Economic Lessons from American History
John Steele Gordon
Author, An Empire of Wealth:
The Epic History of American Economic Power
July/August 2012
JOHN STEELE GORDON was educated at Millbrook School and Vanderbilt
University. His articles have appeared in numerous publications,
including Forbes, Worth, National Review,
Commentary, the New York Times, and the Wall Street
Journal. He is a contributing editor at American Heritage,
where he wrote the “Business of America” column for many years, and
currently writes “The Long View” column for Barron’s. He is the
author of several books, including Hamilton’s Blessing: The
Extraordinary Life and Times of Our National Debt, The Great
Game: The Emergence of Wall Street as a World Power, and An
Empire of Wealth: The Epic History of American Economic Power.
The following is adapted from a lecture delivered on February 27,
2012, aboard the Crystal Symphony during a Hillsdale College cruise from
Rio de Janeiro to Buenos Aires.
AMERICA is still a young country. Only 405
years separate us from our ultimate origins at Jamestown, Virginia,
while France and Britain are 1,000 years old, China 3,000, and Egypt
5,000. But what a 400 years it has been in the economic history of
humankind!
When the Susan Constant, Discovery, and Godspeed
dropped anchor in the James River in the spring of 1607, most human
beings made their livings in agriculture and with the power of their own
muscles. Life expectancy at birth was perhaps 30 years. Epidemics
routinely swept through cities, carrying off old and young alike by the
thousands. History tends to dwell on a small percent of the population
at the top of the heap, but the vast mass of humanity lived lives that
were, in the words of Thomas Hobbes, “nasty, brutish, and short.”
Today we live in a world far beyond the imagination of those who were
alive in 1607. The poorest family in America today enjoys a standard of
living that would have been considered opulent 400 years ago. And for
most of this time it was the United States that was leading the world
into the future, politically and economically.
This astonishing economic transformation provides rich lessons in
examples of what to do and not do. Let me suggest five.
1. Governments Are Terrible Investors
When the Solyndra Corporation filed for
bankruptcy last summer, it left the taxpayers on the hook for a loan of
$535 million that the government had guaranteed. In a
half-billion-dollar example of how governments often throw good money
after bad, the government had even agreed to subordinate the loan as the
company’s troubles worsened, putting taxpayers at the back of the line.
In retrospect, it is clear that the motive behind the loan guarantee was
political: to foster green energy, an obsession of the left. And that’s
the problem with government investment: Politicians make political
decisions, not economic ones. They’re playing with other people’s money,
after all.
History is littered with government investment disasters. The Clinch
River Breeder Reactor, for instance, authorized in 1971, was estimated
to cost $400 million to build. The project ran through $8 billion before
it was canceled, unbuilt, in 1983. A half century earlier, the Woodrow
Wilson administration thought it could produce armor plate for
battleships cheaper than the steel companies. The plant the government
built, millions over budget when completed, could not produce armor
plate for less than twice what the steel companies charged. In the end
it produced one batch—later sold for scrap—and shut down.
Going back even farther, to the dawn of the industrial age, consider the
Erie Railway. In order to get political support for building the Erie
Canal, Governor DeWitt Clinton promised the New York counties that
bordered Pennsylvania (known as the “Southern Tier”) an “avenue” of
their own once the canal was completed. The canal was an enormous
success, but as such it affected the state’s politics. A group of
politicians from along its pathway, the so-called Canal Ring, soon
dominated state government. They were not keen on helping to build what
would necessarily be competition.
A canal through the mountainous terrain of the Southern Tier was
impossible, and by the 1830s, railroads were the hot new transportation
technology. But only with the utmost effort did Southern Tier
politicians induce the Legislature to grant a charter for a railroad to
run from the Hudson River to Lake Erie through their counties. And the
charter almost guaranteed economic failure: It required the railroad to
run wholly within New York State. As a result, it could not have its
eastern terminus in New Jersey, opposite New York City, but had to end
instead in the town of Piermont, 20 miles to the north. It was also
forbidden to run to Buffalo, where the Erie Canal entered Lake Erie,
terminating instead in Dunkirk, a town 20 miles south. Thus it would run
483 miles between two towns of no importance and through sparsely
settled lands in between—not unlike the current proposed California
high-speed rail project, the first segment of which would run between
Fresno and Bakersfield and cost $9 billion.
The Erie Railway was initially estimated to cost $4,726,260 and to take
five years to build. In fact, it would take $23.5 million and 17 years.
With the depression that began in 1837, it soon became clear that only
massive state aid would see the project through. So New York State
agreed to put up $200,000 for every $100,000 raised through stock sales.
