W. P.

KENNEDY*
University of Essex

England will not be able to hold her own against the other nations by
the mere sedulous practice of familiar process.. . . Her chief remaining
advantageliesin that unapproachedfreedom of movement, that viabil-
ity that gives her much of the strength without the cumbrousnessand
want of elasticity of a singlehugefirm extending over the entire land.
Alfred Marshall-1903
A strong but often uncritical pessimism runs tbrougb the his-
toriography of the development of the British economy during the
half century before 1914. A tradition of seeing a dramatic check in
long term economic growth was fostered both by Royal Commis-
sions reporting on real distress and by journalists sounding alarm
over the rather vague threats of economic growth abroad. The diffi-
culties the British economy experienced in the interwar period fur-
ther contributed to historians’ unfavourable appraisals of Victorian
and Edwardian economic foundations. Even though much of the
interwar economy was obviously and painfully idle, the rate of
growth of gross national product was still marginally more rapid
than that achieved before the war.’ Thus, it has been easy for his-
torians to believe the prewar economy must havc been operatini

*I wish to thank D. H. Aldcroft, A. B. Atkinson, C. J. Bliss, S. L.

Engerman, P. J. Hammond, L. Hannah, J. R. T. Hughes, E. L. Jones,
R. Masson,A. N. D. McAuley, an anonymousreferee, and the participants
of the conference on “The International Economy and British Growth,
1860-1913”,held at Harvard University, September1973, for helpful com-
ments and criticisms on various drafts of this paper. Any errors are, of
course,my responsibility.
An expandedversion of the appendicesof this paper are available upon
requestfrom the author.
“The average rate of growth of gross national product From 1870 to
1913,measuredin 1900 factor prices, was 1.99%. The average growth of
GNP,from 1924to 1938 measured.in 1938 factor prices, was 2.06%. The
figuresusedare from C. H. Feinstein,(1972)pp. T14-T16.
416 Explorations in Economic History

below its potential, though in a manner more subtle than that of the
interwar period.
As the quantitative evidence accumulates, more searching analy-
ses of the economic performance of the period have appeared. In
important ways, these studies attempt to dispel the pessimism sur-
rounding the era. Perhaps the most important recent study in this
vein has been Donald McCloskey’s “Did Victorian Britain Fail?”
His article threw the whole issue of performance into sharp relief
by establishing a criterion of the capacity for growth, by allaying
suspicions that the vast amounts of capital invested abroad could
have made an important difference to domestic growth, and by
showing that the much-acclaimed deterioration in productivity was
“too short, too late, and too uncertain to justify the dramatic de-
scription ‘climacteric’.“2
Regarding this last issue of productivity, McCloskey notes that
the results, which are very sensitive to small errors in such notori-
ously unreliable series as the estimates of real gross national product
and of the capital stock, must be treated carefully. The first part of
this paper attempts to show that McCloskey’s conclusions regarding
the limits of growth and the domestic impact of foreign investment
are as sensitive to debatable assumptions and tentative estimates
as is his conclusion regarding productivity. Therefore, the answers
McCloskey offers to the questions he posed so clearly must be re-
garded at best as conjectures and not as demonstrated propositions.
Furthermore, the~examination of these conjectures suggests that they
may actually be misleading.
Because the issues McCloskey addresses are so central to any
assessment of British economic development before 1914, it is inap-
propriately nihilistic to challenge his answers on the basis of his
assumptions and data without offering an alternative solution. The
argument of the latter, part of this paper is that Britain’s resources
didpermit more rapid growth, but that such growth did not occur
because of the consequences of the massive allocation of capital to
conservative foreign investments. This argument does not imply
irrationality on the’part of British investors but it does raise impor-
tant questions regarding the efficiency of Britain’s capital markets in
the half century before 1914.
Limits to British Growth?
McCloskey’s paper marks perhaps the first attempt to establish
precisely the dimensions of an alleged “climacteric” in the rate of
2D. N. McCloskey, (1970), p. 459.
 Foreign Investment, Trade and Growth 417

British economic growth before 19,14. This is done by first estimating

the economy’s capacity to grow in that period. McCloskey’s esti-
mate shows that belief in a climacteric was misplaced, for the
economy was growing as rapidly as its resources permitted. This
estimate rests on four assumptions:3 (1) the rate of growth of output
is determined by the rates of growth of three inputs-the capital
stock, the labour force and disembodied technical progress (that is,
realized technological progress is itself a function neither of the rate
of growth nor of the structure of the capital stock), (2) output and
each of the three input factors can be unambiguously represented by
appropriate index numbers; hence all questions of structure may be
ignored; (3) of these three inputs, the rate of growth of the capital
stock is the only variable which can usefully be described as endoge-
nous to the economy; (4) the production function is of the Cobb-
Douglas type with constant returns to scale.4 The rate of growth of
output is then derived from equation (1)’
(1) Q, = e”K;Lf
(2) 0,/Q, = C&>i/K + W-6/~, -t X
where
Q, = output at lime t.
K, = flow of capital services (assumed to be uniquely related
to the capital stock) at time t.
L, = flow of labour services (assumed to be uniquely related
to the labour force) at time t.
x = rate of disembodied technological progress (assumed
constant).
S,, = ty = capital’s share of output at time t (assumed con-
stant over time).
& = /3 = labour’s share of output at time t (assumed constant
over time).

WcCloskey actually concerns himself with the growth of gross rather

than final output. Since he specifies that a constantly decreasing amount of
intermediate product is needed to produce final output, it is only necessary
here to consider final output and capture the decrease in necessary inter-
mediate production in the index of technicai change.
4Had a production function with a higher (lower) elasticity of substitu-
tion than unity been used, the limits to growth would have been less (more)
restrictive.
SEquation (1) could have contained a fixed factor such ‘as land. Since
the services provided by the fixed factor, by definition, do not change over
time the factor need not appear in equation (2).
418 Explorations in Economic History

Qt (etc.) = the change of output at time-t (all rates of change are

taken as averages of the historical rates and are hence
treated as constants).
If we use the values suggested in McCloskey’s article (these fig-
ures represent the estimated average values taken by the parameters
between 1870-72 and 1907-10):
h = .0120; s, = .44; t/t = .0102; S, = 52; k/K = .0143;
&/Qt = (.44)(.0143) + (.52)(.0102) + .0120 = .0236.
The average rate of growth of real national income which
McCloskey attributes to the actual performance of the British econ-
omy from 1872 to 1907, then, is 2.4% per year. The crucial step in
deciding whether 2.4% is at or below the limit imposed by the
economy’s resources actually turns on the choice of capital-output
ratio. If one accepts the ratio of 4.9, a savings rate of 10.4% of
national income implies a rate of growth of the capital stock of
2.1%.6 If 2.1% is used as the appropriate growth of the capital stock,
then the potential growth rate is 2.7% which is about 13% higher
than the reported rate of real national income growth.7 Suppose,
however, we use a capital output ratio of 4.0, which is the average,

