A DISCUSSION OF
SOME OF THE
FUNDAMENTAL CONSIDERATIONS
INVOLVED IN A
SATISFACTORY SOLUTION
OF
THE RAILROAD PROBLEM
JOHN E. OLDHAM
THE RAILROAD PROBLEM
A satisfactory and permanent solution of the railroad
problem calls for the consideration of many complex ques¬
tions on which there is much difference of opinion. The
various plans presented, however, indicate that this dif¬
ference relates more to the methods to be employed than to
the purpose to be served.
As to the purpose, the Railway Executives, in submitting
their plan to the Senate Committee on Interstate Commerce,
begin with the declaration that "the fundamental and es¬
sential purpose to be accomplished is to furnish the public
with safe, efficient and adequate transportation at the low¬
est cost consistent with such service and with due regard
to the best interests of the owners and employes and, also,
adequate to the Nation's needs even in times of great na¬
tional emergency or peril." Again, Former Secretary Mc-
Adoo, in his argument for a five-year extension of the period
of Federal Control before the same Committee, stated that
"the railroads are public servants and in times of peace the
first consideration should be to furnish adequate service
at the lowest possible cost." The Interstate Commerce
Commission, testifying in regard to the future of the rail¬
roads, stated "that whatever line of policy is determined
upon, the fundamental aim is to secure transportation sys¬
tems that would be adequate for the Nation's needs even
in time of national stress or peril and that will furnish to
the public safe and adequate transportation at the lowest
cost consistent with that service."
Other plans have been offered with similar statements
and it therefore seems fair to conclude that any plan to be
generally acceptable must be developed along lines which
will aim first of all to supply transportation at the lowest
cost consistent with satisfactory and adequate service, thus
recognizing the public interest as of primary importance
and paramount to any individual or private interest.
1
Possible Methods of Solution
As to methods, it has been said, broadly speaking, that
there are three permanent solutions of the railroad problem
—or three general lines along which plans might be devel¬
oped—and these have been briefly outlined as follows:
"To have outright government control of all the rail¬
roads."
"To send the railroads back into the private control of the
several hundred old companies."
"To reconstruct the railroad map along logical lines so
as to wipe out these hundreds of different railroad com¬
panies and substitute a comparatively few companies which
under close and strict Government control can be expected
to combine the advantages of Government control, includ¬
ing unified control of these roads where it is needed, with
the advantage of the initiative of private management."
The first method would provide for Government control
and management; the second and third for private control
and management. Again, the first method would result in
the entire elimination of competition; the second would
result in maintaining extensive competition among a large
number of companies operating under varying and unequal
conditions; the third would limit competition to a relatively
few companies operating under somewhat similar con¬
ditions.
Government ownership and management and the extent
and kind of competition which should be preserved are thus
fundamental questions and because of their important
bearing on the future railroad policy of the country, should
be carefully considered before an attempt is made to formu¬
late a permanent plan in detail.
Impracticabilitp of Government Ownership
In regard to the question of Government ownership and
management, no extended discussion seems necessary. It
should be sufficient to suggest that history in this country
and elsewhere furnishes so few examples of successful gov¬
ernment management of business enterprises that there is
2
little reason to expect that this method would prove either
as efficient or as satisfactory to the public as private control.
The conclusion that the public interest will be served
better under private management is well supported
by the recent report of the special committee of the Mer¬
chants' Association of New York, which was appointed to
consider the subject of municipal, State and National op¬
eration of utilities. In dealing with the causes of the fail¬
ures of Government management in general, the report
says:
"No business, whether public or pi'ivate, can be operated
efficiently and without great waste under the constant in¬
jection at the top of new, untried and often unfit executives
and managers; nor with the rank and file deprived, by lack
of opportunity for advancement, of the incentive to zeal
and energy.
"Political expediency is nearly always the determining
consideration in appointments to the higher places. Those
places are the rewards of political service, and the appoint¬
ees, while perhaps proficient politicians, are seldom pro¬
ficient business executives. Their immediate subordinates
are likewise appointed for political reasons, and fitness is
a secondary consideration.
"Thus the executives under political control are often
without business experience or capacity; they are usually
without the long experience, the intimate knowledge, and
the special ability and skill indispensable to highly efficient
administration and their official acts are often directed by
political methods opposed to the proper conduct of the
business undertaking.
"These initial defects, due to political methods of selec¬
tion and inseparable from political control, are magnified
and perpetuated by the changes which follow every election.
Because of these frequent changes executive officials seldom
remain in office long enough to acquire the experience and
learn the sound methods necessary to efficiency and econ¬
omy. At frequent intervals the executive heads are all,
or nearly all, supplanted by new appointees, likewise with¬
out the qualifications necessary to fitness, and whatever
3
progress toward sound administration may have been re¬
cently made is likely to be nullified by changes in methods
which almost always follow changes in officials.
"Lack of opportunity in the lower ranks of the public
service has a deadening influence upon the zeal and energy
of the entire body of minor officials and the clerical staff.
The higher offices, with their larger salaries, being usually
bestowed as rewards for political services, are seldom open
to minor officials and clerks, however capable and however
meritorious their services. Therefore, they cannot rise
beyond a modest minor position. As there is little oppor¬
tunity to rise, and therefore no sufficient reward for ability
and initiative for exceptional diligence, application and de¬
votion to duty, the minimum of service is given.
"The conditions of incompetent administration at the
head and perfunctory service in the lower ranks are fatal
to economic efficiency. The administrative heads, knowing
little of the business, are not capable of devising and in¬
stalling really efficient methods. They are therefore con¬
tent to let the old methods continue, as the easiest way of
getting along. The lower officials have neither the incentive
nor the power to depart from methods in which they have
long been trained and to which they have become wedded
by long usage; in fact, any attempt at change is usually
resented and resisted.
"Hence the business proceeds almost wholly by force of
long-entrenched routine, impervious and hostile to new
methods, ignorant or unregardful of waste and inertia, hat¬
ing reform, and deadly to the spirit of progress and
efficiency; while in the case of private operation we find
continuously brought into play the qualities and the condi¬
tions which tend to maximum business efficiency—experi¬
ence, knowledge, special training, and the zeal arising from
opportunity and self-interest.
"The conditions that produce this result cannot be
changed so long as popular choice and frequent changes
of officials remain fundamentals of our political systems."
This is a characteristic statement of the conclusions
which seem to have been almost universally reached by
4
those who have studied intimately the workings of Govern¬
ment ownership and operation in general and are especially
.applicable to the railroad situation.
Desirability of Eliminating Wasteful Competition
In regard to the matter of competition, consideration
should be given to the amount and kind of competition
which promises the most satisfactory results, taking into
account the cost of operation and the quality of service.
It may be assumed that competition in rates is not to
be desired and is not consistent either with the public in¬
terest or the interest of security holders. Competition of
this kind will, therefore, be passed without discussion.
The elimination of competition in rates leaves to be con¬
sidered other forms of competition, particularly competi¬
tion in service and facilities—and especially from the point
of view of its effect, in waste in operation and in waste of
capital. Competition in service, as well as competition of
other kinds, must also be considered from the point of view
of their importance in fostering and stimulating individual
initiative.
