Capital Market Efficiency in the British Industrial Revolution: The Case of the Lancashire Cotton Industry, 1760-1840

Abstract

Recent debates on the industrial revolution have continued to showcase the role of the cotton textile industry. These discussions have centred on the Schumpeterian view of rapid growth based on a disequilibrium model in which capital market imperfections allow innovative firms to restrict entry, thereby earning long run super-normal profits. Neo-classical interpretations, in contrast, argue that firms were relatively untroubled by capital market imperfections and experienced few problems accessing finance, facilitating entry and rapid adjustments to equilibrium profit levels, with the gains from technological innovation transmitted through falling prices. Important questions can therefore be addressed by examining further the question of capital market efficiency. To operate efficiently, inter alia, a capital market should allow freedom of access, equalise rates of profit across sectors and accurately price the risk of economic activity. To investigate efficiency of the capital market in these respects, the paper uses firm level data to examine whether or not, first the firm’s access to capital was restricted by outdated business practices, second, whether capital goods suppliers were able to charge monopoly rents to textile firms and third, whether the cost of finance accurately reflected the risk of the enterprise. The research uses archival evidence for a sample of cotton textile firms and the steam engine manufacturer, Boulton and Watt. These records are investigated to examine how, and at what cost, firms accessed financial resources. The results show that an important source of disequilibrium was the slow pace of capital market development relative to the technological pace and demands of industrialisation. The underdeveloped capital market perpetuated pre-industrial methods of finance, including high dependency on bills of exchange at prescriptive interest rates. Although some entrepreneurs took advantage of the most efficient steam technology, returns did not systematically reflect underlying risk. At the same time, profitable opportunities remained for firms entering the market using old technology and traditional organisational networks. For these reasons, cotton firms had the potential of super-normal profits but these opportunities were dissipated by the costs of circulation arising from capital market inefficiencies and the rents associated with monopoly, asset mispricing, arbitrage and fraud. As a consequence, although the story of the industrial revolution is one of Schumpeterian disequilibrium, the apparent lack of sustained abnormal profits in manufacturing reflected embedded local networks of capital and transaction cost, rather than the neo-classical story of rapid adjustment to equilibrium.