Sunday, November 9, 2008

Proof of Free Market Superiority Over Government Funded Waste

The Myth of the Robber Barons

by Burton W. Folsom, Jr.

This article is adapted from a lecture Professor Folsom gave at the History and Liberty seminar at FEE in June. For readers who are interested in finding out more about these lost lessons of history we recommend Professor Folsom's popular book, The Myth of the Robber Barons, now in its fifth edition.

In the ongoing war of ideas in American history, those who advocate government action as an engine of economic development have been encouraged by a general and all-too-human tendency to avoid thinking deeply. Because we have a long history of government intervention in the economy, the assumption—both among those who design government programs and among the constituencies that support them—has usually been that government action accomplishes its objectives. Even people who have reservations about bureaucratic inefficiency reason that we wouldn't have turned to government so many times in the past if government hadn't accomplished something.

Three Assumptions About Capitalism

This shallow conclusion dovetails with another set of assumptions: First, that the free market, with its economic uncertainty, competitive stress, and constant potential for failure, needs the steadying hand of government regulation; second, that businessmen tend to be unscrupulous, reflecting the classic cliché image of the “robber baron,” eager to seize any opportunity to steal from the public; and third, that because government can mobilize a wide array of forces across the political and business landscape, government programs therefore can move the economy more effectively than can the varied and often conflicting efforts of private enterprise.

But the closer we look at public-sector economic initiatives, the more difficult it becomes to defend government as a wellspring of progress. Indeed, an honest examination of our economic history—going back long before the twentieth century—reveals that, more often than not, when government programs and individual enterprise have gone head to head, the private sector has achieved more progress at less cost with greater benefit to consumers and the economy at large.

Competition Versus Subsidy in the Steamship Industry

America's early experience with the steamship industry provides an illustrative case. By the 1840s,the technology of steam-powered water transport had reached the point where it became practical to build large ocean-going vessels, and steamships began plying the route between New York City and Liverpool, England. An enterprising fellow named Edward K. Collins approached the U.S. Congress with a plan to develop a steamship fleet that could compete with Britain's Cunard Company. Since the Cunard operation was subsidized by the British government, Collins asked Congress to provide him with a grant of $3 million to underwrite the construction of five vessels and a yearly supplement of $385,000 so he could strive to best Cunard's fare of $200 per passenger and its rates for carrying freight and mail.

Playing skillfully on congressional fears about British domination of the transatlantic trade, and promising that his ships could serve as the basis of a merchant marine fleet in the event of war, Collins got his money. He then proceeded to build four very large and luxurious ships, instead of the five smaller vessels provided for in the agreement, and he took far longer than anticipated to get his fleet into operation.

Collins ran his ships on the same schedule as Cunard, sailing every two weeks, and he often did beat Cunard's crossing time by one day, though at considerably higher operating costs. But while he had promised Congress that his yearly subsidy could eventually be phased out, he was soon lobbying for annual increases to about $500,000, $600,000, $700,000, and then to more than $800,000 per year.

Cornelius Vanderbilt, who had made his mark as an operator of river steamboats, approached Congress with a proposal for an “Atlantic ferry,” promising to match Collins's two-week sailing schedule at half the cost of Collins's subsidy. Congress debated Vanderbilt's proposal. But it doubted his ability. Having made a commitment to Collins—and by now a considerable investment as well—Congress turned Vanderbilt down.

Vanderbilt was undeterred. He went into operation without a subsidy, using privately financed ships, set up a self-insurance arrangement by which he was able to save on payments to outside insurers, and ran his ships at slower speeds to save fuel. He also reduced the fare, and he invented a new, cheaper passenger class, by which people could travel below decks, in what was called steerage, for as little as $30. Vanderbilt's “sardine class” made it possible for many immigrants to come to America.

After a year, Vanderbilt's operation was flourishing, and Collins, in serious trouble from competition with Vanderbilt, went to Congress to ask that his subsidy be raised, yet again, to more than $850,000. Collins managed to persuade the congressmen to conclude that since they started with Collins, it would be disloyal to take his money away now.

But Collins recognized that each time he went back to Congress for more money, the vote was closer. He decided that if he couldn't beat Vanderbilt on price, he would concentrate on beating his crossing time, demonstrating that the Collins line clearly offered the most efficient way to get from Liverpool to New York City. This strategy had its dangers. Long beset with maintenance problems because their engines were too large for their hulls, Collins's ships began to feel the strain of this high-speed policy. Two of the ships—half his fleet—sank, killing almost 500 passengers, and Collins faced the humiliation of going back to Congress to beg for an emergency $1 million appropriation to construct a replacement vessel.

Again Congress funded him. But the new ship, The Adriatic, was so hastily and poorly constructed that it had to be sold at auction after its first voyage—at a $900,000 loss. When Collins went back to Congress for still more money to build yet another ship, he was finally turned down.

It is interesting to look at the reaction in Congress after being embarrassed again and again by the subsidies to Collins. Senator Judah Benjamin of Louisiana said, “I believe [the Collins line] has been our most miserably managed.” Senator Robert Hunter of Virginia went even further. “The whole system was wrong,” he said. “It ought to have been left, like any other trade, to competition.” Senator John Thompson of Kentucky insisted, “Give neither this line nor any other line a subsidy. Let the Collins line die. I want a tabula rasa . . . a new beginning.”

