• The Invisible Hand

The Moment that Made Britain's Economy

Special report

1688 was the turning point for England which made us the strongest economy of our day and set the blueprint for all future economic development.


In 1687, Britain was an average to poor economy. Like most other countries we had a hereditary monarchy commanding matters of taxation and government and with overall authority to dismiss Parliament. We were barely different from France and Spain who had the absolutist monarchs Louis XIV of France and Charles II of Spain. We still had an undeveloped financial system and a dysfunctional system of property rights. This all began to change in 1688 when a foreign leader effectively wandered into England and took the throne.



The Magna Carta of 1215 was the first step in Britain towards constraints on royal power. Yet this only made superficial changes to royal authority which were quickly ignored. The Tudors brought this hereditary power to a peak and ran absolutist states. However, royal power first saw its main opposition from Parliament in the reign of Charles I. He was determined to be an absolute monarch. The Crown still had authority over raising money, spending money and they could give out lucrative monopoly contracts. These Stuart rulers consistently ran budget deficits and had to sell Crown lands to pay off massive debts. The centralisation of power made it very easy to avoid paying debts. Parliament stood up to the King in 1642 and launched the English Civil War. Although the Parliamentarians won they established a military dictatorship under Oliver Cromwell which proved so unpopular and ineffective that Charles II was brought in from exile to become King again.


One might think the next two monarch's would be more conciliatory to Parliament given they had chopped their father's head off. However, they still had fundamental policy and particularly religious disagreements. When James II became King in 1685 there was little appetite for any more absolutist rule. Therefore, a group of nobles called the 'Immortal Seven' invited William of Orange from the Netherlands to become King because he had a distant claim through his wife. It is a sign of the unpopularity of James II that William was allowed to simply take the throne without any major confrontations. This would be the 'Glorious Revolution' and the start of fundamental political and economic change in Britain.


William of Orange, later William III of England

Unlike his predecessors, William III recognised that no British monarch could wield the same power as other European monarchs and power would have to be transferred to Parliament to avoid revolution and war. Therefore, in 1689 the Bill of Rights was issued which meant taxes could only be raised with the authority of Parliament and the monarch could not suspend laws issued by Parliament. Clause 8 said that elections would be 'free' and clause 13 said that Parliament should meet 'frequently'. Of course only 2% of people could vote but that was infinitely more accountability for the policymakers than 0% before. In the end it would be petitioning which proved to be much more effective in delivering change. Anybody could petition Parliament and they usually listened.


Importance of institutions


The fundamental question in economisc is why are some countries richer than others. Why is a US citizen 77 times richer on average compared to an Ethiopian person today? Why did Britain grow rich while Asia and the rest of Europe stagnated? Most economists have a simple explanation: long term economic outcomes are a function of endowments and institutions. Countries like Russia or Brazil have the world's best resources, yet very poor institutions so they are poor. Meanwhile the US has great institutions and natural resources so they are rich. Institutions can cover political institutions as well as economic institutions such as property rights and market structures.



The most important institution is the commitment to strong property rights. This means individual factors of production are safe and secure and the profits from their use goes directly to their owners. This avoid problems like the tragedy of the commons where common resources become overused and degraded. It also overcomes the free rider problem where people can benefit from a good or service without putting any work into it or making any payments. Private property encourages people to develop their capital and invent new capital which they can derive all the benefits and profits from. The problem with an absolutist monarch is their ability to subvert property rights for their own benefit. This can lower the expected returns from investment and therefore creates a low incentive to invest. The only credible way to protect property rights is to take this power away from the monarch and constrain them with a set of rules (constitution).


