Economic History Association
The Central Pacific Railroad and the Railroad Land Grant Controversy
Author(s): Heywood Fleisig
Source: The Journal of Economic History, Vol. 35, No. 3 (Sep., 1975), pp. 552-566
Published by: Cambridge University Press on behalf of the Economic History Association
Stable URL: http://www.jstor.org/stable/2119557
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The Central Pacific Railroad and the
Railroad Land Grant Controversy
To
the publicof the 1860's,federalloans and land grantsto
the pioneerPacificrailroadsrepresentedaid necessaryto secure
an economicallyand politically desirabletechnologicalfeat; to the
public of the 1870'sthey representedplunder.Scandal,hinted before
the driving of the legendary Golden Spike in 1869, sporadically
dominatedthe nationalpoliticaldebatesof the 1870'sand the 1880's.
The issue subsided by the 1900's,leaving only a residual popular
impressionof ample governmentaid to railroads.1Among professionalhistorians,the debate was revivedin the mid-1940'sby Robert
S. Henry'srevisionistarticlejustifyingthe land grants.2The ensuing
discussionlargelyrestoredthe originalconsensusthat the land grants
representedexcessivesubsidization.'
The two most recent studiesof the question,however,have undermined this position.RobertFogel finds that promoters'profitswere
not substantiallygreater than the minimum necessary to induce
them to build the Union Pacific,4while Lloyd Mercerconcludesthat
As the
federal land grants to the Central Pacific were "rational.""
debate has revived,proposalsto divest the CentralPacific (now the
SouthernPacific) of its lands are again being discussed."
This paper confirmsthe traditionalview that subsidies to the
I am indebted to Erwin Blackstone for a number of helpful comments, and to
Madeleine Kleiner and John Sturc for their valuable research assistance. I am, of
course, responsible for any remaining errors. This a er should not be interpreted
as reflecting the views of the Board of Governors of the Federal Reserve System or
other members of its staff.
1 Charles S. Morgan, 'Problems in the Appraisal of the Railroad Land Grants,"
reprinted in V. Carstensen,ed., The Public Lands (Madison, 1968), pp. 163-164.
2 Robert S. Henry, "The Railroad Land Grant Legend in American History Texts,"
reprinted in V. Carstensen,ed., The Public Lands, pp. 121-144.
3 The comments of the main protagonists are reprinted in V. Carstensen, ed., The
Public Lands, pp. 121-179.
4 Robert W. Fogel, The Union Pacific Railroad (Baltimore, 1969).
6 L. ?. Mercer, "Rates of Return for Land Grant Railroads: The Central Pacific
System,' TiE JOURNAL OF ECONoMIcHISTORY, XXX (September 1970), pp. 606-626.
L. J. Mercer, "Land Grants to American Railroads: Social Cost or Social Benefit?,"
Business History Review, XLIHI (Summer 1969), 134-151.
6 "A New Fight Erupts Over Land Grants,"Business Week, September 16, 1972,
p. 35; see also the statement by Senator Fred Harris, CongressionalRecord, CXVIII,
No. 146, September 19, 1972.
552
Central Pacific Railroad
553
Central Pacific were "excessive"at the margin, where "excessive"
describessubsidizationthat influencedneither the decisionto invest
in the railroadnor the speed of its construction.7My conclusionis
obtained by showing that the rate of return excluding land grants
was sufficientto have induced constructionat a maximumrate of
speed, implying that the entire land grant was an excessive subsidy
-what a reasonableman might reasonablyterm a "giveaway."
THE REALIZED RATE OF RMETUR ON ENTREPRENEURAL
CAPITAL
The influenceof the federal PacificRailroadsubsidy acts of 1862
and 1864 on the decisionto constructthe railroaddependedon their
effect on the rate of returnon entrepreneurialcapital. This section
treats the realized rate of return on entrepreneurialcapital; the
following section addressesthe more difficult question of the expected rate of returnon entrepreneurialcapital.
Some estimates have been made of the effect of land grants in
altering the overall private rate of return to the Central Pacific.8
The correct measure of the degree of governmentinducement is,
however,the effect on the rate of returnon entrepreneurialcapital.9
So long as the overallrate of returnon capital was greaterthan the
interestrateon borrowedfunds, the rate of returnon entrepreneurial
7 Treatments of Robert Fogel's justification of the Union Pacific's subsidy appear
elsewhere. See H. Fleisig, "Fogel's Defense of the Credit Mobilier," forthcoming,
Journal of Political Economy; H. Fleisig, "The Union Pacific Railroad and the Railroad Land Grant Controversy,"Explorations in Economic History, XI (Fall 1973),
155-172; H. Fleisig, "The Financial Condition of the Union Pacific Railroad, 18641867," mimeo, Cornell University, Department of Economics, December 1972.