Considering first the economic effect of competition in
service, it may be pointed out that in order to overcome
much of the waste in operation which formerly existed un¬
der private management, as well as to facilitate the move¬
ment of traffic, the present Railroad Administration has
made numerous changes in operating methods and it
is quite generally agreed that many of these changes prom¬
ise to be of such value that they should be preserved
whether operation in the future is to be under public or
private management.
Without attempting to discuss these changes in detail,
it may be said, generally speaking, that they have been
made with a view to a reduction of operating expenses by
more economical routing of traffic—that is to say, by mak¬
ing use of the shortest routes as well as routes uncongested
by traffic; by such control of traffic at the sources as will
prevent congestion at the terminals; by better distribution
5
and control of the car supply of the railroads as a whole;
by the reduction of unnecessary passenger train service;
and by other means which need not be enumerated at this
time.
It may be said further that it is expected to accomplish
these results by a more extensive joint use of facilities and
by greater co-operation in handling traffic than has been
possible under existing laws, or can be expected without a
more extended common interest in the results of operation
of the properties as a whole. If this purpose were carried
out, competition would necessarily be greatly reduced, for
unification and competition are not consistent.
A more extensive joint use of properties would not
only reduce waste in operation, but it would serve
also to prevent waste of capital by making it un¬
necessary to increase the capacity of individual properties,
or to construct new lines, when traffic requirements could
be met as well, or better, by the more effective use of facil¬
ities already existing. It is plain that the cost of service
is increased, and an unnecessary burden is thus placed upon
the public when capital charges are increased in order to
provide facilities of greater capacity than necessary to meet
the demands of satisfactory and adequate service.
The public interest accordingly will not be served by a
railroad policy which fails to make the most effective use
of existing facilities or encourages further duplication of
investment in terminals, tracks, equipment or other facili¬
ties which would not be necessary if there were a larger
common interest in operation and in the ownership of ex¬
isting properties.
Desirability of Eliminating Weak Systems
Greater unification of operation and control in addi¬
tion to eliminating waste in operation and waste of capital
among competing companies will serve also to overcome in
large measure the disadvantages to the public which result
from the disparity in operating and financial conditions be¬
tween strong and weak systems serving the same territory
even though not directly competing in service.
6
It is well understood that some of these roads, having
cost more to construct than others, require higher rates to
offset charges upon the larger investment in their prop¬
erties; and others, being less advantageously located, re¬
quire higher rates to offset higher cost of operation, even
though operation is as efficient as circumstances permit.
It is clear, therefore, that rates which permit a majority
of the most favored roads to earn an adequate return on
their investment are insufficient to provide a fair return
for the roads which have required a greater investment or
are less advantageously located. On the other hand, rates
sufficiently high to provide compensation which the prop¬
erty investment of the weak roads may justify provide
too liberal a return for the strong roads and thus placq an
unfair burden upon the public.
The maintenance of strong and weak systems under
these conditions is, therefore, a burden on the public,
whether in the form of excessive rates to enable the weak
roads to be prosperous, or, in the form of inefficient opera¬
tion and unsatisfactory service if the weak roads are al¬
lowed to remain unsuccessful.
Desirability of Preserving Individual Initiative
While there appear to be sound reasons for materially
reducing much of the existing competition in service, it is
possible, nevertheless, that some competition of this kind
may be retained without the economic losses which have
been referred to when such competition is too extensive.
Consideration should be given to the contention that such
competition is essential as an incentive to individual ini¬
tiative. It is held that without such incentive, railroad
development would be retarded, railroad managements
would be less energetic and less progressive and service
would be less satisfactory.
The importance of preserving individual initiative is not
questioned but it is still necessary to consider the extent
to which incentive is supplied by competition in service
and facilities and the extent to which it is dependent upon
other factors. This is largely a matter of opinion and
7
cannot be satisfactorily determined by evidence which
is entirely conclusive. It may be said, however, that
there is evidence to indicate that this incentive is
more largely dependent upon proper inducements to capi¬
tal and upon such competition—if it can be called competi¬
tion—as arises from the force of example than upon com¬
petition in service.
Consideration of the circumstances under which invest¬
ments have been made in public utility enterprises suggests
that competition in service has not been an important fac¬
tor in the development which has taken place in recent years
at least. Investment in electric light and power companies,
local transportation and telephone companies now amounts
to approximately $15,000,000,000, according to reliable esti¬
mates—a total which nearly equals the investment in the
railroads of the country; and a considerable part of this
investment has been made under conditions where compe¬
tition and duplication of service were prohibited.
The growth of these companies continued so long as
proper inducements were offered to capital. On the other
hand, development was checked when these inducements
ceased to be sufficiently attractive. While it is clear that
the growth which has taken place has been largely the result
of inducements offered to capital, it is fair to conclude that
improvements in methods of operation and higher stand¬
ards of efficiency have been due largely to the existence of a
reasonable number of separate, independent companies op¬
erating under different managements. For the most part,
uniform accounting methods have been generally adopted
and it has thus been possible, by intelligent comparison of
the results obtained by companies operating under similar
conditions, to determine the best methods of operation and
to establish standards of efficiency which all companies
have been expected to attain.
Unification of properties and facilities should not be car¬
ried to a point where there would be no diversity of man¬
agement, but, as among public utility companies, while it
should be the aim to eliminate wasteful competition, there
should still remain competition in management by the pre-
8
servation of a sufficient number of separate organizations
to provide a basis for comparing different operating and
financial methods.
By intelligent comparisons it should be possible to de¬
termine whether the railroad business of a community is
being handled efficiently and economically just as it is pos¬
sible, by comparing one electric power plant with another,
to determine whether power is being generated economi¬
cally and, by comparing other operating details, to de¬
termine whether the electric business as a whole is being
managed according to accepted standards.
In providing a sufficient number of railroad organiza¬
tions to give comparison of operating results and methods,
it should be the aim to maintain systems where there would
be the greatest similarity in operating conditions. This
would involve in itself a certain amount of competition
among strong systems operating in the same territory, but
the wasteful competition could largely be done away with,
through arrangements for the pooling of traffic and facilities
or through other co-operative methods under proper re¬
strictions. Such companies as existed would afford the
incentive coming from intelligent comparisons and the force
of example; and if to the force of example were added the
stimulus of proper financial reward the incentive would
probably be sufficient to insure high standards of opera¬
tion, efficiency, and progress.
Summary of Methods to be Followed
Summarizing the foregoing, it seems clear that a rail¬
road plan, to be consistent with the principle of the most
satisfactory service at the least cost, should be developed
along lines which will aim to preserve private ownership
and management; (it may be assumed under such Govern¬
ment control as will fully protect the public interests) ; to
abolish competition in service which is likely to result in
any substantial waste in operation or waste of capital;
and to overcome the objection to the existence of weak sys¬
tems where conditions are not favorable for efficient and
economical operation. It should further aim to stimulate
9
individual initiative by continuing a reasonable number of
large systems operating under conditions sufficiently alike
to make a comparison of operating statistics of value, and
through them to establish standards by which results can
be satisfactorily measured.
