written report

Surveys in the Economic History of Australia

CAPITAL MARKETS AND CAPITAL FORMATION IN AUSTRALIA, 1890–1945

By D.T. Merrett University of Melbourne

This survey article examines the interaction between the domestic capital markets and capital formation in Australia from the 1890s up to the end of World War II. The disenchantment of the City of London with Australian securities in the 1890s opened a window for the development of domestic capital markets. It was the demands of the government for funds, especially during both wars, that transformed the scale and character of local markets. Local deposit taking institutions and stock exchanges handled a sufficient volume of domestic savings to fund the lion's share of both public and private sector capital formation.

INTRODUCTION

This survey is the first of two that explores the dynamics and interaction of domestic capital formation and the evolution of Australian capital markets. Over the 100 years separating the depression of the 1890s and the deep recession of the early 1990s, a large and rising share of Australia's resources was devoted to capital formation. This investment was both a cause and a consequence of a process of economic development that came to rely increasingly on urban-based manufacturing and service sectors that required large capital inputs. The volume and direction of this investment was largely driven by responses of the public sector and private businesses to two powerful forces, the speed of population growth, particularly net immigration, and the erection and subsequent subsidence of trade barriers. Furthermore, the share of investment undertaken by the private sector came to overshadow that of the once dominant government sector.

Somewhat surprisingly, in view of contemporary concerns about the nation's low rates of saving and high external debt, domestic savings paid for the greater part of capital formation undertaken within Australia. However, there have been shorter periods, most notably in the 1920s and 1980s, when

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foreign savings were of particular importance. Yet even in these atypical decades, foreign savings did not amount to more than 30 per cent of total savings in the 1920s or reach even 10 per cent in the 1980s.1 Funding investments from domestic savings placed new demands on local capital markets; responses to these demands were generally positive. In the process, Australian capital markets underwent very significant changes in terms of the range of services they provided and the manner in which they operated. By the 1980s these markets were considerably more mature than had been the case a century earlier. However, for all the innovation that had taken place, capital markets played a passive role of simply accommodating the demands of investors.

This survey will cover the period from the 1890s up to 1945. It will begin with a brief overview of the period before discussing developments from the 1890s to World War I, and the years from 1918 to the end of World War II.

Poor investment decisions by both governments and private business in the 1880s, and widespread collapses among overstretched financial institutions in the 1890s, contributed to the depth and duration of the subsequent depression. That long period of economic expansion after the gold rushes of the 1850s left a legacy in terms of a stock of capital skewed towards a narrow range of activities and a set of financial institutions and capital markets that, although shaped by British experience, were uniquely Australian. Despite the developments that had taken place in the financial and capital markets in the decades before the bank crashes, the narrow range of services provided by banks and other financial intermediaries, together with the underdeveloped character of colonial stock exchanges, were indicative of a relatively immature economy that was still in many respects an appendage of the United Kingdom.

The experience of the 1890s had very important long-term implications for the subsequent development of antipodean capital markets. The depression of the 1890s dampened the demand for new large-scale investment for nearly two decades. In brief, recovery took place without substantial increases in investment. However, the loss of reputation by Australian borrowers in the London market in the early 1890s, and subsequent downgrading of credit ratings, set in train a series of developments which were to transform local capital markets. Australian borrowers in the London market came to rely on British intermediaries, so ending the investment banking function undertaken in the late nineteenth century by Australian banks. Commercial banking and investment banking were effectively separated without the impress of a US- style Glass Steagall Act, a specialization of function which gave Australian capital markets an unusual twist.

The growth of the Australian capital market over the half century after 1890 was driven first and foremost by the demands placed upon it by the public sector. Before the depression of the 1930s, Australian governments still

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looked abroad, primarily to London, for long-term development capital. However, there were two critical episodes when the financial needs of the Australian government rose dramatically at a time when overseas capital markets were closed: both were during the two world wars. The sheer volume of war-related government debt transformed the Australian financial system, and ensured that the primary business of local capital markets remained in the issuance and trading of government fixed-interest securities up until the 1960s or 1970s. Furthermore, it thrust two federal government institutions – the Loan Council and the Commonwealth Bank of Australia – into a central position in the workings of the market.

Australian stock exchanges, which were established in the various colonies from the 1860s onwards, initially owed their existence to the flourishing market for shares in mines. Mining had a voracious demand for capital to finance the exploration and development of new ore bodies. Money had to be spent before the size of the ore body or its quality could be known with any certainty. The risks and rewards were high. Speculative mining shares were more important to the operations of the market than `industrial' stocks until well after World War II. The preponderance of mining stocks on the boards of the stock exchanges gave a peculiar flavour to their operations and the type of clientele using the services of the brokers. The stock market was a place for gamblers, not the faint-hearted, and a place for individual rather than institutional investors. Discoveries of new fields, particularly gold in Western Australia in the 1890s, spawned wild booms followed by busts. Fortunes were won and lost in markets where a few unscrupulous promoters, stockbrokers and dishonest geologists fleeced gullible investors. Foreign investors were as ready to chance their arm as the locals, and mining shares attracted the lion's share of foreign money coming on to Australian exchanges.

The development of a market for the issue of the shares, debentures and bonds of private non-mining businesses grew slowly and in a more sedate fashion. A small market for `industrials' had emerged by the 1890s, consisting largely of the issues of banks, gas companies, shipping companies, and breweries. The list grew slowly before World War I as Australian businesses were slow to incorporate and even slower to take advantage of listing on an exchange to raise new equity. Firms continued to finance their day-to-day operations and their long-term expansion using a combination of their own financial resources and short-term debt from banks and trade creditors. The domestic stock exchanges, comprising a smallish number of broking firms whose partners operated with minimal capital resources and unlimited liability, managed to meet, and underwrite, the modestly expanding demands of the new issue market in the interwar years.

