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Tuesday, October 14, 2008

Govt. intervention? A venerable American tradition

As debates about how the federal government should respond to the credit crisis have shifted over the last week towards equity stakes in financial firms and initiatives to boost economic growth and create jobs, one thing is clear:  Americans need a crash course on the history of their government’s role in the United States’ economic growth.  Why we (including reporters and most historians) know so little about that history is a question for another day.  The point here is that most Americans have little idea that we have a long and venerable tradition of government action to encourage and support economic growth.

I am not talking about the basic legal framework that has supported the rights of private property throughout our history.  We can take knowledge of that for granted, I think.  But few Americans realize just how deeply, continuously, and thoroughly the American government has actively supported and encouraged economic growth.  A richer sense of our own history—of the impressive support the American government has provided for economic growth throughout our history, and of the multifaceted ways in which it has done so—will help to put current debates in a broader perspective.  Knowing what we, as a nation, have done in the past makes it easier to think anew about what we might do today and tomorrow.

Equity Holdings

Take the question of equity holdings by the federal government, which was finally incorporated as an option into the bill that passed Congress last week and now is being actively considered (under competitive pressure from Europe).  The idea is that financial aid should be extended in a form that gives taxpayers an ownership stake in companies that receive financial aid.  One frequently-heard argument against the proposal was that “we don’t do that” in the United States.  Unlike, say, the French or the Germans, we supposedly do not have a long tradition of state ownership of shares in private companies. 

But, in fact, we do, and our tradition dates back to the founding.  In 1791, two years after the U.S. Constitution took effect, Congress chartered the first Bank of the United States with an authorized capital of $10,000,000—a behemoth institution at the time.  The bank was created, amidst raging controversy, to aid the new federal government in managing its finances (federal government securities had to be used in partial payment for stock in the bank).  As an equivalent percentage of U.S. GDP in 2007, the Bank of the United States’ share capital would amount to about $671 billion. The bank’s charter limited individual shareholdings to 1,000 shares, but authorized the federal government to buy up to 5,000 shares—which it did.  The nominal value of the federal government’s shares—$2,000,000—would be about $134 billion in today’s terms (as a comparable proportion of 2007 GDP).

The first Bank of the United States was allowed to die in 1811, when its twenty-year charter expired, but five years later, in the aftermath of the War of 1812, Congress created the second Bank of the United States for similar reasons.  Chartered with a twenty-year life, its authorized capital was $35 million or, as a comparable share of 2007 GDP, about $596 billion dollars.  Again, the federal government bought 20% of its shares, giving it a nominal stake in the bank of $7 million, or $119 billion in 2007 GDP dollars.

In our own history, in other words, equity holdings by the federal government were a valuable tool for shoring up the American financial system during its first half-century.

Collective Action Problems

Or consider what the federal government has done in the past to help businesses solve collective-action problems.  If the core problem in the credit crisis is uncertainties about the value of exotic, mortgage-backed assets, this is a classic collective-action problem:  Individual firms, under intense competitive pressure to attract capital, are unable to do what would be best for the industry as a whole—fully disclose their risks.  By tackling this problem, the federal government is building on its own long  history of helping businesses solve collective-action problems. 

In the 1920s, for example, the Department of Commerce launched an initiative to solve a collective-action problem that was limiting American industry’s ability to mass produce.  The problem manufacturers faced was that multiplying their product offerings was an effective way to attract consumers, especially during the post-WWI recession.  The result was an “over-diversity” of products that was incompatible with high-volume production.  “Mass production” only makes economic sense (as Henry Ford well knew) if the number of products can be limited, but manufacturers were unable to take this critical step towards mass production on their own.  

