Economic Perspective on the Building of the Canadian Pacific Railway Introduction Chronology of The

Economic Perspective on the Building of the Canadian Pacific Railway

Livio Di Matteo

Introduction

The nineteenth-century national policies of the Canadian government, a triad of land, railway, and commercial policies, aimed at making the Canadian West an investment frontier of Central Canada. Through the policy of land grants in the West, the Dominion government sought to settle the region with farmers, who would serve as a market for the manufactured goods of an Eastern and Central Canadian industry that in turn would be protected by the national policy tariffs. The crucial link between the two policies was the building of a transcontinental railway that would create a national economic space along an east-west axis. The building of the Canadian Pacific Railway (CPR), then, was the key ingredient in early Canadian political and economic development as well as "a landmark in the spread of Western civilization over the northern half of North America." [1]

The completion of the CPR in 1885 was more than an impressive transcontinental engineering achievement; it was also a significant joint economic undertaking by the public and the private sectors. Crucial to the success of the CPR as a nation-building device was the choice of route through the Canadian shield as well as the contribution of substantial government financial aid. In the absence of government assistance, the CPR would probably not have been constructed by private interests when it was, although whether government assistance to the CPR was too generous is still a matter of debate. Opinion as to whether the subsidies were necessary depends on whether one views the investment decision from an ex post or ex ante perspective, from after the railway was built or before. [2]

Chronology Of The CPR

Railways were the transportation innovation that drove nineteenth century industrial progress; they reached their zenith with transcontinental lines such as the CPR. The basic chronology of the construction of the CPR is well established in the historical literature. In 1871, the province of British Columbia was admitted to the Canadian federation. As part of the terms of entry, the Canadian government undertook to commence construction on a railway from Central Canada to the Pacific within two years and to complete the project within ten years. In 1872, the Conservative government of Prime Minister John A. Macdonald awarded the contract to build the railway to the Canadian Pacific Railway Company, of which Sir Hugh Allan was President. In April of 1872, Sanford Fleming, the chief project engineer, settled on a northerly route for the Canadian Pacific Railway that would take it through

the Yellowhead Pass and then down to Burrard Inlet. The project fell apart in 1873 when the Pacific Scandal revealed that Sir Hugh Allan, prior to his company being awarded the railway contract, had subsidized the Macdonald Conservatives in the 1872 election campaign. The Macdonald government resigned, and the Liberals under Alexander Mackenzie were elected to power in the January 1874 election.

The Mackenzie government began construction of the line on its own in small, incremental, and cautious steps. By 1877, a line from Fort William (now Thunder Bay) to Winnipeg had been completed as well as the section from Kamloops to Port Moody in British Columbia. The main difference between the policies of the Conservative and Liberal governments, when it came to railway construction, was the speed with which each was willing to pursue the project. The Liberals, on the whole, were much more cautious, being prepared to wait rather than accept a time limit for completion. [3]

In 1878, the Macdonald Conservatives were returned to power with the completion of the CPR as a central plank of the national policies. The slow rate of progress on the transcontinental railway helped make the case for again having a private company assume the project. In 1880, the government awarded the contract and charter for the transcontinental railway to the Canadian Pacific Railway Syndicate under interests led by fur trader, financier, and diplomat Donald Alexander Smith, transportation official and railway magnate James Jerome Hill, and banker and cousin to Donald Smith, George Stephen. The dynamic William C. Van Horne was hired as the project manager. The CPR charter dealt with constructing a line from Callander (near North Bay), Ontario, to the Pacific coast but the CPR was allowed to operate in Central and Eastern Canada as well.

During the spring of 1882, the syndicate completed the line from Fort William, Ontario, to Selkirk, Manitoba, and the line reached Regina by summer's end. As well, in 1882, an alternate and more southerly pass, the Roger's Pass, was discovered through the Selkirk Mountains by surveyor Albert Bowman Rogers. The new route of the railway, which had been altered to go through the southerly Palliser's Triangle subject to the alternate pass to the Yellowhead being 100 miles or more from the U.S. boundary, was successfully implemented. In 1885, the line around the rugged Lake Superior north shore connecting Fort William to Callander was completed; its usefulness was demonstrated when it was used to dispatch troops to quell the North-West Rebellion in Saskatchewan. The transcontinental rail line was finished with the driving of the Last Spike at Craigellachie, British Columbia, on 7 November 1885. The first through passenger train left Montreal on 28 June 1886 and arrived at Port Moody, British Columbia, on 4 July 1886.