The most immediate effect of the events of the 1890s was on the perception of the safety of the trading banks, the country's premier financial institutions. Directors and managers of trading banks reacted to the closures and

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reconstructions of the 1890s by behaving in a very conservative fashion up to the outbreak of World War II. These privately-owned banks steadily lost market share to government-owned competitors, and non-bank financial intermediaries. Private banks became embroiled in political issues and public controversy in the 1930s and 1940s. They gradually became enmeshed in the web of regulations spun by the federal government and put into effect by the Commonwealth Bank of Australia and later by the Reserve Bank of Australia. The regulations flowing from the wartime legislation were primarily concerned with controlling the volume of bank lending. The idea was that rather than amplify the cycle of boom and bust – a charge levelled against the banks by their critics at the royal commission held in the mid-1930s – changes in the volume of bank lending should be used to offset cyclical movements.

DEPRESSION AND RECOVERY, 1890–1918

During the second half of the nineteenth century the needs of borrowers, both government and private businesses, had exerted a powerful influence on the structural form and behaviour of Australian financial institutions and capital markets. An abrupt end to a long period of sustained economic expansion from the gold rushes onwards placed severe strains on the financial system, and some sections collapsed leaving a trail of anger and suspicion towards financial institutions that remained long after the settlement of the outstanding financial claims. By the outbreak of World War I, Australia's capital markets and financial institutions were different in many respects to what they had been a quarter of a century earlier. The wreckage of the 1890s had been cleared away, leaving the private banks with repaired and strengthened balance sheets. However, they would never again dominate the financial markets as they had before 1890. A much reduced and different set of demands for investment funds provided opportunities to other types of financial institutions to play a larger role.

In 1890 the private commercial banks, known colloquially as `trading banks', bore a distinctively Scottish stamp, having established far-flung branch networks decades before the growth of branch networks by British clearing houses. In many other respects, however, these banks reflected their British heritage. A number were British-owned and managed from London, while the majority were domiciled locally. All were heavily engaged in financing international trade, and the transfer of funds to and from Australia, as well as accepting deposits, making loans and issuing notes. British banking principles and precepts were highly influential, although – contrary to British orthodoxy – landed property, livestock and other illiquid securities, were gradually accepted as collateral for loans. They differed from their British

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cousins, who operated in the most sophisticated and highly specialized financial centre in the world, the City of London, in one important respect: Australian banks spread their wings into capital-market activities because there were no local equivalents of merchant banks. Consortia of Australian banks had acted as agents to raise loans for colonial governments in London since the 1860s.

The two dozen trading banks dominated the domestic financial markets as they held more than two-thirds of the assets of all financial institutions (Pope, 1986). They were followed at a distance by a number of smaller deposit-taking institutions of whom savings banks were the most important. Savings banks, operated by trustees or, more generally, by colonial governments, had taken root with the express purpose of encouraging thrift amongst the poorer classes. Colonial governments soon came to appreciate the usefulness of this deposit base as a means of funding government debt issue. Savings banks were to play a far more important role after the crash. A number of other private non-bank financial intermediaries, such as building societies, land and mortgage societies, and so on, operated on the margins of the system, and were particularly active in the boom and crash. Pastoral companies, whose principal business was as commission agents, had also become bankers to many of their clients. While life companies also lent to their customers, most of the lending of all the non-bank financial intermediaries was related to property, either directly or indirectly.

The volume of business done on the local stock exchanges was dwarfed by the operations of financial intermediaries. These exchanges2 served colonial rather than national markets. The largest, Melbourne and Sydney, could support no more than three or four dozen brokers. These individuals or small partnerships dealt in a narrow range of thinly-traded `industrial' securities. However, their main business was in mining scrip, a trade facilitated by the passage of a bill in Victoria in 1871 which allowed the creation of a no-liability mining company. Investors could forfeit their partly paid shares rather than pay calls in failing ventures. The stock exchanges were touched by the `land boom' of the 1880s: a number of land companies floated new securities, and other businesses sought to capitalize on the optimism of the time by incorporating themselves and issuing shares. However, it was the discovery and working of the rich mining fields at Broken Hill and in northern Tasmania that captivated the stock exchanges in the late 1880s.

While the exact causes of the 1890s depression are still a matter of dispute,3

the link between the end of the speculative bubble in the property market and the distress suffered by financial intermediaries is clear cut. Much of the trading in property, whether in large sheep runs, broad acre sub-division on the outskirts of Melbourne, or suburban housing, had been financed by lending by pastoral companies, building societies, land mortgage companies and trading banks.4 Property owned by defaulting borrowers found its way

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on to the balance sheets of financial institutions. Many of the fringe institutions had been trading in property on their own account and were swept away. The trading banks held out longest, but as bankers to the other financial intermediaries a secondary flood of depreciated property, offered to them as collateral, led to large losses and the writing down of their capital. After a small number of bank failures in 1892, the dam broke in late January of 1893. By May of that year, 13 of the 22 banks which issued their own notes had shut their doors, either permanently or temporarily.

While the land boom was driven by greed and tinged with fraud, the bank crashes cannot be explained in similarly simple terms. Most Australian bankers were upright men who would not knowingly place their shareholders, customers or depositors at risk. Only a handful used the bank's money to finance their own or their associates' speculations. One or two institutions did try to disguise their true financial position by issuing fraudulent accounts.

Two salient facts help to explain the magnitude of the crash (Merrett, 1989: 60–85). First, the prudential strength of the banking system as a whole had been progressively weakened over the preceding two decades. Fierce competition for market share from new entrants drove all banks to cut margins between lending and deposit rates, and to accept higher lending risks. Some bankers did not foresee the dangers of concentrating their lending on a smallish number of very large customers or having most of their loans tied up in a single industry or geographic region. While the risks carried in the balance sheets grew through the 1870s and particularly the 1880s, bankers weakened their ability to meet bad times by allowing both their ratio of gold and cash to deposits, and of capital plus reserves to loans, to fall. These developments reduced the banks' capacity to meet any sudden withdrawal of depositors' funds, and to absorb losses rather than go into liquidation. Second, once the bank crashes were under way, an action triggered by the failure of Victoria's largest bank, the Commercial Bank of Australia, shareholders and depositors panicked. Shareholders were better informed about the likelihood of failure than depositors. The latter rushed to withdraw their funds from strong and weak alike.

