Economic History Association

Integration of International Capital Markets: Quantitative Evidence from the Eighteenth to

Twentieth Centuries
Author(s): Larry Neal
Source: The Journal of Economic History, Vol. 45, No. 2, The Tasks of Economic History
(Jun., 1985), pp. 219-226
Published by: Cambridge University Press on behalf of the Economic History Association
Stable URL: http://www.jstor.org/stable/2121688
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 Integration of International Capital
Markets:
Quantitative Evidence
from the Eighteenth to Twentieth
Centuries
LARRY NEAL

The integrationof capital marketsis usually tested with an interestrate arbitrage

model even thoughmuch differentfinancialassets must be compared.This paper
comparesprices of identicalassets that are tradedsimultaneouslyin two or more
markets.The range, average level, and time series patternof the differencescan
be used to infer threshold levels, transactioncost levels, and the efficiency of
arbitrageoperations, respectively. Examples are given for financialcrises from
1745to 1907, using prices from the London, Amsterdam,Paris, and New York
stock exchanges. These show Europeancapital marketsto be well integratedby
mid-eighteenthcentury.

M EASURINGthe degree of integrationin financialmarketsis

difficult both theoretically and empirically. The difficulties are
well illustratedin the literaturedealingwith Americancapitalmarketsin
the late nineteenth century.' This literaturedemonstratesthe inherent
weaknesses in trying to measure an economic phenomenon-integra-
tion of capital marketsin this case-with a variablemeasuringrod. The
measuringrod, the short-terminterest rates earned by banks on a broad
class of loans, must vary as local regulationsvary, as the riskiness and
durationof the loans within the category vary, and as monopoly rents
vary. All these variationsmust be allowed for if a consistent measuring

Journal of Economic History, Vol. XLV, No. 2 (June 1985). ? The Economic History
Association. All rightsreserved. ISSN 0022-0507.
The authoris Professorof Economics, Universityof Illinois, Urbana,Illinois61801.He wishes
to acknowledgethe inspirationof DonaldMcCloskeyfor this paper,the researchassistanceof Eric
Schubert,and useful commentsby JeremyAtack, DavidGood, Peter Lindert,and membersof the
University of Illinois Economic History Workshop. Research was supportedby the National
Science Foundationand the Universityof Illinois ResearchBoard.
' The literaturebeginswith Lance Davis, "The InvestmentMarket,1870-1914:The Evolutionof
a National Market,"this JOURNAL, 25 (Sept. 1965), pp. 355-99 (commercialpaper market);and
continueswith RichardSylla, "Federal Policy, BankingMarketStructure,and CapitalMobiliza-
tion in the United States, 1863-1913,"this JOURNAL, 29 (Dec. 1969),pp. 657-86 (nationalbanks);
L. Neal, "TrustCompaniesand FinancialInnovation, 1897-1914,"Business HistoryReview, 45
(Fall 1971), pp. 35-51 (trust companies);J. James, "The Developmentof the National Money
Market, 1893-1911," this JOURNAL, 36 (Dec. 1976), pp. 878-97 (local monopoly); R. Keehn,
"Federal Bank Policy, Bank MarketStructure,and Bank Performance:Wisconsin, 1863-1914,"
Business HistoryReview, 15 (March 1980)(local regulations);and M. Sushkaand W. B. Barrett,
"BankingStructureand the NationalCapitalMarket, 1869-1914,"this JOURNAL, 44 (June 1984),
pp. 463-477 (risk premia).

