Federal regulation of the economy is a thorny issue, and has one of the most strict partisan polarizations of any issue in politics today. If you’re a conservative, you probably rigorously oppose regulation; if you’re a liberal, you probably rigorously support it. The argument, which you’ve no doubt heard a dozen times in full, goes something like this:
Pro: “It’s necessary.”
Con: “No, it’s not.”
Pro: “Yes, it is. Without regulation, we can’t protect consumers or the economy.”
Con: “No, it isn’t. We don’t need to protect the economy. The market self-regulates, if left to itself, and consumers are part of how that works.”
Pro: “Recession, anyone? The market is obviously incapable of self-regulation, so it is necessary. Someone’s gotta set the rules.”
Con: “It is not. The market is perfectly capable of self-regulation, like all complex systems are; the pathologies that we witness in the market, which you undoubtedly blame on capitalism, are in fact the result of external regulation being applied, injecting signals into feedback loops and screwing with compensentory mechanisms already in place. External regulation is simply not needed.”
Pro: “But we need to apply external regulation, because the players in the market don’t act ethically unless they’re being watched. Regulation is needed.”
Con: “Maybe watchers are needed, but in fact the watchers are natively part of the system already. Adding another layer of watchers doesn’t provide any net gain, but it does introduce those pathologies I mentioned…as well as a lot of extra costs. It is not needed.”
Pro: “Regulation is still necessary because it promotes full employment. The bigger the government, the higher the employment rate.”
Con: “But that’s only a comforting illusion, since it doesn’t promote productivity. Government employment may take people off of the unemployment rolls, but it doesn’t actually produce anything. Is not.”
Pro: “Employing citizens is still a noble pursuit, and it gives the government a raison d’ etre. Is.”
Con: “Pardon your French, but it gives government carte blanche to interfere with our lives. Is not.”
Pro: “It promotes workplace safety. Is.”
Con: “Unsafe workplaces are still inherently unsafe. And some workers prefer unsafe workplaces, because those allow them to demand a premium for their labor. Is not.”
Pro: “Regulation promotes environmental responsibility. Is.”
Con: “Pollution still happens. Is not.”
Pro: “Regulation promotes consumer safety. Is.”
Con: “No, it doesn’t. Caveat emptor is still the only real rule of consumer spending. Therefore…is not.”
Pro: “It promotes equality in the market. Is.”
Con: “It provides the comforting illusion of promoting equality of outcome, while in fact tilting the playing field unfairly. What it really does is promote monopoly. Is not.”
Pro: “Hogwash. As was shown during the New Deal, it stabilizes the economy and helps prevent recession. Is.”
Con: “As was shown during the New Deal, regulation destabilizes the economy and has never prevented, or corrected, a single recession. Ever. Is not.”
Pro: “Well, it did help end the Great Depression, didn’t it?”
Con: “Ha! The Great Depression became the Great Depression—and took a double dip—because of regulation! Just like—and you’re gonna love this—the current recession under Obama. Is not.”
Pro: “You can’ t prove that, and anyway, Keynes was an influential genius. How can someone whose ideas have been so accepted for so long be so wrong?”
Con: “Friedman and Hayek were also influential geniuses, and Nobel winners to boot. Moreover, their theories have actually produced results. Is not.”
Pro: “Krugman has a Nobel, too, you know. Is.”
Con: “Krugman is a partisan hack who sells columns by attacking Republicans, in effect by promoting divisiveness via derisiveness. He has nothing new to say; he just regurgitates Keynes ad sprinkles insults on top. I’m not sure his Nobel should count. At any rate, our side has two awards. Is not.”
Pro: (rolls eyes) “OK, Mr. Appeal to Authority. Is.”
Con: “Hey, you brought up Keynes. Is not.”
Pro: “And with good reason. Keynes’ theory has promoted more social justice than Friedman ever did, working for freaking fascists like Pinochet. Is.”
Con: “Keynes’ theory allowed for the long-term economic stagnation of poor nations like Bolivia, Peru, and India, and even such first-world nations as Great Britain and France. And Friedman never worked for Pinochet; he simply gave a series of lectures in Chile. It was Allende’s preceding socialist government that caused Chile’s economic problems, by nationalizing so much industry. It took the application of Hayek’s and Friedman’s principles to reverse all that damage and promote real prosperity. And you can’t even define ‘social justice,’ can you? Is not.”
Pro: “At what cost? All free markets ever do is concentrate wealth at the top, and widen the gap between rich and poor. Capitalism creates poverty, and regulation is how we work against that! Is!”
Con: “Nonsense. It’s corporatism that concentrates wealth at the top, and corporatism is the inevitable result of regulation, which promotes an unhealthy and ever-burgeoning relationship between state and industry. That way lies fascism. Is not.”
Pro: “Whatev. Bolivia and Peru are still poor as hell. How do you explain that?”
Con: “The lack of private property rights enforcement, obviously. Read some Hernandez de Soto, would ya? Even the Shining Path knew he was right, which was why they targeted him for assassination. Is not.”
Pro: “So how do you explain the fact that 1% of the people in this country own 99% of the wealth?”
Con: “They don’t. Hyperbole much? The top 5% of the people in this country own about 30% of the wealth, but that varies from year to year. And the upper class continues to grow. Class warfare is a myth, because class mobility is reality. Every year this country—and all countries, including those in Asia and even, these days, Africa—add more people to the rolls of the millionaire and billionaire classes. One in twenty American households has a millionaire right now. That’s not an insignificant number, pal. Is NOT.”
Pro: “They get that wealth by stealing it from the lower classes! Wealth is inherently exploitive, and capitalism is inherently imperialistic! That’s why we need regulation! IS!!!”
Con: “The economy is not a zero-sum game, as demonstrated by the Pareto efficiency model. Creating wealth means distributing wealth; that’s inherent in the investment process. Socialistic schemes cannot create wealth; they can only redistribute it. Capitalism requires that wealth circulates so that investments can be repaid. Rising tides, and all that. It’s regulation that slows the flow of capital, regulation that requires a heavy tax burden, and regulation that promotes corruption. It’s regulation, therefore, that counters the wealth creation process inherent in capitalism. It follows that regulation is, to some extent, responsible for the entrenchment of poverty. Most emphatically, is not.”
Pro: “Sorry, dude, but it’s pure greed, plain and simple, that causes that. Is. Is is is is.”
Con: “Economic matters are never plain and simple, and the easiest assumptions to make are usually the ones that are most easily overturned by facts. Liberals always treat the successful as bad guys. Why is that? Prejudicial preference for the underdog, perhaps? Do you guys even realize how bigoted you are? The fact is that regulation and taxes create a risk-averse climate for business, which is what suppresses economic growth in bad times and compels employers to go overseas in good times. Price controls such as minimum wage force employers to shed portions of their workforce. The government, at least as much as the corporations, is a driver of unemployment. So….is not.”
Pro: “Greed compels employers to go overseas! Is, dammit!”
Con: “Legal and ethical commitment to shareholders is not greed. It’s responsibility. Is not.”
Pro: “Any time any one person has more of anything than another person, it’s greed, pure and simple. Is.”
And so on and so forth, with very little progress on either side. (Yes, many of these arguments are lifted essentially verbatim from debates I’ve witnessed and participated in.) Both sides have firm opinions, some rooted in fact, some rooted in prejudice. Some of the salient facts follow.
Con:
--Regulation does create risk aversion in the market, slowing the pace of investment and therefore slowing the pace of recovery.
--Regulation does provide incentive for companies to seek employment overseas.
--Regulation does require a significant tax burden, which further compels companies to go overseas, and which inhibits the productivity of those which remain.
--Regulation does promote corruption, by inviting players on both sides of the public / private divide to get together and collude on the rules of the game.
