Causes and dynamics of equity market run-ups and “bubbles”: Lessons from the boom and bust of Britain's railway mania of the 1840s

Abstract

Equity market run-ups (also known by the fraught term, “bubbles”) have riveted the attention of investors, asset managers, regulators, and central bankers for centuries. Commonly defined as a departure of prices from fundamental values dominated by a self-fulfilling feedback loop between expected prices and current prices, such episodes summon the conventional view that run-ups reflect market irrationality. Some run-ups preceded spectacular crashes and spawned serious economic contractions, from which new regimes of prudential regulation and pre-emption followed. Iconic examples were the Mississippi Bubble (1720), the South Sea Bubble (1720), the “Roaring Twenties” (1924–1929), and the Housing Bubble (of 2003–2008). Yet other run-ups have produced no long-lasting effects.3 Success in distinguishing malign run-ups from their benign counterparts depends on a deep understanding of their causes and dynamics.

Making use of these four propositions, we offer insights into the causes of one of the most prominent run-ups of the 19th century and then offer reflections upon their implications.

Yet why does discernment about run-ups matter? Central bankers and regulators often debate whether and how to intervene in run-ups and slumps. Household investors and professional asset managers struggle to adjust portfolios to unusual market conditions. CEOs and CFOs labor to make sense of unusual changes in their share prices in an effort to sustain efficient capital allocation. As a result, the astute official, investor, or executive should: (1) look for economic shocks that might explain the run-up; (2) assess the sufficiency and quality of information about them; and (3) ascertain which investors are trading—who is at the margin?

New research on Britain's “Railway Mania” of the 1840s by Atta-Darkua, Bruner, and Miller (2024) provides the foundation for this discussion. In 1844, British Prime Minister Robert Peel commenced a legislative reform of laws, regulations, and customs that constrained economic growth, restricted foreign trade, limited the ability of entrepreneurs to form new companies, checked the Bank of England's lending, challenged investors’ property rights, and constrained governance in the burgeoning railway industry. Altogether, Peel's initiative amounted to one of the most significant liberalizations in economic history.5 This programmatic onslaught coincided with a remarkable run-up in British railway equity prices from early 1844 to August 1845. Charles Mackay, a contemporary writer described the “mania” as the “greatest example in British history of the infatuation of the people for commercial gambling” ([1841], 1980, p. 88). Then in the fall of 1845, the run-up turned into an equity price slump, followed by a modest recovery, and then a long and deep deflation in both stock prices and economic activity. This process triggered serious civil unrest in Britain. Indeed, Karl Marx and Friedrich Engels (Marx & Engels, 1850) went so far as to suggest that the railway “mania” and subsequent commercial crisis were capable of setting off a communist revolution across Europe.

Our earlier study was the first to confirm the association of a government policy shock with the run-up of 1844–1845.10 In this article, we build upon the insights of that study to explore the inflation and deflation stages of the run-up, and to consider the why and the how of run-ups. The discussion here offers preliminary evidence about the dynamics of the run-up, on which we hope to stimulate research on run-ups and careful reflection for policymakers.11

Markus Brunnermeier (2018) summarizes a growing literature on bubbles by attributing these events to limits to arbitrage, asymmetric information,12 overconfidence,13 and cognitive biases.14 Austrian economists and monetarists argue that expansion of the money supply and availability of credit presage runups.15 However, none of these theories suggests why a run-up starts, or how it advances.

The Conservative (Tory) Party gained a parliamentary majority in the British general election of July 1841, which presaged the rise of Robert Peel as Prime Minister. He led a party sustained by the nobility, gentry, industrialists, and rising middle class. As a reform-oriented conservative, he stood apart from the more reactionary elements in his party. Peel recoiled from the social privations and civil unrest associated with the Industrial Revolution its business cycles. However, he sensed that intra-party resistance to his reform ideas would erode his political power. “Peel's convictions became firmer and his language harsher and more defiant,” wrote his biographer (Hurd, 2007, 255). By the start of the 1844 parliamentary session, Peel decided to wager his political capital on a range of laws addressing social, political, and economic problems.

The diffusion of railway technology had been growing for years, beginning with the founding of the first inter-city steam-driven railway, the Liverpool and Manchester, in 1830. A smaller boom of railway expansion occurred in the mid-1830s, only to recede with depressed conditions in the late 1830s. After a recession that lasted from 1841 to 1843,22 the run-up popularly known as the “railway mania” began in earnest.

Figure 1 depicts the equity market23 run-up (January 1, 1844–August 9, 1845) and slump (late August and thereafter). Cumulative returns associated with the run-up amounted to 29.7% on a broad portfolio of stocks, and 63.5% on a portfolio of railway stocks.

Our analysis of the returns to shareholders yields three important insights. First, the equity market run-up was a railway sector phenomenon. We examined equities in other industrial sectors and found only modest positive cumulative returns to shareholders. Spillovers from the railway sector to other sectors seem to have been scant: returns were small and generally insignificant—but positive—for a portfolio of banks, and smaller yet among firms in the insurance, metals, and shipping sectors over the same period.

Second, the run-up was significantly associated with events in Peel's liberalization program. Drawing on hand-collected data and an empirical research method not previously used in the analysis of run-ups, our study found a significant association between events in Peel's liberalizing program and returns to shareholders. From January 1, 1844 to August 9, 1845, event returns accumulated to 58.7% for railways and 46.2% for the broader diversified portfolio.25 Further analysis revealed that railways in the South and Midlands regions of England (areas with dense populations and concentrations of manufacturing and trading firms) saw significantly greater returns to railway shareholders. Finally, the largest firms (those that led a process of industry consolidation into country-wide systems) experienced significantly greater shareholder returns.

