Flandreau M. et al. (2009) The question was not how to develop finance

Flandreau, Marc, Christophe Galimard, Clemens Jobst and Pilar Nogués-Marco (2009) “The bell-jar: commercial interest rates betwee two revolutions” in The Origin and Development of Financial Markets and Institutions. From the Seventeenth Century to the Present, eds. Jeremy Atack and Larry Neal, Cambridge: Cambridge University Press, 161-208.

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An earlier version of this paper is available here.

For institutionalist economists as well as for contemporary commentators, the wealth of nations in 18th century Europe was rooted in their political system which influenced the level of interest rates and thus trade (p.165). The confidence investors had in the government’s credit was thus seen as critical (tellingly John Law’s primary aim was to bring interest rates down; p.166).

In underdeveloped economies (such as pre-1800 Europe) from a sector to another interest rates vary widely (p.168). Only the lowest constitute a meaningful benchmark. At the time short-term commercial rates used amongst them by top “risk-free” merchant bankers, constituted such a rate (p.170).  The lack of formal centralized exchange however makes it difficult to compile interest rates for a given city, since the cost of capital may have significantly varied from a bilateral transaction to another. At best practitioners may have had a “mental average” (p.173).

Modelling the bell jar

Theoretically, the authors demonstrate that financial development is a top-down process that can be conducted at an international level with no local interest rate to beginning with. The system can produce its own domestic rates; the perception foreign merchant bankers have regarding the economic situation of a given financial centre are sufficient to produce local interest rates (p.179). The interest rates created by foreign expectations are christened by the authors shadow interest rates (SIR).

Using different datasets from Paris, London and Amsterdam, the authors determine that on average the SIR were quite low, indicating that commercial credit was already well developed. These findings appear robust enough since high SIR occurred during the monetary crises located by the literature (p.190).

Very real shadows

Surprisingly, the SIR for the three cities did not display major differences; however two clear  trends can be observed: SIR for Paris remained slightly above those of the other two and those of London became and remained the lowest as early as the 1730s. It is also important to remark that the SIR for the three cities increased over the century, thus ruling out nationally idiosyncratic causes for each of these countries.

All three centres displayed highly seasonal patterns of fluctuation (p.191). This pattern diminished towards the end of the century, maybe indicating that the markets managed to use each other as lenders of last resort (p.193). Integration did occur, but crucially a hierarchy also appeared; the connexion between London and Amsterdam or London and Paris for instance were significantly strong than the one between Paris and Amsterdam, the latter also appears to have been exclusively a one-way route since little Parisian capital was borrowed by Amsterdam merchants (p.194).

Corporate ceiling

“Yields on British consols overlap nicely with London [shadow] commercial rates. […] This means that the reorganization of Britain’s government following the Glorious Revolution in 1688 essentially established its credit on the same footing as the best commercial signatures in Amsterdam when they borrowed sterling from their London counterparts” (p.195).

On the other hand, in France, the yields of government remained consistently above the best commercial rates. In effect, it seems that a de facto “corporate ceiling” (as opposed to the present sovereign ceiling) existed in pre-modern Europe, major merchants, not the government, being the top risk-free borrower (p.197).

Conclusion

It may be that the merchant bankers created early on the modern financial instruments necessary to their trade and gradually brought in their isolated bell jar “those sectors that were fortunate enough to attract [their] attention.” This view –clearly opposed to North and Weingast’s theories – is less attached to both political and national explanations. This way, the Glorious Revolution for instance allowed the English government to catch up (p.198) with corporate best practice rather than created any new instruments.

If national borders had less impact than traditionally assumed, continental finance was not a flat blank slate either; it had “capitals, hubs, highways, secondary routes and direction of circulation” (p.199).

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).

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