An economic history of europe knowledge, institutions and growth, 600 to the present

Padstow Cornwall A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Persson, Karl Gunnar, 1943– An economic

A N E C O N O M I C H I S T O R Y O F E U R O P E

This revised and extended edition of the leading textbook on European economic history hasbeen updated to take account of contemporary economic developments and the latest researchand debates A concise and accessible introduction that covers the full sweep of Europeanhistory, the book focuses on the interplay between the development of institutions and thegeneration and diffusion of knowledge-based technologies With simple explanations of keyeconomic principles, the book is an ideal introduction for students in History and Economics.Revised textboxes and figures, an extensive glossary, suggestions for further reading and a suite

of online resources lead students to a comprehensive understanding of the subject New materialcovers contemporary economic developments such as the financial crises of 2007/2008, theEurozone crisis, new trends in inequality and the austerity debates This remains the onlytextbook students need to understand Europe’s unique economic development and its global

context

KARL GUNNAR PERSSON is Emeritus Professor in the Department of Economics at theUniversity of Copenhagen, where he has been teaching comparative economic history and the

history of globalization over the last five decades He is the author of Pre-Industrial Economic

Growth: Social Organization and Technological Progress in Europe (1988) and Grain

Markets in Europe 1500–1900: Integration and Deregulation (1999).

PAUL SHARP is Professor in the Department of Business and Economics at the University ofSouthern Denmark, where he lectures in economic history He has worked on a variety of topics,but his recent focus has been on agriculture in economic history He has published widely in the

leading economic history journals such as the Journal of Economic History, and the Economic

History Review, in leading economics journals in growth and development, as well as in history

journals He is currently working on a book on the economic history of the Danish dairy industry

N E W A P P R O A C H E S T O E C O N O M I C A N D S O C I A L H I S T O R Y

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Nigel Goose, University of Hertfordshire

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New Approaches to Economic and Social History is an important new textbook series

published in association with the Economic History Society It provides concise but

authoritative surveys of major themes and issues in world economic and social history from thepost-Roman recovery to the present day Books in the series are by recognised authoritiesoperating at the cutting edge of their field with an ability to write clearly and succinctly Theseries consists principally of single-author works – academically rigorous and groundbreaking –which offer comprehensive, analytical guides at a length and level accessible to advanced

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First published 2010 Second edition 2015 Printed in the United Kingdom by TJ International Ltd Padstow Cornwall

A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data

Persson, Karl Gunnar, 1943–

An economic history of Europe : knowledge, institutions and growth, 600 to the present / Karl Gunnar

Persson and Paul Sharp – Second edition.

pages cm – (New approaches to economic and social history) Revised edition of the author’s An economic history of Europe : knowledge, institutions and growth,

600 to the present, published in 2010.

Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or

appropriate.

Preface to the second edition

Preface to the first edition

Introduction: What is economic history?

Efficiency in the use of resources shapes the wealth of nations

Outline of the chapters

1The making of Europe

1.1The geo-economic continuity of Europe

1.2Europe trades, therefore it is!

1.3The limits of geographical integration

1.4From geo-economics to geo-politics: the European Union

2Europe from obscurity to economic recovery

2.1Light in the Dark Ages

2.2Gains from division of labour: Adam Smith revisited

2.3Division of labour is constrained by insufficient demand

2.4Division of labour promotes technological change

2.5After the post-Roman crisis: the economic renaissance of the ninth to fifteenth centuries2.6Population

2.7The restoration of a monetary system

2.8Transport and trade routes

2.9Urbanization

2.10Production and technology

3Population, economic growth and resource constraints

3.1Historical trends in population growth

3.2The Malthusian theory of population growth and stagnation

3.3Is the Malthusian theory testable?

3.4The secrets of agricultural progress

3.5Understanding fertility strategies

3.6The demographic transition

4The nature and extent of economic growth in the pre-industrial epoch

4.1Understanding pre-industrial growth

4.2Accounting for pre-industrial productivity growth

4.3Wages and income distribution

4.4The Great Divergence: when did Europe forge ahead?

Appendix: The dual approach to total factor productivity measurement

5Institutions and growth

5.1Institutions and efficiency

5.2The peculiarity of institutional explanations

5.3The characteristics of a modern economy

5.4Market performance in history

5.5The evolution of land and labour markets: the rise and decline of serfdom

5.6Firms and farms

5.7Co-operatives and hold-up

5.8Contracts, risks and contract enforcement

5.9Asymmetric information, reputation and self-enforcing contracts

6Knowledge, technology transfer and convergence

6.1Industrial Revolution, Industrious Revolution and Industrial Enlightenment

6.2Science and entrepreneurship

6.3The impact of new knowledge: brains replace muscles

6.4The lasting impact of nineteenth-century discoveries and twentieth-century accomplishments6.5Technology transfer and catch-up

6.5.1Why was Germany a late industrial nation … and why did it grow faster than Britain once itstarted to grow?

6.5.2Human and capital investment

6.5.3Research and development

6.5.4Industrial relations

6.6Convergence in the long run: three stories

6.7Why is Europe not closing the income and productivity gap relative to the US economy?

7Money, credit and banking

7.1The origins of money

7.2The revival of the monetary system in Europe: coins and bills of exchange

7.3Usury and interest rates in the long run

7.4The emergence of paper money

7.5What do banks do?

7.6The impact of banks on economic growth

7.7Banks versus stock markets

7.8Reflections on recent financial crises

Appendix: The bill of exchange further explored

8Trade, tariffs and growth

8.1The comparative advantage argument for free trade and its consequences

8.2Trade patterns in history: the difference between nineteenth and twentieth-century trade

8.3Trade policy and growth

8.4Lessons from history

8.4.1From mercantilism to free trade

8.4.2The disintegration of international trade in the interwar period

8.4.3The restoration of the free trade regime after the Second World War

8.4.4Tariffs and growth

Appendix: Comparative advantage

9International monetary regimes in history

9.1Why is an international monetary system necessary?

9.2How do policymakers choose the international monetary regime?

9.3International monetary regimes in history

9.3.1The International Gold Standard c 1870–1914

9.3.2The interwar years

9.3.3The Bretton Woods System

9.3.4The world of floating exchange rates

9.3.5The Eurozone Crisis in the light of the historical experience

10The era of political economy: from the minimal state to the Welfare State in the twentieth century10.1Economy and politics at the close of the nineteenth century

10.2The long farewell to economic orthodoxy: the response to the Great Depression

10.3Successes and failures of macroeconomic management in the second half of the twentieth century:from full employment to inflation targeting

10.4Have austerity policies worked in recent history?

10.5Karl Marx’s trap: the rise and fall of the socialist economies in Europe

10.6A market failure theory of the Welfare State

11Inequality among and within nations: past, present, future

11.1Why is there inequality?

11.2Measuring inequality

11.3Gender inequality

11.4Is inequality on the rise again?

11.5World income distribution

11.6Towards a broader concept of welfare

11.7Speculations about future trends in world income inequality

12Globalization and its challenge to Europe

12.1Globalization and the law of one price

12.2What drives globalization?