6I? = sQ where s is the rate of savings out of final output. K = kQ where

k is the capital-output ratio. i/K = s/k. Note that when the capital stock
grows more slowly than output, the economy is not moving along a steady
stategrowth path. In relatively short periods a constant capital output ratio
may be a tolerable approximation to reality, but it is not so acceptableover
periodsof forty or fifty years. Between 1870and 1913 Feinsteinhas reported
that the ratio fell from 4.4 to 3.8, reaching as low as 3.6 in 1898and 1899.
SeeFeinstein,(1972),pp. T51-52.
7McCloskey’s useof a capital stock growth rate 1.43%per year omits
considerationof British holdingsof foreign capital. Sincethe purposehere is
to reconsiderwhat constitutes a reasonableleast upper bound to potential
British output, the maximum feasiblerate of growth of the domesticcapital
stock should be used.This implies that our calculation include as available
for domestic capital formation those resourcesactually invested abroad.
Had mojt British foreign investment been so bold as to yield, on average,
higher rates of return than domestic investments, the maximum feasible
British growth wou!d require considerableforeign investment. As shall be
arguedlater, the averagedomesticinvestment returned a greater yield than
foreign investment. Although this was not by any meansinevitable, indeed
perhaps25% of British foreign investmentsearnedas much as good domes-
tic projects, neverthelessthe calculation made here only considers the
limits to growth imposedby the constraint of all capital formation occur-
ring at home.
 Foreign investment, Trade and Growth 419

using Feinstein’s data, for the period from 1870 to 1914. Then the
rate of growth of the capital stock is 2.6% with a savings rate of
10.4% final output; the potential growth rate of the economy is then
3% per year, 25% higher than the reported rate.
Now let us calculate a feasible least upper bound for the growth
of the British economy during the four decades before the Great
War, using the more reasonable capital output ratio of 4.0.’ Suppose
the total savings available for British capital formation was the
American level of 13.7% of net national income rather than 10.4%.
Suppose, in this hypothetical world, that emigration was sensitive to
economic growth rates and that the better performance of the econ-
omy would have ended emigration, or even have begun to attract
more immigrants from Europe, and that therefore the rate of popu-
lation growth would have been 1.6% per year rather than 1,02x.
Finally, let us use the value given by McCloskey to U.K. total
factor productivity for the period 1872-1907; this value was esti-
mated at 1.2.9 When this new set of values is used in equation (21,

sAn even lower capital-output ratio representing the lowest value re-
ported by Feinstein for the pre-1914 period, 3.6 for the years 1898 and 1899,
could easily be justified for the calculation of a supremum. Such a value
would be considerably closer to the U.S. capital-output ratio, calculated
by Gallman and Howle (1971) to be 2.1. (Gallman and Howle found the
ratio of capital to income originating in agriculture to be 2.1; in mining
and manufacturing, 1.5; in all other sectors, 2.9.) Because in the process of
calculating a reasonable supremum the rate of implied output grows faster
than the corresponding capital stock, the annual changes in the resulting
capital-output ratio should be taken into account. The data and procedure
used here, however, are sufficiently crude as not to warrant a more accurate
estimate of the limits to British growth. It may be noted that use of a con-
stant capital-output ratio of 4 in these circumstances underestimates the
?rue” supremum.
9The choice of an estimate for technological progress focuses attention
on important issues. The belief that technological change can be unambigu-
ously represented by a “residual” rests on very strong and almost surely
incorrect assumptions. First, it is assumed that technical change is not a
function of changes in other variables such as the capital stock. This rules
out such appealing concepts as Arrow’s paradigm of learning by experience
and the possibility that technical change is the product of costly research and
development: Secondly, it is assumed that technical change is “neutral” in
its potential impact upon factor supply. Abramovitz and David (1973) argue
strongly against this assumption. They write: “Insofar as technological
change has not been neutral, we cannot gauge its full impact without con-
sidering its effects upon the changing quantities in which the various produc-
tive inputs have been supplied. In these circumstances it seems to US to be
420 Explorations in Economic History

the resulting growth supremum is then 3.54% per year. This figure is
only .85x per year below the level claimed to require phenomenally
high savings levels to reach and is nearly 50% higher than the
recorded rate. Higher rates could be urged as reasonable least upper
bounds to growth by accepting a higher savings rate or by using a
lower capital-output ratio. ‘O The point is by now clear: the calcula-
tion of the limits to growth in this one equation model is sensitive
to the data and assumptions employed. Since the potential limits to
British economic growth may very well have been less binding than
McCloskey believes, it is important to examine closely the second
demonstration in his paper.
This demonstration denies that retention of the resources Britain

fundamentally misleading to persist in seeking to apportion the growth of

per capita product between the exclusive contributions of Invention and
Accumulation,” (p. 438).
Abramovitz and David find that with crude measurements, which tend
to exaggerate the residual, total U.S. conventional factor productivity was
no more than 0.5% per year; this is a value of less than 40% of the value
attributed by McCloskey for the U.K. for the period 1860-1900.
Yet while Abramovitz and David find the U.S. nineteenth century
“residual” to be relatively small, Gallman and Howle find output per unit
of capital to about twice the U.K. value and the first censuses of production
in the U.S. (1909) and the U.K. (1907) found that U.S. output per man was
also nearly twice the value obtained in the U.K. This disparity in factor
productivity, which has been noted in later periods, is certainly not a sudden
occurrence but rather the outcome of long evolution on both sides of the
Atlantic. The ambiguity of the “residual” measure is also emphasized by
the finding that for the very period McCloskey records a negative value of
U.K. productivity growth, Abramovitz and David note the beginning of a
sharp acceleration of total conventional factor productivity in the U.S.
tOMcCloskey uses net investment and net national income as the basis
for the estimation of the fraction of income saved which he employs in his
calculation of the rate of growth of the capital stock. The relevant capital-
output ratio in this case is not the familiar gross capital-gross output ratio
as tabulated by Feinstein (1972, Table 20) but rather the ratio of final out-
put net of capital consumption to the net capital stock. Feinstein’s data (net
capital stock in 1900 prices, Table 43, col. 9; net national product at 1900
factor cost, Table 5, col. 15) shows that this net capital-output ratio fell
from 2.79 in 1870 to 2.25 in 1910 with a low of approximately 2.15 around
the turn of the century. The use of this net capital-output ratio to translate
net savings irnto growth of the capital stock, allowing for depreciation,
indicates that the net capital stock, given a savings rate of 13.7% would
grow at $.48% per year; given a savings rate of 10.4% the growth of the net
capital,stock:would be 4.16%. The corresponding growth suprema, ceteris
paribus, would then be 4.44%and 3.80%respectively.
 Foreign Investment, Trade and Growth 421

invested abroad before 1914 would have produced, greater growth at

home. This claim is absolutely fundamental to any evaluation of the
performance of the Victorian economy. If it can be shown, regard-
less of which counterfactual rearrangement of the resources sent
abroad is suggested, that British incomes would have been no more
than marginally higher, then there is every reason to view the
Victorian-Edwardian period as literally a golden age. In such cir-
cumstances, no alternative world easily imagined would have pos-
sessed a higher material standard of living. Yet it is the historically
unique level of foreign investment which attracts the historian’s
attention when considering the alternative avenues of development
open to Britain in the last half century of the long peace. The in-
vestment flows abroad were so large relative to the size of the econ-
omy that to imagine the consequences of their being altered requires
a conception of a radically different economy. McGloskey’s demon-
stration of the impact of diverting investment from abroad to do-
mestic projects (despite correctly granting very large differentials
between foreign and domestic rates of return; see below), does not
involve a complete specification of the manner in which the British
economy could have utilized those resources, and for that reason is
misleading. As we shall see below, if an initial differential between
foreign and domestic rates of return existed, the process of reducing
that differential would change the structure of the economy, raise
incomes, increase the level and change the structure of demand, raise
domestic wages, and, depending upon the counterfactual hypotheses
one is willing, to entertain, even raise the return to ,capital through
a multiplier process. Ultimately, it is the extent of the shift in the
demand-for-capital curve, not movements along it, which determines
the outcome of a redirection of investment.
The problem posed by McCloskey actually requires the solution
of a general equilibrium model of the British economy under condi-
tions of a counterfactual level of domestic investment substantially
above that which historically occurred. The solution will not be at-
tempted here, but some outlines of the solution can be shown. In
doing so, the strong assumptions McCloskey required to achieve his
results will be made clear.
Let us rewrite equation (1) in a more general form:

(3) Q = AprL”-@

where A = technical progress parameter, P = economies of scale

parameter, and 8 = distributional parameter.
422 Explorations in Economic History