Even that was not enough, however, and the railroad issued a blizzard of
first mortgage bonds, second mortgage bonds, convertible bonds, and
subordinated debentures to raise the needed money. This mountain of debt
got the Erie completed in 1851, but it would haunt the railroad
throughout its existence. Indeed, the Erie Railway would pass through
bankruptcy no fewer than six times before it disappeared as a corporate
entity in the early 1970s.
Why was the Erie Canal a huge success—it even came in under budget and
ahead of schedule—that made huge profits from the very beginning, while
the Erie Railway was a monumental failure? One reason was that canal
technology was well-established and well-understood by the early 19th
century. More important, the route of the Erie Canal was the only place
a canal could be built through the Appalachian Mountains. Thus it would
have no competition. And the reason the canal was built by government
was that the project was simply too big for a private company to handle.
A very similar situation arose in the 1950s. Three decades before, a
young U.S. Army captain had joined an expedition in which the Army had
sent a large convoy of trucks from Washington to San Francisco, to learn
the difficulties of doing so. They were very considerable because the
nation’s road network hardly deserved the term. By the 1950s, that young
captain had become president of the United States and road-building
technology was well understood. Dwight Eisenhower pushed a national
network of limited-access roads through Congress, and the country has
hugely benefitted from the Interstate Highway System ever since.
Both the Erie Canal and the Interstate Highway System are passive
carriers of commerce. Anyone can use them for a fee, although many
Interstates are paid for through the Highway Trust Fund. But a railroad
is a business that can only be profitable with careful attention to the
bottom line forced by competition. And governments are notoriously bad
at running businesses because government businesses are always
monopolies. Just remember your last customer-friendly visit to the
Department of Motor Vehicles.
In addition to building infrastructure such as the Erie Canal and the
Interstate Highway System, government can be good at doing basic
research, such as in space technology, where the costs were far beyond
the reach of any private organization. Only government resources could
have put men on the moon. Nevertheless, I’m encouraged to see that the
next generation of rockets is being developed by private companies, not
NASA. That’s a step in the right direction.
Unfortunately, we are headed the other way with the American medical
industry.
2. Politicians Have Self-Interest Too
In 1992, New York State found itself $200 million short of having a
balanced budget, which the state constitution requires. The total state
budget was about $40 billion, so it could have been balanced by cutting
one half of one percent—the equivalent of a family with an after-tax
income of $100,000 finding ways to save less than 50 dollars a month.
So did New York cut its budget? Don’t be silly. Instead, it had a state
agency issue $200 million in bonds and use the money to buy Attica State
Prison from the state. The state took the $200 million its own agency
had borrowed, called it income, and declared the budget balanced. New
York now rents the prison from its own agency at a price sufficient to
service the bonds.
Had any private company sold, say, its corporate headquarters to a
wholly-owned subsidiary and called the money received income, its
management would be in Club Fed. So why wasn’t Governor Mario Cuomo or
the state comptroller thrown in jail for what was a patent act of
accounting fraud? Because government, unlike corporations, can keep
their books as they please. And why must corporations obey accounting
rules? In a beautiful example of Adam Smith’s invisible hand at work, it
was the self-interest of Wall Street bankers and brokers that produced
one of the great ideas in American economic history.
In the 1880s the great Wall Street banks that were emerging at that
time, such as J. P. Morgan & Co. and Kuhn Loeb, as well as the New York
Stock Exchange, began demanding two new ways of doing business: First,
listed firms, and those hoping to raise capital through the banks, were
required to keep their books according to what became known as Generally
Accepted Accounting Principles. There are many ways to keep honest
books—and, of course, an infinite number of ways to keep dishonest
ones—so it’s important that all companies keep them the same way, so
that they can be compared and a company’s true financial picture seen.
Second, these firms were required to have their books certified as
honest and complete by independent accountants. It was at this time that
accountancy became an independent, self-governing profession, like law
and medicine.
But while J. P. Morgan was probably the most powerful banker who has
ever lived, not even he had the power to force governments to adhere to
Generally Accepted Accounting Principles and submit their books to
independent certification. And because it is in the self-interest of
politicians to cook the books—just as corporate managers did until Wall
Street forced them to change their ways—they continue to commit
accounting fraud on a massive scale. This is no small part of the reason
that the federal government and many state governments are in financial
crisis today.
In 1976 New York City went broke, thanks to spending borrowed money and
hiding the fact by means of fraudulent accounting. The state refused to
help until the city agreed to do two things: adhere to Generally
Accepted Accounting Principles and have its books certified by
independent accountants. What a concept! Needless to say, the state
imposed no such discipline on itself. So here we are, 36 years later,
and the city is in pretty good financial shape while the State of New
York is a financial basket case, almost as badly off as California.