Such a plan would obviously follow the third method of
the solutions referred to at the beginning of this discussion,
where the number of railroad companies would be relatively
few. This would require the co-ordination of facilities of
existing systems to a large extent, either by the consolida¬
tion of properties or by some arrangement which would
permit them to be operated and managed more nearly as
a unit.
All of the considerations which have been stated above
seem to show conclusively that such a policy with regard to
the railroads, namely, the retention of a comparatively
few self-supporting systems, is best suited to the principle
which it is desirable to follow, and it is believed that it
can also be shown that such a method of solution is the
one most easily adapted to the facts and conditions of
the railroad situation as they exist at present.
Consolidation Along Natural Lines
Certain phases of these facts and conditions, and their
history, are significant as showing that the suggestions
made above for further unification are consistent with the
tendencies which have developed the transportation sys¬
tems of the country in their present form.
In the early days of the railroad industry, distribution
of commodities was on a much narrower scale than at pres¬
ent, and small railroad systems were built by local capital
to meet local needs. As these railroad systems gradually
met and through connections were established it became
possible for commodities to be carried into a very much
wider field of distribution. Industries sought new markets
and the railroads sought new business, and the result was
a much greater distance of travel for commodities and a
necessarily much closer connection between the railroads
of the various parts of the country.
10
The necessity of carrying goods greater distances led to
the establishment of traffic relations between connecting
railroads, and finally to actual consolidation of roads which
formed main highways of transportation. Intercompany
relations were brought about by mergers, leases, stock con¬
trol, or by traffic connections so permanently maintained as
to become traditional.
In this process of uniting the main lines of communica¬
tion, it was quite natural that the stronger and better situ¬
ated lines should consolidate and that the smaller and less
favorably situated properties should frequently be left to
shift for themselves; and this fact accounts, to some extent,
for the inequalities between the strong and the weak roads
as they exist today.
These consolidations seem for the most part to have fol¬
lowed natural lines and to have been for the good of the
communities served. While some injustice may have arisen
through the entire railroad service of a district falling into
the hands of a single group of interests, yet, as a general
thing, the service provided by the larger and stronger com¬
panies has been superior to that which could have been
furnished by a number of smaller companies operating the
same mileage.
It is probable that further consolidations would have
taken place and more complete unification of properties
would have been brought about had not the courts decided
that legislation primarily enacted to control large com¬
binations of capital in industrial enterprises was equally
applicable to railroads.
If it is now thought desirable to revive this tendency
toward combination along natural lines so as to create a
few large and self-supporting systems as outlined above,
it may be advisable to study the direction which this
consolidation was taking, at the time of its suspension,
with regard to affiliated ownership of various lines and also
to study the natural traffic alliances which exist even
though no permanent financial relationship has been estab¬
lished. It is believed that a study of this kind will show
that progress toward unification has been made to a much
II
greater extent than is generally realized and that the prob¬
lem is very much simplified because of this fact.
Basis for Consolidations
The Report of the Interstate Commerce Commission for
the year ended June 30, 1916, shows that in the United
States there were 178 Class I roads—that is, roads with
an annual gross operating income of $1,000,000 and up¬
wards, and 268 Class II roads, or roads with an annual
gross operating income in excess of $100,000 and less than
$1,000,000. The combined earnings of all Class I and
Class II roads for the year were $3,456,932,641, of which
$3,381,597,866, or 97.8 per cent, were earnings of the Class
I roads, and $75,334,775, or 2.2 per cent were earnings of
the Class II roads.
Present purposes will be served by considering only
Class I roads. While many of these systems maintain sep¬
arate corporate organizations and make separate reports,
the number which maintain entire financial independence
is materially smaller. For example, the Pennsylvania Rail¬
road and its affiliated companies own a majority of the
entire capital stock of 11 of these systems; the New York
Central, 9; the Atlantic Coast Line and Louisville & Nash¬
ville, 9; the Southern Railway, 8; the Northern Pacific, 8;
the Southern Pacific, 7; and there are numerous instances
of similar relationships among the remaining companies.
If it be assumed that control through stock ownership es¬
tablishes such unification of interests that the various com¬
panies grouped in this way can be properly considered as
individual systems, the number of separate and independ¬
ent systems would be reduced to 85.
In the Eastern District the combined earnings of 10 sys¬
tems computed upon this basis, amounted to $1,328,833,504,
or 87.44 per cent of the earnings of the entire district. The
combined earnings of the 19 remaining roads amounted to
only $190,811,564, or 12.56 per cent of the whole.
In the Southern District the gross operating income of
5 systems amounted to $445,341,909, which is equal to
88.22 per cent of the whole, the balance, $59,475,126, which
12
is equal to 11.78 per cent, being divided among the 12 re¬
maining systems.
In the Western District the gross operating income of
7 systems amounted to $908,217,657, or 66.92 per cent of
the whole, the balance of $448,918,106, equal to 33.08 per
cent, being divided among 32 systems.
Combining these three districts, the total earnings of
the 22 systems amounted to $2,682,393,070, which is 79.3
per cent of the combined earnings of the Class I roads of the
country as a whole, the balance, $699,204,796, being divided
among 63 systems.
It will be seen from these figures that the process of
co-ordinating and unifying the transportation systems of
the country is already well advanced. If it be assumed that
such co-ordination of facilities as has already taken place
among the railroads mentioned above is the result of nat¬
ural traffic relations, and that it is desirable to continue this
policy, the best solution of the railroad problem would be
to develop a plan which would aim to preserve the larger
and stronger systems as they exist at present and provide
for further unification with these systems as a basis.
While it is probable that these 22 systems might con¬
tinue to operate independently without any great dis¬
advantage to the public from an economic standpoint,
nevertheless, if it appears to be desirable, some further
combinations among these 22 systems could be readily made
so as to materially reduce this number.
Possible Grouping
In order to make the situation clearer two statements
have been prepared, the first of which shows the gross op¬
erating income and mileage of these 22 systems whose
combined earnings represent 79.3 per cent of the gross
operating income of all Class I railroads in the United
States for the year 1916; and the second a tentative sug¬
gestion for 13 systems resulting from further unification.
These statements follow and are marked Exhibit A and
Exhibit B.
13
EXHIBIT A
CORPORATE NAME
EASTERN DISTRICT
Pennsylvania R.R. Co.
New York Central R.R. Co.
Baltimore & Ohio R.R. Co.
Philadelphia & Reading Co.
New York, New Haven & Hartford R.R. Co.
Erie R.R. Co.
Boston & Maine R.R. Co.
Delaware Lackawana & Western R.R. Co.
Lehigh Valley R.R. Co.
Delaware & Hudson Co.
SOUTHERN DISTRICT
Atlantic Coast Line R.R. Co.
Southern Railway Co.
Illinois Central R.R. Co.
Norfolk & Western Railway Co.
Chesapeake & Ohio Railway Co.
WESTERN DISTRICT
Northern Pacific Railway Co.
Southern Pacific Co.
Atchison, Topeka & Santa Fe Railway Co.
Union Pacific Co.
Chicago & Northwestern Railway Co.
Chicago Milwaukee & St Paul Railway Co.
Great Northern Railway Co.