--Regulation also promotes an unhealthy relationship between lawmakers and lawyers, who are ultimately the primary beneficiaries of all regulation.
--Regulation, in combination with lobbying, encourages and rewards rent-seeking behavior.
--Regulation slows the flow of funds through the economy, thereby causing inefficiency, distorting the market by interfering with response times.
--Many regulations are tantamount to price controls, which, by interfering with price signals, distort the market further.
--Although the regulatory bureaucracy employs a vast number of people, those workers are unproductive in the sense that they don’t manufacture or sell anything. They therefore pose a net drain, or at best an even break, in a market that depends on productivity in order to expand.
Pro:
--“Social value” regulations actually do appear, in some cases, to provide a benefit to society. This is a special case of the problem of "externalities," in particular negative externalities, which result from firms not expending enough of their own resources in order to produce a good, causing some costs to fall on society.
--Environmental protection regulations, when they work, may provide a net benefit to society and to the ecosphere. This is another special case of negative externalities; companies can shirk the costs of properly disposing of wastes, for instance, in such a way as to pollute the environment, increasing society's cost of using that environment.
--Some market niches, such as “natural monopolies,” actually require some sort of regulation, as there is no competition to regulate them. This is yet another special case of negative externalities.
--Aaaaaand that’s about it. Most of the purported benefits of regulation are either not benefits at all, or accrue from other sources, such as business ethics, the market’s self-regulatory behavior, and the ethics of the consumer. Outside of the context of externalities, there doesn't appear to be a valid rationale for regulating the market.
Liberals tend to argue, hopelessly, that regulation is a necessary counter to the burgeoning size and power of multinational corporate behemoths. Conservatives counter, accurately, that the power of corporate behemoths is a consequence of regulation, and point to the fact that corporate power and strength have only increased over the past century, despite an ever-increasing regulatory burden. Regulation is the conduit whereby rent-seeking behavior (lobbying) is rewarded. Conservatives point out that rent-seeking is also the driver of the growth of the welfare state and of organized labor, and note that corporate wealth is the only factor holding these two in check. All three factors erode individual sovereignty and the wealth of the middle class, but corporate power can be seen as a compensatory mechanism against the other two, by providing for the creation of jobs and of wealth in general (two things that organized labor and welfare cannot accomplish).
So where you stand on the issue of regulation is almost necessarily purely a matter of partisanship, and secondarily a matter of economic understanding. If you favor rent-seeking on behalf of the welfare state and organized labor, you support regulation. If you favor rent-seeking on behalf of the corporate state, or despise rent-seeking altogether, you oppose regulation. If you believe that laborers are uniformly liberal, or that environmentalists are uniformly liberal (both of which are patently false), you will claim credit on behalf of liberalism for regulation’s successes. If you know that corporatism, rather than capitalism, is the cause of corporate gigantism, you will allow liberals to claim credit for regulation, because this places the blame on them for the abuses of multinational corporations. If you believe that collective bargaining actually empowers employees and promotes the welfare of labor as a class, you will claim credit on behalf of liberalism for the excesses of labor unions, arguing that workplace safety has benefited from their efforts. If you know that collective bargaining actually depresses wages, suppresses competition among employees, restricts the availability of jobs and vastly raises the costs of running a business, you will allow liberals to claim credit for regulation, because this places the blame on them for the failure of many companies that were dragged under by the demands of unions and the regulatory burden…as well as the lengthening and deepening of every recession of the 20th and 21st centuries.
What few people on both sides of the issue are willing to admit is that most of deregulation’s wild successes have come not at the hands of Republicans, but at the hands of Democrats. Anybody who ventures into a debate over Reaganism will likely hear from a liberal participant words to the effect “Trickle-down economics was proven to be false.” We will examine this proposition in detail, especially in the context of Bill Clinton’s success at implementing it. We will also look at the contributions of Richard Nixon to regulation…as well as the contributions of Edward Kennedy and Jimmy Carter to deregulation. Throughout, I will provide a very brief history of a handful of industries, in order to illustrate the cons. Then I will provide an even briefer history of the successes of regulation, in order to illustrate the pros. Then I will discuss what happens when industry is deregulated, and allow you to draw conclusions about deregulation’s effects on society. The conceptual organization doesn’t follow the historical timeline, so we’ll visit some events out of order. And in keeping with the theme of market-as-complex-system (my “jungle metaphor”), I will resort frequently to analogies from natural science. The conclusion will recapitulate the discussion of the most successful drivers of regulation and deregulation, in order to apportion credit and blame appropriately. But first, I want to cover some of the authoritative material on regulation, to provide a clear view of the actual pros and cons and elevate them above the perceptions and myths pervading American political discourse.
The first authority any economic treatise should appeal to is, of course, Adam Smith. He wrote the book on macroeconomics—An Inquiry into the Nature and Causes of the Wealth of Nations—right around the time the Revolutionary War broke out. He drew detailed comparisons between the New England colonies, Europe, and the Latin colonies. Although all colonies in the New World had been chartered for the explicit purpose of profiting their respective Crowns, no colony ever turned a consistent profit. Great Britain therefore made use of a secondary set of objectives, such as providing living space for the more pioneering (read that: “dissatisfied”) members of its society, and encouraging the growth of market economies whose output could serve its own trade. Their collective output consisted mostly of industrial produce (woodcraft), materials (timber and cotton), and consumables (tobacco). The Latin colonies, in contrast, were established to return precious metals and gems back to the royal treasuries, to benefit the monarchy directly rather than to benefit the economy in general. The main economic produce, in other words, was wealth itself, currency. This rather more rigorous and controlled activity engendered a curious set of inconsistencies in colonial policy. Although slavery was officially forbidden in Latin America, there was little to prevent the local governments from virtually enslaving most native populations, and killing off those they couldn’t. And ordinary monarchic economic paranoia was such that these economies were very tightly regulated, because every scrap of mining output had to be accounted for.
From the chapter “Colonies” (Part 2, “Causes of Prosperity in New Colonies”):
The colony of a civilized nation which takes possession either of a waste country, or of one so thinly inhabited that the natives easily give place to the new settlers, advances more rapidly to wealth and greatness than any other human society.
The colonists carry out with them a knowledge of agriculture and of other useful arts superior to what can grow up of its own accord in the course of many centuries among savage and barbarous nations. They carry out with them, too, the habit of subordination, some notion of the regular government which takes place in their own country, of the system of laws which supports it, and of a regular administration of justice; and they naturally establish something of the same kind in the new settlement. But among savage and barbarous nations, the natural progress of law and government is still slower than the natural progress of arts, after law and government have been so far established as is necessary for their protection. Every colonist gets more land than he can possibly cultivate. He has no rent, and scarce any taxes to pay. No landlord shares with him in its produce, and the share of the sovereign is commonly but a trifle. He has every motive to render as great as possible a produce, which is thus to be almost entirely his own. But his land is commonly so extensive that, with all his own industry, and with all the industry of other people whom he can get to employ, he can seldom make it produce the tenth part of what it is capable of producing. He is eager, therefore, to collect laborers from all quarters, and to reward them with the most liberal wages. But those liberal wages, joined to the plenty and cheapness of land, soon make those labourers leave him, in order to become landlords themselves, and to reward, with equal liberality, other labourers, who soon leave them for the same reason that they left their first master. The liberal reward of labour encourages marriage. The children, during the tender years of infancy, are well fed and properly taken care of, and when they are grown up, the value of their labour greatly overpays their maintenance. When arrived at maturity, the high price of labour, and the low price of land, enable them to establish themselves in the same manner as their fathers did before them.