Maybe New York City should offer to help the state—once, of course, it
agrees to keep honest books.
3. Immigration is a Good Thing
Everyone living today in the United States
either has ancestors who said goodbye to everyone and everything they
had ever known, traveling to a strange land in search of a better life,
or did so himself. That takes a lot of guts and a lot of gumption. Both
are inheritable qualities.
The French and Spanish governments, far more authoritarian than the
British, were very careful about who they permitted to emigrate to their
colonies. They wanted no troublemakers, no dissidents, and especially no
religious heretics. The British government, on the other hand, couldn’t
have cared less who went to its colonies. The result was a remarkably
feisty mix of people. Many just marched to the beat of a distant
drummer. More than a few arrived one jump ahead of the sheriff—and
others one jump behind him, having been transported as criminals. But
the bulk came of their own free will, and have been coming ever since,
in hopes of finding a better and richer life. Even those who arrived as
slaves, and thus had no choice about it, survived an ordeal that is
utterly beyond modern imagination and passed that incredible strength
down to their descendants.
But while immigration made this country, there has been a long history
of anti-immigration in America, beginning as early as the 1840s when the
Irish, fleeing the famine, began to pour into our burgeoning eastern
cities. Western states later pressured the federal government to limit
and even exclude immigration from China and Japan. In the 1920s we
limited all immigration, trying to make the ethnic mix that was then in
place permanent.
To be sure, we need to secure our borders. All sovereign governments
have a right and a duty to decide who gets to come in. But it is
entirely in our interest to allow in those who want to work hard and
succeed, for that makes us all richer. And in a time when by far the
most precious economic asset is human capital (a phrase not coined until
the mid-18th century), turning away those who possess it makes no sense.
In particular, current regulations regarding H-1B visas and visas issued
to foreign postgraduate students at American universities often force
the holders to return to their native countries after they finish their
studies or the particular job for which they were admitted. Many of
these highly educated and highly skilled people wish to stay. Instead of
letting them, we send them back to work in economies that compete with
us. That’s nuts.
4. Good Ideas Spread, Bad Ones Don’t
In colonial times we had a chaotic money
supply. Britain forbade the export of British coins, so while American
colonists kept their accounts in pounds, shillings, and pence, what
circulated in day-to-day transactions was a hodgepodge of Spanish,
French, Portuguese, and some British coins, warehouse certificates for
tobacco and other products, paper money printed by the colonies—until
the British government forbade that too—and even wampum, the form of
money used by the Indians.
After the Revolution, the need to create a national money supply was an
urgent task of the new nation. The question of what unit of account to
adopt was a complex one because the colonists were accustomed to so many
different, and often incommensurate, units. Robert Morris, who had done
so much to keep the Revolution financially afloat, tried to bridge the
differences by finding the lowest common divisor of the monetary units
encountered in each state, calculating this to be 1/1,440th of a Spanish
dollar. He proposed that this unit be multiplied by 1000, making the new
American monetary unit equal to 25/36ths of a Spanish dollar. Thomas
Jefferson—whose role in this process amounted to his one and only
positive contribution to the financial system of the United
States—argued instead for simply using the dollar.
Once the dollar was chosen, it would have been natural to adopt the
British system of dividing the basic unit into twenty smaller units, and
those into twelve still smaller units, the way American merchants kept
their accounts. The Spanish system in use in the colonies—cutting
dollars into halves, quarters, and eighths, called bits—would have been
a natural idea as well. But Jefferson advocated making smaller units
decimal fractions of the dollar, arguing that “in all cases where we are
free to choose between easy and difficult modes of operation, it is most
rational to choose the easy.”
That made Jefferson the first person in history to advocate a system of
decimal coinage, and the United States the first country to adopt one.
This was a very good idea, and, as good ideas always do, it quickly
spread. Today every country on earth has a decimal currency system.
But if Jefferson’s decimal coinage concept was a good idea that quickly
spread around the world, another idea that developed here at that time
was lousy: the so-called American Rule, whereby each side in a civil
legal case pays its own court costs regardless of outcome. This was
different from the English system where the loser has to pay the court
costs of both sides.
The American Rule came about as what might be called a deadbeat’s relief
act. The Treaty of Paris (which ended the American Revolution)
stipulated that British creditors could sue in American courts in order
to collect debts owed them by people who were now American citizens. To
make it less likely that they would do so, state legislatures passed the
American Rule. With the British merchant stuck paying his own court
costs, he had little incentive to go to court unless the debt was
considerable.
