The Wage That Attracts Capital

I

WHATEVER may have been the sociological and political defects of the laissez-faire policy under which modern industry has grown up, the system had at least this merit, that it offered alluring speculative inducements to capital. Investment in railroads, mines, and factories, in the things that we mean when we speak of building up the country, was unstinted, under the old rule of the game that rewarded risk by placing no limits to the profits of success. It is an exceedingly important question whether the new rule, which tends to limit profits without any corresponding abatement of risk, is going to succeed, or whether it is going to break down because new capital cannot be had in adequate amounts for the wage which the government will allow it to receive. As a matter of fact, we are confronting some new problems, of firstrate importance, which have yet to be thoroughly tried out anywhere in the world.

The Hadley Railroad Securities Commission brought this point out rather emphatically, in its bearing on railroad development. The report of the Commission to President Taft (November 1, 1911) shows how this development is now endangered by the ‘reluctance of investors to purchase new issues of railroad securities in the amounts required,’ and goes on to say: —

‘We hear much about a reasonable return on capital. A reasonable return is one which, under honest accounting and responsible management, will attract the amount of investors’ money needed for the development of our railroad facilities. More than this is an unnecessary public burden. Less than this means a check to railroad construction and to the development of traffic. Where the investment is secure, a reasonable return is a rate which approximates the rate of interest which prevails in other lines of industry. Where the future is uncertain the investor demands, and is justified in demanding, a chance of added profit to compensate for his risk. We cannot secure the immense amount of capital needed unless we make profits and risks commensurate. If rates are going to be reduced whenever dividends exceed current rates of interest, investors will seek other fields where the hazard is less or the opportunity greater. In no event can we expect railroads to be developed merely to pay their owners such a return as they could have obtained by the purchase of investment securities which do not involve the hazards of construction or the risks of operation.’

It is interesting to look into this aspect of the question a little further and see if we can determine what capital is requiring to-day; what wage attracts it, and what has occasioned some of the recent variations in its point of view. Indeed, the extreme recency of the existence of liquid capital in really sizable amounts, is one highly important factor in the situation, and one which has received comparatively little attention. Bagehot, writing in England, in 1873, says: —

‘We have entirely lost the idea that any undertaking likely to pay — and seen to be likely — can perish for want of money; yet no idea was more familiar to our ancestors, or is more common now in most countries. A citizen of London in Queen Elizabeth’s time could not have imagined our state of mind. He would have thought that it was of no use inventing railways (if he could have understood what a railway meant) for you would not have been able to collect the capital with which to make them. At this moment, in colonies and all rude countries, there is no large sum of transferable money; there is no fund from which you can borrow, and out of which you can make immense works.’

Liquid capital, available for investment in general development work, as distinct from its intensive use on the farm or in the local industry which created it, depends clearly on three basic factors: order, good communications, and credit in a more or less highly organized form. These factors, in combination, are very modern — considerably less than a hundred years old, and their effect has been cumulative and unprecedentedly rapid in the last fifty years, through the piling up of marginal profits on credit transactions.

This process is thoroughly familiar to all of us, yet at this time it seems worth restatement and analysis, since the attitude of governing bodies is being directed sharply toward these marginal accumulations at two points: at the store of capital in individual hands, through various forms of super-taxes and death duties; and at the source of production, through rate-regulation and the control of monopoly and trade agreements. Thus we have to-day the contrast of an immense supply of floating capital, so harassed by regulative propaganda, all over the world, that it is harder than it has been in many years to finance enterprises of the most constructive and conservative sort. Nor must we forget, in speaking of ‘liquid capital,’ that this essential characteristic of fluidity, or availability, has been increased out of all proportion to the world’s total store of capital, by credit organization in connection with the basic factors mentioned above.

When the Fuggers, of Augsburg, built up their banking aristocracy that financed popes and emperors, capital available for development work was much more nearly synonymous with bullion. The Fuggers equipped fleets to trade in the East; they operated mines, and dealt in gold, silver, and copper, as well as in the cloth stuffs that were the foundation of their greatness; and their business was exceedingly profitable: the capital of the house increased from 200,000 florins, in 1511, to 2,000,000 in 1527 and 5,000,000 in 1546. But when they developed a mine, or traded in the East, without the modern distribution of risk and profit attendant upon the use of stock, bonds, or parcel loans, their capital worked slowly, although the profit margin was so high that a modern merchant-banker, who turns his capital over twenty times as often, would scarcely do as well. Modern banking, in fact, works exactly the other way, and seeks quickness of turn-over for a small marginal profit, with risk distributed through the re-pledge of purchased securities, so that a million dollars of banking capital (which is, or should be, the most liquid kind) will probably serve to float, as many ventures to-day as twenty millions would have done in the sixteenth century.

