Chapter 27: Finance and Industrialization

Going back to the 1600s, the development of modern financial systems transformed life on planet earth. Debt markets and stock markets helped industrialization spread and remain ever-growing. They’ve also created a new phenomenon: The boom-and-bust cycle. And it seems that we, as a species, have decided that the key benefits of financial modernization – technological progress and mostly continuous economic growth – outweigh the anxieties and the risks of it.

Sources for this episode include:

Ferguson, Niall. The Accent of Money: A Financial History of the World. Penguin Books. 2008.

Heaton, Herbert. “Financing the Industrial Revolution.” Bulletin of the Business Historical Society, vol. 11, no. 1, 1937, pp. 1–10.

Khanna, Sushil. “Capital and Finance in the Industrial Revolution: Lessons for the Third World.” Economic and Political Weekly, vol. 13, no. 46, 1978, pp. 1889–1898.

Mackay, Charles. Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. Richard Bentley. 1841.

Rosen, William. The Most Powerful Idea in the World: A Story of Steam, Industry, and Invention. University of Chicago Press. 2010.

“The King of Con-Men: The biggest fraud in history is a warning to professional and amateur investors alike.” The Economist. 22 Dec 2012.

Wile, Rob. “Here’s Why The World’s First Central Banker Got the Death Penalty.” Business Insider. 8 Apr 2013. https://www.businessinsider.com/johan-palmstruch-central-banking-sweden-2013-4

Full Transcript

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When you hear the word “finance” what do you think it means?

I suppose if we were to try to answer that question, we might come up with enough material to write a book. And, in fact, many people have written some pretty comprehensive books about everything that finance encompasses.

But if you boil it down to some key concepts, probably the most important is going to be that of investment – taking money and turning it into more money.

And there are a number of ways of doing that. But today, I want to focus on the two most obvious means of investing.

Number one is lending. Now, when we think of lending, we tend to think of the banks providing mortgages and other loans. But it also includes the bond market.

Number two is enterprise ownership. Often times we think of this through the lens of the entrepreneur. When someone starts a business, she’ll take her savings and use them to buy the materials she needs to produce the goods or services she’ll sell to customers. But alternatively, there’s also stock ownership. Someone else can come around and purchase a share of her business, investing his money in her enterprise, and then pocketing a certain percentage of the profits.

And entire debt markets and stock markets developed around these investment strategies. Nowadays, these markets dominate a huge portion of our economies. Any form of saving is effectively an investment in the debt market or the stock market. Our pensions, IRAs, 401(K)s, and even our savings accounts at the local bank are all investing in these markets. That’s how we earn a return on them.

These financial systems gave us the world we enjoy today. Because of the bankers and the stock market investors, somebody invented the phone you’re using to listen to this podcast. Because of them, somebody was able to make the clothes you’re wearing. Financial systems are how most people get a college education, a house, and a car. Modern finance made the modern world.

And yet, most people hate modern finance. Those same bankers and stock market investors tanked the global economy in 2008. They got bonuses while the rest of us lost our jobs, or our raises, or our savings, or all of the above. The average American will probably see seven or eight economic collapses in his or her lifetime. Financial crises are a regular part of economic life, and they always lead to (at least some) homelessness, divorces, and suicides.

Going back to the 1600s, the development of modern financial systems transformed life on planet earth. And as industrialization picked up, high finance helped it spread and remain ever-growing. And it seems that we, as a species, have decided that the key benefits of financial modernization – technological progress and mostly continuous economic growth – outweigh the anxieties and the risks of it.

And so, we have elected to live with both the boom and the bust.


This is the Industrial Revolutions

Chapter 27: Finance and Industrialization


Part 1: Building the Future

It was 1656 when King Charles X Gustav of Sweden deputized a Dutch entrepreneur to start a bank. His name was Johan Palmstruch.

Originally born in Riga, Latvia to a trader merchant based there, Palmstruch had emigrated to Sweden about a decade earlier. He had long wanted to go into banking and had proposed a bank charter to the king on two prior occasions. The third time was the charm when he promised the crown one half of all bank profits.

