THE APOTHEOSIS OF THE RENTIER: HOW NAPOLEONIC WAR FINANCE KICK-STARTED THE INDUSTRIAL REVOLUTION.

• Author: Hutchinson, Martin
• Position: Report

[T]his state of affairs ... would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.... I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work.

John Maynard Keynes ([1936] 1977: 375-76)

The development of Britain's economy in the years following the end of the Napoleonic Wars was heavily influenced by the peculiar nature of British government wartime finance. Instead of issuing bonds with higher coupons as interest rates rose, which governments normally did in wartime, British governments from the 1750s onward relied mostly on 3 percent "Consols", i.e., perpetual bonds with a 3 percent coupon issued at deep discounts. In a world in which equity markets were almost nonexistent and in which there was a gigantic government bond market swollen by war financing, fluctuations in the prices of Consols caused swings in investor wealth that had major economic effects, which have been much underappreciated. After a positive wealth effect in the postwar 1780s and a negative one in the late 1790s, the large, long-lasting bond price increase after 1813 played a major role in capitalizing the Industrial Revolution's final take-off and the acceleration of economic growth to near-modern levels. As Jeffrey Williamson (1984: 688) noted when discussing the slow start to the Industrial Revolution, "Somewhere around the 1820s Britain passed dirough a secular turning point." In this article, we argue that the key to that turning point was the massive wealth effect of the postwar increase in Consols' prices.

The Napoleonic Wars' Financing Mechanism

Normally, when a government wants to borrow to finance a war, it knows that its borrowing will cause interest rates to rise, especially if there is inflation. For example, if peacetime interest rates are about 3 percent, the government might issue a 5 percent bond of 20-year maturity rather than say the usual 3 percent peacetime bond. When the bond matures 20 years later and peace reigns again, the government can refinance the bond at 3 percent. Investors holding the 5 percent bond receive a higher interest rate, but no capital gain if they hold the bond to maturity and only a modest gain if they sell mid-term at a premium while bond prices are higher than normal.

That approach broadly describes how the U.S. wars in Korea and Vietnam were financed, as well as both U.S. and British contributions to the two world wars. Earlier, the U.K. government had used a similar approach to finance the War of the Spanish Succession (1702-13), mostly at interest rates of 8-10 percent and with heavy use of tontines and lotteries.

The U.K. government adopted a different approach with its next major wars. In 1751, Sampson Gideon, a brilliant Jewish-British financier, persuaded Prime Minister Henry Pelham to convert most of the outstanding British government debt into 3 percent Consolidated Annuities (the famous Consols). Until their ill-advised redemption in 2015, these were perpetual--that is, they had an infinite maturity--and paid 3 percent interest each year. (1) When the government wanted to finance a war, instead of issuing 5 percent bonds at par, it issued 3 percent Consols at perhaps 60 percent of the "par" principal amount, which would then yield 5 percent (i.e., 3 percent/60 percent) on a running yield basis.

Gideon's thinking was as follows: since all wars were temporary, people who bought 3 percent bonds at 60 percent would make generous 5 percent yields during the war and would then make a large capital gain afterwards, when yields dropped to 3 percent and the bonds went back to par. The Consols were therefore an attractive investment. The government could then find buyers even in war years, provided (as was the case) that there was confidence that Britain would later repay its debts in full.

Not only did investors enjoy strong yields, but they also made big capital gains when peace came: 21 percentage points in six years after the bottom in 1762 as the Seven Years Wars (1756-63) drew to an end, and 33 percentage points in 10 years after the wartime bottom in 1782, as the American War of Independence (1775-82) drew to an end. (2)

There was then strong demand for new issues of Consols throughout the major wars over the course of the following 50-plus years--the Seven Years War, the American Wars, and the French Revolutionary and Napoleonic Wars (1793-1815, with short remissions).

The Consols enabled Britain to finance heavy military expenditures when its rival France, which had no such mechanism, was unable to do so without financially crippling itself. Gideon's clever structure, which gave windfall profits at the end of each war to inventory-holding bond dealers like himself, was central to Britain's acquiring its empire and to not losing it again after the American colonies broke away.

