When you look back at the railroad boom, presumably there was a moment where it made sense and then things started to get out of control. There was too much debt. There was too much speculation. Whereabouts in that cycle do you believe we are in this moment, or is it too hard to tell?
We're definitely in the manic phase. 1871 was maybe the point at which you could have said this is perfectly rational and it's reasonable. By the end of 1872, we'd exceeded all bounds. So I'm sure that we have entered the manic phase.
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Another AI data center operator just shelved its IPO. That news, along with a growing number of delayed data center listings, is raising questions about investor appetite for these infrastructure assets. And it's also fueling an even bigger question, which is, is the data center boom actually a bubble? As investors try to make sense of this moment, many are turning to history for comparisons, including the railroad bubble of the 1800s. Ben Carlson called it one of the closest historical analogies to this moment. Derek Thompson published a newsletter titled, "AI could be the railroad of the 21st century." And a recent Yahoo Finance article warned, "Don't overlook how this moment is also creeping up on the railroad bust in the late 1800s." But how closely does today's AI buildout actually resemble the railroad boom? What happened in the years leading up to the crash? And are we seeing the same warning signs today?
To dig into that question, we are bringing in Pulitzer Prize-winning author and financial historian who recently wrote a book all about the railroad bubble. Satya Nadella called it the book to read right now and noted all of us are reading this. So here is our conversation with Liaquat Ahamed, author of 1873: The Rothschilds, the First Great Depression, and the Making of the Modern World. Liaquat, thank you so much for joining us.
You wrote that the year 1873 marked the first, you said, truly significant global financial crisis. Many have called it the Panic of 1873. Let's just rewind a little bit. Let's start with the events that led to this crash. How did this boom begin and how did it turn into a bubble? Let's turn the clock back to 1870.
The world has been through a 20-year boom, and it's a boom that is the first era of globalization. GDP doubled in those 20 years. Trade went up five times, and fueling the boom was a new technology, the railroads, and that was a truly global phenomenon. There was a railroad boom in Europe. There was a railroad boom in the US, and there was a railroad boom actually around the world, in Argentina, right around the world.
And making this boom possible was an expansion in borrowing through the bond market. The bond market had been invented essentially to finance governments in the early 19th century, and from around 1850 it shifted to becoming the primary financing vehicle for railroads. And most of the money was borrowed. The $3 billion a year that eventually went into railroads, three-quarters of that was borrowed money, so not equities. So that's the lead-up.
A giant cloud appeared in 1871, and that was war. The most surprising war in the 19th century, started by the French emperor Napoleon, who was a sort of, how shall I put it, he was a celebrity with no coherent ideology who came to power through the ballot box and then used his power to make himself emperor. So I don't want you to draw too many analogies to today, but he was a character, and he launched the most disastrous war in French history when he attacked his neighbor Prussia, thinking that this is the way that he would dominate Europe. Instead, he was defeated on the battlefield.
The Prussians imposed a giant fine on France of a billion dollars, which is equivalent to $1.5 trillion today. You would have thought that would have led to the end of the boom. But in the perverse way of financial markets, it actually fueled a sequence of bubbles.
The billion dollars that France raised was 10 times oversubscribed, and it awoke everyone to the fact that there was this giant amount of money waiting to be invested, and it fueled a bubble in the German and Austrian stock markets. It fueled all of the money that was destined for Europe went into the US stock market and fueled a bubble, or let's just say a boom. Let's not call it a bubble for the moment. And also fueled massive, the London Stock Exchange became a giant casino. So you had three booms going on at the same time, all with separate causes, but all fueled by too much money.
Just some of the players who feature in this story, two names that I'd like for you to tell us about. One, the Rothschilds, who feature prominently in your book, and also Jay Cooke. Who were these people and what roles did they play in these investment booms?
The Rothschilds in 1873 were the richest family in the world. They had made their money in the early 19th century as smugglers, helping the British evade the French blockade during the Napoleonic Wars. They became rich, and they had a network, there were five brothers, and they had a network of connections across Europe. Then after the Napoleonic Wars, they became the primary lenders to governments as governments in Europe were reconstructing after the Napoleonic Wars. And so by 1850, they were the richest family in the world, all from banking. They almost went under in 1848 when revolution swept Europe, but they were bailed out by the French government and then shifted focus to the railroads.
And by 1873, they were the primary lenders to railroads and other infrastructure projects around the world. The one market that the Rothschilds never were able to enter was the US, or decided not to enter. Back in the 1840s, when the US capital market was in its infancy, the Rothschilds lost a ton of money lending to American states for the canal boom.
And they vowed after that, because the states were able to claim sovereign immunity, they were never able to recover their investment in canal bonds. And so they vowed not to ever invest in the US market. They decided it was a frontier market that was essentially a banana republic. And so they became the richest family in the world despite having nothing to do with the most successful country of the mid-19th century, which was the US. Their place was taken by a man by the name of Jay Cooke.
He made his fortune during the Civil War helping the Union government finance the war effort. And essentially what he did was take the innovation that the Rothschilds had come up with, which is the bond market, and democratized it, and essentially financed the Union government by selling bonds in small denominations to households across the North.
