How Nineteenth-Century Americans Responded to Government Corruption
Constitutional and Legal Reform Dealt Mercantilist Interventionism an Enormous Blow
APRIL 01, 2004 by JAMES ROLPH EDWARDS
Filed Under : Government Intervention, Market Failure, Subsidies, Special Interests, Interventionism, Mercantilism, Economic HIstory
James Rolph Edwards is an associate professor of economics at Montana State University-Northern.
From its origin as a distinct secular scientific discipline with the French Physiocratic school in the middle of the eighteenth century, and the British classical school that followed, economics had a pro-market, limited-government orientation. Indeed, intellectual historians and political philosophers often refer to it as “economic liberalism,” in contrast with the classical liberal political philosophy of natural rights, human equality, and constitutionally limited government, which emerged somewhat earlier. Complementing that political philosophy, the teachings of the economists are known to have helped institutionalize liberal regimes and policies based on private property and voluntary exchange.
The effects of such regimes and policies were startling, first in Britain and then in America. Centuries of medieval stagnation gave way, and for the first time in recorded history, continuing economic growth with rising real incomes for ordinary persons became the norm. In the eighteenth century, real income had stagnated in the American colonies under British mercantile policy. Over the nineteenth century, however, closely following ratification of the Constitution in 1788, real incomes in America grew at an average annual rate 50 times above that experienced in the Old World during the sixteenth and seventeenth centuries. Average life spans rose rapidly, and life-changing inventions and innovations of all kinds emerged at a dazzling pace.
Fairly early in the twentieth century, however, most economists in America succumbed to the interventionist perspective of political progressivism and welfare liberalism. In this “public interest” perspective, the regime of private property and voluntary exchange was and is believed to be subject to massive and frequent market failures—externalities, monopolies, corporate exploitation of workers, and so on—which are assumed to require interventions by public-spirited government officials in the form of taxation, subsidies, or administrative regulation.1 For decades economic analysis focused strongly on the nature of market failures and on regulatory prescriptions. Government intervention expanded apace, progressively restricting economic freedom.
However, a reversion of opinion by many economists back toward the classical-liberal roots of the profession began in the 1960s and accelerated in the 1970s due to three developments. The first was the increased professional influence of Milton Friedman and the Chicago school of economics, which had a strong free-market orientation. The second factor was that economists had, by that time (the 1960s), several decades of regulatory practice to observe and analyze. The picture emerging from careful studies was not one of social problems being cured by beneficent regulators. The third factor was the resurgence of the Austrian school, which had always defended free markets and opposed statist interventionism, but which had almost disappeared in the 1940s.
Oddly (or perhaps not so oddly), this resurgence of skepticism among economists about the political motivations for and beneficial character of government intervention overlapped a new burst of regulatory activity in the late 1960s and early 1970s. In that period the Johnson and Nixon administrations established the EPA, OSHA, NHTSA, CPSC, and many additional regulatory agencies with enormous budgets and vast powers. Since then, evidence has continued to accumulate that regulation normally does more harm than good. If regulatory activities were in fact solving social problems and overcoming market failures by acting to end racial discrimination, business monopoly, labor exploitation, externalities, unsafe working conditions, and the like, they should have increased productivity and economic growth.2 Instead, after 1972, productivity growth fell below its historic 2 percent long-run annual average, and stayed below it for over 20 years, in an episode economists termed the Great Productivity Slowdown. Richard K. Vedder has shown empirically that increasing regulation was a primary cause of the slowdown and that we suffered staggering losses in real income as a result.3
Politics of Intervention
Suspicion among economists over the motives for regulatory intervention emerged not only because the forms and effects of regulation diverged from economists’ models and predictions, but also because firms were often observed seeking regulation, rather than opposing it. Major firms in the trucking industry, for example, had lobbied for passage of the National Motor Carrier Act of 1935, bringing the industry under regulatory control of the Interstate Commerce Commission, which had been created in 1877 to regulate the railroads. And in 1938 the airlines lobbied Congress to pass the Civil Aeronautics Act, establishing a government-enforced cartel over the air-passenger industry.4
George Stigler was among the first economists to wonder whether, given that economic agents often demand regulation, something like market exchange was occurring between those parties and legislators. He was a pioneer in attempting to model supply and demand in such a market.5 A student of industrial organization and cartels, Stigler was aware that private cartels are unstable: The fixing of a price above the competitive level motivates members of the cartel to undercut the fixed price for personal gain. Also, the high price attracts outside competitors into the market, adding to supply and making it impossible to maintain the cartel price. He also knew that entry can be prevented, and cartel arrangements enforced, if the cartel can persuade the government to use its coercive legislative and police powers in those efforts.
Political officials will not grant and enforce such a legal cartel arrangement for nothing, however. Private interests seeking monopoly or cartel gains at the expense of their competitors and the public will have to pay the politicians for granting them. The payments assume diverse forms, such as campaign contributions, wining and dining by lobbyists, literal bribes, speaking fees, and the promise of jobs after their political careers end. In essence, the politicians operate an auction market where various interests bid for redistributive legislation. Obviously, this may take many forms beyond the literal regulatory cartelization legislation stressed by Stigler. Examples include efforts by firms and other private interests to obtain such things as targeted income transfers, farm price supports, tariffs on imports competing with domestic products, and so on.
