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Railways and the Electronic Age
From: London School of Economics and Political Science
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Dudley BainesNicholas CraftsTim Leunig |
EDITOR'S INTRODUCTION |
 It was a technological revolution that transformed and powered national economies. It gave rise to excitable stock markets, a flurry of start-ups, fraud and new modes of management. The technological revolution being referred to here is not the information and communication technologies or dot-com boom but the railway mania of nineteenth-century Britain.
Economic historians Nicholas Crafts, Dudley Baines and Timothy Leunig compare the nature and impact of the railway mania with the information technology boom. Since the collapse of share prices in April 2000, doubts have set in about the viability and longevity of the information technology age. Are we in for endless cycles of electronic boom and bust? Exploiting the historical comparison with railways, Crafts, Baines and Leunig address these questions and show that there may be more grounds for optimism than originally thought. |
 he last decade has seen the American economy enjoy rates of growth that few could have predicted. This success occurred while we witnessed the revolution in information and communications technology (ICT). Yet, as the economy has boomed, economists continued to debate what is termed the "Solow productivity paradox." This states that although we can see computers everywhere, we cannot find evidence that they have raised productivity. |
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| The Erie Railway circa 1880. | |
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Despite economists' pessimism, the price of new technology shares rose spectacularly, especially in the United States. Ironically, the technology share price collapse in the spring of 2000 occurred just when economists began to realise that ICT was actually having a substantial effect on American economic growth. However, it is clear that we have a long way to go before we can say that we understand what impact this new technological revolution will have on economy, business and investors. |
In such circumstances, it is always appealing--and often useful--to try to find comparisons from history. The position that the United States holds today, as the world's leading economy, was held by Britain in the mid-nineteenth century. That economy also witnessed a dramatic technological change, one that created excitement and uncertainty among the Victorians on a scale similar to the impact of the Internet today. |
That technology was, of course, the railway. Then as now, the reaction of the investment community was feverish but the impact on the real economy was initially quite small. We can take advantage of hindsight and of some research to explore the lessons of the early years of railways in Britain for thinking about the economics of the ICT revolution. Investor, analyst and user of ICTs alike will find certain questions of interest: |
How did the stock market react to railways?
There was huge speculation in railway shares followed by a spectacular crash in 1845 even in the shares of those companies that would become giants of the industry in later decades. Then as now, stock markets found that pricing shares associated with an exciting new technology is extremely difficult, reflecting the considerable uncertainty about the value of the technology, both to the economy as a whole and to the shareholders. An important implication is that the crash in technology shares in the spring of 2000 does not necessarily imply that economists who believe that ICT has raised sustainable growth in the American economy are wrong. |
What was the impact of the railway on economic growth?
Initially, the railway contributed little to growth, but its impact became more significant as the network grew, as technology improved and the potential for freight as well as passengers developed. By 1870, the best estimate is that national income would have been about 10 per cent lower had the railway not been invented. Over the previous 30 years, the average impact on the growth rate of the economy was about .25 per cent per year. By comparison, the impact of ICT on growth in the USA between 1974 and 1995 was about three times larger, even before the late-1990s ICT productivity boom. This suggests that the mid-1990s "Solow paradox" was primarily a result of inflated expectations and that, by historical standards, ICT had already had a major economic impact. |
How did the railway affect management?