The CPR continued to expand in Eastern and Central Canada in the 1880s through further construction and acquisition and its mileage grew from 4,338 miles in 1885 to 7,000 miles by 1899. The construction of a short line through Maine by the CPR in 1890 linked Montreal, Quebec, to Saint John, New Brunswick, gave the CPR a coast-to-coast capability, and in the process further undermined its competition-the circuitous Intercolonial Railway which ran from Rivière-du-Loup, Quebec, to Truro, Nova Scotia. The rolling stock of the CPR also grew tremendously between 1886 and 1899. The number of freight and cattle cars increased from 8,235 to 19,005; the number of first and second class passenger cars rose from 209 to 627, and the number of locomotives nearly doubled from 372 to 690. [4] The volume of freight carried by the CPR and the number of passengers tripled between 1886 and 1899, while the grain carried quadrupled across the same period. As the West was settled, the growing grain trade also resulted in the CPR erecting elevators at collection points on the Prairies as well as terminal elevators at the Lakehead, which cleaned, treated, and stored grain before loading it on lake vessels for export to world markets. By 1900, the CPR had built five terminal elevators at the Lakehead with a combined capacity of 7.5 million bushels.

Selecting the Route

The final route of the CPR was a matter of much contention. In Central Canada, the geographic obstacle of the Canadian Shield, with its muskeg and rock, stood greatly to increase the cost of the project. Indeed, James J. Hill resigned his directorship with the CPR in 1883 in part to protest the building of the main line along the north shore of Lake Superior. Meanwhile, in the West, the choice of route was between a southerly course that would take the railway through the arid Palliser's Triangle and a more northerly course through Saskatchewan, Edmonton, the Yellowhead Pass, and then down to Kamloops and Port Moody. The decision had important economic consequences, as the more northerly route was seen as possibly adding to the railway line's cost and distance while the more southerly route would add a significant quantity of agricultural land to the railway's service area.

Fleming had proposed the more northerly route. It would pass through an area of arable land known as the "fertile belt" in comparison to the dry region covering much of southern Saskatchewan known as Palliser's Triangle. However, during the early 1880s, CPR botanist John Macoun argued that the arid Palliser's Triangle was composed of clay soil that would actually hold more moisture if broken by the plough-making the area suitable for agricultural settlement and, therefore, for the route for the CPR. This optimistic assessment provided an additional justification for the southerly route and added thousands more acres to the potential land for settlement. The droughts of the1920s and 1930s would show the folly of agricultural settlement in Palliser's Triangle. The discovery of the more southerly Roger's Pass indeed cemented the choice of the southern route while the more northerly route eventually became the route of the Canadian National Railways. The CPR generally preferred the most southerly route, possibly fearing that, in the long run, competing railways could be built to the south of its main line. As well, there was the concern that the grains available at the time might not be as safe a crop in the more northerly latitudes.

Given the expense of building through the Canadian Shield, a number of proposals for the line from Ontario to the West had been made. Most of these proposals involved going through the United States and coming up through Minneapolis and Red River to Winnipeg. Indeed, a rival offer put forth by the Grand Trunk in the 1870s suggested using the Grand Trunk line from Quebec City to Sarnia, American railways from Sarnia to Winnipeg, and only building a line from Winnipeg to the Pacific. Another proposal suggested a main trunk line from Winnipeg to Fort William, a ferry link to convey the rail cars across Lake Superior, and a connecting line at Sault Ste. Marie, but the limitations of this route in winter were obvious.

