Financial globalization has both been hailed as a promising opportunity and castigated as a source of instability. Cross-border integration of capital markets should enhance the efficiency in the allocation of capital. But it also brings about additional risks and instability in the context of a particularly hazardous contractual environment, as the usual agency problems are more complex across borders and legal jurisdictions, or over long distances. Financial markets try to compensate for these hazards, namely through the offices of rating agencies, and by charging risk premiums. Nevertheless, “contagion,” “sudden stops,” and “second generation” financial crises have shown the difficulty of predicting financial disturbances from measures of economic fundamentals. Markets and governments have also created institutions to expedite the solution and minimize the costs of crises for both parties. These institutions and their reflection on the operation of international capital markets and the direction of capital flows are the object of this dissertation.

As frequently reminded, globalization is not a 30-odd-year trend started in the last quarter of the past century. The last quarter of the previous century and the Belle Epoque experienced a similar movement of worldwide economic integration, particularly in financial markets.Footnote ¹ The scope and the nature of problems brought about by this process speak “directly and eloquently to globalization debates today.”Footnote ² Such realization informed the object of this dissertation—the institutional framework underlying the first globalized capital market, between 1870 and 1914. Within this structure, this study concentrates on two main institutions: bondholders' protective organizations and the gold standard, as provider of monetary and exchange rate stability.

The first chapter in this dissertation studies the international market for sovereign debt, from the viewpoint of postdefault governance. Creditors' claims in this market are especially fragile because governments have been largely successful in shielding themselves behind sovereign immunity.Footnote ³ Contrary to today, the pre-1914 period was characterized by the absence of multilaterals, which, like the IMF, can aggravate the moral hazard problem.Footnote ⁴ Many policy prescriptions suggest that the IMF should opt out from sovereign workouts and be replaced with market-based solutions. Hence, the prewar period offers an ideal setting to test the capacity of the latter to provide for orderly workouts. The chapter concentrates on the role of bondholders' self-help organizations. These institutions contributed to align the sovereign's incentives through a reputational mechanism, making it harder for a defaulter to refinance itself before settling old debts. Bondholders' organizations have attracted some attention in the literature on the reform of financial architecture, but two important dimensions have been neglected: the degree of institutional variation that characterized these entities, and the strategic interaction among them.Footnote ⁵ The hypothesis in this chapter is that both dimensions are relevant for assessing the institutional advantages of these organizations and for the possibility of recreating them today.

During the period of study three broad categories of bondholders' organizations were active in the main capital markets (London, Paris, and Berlin). The first was formed by ad hoc committees created to deal with each individual default and dissolved thereafter. The second worked through the indirect representation of bondholders' interests by banks who had issued or underwritten the securities. Finally, a model emerged of permanent and independent bondholders' organizations. Britain was the first country to adopt the third solution, creating the Corporation of Foreign Bondholders in 1873. Continental markets tended to swing between the other two categories, with Germany favoring the model of indirect representation.

To test the hypothesis, a data set of sovereign defaults and workouts between 1870 and 1913 was used. After controlling for a number of characteristics of the debtors and the creditors, the empirical analysis underscores the importance of institutional design at the level of creditors' representation. Bondholders-run organizations yielded better results (in terms of default duration and haircut), especially when they were ongoing and independent. The intermediation of financial houses was less beneficial for the bondholders because of conflicts of interest. By intervening in the workouts, banks were catering to two conflicting classes of clients: the investors, to whom they had sold the bonds and the sovereigns, whom they wanted to refinance.

Two main implications follow from this analysis. First, that there is potential for decentralized market-based institutions to improve governance. Second, that orderly workouts require that the settlement of old debts and the refinancing of defaulting countries be entrusted to separate segments of the financial markets.

The comparative study of bondholders' committees should also provide for a better understanding of the stylized facts about the history of capital flows and security markets. Arguably, markets where institutions were friendlier to defaulters (as Germany) should have attracted lower quality bonds, while investment grade countries would face better conditions in financial centers with better investor protection.