In other countries, rent and profit eat up wages, and the two superior orders of people oppress the inferior one. But in new colonies the interest of the two superior orders obliges them to treat the inferior one with more generosity and humanity; at least where that inferior one is not in a state of slavery. Wastelands of the greatest natural fertility are to be had for a trifle. The increase of revenue which the proprietor, who is always the undertaker, expects from their improvement, constitutes his profit which in these circumstances is commonly very great. But this great profit cannot be made without employing the labour of other people in clearing and cultivating the land; and the disproportion between the great extend of the land and the small number of the people, which commonly takes place in new colonies, makes it difficult for him to get this labour. He does not, therefore, dispute about wages, but is willing to employ labour at any price. The high wages of labour encourage population. The cheapness and plenty of good land encourage improvement, and enable the proprietor to pay those high wages. In those wages consists almost the whole price of the land; and though they are high considered as the wages of labour, they are low considered as the price of what is so very valuable. What encourages the progress of population and improvement encourages that of real wealth and greatness.
Interesting. At once, the Old Man informs us that in the absence of price controls (such as minimum wage restrictions), employers can compete for labor on the basis of wages, and that a society’s social progress is tightly coupled to its economic growth. It gets better:
The progress of many of the ancient Greek colonies towards wealth and greatness seems accordingly to have been very rapid. In the course of a century or two, several of them appear to have rivalled, eand even to have surpassed their mother cities. Syracuse and Agrigentum in Sicily, Tarentum and Locri in Italy, Ephesus and Miletus in Lesser Asia, appear by all accounts to have been at least equal to any of the cities of ancient Greece. Though posterior in their establishment, yet all the arts of refinement, philosophy, poetry, and eloquence seem to have been cultivated as early, and to have been improved as highly in them as in any part of the mother country. The schools of the two oldest Greek philosophers, those of Thales and Pythagoras, were established, it is remarkable, not in ancient Greece, but the one in an Asiatic, the other in an Italian colony. All those colonies had established themselves in countries inhabited by savage and barbarous nations, who easily gave place to the new settlers. They had plenty of good land, and as they were altogether independent of the mother city, they were at liberty to manage their own affairs in the way that they judged was most suitable to their own interest.
Now he’s clearly favoring decentralization of economic controls. But read on:
The history of the Roman colonies is by no means so brilliant. Some of them, indeed, such as Florence, have in the course of many ages, and after the fall of the mother city, grown up to be considerable states. But since, the progress of no one of them seems ever to have been very rapid. They were all established in conquered provinces, which in most cases had been fully inhabited before. The quantity of land assigned to each colonist was seldom very considerable, and as the colony was not independent, they were not always at liberty to manage their own affairs in the way they judged was most suitable to their own interest.
In the plenty of good land, the European colonies established in America and the West Indies resemble, and even greatly surpass, those of ancient Greece. In their dependency upon the mother state, they resemble those of ancient Rome; but their great distance from Europe has in all of them alleviated more or less the effects of this dependency. Their situation has placed them less in the view and less in the power of their mother country. In pursuing their interest their own way, their conduct has, on many occasions, been overlooked, either because not known or not understood in Europe; and upon some occasions it has been fairly suffered and submitted to, because their distance rendered it difficult to restrain it. Even the violent and arbitrary government of Spain has, upon many occasions, been obliged to recall or soften the orders which had been given for the government of her colonies for fear of a general insurrection. The progress of all the European colonies in wealth, population, and improvement, has accordingly been very great.
The crown of Spain, by its share of the gold and silver, derived some revenue from its colonies from the moment of their first establishment. It was a revenue, too, of a nature to excite in human avidity the most extravagant expectations of still greater riches. The Spanish colonies, therefore, from the moment of their first establishment, attracted very much the attention of their mother country, while those of the other European nations were for a long time in a great measure neglected.
He goes on to mention the “cruel destruction of the natives which followed the conquest” and the Spanish expulsion of non-Spaniards from their lands (“The French, who attempted to settle in Florida, were all murdered by the Spaniards”). He as much as predicts that the Latin colonies will mature at a slower rate than their English counterparts (they did), that violence will remain entrenched in their society (as it appears to have), and that their governments will continue to be riddled with corruption (they are). His conclusion is clear: corruption relies on regulation for its existence. Every external rule binding business is an invitation to the unethical players on both sides of the public / private divide. This is borne out to a much wider degree by an inspection of the “Perceived Corruption Index” (and others of its kind, for those who dispute its particular methodology). These indices list the world’s nations and rank them on a comparative scale of apparent corruption. One relationship becomes apparent rather quickly: the greater the degree of government involvement in the market, the more corrupt that government is. I can identify several categories of high-ranking nations: planned economies (communist and socialist states), post-colonial societies in Asia and Africa (many of whom fall under either the “failed state” or “mixed economy” headings), and Latin American nations, which Smith has ably covered here. Many unfortunate African nations on the list were similarly tasked with exporting wealth directly in the form of currency, and even now mining output is their main industry. And comparisons of Africa to the levels of violence, poverty and oppression in Latin America fare pretty poorly. Another example is India, which after World War II adopted a democratic-socialist system, and quickly became mired in a corrupt, burdensome bureaucracy, the so-called “Permit Raj,” in which absolutely nothing could be accomplished by any private party without a tall stack of approvals from authorities at all levels of government, demanding graft and apportioning favor as they saw fit.
And, as is the case with Latin American developing nations, corruption, once entrenched, remains in place (much like economic regulation itself). India has undergone a seismic shift in economic policy over the past couple of decades, in the process becoming one of the world’s economic powerhouses (especially in the technology sector). But corruption remains endemic, to the extent that Ghandi-style hunger strikes have been carried out in protest (as by Anna Huzare, during August 2011). It would have been far better for India and Latin America to mature in a less regulatory climate, preventing this degree of corruption altogether.
According to Peruvian economist Hernandez de Soto Polar, these nations, in restricting trade and personal involvement in the market since their inception as colonies, have inhibited the development of private property rights that would otherwise have helped lift much of the lower class out of poverty by now. While it’s not necessarily the case that governments in poor countries suppress property rights, it’s fairly common that corrupt governments will suppress property rights. And in the sense of suppressing property rights, government regulation definitely transfers sovereignty from the individual to the state. But in a wider sense, this is done by all regulation that directs our behavior in the market. The market is, after the family, the most important social context that most humans will ever participate in. It is in the buying and selling of goods, and the exercise of our values therein, that we exercise the greater part of the liberty we are accorded. A progressive will fight tooth and nail to secure the liberty of the individual to engage in whatever practices he pleases in the bedroom, in private, out of sight of society and the state, never quite comprehending that it is our public activity, our participation in society, that comprises by far the largest share of civil rights. It can be argued that no Blue Law ever prevented a single act of sodomy, and that prohibitions against alcohol and drugs have utterly failed to deliver on their promises to kick intoxicants out of America. But every single day, individuals are prevented by regulation from exercising their own freedom of choice in the market. Progressives, generally favoring equality over liberty, are fine with this; conservatives and libertarians are not.
Smith also covers other effects of regulation, collectively termed “restraint of trade;” this coverage is most thorough in the preceding chapter “The Unreasonableness of Restraints.” He is regarded by many modern economists as the father of free trade, and while his distaste for regulation was rooted in the colonial nature of the world economy in his day, his warnings about its impact still apply in full today. Of course, modern progressives have an exactly backward conception of “restraint of trade,” regarding it as ensuing from corporate activity and not from government. I’ll be laboring to dispel that notion as the essay unfolds.
