Chapter Two: The Ideological Divide

Modern socialists – that is, those not advocating a Marxian fantasy world in which the state abolishes itself upon the destruction of all classes and the implementation of “true” communism – often would have you believe that the attack upon ever greater government intrusion into the lives of the citizenry is some new phenomenon, born of the Reagan Revolution, reared by Newt Gingrich and kept alive by a radical fringe element – led by Grover Norquist - that wishes to tumble us all back to the dark ages. As this fairytale goes, the Founding Fathers were unapologetic advocates of governmental action [1] in essentially every part of our lives in order to achieve a “more just” society and anti-governmental sentiment did not really amount to much before Franklin Delano Roosevelt “saved” capitalism and selfish rich people refused to pay their fair share.

As is so frequently the case, actual history has a tendency to deviate substantially from socialist mythology. Distrust of government dates back probably as long as states have existed, certainly as far back as the ancient Greeks when Antigone, openly refusing to heed a rulers' decree, replied “ekhous apiston tênd anarkhian polei" (Nor am I ashamed to act in defiant opposition to the rulers of the city) [2] Put simply, the evolution of anti-government sentiments tracks very closely each practical application of greater governmental power.

Then, as now, this war of ideas was waged not in secret cabals and hidden chambers, but in the full light of day. A whole library of work from Karl Marx to David Friedman, from John Maynard Keynes to Murray Rothbard, and, historically, from Niccolo Machiavelli’s The Prince to Grover Norquist’s Leave Us Alone - Getting the Government's Hands Off Our Money, Our Guns, Our Lives. And the real world implications of these visions have been examined, again openly, from the likes of Adam Smith to John Kenneth Galbraith to James M. Buchanan.

Charges of “conspiracy” on either hand serve only to undermine the credibility of those making such charges. At the very moment that a group of individuals meets each Wednesday at the offices of Americans for Tax Reform to discuss ways “to cut government in half in twenty-five years … to get it down to the size where we can drown it in the bathtub", [3] still others are meeting at the National Committee for an Effective Congress and at those of Moveon.org. In fact, according to USA Today, “at the urging of House Democratic leader Richard Gephardt, a group of labor leaders, environmentalists, abortion-rights activists and others ... began a weekly session [every Wednesday] chaired by Rep. Rosa DeLauro, D-Conn…. to provide ‘an open exchange of information about a shared agenda.’” [4] This is not to say that anything is wrong with the meetings of any of these organizations, but it does demonstrate, particularly when Norquist’s statement is so secret that it is perhaps his most repeated missive, [5] that referring to such meetings as conspiratorial is foolish at best and blatantly dishonest at worst.

Correcting History: From Mercantilism to Adam Smith

In their ideological zeal to discredit any opinion not fully embracing the pro-government stance, some would have you believe that the push for a smaller or more-controlled government is some new creation that sprang magically into being when Ronald Reagan famously announced “Government isn’t the solution; it’s the problem” [6] and subsequently expanded upon it by saying “The ten most dangerous words in the English language are 'Hi, I'm from the government, and I'm here to help’” [7] In reality, the realization that government is more often the creator of problems rather than their solution has been learned, forgotten and relearned over and over again throughout history. When David Boaz suggested that the “real problem in the United States is the same one being recognized all over the world: too much government” he was discussing merely this latest relearning process and it had clearly been underway since at least the 1950s. He further argued not that this realization would result in any sort of conspiratorial backlash but simply that “in a fast-changing world where every individual has unprecedented access to information, centralized bureaucracies and coercive regulations just can't keep up with the real economy.” [8]

For most of human history, the economic concerns of the state fell into only two categories, taxation and slavery. In the first instance, the power of the state was used both to finance the crown and to enforce its authority. The concept of state intervention into the economy to achieve national goals did not arise until very recently from an historical standpoint, as is detailed below. Slavery is now, and has always been, a state enforced and protected institution. From ancient times we know that slavery was a governmental response to the care of prisoners of war, the penalty for commission of a crime, and a penalty for failure to pay debts. Moreover, while slavery can be characterized as an economic intervention, intertwined as it is with the concepts of property ownership, labor and industry, economic arguments were never put forth to bring it into existence and were only used in relatively recent history – untenable as such arguments are – as a reason for the institution’s retention. Slavery has always been a state creation, not a capitalistic one.

Economic intervention as a deliberate government policy did not really come into existence until the 16^th Century.  Machiavelli’s The Prince, written in 1513, was not published until 1532. It was probably the first tract regarding the proper exercise of state power of modern times. In 1589, a response was penned by Giovanni Botero entitled The Reason of State.  In it, Botero argued that Machiavelli’s view was amoral, but the most enduring aspect of Botero’s work was that he presented economics as an aspect of politics and the national interest.