And it was a brilliant strategy because he tapped into the inherent patriotism of people in the North and raised $2 billion. By the end of the Civil War, he was one of the two or three richest men in the United States. He was talked about as a Treasury Secretary. He was a friend of the presidents, and he decides to go into the railroad business, the railroad bond business.
The first transcontinental railroad had been completed in 1869, the Union Pacific. He decides to lend his support to a second transcontinental railroad, the Northern Pacific, which was going to take a more northerly route from the east coast right to the west coast. In the early 1870s, he's committed to raising $100 million, or the equivalent today of whatever $100 billion, for this railroad. So that's where we stand on the eve of 1873.
And then comes the crash, which triggered an economic depression that lasted for around four years. What actually triggered this crash?
It started out in Vienna and Berlin when the stock market, which had gone up 300%, collapsed. But it was not the main event of that year. The main event was in September of 1873.
Jay Cooke, who everyone assumed could lay his hands on vast amounts of capital, announces that he is not able to complete the financing of the Northern Pacific. Now the analogy today would be if OpenAI announced that they had committed to raising whatever a trillion dollars and they were unable to complete their financing.
The psychological impact that that had, that everyone assumed that Jay Cooke was the friend of the president, he knew every banker in Europe, the fact that he wasn't able to complete the financing had a giant psychological impact on markets. Every railroad company that was trying to raise capital said, look, if Jay Cooke and Company can't raise the money, who am I to try to raise capital? Within three months, railroad construction had ground to a halt. Within a year, a quarter of the railroad companies in the US had defaulted, and it had this massive cascading effect across the market.
What was the economic damage beyond drawdowns in the stock market? How was it that stocks going down led to this economic depression that didn't just last a couple of months but went on for years?
The biggest impact was obviously in the bond market because the US stock market at that time was one to two billion, it went down 20, 30%. The bond market was three times as large, and with defaults in railroad bonds amounting to eventually a billion dollars in nominal terms. Probably the cost was $500 million, which was significant.
It was actually, oddly enough, not the biggest factor behind the depression that followed because superimposed upon this boom-bust cycle, we had a giant mistake in monetary policy. And the history of markets is that the economy is surprisingly resilient to boom-bust cycles. It's when you impose giant mistakes in monetary and fiscal policy on top of that that you get what one would call a depression.
And in the middle of 1873, Germany decides to abandon silver as a basis for its currency and shift to gold. In the US, legislation is passed which omits to include silver as a basis for the monetary system. The combination of those two things leads silver prices to go down by 30, 40%.
Now until then there were two metals that formed the sort of solid foundation for the monetary system, gold and silver. And every time there was a panic, everyone would gravitate to one of those two metals. With silver prices collapsing, silver was no longer a safe asset, and all of the sort of flight to safety got concentrated into gold. And as a consequence, you got this tightening of credit around the world just when you were going through a downturn caused by the collapse of the railroad boom.
And that is what transformed what was a normal down cycle into a global depression, which caused prices to fall by 30 to 40%. So the big question we're going to have to ask ourselves when we project forward is, is there any giant mistake in monetary policy waiting to happen this time round?
We'll be right back after the break. And if you're enjoying the show so far, send it to a friend and please follow us on YouTube, Spotify, or wherever you get your podcasts.
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We're back with Prof G Markets. Well, this is I think probably a good place to start making the comparisons. I guess I'll just start with a pretty general question, which is obviously we're seeing a massive data center buildout today. I think that the data center would be the analogy to the railroads. Do you think that this is an apt comparison? We'll dig into it more specifically, but on a general level, do you think that this comparison makes sense?
Yes, very much so. Because the key risk in the data center boom is overbuilding, and overbuilding financed by debt. Until recently, the bulk of the money going into data center construction was from hyperscalers and it was being financed out of earnings. But the scale of the construction boom in data centers has been so large that the resources of the large tech companies has not been enough and they've turned to financing through debt.
And what makes it particularly worrying is that much of this debt is quite opaque. We don't actually know how much debt there is. At the center is a company like Nvidia, which is essentially lending to its customers. It doesn't call it lending, but it is a form of lending, and so we don't really know how much of the construction is being financed by debt. So that's the first comparison.
The second is by 1873, it is clear that there has been overbuilding, and it shows up in the form of excess capacity on railroad lines and an erosion in profitability of railroad lines. So by the end of 1872, only a quarter of the railroad companies are able to pay dividends. And I suppose the analogy today is, you know, is all of this data center construction leading to a fall in the prices of their output, which I suppose is tokens, and token prices are going down. So that's the second analogy.
And then the third is because of a collapse in the stock markets across Europe, not related to data centers but just related to a stock market bubble, it leads to financing problems. So for railroad companies, they begin to have to pay up to issue bonds, and until then they've been borrowing at five, six percent, now that spikes up to nine percent. So the combination of overbuilding, erosion of profitability, and sort of constraints in financing show up at the end of 1872, beginning of 1873. And the question we have to ask ourselves is, are those three things appearing today?
