🔎Has there ever been a capex boom that didn't end in tears?
Spoiler alert: No.
TLDR Summary
Mixing a new capital-intensive innovation with risk-loving investors has always and everywhere ended in tears. There is not a single example where initial excitement with broad investor participation seamlessly led to sustained positive asset returns.
In all instances, investor attention lowered industry cost of capital below healthy levels, often aided by an accommodating liquidity environment from a macro perspective. This encouraged overinvestment and led to disappointing returns later after unexpected liquidity shocks ended the party.
In most instances, the use of explicit leverage was key to trigger the sell-off, sometimes at the corporate level, sometimes at the investor level, oftentimes at both levels. This accelerated crashes. But it is not a necessary condition for disappointing long-term returns. Devastating levered returns always come with insufficient unlevered returns.
In many instances, the long-term benefits of the innovation didn’t accrue to the shareholders of the capex spenders, but to their customers and their customers’ shareholders. Capital intensity proved to be permanent rather than transient. The most important learning point from studying history is this: If an industry is caught in a ruinous capex arms race, bet on their customers instead.
This article can be viewed as an addendum on my piece on Big Tech from a few days ago. It addresses the question whether Big Tech’s lofty valuations can actually be justified if the technology is powerful enough to change the world. I am attempting to answer that question by looking at several innovations in the past. Innovations that were both powerful and capital intensive. Did those make investors rich?
Before we look into some historical instances of innovation-driven capex cycles, I want to take a moment to explain the basics of the Gold Standard. During most of history, liquidity creation and contraction happened very differently than it is supposed to work today. Understanding the historical liquidity mechanism is important to understand how the following capex booms started and ended.
Today, we understand monetary policy primarily as a countercyclical tool to smoothen the cyclical nature of the economy. Create liquidity into economic weakness and destroy it into strength in order to avoid excesses with respect to unemployment and inflation. Whether central banks have actually been able to deliver on that matter is a different question, of course. Officially, it is their objective.
Back then, monetary policy worked differently. Monetary policy was often deliberately procyclical. They tightened into weakness and kept it easy into strength.
Why was monetary policy procyclical under the Gold Standard?
In a monetary system operating based on the Gold Standard, a central bank (or more generally the monetary authority for a currency) guarantees that they will issue bank notes to market participants for depositing gold with them at a predetermined rate. The global Gold Standard was effectively a system of fixed FX rates because every major currency was fixed to Gold. This can create problems if countries differ in economic success and productivity. Strong economies see speculative excesses. Weak ones see excessive recessions.
For instance, if US companies innovated faster than UK companies, their products would be better and/or cheaper than their overseas counterparts. This would cause a trade deficit in the UK because consumers prefer US products. Consumers would then exchange their Pounds for Gold at the Bank of England and then exchange that Gold for Dollars at the Fed to buy these products.
The same is true for assets by the way. If a British investor wanted to buy US assets, he would have to redeem his Pounds for Gold at the Bank of England, redeem that Gold for Dollars in the US and use those Dollars to buy US assets.
As a result of increased demand for US goods, services or assets, money supply would reduce in the UK and increase in the US. In theory, this should cause inflation in the US and deflation in the UK, making UK companies more competitive and rebalance the system. This self-correcting mechanism is called the price-specie mechanism developed by David Hume.
It came with a problem though: The Bank of England might eventually run out of Gold which may threaten the convertibility of the Pound. Most countries operating under the Gold Standard had a Gold coverage ratio of only about 40-50%.
To defend the convertibility, the Bank of England would then have to raise its discount rate which was the rate at which it lent money to commercial banks. Increasing the discount rate would raise the overall interest rate level in the economy which would make it more attractive to hold cash instead of redeeming it for Gold at the central bank.
Unfortunately, this can quickly lead into a death spiral because it effectively means that the central bank has to tighten into economic weakening. It disincentivizes borrowing at a time when borrowing is needed to fuel the economy. A small economic contraction can quickly become a full blown depression.
Having established this, let’s now look into some historical examples of capex booms, starting with railroads.