How Important Historically Were Financial Systems for

Growth in the U.K., U.S., Germany, and Japan?

Franklin Allen, Forrest Capie, Caroline Fohlin, Hideaki Miyajima,

Richard Sylla, Geoffrey Wood, and Yishay Yafeh*

October 25, 2010

Abstract

The case studies for each country survey the literature on the role of their

financial systems in their development. The sources of finance for industrial

development include (i) banks, (ii) securities markets, (iii) internal finance, (iv)

alternative sources of finance such as angel finance, trade credit, families, and friends,

and (v) governments. All four countries had sophisticated financial systems and all four

grew successfully. The fact that they had different financial systems suggests that if there

is an optimal financial structure for a country it does not lead to a significantly greater

level of growth than other possible structures. The experiences of the four countries

considered suggest that a variety of financial structures can lead to high rates of growth in

real per capita GDP.

* Allen is at University of Pennsylvania, Capie and Wood are at City University London, Fohlin is at Johns

Hopkins University, Miyajima is at Waseda University, Sylla is at New York University and Yafeh is at the

Hebrew University. Allen is the corresponding author, allenf@wharton.upenn.edu. Prepared for the World

Bank Project on Financial Structure.

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1. Introduction

(Franklin Allen)

The relationship between the growth rate of an economy and its financial structure

is a long-debated issue. On the one hand, Bagehot (1873) and Hicks (1969) argue that the

UK's financial system played an important role in the Industrial Revolution. On the other

hand, Robinson (1952) suggests that the causation goes the other way and that the

financial system developed as a result of economic growth. Levine (1997) provides an

excellent overview of the literature on economic growth and financial development.

In a pioneering study using cross-country data, Goldsmith (1969) found a

relationship between growth and financial development. However, his study was based

on limited data and did not control in a satisfactory way for other factors affecting growth.

In a series of studies King and Levine (1993a, b, c) consider data for 80 countries over

the period 1960-1989 and carefully control for other factors affecting growth. They find a

strong relationship between growth and financial development and also find evidence that

the level of financial development is a good predictor of future economic growth. In an

innovative study Rajan and Zingales (1998) use data from the US to find which industries

rely on external finance and investigate whether these industries grow faster in countries

with better developed financial systems. They find a positive correlation between growth

rates and financial development, suggesting that finance is important for growth.

Demirguç-Kunt and Maksimovic (1996) consider firm-level data from 30 countries and

argue that access to stock markets leads to faster growth. In an influential contribution,

McKinnon (1973) did case studies of Argentina, Brazil, Chile, Germany, Korea,

Indonesia and Taiwan in the period after the Second World War. His conclusion from

these cases is that better financial systems support faster economic growth. Taken

together these studies provide considerable support for a relationship between finance

and growth.

A large number of theoretical studies consider the growth-finance relationship.

Hicks (1969) and Bencivenga, Smith and Starr (1995) argue that the liquidity provided by

capital markets was key in allowing growth in the UK Industrial Revolution. Many of the

products produced early in the Industrial Revolution had been invented some time before

but lack of long-term finance delayed their manufacture. Liquid capital markets allowed

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the projects to be financed by savers with short time horizons and/or uncertain liquidity

needs. Similarly, Bencivenga and Smith (1991) argue that intermediaries may be able to

enhance liquidity, while at the same time funding long-lived projects. Greenwood and

Jovanovic (1990) point out that intermediaries that can effectively process information

about entrepreneurs and projects can induce a higher rate of growth. King and Levine

(1993c) suggest that intermediaries can also do a better job of choosing innovations.

Another avenue for increasing growth is the higher expected returns that can be achieved

if risk is reduced through diversification (Saint-Paul (1982)). Boyd and Smith (1996,

1998) suggest that banks are important at low levels of development while markets

become more important as income rises. Rajan and Zingales (2001) suggest that banks

are less dependent than markets on the legal system. Hence, banks can do better when the

legal system is weak and markets do better when the legal system is more developed.

In this paper we consider the importance of financial structure for economic

growth by considering the historical experience of the United Kingdom, the United States,

Germany and Japan. The first part of this issue is how important was the overall

development of the financial system for growth in these four countries? The second is

that there are a number of sources of finance for industrial development and how

important is the mix of these. These sources include: (i) banks; (ii) securities markets;

(iii) internal finance; (iv) alternative sources of finance such as angel finance, trade credit,

families, and friends; and (v) governments. In particular, is there an optimal financial

structure for growth?

Forrest Capie and Geoffrey Wood explain in Section 2 that the United Kingdom

is a complex example of the importance of finance for growth. There was a financial

revolution from 1690 to 1720 that preceded the start of the Industrial Revolution that can

be dated to around 1740. Among other things, this financial revolution involved the

foundation of the Bank of England, the adoption of sound government finance and the

development of the stock market in London. On the face of it this would seem to support

the importance of finance to growth. The weakness of this argument is that by a number

of measures, the extent of financial intermediation was limited.

Better support for the theory of the importance of finance is provided by the

U.K.‘s experience in the 19th

century. In this case the intermediation provided by the

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banking system expanded significantly as the Bank of England started to act as lender of

last resort. This development was subsequently followed by a jump in the growth rate in

the real economy.

The finance provided by the banking system came in the form of overdrafts that

were often rolled over so that they were essentially medium or long term in nature. The

underwriting of trade bills was also important. The London Stock Exchange was

important as a venue for issuing and trading the debt of the British and various other

governments rather than company shares. However, a significant amount of capital was

raised through the issue of shares in regional and local stock markets all over the country.

The stock exchanges were particularly important for raising finance for the railways.

Perhaps the most important source of funds was internal finance in the form of

retained earnings. The authors provide an estimate that around 70 percent of funds came

from this source. There is anecdotal evidence that angel finance was significant. The

U.K. government did not in the general course of affairs provide funds for industry.

In Section 3, Richard Sylla argues that the United States is the leading historical

example of a country where the financial system developed before a significant increase

in the rate of economic growth. The change in the financial system arguably played an

important part in enabling the jump in the growth rate. Alexander Hamilton, the

Secretary of the Treasury from 1789-1795, played a significant role in the modernization

of the financial system. The creation of the First Bank of the United States (1791-1811)

helped the banking system to develop. The bank acted as the government‘s fiscal agent

but also undertook normal commercial bank activities and opened branches across the

nation. It provided a model for other banks to follow and as a result the U.S. started to

develop a sophisticated banking system. Hamilton also reformed the government‘s

finances and ensured the issue of sound public debt. This helped the foundation of

securities markets and stock exchanges to trade these and other security issues. By the

middle of the 1790‘s the U.S. had all the elements of a modern financial system in place.

This allowed the economy to grow at a real per capita growth rate of 1-2 percent year

from then until modern times.

All the sources of finance played an important role in this growth. The banking

system developed significantly throughout this period. This growth continued even after

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the failure to renew the charter of the Second Bank of the United States in 1836 led to its

demise and the country had no central bank until the Federal Reserve began operations in

1914. By then the U.S. banking system had a third of total world deposits and these were

more than those of the banking systems of Germany, Great Britain and France put

together. The securities markets and stock exchanges also facilitated a number of

investment booms that fostered economic growth. These included state-government debt

issues to fund infrastructure and the development of cities, stock and bond issues to fund

the railroads in the middle and late 19th

century and large scale industrial enterprises in

the 20th

century.

Banks and markets were not substitutes but rather were complements. Funds

were collected by banks around the country and placed on deposit in New York. These

deposits funded call loans to buy stocks on the New York Stock Exchange and this

considerably helped large scale corporate finance.

The Federal government issued debt to raise money to fight wars and a variety of

other purposes such as funding the Louisiana Purchase. During peace time these debts

were paid down and state governments borrowed in their place to fund infrastructure

projects. Internal finance in the form of retained earnings is not well documented but

appears to have been important. The use of trade credit was greatly eased by the

development of credit reports by the two firms Dunn and Bradstreet that were later to

merge. Angel finance also appears to be important but again was not systematically

reported.

Japan went through the industrial revolution later than the U.K. and U.S.

Caroline Fohlin recounts in Section 4 that in Germany industrialization began in the early

decades of the 19th

century but that economic growth took off in the third quarter of that

century. The heavy financing needs for railroads led to new financial institutions and

reinvigorated the securities markets. There is some statistical evidence of a causative

relationship between the level of joint-stock banking assets and output growth in the

railroad sector during the 1850s through 1870s. However, there is no general statistical

relationship between banking assets and aggregate output.

With regard to the role of different types of finance the universal banks are

usually given most of the credit for providing commercial and industrial finance. The

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savings banks (Sparkassen) also played a significant role and in fact actually mobilized

more capital than the large nationwide universal banks. In the first two thirds of the 19th

century tight restrictions on incorporation and the granting of limited liability meant that

securities markets could only play a limited role. Once the government liberalized

incorporation, particularly in the 1870 Company Law, existing stock markets rapidly

expanded their business and new ones opened. However, a large proportion of the

finance raised in new issues allowed owners to diversify their wealth rather than raise

new funds for investment.

Internal finance was very important for joint-stock companies. We know this

from the accounts that they were required to submit. There is no reliable data on angel

finance but anecdotal evidence suggests that this was important. Also firms partly used

trade credit to finance their operations as they were allowed to roll it over continually.

Government at both the state and federal levels played an important role in

funding development. They nationalized the railroads and funded large amounts of

military and industrial infrastructure. State and local governments also owned parts of

the banking system, for example, the regional Landesbanken. They also intervened in the

financial system in a number of other ways such as taxing stock market transactions.

In Section 5, Hideaki Miyajima and Yishay Yafeh recount the Japanese

experience. They consider the subperiods from the Meiji Restoration up to the start of

World War I and the interwar period separately. Not only did Japan‘s financial and

economic development occur much later than in the other three countries considered, but

the whole process was more compressed in terms of time. During the first subperiod the

Bank of Japan was founded, networks of commercial banks were created, and stock

exchanges were set up. Financing of businesses depended on their size and industry,.

Family controlled business groups (Zaibatsu) depended primarily on retained earnings to

finance their growth. Other modern firms relied heavily on equity finance. Often this

would take the form of indirect bank lending when small shareholders would borrow to

buy shares and use them as collateral for the loan. From 1902-1915 manufacturing firms‘

internal funds‘ accounted for 16 percent of funds while equity accounted for 50 percent.

Trade credit granted by wholesalers and banks also played an important role in traditional

sectors such as raw silk, cotton weaving and pottery.

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During the period 1914-1940, the use of each type of finance by different sectors

became even more distinct. Small and medium sized firms borrowed from banks, electric

utilities raised money with bonds, and large corporations used equity. Prior to the

financial crisis of 1927, many Zaibatsu raised money through closely related ―organ

banks‖ that they set up. However, many of these firms and banks failed as a result of the

crisis. Particularly after the crisis, stock exchanges played an important role in the raising

of equity finance. The heavy use of equity finance occurred despite very little formal

investor protection. It seems that informal mechanisms provided trust and confidence in

this form of financing.

