Evaluate the macroeconomic and structural effects of overseas investment during the period 1870-1913.

The second mechanism which could have allowed income to impact Britain’s balance of trade is the absorption effect; this works by the rise in overseas incomes generates a rise in consumption and domestic absorption (lower exports, higher imports) which worsens the trade balance. Rowthorn and Wells constructed a model in which the expansion of overseas assets and income can spontaneously lead to a permanent balance of trade deficit which turns the lending country into a rentier nation. The crucial condition for this to occur is that the rate of return on overseas investment is greater than the growth rate of the domestic economy (this creates a situation where the rise in consumption cannot be met by the increase in domestic production). During this period 1870-1913 the real rate of return on overseas assets was considerably higher than the UK growth rate. Change in the trade balance must be offset by changes in other elements of the national income accounts. In particular, they can be offset by changes in domestic investment, the propensity to consume and a change in foreign income. The worsening trade balance saw temporary improvements in two period (1877-1890 and 1898-1913). The improvement in those periods can be largely attributed to a fall in domestic investment reducing absorption, although the second period was assisted by a fall in the propensity to consume. Rowthorn and Solomou support their analysis with an econometric estimation of the consumption function. They find a propensity to consume out of domestic income of 0.5, and a propensity to consume out of overseas income of 0.53. Therefore it seems that absorption effects were significant and adverse but Dutch Disease was not a problem for the UK economy in this period.

It is possible that had capital not been exported and instead been directed towards UK projects this would have led to diminishing returns to capital, which is central to the neo-classical theorem. The argument is that a substantial diversion of funds from foreign projects to home investment would have lowered returns on home capital: in Hick’s words “the marginal efficiency of capital will be lower the greater the amount of capital goods already possessed”. However, the “Hayek effect” must be considered, where capital expenditure can raise or lower the returns on capital already in place, such as finishing a half-built railway, or undertaking repairs and maintenance. Hayek demonstrated that it is normal for capital to be an improving extension to existing capital (i.e. breaking a bottleneck, social over head capital or increasing returns). Also, diminishing capital returns assumes that full employment existed; in reality trade-union unemployment fluctuated between 2-10%. While there was a lack of spare labour available in British agriculture, there was still a vast reservoir for more informal industries. Wood showed that most of the recorded rise in British wages at the time derived precisely from the switch from lower-paid to higher-paid employment, rather than from the wage rise in any given employment. Unemployment was connected with the capital export debate: Hobson proclaimed in 1911 that in view of the high level of capital exports, “we cannot wonder at the increase in unemployment and of distress among the working classes”. Had capital been diverted from foreign to home destinations, it might have absorbed this unemployed or underemployed labour without endangering the rate of its own return.

It seems there were notable adverse consequences of excessive overseas investment. However, there is opposition to this view in that keeping investment domestic would have ineffective; for example, McCloskey quoted famously that “by keeping savings at home, the British people could have had two Forth bridges, two bakerloo lines, two London housing stocks, two Port Sunlights”. In addition British investment in overseas capital lowered the price of foreign foodstuffs and raw materials. This improved Britain’s terms of trade by approximately 0.1% per annum. In conclusion it is difficult to state whether the overall macroeconomic and structural effect of overseas investment over the period 1870-191 was positive or negative.