Why was there such a pervasive problem of overbuilding when it came to railroads? Why was it that the railroad companies couldn't accurately assess the demand for this new technology that was actually transformative and did change the world for the better? But still we say that they overbuilt because they didn't have a business model that made sense and they had to look back and say, okay, we made a mistake here. So why was it that they landed in that position of overbuilding?
A few months ago, they asked Satya Nadella, who's the CEO of Microsoft, you know, how are you going to prevent overbuilding? And very kindly he referenced my book and said, you know, everyone's reading this book and what we're going to do is be very careful. And I think he got the wrong end of the stick because each individual railroad company, in the same way that each individual tech company is trying to be careful, it's the collectivity of their decisions that leads to overbuilding.
Because what it would require to prevent overbuilding, it would require some sort of collective action. And you have something of a prisoner's dilemma here, that each one thinks, I'm going to be the one to get on top. So I would be giving up market share if I slowed down my construction. But the problem is you add all of their individual decisions up and you end up with an overbuilding boom. Is there a solution to this? Probably not. I mean, I think it's just inherent in the competitive situation that everyone wants to be one of the two or three companies that comes out on top.
Does that essentially mean that whenever a new technology comes along that is transformative, that there will inevitably be a crash at some point?
There have been four or five private investment booms in US history. The 1870s, which by the way was actually three mini booms and busts. So there was one in the 1870s, there was another one in the 1880s, and there was another one in the 1890s. So the railroad boom was actually three booms and busts. The 1920s, when private investment jumped by five percent of GDP for a few years, the dot-com bubble of the late 1990s, the real estate bubble of the mid-2000s.
All of them led to a jump in private investment of two to four percent of GDP. All of them lasted two to four years. All of them ended up with excess capacity. And all of them, interestingly, ended up with a spike in interest rates as everyone was competing for capital in the final stages of the boom, and all of them ended up with a crash. Will this time be different? You know, I'm answering that's a rhetorical question.
I guess the question then becomes timing. When would it all unfold? If we believe that this is just what happens, you have technology booms and then suddenly there's overcapacity and we all look around and we suddenly lose confidence and it crashes. Just looking at what happened during the railroad boom leading up to the crash, based on some of the data in your book, more than three-quarters of railroad construction was financed with debt leading up to the crash. You mentioned that there is a lot more debt being issued to build data centers and to fund the AI buildout. But I don't think it's that high. Am I correct? And if so, then perhaps we have more room to run.
The data center boom has been going, let's say, for two years. We've had booms go on for four years. So we could be halfway through the process. So, you know, there is almost nothing in history that allows you to pinpoint the timing. I can't be any more precise than that.
The size of the private investment booms were anywhere from two to four percent of GDP. In fact, since 1873, it reached five percent of GDP. This current boom is not at five percent of GDP. We're, you know, next year we're projected to put in, I don't know, $1.5 trillion. That's probably four percent of GDP, three to four percent. We're not at the sort of extremes that we've experienced in the past.
Why is it that we should be looking at percentage of GDP as a metric for whether we are at the top? Like, what is it about that measurement that makes it relevant and important in terms of predicting crashes?
You get a series of knock-on effects of these private investment booms. Essentially, it starts crowding out all other forms of investment. And we're already beginning to see the market, you know, the stock market is overwhelmed by AI. It's become the story, the one story. It's actually become a global story. It also causes, there's a sort of limited capacity to finance more than three to four percent of GDP in one go.
And you're beginning to see that in the form of the spike in interest rates. Interest rates have risen whatever 150 basis points in the long end in the US, even more in other countries. And that's what you typically get, it shows up because these booms absorb such a large percentage of the world's savings that it causes interest rates to spike up, which causes all sorts of knock-on effects in terms of default rates on other things.
So we have interest rates rising. It appears that we are going into a rate hiking cycle. Of course, yields are soaring to levels that we haven't seen in decades. We've also seen some smaller signs that might be predicting that perhaps we're about to enter the correction. For example, a lot of these data centers that were supposed to go public are now delaying their IPOs. In some cases, they're just deciding we're not going to go public at all. There was an AI startup recently that filed for bankruptcy. I guess when you look at today and you compare it to 1873, what were some of the warning signs that appeared before the crash, and to what extent do they mirror any of the red flags that we're seeing today?
I don't want to be mechanical about it because history is full of random effects. But one of the factors that caused Jay Cooke and Company to not be able to complete his financing was his railroads ran into the wars against the Indians and the Sioux and Sitting Bull and all of those sort of, his goal to complete the Northern Pacific ran slap up against a war in the Northern Territories. I suppose the modern-day equivalent is the political protest against the construction of data centers.
So it's not Sitting Bull, but it's a lot of people not wanting local communities.
Exactly. So, you know, there's always sort of some random effect that actually adds a little more color to the story. So that's one of the things I would worry about. And I've never quite got my head around how you measure the output of these data centers.
But the other big factor is the erosion of profitability. And I don't know how you measure that, whether there is an erosion of profitability, whether the demand for tokens is inexhaustible. But, you know, that's where I would start looking for trouble.