By 1657 then, the Stockholms Banco was in operation. Much like the Dutch Wisselbank, this Swedish bank would create a means of exchange between merchants by issuing banknotes. Customers would put their silver or gold – but most often, their plate-shaped copper coins, called dalers – in the bank, which would serve as their deposits. Then they could get banknotes for the amounts deposited, like receipts, and use them as paper currency.

Stockholms Banco would also serve as a lender, providing a much-needed source of credit during an age when usury laws still hampered investment. Just like with our savings accounts today, the bank would use the money stored there by depositors to make loans.

This is how Palmstruch was a financial innovator. He would keep some of the metallic deposits in the bank as the reserve – in other words, he wouldn’t loan it out. But it was a small proportion of the deposits. Most of it he loaned in banknotes.

If you have $100 in a savings account, your bank might keep $10 in reserves and loan out the other $90 to your neighbor. Let’s say the bank earns 5% interest on that $90 loan. That’s $4.50 profit to the bank, a tiny amount of which the bank will give to you as the depositor. (Let’s say 50 cents.) So now you have $100.50. Your neighbor has $90. The bank has $4. What started as $100 suddenly turns into $194.50 in total economic value. And if your neighbor deposits some of that money into another bank, the value created only continues to grow.

This is called fractional reserve banking, and it’s what Palmstruch pioneered. If you think it sounds like trickster magic, you’re not alone. It’s stuff like this that makes people very distrustful of banks. But it’s also stuff like this that has led to explosive economic growth. The expanding money supply has opened greater and greater access to credit, allowing greater and greater investment in capital, labor, and technological innovation; creating greater and greater productivity; generating greater and greater incomes; allowing for even greater and greater levels of investment from there.

Albeit, in the early stages of the Industrial Revolution, access to credit was not as important as it would be later on. Most of the new enterprises, especially in metallurgy, were started by those nonconformist Protestants whose families had been accumulating capital for decades.

And the industry that was revolutionized the most – textiles – required relatively little money for new start-ups. Anyway, many of the textile entrepreneurs started small with existing mill equipment they converted for yarn or cloth production and then scaled up as they generated profits. Others – like Sir Richard Arkwright – found partners who’d invest in their start-ups. Occasionally, they would need access to credit for operating expenses. When they did, they would usually tap little commercial banks, not investment houses, for short term loans.

But investment banking picked up with the introduction of the railroads – and, yes, episodes about the locomotive and railroads are coming soon. And after the Panic of 1825, manufacturers and merchants began pooling their capital in joint stock investment banks that could lend larger amounts for such infrastructure development. And yes, we’ll also discuss the credit boom that came with the railroad boom in an upcoming episode. Because don’t forget, we need to talk about that pioneering finance family, the Rothschilds.

But investment banking did play one important role in the early development of the industrial economy: It helped fund the trade missions with the wider world. Firms like Barings specialized in merchant banking, lending money to the shipping outfits that transported wool, tobacco, and other commodities back and forth across the Atlantic, as well as slaves. This, along with the modernization of insurance, helped Britain gradually come to dominate international trade during these years, resulting in low prices for the raw materials fueling industrialization.

These private merchant banks, mostly in London, stood in contrast to the more traditional county banks, which would lend to farmers and landowners. The county banks could provide mortgages to yeomen farmers and the landed aristocracy alike, whenever they wanted to expand and consolidate their holdings through enclosure. (Shout out Chapters 4 and 6!) Unlike the merchant banks, which dealt in myriads of unpredictable risk, the county banks would succeed or fail depending on the harvests. A bad harvest in a traditional English county could put the local bank out of business. But since the British Agricultural Revolution was booming, the county banks usually did quite well during this period and they kept swelling in numbers.

And then there was the Central Bank. As I’ve mentioned before, the Bank of England helped stimulate industrial development by lending huge sums to the crown, which used those loans to invest in the materials of war – guns, cannons, etc. As a result, those materials started getting mass produced by a rising industrial class, especially in the metallurgical sector around Birmingham. The Bank of England also got monopoly status for issuing banknotes in the kingdom, effectively unifying the nation’s monetary system.

Because the government was a reliable customer for the Bank of England, the Bank’s revenues could be used for other capital investments, including the City and county banks, which used said capital for investments of their own.