Equation (3) implies a capital demand function which may be

written in either of two ways depending upon whether output is
fixed or is allowed to vary:

where output is held fixed at Q,,; and

(4b) K* = [1U(MR)4AFr-l+‘(‘-e)w-‘(‘-e)]‘/(’-’)
(MR), = marginal revenue obtained from the sale of output Q,
where Q is free to vary, F = 6[(1 - 8)/19]~(‘-~) a constant determined
by the structural parameters of the production function, r = market
price for a unit of capital services, w = market .price for a unit of
labour services, (see Appendix A).
An own-price elasticity of demand can be derived for such a
capital demand function. ‘I The elasticity of demand for capital when
output is fixed is given below:‘*
‘IThe usual definition of the own-price elasticity of demand is in
general (aQ/Q)/(aP/P). For the case here it should be (K/K)/(&/r),
and, by the definition used here, if the elasticity is equal to the share of
noncapital inputs in national income, then the elasticity of demand is less
than unity. Total income at homefalls when more capital is invested domes-
tically since capital’s marginal revenue product is, by implication, negative.
Because this fall in income is not observed in McCloskey’s table (see
McCloskey, (1970) p. 455, Table 1) he must be using another definition
which appears to be the inverse of the one used here. For the definition of
elasticity which seems to be universally used, see A. C. Chiang, (1967),
p. 198 or P. A. Samuelson (1965), p. 105.
This would appear to be McCloskey’s derivation of the elasticity coeffi-
cient:
(1) P-K/Q = c (a constant)
(2) F+ R - g = 0 where the bars signify proportional changes in the
variable
(3) 0 = skg since labour and technology are held constant
F=Q-iy=QE-~=(.Q- I)R
F/K = (sk - 1) which is taken to be the appropriate elasticity.
As suggested above, this definition is the inverse of the one usually encoun-
tered. Furthermore, it is not derived directly from a capital demand func-
tion, which leads to difficulties in interpretation.
‘*One may wonder why the elasticity of demand for capital with fixed
output is not unity. Derivation of a labour demand curve similar to (4a)
yields an answer. As capital costs fall, holding output constant, the de-
mand for labour also falls. The interpretation of this larger elasticity would
appear to be that if more were invested at home, the pressure to emigrate
would increase.
 Foreign Investment, Trade and Growth 423

aK -(l _ e) [$?]“@[y!. $]-(‘-@~r-u-,,-*,

dr=
(5a) dK r
-(l - 6).
arx =
Using equation (4b) rather than (4a) produces a different conclusion.
However, obtaining an answer without specifying a complete general
equilibrium mode requires that marginal revenue equal “price” for
the relevant range of output and that, as before, wage rates remain
unaffected by changes in the price of capital services.
If these assumptions are granted then,

a&? 1 -l”‘?; 6) [pp~I;r-l+‘u-8) w-‘(l- 8 1~/O--P) r-1

dr
(5b) dK*
-.- r = - 1 - /6(1 - 0)
ar K* 1-P
If we drop the assumption that output remains constant when the
domestic cost of capital falls, but keep the assumptions that mar-
ginal revenue is positive a’nd constant and that changes in the cost
of capital services leave the level of wages unchanged, then the
elasticity depends on the returns to scale, p.13Bringing capital home,
thereby reducing the differential between home and foreign rates of
return on investment (differentials which McCloskey concedes could
be as high as 5%),14has an impact which depends on the value given
to 1-1,on the total amount of capital which could be brought home,

isWhenp = 1, the elasticity is undefined;only when there are decreasing

returns to scale,0 < p < 1 is1~1< 1unambiguously. 1 < b < 1/(l - 8) implies
an upward slopingdemandcurve for capital while, for g > l/( 1 - e), f ap-
proaches- (l-0) asymptotically. While it is not easyto interpret a capital
demandcurve on suchan aggregatedbasisasis usedhere, there would seem
to bemoderately decreasingreturns to scalein the relevant range of output.
(I would like to thank A. B. Atkinson for pointing out that 7 2 -(I - 8)
whenp > 1).
idThe existenceof higher rates of return on British domestic capital
investmentsascomparedto British foreign investmentsis central to the dis-
cussion.The evidencefor this differential restsupon calculations of average
rates of return on foreign and domesticinvestment rather than upon direct
evidenceon marginal rates of return which is necessaryfor the argument.
The discussionbelow on the characteristicsof foreign investments presents
evidence to suggestthat very considerable marginal differentials existed
between the typical foreign investment and the domestic projects most
likely to have benefitedfrom a shift in investmentpatterns.
424 Explorations in Economic History

and on the differential to be eliminated. If p is close to unity, very

large amounts of capital could be invested in Britain while leaving
the interest rate virtually unchanged. If the differential is large, the
gains from the switch are correspondingly large as well.”
From an historical standpoint, however, the interesting ques-
tions are avoided by the assumptions. The relaxation of the assump-
tion of constant price requires that a demand curve for aggregate
output be found. If, as would surely have happened, a high level of
domestic investment resulted in a changed composition of output,
then it becomes increasingly difficult to maintain usefully the concept
of a composite good. Furthermore, even if the composite good as-
sumption is accepted, there is no reason to believe that the demand
function for the composite good would have remained unchanged as
investment patterns changed. Instead, as incomes rose as a result of
eliminating the observed return differential, the demand curve would
have shifted outward. Therefore, whether the “price” (and hence the
marginal revenue) of the composite good would have risen or fallen
depends on whether or not shifts of the entire demand curve would
have outweighed movements along the curve.
The assumption that wages were not influenced by changes in
the cost of capital services highlights the importance of income in
determining the significance of eliminating any given yield differ-
ential. As the price of capital services falls and output rises, ceteris
paribus, the demand for labour services rises. An accompanying
rise in wages acts to reduce the incentive to invest in the domestic
economy. Rising incomes (assuming the propensity to consume to be
less than unity), however, increase both the demand for consumer
goods and the supply of savings; both of these factors act to increase
or to maintain the advantages of domestic investment beyond those
gained by the original elimination of the differential in rates of
return.
A satisfying solution to the problem McCloskey poses, that of
estimating the impact of counterfactually higher levels of investment
in the British economy in the half century before 1914, therefore,
involves a much more detailed specification of the likely changes in

*SMcCloskey notes that as the gap becomes greater than 3% the advan-
tage of closing the gap diminishes. This is a result of choosing the value of
the rest of the world’s capital stock at only X20 billion. A higher value of the
foreign capital stock forestalls the setting-in of such diminishing returns
because foreign interest rates would then rise less rapidly as the repatriation
of British funds occurred.
 Foreign Investment, Trade and Growth 425

the structure of output, wage levels and income distribution than has
so far been offered. Estimates of the impact of greater domestic
investment which ignore these considerations are likely to be mis-
leading. As equation (5b) shows, one obtains results that are sensi-
tive to the values attributed to the parameters; the value of these
aggregate parameters is in turn determined by the structure of the
economy. It is precisely this structure which a changed investment
pattern would have altered. In contrast to McCloskey’s conclusions,
further research may well show that the impact of altered invest-
ment flows might have been very significant.
Characteristics of British Investment, 1870-1914
Recognition of the very strong possibility that the British econ-
omy was capable of substantially better performance immediately
requires an explanation of why it did not occur. Perhaps most
fundamentally, the pronounced risk aversion implicit in the rational
behaviour of a very large and important segment of private British
wealth-holders significantly constricted resources flowing into in-
herently profitable but risky ventures. (The evidence for this claim
is developed more fully below.) To the extent that large gambles on
new technology, new lines of production, and new markets are an
inevitable part of rapid economic growth, the risk preferences of
British wealth-holders, served by a sophisticated capital market,
were not conducive to growth.i6 The avoida’nce of risk on the part of
British wealth-holders in the half century before 19 14 required large
purchases of high-gradeforeign bonds and other trustworthy fureigrt
securities. The structure of yields on home and foreign investments,
under the presumption of rationality, strongly implies that high-
grade foreign bonds were better substitutes (but not perfect substi-
tutes) for safe domestic investments than were most domestic British
equities and other forms of real domestic capital formation. This
pattern of portfolio selection, resulting in massive foreign invest-
ment, had a l’arge role in determining both the level and the struc-
r6Another way of making this argument is to say that Britain, in part,
got the rate of growth that the typical British wealth-holder wanted. If there
were no externalities and if capital markets were perfeet, even in an Arrbw-
Debru sense, pronounced risk aversion would imply a lower expected rate of
growth than that which would obtain were investors n(ihing to take bigger
risks in order to achieve higher returns. In such a hypothetical example,
the rate of growth of an economy is not only determined by natural re-
sour& and technology, but also by ‘investors’ trafde-offs between risk and
return. Slower growth may be preferred when expansion is risky.
426 Explorations in Economic History