It was this concept that evolved over the following decades as an embrace of mercantilism – the economic theory that links national economic prosperity to its supply of capital as determined by a positive trade balance. It is essentially this theory that is behind every claim that we face economic ruin (or are losing jobs) as a result of an out-of-control trade deficit. This theory’s greatest proponent was perhaps the English merchant Thomas Mun who believed “gold was a stable measure of wealth, and trade should be centrally regulated by the government to produce an excess of exports over imports in order to gain more gold for the country.” [9] Mun laid out much of his thesis in A Discourse of Trade, from England unto the East Indies (1621) and expanded upon it in England’s Treasure by Forraign Trade (1664) published after his death.

The embrace of mercantilism by European governments was the dominant economic trend until the late 18^th century. It was, after all, being implemented by human beings acting in what they believed to be their own best interests. As Lord Bolingbroke observed in a letter to Sir William Windham in 1717, “I am afraid that we came to Court in the same dispositions as all parties have done; that the principal spring of our actions was to have the government of the state in our hands; that our principal views were the conservation of this power, great employments to ourselves, and great opportunities of rewarding those who had helped to raise us, and of hurting those who stood in opposition to us.” [10] While the nature of government action has changed in the intervening three centuries, the nature of the individuals acting as its agents has clearly not changed in the slightest. Perhaps that is why Edmund Burke famously advocated the abolition of government in A Vindication of Natural Society (1756).

By 1773, the very same year that a revolt against taxation broke out in Boston Harbor, a student of moral philosophy and political economy from Kirkcaldy, Scotland, had begun a series of lectures that he would eventually expand into one of the most influential works of all time. Notes on these lectures, recorded by a student, were published more than a century later in Lectures on Justice, Police, Revenue and Arms (1896) by E. Cannan. The man was Adam Smith, oft described as the father of modern economics, and within three years he would publish An Inquiry into the Nature and Causes of the Wealth of Nations.

The Wealth of Nations is likely the earliest well-known critical evaluation and rejection of governmental interference in the economy. [11] It destroys the arguments of the mercantilists (though, sadly, such ideas survive today), attacks the government-supported guild system (monopoly created, as is nearly always the case, by the state) and undermines the economic argument in favor of slavery. It was perhaps the first fully articulated defense of the free market and, with a few exceptions (most notably his failure to foresee the subsequent embrace of the concept of marginal utility as a determinant of value and his attempt to artificially distinguish rent from other capital sources), it has stood the test of time. The important thing to note in this discussion is that it completely repudiated the the two major governmental forays into the economy underway at the time.

Some have argued that this moral philosopher, frequently referenced by modern capitalists, believed that the embrace of the free market would inevitably retain the institution of slavery. That position is preposterous. [12] Smith was a believer in the concept of “perfect liberty” and his assessment of slavery is quite clear:

“It appears, accordingly, from the experience of all ages and nations, I believe, that the work done by freemen comes cheaper in the end than that performed by slaves. It is found to do so even at Boston, New York, and Philadelphia, where the wages of common labour are so very high.” [13]

“But if great improvements are seldom to be expected from great proprietors, they are least of all to be expected when they employ slaves for their workmen. The experience of all ages and nations, I believe, demonstrates that the work done by slaves, though it appears to cost only their maintenance, is in the end the dearest of any. A person who can acquire no property, can have no other interest but to eat as much, and to labour as little as possible. Whatever work he does beyond what is sufficient to purchase his own maintenance can be squeezed out of him by violence only, and not by any interest of his own.” [14]

The bulk of this seminal volume was not directed at slavery but rather at the major tenets of mercantilism: the notion that the accumulation of gold bullion or other precious metals – primarily by ensuring a positive international trade balance – was the key to national economic success and that protectionist tariffs (a monopolization of home markets) yielded economic benefits. I will not present Smith’s entire argument here. There are, however, a couple of excerpts from The Wealth of Nations that sum up the position rather nicely:

“To give the monopoly of the home-market to the produce of domestic industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must, in almost all cases, be either a useless or a hurtful regulation.” [15]

“To expect, indeed, that the freedom of trade should ever be entirely restored in Great Britain is as absurd as to expect that an Oceana or Utopia should ever be established in it. Not only the prejudices of the public, but what is much more unconquerable, the private interests of many individuals, irresistibly oppose it…. The Member of Parliament who supports every proposal for strengthening this monopoly is sure to acquire not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance. If he opposes them, on the contrary, and still more if he has authority enough to be able to thwart them, neither the most acknowledged probity, nor the highest rank, nor the greatest public services can protect him from the most infamous abuse and detraction, from personal insults, nor sometimes from real danger, arising from the insolent outrage of furious and disappointed monopolists.” [16]

