How US History Unravels the American Myth of Free Markets

Thursday, 07/9/2009 - 11:58 am by Henry Liu | One Comment

Roosevelt Institute Braintruster Henry C.K. Liu takes an unconventional look at American history–and finds that government regulation of the economy is the norm. More often than not, in fact, it’s the best thing, for the social good and for efficiency.

Adam Smith published The Wealth of Nations in 1776, the year the United States declared independence. By the time the constitution was framed 11 years later, the founding fathers were deeply influenced by Smith’s ideas, which constituted a reasoned abhorrence of trade monopoly and of government policy in restricting trade.

What Smith abhorred most was a policy known as mercantilism, which was practiced by all major powers at the time. It is necessary to bear in mind that Smith’s notion of the limitation of government action was exclusively related to mercantilist issues of trade restraint. Smith never advocated government tolerance of trade restraint, whether by other governments or by big business monopolies. In fact, Smith advocated an activist government against market failures. A truly free market cannot tolerate monopolistic practices. Yet unregulated markets naturally drift towards monopolies. In other words, markets fail when deregulated.

As we well know: After more than a decade of deregulation, the evidence of market failure is everywhere.

A central aim of mercantilism was to ensure that a nation’s exports remained higher in value than its imports, the surplus in that era being paid only in specie money (gold-backed as opposed to fiat money). This trade surplus in gold permitted the surplus country, such as England, to invest in more factories to manufacture more for export, thus bringing home more gold. The importing regions, such as the American colonies, not only found the gold reserves backing their currency depleted, causing free-fall devaluation (not unlike that faced by current Asian currencies), but also wanting in surplus capital for building factories for export. So despite plentiful iron ore in America, only pig iron was exported to England in return for English finished iron goods.

In 1795, when the Americans began finally to wake up to their disadvantaged trade relationship and raise European (mostly French and Dutch) capital to start a manufacturing industry, England decreed the Iron Act, forbidding the manufacture of iron goods in America, which caused great dissatisfaction among the prospering colonials. Smith favored an opposite government policy toward economic production and trade, a policy that came to be known as “laissez faire” (because the English, having nothing to do with such heretical ideas, refuse to give it an English name). Laissez faire–French for leave alone”–meant nothing of the sort. It meant an activist government policy to counteract mercantilism. When neo-liberal economists propagandize “laissez faire” as no government in trade affairs, they are simply bad historians, and at this juncture in history, when the failures of neo-liberal market fundamentalism are pervasive and discernible, the myth of the American system as anti-statist and anti-planning needs to be re-examined.

Another interesting item about Adam Smith was that he advocated, in 1776, a graduated income tax, “the time of payment, the manner of payment, and the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person”. Reaganites should put that in their hats and eat it.

The Original Bailout: Madison, Hamilton and the Banks

After the ratification of the US constitution, among the first acts of Congress was to adopt, on September 2, 1789, a motion by James Madison to establish a Treasury Department, and to instruct the future secretary to “digest and prepare plans for the improvement of the revenue and for the support of the public credit”. This instruction led Alexander Hamilton, the first secretary of the treasury, to establish the first Bank of the United States in 1791, which after many transformations ended up as the Federal Reserve system of today.

Hamilton also engineered the first government bailout of private investors in US history by making the government buy from investors/speculators, at face value, all the market-discounted debt instruments and paper money various state governments as well as that the federal government had issued during the War of Independence. Since one of the causes for independence had been the right to manufacture, Hamilton launched a national plan to develop manufacturing that included government subsidies (called bounties). He also instituted protective tariffs on imports, and committed massive public investment in infrastructure. It was the first industrial policy in US history, a classic national planning measure.

More Than your Much-Maligned National Planning: The Louisiana Purchase, National Road and Rail Transport

Thomas Jefferson was directly involved in land planning for political purposes in contrast to economic efficiency. He believed that his notion of democratic government could be safeguarded by the widespread ownership of land by small farmers. He would fail in this aim, as 28 percent of the land in the United States today is still in government hands, and most non-residential land is owned by big corporations. Jefferson was influenced by the economic doctrines of the French physiocrats, who claimed that the ultimate source of wealth was land. Jefferson, as president, bought from Napoleon Bonaparte the Louisiana Purchase in 1803, doubling the land area (and the intrinsic wealth) of the nation. It was an act of national planning heroic in dimension.

John Quincy Adams, in 1807, as senator, shepherded through Congress a resolution to direct the treasury secretary to draw up a plan for internal transportation. The ensuing Gallatin Plan, named after secretary Albert Gallatin, aimed to connect the states on a north-south axis and to provide for transport from the west to the eastern seaboard. The railroads in the US did not have the benefit of central planning, except in land policy. But that did not mean the government was not involved. In encouraging its development for advancing the national interest, the government granted large tracts of public land to railroad companies to connect the Midwest and the Pacific. Twenty square miles of public land (alternative quarter-sections along the entire rail line) was granted to private railroad companies for every mile of track, and the feasibility norm for return on capital in the new industry was 200 percent annually, excessive by any measure.