The crisis was brought to an end without any appropriate intervention by the colonial governments. Governments in New South Wales and Queensland took action to avert a liquidity crisis by passing legislation making privately- issued bank notes legal tender – a temporary and unnecessary measure – while the Queensland government, also unnecessarily, replaced private issues with its own notes. This latter government also `rescued' that colony's largest bank, the National Bank of Queensland. In Victoria, where the crisis was most severe, government action was the least effective. The government urged the local banks to give financial support to one another, blissfully unaware of the consequences that would have followed had they done so (Merrett, 1993: 122– 42), and proclaimed a bank holiday that brought the crisis to a head.

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The action taken by the Commercial Bank after its closure provided the mechanism that brought the sorry episode to an end. The directors of the Commercial Bank put a proposal to its shareholders and its creditors that the bank be `reconstructed', a procedure made possible by an innovation in British company law in the 1870s. The reconstruction schemes were subject to the scrutiny of the courts, and creditors were particularly active in defending their position. In essence, the way they operated was as follows: the depositors agreed to convert their term deposits into debentures – although some part was converted into preference shares in a minority of cases, and only the Commercial made it compulsory – while the shareholders agreed to put additional capital into the banks to meet the existing losses and to allow the businesses to continue. In the end, the depositors in all the reconstructed banks were repaid in full, with interest. They were also able to get cash for their claims before the agreed dates of maturity as a market sprang up in bank deposit receipts in 1893. It was the bank shareholders who lost most heavily, suffering paper losses as share prices crashed, putting up new capital, and receiving no dividends for many years.

Once the Commercial had shown the way, other banks opted for reconstruction rather than waiting out the panic withdrawals which might render them insolvent. Reconstruction was a superior outcome for all parties than liquidation and the realization of bank assets in the depressed asset markets of the 1890s. A negotiated settlement offered the prospect of a known minimized loss for both parties. Shareholders were not anxious for the banks to be liquidated as, in many cases, a double liability on shares would arise in these circumstances. Australian banks converted »57 million of deposits into deferred deposits receipts and inscribed deposit stock in 1893, »38 million of which was due to residents in Australia (Merrett, 1993: table 3: 10). This latter figure was 40 per cent of all trading bank deposits in Australia. By 1914, only »5 million was still outstanding.

While the reconstruction schemes solved the immediate crisis facing banks, they did the banks incalculable harm in the longer term. The legal complexities surrounding the schemes, the litigation associated with some and the renegotiation of a number of schemes in 1895 and 1896, gave rise to widespread misunderstandings. It came to be commonly believed that the banks, particularly their directors and most senior managers, had used this device to escape the inevitable exposure, trial and convictions that they richly deserved, had they been wound up as insolvent.5 Greed and fraud, it was alleged, resulted in the banks' collapse, and widespread loss by depositors, and those responsible had used a legal device for their own protection. Banks lost their reputation and standing with the community, neither of which they have been able to regain.

Government banks were the main beneficiaries of the tarnished image of the commercial banks. In the darkest days of the banking crisis, the Victorian

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government had propped up its state bank by pledging taxpayers' money to guarantee its solvency. State banks, and later the Commonwealth Bank of Australia's savings and trading bank arms, offered riskless bank deposits. In 1890, savings bank deposits amounted to 16 per cent of those in trading banks. By 1914, savings bank deposits had risen to 55 per cent (Pope, 1986: table 1). Insurance companies also moved to tap the savings of the working man by offering `industrial' life policies sold by a small weekly payment. The number of policies sold by 1914 was approaching 600,000 (Gray, 1956: table 10: 80– 81). Trading banks slowly rebuilt their balance sheets by strengthening their capital position and maintaining higher levels of liquidity. However, the long- suffering shareholders were offered little reward in terms of higher dividends or share prices, even when profits were eventually restored. After decades of adventurous growth, Australia's banks became staid and cautious. Savings banks and insurance companies were to be their new competitors for deposits, as the depression of the 1890s had effectively ended the challenge of property- related institutions, such as land banks and building societies, and the pastoral companies.

The recovery of the economy from the depression was largely the result of a marked upswing in commodity prices over the two decades before the war, the discovery of gold in Western Australia, and the end of one of the worst droughts on record in eastern Australia in 1902. Unlike the period of prosperity before 1890, this economic expansion did not rely on heavy investments (Sinclair, 1970: 15–16), at least until around 1910. Indeed, it could be argued that the earlier construction boom had created an excess supply of physical assets – in transport and communications, the pastoral industry, and residential housing – that was only gradually worked off. Output grew most rapidly in agriculture, mining and manufacturing, none of which required capital on the scale provided in the decades prior to 1890. However, the financing needs of each sector came to shape the evolution of the domestic capital market.

Australian colonial governments had been larger borrowers in the London market than any private concern in the 1870s and 1880s. However, the London market turned against Australian government loans from the early 1890s until the end of the first decade of the new century. The restoration of their standing was due not only to `sound finance' policies followed by colonial Treasurers, but by their use of the house of Nivison, a London stockbroker, who came to control the applications of Australian governments to the London market.6 Colonial governments had ceased to use Australian banks as their London agents even before the depression, for they could obtain better terms using the Bank of England and the London and Westminster Bank. Nivison provided even better service in two ways. As agent to all governments, the problem of competing issues was eliminated. Second, Nivison provided an underwriting service which was far more successful than the previous system of

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having investors' tender for issues. Australian governments returned to the market in the early 1900s to make a series of modest conversion loans. It was not until around 1910, when the expenditures on a series of new large-scale construction projects outstripped the capacity of the domestic market, that the state governments returned to the London market on a large scale.