The American Rule was a relatively minor anomaly in our legal system
until the mid-20th century. But since then, as lawyers’ ethics changed
and they became much more active in seeking cases, the American Rule has
proved an engine of litigation. For every malpractice case filed in
1960, for instance, 300 are filed today. In practice, the American Rule
has become an open invitation, frequently accepted, to legal extortion:
“Pay us $25,000 to go away or spend $250,000 to defend yourself
successfully in court. Your choice.”
Trial lawyers defend the American Rule fiercely. They also make more
political contributions, mostly to Democrats, than any other set of
donors except labor unions. One of their main arguments for the status
quo is that the vast number of lawsuits from which they profit so
handsomely force doctors, manufacturers, and others to be more careful
than they otherwise might be. Private lawsuits, these lawyers maintain,
police the public marketplace by going after bad guys so the government
doesn’t have to—a curious assertion, given that policing the marketplace
has long been considered a quintessential function of government.
The reason for this is that when policing has been in private hands,
self-interest and the public interest inevitably conflicted. The private
armies of the Middle Ages all too often turned into bands of brigands or
rebels. The naval privateers who flourished in the 16th to 18th
centuries were also private citizens pursuing private gain while
performing a public service by raiding an enemy’s commerce during
wartime. In the War of 1812, for instance, American privateers pushed
British insurance rates up to 30 percent of the value of ship and cargo.
But when a war ended, privateers had a bad habit of turning into pirates
or, after the War of 1812, into slavers.
Predictably, the American Rule has spread exactly nowhere since its
inception at the same time as the decimal coinage system. There is not
another country in the common-law world that uses it. Indeed, the only
other country on the planet that has a version of the American Rule is
Japan, where a very different legal system makes it extremely difficult
to get into court at all.
The United States has more lawyers and more lawsuits, per capita, than
any other country. But lawsuits don’t create wealth, they only transfer
it from one party to another, with lawyers taking a big cut along the
way. Few things would help the American economy more than ending the
American Rule. Texas reformed its tort law system a few years ago and
the results have been dramatic. Doctors have been moving into the state,
not out of it, and malpractice insurance costs have fallen 25 percent.
And remember, good ideas always spread.
5. Markets Hate Uncertainty
The Great Depression that started in the fall
of 1929 ended, at least technically, in early March 1933. The stock
market, almost always a leading indicator, had bottomed out the previous
June, down 90 percent from its high in September 1929. 1933 would be the
second best year for the Dow Jones average in the entire 20th century,
coming off, of course, a very low base.
But recovery was very slow in coming. Unemployment, over 25 percent in
1933, was still at 17 percent as late as 1939. Indeed, in 1937, when the
economy suddenly turned south again, there was a problem: what to call
the new downturn. Most people thought the country was still in a
depression, so that word wouldn’t do. But economists, delighted to have
a problem that they could actually solve, came up with the word
“recession,” and that’s what we have been using ever since.
Usually, when there has been a steep decline in economic activity,
recovery is equally steep. The valley is V-shaped. That is what happened
in 1920, when there had been a severe post-war depression and then a
strong recovery. So why was the recovery so slow in the 1930s? One
reason, according to an increasing number of economic historians, is
that Franklin Roosevelt had a bad habit of changing his mind. While
highly intelligent, he was no student of economics and seldom read books
as an adult. So much of his program was, essentially, seat-of-his-pants
policy. First there was the National Recovery Administration, which
amounted to a vast cartelization of the American economy. When the
Supreme Court threw it out—by a unanimous vote—FDR moved on to other
remedies, including big tax increases on the rich.
But markets, which can function even in disaster with ruthless
efficiency, hate uncertainty. When uncertainty regarding the future is
high, they tend to tread water. As a result, there was what is known as
a “strike of capital.” While corporations often had large cash
balances—General Motors made a profit in every year of the Great
Depression—and banks had money to lend, there was little investment and
few loans made. Both the banks and the corporations were too uncertain
about what the government was going to do next.
That is precisely what is happening today. Banks and corporations have
plenty of money. Apple alone is sitting on about $100 billion worth of
corporate cash. And yet the recovery from the crash of 2008 has been
tepid at best. The valley is U-shaped. Undoubtedly a big reason for that
is the enormous uncertainty that has plagued the country since 2008.
Will health care—one-sixth of the American economy—be taken over by the
folks who run the post office? Will the Bush tax cuts be ended or
continued? Will the corporate income tax go up or down? Will
manufacturing get a special tax deal? Will so-called millionaires—who,
when you listen carefully to what liberal politicians are saying, can
earn as little as $200,000 a year—be forced suddenly to pay “their fair
share”?
Who knows? So firms and banks are postponing investment decisions until
the future is clearer. Perhaps the clearing will happen on November 6.
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