5. The Capital of Capitalism
Capitalism. For better or for worse, the world’s economy is now dominated by it, in one flavour or another. Britain effectively invented capitalism in the 1700s (my excuse for the terrible title) and produced Adam Smith, the man who made sense of it. But how well do we understand capital, the concept that underpins capitalism? And how did capital take over our economy in the first place?
Capital is what happens when people’s wealth is invested into some kind of productive use*. That productive use could be a new tool, machine or vehicle, a new factory or office, a new business venture; anything that can be used to make more stuff.
The word productive is important here, for two reasons. First, because productive things make a return, which means investing capital normally means getting even more capital. Second, as you can read in part 3 of this blog, because productivity is the main thing that causes economic growth.
To help understand why capital is so important, imagine you’re a citizen of the pre-industrial, pre-capitalism economy. If you’d had an invention or a business idea in Tudor or Stuart Britain, you couldn’t walk into your local bank to ask for a loan. You certainly couldn’t have gone on Dragon’s Den, or floated your idea on the stock market. You might have been able to persuade your family to put their savings into it (in the unlikely event they had any), but it would be hard to scale it up much further, or overcome any setbacks in production.
If James Watt, or George Stephenson or Isambard Kingdom Brunel had been born in pre-industrial Britain, their names would likely never have made it into the history books. They may have made a prototype steam engine, train or steam ship, but how would they have built more of them and scaled them up across the country? Without an injection of capital to get new ideas off the ground, to take the risks that are involved with innovation, it is very hard for inventions to take hold. For all we know, medieval Britain may have been full of genius inventors and entrepreneurs, but they would have had few ways of turning their ideas into full blown businesses.
So when did capital start to become widely available? We can first pick up the data trail in 1760, the year often recognised as the start of the Industrial Revolution. The UK’s total capital stock then was around £17 billion in today’s prices, around £2,000 per person. That may sound like a lot, but given that should cover everyone’s life savings, it’s a fairly meagre amount. Today, the UK’s capital stock stands at over £3 trillion, around £50,000 per person. The graphic** below shows how the capital stock grew over that time. What you’ll notice is that the capital stock doesn’t really start to gather pace until well into the 1800s, in the age of railways and steel.
Capital has also become a much bigger share of the UK economy over time, even as it has grown rapidly. The chart below*** shows how Britain has spent its money (known as aggregate demand in economics) each year since 1830. Capital investment (the green line) made up just 3% of the economy in 1830, but it peaked at 22% in 1972****, with the most dramatic increases coming post World War 2. You may also notice the huge spike in Government spending during the two World Wars.
How did capital take off after the industrial revolution, to such an extent that we now name our economic system after it?
For capital to work, you need two things: people with spare money that they want to invest (let’s call these “savings”); and things to invest that money in which will generate a return to the investor (let’s call these “businesses”).
On the savings side, the exploitation of the New World and the lucrative international trade that came with it created a new group of wealthy merchants and financiers with large piles of money. These people weren’t, for the most part, nobles or aristocrats, and so did not plough their fortunes into land, castles or warfare. They largely kept their money within the urban, commercial systems within which they operated.
But whereas their medieval predecessors may have stored their money as gold and kept it locked away in their homes, there was now a problem with the “back of the sofa” approach to wealth management: inflation. The years between about 1550 and 1650 saw a burst of inflation in Britain, part of what was known as the Price Revolution. As the Spanish Empire brought huge quantities of gold and silver into Europe from the Americas to be used as money, the value of that gold and silver dropped. Prices in Britain increased roughly threefold in the hundred years between 1550 and 1650*****. If you’d buried your fortune of gold and silver for a hundred years, it would have lost two thirds of its value by the time you dug it out again.
As a result, those with money had to find something that would make their money grow, to beat inflation. And that meant investing it in productive uses — new ventures, new businesses, anything that could generate a return on their investment. And of course, that was rather good news for the economy.
Inflation (in moderation of course) still plays an important role in driving investment today, by forcing investors to seek more productive, higher return places to put their money******.
On the other side, the business side, there were also new things to invest in.