Mileage
Operated
Gross Operating
Income
11 215
413 527 860
13 302
353 353 261
5 172
123 474 168
2 099
97 152 391
2 874
90 124 838
2 398
76 473 575
2 298
52 075 428
955
49 335 739
1 444
47 382 569
886
25 933 675
12 244
121 647 573
10 609
115 541 820
8 073
95 197 392
2 086
57 304 586
2 736
55 650 538
19 362
202 386 954
10 852
151 514 357
11 843
138 768 080
9 346
117 802 261
9 861
110 836 429
10 208
105 646 484
8 031
81 233 092
Total Mileage Operated Total Gross Operating
by Districts Income by Districts
42 643
1 328 833 504
35 748
445 341 909
TOTAL Eastern, Southern & Western Districts
79 523
157 914
908 217 657
2 682 393 070
CORPORATE NAME
EASTERN DISTRICT
(Pennsylvania R. R.
(New York, New Haven & Hartford R.R.
(New York Central R.R.
(Boston & Maine R.R.
(Baltimore & Ohio R.R.
(Philadelphia & Reading Railway
(Erie R R.
(Delaware, Lackawana & Western R.R.
(Lehigh Valley R.R.
(Delaware & Hudson Co.
SOUTHERN DISTRICT
Atlantic Coast Line R.R.
Southern Railway Co.
Illinois Central R.R.
(Norfolk & Western Railway
(Chesapeake & Ohio Railway
WESTERN DISTRICT
Southern Pacific Co.
Atchison, Topeka & Santa Fe Railway
Chicago, Milwaukee & St Paul Railway
(Northern Pacific Railway
(Great Northern Railway
(Union Pacific Co.
(Chicago & Northwestern Railway Co.
TOTAL Eastern, Southern & Wi
EXHIBIT B
Mileage
Operated
Gross Operating
Income
Mileage
Operated
Gross
Operating
Income
11 215
2 874
413 527 860
90 124 838
14 089
503 652 698
13 302
2 298
353 353 261
52 075 428
15 600
405 428 689
5 172
2 099
123 474 168
97 152 391
7 271
220 626 559
2 398
955
1 444
886
76 473 575
49 335 739
47 382 569
25 933 675
5 683
199 125 558
Total Mileage
Operated
by Districts
42 643
Total Gr, Oper¬
ating Income
by Districts
1 328 833 504
12 244 121 647 573
10 609 115 541 820
8 073 95 197 392
2 086 57 304 586
2 736 55 650 538 4 822 112 955 124 35 748 445 341 909
10 852 151 544 357
11 843 138 768 080
10 208 105 646 484
19 362 202 386 954
8 051 81 233 092 27 413 283 620 046
9 346 117 802 261
9 861 110 836 429 19 207 228 638 690 79 523 908 217 6=7
n Districts 157 914 2 682 393 070
If the numerous lines which are tributary to these sys¬
tems were gradually absorbed on some basis which was
fair and mutually satisfactory, there would eventually be
four systems in the Eastern District, four in the Southern,
and five in the Western. They would cover every part of
the United States; there would be some competition in
service but under such conditions that waste in operation
and waste in capital would be largely eliminated. Such
competition as remained, preventing the attainment of
the best economic results, could be controlled by pooling
of traffic and facilities under proper Governmental regula¬
tion. The disadvantages to the public due to the existence
of weak systems would be overcome. It would be possible
to test rates more easily and more accurately by their rela¬
tion to a few strong systems operating with equal advan¬
tages than by considering them in their relationship to a
large number of systems operating under varying and un¬
equal conditions. There would be a sufficient number of
systems operating under similar conditions and under dif¬
ferent managements to establish standards by which results
could be measured, and to encourage rivalry in manage¬
ment and foster individual initiative.
If the various railroad systems of the country were to
be merged in some such way as suggested, the natural al¬
liance of the remaining roads would appear to be clear in
many cases. For example, the Maine Central and the
Bangor & Aroostook systems would naturally become a part
of the New York Central. In other cases it would not be
so clear. For example, the Western Pacific, the Denver &
Rio Grande and Missouri & Pacific, the Rock Island and
the Southwestern systems might be allied with some of the
basic systems already proposed, or they might be combined
so as to form one or more additional systems.
Again it is probable that some changes might be made
with advantage in the grouping of the original thirteen
systems. For example, the Baltimore & Ohio might take
over only the Central of New Jersey, which is a part of
the Reading System, and the Philadelphia & Reading might
become a part of the New York Central or be merged with
16
a group made up of the Delaware, Lackawanna & Western,
Lehigh Valley, et al; or again the Norfolk & Western and
Chesapeake & Ohio Systems might be merged with the
Baltimore & Ohio, and in this way the basic systems would
be reduced to twelve.
It is not the intention to suggest an arbitrary, complete,
or final distribution of the various systems, but rather to
present the matter in this form, as a tentative grouping to
indicate more clearly the application of the principles which
have been outlined, and show that the relations of the va¬
rious systems are such that a plan could be worked out along
these lines without revolutionizing or disrupting the pres¬
ent transportation systems of the country and to show, fur¬
ther, that such a method would be in accord with methods
which had been followed in the past.
Basis of Sound Credit for Future
The conclusion that the public interest will be served
better under private management pre-supposes that legis¬
lation will be enacted which will have in view the estab¬
lishment and maintenance of credit upon such a perman¬
ently sound basis that private management can obtain
capital in sufficient amounts to provide whatever facilities
are necessary to meet the traffic requirements of the
country. This demands that no systems of weak and un¬
certain credit should remain. If railroad credit is to be
established on such a basis, there must be assurance that
rates will be sufficient to provide a reasonable return on a
reasonable amount of capitalization; and further, even if
a reasonable return on a reasonable capitalization is pro¬
vided, it must be understood that credit will still be un¬
certain unless the capitalization is properly divided between
securities with fixed and contingent charges, or, as it is more
commonly but less correctly stated, between stocks and
bonds. It is necessary, first of all, that the fundamental
principles of credit should be clearly understood; the amount
of capital on which a return should be paid must be def¬
initely determined; there must be agreement as to the rate
of return which is reasonable and also upon the margin of
17
earnings which is required to establish confidence in the
stability of railroad investments, both stocks and bonds.
Assuming that the amount of property investment can
be agreed upon and set up as a basis of rate making, the
whole problem will be simplified and there will be much less
misunderstanding in the future if a plan can be developed
along lines which will result in such an adjustment of out¬
standing capital obligations that the total face value of
stocks, bonds, and other forms of indebtedness are made
proportionate to the property investment so that the term
"property investment" and "capitalization" can be used
interchangeably.
Discussing first of all the proper ratio of stock and bonds
—bonds for this purpose being understood to include all
obligations carrying a fixed charge—it may be said that ex¬
perience shows that railroads which in the past have been
able consistently to finance a considerable part of their
requirements by the issue of stock, which is usually con¬
sidered evidence of high credit, have been railroads which
have earned their fixed charges two and one-half times over
and which have not paid out substantially more than 30
per cent of their net earnings for both fixed charges and
dividends. Under these circumstances there has been left
a balance of approximately 20 per cent of net income which
has been carried to surplus, thus affording the necessary
assurance that even if there should be a considerable tem-
porarj reduction in earnings, due to business depression or
other unforeseen circumstances, the ability of the company
to maintain its dividend payments would not be threatened,
and also permitting liberal contributions to improvements
In the property without increasing capitalization.