The epicenter of all the financial activity was the old City of London – that square mile on the north bank of the River Thames which the Romans settled in the first century AD. Now, this can be confusing because it is part of modern London, which is a very big city, but we call that big city “Greater London” – the phrase “the City of London” (or “the City” for short) refers only to that small district in the middle of London. Buckingham Palace, Big Ben, and the Globe Theater, for example, are in London, but they are not in the City of London.

In the Middle Ages, London was that square mile. It had a wall around it and it served as a market city. The streets there are still named after some of the products you could buy on said streets – Bread Street, Wood Street, etc. By the time of the first Industrial Revolution, Greater London had grown out around it and financial outfits like the Bank of England, Lloyds of London, and others settled there in the epicenter. London was the home to 170 of the country’s 290 banks in 1784, and most of them resided in the City. The City remains the financial district of London to this day.

The most significant role of the banks in those earlier years of industrialization was discounting bills of exchange – basically, providing liquid capital to help transactions along between merchants and industrialists.

So, the role of investment banking may have been limited prior to the 1820s, but the role of stocks was huge. The introduction of the joint-stock, limited-liability corporation (first by the Dutch and then by the English) began as a means of funding trade expeditions, but it could be applied to so many economic pursuits. By pooling resources and limiting liability, investors were protected from losing all their wealth if the venture failed. Convincing investors to take risks is Step #1 for economic growth.

And while the railroads were built with capital raised from loans, earlier transport infrastructure was built by joint-stock, limited-liability corporations. Canal-mania was made possible by the stock market. Investors bought an estimated £20 million worth of shares in canal companies during those years. (That comes out to roughly $2 billion today.)

And the joint-stock corporation also served as an excellent model for investing even in businesses that weren’t on the stock exchange. Plenty of industrialists would privately sell stock in their businesses to investors, raising capital for long-term investments, like bigger buildings and iron machines, to take their enterprises to the next level.

These financial systems – banking and stock investing – led to accelerated growth in Britain during the first Industrial Revolution. The accumulation of capital expanded about 5% during the first half of the 18th Century, that period of the Industrious Revolution. As Britain entered the Industrial Revolution in the 1760s and 1770s, the rate of capital accumulation grew to 6.5%. During the first couple decades of the 19th Century it went up to about 8-or-9% and hit a whopping 11% during the 1830s.

And as time went on, this capital was becoming more and more concentrated in more and more productive machines (like the steam engine) – increasing outputs and, by extension, economic growth even further. At the same time, this “fixed capital” – the machines and other equipment – became a smaller and smaller percentage of total capital. The rest of it, the “circulating capital”, allowed successful entrepreneurs to invest in additional new enterprises, creating still more channels for economic growth.

When people talk about “capitalism” this is what they’re referring to – not an economic theory, per se, but a system of capital accumulation, reinvestment, and continuous growth. It’s why the majority of the world’s population went from living in huts to not living in huts.

At the same time, this capitalist system has definite drawbacks. Among them is the fact that – every now and then – it all falls apart.


Part 2: Panic Becomes the New Normal

Let’s talk about Johan Palmstruch and his Stockholms Banco in Sweden again. Because I haven’t yet told you how that story ends.

For the first six years of the bank’s history, things went great. They were lending lots of money and earning lots of interest on those loans, expanding the money supply, and generally improving the Swedish economy.

But then the king died, which meant new daler coins would need to be minted. Because his son and heir was only 5 years old, authority was placed in the hands of a regency council, who decided to save a little money by getting cheaper copper plates. Well, that made the bank’s customers want their old, more valuable copper back from the bank. Except, if they all tried to get it back, it would be what we now call a “run on the bank” – Palmstruch had loaned out waaaaaay too much of their deposits and wouldn’t be able to redeem all the banknotes at once.

So, then he came up with a band-aid solution: He’d print out way more banknotes than people could gather and redeem at once. That bought him some time – a few years in fact. But then in 1668, some dude showed up at the bank and tried to withdraw 10,000 dalers from his account. The bank couldn’t cover it, and word got out. The bank run finally came.