ture of demand which British entrepreneurs faced. If foreign in-

vestments were not maintained, as from 1873 to 1878 and from
1890 to 1901, British wealth holders did not immediately find
domestic substitutes and the overall level of investment fell; this
fall in total investment triggered substantial depressions in the
1870’s and 1890’s. Foreign investments also greatly affected the
structure of demand for British goods by stimulating the demand for
British exports. The export sector, however, was not the entire
economy. Because British industries rarely exported their goods until
after the establishment of a strong home market, foreign investment,
by stimulating demand for the export industries of long standing,
discouraged, but did not stop, the development of new export in-
dustries, which included the manufacture of the most technologically
advanced goods of the period.
Finally, afthough British capital markets were perhaps the best
in the world before 1914, they were not perfect and their perfor-
mance may very well have seriously amplified the consequences
of the strong preference for risk avoidance among wealth-holders.”
British capital market operations are suspect on two grounds. No
capital market, in the absence of a complete set of contingency
markets for all the goods and services which determine economic
welfare, can ensure that social and private rates of return are
equated; in general, the gap between social and private rates of re-
turn is probably quite large. l8 Since British investments overseas
were heavily dominated by fixed interest securities issued by public
or quasi-public utilities, any externalities were largely captured by

iTFor example, an important article by J. E. Stiglitz (1972) shows that

when there does not exist a complete set of markets for contingent claims
(i.e. futures markets for all commodities of any date under any circum-
stances) stock market allocations of investment are not generally Pareto
optimal. In particular, under fairly general assumptions, the stock market
allocates too much to safe investments and too little to higher yielding but
riskier investments; also firms choose the wrong technique in the absence of
additional information which stock markets do not provide.
Since no capital market allows efficient allocation of investment, com-
parisons of the efficiency of different institutional arrangements involve
comparisons of second-best solutions. It is not clear, then, that British
capital markets allowed a better allocation of investment than did American
or German capital markets despite their defects.
isFor example, Robert Solow has argued that for the U.S. after 1945,
social rates of return may have been as much as 10% higher than private
rates of return. See R. M. Solow, (1963), pp. 70-72,96-97.
 Foreign Investment, Trade and Growth 427

foreigners. lg Conversely, the externalities of domestic investment,

particularly in transmitting new technical knowledge and lowering
other input costs, were captured largely at home. The other consid-
eration which invites a critical examination of the London capital
market is the limited use which seems, at least ex post, to have been
made of opportunities for efficient diversilication.20 It does not seem
reasonable to suppose that the covariances of profitability among
British firms were so great that massive foreign investment was an
inevitable part of efficient diversification. Then, as now, the profit-
ability of a given industry depended upon the business cycle; but,
of course, not all industries were affected in the same way at the

lgForeign investment did bring some indirect benefits to Britain. By

opening up more sources of food and raw materials, their costs were re-
duced in world markets. Since Britain was a major importer of raw materials
she correspondingly benefited from this; reduced food costs, however, do
not show up in private yields on foreign investment. To answer the question
of how large this gain was, it would be necessary to examine the relation-
ship between a given country or area’s exports to Britain and its borrowing
from Britain. If the British lending was a relatively small part of total
investment, as it was in the U.S. after 1870, the case for large externalities
is reduced. However, it may be deceptive to call 2% “small”; the issue may
require, again, a general equilibrium model of the foreign .economy to deter-
mine just how sensitive the growth of exports useful to Britain were to
small variations in foreign lending. A closely related issue is the deter-
mination of whether the externalities could have been better reaped, from a
British point of view, by direct ownership and control rather than by port-
folio investment.
2sIt has been assumed throughout this paper tha,t British capital mar-
kets were sufficiently good to ensure that riskier investments promised, ex
ante, higher expected yields than did safer investments. Michael Edelstein,
(1971) pp. 83-105 has argued that at least the most likely distortions of this
ordering were not serious. It has not been shown, however, that the port-
folios of those who invested abroad were efficiently diversified. To demon-
strate this, it would be necessary to show that portfolios composed of large
groups of domestic equities, perhaps chosen at random, could not have
earned a greater return with no increase in variance than could a typical
portfolio of foreign securities (mostly bonds). If, on the other hand, it is easy
to find examples of portfolios more efficient than those comprised of typical
foreign securities, then necessary, but not sufficient, evidence exists to verify
the failure of efficient diversifying institutions to piay an im,portant role in
Britain. The focus is properly on institutional behavior rather than on that
of individuals. Individuals undoubtedly diversified their wealth h’oldings,
but economies of scale in collecting infarmation and in buying and selling
securities dictated that institutions serving large numbers of investors per-
form the major work in permitting efficient diversificatian.
428 Explorations in Economic History

same time. Furthermore, even if massive foreign investment had

been necessary to achieve optimal portfolio diversification, efficient
world-wide investment would surely have offered more than the 4%
to 5% average return actually earned on British foreign investment
without having increased the aggregate yield’s variation. The low
variance of the aggregate British portfolio of foreign investments
was achieved almost entirely by the purchase of securities whose
variance, individually, was low. Since efficient diversification often
permits the existence of a portfolio which possesses a lower variance
than any single security in the portfolio, British investors as a group
did not seem to be exploiting the advantages of diversification which
their worldwide investments must potentially have offered. The very
small holdings of securities of foreign manufactures, about 4% of
the total,21 reinforces this conclusion, for it was in this category
that the highest expected returns were found and, of course, the for-
tunes of foreign manufacturing industries varied sufficiently over
time to suggest low profit covariances between large industrial
groups. The consequences for Britain of this possible failure to
achieve m&e &icient diyersification are clear; the securities of small,
venturesome domestic firms with good growth prospects were under-
valued, there were too few purchases of the equities of foreign
manufacturing firms and, in general, the yield on the total portfolio
of domestic and foreign investments was less than might reasonably
have been expected* even after taking account of the marked prefer-
ence for low variances of earnings.
That British foreign investment was indeed conservative, reveal-
ing a marked preference for low variance of returns at the cost of
forgoing higher yields, may be seen in an examination of three
characteristics: (1) the infrequency of defaults on foreign invest-

