capital remained high and even rose for half a century - there is no evidence of capital chasing high returns, driving down rates of return in consequence 

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