12.3The phases of globalization

12.3.1Capital markets

12.3.2Commodity markets

12.3.3Labour markets

12.4Globalization and divergence

12.5Globalization backlash: three cases

12.5.1Trade openness and migration

12.5.2The retreat from the world economy

12.5.3The tale of the twin farm protests

Appendix: Freight rates and globalization

Glossary

Index

4.1Total factor productivity in French agriculture 1522–1789 Per cent per year

4.2.GDP per head in European and Asian nations 1300–1850 (1990 international dollars)

5.1Number of co-operative and proprietary creameries 1888–1909

6.1TFP growth and new and old estimates of national product growth in Britain during the IndustrialRevolution Per cent per year

8.1Merchandise trade patterns in the UK and the USA 1880–1913

8.2Merchandise trade patterns in Western Europe 1963–1999

8.3The European trade regimes

9.1The Eurozone crisis in figures: an Optimal Currency Area?

9.2Exchange rate systems

10.1GDP per capita in the USA, Russia and Eastern Europe relative to Western Europe 1950–90.Western Europe = 1

10.2The uses of local and central government spending in Europe in 2005 Percentage of total

2.1Gains from division of labour

2.2Virtuous and vicious processes in technological progress/regress

2.3Urbanization in Europe and China: urban population as a percentage of total population

2.4An approximation of metal production in the northern hemisphere as revealed by lead emissionsfound in the Greenland ice cap

3.1European population 400 BCE to 2000 CE Millions

3.2Malthus graphically speaking

3.3Real farm wages in England and fluctuations in northern hemisphere temperature 1560–1880

3.4Old and new total fertility regimes relative to a population growth isoquant of 0.1–0.4 per cent peryear

4.1Malthusian and Smithian forces in economic growth

6.1Patent applications per year in various European nations 1860–1916 Per 1000 inhabitants

Source: WIPO Statistics Database

6.2Annual rate of growth of GDP per capita 1870–1914, per cent, and GDP per head in 1870

Constant 1990 international dollars

6.3Annual rate of growth of GDP per capita 1914–50, per cent, and GDP per head in 1914 Constant

1990 international dollars

6.4Annual rate of growth of GDP per capita 1950–75, per cent, and GDP per head in 1950 Constant

1990 international dollars

6.5Log GDP per capita 1860–2000 in Argentina, Scandinavia and the USA 1990 $

6.6Log GDP per capita 1860–2000 in Germany, Ireland, Czechoslovakia and Italy 1990 $

6.7Log GDP per capita 1860–2000 in France, Spain and United Kingdom 1990 $

7.1Spontaneous evolution of wheat as money when there is no coincidence of wants

7.2The bill of exchange

8.1The infant-industry argument for protection

8.2The first free trade era in Europe

8.3Average protection (%) for 24 countries 1865–2000

8.4The volume of world trade after two great shocks

9.1The (Obstfeld–Taylor) open economy trilemma: pick two policy goals, only two but any two

9.2Contrasting fortunes: GDP/capita of France and the UK 1920–1939 (1990-GK$, 1929=100)

10.1Unemployment paves the way for Adolf Hitler

10.2Comparing the Great Depression and the Great Recession: world industrial output, now vs then.Eurozone industrial output in the Great Recession

10.3Net welfare state balance of a typical household over its life cycle

11.1Gini distributions in economies from 10,000 BCE to the present

11.2The actual Gini coefficient as a share of the maximum Gini over time

11.3HDI and GDP per head 1870–2000

12.1Globalization means a stronger inverse link between domestic production costs and employment12.2Real domestic (USA rail) and transatlantic freight rates 1850–1990 (1884 = 1)

12.3Nominal interest rate differentials between USA and UK on similar assets 1870–2000

12.4Price convergence between the UK and USA 1800–1975 Price of wheat in UK relative to price

in Chicago and New York

12.5Openness and labour standards in 1913

12.6Freight rate reductions extend the frontier and increase price and income for non-frontier farmers

1.1The Roman Empire around 200 CE

1.2The Carolingian Empire around 850 CE

1.3The European Union 2010

2.1Merchant communications in the early centuries of European revival

0.1The surprising effect of technological progress

1.1A short history of standardization

2.1Income levels and division of labour in the pre-industrial era

2.2Ship size and the principle of economies of scale

2.3The mill was the first general purpose technology

3.1Some basic demographic concepts

3.2Malthus in cointegration space

3.3Heavy ploughs and heavy soils

3.4An example of increasing productivity: more grain from less land

4.1Total factor productivity growth in pre-plague English agriculture

4.2Urbanization means higher labour productivity

4.3Why real wage data are a poor guide to real per capita income changes

5.1Religion and growth: Max Weber and the Protestant Work Ethic

5.2Why sharecropping reduces work and output

6.1What we talk about when we talk about real economic growth

6.2Why did the Industrial Revolution start in Britain?

9.1Using the national accounting identity to show that foreign investment is restricted without aninternational monetary system

9.2Example: why was the gold standard a fixed exchange rate system?

9.3Money Wars: the making of the Bretton Woods System

9.4The Optimal Currency Area Criteria

9.5Politics and monetary unions

10.1Growth disasters and the Great Depression

10.2The spending multiplier controversy

10.3Keynesianism under scrutiny: stirred but not shaken

10.4The Great Depression vs the Great Recession

11.1Social mobility: back on the research agenda of economists

12.1King Cotton: the global fibre

Preface to the second edition

This edition has been thoroughly revised and a large amount of new material has been addedreflecting new research results and the recent development of the European economy Paul Sharp, myformer PhD student and now Professor at the University of Southern Denmark in Odense, has assisted

me in this work and he has the principal responsibility for Chapters 8 and 9

We thank Marc Klemp for revising the Glossary and for his comments and suggestions on

Chapter 3

Claudia Riani has contributed to the development of the companion website and we thank MartinLundrup Ingerslev for research assistance

Preface to the first edition

This book evolved over the years from the lectures I have given and give to my students at theDepartment of Economics in Copenhagen I have, however, attempted to write a book for a wideraudience who are searching for a very concise introduction to European economic history which is intune with recent research I make use of a few basic and simple economic tools which turn out to bevery effective in the interpretation of history The book offers a panoramic view rather than close-ups However, the analytical framework will be useful in further studies of the specialized literature.For readers with little background knowledge in economics I provide a glossary defining keyconcepts, which are marked in bold, for example barter Economic ideas demanding more attentionare explained in the text or in appendices

This is a work of synthesis, but it attempts to give challenging and new insights I am indebted togenerations of economic historians as well as to a great many of my contemporaries That normallyshows itself in endless footnotes, which not only interrupt the narrative flow but also drown thegeneral historical trends amidst all the details Instead, I have chosen to end each chapter with aselective list of references which is also a suggestion for further reading Authors I am particularlyinfluenced by are referred to in the main text

A large number of colleagues have guided me Cormac Ó Gráda has as usual been a verystimulating critic and Paul Sharp has not only saved me from embarrassing grammatical errors but isalso the co-author of two chapters I would also like to thank Carl-Johan Dalgaard, Bodil Ejrnæs,Giovanni Federico, Christian Groth, Tim Guinnane, Ingrid Henriksen, Derek Keene, Markus Lampe,Barbro Nedstam and Jacob Weisdorf for helpful comments and suggestions