219
220 Neal

instrumentis to be obtained. If they are not, then the possibility always

remainsthat divergences or convergences of interest rates between two
capital markets may be due to factors other than integration or
separation of the two markets. These difficultiesof interpretationare
inherent in the use of the interest rate arbitrage model to derive a
measuringstandard.
In this paper, I take avantageof a previously overlooked possibility-
the differencein the price of a share of stock as quoted on the same day
in both the domestic exchange for the company and on a foreign
exchange. Machiup refers to this as the simplest test of all for market
integration, since the product is not only standardizedbut identical in
the two markets and the cost of transportbetween the two markets is
essentially zero.2 Morgenstern goes so far as to assert "on different
nationalstock marketsthe prices of the same shares are as a rule not at
variance, owing to perfect arbitrage."3This enables us to avoid all the
problems mentioned above that are associated with using interest rates
on short-termor long-term securities as measures of financialintegra-
tion.
But even for the price of the same stock, differences in the two
marketsmay still arise from delays in informationand from differences
in investor preferences in response to the information,which will be
reflectedin price differences. These price differencesprovide a measure
of the separationor lack of integrationof the two markets.The absolute
level of these price differences depends only on the transactions costs
between the two markets. (Since the largest portion of transactions
costs, however, turns out to be brokers' fees, and these are chargedas
percentagesof the sale value in each marketexaminedin this paper, it is
the percentageshare of the price differencesto the average value of the
shares in the two marketsthat is the best measureof transactionscosts.)
The durationof a given price discrepancybetween the two marketswill
depend on the length of time requiredfor the transmissionof informa-
tion between the two markets.Theaverage differencein price between
the two markets will normally depend on differences in quoting prices
(for example, money prices are usually lower than term or on account
prices) and on the differencesin transactionscosts of all kinds (taxes on
transfers, brokers' fees, implicit interest rates for trading on account
times the normallength of settlement)between the two markets, and on
the typical premiumor discount ruling in the exchange rate of the two
currencies involved. If perfect arbitrage occurs nevertheless within
these constraints of transactions costs, informationdelays, and price
movements in the intervening foreign exchange market, there should

2 Fritz Machiup, A History of Thought on Economic Integration (New York, 1977), p. 26.
3 Oskar Morgenstern, International Financial Transactions and Business Cycles
(Princeton,
1959), p. 508.
 Integration of Capital Markets 221

exist no detectabletime seriespatternin the pricedifferencesbetween

the two markets.Thatis, the randomwalkbehaviorof efficientmarkets
(in the weak sense of Fama)shouldbe observednot only for the price
movementsin each market,butalso in the differencesof pricebetween
the two markets.If somethingotherthana randomwalkis observed,
thenunexploitedarbitrageopportunitiesremainbetweenthe two mar-
kets and they cannotbe consideredfully integrated.
Startingin the secondquarterof the eighteenthcentury,we havedata
on the prices of sharesof the majorBritishjoint stock companiesas
tradedon the Amsterdamexchange. By the end of the nineteenth
century,we have daily data on pricesof Americanrailroadsharesas
tradedin eachof the majorEuropeanstockexchanges.At thistimeeach
marketwas informedwithinhoursof pricesin theothermarketsby way
of multiplesubmarinecables.Moreover,forwardorderswereregularly
placedby Londontradersfor particularsecuritiesandforeignexchange
in the New Yorkmarketto takeeffectafterthe Londonmarketclosed.
There were still no formaltaxes, regulations,or controlson capital
movements.Further,each countrywas formallyon a fullgoldstandard
so therewereno uncertaintiesassociatedwithacceptabilityof a means
of paymentacrossnationalboundaries.In short,all the conditionsfor
the perfectarbitrageof Morgensternwere in place and working.We
have then, in these historicalshare-pricedata across two or more
nationalmarkets,the possibilityof measuringtheintegrationof Europe-
an capitalmarketsagainstthe standardssetjust beforeWorldWarI for
nearlytwo centuriesof experience,the very centuriesthat witnessed
the buddingand full floweringof the world capitalisteconomy. Did
integrationproceedin a steadypace, or in fits and starts?How did it
respondto politicaldivisions,wars, changesin tradepolicies,changes
in monetarystandards,periodsof inflationand depression?These are
someof the questionsthatcan be tackledin principleusingthese data,
but in this exploratoryeffortthey will have to be ignored.Firstmust
comethe workof developingthis alternativestandardof measurement.