Collins had his subsidy stripped and had to compete head to head—unsupported—with Vanderbilt. Within a year, Collins went bankrupt, and Vanderbilt was the dominant force on the seas from the American side.

Competition Versus Subsidy in the Railroad Industry

It would be comforting to report that the United States learned its lesson about the effects of federal subsidies from the Collins/Vanderbilt experience. Unfortunately, less than a decade later, would-be railroad builders were coming to Congress begging for money to span the nation with transcontinental lines. Congress subsidized three transcontinental rail-roads: the Union Pacific, the Central Pacific, and later the Northern Pacific.

These companies, which were provided with money and land by the government, had no incentive to build their lines efficiently, along straight routes with even grades and proper materials. Eventually they went bankrupt. The Union Pacific and the Central Pacific did so only after eating up 44 million acres of free land and $61 million in cash loans. Large sections of the lines they did complete soon had to be rebuilt and sometimes even relocated due to shoddy construction.

The privately funded Great Northern, which, by contrast, operated on a shoestring budget, was a success. Unlike his competitors, James J. Hill built the Great Northern for durability and efficiency. “What we want,” he said, “is the best possible line, shortest distance, lowest grades, and least curvature that we can build.” That meant he personally supervised the surveying and construction. “I find that it pays to be where the money is being spent,” he noted. He believed that building a functional and durable product actually saved money. For example, he usually imported high-quality Bessemer rails, even though they cost more than those made in America. He was thinking about the future, and quality building cut costs in the long run. When Hill constructed the solid granite Stone Arch Bridge—2,100 feet long, 28 feet wide, and 82 feet high across the Mississippi River—it became the Minneapolis landmark for decades. Yet today Hill is regarded as just another member among the ranks of the greedy, amoral “get-rich-quick” capitalists.

After the transcontinental railroad episode, Congress increasingly began to take the position that American business success would be based on entrepreneurship, not subsidy, relying on those whom I call market entrepreneurs rather than political entrepreneurs. If you look at industries after the Civil War—particularly steel, oil, and chemicals—you find that time and again American market entrepreneurs stepped in and defeated competition from Europe, without subsidies.

Andrew Carnegie and the Steel Industry

When Andrew Carnegie founded Carnegie Steel in 1872, the biggest steel producer in the world was England and the going price of steel rails was about $56 per ton. Carnegie was an eager innovator. He adopted the revolutionary Bessemer process and introduced new accounting methods to make his operations more efficient, applied a merit-pay system to reward his workers, and implemented many employee-suggested ideas. Carnegie Steel became so efficient that by 1900 the company could produce steel rails at $11.50 per ton, and its rail output surpassed that of all the steel mills in England combined. Other U.S. firms followed Carnegie's lead, and America became the dominant steel producer of the world.

John D. Rockefeller and the Oil Industry

Our story would not be complete without recalling the success of John D. Rockefeller. By the 1890s, Standard Oil had a 60 percent market share of all the oil sold in the world. Rockefeller sold the oil at eight cents a gallon—that would be around $1.60 today. Eight cents a gallon! Nobody in the world could do it that cheaply. Kerosene was so inexpensive that people could light their homes for less than one cent an hour.

Rockefeller, the first billionaire in U.S. history, made a fraction of a cent on each gallon of oil his company sold. He had the foresight to say that his goal was to make it for six cents, sell it for eight cents, and use the two cents for research and development. Rockefeller realized that finding new uses for oil was the key to success. (Other companies would take a barrel of oil out of the ground, heat it to get the kerosene, and dump the excess as waste into rivers.) Eventually Standard Oil discovered and produced scores of byproducts, including candle wax, soap, petroleum jelly, tars, and lubricating oils.

Because of this resourcefulness, Rockefeller might well be called the first environmentalist. (He also could be credited with species preservation: the whaling industry declined precipitously as kerosene displaced whale oil in lighting.)

But all this did not make him popular. Competitors did not like him, and public opposition mounted. Standard Oil had already begun to lose market share to competitors because it failed to invest in the Texas oil fields in 1900. But despite this declining market share, successful antitrust litigation resulted in the company's being split into 34 companies.

Time and again, experience has shown that while private enterprise, carried on in an environment of open competition, delivers the best products and services at the best price, government intervention stifles initiative, subsidizes inefficiency, and raises costs. But if we have difficulty learning from history, it is often because our true economic history is largely hidden from us. We would be hard pressed to find anything about Vanderbilt's success or Collins's government-backed failure in the steamship business by examining the conventional history textbooks or taking a history course at most colleges or universities. The information simply isn't included.

The Greatest Generation?

I want to end on a positive note. The success of the market entrepreneurs of the post-Civil War era depended on their ability to serve consumers. When they started their enterprises, the United States was a second-rate power; during their lifetimes they spurred American industry to world dominance. Their accomplishments in transportation, steel, oil, and chemicals led to the unparalleled economic progress of the late 1800s, contributed to American prosperity, and prepared the way for future innovation.

Along with our Founding Fathers and the World War II generation, this remarkable group of entreprenurs, has a rightful claim to being America's greatest generation.

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