I.

The defects I hope to demonstrate will first be discussed in connection with an example used by him to bring out one of his points. He says, ". . . if a plant had been built at times of low costs, at $1,000,000 and the capital had been raised to the extent of $750,000 by an issue at par of 5 per cent 30-year bonds and to the extent of $250,000 by stock at par, and ten years later the price level was 75 per cent higher and the interest rates 8 per cent, it would be a fantastic result to hold that a rate was confiscatory, unless it yielded 8 per cent on the then reproduction cost of $1,750,000. For that would yield an income of $140,000, which would give the bondholders $37,500; and to the holders of the $250,000 stock $102,500, a return of 41 per cent per annum.'

If a case involving these figures were before a Public Utilities Commission composed of so-called "progressives," it might and probably would fix rates that would limit the return to the stockholders to $12,500. And Mr. Justice Brandeis would not consider that these rates improperly deprived the stockholders of their property as $12,500 is equal to a return of 5 per cent (the rate of return that was reasonable when the company was started) on $250,000 (the amount of cash originally put into the company by the stockholders). There is a vast difference between $12,500 and $102,500 but I hope to show that the former is at least as fantastic if not more so than the latter. For the sake of convenience, the time of low interest rates and prices when the company in the example was formed will be referred to as 1910 and the time of high interest rates and prices will be referred to as 1920.

money.

In 1910 the stockholders started the company with $250,000 in This money, however, represented a certain purchasing power in clothes, houses, food or in anything else which they might purchase with it. And it is on this money that they should have the opportunity to earn a fair return. For the present I am not quarreling with the statement that it is on the capital prudently invested that the stockholders are entitled to earn a return, but I am quarreling with the idea that money can be used as a measure of that capital over any period of time. It is only necessary to glance at the index of commodity prices published by the Department of Labor to see this failing of money. Everyone is familiar with the

6 262 U. S. 276, 305.

large fluctuations that obtained in war-time but even the comparatively small fluctuations prior to the war were sufficiently large to destroy the sanctity of money as a measure of value. For example, from 76 (1913 prices equal 100) in 1892, the index dropped to 69 in two years and to 66 in two years more; from 69 in 1898 it rose abruptly to 80 in the same short period of two years; and from 85 in 1905 it rose to 94 again in two years.

A man who bought stock in a utility started in 1897, which brought him 6 per cent would discover, if prudent investment was used as the rate base and if money was used as the measure of prudent investment over the entire period, that in less than ten years he was really only getting 4.27 per cent per annum on the money he put into the company because that money was worth about 30 per cent more than 1907 money. In short, when a stockholder has invested money of a certain quality, he ought to get his return in money of the same quality so that if the money we have to give him is poorer, we ought to give him more of it, and if it is better, we are foolish to give him as much.

Whether the rate of return should vary from that originally allowed presents a somewhat similar problem. It comes down to this question, "Have we any obligation to fix rates that are high enough to give the company an opportunity to earn enough to keep its stock at par,' assuming it was issued at par?" It seems to me that we have. If a man bought stock when a reasonable return on his investment was 4 per cent and then conditions changed so that a reasonable return on such stocks was 6 per cent, and we did not allow him the additional 2 per cent, his stock would drop from 100 to below 70. He will then have sustained a loss in the value of his capital of over 30 per cent.

Mr. Justice Brandeis seeks to make the stock of public utilities more of an investment and less of a speculation for, "In speculative enterprises the capital cost of money is always high." Will not the stock be far less speculative if the purchaser knows that he can always sell for approximately the same price for which he bought and that his capital won't be subject to wide fluctuations with every change of interest rates? Mr. Justice Brandeis reasons that the stocks will be less of a speculation if we say to the investor at the time the company is started, "The prevailing rate of return on

"By "par" is here meant the real rather than the money cost to the investor. 8 262 U. S. 276, 307.

investments of this character is now 6 per cent. You will not have to worry about interest rates going up or down; we will give you the opportunity to earn 6 per cent no matter what happens to them." But if we say this we are overlooking the fact that to an investor the preservation of his principal is far more important than his income. We are in effect asking him to invest in interest and speculate in principal whereas if we adjust his return with the rise and fall in interest rates, he is speculating in interest and investing in principal. The speculation in interest is undesirable but it is the least undesirable of the two alternatives as it is so comparatively small. That this "speculation in principal" under constant interest rates is fact and not idle theory is substantiated by the course of the Liberty Bond market. The return on these bonds represents practically pure interest in that it contains no allowance for risk and lack of marketability. Despite their tax exempt features, they sold so low in 1920 as to be on practically a 6 per cent basis; that is to say, if they were purchased in 1920 the 44 per cent interest plus the increase in value up to par at maturity apportioned partly to each year would bring a return of practically 6 per cent per annum on the purchase price. The bonds of the Third Liberty Loan sold to yield 61⁄2 per cent and those of the Victory Loan to yield over 6.60 per cent. Since there was no question of their safety, the drop in their market value was the result of an increase in the prevailing interest rates. Stock issued at par yielding 44 per cent would drop to 70 if the prevailing return on similar securities rose to 6 per cent. And this 30 per cent drop in value would result from the change in interest rates alone.