8 Most recently, Lloyd Mercer found that the private rate of return on the Central
Pacific "system"was 12.9 percent without the land ?rant and 14.1 percent with the
land grant. See L. J. Mercer, "Land Grants . . .,
p. 142. Mercer calculated the
total private rate of return on private capital in the Central Pacific system, including
the original Central Pacific line from Sacramentoto PromontoryPoint, the Southern
Pacific, and the Western Pacific. This paper treats the rate of return on entrepreneurial
capital on the original Central Pacific line, giving a better indication of the inducement to the original promoters to build the pioneer line. If the land grants were
unnecessary for these lines, there Is some presumption that they were unnecessary
for later lines whose technical and economic feasibility were more certain.
9 The point has been made before in this debate. See, for example, the interroation of Collis P. Huntington by Senator John Morgan in "GovernmentDebt of te
Pacific Railroads.Notes of Hearings before the Committee on Pacific Railroadsof the
Senate of the United States on the Subject of the Indebtedness of the Pacific Railroads
to the Government," U.S. Senate, February 1, 1896, pp. 227-282. See also Stuart
Daggett, Chapters on the History of the Southern Pacific (N.Y., 1922), pp. 80-81;
Carter Goodrich, Government Promotion of American Canals and Railroads, 18001890 (N.Y., 1960), p. 187; and Stanley L. Engerman, "Some Economic Issues
Relating to Railroad Subsidies and the Evaluation of Land Grants," TEE JourNAL
OF ECONOMICHISTORY, XXXII (June, 1972), 456-457.
554
Fleisig
capital would increase at an increasingrate with the proportionof
outside non-equityfunds.10Since $43.5 million (1869 = 100) of the
estimated $44.2 million (1869 - 100) needed to build the railroad
was suppliedby variousbond issues, and since short term debt rose
by $10 million between 1863 and 1869, the subsidy acts permitted
the entrepreneurialrate of return to diverge sharplyfrom the private rate of return."
10
One simple formulation of the rate of return on entrepreneurialcapital is
K Rk-L'vi
K-L
where (Re) is the rate of return on entrepreneurialcapital, (K) is the total investmenlt, (Rk) is the overall private rate of return on capital, (L) is borrowed capital,
(i) is the cost of borrowed funds, and (K - L) is entrepreneurialcapital. If i < Rk,
8Rl
a2R0
e are positive; moreover, limit Redoes not exist.
e and
both
L K
aL2
aL
11 For the estimated cost of constructionand its conversion to constant value paper
dollars, see Table A-1, line 2C, and accompanying notes. Estimated bond sales of
$43.1 million were calculated from the bond issue information shown in Table A-1,
line 6.
Interest payments on the permanent debt were taken from H. V. Poor, Manual of
the Railroadsof the United States (New York, 1873), p. 681. Bond sales were estimated by capitalizing the earliest interest payments at 7 percent (the coupon rate
on the Convertible bonds) until the total interest payments were large enough to
account for the sale of all Convertible bonds; the remaining interest payments were
capitalized at 6 percent, the coupon borne by the First Mortgage bonds. If the assumption that the Convertible bonds were sold first is untrue, then the promotershad
slightly more non-equity capital during the early years than we have estimated.
The estimate also assumes that First and Second (government) Mortgage bonds
were sold at par. Price quotation on Central Pacific First Mortgage bonds are not
available prior to 1868. E 1868 and 1869 bond prices ranged between 97 and 103
for three observed dates. See Commercial and financial Chronicle, September 19,
1868; October 24, 1868; July 24, 1869.
Sales at or above par also reflect the earlier experience of the Central Pacific. In a
memo submitted to me Pacific Railway Commission, Stanford listed the "discounts"
on each class of bond received by the Central Pacific; U.S. Pacific Railway Come
mission, "Report . . . [and] . . . Testimony," Senate Executive Document No. 51,
50th Congress, 1st Session, DI: 2505-2509; DI: 2507, p. 2731. Hereafter referred
to as "P.R.C., Hearings." The table does not indicate that they are discounts of the
gold price under the currency price, but the text elsewhere makes that amply clear
(DI: 2507, pp. 2527, 2528). Though this mistitled table has misled some writers into
thinking that the bonds sold at substantial discounts under par in currency (for
example, S. Daggett, Southern Pacific, p. 25), one later investigation partly clarified
the matter, noting that the government bonds (Second Mortgage bonds) sold at
slightly over par (U.S. Federal Coordinatorof Transportation,Public Aids to Transportation, Vor. II, p. 138; Washington: Government Printing Office, 1938). Stanford
concedes the currency premium of the Second Mortgage bonds and also states that
the First Mortgage bonds were sold at "like discounts" in gold, implying that they
also sold at prices slightly over par (P.R.C., Hearings, DI: 2507, pp. 2465, 2428).