Section 6 draws conclusions from the experience of the four countries concerning

the relationship between financial structure and growth. First, for the U.K. and the U.S.

there is significant evidence that an improved financial structure led to a higher growth

rate. In Germany there is some evidence of this, while in Japan the process of both

financial and industrial development was much more compressed and makes causation

more difficult to establish.

Perhaps the most important conclusion, however, concerns the different types of

finance that were used in each country. Banks played an important role in all countries.

In the U.K. this took the form of rollover of overdrafts. In the U.S. the banking system

was particularly effective in mobilizing deposits and funding firms. In Germany the

universal and other banks played an important role in funding industry. In Japan banks

funded certain parts of industry, particularly small and medium enterprises. There was a

significant difference in the use of equity in the four countries. In the U.K. it was

important for a wide range of firms including firms listed on regional and local exchanges

as well as for the railways. In the U.S. it was important for the railroads in the 19th

century and large industrial corporations particularly in the early 20th

century. In

Germany the importance varied over time, with equity becoming more widely used after

it became easier for firms to incorporate in 1870. In Japan significant amounts of equity

finance were used by large industrial corporations throughout the period from the Meiji

Restoration up until World War II.

Angel finance seems to have been important in all four countries. Unfortunately

there is little in the way of hard evidence to support this. Trade credit is also important in

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each country but seems to have been particularly important in Japan. The role of

government in providing finance differs significantly across the four countries. In the

U.K. the government was very little involved while at the other extreme in Germany the

federal and state governments were involved in a number of wayssuch as nationalizing

the railways.

All four countries had sophisticated financial systems and all four grew

successfully. The fact that their financial systems were so different in a number of ways

suggests that if there is an optimal financial structure for a country it does not lead to a

significantly greater level of growth than other possible structures. The experiences of

the four countries considered suggest that a variety of financial structures can lead to high

rates of growth in real per capita GDP.

2. The United Kingdom

(Forrest Capie and Geoffrey Wood)

Introduction. Modern economic growth was defined by Simon Kuznets ‗as a sustained

increase in per capita or per worker product …‘.(Kuznets, p.1) The beginnings of this

sustained rise can be found in the 18th

century in England/northwest Europe. There had

been periods of progress and prosperity before in world history but they had been

relatively short-lived and stagnation or decline inevitably followed. What was different

after the 18th

century was that growth was permanently sustained. The causes of this

continue to keep economists and historians busy, and within all the explanations the role

of finance has long featured.

Study of the relationship between finance and economic development goes back a

long way; certainly to the 19th

century, and it was touched on in The Wealth of Nations.

After a time when the focus was elsewhere, study of the role of finance in growth re-

emerged in recent times. A major contributor to the research was Ross Levine. In a

summarizing statement he wrote, ‗Although conclusions must be stated hesitantly and

with ample qualifications, the preponderance of theoretical reasoning and empirical

evidence suggests a positive, first order relationship between financial development and

economic growth. … There is even evidence that the level of financial development is a

good predictor of future rates of economic growth.‘ (JEL 1997 pp. 688,9) How to

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measure the ―level of financial development‖ is not immediately obvious, of course; we

set out various measures below.

Emphasis on the importance of finance has been widely endorsed by both

economists and economic historians in the last decade or so. In his American Economic

History Association Presidential Address Richard Sylla made a strong case for this being

so for the United States. Rousseau provided econometric back-up for the four major

economies of the Netherlands, England, the U.S. and Japan (Federal Reserve Bank of St

Louis Review July/August 2003 pp. 81-106).

England. The case for the role of finance in economic growth in England (Britain?1)

does, at least at first glance, also look compelling. The story would be of the following

kind.

The industrial revolution is commonly thought of as beginning in the 18th

century.

It was initially precisely dated by Ashton as being a process which started in 1760 and

continued to about 1830. That timing was later revised by Rostow, with his equally

precise dating of the ‗take-off‘ being 1786. More recent work seems to have been intent

on taking the beginnings back further, so that years such as 1740 or even earlier have

become more acceptable. Be all that as it may, by that reckoning the British industrial

revolution was essentially a mid-eighteenth century phenomenon. But irrespective of all

the differences of views over dating, however, it is widely accepted that there was in

England a financial revolution which preceded the industrial one. It occurred at the end

of the 17th

century, in the 1690s, or stretching from 1690 to 1720.

What did this financial revolution comprise, and why is it dated as it is? A long

list of innovations and changes can be given, from the establishment of the Bank of

England in 1694 and the prospering of commercial fractional reserve banking following

its beginnings in the 1670s (and particularly from the 1690s onwards), through the reform

of the coinage in 1696, and the establishment of credible government debt, credible in the

sense that there was by then widespread acceptance that government would honor its

pledges and was free from the irresponsible spending and revenue-raising of monarchies

1 Which is discussed depends to an extent on the availability of data; there exists the possibility that the

timing of developments differed slightly in the two countries.

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(see Dickson (1967) and Neal (1990)). There was also the appearance of a stock market,

recognizable as such to modern eyes, in the 1690s. While elements of this financial

revolution may have contributed to the South Sea bubble and panic of 1720, other aspects

provided for its resolution, and indeed English financial markets quickly settled down

after the crisis, unlike, for example, those of Paris following the near contemporaneous

Mississippi Bubble. There was thus clearly a financial revolution ahead of the industrial

revolution, and on the surface there would therefore seem to be a good case for saying

that British experience fitted the general story that is increasingly being told of financial

development preceding growth in the real economy.

Banking and other measures. But some further things need to be said. While it is true

that fractional reserve banking became established in the late 17th

century the extent of

financial intermediation was quite limited. The size of the banking multiplier, one term

for the amount by which the monetary base is multiplied to produce the money stock,2

(one measure of financial intermediation) remained small throughout the 18th

century.

The multiplier was probably no more than 1.5 at the beginning of the 18th

century and

seems not to have changed much by the end. There was of course a great growth in

banking in that century. The number of banks rose rapidly, particularly in the second half

of the century, so that by the end there were around 800. They were spread across most of

the country and engaged in all manner of enterprises. But the scale of intermediation as

captured by the banking multiplier seems not to have changed much (Capie (2004)). The

substantial growth in financial intermediation as measured by the multiplier came in the

19th

century, when the multiplier grew to around 4 and then stayed at that level for

another hundred years. This increase in the multiplier was to an extent associated with the

emergence of the doctrine that the central bank should act as lender of last resort to the

banking system. First suggested by Francis Baring in 1796, it was fully developed by

Henry Thornton in 1803, popularized in the numerous writings of Walter Bagehot, and

fully adopted by the Bank of England by the 1870s. The central bank‘s being willing to

act thus in a crisis of course made fractional reserve banking safer – for both the bankers

and their customers.

2 Various ways of calculating this number are set out in Capie and Webber (1985).

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Another measure of financial intermediation, additional and complementary to the

banking multiplier, was proposed by Mancur Olson and colleagues. They were looking

for a monetary measure which captured the ‗enforceability and the security of property

rights‘. They called this ‗contract intensive money‘ (CIM). The idea was that when

lending took place in the expectation of later returns the parties involved needed to be

confident that the contract would be honored, and if not honored then enforceable, and

predictably so, at law. Where confidence was high there would be a lot of commercial

and economic activity, and the measure would be high. CIM was the ratio of non-

currency money to total money supply. A high CIM indicates a developed banking

system and capital markets. And the higher CIM is, the greater are the gains from

specialization in production, and so the higher is the capital stock, productivity and per

capita income. Developed capital markets allow firms to be bigger, and to also, should

they wish, to be more specialized. The former comes from the increased availability of

capital, the latter from the capacity to ride out transitory adverse shocks by borrowing –

this latter being particularly facilitated by the invention of the overdraft. The overdraft is

generally regarded as a Scottish invention, appearing first in the Scottish banks in the 18th

century and then rapidly being adopted in England. (The banking systems of the two

countries were separate in essential ways until the second half of the 20th

century.)

Consistent with the data from the banking sector (the banking multiplier) the best

estimates of CIM for the British economy in the 18th

century show no rise across the

period, but start to rise with the banking multiplier.

It may be that, as recent work has been showing, the rate of growth of the real

economy in the 18th

century was in fact quite low. It was sustained growth, but, according

to Crafts and Harley (1992), for the fifty years or so after 1740 it was probably no more

than 1 per cent per annum. So if there was little to get excited about on the growth front it

should not be surprising that the growth of financial intermediation was less exciting than

some have suggested (for these measures see Goldsmith (1985)). But the story still holds.

The real spurt in the growth of the economy (to something closer to 3 per cent per

annum) comes when we are closer to the middle decades of the 19th

century, as did the

important rise in financial intermediation; and indeed, the latter preceded the former.

These were the years when the ―6 partner rule‖ was abolished, allowing banks to expand

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geographically and of course in size. Between the abolishing of that rule (1825) and when

the Midland Bank (the amalgamation of numerous small banks) was the biggest bank in

the world were only some 60 years. The nature of bank finance did, however, change

little over the period – it comprised overdrafts (usually unsecured) and the underwriting

of trade bills. Overdrafts were said to be in the main for working capital but they could

be, and were, rolled over for many years and so in effect provided medium to long-term

finance.

If finance was not intermediated by the banking system on any significant scale in

the early part of Britain‘s industrialization, where then did finance come from? How did

funds get from savers to investors? We consider in turn internal finance, ―alternative‖

means (family and so forth), securities markets (including in particular local, regionalized,

securities markets), and the role of government. We consider these in that order.

Internal finance. Investment finance from retained profits is an important source of

finance in the twenty-first century, and has been so in the U.K. since the very beginning

of industrialization. The practice of reinvesting profits developed from the earliest times,

and as late as the 19th

century it was still an important piece in the pattern, with

something of the order of 70 per cent of funds coming from this source. (That kind of

proportion also happened to be what has been seen for many other developed countries.)

“Alternative finance”. As with internal finance from retained profits, the data are not

abundant for ―alternative‖ finance either. But the narrative that is found in the texts is that

in the early stages of industrialization funds were most commonly sought and obtained

from within family and a close circle of friends or acquaintances.

Securities markets. These developed in Britain at a comparatively early date – by the

early 18th

century they were well established. But these markets were dominated for

many years, indeed, until well into the 19th

century, by government securities. Debt

financed wars had left a large stock of government debt, and this debt was both the

largest part of the market and the part most actively traded. The market was used to raise

new capital, but here a major role, perhaps the major role, was played not by the London

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Stock Exchange but by the regional exchanges. There were stock exchanges scattered

over the country. For example, there were exchanges in Birmingham, Manchester,

Liverpool, Newcastle, Edinburgh, and Glasgow; and these were only the major regional

exchanges – there were also numerous smaller ones. These exchanges specialized in

firms located in their respective regions, and funds for these firms were raised on them

and the shares, once issued, were traded on them. This specialization of course reflected

the concentration of information about these firms in their local areas. Figures for the

amounts of capital raised are not readily or reliably available, and nor are figures for

turnover.

All these exchanges, for the informational reasons that led to local exchanges

dealing with local firms, were, of course, primarily sources of funds for established firms.

Start ups then as now resorted to family, friends, bank, or other sources of finance.