Panic ensued. Businesses had grown accustomed to operating with paper money and their lines of credit as capital for short-term transactions. Now paper money was practically worthless and credit was frozen. A very, very deep economic downturn followed. It is the first known recession, in the world, caused by a contraction in the money supply. It would not be the last.

For the crime of “bad bookkeeping” – but, really, for putting Sweden through economic Hell –Palmstruch was sentenced to death (though it was commuted to a couple years in prison). His bank, meanwhile, underwent serious reforms and got a new name – the Riksbank, which remains the Central Bank of Sweden to this day.

And Palmstruch’s great innovation – fractional reserve banking – became frowned upon (for obvious reasons) for a very long time. Central Banks adopted reserve requirements, dictating a how much money the bank must have on hand versus how much it can loan out. Today, the reserve requirement (or cash reserve ratio, or liquidity ratio), is typically pretty low. (It’s just 1% in the Eurozone, for example.)

But when it comes to innovative financial systems, there is just no shortage of ways they can tank the economy.

This is as true in the stock market as it is with the banks. Investors become overly-optimistic about certain stocks and overtrade, the prospects of easy capital gains attract additional investors, soon enough the prices are way higher than they should be, folks start to realize that the profit potential of owning said stocks couldn’t possibly justify their prices, and suddenly everyone is stampeding to exit the market without losing everything, because the bubble has burst.

One of the first documented cases of this bubble phenomenon is also one of the most ridiculous cases in history. It wasn’t even about stocks – it was about, no joke, tulips.

In the 1630s, the Dutch got really into tulips because, you know, they’re pretty. And the prices of tulips started going up. Then a bunch of merchants decided to invest in tulip bulbs, not simply to admire them, but to resell at a mark-up. When it became clear this was happening, tulips took on an artificial value for their capital gains potential, and speculators invested heavily. Basically, it became a get-rich-quick scheme.

This process kept driving up prices until eventually a single bulb cost as much as two boxes of wheat, four boxes of rye, four oxen, eight pigs, twelve sheep, two barrels of wine, four barrels of beer, two barrels of butter, a thousand pounds of cheese, a bed, a suit of clothes, and a silver drinking cup – all combined…for a tulip. Sure enough, the bubble burst in 1637 and the Dutch economy collapsed.

Then there was the infamous Mississippi Company bubble. In the early 18th Century, a Scotsman from Edinburgh made his way to Paris, by way of Turin, by way of Venice, by way of Amsterdam, by way of London, where he had been convicted of murder. His name was John Law, and the French were under no illusions about who this guy was. He was a gambler and a loose cannon. But he also came off as a genius for his understanding of financial systems at a time when France was reeling from the fiscal recklessness of their late king, Louis XIV.

Originally, Law proposed creating a central bank for France, but it was rejected. So instead he set up a private bank that could still issue banknotes. Then, in 1717, Law bought the Mississippi Company, the trading outfit for the French territory of Louisiana. He turned it into the Company of the West, a joint-stock corporation, which the government propped up. Then the bank was made the official Royal Bank and Law took over the French East India Company and China Company.

Now Law had to start making these ventures profitable. He tried to get Europeans to settle French territory in North America to increase trade opportunities for the Company of the West. To do so, he waged a not-always-totally-honest marketing campaign about the riches to be found there. Well, that led to not so much emigration, but a lot of investment in the company. The stock price soared. As it did, the Royal Bank needed to print more money for investors so they could purchase their shares.

If you have a basic understanding of economics, you can see how friggin’ disastrous this is going to turn out. But at the time, there was little experience with such bubbles. Settlers arrived in Louisiana, realized it would take a lot of time and effort to get the territory’s economy up and running, and so, the stock bubble burst in 1720. And when the price of the stock collapsed, with the huge number of banknotes floating around in the economy, a sudden wave of hyperinflation hit France hard. Law left the country broke and disgraced.

The same year as the Mississippi Company crisis, Great Britain got its own taste of financial bubbles with the collapse of the South Seas Company. To fund the British military in the War of Spanish Succession, a London banker named John Blunt came up with an idea to convert government debt into equity in a joint-stock trade corporation. The South Seas Company would pay the government’s debt for a British trade monopoly with South America. Marketing the company and selling its stock much like how Law did with the Mississippi Company, Blunt managed to drive up the price of a share from £100 to £1,000 in eight months – ten times the average annual income of a British artisan.