To illustrate, on the basis of $100,000 net earnings;
$40,000 would be available for fixed charges, $40,000 for
dividends, and $20,000 for surplus. Assuming that the
$40,000 fixed charges representing interest on bonds were
capitalized on a 5 per cent basis, and $40,000 representing
dividends on stock were capitalized on a 6 per cent basis,
the total resulting capitalization would be $1,466,000—ap¬
proximately $800,000 bonds and $660,000 stock—the bonds
18
representing about 54 per cent of the total capitalization
and the stock 46 per cent. Earnings of $100,000 on the
total capitalization or property investment of $1,466,000
would be at the rate of 6.80 per cent, and, of this, a sum
equivalent to 5.44 per cent would be distributed to security
holders, leaving a balance of 1.36 per cent to be returned
to the property in some form.
This is not an arbitrary or theoretical standard of credit.
It represents substantially the conditions which prevailed
during the period prior to 1910 when the more prosperous
railroad systems of the country financed a considerable part
of their requirements by the issue of stock, and therefore,
indicates the conditions which were satisfactory to in¬
vestors. It may be said further that there were few rail¬
roads which complied with these conditions that did not
finance to some extent by the issue of stock; and, on the
other hand, that there were few instances where stock was
issued where such conditions did not exist.
It is reasonable to expect that it will require the main¬
tenance of equally favorable conditions to sustain credit in
the future; that is, a like relation between bonds and stocks,
and a like margin of earnings above the interest and divi¬
dends, in order to make railroad enterprises satisfactory
fields for investment.
The matter of credit is absolutely essential to the per¬
manent success of any railroad program, and it has also
a most important bearing on the immediate problem of the
return of the railroads to private management. If it be
agreed that the best solution of the railroad problem re¬
quires that the existing railroad systems should be amal¬
gamated in some such way as suggested, it is necessary
to consider whether the various combinations should be
worked out after returning the individual properties to
their pre-war status, and after first re-establishing their
operating organizations, and restoring conditions as nearly
as possible to those which prevailed at the time they were
taken over, or whether the various consolidations should
be worked out in advance of, or coincident with, their re¬
turn to the owners.
19
Support of Credit During Transition Period
To restore the individual properties to their pre-war
status while a plan of amalgamation was being worked out
would mean the deliberate creation of a transition period
during which the very evils which this proposed solution
of the railroad problem is desired to remedy would be in¬
creased in number and aggravated in intensity. Every
argument against the return of the roads to the private
control of the several hundred old companies as a per¬
manent solution of the problem, every condition which
makes a return to anything approaching the situation which
existed prior to January 1, 1918, impossible, applies with
equal force to the proposal to resume the pre-war status
during this transition period. If the future relationships
of the railroads are to be worked out upon the principle of
eliminating wasteful competition in financing and opera¬
tion it is manifestly absurd to set aside that principle for
the period during which arrangements are being made to
carry its application to a logical conclusion. More¬
over, there is involved in any such program the danger of
destroying that credit of the railroads upon which depends
the possibility of obtaining an equitable basis for the finan¬
cial arrangements to be entered into as a necessary fea¬
ture of the proposed combinations. It is a grave objection
to the restoration of the individual roads to private
management that in many instances the credit of these
properties would be dissipated immediately upon the cessa¬
tion of Government responsibility for their maintenance
and a fair return upon the investment which they repre¬
sent. In the process of constraining all the railroads taken
over to the single purpose of serving the Nation's war
needs, many of them have necessarily lost business and
now find themselves burdened with obligations arising di¬
rectly from the fact that their control has been in other
hands for a year or more. Under the circumstances they
have no credit other than that which proceeds from the
Government guarantee of rental and a belief that Govern¬
ment control will end under conditions which will insure
the stability of their credit.
20
Assuming that the plan of consolidation as outlined above
had been accepted, it would be most unfair to withdraw
Government support from the credit of those roads which
have suffered because of their seizure by the Government.
To return them to their individual companies and then
later on to combine them upon terms reflecting the loss of
credit sustained by them as a result of such return would
be unfair and unjust because the position of some companies
will have improved at the expense of others. Under the
circumstances the interests of the several companies which
are to become parties to the merger should be determined
on the basis of the relationships which existed prior to
Federal control—and which cannot be restored—rather
than by the new relationships brought about as the result
of such control. From every point of view the breaking of
the continuity of credit by a temporary return of the prop¬
erties to their pre-war status must be regarded as danger¬
ous procedure. Taken in conjunction with others, this ob¬
jection to returning the properties as a condition precedent
to the proposed amalgamations appears conclusive.
There remains for consideration the proposal to inaug¬
urate the contemplated amalgamations during the period
of Government control so that they will have been accom¬
plished by the time such control is ended. It is obvious
that under the conditions of Government control there
would be little difficulty in making the physical arrange¬
ments involved in forming the proposed systems. It is
likewise clear that with all the roads on the same basis
of a guaranteed credit standing, the financial arrange¬
ments by which the amalgamations would be completed
could be determined with greater justice to security holders
than would be possible if such guarantee of credit were
withdrawn prior to the amalgamation.
The arrangements for unification of properties and the
necessary readjustments of capitalization, will require some
time. The security holders will have much greater con¬
fidence if the transition takes place while their respective
systems are in receipt of a fixed revenue, than if they are
21
obliged to face for a period the inequalities in results caused
by Federal control.
What may not appear so readily, but a matter equally
demonstrable, is that it will be necessary to the largest
benefit from the proposed reorganization that the Govern¬
ment continue to guarantee the credit of the new systems
beyond the time when its actual management of the roads
ceases. How long that guarantee ought to continue will
be determined by the rapidity with which the plan here
proposed proves to be a solution of our railroad problem
and the length of time it requires for such readjustment
of income to expenses as may be necessary to re-establish
the railroad business on a sound and. profitable basis.
The continuance of the Government guarantee will
in itself tend to quicken readjustment to the new arrange¬
ment. The essential thing, however, is that the com¬
binations may be entered into with the confidence that
Government support of credit will insure a steady supply
of funds for maintenance, improvement, and extensions,
and that this support will not be withdrawn until the
railroad systems of the country are again on a stable
basis—able to meet requirements and to offer inducements
to capital as sound investments.
Some such arrangements as outlined will not only serve
the public interest and the interest of investors, but will be
of the greatest advantage to the Government. It should
not be overlooked that large sums are already owed the
Government by the railroads and these sums are sure to
become increasingly larger as credit declines and is less
certain. With stability of credit maintained there will be
less dependence upon direct Government aid for financing
during the transition period, and there will also be greater
assurance of the eventual payment of the advances already
made by the Government.
Objections to Permanent Government Guarantee
Necessary, however, as such a Government guarantee of
credit will be during the period of readjustment to the
changes proposed, its continuation as a permanent policy is
22
quite another matter and presents a question of funda¬
mental importance because of its bearing on the problem of
future financing.