Most of the state governments' projects were designed to facilitate the settlement of a larger population in rural areas. From the 1880s, many colonial governments had been implementing a policy of `closer settlement' through compulsory acquisition and subdivision of private freehold, the resumption of leasehold and the sale of crown land. Access to small blocks of land, together with new farming practices – particularly in irrigation areas, wheat farming and dairying – did lead to the sorts of developments that governments wanted. Governments, however, were drawn increasingly into financing much of Australia's farming, while the trading banks continued their association with the pastoral industry. State banks established credit fonciers, and Treasury departments spawned agricultural banks in some states. These ventures, so appealing in the decades of rising commodity prices before 1914, were to have an unhappy sequel in the interwar period.

Local government authorities required large amounts of money to finance their construction works in the 1890s when London was unreceptive to any new Australian loans. Bodies such as the newly created Melbourne and Metropolitan Board of Works, raised millions of pounds on the local stock exchange. State governments, local governments and semi-government bodies tapped domestic capital markets in the 1890s and 1900s. Loans outstanding on Australian stock registers rose from »26 million in 1899 to »114 million in 1913 (Nash, 1899; 1914). The issuance and trade in fixed interest securities altered the character of the market in important ways, and laid the foundations for the ease with which governments turned to the market after 1914.

It was the mining industry that kept Australia in the eyes of British investors in the 1890s and 1900s. Those speculating in mining shares were very different from the conservative investors and trustees who purchased safe colonial government stock. The discovery of gold in Western Australia in the early 1890s attracted the interest of British investors (Appleyard and Davies, 1988: 160–89), many of whom had lost money in South Africa. Thousands of leases were registered in Western Australia and hundreds of companies were floated on the London exchange. An estimated »70 million pounds was raised by these companies, however, the lion's share, possibly more than »60 million, stayed in the pockets of promoters and speculators in London. The development of one of the world's most productive gold fields was helped by the modest amounts actually employed.

On the other hand, development of the base metal mines at Broken Hill in New South Wales and Mount Lyell in northern Tasmania, did involve a

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substantial involvement by Australian stock exchanges (Salsbury and Sweeney, 1988: 133–8; Hall, 1968: 133–47). Despite the wild speculation in the original shares of the Broken Hill Proprietary Limited, the long-life base metal mines soon came to be regarded as `blue chip' rather than speculative investments. A group of mines and smelting companies operating on the Broken Hill field, known as the Collins House group, became expert at raising finance for the exploration and development of mines, and for associated industrial ventures. Men such as E. L. Baillieu, W.S. Robinson and Francis Govett developed the capacity, partly through associates on both the Melbourne and London exchanges, to act as an in-house merchant bank for a large and powerful group of mining companies (Richardson, 1988: 226–53).

The field of potential business for the exchanges was considerably enlarged by the widespread business failures of the 1890s, for these had demonstrated the dangers of unlimited liability in sole proprietorship or partnerships, the most common form of business arrangement. Subsequently, many businesses sought to take advantage of limited liability which had been available since the 1860s by virtue of the company acts. The number of incorporated businesses rose, in broad terms, from less than 500 in 1899 to nearly 2500 by 1913 (Nash, 1899; 1914). While few of these companies had chosen to list on the local stock exchanges, their existence did widen the market for non-mining stock as brokers became involved in private placements of shares of these tightly held companies.

Capital formation fell sharply as a proportion of gross domestic product (GDP) during the 1890s but recovered to nearly match its 1891 peak by 1914.7 The upswing in aggregate investment was underpinned by government spending on public works. The depression had not deflected colonial and state governments from their long-term development programs that combined large-scale public works to assist rural industries and immigration. By 1910, state governments' public works, primarily railway construction, were in full swing, and they were actively boosting migration. Renewed flows of migrants stimulated residential construction outlays. The latter were already showing a modest increase, for the excess stock of dwellings built in the 1880s had been absorbed by the early 1900s. Private non-dwelling investment also recovered after 1900, although it was dominated by public sector outlays up to the war. The composition of private capital formation shifted decisively after 1890 as outlays on assets in the pastoral industry declined sharply. Investment was more broadly based: mining, farming, manufacturing and service industries led the process of recovery and renewed economic expansion.

This upswing in capital formation before 1914 was financed almost completely by domestic savings. As noted above, Australian governments were unwelcome borrowers in London in the 1890s and early 1900s. Many British investors in Australian banks, pastoral companies, mines and other businesses suffered heavy losses as security prices crashed or, worse, businesses

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failed. Australia was a net exporter of capital from the mid-1890s until around 1910. Local capital markets and financial institutions met the demands placed upon them by local investors without undue strain. Domestic interest rates, measured by trading bank deposit rates and the yield on government securities, were marginally lower in the 1890s and 1900s than they had been in the 1880s when British capital flooded the country. The local stock exchanges, in particular, proved themselves capable of meeting the requirements of governments and local companies for new issues.

Despite the developments that had taken place in the domestic financial system and capital market before 1914, both remained immature in many respects. This is demonstrated by the fact that in 1914 more than a half of all outstanding financial claims were generated by the banks in the form of currency and demand deposits, term deposits and bank loans. Non-bank financial intermediaries' deposits and loans, and the reserves of life offices, made up less than 15 per cent, while capital market instruments, such as government securities and shares, made up the balance of a little more than a third. In the USA in 1900, by contrast, claims against financial institutions comprised only 21 per cent of outstanding financial instruments, claims against non-financial institutions 56 per cent, and corporate stock 23 per cent (Goldsmith, 1969: table 1.1: 10–11).