As the preceding passages indicate, the man from Kirkcaldy held particular contempt for monopoly. Perhaps his second most quoted passage (after his reference to the “invisible hand”) concerns this very issue:

“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.” [17]

Sadly, this statement is often misconstrued as an attack upon the unregulated free market. It is, in fact, an attack upon the state-imposed guild system that existed in England at the time. [18] Adam Smith was consistently critical of governmental intervention into the economy not on the basis of mere personal animus, but upon his observations on human action and the empirical evidence of the relative success or failure of such interventions. [19]

"That government which governs best, governs least."

This quote is often attributed to Thomas Jefferson, but such is not the case. Instead, the earliest attribution of the specific quote is Henry David Thoreau’s Civil Disobedience (1849), though it also appeared in another form ("The best government is that which governs least.”) from the pen of editor John L. O’Sullivan in The United States Magazine and Democratic Review (1837). [20] But often those most eager to point out the Jefferson misattribution leap to the false conclusion that he would not have said it.

Far from indicating that such a statement was inconsistent with Jefferson’s outlook, the statement

"We are now vibrating between too much and too little government, and the pendulum will rest finally in the middle" from Jefferson’s letter to Samuel Smith (1788) [21] does nothing more than demonstrate his concern that “too much government” was problematic and was expressed at a time when government was several orders of magnitude smaller than it is today. The argument is not that Jefferson favored of the abolition of government, but that he had legitimate concerns that it could grow too powerful. In fact, Jefferson spoke favorably of a society without government on more than one occasion, such as:

“The basis of our governments being the opinion of the people, the very first object should be to keep that right; and were it left to me to decide whether we should have a government without newspapers or newspapers without a government, I should not hesitate a moment to prefer the latter. But I should mean that every man should receive those papers and be capable of reading them. I am convinced that those societies (as the Indians) which live without government enjoy in their general mass an infinitely greater degree of happiness than those who live under the European governments. Among the former, public opinion is in the place of law and restrains morals as powerfully as laws ever did anywhere. Among the latter, under pretense of governing, they have divided their nations into two classes, wolves and sheep. I do not exaggerate. This is a true picture of Europe." [22]

This quotation strikes to the very center of the issue. The Jeffersonian view was not antithetical to government, per se, but was particularly concerned with its restraint to ensure the liberties of the populace. It was the very reasoning behind the construction of a Constitutional form of government with very specific enumerated powers. Consider the words of James Madison, father of the Constitution:

“If Congress can do whatever in their discretion can be done by money, and will promote the General Welfare, the Government is no longer a limited one, possessing enumerated powers, but an indefinite one, subject to particular exceptions.” [23]

“Since the general civilization of mankind, I believe there are more instances of the abridgment of the freedom of the people by gradual and silent encroachments of those in power than by violent and sudden usurpations.” [23]

“With respect to the words general welfare, I have always regarded them as qualified by the detail of powers connected with them. To take them in a literal and unlimited sense would be a metamorphosis of the Constitution into a character which there is a host of proofs was not contemplated by its creators.” [24]

These are not the words of men in favor of or merely indifferent to the expansion of government into essentially any area of human endeavor, particularly on economic grounds. Far from being unable to forsee the “needs” of scoiety that might otherwise warrant the rise of the welfare state, Madison expressly rejects the entry of government into the realm of public “benevolence”.

Such views may be contrasted with those of Alexander Hamilton who was far more enamored of governmental power. [25] It was Hamilton, for example, that in 1791, as Secretary of the Treasury, convinced Congress to tax distilled spirits, ostensibly to pay down the national debt incurred during the Revolutionary War, but "more as a measure of social discipline than as a source of revenue." [26] and because he "wanted the tax imposed to advance and secure the power of the new federal government." [27] It should be remembered that it was this action that precipitated the Whiskey Rebellion of 1794.

At the risk of over-reliance on quotations, consider this one from Samuel Adams:

"If ye love wealth better than liberty, the tranquillity of servitude than the animating contest of freedom--go from us in peace. We ask not your counsels or arms. Crouch down and lick the hands which feed you. May your chains sit lightly upon you, and may posterity forget that ye were our countrymen!" [28]

What could compel such men as Adam Smith, David Hume, Thomas Jefferson and James Madison to so reject the policy of governmental intervention that is so vehemently defended by pro-government thinkers, not merely those in the extreme Marxian mold, but those who believe passionately that capitalism is fine in “some” cases but must be supplanted with the welfare state in others else, in their view, all of society will collapse? It comes down to observation vs. mythology. These men applied analytical techniques to the world around them to ascertain the complexities of human behavior and societal function.