Stanford'stestimony was aimed at demonstratingthe physical and financial difficulties
of construction,he had every reason to mention discounts below par in terms of currency had they existed, and, indeed, does so for other classes of bonds. Among these,
Central Pacific Railroad
555
The initial investment of Collis Huntington, Leland Stanford,
MarkHopkins and Charles Crocker(hereafter referred to as "the
promoters")in the CentralPacificamounted,at most, to $60,000by
the end of 1863.12 Over the course of constructionthe promoters
paid in a total of $215,600 in cash on CentralPacific stock.'3The
the city and county aid bonds are excluded from our estimate, imparting a slight bias
against our conclusions.
Using Stanford's currency price of gold of approximately $1.40 for 1865-1866, his
assertion that sales of $1,483,000 in Convertible bonds yielded $830,000 in gold,
implies a currency bond price of approximately 80 (DI: 2507, pp. 2528, 2731).
Since originally these bonds were used directly to purchase materials, however,
and not marketed for cash, the discount is not strictly a market discount (David
Lavender, The Great Persuader [Garden City, N.Y., 1970], p. 130). The estimate
in the text assumes a market price of 80.
The same procedure applied to Stanford's estimate of the amount realized from
the State Aid bonds yields a currency market price of about 92. However, the listed
currency prices of these bonds ranged from 153-165 in 1864 to 114-158 between
January and August 1865; Bankers' Magazine (October 1865) p. 287. The estimate
in the text assumes a market price of 92.
12 Each of the four promoters subscribed to 150 shares on June 28, 1861. A 10
percent installment was required on the par value of $15,000, or $1500 each. See
S. Daggett, Southern Pacific ... , p. 19; Marry J. Carman and Charles H. Mueller,
"The Contract and Finance Company and the Central Pacific Railroad," The
Mississippi Valley Historical Review, XIV (December 1927), 328-329; D. Lavender,
The Great Persuader, pp. 94-95. It is unclear when the stock was completely paid
for. Lavender states that the eighth 10 percent installment was called for on November 13, 1863; D. Lavender, The Great Persuader p. 141. The stock records of the
Central Pacific show that Charles Crocker was still making payments on his 150
shares in 1864. Leland Stanford did not make his final payment on the initial 150
shares until December 31, 1865; P.R.C., Hearings, DI: 2507, pp. 2554, 3502-3503.
The calculation of the internal rate of return made below assumes that the initial
stock purchases were completed by mid-1863, biasing the calculated internal rate
of return downward in two ways. First, it pushes investment into the early years.
Second, it raises the possibility that later payments on stock were made out of railroad or construction profits; such reinvestment of profits is implicitly assumed in the
calculation of the internal rate of return and is not part of the initial investment on
which the rate of return is being calculated. There is no evidence on the other pror..oters; however, they generally maintained strict paity among themselves. Each
ultimately purchased 650 shares of Central Pacific sto for cash, each was an equal
participant in the divided profits of the Crocker Construction Company and the
Contract and Finance Company, and each received identical blocks of Central Pacific
stock in exchange for their-holdings of affiliatedrailroads (Western Pacific, California
and Oregon, San Joaquin Valley, and the San Francisco, Oakland and Alameda),
which they controlled through the Contract and Finance Company. P.R.C., Hearings,
DI: 2505, pp. 71-72; DI: 2507, pp. 2550-2558.