Regulation is also often demanded as a means of smoothing the business cycle, of preventing (or at least mitigating) recessions and getting the economy back on track. There is little evidence that this has ever actually worked as advertised. There are some legitimate instances of governments becoming involved in order to rebuild wartorn economies and infrastructures, as was the case in virtually the entirety of Europe (including, under the Marshall Plan, those nations overseen by Allied occupiers). When there is no capital to invest, and no means of production with which to produce, governments pretty much have to step in and take control of matters. This is the approach taken by Britain and France, and although there was rapid economic growth as a result, it eventually slowed down and stalled altogether. Part of the problem was the inability of state-held enterprise to match private enterprise in terms of efficiency (owing to the lack of competition); and part of it was due to the entitlement mentality that settled in among populaces who demanded cradle-to-grave care…care that becomes prohibitively expensive as populations age and expand in numbers.
I like to compare nations sharing similar geographical circumstances, but with differing economic approaches, in order to demonstrate how this plays out. France and Germany, for instance, represent two continental nations of reasonably large geographic spread and diversity, with ample agricultural and industrial infrastructure, democratic government, and traditions and family structures that are centuries old, having matured in place. They both have extensive coastline and river navigation, and both were of a similarly modernized character in the 1940s (despite the wartime destruction of many of the urban centers and much of the technological support for infrastructure). There was, in short, little of a geographic nature to distinguish the two coming into the 1950s. But they took markedly different routes to prosperity. Germany was operating under the strict controls of the Marshall Plan; France had adopted a socialist approach, with nationalization of key sectors and provisions for an expansive welfare state.
For a while France was much the better off; by 1947, Germany was once again facing hyperinflation, and the black and gray markets had become the predominant mode of exchange, while France was moving into the beginning of its “Thirty Glorious Years.” Price controls imposed by the Allied occupiers only exacerbated Germany’s inflation problem. The problem was solved unilaterally by Ludwig Erhard, who was elected to the post of Director of Economics in 1948. He instituted currency reform, introducing the Deutsche Mark and, to the chagrin of his Marshall handlers, abolishing all price controls. Overnight, hyperinflation was tamed, and the black and gray markets disappeared. He became Minister of Economics under Chancellor Konrad Adenauer the next year (later ascending himself to the post of Chancellor). His relatively laissez-faire approach to economic governance helped bring about the “German Economic Miracle.” By the mid-1950s, a scant decade after the end of the war, Germany was Europe’s primary economic powerhouse, and remains so to this day.
France, meanwhile, got off to a running start due to government investment and nationalization, but eventually slowed under the weight of its burgeoning welfare class. It was during the early 1970s that the dirigisme policy began to show serious signs of disrepair; the oil shocks impacted economies all over the world, and it was found that those economies with a high degree of central planning or regulatory intervention (including, at the time, the United States) fared the worst in recovery. Yet the policymakers adhered to their original course, and socialists continued to be elected until the early 1980s. Francois Mitterand took the helm in 1981, promising to deepen the socialist experiment, but two years later, the entire policy had to be abandoned in the face of its dire results. Privatization of nationalized industries followed, and a policy of “rigor” (rigeur) was imposed. Today France still maintains a high degree of welfare entitlement, but its relatively unregulated market has kept it largely free from the economic turmoil and threat of austerity measures that typify other European welfare states (notably Greece) as the 2008-2009 recession continues to throw aftershocks.
A similar contrast can be made between two island societies, both with immense agricultural and industrial infrastructure for their small size, and both with initially deep, generations-old pockets of wealth that were all but wiped out by the war, both dependent upon shipping for material resources and both former ocean-spanning empires. Japan was essentially completely rebuilt by the Allied occupiers, and despite its earlier xenophobia regarding cultural influences, absorbed much of the capitalist philosophy of the conqueror. It became an early innovator in electronics and digital technology, and rushed toward the front of the world economic stage where it remained for several decades. Great Britain, on the other hand, immediately adopted a democratic-socialist approach, instituting cradle-to-the-grave welfare care and allowing its labor unions to take a direct hand in shaping political affairs. As a result, it was unable to recover from the oil shocks of the 1970s, and by 1980, had stagnated remarkably. Labor unions held the nation hostage by refusing to clean up garbage or produce an adequate coal supply. This state of affairs led to the election to the Prime Minister post of Margaret Thatcher, who immediately instituted market reforms and reversed much of the socialist trend. The Britain of today holds only a fraction of its former hegemony, but is nonetheless regarded as a world leader, and has managed to weather the most recent recession much more capably than many of its peers in the Euro zone.
Of course, such comparisons can only apply to a degree in the context of regulatory behavior, as the European manner of economic involvement has tended to prefer nationalization over regulation. Nonetheless, they offer a telling look at the general inflexibility of government operation of economy, as well as the burdens imposed by the entitlement mindset. If American-style economic regulation is in any way analgous to European-style nationalizing and planning, then we ought to see similar symptoms of inflexibility and entitlement mindset. And these we do in fact see: the unwillingness of the market to recover from recession, the hesitation of companies to hire new labor, the bristling of the welfare state and organized labor at the mention of austerity measures.
Another historical example proffered by pro-regulation liberals is the Great Depression. If current high school history and political-science classes are anything like what they were when I was a teenager, they teach that the New Deal helped ameliorate the effects of the Depression, preventing it from dragging on indefinitely and stimulating the economy by providing employment to the unemployed. This teaching is often followed by the evidently-contradictory position that the entry of the United States into World War II brought about the end of the Depression. Although this latter statement seems to undercut the New Deal’s contribution to ending the Depression, both propositions actually are consistent with Keynesianism. Unfortunately, Keynesian principle has been shown to be flawed in a number of ways since then, and even worse, Keynes’ teachings played essentially no role in the first half of the New Deal, undermining at least half of the credit. Franklin Delano Roosevelt’s guiding light during the initial implementation of the Deal wasn’t Keynes, but rather a little-regarded (and even then, already largely discredited) theory known as “underconsumption,” which held that the recession of 1929 was brought about by a gap between the availability of goods and the willingness of the public to purchase them…in essence, a universal glut that drove prices down and caused businesses to fail or shrink, shedding laborers in the process. According to the theory of Lionel Robbins, there is a glimmer of truth to this, but no more. Robbins isn’t typically credited with contributing to the theory of “spontaneous order” underlying Austrian economics, but he did arguably set it in motion by characterizing the Depression as the result of an equilibrium gone awry, a phenomenon that we today recognize as chaos. Simply put, complex systems tend toward equilibrium if left on their own, but random and significant changes to the inputs can cause the system to oscillate widely until a new equilibrium is achieved. A natural analogue to this is an ecosystem with many niches and many species occupying them: although under normal circumstances, the ecosystem coevolves along with those species, thereby retaining its ability to accommodate them, it can be shocked by a sudden climate change or the extinction of a key species (as from introduced disease); the more such shocks it suffers in any given interval, the less likely it is to recover fully, although diversity does provide substantial hedge against failure. But even in the absence of massive shocks, it’s possible, according to mathematical models, for such a system to fail suddenly, if enough small shocks accumulate so as to limit the diversity of any population, or to limit the numbers of any population, below the threshold of their utility to the system as a whole. And such models have been viable enough to put forth as explanations for mass extinction events in the deep past. (And it’s noteworthy that economic models are premised in mathematics that operate the same way as ecological models. In order to test an economic model, you “shock the system” by providing inputs to the equations that represent extreme or boundary conditions; the model’s outputs then demonstrate how well that system responds to shocks.)