While the subject of future financing has already been
touched upon in the general discussion of credit, it will
be well to consider it in greater detail in view of the large
amounts of new capital which must be raised in the future.
It has been estimated that at least $1,000,000,000 of new
capital will be required annually to provide for the needs
of the railroads as a whole in order that facilities may
keep pace with the business offered and in order to meet
maturing obligations. To raise these vast sums will re¬
quire a comprehensive and well considered financial policy.
If a plan is to be worked out in line with the purpose already
stated, namely, to furnish transportation at the lowest
cost consistent with adequate service, not only must capital
be had but it must be obtained on economical terms.
Government credit is superior to corporate credit and it
might appear therefore, at first sight, that a Government
guarantee of railroad securities, or a guarantee of earn¬
ings sufficient to pay fixed charges and reasonable dividends,
in whole or in part, would prove to be the most economical
method of financing. Such use of the public credit, how¬
ever, is open to several of the objections to Government
ownership and management which have been referred to,
and it is believed that the small advantage expected from
it would be more than offset by the failure to get the most
efficient operating results.
The inevitable outcome of a guarantee of interest and
dividends sufficient to provide the maximum return to
which investors are entitled would be a demand that the
Government participate in the management to a greater
extent than is desirable if the greatest benefits from private
operation are to be obtained. A Government guarantee
would present a situation analogous to the Boston Elevated
and Bay State Street Railway situations where legislation
providing for the guarantee of securities by the State of
Massachusetts also provided that the responsibility for
management should be vested in the hands of trustees
23
appointed by the Governor of the State. Whatever the
extent of the participation in the management at the out¬
set, it is probable that under such circumstances the
Government would eventually become such a dominating
influence that individual initiative would be greatly lessened
and the benefits to be expected from private management
would be partially, if not entirely lost.
The same objection would apply to a guarantee of mini¬
mum earnings. Moreover, it is difficult to see how there
would be, under a guarantee of minimum earnings, any
appreciable saving in the cost to the public if it were the
purpose to provide rates which would give the investor the
maximum to which he was entitled since the plan on its
face would recognize that these minimum earnings did
not represent an adequate return on invested capital and
it would be necessary, therefore, to provide for rates which
would give a return in addition to the minimum. The
difficulty would be, however, that the minimum return
would probably soon come to be recognized as the maximum
return to which the investor was entitled, and any sub¬
stantial return above the minimum would be looked upon
with suspicion and taken as evidence that rates were too
high.
It is possible that a guarantee of minimum earnings
somewhat exceeding fixed charges might enable limited
borrowing on more favorable terms for a time. To
maintain credit permanently, however, requires the issu¬
ance of proportionate amounts of stock, and to issue stock
requires that dividends be permanently assured. Under
such a guarantee as suggested dividends would be no more,
and perhaps less certain than in a plan which did not in¬
clude a guarantee, but which recognized the necessity of
providing such dividends as were essential to maintain
railroad stocks on a sound investment basis.
A guarantee of minimum earnings would not provide a
financial policy that would command the confidence of in¬
vestors. It would indicate first, the need of a guarantee,
implying a feeling that railroad rates were not to be put
on a sufficiently liberal basis to assure even a minimum
24
return; and would, accordingly, create the gravest doubts
in the minds of investors as to whether the regulating
authorities would assume the responsibility of making
rates that would consistently provide a return in excess
of the guaranteed minimum sufficient to protect existing
investment and attract new capital.
Under all the circumstances, it seems probable that
credit will be better sustained and new capital will be
obtained more readily, if there is assurance that the rail¬
roads will be self-supporting as the result of the establish¬
ment of a policy under which an adequate return is clearly
and satisfactorily defined and the responsibility is placed
upon the regulating authorities to establish rates which
will yield such return, than under a policy which assures
a minimum return only and leaves the prospect of payment
of a fair and reasonable return surrounded with uncer¬
tainty and doubt.
In considering economy in financing, it should be kept
in mind that a high standard of private credit creates a
sound investment, and the sounder the investment the
lower the rates at which capital is obtainable. It, there¬
fore, follows that the difference between obtaining capital
on Government credit and obtaining it on corporate credit
is much less when credit is on a sound basis than when
credit is weak and uncertain, and this emphasizes the im¬
portance of establishing railroad credit on the soundest
possible basis if financing is to be accomplished on the
most favorable terms.
Necessity for Surplus Earnings
Furthermore, it may be said that the more favorable
economic results which are claimed for Government
financing over sound corporate financing are frequently
overstated, because in Government financing an adequate
return is considered to consist only of the amounts re¬
quired to pay interest and dividends, while in corporate
financing an adequate return is generally understood to be
not only the amounts required to pay interest and divi¬
dends, but also the additional amount necessary to be
25
earned in order satisfactorily to insure such payments.
In comparing the cost of Government and corporate financ¬
ing, the difference should not be regarded as the amounts
paid out for interest and dividends by the Government and
the amount earned on capital under private management,
but consideration should be given only to the amounts, in
each case, which are paid out as interest and dividends.
For example, it has been suggested in some plans that
financing might be accomplished through a Government
guarantee on a 41/2 per cent basis and that private financ¬
ing requires, for example, that 7 per cent be earned on
invested capital. Deductions based on these considerations
have made it appear that there would be a saving equivalent
to 21/2 per cent on invested capital, if advantage were taken
of Government credit. The difference, however, would be
much less if the comparison were confined to the amounts
actually required for interest and dividends.
Corporate financing requires the existence of a sur¬
plus and if the surplus required to maintain confidence in
investments be considered as an amount equivalent to 20
per cent of net earnings or, stated in another way, that
earnings should equal 125 per cent of the amount required
for interest and dividends, only 80 per cent of the amount
earned would be paid out to security holders. If but 80
per cent of the 7 per cent were paid out the net amount dis¬
tributed as interest and dividends would be but 5.60 per cent,
and the difference in cost of financing would be the difference
only between 41/2 per cent and 5.60 per cent, or a little over 1
per cent.
Because it is possible, where the public credit is used,
to provide through taxation for a deficit after it appears,
it is not necessary to provide in advance for rates which
will substantially exceed the amount of interest and divi¬
dends, but as private financing is not protected in the same
way it becomes necessary to provide against a possible
deficit by charging sufficient rates in advance to exceed
substantially the amounts necessary for these payments;
in other words, to provide a surplus.
If the public is called upon to pay rates which yield not
26
only an income sufficient to pay the return to which the
investor is entitled but also an additional amount for the
purpose of assuring the payment of such return, this fact
must be taken into consideration in determining the dis¬
position of the income in excess of the required payments.
It seems fair to conclude that the excess should in some way
be conserved for the benefit of the public from whom it is
collected; and if this were done, the difference between
the cost of public and private financing would be less
marked, as in the example just stated. To the extent that
this surplus is conserved and expended for additions and
improvements, and not used as a basis for future rates,
property investment will be increased without the addition
of new capital which would otherwise be required, and rates
would be correspondingly lower, being based on a propor¬
tionately smaller investment.