21SeeMatthew Simon, (1967), pp. 40-42; the extractive sector, also

a likely source of large returns, comprised only 12% of the total while social
overhead capital projects, typically possessing low variance, made up 69%
of the total. Mistaken calculations, especially in the middle of the nine-
teenth century, were often made. But in the aggregate, the informed, con-
servative nature of British foreign investment is unmistakable.
220nly an examination of actual portfolios can determine the extent
to which efficient diversification was achieved. Because the evidence pre-
sented here refers only to aggregates, it is entirely possible that many in-
dividual portfolios which made up the aggregate were well diversified. But
the weight ,of low-variance, low-return securities bulked so large in the
aggregate that the relative proportion of portfolios efficiently diversified
must have been small.
 Foreign Investment, Trade and Growth

ments, (2) the preponderance of fixed-interest securities in the aggre-

gate portfolio of British foreign assets and (3) the relatively low rate
of return as compared to ‘estimates of the yields on the Biitish
domestic real capital stock.
In no sense was British foreign investment, especially after 1880,
thrown away. Englishmen got very largely the returns they paid for
and generally enjoyed capital gains as well. This is in marked con-
trast to the nineteenth century French experience with foreign irrvest-
ment. The countries in which Britain invested were either prosperous
and growing or, as in the case of India, were exceptionally friendly
to British interests. Growing countries such as the U.S., which was
the largest single recipient of British foreign investment, had the
means to honor their debts and the incentive to maintain ,their credit;
British civil servants in the closely governed parts of the Empire
saw to it that defaults in areas of their jurisdiction did not occur.
Little was lent to bankrupt princes and insolvent potentates. By
1913, the experienced dealers in the London capital market had be-
come so skilled in steering their clients away from bad loans that
a close, contemporary observer of British foreign investment, R.A.
Lehfeldt, could treat defaults as a rapidly vanishing phenomenon.23
Cairncross estimated that for the decade 1870-80, which stands out
as a particularly bad period for foreign investments, the yield in
dividends was 5.4% and aggregate foreign investments actually ap-
preciated by 0.7%. 24 Defaults were never severe enough to reduce
sign~ificantty the aggregate rate of return.*’ After 1880, and par-
ticularly after 1890, this record improved, The majority of British
investors never pursued high yields to the point where, in the worst
years, defaults radically reduced the realized return. It is not sur-
prising then, that aggregate yields relative to the investment, even
in the best years, were not breathtaking either.
That British foreign investments exhibited a low variance in
their yield becomes more easily understood with the realization that
the preferred instrument of foreign investment was the fixed-interest
security rather than equities. The careful, prudent choice of foreign

23R. A. Lehfeldt, ( 1913), pp. 200-20 1.

24A. K. Cairncross, (1953), p229.
*5The cprality of British foreign investments was sometimes amazing.
In 1891 Argentina repudiated its public debt; yet the railroads and export
facilities wbase construction incurred the debt were built and by the turn
ofthe century the debts were made good. See A. G. Ford, (1962), pp. 141-
165.
430 Explorations in Economic History

assets protected the British investor against default, but for most
foreign investments there was no way for them to share fully in
capital gains, for the yields were fixed. R.A. Lehfeldt, in a study of
British foreign investments between 1888 and 1911, observed that for
large issues, which usually accounted for between one-halt and two-
thirds of the total amount raised by overseas borrowers, “the first
point that stands out is the insignificance of shares.“26 For the
medium class issues, those, between f900,OOO and X200,000, which
he examined in the years 1911-1913, Lehfeldt observed: “Again the
preference for loans, as compared with shares, which is so marked
a feature of the ‘large’ investments, is reproduced in the ‘medium’,
though not quite so intensively-share issues constitute about one-
eighth of the large, one-fourth of the medium class.“27 Although his
coverage is not complete since he is dealing with only about 75%
of the total money calls as calculated by Simon,*’ Lehfeldt probably
presents an accurate picture of the division between shares and fixed
interest securities as instruments of long term British foreign invest-
ment. In fact, because Lehfeldt covered the period of the heaviest
British foreign investment which occurred before the war, a time
when equities were much more widely purchased than they had been
earlier in the last half century of peace, he undoubtedly overstates
the share of equities in the fifty year period.
Lehfeldt’s conclusions regarding the predominance of bonds are
borne out by a study conducted by G.L. Ayers of foreign investment
in the important years 1899-191 3.29 He found that only in 1910 did
sales of ordinary shares, carrying no guarantee of nor limit to yield,
exceed X30 million. Annual purchases of shares were usually below
X20 million; only in the years 1909-1912 was this level broken for
the period 1899-1913. For the period 1899-1913 total money calls
for foreign investments averaged X12.5 million.30 The figure for 1910

26R. A. Lehfeldt, (1913), p. 199.

*7R. A. Lehfeldt, (1914), p. 434.
*sMatthew Simon, (1967), pp. 33-60.
29G. L. Ayers, (1937) especially chart, p. 52.
30The information on new purchases is much better than that on sales,
which is almost nonexistent. Hence it is not possible to know precisely how
aggregate portfolio holdings compared with the annual flow of assets into
the portfolio. There is no reason to assume that bonds were more likely to
be sold than equities. In fact the reverse was probably true; those who
brought shares probably took a more aggressive, and perhaps professional,
attitude toward the management of their portfolios and were hence more
likely to prune their portfolio more frequently, meaning that the gross in-
 Foreign Investment, Trade and Growth 431

was X1.98 million. Towards the end of the period ordinary industrial
shares appeared in the aggregate British portfolio of foreign invest-
ments, but they were neither representative nor particularly venture-
some.31 The nature of British foreign investment is well captured
by C.K. Hobson; in a sharp contrast with American foreign invest-
ment in Canada, Hobson wrote:
Americans come into Canada and buy a lumber proposition, a com-
mercial enterprise, or a branch of some of their own enterprises in
one of the provinces. In these cases they go to the country themseIves
and look after the business in which they are interested. British inves-
tors, on the other hand, remain quite satisfied if their mod&ate interest
and dividends are forthcoming at the proper time and their loans are
met at maturity. There has in recent years been an extensive movement
of British capital into Canadian industrial enterprise, but even here
there is a distinction between British and American capital investments,
as in mines which have frequently been first developed by Americans,
and subsequently sold to British buyers.32

flow of shares relative to fixed interest securities very likely over-represented

their importance in the aggregate British portfolio of foreign securities.
31C. K. Hpbson (1914) noted in his book that: “There is however, a
new characteristic visible in the course of foreign investment during the
past few years, namely a tendency to invest in manufacturing and industrial
concerns.. . . A considerable amount of United States Steel Corporation is
held here,” (p. 159). The explicit mention of U.S. Steel is revealing. (George
Paish, in a discussion of his 1911 paper before the Royal Statistical Society,
also mentioned the U.S. Steel Corp. See George Paish, (191 I), p, 197.) Such
mention evakes a strong image of what the consequences of a different pat-
tern of foreign investment might have been. In 1889 Andrew Carnegie had
offered to sell out to a group of English capitalists (J. R. T. Hughes, (1966),
pp. 261). If they had taken him up and had brought the most dynamic steel
company in the,U.S. rather than U.S. railway bonds, their returns would
have been much larger. Such a direct stake in the active management of real
capital abroad, if it had occurred, would have put British foreign investment
before 1914 in a rather different perspective than that which followed from
the more limited stake owned by bond holders, As it was, it was not until
Morgan created U.S. Steel twelve years later that the entrepreneurial prdfits
from the formation of a giant, quasi-monopolistic steel firm were reaped.
There were other examples: Hughes (1966, p. 288) cites the spectacle of
Henry Ford sitting on a Detroit curb, cryifig from frustration in not being
able to raise money to make cars. The Ford in the world’s future could
have been quite different had the agents of English investors been as quick
to spot promising American industrial issues as they were to spot railroad
bonds’and tea and rubber plantations. Ford eventually raised the money,
mainly from individuals; would it have been possible had Detroiters been
accustomed to investing heavily in foreign railways?
32Hobson, (1914), p. 28-29.
432 Explorations in Economic History