They did not assume, for example, that air pollution is best solved by government – there is no evidence to support such a claim – or that lack of health insurance coverage is more damaging than the rationing of care that takes place under so-called universal health care systems – it isn’t – or that it is rational to accept on face value the assertion that child poverty is highest in the US among “advanced Western nations” – when poverty is calculated on radically different bases and the US has the wealthiest “poor” on the planet – or that government is even capable of assessing, let alone addressing the perceived “threats” of economic globalization, nuclear proliferation or climate change. Instead of simply accepting prevailing wisdom of their times, consisting then, as now, mostly of popular rhetoric rather than fact, these thinkers took the time to examine the claims of governmental competency … and found them wanting.

In the mid-1800s, a new ideological concept began to take hold: socialism. Initially, the movement began as merely a response to the supposed injustices of the Industrial Revolution. Unlike later socialists, not all of these were enamored with a governmental role in solving society’s problems. Pierre-Joseph Proudhon, for example, was the first to describe himself as an anarchist in the modern ideological sense. [29]

The appeal of socialism is easily understood. Like all utopian systems it seems to provide solutions to a wide variety of problems with few, if any, drawbacks. (This description applies even to partial adoptions of socialism to the extent that it is applied to a specific societal problem.) It has the additional appeal that the solution appears to be the application of human will and planning where chaos otherwise reigns. Surely, planning must deliver better results than a lack of planning. Thus, the concept of socialism flourished, albeit not without difficulty.

“[T]he basic conception of Socialism had been quite clearly worked out in the course of the second quarter of the nineteenth century by those writers designated by Marxism as ‘Utopian Socialists.’ Schemes for a socialist order of society were extensively discussed at that time, but the discussion did not go in their favour. The Utopians had not succeeded in planning social structures that would withstand the criticisms of economists and sociologists….

“It was at this moment that Marx appeared…. [H]e was not slow in finding a way out of the dilemma in which socialists found themselves. Since Science and Logic had argued against Socialism, it was imperative to devise a system which could be relied on to defend it against such unpalatable criticism. This was the task which Marxism undertook to perform. It had three lines of procedure. First, it denied that Logic is universally valid for all mankind and for all ages. Thought, it stated, was determined by the class of the thinkers; was in fact an ‘ideological superstructure’ of their class interests. The type of reasoning which had refuted the socialist idea was ‘revealed’ as ‘bourgeois’ reasoning, an apology for Capitalism. Secondly, it laid it down that the dialectical development led of necessity to Socialism; that the aim and end of all history was the socialization of the means of production by the expropriation of the expropriators—the negation of negation. Finally, it was ruled that no one should be allowed to put forward, as the Utopians had done, any definite proposals for the construction of the Socialist Promised Land. Since the coming of Socialism was inevitable, Science would best renounce all attempt to determine its nature….

“[I]f we include under the term ‘Marxist’ all who have accepted the basic Marxian principles—that class conditions thought, that Socialism is inevitable, and that research into the being and working of the socialist community is unscientific—we shall find very few non-Marxists in Europe east of the Rhine, and even in Western Europe and the United States many more supporters than opponents of Marxism. Professed Christians attack the materialism of Marxists, monarchists their republicanism, nationalists their internationalism; yet they themselves, each in turn, wish to be known as Christian Socialists, State Socialists, National Socialists [Note: this fundamental observation was made in January, 1932]. They assert that their particular brand of Socialism is the only true one—that which ‘shall’ come, bringing with it happiness and contentment. The Socialism of others, they say, has not the genuine class origin of their own. At the same time they scrupulously respect Marx's prohibition of any inquiry into the institutions of the socialist economy of the future... Of course, not Marxists alone, but most of those who emphatically declare themselves anti-Marxists, think entirely on Marxist lines and have adopted Marx's arbitrary, unconfirmed and easily refutable dogmas. If and when they come into power, they govern and work entirely in the socialist spirit.