To Robbins, the global market as it existed prior to World War I was just such an equilibrium, in which price signals (the result of interplay between supply and demand) provided the feedback mechanism which kept employers, and therefore the market, stable. (Much more recently, Daniel Yergin, in his book The Commanding Heights, characterized this slowly-shifting equilibrium as the first Age of Globalization; consumers participating in mail-order sales from all over the world, without restraint, comprised the diversity required to provide the necessary robustness.) In his view, the tumult occasioned by the Great War broke down these mechanisms and isolated markets from their means of production, causing price signals to be distorted, misdirected and obliterated altogether. Gluts can and do arise under these conditions, but so do shortages; so underconsumption, as merely one consequence, is not likely to be the sole cause of this kind of market breakdown. And the Depression seems vast and complex enough in scope that it is far more likely that a number of competing and coinciding causes contributed to its growth. A shortage here and a glut there, with no reconciliatory mechanism intervening in between, can certainly spell trouble for producers as well as consumers, especially when multiplied across entire sectors and nations. But Robbins goes further, arguing that the exceptional shortages occasioned by the war effort and the utter destruction of much of Europe’s means of production, compounded by various post-facto regulatory efforts by the nations involved (and especially by punitive reparations measures), made the situation much worse. None of these was a cause of the Depression in and of itself, but they all weakened the global economy’s foundation by preventing markets from responding in a timely fashion to shocks. And those shocks, once they came, were therefore devastating. One such shock was the severe drought that hit the Midwest and ruined thousands of farmers. This was not in itself the result of government policy, but merely a natural disaster compounded by the poor soil-husbandry practices of the farmers of the day. In essence, the entire top layer of soil simply dried up and blew away, carrying away the carbon, nitrogen and complex nutrients that agriculture—and indeed, the ecosystem at large—requires. The resulting lunar landscape of windstorms and choking dirt was termed the Dust Bowl.
Beyond Nature’s contributions, though, the onset of the first of the two 1930s recessions seems to have come about as the result of a perfect storm of government intervention. Great Britain had operated on a gold specie standard for some time during the first quarter of the 20th century, but in 1925 repealed that standard and implemented a gold exchange standard instead. This was done in order to stem the outflow of gold to the United States, among other destinations. The drop in gold’s availability in the US presented one of several closely-spaced shocks. In 1931, Britain abandoned the gold standard altogether, creating a substantial drop in demand. Economists’ opinions differ on the role gold played in the United States’ Great Depression, but one lucid argument emerged from the Chicago school under Milton Friedman. The Federal Reserve is a frequent target of Chicagoans, who lay a substantial portion of the Depression’s blame on it. In Friedman’s argument, the US’ reliance on the gold standard meant that the Federal Reserve could not expand the money supply arbitrarily. Because the money supply could not expand at will, interest rates could not be reduced at will, and this severely impacted the availability of loans for investment, causing economic contraction.
Another causative factor has been promoted by the Austrian school, led by F. A. Hayek and his mentor, Ludwig von Mises. According to them, intemperate extension of credit causes business cycles. In this view, recessions are inevitable as long as there are preceding expansions driving irrational exuberance and optimism in trading. This view alleviates some of the blame that would otherwise be placed on governments, at least insofar as recessions themselves are concerned; however, it does nothing to forgive governments for exacerbating the effects of recession, as by contributing to economic shocks (via changes to currency standards) and mismanaging the money supply (via the Federal Reserve). And it’s easy to grasp that an ordinary cyclical downturn in the economy can be deepened by a failure to mitigate its impact through adjusting interest rates accordingly. However, there are still more factors to consider. Other authorities point to the Smoot-Hawley Tariff of 1930 as a source of shortages, not least because it provoked other nations into enacting punitive tariffs of their own. Burton W. Folsom, in his book New Deal or Raw Deal?, argues that European retaliatory tariffs caused unavailabilities in materials and parts for watches, automobiles, and many other machines heavily consumed by Americans (not least in the form of means of production). The producing companies’ costs skyrocketed, and these costs were passed on to the consumer. If “underconsumption” played any role in the Depression, then, it came about after the recession was underway, when prices for many goods were driven so high as to be unattainable to many who had become accustomed to the Industrial Age’s high-volume, low-cost factory production mechanisms. By the time all of the world’s economies had finished enacting their own tariffs in response, American imports and exports had been reduced by half. (And even as controversial as this impact was to the American economy, it’s fairly obvious, given the impact to Canada and Caribbean nations, that the rest of the world suffered as a result.)
And this is as point of pivotal importance to the regulation debate. Unemployment had peaked at about 9% following the stock market crash of 1929, and begun to fall off (to about 6% just prior to the tariff). Following the implementation of Smoot-Hawley, it began to rise precipitously, eventually peaking in the double digits. (11.6% is one figure given for the period immediately following the tariff; by 1933, the number was at 25%. But we do have to allow somewhat for the imprecision of recordkeeping at that point in history.) However well-intentioned, the US government’s first foray into regulatory correction of the market was disastrous. But this was not the last foray. Roosevelt, already convinced of his own greatness and infallibility, was determined to foist his vision of an economic safety net on the nation, and began in earnest in 1933. Historically, the Deal is regarded as two separate Deals, the second taking place from 1934 – 1936. The economy by the time of the Second New Deal had begun to exhibit what is known today as a “double dip,” indicating that the recovery up til that point was either incomplete or illusory.
The pillars of Roosevelt’s plan were the “Three R’s”: Relief, Recovery and Reform. Relief consisted of those measures taken to alleviate unemployment and poverty; recovery comprised those measures taken to stimulate the economy; and reform was the collective measures taken to prevent depression in the future. When each pillar is examined in detail, it is found to be an abject failure; when the expense and expansion of government associated with each are examined, they are easily regarded as tragedies. Relief took the form of employment programs and subsidies for threatened sectors; recovery took the form of price controls and other regulations; and reform took the form of legislation intended to prevent what FDR saw as the “abuses” that made the Depression possible. The Glass-Steagall Acts of 1932 and 1933 were just such measures, implemented in order to prevent banks from failing. Beyond these was a slew of acronymed agencies created ostensibly under the aegis of the Executive Branch, all in effect comprising a new, and quite unconstitutional, “Fourth Branch of government” (although in reality, merely extending the reach and power of the President). Of all the agencies created during this time, only a few are still widely regarded as beneficial and sustainable overall (such as the Tennessee Valley Authority). Several agencies and laws passed during the Depression were found to be unconstitutional and eventually repealed. And many others were hotly contested by conservatives and by industry. Some, for instance, controlled the number of tires that a rubber company could manufacture, as well as the price they could be sold for. This created distinct disadvantages for some companies and distinct advantages for others, effectively tilting the market in favor of specific players (precisely in accordance with the predictions of Robbins and Hayek). The stated intent of this kind of rule was to prevent competition from causing the failure of poor performers, and thereby dumping even more unemployed on the workforce. However, rather than improving the price outlook and stabilizing the sectors in question, these kinds of regulations actually forced more unemployment, because companies were still driven out of business by the distorted market; it just happened that these companies weren’t the poorest performers, but players from all over the board. With price signals thusly distorted, and competition thusly quashed, the market’s difficulty in recovering was greatly compounded. As Folsom writes about the NRA (National Recovery Act, formerly the National Industrial Recovery Act):
America’s traditional free market system, where businesses compete and innovate to sell products of varying price and quality to choosy customers, was overthrown. With the NRA, a majority in any industry had approval and legal force to determine how much a factory could expand, what wages had to be paid, the number of hours t obe worked, and the prices ofa ll products within the industry. According to law, a businessman in that industry might or might not help write the code for his industry, but whether he did or not, he would be bound by the terms of the code and subject to a fine or jail term if he violated the code.
Adam Smith in 1776 explicitly warned against such a price-fixing system and observed what would happen if it were to occur. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Smith went on to conclude, “But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.”
Smith, then, would not have been surprised to hear the initial reaction of many businessmen to the NRA. “Washington hotels rejoice and Cabinet members groan,” wrote one observer, “over the wild rush of business men to the capital to find out about the new industrial plan. They want to know everything, but mostly how to punish the rascal who has been cutting prices in their industry, and how to fix some nice new prices.” In other words, the more than 540 codes that were written into law had the strong tendency to raise prices, raise wages, reduce working hours, and remove competition” [all factors contrary to increasing production, much less to hiring unemployed labor, and thereby to stimulating recovery] “as well as innovation of industrial products.”