Railways were one of the first industries in which expenses did not vary markedly with sales. This meant that new business models were required to ensure profitability. There are obvious parallels with the ICT sector, notably with Internet firms. Both railways and Internet firms incur large up-front expenses prior to gaining substantial amounts of revenue, and, in the early stages at least, both operate under considerable uncertainty about the size of the market and potential profitability. |
The new demands on management in both eras also led to new demands on accountancy. The railways use of long-lived capital forced accountants to devise new and more sensible rules of how to value assets. In contrast, many telecommunications firms' business models are based around the cost of acquiring customers, so accountants are now working on different models of how to value customers. Finally, as with railways, accountants are today working to ensure that accounts reflect the true position of the firm. New rules are currently being proposed to ensure that the cost to shareholders of stock options granted to employees is fully reflected in the accounts. |
The railway mania, 1844-7
 Industrial railways had been common in many parts of the country since the late eighteenth century, usually hauling minerals to low-cost water transport. The development of the railway system as we know it followed the success of the Liverpool and Manchester Railway of 1830. For the first time, all trains were hauled by steam. Adequate investment allowed quality engineering to produce what were then seen as high speeds--105 minutes for the 35 miles. Moreover, management thinking on railways had developed and the Liverpool and Manchester Railway operated its own traffic, rather than acting as a turnpike, whereby the company provided the track but independent carriers ran their own trains. Their success led to the first railway boom of 1836-7, with many railways proposed to parliament. Only 970 miles had been sanctioned before 1836, but 955 miles were sanctioned in 1836 alone and a further 543 in 1837. |
The boom lasted 18 months, until it was clear that the existing companies were overextended, and when a balance of payments deficit led to a rise in interest rates, the boom collapsed. Most of the proposed lines were completed, however, and by 1842 a crude system stretching 2,000 miles connected London, Birmingham, Manchester, Leeds, Newcastle, Bristol, Exeter, Southampton, Brighton and Dover. |
By the early 1840s, most "first boom" railways had become profitable. In 1844, the average dividend of the 11 most important companies was 5.8 percent. This led to a second, much more violent boom--the "railway mania." The exact number of proposals is difficult to establish, but in November 1845, 620 schemes, with a total capitalisation of
£ 563,000,000, were before Parliament and another 643 were awaiting registration or a prospectus. Speculation in the share price was attractive for several reasons. The earlier lines had demonstrated that a railway built between two principal towns would carry all passenger traffic in about 40 per cent of the time previously taken by the fastest coaches and at the same price. |
We can see from the prospectuses that the railways were aiming mainly at existing first- and second-class passenger traffic. There was little belief at the time that the market could be expanded by reducing fares. Freight was secondary. As late as 1847, each mile of track carried, on average, only 83 tons of freight per week. Most railways were uninterested in third-class passengers, until an act of 1844 forced them to make a token provision. |
Britain was the only country where the government took no part in the planning or finance of railways. There was some attempt to monitor applications, but the legislation was poorly drafted and poorly enforced. Hence, opportunities for speculation were considerable, leading to a rapid increase in the share price. Share ownership rose somewhat in the late-1830s boom and considerably so in the late 1840s. The very early lines were supported by those with a direct interest in the traffic. Then mercantile capital dominated, with railways financed by people other than those planning to use the route. |
By the 1840s, the London Stock Exchange had become an important conduit for investment capital. Shareholding spread to include those with no interest in any particular line, which is consistent with a shift from "insiders" to "outsiders." The proportion of "gentlemen" and female shareholders increased markedly from the 1830s to the mid-1840s, for example. |
The practice of making calls on shares also encouraged speculation. Purchasers did not pay the full price up front. Subsequent calls were made as, and if, construction occurred. In effect, shares were bought on margin. If share prices were expected to rise, the purchasers were buying forward at a discounted price. Many other dubious practices were used to manipulate the share price, including rigged shareholder meetings, planting false information in the extensive railway press and issuing false prospectuses. Accounting methods were primitive allowing the true financial position of the company to be concealed. Capital and revenue accounts were confused, and dividends could be paid out of new issues. Traffic returns were manipulated if they could affect the share price. |
The success or failure of flotations rested on several factors--although there must have been an irrational element. First, mover advantage was important. Since it was assumed that railways would dominate all traffic, the mania was, in effect, a race to connect all the major towns with the neighbouring towns. Hence, initial access to a city centre from a new direction was critical. However, actual access to the city centre was often too expensive. This could lead to a different, and unconnected, station for each company. Birmingham, for example, initially had four only tenuously connected stations. Very large sums were spent on urban extensions in later decades. |