The key social problem associated with private efforts to obtain redistributive legislation (termed “political rent-seeking”) was made clear by Gordon Tullock, in another breakthrough paper.6 Scarce resources (money and lawyers’ and lobbyists’ time, among other things) that are used in such efforts are diverted from more productive uses, and the real output they would have otherwise generated is lost. Indeed, Tullock demonstrated that when rent-seeking is competitive, the entire discounted present value of the prospective future gains being sought through redistributive legislation will be expended as rent-seeking costs. Redistributive politics is thus a negative-sum game. There are winners and there are losers, but the sum of the losses exceeds the sum of the gains, and the members of society as a whole are made poorer than they otherwise would be.7
Recently there has been another breakthrough in describing the interaction between political authorities and private interests. Economist Fred S. McChesney of Northwestern University noticed that many payments by private parties to legislators could not be explained as efforts to obtain economic rents at public expense through legislation. Instead, the parties making the payments were simply attempting to protect wealth and income they already possessed from being reduced or eliminated by costly legislation targeted at them. The basic insight here seems obvious: Politicians who have the power to grant special benefits, and can generate payments from private interests seeking to be the beneficiaries, will also have the power to impose legislative harms and can generate payments from private parties by threatening to do so.8 McChesney calls this process “rent extraction,” or legislative extortion.
This can take many forms, including threats to impose excise taxes or costly regulation (including price controls), or even threats to deregulate industries previously cartelized through regulation. Officials in federal, state, and local regulatory agencies can also engage in rent-extraction by such practices as threatening to withhold licenses required to do business or to initiate antitrust prosecutions. It is notable, for example, that Bill Gates gave little in political contributions before the Microsoft prosecution and has given very much since it began.
McChesney stresses that, just as with political rent-seeking, there are real costs associated with rent extraction. First, the risk that government officials will use their legislative or administrative power to reduce private returns on invested capital diminishes the incentive private entrepreneurs have to invest in the first place. In addition, there are transactions costs (including bargaining and information gathering) incurred in the process. Also, risks of rent-extraction motivate some economic agents to hide their resources to avoid political extortion, and there are deadweight costs associated with doing so.
Public Choice economists have long argued that minimizing rent-seeking behavior and its associated costs requires constitutional reforms restricting the power of legislators to grant special favors. Few people will waste time or money trying to influence a legislator who has no power to grant them a subsidy or protected position in the market. McChesney likewise recognizes that limiting government authority to its minimum legitimate functions would minimize rent-extraction. Who would make extortion payments to politicians lacking power to carry out their threats?
A Look Back
The immediate question becomes whether such constitutional reforms are feasible. History provides a fairly unambiguous answer, because such reforms have been applied, and have worked, in the past. The fact that the U.S. Constitution placed so many prescriptive (Article I, section eight) and proscriptive (including Article I, section 9, and the Bill of Rights) limits on the legislative power of Congress is a primary reason so little interventionist activity was engaged in at the federal level before the Civil War. State officials, in contrast, were under much less constraint and engaged in a great deal of rent-seeking and rent-extracting economic intervention. When the effects of such activities became clear to the public, however, constitutional reforms were applied at that level of government also. Oddly, this history is little known.
One of the first political parties in the United States, the Federalists, was a mercantilist party advocating central banking, internal excise taxes, and federal funding of the building of canals and turnpikes.9 Its Jeffersonian opponents in Congress, citing a lack of constitutional authority, predicting that fraud and collusion would result, and stressing the regional redistributions likely to be generated by any particular transportation subsidy, largely frustrated the Federalist program of “internal improvements.” At the state level, however, constitutional provisions were less restrictive and the case for canal and turnpike subsidies seemed initially more compelling.10
State officials wanted to subsidize grandiose canal and turnpike projects precisely in such instances where market entrepreneurs were unwilling to venture because of likely unprofitability. The officials easily assumed—usually falsely—that subsidies would make those projects profitable. In some cases, such as the Erie Canal, built by New York state with borrowed money and revenue from an excise tax on salt between 1817 and 1825, that appeared to be true. The Erie made money, though its profitability was mostly due to the state’s suppressing of competition from other canals and railroads built along segments of its route.
The apparent success of the Erie, however, motivated New York and other states to subsidize many other projects. These subsidies, often in the form of state stock or bond purchases to capitalize franchised private builders, were associated with massive and repeated rent-seeking corruption, generating political scandals that outraged the public in state after state. Worse, most of the projects lost money, and the financial conditions of the states heavily involved in such projects consequently deteriorated, putting many of them in serious trouble.