Weak institutions can also mean transactions can be subject to ex post opportunism. This is particularly the case when it comes to a monarch repaying their debt. There is little disincentive for a sovereign ruler not to default on their debt, especially in times of war when the sovereign heavily discounts the value of future money. The problem with defaulting on debt is that it makes investors less likely to lend to you in the future. Often the monarch would pay only a fifth of loans back and could take up to 20 years to fulfil contracts they did pay back. Clearly this is not an appealing investment for money lenders. Instead they will require a high interest rate to compensate them for added risk which brings higher costs for the government. A contract needs to be self-enforcing which means the major parties have an incentive to keep to its terms. Institutions are vital for protecting against reneging on contracts, but, reputation of debtors is also important.


Political institutions underpin all other institutions since they bring the ability to change the current economic order and hold poor policy to account. Although Parliament was far from representative it was much easier for the private interests of one individual to be drowned out against the overwhelming opinion.


Economic developments

Agriculture was still the dominant sector in most economies so institutional changes in this sector had widespread impacts. Changes in the agricultural sector would create the agricultural revolution which later went on to create the economic conditions which would allow an industrial workforce and factory system to develop. For example, a national system of markets was established following the strengthening of contract laws and property rights. This allowed farms to exploit economies of scale and regional specialisation could occur. However, the biggest changes were in property rights particularly the enclosure of common land which affected 21% of English land. This privatised and consolidated open arable fields which the Crown had previously owned. Most of these changes came directly from acts of Parliament especially in the years 1729-30 and 1742-43. This enclosure helped to tackle the problem of tragedy of the commons and created an incentive to make the necessary improvements to land which would allow the rapid increase in agricultural productivity to occur.


Before the Glorious Revolution the Crown had the power to grant monopolies. This could be extremely lucrative for the Crown especially under times of fiscal constraint for monarch such as war or domestic unrest. However, this was extremely inefficient since monopoly contracts were not based on which firm which was the most productive and they closed markets from competition which led to higher prices for consumers and less choice. One example of the quashing of monopolies was the ending of the monopoly of the Royal African Company which was the direct result of petitions from Parliament. Another major piece of legislation which came from petitions was the Manchester Act of 1736 which removed all restrictions on the cotton industry. This paved the way for mechanisation of the textiles industry which was central in the Industrial Revolution,


Financial Revolution


With the Glorious Revolution came an overhaul of finance in Britain, particularly in how the government generated revenue and paid back debt. Powers over fiscal policy had been transferred to Parliament, which was more credible than the monarch. The monarch could very easily default on their debt especially in times of war, while Parliament recognised the importance of credible commitments to repay debts since they took a long-term, less self-interested perspective. This commitment lowered the rate of interest since borrowers felt more secure so the government could expand expenditure up to 10% of national income. It was especially politically controversial at this time to raise taxes so government borrowing was much more important as a source of emergency income. Also in this period the bureaucracy was strengthened and made more meritocratic which allowed tax collection to be done more efficiently. North and Weingast (1989) believe in particular that it was the financial revolution which served as the turning point for the British economy.



Another notable development was the foundation of the Bank of England in 1694 which was done to help lend to the state. This proved to be an effective method of borrowing since the Bank over time developed a reputation for honouring commitments and managing public finances. There are three key mechanisms through which financial institutions bring about greater economic growth. Firstly the financial sector serves as a method of payment, although small payments were made in cash, financial services allowed longer term contracts to be paid for easily and therefore helped facilitate long term trade. Secondly they allow for savings and therefore borrowing to occurs. This transfers money from those who have too much (savers) to those who have greater demand for money (borrowers) therefore it delivers a Pareto efficient outcome. Finally, the financial sector allows for better risk management through the insurance market. This is particularly important in an agriculture based economy where revenue can be highly uncertain and volatile.


Conclusion


While other countries continued to have extractive institutions England moved ahead of the time and founded the basis of our modern day political institutions. The threat to the monarch of execution proved sufficient to make the monarch yield their power and allow real growth to occur. Key developments included the formation of strong property rights, the challenge to monopolies and the growth in sophisticated and credibility in the financial. These simple changes made Britain the first industrial economy and set the institutional framework for many other nations including the United States of America.




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