18 Of 6303 shares of stock Sold for cash (at a par value of $100) by 1869, 2156
had been purchased for cash by the promoters. The increase from 705 shares to
2156 took place in 1865, when the Central Pacific began collecting federal subsidy
bonds. The promoters owned 390,123 shares of stock in 1869 w e non-promoters
owned 11,528 shares. Of the promoters' holdings, 384,710 shares were charged to
construction account by the Central Pacific. In 1870, the promoters received another
99,775 shares of Central Pacific stock in exchange for their holdings in other California railroads that they were constructing at the same time as the Central Pacific;
non-promoter holdings remained at 11,528 shares. These data were obtained by
556
Fleisig
internal rate of return calculated below assumes the reinvestment
of profitsearned during the project'slife, so additional stock purchases do not represent part of the investment unless it can be
argued convincinglythat they were funds invested in addition to
profit receipts and were necessary to secure further profits. Such
a position is unlikely, since the funds representedless than 1/2percent of estimatedtotal constructioncosts and occurredduringyears
when there is no suggestionof any shortageof funds.'4
Ile actual cost of constructionof the railroad was placed at
$32.2 million by the Pacific RailroadCommission.'5The promoters'
constructioncompanies (CrockerConstructionCompany;Contract
and Finance Company) had sole charge of all construction,save a
few miles at the beginning.'5 For this construction,the Central
Pacificrecordedan expenditureof $90 million in gold and stock at
par value. Of this, $40.2 million was payment in stock at par value
and $49.8millionwas paymentin gold.'7
Since the stock was not publicly listed on any exchange,the estimate of total profit also depends on the estimated marketvalue of
the stock. Throughoutthe period, the Central Pacific sold small
numbersof sharesat a par value of $100. It is problematical,however, whether the large blocs of stock which the promoterswere
assigningto their constructioncompanieswould have been saleable
at par simplybecause some sharessold at par. One escape from this
problemis to value the sharesat the averageprice-earningsratio for
railroadstocks during those years; anotheris to value the stock at
zero.18
tabulating the list of Central Pacific stockholder transactionspresented by the Pacific
Railway Commission, Hearings, DI: 2507, pp. 2550-2558.
14 The Central Pacific had avaible
to it funds in considerable excess of those
needed for construction from 1862. Estimated cumulative construction cost is shown
in Appendix Table A-1, line 7; estimated bond resources of the railroad are shown in
Tabfe A-1, line 6. This table excludes all other local aid, such as the bonds of San
Francisco County and the stock subscriptions of Sacramento and Placer Counties,
totalling $950,000. In mid-1865, eastern journalist Samuel Bowles reported that the
Central Pacific still had no need to sell its land, U.S. bonds, First Mortgage bonds,
or State Aid bonds; Samuel Bowles, Across the Continent (Ann Arbor: University
Microfilm, Mich., 1966; originally published 1865), pp. 270-271.
15 For a reconciliationbetween bs figure and that shown in Appendix Table A-1,
line 2C, see Appendix Table A-1, notes a and c.
16 U.S. F(Zeral Coordinator f Transportation, Public Aids to Transportation,
Vol. 2, p. 18.
17 See the annual balance sheets of the Central Pacific, P.R.C., Hearings, DI:
2509, pp. 4526-4558.
18 According to the Central Pacific stockholder transaction list, Huntington ceased
acquiring stock for public sale in 1868 and other public cash purchases ceased in
Central Pacific Railroad
557
Finally, the rate of returnon entrepreneurialcapital will depend
on the time pattern of realizedprofits.In the absence of any direct
evidence, I have assumed that profits occurred in proportionto
recorded constructionexpenditures.To test the sensitivity of the
calculationsto the assumedtime pattern of profitsand investment,
however,I have also calculatedthe rate of returnassumingthat all
investmentoccurs in the firstperiod (1861) and all profitsoccur in
the last period ( 1869).
The annual rate of return on the promoters'investment under
various combinationsof these assumptionsranges from 90 percent
to 493 percent.'9 These rates of return compare favorably with
plausiblealternativeratesof returnof 15 percentto 24 percentavailable to entrepreneurs.20
Moreover,since the bonds were issuable
only as work on the road proceeded,2'constructionwas necessary
in orderto realize these rates of return.Thus, the subsidiesexclud1869; P.R.C., Hearings, DI: 2507, pp. 2550-2558. This decline in non-promotersales,
at a time when the railroadwas clearly going to be completed and was earning substantial profits even before completion, is curious and can probably be attributed to
fears of watering or attempts by the promoters to maintain contro.
The proposed method of valuing fhe stock is discussed in Appendix Table A-1,
note f. For those skeptical of this method, the rate of return assuming the stock is
valued at zero is also presented.
19 We assume the investment of $60,000 takes place in three installments ($6,000
in mid-1861, $27,000 in mid-1862, and $27,000 in mid-1863) and deflate in the
manner discussed in Appendix Table A-1, note a. Assuming the stock is worth nothing, the annual rate of return derived from Appendix Table 1, line 5 is 401 percent.
Including the stock at its estimated market value, the rate of return is 493 percent.
To check the sensitivity of the results to the estimated time pattern of investment,
we assume the entire investment takes place in mid-1861 and the entire profit is not
realized until mid-1869. If stocks are vaued at zero, the rate of return is 90 percent;
if stocks are set at their estimated market value, the rate of return is 113 percent.
All calculations assume that the original investment is lost at the end of the investment period; however, the rates of return are so high that the converse assumption
produces no significant change in results (to two decimal places). Since each series
contains one sign reversal, the rates of return are unique (Descartes' Rule of Signs).