The slow agricultural revolution had seen a gentle introduction of new, productivity-enhancing techniques to the British economy. It had produced a surplus of food, creating demand for new goods, and had also displaced a growing number of people off the land to seek work in cities. The growth in overseas trade, most importantly the textiles market, further added to the opportunities for business. And Britain in the 1700s and 1800s also enjoyed a degree of stability and liberalism in its governance, which gave investors more confidence that their money would not be lost to political trouble.
All of these factors, and no doubt plenty more, came together to create a slew of ideas and projects and business propositions for the first capitalists to invest in. Textiles factories, with new technologies and huge export markets. Canals to transport the bulky loads produced by industry, and then the railways some 70 years later. Coal mines, initially to heat homes but later to drive steam engines for many purposes. Shipyards, initially using wood but then iron and steel. Iron and steelworks for ships, building, bridges and more machines.
Investors fed in capital to get these ventures off the ground. The ventures generated immense returns (and sometimes catastrophic failures), making the investors richer (mostly) and creating more rich people with money to invest. The capital went back in, the innovators and entrepreneurs got more numerous and bolder, the demand for goods grew, and the capital came back with hefty interest once again. This cycle has, with a few significant bumps along the way, continued ever since. And it has made all of us richer, and some of us very rich indeed — far beyond the wildest dreams of any medieval king.
In today’s economy, capital is so important it has become a major industry of its own. Our bank accounts, pensions, investments and life savings are all part of a complex — sometimes too complex — global system. The modern financial system helps people save for their retirements, or to pass on money to their children, while also supporting a wide range of new business ventures.
But there is one crucial aspect of capital that has shifted in the last decade or so: the “productive” investment part. Since the 2008 financial crisis, investors have generally piled their money into much safer assets, such as lending money to Governments. Many major businesses have bought back their own shares rather than invest spare cash in growing further. Capital has become more available than ever, with record low interest rates and huge injections of cash from central banks, but it has not always found its way to the high risk, high return investments that tend to drive economic growth. In the UK, a lot of this extra capital has been pumped into the housing market. This may have made a lot of people wealthier, but housing is not a productive investment — a house whose price increases with a rising market is still fundamentally the same house.
This shift towards safer, less productive investments has coincided with a period of slower economic growth (especially when you look at underlying productivity). There are plenty of possible explanations for this shift to safety. It is possible, as I speculated here, that the supply of brilliant ideas has slowed down, and so there are few decent high return investments out there. It is possible that the enormous damage done to banks by their risky lending before the financial crisis has pushed them towards safer investments. It is also possible that a burst of inflation, much like the pre-industrial Price Revolution, is needed to drive money away from safe harbours and in search of more productive investments.
Whatever the explanation, our drift away from the central idea of capital — investing in productive things which make the economy grow — should give us pause for thought. Whatever your view of its faults, it is undeniable that capitalism has made us richer, and enabled a whole wave of innovations that have transformed our standard of living. As we tackle our current economic travails, it is possible that the answer is more capitalism — in its original, productive sense — not less.
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* When economists talk about capital, they sometimes mean the money that’s invested (aka financial capital) and they sometimes mean the productive item invested in (aka physical capital). I’ve not really tried to distinguish the two because they are closely related.
** This chart shows the Non-dwellings capital stock composite measure from table A.55 of the Millennium of Macro dataset and has been deflated using the GDP deflator. I’ve used the free tools from Gapminder.org for the animation
*** This chart uses the composite measures for consumption, investment and government expenditure, each divided by GDP, from table A.12 of the Millennium of Macro dataset
**** You may have noticed the growth in capital beginning to level off after the 1970s. This may partly reflect a re-orientation of the UK economy away from investment and towards consumption. However, another important factor is the growth in “intangible capital” — such as investments in research, software and branding — which is not well captured within the national accounts. Jonathan Haskel and Stian Westlake’s book “Capitalism without Capital” is to my knowledge the authoritative work on this.
*****This is based on the GDP deflator in the Millennium of Macro dataset
****** Ryan Avent’s 2012 article in The Economist, “What would Friedman do?”, gives a brilliant explanation of why inflation can help invigorate a depressed economy and I thoroughly recommend you read it if you can.