Mette Bjarnholt was my research assistant during the initial phase of the project and MarcKlemp and Mekdim D Regassa in the final stage and they have all been enthusiastic and good to havearound

Introduction: What is economic history?

as land, but the fertility of land can and must be restored after harvest Over thousands of years ofagriculture, mankind learned how animal dung, rotation of crops and the introduction of nitrogen-fixing crops could increase the yearly harvest Natural resources such as coal, oil and iron ore are,however, non-renewable Other resources are made by mankind Capital, for example factorybuildings and machinery and tools, is therefore renewable Labour, finally, is a resource whosesupply relies on how well mankind uses the other resources at hand But labour has been in increasingsupply since the transition from hunter-gatherer technology to agriculture about ten thousand yearsago The skills of labour, so-called human capital, were primarily based on learning by doing, and it

is only since the nineteenth century that formal education has played an important role

Efficiency is determined by the technology of production and by the institutions that give access

to the use of resources A convenient way of measuring efficiency is total factor productivity Themore output you get from a given amount of resources the higher the level of total factor productivity

in an economy You can measure the growth of total factor productivity by the growth in output which

is not caused by an increase in inputs in production Total factor productivity growth is caused bybetter use of resources due to new technological knowledge and better organization of production

Institutions can be understood as the rules of the game for economic life Institutions orprinciples such as the Rights of Man matter because if labour is not free to move it is unlikely that

labour will find its most productive employment Workers who are not properly rewarded will haveevery reason to shirk, that is, not to offer sufficient effort Owners of capital need assurances fromruling elites that their property will not be arbitrarily expropriated before they will be willing toinvest Inequalities in the distribution of income and wealth tend to trigger off distributional conflicts

in nations, which hamper growth because political conflicts create uncertainty about the rules of thegame in the future

Economic history traces the efficiency characteristics of institutions by studying the development

of commodity and labour markets, financial intermediaries (banks), the legal framework of contractenforcement, property rights, openness to trade and international capital flows Property rights overresources can be more or less well defined and they impact on the use and distribution of resources.Markets can be more or less efficient depending on their competitive nature and the speed at whichnew information about supply and demand conditions is spread Markets can be thin, that is trade can

be infrequent and engage few participants at a time; or thick, which means that markets are almostcontinuous and involve a large number of traders In history, markets have tended to become thickerand more efficient over time Money facilitates trade and exchange and banks can help savers withincomplete knowledge to find good investment opportunities High risks can deter people from trade,but insurance can reduce these risks Openness to trade and factor flows has varied dramaticallythroughout history Even though there is evidence that openness tends to increase efficiency in the use

of resources, there are losers as well as winners within any nations from the practice of internationaltrade Although the long-run historical trend has been one of increasing openness, there are significantsetbacks in this process driven by those who fear to or actually do lose from free trade Openness canincrease risk because open economies are more exposed to shocks originating in the world economy

It is possible that openness is therefore linked to the evolution of specific institutions, such as theWelfare State, that alleviate these effects of openness Government sets the rules of the game, andtries to uphold law and order But since governments have a monopoly of force, good andaccountable government is far from the rule Corruption and bad government is a major reason whyeconomies fail

Technology is knowledge about how to use resources in the production of goods and services.The ability to make iron out of iron ore is based on knowledge originally derived from trial and error.Without that knowledge iron ore would be useless, as it was throughout most of the history ofmankind Modern technologies differ from pre-nineteenth-century technologies mainly by the fact thatthey are developed from theoretical and scientific inquiry about the world, which over the span of

just 200 years has expanded the knowledge base at an ever-increasing rate.

Often such knowledge will be ‘embedded’ in particular pieces of production equipment andtools Think of a modern PC It is a useful tool in a wide variety of operations, and a large amount ofprior knowledge is embedded in it in the sense that the operations you can perform with the computerrely on the prior knowledge needed to construct the computer and its software

Although some natural resources may have been depleted over time, such as oil and minerals,there has been an increase in the efficiency of their use The general technological trend in history hasbeen that the amount of resources you need to produce a given amount of output has declined Late-nineteenth-century economists all agreed that coal deposits would be exhausted in the near future,which would put an end to prosperity It did not happen because another non-renewable resource, oil,and renewable energy sources such as hydroelectricity, replaced coal as a major source of energy Inthe long run oil resources will be exhausted if no alternative energy resources, renewable or non-renewable, are exploited

Material resources, such as capital equipment, land and natural resources, are what we can call

rival goods You cannot both use the coal and keep it Your use of a particular machine hinders others

from its use However, the factors that generate efficiency, that is technology and institutions, are rival Your use of common knowledge to construct a new efficient tool does not preclude others from

non-using the same knowledge It is true that some knowledge is not immediately and freely accessible toall because of patent protection Such protection is an institutional mechanism to stimulate researchspending, but patents expire, after which private knowledge becomes common knowledge.Knowledge of a new institutional mechanism – say a change in corporate taxation, which givesinvestors incentives to invest in sophisticated production technology – can be imitated in any nation.The non-rival nature of knowledge about technologies and institutions gives it an almost limitlesspotential to change the efficiency of production

Box 0.1 The surprising effect of technological progress

Technological progress saves resources and is measured by total factor productivity (tfp).Total factor productivity is an indicator of the level of technological know-how in a society Wewill later substantiate the claim that there has been a slow but increasing rate of total factorproductivity growth over time In this example we quantify the impact

Imagine a typical economy in Europe around the year 1000 The yearly income per headwas close to subsistence level, say 500 constant so-called international dollars of 1990, which

simply means the value of the basket of goods this sum of money would buy in 1990 prices.

Over the next 500 years a conservative estimate of total factor productivity growth wouldsuggest 0.1 per cent per year From 1500 to 1800 we estimate it to be 0.2 per cent, from 1800 to

1900 to be 0.5 percent and 1 per cent between 1900 and the present (2014)

The question is now the following: How much resources do we need to use today to

produce that subsistence basket of the year 1000 The answer is: only 7 per cent of the resourcesused in the year 1000!

Do we really need to worry about the environmental effects of growth when it seems to beassociated with better use of resources? Yes we do, because over the same period income perhead has increased about 50 times, meaning that per capita use of resources has increased byabout 3.5 times, of which about a quarter of resources are non-renewable

In recent years, climate change has come to the forefront in the political and economic debate Whatrole, if any, has climate in the framework sketched here? Climate is best seen as a factor, along withtechnology and institutions, which determines the degree of efficiency with which resources can beused Climate change is certainly not new to economic historians, but neither the extent of thesechanges nor their effects have been sufficiently explored The so-called Little Ice Age, in the EarlyModern period (1450–1650), is according to one line of research responsible for a decline in outputproduced by given resources and technology As a contrast, the contemporary discussion focuses onthe potential increasing costs of production from global warming, although the impact may differsignificantly among regions and sectors in the world

Resource endowments of nations as far as land and mineral deposits are concerned have notchanged over time The dramatic changes that economic historians focus on are how human capital,technologies and institutions develop over time to facilitate the access to and efficient use ofresources that permit income and wealth to grow Initial resource endowments matter, but it isincreased efficiency in their use which has permitted economies to enjoy increasing wealth throughoutthe course of history At this stage we can formulate a strong proposition which will be corroborated

in the subsequent chapters:

Proposition 1: Economies that are richly endowed with resources are not necessarily rich buteconomies which use resources efficiently are almost always rich irrespective of their resourceendowment

Outline of the chapters

Our story begins at a time when the first European civilization, the Roman Empire, had declined

Chapter 1 examines the surprising geo-political continuity of Europe despite the endemic politicaland territorial conflicts One question asked is what shapes regional entities such as Europe Thegravity theory of trade notes that trade is stimulated by proximity and similarity and stresses thegravitational attraction of large core economies The chapter advances the idea that trade has been amajor force of integration, not only economic but also cultural and political Initial barriers to tradetend to develop into trade-inhibiting border effects which define the limits of regional entities

Proposition 2: Europe trades, therefore it is!