The Australian financial system still revolved around banks with a modest fringeofotherfinancialintermediariesandarelativelyunderdevelopedcapital market. This situation reflected the exceptional position occupied by the trading banks in the second half of the nineteenth century. At this time most businesses were still small family affairs that did not use capital intensive techniques of production. Their demands for capital funds were modest. The bigger banks possessed the resources to provide what was in effect long-term capital to just about any of their customers. Bank lending on this scale had blunted the development of a substitute domestic capital market to service businesses. However, new large-scale capital intensive companies began to emerge with increasing frequency in mining and smelting, brewing, food processingandmetalworking.Thegrowthofthesenewindustrialandretailing giants would come to tax the resources of the banks in the twentieth century.

The development of the domestic capital market had been retarded further by the ease with which Australian borrowers, particularly governments, could raise large sums in London. The City of London offered many advantages in terms of the size of issues it could absorb, and lower fees. The depth of trading in the secondary markets provided much higher levels of marketability and liquidity for holders of securities than was possible in provincial exchanges. London also possessed a set of specialized institutions, such as merchant banks, that increased the efficiency of origination and distribution of new issues. Australian capital markets, by contrast, were significantly smaller and less specialized, and lacked the services of investment bankers.

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WORLD WAR I TO WORLD WAR II

The 30 years spanning the two world wars saw a number of significant changes in the aggregate level of capital formation and its composition, Australia's reliance on foreign savings, and in the scope and maturity of domestic capital markets. Expenditures on capital formation became remarkably volatile and added an element of instability to the economy. Investment as a proportion of GDP fell sharply during World War I, plunging below the trough of the 1890s, before rebounding quickly in the early 1920s where it remained on a plateau before sliding down in the late 1920s into another steep trough by 1931. The renewed investment associated with recovery from the depression of the 1930s did not match the ratios of capital formation to GDP achieved in the 1920s. However, this modest growth disguises the fact that private sector investment in dwellings and machinery and other structures increased far faster than public sector investment outlays. From this point on, the public sector relinquished its position as the most important source of investment expenditures. Capital formation fell precipitously during World War II, reaching a trough far lower than that experienced in either World War I or the 1930s depression. The majority of funds used to finance these investments continued to come from local savings. In the 1920s, when governments raised very large sums abroad, foreign savings played a more important role. However, the costs of servicing the large foreign debt in the 1930s were to have important consequences for the financing of government capital formation.

World War I had a profound short-term and long-term impact on Australian capital formation and its capital markets. Australian governments put aside their long-term concerns to promote economic development and concentrated on waging war. British authorities made it plain that the Australian government should not expect to approach the London market for funds. Public works projects that had picked up from around 1910 quickly ran down, dragging the ratio of investment spending to GDP in their wake, despite state governments' borrowing what they could on local markets. However, it was soaring government military expenditures that transformed domestic capital markets. Large armies were raised, equipped and sent abroad. Most of the monies needed were raised by loans, with higher taxes and an increased supply of Commonwealth government issued paper money making up the balance.

Between the first war loan of 1915 and the War Gratuity Redemption and Conversion Loan of 1924, »274 million had been subscribed by 876,000 applicants.8 Most of the loans were taken up by individuals rather than by financial institutions such as banks and insurance companies. In a wave of patriotic fervour, men and women drew on bank deposits, took out bank loans and sold shares, to buy war bonds. At the end of the process, many of Australia's one million households owned a financial asset that was traded on

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the stock exchanges. The legacy of this wartime financing was to convert Australian stock exchanges to a primarily fixed-interest market for another generation. While war financing transformed and democratized capital markets, it also thrust a new institution forward. The issue and management of these ten war loans was in the hands of the Commonwealth Bank of Australia, an institution established by the federal government in 1912. The private banks, which had raised loans for governments in the City of London before 1890, were bypassed.

The 1920s saw state governments returning in force to international capital markets, particularly London. The motives and the patterns of expenditures were broadly similar to those of the 1870s and 1880s, and the five years prior to the war. Governments were actively promoting population growth via assisted immigration and the construction of infrastructure for farming activities.9 Railway building took the lion's share of the funds, with telephones, irrigation, roads, water and sewerage, and so on, also requiring large-scale funding. The British government accepted that such policies would strengthen the Empire, and committed funds on a pro rata basis for migrants received.

The wisdom of such a development strategy had come under question by the end of the decade. The economic conditions that underpinned the idea ^ a buoyant international economy and high commodity prices ^ did not materialize after the war. Export prices peaked in 1925, while Australian cost levels continued to rise. The terms of trade, the ratio of export to import prices, moved sharply against Australia and other primary producing economies. Rising trade barriers in European economies, a slower growth in demand for foodstuffs and raw materials, and an expansion of supply from around the world signalled that trouble lay ahead for Australia in servicing her growing foreign debt.

A matter of more immediate concern was the losses being made on completed infrastructure works that were operated as government-owned utilities (Sinclair, 1970). Poorly planned investments and bad management of key areas, such as the railways, were placing burdens on state budgets well before the end of the decade. A major problem was that the public sector had been constructing infrastructure ahead of private-sector settlement or complementary investments in the rural sector. Many of the public-sector investments were viable only if more settlers arrived who would increase patronage. Falling export prices and steadily rising unemployment deterred migrants, and the losses continued to rise.

Australian governments continued to seek funds abroad in the 1920s ^ despite an informal rationing of funds for overseas investment by British authorities prior to that country's return to the gold standard in 1925 ^ because there was a concern that further heavy borrowing on local markets would drive up domestic interest rates. Competition among the states for

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funds in London became so intense that a mechanism more powerful than the informal advice of Nivison and Co. was needed to restore order. In 1923, the federal and state governments agreed to arrange all borrowings through a voluntary Loan Council.10 This body assumed statutory powers in 1929 as a result of the amendment to the federal constitution following the Financial Agreement of 1927. The federal government was able to impress its views on the rest of the states as it needed the support of only two to have a majority. From the early 1920s, it was the federal government, and no longer the states, that effectively decided the amount of public-sector borrowing and debt management. The Loan Council was to become an even more important institution in the operation of Australian capital markets than the Commonwealth Bank of Australia.