The disadvantage of Gideon's structure from the fiscal point of view was that, for each 100 [pounds sterling] of war expenditure on 3 percent Consols issued at 60 percent of par, 167 [pounds sterling] was typically added to the debt. But since the debt was perpetual and never needed to be redeemed, this feature of Consols finance was not regarded as a major fiscal disadvantage. Lord North, chancellor of the exchequer from 1767 to 1782 and prime minister through the American War of Independence, liked the structure because "it was the interest that the people were burdened with the paying of and not the capital." (3)

The interest cost was indeed the same, or even slightly lower than through issuing new 5-6 percent debt at par, because the Consols' attractiveness to speculators allowed them to be sold at a slightly lower running yield. However, over the course of the century after peace returned in 1815, Britain's outstanding debt would decline only to 650 million [pounds sterling] in 1914, although the growth in the British economy meant that debt represented only 30 percent of GDP compared to a peak of around 260 percent of GDP in 1819.

The rise in the prices of British Consols from 1813 onward appears to have been due, in part, to a reduction in their perceived risk as the Allies approached France and peace returned, and, in part, to a drastic reduction in the annual supply of new Consols through budget deficit financing. (4)

Table 1 shows gross public income and expenditure for the years 1812-27, with the surplus or deficit; it also shows the funded and unfunded debt outstanding at the start of each year, and the increase in debt during the year. (5)

The deficit figures and debt increase figures in Table 1 do not tally because of the timing of government payments and debt financings. For example, the 1814 military campaign was largely financed by a 22 million [pounds sterling] debt issue (increasing the amount of 3 percent debt outstanding by 38.9 million [pounds sterling]) on the morning of the supplementary Budget of November 15, 1813. Nevertheless, the overall trend is clear: huge deficits and increases in the supply of Consols during the war years of 1812-15 were followed by near-balanced budgets in 1816-19 and surpluses thereafter, while the supply of Consols stopped increasing from 1816 onward, except for a modest blip in 1819-20 caused by funding 10 million [pounds sterling] of the Bank of England's holdings of Exchequer Bills in connection with the return to gold. (6)

Table 2 sets out the 823 million [pounds sterling] of British and Irish government funded and unfunded debt that was held by the public on February 1, 1817, a date chosen so the special "emergency" financings for the Waterloo campaign were out of the way.

By far the greatest part of the outstanding debt, 562 million [pounds sterling] or 68 percent of the total, consisted of perpetual securities bearing a 3 percent interest rate, payable twice yearly. The largest single tranche, 384 million [pounds sterling], consisted of "Consolidated Annuities," the 3 percent Consols, which paid interest in January and July. There was also an exactly equivalent obligation, the Reduced Annuities, with principal amount of 148 million [pounds sterling], which differed from Consols only in paying interest in April and October. Dealers would arbitrage between these two securities, with the Reduced Annuities generally trading at a small discount (subject to fluctuations before and after their interest payment dates) because of their somewhat lesser liquidity. There were also two relatively small older issues with 3 percent coupons, reflecting refinancings of debt incurred early in the 18th century, for the Bank of England and the South Sea Company, of 16 million [pounds sterling] and 14 million [pounds sterling], respectively.

In addition to the perpetual 3 percent debt, there was 211 million [pounds sterling] of 4 percent and 5 percent debt, which would be refinanced after the war as interest rates declined. The 4 percent debt, totaling 75 million [pounds sterling], took the form of 4 percent Consols, while the 5 percent debt, totaling 136 million [pounds sterling], originally contracted in many cases by the Navy and Army directly, had been consolidated into 5 percent Consols. By the 1820s, the 5 percent debt was trading above par. There were then two refinancing operations carried out at the end of 1823 and in early 1824, one converting 135 million [pounds sterling] of 5 percent Consols into 4 percent Consols and the second converting 80 million [pounds sterling] of 4 percent Consols into a new issue of 3.5 percent Consols. (7)

Finally, in 1817 there was 50 million [pounds sterling] of short-term debt, mostly in the form of Exchequer Bills, which were short-term instruments, generally converted into long-term debt as new issues were undertaken. The 50 million [pounds sterling] outstanding in February 1817 was high by historical standards, a residue of the...