The exchanges were, however, particularly important in the finance of the

railways. This important element of infrastructure, which had replaced canals as the main

method of transport of goods by around the middle of the 19th

century, had very large

financing requirements. The heyday of railway investment was the Victorian era.

Between the 1830s and the 1860s some hundreds of railway companies were floated, and

huge amounts of capital were raised for them. Although the demands of the railways for

capital declined from the 1870s on, the stock exchanges, perhaps having been prompted

by the railways to a more important role than heretofore, continued to be important in the

late 19th

century for the large companies, and particularly in some sectors such as

brewing.

Government as a source of finance. Government can never be a source of finance in the

sense that individuals can be. Governments can, however, transfer funds, having raised

them by either taxation or borrowing (money creation as a source of revenue being out of

the question under the gold standard). But throughout the years of Britain‘s economic

development the British government had a policy of laissez faire. Either by deliberate,

philosophy-based choice, or by accident, government was small and non-interventionist.

Where industry was assisted it was by tariff, not by subsidy or loan (and tariffs were low).

Indeed, it is notable that Britain‘s growth rate accelerated – whichever date one chooses

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for its acceleration – without any change in the size, scope, or activities of government.

Government remained small until the First World War.

Concluding remarks. The recently emerging view is that financial development is an

essential precondition for economic growth. Study of British experience reinforces this.

There can be no growth without the prior development of finance.

3. The United States

(Richard Sylla)

Financial development and economic growth. The U.S. provides perhaps the leading

historical example of finance-led economic growth. During the long colonial period, the

War of Independence, and the postwar confederation, 1607-1789, Americans were

relatively well off economically compared to others in the world. But that was mostly the

result of a limited, if rapidly growing population enjoying an abundance of new-world

resources. Defining modern economic growth as sustained increases of per capita

income and product of 1 percent per year or more, the consensus of economic historians

is that in these nearly two centuries there was little if any economic growth. Then,

beginning around 1790, growth became modern. The U.S. economy experienced

sustained and gradually accelerating real per capita growth rates of 1-2 percent per year

for the next two centuries, right up to our own time. Industrial production, a key

component of modern growth, appears to have increased at a sustained rate of about 5

percent per year from 1790 into the early 20th

century, no doubt contributing to the

gradual acceleration of the modern economic growth rate of broader GDP.3

What makes the 1790s break from pre-modern to modern growth interesting is

that it occurred at the very time the U.S. was having a financial revolution, that is, the

emergence of a modern, articulated financial system involving the installation of sound

public finances and debt management, a stable dollar currency, a central bank, a banking

system, securities markets and stock exchanges, and a regime of easy incorporation for

business enterprises. None of these key institutional components of a modern financial

3 Johnston and Williamson (2009) provide the best current estimates of nominal and real U.S. GDP, total

and per capita, annually from 1790 to the present; Davis (2004) gives annual industrial production from

1790 to 1915.

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system was present in the 1780s. All were present by the mid 1790s, and they continued

to develop thereafter, albeit with occasional setbacks. The guiding hand of the financial

revolution was that of Alexander Hamilton, secretary of the treasury from 1789 to 1795.

In the execution of his grand plan for financial modernization Hamilton, of course, had

the help of Congress, the president, state legislatures, and the nascent business and

financial communities. Implementation of the plan also provoked a vigorous opposition

and the emergence of political parties. From that time to the present, financial

developments, regulations, and reforms have been among the staples of U.S. politics and

the country‘s historiography.4

Economic historians in recent decades have shifted attention away from the

politics of U.S. financial development and toward the role of finance in the country‘s

steady growth. Half a century ago, not much was known about growth in the early

decades, but it was assumed that modern growth must have begun as a result of the

transportation, communications, and industrial revolutions of the early to mid-19th

century. These brought to the country improved roads, navigation with steamboats,

canals, railroads, telegraphs, textile factories, and a variety of other light industries. Later

in the century, innovations such as telephony and electric power, and the emergence of

heavy industries and large corporations in many industries sustained, even increased,

growth rates.

Today we have a better, if still imperfect, grasp of when growth accelerated,

earlier than previously suspected. We also are now more aware than that when the

transportation, communications, and industrial revolutions arose in the early to mid 19th

century, they were financed by a banking system and securities markets that had emerged

earlier, in the last decade of the 18th

century. Even the country‘s vast geographic

expansion, which tripled its size during the half century between 1803 and 1853,

depended on the prior financial system. A famous example was the Louisiana Purchase

of 1803, financed by issuing federal government bonds denominated in U.S. dollars and

sending them to Napoleon‘s France, which in turn sold them to European private

4 For comparative perspectives on the U.S. financial revolution and evidence that it did indeed jump-start

U.S. economic growth, see Rousseau and Sylla (2003, 2005). For details of the financial revolution, its

first crisis in 1792, and how it played out in the early decades of U.S. history, see Bodenhorn (2010), Sylla

(1998, 2005, 2008, 2009, 2010), Wright (2002, 2008, 2010), Sylla, Wilson, and Wright (2006), and Sylla,

Wright, and Cowen (2009).

15

investors. By 1803, the securities of what fifteen years before had been a bankrupt

government in default on its debts enjoyed a prime credit rating in international financial

markets. Encouraged by the presence of modern financial institutions and markets in the

U.S., foreign investors beginning in the 1790s and continuing for decades, even centuries,

would transfer large amounts of capital to the U.S. by purchasing the securities of

governments, railroads, and industrial firms, and by directly investing in the country.5

Growth of the banking system. In 1790, there were but three local, corporate banks in

the U.S., all founded in the previous decade, with a combined capital of $3 million.

When Congress in 1791 authorized Hamilton‘s Bank of the United States (BUS), its

twenty-year charter provided a model for those of other banks and its presence acted as a

catalyst to stimulate banking development at the state level. The first BUS was a much

larger corporation than any of the local banks, with $10 million of capital, 20 percent of

which was subscribed by the federal government. In addition to being the government‘s

fiscal agent, the BUS would carry on an ordinary commercial banking business, and it

was given the authority to open branches nationwide. The second BUS, a similar but

larger institution with $35 million in capital and more nationwide branches, operated

from 1816 to 1836.

Both BUSs for the most part were well-managed institutions. By virtue of their

interstate branching privileges, they provided the country with an efficient interstate,

interregional payments system. They also developed central-bank regulatory powers by

virtue of their special relationship with the federal government, which made them

recipients of the monetary liabilities of state banks as Americans made tax and other

payments. The powers and privileges of the two BUSs, however, became political

liabilities in the context of the U.S. federal system, leading to non-renewal of their

charters in 1811 and 1836. The U.S. would not again have a central bank until 1914,

when the Federal Reserve System began its long run. In the interim, 1836 to 1914, the

domestic payments system, relying on note brokers and correspondent banking, was less

5 See Sylla, Wilson, and Wright (2006) and Wilkins (1989) for the origins and development of foreign

investment in the U.S.

16

efficient than it had been. And banking crises were more frequent when the central bank

was absent. Those were major reasons for reinstituting a central bank in 1914.

Starting in 1791, states responded to the federal BUS initiative by granting more

corporate banking charters: there were 20 state banks by 1795, more than a hundred by

1810, nearly 600 by the mid 1830s, and some 1,600 by 1860. These were banks of

discount, deposit, and note issue. Some were large banks in leading cities, while many

more were small country banks, or what today would be called community banks.

State banking systems expanded rapidly for two main reasons. First, the rapid

growth of the economy increased demands for credit, making banking quite a profitable

business. In fact, many banks in New England states were established by entrepreneurs

who used them as funding agencies—insider lending—for their industrial and

commercial ventures.6 Second, in an example of incentive compatibility, states quickly

discovered that banks could be made to share their profits with state governments via

partial or total state ownership of bank stock, via taxation of bank capital, via the

charging of ―bonus‖ fees to banks for the grants of corporate charters, and via state-

directed lending requirements.

State-chartered banks were supplemented by private unincorporated banks and

brokers, probably numbering in the hundreds by the 1850s, which could carry on a

discount and deposit business but were prohibited from issuing bank notes. A number of

the private bankers became investment bankers, underwriting securities issues and

mediating the flow of capital from Europe to the United States. By the middle of the 19th

century the U.S. was probably as ―well banked‖ as any country in the world, and its

banking system served to mobilize and allocate capital throughout the country with

seeming efficiency.7

Nonetheless, from a later perspective that was just a start. During the Civil War

(1861-1865) the federal government re-entered the activity of bank chartering by

establishing the National Banking System, a system that granted federal charters to old

state banks and newly established national banks. National banks had to buy government

bonds, which aided the Treasury‘s war financing. National banks could use the bonds as

6 Lamoreaux (1994).

7 Bodenhorn (2000); Wright (2002).

17

collateral for national bank note issues. State-bank note issues were taxed out of existence

in 1866, with the result that the U.S. at long last had a fairly uniform paper currency that

was, de jure or de facto, a liability of the federal government. State banks, however,

survived the loss of note-issuing privileges; they continued and even thrived as banks of

discount and deposit, as did private bankers. Thus, in 1914 on the eve of World War I,

the U.S. commercial banking system featured no fewer than 27,213 independent banks,

of which 7,518 were national and 19,718 were state-chartered institutions.8 A few of

these banks in New York and other major cities were among the largest in the world. But

most were small, one-office (or unit, as opposed to branch) banks because most state

banking laws disallowed anything else. State preferences were allowed to dictate even

what national banks could do in the state of their domicile.

Industrialist Andrew Carnegie titled an address to the Economic Club of New

York in 1908, shortly after the bank panic of 1907, ―The Worst Banking System in the

World.‖ He referred, of course, to the U.S. banking system. Since the 1830s it lacked a

central bank to act as a lender of last resort in crises. It based its bank note currency on

an inelastic supply of U.S. government bonds. Its unit banks lacked the safety of

diversified loan portfolios that larger branch-bank systems might have conferred. In

1914, the advent of the Federal Reserve System would alleviate the first two weaknesses

of U.S. banking, and in the following decades of the 20th

century restrictions on branch

banking would gradually disappear.9

But not all was negative in the pre-1914 U.S. banking scene. ―The worst

commercial banking system in the world‖ was also by a good measure the world‘s

largest, with well over a third of total world deposits, greater than the combined deposits

of the banks of Germany, Britain, and France.10

Whatever were the problems of U.S.

banking, a comparatively limited access of Americans to bank credit was not one of

them.

Securities markets. Active securities markets arose in a number of U.S. cities starting in

the early 1790s, when Philadelphia (in 1790) and New York (in 1792) even opened stock

8 Federal Reserve System (1959).

9 White (1983).

10 Michie (2003).

18

exchanges. The impetus was the sudden appearance of three new issues of U.S.

government bonds with a par value of some $63 million, and $10 million par value of

shares of the Bank of the United States. These new issues, with a par value that

approximated 40 percent of US GDP, were a part of Hamilton‘s debt-restructuring and

national-bank initiatives. Because government revenues were uncertain, one of the new

issues was a zero-coupon bond for ten years, and very likely the world‘s first ―zero.‖

Shares of banks, insurance companies, and other corporations chartered by states also

appeared in newspaper listings of securities traded. As of 1790, there were fewer than 30

business corporations in the U.S. A decade later there would be 300. By 1860 the states

had chartered some 25-30,000 corporations, and that impressive total would rise ten-fold

by the early 20th

century. The comparative ease of forming corporations was a distinctive

feature of U.S. financial and economic development. Then, as now, the number of listed

and actively traded corporations was small in relation to the total number of them. But

even unlisted and inactively traded corporations raised funds through stock issues, kept

money in banks, and relied on bank loans.