SELECTING EPISODES FOR COMPARISON

The interest rate arbitragemodel, used in previous studies, has

proven difficultto specify correctly in theoreticalterms and more
difficult,even treacherous,to implementempirically.Morgenstern
found it to work as expected duringthe late nineteenthand early
twentiethcenturiesonly duringperiodsof financialcrisis. These are
periodswheninterestrateschangedsharplyin the financialmarketthat
originatedthe crisis,creatinglargeinterestratedifferentials
internation-
ally. Only then could Morgenstern findthe sequence he expectedin the
interestratearbitragemodel-gold flowing into the marketwith higher
222 Neal

interest rates, its exchange rate rising, and then its prices rising. By
contrast, the asset-pricingmodel described above might be expected to
work least well duringsuch episodes. A liquidityscramblein one center
should drive down prices of all financialassets and if the crisis had not
yet appeared in the other market where the security was traded, we
would expect a larger than normal gap in the price to emerge between
the two markets. (This would be the corollaryof an unusualwideningof
the interest rate differentialin the interest rate arbitragemodel.)
For this first effort, we may as well measure capital market integra-
tion with the asset-pricingmodel duringsuccessive financialcrises that
were propagatedfrom one of the financialcenters to the other, that is, in
the "worst case scenario." The crises were selected on groundsof both
the availability of data and their characteristics as truly international
crises that affected both markets but with differences in intensity and
timing. Meeting these joint criteriawere the crises of 1745, 1763, 1772,
and 1793for the capital markets of London and Amsterdam;the crises
of 1825, 1873, and 1907for the London and Paris markets;the crises of
1873 and 1907 for the New York and London markets in American
railroadstocks; and the crisis of 1907for the Amsterdammarket once
again.

RESULTS

The results of measuringthe price differencesfor the various securi-

ties across the several marketsin these financialcrises spanningnearly
two centuries are shown in Table 1. This shows the average of the
percentage absolute price differences, and their variances in order to
comparethe effect of transactionscosts in each marketand between the
two markets on price differences. The remaining statistics-the stan-
dard deviation, the maximum difference that was observed, the mini-
mum difference, the range of the differences, and then for good
measure, the autoregressivemoving averagetime series model that best
describes the dynamic patternof the differences-are calculatedfor the
percentage actual price differences. These are the precise statistical
measures that reflect the concepts of transactions costs, delays in
information, and the degree to which arbitrageis carried out. Other
measures might be devised to reflect other aspects of integration(for
example, longest run of observations greater than one standarddevi-
ation from the average difference) but these seem to cover the most
obvious dimensions of integrationacross each pair of markets.4
4 The Amsterdamprices were adjustedbefore takingthe differencewith the Londonprice. The
adjustmentarises fromthe discoverythat Amsterdampriceswere consistentlyhigherthanLondon
prices. This led to the determinationthatthe Amsterdampriceswere time prices while the London
prices were spot. (L. Neal, "EfficientMarketsin the EighteenthCentury?The Amsterdamand
London Stock Exchanges," in Jeremy Atack, ed., Proceedings of the Business History Conference
 Integration of Capital Markets 223

TABLE I
SUMMARYSTATISTICSON STOCKMARKETINTEGRATIONIN CRISESOF THE
EIGHTEENTHAND NINETEENTHCENTURIES

Auto-
Maximum Minimum regressive
Standard Difference Difference Moving
Name Average Variance Deviation Observed Observed Range Average
EIGHTEENTHCENTURY
Bank of Englandand East India Companyshares quoted on the Amsterdamand London stock
exchanges(averageand varianceare for percentageabsolutepricedifferences,remainingstatistics
are for percentageactualdifferences).

A. The Crisisof 1745 (biweekly,June 1744-June 1747)

Bank 0.999 0.518 1.190 3.783 -2.923 6.706 (3,0)
East India 1.345 1.293 1.709 7.008 -4.619 11.627 (1,0)

B. The Crisisof 1763(biweekly,June 1761-June1764)

Bank 1.062 0.869 1.356 4.934 -2.293 7.227 (0,0)
East India 1.448 1.366 1.824 4.991 -3.382 8.373 (1,0)

C. The Crisisof 1772(biweekly,Jan. 1772-Jan. 1775)

Bank 0.714 0.266 0.798 1.569 -2.599 4.168 (1,0)
East India 1.591 1.532 1.951 5.610 -4.582 10.192 (1,1)

D. The Crisisof 1793 (biweekly,Dec. 1791-Dec. 1794)

Bank 1.180 1.822 1.671 8.751 -2.685 11.436 (1,1)
East India 1.342 2.706 2.078 9.156 -8.923 18.079 (1,1)

NINETEENTHCENTURY
(Average and variance are for absolute percentage differences of prices in the two markets
compared;remainingstatistics are for percentageactualdifferences.)