Before the nineteenth century technological progress was very slow and rested on a thin base ofknowledge which was mainly derived from experience acquired from learning by doing and thedivision of labour Division of labour was the primary source of efficiency gains in production andtriggered the development of institutions, markets, money and contract enforcement rules, whichfacilitated exchange Without the exchange of services and goods there was no scope for people tospecialize in separate skills In Chapter 2 we develop a simple explanation of the rise and fall ofeconomies stressing the ups and downs of orderly markets, urban settlements and trade nodes anddivision of labour The positive effects of population growth are stressed when the declining trend inthe aftermath of the decline of the Roman Empire is reversed The decline of the Roman Empire is astory of institutional and political breakdown with severe consequences for economic welfare Aninteresting question arises here: are modern economies immune to institutional failures? As we willsee in subsequent chapters, the answer is no!

Proposition 3: The forces that stimulate division of labour (specialization), that is political order,population growth, money supply and exchange, were essential for the revival of the Europeaneconomy in the early Middle Ages and started a process of slow growth of welfare based on skillperfection and learning by doing

Economics and economic history tell us, first, that more resources per producer generally increaseoutput and income Second, and more interestingly, even within the constraints of resources which are

in fixed supply, such as land, output and income per person will increase if a person learns how to

increase efficiency in her use of resources For example, the yield of wheat per year from a hectare of

land has increased continuously and dramatically in the course of history In Chapter 3 we focus onhow the fixed supply of land can constrain growth, but only insofar as technology is stagnating

Proposition 4: Technological progress is essentially resource saving, which makes explanations

relying on binding resource constraints insufficient and often inappropriate for historical analysisexcept with regard to economies that are characterized by technological stagnation.

The lesson from history is that technological change can relieve the economy of the constraints of aresource in fixed supply More paradoxically, we find that an increase in population can stimulateboth technological change and division of labour, thereby counteracting the impact of diminishing returns when land resources per producer fall In Chapter 4 we explore this finding further The pre-industrial economies differed in their capacity to balance negative and positive effects frompopulation increase The outcome is not deterministic: some regions and nations experience sloweconomic growth while others have periods of growth followed by stagnation

Proposition 5: Population growth tends to increase demand and hence division of labour as well astechnological progress (Pepys’ rule)

We often take institutions as given, but in a historical analysis, we cannot and should not do so.Institutions develop spontaneously or by design; they regulate use of and access to resources and theconditions for exchange It is useful to look for efficiency characteristics in institutions In the absence

of contract enforcement mechanisms, exchange which involves future delivery will be severelyrestricted, for example However, institutions which regulate the access to resources, that is propertyrights, have an impact on the distribution of welfare, and persistent institutions may survive onlybecause they serve powerful elites I n Chapter 5 we discuss the interpretation and impact ofinstitutions and note that there is often a bewildering variety of institutional solutions to the sameeconomic problem We ask questions like the following: why are farms generally small and managed

by those who work there, whereas industrial firms are large and managed by those who own the firmrather than those who provide labour services? It turns out that in some cases institutions fail becausethey are inefficient, but history also tells us that inefficient institutions may survive because they servevested interests and powerful elites

Proposition 6: Institutions leading to efficient outcomes are often stable, but stable institutions do notnecessarily promote growth and welfare

The industrial revolution in the eighteenth and nineteenth centuries was founded on a set of moderninstitutions as well as new mechanisms serving the growth of science Chapter 6 explores thefoundations of modern economic growth and the conditions for technology transfer During most of thehistory of mankind technology has been based on knowledge derived from experience in production,which is learning by doing Such knowledge can develop by chance or by deliberate trial and error.However, these technologies are not based on theoretical or scientific understanding The great leap

forward in technological development is associated with the breakthrough in the nineteenth century ofknowledge gained through theoretical and scientific inquiry This industrial enlightenment, as it hasbeen called, has its roots in preceding centuries but becomes a decisive force only in the second half

of the nineteenth century From being slow, technological progress became the prime mover ofeconomic growth by the end of the nineteenth century It turns out that the vast majority of productsand production processes that came to dominate the twentieth century were invented in the nineteenthcentury Since technology is essentially the useful application of knowledge and ideas, which are non-rival in nature (i.e your use of knowledge does not reduce the availability of it), we would expecttransfer of best-practice technology among nations to lead to convergence in the levels of technology

and income across nations We do indeed observe this convergence, but it is not universal This is a

paradox since we are arguing that what matters is a factor – ideas and knowledge – which is rival However, being in the public domain does not imply being easily accessible or easily applied

non-We need to know why some nations were not able to use available knowledge of superior

technologies and develop institutions which helped the efficient use of resources It turns out thattechnology transfer is dependent on institutional and educational pre-conditions which, if absent, willmake transfer imperfect

Proposition 7: Science and R&D (Research and Development) are recent phenomena intechnological development Fast technology transfer after 1850 led to convergence based on catch-upamong economies that had an appropriate educational and institutional infrastructure

Over thousands of years money developed into an increasingly efficient instrument of credit andpayment Banks are a more recent phenomenon, emerging only in the late medieval period and notreaching maturity until the nineteenth century Banks are intermediaries between savers and investors(spenders) They reconcile the savers’ desire to hold liquid assets with the investors’ need for long-term finance, and they reduce risks by holding diversified asset portfolios beyond the reach ofindividual savers Despite the inherently risky nature of banking and finance, it is possible to showhow banks over time reduced risk and costs in transactions Furthermore, the development of banksincreased savings and investment The breakdown of a financial system in twelfth-century Europewould have effects on trade, but in the present world it threatens all economic activities Theevolution of money, credit and banking is explored in Chapter 7

Proposition 8: Banks have developed as intermediaries between savers and investors by reducingrisk in saving, by solving informational asymmetries and by monitoring borrowers more efficientlythan savers would be able to on their own

Before the Industrial Revolution, international capital flows and international trade were limited; thefirst wave of globalization occurred in the nineteenth century The institutional foundations of afunctioning international trading system and monetary regime are explored in Chapters 8 and 9.Although there are net gains for nations that trade, there are winners and losers within each nation.Sometimes the losers dictate trade policy and the result will be trade restrictions and a globalizationbacklash, as in the interwar period (1920–40) While it is easy to understand that a majority of loserscan dictate protectionist policies, like landowners in Europe in the closing decades of the nineteenthcentury, we also face the paradox that small minority groups, such as farmers, can lobby successfullyfor tariff protection 100 years later Explain that!