When the principle becomes recognized and established
that the purpose of a surplus is primarily to assure the
payment of just and reasonable compensation on invested
capital, and that whatever surplus is accumulated by the
payment of rates higher than necessary for this purpose
will be conserved for the benefit of the public and will not be
used to give a larger return to security holders than that
to which they are fairly entitled, much of the conflict over
charging rates sufficient to sustain railroad credit will dis¬
appear. It may even be possible that if flexible regulation
of rates is established as a permanent policy investors may
ultimately be satisfied with a smaller proportion of surplus
in the belief that the business is less subject to contingencies
under the new conditions.
It is obvious that such a policy toward rates would limit
maximum dividends to moderate payments and the result
would be that the market for railroad stocks would be con¬
fined largely to investors who are willing to take a low
rate of return provided the risk of the investment is re¬
duced to a minimum. Investors who are attracted more
largely by prospects of increased dividends or an occasional
distribution of extra dividends may be expected to look to
27
other fields of investment where there is a greater risk and
the return is commensurate with such risk.
If there is reasonable assurance that satisfactory divi¬
dends will be permanently maintained and stockholders are
permitted to subscribe for new issues of stock from time
to time at prices somewhat below the current market, the
authorization to issue and the price to be approved by the
Interstate Commerce Commission or some similar body,
there is every reason to believe that the inducement offered
to stockholders will be sufficient to make the flotation of new
issues successful; credit will be maintained, and it will "be
possible for the railroads to obtain capital properly to de¬
velop their facilities.
Measure of Fair Earnings
The terms under which capital can be obtained in the
future cannot be determined in advance. The rates of in¬
terest on borrowed capital and the rates of dividend which
will have to be paid on stocks to make them attractive to
investors, will depend upon general market conditions, and
in view of the upward trend of interest rates it seems prob¬
able that capital will not be obtainable, during the next
few years at least, at as low rates as formerly.
The suggestion contained in some of the plans that a 6
per cent return on property investment should serve as
a standard for measuring an adequate return for the future
should be examined with some care.
Even if it should prove that such a return on property
investment has been adequate in the past to provide rea¬
sonable compensation for invested capital and an additional
amount to provide the necessary margin of safety, it is
by no means certain that the same return will prove to
ue adequate for the future. Moreover, an examination of
the available data covering the prices of both stocks and
bonds of the best railroad systems of the country covering
the past ten years plainly indicates that a 6 per cent re¬
turn has not been sufficient, even during this period, to
provide the necessary margin over the amounts required
to pay interest and dividends on investments of new capital.
28
The fact that the issues of railroad stock practically ceased
toward the end of this period points unmistakably to this
conclusion.
During the ten years 1908 to 1917, the range in the in¬
come yield of twelve of the best standard issues of railroad
stocks was from 4.53 per cent to 6.11 per cent.
For the first five years of the period 1908 to 1912, the
combined average yield ranged from 4.53 per cent to 5.49
per cent with an average for the period of 5 05 per cent.
For the second five years 1913 to 1917, the combined
average yield ranged from 5.39 per cent to 6.11 per cent,
with an average for the period of 5.63 per cent.
The average yield of these same stocks as of May 1,
1919, was 6.96 per cent.
For the same period the average income yield on the
best issues of underlying railroad bonds ranged from 4
per cent to 4.62 per cent.
The average for the first five years 1908 to 1912 was 4.09
per cent, and for the second five years, 1913 to 1917, it
was 4.44 per cent.
The average yield of these bonds as of May 1, 1919, was
approximately 5.16 per cent.
Assuming that financing had been accomplished by the
issue of equal amounts of bonds and stocks, and assuming
further that it had been possible to obtain capital on terms
based on the average income yield of these bonds and
stocks, without taking into account any provision for a
margin of safety and measured only by the rate of return
on these bonds and stocks, the average cost of new capital
for the period 1908 to 1912 would have been 4.57 per cent,
and for the years 1913 to 1917 5.04 per cent.
On the basis of the present market prices of bonds and
stocks, the cost of capital would be 6.06 per cent.
Under these conditions capital would have been obtained
on the most favorable terms, for not only would advantage
have been taken of the prices which are available to roads
cf the highest credit only, but no account would have been
taken of the effect on prices which would have resulted
from placing large amounts of new stock on the market;
29
nor would any consideration have been given to the fact
that underlying bonds are not generally available for financ¬
ing and it is necessary to issue, to a large extent, junior
issues with an additional yield of at least J/2 of 1 Per cent.
Even under these most favorable circumstances, it would
have taken earnings of 5.71 per cent on new capital for
the years 1908 to 1912, if income had been sufficient to
provide a surplus equivalent to 20 per cent of net earnings
above the amounts required for interest and dividends.
On a similar basis, during the five years 1913 to 1917,
it would have required earnings of 6.30 per cent.
On the basis of market price? May 1, 1919, it would re¬
quire earnings of 7.58 per cent on new capital.
These figures plainly show that there are wide fluctua¬
tions in the prices of securities—both bonds and stocks—
and these fluctuations in prices cause a change in the
amount of interest and dividends necessary to be paid in
order to obtain capital.
An adequate return, being measured by varying amounts
of interest and dividends, cannot be determined by any
fixed and unchangeable rate of return on invented capital
or property investment and any plan, therefore, which aims
to establish a rule of rate making on such a basis ignores
the fact that the price of capital is subject to fluctuations
and changes which may approximate those that take place
in the prices of labor and materials. If capital could be
obtained on an average of 4 per cent, a return on property
investment of 5 per cent would produce income sufficient
to maintain the margin of safety to which reference has
been made. On the other hand, if the market price of
capital were 8 per cent, a return of 10 per cent on property
investment would be required to maintain this margin.
To establish any given return on property investment as
a basis of rate making is open to the objection that the
rates may not prove high enough to produce an adequate
return, and in that case new capital will not be made avail¬
able, or, it may produce more than an adequate return, in
which case the public will have been charged unnecessarily
high rates.
30
Assurance of Fair Earnings
to Maf(e Railroads Self-Supporting
In the history of rate regulation for railroads and
other utilities it is believed that there has been no
instance in which standards of rate making have been
established in the legislation creating the rate making body.
This matter has been left for the regulating bodies them¬
selves to work out, and the results have been lacking in
uniformity, and for the most part unsatisfactory both to
the companies and to the public. The usual plan has been
to set up a valuation for a company whose rates were under
consideration, the basis of this valuation varying widely
in different localities and at different periods and to permit
an earning power, based on this valuation, and usually at
a fixed rate varying for the most part from 6 to 8 per cent.
This method of rate making has thrown upon the regu¬
lating bodies a responsibility which they have not fully
accepted. They have for the most part been unwilling to
act except on the basis of conditions which had been so
long in existence, that when the remedy came, it often
came too late. They have been almost universally inclined
to act on the basis of a fixed rate of return, the fallacy of
which has already been discussed; and they have apparently
proceeded on the theory that if a company could borrow
money on any terms, it had good credit. The result
has been almost fatal to railroads and utilities alike;
and not only investors, but many of the best operating
men, have concluded that conditions in these enterprises
made success impossible, and have withdrawn in dis¬
couragement.