The average rates of return which the British portfolio of for-

eign investments yielded are entirely consistent with the description
of the aggregate portfolio as bond-laden, conservative and chosen
to suit the tastes of discriminating rentiers. The most detailed studies
made of the earnings of the aggregate portfolio are ‘those of Sir
George Paish. In 1909, he made a thorough examination of the
returns to Britain from foreign investments with the aid of the Re-
ports of the Commissioners of Inland Revenue. These reports de-
tailed the incomes to British taxpayers from Indian, colonial and
foreign government stocks, municipal securities and railways.33 Paish
supplemented this partial information on overseas earnings by
examining the statements of 2172 public companies which had raised
money through the English capital market. His comprehensive
study, however, had one significant omission which must be kept in
mind in the following discussion. It covered only foreign portfolio
investment; he did not include direct private investment abroad,
which he guessed to involve ~300,000,000 to ~500,000,000 or 7.5%
to 12.5% of total foreign investment. 34 Direct investment generally
brought with it direct control over foreign assets. Only the best
informed and least risk averse of British investors made such invest-
ments; the yields on these investments were correspondingly higher.
(See Appendix B).
Paish’s study of foreign portfolio investment showed that in
1907, 38% of total British foreign holdings of &2693,7m. earned
between 3% and 4% interest; 42% earned between 4% and 5% inter-
est; only 18.5% of total holdings earned more than 5% and, of this
amount, 11% earned more than a 10% rate of return. (See Appendix
B for sources.) The British holdings yielding more than a 10%
return accounted for a full quarter of total British portfolio income
earned abroad. These figures, of course, are only average rates of
return. Between 1907 and 1913, Paish calculated that British foreign
portfolio investment, already large, rose by a further 38% to
X3714.7m. This massive flow of new investment did not substantially
alter the sectoral distribution of British portfolio investment. Rail-
roads in 1913 accounted for 40.9% of total portfolio investment,
whereas in 1907 they had accounted for 44.5%. Commercial and
industrial investment rose to 3.9% in 1913, from 2.9% in 1907;
municipal bonds rose from 2.2% in 1907 to 4.0% in 1913. Despite

33George Paish, (1909), pp. 465-480.

j4Paish, (1909), p. 490, and Paish (191 l), p. 191.
 Foreign Investment, Trade and Growth 433

this massive investment in roughly the same pattern as the p.revious

holdings, there is no evidence of a sudden alteration in the rates of
return on foreign investments. The marginal rates of return within
large categories, at least as shown by the increase between 1907 and
1913, were approximately equal to the average which obtained in
1907.
The price of foregone potential yield with which the typical
British investor bought his stable foreign income can begin to be
appreciated by a contrast with aggregate private rates of return on
domestic real capital. The yield on the gross domestic capital stock
for the years 1910-1914 can be shown to be 10.6%; the yield on the
private, gross domestic capital stock (excluding dwellings) can be
approximated at 11.3%. 35 These are, again, only average private
yields and not the marginal yields upon which investment decisions
depend. However, aggregate profit figures, which are closely corre-
lated to yields, show much more fluctuation over Ihe business cycle
than they show over variations in the rate of invebtment; the effect
of shifts in the capital demand schedule dominate movements along
the schedule. Indeed, to the extent that the rate of technical change
accelerated, economies of Scale existed, or new markets were opened,
the marginal yield on many investments may have surpassed by a
wide margin the average yield. In any event, there is no evidence
of sharply decreasing returns to investment indicating that marginal
rates of return were well ibelow the average,36 To the extent that
private yields on investment were less than social yields, the true
difference is probably underestimated even further.

35The method of calculating these yields was to equate the income from
the relevant gross domestic capital stock, valued at current replacement
price+, with property’s share of GDP; all the data is from Feinstein (1968,
Table 6; 1972, p. T12 eel. (5), p. T104, col. (5)). Inadequacies of data make
calculations for earlier Yeats more speculative. The period 1910-1913, how-
ever, is very interesting, for it was a time of relatively heavy foreign invest-
ment. Furthermore, the average rate of return on dometitic capital does not
seem ‘to be unusually high during those years. See Phelps-Brown and Weber,
(1953) (Figs. 3 iind 5).
36The converse would appear to be true. First, over this. period,, the
domestic net capital stock vdlued at current replacement costs increased by
almost loo/, inore than the sum of the gross investment, indicatisg substan-
tial dapital gains in money terms on real assets. Secondly, althbugh the
average rate.of &urn on all property valued at current replacement costs
fell slightly over the years 1910-1913, the drop was consistent with a mar-
ginal rate of, return of nearly 9%, assuming that all of the change in yields
wasbrought about by the most recent investment. Of course, if the structure
434 Explorations in Economic History

In the aggregate, then, since British domestic investments as a

group yielded a higher private return than did the assets which
comprised the bulk of the British foreign portfolio, domestic invest-
ments, assuming rationality, were riskier. Colonial and foreign in-
vestments were not perfect substitutes for the safest domestic se-
curities; this fact was reflected in the higher yields apparently earned
on colonial and foreign securities when compared with the yields
earned by domestic securities of the same type. Foreign and colonial
railroad bonds, however, must have been better substitutes for the
safest domestic bonds in the eyes of many savers than were domestic
industrial equities. Only a small proportion, no more than a quarter,
of total British foreign investment, including both direct and port-
folio investments, earned a yield as high as that which was earned
on the average unit of domestic real capital invested in manufactur-
ing, mining, construction and financial services. The yield on some
of the more venturesome projects in British industry must have been
far higher than average.

The Consequences of British Foreign Investment, 1870-1914

British aggregate risk preferences influenced in three important
ways the performance of British entrepreneurs: (1) they acted to
reduce aggregate capital formation for the long periods of time
when foreign investment was out of favour; (2) they acted to main-
tain a pattern of demand which discouraged structural change within
the economy; and (3) they acted to increase the cost of domestic
capital formation.
First, the heavy dependence on foreign investment displayed by
essentially risk-averse investors exposed Britain to prolonged periods
of reduced capital formation in a manner which the U.S. and Ger-
many, facing stronger domestic demands, did not experience. Move-
ments in foreign investment dominated British capital formation.
Twice in the’ period from 1870 to 1914 total British investment as a
proportion of income dropped sharply below the long term average.

of yields had changed so as to inflict heavy capital losses on previous in-

vestments, it YouId still be possible that the most recent investments, per-
haps concentrated in new sectors, would offer very high returns.
Little more can be gleaned from further study of these aggregates. Data
are still needed on marginal rates of return at the firm level. Such studies
will be compli ated, however, by the fact that rates of return will depend in
part on the va ues of macro-variables beyond the control of individual firms,
as well as on t i e type of investment made.
 Foreign Investment, Trade and Growth 43s

On both occasions, from 1876 to 1880 and from 1893 to 1898, for-
eign investment fell much more steeply than did domestic fixed
capital formation. On the other hand, at those times when total
investment rates were rising above the long term average, as from
1870 to 1872 and from 1903 to 1913, foreign investment was ex-
periencing a pronounced boom; when the total savings rates were
approaching a prewar high in the period 1905-1913, domestic invest-
ment rates were falling. Only in the years 1894 to 1900 did domestic
investment dominate the movement of total investment, pulling up
total investment relative to GNP while foreign investment continued
to decline. The inference drawn from these movements in investment
behavior is that the domestic economy alone could not absorb the
massive levels of savings Britain generated;37 when foreign invest-
ment was out of favour, as it was from 1872 to 1877 and from 1890
to 1901, rentiers either increased consumption or increased their
holdings of money balances. Had they been willing to accept domes-
tic substitutes more readily, investment levels would surely have been
higher. As it was, only when interest rates sank to record lows in
the 1890’s at the cost of deep depression, were sufficient substitutes
for foreign investments found, often in mortgages, to reverse the
trend of total investment without the stimulus of renewed foreign
lending. Cairncross has described the general phenomenon well:

The alternative may have been to accumulate capital abroad or none

at all. Our foreign investments were made largely in times of boom
out of the abundance of high profits, and when nearly the whole em-
ployable population was at work. Is it certain that, if there had been
no convenient “sinks” for British capital in foreign countries, the
income from which that capital was provided would even have been
created?38

