Today is the first day of the US government shutdown, which was triggered by a political impasse in Washington. It is a good time to reflect on what economic historians have said about public finance.
Right now, the media are obsessed with the likely short-term impact of the shutdown on financial markets. Others have discussed what I regard as more fundamental question: what would be the impact of the US government defaults on its scheduled debt payments because of the political gridlock. Evidence that the US government was incapable or rather unwilling to pay interest on its debts promptly would likely raise its borrowing costs. The 1979 US government default on part of its debt, which was caused by a mere computer problem made it harder for the US government to borrow.
The conventional wisdom is that an increase in US government borrowing costs would be bad news for private borrowers. Economic history suggests that there could be a silver lining if investors perceive government bonds as relatively risky, as government borrowing crowds out private borrowing. In this context, it is worthwhile considering the argument of Peter Temin and Hans-Joachim Voth, Prometheus Shackled: Goldsmith Banks and England’s financial revolution after 1700. Oxford: Oxford University Press, 2013. These authors challenge the traditional view that the reduction in public sector borrowing costs that followed the Glorious Revolution in 1688 contributed to the Industrial Revolution of the eighteenth century. They suggest the 1688 political settlement, which led investors to feel more confident that the government would repay money, resulted in the diversion of capital from industrial enterprises and into the state, which then spent the money on activities with a low social rate of return. In other words, low borrowing costs allowed the British government to go on a military and naval spending spree that starved the private sector of funds. The Industrial Revolution began in Britain despite rather than because of the post-1688 Financial Revolution.
After 1688, Britain underwent a revolution in public finance, and the cost of borrowing declined sharply. Leading scholars have argued that easier credit for the government, made possible by better property-rights protection, lead to a rapid expansion of private credit. The Industrial Revolution, according to this view, is the result of the preceding revolution in public finance.
In Prometheus Shackled, prominent economic historians Peter Temin and Hans-Joachim Voth examine this hypothesis using new, detailed archival data from 18th century banks. They conclude the opposite: the financial revolution led to an explosion of public debt, but it stifled private credit. This led to markedly slower growth in the English economy. Temin and Voth collected detailed data from several goldsmith banks: Child’s, Gosling’s, Freame and Gould, Hoare’s, and Duncombe and Kent. The excellent records from Hoare’s, founded by Sir Richard Hoare in 1672, offer particular insight.
Numerous entrants into the banking business tried their hand at deposit-taking and lending in the early 17th century; few survived and fewer thrived. Hoare’s and a small group of competitors did both. Temin and Voth chart the growth of the successful banks in the face of frequent wars and heavy-handed regulations. Their new data allows insights into the interaction between financial and economic development. Government regulations such as (a sharply lower) maximum interest rate caused severe misallocation of credit, and a misguided attempt to lighten the nation’s debt burden led directly to the South Sea Bubble in 1720. Frequent wars caused banks to call in loans, resulting in a sharply slower economic growth rate. Based on detailed micro-data, the authors present conclusive evidence that wartime borrowing crowded out investment. Far from fostering economic development, England’s financial revolution after 1688 did much to stifle it — the Hanoverian “warfare state” was a key reason for slow growth during Britain’s Industrial Revolution. Prometheus Shackled is a revealing new take on one of the most important periods of economic and financial development.
The argument of Temin and Voth complements an argument I made in a book published in 2008. That book showed that Canadian Confederation, i.e., the political union of the British North American colonies in the 1860s was designed to improve their collective creditworthiness (i.e., to facilitate public-sector borrowing). I also showed that Confederation in 1867 was followed by a massive borrowing and spending spree and a rising Debt-to-GDP ratio. In the book’s conclusion, I speculated that this massive spending spree, which was devoted to public works projects of dubious economic value, may have reduced overall economic growth by crowding out private investment. The Canadian economy grew very slowly between 1873 and the mid-1890s. Indeed, Canada became a massive net exporter of people, as many young Canadians flocked to the United States, where the private sector was booming and the government was focused on paying off the massive debt incurred during the Civil War. Of course, certain private interests in Canada benefited from government largesse. They did very well, even though the country haemorrhaged people.
Anyway, the research by Temin and Voth suggests that if a US government default on its debt permanently increases its borrowing costs, capital will be diverted from US government uses to private borrowers. Whether this would be good for long-run economic growth is difficult to say. The US government spends its borrowed money on some very good things, such as medical research, but it also squanders money on unnecessary wars and the like. Surely this money would be better used in Silicon Valley or in building new shopping centres.
The Past Speaks 