“The incomparable success of Marxism is due to the prospect it offers of fulfilling those dream-aspirations and dreams of vengeance which have been so deeply embedded in the human soul from time immemorial. It promises a Paradise on earth, a Land of Heart's Desire full of happiness and enjoyment, and—sweeter still to the losers in life's game—humiliation of all who are stronger and better than the multitude.” [30]

In the wake of World War I, a young economics student put it thus: “We felt that the civilization in which we had grown up had collapsed. We were determined to build a better world, and it was this desire to reconstruct society that led many of us to the study of economics. Socialism promised to fulfill our hopes for a more rational, more just world.” [31]

In 1922, however, a book was published that would materially alter that young man’s perceptions and those of the economic world with regard to the viability of government-run enterprises. Socialism, and Economic and Sociological Analysis, by Ludwig von Mises, subjected the tenets of socialism to logical scrutiny and critical analysis … and found it unworkable. The flaw in the socialist argument was, in at least one respect, very simple: centralized planning was not, in fact, imposing human will and order upon chaos. Instead, central planners were attempting to impose their own will and plans in preference to those of the free individuals interacting in the marketplace. Worst of all, it is readily apparent that no individual or group of individuals is equipped with either the flexibility or the knowledge base necessary to make decisions regarding the allocation of resources in any manner that could possibly be as efficient as that already taking place in the marketplace. This was primarily because extra-market activity such as must exist under a socialist system (or response to a specific problem) short-circuits the pricing mechanism that signals where the rational allocation of resources is most efficient. This dilemma, known as the “socialist calculation problem” had initially been put forth in a 1920 article entitled “Economic Calculation in the Socialist Commonwealth”. [32]

Still, as is abundantly evident, socialist movements remain all too powerful. The observation, three quarters of a century ago, that those embracing a socialist viewpoint are quite eager to avoid the label – and assert that their own variant is the only true and viable one – is, if anything, more apparent today than it was before the Great Depression. It was not, by any means, the only observation made by Mises that was eerily prescient. His assessment of social security programs, for example, writen in 1949, could easily have been written yesterday:

“In the process of government interference with saving and investment, Paul in the year 1940 saves by paying one hundred dollars to the national social security institution. He receives in exchange a claim which is virtually an unconditional government IOU. If the government spends the hundred dollars for current expenditure, no additional capital comes into existence, and no increase in the productivity of labor results. The government's IOU is a check drawn upon the future taxpayers. In 1970 a certain Peter may have to fulfill the government's promise although he himself does not derive any benefit from the fact that Paul in 1940 saved one hundred dollars.

“Thus it becomes obvious that there is no need to look at Soviet Russia in order to comprehend the role that public finance plays in our day. The trumpery argument that the public debt is no burden because "we owe it to ourselves" is delusive. The Pauls of 1940 do not owe it to themselves. It is the Peters of 1970 who owe it to the Pauls of 1940. The whole system is the acme of the short-run principle. The statesmen of 1940 solve their problems by shifting them to the statesmen of 1970. On that date the statesmen of 1940 will be either dead or elder statesmen glorying in their wonderful achievement, social security.”

Mises also notes that “It makes no difference whether Paul himself pays these hundred dollars or whether the law obliges his employer to pay it.” [33]

The next chapter explores the viability of such programs and their ultimate impact on society.

[1] Historian Garry Wills makes this unpersuasive argument (because it is a-historical as will be explored to some extent in this chapter) in A Necessary Evil: A History of American Distrust of Government, 1999, but then Wills concedes at the outset he “began this book in 1994, when the fear of government manifested itself in the off-year election of a Republican majority to Congress” and bemoans a view that he says “asks us to love our country by hating our government … turns our founding fathers into unfounders, that glamorizes frontier settlers in order to demean what they settled, that obliges us to despise the very people we vote for." The book, while full of historical references that do not fully support his thesis is, in the words of John J. Miller of Amazon.com Review “is plainly motivated by contemporary politics.” (http://www.amazon.com/Necessary-Evil-American-Distrust-Government/dp/0684844893).

[2] “history of anarchism”, Anarchopedia: http://eng.anarchopedia.org/history_of_anarchism

[3] Robert Dreyfuss, "Grover Norquist: 'Field Marshal' of the Bush Plan", The Nation, April 26, 2001: http://www.thenation.com/doc/20010514/dreyfuss

[4] Susan Page, “Norquist's power high, profile low”, USA Today, June 1, 2001: http://www.usatoday.com/news/washington/2001-06-01-grover.htm

[5] Beyond The Nation reference, there is Sourcewatch (http://www.sourcewatch.org/index.php?title=Grover_Norquist) which absurdly blames the return to deficits on tax cuts and military spending, dKosopedia (http://www.dkosopedia.com/wiki/Grover_Norquist), People for the American Way’s Right Wing Watch (http://www.rightwingwatch.org/category/individuals/grover-norquist), among countless others.