Third, as Figure 1 shows, the run-up was not a monotonic advance. Two phases emerged—a slower gain on railway equities of 24% January–August 1844, and a greater gain of 32.5% January–August 1845.26 It is important to note that the two phases of high returns were contemporaneous with sessions of Parliament which typically met from January to the end of August each year.

The run-up peaked on August 9, 1845, followed by a decline that began slowly and then accelerated. Fears of wars in Mexico and Oregon, reports of a catastrophic potato harvest in Ireland, and eyewitness accounts of shareholder defaults on call loans occupied news stories in September and October. On October 16, the Bank of England raised its base rate to 3% (from 2.5%)—and the next month would raise it to 3.5%.44 Then on November 17, The Times of London printed an investigative tally of the capital required to finance the railway expansion proposed by existing and new firms: the startling sum was £590 million,45 more than Britain's gross domestic product in 1845 and more than twice its monetary base.46 During parliamentary debates over the railway mania in 1846, members anguished over the ability of Britain's financial markets to fund the expansion.

Associated with the adverse news, share prices of railway companies fell about 20% from August to December 1845. By the end of 1848, the declines had erased the entire run-up. As Figure 1 shows, the deflation in railway share prices occurred in two phases. The first phase from August to December 1845 looked more like a simple equity market “correction.” The 4-month market slump may have frightened speculators but was unlikely to create the kind of severe wealth effect necessary to destabilize a financial system.

A brief rebound in the winter and spring of 1846 seemed to imply the end of the railway selloff. The rebound coincided with another round of railway legislation aimed at improving transparency, suppressing frauds, and simplifying the resolution of firms in bankruptcy. Meanwhile, as Figure 2 shows, the momentum for railway construction and sale of shares in new companies continued unabated through much of 1846.

Arguably, the share price decline from mid-1846 to 1848 is not simply a continuation of the slump in railway share prices in late 1845, but rather a new slump of broader and more serious proportions.

In sum, the years following August 1845 saw a collection of powerful adversities. As Figure 4 shows, economic growth in Britain stalled beginning in 1847.

The distance between the solid and dotted lines in Figure 4 is an indication of the output gap between potential and actual economic performance. The recession of 1847–1850 was not followed by a ‘V-shaped’ recovery, but was associated with lingering underperformance. The grand narrative of Britain's financial markets in the 1840s is one of boom and bust. The long slump in railway shares after August 1845 features prominently in the conventional views about the impact of the railway run-up. Sir Ralph L. Wedgewood, General Manager of the London and Northwest Railway wrote, “The railway mania ran its course with disaster in its train, and with abiding injury to the railway structure of the country.”48 However, the macroeconomic problems beginning in 1846 seem equally, if not more, likely to be the cause of the “disaster” that ensued.

We have argued that shocks such as sudden and consequential changes in government policy or the diffusion of a new technology can drive a run-up. Prior research sustains the impact of new technology as a driver of economic growth and equity market trends.49 Similarly, prior scholarship supports our argument that sudden and consequential changes in government policy can stimulate a run-up. Regulatory changes represent fundamental mechanisms through which governments can affect the economy and stock prices. Roberts (1990) demonstrates how anticipated policy shifts can substantially impact stock returns, particularly in politically sensitive sectors like defense, where regulatory decisions can dramatically alter firm cash flows. Similarly, Leblang and Mukherjee (2005) and Fuss and Bechtel (2008) provide comprehensive examinations on how political transitions create variations in stock market returns.

Monetary policy emerges as another critical domain of regulatory intervention. Kindleberger (1978) examines how expansionary monetary policies and credit market access can amplify stock prices and contribute to market run-ups. Bernanke and Kuttner (2005) further clarify this interaction, showing that unanticipated monetary policy interventions can produce significant effects on stock prices.

Regulatory changes that open stock markets to new investors can also have significant price impacts. Henry (2000, 2007) documents positive returns around market liberalization episodes that reduce barriers to foreign investment.

The economic impact of liberalization extends beyond immediate price effects to broader economic outcomes. Bekaert et al. (2001) show that financial liberalization is associated with increased real economic growth, primarily through expanded investment in local markets. This growth impact can appear as one-off increases around liberalizing episodes (Henry, 2000, 2007) and as permanent increases in growth rates (Fuchs-Schundeln & Funke, 2003). While liberalization stimulates growth, this benefit comes with increased systemic risks. Tornell et al. (2004) demonstrate that economies experiencing higher growth become more susceptible to boom-bust cycles. This relationship between growth and market instability has sparked debate about the predictability of market downturns.

This discussion of Britain's railway mania of the 1840s sheds light on five challenges for decision-makers.

Economic history can inform one's understanding of run-ups and slumps. Mark Twain supposedly said that history does not repeat itself, but it rhymes.54 In that sense, a deeper grasp of Britain's railway mania of the 1840s can help to illuminate equity market responses to other policy and technology shocks, including those in the U.S. oil and steel industries (1870–1890), automobiles (1890–1930), telephones (1910–1920), hydrocarbons (1970–1980), media (1980–2000), internet search (1990–2010), airlines (2000–2015), and chemicals (2015–2020).55