Chapter two compares the foreign investment patterns of two of the largest capital exporting countries before 1914: Great Britain and Germany. Other than the interest in comparing markets with different investment protection mechanisms, this chapter is motivated by the traditional contrast in the literature between “revenue” and “developmental” finance.Footnote ⁶ Compared to British “developmental” investment, French and German “revenue finance” was unproductive, because instead of chasing after long-term “fundamentals” in emerging economies it was mainly lured by government loans raised to finances wars, current expenditure, or other fruitless aims. These riskier securities had often to be promoted in the Continental markets through the intervention of local governments.

Although it is undeniable that political intervention did condition foreign investment, in a period remarkable for its low levels of capital markets regulation, the implicit hypothesis that more 'politicized' financial centers could compete with more 'market-based' ones seems contrived. Private investors always had the choice of channeling their monies through financial centers allegedly immune to political suasion, as London.

Up to recently, the only fully disaggregated database of pre-1914 foreign investment covered British capital exports since 1865.Footnote ⁷ In the absence of other comparable databases, the literature has drawn inferences exclusively from British data or then from aggregate stock estimates available for a few dates.Footnote ⁸ Instead, this chapter offers new empirical evidence by compiling a comprehensive dataset of German capital exports, 1883–1913. This allows testing the conventional view about the distinctiveness of British investment.

This chapter follows previous work by Michael Clemens and Jeffrey Williamson in identifying the pull factors to foreign investment negotiated in Great Britain and Germany.Footnote ⁹ The empirical analysis supports the view that German capital flows responded to long-term fundamentals as much as British investment did. The sharp distinction in the literature between “developmental” and “revenue” finances is probably a figment of the absence of detailed data on capital flows. In this limited information set, European investments are too readily classified as “unproductive,” whereas American or Australasian applications are associated with “developmental” investment.

Among the pull factors, natural resources mattered more than demographic fundamentals in attracting European investment. Next to them, monetary stability also played a prominent role, followed by colonial affiliation and the quality of local political institutions. The latter result underscores the conclusion confirmed in studies of contemporary capital flows, that the long-run economic potential is not enough to attract foreign capital, in the absence of supportive political and economic institutions.Footnote ¹⁰

A somewhat surprising result is the strong and significant impact of the gold standard for the attraction of foreign finance. Even if less relevant in setting spreads, this result suggests that membership in the gold standard conditioned the size of capital flows towards emerging economies (credit rationing).

The significance of monetary regimes evidenced in chapter two begs the question of how countries were able to keep a credible allegiance to gold convertibility. Although a typical hard peg, the system was remarkably successful during its “classical” period. The stability of the gold standard before 1914 has been the subject of an extensive literature.Footnote ¹¹ A particular strand follows up on the target zones models (TZ) to argue for a considerable degree of domestic policy autonomy within the gold standard.Footnote ¹²

The last chapter in this dissertation is occupied with a case study of the institutional foundations of exchange rate stability within the classical gold standard. The country under study, Portugal, fits in the typical “periphery” of countries characterized by a persistent current account deficit, and dependency on foreign capital inflows. Despite that, Portugal enjoyed a relatively long participation in the system (1854–1891), remarkably free from convertibility crises and other disturbances that beset peripheral countries who adopted this regime.

This chapter shows the role of large market players in sustaining currency stability, over and beyond the atomistic forces of arbitrage and speculation assumed in conventional theoretical frameworks. During this period Portugal had no central bank. As in other countries, a private corporation, the Bank of Portugal, performed a mixed role. As commercial bank, it competed with other banks for profit, while, as emission bank, was bound by the rule of convertibility. The Bank of Portugal was the largest banking house and banknote issuer and held the largest gold reserve in the banking system. These circumstances made it the leading player in the foreign exchange market, with a vested, albeit unwilling, interest in stability. Bank directors knew that an excessive devaluation would translate into a run on its reserve, which they tried to discourage with a number of “gold devices.”

In particular, the bank intervened in the foreign exchange market by selling short bills on London at a cheaper rate than the market, in an attempt to prevent the exchange from reaching the gold export point. Quantitative and documentary evidence show that these interventions were instrumental in maintaining exchange rate stability. Moreover, applying the augmented TZ model with devaluation expectations, we could show that expectations reacted to the Bank's reserves policy in a stabilizing fashion.Footnote ¹³

This chapter therefore illustrates the trade-offs between domestic monetary autonomy and currency stability in a peripheral nation within the classical gold standard.