[6] Ronald Reagan’s First Inaugural Address, found at http://www.reaganlibrary.com/reagan/speeches/first.asp

[7] Ronald Reagan’s Remarks to Representatives of the Future Farmers of America, July 28, 1988: http://www.reagan.utexas.edu/archives/speeches/1988/072888c.htm

[8] David Boaz, Libertarianism: A Primer, 1997, selected excerpts can be found here: http://www.libertarianism.org/

[9] Editors. "Thomas Mun". The Literary Encyclopedia. 5 October 2004.
http://www.litencyc.com/php/speople.php?rec=true&UID=5846, accessed 1 November 2008

[10] The Project Gutenberg EBook of Letters to Sir William Windham and Mr. Pope by Lord Bolingbroke, February, 2004 [EBook #5132], Les Bowler, St. Ives, Dorset: http://www.gutenberg.org/dirs/etext04/ltww10h.htm

[11] To be fair, the French physiocrats had completely rejected mercantilism long before The Wealth of Nations was published. Economist Joseph Schumpeter, in his History of Economic Analysis argued, “The fact is that The Wealth of Nations does not contain a single analytic idea, principle, or method that was entirely new in 1776." He goes on to say that “His very limitation made for success. Had he been more brilliant, he would not have been taken so seriously. Had he dug more deeply, had he unearthed more recondite truth, had he used more difficult and ingenious methods, he would not have been understood. But he had no such ambitions; in fact he disliked whatever went beyond plain common sense. He never moved above the heads of even the dullest readers. He led them on gently, encouraging them by trivialities and homely observations, making them feel comfortable all along.” (Schumpeter 1954a, 185)” see: “Schumpeter’s Assessment of Adam Smith and The Wealth of Nations: Why He Got It Wrong” by Andreas Ortmannand David Baranowski, May 2001: http://home.cerge-ei.cz/ortmann/Papers/09SchumpeterWrongYK.pdf. I do not agree with Schumpeter’s assessment. In particular, given that my own talents, if I may be so bold, are in the area of making economic principles accessible to the layman, I find the second assessment unduly harsh.

[12] Professor Gavin Kennedy, “A Sad Attack on Adam Smith's Reputation” Edinburgh, Scotland (UK), Adam Smith’s Lost Legacy, http://adamsmithslostlegacy.com/2005/07/sad-attack-on-adam-smiths-reputation.html, [Professor Kennedy is the author of a book of the ame name: Adam Smith’s Lost Legacy (http://www.amazon.com/Adam-Smiths-Legacy-Gavin-Kennedy/dp/1403947899/ref=sr_1_1?ie=UTF8&s=books&qid=1225723698&sr=1-1)

[13] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter 8, paragraph 40: http://www.econlib.org/library/Smith/smWN3.html#B.I,%20Ch.8,%20Of%20the%20Wages%20of%20Labour

[14] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book III, Chapter 2, paragraph 9: http://www.econlib.org/library/Smith/smWN10.html#B.III,%20Ch.2,%20Of%20the%20Discouragement%20of%20Agriculture%20in%20the%20Ancient%20State%20of%20Europe%20after%20the%20Fall%20of%20the%20Roman%20Empire

[15] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book IV, Chapter 2, paragraph 11: http://www.econlib.org/library/Smith/smWN13.html#B.IV,%20Ch.2,%20Of%20Restraints%20upon%20the%20Importation%20from%20Foreign%20Countries

[16] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book IV, Chapter 2, paragraph 43: http://www.econlib.org/library/Smith/smWN13.html#B.IV,%20Ch.2,%20Of%20Restraints%20upon%20the%20Importation%20from%20Foreign%20Countries

[17] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter 10, paragraph 82: http://www.econlib.org/library/Smith/smWN4.html#B.I,%20Ch.10,%20Of%20Wages%20and%20Profit%20in%20the%20Different%20Employments%20of%20Labour%20and%20Stock

[21] Thomas Jefferson letter to William Stephens Smith, February 2, 1788, Online Library of Liberty: http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=802&chapter=86690&layout=html

[22] The Founders’ Constitution, Amendment I (Speech and Press) Thomas Jefferson to Edward Carrington, January 16, 1787, Papers 11:48—49: http://press-pubs.uchicago.edu/founders/print_documents/amendI_speechs8.html

[23] Quotes can be found here: http://www.quotationcollection.com/author/James_Madison/quotes; respectively, they are from (1) 1792, Letters and Other Writings of James Madison, Fendall, ed., vol. 1 (546) (2) a speech in the Virginia Convention, Richmond, Virginia, June 6, 1788.—The Papers of James Madison, ed. Robert A. Rutland and Charles F. Hobson, vol. 11, p. 79 (1977)

[24] Letter to James Robertson, April 20, 1831 (Madison, 1865, IV, page 174): http://en.wikiquote.org/wiki/James_Madison

[28] “Samuel Adams Advocates American Independence”, speech at the Philadelphia State House, August 1, 1776: http://www.nationalcenter.org/SamuelAdams1776.html