E. The Crisisof 1825(weekly,July 1824-July1826)

(Frenchrentes, 5%and 3%, are comparedin London and Paris.)
5%rente 0.576 0.527 0.922 4.675 -3.505 8.180 (0,1)
3%rente 0.842 0.825 1.177 3.922 -1.484 5.405 (0,1)

F. The Crisisof 1873 (weekly,July 1872-July1874)

(Frenchrentes, 5% and 3%, are comparedin London and Paris.)
5%rente 1.497 1.003 1.102 1.477 -5.191 6.668 (1,2)
3%rente 1.764 1.029 1.045 0.510 -4.183 4.692 (3,0)

(Americanrailroadstocks, the Erie and the Illinois Central,are comparedin London and New
York)
Erie 2.099 4.845 2.846 9.678 -4.487 14.165 (3,0)
IllinoisCentral 1.799 3.358 2.564 9.800 -7.776 17.576 (1,1)
224 Neal

TABLE 1-continued
SUMMARYSTATISTICSON STOCKMARKETINTEGRATIONIN CRISES OF THE
EIGHTEENTHAND NINETEENTH CENTURIES
Auto-
Maximum Minimum regressive
Standard Difference Difference Moving
Name Average Variance Deviation Observed Observed Range Average

G. The Crisisof 1907 (weekly,July 1906-July1908)

(Stock of the Erie railroad, compared on the London, Amsterdam, and New York Stock
Exchanges)
London- 3.187 4.728 2.751 11.579 -8.835 20.414 (4,1)
New York
Amsterdam- 2.250 5.837 2.784 15.464 -3.125 18.589 (2,2)
New York
London- 1.817 1.480 1.994 5.000 -5.714 10.714 (2,1)
Amsterdam

(Stock of the SouthernPacific railroad,comparedon the London, Amsterdam,and New York

Stock Exchanges)
London- 2.595 1.733 1.407 7.617 -0.926 8.543 (1, 1)
New York
Amsterdam- 1.095 0.882 1.440 4.893 -4.823 9.715 (0,0)
New York
London- 2.643 1.734 1.421 9.286 -0.926 10.212 (1,1)
Amsterdam
Sources: For the eighteenth century: London: The Course of the Exchange (appearingsemi-
weekly, with daily prices). Amsterdam:Van Dillen (1931), from the AmsterdamscheCourant
(takenfortnightly).
For the nineteenthcentury:For 1825:London:TheTimes(Thursdayissue or closest matchto Paris
quote). Paris:Le MoniteurUniversel(Thursdayissue or closest businessday). For 1873:London:
The Times(Thursdayissue or closest matchto eitherParisor New York quote). Paris:Le Figaro
(Thursdayissue or closest business day). New York: The Commercialand Financial Chronicle
(monthlysummary).For 1907:London,Amsterdam,andNew York:TheTimes(Thursdayissue or
closest matchto quote of New York or Amsterdam).

Panels A-D for the eighteenth century (Table 1) show essentially the
same values in each crisis episode for the averages, variances, standard
deviations, ranges, and patterns of the autoregressivemoving averages
(ARMA). The exceptions to this observation are that the ranges are
always greaterfor East India stock than for Bank of Englandstock, and
that the ranges for both are noticeably greaterin the 1793crisis. This is
evidence that market integration might, in fact, have been breaking
down at the end of the eighteenth century in the face of the political

