Quinn S. (2001) Public debt to private finance: “Drop dead”

Quinn, Stephen (2001) “The Glorious Revolution’s Effect on English Private Finance: A Microhistory 1680-1705”, The Journal of Economic History, 61/3: 593-615.

Picture 5Picture 4Picture 6

Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished).

Introduction

According to North and Weingast’s famous thesis, the investiture of William III of England in 1688, the “Glorious Revolution”, triggered a quick modernization of the British financial system – prompting in turn a fall of the interest rates. But the arrival of the new king also led the realm into a new war against France which lasted nine years and increased public debt from £1 million to £19 million (⅓ of the national income; p.593).

Such a hemorrhage should have siphoned cash away from private investors (crowding out effect), but North and Weingast have argued that this negative effect had been more than offset by the increase of capital supply that followed the renewal of the sovereign’s credibility. To test this hypothesis, the author uses the rates of returns collected from the books of a successful and well-connected London goldsmith banker, Sir Francis Child (p.594).

Confidence argument

Before the Glorious Revolution, due to the high risk of default, interest rates asked to the king reached 8-12% (compared with 6% for private loans; p.595). After 1688 however, interest rates on public loans gradually declined to 3%. Potential regicide by the Parliament was deemed a credible enforcement method. Thank to lesser risks and to new products (e.g. East India Company or Bank of England bonds), liquidity increased and more savings were invested on capital markets.

Unfortunately, the war caused interest rate to increase, thus muddling the impact of institutional reform upon the markets (p.596). In theory: “if the government’s risk premium suddenly disappears, government rates will fall and private rates will rise until the two rates are equal and all arbitrage opportunities vanish” (p.598). However, this is true only if the two are perfect substitutes (except for the risk premium).

Supply or demand shock?

The North and Weingast argument suggests that the fall of government rates did not create extra competition for private lending but instead offered a complementary investment allowing to increase money fluidity (p.599).

“With less chance of a panic, the public became more inclined to save and lenders more willing to adjust their portfolios towards private debt instead of precautionary cash. Less systematic risk may also have encouraged financial entrepreneurship.”

By 1705 a new cycle of war spending started so if the short-terms effect of the Glorious Revolution are to be observed it is between 1697 and 1705. During that period three things may have happened:

  1. Private interest rates may have fallen due to a supply shock (sudden influx of capital while demand remains the same).
  2. Private interest rates may have increased due to a demand shock caused by a crowding-out phenomenon (public demand increases faster than supply).
  3. Private interest rates may have increased due to a demand shock caused by increased private demand (p.600).

Higher interest rates

Through the reconstruction of over 2000 loans, the author shows that interest rates on private loans appear higher after 1690 than before (p.603): “Returns on interest-bearing loans to individuals were 6.9 percent in [the 1697-1705 period], versus 6.1 percent” between 1680 and 1688. Moreover part of this increase may be masked by the fact that the use of pawns by the debtor to guarantee a loan was becoming more common.

Fig. 2 p.611

Fig. 2 p.611

During the war, this phenomenon can readily be explained by the greater importance taken by public borrowing in Child’s activity: government debt represents over 50% of the value loaned during these nine years. The readiness of a single banker to invest so much in a market that used to be reserved to powerful syndicates clearly indicates “the deepening of the market for public debt” (p.605).

After the war “the gap between private and public rates disappeared. Indeed, private debt may have begun to carry a risk premium relative to government debt” (p.606). Taking various factors into accounts, the author estimates that interests on large private loans may have grow by about 1.5% after 1688 (p.608).

Picture 3

Fig.3 p.612

Conclusion

Child’s activity suggests private rates did not decrease during the war due to a crowding out effect caused by government borrowing, while after the war increase private demand for funds accounted for interest rates stickiness (p.612). The latter argument is backed by the fact that the spread between long and short rates widened, which is consistent with bolstered demand (rather than supply as assumed by North and Weingast).

Paradoxically, the Glorious Revolution triggered financial modernization and at the same time created serious problems for private finance. The effect of that positive institutional reform was thus both to hinder and foster economic growth (p.613).

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