In the end, however, the Canadian government chose an all-Canadian route, in spite of the expense of laying track around Lake Superior. The grounds for this decision were essentially political. Given that the Western railway project was a nation-building exercise and a defensive action to secure the North- West Territory for Canada against American expansion, it made little sense to have the route go through the United States. As well, the all-Canadian CPR project was in Britain's imperial military interests; as Vernon Fowke wrote: "It was also to be a link in an imperial chain, a vital part of the 'all red route' which was to bind together the various portions of the far-flung empire." [5] Its potential military transport significance was not lost on the United States, and the American Ambassador in London informed the British Government that the completion of the CPR would not be regarded with favour.

The Case for Subsidizing Railway Construction

The Canadian Pacific Railway was constructed by private interests with government assistance. In many ways, the CPR was a Canadian "mega-project," one in a line of projects that have included the

Intercolonial Railway, the St. Lawrence Seaway and canal system, the Trans-Canada Highway, and, most recently, the fixed link to Prince Edward Island. The poor performance of the Mackenzie government in railway construction during the 1870s illustrated that the project was so capital intensive that public assistance was needed in the form of land and cash subsidies as well as various tax exemptions.

The general consensus amongst economic historians is that, in the absence of government assistance, the CPR would not have been built when it was but rather would have been postponed to a much later date when the much denser Western population needed to support rail traffic was present. In 1871, at about the time the CPR was proposed, the population of Canada was 3.7 million with little more than 100,000 people west of Ontario. Of course, postponement risked the construction of north-south lines linking Canada into the American rail grid and eliminating any need for a Canadian transcontinental rail line.

The economic case for financial assistance to rail companies is relatively straightforward and lies in the economic characteristics of railway construction. For example, one cannot build half a railway between Winnipeg and Vancouver, wait for freight traffic to develop, and then complete the rest of the railway. The railway had to be built in its entirety resulting in high initial capital costs of construction in advance of revenue flow, a problem intensified by the great distance the railroad was expected to cross. Moreover, a certain amount of risk attaches to any such project that commits a large amount of capital to a use that is not easily reversible once constructed.

To understand the risk involved, one has to remember that the decision to build the CPR was a policy decision made in the face of uncertainty. Had the wheat boom not occurred and Western settlement not been generated after the mid-1890s, then the CPR could have been left holding the bag. [6] Given the distribution of Canadian population prior to 1900, a decision to build a transcontinental railway was a project high in risk and without immediate profit to the private sector. The economic case for subsidizing the transcontinental rail line can also be made on the grounds that the rail line's construction entailed both private and social benefits and that private interests would generally ignore the social benefits. [7] The private costs and benefits of railway construction are straightforward. The demand for railway travel by both freight and passengers generates revenues for private firms that compensate for the capital and operating costs of building the railway and provide a return to the entrepreneurs as profit. A public finance economist would argue that the construction of the railway entails external effects; that is, social costs and benefits are not taken into account by a market process that emphasizes only private costs and benefits. [8] In such a situation, the market will fail to provide a good that may have very high social benefits because it exceeds the private cost of construction. As a result, a case can be made for government assistance to correct the market failure.

The social or external benefits to railway construction that private entrepreneurs might not consider include the economic linkages that railway construction creates. Linkages are the spread effect an economic activity has on other sectors of the economy. For example, the demand for material inputs and labour for railway construction from the domestic economy provides a powerful economic stimulus to economic development-a fact not lost on Canadian governments interested in economic nation building. W.W. Rostow has argued that the introduction of railroads has historically been the single most important initiator of economic take-offs by lowering transport costs and widening the market, by leading to the development of a new export sector, and by leading to the development of modern coal, iron and engineering industries. [9]

Another social benefit of railway construction was that it lowered transportation costs and expanded the potential market size available to entrepreneurs in other industries, particularly once Western settlement was well underway. For example, a manufacturer in Berlin, Ontario who previously served primarily the

southern Ontario market, now had market opportunities in Western Canada because of the rail link. This expansion of market size created opportunities for both investment and entrepreneurial development, which in the long run also benefited economic nation building. Excess social benefits may also accrue to farmers. The railway must charge the same rate to all and thus cannot extract from each user a price equivalent to their valuation of the transport service.