The development of the steam railroad engine and rapid expansion of the railroad industry after 1830, though an enormous stimulus to economic growth through reduced transport cost between locales not capable of being connected by waterways, in some ways exacerbated the problems of the state governments. For one thing, the railroads, like the turnpike and canal corporations before them, had to obtain incorporation charters or permits from the governments. In return, state authorities frequently extracted rents. Canal and turnpike companies lobbied state legislators to prevent competing railroads from being built. This motivated counter-lobbying from the railroads, further enriching the legislators, but wasting scarce resources.11 In many cases, the legislators offered subsidies to the railroad bidding highest for the legislative franchise to build a particular route. Consequently, many railroads were built to obtain the subsidies not to profit from operations. Such roads were often not completed, or otherwise lost money, leaving the states further in debt.
By the early 1840s the citizens in many states had had enough of scandals and financial crises generated by “internal improvement” subsidies. Around 1842, under pressure from angry citizens led by Jacksonian reformers, Indiana, Illinois, and Michigan all amended their constitutions to forbid or restrict their legislatures from providing subsidies to private corporations. They were followed in 1845 by Louisiana, in 1846 by New York, in 1850 by Kentucky, in 1851 by Maryland and Ohio, and in 1857 by Missouri and Pennsylvania. On top of this, under the same public pressures, many states had begun passing general incorporation laws, allowing virtually any group of aspiring business associates to incorporate. This removed state power to extract rents from private parties to obtain or retain incorporation, and also made corporations truly private, rather than quasi-public, business entities.12
These events significantly contracted the boundaries of the public sector relative to the private sector, providing crucial conditions for rapid economic growth to occur in the remainder of the nineteenth century.
This massive public revulsion and wave of constitutional and legal reform had important national implications. Mercantilist interventionism had been dealt an enormous blow, and, with it, so had a major political party. Since 1834, the mercantilist party in the United States had been the Whigs, who favored public infrastructure subsidies, paper money, and high tariffs. Their opponents were the Jacksonian Democrats, who had a classical-liberal ideology favoring low tariffs, hard money, and opposition to government economic interventions. The rejection of mercantilism by the public was to no small extent a rejection of the Whigs. This and other factors caused the Whig party to break up and be replaced by the Republican party after 1854.13
What followed then, we all know: a civil war over tariffs and slavery that badly injured the South and, with the Southern Democrats out of Congress, a new wave of statist and mercantilist policy under the Republicans, including the corrupt and unnecessary federal subsidization of the first transcontinental railroads.14These traumatic events seem to have overshadowed and reversed an enormous victory for those who favored limited government and opposed corrupt rent-seeking and rent-extraction, which occurred over the two decades prior to the war.
- See, for example, Leverett S. Lyon and Victor Abramson, Government and Economic Life: Development and Current Issues of American Public Policy (New York: Brookings Institution, 1940).
- For the logic of this claim, see James Rolph Edwards, Regulation, the Constitution, and the Economy: The Regulatory Road to Serfdom (Lanham, Md.: University Press of America, 1998), pp. 166 and 169–70.
- Richard K. Vedder, “Federal Regulation’s Impact on the Productivity Slowdown: A Trillion Dollar Drag,” CSAB Policy Study Number 131, July 1996.
- See William A. Jordan, Airline Regulation in America: Effects and Imperfections (Westport, Conn.: Greenwood Press, 1979 ).
- George Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics and Management Science, Spring 1971, pp. 3–21.
- Gordon Tullock, “The Welfare Costs of Tariffs, Monopoly, and Theft,” Western Economic Journal, June 1967, pp. 224–32. For a description of rent-seeking see Sanford Ikeda, “Rent-Seeking: A Primer,” Ideas on Liberty, November 2003.
- This is so not just because of the rent-seeking cost, however, but also because of the overhead costs of administering the transfers or regulating the cartel, the deadweight costs of taxation to finance such activities, and so on.
- Fred S. McChesney, Money for Nothing: Politicians, Rent Extraction, and Legislative Extortion (Cambridge Mass.: Harvard University Press, 1997).
- It is important to know that the late medieval European monarchies were mercantilist, rent-seeking societies, replete with franchised monopolies, cartels, and trade restrictions. Mercantile practices had to be largely eliminated for free societies with efficient market systems to emerge. The motives for mercantile policies never quite disappear, however.
- The standard source here is Carter Goodrich, Government Promotion of Canals and Railroads (New York: Columbia University Press, 1960). Goodrich’s bias, however, is easily shown. Repeatedly implying that state and federal subsidies were beneficial on net, he never once even mentions James J. Hill, who built the Great Northern Transcontinental railroad in the 1890s without a cent of either federal or state subsidy, an achievement that dwarfs the building of the Erie Canal.
- Stewart H. Holbrook, The Story of American Railroads (New York: Crown Publishers, 1947), p. 231, describes these conditions well.
- Robert Hessen, In Defense of the Corporation (Stanford Cal.: Hoover Institution, 1979), pp. 29–30.
- The failure to recognize the nature and importance of these events leads historians to vague and convoluted explanations for the demise of the Whig party. See, for example, Michael F. Holt, The Rise and Fall of the American Whig Party (New York: Oxford University Press, 1999), chapter 26.
- See Burton W. Folsom, The Myth of the Robber Barons (Herndon, Va.: Young America’s Foundation, 1991), chapter 2.