Not only did this encourage speculators to buy South Seas Company stock, but also to set up similar speculative ventures. One promised to create a perpetual motion machines and capitalized at £1 million. Another joint-stock venture, somewhat humorously, went on the market with the name “A Company for carrying on an undertaking of great advantage, but no one to know what it is.”

To combat this rising tide of crap, Parliament that summer passed the Bubble Act of 1720, forbidding the formation of new joint stock ventures without royal charter. Among those who lobbied for the bill was Blunt, hoping to limit the South Seas Company’s competition in the stock market. But just months later, the South Seas Company bubble burst. The economy contracted with the huge loss of financial capital. Among the investors affected was Sir Isaac Newton, who them famously quipped, “I can calculate the movement of the stars, but not the madness of men.”

These experiences led Europeans to become fairly risk adverse for the next half century. But by the time the Industrial Revolution was taking off, financial crises would strike again. In 1772, a partner at the London investment banking house Neal, James, Fordyce and Down lost £300,000 trying to short East India Company stock. Unable to pay his debts, he fled to France, leaving the City in a panic. A liquidity crisis followed as bankers froze their credit. The effects could be felt across Europe, but nowhere more than in Scotland, where the entire banking sector collapsed. Among those affected was our old friend, the iron and chemical manufacturer John Roebuck, who then had to sell his shares in James Watt’s steam engine business to Matthew Boulton.

In 1796, a land speculation bubble in the new United States prompted a bill in Britain to prevent a run on the Bank of England. What it caused instead was a credit freeze on both sides of the Atlantic.

The British economy contracted again after the end of the Napoleonic Wars, because suddenly the government didn’t need to spend as much money with the country’s war contractors. Nearly 300 banks failed in the aftermath. Another credit crunch followed in the US in 1819.

And then there was the Panic of 1825.

A few years earlier, a Scottish general named Gregor MacGregor – who had served under Simón Bolívar during a stint in the Venezuelan army – was visiting the court of George Frederic Augustus the First, King of the Miskito, an mixed race African and Native American people in modern day Honduras. The king granted a strip of land to MacGregor, which the Scotsman dubbed “Poyais.”

What followed was perhaps the most insane con job in all of history. MacGregor made up a constitution for Poyais, a flag, army uniforms, and commercial banking paperwork. Then he went to London and started a massive publicity campaign for his made-up country. He commissioned artwork of the land and had ballads written about it. Calling it the “Land of Opportunity”, MacGregor claimed Poyais was abundant in natural resources and encouraged settlers to come. All they needed to do was exchange their British pounds (a real currency) for Bank of Poyais dollars (a fake currency).

In 1822, hundreds of Brits – mostly MacGregor’s fellow Scots – boarded a total of seven ships to Poyais. They landed on the beach and waited for somebody to come greet them. After a while, when nobody showed up, they realized they’d been duped. There was no nation of Poyais. It was just some empty land in Central America. Within the next year, Poyais bond prices – yes, MacGregor was issuing bonds – collapsed, sparking a panic about all sovereign debt in Latin America. By 1825, Colombian bonds lost half their value.

This was hardly the only event responsible for the pending crisis, but it does seem to have kick-started it. The unsustainable expansion of county banks before 1815 didn’t help. Nor did the Bank of England’s post-Napoleonic deflationary policies – interest rates were too low to encourage investors to buy government bonds.

The stock market contracted significantly in 1825 and 1826. Bankruptcy rates more than doubled. Seventy county banks collapsed. The Bank of England required a gold bullion bailout from the Bank of France to stay afloat. Recession hit the United Kingdom and spread to the Continent, to Latin America, and to the United States.

Previous financial collapses had hit investors hard, but they were limited – they didn’t spread across the globe. This was the first known international economic crisis not attributable to something like war, or famine, or disease. It marked the beginning of what we call the business cycle – the routine financial crises that cause widespread economic downturns.

And the people of the time must have been thinking, “What the hell is going on?” And some would seek answers. The era of Classical Economics was now in full swing – next week, on the Industrial Revolutions.


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Dave Broker