Proposition 9: Net gains from trade do not preclude winners and losers The protectionist paradox isthat both large and small groups can successfully lobby for protectionism and win, but for differentreasons Bad times foster protectionism, but good times help free trade forces

International monetary regimes, discussed in Chapter 9, have varied significantly throughout history.The relative merits of fixed exchange rates vs floating exchange rates cannot be determined in astraightforward way The advantages of fixed exchange rates in stimulating trade and capital mobilitywere noted in the nineteenth century, but these phenomena have also been present in the floatingexchange rate regimes emerging since the mid 1970s Fixed exchange rates tend to restrict the ability

of policymakers to impact on domestic economies, and floating exchange rates are therefore favouredwhen there is a demand for an activist domestic economic policy, as emerged after the breakthrough

of democracy in Europe in the early twentieth century Although economic orthodoxy led Europe back

to the Gold Standard, a fixed exchange rate regime, it had neither the equilibrating mechanisms northe longevity of the classical Gold Standard of the period before the First World War The lessonsfrom the interwar period were applied in the exchange rate regime introduced after the Second WorldWar, giving nations more say over domestic monetary policy at the expense of free capital mobility.But a system with fixed exchange rates in the short run and adjustable exchange rates in the long runfell victim to its own contradictions The twentieth century was not made for fixed exchange rates.Proposition 10: The historical record suggests that widespread democracy seems to be difficult toreconcile with a fixed exchange rate policy because such a policy constrains domestic economicpolicy options

Chapter 10 explores economic growth and economic policy in the twentieth century That century can

be described as the era of political economy because it witnessed the transformation of the minimalstate to the activist state The balance between politics and markets differed and the ‘over-

politicized’ economies of the Socialist bloc ultimately failed because they did not deliver the goodspromised The mixed approach favoured in the rest of Europe was more successful in the combination

of competitive markets and extensive insurance schemes provided by the Welfare State We interpretWelfare State provisions as a response to market failures in insurance and the need for life-cyclesmoothing of income

The book illustrates the fragility of free trade policies and fixed exchange rates under pressurefrom an international crisis But we also demonstrate the power of economic policies in revivinggrowth in a depression, and the tragedy of erroneous policy responses, as in Germany leading to theascent of Adolf Hitler The interwar period paved the way for a new economic policy regimecharacterized by more active fiscal and monetary policies of Keynesian persuasion We shallchronicle its birth, near-death and resurrection

Proposition 11: The idea that the economy was a self-regulating and equilibrating process was killed

by the Great Depression, and after the Second World War Europe worked out a new balance betweenpolitics and economics, paving the way for activist fiscal and monetary policies The Welfare State isprimarily an inter-temporal redistribution institution which is explained by market failures and humanlack of self-control

Chapter 11 discusses inequality, past and present While Europe converged, the income gap betweenthe rich industrialized countries and the rest of the world increased dramatically from around 1800and has gone on increasing up to the present The developing nations are poor mainly because theyare not capable of creating the institutional and educational conditions for technology transfer Thespectacular growth in recent decades of economies in South East Asia indicates the power ofinstitutional change Industrialization and modernization usually increase inequality within nationsbecause of bottlenecks in the supply of skilled people But by expanding human capital investmentand easing access to higher education inequality will be reduced, as in Europe in the twentiethcentury However, there are persistent wage differences between men and women that are based ondiscrimination

Proposition 12: World income inequality has probably peaked after 200 years of increased incomegaps More equality ahead need not be just wishful thinking but will be the result of an increasingnumber of nations getting the institutional infrastructure needed for technology transfer

Chapter 12 deals with the challenge and opportunities of globalization We argue that, on balance,globalization brings net benefits to the world economy But there are losers and winners A number ofquestions will be addressed Will globalization put downward pressure on (unskilled) wages in the

rich countries? Will wages in poor and rich countries converge? Will there be a ‘race to the bottom’

as regards ‘labour standards’, that is hours and conditions of work? The preliminary answer to thefirst two questions is yes, but it is no to the last question – if we are allowed to judge from theexperience of the first era of globalization

Proposition 13: The world economy just before the First World War was as globalized as the worldeconomy today There was convergence of wages in the first era but not a race to the bottom in

‘labour standards’

The making of Europe

◈

1.1 The geo-economic continuity of Europe

The formation of Europe was a long historical process which involved political, cultural andeconomic forces The most striking fact is the geo-economic persistence and continuity of Europeduring the last two millennia We will deal with the integrative impact of trade as well as its border-maintaining effect in shaping and maintaining Europe Trade was the cohesive force when political,religious and military conflicts threatened to tear Europe apart

If we let the core of Europe be defined by the borders of the European Union, we can trace backthe origins of that geographical entity to the Roman and Carolingian empires, the latter emerging in theninth century, several centuries after the collapse of the Roman Empire (See Maps 1.1–1.3.) About

80 per cent of the total population of the Roman Empire around the year 100 AD lived within thepresent (2010) borders of the European Union It stretched from the Atlantic coast to the Black Sea.Ireland, the northern periphery of Europe, Scandinavia and Russia were touched by neither the Romannor the Carolingian rulers Russia’s relationship to Europe has remained ambivalent throughout itshistory, with periods of self-imposed isolation as well as enthusiastic embracing of European ideals,and Scandinavia was late in joining the European Union; in fact Norway is still making up its mindwhether to join or not

Map 1.1

The Roman Empire around 200 CE

Map 1.2

The Carolingian Empire around 850 CE

Map 1.3

The European Union 2010

The Carolingian Empire represented the revival of political order after the disintegration of theRoman Empire, and also the emergence on the political scene of Germanic peoples, whoamalgamated their own traditions with the adopted culture, law and language of their Romanpredecessors in their south and westward push Germanic tribes also advanced towards the east, butkept their own language and pushed the Slavic languages back eastward when they subjected theindigenous peoples and their land It took centuries, in fact a millennium of conflicts, for the presentmap of nation states forming the European Union to emerge, and it is worth noting that the heartland ofthe Roman Empire, that is Italy, was not again a nation state until the late nineteenth century AfterRome and after the partition of the Carolingian Empire the new nations remained smaller At oneextreme we have the prosperous merchant city states of Italy, for example Venice, emerging in theeleventh century, and at the other extreme a large nation state emerging in France as the western part

of the disintegrating Carolingian Empire The age of empires was not to appear again until theEuropean colonial expansion of the nineteenth century

We delineate a nation or a union of nations by borders because borders represent the limit of

political authority and the capacity of the state to tax and spend on roads and public goods, such asdefence and law and order institutions Nations form because they offer economies of scale inproviding these public goods and a public authority, the state, is better suited than markets inproviding non-excludable services, that is services such as defence and law and order If suchservices are provided they will be available to everybody within a territory The size distribution ofnations has varied dramatically throughout history, but the reason for that has probably more to dowith politics and ethnicity than with economics Since the breakdown of the unified CarolingianEmpire, national borders have been redrawn repeatedly after bitter and costly conflicts The greathistorical paradox is that despite disruptive political forces Europe remained as a unit of cultural andinstitutional homogeneity because of strong cohesive forces, of which trade was the most important.

