15 September 2011

Dotcom Fever

Andrew Odlyzko, whose perceptive studies of dot com fever I've noted elsewhere, has released Charles Mackay's own extraordinary popular delusions and the Railway Mania [PDF].

He comments that -
Charles Mackay's book Extraordinary Popular Delusions and the Madness of Crowds enjoys extraordinarily high renown in the financial industry and among the press and the public. It also has an extraordinarily low reputation among historians.

This paper argues that Mackay's sins of commission were dwarfed by his sins of omission. He lived through several giant investment manias in Britain, yet he did not discuss them in his books. An investigation of Mackay's newspaper writings shows that he was one of the most ardent cheerleaders for the Railway Mania, the greatest and most destructive of these episodes of extreme investor exuberance.

Mackay's story provides another example of a renowned expert on bubbles who decides that "this time is different." His moves through a sequence of delusions help explain the length and damage of the Railway Mania. He was a free market and technology enthusiast, and faced many issues that are important today, such as government ownership or regulation, interconnection, standardization, structural separation, and analogs to net neutrality. A crushing national debt and high unemployment in an economy pulling out of a deep depression (and in perceived danger of falling into another one) were very important in shaping attitudes towards railway expansion. The analogies and contrasts between Mackay's time and ours are instructive.
He concludes that -
Always an enthusiastic supporter of technological and economic progress, as well as of free markets, he started out with moderately cautious expectations in the fall of 1844, but then developed into one of the most rabid proponents of railway expansion. He fully partook of the principal delusion of the Mania, namely that a huge expansion of the railway network could be carried out with profit to both the nation and investors. He never wavered in this belief, even as events and opinions of others led to him to modify some of his positions and fall into other delusions. He did not recover his senses during his time at the Argus.

Mackay’s blindness to the fatal defect of the Mania was essentially universal among his compatriots, and appears common during financial manias, part of the conviction that “this time is different” [39,45]. It is notable that while he put serious thought and effort into combating the poetry of Wordsworth and the warnings of The Times that he perceived as hostile to rapid railway expansion, he did not even bother refuting the (relatively rare) warnings that the new lines would be unprofitable. He apparently did not think they were credible enough to be worth attacking. Can bubbles be recognized before they they inflate too far? That is still an open question. However, it is clear that without searching for bubbles, one will not find them. Most observers of the past decade did not even look, and neither did Mackay.

Mackay’s enthusiasm for railway expansion was likely sustained from 1846 on by the prospect that the bountiful profits from this industry would relieve the burden of an oppressive national debt. This enthusiasm was probably also reinforced by his vision of being able to control undesirable behavior of an infrastructure monopoly through modifications of charters of the expected waves of new entrants. This vision enabled Mackay to stick to his laissez faire views. It is amusing that it was only the Sunday trains issue that led him to abandon his cherished doctrine and call for government intervention.

Mackay’s story helps explain why British investors were so slow to recognize and acknowledge their impending doom. At the height of the Mania, in the fall of 1845, the most prominent skeptics, such as James Morrison, James Wilson, and The Times, were warning investors that fast railway expansion would lead to declines in share prices through the pressure of capital calls and the disruption of financial markets. When share prices started to decline, as they predicted, the cause for the decline was assumed to be the one they had presented, namely the pressure of the “calls,” the demands from railways for money from shareholders. But the fundamental problem of the industry was that the new projects were not going to be profitable. Even after calls stopped, railway share prices remained at the depressed levels seen in 1849–50 in Fig. 1. The decline in prices visible in that figure was likely the result of increasing numbers of investors guessing or deducing that profits were going to disappoint. But public discussion was fixated on the issue of calls, and the realization of the size of the investment disaster was slow to come [40].

Mackay was more gullible than most, as the discussion of Mesmerism and other topics in this paper demonstrates. However, even far deeper and more perceptive of his contemporaries, such as James Morrison and James Wilson, also suffered from the main delusion of the Mania. Railways were not just investments with promising profit prospects for individual investors, they were a dazzling new technology that was transforming society, “annihilating time and space,” in a phrase that was heard frequently at the time. Bentinck, Disraeli, and others credited them during the discussions of how to relieve the Irish Famine with having miraculously pulled Britain out of the deep depression of the early 1840s. Few were able to resist the siren song. The one who managed to stay sober the best was Dionysius Lardner, see [37]. His 1846 survey of the railway industry [22] pointed out most of the fatal defects of the Railway Mania. Lardner had once been an insider in the British scientific establishment, but then disgraced himself and ended up spending several years traveling in the U.S. At the time of the Mania he was living in Paris. His varied experiences, status, and location likely all contributed towards maintaining a distance from the British herd, and enabled him to see what was wrong.

The story of Mackay’s extraordinary popular delusions is amusing. But it is also instructive. It shows how crowd effects and personal biases influence decision making in times of rapid change and poor information. It suggests that it would be worthwhile to investigate the reactions of various other individuals from the Railway Mania period. There seemed to be a great reluctance among participants in this episode of extreme investor exuberance to even acknowledge their involvement in it and to analyze what happened. As just one example, John Stuart Mill’s publications and correspondence do contain a few interesting passages about railways, but we have to go to archival sources, as in [6], to learn that he was involved in some of the most speculative railway projects with the Glenmutchkin flavor. More investigations, especially in cases, such as that of Charles Mackay, where we can find extensive contemporary documentation about particular individuals’ thoughts and writings, could help illuminate the Railway Mania and lead to a better understanding of manias in general.