While state governments sought the bulk of their funds abroad, the demands on the domestic capital market rose considerably. Local governments and semi-government authorities, such as gas and electricity utilities, increasingly used the local share markets to raise funds. Businesses sought fresh capital to increase capacity in the brief period of postwar prosperity. Manufacturers, enjoying higher levels of protection against competition from imports, busily built additional factories and upgraded their equipment. More companies listed their securities on the stock exchanges. The new issue market for non-mining companies was active in the 1920s, with more than »75 million worth of shares and debentures being offered to investors between 1924 and 1929.11 The local stock exchanges received another fillip due to the federal government's active engagement in a series of conversion loans as part of its debt management responsibilities, all of which provided fees and commissions for brokers.

In the nineteenth century most foreign capital coming to Australia had been raised by Australian borrowers by issuing bonds, shares or debentures on the London capital market. Australian banks had also briefly sought deposits in the United Kingdom. On the other hand, direct investment by foreign companies in Australian operations was rare before 1890, although not unknown. However, the 1920s marked a sharp upturn in this type of transfer of capital to Australia. British firms ^ which made significant moves into confectionery, textiles, chemicals, and engineering ^ were joined by large numbers of American companies in automobiles, rubber, food products, and textiles. It has been estimated that foreign direct investment accounted for roughly a quarter of capital formation in Australian manufacturing in the 1920s (Forster, 1964: 200^2).

Investments in farming and housing were funded by financial institutions rather than the capital market. Government-owned banks, the state savings banks and the Commonwealth Bank of Australia, took a leading role in lending to both industries. Advancing money to farmers had been an integral part of state banking since the late nineteenth century. Policies to promote

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closer settlement, soldier settlement after World War I, and Empire Settlement in the 1920s, drew state banks and government departments into a closer embrace with small-scale farmers. Many of these new settlers fell victim to falling export prices and rising wage and material costs in the mid- to late-1920s. It was the government banks, including the Rural Credits Department of the Commonwealth Bank that opened in 1925, which took the risks and absorbed the losses from farmers in the 1920s and 1930s (Murray and White, 1992), just as the private trading banks had done with the pastoral industry in the 1880s and 1890s.

The demand for housing rose strongly in the 1920s, pushed along by higher levels of immigration and a backlog of unsatisfied demand held over from the war. Building societies had been the main provider of funds to the residential construction industry in the 1880s but most of them had been swept away in the maelstrom of the 1890s. Private trading banks were not willing providers of funds for housing before they established their own savings bank subsidiaries in the late 1950s, so the field was left to state banks and the savings-bank arm of the Commonwealth Bank of Australia. The Commonwealth government also entered the arena of providing funds for housing through its establishment of a War Service Homes Commission which was to provide homes for ex-servicemen. Commonwealth monies flowed through the state savings banks which acted as agents for the Commission. These state banks also lent large sums from their own resources (Hill, 1959). The State Savings Bank of Victoria was the major provider of funds for new houses in that state by the mid-1920s. The close connection between government-owned banks and the residential construction industry was indicative of an increasingly segmented financial system where funds were `trapped' in serving particular markets. Sometimes, as in the case of rural lending, the rates of interest did not reflect the risks involved.

The authority and position of the private trading banks in the financial system had been seriously diminished before the onset of the 1930s depression. Both the Commonwealth and state banks continued to win an increasing share of deposits away from the trading banks throughout the 1920s. While no legislation had emerged as a result of the 1890s bank crashes that limited their autonomy, the private banks were increasingly forced to do the bidding of government. They had lost their right to issue bank notes in 1910, and had been unable to prevent the establishment of the Commonwealth Bank of Australia in 1912. During the war it was the government who suspended the operation of the gold standard, while the banks negotiated with the Commonwealth Bank for a share of the financing of bulk purchases of rural produce. Business that the trading banks would once have called their own, and matters of policy such as those concerning the monetary backing for the note issue, were passing into the hands of the federal government or the Commonwealth Bank.12

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Trading banks behaved in an increasingly conservative fashion in the 1920s. A wave of mergers between 1917 and 1931 reduced their number from twenty-two to nine. The larger banks, with a nationwide network of branches, were now better able to spread risks. A smaller number of banks found it easier to agree on a common set of interest rates and fees. They became a cartel, discouraging competition from existing members and driving off foreign challengers. They did not innovate in ways that reduced their operating costs, nor did they introduce new services to their customers. This lack of drive, together with an extreme conservatism in lending, drove disappointed borrowers to find other sources of funds. However, these institutions remained at the heart of the financial system not only because they still commanded a very large share of the deposit base, but because they alone could operate the domestic chequing system, arrange for international payments and receipts, and buy and sell foreign exchange.

Capital formation, especially that undertaken by the private sector, was declining even before the collapse of security prices on Wall Street in October 1929 signalled the onset of the 1930s depression. Australian governments, whose public works programs had sustained aggregate investment outlays, faced very serious problems in raising additional funding once international capital markets effectively closed to new issues, especially to those from heavily indebted primary producing economies. In such circumstances, it was not surprising that capital formation fell away sharply from a peak of around 18 per cent of GDP in 1927/8 to a trough of around 10 per cent of GDP in 1931/2. The climate for private sector investment worsened as profits fell, and as the list of business failures rose.

Australia faced a number of acute economic and social problems during the depression. There was little consensus among the conservatives and the Labor Party sides of politics about how these problems could best be solved (Schedvin, 1970). The trading banks were drawn into the political debate on the side of the conservative groupings, earning themselves the undying enmity of the Labor Party and its trade union supporters. The Commonwealth Bank, which was independent of the federal parliament, emerged as a central bank that acted in defiance of the wishes of the Australian Labor Party government. It was the Bank and the Loan Council that emerged as the key policy-making institutions that enforced reductions in government borrowing and spending as agreed upon in the Premiers' Plan of 1931. The federal Labor Party, which held office from 1929 to1931, was itself divided. It split into warring factions, one of which joined with the conservatives to form a new government. The labour movement never forgave either the Commonwealth Bank or the trading banks for their part in the formulation of conservative economic policies. These policies, it believed, caused unnecessary hardship to the more than a quarter of the workforce who lost their jobs. The strength of feeling against the banks was so strong that the conservative government set up a

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royal commission to inquire into the banking system in 1935. Its recommendations were to legitimate the far-reaching and sudden regulation of banking seven years later.