37The inability of the domestic economy to absorb a sudden inflow of

savings, induced by a reluctance of rentiers to continue to lend abroad,
should probably not be considered proof of entrepreneurial failures, al-
though it does raise further questions about capital market operations.
Entreprenuers only supply securities; they do not unilaterally determine
the equilibrium price of the securities. No doubt entreprenuers used capital
market facilities to achieve the cheapest funding possible, but if savers
demanded only the highest-grade securities, as would be the case after a
bad foreign scare, it would often not have been possible to sell less secure
debentures or equities. Many firms, under these conditions, would not have
been able to exploit the enlarged pool of domestically available investment
funds.
3aA. K. Cairncross (1954), p. 232.
436 Explorations in Economic History

As A.G. Ford has recognized, foreign investment was linked to

the aggregate level of British demand through exports.39 The precise
relationship between foreign investment and exports is complicated
because of the intricate network of multilateral trade flows which
had developed by the end of the nineteenth century. British loans
increased liquidity abroad and relaxed a constraint on foreigners’
import flows. Those imports, however, often did not come directly
from Britain even when the loans did. Nevertheless, a cessation of
foreign investment almost invariably meant a decline in exports.
Without a corresponding increase in domestic investment to take up
the slack, the economy was faced with excess capacity and depressed
markets. Full employment often did not return until foreign demand
and foreign investments were again rising.40
Although it has long been recognized that all industrial countries
experience a decline in the proportion of GNP invested during a re-
cession, Britain was uniquely dependent on external stimuli to end
her investment slumps. The conservative nature of British foreign
investment, which did not find real capital formation in the domestic
economy as inviting as portfolio investment abroad, may be an im-
portant part of the explanation of why Britain did not face the de-
mand pressures experienced by other developed countries and hence
why Britain did not maintain the levels of capital formation achieved
by other countries. Furthermore the impact was cumulative; each
investment slump prolonged by delayed external demand reduced
future income.
British foreign investment crucially affected the structure of
domestic demand as well as its leveL4’ Foreign investment impor-
tantly affected the export sector; directly or Iindirectly, large amounts
of foreign lending were translated into extensive orders for exports.
Because of the high levels of transactions costs involved in trading
over long distances, the variety and diversity of exports was con-
siderably less than that of British manufactured goods in general.
For example, in 1907, a year rich in data as a result of the Census of
Production, 46% of British exports were comprised of coal and tex-

39A. G. Ford, (1965), pp. 19-30.

40Cairncross (1954), p. 188.
4rH. W. Richardson (1969) p. 194 made the same point: “. . . boom
conditions (especially exports) in the staple trades did not favour a shift of
entrepreneurs from old industries to new.” Richardson did not emphasize,
however, the extent to which foreign investment contributed to overcommit-
ment.
 Foreign Investment, Trade and Growth 437

tiles while domestic consumption of those goods amounted to only

17% of the total value of traded goods both produced and consumed
in Britain. Since the beneficiaries of increased demand for exports
were generally well-established industries, foreign investment re-
duced the incentive to diversify through the creation of new lines
of goods because the new lines usually depended on domestic mar-
kets for their initial development. In this regard, the patchy per-
formance of the British capital goods industry in developing new
products, especially new types of machine tools, is a measure of the
domestic impact of foreign investment. The importance of domestic
demand for the development of the capital goods industry is well
known.42 For example, S. B. Saul has emphasized the crucial role of
the home investment boom of the 1890’s in firmly establishing new
machinery techniques, especially the use of millers and turret
lathes, often of American design. 43The critical importance of domes-
tic demand stems from the nature of information flows concerning
capital goods. British firms were more familiar with British engineer-
ing equipment than were foreigners. Foreign investment switched
demand for capital goods from domestic customers with a high
propensity to use British equipment to customers with a lower pro-
pensity; this was especially true of the newest types of equipment.
An indication of the difference between the propensity of domestic
and foreign managers to use British capital equipment can be seen
from the 1907 Census of Production. In 1907, when Britain invested
more abroad than at home, 66% of the value of capital goods pro-
duced dn Britain was sold to British users; exports claimed the rest.
This would suggest that British domestic investment projects were
over twice as likely to use British equipment as were foreign proj-
ects.& Furthermore, the tendency for export production to be less

4%. B. Saul (1968a), especially pp. 209-237.

4%. B. Saul, (1968b), pp. 29,4 1.
“Since there would have been some demand, especially in Europe-
the world’s biggest market for imported capital goods-for British machin-
ery and tools without any foreign investment on Britain’s part, the role
which British foreign investment played in stimulating demand for British
capital goods is obscure.’ If foreign demand depended on the competitive
performance of the industry as compared to other major producers, foreign
investment, to the extent that it only partially replaced domestic investment,
may have adversely affected export prospects by reducing the incentive for
domestic producers to expand capacity and introduce new lines of machines.
Furthermore, domestic producers, mostly relatively small firms, were much
less able to respond quickly to foreign needs than they were able to antici-
438 Explorations in Economic History

diverse than production for domestic use was reinforced by the con-
centration of engineering export markets in the less industrialized
countries,45 with their more rudimentary requirements. By reducing
the level of demand for British engineering goods and by deflecting
what demand there was away from new lines, British foreign invest-
ment thus depressed the profitability and retarded the ‘expansion
and diversification of domestic engineering firms (relative to what
might have been reached with more extensive domestic investment)
and contributed to the incomplete development of the engineering
industries before 1914.46 This in turn raised the costs of those firms
which used engineering goods as inputs; they either had to import
the equipment or make do with less useful but readily available
domestic goods. The experience of the engineering industry was an
important example of the long run consequences of, foreign invest-
ment for the nature and characteristics of structural change in
British industry.
The domestic impact of British foreign investment was not re-
stricted to the impact on the level and structure of demand. It also
affected British entrepreneurs by raising the cost of capital forma-
tion over what it would have been had investors exhibited a greater
preference for risk or had the existing capital markets diversified
risk-taking more efficiently. It was not a matter of high-risk domestic
projects not being able to raise money at any price, but rather, the
funds available for risky projects at any given rate were fewer than
would have been the case had preferences favoured more risk:taking
or had the capital market diversified risks more efficiently. In con-
trast, the resources available at any given price to entrepreneurs in
established industries such as textiles, iron manufacturing and ship-
building, which were able either to borrow on the basis of proven
earnings or to exploit an existing cash flow, were quite different
from the resources available to entrepreneurs in newer areas such as
automobiles and electrical engineering. This relatively easy avail-
ability of funds to established industries further reinforced the ten-
dency toward overcommitment. Similarly, industries which faced

pate and fulfill the needs of local users. On the other hand, foreign invest-
ment undoubtedly stimulated investment in domestic export industries.
However, because these were established industries with large capacity ex-
periencing relatively slow technical change, they did not generate high levels
of demand on the capital goods industries.
4%. B. Saul, (1965), p. 16,
4%. B. Saul, (1972), p. 142.
 Foreign Investment, Trade and Growth 439

large, discrete investment decisions, thus giving the investment an

all or nothing character, found borrowing more difficult than in the
U.S. or Germany. The difference between the performance of the
British bicycle and automobile industries may exemplify the contrast
between the ability of small but venturesome projects to raise money
and the difficulty of larger, riskier, but much more profitable ven-
tures in doing so. 47By affecting both the structure of capital supplies
available domestically to British firms and the level and structure of
demand for the output of British firms, foreign investment, perhaps
more than any other single factor, acted to freeze the structure of the
British economy in the position seen to be so precarious in the inter-
war period.
Conclusion
It is not surprising to find careful studies showing that in the
economic environment of pre-1914 Britain there were few missed
opportunities for individuals acting rationally under constraints be-
yond their control. Only by considering the total impact of foreign
investment on the domestic economy, however, does the perfor-
mance of the economy and the achievements of its entrepreneurs be-
gin to become fully comprehensible.“8 With such a large proportion
of British resources held in the form of foreign fixed-interest securi-
ties, the growth potential of the economy was naturally restricted
and the behaviour of individual entrepreneurs reflected this restric-

