Assistant Professor of Finance
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Innovation is indispensable to long-term economic growth and prosperity. In light of this, it is unsurprising that the identification of the types of institutions most conducive to innovation has become a flourishing field of study for economists and others.
From the English common law to the US bankruptcy code, many and varied institutional arrangements have been named as providing an environment friendly to the process famously described by Joseph Schumpeter as “creative destruction”.
Military occupation by a foreign power has not tended to feature in the literature, other than, perhaps, as an example of a positively unfriendly climate for innovators. Yet our research shows clearly that, given the right conditions, this can indeed prove an institutional spur to innovation.
The fact of occupation itself would not, of course, qualify as providing these conditions. What would be needed would be for the occupiers to bring with them a set of institutional arrangements and a philosophical outlook that would significantly change the prospects for innovation in the occupied territory.
Such a set of circumstances occurred between 1795 and 1813. Revolutionary France, threatened by a military coalition of the then-fragmented German kingdoms, occupied all German territory west of the Rhine. The military successes of Napoleon Bonaparte led to further territorial losses, and it was not until French reverses in 1813, followed by the debacle of Waterloo in 1815, that the occupation came to an end.
The clash between France and the German states was about more than military rivalry. It was a confrontation of quite different political and social philosophies.
With their occupation, the French brought with them the ideas unleashed by the French Revolution of 1789. These ideas included personal freedom and equal rights, notions that led naturally to a widening of economic opportunity, with the lowering of entry barriers, the reduction of product and labour market distortions and, overall, a more level playing field for people and businesses.
Economic arrangements in the German states could hardly have been more different. Well into the late 18th century, so-called extractive institutions – named because they extract unearned money and privileges from the many for the benefit of the few – remained common. Their chief purpose was to maintain the power and wealth of the elites, both the nobility and the urban oligarchs who curbed genuine entrepreneurship through monopolistic guilds.
These guilds, associations of merchants and craftspeople, set standards for training and product quality but created barriers to entry and sought to protect their members’ living by obstructing the introduction of labour-saving production methods.
Even beyond the reach of the guilds, innovation was stifled. Factory-based businesses, such as ironworks, required a hard-to-obtain trading licence and entrepreneurs needed to stay on good terms with the local administration or find themselves out of business.
Nor was there any “separation of powers” between the administration and the judiciary. Property, government, internal security, judicial functions and real estate frequently involved the same people, or even just one person. It would not have been unusual for the lord of the manor to be simultaneously police chief, judge, mayor and the largest landowner.
One final institution prevalent in the German states and almost guaranteed to deter innovation could be found in the countryside: serfdom. The precise details varied from one region to another, but the essential features were land ownership concentrated among a small number of nobles, with the estates divided into smaller plots which were then cultivated by serfs. “Tribute” would be due to the nobles from the serfs.
All these aspects of German economic life were changed radically in those territories occupied by the French. The privileges of the guilds were abolished by decree. The system of restrictive trade licences was greatly liberalised. Key to encouragement of innovation is a fair and open justice system that can give entrepreneurs confidence that their property will be protected. The French swept away the “patrimonial” courts, those run by, and in the interests of, local grandees, and introduced the civil code.
Finally, the French first abolished serfdom and then instigated land reform, transferring ownership of some land from the nobles to the peasants.
Where is the evidence that these changes had a positive effect on innovation? We scrutinised data for the granting of patents at the level of individual counties, relying on patent issue as a measure of innovation. In short, we found that the number of patents per capita was more than twice as high in those counties that had experienced the longest period of French occupation than in counties that were never occupied.
The long-term beneficial impact of institutional reform on innovation is especially marked in the high-tech industries of that time. These included the chemicals and electrical engineering sectors, which gave birth to new products such as the light bulb, pharmaceuticals and electricity generation.
There were nearly four times as many high-tech patents issued in about 1900 for those counties that had undergone the longest period of French occupation than for those that had not been occupied and which retained some features of the previously mentioned extractive institutions.
It’s striking that we can see the long-lasting effect of French institutional reform on innovation 100 years after the initial occupation, in what by then was a united Imperial Germany.
Two aspects of the 1795-1813 occupation make it especially suitable for a study on the institutional impact on innovation. The first is that the timing of the occupation and the areas to be occupied were entirely matters for the French. This may sound obvious, but it is important in underlining that the Germans had no role in selecting the territories involved.
The second is that France made those selections on military and strategic criteria, to create a buffer between France and its rivals in Austria-Hungary and Prussia, and not on economic grounds. There is no question that Napoleon was looking to acquire territories on the basis of their innovation and growth potential.
That said, it could still be objected that, by chance, the French occupied areas that happened to have high growth potential. This can be dispelled by looking at Saxony, the region thought at the conclusion of the Napoleonic Wars to have among the best prospects for economic prosperity. Rhineland-Westphalia, which experienced the longest period of occupation and thus the deepest institutional changes, became significantly more innovative than unoccupied Saxony.
The impact of institutional change on innovation, we found, increased markedly in those counties in which reform was complemented by more developed financial institutions. Our research shows that, contrary to what some believe, the development of a financial sector alone may not lead to more innovation. This development working alongside good institutions is what seems to lead to innovation and economic growth.
Social norms, too, are important. We found that the effect of institutional reform was weaker in terms of spurring innovation in those countries that were part of former ecclesiastical states and where social norms were strongly influenced by the Catholic Church.
What is perhaps most remarkable about our findings is that the economic impact of the French occupation was entirely unintended and came about as the byproduct of a purely military and geopolitical strategy. But the events of those years have given us a fascinating and rewarding opportunity to gauge the enormous importance of the types and quality of institutions on innovation and thus on economic growth prospects.
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