Now to return to the original example of the company starting in business in 1910 with a capital of $1,000,000 as cited above. Under Mr. Justice Brandeis' theory, a man who put $100 into the company for which he received one share of stock, would not be improperly deprived of his property if rates were fixed that gave the company an opportunity to earn $5 a share, equal to $12,500 on its entire stock capitalization. Out of this $5 a share, the company in most states would have to pay the present federal income tax of 121⁄2 per cent or 621⁄2c a share leaving $4.37% available for dividends. A conservatively managed company would not pay out this entire amount and moreover the public would be the first to

• In connection with the importance to the investor of a principal having a stable value, the many demands that the government keep these bonds at par will be recalled.

suffer if it did as every time the smallest extension of service was desired, more stock or bonds would have to be sold to raise the necessary capital. For the sake of simplicity, however, the most favorable conditions possible will be assumed, i.e., that the company is operating in a state that allows the federal income tax to be deducted as an expense and that it was in a position to pay its entire earnings in dividends so that our investor who bought one share would receive $5 a year. In 1920 with rates on similar investments approximating 8 per cent his stock would sell for 621⁄2 at the most and might well sell lower. He sells for 621⁄2 and what does he get? He gets 621⁄2 dollars that are worth only 58 per cent of the dollars that he put in since the price level has risen 75 per cent, or in other words out of an original investment of $100 he gets only $35.71 making a loss of 64.29 per cent of his capital, a result that he might well be entitled to call fantastic. And this result is not something that just might happen: it is a result that follows from Mr. Justice Brandeis' theory under the conditions most favorable to his theory just as surely as night follows day.

How then are we going to preserve the investor's property from any so thoroughgoing a loss in value? What is the lowest return we can give him without reducing the value of his investment? We must fix rates that will give the company the opportunity to earn $14 a share, $8 being the current rate of return and $6 more to compensate for the 75 per cent rise in prices. The stock could then sell as high as 175 so that our original investor could sell his one share and get just as much value, just as much purchasing power in clothes, food, houses, etc., as he put in in 1910. He would then be, as he should be, in the same position as another investor who invested $175 of cheap money in 1920 (the same as $100 of 1910 money) and received the current return of 8 per cent or $14.

If it be asked why we should increase the money income of an investor in public utility stock upon a rise in prices and decrease it upon a fall in prices when we leave everyone else to shift for himself, the answer is that everyone else has had the opportunity to put his money into something that will participate in a general rise or fall in the price level. If, by controlling rates, we are going to control the natural play of economic forces which if left alone would cause a rise or fall in the price of public utility stocks with the rise or fall

of the general price level,10 we must not so use our control as to subject the investors to hardships not shared by everyone else.

The Interstate Commerce Commission is now engaged in making a valuation of the railroads for rate making purposes. The value found is that of 1914. It would be interesting to know what certain members of that body and others who do not favor a change in the value or rate base to correspond with the rise in the general price level would do if our currency had depreciated to the same extent as that of some of the European countries. Unless the rate base was changed, a $100 share of a public utility, under conditions similar to those in France for example, would be worth somewhere around $30, and under conditions similar to those in Germany, would be worth a good deal less than one cent.

If it be said that high interest rates are caused by high prices and that the very reason for their existence is to compensate for high prices and therefore if we adjust the stockholder's return for the former we need not do so for the latter, the answer is that in the first place high prices are not the cause of high interest rates and in the second place that the one does not in fact compensate the investor for the other. On the question of causation, the opinion of the economists is stated by Professor F. W. Taussig as follows, "Both rising interest and prices are in large degree due to a common cause, the general fever of activity."11 On the question of compensation, we have seen that adjustment for both factors is necessary in that although an adjustment for interest will keep stock at par, the price of the stock must be increased proportionately to prevent loss through increased prices.

If it be said that the theory set forth above will make every investor a stock market addict in that his public utility stock will vary widely in price, the obvious answer is that although it will

10 Theoretically, if the price of everything, commodities, land, service, labor, etc., was suddenly doubled, the price of all stocks would double, as they represent in reality nothing but a part ownership of something which, according to our premise, has doubled in price. And despite the fact that stock prices are influenced by many diverse factors, that changes in them and changes in commodity prices are in fact coincident phenomena, can readily be seen from the charts of commodity prices and industrial stock averages published in the bulletins of the U. S. Department of Labor and the Harvard University Bureau of Economic Research. For example, both industrial stock averages and commodity prices were low in 1903 and 1904, both rose in 1905 to a high in 1906 and 1907, both fell in 1907 to a low in the latter part of 1907 and 1908, both rose in 1909, both fell in 1910 and 1911, both rose in 1912, and then both gradually fell off until the latter part of 1914 and the first part of 1915 when the enormous rise in both due to the war commenced. 111 Principles of Economics (2d ed.) 309.