From the 1790s into the 20th

century, securities markets and stock exchanges were

allowed to develop with minimal public oversight and regulation. These markets and the

investment banking industry that developed along with them facilitated a number of

investment booms that fostered economic growth. These included large-scale state

government debt issues incurred for transportation and banking enterprises during the

internal-improvement boom of the 1820s and 1830s, the corporate securities that financed

railroad expansion from the 1830s into the 20th

century, the local government debt issues

to finance city growth in an increasingly urbanized society, and the securities issues of

large industrial enterprises that emerged in the late 19th

and early 20th

centuries. Public

stock markets grew rapidly from the 1880s to the 1930s to make liquid the securities of

increasing numbers of large, capital-intensive enterprises. Trading also became more

concentrated as firms shifted their listings from regional markets to the larger exchanges

and markets of New York.11

Since a modern financial system emerged so early and then grew so rapidly in the

U.S., foreign banks had a minimal presence. They simply were not needed. But foreign

11

O‘Sullivan (2007)

19

help was welcome in two areas, the financing of international trade and the export of

American securities or, in other words, the import of foreign capital. European financial

houses excelled at trade finance, and would not be challenged by Americans until the 20th

century. Securities exports might be considered a joint venture with foreign financiers,

since American private bankers established European affiliates, and immigrants from

Europe became private bankers in the U.S., relying on their old-world connections to

place American securities abroad.

Links of the banking system and the securities markets. Financial systems are often

described as being either bank- or market-oriented, and these are considered to be

alternatives to one another. U.S. financial history, however, suggests that banks and

markets can be complementary. In the early 19th

century, country and city banks kept

some of their reserves in the form of deposits at banks in major cities. This was done to

facilitate long-distance payments and note clearing. Large city banks began to compete

for these bankers‘ balances by paying interest on them. They could afford to do that

because the interbank balances could be lent out on call to finance securities markets.

New York, as the leading port and the city with the largest securities markets, became a

magnet for bankers‘ balances, especially after the 1860s when the National Banking

System institutionalized the practice of counting interbank balances as a part of banks‘

required reserves. The bankers‘ balance-call loan system became a powerful mechanism

for mobilizing and concentrating bank funds from all over the U.S. in large banks,

especially those of New York. Concentration of interbank balances in New York banks

facilitated the operations of the city‘s primary and secondary securities markets. This was

a boon to large-scale corporate finance.12

Thus in the U.S. case, the banking system and

the securities markets worked in tandem to finance high rates of capital formation and

economic growth.

Governments as demanders and suppliers of finance. The federal government in the

long 19th

century, 1789-1914, practiced tax smoothing by borrowing heavily to finance

wars, and then paying down its debts in peacetime to return funds to the capital markets.

12

Sylla (1975); James (1978).

20

That is what happened after the quasi-war with France (1798-1800), the War of 1812

(1812-15), the Mexican War (1846-48), the Civil War (1861-65), and the Spanish-

American War (1898). Since the wartime borrowing often took place when interest rates

were elevated and prices inflated, and the debt reductions occurred when prices and

interest rates were lower, tax smoothing in practice likely made a net contribution to

capital formation and economic growth. Clearly that was the case when, as sometimes

happened, the government paid more than par value to repurchase its debt.

The government also promoted capital formation by ―spending‖ a portion of its

considerable land resources to promote transportation improvements (e.g., land grants to

railroad corporations, which sold the land to finance construction) and human capital

(land grants to states, which sold the land to finance schools and land-grant colleges).

Before 1820, recognizing that private financial facilities were lacking on the expanding

western frontier, the federal government even acted as a financial intermediary by

granting credit to settlers for land purchases. It also provided credit to import merchants

by allowing them to pay import duties, a principal source of federal revenue, several

months after the tax liabilities were incurred.

In the aftermath of wars, as the federal government returned funds to the capital

markets by paying down its debt, state and local governments increased their borrowing

to finance transportation and other infrastructural improvements. A notable example

came after the War of 1812, when the federal government totally extinguished a national

debt of $127 million between 1816 and 1836, while state governments, to finance

transportation and banking investments, ran up debts of $200 million by 1840. Similarly,

after the Civil War the federal government ran budget surpluses every year from 1866 to

1893, substantially reducing its debt while state and local governments increased their

debts.13

Money made available by federal debt repayments also found its way into

corporate securities. It was frequently observed that Treasury announcements of

imminent debt redemptions led to rises in the market prices of stocks and bonds.

Internal finance. Both corporations, of which there were many in the U.S., and

unincorporated enterprises, of which there were even more, plowed back portions of their

13

Ibid.

21

profits into expansion of their businesses. For the 19th

century, how internal finance

compared with external finance has not been a topic much investigated. For

corporations, we do know that dividend payouts were a greater proportion of earnings

than they became in the 20th

century. Stock investment returns before the 20th

century

were weighted more toward dividends and less to price appreciation, in part because in

that era of limited transparency and corporate reporting dividends were an investor‘s

primary signal of how well a company was performing.14

Internal finance, the plowing back of retained earnings into firm expansion, is

often viewed as a substitute for external finance, and no doubt in many cases it was. But

in some cases it may have been a complement. In the dynamic context of an articulated

financial system, external finance facilitated internal finance: business enterprises having

access to banks and/or capital markets for working capital needs could channel more of

their profits into fixed investments. Without such access, the enterprises would have to

look after their working capital needs on their own. Rapid growth of the U.S. banking

system meant that many enterprises could rely on bank loans for working capital. By the

1830s a commercial paper market also emerged, and in the late 19th

and early 20th

centuries it became an important source of short-term financing for many companies. The

availability of bank and market financing for working capital needs thus freed up more of

a firm‘s internally generated funds for fixed capital investment.15

Trade credit and angel finance. Trade credit is as old as the hills, but until the modern

era it was pretty much confined to traders who had a personal knowledge of one another,

either familial or as part of social group or network. For the U.S. to take advantage of its

geographically extensive free-trade area, it was necessary to find a way to grant trade

credit impersonally. Beginning in the 1830s, a unique American solution to the problem

was the credit reporting firm. These firms hired third-party agents in the various

communities of the U.S. to report on the character and creditworthiness of local

businessmen and companies, and then sold the information gathered to other firms that

were asked to grant trade credit. By the 1850s, two firms, Dun and Bradstreet (which

14

Baskin (1988). 15

James (1978, 1995).

22

later would merge to become Dun & Bradstreet) were publishing reference books rating

the creditworthiness of tens of thousands of firms in the U.S. and Canada. In the 20th

century the business model developed by the early credit reporting firms would be

extended from trade to consumer credit, as well as to the business of credit rating

agencies. Credit reporting and credit rating agencies expanded the scope of finance by

reducing informational asymmetries between lenders and borrowers.16

As with internal and external finance, trade credit in the context of the U.S.

financial system should be viewed more as a complement of than a substitute for bank

and market finance. Many firms granting trade credit could do so because they had

access to bank and market funding even if the firms asking for trade credit did not enjoy

such access. The same argument applies also to angel and venture capital financing. For

entrepreneurs seeking funds to implement their ideas, such as Robert Fulton in steam

navigation or Thomas Edison in electricity and electric lighting, such angel financing

might have been their only option. But Fulton‘s partner and angel financier in

developing the first commercially successful steamboat was Robert Livingston, a wealthy

man who had access to the formal financial system, as did Edison‘s early financiers such

as J. P. Morgan and his partners. A holistic view of a modern financial system often

reveals that what might at first glance appear to be alternative or substitute forms of

financing are in fact complements.

Concluding comments. The U.S. almost from its inception was blessed with a modern,

dynamic financial system. Since it began its modern economic growth trajectory at

virtually the same time, one can make a strong case that modern financial arrangements

led to economic growth. Hamilton, a student of financial history, drew amply on

European precedents in his plan for U.S. financial modernization. He also introduced

some novel concepts, and others would emerge as the system developed. It was an

innovative system, and one that exhibited positive network externalities as one or another

of its components generated value for other components. These externalities along with

efficient resource allocation and risk management facilitation are at the heart of finance‘s

contributions to economic growth. Modern financial systems, of course, can also

16

Olegario (2006); Sylla (2002).

23

generate negative externalities, more commonly known as financial crises. Few blessings

are unmixed.

4. Germany

(Caroline Fohlin)

Introduction. Germany spent most of the 19th

century as a fragmented group of

sovereign states. Starting out that century with backward agrarian institutions, low

agricultural productivity, multiple and seigniorage-heavy monetary systems, and a near

landlocked position in central Europe, the states that later comprised the German empire

did not possess a lot of what economic historians would call ―preconditions‖ for

industrialization. The German states differed considerably in their levels of economic

and financial development, as well as in their fiscal and monetary policy, hindering

coherent conclusions about German economic growth and its causes before unification

under the Second Reich, the Kaiserreich, in 1871. This difficulty has not prevented

economic historians from attempting to estimate growth rates over the 17th

through 19th

centuries, and heated debate has often arisen over exactly when Germany‘s economic

growth ―took off‖ into sustained, modern-style rates. As a general rule, economic

historians identify a structural shift in growth rates over the third quarter of the 19th

century, with slow but positive growth for the century and a half prior—albeit interrupted

by major shocks in the form of revolution and the Napoleonic Wars—and much higher

growth rates during and following this key early industrialization phase.17

At the start of the 19th

century, on the order of 80 percent of the German

population engaged in agriculture, mostly at subsistence levels and many shackled by low

productivity, serfdom and restrictive agrarian laws and practices. Agrarian reforms in the

first two decades of that century, paved the way for protoindustrialization, allowing labor

to move into production in handicrafts, textiles and metal-working.18

The German

customs union in 1834 reduced tariff barriers among the states and gave impetus for

increased production as well as for transportation networks, drawing more labor out of

agriculture and into industry.

17

Pfister (2008). 18

Pierenkemper and Tilly (2004) provide extensive details of both the agrarian reforms and the customs

union and their impact on the industrialization process.

24

Germany passed through similar stages of industrial development as other

European countries in the 19th

century, beginning with textiles, light manufacturing, and

basic metal working in the early-middle century, moving on to chemicals, large-scale

mining, steel works, and railroads in the several decades after the 1840s, all the while

developing new modes of transportation that integrated its previously very fragmented

markets and allowed productive factors to move about. Heavy industry, using refined

steel-making techniques, larger scale production methods, engineering-based technology,

and electrification, took hold in the last quarter of the 19th

century, especially in the 1890s,

and grew rapidly for several decades to follow.

