Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865-1914. (Book Reviews).

By Lance E. Davis and Robert E. Gallman.

New York: Cambridge University Press, 2001. Pp. vii, 986. $100.00.

The economic history team of Lance Davis and Robert Gallman produced some of the most innovative and productive efforts in the field over the four-plus decades of their joint efforts. When flying solo, Davis focused on the innovations that arise over time in financial institutions and markets that help finance investment in the real economy, while Gallman measured how the real economy grew over time, especially in terms of capital formation. When teaming up, they showed how financial innovations increased the supply of savings in the American economy, which then led to sustained high levels of capital formation, which in turn helped generate the ongoing economic miracle of the American economy. Sadly, Robert Gallman passed away before this final work appeared in print. Happily, it stands as the magnum opus of their collaborative efforts.

The ambition of this book is to document the "natural experiment" in generating the institutional innovations necessary to finance the capital flows needed to exploit the natural resources of four frontier economies in the late nineteenth century--the United States, Canada, Australia, and Argentina. All four benefited greatly from the sustained capital flows emanating from Great Britain, as is well known. How greatly? Table after table calculates the contribution that British savings made to the flow of foreign savings coming to each economy in each decade from 1870 to 1914. Then the contribution of all foreign savings to each economy and the share of domestic savings are calculated. Basically, the authors find that Britain's contribution toward financing capital formation rose sharply from around 10 to 20% for the United States to steadily increasing proportions for Canada, Australia, and then Argentina over the course of the late nineteenth century, the period of the world's first global financial market ce ntered in the City of London.

What makes this finding especially interesting is that all four frontier economies had the opportunity to adopt British financial institutions, then the most advanced and effective in the world. But, as rich and diverse as the British financial sector was, as detailed in Chapter 2, each frontier country adopted for its own purposes just the one aspect of the British financial system that seemed most useful for financing construction of that country's railroad network. The United States picked British-style merchant banks, building on its long history of association with the House of Baring, but ignored Scottish-style banking, preferring to stick with English-style country banking. Canada and Australia, starting later, wisely picked Scottish banking, joint-stock banks with extensive branching, and a physical presence in London. Argentina, off to a bad start with Barings early in the nineteenth century, had to accept British incorporation of its railroads and banks to get its share of British savings flowing in to the construction of its infrastructure.

Each country then adapted the British-style financial institution it had acquired by innovating according to its own political and economic dynamic. In the United States, the first-generation investment affiliates, mere branches of the British merchant banks, evolved into independent investment banks in the second generation that were responsible for generating the finance of U.S. trunk railroads. These in turn were overtaken by third-generation investment banks, which moved into finance of capital in the industrial and commercial sector. Canada's financing of its infrastructure depended on government guarantees of bonds issued by railroads, canals, or utilities, and these bonds could then be placed in the London market. When tapping into Canadian domestic savings, bond houses arose that could place new issues within a narrow circle of Canadian financial institutions and wealthy individuals. Australia's London-based banks developed securitized mortgage bonds so that they could indirectly (and ultimately disas trously) invest in overpriced mortgages. Argentina developed a security more directly based on land mortgages, the cedula, which became a favorite asset for Argentina's banks, which were mostly foreign and mostly British.

What lessons do Davis and Gallman draw from the detailed examination of each country's financial sector and its innovations in response to the challenges of tapping into the vast pool of savings available in London? Ultimately, the less successful the frontier economy was in financing its development with foreign funds, the better it performed in the long run. Why? Because then the innovative efforts of the frontier economy's financial sector turned to ways it could attract domestic savings, and these continued to finance domestic capital formation whenever the supply of British funds slackened or stopped entirely. Implicitly, the Davis-Gallman study suggests as well that the more a frontier economy's financial innovations were directed toward developing and sustaining its capital markets, as opposed to its banking institutions, the better it was able to recover from shocks inflicted by regime changes, whatever the source or severity of the shocks. This held especially so in coping with the shock of the compl ete withdrawal of European finance during World War I, as the authors demonstrate in Chapter 8, "Skipping Ahead: The Evolution of the World's Finance Markets, 1914-1990."

But this insight also seems to hold up when, in Chapter 9, "Lessons from the Past," they examine the state of the world's financial markets in the 1990s, with special attention to the case of Japan. A masterly survey of the development of Japan's financial sector from the Meiji reforms to 1970 elicits a number of striking parallels with the various missteps in financial development that the authors uncovered for Argentina and Australia in particular. The imitation of the Japanese financial strategies by the Asian tigers in the 1990s also presaged the Asian crises in 1997 and the Latin American crises starting with the Mexican meltdown in 1995. Time and again, "overbanking" turns out to be the culprit, when a country relies more on banks to be financial intermediaries than on capital markets that can provide information needed for long-term intermediation. Excessive reliance on banks in a country leads to progressive mismatching of the maturity of assets and liabilities, especially when investment opportunitie s in the country are concentrated in the property markets. Increased diversity of financial institutions, starting with investment banks and moving on to insurance companies, helps to lessen the extent of mismatched maturities of financial claims. Further, if a country is equipped with deep, liquid capital markets, these can provide essential safety valves for each set of financial institutions whenever shocks do occur.

So the authors conclude that yes, indeed, there are lessons from history, but as the length and detail of their study demonstrates, these lessons are difficult to learn. And, as the authors point out again and again in their appraisals of the political and economic obstacles to reform that arose in each country, both in the nineteenth century global financial marketplace and in today's, the lessons of history are, unfortunately, even more difficult to implement.