During World War One, the War Industries Board had made important strides in shifting critical industries from craft-based to mass-production methods, but back-sliding set in when the war ended.  As manufacturers competed intensely for consumer dollars, the variety of products began to swell again.  So Secretary of Commerce Herbert Hoover set up an administrative mechanism for industries to co-operate in reducing the number of products they offered consumers so that they could reap the economies of mass production.  Among notable successes achieved by introducing what was called “Simplified Practice” was a reduction in the types of paving bricks from 66 to 4; in types of sheet steel from 1,819 to 263; in types of milk bottle caps from 29 to 1; in types of hospital beds from 67 to 4; and in types of brass lavatory and sink traps, from 1,114 to 72.

Had the federal government acted earlier in the current crisis, it might have done something similar, setting up a mechanism to enable financial firms to act co-operatively—under careful government oversight and with full transparency, of course—so that they could tackle the challenging task of figuring out how to value mortgage-based assets themselves.  Instead, with urgent action apparently needed to unfreeze credit markets, the federal government will evidently be taking more direct action, buying up “toxic assets” and recapitalizing banks in hopes that this will get credit flowing again.  Once this crisis is over, however, the way that Herbert Hoover facilitated co-operative action among manufacturers in the 1920s might provide a model for the financial industry in the future.

In the meantime, as the government’s mammoth undertaking gets underway, another worthy tradition in American history, now all but forgotten, suggests that the financial industry should be furnishing  the needed technical expertise on a pro-bono basis, not as outside contractors working on the taxpayers' dollar to solve problems of their own making.  In the emergency mobilization of the American economy during both world wars, leading figures from the business world stepped forward and headed wartime agencies for a token salary.  Known as “dollar-a-year men,” they included executives, for example, from AT&T, General Motors, U.S. Steel, and Sears, Roebuck, enlisted for their expertise in communications, manufacturing, and distribution.  In the current emergency, financial executives would stand on long tradition if they stepped forward as the twenty-first century’s “dollar-a-year men.”

Investment in the “real” economy

In the coming months (perhaps years), we are likely to endure a sharp contraction of the financial industry, if not the economy as a whole.  To ease or prevent an economic contraction, a number of proposals to have the government invest in the “real” economy are in play.  Here, too, we have a venerable tradition in American history.  It, too, extends back to the early years of the Republic, when the American states funded the construction of thousands of miles of canals, providing some 70 percent of all investment.  The tradition continued when railroad construction began in earnest around 1830.  American states and cities contributed nearly 45 percent of the capital invested in railroads during the 1830s.  Of the $1 billion invested in railroads up to 1860, some 25-30 percent was government funded—in 2007 GDP terms, equivalent to about $800 billion.

This was just the beginning.  In the last half of the nineteenth century, the federal government provided millions of acres in land grants to railroads, along with various other subsidies.  In the early twentieth century, it subsidized electrification and the extension of telephone service into rural areas.  In 1956, Congress passed legislation to build 41,000 miles of interstate highways in what President Dwight Eisenhower proudly lauded as “the greatest public works program in the history of the world.”  As a share of 2007 GDP, the cost of the interstate system (some $32 billion at the time) would be equivalent to about $1 trillion. On a smaller scale, there are countless other examples of government investment in the “real” economy—from the War Department's decades-long initiatve in the antebellum years to develop interchangeable parts in gun manufacturing to the decades-long work of the Defense Advanced Research Projects Agency, which gave birth to the inventions underlying the Internet as well as nanotechnolgy.

To offset what seems to be an inevitable contraction of the financial industry, why not build on this venerable tradition?  These days we may not be able to afford a project the size of the interstate highway system, but even half of the $700 billion at play in the bailout plan would go a long way towards rebuilding our crumbling infrastructure, reorienting our energy use, making education and health care more affordable, creating jobs, and stimulating consumption (not to mention mortgage payments).

Realigning regulation

The United States will also have to face—once again—the task of realigning the spatial dimensions of business regulation.  The mantel of financial regulation seems likely to be expanded within the U.S. to cover financial instruments and entities not currently regulated, but the jurisdiction of U.S. law ends at our borders and the operations of the largest financial firms do not.  We faced a very similar situation in the nineteenth century, when railroads became the first businesses (after the slave trade) to cross state lines, challenging and undermining the American states’ traditional powers to regulate transportation.