But the very perfection of the devices for assembling capital and getting the utmost service out of it, has undoubtedly been a cause of social friction; money has seemed to flow into certain channels too readily, as compared with the individual worker’s difficulty in obtaining it. Meantime, with ever-widening suffrage and ever-increasing newspaper appeal, the world has about given up the doctrine of laissez faire, and is forging ahead pretty rapidly in social experiment. Since the beginning of the second Roosevelt administration in this country, programmes of governmental control and restriction of enterprises that depend on the constant influx of new capital, have played a new and a highly important part, and there is every indication that they are going further. The wage which commercial enterprise holds out to capital has been modified, perhaps more than we realize; modified so much that certain kinds of development have been retarded seriously, pending determination of the point where capital, when eager for employment, will or will not work under the terms and conditions established by the government.

II

The extent of these changes is easy to forget, unless we make a general survey of the investment field and note what has happened to each component part of it during the last few years. Thus, we might fairly group the bulk of general, unspecialized investment in this country, somewhat as follows:—

Land and buildings.

Government, state, and municipal obligations.

Transportation companies and other ‘public utilities.’

Industrials.

Of these classifications, real estate has probably been affected least, but increases in taxation have been progressive and exceedingly rapid, and we cannot feel that our governing bodies will be likely to work either more cheaply or much more efficiently as the years go on. Indeed, there are indications, both strong and numerous, that public benefits at the taxpayer’s cost are in their infancy in this country, and have much further to go even in those parts of Europe where the tax rate is already far higher than it is in the most reckless American communities. We have yet to contend with any substantial programme of municipal housing, for example, although it has been really forced on many congested foreign cities, usually at a very considerable net cost to the taxpayer.

Land and buildings bear the brunt of this sort of thing. They pay the bulk of the taxes, owing to their unhappy inability to be concealed; and their owners recognize the likelihood that they are pretty sure to be prominent contributors to all the programmes of social betterment arising from the changing tendencies of civic responsibility.

In the case of transportation and other public-utility investments, the present-day changes are, of course, very marked. We see a clear governmental disposition to limit profits to an assumed normal interest rate (as described in the Hadley report) in spite of the economic absurdities which the process may entail. For example, the United States Supreme Court, in the so-called Minnesota Rate Cases, specifically permitted the Minneapolis and St. Louis, which was not earning what the court considered to be a fair return on the investment, to maintain a higher schedule of rates than the Great Northern and Northern Pacific in the same territory. Of course this permission was not worth much to the Minneapolis and St. Louis, which, in open territory, is economically and commercially obliged to maintain rates at least as low as its competitors, or even that business which it has will be taken away from it! Yet this unique commercial maxim, that the proper procedure for weak competitors is to charge more than their strong competitors do, is the goal you must needs arrive at if you determine rates in competitive territory by limiting invested capital to a fixed return; there is no escaping it. The rate that will just permit the best located, best built, and best operated road to earn six per cent, will quite certainly fall short of a living wage for the less fortunate roads in the same district, although they are sure to be performing indispensable transportation services to the farmers and manufacturers along their lines.

Turning this question around, the investor naturally asks why he should contribute any capital to the upbuilding and extension of the weaker roads, and the government has, as yet, no answer to give him. Nor is any inducement held out to capital to perfect the stronger roads. In the Kansas City Southern case, decided in November, 1913, the Supreme Court held that portions of a railroad abandoned in the process of grade-revision work cannot be counted as part of the capital investment (on which the court in the Minnesota cases computed the normal interest return).