“It has been argued that virtually every new industry in Britain could
obtain funds on some terms. S. B. Saul has demonstrated this for one of the
most important industries (Saul, (1962), pp. 22-44). He shows that some
firms at some times were able to obtain funds from the stock market. No-
where does he argue that if funds had been cheaper and more readily avail-
able that expansion could have been no faster. Rather, he states the oppo-
site: “The depression late in that year (1907) hit the industry badly; Daimler,
Rover and Humber all suffered heavy losses and Argyll, one of the biggest
makers in Europe, went into liquidation. Recovery was slow in that little
fresh capital was attracted until 1912-13, but output rose steadily from
10500 commercial vehicles in 1908 to 34000 in 1913.” (Saul, (1962) p. 24). In
short, at a time when markets were growing, the automobile industry could
not get the resources to exploit fully, the opportunity. Growth was,, in part,
a functio’n of the ability to attract funds and at a crucial period of the indus-
try’s development, the capital market was reluctant to push expansion more
rapidly.
@The importance of constraints beyond an individual’s control has
been recognized in discussions of Victorian entrepreneurship. D. N.
McCloskey and L. G. Sandberg, (197 1) wrote: “Individual rationality, how-
440 Explorations in Economic History

tion. It seems reasonable to conclude, not that British resources were

incapable of sustaining more rapid growth, but rather that re-
sources were not deployed to exploit opportunities which did exist.
As suggested earlier, satisfactory answers to questions about the
development of the British economy’s structure depend upon the
successful construction of a general equilibrium model of the econ-
omy. Then counterfactual hypotheses could be rigorously tested
and their sensitivity to different assumptions made clear. When such
models are constructed, however, foreign investment must be given a
prominent role, for it is upon the opportunity cost of such invest-
ment and the structural pattern which it molded that the judgements
of the Victorian-Edwardian economy will depend.
APPENDIX A
Equations 4a and 4b are obtained from the minimization of a
cost function subject to an output constraint satisfied by a Cobb-
Douglas production function. Equation 4b follows by noting that
output should be a function of marginal cost, which in turn is given
by setting the derivative of the minimized cost function with respect
to output equal to the marginal revenue obtained by selling the out-
put. For this way demand considerations enter directly into calcula-
tion of the elasticity.

APPENDIX B
The basis for this evidence is a series of three articles by Sir
George Paish:
1. “Great Britain’s Capital Investments in Other Lands” Jour-
nal of the Royal Statistical Society Vol. LXXII, 1909, pp.
465-495 (including discussion);

ever, doesnot necessarilyproduce aggregaterationality, and the literature

on entrepreneurial failure can be interpreted as arguing in part that there
were not only individual but also aggregateirrationalities.” Two very com-
plicated issuesare involved here. The first involves situations in which,
becauseof the presenceof uncertainty, indivisibilities, or externalities, the
equilibrium position of a competitive system is not Pareto optimal (i.e.
aggregateirrationalities exist). In such a situation, it may not be clear, out-
sideof a form of central planning, how to guaranteethat only Pareto opti-
mal outcomesare reached.There may be no feasible mechanismfor achiev-
ing Pareto optimality. The secondissueturns on the familiar problem of
deciding which of a set of Pareto optimal states is preferred by society.
The choicemay depend,asperhapsit did in Victorian Britain, very crucially
on the distribution of incomeand wealth.
 Foreign Investment, Trade and Growth 441

2. “Great Britain’s Capital Investments in Individual Colonial

and Foreign Countries” Journal of the Royal Statistical Soci-
ety, Vol. LXXIV, 1911, pp. 167-200, (including discussion).;
3. “The Export of Capital and the Cost of Living” Transac-
tions of The Manchester Statistical Society, Session 1913-
1914, pp. 63-92.
The discussions which followed the papers given to the Royal
Statistical Society provide most of the detailed information on
Paish’s data, including their omissions and extent of coverage. His
figures may be compared with Matthew Simon’s series of new British
portfolio investment and Charles Feinstein’s “net investment
abroad” series.

Simon Paish Feinstein

1904 85.0 - 121
1907 116.3 89.4 162
1908 147.4 145.9 150
1909 175.7 182.4 142
1910 198.0 189.1 174
1911 169.2 164.0 204
1912 200.7 160.0 203
1913 217.4 196.7 235

Simons’s figures are probably more accurate than Paish’s; hence

Paish tended to underestimate British new foreign portfolio invest-
ment. There must have been serious gaps in both Simon’s and
Paish’s stock estimates. Neither one of them included private direct
investment abroad nor did they include sales of foreign securities
by British citizens. There is no indication of the nature of the sales
in terms of industrial classification or location. The problem is im-
portant, for the presence of sales from the aggregate British port-
folio may invalidate Paish’s distribution of portfolio foreign invest-
ment by both country and industrial classification. Information on
sales of previously purchased foreign securities may also affect
Simon’s conclusions regarding the nature of foreign investment in
terms of both its geographical and industrial characteristics.
If Feinstein’s figures of the major components of the current
account of foreign trade, especially the series of property income
earned and owned abroad is roughly correct, then the series that
results, net foreign investment, should be roughly correct. The prob-
lem therefore, is to identify the financial instruments which brought
about this net foreign investment. The instruments are related as
442 Explorations in Economic History

follows (the description of each category is interpreted as the annual

figure):
[foreign issues purchased by British firms or individuals (K)] -
[sale of previously held foreign issues to foreigners (U)] + [direct
British investment abroad (U)] - [d irect and portfolio investment
by foreigners in British firms (U)] + [short term lending (U)] -
[short term borrowing (U)] = net foreign investment in any given
year (K), where (U) = series unknown, (K) = series known.
It is reasonable to believe that in years of large purchases of
foreign issues as reported by both Paish and Simon the sale of pre-
viously held foreign issues would be small and distributed differently
from the composition of the new purchases. In years of low levels of
foreign purchases, years usually characterized by distrust of foreign
investment in general, it is not possible to make even such a rough
estimate. For this reason, since his data related to a period of heavy
foreign investment, Paish’s figures on the industrial (and geograph-
ical) distribution of British foreign investments are more reliable, in
the absence of further information of other elements of British inter-
national finances (especially information on the sale to foreigners of
previously held foreign securities) than are Simon’s figures. It is not
especially revealing over a long period simply to add the annual
gross purchases of foreign securities without, at the same time,
making an assumption about the disposition of previous purchases.
An estimate of the disposition of previous foreign investments re-
mains to be done.
Overall, Paish’s articles remain the best source of information
on the nature and distribution of British foreign investment. It must
be used with some caution, however, especially in the absence of
more information on sales.
APPENDIX C
The calculations of the average rate of return on domestic fixed
capital were found by comparing estimates of property’s share of
domestic income with various capital stock estimates. The series
used were all taken from Feinstein, (1972). The series were: compro-
mise GDP (p. T-12, col. 5); gross domestic capital stock at current
replacement cost (p. T-104, col. 5); property’s share of GDP exclu-
sive of rent on land and buildings, which was found using the series
for rent (p. T-5, col. 6); value of the capital stock exclusive of dwell-
ings, which was found using the value of dwellings (p. T-104, col. 1);
 Foreign Investment, Trade and Growth 443

capital consumption (p. T 14-15, col. 14). Finally the value of the
private capital stock excluding dwellings was found by substracting
the val,ue of the public capital stock from total capital stock exclud-
ing dwellings. The value of public capital was estimated by summing
the previous forty years’ capital investment outlay on the part of the
national and local government. Such investment was assumed by
Feinstein to last for forty years; at the end of that time it was as-
sumed suddenly to be worth nothing.
Property’s share of domestic income is found in C. H. Fein-
stein, “Changes in the Distribution of the National Income in the.
United Kingdom since 1860”, in J. Marchal and B. Ducros, (1968),
pp. 126, 129.
APPENDIX D
The proportion of British manufacturing output exported and
consumed at home are found using the data in the 1907 Census of
Production (Cd. 6320).
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