Further, the prospect of amalgamations--particularly, end-on amalgamations--had an effect on the share price. Let us assume that there are two (actual or potential) companies running from A to B and a further company running from B to C. If one of the former amalgamated with the latter, the remaining company would lose all through traffic. This was a key factor in the appeal of George Hudson, the "Railway King." Hudson controlled the Midland Railway, an 1844 amalgamation, which ran from Bristol to York, via Birmingham, as well the main lines in East Anglia and the North East. As a result of being able to supply through traffic, his name, if associated with a project, would initially add a premium to the share price. Hudson ultimately lost control of the Midland Railway and (as the share price collapsed) was accused of fraud |
Railways and the economy, 1830-70
By the end of 1845, the bubble in railway shares had well and truly burst. By 1848, even the best companies had lost 50 percent of their net worth. |
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| Fig. 1: GWR and LNWR Share Prices (£), 1844-1851. | |
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Many companies collapsed, leading to serious investor losses and protracted litigation. The speculative boom and bust known to the Victorians as the Railway Mania illustrates the difficulty then, as now, in valuing new technology economic activities Nevertheless, in the next 25 years the railway had a major impact on British economic growth, confirming that the early Victorians were right to sense that the steam railway was a major technological breakthrough. |
 When the railway mania began, in 1844, only about 2,000 miles of track were open. By the early 1850s, when the core of the network was complete, this had risen to about 7,000 miles. The only subsequent main line additions were the Great Central extension to London, the Leeds-Carlisle line and extensions into Cornwall, Wales and northern Scotland. In other words, the railway system of 1852 was very similar to the network envisaged in the classic Beeching Report of 1965. |
By the 1870s, railway mileage had doubled again, as the figure below indicates. |
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| Fig. 2: Railway length in miles (includes Ireland until 1847). | |
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 Total construction costs to 1870 amounted to about £ 250 million, a massive sum for an economy whose GDP only reached £ 1 billion per year in 1866. Gross railway revenues which were around £ 5 million per year in 1844 had tripled by 1852, when freight overtook passengers for the first time and had risen to £ 23 million by 1870 (just under 5 per cent of GDP), when about 4.4 billion ton-miles were carried (see Figure 3, top left). |
This was a period of falling prices, as network growth increased competition and as significant management innovations allowed companies to set prices more accurately. By far the most important category of freight traffic was coal, which was very expensive to transport by road but was the key energy input of industrial revolution technology. Despite the share price crash of the mid-1840s, railways turned out to be profitable. The net earnings reported in Figure 4 show that the investment had been paid back by 1870. |
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| Fig. 4: Net Earnings and Social Savings of Railways in England and Wales (£ mn). | |
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The benefits to the national economy from the introduction of railways have traditionally been calculated by estimating the cost savings of using rail transport compared with the next best alternatives: road and water. Where a direct water route was available, there might well be no saving. The most important savings were associated with passenger transport, where by the 1860s rail offered speed and comfort that could hardly have been matched by the most de-luxe stagecoach alternative. The best available estimate suggests that these "social savings"--which accrued to transport users--were worth about 10 per cent of national income by 1870. |
At that point, contemporaries' concern as to whether this technology would deliver meaningful benefits was legitimate. Combining these benefits to users and the private profits to railway companies, Gary Hawke calculated that the social rate of return on the construction of railways prior to 1870 was between 15 and 20 per cent. An ever-increasing fraction of that went to rail users in the form of a better service at a lower cost. |
There was a general acceleration in growth of real GDP from an average during the early industrial revolution years of about 1.5 per cent to about 2.5 per cent per year during the mid-nineteenth century. On the basis of such social savings calculations, railways may have made a contribution that was on average equivalent to about 0.1 per cent per year between 1840 and 1870. We get bigger overall results for 1840-70 from a growth accounting exercise,
which includes the return to capital employed as well as the benefits of cost savings. |
This suggests that railways made a contribution of about .25 per cent per year. The growth accounting exercise also makes explicit why railways cannot dominate the growth outcome: they are simply not big enough relative to total economic activity to do so. Even in 1870 the railways accounted for less than one-twentieth of national income. |
