Shattered Rails, Ruined Credit: Financial Fragility and Railroad Operations in the Great Depression

Daniel A. Schiffman

Bar Ilan University

Abstract. The theory of “financial fragility” emphasizes the role of weak balance sheets in propagating and magnifying macroeconomic shocks. I use a new panel dataset to investigate the relationship between financial fragility and real activity on U.S. railroads during 1929-1940. First, I formulate a flexible accelerator model of maintenance expenditures and employment. Then, using the model as a benchmark, I ask whether a firm’s degree of leverage, bankruptcy status, and size affect the responses of employment and maintenance expenditures to changes in operating revenues.

    My results provide strong support for the predictions of the financial fragility theory. Leverage and bankruptcy status had the greatest effect during the worst years of the Depression and their impact differed systematically by firm size. Firm leverage had a large negative effect and generally affected small firms only. That is, firms whose fixed interest burdens were heavier than average exhibited lower than average annual growth in maintenance and employment; in general, this was true of small firms only. Bankruptcy effects were large and positive, and were present in large firms only. In other words, large firms that were in bankruptcy exhibited higher annual growth in maintenance and employment. Various categories of maintenance expenditure were not equally sensitive to financial effects; I find that highly indebted firms mainly used track maintenance to absorb revenue shocks.

    U.S. Government attempted to keep the railroads out of bankruptcy through loans from the Reconstruction Finance Corporation. I conclude that this policy was counterproductive.

JEL Classification: E22, N12, N72, N22.