The simultaneous collapse of commodity prices and the closure of international capital markets in late 1929 generated a crisis in Australia's balance-of-payments position. Export income shrank while import spending continued to run at high levels. A strong flow of external earnings or new borrowings was needed to service its very large outstanding foreign debt. Australia chose to bow to the pressures from Britain, the country's largest creditor, and service the debt rather than take the path of repudiation followed by a number of Latin American countries.The decision to honour the debt made the defence of the balance of payments, and the maintenance of the parity of the Australian and British currencies, of paramount importance. The Commonwealth Bank and the trading banks haggled over the extent to which the former had priority access to those reserves of foreign currency, which were held as `London funds' or short-term sterling balances by the trading banks. They also argued about whether the Commonwealth Bank had any right to be informed of the size of balances held by the banks. More importantly, policies designed to reduce imports ^ such as import quotas, surcharges and higher tariffs ^ had the unintended consequence of sowing the seeds of economic revival, as did the belated devaluation of the Australian pound. It was higher trade barriers and a depreciated currency which did most to stimulate the expansion of manufacturing output, employment, and investment.

Private-sector capital formation recovered strongly from around 1932 up until the outbreak of war in 1939. Most of the expansion came from new investment in manufacturing industries that were benefiting from the heightened trade barriers. Increased output placed pressure on existing plant, for this had not been expanded since the early and mid-1920s. Apart from renewed interest in gold mining, particularly in Western Australia, investment in the depressed rural sector shrank. It was a decisive moment in Australian economic development in a number of respects. The thrust of capital formation was henceforth set by the private, rather than the public, sector (see Sinclair, 1970; and Butlin, Barnard and Pincus, 1982). Private businesses made investment decisions in the light of anticipated profits, and they had decided that the bulk of new capital would be allocated to urban- based industries. Reluctantly, governments came to abandon their traditional policies of promoting rural development by taking a leading role in constructing and operating a range of publicly-owned business enterprises. Public-sector investment was to follow the lead of private-sector decisions, and accommodate the growing demands for urban infrastructure.

Investment in dwellings also recovered strongly in the 1930s. Unlike earlier periods of high levels of residential construction, this upswing was not driven

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by high levels of immigration. It was a response, in part, to the relocation of population, due in large part to the growth of the regional iron and steel centres at Newcastle and Port Kembla in New South Wales, and in South Australia (Sinclair, 1970: 44). The rise in real incomes of those still in employment in the 1930s gave rise to an increased demand for new housing, while governments in a number of states embarked on the destruction and replacement of old, poor-quality, housing stock in inner suburbs.

This recovery in the level of private sector capital formation was financed almost entirely from domestic savings. Australian governments approached the London market in the 1930s but to refund existing debt rather than to raise new money. Public-sector borrowing on local markets was quite substantial, exceeding the amount raised in the 1920s. However, a significant part of this increase in public sector debt was in the form of short-term Treasury bills which were funded by financial institutions. Indeed, trading banks and particularly savings banks took up the majority of all short- and long-term debt issued by the Loan Council in the 1930s. The non-bank public increased their holdings of government securities by only »90 million between 1931 and 1939, compared to an increase of »134 million in the 1920s.

While the issuance and trading in fixed interest securities continued to provide the bread and butter of the stock exchanges, the market in equities developed strongly as the economy recovered. Financial institutions were less willing to extend credit in the depths of the depression. For instance, lending by trading banks did not regain its 1930 peak until 1937. Consequently, many companies sought to supplement their internal sources of finance by making new issues on the stock exchange. The number of new issues noted in the financial press between 1930 and 1939 numbered more than 700, and offered securities of more than »70 million to investors. The marketability of equities rose steadily as leading stockbrokers, such as J. B. Were of Melbourne, built up large lists of clients who were provided with a regular flow of high quality information concerning listed and unlisted companies (Ellis, 1954). Stock exchange listing requirements were more onerous than the company laws, and listed companies were compelled to make fuller disclosure of their affairs (see Salsbury and Sweeney, 1988: 202^8). While some shady company promoters and less than scrupulously honest brokers did exist, the exchanges operated in a fashion that warranted the confidence given them by the large number of individual investors. The depth of trading was enhanced further as a number of broking houses established unit trusts in the late 1920s that allowed small investors to acquire a diversified portfolio.

World War II had significant short- and long-term effects on Australian capital formation and capital markets.13 In the early phase of the war, before the Japanese assault on Pearl Harbour in December 1941, the Australian government diverted a fairly modest proportion of the nation's resources to military ends. As the war effort built up, one of the first areas of civilian

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activity to be squeezed was public and private capital formation. Governments could control their own non-war investment spending, and the federal government constrained the levels of private spending by a combination of capital issues controls and the licensing of construction activities. The deterioration of the military situation in both Europe and the Pacific in early 1942 led the newly elected Labor government to impose a sweeping set of direct controls over all parts of the economy. Labour was conscripted for military and civilian duties, non-essential industries were run down, and their surplus resources transferred to war work. Wages, prices (including security prices), and rents were fixed. Private sector investment in `non-essential' areas fell to very low levels for the duration of the conflict. Vital areas such as the engineering and munitions sectors received little in the way of additional plant and equipment. On the other hand, public investment in roads and aerodromes for military usage rose sharply.