As the succeeding sections explain in detail, and like most economies that

reached high levels of industrial development by the start of the 20th

century, Germany

built up a sophisticated financial system over the latter half of the 19th

century. While

private bankers and securities markets appeared centuries earlier, the first great wave of

financial development came in the 1850s. This financial ‗revolution‘ coincided with (and

was facilitated by) major reforms of currency and monetary policy as well as with rapid

developments in industry and transportation, most notably the railroads. Railroads

accelerated the movement of inputs and outputs made feasible by previous institutional

developments (agrarian reform and customs union), but also demanded massive

quantities of raw materials and labor to produce rails, rolling stock, engines, and the fuel

to make them go.

The finance-growth nexus in Germany therefore begins with the financing of

the railroads. The railroads‘ large-scale production and operations required financing

beyond the means of any one individual, and thereby stimulated the accumulation and

mobilization of financial capital on unprecedented scale. Throughout the third quarter of

the 19th

century, German railroad finance helped engender new financial institutions and

instruments, both private and public, and gave new life to securities markets as a means

of financing private debt and equity.

Clearly, the German financial system played an important role in economic

growth during this period. It is hard to imagine the industrialization process absent the

institutions and markets that funneled capital toward productive enterprise. The

financial and real sectors both developed rapidly from the 1850s to World War I, and

25

beyond. And one study has been able to pin down a statistically causal relationship

between development of joint-stock banking assets and output growth in (primarily) the

railroad sector during the 1850s through 1870s.19

We cannot, however, find a robust

causal relationship between financial and real growth after the 1880s or over the full

period from the 1850s to World War I.20

In this purely statistical sense, we can say that German growth was not ―finance

led.‖ But that‘s probably not the most interesting or useful question to ask about

financial systems and growth. Even if we could pin down a robust statistical relationship

at the aggregate level, the results would not explain whether a certain type of financial

system, or a particular structure of financial institutions, caused economic growth.21

These questions are more helpful but naturally a lot harder to answer. More interesting

than these statistical analyses is a more finely-tuned study of the evolving shape of

institutions and systems, and of the surrounding laws and regulation, and how they

actually worked in channeling capital to productive uses. With that goal in mind, we turn

to an examination of the various components of the German financial system and their

roles in promoting economic growth historically.22

Banks and other financial institutions. Despite its late start in financial and industrial

development relative to Great Britain, German financiers had created a large range of

financial institutions by the mid-19th

century: everything from large, universal banks to

small, regional (but also publicly traded) banks, private bankers, savings banks, rural

(mostly) credit cooperatives, public and private mortgage banks, and various forms of

insurance companies (important for their extensive investment portfolios and industrial

involvement).

In thinking about industrial finance in Germany, the ‗universal‘ banks get the

lion‘s share of the credit. These publicly-traded banks initially evolved out of the private

banking houses and first appeared in the form of the A. Schaaffhausen‘scher Bankverein

during, and as a result of, the crisis of 1848. Joint-stock banks—of which large,

19

Burhop (2006). 20

Fohlin (1999) and Burhop (2006). 21

For a more extensive discussion of comparative financial system design and industrial development, see

Fohlin (2011, forthcoming). 22

Most of the following is based on Fohlin (2007a).

26

nationwide universal banks comprised a subset—grew rapidly in the 1850s but made up

less than 10 percent of financial institution assets during the first great wave of

industrialization (around 1860 and even 1880), but their share rose to nearly a quarter

after the industrialization process had taken its course, by the start of World War I.23

Nationwide branching began with the formation of the Deutsche Bank in 1870.24

Partly

via buyouts of smaller banks, particularly myriad local private bankers and provincial

joint-stock banks, the large banks created national networks and began taking time

deposits and eventually demand deposits. But the expansion of branching networks

developed rather slowly during industrialization and only really accelerated after World

War I.25

Perhaps more important to economic growth are the uses toward which these

institutions put their capital. The universal banks mainly financed commercial and

industrial clients, and the largest among them dominated the national scene by the late

19th

century. These institutions provided the full range of corporate lending services,

from very short term lending, to credits on current account and commercial paper. The

banks probably played a more direct and more critical part in capital mobilization during

the earlier phase of industrialization prior to free incorporation (1850-70), due to the

relatively small scale of industrial firms and of the industrial sector as a whole. After the

liberalization of incorporation, the universal banks served as the primary conduit to

capital markets for industrial issues and also for brokerage transactions. The largest

banks played a key role in organizing the new issues of large corporate enterprises, often

taking over the new issue and selling the shares off to clients and later on the stock

exchanges.26

Major pre-WWI new issues booms took place in the early 1870s and the

latter half of the 1890s.

23

Goldsmith, 1985, tabulated in Fohlin, 2007a. 24

Notably, Riesser (1911) claims that the Cologne-based Schaaffhausen‘sche Bankverein proposed the

creation of a branch in Berlin in 1851, but their petition to do so (such matters were still tightly controlled

at this time) was refused by the government. 25

Fohlin (2002, 2007a). 26

Fohlin (2007a) analyzes the role of the large banks in-depth. Fohlin (2010) and included references

analyze the new issues markets and the role of asymmetric information and market power among the large

universal bank-underwriters during the 1880s. Burhop (forthcoming) and Lehmann (2010) look at new

issues markets during early and later time periods.

27

Smaller joint-stock banks and private bankers participated to some extent in

underwriting consortia usually led by larger, Berlin-based ‗great banks.‘ These smaller

banks also developed commercial banking relationships with larger banks, which could

evolve into equity stakes by the latter in the former and eventually mergers or

acquisitions. By maintaining local management, the smaller banks in the provinces could

continue their local ties to the community, and the attendant information and marketing

benefits of those ties, but the smaller partners did face growing demands and limitations

on their decision-making from the central administration.

Though the joint-stock banks played the most direct role in industrial finance,

the savings banks (Sparkassen), as a group, also deserve their due: in the latter half of the

19th

century, they actually mobilized more capital than the large nationwide universal

banks, providing government guaranteed and liquid repositories for individuals‘ savings

that could then be channeled into diverse investments throughout the economy. They

maintained a local orientation and financed low-risk needs, but they also tied into the

commercial banking networks and thereby indirectly helped mobilize smaller deposits

towards high-growth sectors.

Germany‘s late industrial development meant that a large portion of the

population remained in rural areas long into the 19th

century, and yet the financial

revolution reached into these areas as well. Credit cooperatives, among them the

Raiffeisen banks, dotted the rural landscape over the second half of the 19th

century.

Tiny in size, but profuse in numbers, they offered long-term lending on the basis of short-

term deposits. Geographical constraints focused coops narrowly on their communities

and allowed them to lend on soft information about borrowers and their projects.27

Mortgage banks (Hypothekenbanken) focused narrowly on lending collateralized

by real estate. These banks issued mortgage-backed bonds (Pfandbriefe) that were an

important source of credit for infrastructure development in 19th

and early 20th

century.28

These banks operated in a more arms-length manner, due to hypothecation and

securitization of their assets. The mortgage banks‘ securities transactions were

27

Guinanne (2004). 28

Orazio Mastroeni (2001) for information on modern Pfandbrief markets in Europe

http://www.bis.org/publ/bppdf/bispap05b.pdf

28

considered safe and remained on their balance sheets. Another set of institutions, the

Landschaften, also provided mortgage credit, mainly on rural land.

While the large, nationwide banks gained an advantage in capital mobilization

and redistribution in the pre-war era, all of the smaller-scale institutions contributed. The

credit cooperatives, for example, formed ―Centrals‖ to gather funds from surplus regions

and employ them in deficit regions. They thereby simultaneously helped improve

portfolio diversification and systemic stability. The savings banks used Landesbanken to

serve a similar role. The latter, along with the Postbank system, eventually developed an

extensive branching system like those of the commercial banks, but that process took

place primarily after industrialization and even after World War II.29

The German banking system enjoyed substantial stability toward the end of the

19th

century, but not for the entirety of its industrialization period. Indeed, the financial

revolution of the 1850s (and the second wave of the early 1870s) was fraught with

failures. A large number of joint-stock banks were formed, and a large proportion of

them failed. Crises in the 1850s and 1870s in particular weeded out the weakest banks.

The overhaul of the monetary system and creation in 1876 of a strong central bank that

provided unified note issuance and LOLR facilities, created a solid foundation for

subsequent banking development. Adding to these factors, the specialization of financial

functions among a range of institutions, as well as the increasingly national scope of

branching, the stability of the system improved significantly even by the 1880s.30

Periodic financial crises still erupted in the early 1890s, 1900-01, and 1907-08, but fewer

institutions outright failed, and the largest institutions weathered the storms well.

As the large banks grasped opportunities to expand via absorption of private

banking houses and smaller joint-stock banks, the joint-stock banking sector increased its

concentration over the industrialization period and beyond.31

Growing concentration

raised concerns about the power of the great banks and their domination over industry,

but modern studies have found mixed evidence on those claims. In the commercial loan

market, the German universal banks behaved in line with active competition, and at least

29

Fohlin (2007a, chapter 8) surveys the development of the German financial system after World War I. 30

Holtfrerich (1989). The last section here discusses more of the government‘s role in development. 31

Fohlin (2002) looks at the role of changing regulation and stock market taxation on the growth and

concentration of the universal banking sector.

29

large industrial enterprises maintained relationships with multiple banks.32

The

investment banking side of the universal banks was likely less competitive, since the

largest banks held a significant advantage in ensuring that large issues succeeded.

Universal banks earned large fees on new issues, and those fees increased with the

market share of the bank.33

Yet Feldman (1998) shows via diary entries of the famous

industrialist Hugo Stinnes that even the largest banks ‗squabbled‘ over their shares in

underwriting consortia for large, important new issues.34

Securities markets. New stock and bond issues became big business for the largest

universal banks as early as the 1871 ‗Gründerboom‘ that followed the German victory in

the Franco-Prussian war. Financial markets had appeared in important commercial

centers early on—Cologne in 1553, Hamburg in 1558, and Frankfurt in 1585—but they

remained focused on commercial paper and only sporadically active until growing needs

from industry and government arrived in the 19th

century.35

Increases in agricultural

productivity spurred demand for commodities markets. Government debt issues created a

parallel need for bond markets, while increasing industrial and trading activities drove

markets in commercial paper. In principle, these functions must have mobilized capital

in the early industrialization phase by creating a ready market for commodities and debt

securities, but so far there has been little quantitative research on the subject. At the same

time, given the tight restrictions on incorporation and limited liability in the first two-

thirds of the 19th

century, the markets could play only a limited role in the financing of

industry during the first phase of industrialization.

Once the government liberalized incorporation, most notably in the 1870

company law (Aktiengesetz), existing stock markets dramatically expanded their business

32

Fohlin (2007a) shows concentration ratios compared to the U.K. and U.S. (which was not really

comparable due to its limits on branching and interstate banking). Both Germany and the U.S. demonstrate

a high degree of competitiveness from the 1880s to 1918, based on price markup models. See Fohlin

(2008) on competition in U.S. commercial banking markets. Wellhöner‘s (1989) archival evidence

demonstrates that the large corporate clients of the universal banks were not dominated by those banks, as

the traditional (cf Hilferding) ‗Bankenmacht‘ story goes. 33

Based on data from the 1880s (Fohlin (2010)). 34

See Feldman‘s (1998) biography of Stinnes. 35

Fohlin (2007a), chapter 7, as well as Fohlin (2007b), provide extensive details and references to the

literature. Founding dates come from websites of the Hamburg and Frankfurt exchanges and of the city of

Cologne.

