A nice new paper (.pdf) from University of Minnesota mathematician Andrew Odlyzko discusses, with ample historical evidence, the experience of investors in the American and British railway systems during the 1830s and 1840s. His conclusion is that, contra Rogoff and Reinhart, this time was in fact different. Investors did well with their investments, and there were few tears after the mania subsided.
What was different? I can venture a few hypotheses. The first is that investment in this capital-intensive system was restricted to a relatively few number of individuals. I doubt that the data exists, but I would suspect that the fraction of American households which were able to make investments in the railway system was very, very small. Economists would call this a “credit market imperfection”, but common sense just says that only the rich could get in on the action here. Given the fact the the supply of outrageously lucrative investment opportunities in railroads was small compared to the amount of capital to throw at them, it does make sense that whomever had sufficient liquidity made out quite well.
The other thing to note is that America’s size and natural resources are not given enough credit for its eventual economic domination during the 20th century. Yes, the building of the railroads was instrumental to making that domination a reality. Given the American mentality to work like a madman in pursuit of the American dream, such a huge, gaping opportunity to expand the infrastructure of the American economy to the western states was undoubtedly extremely profitable. The modern day countries that come to mind are China and India, but their cultural and political natures are far removed from the United States of the 19th century. I would be surprised if Warren Buffett and Charlie Munger do not have similar views, as their purchase of Burlington Northern (BNI) shows they see the value of the railroad system in the 21st century, for many of the same reasons which existed in the 19th century.
Compared to the South Sea bubble, the American railway mania of the 1830s and 1840s did in fact have enormous real commercial appeal. The idea was to make fixed capital investments resulting in equipment whose rental value (net of relatively small maintenance costs) would swell as the country developed economically for decades to come. Dutch tulips had no such economic value.
In fact, this episode of American economic history calls to mind a seminal paper by economists Murphy, Shleifer and Vishny called “Industrialization and the Big Push”, which was published in the Journal of Political Economy in 1989. To give due credit, it was based on an idea from Paul Rosenstein-Rodan which dates to the 1940s. The idea was that the decision of firms and governments to make massive investments depends on the decisions of other local actors to make similar such investments – in a “big push”. If Fred and Joe down the block are going to invest, then the likelihood that I will make a profit by investing increases (due to "agglomeration economies" and "positive externalities"). Paul Krugman’s work on international trade, which eventually won him a Nobel Prize, has similar overtones (and Krugman discusses these ideas in an excellent, very readable book from 1997 called Development, Geography, and Economic Theory). There is an enormous amount of truth to this insight, as the experience of Singapore can attest.
So what happened was that investment in the railways got off the ground, as it should have, and while plenty of money was thrown that way, it wasn’t enough to make a ridiculous price run-up a la the standard bubble scenario, due to the fact that 1830s investors didn’t possess online stock trading capabilities (to say nothing of the fact that the average citizen didn’t have much money to throw around to begin with). As Odlyzko’s article explains, there was actually much doubt as to whether these investments would pay off. And for good reason. But the big push did occur. America industrialized and made good use of its natural resources and immigrant energies, and we all know the story of what happened in the 20th century. But it was risky business at the time.
Are there any modern day parallels?
The most glaring one that springs to mind is clean energy (and not gold). Yes, as Charle Munger thinks, it is the wave of the future. But it is still getting off the ground. Will the big push in solar energy occur? Of course. There is too much capacity in solar wafer production, even in 2010, for it not to. Government subsidies will help of course, but the phenomenon will be self-sustaining in the end.
The general formula here is that if a new investment craze actually promotes investments in something which has real economic value for the long-term and could throw off dividends, such as LDK Solar's (NYSE:LDK) manufacturing capabilities, it may be worthwhile. The downside risk is that today’s world capital markets are open to everyone, so it is likely that any mania will eventually eventually result in massive buying sprees from unsophisticated parties. The moral is to be be careful, and to buy in at the right time.
Disclosure: Long LDK.