20 Oakes Ames and Sidney Dillon, key promoters of the Union Pacific, regarded
rates of return of 15 percent to 20 percent sufficientto make railroad projects attractive; U.S. House of Representatives,"Affairsof the Union Pacific RailroadCompany,"
House Report No. 78, 42nd Congress, 3d Session, DI: 1577, pp. 28, 256. McCague
claims that Comstock mining shares regularly bore annual returns of 24 percent;
J. McCague, Moguls and Iron Men; (New York, 1964), p. 45; while Daggett cites 2
percent per month as a common short term interest rate in California; S. Daggett,
Southern Pacific, pp. 23-24. A rebuttal of this argumentof the form that entrepreneurs
might commonly have faced projects yielding rates of return of 90 percent to 493
percent annually over periods as long as eight years, on investments as large as
V60,000, is impossible to reconcile with the realized annual average rate of growth
of the economy as a whole.
21 Act of July 1, 1862, 12 Stat. U.S., 489, section 5; Amendment of July 2, 1864,
13 Stat. U.S., 356, sections 7, 8, and 10.
558
Fleisig
ing the land grantswould have amply secured the constructionof
the railroadat the same pace.22The land grants were necessary
neitherto affectthe decisionto constructnor to ensurethat the pace
of constructionwould be satisfactory:they were, in theirentirety,an
excessivesubsidy.
THE EXPECTED RATE OF IRETURN ON ENTREPRENEURIAL CAPITAL
Realizedreturnsof 90 percent to 493 percent per year when reasonable alternativeentrepreneurialrates of return ranged between
15 percent and 24 percent might, offhand,be consideredmore than
sufficientto indicate that additional subsidizationin the form of
land grantswas excessive.As defendersof the subsidy policy have
long realized,however,the questionof sufficiencyor redundancyof
subsidizationhinges on the ex ante or expected rate of return.
Severalstrategieshave been proposedfor dealing with this difficult question.The earliestapproachwas simplyto collect quotations
indicatingthe entrepreneurialdaringnecessaryfor the venture.Unfortunately,such an approachyields no estimate of the ex ante return, and with rates of return of the size realized, agreementthat
the expected returnwas lower leaves room for both attackersand
defendersof the land grantsto be right.
RobertFogel employeda two-outcomeversionof a Von NeumannMorgensterngame to treat a similarprobleminvolvingthe ex ante
returnto the Union Pacific." Fogel's approachwas ingenious, but
it ultimatelyyielded a solutionwith spuriousprecision.24
Some indication that the Central Pacific was not generally regardedas a particularlyriskyventureis given by the yields on CentralPacificbonds: for three dates in 1868and 1869these yields were
always more than one standarddeviationbelow the mean yield for
all railroadbonds and, remarkably,lower than the yields on such
establishedeastern roads as the Baltimoreand Ohio, the Pennsylvania, and the New York Central.25These data alone do not of
22 How changes in the difference between the alternative cost of funds and the
internal rate of return on a given project affect the rate of investment is an unsettled
issue. The argument in the text implicitly assumes that a project yielding 90 percent
to 493 percent annually over an eight year period would already be calling forth a
maximum entrepreneurialresponse.
23 Robert Fogel, Union Pacific, pp. 81-84.
24 H. Fleisig, "Fogel's Defense."
25 Central Pacific bond prices were quoted infrequently in the Commercial and
Financial Chronicle during this period. For each date on which a Central Pacific
Central Pacific Railroad
559
coursesolve our problem.It is difficultto establishan unambiguous
relationbetween the risk taken by bondholdersand the risk taken
by the promoters.20
Moreover,the earliestpublished CentralPacific
quotationsappearin 1868,somewhatlate to give a soundimpression
of the market'sview of the risk during the early and more difficult
yearsof construction.
One possible route through these difficultiesis a reconstruction
of the ex ante decision on the basis of informationavailableto the
promotersat the time of the passage of the Act of 1862. That Act
clearly specifiedthat the CentralPacificwas entitled to a minimum
of $739,000in subsidybonds upon completionof the firstforty miles
of track.27The need for capital to financethe constructionwas met
quotatonwas available, a yield curve (yield as a function of years-to-maturity)was
itted to the yields and maturities for the seventy to eighty other railroad bonds
listed for that date. The linear curves so fitted had (adjusted) values of R2 ranging
between .007 to .02 and in no case was the regression as a whole significant at the
5 percent level. The coefficient of the independent variable, number of years to
maturity, was never significant at the 10 percent level. The absence of autocorrelation was taken to mean that experimentationwith other theoretically plausible yield
curves would be equally fruitless; in the absence of any theoretical justification for
higher order polynomials which would have produced a better fit, no further testing
was undertaken.