30

and new ones sprang up in most areas of Germany by the end of the 19th

century. The

Berlin Stock Exchange became Germany‘s premier stock market, drawing hundreds of

companies to list their shares there in the early 1870s. But the bust that followed that

boom led to a drop-off in new issues for several years. The IPO cycle rose and fell, but

the new issues market increasingly became a way for founding entrepreneurs to diversify

their assets and for large firms to grow larger by building new facilities and by taking

over existing ones.

Thus, even during the later stages of industrialization, only a small portion of

stock market business funneled capital into truly new enterprises, and it is therefore

difficult to assess the impact of securities markets on economic growth simply by

measuring the volume of IPOs or other offerings. Surely, the indirect effects of highly-

functioning securities markets aided economic growth. We know that the Berlin Stock

Exchange operated with relatively high liquidity and low transactions costs, and with

substantial efficiency.36

We can surmise that the availability of such liquid and efficient

markets made it more likely that investors would invest in new ventures, given their

greater confidence that they could later sell those stakes to gain liquidity when needed.

And companies that listed their shares on the stock exchanges, and thereby opened

themselves up to closer scrutiny and the oversight of shareholders, outperformed those

that remained (most likely) more closely held and perhaps more capital constrained.37

Internal finance and alternative sources of finance. While banks and stock markets

mobilized vast amounts of capital for industry over the industrialization period, industrial

firms financed a substantial portion of their investments out of retained earnings. We

know the most about the financing of joint-stock corporations after 1870, by virtue of

their legally-mandated public reporting of financial accounts in an annual report. These

joint-stock corporations, many of which were closely held and not listed on a stock

36

See Fohlin and Reinhold (2010) on the cross-section of common stock returns; Burhop and Gelman

(2008) for market efficiency tests; and Gehrig and Fohlin (2006) on liquidity measures. 37

Fohlin (2007a), chapter 6, analyzes company balance sheet data to study the impact of both banking

relationships (board seats) and stock market listings and finds the latter much more important to firm

performance.

31

exchange, held financial assets—primarily cash and receivables—averaging 20-30

percent of total assets in the period 1895-1912.38

We have much less widespread historical evidence and research on the alternative

sources of finance available to German firms over the industrialization period. Angel

finance must have played some role, but its extent is not known and, by its nature, may

not be knowable. As in most places, entrepreneurial firms started out as family

businesses. Even some that became extremely large—such as Krupp—remained family

businesses for several generations. Although these firms reached out for external

financing, their own wealth and that of family members comprised the foundation of the

firms‘ capital. Once a firm had gone public, and especially once it had gained listing on a

stock exchange, family and friends diminished in importance. Still, German corporations

often remained closely held even after issuing stock, though decreasingly so over the late

19th

century. As company founders aged, and securities markets expanded, many

families sought the diversification benefits of selling off stakes to a wider range of

shareholders.39

The largest firms, especially the large, universal banks and insurance

companies, were the most likely to become widely held. Little evidence remains on

ownership structure of German firms, because the system used bearer shares, whose

ownership is not registered as a rule.40

We can quantify trade credit a bit better, at least among firms that left archival

records or published balance sheets. Based on the balance sheets of corporations, it

appears that firms partly financed operations via trade credit. Since the German

universal banks and private bankers offered current account services, allowing firms to

roll over credits for longer periods, trade credits may have served as auxiliary sources.

Government’s role. German governments (both state and federal levels) potentially

influenced the rate and direction of economic growth in a range of ways, both direct and

indirect, but the government role is too complex and variable to permit strong

generalizations. Most directly, government financed industrial development via the

38

Fohlin (2007a), p. 171. 39

Fohlin (2005, 2007a). James (2006) argues that the family firm remained key to the German system. 40

Franks, Mayer, and Wagner (2006) pull together some scattered archival evidence, but we still cannot

draw general patterns.

32

nationalization of railroads and enormous financing of military and industrial

infrastructure. The nationalization of the railways began with partial participation by the

State, for example, in the Cologne-Minden Railway in 1843. The state could guarantee a

basic level of dividends to outside shareholders in return for a greater share of profits in

good years. State owned railways increased from 56 percent in 1870 to 82 percent in

1880.41

Prussia-Hesse purchased 8,400 miles of road between 1879 and 1885, and

Saxony purchased over 780 miles between 1871 and 1907.42

While the government

clearly poured enormous resources into the railroads, and the railroads obviously spurred

economic growth, the nationalization approach did not necessarily increase growth over

the alternative approach of leaving the railroads in the hands of private investors.43

Likewise, government spending on military and infrastructure may have spurred growth,

or it may have simply redirected capital to alternate uses.44

The broad-scale

nationalization of the railroads took place despite the development of active financial

markets and institutions. Government backing and ownership of banks and industrial

enterprise became more prevalent after industrialization—to some extent in the 1930s

(notably with the bail-out of large universal banks in the 1931 crisis) and then more

prevalently during the post-WWII reconstruction.

Governments played another key role, through creation and backing of certain

types of financial institutions and of central banks—first at the state level, such as in

Bavaria, Saxony, Prussia, and elsewhere, then with the Reichsbank as of 1876. Along

with credit facilities, the Reichsbank set interest rates and issued the new currency, which

unified the former plethora of monetary systems into one—itself significantly reducing

transactions costs in trade and finance. Provincial governments operated Landesbanken,

which provided local finance and served as regional central banks for the savings banks.45

41

Wessel (1982). 42

Bogart (2007), p. 47 (Table 1). 43

On the one hand, nationalization may have accelerated the completion of the German rail network and

lessened volatility of railroad investment (Field (1980)), but it may have also skewed the allocation of

capital in such a way as to reduce investment efficiency (Fremdling (1980)). Dunlavy (1994) argues that

Prussia‘s ―hands-off‖ approach to early railroads encouraged the creation of a complete railroad system, in

contrast to the more fragmented but active government involvement that she argues impeded railroad

development in the United States. 44

For example, the shipbuilding race against Britain in the run-up to World War I, funneled massive

resources into that one industry. (Maurer, 1997). 45

Fohlin (2007a), p. 24.

33

Postal savings banks appeared in 1909 and evolved into an important part of the financial

system, primarily along the lines of private savings banks.

The German government regulated a range of areas impacting the financing of

industrial development in the 19th

and early 20th

centuries. The most obvious is the

regulation of bank note issue that unified the currency, the conservative monetary policy

under the Reichsbank, and the laissez faire regulation on universal banks that had

relinquished the right to issue notes and therefore shifted fully into commercial and

investment banking. Regulation also encouraged development of other forms of credit

institutions at regional levels, such as the savings banks, postal banks, and Landesbanken

already discussed.

German law worked to protect shareholders, creating rights and obligations under

the shareholder law of 1870 (Aktiengesetz) and attempting to strengthen corporate

governance provisions with the 1884 revision to that law.46

At the same time, the

government took what we might consider misguided regulatory steps in the imposition of

stock exchange taxes starting in the 1880s and with certain provisions of the stock

exchange law (Börsengesetz) of 1896, including the infamous ban on trading in many

futures. These regulations perhaps affected economic growth around the edges, but the

rapid and relatively stable growth of the German economy over the period in question

suggests on the face of it that regulation did not impede growth.

Concluding remarks. A long tradition of German economic history has credited the

universal banks with near-heroic feats in propelling industrialization from their

beginnings in 1848 until World War I. The joint-stock banks did channel funds to large

enterprises throughout the period from 1850 to 1913.47

These banks must have helped

promote growth by expanding capital supply, but their organizational form and business

model did not in itself promote higher rates of growth.

The universal banks were also just one part of a complex, evolving financial

system that included—especially after 1870—a variety of financial institutions to serve

46

Fohlin (2002, 2007b) and Fear and Kobrak (2006). Also Burhop and Gelman (2008). 47

As I argued in Fohlin (2007a), they developed most of what have become their characteristic features—

interlocking directorates, proxy-voting, equity stakes, for example—during and after the later stages of

industrialization.

34

disparate clientele at all levels of the population; active capital markets that worked in

concert with joint-stock banks; and a unified monetary policy, solid LOLR, and

supporting financial and corporate regulations.

The German case also highlights the feedback mechanism, or mutual

reinforcement, between financial and real sector growth. The long-standing existence of

banking firms and securities markets prior to industrialization demonstrates that simply

putting financial institutions in place did not create economic growth. But having those

institutions and markets ready to go, and having the ability to quickly create new ones

when the need finally arose, helped emergent industry grow more rapidly.

Finally, it is important to appreciate that the effectiveness of the German financial

system as a whole has varied over time. Financial institutions historically emerged and

adapted to meet the changing needs of industry within the constraints of technology,

imagination, and government regulation. But as the system and its institutions matured,

it often became less flexible and adaptable. Some institutions outlived their usefulness or

failed to adapt quickly enough, while some potentially useful institutions emerged late or

not at all. Thus, the finance-growth connection has almost certainly varied more over

time within Germany than it has differed between Germany and other countries with

similarly high levels of economic development.48

5. Japan

(Hideaki Miyajima and Yishay Yafeh)

Introduction. The early financial history of modern Japan can be divided into two sub-

periods: the period from the Meiji Restoration (1868) to the outbreak of World War I, and

the interwar period (here we do not discuss the post World War II era).

The first period was characterized primarily by the establishment of modern

institutions such as the Bank of Japan, networks of commercial banks, property rights,

stock exchanges, and corporate law. This period was also characterized by the integration

of Japan into the international financial system primarily through debt issuances in

London by the Japanese government and subsequently also by some non-government

48

See the discussion in Fohlin (2011, forthcoming), evaluating the cross-country evidence on political,

economic, and legal factors in the relationship between financial development and growth.

35

entities. In the financial system, corporate growth during the Meiji period was financed in

various ways: While family firms and family-controlled business groups depended

primarily on internal funds (as is often the case elsewhere) modern industry was financed

to a surprising extent by equity. Small and medium-sized firms were financially backed

by merchant credit combined with local bank lending.

The second (interwar) period, from World War I to 1940, was characterized

primarily by changes in the industrial organization and corporate control aspects of the

Japanese economy. These changes were primarily related to the fast growth of family-

controlled pyramidal groups, the zaibatsu, whose origins date back to the late 19th

century,

but whose rate of diversification and expansion increased significantly during this period.

The increased influence of several large groups affected not only the economic (and

political) structure of Japan, but also its financial system. The growth of the zaibatsu in

the first half of this period (1914-1927) was accompanied by the emergence, and failure,

of ―organ banks,‖ an early version of what is now called ―related lending,‖ whereby some

large firms depended heavily on bank finance, establishing exclusive relationships with

their ―organ‖ bank, and often ending in failure during the crisis of 1927. In the second

half of this period (1927-1940), after the 1927 crisis, stock markets played an important

role as a source of funds despite the absence of formal mechanisms of investor protection

and the dominance of (tunneling-prone?) family-controlled pyramidal groups. In fact,

investors seem to have been eager to invest in the equity of zaibatsu-affiliated firms,

perhaps because they were considered low risk or because they were regarded as

entrepreneurial and successful, as well as closely connected to the government.