[29] Proudhon’s initial claim to fame was his declaration that “Property is theft!” (Pierre-Joseph Proudhon, What is Property? Or, an Inquiry into the Principle of Right and of Government, 1840 (http://www.marxists.org/reference/subject/economics/proudhon/property/index.htm) but recanted these views later in life arguing in Theory of Property, published after his death, "property is the only power that can act as a counterweight to the State." This lead Karl Marx, who had been influenced by Proudhon’s earlier work, to dismiss him as a member of the “socialistic bourgeois “(Karl Marx and Frederick Engels, Manifesto of the Communist Party, part 3, section 2, 1847: http://www.marxists.org/archive/marx/works/1848/communist-manifesto/ch03.htm)

[30] Ludwig von Mises, Socialism, and Economic and Sociological Analysis, 1922, Preface to the Second German Edition, January, 1932: http://mises.org/books/socialism/preface_second_german_edition.aspx

[31] F. A. Hayek, Foreword to to Ludwig von Mises’ Socialism, and Economic and Sociological Analysis (1922), August, 1978. Partial text is available online here: http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/prof_friedrichvonhayek.html

[32] Ludwig von Mises, “Economic Calculation in the Socialist Commonwealth”, 1920, http://mises.org/pdf/econcalc.pdf; a reasonably good description of the problem can be found here: http://en.wikipedia.org/wiki/Economic_calculation_problem#cite_note-Mises-0

[33] Ludwig von Mises, Human Action: A Treatise on Economics, Part 6, Chapter XXXV, paragraphs 53, 54:

http://www.econlib.org/library/Mises/HmA/msHmA35.html

Despite all of the gnashing of teeth and pointing of fingers that engenders every crisis, it must be remembered that presidents are not really magical Wizard-Kings that can wave their magic wand and instantly transform something as complex as the entire economy overnight. Typically, it takes as much as six years for presidential economic policy to be fully realized though some actions – almost universally bad ones – can have a more immediate impact. Thus, despite the misconceptions of those who cannot grasp this simple concept, it should come a no surprise that the economically irresponsible policies of the administration would eventually result in yet another recession…

Having addressed the initial cause of the current financial crisis – irresponsible monetary policy by the Fed – and before moving on to the culpability of government sponsored (that is, “run”) entities, let’s take a moment to examine the sheer mendacity of the New York Times editorial board who, a bit less than two weeks ago opined, “Don’t Blame the New Deal”.

The editorial, published September 27 begins with the assertion that “[t]his year’s serial bailouts are proof of a colossal regulatory failure … [as] antiregulation disciples of the Reagan Revolution have eliminated vital laws, blocked the enactment of much-needed new regulations, or simply refused to exercise their legal authority “  There’s only one problem with that position: it is absurd on its face.  There is, in fact, not a single example of deregulatory action that can be demonstrated to have contributed to the current crisis in any way.  That does not, however, dissuade the Times from making a valiant, if misguided, attempt to show otherwise.

The first club out of the Times’ bag is “predatory lending”, a staple of liberal demagoguery and economic illiteracy.  The editorial complains that Greenspan, and subsequently Bernanke – who, as already examined, have more than sufficient responsibility for current conditions – failed to heed a congressional mandate to curb this practice.  There’s only one problem: it doesn’t exist.  It cannot possibly exist.

The concept of predatory lending is based on the premise that unscrupulous lenders will trick unwary borrowers into taking loans that they cannot possibly afford in order to rake in big bucks at borrower expense.  The problem, of course, is that defaulted loans are vastly more expensive than any revenue stream than could possibly be earned before failure occurs.  In order for the “predatory lending” scenario to be possible, an entire industry must be staffed with people who knowingly and willfully chose to act against their own interests.  Utter nonsense.  While some unscrupulous mortgage generation shops may have been willing to say anything to get people in the door, such actions cannot convince ultimate lenders to underwrite the risks.  That requires a market distortion of gargantuan proportions … and in that regard, the Fed was happy to oblige.

The next canard out of the bag was the suggestion that limits on shareholder lawsuits passed in 1995 in some way opened the floodgates to misstatement of financial condition.  Nothing could be further from the truth.  The Private Securities Litigation Reform Act of 1995 required nothing more than that the plaintiff in such a suit demonstrate that he suffered economic harm due to a deliberate “material misrepresentation or ommission”.  That protects no one from the kind of activity the Times alleges took place under a “sense of immunity”.  Moreover, the editorial absurdly blames the Enron fiasco on this change even though the company’s actions were unequivocally fraudulent – thus, obviously not impacted by the law change – and began before the legislation was passed (shadow companies were set up beginning in the early 1990s).