In the absence of a yield curve, another appropriatemeasure of the market'smeasure of the risk in Central Pacific bonds is the instanceof the Central Pacific yield
from the mean yield of all railroad bonds, regardless of maturity, in standard deviation units. The mean yield to maturity of all railroad bonds on September 19, 1868
was 7.11 percent (s = .128); the yield to maturity on Central Pacific First Mortgage
bonds, priced at 103 bid, was 5.8 percent; the yield to maturity on Central Pacific
Convertible bonds, priced at 110 bid, was 5.10 percent. The mean yield of all railroad bonds on October 24, 1868 was 7.2 percent (s = .99) while the yield on
Central Pacific First Mortgage bonds, priced at 103 asked, was 5.8 percent. The
mean yield of all railroadfonds on July 24, 1869 was 7.4 percent (s = .88) while
the yield on CentralPacific First Mortgagebonds, priced at 97 asked, was 6.2 percent.
In each case, Central Pacific yields are more than one standard deviation be ow the
mean yield for all railroad bonds. On the same set of dates, yields on New York
Central Premium Sinking Fund Bonds ranged from 6.55 percent to 6.60 percent,
Pennsylvania Railroad Second Mortgage Bonds ranged from 6.35 percent to 6.60
percent, and Baltimore and Ohio Mortgage Sinking Fund Bonds ranged from 6.00
percent to 6.40 percent. Illinois Central Construction Bonds, however, ranged from
3.75 percent to 3.55 percent. In each case, where more than one bond was quoted,
the one with the lowest yield was chosen. All bond yields were calculated from price,
coupon, and maturity data in the Commercialand Financial Chronicle.
26 H. Fleisig, "Fogel's Defense," pp. 14-15.
27 The Act of 1862 (12 Stat. U.S., 489) provided for a government issue of
$16,000 per mile on the easier construction, to be delivered after 40 miles of track
were complete (section 5). On this section the government was to retain 25 percent
of the bonds until the completion of the entire railroad (section 17). For a distance
150 miles east of the "western base" of the Sierra Nevadas, the loan was $48,000
per mile (section 11), with 15 percent retained until completion of the entire road
(section 17). It was commonly agreed that the "western base" of the Sierra Nevadas
was approximately 31 miles east of Sacramento. However, the "western base" was
560
Fleisig
by the issue of $1.5 million in bonds eventually convertibleto U.S.
governmentbonds.28The promoters,as contractors,were entitled to
10 percent of the total constructionexpendituresas a "fair,""reasonable,"and "customary"profit on construction.29Tus, expenditure of the bonds would have yielded $150,000in profit.The market
price of these first bonds is unclear,but the promoterscould meet
any objectionablediscount simply by issuing more bonds to raise
the total amount financed back to some acceptable level.30 The
rate of return realized by the promoterswould then depend on
the speed with which they spent the money, a problem which is
trivial to moderncost-pluscontractorsand which was just as easily
solved then. I assume that the promotersexpected to spend funds
at the rate at which they did spend funds. The annualrate of return
from this collection of assumptionsvaries but does not fall below
71 percent per year.3'It would have been in their interest to have
begun constructionand to have continuedso long as bond revenues
covered the cost of construction.If ever this failed to happen, they
could permitthe railroadto go bankrupt,takingtheir place, as contractors,along with other first claimantson the railroad'sassets.
This account neglects the expectations of construction profits
greaterthan 10 percent of cost, substantialrailroad operatingearnings,82 future beneficial revisions and clarificationsof the subsidy
ultimately fixed by Presidential executive order at a point 7 miles east of Sacramento,
and the bond retention provisions were repealed in the Amendment of 1864. Edwin
L. Sabin, Building the Pacific Railway (Philadelphia, 1919), p. 67; 13 U.S. Stat. 356,
section 7. Thus, the Central Pacific finally received $1,696,000 in bonds for the first
40 miles out of Sacramento.
28 The promoters formally accepted the terms of the subsidy act on November 1,
1862; the bonds were issued in December; D. Lavender, The Great Persuader,p. 121;
U.S. Department of the Interior, Office of the Commissionerof Railroads, Report of
the Commissioner of Railroads, 1883 (Washington: Government Printing Office,
1883), pp. 680-681.
29 P.R.C., Hearings, DI: 2505, p. 83; DI: 2508, p. 3797.
30 Lavender reports the prospect of discounts wicA
apparently surprised Huntington. He has no evidence, however, on the size of the discounts (D. Lavender, The
Great Persuader,pp. 128-130). See note 11 for further discussion.