The final social benefit afforded by railway construction was primarily political in that the nation was linked from East to West. The symbolic political power of linking the nation with a ribbon of steel in the nineteenth century should not be underestimated. After all, the motto on the young Dominion's armorial bearings was "A Mari Usque Ad Mare," and the completion of the CPR indeed linked the Dominion from sea to sea. Canadian policy can also be seen as "defensive expansionism." [10] According to this theory, the state in Canada strove to promote economic growth and expansion across the northern half of North America in an effort to outflank the United States. Thus, the building of the CPR was part of a strategy to secure the West for Canada in the face of a stronger and more aggressive American economy. Again, such a strategy is not a task for private companies, whose primary aim is to maximize profits, but a task for the public sector, again providing justification for government financial assistance.

The Subsidies

The amount of Dominion government assistance provided to the CPR was quite substantial since the Macdonald government, after its re-election in 1878, found no private bidders for the project for two years. The Syndicate put together in 1880 to build the railway received the following terms in return for completing a railway from Northern Ontario to the Pacific by May of 1891. First the Dominion government was to provide a direct subsidy of $25 million in cash and 25 million acres of land. Second, sections of track already built by the government at its own expense were to be given to the CPR without charge. This provision referred to the sections of track built from Fort William to Selkirk and from Kamloops to Port Moody-700 miles of track costing approximately $38 million. Third, all materials required for the construction and operation of the CPR were to be exempted from taxation. As well, all imported construction materials were to be allowed into Canada duty-free. Moreover, CPR lands were not to be taxed for twenty years unless they were sold or occupied. Fourth, the government promised not to regulate freight rates until the CPR was earning a 10 per cent return on its capital. Fifth, the construction of any competing railway south of the CPR was prohibited for twenty years. This stipulation was known as the monopoly clause of the agreement.

Under these terms, the Syndicate not only fulfilled the Canadian government's goal of completing a transcontinental rail line but also completed the project six years ahead of schedule. The terms were quite generous as the value of the completed sections of the track and the cash subsidy alone totalled $63 million-equivalent to 11 per cent of Canada's entire Gross National Product in 1885. The value of the land grants, tax and tariff exemptions must also be added to this figure. Not surprisingly, the terms of the contract sparked considerable debate in the House of Commons. Opponents criticized the government for providing too much public money, choice picks of land for the land grant, overly generous tax exemptions, and a virtual monopoly for the CPR.

Referring to the Syndicate members, Edward Blake, the leader of the opposition, charged, "They are not entitled to ask, Sir, for the privileges given to men who build railways at their own risk. They do not occupy that position. You are giving them the money to build up a monopoly of trade, and giving them statutory security for that monopoly and you are bound to restrain them." [11]

Evaluating the Subsidy to the CPR

As mentioned, the general consensus today is that in the absence of government assistance, the CPR would not have been built when it was, if at all. After all, no host of investors lined up to build transcontinental railways in Canada without public assistance. Perhaps the more pertinent issue is whether the government assistance was excessive. In his seminal study of the CPR, economic historian Harold Innis, after examining the data on the railroad's operating expenses and revenues, concluded that the CPR was profitable in accounting terms. The ratio of total expenses to gross earnings for the CPR for the period 1882 to 1899 declined from approximately 74 per cent to 58 per cent while net earnings rose from just under $400,000 to just over $12,000,000. Innis also estimated the efficiency of the operations of the CPR by calculating the earnings per train mile, which rose from 1.30 cents per train mile in 1885 to 1.58 cents by 1899. During the Western settlement boom period of the early twentieth century, earnings per train mile rose from 1.69 cents in 1901 to 2.72 cents in 1914 and continued to rise both during and after the First World War (1914-1918) to reach 4.89 cents per train mile in 1921. [12]

Whereas Innis had examined the accounting profitability of the CPR project in terms of the difference between costs and revenues, economic historian Peter George sought to determine the economic profitability, that is, whether the CPR had a rate of return that was comparable to the return on other investments at the time. For private investors to undertake the building of the CPR, they would have to believe they would earn a rate of return on the project at least equal to that available on the next best opportunity. The difference between the private rate of return that could be earned on the CPR and the average market rate of return on other opportunities would be the amount that government would be required to provide against the cash cost of construction of the project to increase its value so that it would compare attractively to other market opportunities.