Why would Roosevelt and certain New Dealers be so eager to see higher wages and prices, without an increase in productivity, and with less competition? As part of their faith in the underconsumption theory, they believed that artificially higher wages meant greater purchasing power, which they believed would help Americans out of the Great Depression. If people earned more, they could buy more, and that would stimulate industrial and economic recovery….
Folsom spends some time analyzing how the US steel industry had prospered under the innovations introduced by Dale Carnegie during his competitive run against U.S. Steel, the subsidized national producer.
Elbert Gary, the chairman of the board (of U.S. Steel), had an NRA mentality: U.S. Steel was on top; let’s keep things the same. “Prices should always be reasonable,” Gary said. “What we want is stability.” But what is a reasonable price for steel rails? It was $56 per ton in 1872, and less than half of that in 1900. Would the stability of 1872 have been good for Carnegie? Would it have been good for the users of steel anywhere in the world? Would it have been good for the United States, which came to dominate the world market for steel after 1872 through innovation and competition?
In 1925, Gary said, in words that could have been spoken by Hugh Johnson ten years later, “We believe in competition, in vigorous, energetic, unyielding competition….But we do not believe, or certainly most of us do not believe, in unfair, destructive, unrighteous competition, which is calculated to ruin the competitor. We believe…that stability and just dealing are desirable and beneficial to all…” What Gary is saying is, “Let’s compete, but let’s not try too hard and let’s make sure we keep prices high enough to give business to every steel company.” If Carnegie had believed that, and the United States had instituted an NRA in 1872, steel rails fifty years later would probably have been priced at over $50 per ton and England and Germany would have continued to be the dominant world producers of steel. Rail and trolley travel for all Americans would have been more expensive, and the millions of poor immigrants to America would have paid more for rail travel and had less for food and shelter.
At once, Folsom is arguing that competition reduced prices in steel, thereby improving the industrial outlook for the young nation, and also that this price reduction benefited the consumer directly, lowering the bar to immigration. In a word, this competition helped make possible the modern United States as we know it.
Under Gary’s philosophy, steel prices ceased to decline and innovation was almost halted. Finally, at Bethlehem Steel, under the management of Charles M. Schwab, real competition in steel began around 1910. Schwab, with almost no support from the other contented steel producers, invested in structural steel to build bridges and skyscrapers. He innovated with the “Bethlehem beam,” which allowed for the constructing of steel beams directly from an ingot as a single section, instead of riveting smaller beams together. Schwab’s astonishing success transformed the steel market. Structural steel became a popular product [thereby helping usher in the age of the skyscraper]. The New York Times called Bethlehem Steel “possibly the most efficient, profitable, self-contained steel plant in the country.” Officers at U.S. Steel, meanwhile, spoke of idle factories and a demoralized workforce. Its market share declined from 61.6 to 39.9 percent from 1901 to 1921. If only Gary could have had an NRA in 1901, U.S. Steel’s domination would have been fully protected by law. Schwab, with a fixed market share assigned to him, would have had no incentive (and possibly no legal grounds) to risk his capital in the nascent structural steel market. American progress in structural steel would have been almost nonexistent; the United States would have had fewer bridges and skyscrapers or would eventually have had to import that steel from abroad, where no limit existed on output, innovation and market share.
Cheaper steel meant cheaper cars, and Henry Ford took advantage of that. He took the cheaper steel, and the increasing varieties of steel, and built an assembly line and began making Model Ts. Ford, by about 1920, had captured over one-half of the American car market and had cut the cost of a car from $3,000 to about $300. But General Motors, under competitive pressure from Ford, showed the ability to improve its own product. Chevrolet innovated with an ignition starter and a gas tank gauge. By 1928, Ford had abandoned the Model T and began working on the Model A, with a new and improved V-8 engine. Competition brought out the best in Ford and in William Durant at GM. American travelers were the winners.
If we had had an NRA in 1905, we would have had higher-priced steel, no assembly line, and a small car market with few Americans able to afford the expensive vehicles built then by Buick, Oldsmobile, and Ford. If an NRA had been instituted in 1905, many in the transportation business would have been delighted—the makers of carriages and buggy whips would have attracted more capital; the makers of expensive Packards and Pierce-Arrow cars may have been able to stay in business; street cleaners, especially the ones who cleaned 1.3 million pounds of horse manure daily in New York City alone, all would have had protected jobs. These and others would have liked Johnson’s call for “fair competition” to escape the price-cutting Ford, who was following a vision to put a car in every garage. But most Americans would have been poorer with their high-priced carriages and more expensive traveling. Beyond all that, Ford even innovated with high wages and massive increases in employment. In 1910, 140,000 people in the United States worked in the auto industry. By 1930, with better and cheaper cars, there were 380,000 doing so.
The story of the dynamic nature of the steel and car industries shows three things. First, competition is necessary for new and cheaper products to appear on the market. Second, competition is also a sensible way to set prices and wages. Third, many businessmen want to avoid competition—to them “fair competition” is letting them set prices, wages, hours of work, and market share. Like Hugh Johnson, they will talk soothingly about the need for codes of fair competition to hold price cutters like Henry Ford in check. If that happens, innovation declines and customers pay more.
When the NRA went into effect in 1933, Senator William Borah (R-Idaho), who opposed the bill, received about nine thousand complaints from businessmen and entrepreneurs who were damaged by the law’s restrictions. That was more letters than he’d received when he had fought the League of Nations almost fifteen years earlier. Reading some of these thousands of letters reveals the damage done to the American economy when it was strapped in the NRA straitjacket.
The tire industry is a good place to start because it is closely linked with the steel and auto industries. When the major tire makers, Goodyear, Goodrich, and Firestone, got together and wrote the NRA tire code, the price of tires immediately soared. That meant, first of all, that the price of cars had to be raised. That hurt America’s export market in cars and it also meant that fewer Americans could afford to pay the increased cost of a new car in the Great Depression days of 1933. Not surprisingly, American car sales continued to decline, and in 1933 were only one-third of what they were in 1929.
But the problem of fixing high tire prices went further. Within the tire industry, high fixed prices meant that large companies could easily seize business from smaller producers. Larger companies, with national networks of stores, could promise buyers service for their tires almost anywhere in the nation. From these “great master stations,” Goodyear, Firestone and Goodrich advertised heavily and hired salesmen to publicize their companies and sell their tires nationwide.
Among those damaged was Carl Pharis, the general manager of Pharis Tire and Rubber Company in Newar, Ohio. Pharis employed over one thousand people, mainly in the Newark area. His company grew because, in Pharis’ words, “we could make the best possible rubber tire and sell it at the lowest price consistent with a modest but safe profit.” He and his employees had survived the grim Great Depression years because they had lower prices, a good tire, and solid support in central Ohio from buyers who knew the company because it was local and because it priced its tires lower than the larger firms. As Pharis said, “It is obvious that they cannot make as good a tire as we make and sell it at the price at which we can sell at a profit.”
Then came the NRA with its high fixed prices for tires. As Pharis said, “Since the industry began to formulate a Code under the N. R. A., in June, 1933, we have at all times opposed any form of price-fixing. We believe it to be illegal and we know it to be oppressive.” He added, “We quite understand that, if we were compelled to sell our tires at exactly the same price as they sell their tires, their great national consumer acceptance would soon capture our purchasers and ruin us. Since we have so little of this consumer publicity when compared with them, our only hope is in our ability to make as good or a better tire than they make and to sell it at a lesser price…”
Since Pharis and other small companies were no longer allowed to sell tires at discounted rates, Goodyear and Firestone “could go out just as they have gone out,” Pharis noted, “and say to prospective customers that, since they had to pay the same price, it would be wiser if they bought the nationally advertised lines.”