Let us see how this works out. The Central Pacific Railroad, as originally located, ran around the north end of Great Salt Lake, through mountainous country, where grades and curvature put a constant burden on traffic. After the Union Pacific consolidations were completed, and the credit of the Central Pacific, through its affiliation, had become strong, the company’s engineers undertook and carried through to successful completion a most extraordinary exploit. At a cost of some $9,000,000, they built a new railroad, 104 miles long, straight across Great Salt Lake on an immense trestle and embankment, and thereby cut off almost 44 miles of linear distance besides taking out some four thousand degrees of curvature and reducing the maximum grade from 89.76 feet to 21.12 feet per mile. The old, crooked, roundabout line naturally lost most of its utility after the cut-off was built, although it was built as well as the resources of its period permitted, and undoubtedly represented an investment of a sum comparable with that which was spent on the cut-off, when we take into account both the first cost and the heavy rehabilitation work which took place under the Harriman control.

Now, to intensify the illustration, let us regard this section of the Central Pacific, from Ogden to Lucin, as an independent railroad, and let us assume that the old roundabout line was, in fact, discarded and dismantled as part of the transportation machine. Under these circumstances, the application of the Supreme Court’s Kansas City Southern ruling would apparently require the Ogden-Lucin cut-off to carry freight and passengers free. It could charge rates which would net six or seven per cent on the capital invested in the new line after deducting the cost of the discarded line. But as the costs of the new and the old lines were substantially the same, such deduction would wipe out the new investment, and a seven per cent return on zero equals zero!

The reader will observe that an escape is provided from this dilemma if the useless mileage be kept alive technically, and if occasional trains are run over it, although this kind of operation is exceedingly costly. The vital point remains, that the discarded-mileage policy set forth in the Kansas City Southern decision encourages piecemeal improvement work (since betterments which do not involve abandonment of line can be added to the investment account on which interest and dividends can be paid if earned); but we cannot doubt that it tends sharply to discourage the root-and-branch reconstruction which has brought about the rapid building up of the American transportation system to its present efficiency.

It is no part of this study to enter into the controversial field of railroadrate regulation, and enough has been said to show how the inducements for new capital to enter railroad development have been cut down. Indeed, the issuing of share capital for new construction has been all but shut off, partly for the reasons outlined and partly because of the difficulty, under various state laws, of getting stock out below par. The promoter and speculative developer have been forced away from stock, which is what ought to be sold for hazardous development, and into bonds, which ought not to be sold for hazardous development. It has been the inalienable right of the American railroad developer, from the earliest times, to be wiped-out for the benefit of the community, but the bondholder recognizes no such privilege. He is a creditor, not a proprietor, and when his bonds default he stands squarely in the path of progress and readjustment until he is taken care of.

It must not be overlooked in this connection that the recent noteworthy extensions of governmental supervision over American industry, the effects of which have undoubtedly been cumulative in the last two years, have fallen concurrently with a world-wide period of economic readjustment, and that the two things have no necessary connection with each other, although it is clear that both have worked together to depress securities and alarm the investor.

Thus an analysis of the present railroad situation discloses many familiar points, mixed up with some of the new ones to which reference has been made. Ever since the recovery from the panic of 1907, operating expenses have pressed net earnings hard, so that the immense increases in gross earnings have been almost entirely absorbed by the increased cost of labor and materials. So far, this is entirely familiar; it had a counterpart in 1903, and has quite regularly followed our successive periods of industrial activity, as in 1890,1884, and 1873. In each of these years there was the same discouragement, the same feeling that the railroads were being obliged to go ahead very rapidly in order to remain in the same place. In each case, also, the readjustment followed promptly. Industry declined; traffic fell off; labor became abundant and efficient instead of scarce and inefficient; the cost of materials (especially those in which the labor cost is relatively high) fell off, so that the roads did a diminished business at less cost, and in many instances were able to give a good account of net profits.

Then, in each case, the return of industrial activity yielded a few exceptionally profitable years, before increasing costs neutralized the traffic gains. This much is familiar, and history can be counted on to repeat itself. The new factor to-day is the double government supervision under the Interstate Commerce Act and the Sherman Act, both of which are duplicated and reduplicated in their essentials by a mass of state legislation. The Erdmann Act, in its application to wageincreases, is also a new factor, but scarcely a first-class one.