In a complicated political process spanning the years from the 1850s to the 1880s, punctuated by disastrous rate wars, railroad regulation was realigned to accommodate this new reality.  With the passage of the Interstate Commerce Act in 1887, regulation of interstate railroad rates shifted from the state to the national level.  In subsequent decades, as other American businesses became increasingly national in scope, so did other aspects of business regulation—always amidst great controversy and never completely so.  (Antitrust policy was effectively nationalized after 1890, as was securities regulation during the New Deal, for example, but incorporation policy has remained largely in the hands of the states.)

The financial industry has undergone a similar spatial realignment in the last two decades.  Where giant railroad systems spanned the American continent by the late nineteenth century, financial companies now span the globe.  As a result, nations today, much like the American states in the nineteenth century, are facing a competitive “race to the bottom” in business regulation.  International regulatory competition was one of the factors Alan Greenspan cited in arguing (successfully) against federal regulation of over-the-counter derivatives in 2000: if the U.S. regulated derivatives more stringently than other nations, the derivatives market — and its associated revenues and jobs — would migrate to more favorable jurisdictions.

In the coming years, the force of competition among nations to attract capital is likely to intensify.  We can stay the course, dealing as best we can with the periodic crises engendered by the laxity of national regulation that intense international competition promotes, or we can begin the hard work of doing what Americans did in an earlier era—realigning business regulation in light of the new spatial realities of business.  In the present environment, fortunately, we would find eager allies abroad if we chose realignment.

As we debate what to do next, let us at least agree on this:  the American government has a long and rich history of initiatives, large and small, to support economic growth.  “Laissez-faire” is a myth.  Our history of government action, in times of crisis as well as in normal times, extends back to the founding.  The question today is not whether the government should do something, but what it should do this time.  In view of our history, very little is off the table.

Thursday, January 24, 2008

The ineffable resilience of capitalism?

My lecture course is off and running again this week, and as I said to my students on Tuesday, I can't imagine a more exciting time to study the history of American capitalism. For a historian (not to mention those with more intimate connections), the fascinations are endless.

This morning's financial pages have me mulling over two dimensions of the current economic mess:
  • Risk
This is a core attribute of capitalist activity, as everyone knows. Read the letters of Manhattan merchant Gerard R. Beekman from the 1760s (as my students are doing) and you will get a very concrete sense of the array of risks that traders faced in his time. Over the long haul, business people have continually sought, as he did, to minimize risk, the methods changing as the nature of risks changed. If they ever achieved complete success, of course, not much would be left of capitalism.

What is fascinating about the current crisis in the money/housing markets is that financial people by the 1990s thought they had mastered risk -- for example, by slicing and dicing it into collaterized debt obligations and the like -- only to discover that they had done their work too well. They spread risks so broadly that no one knows for sure where they are anymore and now everyone is potentially at risk. So what's that about? The ineffable resilience of capitalism?
  • Competition
Another of those core attributes of a capitalist economy. And, like risk, competition is something that business people have spent extraordinary energy trying to reduce -- in the informal ways famously noted by Adam Smith, by means of cartels in the 1870s and 1880s, via mergers during the Great Merger Movement at the turn of the twentieth century, and so on into the early twenty-first century. The resulting oligopolies are so common in so many lines of business that they have become naturalized and thus go largely unnoticed today.

Occasionally, however, events force us to notice them and to confront the reality that oligopoly-building to reduce competition has generated a variety of new risks. Consider the recent financial turmoils: suddenly everybody knows that there are only a handful of big auditing firms, or that only two bond insurance companies carry on most of the business (the big new concern in the financial pages). Success in reducing competition to a handful firms
in these lines of business has made large segments of American business dependent on their health, in effect increasing risk for everyone else. The ineffable resilience of capitalism?