1.2 Europe trades, therefore it is!

Following the so-called gravity theory of trade we can predict the volume of trade between two

nations by two determinants: the size of the economies as measured by national income and thedistance between them The task of determining the volume of trade differs from the task ofdetermining the commodity composition of trade which is the subject of Chapter 8 The larger thecombined size of two economies the larger the volume of trade, but distance imposes a negative effect

on trade We add to the traditional gravity theory the insight from Henri Pirenne (see below) thatcultural, religious and jurisdictional differences between nations have a negative impact on tradesimilar to that of geographical distance We call these barriers to trade differences in economicculture or border effects for short However, unlike distance which is constant, cultural differences

or border effects tend to be eroded by trade because trade promotes common weights and measures, alingua franca, that is a language understood across local languages, and harmonization of commercial

l aw Since trade involves human interchange it also transfers preferences and new knowledge,technology, trust and cooperation, which means that economic culture is becoming shared across

nations and regions Trade, in other words, generates similarity of nations.

As division of labour gains momentum, as it does in the second millennium, a period usuallyreferred to as the commercial revolution, trade becomes increasingly long distance with a separationnot only in space but also in time of contracting and contract fulfilment, between shipping goods andpayment of goods It eventually involves trade between strangers This is the context for what hasbeen called the ‘fundamental problem of exchange’ The difficulties in establishing lasting long-

distance trade relationships between strangers were embedded in imperfect and asymmetricinformation, uncertainty and greater risks compared to spot exchange Contract enforcement problemswere formidable because legal traditions and procedures differed between cities and nations Onemajor accomplishment in the first half of the second millennium was the establishment of aninstitutional framework needed for exchange to handle the ‘fundamental problem of exchange’ If asedentary merchant trader, say, in Bruges provided the financing and the goods in the transaction andused an agent in some other city to conclude the trade that agent could exploit the fact that fullinformation was not immediately revealed to the principal For example the agent might claim, rightly

or wrongly that the quality of goods in transit had deteriorated and fetched a price lower thanexpected Trust relationships in a family firm certainly helped to avoid the problem of fraudulentbehaviour and the persistence of that type of firm indicates a beneficial characteristic However,there is an evolution from trade relying mainly on family and kin relationships, in which peer pressurewas a major mechanism to secure proper conduct, to exchange relations built upon the use of formalinstitutions of contract enforcement and conflict resolution and an extension of trust relationshipsbeyond the confines of family and ethnic group

We can illuminate the argument by an example from history The Arab conquest in the eighth andninth centuries of northern Africa and the Iberian Peninsula, once part of the Roman Empire, created acultural and religious barrier to trade in the Mediterranean, which had not been there before The core

of Europe moved away from the Mediterranean world towards western and central Europe HenriPirenne, a Belgian economic historian (1862–1935), focused on what were later called bordereffects, in this case the negative effects on trade of a cultural and religious divide, in analysing thedecline in Mediterranean trade and imports to northern and Western Europe after the Arab conquest.Why would religious and cultural differences affect trade negatively? In the context of long-distancetrade exporters and importers need to trust each other, as pointed out above By and large trust iseasier to build if people share common beliefs and a common code of conduct that develops intocommon rules of contract enforcement Within Europe a fairly uniform set of rules and institutionsemerged as trade picked up in the medieval period to assist in settling contractual disagreements,honouring promises and protecting foreign merchants from arbitrary actions by local merchants

Recent research based on the ample finds of Arab coins in Western Europe suggests that thetrade between the Arab and European nations probably did not decline as much as maintained byPirenne and not just for the reasons he suggested Part of the reason for the low trading activity wasprobably the fact that Europe was just recovering from the economic decline following the demise of

the Roman Empire Poor nations simply do not trade much, as suggested by the gravity theory of trade.

To the Arabs Europe was a backwater However, Pirenne was right in focusing on border effects andpointing out that previously flourishing trade relations deteriorated as a consequence of a cultural andreligious divide Another telling illustration of border effects is the geographical diffusion of lateRoman high-quality pottery from a particular production site in southern France The pottery wasshipped as far as Hadrian’s Wall in Britain, and all over the Empire including North Africa, but thereare practically no finds north of the River Rhine in Germany, which runs along the Roman border innorthwestern Europe as indicated in Map 1.1 So the border of the Empire constituted a formidableobstacle for this and other commodities because the population north of the Rhine lacked the means tobuy high quality pottery, as trading networks were poorly developed and because taste andpreferences differed across borders

These two examples provide other insights The Mediterranean world has not regained itsformer economic integration The border effects discussed by Pirenne were not eroded in thecenturies following the Arab expansion Part of the reason was the Arab world slid into relativebackwardness which reduced trade opportunities with Europe when the Muslim Golden Age came to

an end at the beginning of the second millennium partly because of religious fundamentalism Theborder effects imposed by the Roman borders in northwestern Europe were, however, effectivelyreduced during the medieval resurgence of the European economy as Germans pushed eastwards Avibrant economic trading area including the Baltic and northern Europe including the Norwegiancoastline was well established by the thirteenth century and followed a religious unification with theexpansion of Christianity into these areas

Throughout history, the volume of trade has been stimulated by the size, proximity and similarity

of nations Nations close to each other trade more with each other than with economies far away This

is true today but was even truer in the past, when land transport costs were often prohibitively highfor commodities other than luxury goods: silk was transported over long distances, but bulkycommodities like grain were not Before the expansion of railways in the nineteenth century landtransport costs were high Costs differed widely in the past with packhorses being the most expensiveand in fact the only means available over some of the passes across the Alps Transport by cartsreduced costs considerably Transport of goods like courier services were handled by specialists and

on a regular basis from the beginning of the second millennium Commodities were reloaded at timesexploiting the much cheaper rates by water, approximately 10–25 per cent of road transport charges.However, open seas maritime trade often added considerable mileage For example, much of the

gains from lower transport charges between say, Bruges and Venice, were lost by the long distanceover sea relative to the land passage The carrying capacity of ships in maritime trade increasedapproximately by a factor of five over the first half of the second millennium but interestingly manningdid not increase proportionally which reveals increasing labour productivity in shipping Moderninsurance with the merchant paying a fee developed in the fourteenth century with rates around 10–15per cent of value of cargo, compared to 1–2 per cent in late-nineteenth-century trade This dramaticfall over time reflects safer ships and the extinction of pirating at sea and robbery of transport onland.