George focused his study on the period 1886 to 1895. He defined the annual private rate of return of the CPR project as the ratio of railway earnings in a given year to the cost of the investment expenditures up to and including that year. Basing the estimate of a private rate of return on the book value (the amount shown in the CPR's own accounts) of the investment in the railway yields annual estimates over the period ranging from 1.9 to 3.5 per cent. These figures do not compare favourably with market rates of return on investment in comparable projects of the time, which ranged from 6 to 10 per cent. However, the book value of the company's expenditures is not an accurate reflection of the true costs of the project because the costs frequently did not represent the actual cash outlay on expenditures but the par value (the nominal or face value) of bonds and shares issued to finance the project. As a result, rates of return based on the book value of CPR railway expenditures are downward biased; that is, costs are overestimated and, therefore, returns underestimated.

According to George, the rate of return ought to be based on the actual cash costs of construction, including government expenditures on construction less the subsidy paid to the CPR and expenditures by the CPR itself. Government expenditures on the CPR were for surveying, excavation, tracklaying, timber, and rails. CPR expenditures were for the construction of the main line from Montreal to Vancouver, the branch lines, the improvements on leased lines, and the estimated value of leased railway lines acquired prior to 1896. Taking the company's annual net earnings (the excess of revenues over expenses) and the estimates of construction expenditure by both the CPR and the government of Canada up to 1895, and factoring in depreciation (the loss in value of assets from wear and tear) as well as the rate of inflation (the increase in the general price level) by converting the values into 1885 constant dollars, a calculation of the rates of return to the project can be made. George found that in non- inflation adjusted dollars, the private rate of return for the period 1886-1895 ranged from 2.1 to 4.1 per cent, while for the inflation adjusted figures the return ranged from 2.2 to 4.4 per cent (or an average rate of 3.4 per cent). Given that the normal rate of return on investment was in the 6 to 10 per cent range, these estimates demonstrate that the CPR was not privately profitable and did require a subsidy to make the project attractive to private investors.

George then estimated the value of the government subsidy to the CPR in 1885, adding the value of the government built sections of the railway, the cash subsidies, the land subsidy, the tax exemptions, and the remission of customs duties on imported materials used in construction. Several aspects of the subsidy were not quantifiable, such as the value of lands for its right of way, the value of construction materials the CPR was authorized to take from Crown Lands, and the monopoly privileges that were granted for a 20 year period. The total value of the quantifiable aspects of the subsidy, assuming a 10 per cent rate of interest, was estimated to be $121.2 million or $107.6 million in 1885 dollars. Assuming a 6 per cent rate of interest, the value of the subsidy was $145.6 million or $120.2 million in 1885 dollars. [13]

George's next step was to estimate what amount of financial assistance or subsidy was required to bring the CPR project up to market rates of return. What amount had to be added to the company's net earnings as a subsidy in order to bring the rate of return of the project up to market levels? George calculated the amount of subsidy required to bring the rate of return of the CPR project up to 6, 8 and 10 per cent. In non-inflation adjusted dollars, the value of the required subsidy ranged from $68.3 million to $81.1 million while in 1885 constant dollars, the subsidy ranged from to $59.2 million to $73.5 million.

The subsidies actually paid to the CPR in 1885 constant dollars exceeded the required subsidy by amounts ranging from $61 million to $39.8 million to $34.1 million when the rate of return or interest rate ranged from 6 to 8 to 10 per cent respectively. George thus concluded that the value of the subsidies awarded to the CPR by the government of Canada were indeed excessive. He cautioned, however, that the value of the subsidies is excessive ex post and that a complete answer would also involve examining the value of the subsidy during the ex ante circumstances that governed the formulation of the contract between the CPR and the Dominion government.