The lack of government supervision and regulation led to widespread political corruption and fraud against investors, and the rate fixing and price gouging resulted in reduced economic efficiency that eventually destroyed the industry, except during periods of war planning. It was only when such abuses ran up against another powerful special interest, the shipping industry, that an Interstate Commerce Commission was formed to control the railroads, but still to little avail. The monopolistic pricing practices of the railroad were a key factor in the unethical formation of John D Rockefeller’s oil empire.

Big Recessions, Big Interventions–all before 1920

Between the Civil War and World War I, there were three major economic recessions: 1873, 1883, and 1907. In contrast to Adam Smith’s doctrines, during those periods, “trusts” were organized to eliminate competition at the expense of small businesses, farmers, consumers and especially labor. As late as 1920, 12-hour days and seven-day work weeks were common practice in the steel industry, while industrial companies enjoyed protective tariffs from government and generous tax benefits such as accelerated depreciation for tax purposes, all government pro-business intervention measures.

The Sherman Anti-Trust Act was adopted in 1890 to prohibit restraint of trade, a true classic Adam Smith measure. But the act has had a history of difficult enforcement due to conservative regulatory and constitutional interpretation and circumvention devices, such as holding companies and interlocking directorates, that even the later Clayton Act of 1914 failed to achieve an effective curb. Whether anti-trust measures belong to the category of national planning depends on who is being busted and the attitude of the categorizer toward planning. Conceptually, they are planning measures pure and simple.

Social Darwinism, resurrected as a miracle diet for national prosperity in the 1890s, went briefly out of fashion in the US in the 1920s. In its place, conservatives peddled new arguments that economic planning for the collective good was beyond human capacity (the futility/unintended consequence argument), and as being alien to traditional American values, in denial of historical fact.

Roosevelt I: Teddy’s New Nationalism

World War I forced the US into war planning. The War Industries Board, the Food Administration, with a government-owned Grain Corp, injected purposeful priority in resource allocation to maximize production efficiency, with guaranteed markets and price-stabilizing measures. Labor standards were instituted, along with recognition of unions and the right to collective bargaining. Women joined the labor force with the beginning of the principle of equal pay for equal work. The government-run Railroad Administration in 1918 handled 10 million ton-miles more than the private companies did under a free market in 1917.

After the war, national economic planning advocates sought to continue planning under Theodore Roosevelt’s prewar campaign theme of New Nationalism, the so-called “Square Deal.” An influential book by Herbert Croly, The Promise of American Life, argued for a Hamiltonian government interventionist approach toward Jeffersonian populist ends.

War and revolution being half-brothers, the postwar vision of an ideal economic order came from socialists, syndicalists, guild socialists, and promoters of consumer cooperatives. Even the Catholics opposed the “servile state” and offered a program of “distributivism”. Of course, the Church has more than 2,000 years of experience in institutional planning.

Little if any of the liberal vision touched isolationist America, which was eager for a “return to normalcy,” with wholesale abandonment of the progressive social regime that won the war. Labor standards suffered serious slippage, with minimum wage/maximum hours requirements and collective bargaining discarded as wartime anachronisms, if not outright evils.

A speculation/inflation spiral developed with the sudden end of wartime price control, fueled by easy credit for speculation. As much as one-third of asset value was based on inflation anticipation. The collapse came quickly, in 1920-21, the sharpest recession in recent memory, with severe deflation, causing high unemployment (4.75 million), farm failures (453,000) and business bankruptcies (100,000). Yet the 1920-21 recession, though severe, was short. Prosperity returned, subject only to a slight dip in 1924 and again in 1927. Corporate profit rose at an annual rate of 9 percent. Stock prices rose at an annual rate of 14 percent by 1927, even before the start of the final bull market run that ended in the crash two years later. Workers and farmers, who fared well under wartime planning, did not share in this postwar boom, the so-called Coolidge prosperity, also know in history as the New Era. Between 1919 and 1930, mergers and acquisitions eliminated 8,000 manufacturing and mining companies, and 5,000 public utilities.

Ultimately 10 holding companies controlled 72 percent of all electricity sales. By 1929, fewer than 200 companies owned half of the corporate assets and 20 percent of the national wealth. The concentration of ownership enabled the business owners to increase their income three times as fast as their employees’, which was not at all what Adam Smith had in mind.

Hoover’s Big Mistake: Leaving It Alone

The 1929 crash eventually forced president Herbert Hoover, the engineer-turned-free-enterprise-businessman, to resort to planning by carrying out a campaign promise to aid farmers in the Agricultural Marketing Act, which called for self-regulating producers’ cooperatives for each crop, with price control and government-guaranteed markets. While the stock-market crash was not the cause of the Depression, it was one of the factors that intensified it.