The section illustrates three interesting points. First, we provide a historical

example of a shift in the nature of a financial system over time. Second, we describe the

concurrent emergence and growth of the zaibatsu business groups and stock market

finance in an environment where formal investor protection is less than fully developed.

Finally, we suggest that equity finance may have been supported by ―informal‖

institutions which provided trust and confidence.

The rest of the section is organized as follows. The next subsection provides an

overview of the establishment of economic institutions in Meiji Japan and its integration

into the global financial system of the pre-World War I era. The following subsection

36

focuses on the emergence and growth of the zaibatsu groups and the relation between this

phenomenon and the ―division of labor‖ between different intermediaries within the

financial system. The evolution of Japan‘s financial system in the interwar period is

discussed next. The final subsection concludes.

The emergence of Japan’s financial system institutions. Following the turmoil of the

1870s, the decade immediately after the Meiji Restoration, Japan embarked upon a series

of reforms designed to set up the institutions of a modern economy and financial system.

Table 1 lists some of the events and institutional changes of that period; the Meiji period

reforms included setting up the foundations of modern banking starting with the

amendment of the National Bank Act in 1876, which was followed by the establishment

of a central bank, the Bank of Japan, in 1882. In 1890, the banking law was amended, and

the government introduced a banking licensing system. Initially, bank capital was based

on equity and on borrowing from the Bank of Japan; deposits did not account for much

until the early 20th

century. The banking system consisted of many small and local banks

which competed intensively, especially in offering loans to households (landowners,

merchants) which were indirectly channeled to commercial activities. In addition to many

small privately-owned domestic banks, the banking system included also government-

established banks (e.g. the Industrial Bank of Japan) with specific developmental goals.

Foreign banks did not play a role in the Japanese financial system of the time. Stock

markets were established in Tokyo and Osaka in 1878; apparently, these were not a major

source of capital in the pre-World War I era, although by some estimates market

capitalization in Japan of the early 20th

century was already quite high.49

Beside specific measures to establish a financial system, Japan of the Meiji period

took considerable steps to set up the institutions of a modern market economy and, in

particular, to explicitly define and protect property rights, both in the promulgation of the

Meiji Constitution (1889) and in the subsequent enactment of the corporate law (1890).

Another fundamental economic change of the Meiji period was the privatization program

of the early 1880s in which the government sold ―model factories‖ it had set up earlier to

49

See Rajan and Zingales (2003a). However, measuring the extent to which equity finance was used in

Japan during this period is not straightforward so these estimates should be treated with caution, see below.

37

private hands; some of the entrepreneurs involved in buying these government assets (e.g.

Iwasaki, a former low ranking samurai) ended up controlling the main pyramidal groups

which would dominate the economic scene of Japan in later decades (Mitsubishi in this

case), thus providing the earliest documented historical evidence on the link between

mass privatization and the formation of business groups.

Also during the Meiji period, in 1897, Japan adopted the Gold Standard, the

policy tool used by contemporary developed economies to signal commitment to a stable

macroeconomic environment. This reform was part of Japan‘s attempt to become

integrated in the global financial system of the time with London at its core (indeed, one

of the explicit objectives of adopting the Gold Standard was to raise capital in London).

In the decade following the adoption of the Gold Standard, Japan became one of the

largest borrowers on the London market, the spreads (risk premium relative to British

government debt) on Japanese bonds declined significantly, and non-government entities

began to tap the London market for capital. This trend became especially pronounced

following Japan‘s surprising military victory over Russia in 1904-1905 which was

interpreted as a very credible signal of economic development and good macro

management by investors in London.50

By the end of the Meiji period (1912) Japan was a stable, open economy with a

set of institutions which could be considered comparable to the standard of contemporary

continental Europe. In conjunction with the institutional changes of the Meiji period, this

era witnessed the emergence of a preliminary ―division of labor‖ between financial

intermediaries whereby different funding sources were used to finance different types of

firms: bank loans were primarily used by small and medium-size family-owned firms;

equity finance was primarily used by large corporations.

The early industrialization and financial division of labor. In this section we discuss

the emergence of business groups and the continued development of a ―division of labor‖

(specialization) between financial intermediaries.

50

See Sussman and Yafeh (2000) and Hoshi and Kashap (2001), chapter 2, for more information on the

institutional changes of the Meiji period.

38

Family-controlled Business Groups Initially Relied on Retained Earnings: Family-

controlled pyramidal groups, called zaibatsu (―financial cliques‖) played an important

role in Japanese industrialization. Their emergence was initially related to the sale of

government-owned assets to, and the signing of government procurement contracts with,

a small number of wealthy and trusted individuals, as is typical in the emergence process

of business groups in many countries. The major zaibatsu groups originally diversified

into mining, shipbuilding, international trade, financial services and more with

government support and encouragement. Although there were some occasions in which a

business group (e.g. Mitsui) used bank loans to finance growth for a limited time, major

business groups depended, for the most part on internal finance, allocating high profits

from their core businesses (normally mining) to other growing sectors.

It is possible to argue that in Japan‘s early stages of economic and financial

development, these groups made up for ―missing institutions‖ (in capital, labor and other

markets) and contributed to economic development and possibly also to a ―big push.‖ By

1914 (the earliest available figure), the major zaibatsu groups accounted for about 40% of

all assets held by all industrial firms in Japan.51

Other Modern Firms Relied on Equity Finance and on Indirect Bank Lending:

In contrast with family businesses and groups, standalone firms in the modern industries

(e.g. railways, electric utility, cotton spinning, flour mills, paper, breweries, etc.) were not

financed by retained earnings, presumably because profits were relatively low and growth

opportunities high. One estimate suggests that internal resources accounted for only 16%

of funds used by manufacturing firms in Japan between 1902 and 1915 whereas equity

finance accounted for about 50%. These estimates are very crude and subject to

methodological problems (see below) but they do indicate that firms managed to raise

money from external sources.52

It is interesting to note that firms in modern sectors were established as joint-stock

companies from the beginning. For example, cotton spinning firms were started by

51

See Miyajima and Kawamoto (2010) for a recent evaluation of the emergence and growth of the

zaibatsu, and Khanna and Yafeh (2007) for international comparisons of the emergence of business groups

across countries and time periods. Morck and Nakamura (2007) describe the contribution of business

groups in Japan to economic development and present the idea of a group-orchestrated ―big push.‖ 52

Teranishi (2005), p. 51.

39

several merchants who hired technicians, imported cotton spinning machinery and raised

money from small investors, from other local merchants and from wealthy landowners

and farmers. The phenomenon of dispersedly owned joint stock companies in early stages

of modernization raises the question how was it possible for firms to raise money from

small outside investors when investor protection was still rudimentary.

One explanation relates this phenomenon to the presence of ―alternative‖

institutions such as ―business coordinators‖ who played an important role in the process

of issuing shares in the beginning of the 20th

century. The coordinators (zaikai-sewanin)

were outside investors (―venture capitalists‖) who took an equity stake in companies and

marketed their shares to outside shareholders. They were businessmen who were often

senior members of the business community or held director positions in multiple firms.

Due to their business success in the early stages of industrialization, they were highly

respected members of society. One of the functions of these coordinators was to monitor

newly established firms in the face of a large number of cases of fraud. They were also

expected to provide general business advice and to promote business relations with other

firms. This institution could explain why, during the process of modernization in Japan,

companies in major industries took the form of joint stock companies from very early

stages, with a relatively dispersed ownership structure.53

Once modern firms were established, the process of raising equity finance in

Japan at the time was somewhat unusual. Companies sold shares to investors in

―installments‖ at a price which was lower than the share‘s face value (often as low as one

fourth of the face value), but with a commitment from investors to invest more (up to the

face value of their equity) when more funds were needed. When companies required

more capital, they typically did not issue new shares but ―rights‖ (allotments to existing

shareholders) below the market price. Small investors, who received dividends on a

regular basis, were expected to respond on these occasions (i.e. inject capital when rights

were issued).

53

See Miwa and Ramseyer (2002) for further information on business coordinators. One of most famous

coordinators was Eiichi Shibusawa, who founded the Dai-Ichi Kokuritsu Bank, and headed the company

for forty three years. He participated in the establishment of over five hundred firms and held a board

position on forty nine of them.

40

When accumulated dividends and capital injections from existing shareholders

were insufficient, banks played an important role even though bank debt did not finance

firms in modern industries directly. Banks, which did not have enough information on

newly established companies and hesitated to lend to them, offered instead loans to

households (landowners and merchants) taking equity in companies owned by borrowers

as collateral. The use of equity as collateral became quite popular both in financing new

firms and in funding new investments of existing firms; indeed, in 1893-1897, nearly half

of the value of all collateral for bank loans took the form of stocks (equity) in firms

owned by borrowing individuals. These procedures make it very difficult to derive

precise quantitative estimates of the sources of finance used by Japanese firms.

Trade Credit Played an Important Role in More Traditional Sectors: Japanese

economic growth included also the development of indigenous industries such as raw silk,

cotton weaving, pottery, and even green tea in rural areas. These sectors were major

export industries which required capital for their operations. In the early phases of

industrialization (before 1910), credit from merchants and traders (rather than bank loans)

played an important role in providing financing to these sectors. As noted above, banks

were reluctant to lend to small firms directly and therefore local merchants became

intermediaries between banks and small firms or farmers, utilizing their reputation with

the banks and information networks with small firms.

As an illustration, silk producers borrowed mostly from raw silk wholesalers, but

obtained some loans from regional banks or branch offices of large city banks.

Wholesalers borrowed from large banks in Yokohama where silk was exported. Direct

lending to silk producers by banks in Yokohama was almost impossible because of the

lack of information on geographically dispersed, small borrowers (there were 91,751 silk-

reeling factories in 1926). By contrast, wholesalers had a vast network of information

sources on silk producers. It is reported that even regional banks made their lending

decisions on the basis of the lending behavior of wholesalers.54

54

This paragraph draws on Teranishi (2005).

41

The evolution of the Japanese financial system in the interwar period. World War I

generated a boom in the Japanese economy with business opportunities for Japanese

firms in trading, shipping and textiles. Corporate finance during the war and the

immediate postwar period was largely based on the high wartime profits; at the same time,

bank loans as well as equity finance began to play a role in funding corporations, offering

capital at low interest rates. The post-World War I boom ended in 1920, and the Japanese

economy entered into a recession which lasted over a decade. The changes in the

financial system during the 1920s and 1930s took place against the backdrop of

fundamental changes in the Japanese economy as a whole. The Great Depression in Japan

ended with fiscal and monetary expansion, increased military spending, the Manchurian

incident, and the abolition of the Gold Standard (1931).

During this period, the financial system experienced significant developments.