The episode of the railways has three implications for today. First, a big downrating of technology shares on the stock market can happen even in cases where the long-term economic impact of the innovation is substantial. Second, the Solow productivity paradox, seeing computers everywhere except in the productivity statistics, has historical parallels: it was at least two decades into the era of the railway before its macroeconomic impact started to be appreciable. Third, it would be wrong to expect too much from the new economy. Indeed, by historical standards the ICT revolution has already shown itself to be remarkable--growth accounting shows its absolute impact on the growth rate in the United States in the last quarter century has been around three times that of the railway on mid-nineteenth century Britain. |
The railways and management
The largest firms in the world in 1840 must have seemed enormous to those who worked in them. The largest textile mills in Britain and the United States had more than 500 workers, while the Dowlais Iron Works in South Wales--the largest manufacturing enterprise in the world--employed more than 5,000 people. These factories were immensely larger than anything that had gone before, and brought a new experience of work to those who toiled within. |
But they offered limited managerial challenges. The owner or manager--and they were often one and the same--could still walk around the plant in under an hour. If there was a problem, they could look into it themselves, immediately. In that sense, managing the Dowlais Iron Works was not that different from managing a far smaller artisanal workshop. |
Size, then, does not necessarily demand new styles of management or new innovations in management theory. What made the railways different was not just that they were an order of magnitude larger again than the Dowlais works; it was the combination of three factors: the potential for disaster, the ease of making a loss and managers' poor access to information. Other means of transport, such as canals and roads, allow one user to overtake another with relative ease, so little overall co-ordination is needed to ensure the safety of users. The first railway, the Stockton and Darlington, did try a hands-off approach, allowing other companies to run trains on its track. But the result was poor service for everyone, and after eight years this approach was abandoned. From then on, a single company built the tracks and operated the trains that ran on them. |
But the potential for catastrophe remained real: when two trains run on the same piece of track,at the same time, disaster may occur. Indeed, the railways' capital intensity meant that the only way to turn a profit was to run many trains on the same line, and so the only way to offer an assurance of safety was for managers to know where each and every train was at each and every moment. |
To ensure that capital was being used at an intensity compatible with making a profit, whilst guaranteeing that safety was not compromised, managers had to construct a modern management system. In Britain, the pioneer in effective railway management was Captain Mark Huish, of the London and North Western Railway. He developed a system based on regular information reporting at all levels of the organisation, coupled with clearly defined responsibilities for employees. |
As well as making strides in internal organisation, railways made significant progress in pricing theory and practice. In most firms prior to railways, the cost of production was primarily made up of the cost of raw materials and labour embodied in the item being sold. This is not true of railways: the additional cost to the railway of carrying an extra person or parcel is almost zero. But there are very large fixed costs, including building the railway in the first place, that need to be covered if the railway is to survive financially. The same is true of ICT. The cost of producing one computer chip, routing an additional phone call, or taking another Web booking is very small. But the cost of inventing the next generation of chips, or building a high-speed telecommunications network or designing a first rate secure website, is very high. |
Railways found that if they divided the fixed costs equally across all users, many users decided not to use the railway at all. So railways began to charge some customers much more than others, even though the cost of serving each customer was only marginally different. Different classes of travel are the most obvious way to do this, but fares can also be varied with time of day, direction of travel, ticket flexibility and so on. Chip manufacturers have also followed this approach. Intel's 486 chip, in the early 1990s, was available in two versions, the higher-powered DX and the lower-powered SX. The two cost almost the same to manufacture, but by selling the former at a much higher price, Intel was able to better recoup the costs of inventing the 486 family. Pricing different-speed versions of any chip, or the same-distance phone call at different times of the day, are further examples of where ICT firms are following in the footsteps of railway management pioneers. |
Railways and accounting
Captain Mark Huish was a pioneer in accounting theory. He was the first person to think clearly about the role of fixed costs and depreciation in company accounts. Prior to the railway age, companies' profits were calculated as cash received minus cash spent in any one year. So long as fixed assets and depreciation are insignificant, such a system was tolerably accurate. But railways have massive fixed and long-lived assets. |