Every schoolboy was told that Hoover did not have a plan to counteract the Depression, except to wait idly for a return to prosperity around the corner. In fact that was Hoover’s plan, with full support from the business community, based on the assumption that the fundamentals of the economy were sound, and the only trouble was a speculative collapse of the stock market, and the plan was to insulate business against loss of confidence. Hoover also mistakenly believed that private enterprise was the principle element of stability, instead of being a weak point of the economic structure and a destabilizing agent by nature of booms and busts. Hoover’s plan called for an active collective denial, but unfortunately, events were unforgiving. Sounds very familiar to what is going on in the linked economies of the world today.

The Smoot-Hawley Tariff Act was signed into law by Hoover in June 1930, despite a plea from 1,028 members of the American Economic Association to veto it. Import duties were raised to 59 percent, the highest since 1830. Instead of saving the US from the Depression, it plunged the world into a downward spiral that eventually led to World War II.

Meanwhile, early reports of successes in Soviet planning renewed calls from government, business organizations, academe, and labor unions in the US for a more orderly development than the free-for-all ways that had led to the collapse of the New Era. It was a coalition between progressive ideology, which was grudgingly accepted by business, and scientific management, which business enthusiastically endorsed.

In 1928, the Soviet Union, under a new state planning commission called “Gosplan”, worked out the First Five-year Plan, putting an end to Lenin’s New Economic Policy (NEP). This plan succeeded in rapidly developing capital industries but failed in reorganizing agriculture. Many US management engineers were recruited by the Soviet First Five-year Plan. Returning to the US in the depth of the Depression, they brought with them a fresh enthusiasm for national planning within the capitalistic system that excited public interest. In 1931, a book about Russian planning,New Russia’s Primer, even made the Book-of-the-Month Club.

Roosevelt II: A New Deal with New Players

Franklin D Roosevelt became president of the United States on March 4, 1933. Neither an economist nor a central planner, not even a businessman by virtue of being independently rich from birth, FDR was dedicated to public service. He was assisted by his “brain trust”, a group of progressives such as R G Tugwell and Raymond Moley of Columbia, Henry Wallace, an agricultural reformer, Herbert Fei, Adolf Berle and Donald Richberg, experts in law an economics. FDR’s administration marked the entrance of academics into government in the ancient Chinese tradition. But FDR, likening himself to a quarterback, called all the shots, some fundamentally contradictory with others. FDR faced urgent problems: a systemic banking crisis, farm bankruptcies and high unemployment. His first term was consumed with rescuing the capitalistic order from its structural faults, and not the establishment of a new system of central economic planning. Two days after he became president, FDR forbade the export of gold and directed banks not to pay out gold in exchange for currency. The Emergency Banking Act (March 9, five days after inauguration) authorized the Reconstruction Finance Corp to buy bank preferred stocks, a back-door nationalization measure.

Of the three new agencies created in quick succession by first New Dealers - the Agricultural Adjustment Administration (AAA - May 12, 1933), the Tennessee Valley Authority (TVA - May 18, 1933), and the National Industrial Recovery Act (NIRA - June 16, 1933) which authorized industrial planning - only the TVA survived in its original form. The Supreme Court demolished most of NIRA in 1935 and parts of the AAA in 1936. The flurries of socio-economic legislation passed in the “first 100 days” were all interventionist. Despite the Economy Act (March 20, 1933), which pledged to hold down government expenditure and cutting federal salaries by 10 percent, FDR proposed with congressional sanction, huge unemployment relief and other social projects such as the highly successful Civilian Conservation Corps, the first public environmental protection effort; the Federal Emergency Relief Administration; the Civil Works Administration; the Work Progress Administration; the Emergency Farm Mortgage Act; and the Home-Owners’ Loan Act.

The most far-reaching was the Glass-Steagall Act (June 16, 1933), which separated commercial banks from investment banks on the ground of conflict of interest, which was repealed in 1999. The Railroad Coordination Act was passed on the same day as Glass-Steagall.

On January 31, 1934, FDR by permission of Congress devalued the dollar, reducing its gold content by 40 percent. It was a “beggar thy neighbor” devaluation policy opposed by Adam Smith. The first New Deal promoted economic planning in industry and agriculture in the Soviet style (some say the Italian Fascist style), and ran up against a reactionary Supreme Court. The second New Dealers, including Justice Brandeis, whose fear of the stifling of free competition by big business was greater than his embrace of laissez faire, needed a respectable economic theory to support their spending program in an era of declining government revenue. They found him in John Maynard Keynes, through Felix Frankfurter, who introduced Keynes to FDR.

Flash Forward: Time to Rethink Our Reflexive “No” to National Planning

World War II planning was well recognized as the most important contribution to victory. The Cold War gave planning a bad name, as it did anything else that had the slightest leftist association. Grants in support of planning stopped abruptly in academe. But corporate planning that strengthened the corporate system institutionally and theoretically flourished as management science. Just as the church commandeered all talents in the Middle Ages in the name of God, and the monarchies established royal academies to capture all talents in the service of the king, postwar America monopolized all talents, including the whole discipline of planning, in the service of corporate market capitalism, leaving statism starved for talent. Corporate planning flowered in shiny computerized corporate headquarters, while national central planning withered in a neglected garden. But it does not follow that the latter is genetically inferior.