31 If the promoters expected prices to remain
unchanged, and to realize $75,000
in 1862 and $75,000 in 1863, they would have expected to earn 683 percent per
year. If they had perfect price expectations and the case is otherwise unchanged,
they expected a rate of return of 790 percent.
If we shift the expected earnings to 1863 and 1864, with prices expected to remain
unchanged, the expected rate of return is 111 percent. In the same case, assuming
perfect price expectations, the rate of return is 71 percent. Internal rates of return
are again derived from series with one sign reversal and are unique.
32 In January 1865 the promoters projected earnings of $3.8
million (gold) on
the first 31 miles of road. The estimate was based on counts of wagon freight;
Central Pacific Railroad
561
acts,83the use of stock to finance construction,the use of accounts
payable to finance construction,and the receipt of state and local
aid-a standardfeatureof railroadconstructionrenderedeven more
likely by Stanford'stwin position as presidentof the CentralPacific
and governorof California.84
On the other hand, it neglects the apparently unexpected effect of the Civil War in disruptingrailroad
finance,85the ability of oppositionrailroadfactions in Californiato
block (temporarily) the distributionof city and state construction
aids,86and the lag in initial distributionsof the federal government
subsidy bonds.87
As a historical account of the promoter'sex ante decision, it is
rather absurd. It.does serve, however, to underscorethe essential
nature of the subsidy act, the role of leverage therein, and the
substantialrate of returna reasonablebusinessmenmight have expected in the worst of all "plausible"worlds. Indeed, much of the
evidence of CentralPacific "financialdifficulty"-for example,halting constructionin the hope that the county subsidy bonds could
be marketedat higher prices later, or spending less than the maximum possible on early constructionto reserve funds for later construction-shows ratherthat the promotershad (as events proved)
quite reasonableexpectationsthat by diverging from the course of
action suggested by the "worstplausibleworld"they could achieve
American Railroad Journal, January 28, 1865, pp. 83-84. The substantial wagon
freight from the Comstock Lode in Nevada was well-established and the earliest
Central Pacific plans called for prior construction of a wagon toll road which would
feed freight into the end of the line; D. Lavender, The Great Persuader,pp. 87, 94.
83 The amendment of 1864 (13 Stat., 356) dropped the provision that the government reserve fractions of the bonds (section 7), declared that coal and iron lands
were not mineral lands and that they were included in the land grant (section 4),
doubled the land grant (section 4), provided for the issue of 2/3 of the bonds due
in difficult sections prior to completion of the track (section 8), subordinated the
government bonds to second mortgage status, and permitted the company to issue
bonds of the same type and quantity secured by a first mortgage as well as to issue
these on the completion of each 20 mile section (section 10). The amendment of
March 3, 1865 (13 Stat. U.S., 504) permitted the companies to issue First Mortgage
bonds 100 miles in advance of construction. The amendment of July 23, 1866 (14
Stat. U.S., 79) allowed the Central Pacific to build east until it met the Union
Pacific (section 2). There were also helpful executive "clarifications";for example,
see note 27.
84 In 1863 the state legislature passed a bill providing for a grant of $1.5 million
to the Central Pacific while Stanlord was governor. Placer County subscribed to
$250,000 in stock, Sacramento County to $300,000, and San Francisco to $600,000
(S. Daggett, Southern Pacific, pp. 30-33; D. Lavender, The Great Persuader,pp. 130132).
85 D. Lavender, The Great Persuader, p. 128.
86 Ibid., pp. 140, 149, 158-159.
87 Ibid., p. 155.
562
Fleisig
even higher returns.8 On this basis I argue that the expected rate
of returnin the absenceof land grantswas sufficientto have induced
constructionof the CentralPacific. Since the Act clearly specified
that the bonds were to be issued only as constructionprogressed,
the expected rate of return depended as well on the maximum
feasible speed of construction.Thus,the land grantswere necessary
neither to secure the original decision to construct nor to achieve
the desiredspeed of constructionon an ex ante basis.
CONCLUSION
Tlere is little questionthat the CentralPacificwas a daringengineering feat and that, unsubsidized,it would have been a daring
exampleof private enterprise.It was thought at the time that such
a projectwould producesocialreturnssufficientto justifythe investment and Mercer'sestimatesconfirmthis belief.39It was also thought
at the time to be a project that would not be undertakenvery
quickly in the absence of subsidization.That propositionhas not
been tested in this paper, but it seems highly plausible.