In a nutshell, Pharis put it this way: “The Government deliberately raised our prices up towards the prices at which the big companies wanted to sell, at which they could make a profit,…where more easily, with much less loss, they could come down and ‘get us’ and where, bound by N. R. A. decrees, we could not use lower prices, although we could have lowered them and still made a decent profit.”
Pharis was on the verge of closing down and having to lay off all of his one thousand employees. His company, with its low prices and quality tires, could weather the Great Depression, but not the NRA. “If we were asking favors from Government,” Pharis concluded, “there would be little justice in our complaints….And so, if the big fellows, with their too-heavy investments and high costs of manufacturing and selling, cannot successfully compete with us little fellows without Government aid, they should quit.”
Pharis was far from alone in objecting to higher selling prices for tires. Montgomery Ward, one of the country’s largest retailers, reluctantly decided to obey the NRA code. In doing so, the company issued the following statement to customers in newspapers throughout the country:
The NRA, through the Retail Tire Code, effective Monday, May 14, is requiring approximately twenty percent price increases on Ward’s Rambler Tires. We would prefer to continue the low prices made by our economical method of selling tires. We regret that we cannot do so after the NRA order fixing these prices becomes effective next Monday.
-- Burton W. Folsom Jr., New Deal or Raw Deal? chapter 4: “Why Price-Fixing Damaged American Business”
Here we see several impacts to the automotive sector deriving from the NRA, not least the tilting of the tire market in favor of the already-largest manufacturers: the onset of cartelization, as embodied in their council on prices, and the squeeze on the smaller vendors, threatening to dump still more unemployed on the rolls: virtually the opposite of the Act’s intended effects. Folsom spends much of the rest of the chapter discussing another class of NRA victims: those fined and imprisoned for offering discounts on their prices.
Another complication arose from the government’s attempts to employ the unemployed. This was put into practice as a sort of proto-Keynesian program set. Vast numbers of workers were paid to dig ditches. The upside to this is that people were getting paid. The downside is that ditches are of very little intrinsic value, and do little to produce anything else. This resulted in a situation in which government-favored labor, which was largely unproductive, was used to stimulate the growth of an economy that depends on production. Predictably, this kind of employment failed to stimulate the economy. On the public side, government grew tremendously, burgeoning to create and fill several agencies ostensibly devoted to managing and correcting the Depression, but in actuality devoted to simply employing as many people as possible. And the same truth holds: government workers don’t produce anything, and so there is no way to add value to their contributions. Government employment, as it happens, is a net drain, rather than a net boost, to the economy. This is mostly due to the failure of this kind of employment to add value, but also to the various corruptions, losses to inefficiency, and taxes that follow this employment. The return is diminished right off the bat. It can be argued that infrastructure improvements (such as ditches and roads) do facilitate commerce, and therefore have value to the economy; nonetheless, the value of such contributions isn’t immediate enough to justify their use as economic stimulation. By the time a given road is completed, the recession may well be over.
Contrast government employment of bureaucrats and ditch-diggers to private-sector employment in a field that creates and sells a product. Consider, for instance, steel production. One way to stimulate the economy, assuming you have an excess of federal funds on hand with which to do so, would be to invest in an iron mine operating at partial capacity. The idea would be to allow the firm to expand, thereby hiring more miners (and presumably purchasing more of the equipment they need). This immediately provides employment for those new miners, and immediately circulates the money that goes into purchasing the heavy equipment. And, if we’re government employers trying to employ Keynesianism (or FDR’s initial proto-Keynesianism), this is as far as we’ve thought it through: the immediate effects. If we are mining executives or consumers of mining products further downstream, then we’ve already begun working out the rest of the scenario. More miners with more mining equipment means more ore produced in a given interval. This means more ore shipped to refineries and foundries. This means more iron smelted and more parts forged. It means more steel and other alloys produced. It all means more widgets manufactured and sold, and more carriers involved with shipping the products to outlets. All of these steps not only add value to the final product but stimulate related industrial activity. And the mine has an incentive, in the form of an obligation to return on the investment, to see its end through. These are real, tangible, long-term effects that persist in addition to the immediate increase in spending power accorded to the new employees, impacting multiple sectors and expanding employability throughout.
Or consider a simpler, more local variant. Say you instead invest the funds in fast-food restaurants, advising the franchisees to buy more ground beef and make more burgers. This will require them to hire more entry-level employees (the population most immediately impacted by recession). They will in turn manufacture more burgers and attempt to sell them. By application of Say’s Law, the increased supply of burgers will stimulate demand for burgers (not least by flooding the market and lowering prices, making possible Meal Deals of all kinds). Now you have done something to immediately stimulate the economy, but have also created a product to sell, one with real value, whose effects go beyond that initial stimulus. And the increase in sales volume is what these invested-in firms need in order to make return on your investment; the investment becomes part of their incentive to make those sales, driving efficiency.
This general kind of thinking was on Keynes’ mind when he wrote the General Theory of Employment, Interest, and Money, which was published in 1936 and immediately adopted by depressed governments throughout the Western world. And so, beginning in 1936, FDR’s efforts took on a decidedly Keynesian tenor. The basic idea was that by employing labor, more money could be made to circulate through the economy; the tendency of wages to increase in value as they left the laborer’s pocket was termed the “multiplier effect.” (It’s worth pointing out that, as in the case of the Philips Curve, the book doesn’t mention this effect explicitly; it does however arise as a natural consequence of the theory’s math.) Per the General Theory, an effect of up to 8% could be expected if the government judiciously hired and invested. However, we’ve never seen numbers anywhere close to this. Economists’ calculations tend to suggest that historically, the multiplier has fallen around unity (1:1, or no net gain). During the 2008-2009 federal stimulation efforts, President Obama’s economic adviser Christina Romer reportedly calculated that the resulting multiplier would be around 3% (some sources say 4%). Independent analysis of the results suggests it was no greater than 0.8%, or less than unity, with some allowing for as much as 1.2%. It’s my opinion that this discrepancy can be largely accounted for by the government’s emphasis on hiring at the expense of investment, and in its failure to invest at the low ends of long chains of production. But Harvard economist Greg Mankiw offers a more nuanced analysis in a weblog post of December 2008, and Milton Friedman has written extensively on what he regards as both the inaccuracies in Keynesian math and the fundamental flaw in the multiplier concept in A Monetary History of the United States and elsewhere. I would heartily recommend that you check out these views in addition to what I’m arguing here.
It can be seen with little effort that if the government is trying to stimulate the economy by increasing taxes in order to expand its size, thereby taking on more laborers, it will have the opposite effect, by decreasing consumer spending power and decreasing employer hiring and investment power; and this effect will be worse if the government utilizes those tax revenues on activities that create so low a multiplier as to actually decrease the value of the contribution. Under such circumstances, it’s a wonder that the Depression economy was able to recover at all. A far better approach to stimulus was put into practice in 1980 by President Ronald Reagan: “trickle-down” stimulus. This relies on cutting taxes and reducing government spending, the opposite of Keynes’ directives. And it works. Reagan’s initiatives comprised half of the two-pronged approach to fixing Stagflation that emerged early in his first term (the other half comprising Fed Chairman Paul Volcker’s attempt to tame inflation by contracting the money supply). The Fed’s action introduced a sharp recession, but Reagan’s approach to stimulus helped mitigate and shorten the impact, bringing about one of the most historically significant peacetime expansions in history. (Moreover, a proto-Reaganomics approach had been employed decades previously, to great effect; we’ll discuss this further in the context of Andrew Mellon.)