The George study remains the definitive approach to the ex post evaluation of the appropriateness of the size of the subsidy granted to the CPR. Lloyd Mercer presented a critique of Peter George's methodology and constructed alternate estimates of the rate of return to the CPR. Mercer's estimates can be interpreted as more suitable because they are economic rates of return to the project rather than returns based on the broader cost-benefit/present value technique presented by George. Mercer had a much narrower focus, being concerned more with the return to the private owners and promoters of the CPR than with the return to the CPR project as a whole to the Canadian economy. The Mercer paper produced significantly lower estimates of the excess subsidy, but in the end Mercer concurred with George that the CPR was not privately profitable given market returns; the CPR required public assistance, but it received excessive subsidies. [14]

Economists J.C. Herbert Emery and Kenneth McKenzie, argue that the ex post perspective, which values the size of the excess subsidy after the fact, ignores the high degree of risk associated with these projects at the time the decisions were being made. The ex post perspective, by not taking prior uncertainty into account, will almost always condemn government subsidization as inefficient. The transcontinental railway line should be viewed as an example of a "once-and-for-all" irreversible investment made under uncertainty. In 1880, the owners and promoters of the CPR may have anticipated the Western settlement boom that would occur and the development of the Prairie wheat economy that would make their investment profitable, but they could not have been certain that events would unfold as they wished. [15]

At the time the investment decision was being made, the railway was an expensive project into uninhabited territory. Moreover, investors faced the risk that governments might change their policy stance over time and decide that an all-Canadian transcontinental railway was not a worthwhile project after all and that a route that went through the United States was more reasonable. Thus, "in the face of this uncertainty, the subsidy provided by the government may not have been excessive at all, but rather

was compensation to the CPR for exercising its investment option early." [16] Emery and McKenzie treat the grant of the CPR charter as conveying to its owners the monopoly right to build the line either immediately or at any time in the future. The government subsidy was therefore an incentive provided to induce immediate construction. Constructing the railway immediately rather than waiting until the project was more economically viable meant that the CPR had to be compensated for making this decision. In starting the project immediately, the owners of the CPR were foregoing both the right to exercise their option later as well as any other market opportunities that may have existed at the time. With immediate construction, the CPR was foregoing the possibility of waiting a few more years to acquire new information about settlement patterns, grain prices, and government policies. Essentially, the CPR required not only a subsidy for construction but also an additional one for early construction.

They conclude that the subsidy paid to the CPR cannot be viewed as excessive as it was not only a subsidy for construction of the railway but also a compensation payment to begin an irreversible construction project immediately with uncertain future expected economic benefits. As Emery and McKenzie assert: "Even if the probability that the CPR syndicate would lose the investment opportunity by delaying was quite high, only a relatively modest amount of uncertainty regarding the future value of the project was required to give rise to a fairly sizeable option value (the legal right to buy something at a specific time and at a specified price). As such, we think that it is quite likely that the portion of the subsidy granted to the CPR that traditionally has been viewed as excessive may well have been required to compensate the company for foregoing its investment option." [17]

Conclusion

The building of the Canadian Pacific Railway was an important event in Canada's economic and political nation building; it provided the crucial transportation corridor needed to link the Western settlement frontier with the industrial core of the nineteenth-century Canadian economy. While the railway would eventually generate enormous private benefits for its private owners, public sector assistance was necessary given the enormous capital costs of the project as well as the risk and uncertainty associated with its development ahead of settlement. This government subsidy can be justified on economic grounds because of the social benefits associated with the project. Moreover, railroad construction projects received public assistance in most countries in the nineteenth century, suggesting that the Canadian experience with providing assistance for railway construction was not unique.

In hindsight, the subsidies may be seen as excessive, although even the ex post approach does not include the social and political benefits of nation building. When viewed from the perspective of an investment project under uncertainty, the subsidies need no longer be seen as excessive as they may have been the required amount necessary both to subsidize construction as well as to provide the compensation needed to bear the risk and uncertainty of the project by constructing it well ahead of demand. The experience of the CPR provides valuable lessons on the role and extent of government involvement in the provision of the economic infrastructure of an economy. Despite the view often advanced by the business sector that markets provide goods and services efficiently and that government should leave the economy alone, government involvement via some form of public assistance appears to have been necessary when vital and capital intensive economic and social infrastructure was being erected under conditions of high risk and uncertainty. The twenty-first century may be no different from the nineteenth and the twentieth in this respect.