The reluctance of the Commerce Commission to allow rate advances has received abundant comment; much less attention has been paid to the reluctance of the railroads to enter into rate wars, as they habitually used to do in periods of declining traffic. The fact that they are no longer free to make voluntary advances has made them give up entirely the struggle for temporary gain through voluntary decreases, such as characterized the demoralization of the whole rate structure in the early eighties. Most happily deprived of the rebate weapon, the weak roads have sometimes been able to gain special traffic by giving special service; in other instances they have gone along a narrow path with little in prospect but ultimate starvation, but their struggles have not embroiled the whole competitive situation, as they used to do.

The matter may fairly be summed up with the comment that the early conception of the Interstate Commerce Commission as a St. George to the railroads’ dragon—as it has been well characterized— seems to be working around to a point where public policy is beginning to distinguish between regulation and chastisement. Yet it is quite plain that the ‘fair-return’ doctrine is in for a trial, and will carry with it a full measure of indirect chastisement for the unoffending weak roads; the very ones that have never yet been able to pay a legal rate, if indeed they have paid any rate at all, on their original cost of construction.

From an investment standpoint, however, there are certain important offsets to be considered. The gradual development of the ‘fair-return’ point of view (which, of course, does not propose that the receipt of the fair return shall be guaranteed to anybody) has been exceedingly discouraging to new enterprise. This is bad for the country, especially for the undeveloped portions of it, but in so far as it checks speculative movements for competitive railroad building, as, for example, the paralleling of the New York Central by the West Shore, it will be viewed with complete satisfaction by the existing roads. With an embargo on new ventures, it would not take many years for normal traffic growth to make profitable railroads out of most of the country’s weak mileage.

Thus we have presented the clear paradox of a governmental policy which elaborately goes to work to break up railroad combination (as in the Union Pacific case) in the supposed interest of competition, while it effectively shuts off the real, virile competition which follows new construction, by removing the incentive to construct. Many observers see government ownership as the only ultimate solution for difficulties of this sort; difficulties which crowd one another’s heels when safety regulation, wage regulation, and rate regulation, on the one hand, are combined with stock and bond regulation and restricted return on investment, while there is constant effort to find means of disrupting existing railroad systems under the Sherman Act.

III

But government ownership is not a question that specially concerns the investor to-day. The financial programme which would be involved in out-and-out purchase of the lines seems unworkable just now, although a system of leases with a guarantee of dividends on an agreed basis, perhaps lower in some cases than existing rates, might possibly be worked out. This, however, is clearly a matter for future years; neither the necessity for so hazardous an experiment nor any real demand for it is apparent now. In no case should the prospect hold any special terrors for the investor.

I cannot avoid the conclusion that railroad securities in this country are going to find their way back again, cautiously but surely, to the place of preëminence. It is worthy of note that, if the government makes a serious attempt to restrict the total of interest and dividends to a specific return on capital invested, most of the mileage of the country will fall short of a fair return, to-day, on its total investment, so that most roads have room for legal progress upwards, while the inducement to new competition would not be apparent. Moreover, I should rather anticipate the gradual growth of a public policy that would permit rateincreases to balance wage-increases, on honestly managed roads, up to the standard of the statutory six or seven per cent. How this is going to be accomplished, nobody knows, for, as has been pointed out, the rate scale that will just enable the strong road to earn its seven per cent will usually bankrupt its weaker competitor— and bankrupt roads are not a campaign asset for the party that did it. But if we make the daring assumption that the government, through physical valuation, can fix the rate of return as a statutory principle, I cannot see that it menaces the security holders of the strong roads. Viewed as a matter of public policy, the idea seems almost ludicrously bad, but with that we are not concerned.

The inferior position of the weak roads has already been discussed. But here rises traffic density as a silent, unnoticed champion for them, if only new capital can be kept from competing. Traffic density rests on population, not on legislation, and is, in fact, quite unterrified by the latter. The number of roads which the growth of the country has taken from the weak group and definitively placed in the strong group since 1900 is quite extraordinary; that phase of the situation has received but little attention.

It must be noted that the rehabilitation of some of these roads, such as the Northern Pacific, the Union Pacific, the Santa Fé and the Kansas City Southern, was immensely facilitated by the pouring into them of great sums of speculative capital, which will perhaps be less easy to come by when the next group of weak but growing roads seek rehabilitation funds from their bankers. The difficulty which such roads have had, during the past two years, in getting any sort of financial accommodation has, of course, been apparent to everybody; but it is impossible, just now, to separate the respective weights of government policy from those of world-wide credit strain, in determining the final cause of this. I think it would not be hazardous to assert that both factors have worked together.