The railroadland grant controversydoes not turn, however, on
these questions. The focus of that controversyis the question of
whether the promoterswere over-subsidized:whether society redistributedto them assets far in excess of those necessaryto secure
the expectedandrealizedgain in efficiency.40
The answerto that questionlies in the verificationof the counterfactual propositionthat the promoterswould have moved just as
quicklyin the absenceof the land grantsbecause of the other subsidies offeredby the government.We have attemptedto measurethe
promoters'ex ante and ex post rates of returnon their investment.
To the extent that such cases can be constructed,it appears that
the expected rate of return on the promoters'investmentwas well
in excess of what they could have earnedin alternativeinvestments.
Since the bond subsidieswere given on the basis of the amount of
tracklaid, I concludedthat the additionaldonationsof land did not
affect either the decision to constructthe road or the speed of con8 Ibid., p. 148; Samuel Bowles, Across the Continent, pp. 270-271.
Under various assumptions, Mercer found the annual social rate of return from
the Central Pacific system ranging between 12.7 percent and 35.2 percent; his choice
among these estimates is 24.1 percent; L. Mercer, "Rates of Return," pp. 624, 626.
40 This is also Engerman's reading of the debate; S. L. Engerman, "Railroad
Subsidies,"p. 459.
39
Central Pacific Railroad
563
struction.If so, they were redistributionswith no efficiency effect,
somethinga reasonableman might term a 'giveaway."
None of this denies the Pareto optimality of the government
policy. But Pareto optimalityis a useful notion precisely because it
allows us to beg the essential question raised by the participants
in the railroad land grant controversy:how much redistribution
toward the wealthy ought the citizenry endure in exchange for
greatertotal output? Demonstrationsof the efficiencyeffect of the
railroad can, therefore, never be used to settle the land grant
controversy.
No doubt part of the attention attractedby the land grantswas
due to the public's perception of their value, both absolute and
relative to governmentexpenditure.Sales revenues from Central
Pacific land disposal ultimately amounted to $39.9 million; the
entirefederalbudget in 1869was only $322.9million.<
Of course,the marketvalue of an asset is an ambiguousguide to
the importancewhich people may properlyattach to that asset. Different forms of propertymay have the same monetary value and
yet carry with them different"bundles"of rights. For example, a
personwith $1,000,000in bonds and an interest income of $50,000
per year will surely have a different status and possess different
power from the resident of an otherwise identical town who owns
a $1,000,000factorythat earnsa net income of $50,000per year but
whose factory employs all the people in the town. Power is in part
a function of the control that one economic unit can exercise over
the incomeand behaviorof others.
The land subsidy differs considerablyfrom the bond subsidy in
this respect.When the Federalgovernmentgave land to the Central
Pacific,it gave as well controlover the disposalof the land, control
over people workingthe land, an enhanced interest in influencing
state and local governmentpolicies on taxationof the land, on zoning, on urbanland use, and on a variety of other decisionsin which
the CentralPacificwould not have had a pecuniaryinterest had it
not owned the land. It was the exerciseof these rights, some legitimate and some dubious, that earned for the Central Pacific the
sobriquetsof "The Curse of California"and "The Octopus."
It might be argued that the Central Pacific's possession of a
41 Federal Coordinator of Transportation,Public Aids to Transportation,p. 111.
The figure of $39.2 million represents cumulative land grant earnings net of land
sale expenses to 1927; gross land grant earnings were $49.2 million.
564
Fleisig
monopolyon railroadtransportin Californiameant that the titular
possessionof the land was redundantbecause it could have charged
rates sufficientto reduce land earningsto a point the companyconsideredconsistentwith maximumrailroadprofit.42This point is well
taken. The manipulationof land values through the adjustmentof
monopolisticrates is, however, generallyconsidereda fit subjectfor
public policy; national measures to control such behavior, albeit
somewhat ineffective, were taken by 1887. But the same gains
securedby the intelligentmanipulationof the CentralPacific'sland
holdings were generally quite legal, solely because the company
had title to the land.
The railroadland grant controversyhas attained the status of an
"issue"in economic history, interesting sui generis; but as a case
study in anotherlargerissue, it has an importancewhich transcends
its singularcharacteristics:how frequentlyand to what extent, one
must ask, have the existing possessorsof wealth used the power of
governmentto win for themselvesgains which they could not secure
unaided in the marketplace?Insofar as Americanhistory is concerned, the gravity of the question is underscoredby the defense
so frequentlyofferedof the promoters:they behaved like everyone
else.
HEYWOOD FLEISIG, Divisionof
International
Finance,
Federal Reserve Board, and Universityof Maryland
42 This point was raised in an interesting exchange among Stanley Engerman,
Peter McClelland, and Peter Passell at the Columbia University Seminar in Economic
History, October 18, 1971.
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