(Urbana, 1984).A regressionequationwas estimatedrelatingthe excess of the Amsterdamprice

over the London price to the numberof days until the next paymentof dividends.This equation
was then used to calculateAmsterdamprices adjustedto their "'spot"equivalent.The adjustment
reduced the average difference found (Amsterdam spot prices are lower on average than
Amsterdamtime pricesfor both stocks) and reducedthe orderof the estimatedARMAmodels. But
the variance, standard deviation, and range of differences were largely unaffected by this
adjustment.
 Integration of Capital Markets 225

disturbancesthat disruptedtrade and communicationsbetween the two

markets. Otherwise, little change occurred in the degree of integration
of these two markets. Only one case of an ARMA process of (0, 0) order
occurs, East India Company stock in the 1763 crisis.
This evidence for well-integrated markets by the mid-eighteenth
century is more convincing, the more impressiveone findsthe degree of
integrationin this period. Turningto the results of Panels E-G for the
nineteenth century crises, we find that the mid-eighteenth-century
results, indeed, look quite respectable. The average differencesin price
levels between the various markets of the nineteenth century are much
the same right through to 1907. In fact, the largest difference found
occurred in 1907 (for Erie stock compared on the London and New
York exchanges). The variances are also similar, except those for
American railroad stocks in the nineteenth century are substantially
higher. The standard deviations (recall these are for the absolute
percentage differences) are also quite uniform by security and time
period, save for the Americanrailroadstocks. Their standarddeviations
are double the levels for French rentes in the 1873crisis and remainhigh
for Erie stock in the 1907 panic. The range of differences for the
nineteenth-centurysecurities are also much the same as in the eigh-
teenth century with the exception of those for Americanrailroadstocks
in the 1873 crisis and Erie stock in 1907. The range of differences
possible should decrease as the speed of communication of prices
between two markets increases, so our quantitativeevidence indicates
that only the speeding up of communications over the nearly two
centuries under consideration had any effect in improvingthe integra-
tion of Europeancapital markets.And this improvementcould be easily
offset in the case of volatile stocks (Erie in 1907) and uncertaintiesof
exchange rates when governmentalpolicies changed (Americansecuri-
ties in 1873).
But the improvementof communicationsdid not improve integration
to the extent that all possible opportunities for profit from arbitrage
were eliminated. In the ARMA models calculated for the nineteenth
century, we find no random walk until we get to the 1907 panic. Even
there the random walk appears in only one of the six possible cases
(three marketsand two stocks are compared).Even worse is the finding
that in the 1873 crisis the estimated coefficients for the autoregressive
moving average models (not shown in the tables) for each security-
French 3 percent and 5 percent renters,Erie and Illinois Centralstock-
indicate that the ARMA process was explosive, ratherthan dampened!
This is conceivable if a rationalbubble is in progress in one marketand
not in the other, but that situation hardly seems likely for the securities
and markets in question.
In sum, the evidence is that the Amsterdam and London capital
marketsof the eighteenth century were closely integratedeven by early
226 Neal

twentieth-centurystandards,and integratedeven duringfinancialcrises

that affected one market more severely than the other, according to
contemporaryaccounts. This is true, of course, only for the securities
which were listed in both markets. For other securities that were listed
and actively traded in one market but not in the other, however,
integrationcould obviously have taken place throughtradingfirst in one
of the commonly listed securities and then in any of the locally traded
securities. The ease of integrationwould then be improvedby increas-
ing the numberof commonlylisted securities. These do begin to grow in
the nineteenth century and especially after the middle of the century,
with first London and then Parisjoining Amsterdamas markets where
foreign securities could be locally traded.5But the degree of integration
does not seem to have made much progress in terms of decreasing the
average difference in prices and in eliminatingsystematic patterns of
price differences.
5 In 1855the AmsterdamBeurs listed officially87 securities,only 14of whichwere domesticand
2 colonial.Three-fourthsof these, however, were governmentbonds. By January1914,the number
hadgrownprodigiouslyto 1,796of which 691 were domestic, 840 foreign,and 265 colonial. Of the
foreign securities, 194 were issued by North American railroads. (L. Brenninkmeyer,Die
AmsterdamerEffektenboerse[Berlin, 1920],pp. 178-83.) By contrast, we may note that in 1983
only 294 foreignstocks were listed in the United States, up sharplyfrom99 in 1979(BusinessWeek
[July23, 1984],p. 101).