Financing the rapidly expanding war effort, which peaked at the equivalent of nearly 37 per cent of GDP in 1942/3, had other sorts of effects on Australian capital markets. Unlike World War I, the bulk of the additional revenues came from higher taxes. The Commonwealth became the sole collector of taxes on personal and company incomes from June 1942, and raised tax rates. However, the federal government did raise very large loans, which amounted to the equivalent of a quarter of GDP in 1942/3, on the domestic capital market. Once again, it was the Commonwealth Bank which had responsibility for the management of the 17 loans that raised over »1 billion (Mobbs, 1947). The amount of Australian government securities on issue rose nearly one and a half times between 1939 and 1945. While more than a half of this increase was absorbed by banks, the holdings of the non-bank public doubled over the period. Applications to subscribe to the loans, which numbered 3.8 million, came from most Australian families. Government war loans had further democratized Australian capital markets in a similar fashion to the earlier conflict.

The flow of government securities on to domestic capital markets during the war presaged a fundamental shift in behaviour by Australian governments. Sales of foodstuffs and war material to its Allies during the war brought about a dramatic transformation in Australia's balance-of-payments position. An accumulation of external reserves, now under the direct control of the Commonwealth Bank, allowed a retirement of part of Australia's external debt. Memories of the costs of fixed interest obligations abroad in the 1930s persuaded successive governments to utilize domestic rather than international capital markets. No future Australian government would echo the actions of their predecessors of the 1880s and 1920s when new issues by Australian states made up a significant share of international capital movements.

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NOTES

1 These data, together with other references to rates of savings in this chapter, are taken from McLean (1991).

2 There are a number of useful histories of stock exchanges and broking firms. The most comprehensive of these is Salsbury and Sweeney (1986).

3 For an account of the depression and the issues still outstanding, see Sinclair (1976: 47^151, 158^9, and 160^1).

4 Financing investment in property has been dealt with, from very different perspectives, by Butlin (1964) and Cannon (1972).

5 This view of the changed public perception of banks is put most eloquently in Butlin (1961: 302).

6 The changing relationship between Australian governments and the London market is discussed in Hall (1963); Butlin (1964); Davenport-Hines (1988: 190^205); and Gilbert (1971).

7 Data relating to aggregate and sectorial estimates of gross domestic capital formation up to 1939 are drawn from Butlin (1962) and as revised Butlin (1977).

8 War finance is discussed most fully in Scott (1936: ch. 9) and Faulkner (1923: ch. 9). 9 The motivation for developmental expenditures and the pattern of investment spending is

discussed by Sinclair (1970). 10 The most authoritative account of the Australian economy in the inter-war period, and

economic policy matters, is Schedvin (1970). See also Gilbert (1973). 11 Details of new issues offered by Australian companies were taken from the monthly issues of

Jobson's Investment Digest, and The `Wild Cat' Monthly. 12 The best accounts of this complex change in the relationship between the trading banks, the

Commonwealth Bank and the federal government are Schedvin (1970); Butlin (1961); and Giblin (1951).

13 The definitive account of the economy during the war is found in Butlin (1955), and Butlin and Schedvin (1977).

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Butlin, M.W. (1977), A preliminary annual database 1900/01 to 1973/74, Research Discussion Paper 7701, Reserve Bank of Australia (Sydney).

Butlin, N.G. (1962), Australian domestic product, investment and foreign borrowing, 1861^1938/39 (Cambridge).

Butlin, N.G. (1964), Investment in Australian economic development 1861^1900 (Cambridge). Butlin, N.G., Barnard, A., and Pincus, J.J. (1982), Government and capitalism (Sydney). Butlin, S.J. (1955), War economy,1939^42: Australia in the war of 1939^45, Series 4 (Civil) (Canberra). Butlin, S.J. (1961), Australia and New Zealand Bank (London). Butlin, S.J., and Schedvin, C.B. (1977), Wareconomy, 1942^45:Australia inthewar of 1939^45, Series 4

(Civil) (Canberra). Cannon, M. (1972), Land boom and bust (Melbourne). Davenport-Hines, R.P.T. (1988), Lord Glendyne. In R.T. Appleyard and C.B. Schedvin, eds,

Australian financiers: Biographical essays (South Melbourne), pp. 190-205. Ellis, A.T. (1954), The house of Were 1839^1954 (Melbourne). Faulkner, C.C. (1923), The Commonwealth Bank of Australia (Sydney). Forster, C. (1964), Industrial development in Australia 1920^1930 (Canberra). Giblin, L.F. (1951), The growth of a central bank (Melbourne). Gilbert, R.S. (1971), London financial intermediaries and Australian overseas borrowing, 1900^

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Goldsmith, R.W. (1969), Financial structure and development (New Haven and London). Gray, A.C. (1956), Industrial life assurance in Australia and New Zealand (Sydney). Hall, A.R. (1963), The London capital market and Australia 1870^1914 (Canberra). Hall, A.R. (1968), The Stock Exchange of Melbourne and the Victorian economy 1852^1900 (Canberra). Hill, M.R. (1959), Housing finance in Australia 1945^56 (Melbourne). Jobson's Investment Digest of Australia and New Zealand (Sydney). McLean, I.W. (1991), Australian saving since 1861. In Peter J. Stemp, ed., Saving and policy

(Canberra), pp. 1-24. Merrett, D.T. (1989), Australian banking practice and the crisis of 1893, Australian Economic

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been saved by its peers in 1893?. Victorian Historical Journal, 64 (2): 122^42. Mobbs, C.L. (1947), Commonwealth Bank of Australia in the second world war (Sydney). Murray, R., and White, K. (1992), A bank for the people: a history of the State Bank of Victoria (North

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Australian financiers: biographical essays (South Melbourne): pp. 226^53. Salsbury, S., and Sweeney, K. (1988), The bull, the bear and the kangaroo: the history of the Sydney Stock

Exchange (Sydney). Schedvin, C.B. (1970), Australia and the great depression (Sydney). Scott, E. (1936), Australiaduring the war, Vol. XI, Official history of Australia in the war of 1914^18

(Sydney). Sinclair, W.A. (1970), Capital formation. In Colin Forster, ed., Australian economic development in the

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