Trust banks were newly established in the 1920s and engaged in trustee business;

insurance companies were established and played a significant role as ―institutional

investors‖ in the 1930s. More importantly, the ―division of labor‖ between financial

intermediaries, which had started before World War I, became clearer: bank loans were

primarily used by small and medium, family-owned, firms; bonds were mainly used by

electric utilities (the only sector to thrive during the 1920s); and equity finance was

primarily used by large corporations, often group-affiliated.

The Rise and Fall of Organ Banks: Small and medium sized firms, including second tier

business groups tended to be family controlled. As Japanese households accumulated

financial assets in the form of deposits, city and local banks began to lend money to client

firms on the basis of these deposits. In contrast with the indirect methods of bank finance

used earlier, during World War I, investments of second tier family-controlled businesses

groups (whose business activities in trade, shipping, iron and steel had experienced a

boom during the war) were financed by bank debt assumed directly by the companies

rather than indirectly by their owners. The tendency of these family firms to use bank

debt may be related to phenomena described in the literature on present-day family firms,

which often hesitate to dilute their equity ownership and prefer instead to rely on bank

borrowing.

42

Typical examples of such second tier family-controlled groups are the Suzuki

group (which was focused on trade and depended on loans from a quasi-government bank,

the Taiwan Bank) and Kawasaki Shipyards which depended on a city bank (Number 15

Bank). The growth of such companies was often associated with an attempt by the firm

(or group) to establish its own bank. The Furukawa and Asano groups, for instance,

established their own banks during World War I, raising money from external deposits

(such practices were observed also among much smaller family firms and local

businesses). These banks, sometimes called organ banks, often faced financial distress

and in some cases brought about the demise of the entire group (e.g. Suzuki) in the 1920s.

Some authors describe these episodes as early examples of ―related lending‖ and of the

risks associated with them. In the case of Suzuki, for example, group companies

apparently delayed their post-World War I restructuring and instead relied on continuous

borrowing from their group bank. This ―soft budget constraint‖ combined with

continuously increasing leverage continued until both the borrowing firms and their

banks went bankrupt in the Financial Crisis of 1927.55

The Corporate Bond Market and Information generated by Large Banks: Another

important feature of corporate finance during the interwar period in Japan is the corporate

bond market, which was used primarily by electric utility giants in the 1920s and 1930s.

By some estimates, bond issuance accounted for 20% of total external finance in the

period 1928-1940. The development of the bond market was supported by the activities

of five large banks and one quasi-government bank (the Industrial Bank of Japan, IBJ).

They underwrote the issued bonds and offered brokerage services to households. It is

reported that the probability of default on corporate bonds underwritten by one of the

large five banks or IBJ was significantly lower the default probability on bonds

underwritten by other banks and securities houses56

However, as elsewhere, the default

55

See Morck and Nakamura (2005). The banking crisis, in part a legacy of the 1923 Kanto earthquake,

brought about significant consolidation to the Japanese banking system; the number of banks declined from

over 1200 in 1927 to 538 in 1932 (Hoshi and Kashyap, 2001, chapter 2). 56

See Konishi (2002).

43

rate increased during the Great Depression, and the government imposed new collateral

requirements in 1931; the corporate bond market subsequently declined.57

Large Business Groups Relied on Equity Finance: Finally, perhaps the most

noteworthy feature of the interwar period in terms of Japan‘s financial development is the

simultaneous rapid rise of large family-controlled business groups and equity markets

during the 1930s. The value of business group-controlled assets increased nearly ten-fold

between the early 1920s and the early 1940s — the main zaibatsu groups were among the

major beneficiaries of the government-sponsored investment in heavy industry — and

equity finance became their primary source of capital.

Until the rapid financial development of Japanese equity markets in the 1930s, the

major three zaibatsu groups seem to have maintained an active internal capital market to

finance their investments. As diversified pyramidal entities (organized in the first and

second decades of the 20th

century), the major groups had a holding company at the apex

of their pyramid (a partnership with limited liability) controlling lower tiers of firms

organized as joint stock companies. Within these pyramids, large investments and new

entry into ―high technology‖ areas were supported by internal transfers of capital, which

seem to have been especially important in the early phases of development of new

industries. For example, during World War I, groups used their high profits in mining (a

―cash cow sector‖) to channel funds into growing sectors such as chemical or electric

machinery.

In the 1930s, however, the zaibatsu shifted to raising equity finance by carving

out subsidiaries. For example, Mitsui Trading Co. sold 50% its holdings in Toyo Rayon

and used the proceeds to finance Toyo Rayon‘s investment as well as the expansion of

other Mitsui firms. Nissan‘s profitable affiliate, Hitachi, was partially sold out, and the

proceeds were invested in their new business activities such as automobiles. The use of

equity finance by business groups is puzzling; modern evidence suggests that reliance of

pyramidal business groups on equity finance is rare. The prevalence of this phenomenon

in interwar Japan is especially intriguing given the fact that modern (formal) mechanisms

57

See Rajan and Zingales (2003b).

44

of investor protection were, at the time, virtually non-existent (although property rights

were well defined).

A possible explanation could be the support of the government and the perception

of the groups as both safe and wielding monopoly power. In addition, the major groups

tried to establish a reputation for bailing out ailing subsidiaries and thus conveyed to

investors a sense of being low-risk combined with a sense that by investing in the shares

of a group-affiliated company an investor could receive part of the rents associated with

the operations of a large, entrepreneurial and government-favored group. Indeed, not only

did the presence of the zaibatsu not discourage small outside shareholders from investing

in new issues, it may actually have encouraged this activity to the extent that small

shareholders viewed the group structure as a trust mechanism rather than as a mechanism

for minority expropriation. Consequently, in the 1930s, when equity markets thrived,

internal capital markets within business groups were less dependent on retained earnings,

and instead reallocated within the group the funds raised on equity markets.58

Concluding remarks. The financial history of modern Japan is interesting in several

respects. First, Japan‘s financial (and economic) history begins with the establishment of

an entire set of institutions which typically characterize developed economies (a central

bank, property rights, and so forth). In this sense, Meiji Japan offers potential lessons for

contemporary developing economies.

Second, the financial system of Japan played a significant role in financing

industrialization and economic growth, with a clear ―division of labor‖ especially

between banks, which financed small family firms, and equity markets which financed

large-scale corporate groups. The Japanese financial system underwent significant

58

This paragraph draws primarily on Miyajima and Kawamoto (2010) and on Franks, Mayer and Miyajima

(2008). For further discussion of the question why minority shareholders may be willing to invest in the

shares of pyramidal business groups despite fear of ―tunneling,‖ see Khanna and Yafeh (2007). Some

authors argue that the strict control exercised by holding companies over subsidiaries in the largest three

groups was associated with slow entry into new industries and ―hesitation‖ to assume risk, whereas

younger and smaller groups expanded more aggressively (e.g. Morikawa, 1992). A mirror image of the

importance of equity finance as a source of capital for large firms in Japan in the 1930s can be found in the

composition of household assets in which ―securities‖ accounted for about 50% starting in the early

twentieth century, see Hoshi and Kashyap (2001) chapter 2. Hoshi and Kashyap also emphasize that

corporate governance in interwar Japan was primarily driven by shareholder activities on boards, rather

than by bank (lender) monitoring, a common feature in postwar Japan.

45

transformation in the prewar era and relative importance of different financial

intermediaries was far from constant.

Third, prewar Japan provides an example of thriving equity markets combined

with low levels of investor protection, in contrast with what the ―conventional wisdom‖

in financial economics would suggest. Moreover, pyramidal business groups were major

players in these markets, and investors seem to have been willing to invest in their shares

despite the risk of minority shareholder expropriation. To some extent, these anomalies

may be explained by the existence of alternative institutions which helped allay investor

fears of ―tunneling;‖ and in part, this may be due to the size, security and government

support associated with the largest business groups. The shift to a planned economy

towards and during World War II, as well as the postwar reforms and economic

transformation, brought about radical changes in the structure of the Japanese financial

system.

6. Conclusions

(Franklin Allen)

This paper considers the role of a country‘s financial structure in determining its

economic growth using the historical experience of four of the most advanced economies

in the world. The U.K. was the first country to go through the industrial revolution in the

19th

century. This was preceded by a financial revolution. However, the evidence from

the nineteenth century is perhaps more persuasive for the importance of finance for

growth. The U.S. provides the most clear cut example of a financial revolution preceding

an industrial revolution. In Germany there is some evidence of financing causing

economic growth, at least in the railroad industry. In Japan both processes were

compressed.

The role of different types of finance varied across the four countries. Since all

four countries were successful in terms of growth it is difficult to conclude that there is a

unique optimal financial structure for a country that should be widely adopted by other

countries going through the development process. Different types of finance can be used

to fund real economic growth. Bank loans and equity finance were important in all

countries but these operated in different ways.

46

One important aspect of a country‘s financial structure that has not been discussed

in this paper, concerns its effect on industrial structure. Allen and Gale (1999, 2000)

have argued that a country‘s financial structure is important in this respect, with equity

finance through stock exchanges supporting innovative industries and debt finance

through banks being better suited to existing industries. This remains an important topic

for future research.

47

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54

Table 1

Chronology of Financial Development in Japan, 1868-1940

Year Event

1868 Meiji Restoration

1876 Mitsui establishes banking business

1878 Tokyo Stock Exchange established

1881 Privatization begins

1882 The establishment of the Bank of Japan

1889 The Meiji Constitution

1890 Company Law takes effect

1890 Bank Code Revised, commercial banking system established; Mitsui Trading and

Mitsui Bank incorporated (another incorporation boom in 1890s

1894 Listing requirements revised to encourage trading on stock markets

1894-95 Sino-Japanese War

1895 Mitsubishi and Sumitomo incorporate their banking divisions.

1899 Revision of Commercial Code

1902 Industrial Bank of Japan established

1904-05 Russo-Japanese War; Tax reforms: introduction of income tax creates tax

advantages for corporations

1909 Mitsui Partnership established

1911 Commercial Code revised (under incorporation articles, representative director

appointed, fiduciary duties clarified, criminal liability defined.)

1918 Stock Exchange Directive revised under Imperial Ordinance No. 229

Asano Family holding company established; Okura Limited Partnership

established

1920 Tax reforms (advantages to holding companies).

1921 Sumitomo unlimited partnership established; Furukawa Trading de facto

bankrupt, merged with Furukawa Mining; Suzuki Unlimited Partnership

established

1922 Revised Stock Exchange Law promulgated, Stock Exchange Directive and Stock

Exchange Law Enforcement Regulations revised. Bankruptcy Law, Conciliation

Law enacted

1923 Kanto Earthquake

1927 Showa Financial Crisis; Suzuki and Kawasaki Shipbuilding go bankrupt

1928 Banking Law amended

1929 Showa Depression

1931 Manchurian Incident; Furukawa Bank liquidated

1932 May 15 Incident; Hitachi, Nihon Mining (Nissan Group) go public

1934 Accounting guidelines adopted

1936 February 26 Incident

1937- Outbreak of war with China; Mitsubishi, Sumitomoto Holding Company

reorganized as joint stock companies

1938 Commercial Code revised

1939-45 Corporate Profit Dividend and Capital Distribution Directive promulgated.

1943 Munitions Company Law

1945 (Aug) Tokyo Stock Exchange closed