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2 - 8 November 2000
Issue No. 506
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Back to the future

By Frederick Bowie

In the 1840s, England was gripped by Railway mania. The new invention, it was claimed, would transform human existence, creating the means for almost instantaneous communication across the entire country. New worlds would be opened up to economic development, and new orders of wealth created where before was poverty and despair. Nor were the effects to be confined to the material sphere: according to one contemporary newspaper, "the length of our lives, so far as regards the power of acquiring information and disseminating power, will be doubled, and we may be justified in looking for the arrival of a time when the whole world will have become one great family, speaking one language, governed in unity by like laws, and adoring one God."

Where there is hope, there is always a way of stripping people of their hard-earned cash. The public, certain of making a killing, piled into railway shares, and a myriad companies sprang miraculously into existence for no reason other than to gratify the speculative instinct of their fellow man. By November 1845, little more than a year after the passing of the Railway Act, The Times could report that some 1,200 railways were planned, at an estimated cost of more than half a billion pounds. Meanwhile, the railway companies between them had already accumulated liabilities amounting to some 600 million. Both these figures significantly exceeded the national income.

Yet civilised humanity, once in possession of a brokerage account, is rarely a stickler for figures. The fact that certain shares had risen by 500 per cent in less than a year was all the proof that was needed, and the speculators set about financing what, if carried out as planned, might well have been the greatest infrastructural overbuild in the history of mankind. Nor did they have to be wealthy in order to be taken _ more metaphorically than literally, at this stage _ for a ride. The companies were only too happy to sell them shares on subscription, in return for a downpayment of as little as 5 per cent. The problems began once the railway companies decided to stop selling shares and to start building railways. As they started to call the subscriptions due in order to finance the work, shareholders who had bought shares on credit hoping to finance the balance from future gains were forced to sell part of their holdings prematurely so as to meet present debts. Bad money soon forced out good, and a half per cent rise in the Bank of England's interest rates was all it took to precipitate the final crisis. By the end of October 1846, many stocks were down over 40 per cent from their peaks. And that was not the end of the slide, but merely the beginning.

The Railway mania is a fine example, both of how financial bubbles burst, and of the catastrophic effects which they can have on the wider economy. Although the speculative appetite withered as quickly as it had blossomed, the commitments into which the speculators had been drawn did not evaporate with it. By January 1847, calls on railway scrip were averaging some 5 million a month. Capital was drained out of the rest of the economy and diverted into the great work of construction. By the summer, most normal business had virtually ground to a halt. All available funds were commandeered for laying track and installing signals. The network which was to usher in a new era of trade began life by sparking a series of high-profile commercial bankruptcies. These in turn led to bank failures, and by mid-October the Bank of England itself was only 24 hours from having to close its doors. In a move that presaged the US Federal Reserve's 1998 bail-out of Long-Term Capital Management, the government was obliged to bypass its own laws and effectively print money in order to save the financial system from total collapse.

Today, instead of the railways, we have the Internet. The same extraordinary claims of a new era _ many of them doubtless true -- are used to justify the even more extraordinary prices investors are prepared to pay for a piece of the action. Even after the slump of the last few months, the shares of many of those US companies most closely identified with the construction of the network are changing hands at 100, 200 or even 500 times their annual earnings -- supposing that they have any. (The sustainable historic average for this ratio is generally agreed to be 12). Corporations with no income, no sales, and -- in some extreme cases -- no known products, are being valued far more highly than large respected firms with long histories of consistent profitability. In almost every case, the shares are priced as if each individual company had not only invented the future, but owned it outright, lock, stock and barrel.

Take for instance the core market for Internet routers, currently being fought over by two companies, Cisco and Juniper. Routers, which direct data traffic round a network, are clearly an important part of any communications infrastructure. At the same time, they are only one small part: networks require highways as well as junctions, cars as well as roads; and those elements themselves are made up of parts that have to be purchased from elsewhere, maintained and operated. All of that costs money. At the beginning of October, Cisco and Juniper were together valued at $440 billion. That may not sound much compared to US GDP, which last month for the first time topped $10 trillion. However, these two companies are not trying to take over the nation: they simply want to own the Internet. The highly-respected analyst Paul Johnson has estimated that over the next 20 years one trillion dollars will be spent on building the Next-Generation Network. Discount that figure back at 10 per cent, and you get a net present value of only $440 billion _ more or less exactly the market value of these two companies.

I take that to mean that if all the money to be spent on building the Next-Generation Network were to go to Cisco and Juniper, and no one else were to get anything at all _ and if those two companies were able to run profit margins of more or less 100 per cent _ then an investor buying their stock this month could look forward to an annual return, before taxes and inflation, of 10 per cent per annum over the next two decades. I wonder how many of the people who last week were buying Cisco for 100 times earnings will be satisfied with such a 'meagre' return? That $440 billion is also slightly less than the net present value of what China alone will spend on roads and railways over the next decade, according to the World Bank. Yet you could buy all the world's leading train manufacturers (there are only three of them left) for less than one-tenth of that sum, and you'd also get their highly-profitable power generation and avionics businesses thrown in for free. It might seem obvious to us which of these will prove the best investment. But then, we're not 'investors', are we?

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