If the roads mentioned above had abundant resource to speculative capital, however, another group, almost equally successful, has been able to develop without it, by the use of current earnings supplemented by short-term borrowings. The Southern Railway, the Seaboard Air Line, and the Erie, have done this with conspicuous success, although the Erie perhaps came as near bankruptcy in 1908 as any road that has ever escaped it.

Given a deterrent to competitive speculative enterprise, and a rapidly growing country, and I am inclined to think that the railroads will work out their problems successfully, even with the curious economic handicap of a public policy which seeks to limit capital’s maximum return to a low percentage, without any compensating guarantee of a minimum return. It may be taken for granted that we shall have to face, as we have already faced, much that is crude, in the outworking of the governmental policies; much, too, that is unnecessarily harsh, and, in places, grossly unfair. But there is just as much precedent for thinking that the details of administration will become progressively less burdensome and more intelligent, after they find their way into routine channels, and are removed from the sphere of active political discussion.

Thus, I should imagine that capital seeking a high degree of security as its wage (coupled with a broad market and ready convertibility) would find these essentials in railroad securities in the future to even a greater degree than in the past. On the other hand, if speculative capital, which has played so vital a part in building up the country, is to be, for a time, driven away from new ventures, it can still seek its profits in the swings of the market on existing railroad shares, and in purchase of railroad securities which seem to be on the verge of going from the weak class to the strong, with consequent likelihood of appreciation. Few speculative investors are as much concerned with dividend rates as they are with appreciation of principal; a point of view which is entirely sound, in relation to the larger chances of profit.

IV

Government, state, and municipal securities have also been affected profoundly, although in quite a different direction, by the socialistic drift of the last decade. Governmental extravagance, resting on the easy principle of spending somebody else’s money, has increased progressively to a point where the annual output of securities to provide funds for public betterment work looms up out of all proportion to what would have been regarded as a normal increase, even a few years ago. Public obligations of the best grade have always commanded the highest prices of all investment securities, but for many years past, the holder of such bonds has seen new issues come on the market in ever-increasing amounts, while prices have steadily declined. This fact, combined with the world’s tremendous conversion of capital into fixed forms, has had the practical result of lessening the market for public obligations at the same time that the output has increased. The holder knows that his security is unquestioned, but he does not want to lose his profits by buying in a falling market, and he is well aware of the fact that state and municipal bonds of the highest grade, bought ten years ago and sold to-day, show a loss of ten to twenty points; a loss which would, in many cases, reduce the total return on the investment close to the vanishing point.

Moreover, the buyer of state and municipal bonds must close his eyes to degrees of bad book-keeping and uneconomic finance which would never be tolerated in the administration of a railroad. State highway bonds, issued for a long term to pay for roads which motor-traffic may be counted on to destroy in about three years, are a case in point. Nor is there any relief in sight for this general situation of heedless, irresponsible public finance, except, perhaps, in an extension of the ‘city manager’ plan of government, which has been utilized abroad with conspicuous success, and has already made small but hopeful beginnings in this country.

Just now, the market for public obligations is better than it has been in several years, although prices are far from former levels. The stimulus was given by the provision in the incometax law which not only exempts our government, state, and municipal securities, but does not require them even to be reported in the taxpayer’s list. The feeling is undoubtedly widespread that the government is, in effect, conducting an inquisition, and that future social legislation is apt to utilize the information brought out, especially as affecting the surtax. As a matter of fact, local taxes, at the present time, are nominally much more burdensome than the income tax, but the investor, except when handling trust funds, does not ordinarily disclose his list to the taxcollector. Instead, he often compounds on an arbitrary assessment, which local authorities fear to press to the limit because of the ease with which legal residence can be changed, or bonds converted into tax-free stocks. But the payer of the income surtax feels singularly friendless and devoid of representation, and does not altogether like the look of things ahead.

The matter may perhaps be summarized fairly by saying that public securities owe much of their new-found popularity to the fact that capital does not have to admit owning them, but that their broader economic status leaves a good deal to be desired.