Over land a commodity like grain was not normally transported more than 100 km before therailways, but since the cost of sea transport was lower it could be and was shipped over longerdistances by sea, for example from the Baltic coast to the Atlantic ports in Europe already in the

medieval era Dried cod (stoccafisso), was shipped from Norway to the Mediterranean in the late

medieval period, fine cloth made of wool, flax as well as cotton was taken over the Alps tonorthwestern Europe and luxury goods travelled even further The first signs of what is known as thecommercial revolution in the beginning of the second millennium in medieval Europe was theestablishment of periodic fairs such as the Champagne fairs in France, which attracted merchants andbankers from most of Western Europe The location of these fairs southeast of Paris made them aconvenient crossing point for merchants and moneychangers from northwestern and southern Europeand Italy in particular From the surviving lists of participants we can see that merchants from EasternEurope were not participating Although only semi-sedentary these fairs also provided legal services

to facilitate the solution of contractual disputes Officials at fairs could bar merchants with areputation for fraudulent behaviour As trade continued to expand and when increasing volumes oftrade became maritime these fairs were replaced by permanent trading emporia with financial andmore formalized contract enforcing services in the major cities of Europe This development saw there-population of a number of cities which had declined or been abandoned in the post-Roman period

as well as the establishment of new cities

There are economic reasons for the importance of proximity and similarity Proximity isassociated with relatively low transport costs Similarity in economic culture is another word forstandardization and is stimulated by trade when it is increasingly involving long distances and aseparation of time of contracting and delivery and payment In local trade, buyers and sellers getinvolved in mutual negotiation where the goods or samples of the goods can be inspected However,

as trade becomes inter-regional and international a need will emerge for common standards such as

weights, volumes and quality because buyers and sellers might never meet face to face or actually seethe commodities before contracting Therefore commodities must be possible to describe and defineusing a terminology which is understood by the trading partners Common standards will reducetransaction costs because it will make contracts easier to write and fulfilment easier to monitor It isalways difficult to write complete contracts and that spurs another type of standardization, that oflegal procedures for resolution of conflicting interpretations of the contracts When trade started toexpand in the so-called commercial revolution in the first and second century of the secondmillennium traders often used nationals at both ends of the trading network That was the way Italiansbuilt up trading emporia in northwestern Europe and the German Hanse had traders and agents in theBaltic, Russia and around the Western European shores Conflicts were then resolved according tothe law ruling in the export hub However local courts increasingly replaced the jurisdictionalprocesses performed by corporations such as the Hanse once traders found out they were notdiscriminated against.

Another example is the evolution of maritime law which today is a truly international set of legalprinciples known as the Hague–Visby rules or more formally as the ‘International convention for theunification of certain rules of laws relating to the bills of lading’ In the past maritime law regulatedthe obligations and rights of carriers and merchants in case of accidents at sea Is the merchant liablefor the shipping cost if the goods are lost at sea due to a wreckage? That’s one of the many thornyquestions which were addressed by maritime law The first attempts to formulate principlesgoverning arbitration in maritime trade emerged almost simultaneously in the medieval Baltic tradeand in the French–English wine trade What became known as the Rolls of Oléron (1286) named after

a small island off the French coast originated in France, but was widely translated and used innorthwestern Europe from the fourteenth century It was amended and developed in subsequenteditions and became best known as the Visby Sea Law which was edited in the late fifteenth century.The name and spirit survives in the Hague–Visby rules

The diffusion of ideas and goods and the exercise of authority were helped by a commonlanguage Most of the Germanic tribes which flowed into the Roman Empire were fast learning thelanguage and the law of their hosts, but in the rest of Europe, the local languages remained Compared

to the Roman Empire, tenth-century Europe was much less homogeneous in linguistic terms.However, even remote parts never touched by the Romans were replacing local alphabets, like therunes in Scandinavia, by the Latin alphabet Russia is a major exception in this ‘latinization’ as inmany other respects Many tongues were spoken, but traders and merchants often adopted a regionally

uniform language in transactions For example, a variety of German was generally spoken in theBaltic area, since trade was dominated by Germans However, with the advance of the Christian faithwhich also gradually penetrated the Baltic area – often commercial and spiritual missions went hand

in hand – a universal language, Latin, was used all over the western part of Europe since the Churchinsisted on its liturgical use It was also standardized by the Church, but was used not only by theclergy but by the secular elites as well Latin remained the language of natural science well into theeighteenth century The Swedish statesman Axel Oxenstierna, who was heading diplomatic missionsduring the 30 Years War in the seventeenth century insisted on using Latin in negotiations rather thanFrench even though he was fluent in both As a consequence the elites were united by a commonlanguage and learning acquired in universities emerging in the thirteenth century, teaching law andtheology For example, the early thirteenth-century bishop Anders Sunesen in Lund (southernSweden), which was on the periphery of Europe at this time, was educated in France, Italy andEngland There seems to be a spontaneous drift to some lingua franca, a common language, althoughthey differ by epoch From the eighteenth century French became the preferred language of the elites

in Europe only to be displaced by English after the commercial and industrial success of Britain inthe nineteenth century When Germany emerged as a centre of science in the nineteenth century theGerman language became a lingua franca for a short span of time in scientific interchange until Hitlerruined its reputation and wider use

1.3 The limits of geographical integration

We noted the astonishing persistence of the core of Europe defined approximately by the presentborders of the European Union, Map 1.3 But why did the integrating forces of empire building andtrade fail to draw Russia closer to the core of Europe? The Romans came as far as the western shores

of the Black Sea but did not venture into the Russian heartland That can be understood by theconstraints of imperial expansion Although empire building like that of the Romans tended to createhomogeneity in language, religion and law, there were limits to the extension of empire These limitswere set by the interplay of mounting costs of policing frontier areas and the falling revenues frompopulations at a lower level of income

Throughout history the relative poverty of Russia has impeded its integration with the rest ofEurope through trade and prolonged its relative backwardness, and the country serves as a usefulillustration of the dangers of isolation – both imposed by geography, and self-imposed by misguided

policy Despite the fact that Russia covered a vast geographical area it was not a large economy interms of economic size because it was so sparsely populated and its national income was thereforequite small The forces of gravity from the large core economies were too weak to generate sufficienttrade When technology and income levels differ among trading partners, trade volumes will be lowirrespective of proximity, but Russia was in the periphery of Europe and penalized by high tradecosts Relatively rich nations find the export prospects of poor nations too small A lack of commonlyaccepted currency units made transactions difficult or based on barter, which also reduced thevolume of trade As a consequence the initial lack of similarity was not broken dow n Theimplication is that if the periphery is initially poor it may remain poor because it is left untouched bythe knowledge and culture transfer, commodities and institutions that trade is bringing InstitutionallyRussia remained different from the rest of Europe The European Renaissance hardly touched Russiaand the eighteenth-century Enlightenment was embraced only by a small elite Political absolutismremained longer in Russia than anywhere else in Europe It introduced serfdom in the sixteenthcentury when it was abolished elsewhere in Europe In fact Russia was the last European economy toemancipate its peasantry only at the end of the nineteenth century Russia was late to industrialize, late

to participate in normalization of weights and measures, see Box 1.1, and to provide schooling anddid not participate in the drift towards free trade in the second half of the nineteenth century Thescientific awakening which affected Western Europe in the nineteenth century, including its northernfringes in Scandinavia, received only a few contributions from Russia Within the Russian elite aninfluential intellectual current, the Slavophiles, emerged in the 1830s and 1840s to oppose what theyconsidered ‘westernization’ which was identified as commercialization, individualism andrationalism However, by the end of the nineteenth century Russia had started a remarkable catch-upand modernization driven by institutional reform inspired by its Western European neighbours Thatdid not lead to integration because of antagonism to the Russian Revolution in Western Europe andthe deliberate isolation of the young socialist republic after 1917 Stalinist excesses, a devastatingSecond World War and the Cold War after the peace prolonged the economic, cultural and politicalisolation After the demise of the Soviet Union there have been periods of vigorous growth mostlytriggered off by exports of gas and oil However, as can be seen from Table 1.1 below Russiaremains an almost insignificant trading partner of other European nations, although some Europeannations are dependent on gas imports from Russia