If the railroads are to proceed upon a self-supporting-
basis, they must do so under an assurance, plain enough
for anybody to understand, that they will have sufficient
earning power to permit them to continue successfully in
business. Such an assurance can only be had if the legis¬
lation under which they operate contains plain statements
of the standards of rate making and instruction as to how
these standards shall be applied. And as investors and
31
operators alike have been discouraged and repelled by the
rate making conditions of the past, any standards which
are set up for the future must be fair enough and liberal
enough to overcome the effect of past mistakes in regula¬
tion.
Whatever else such legislation contains, it should at least
state plainly, that in default of positive mismanagement,
a railroad should be assured of sufficient rates to meet its
operating expenses and taxes, depreciation, rentals, and
interest and dividends, with a sufficient surplus over and
above all these to attract new capital.
The rates, in other words, must cover the cost of opera¬
tion plus the cost of capital; and the cost of capital should
be as nearly as possible, the actual cost. So far as existing
investment is concerned, both the actual amount of capital
raised and its cost are practically impossible to determine.
Accordingly, some arbitrary method must be adopted by
which an amount of capitalization will be validated, so to
speak, on which the interest and dividends at current rates
will give a fair rate of compensation. For this purpose
an agreed valuation of the property must be adopted and
an amount of income determined which will provide reason¬
able and fair compensation on the valuation, plus a satis¬
factory margin of safety. This margin may be equivalent
to 20 per cent of the net earnings as suggested above, or
whatever other amount may prove to be necessary. To
this should be added the actual interest and dividends on
new capital raised from time tc time, plus a corresponding
margin of safety. The margin of safety is to be used for
the benefit of the public, except that a certain portion should
be maintained in the form of reserves from which dividends
can be paid temporarily at times when the general level
of rates is too low to allow fair dividends to be earned.
The test of fair dividends should be the ability of the rail¬
roads to obtain at least half of their new money through
sales of stock at par or over.
This principle of rate making corresponds closely to the
service at cost principle which has been adopted in a num¬
ber of instances for determining a fair and reasonable re-
32
turn on street railway investment, the only substantial
difference being that the adequacy of return on new capi¬
tal invested is determined by the actual cost of capital
and the required margin of safety rather than by a fixed
rate upon such investment.
It is assumed in setting up these standards that the
various consolidations have been worked out on a basis as
suggested, where their capitalization corresponds with their
fair valuation, and that their proportion of bonds and stock
is correct to start with. These matters have already been
discussed, and it is only to be expected that the railroads
must start fairly if they expect to be treated fairly. The
only test of standards for the future will be their success
in furnishing good transportation at reasonable cost, and
in the end the standards must be made liberal enough to
keep the railroads as successful going concerns. It is be¬
lieved, however, that the intention of living up to these
standards must not be left to the discretion of constantly
shifting boards of regulation no matter how good their
intentions; but must be stated so plainly and so au¬
thoritatively as to constitute a contract between the people
and the railroads, the non-observance of which would be a
breach of faith.
Administration and Supervision
It is not intended at this time to do more than discuss
the principles on which the treatment of the railroads should
proceed. When the correct principles are clearly understood
and adopted it will not be a difficult matter to devise ma¬
chinery for carrying them out. The principles which have
been discussed, however, suggest their own methods to a
certain extent, and some of these may be briefly mentioned.
In the matter of consolidation a joint board should be
established, composed of members of the Inter-State Com¬
merce Commission and of competent railroad men, to decide
upon the grouping of the roads. This grouping should
proceed along logical lines, with due regard for traffic,
operating and financial considerations, as already discussed.
This Board, or some similar body, must prescribe standards
33
of financial soundness to which the companies must con¬
form before their actual consolidation. This means that
they must come in on a basis in which their share in the
consolidation will be proportional to their fair valuation and
in which their security holders must accept stock in the
consolidated company to a fair proportion of the determined
valuation. The decision as to valuation should be on a fair
agreed basis, taking all factors of value into consideration.
As a consolidation is in the public interest, any road
agreeing to consolidate should continue to receive its stan¬
dard return from the Government until the terms of con¬
solidation are worked out and the consolidated roads are
under a system of regulation assuring adequate rates. Any
company which prefers not to consolidate may be given
back to its owners at once, with no provision for a standard
return or other form of guarantee. The guaranteed return
may also be discontinued on any road which does not ar¬
range its affairs for consolidation within a stated reason¬
able time.
Consolidation as outlined will require the modification of
the anti-trust laws and other conflicting laws so as to per¬
mit not only the merger of properties but also joint use
of property and the actual pooling of earnings, when neces¬
sary in the public interest.
In the matter of permanent supervision and regulation,
it is believed that with the principles correctly determined
in the first place any reasonable method will be successful.
There seem to be many advantages in a system of regula¬
tion somewhat along the lines of the Federal Reserve Bank¬
ing System, by which the Inter-State Commerce Commis¬
sion and some of the leading railroad men may be united
into a central body for determining general railroad policies
and watching the tendencies of the comparatively few sys¬
tems as to earnings, financial methods and general useful¬
ness to the public. Similarly, following the Federal Reserve
Banking methods, regional organizations may be set up in
which the Inter-State Commerce Commission and the State
regulating bodies may be represented and in which also
the local railroad heads, shippers and labor interests may
34
have representation. These district bodies should have the
decision in all cases involving local rates, service, labor ques¬
tions, and other local matters, using the central body only
as a court of last resort. The final determination as to
questions affecting labor, should be exercised in all cases
by the same body which has the determination of questions
respecting rates, in order that there shall not be a division
of responsibility in regard to these closely connected factors.
Conclusions
The conclusion was reached in the early part of this
discussion that a consolidation of the railroads into
& relatively few strong systems would provide the
most effective means of overcoming waste in operation,
and of preventing duplication in facilities and consequent
waste of capital. It would also, by equalizing and averag¬
ing conditions, do away with the disadvantages arising
from the existence of strong and weak railroads. Consid¬
eration of the problems which relate to financing leads to
the same conclusion, namely, that only by consolidating the
railroads into financially strong systems will it be possi¬
ble to raise capital for future requirements.
If the roads are properly grouped there will be little
or no difference in the ability of the systems operating in
the same territory to prosper under the same rates, and
the difficult and complicated problem of the disposition of
the excess income of the more prosperous systems will
largely cease to be a serious problem. Such consolidations
will also simplify the problems of regulation and ad¬
ministration.
The first essential step, therefore, in the solution of the
railroad problem is the determination of the grouping
which will best accomplish these results and such provision
as may be necessary to bring about these consolidations at
an early date.
The second is to determine the standards of credit nec¬
essary to be observed, the adjustments which must be
made in the financial structures of the various railroads to
conform to sound standards of credit, and the adoption of
35
a policy toward rates which will be fair both to the public
and to security holders, sufficiently liberal to provide
reasonable compensation on existing investment and to at¬
tract new capital.
The third step is the machinery of administration to
make these policies effective.
It is only by the adoption of a plan which properly meets
the problems involved in all of these three steps that ade¬
quate service can be provided and transportation can be
furnished at the least cost consistent with satisfactory
service. A plan which provides for anything less will
fail to furnish a permanent and satisfactory solution of
the railroad problem.
36
5556 03
73998