Institutions, deficits, and wars: The determinants of British government borrowing costs from the end of the seventeenth century to 1850

What determines differences in interest rates faced by borrowing developing countries? In light of the immense interest in the effects of institutions on economic development following North (1990) and North and Weingast (1989), this chapter uses historical data on sovereign debt drawn from various periods and countries from the 1690s to the 1990s to examine the extent to which changes in institutional quality have an immediate and direct impact on the cost of debt of borrowing nations, in comparison with the role played by wars and episodes of violent political turmoil. Its main conclusion is that, throughout historical periods, geographic zones, and data sets, wars and instability consistently affect borrowing costs, whereas institutional reforms typically do not elicit investor response in the short run, perhaps because a long period of time is needed to establish their credibility, or because the very nature of the reform process is gradual and cumulative.The chapter begins by revisiting earlier work which focused on Britain following the Glorious Revolution (Sussman and Yafeh 2006) to extend the time series data on the cost of Britain's debt to 1850. During that period the cost of British government debt increased substantially. Although Barro (1987) attributes the higher borrowing rates to the effect of temporary military spending on crowding-out of private consumption, the results presented here demonstrate that the rising cost of debt reflects mainly a direct increase in the risk premium due to the uncertainty associated with the outcome of the war. The analysis includes a novel variable– the size of the British navy– that serves as a direct measure of the effect of war-induced risk on government borrowing costs. These findings confirm that risk associated with wars was the primary driver of variation in the cost of Britain's government debt, even when the country was already (relatively) rich, industrialised, and institutionally developed.