Box 1.1 A short history of standardization

Standardization, sometimes called normalization, means the adoption of common, generallyaccepted standards and is essentially a way of reducing transaction costs in human interchange,

be it intellectual or commercial Common product standards ease trade since specific domesticregulation harms export opportunities and stops import of substitutes that do not fulfil domesticrules In fact conflicts around product standards tend to take up much time and effort in tradeliberalization negotiations

In commercial life a generally accepted system of weights and measures of length andvolumes became more pressing as trade became inter-regional and international in the nineteenthcentury

The history of the metric system of measures and weights, that is a decimal ordered system,

is informative It was a product of the late-eighteenth-century French Enlightenment stressing amore precise basis for measures

In the past measures were imprecise and mostly local despite the fact that governments

made attempts to harmonize them For example the French length measure, aune, varied

regionally from 62 to 85 cm It was replaced by the metre, an artefact deposited in Paris whichwas defined precisely as a fraction of the length between the equator and the North Pole It hassince been redefined as in terms of the speed of light in vacuum

The French initiated the drift towards the now almost universally adopted metric system inthe 1790s and tried initially, without success, to get the British to participate in the effort

The diffusion was slow but by the end of the end of the nineteenth century most ofcontinental Europe had adopted the system, with one major exception, Russia, which wentmetric only in 1924 In the case of Russia it reflected the relative isolation from Europe andweak trade The pattern and timing of diffusion reflected intensity of trade within Europe.France’s neighbours were the first to adopt the metric system The UK did not adopt the metricsystem until the close of the twentieth century However UK trade was focused on the

Commonwealth, that is colonies, dominions and former colonies such as the US, which hadmaintained customary systems of weights and measures Many US measures differ slightly fromthe ones adopted in the UK although attempts were made to harmonize them Today, the US isthe only major economy which has not made the metric system mandatory, although its use ispermitted, and sometimes encouraged International trade is a much smaller share of nationalincome than in Europe but there are interesting differences across US industries Industries such

as the pharmaceutical industry which relies on communication with scientists worldwide and

which is heavily trade dependent has gone metric while the beer industry which is mainly

producing for the domestic market remains on measures most of which were inherited from the

British colonial masters International brands like Coca-Cola sometimes use metric even in the

US The tension between customary and metric measures remained well into the twentieth

century in some areas For example the International Convention on Tonnage Measurement of

Ships was not introducing metric measures, length of ship in metres and volume in cubic metres

until 1969 Net or gross tonnage forms the basis for harbour and pilotage dues among other

things It replaced a diverse set of measures However, in everyday parlance older measures are

still in use The English or Long ton is 2240 lb or 1016 kg and thus differs slightly from the

metric ton or tonne of 1000 kg The Long ton has a medieval origin in the wine trade as is the

case with the Hague–Visby rules referred to above Its etymology reveals the background: tunne

in Anglo-Saxon and Old Frisian or tonnel in thirteenth-century French, referred to a cask of wine

of 2240 lb

The nineteenth century, especially its second half, was the the decisive century in the

standardization process Standardized spelling was diffused by compulsory schooling The

standardization of time and international time zones became a national necessity when the

railways were operating with fixed time schedules The telegraph which was built into an

international network connecting the entire world by the 1870s also demanded common

technological standards to operate efficiently

Table 1.1 Intra-European trade and trade with ROW (Rest of the World) in 2005 Percentage of total exports

ROW Denmark France Germany Italy Netherlands Spain Sweden United

Kingdom

Russian Federation

Source: Eurostat

EU25 consists of: Belgium, Czech Republic, Denmark, Germany, Estonia, Greece, Spain, France,Ireland, Italy, Cyprus, Latvia, Lithuania, Luxemburg, Hungary, Malta, Netherlands, Austria, Poland,Portugal, Slovenia, Slovakia, Finland, Sweden, United Kingdom

Size, similarity, proximity and the absence of (strong) border effects stimulate trade Is this predictioncorroborated by the data? Table 1.1 conveys the answer for present-day Europe The table indicatesthat about three-quarters of the trade of individual EU nations is within the EU plus Norway and

Switzerland We also note that for each nation similarity, presumably in language and preferences,

matters a lot Denmark has a larger share of its trade with a comparatively small economy, Sweden,

than with much larger economies, the UK and France But proximity might explain part of the

difference Denmark’s trade with Germany is three times larger than its combined trade with Spainand Italy European trade as a share of income was smaller in the past but it has always beenprimarily intra-European trade When trade among nations expands, it grows roughly in proportion toprevious trade Nations intensive in their trade tend, in other words, to trade more with each other,which is another aspect of the cohesive force of trade This is the combined effect of similarity,border effects with regard to ‘outsiders’ such as Russia, and the fact that trade is stimulated byproximity

1.4 From geo-economics to geo-politics: the European

Union

The Europe we have discussed so far is an entity defined by cultural and institutional similarities.Trade can contribute to the breakdown of initial heterogeneity and maintain similarity in thesedomains, but the formation of the European Union in the latter half of the twentieth century is a newand historically unique experience In its formative years in the 1950s it was dominated by purelyeconomic concerns and the nations participating were those which throughout the second millenniumhad been the battlegrounds for endless military conflicts: France, Germany, Italy and the BENELUXnations Diverging national interests were however still high on the agenda and split Europe into twotrading organizations When the European Economic Community was formed by the Treaty of Rome(1958), the UK was excluded and formed EFTA (the European Free Trade Association) with the rest

of Western Europe However, most EFTA economies traded more with EEC nations than with each

other and continued to do so Hence, EFTA was doomed from its beginning, while the EEC wasgrowing by admitting new members and broadening its agenda The decisive step was to admit the

UK in the early 1970s, which was conditional on reducing Anglo-French discord The trade-creatingeffects of the initial tariff reductions, and the subsequent creation of a single market doing away withnon-tariff barriers to trade, have been impressive and far greater than the tendency to divert tradefrom non-members The relabeling of the European Economic Community as the European Unionindicated a wider and more ambitious agenda of political co-ordination It has been a history of thepolitical elites trying to convince reluctant national electorates of the benefits of political integration,which is however yet to materialize fully The insight on which this chapter has been organized is that

in the past trade has been the cohesive force in a Europe of political and military conflict Politicalco-operation in the EU has added a new dimension to Europe It seems highly unlikely that a militaryconflict could break out among the former bitter enemies in Europe At last geo-politics is in tunewith geo-economics

a common currency The effect will be that trade is diverted from external to internal, intra-union,trade

Suggestions for further reading

The explanation of trade discussed in this chapter is known as the ‘gravity theory’ and is explored inall modern intermediate textbooks on international trade theory It was first applied by Nobel laureate

Jan Tinbergen in Shaping the World Economy (New York : The Twentieth Century Fund, 1962).

There are numerous articles developing the framework S e e E Helpman, M Melitz and Y

Rubinstein, ‘Estimating trade flows: trading partners and trading volumes’ , Quarterly Journal of