A railway that just covers operating costs will not survive in the long run, as rolling stock will need to be replaced and rails themselves may need repairing or even replacing. This led some firms to declare large profits--and large dividends--that were in effect illusory, as they occurred only because the firm had made insufficient allowance for depreciation. Other firms went to the opposite extreme, refusing to pay dividends to build up large "depreciation reserves" that bore no relation to the likely amount of depreciation that had occurred. |
Huish believed that both approaches were arbitrary and wrong, both in the literal sense of misrepresenting the situation and in misleading shareholders--the firm's owners--as to how the firm was performing. Huish made the intellectual breakthrough that assets should be valued not according to their cost of construction, nor their value in the second hand market, but according to their "effective value," their earning capacity in their current use. This is identical to the modern method of reporting "values in existing use." Huish's confidential reports in 1848-9 were used as the basis for Dionysius Lardner's 1850 book, Railway Economy, and his methods of valuing assets were later to influence accounting methodologies in other capital-intensive industries and to be used almost without alteration by the public utilities. |
Today, those same principles are influencing ICT valuations, most obviously in third-generation mobile telephone licenses. Here the issue is how to value customers rather than track, but the principle is the same. Railways are valued at the expected profit per mile over the expected life of the track; mobile phone companies are valued at the expected profit per user, over the lifetime of the license. It is noteworthy that in Britain and Germany, where the auctions were efficiently designed, the valuations reached were very similar levels per capita, suggesting that the companies bidding had a very clear sense of how to value those licenses. Management, whether of the railway or the mobile phone company, has to consider the same issues: how many people will want to use this service, how much will they be prepared to pay and how many close rivals will be able to offer a similar service. |
Railways, investors and fraud
Prior to the railway age, the rich invested their money predominantly in land and government stock. Unlike now, they certainly did not lend it to people they did not know, to invest in businesses they did not understand. The construction of the railway was to change that. Every mile of railway built cost, quite literally, a fortune, and many miles had to be built. No entrepreneur, nor even networks of friends, had such sums to invest. The money, instead, had to come from people unknown to the promoters. That in turn offered insiders new opportunities for fraud. |
And the early railways certainly saw fraud on a large scale. George Hudson, the so-called Railway King and a genuine railway entrepreneur, was also a genuine crook. In 1849, he paid for 900 shares in the Newcastle and Berwick Railway but registered himself as the owner of 10,000, selling them for a profit of £ 145,000 He received dividends on shares that he had not paid for. He purchased rails and other items himself, and then sold them to the companies he ran for vastly inflated prices, so making a fortune. He was able to do this because firms were not required to keep proper accounts, so it was impossible for outsiders to tell whether the company was being run honestly, let alone effectively. Hudson was exposed, and forced into exile. But wiser heads realised that the problem was not Hudson but that, as the Times put it, "The system is to blame. It was a system without rule, without order, without even a definite morality." |
William Gladstone, always keen on morality, was far-sighted enough to recognise that railways were different, and to try to raise public confidence by giving government greater ability to supervise and even regulate railways. But his 1844 bill was voted down by the railway interest, and railways remained open to abuse. The most notorious company fraud of the 1850s was perpetrated by one of the Great Northern Railway's senior employees, its registrar, Leopold Redpath. Realising that there was only one list of shareholders, in his office, he forged share certificates, entered them into the books and sold the forgeries, so making £ 240,000, a sum equivalent to 800 times his salary. The regular auditors did not notice anything, although he was eventually caught by a professional accountant, one William Deloitte. He was found guilty and transported for life. |
Most railways did act on the Redpath scandal to increase the number of checks within their offices, so making it much harder for clerks to defraud the company. But it was not until the 1868 Registration of Railways Act that companies had to publish accounts in a standard format, clearly separating operating revenue from money raised from new issues and loans. |
Today, accountancy and stock markets are far stricter than they were at any point in the nineteenth century, and opportunities for fraud are correspondingly much smaller. That is not, however, to say that all investors have felt fairly treated by insiders, as the case of World Online illustrates. Soon after its high-profile flotation, it emerged that Nina Brink, its chairman, had sold the bulk of her stake ahead of the offering at a fraction of the offer price. The news led to a collapse in the share price. Peter Paul de Vries, the director of VEB, the Dutch shareholders' association, said, "It's a lesson learned. There was no way in the world this company was worth £ 35.5 billion when it floated." The Financial Times reported that VEB intends to file a lawsuit against World Online, alleging that its prospectus was unclear. |
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