V

The ramifications of the new democracy have reached industrial investments from still another angle. Bonds and stocks of small industrial companies have always been regarded as extra-hazardous, for a number of reasons. The ability of the management is a factor of immense importance, and may change overnight. But fully as serious an obstacle, from the investor’s stand-point, has been the risk attendant upon changing market and competitive conditions. And it is frequently as difficult to sell a hundred shares of local industrial stock as it is to sell the company.

Eor these reasons, and a good many others which need not be enumerated here, investors have usually preferred large industrial ventures to small ones, although it is not much more than fifteen years that the securities of industrial corporations have been regarded as suitable investments for general funds in this country.¹

But the recovery from the ‘long drag’ after 1893, brought with it the conception of industrial consolidation and finance on a grand scale, — and it was grandly overdone. In 1901 and 1902, it seemed as if any sort of consolidation would be sure to break new barriers of prosperity if only you could get everybody into it, so that prices could be controlled, trade-arrangements dominated, and ‘overhead’ reduced, by concentrating in one superhuman office the problems that had kept fifty offices busy. It was amazingly easy to sell the securities of these ventures, and the arguments for their existence were plausible, and in many cases correct. Only within the last year or two have the doubters openly maintained that great consolidations do not necessarily gain in efficiency what they lose in flexibility, although 1903 and 1904 demonstrated how slight their control of prices was apt to be.

Yet in the condition of pandemonium now enveloping the great industrial companies because of the hit-andmiss character and application of the Sherman Act, there can be very little doubt that the thing they are being punished for (that is, alleged price-control) is just the thing that they have been least successful at, although it would be greatly to the advantage of trade if they could manage it. Healthy competition has a great deal better chance of staying healthy in a trade where prices tend to be stable than in one where price wars periodically demoralize the industry and kill off the little fellows.

The upshot of the matter seems to be that the industrial organizers of a dozen years ago went too far in their assumptions of the efficiency and the potential trade-control of immense aggregations of manufacturing and distributing units, while they clearly overlooked the fact that they were generating a feeling of suffocation on the part of the small dealer and the consumer which would sooner or later lead to legislative retaliation. On the other hand, any observer of the erratic interpretation and administration of the Sherman Act would be apt to feel that the government, in its efforts to break up trade-conspiracy, has been chasing a good many economic butterflies, and that its harsh utilization of a law which comes near making it unlawful for two competitors to discuss together any programme of mutual trade-benefit, has been of more service to politics than to honest business.

We are not at present concerned with any aspect of the Sherman Act except its effect on the innocent and bewildered investor, but I think nobody will dissent from the proposition that the law and its sensational methods of enforcement have come near removing entirely from the field of conservative investment a considerable group of industrial enterprises which would otherwise attract capital, to the benefit of all concerned. Nor is there any prospect of real relief from this situation until the public ceases to believe that the ideal state of affairs exists when steel companies and coal companies and beef-packers are educated to overproduce, break one another’s prices, and rush down a steep place into the sea of bankruptcy. The salient point is that the investor is quite clear in his desire to avoid the kind of situation which the Sherman Act, as at present interpreted, seems to foster.

Attention is being concentrated, just now, on the interests, or supposed interests, of the consumer, and nobody is thinking much about the producer. Yet when we try to find the consumer and congratulate him, he almost always turns out to be producing something himself. We are pretty sure to reach the conclusion, eventually, that the consumer who does not also produce is as insignificant, numerically and politically, as the man who pays the surtax. In fact, we find ourselves face to face with the terrible suspicion that the non-producing consumer is nobody in the world but the surtaxpayer himself— and surely nobody intended to give him legal protection.

Yet when capital cries out in a loud voice that it will be forced to remain inactive because of the new hazards which have been attached to investment by socialistic governments engaged in the pursuit of votes, we know that this threat, while logical, will not be carried out. Whatever else capital does or does not do, it can be counted on not to remain idle, except during temporary periods when it is severely frightened. It must go out into the world as any other worker does, and struggle for its wage, even though all governments (to paraphrase Professor Sumner) shall unite in authorizing A and B to instruct C how to spend D’s money. But there are a great many parts of the world where capital can find profitable and safe employment to-day, and it seems to me that the tendencies of national development, in this country and elsewhere, are going to be governed to a somewhat larger extent than we realize, by the respective pains which are taken to keep visiting capital well fed and well housed, and, in general, satisfied with the conditions of its employment.