Part of the problem with Keynes’ formulation is the essential lack of empirical study; he created the equations, and his followers have juggled them and imposed various boundary conditions thereon, but few have undertaken the effort to correlate them to real-world history. One consequence of this is the failing of the theory to have any real predictive power. On the other hand, both F. A. Hayek and Milton Friedman have made testable predictions with their theories (predicting the Great Depression and the Stagflation era, respectively). Keynesians seem content to assume that people will behave in the market pretty much as Keynes dictates they will. The basic mathematical principle of the General Theory, the Consumption Function, assumes that there is little variability in the tendencies of people to save, seek tax shelter and respite from inflation, or invest. Friedman’s primary assault on the General Theory attacks the Consumption Function, arguing that it cannot account for the entirety of all motives and actions. This attack is rooted in Hayek’s grasp of complexity, specifically the fact that the players in the market are not automatons following the same program, but individuals influenced by their environment and experiences. This is ultimately just another expression of the machine / jungle dichotomy: the economy is not a machine, with parts moving in lockstep, all driven by a unified motive force, but rather a jungle in which the players follow their own directives, setting their own requirements for success, failure, and opting out of the game, and in which the direction taken by any one player is frequently in opposition to the directions taken by myriad others. Self-direction, indeed, is the main distinction between the two alternatives, and it operates by introducing diversity in motive and method. Progressives who regard the economy as a machine believe it to be manageable by control methods; they see a one-to-one relationship between the inputs and the outputs. Thus, you ought to be able to control, say, the price of a consumer good by, say, setting limits on its production, thereby controlling its supply (a principle that has been fairly thoroughly refuted by the colossal failures of command economies in the USSR, China and India to deliver the demanded quantities of goods). To the contrary, conservatives and libertarians who regard the economy as a jungle do not believe that there is a meaningful, explicit relationship between inputs and outputs, and see the only possible control measures as arising from impacts to the incentives that direct the players. Thus, the only way to regulate the economy is to set limits on quantities such as interest rates and salaries, restricting investment and demand for executive positions, respectively. And while some conservatives might agree that the former approach has some legitimacy in the context of monetary policy, almost none will agree that capping salaries is in any way good either for business, or for businessmen; they will regard this scheme (quite rightly) as an attack on individual liberty.
Another consequence of the General Theory is the emphasis governments place on spending and consumption, over savings and investment. In times of recession, governments are often in the position of exhorting their citizens not to save money but to participate in the market. This often takes the form of taxing savings accounts. The Theory’s spending model distinguishes between savings and investment, offering a distinct function for both quantities. The mathematical upshot is that savings appear as a net drain on the economy, and by analogy, private investment appears less desirable than government deficit spending (which, after all, is spending). It’s somewhat horrifying to realize the oversight here: that bank savings are in fact invested by the bank holding the savings, and many other “savings” schemes involve bonds, stock portfolios, and other investment endeavors. There is no clear-cut line between saving and investment except in the fairly rare case of an individual maintaining complete liquidity by converting all savings to cash and hoarding them in a mattress. Was Keynes truly unaware of this, or merely unwilling to consider its consequences for his theory? The consequence for government policy is staggering: governments, in order to spend on a deficit, must either tax the citizenry more heavily, or go into debt. Raising taxes impacts the money supply to at least the same degree as saving, but lacks the direct benefit to the consumer: the result is no net gain, and perhaps some net loss. Raising funds by selling bonds causes the government to go into debt, creating a strong incentive for the government to later raise taxes (or worse, to inflate the currency to pay off the debt quickly, reducing the purchasing power of wages in precisely the way that Hayek warned about). The entire model seems to be premised on encouraging the government to get involved, for reasons that remain unclear given that the multiplier effect of saving and investment are superior to that of non-productive wages alone. The most objective statement one can make on regulation, given these caveats, is that there is essentially absolutely no reason for the government to play a role in managing the economy, since any role it does play is inherently less efficient and more oppressive than the absence of such a role. To put it another way, the only reason for the government to get involved with managing the economy is to secure votes for pro-regulation candidates.
But although there was already controversy in FDR’s day, most of the considered empirical analysis was still years and decades in the future in 1936. The first round of New Deal reforms had failed to lift the unemployed out of poverty, stimulate economic growth or restore investor confidence. When the second recession came that year, Roosevelt hastily adopted the measures suggested in the General Theory. And he achieved about the same degree of success as with the first Deal. Whether he was deliberately misleading the public is a matter of debate (yet one supported to some degree by members of his inner circle who have pointed out his occasional mendacity regarding economic matters); he did at least provide a degree of moral leadership, which undoubtedly prevented investor and consumer confidence from hitting rock-bottom and staying there. But he had to have been aware of some of the sentiment among his own senior staff. Toward the end of the Depression, his Secretary of the Treasury, Henry Morgenthau, remarked in an address to Congressional Democrats:
We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong…somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises…I say after eight years of this Administration we have just as much unemployment as when we started…And an enormous debt to boot!
--as recounted by Burton W. Folsom Jr. in the preface to New Deal or Raw Deal?
Either FDR was unwilling to accept criticism from his inner circle, or was convinced that such criticism was unwarranted. Either way, he stayed the course, helping keep the United States depressed for a full decade. Elsewhere in the world, the Depression lifted earlier. Somewhere between Roosevelt’s dogged insistence on the correctness of his action, and the inflated GDP numbers used to justify that action, lies the validation that Democrats and other progressives have voiced, decade after decade, since then. It is often pointed out that GDP rose steadily during the implementation of the New Deal, right up until the end of the Depression. However, this ignores the fact that there are no less than three common formulations for GDP, and although under normal circumstances, all three should produce roughly equivalent results, this is not the case during deep depressions, especially when the government is altering the equation by hiring unproductive labor.
The first method is the product (or “output”) approach, which aggregates the outputs of every category of enterprise in order to arrive at the total. The second, “expenditure” approach relies on the principle that the entire product is bought as a unit, so the value of the total product must be equal to the total expenditures that have gone into its production. The third method, the “income” approach, postulates that the incomes of the producers must be equal to the value of their product, determining GDP by finding the sum of all producers’ incomes. It can be seen that the first two methods can produce essentially equivalent results irrespective of the government’s involvement in the economy. However, in the third case, when the market is performing normally (and producers’ income is an accurate reflection of the value of their product), the result is far more accurate than when the government has hired vast numbers of unproductive workers merely in order to provide them income. This is because there is no product, and therefore no value to aggregate. The result is that any GDP figure resulting from this method in a time of heavy government involvement in a depressed economy is fundamentally inaccurate. And yet the Roosevelt administration’s GDP figures have been relied on for decades as proof that the New Deal wrought an increase in GDP over that entire decade.
In the end, the Depression in the United States lifted after our entry into WWII (by most estimates, shortly afterward, by the end of 1942; per other estimates, not until after the end of the war, circa 1947, as our workforce--the occupying servicemen--were returning home in droves, and wartime taxes falling to sane levels, with wartime rationing finally coming to an end). This is another factor Keynesians point to as confirmation of their theory: government spending, by way of ramping up wartime production and hiring military personnel, lifted the economy out of depression. And it’s difficult to explain this away completely; it seems a fair assumption that this degree of mobilization did contribute to the ending of the Depression. However, that kind of mobilization was far and away more acute and militarized than any other government measure taken before or since, and is simply not a realistic approach to mitigating depressions in general. Moreover, there is evidence that American industry was already ramping up production in order to meet the increased demand for steel and other products in Europe, which had already been at war for several years. Although neutrality demanded that US industry not export goods to warring nations, the Lend-Lease Act, signed by Roosevelt, permitted sales of some such goods. In retrospect, this Act contributed far more to Depression relief than anything else he did in office. And the prosperity of the late 1940s and 1950s is due in no small part to the fact that American industry, almost entirely untouched by the war ravages that destroyed capital throughout the rest of the world, was uniquely poised to rebuild that world, remaining ramped up until the rebuilding was complete.
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