The Times, however, wasn’t finished.  It had to hold forth on the greatest indignity of them all – the dismantling of something created under the sainted Roosevelt Administration (which created Fannie Mae in the first place, but that’s a topic for another day).  In 1999, Congress dismantled much of what remained of the Glass-Steagall Act, described by the Times as “a pillar of the New Deal, which separated commercial and investment banking”.  Conspicuously ommitted from the Times’ analysis is the fact that the US is the only country in the world to make such distinctions – and financial institutions in those countries have not suffered ill effect as a result.  It was, in reality, the artificial distinctions under Glass-Steagall that placed the Savings & Loan industry in jeopardy in the 1970s; specifically, as interest rates spiralled out of control – also the result of irresponsible govermental actions – savings and loans faced a rapid outflow of low interest deposits into higher paying securities while their assets were tied up in long-range mortgage securities.  Under Glass-Steagall, S&Ls were unable to diversify as wihdrawals rapidly drove them toward bankruptcy.  By the time Congress acted to fix this problem, which could only have resulted in the collapse of the industry even in the absence of deregulation, the cure was frequently too late and, in cases, S&Ls were in the position of needing to offer products with which they had no experience and little understanding.  The rest is history.

If anything, both the S&L crisis and the current financial meltdown can be blamed in large part, not on the repeal of Glass-Steagall, but on the artificial distinctions that were created under Glass-Steagall in the first place.

Finally, the editorial takes two more completely baseless swipes at the deregulatory (or lack of regulatory) activity over the last eight years, first bemoaning the exclusion of derivatives from the Commodity Exchange Act of 1936 and then blaming the current administration for failing to reform Fannie Mae and Freddie Mac in 2005 because “President Bush wanted to fully privatize them and feared that if they were adequately reformed, privatization would lose steam”.  The first of these assertions I’ll come back to; the second is flatly absurd.  Absent from the selective memory of the writers is the fact that the president doesn’t get to sign legislation until it passes both houses of Congress and the measure was killed in the Senate Committee on Banking, Housing, and Urban Affairs under the Chairmanship of none other than Christopher Dodd (D-CT), who, by some strange coincidence, has received more political contributions from Fannie Mae than any other human being.

As a side note, the obtuseness of the Times editorial board is particularly evident in its clear disdain for the notion that Fannie Mae and Freddie Mac might be privatized even though that would likely have prevented these entities from making the problem worse as the private sector would not have permitted the continued accumulation of unwarranted risk and would almost certainly have detected the chicanery of Franklin Raines much sooner.

That leaves the claim that it was the proliferation of derivatives outside of commodity exchange oversight that caused the problem.  Here, again, the disease is ignored in favor of a symptom.  The unregulated free market is perfectly capable of correctly pricing the risks of essentially any financial instrument.  It is only when pricing signals are radically distorted either by rampant manipulation of the liquidity markets by government in the guise of the Fed or the explicit socialization of losses for certain investment vehicles by the government in the guise of government sponsored entities or both as happened in this particular case that the market cannot perform this function properly and chaos ensues.

I long ago ceased being surprised by the sheer number of people – particularly politicians whose grasp of basic economics rarely gets beyond the ads for X-ray specs and sea monkeys in the back of their Archie comics - who opine with absolute certainty that current conditions could not possibly be “normal” and that prices/wages/supply/demand are either being manipulated by sinister (translated: non-governmental) forces or must be “market failure”.  That so-called “market failure” is inevitably an example of governmental failure is a topic for another day.  For now, let’s deal with the wrongheaded notion that we don’t need to address oil supply issues because the price is only being inflated by those dastardly “speculators”.

Contrary to popular belief, speculators provide a very real and valuable service to the economy.  First of all, by creating a market for futures contracts, the speculator takes on the price risk of the supplier ensuring that the end price warrants the initial investment.  In agricultural products in particular, this transfer of risk ensures that supplies will be higher because farmers need not worry about a potential price collapse that might dissuade them from planting.  Second, the speculator – at the risk of his own resources – removes product from supply during one period in anticipation of greater demand in some later period.  If he has speculated correctly, he will make a profit.  The short term impact is that the reduced supply raises short term prices, but eventually, the speculator must return the product to aggregate supply, reducing prices to a level below what they would otherwise be at that later date.  Thus, the speculator stabilizes overall supply and significantly reduces price volatility.  That oil prices still appear to be quite volatile is not an indication that speculators do not perform this function but, rather, is an indication of just how little impact speculators have on oil prices.

How can this be?  After all, back in May, Michael Masters of Masters Capital Management, LLC gave spectacular testimony before the Senate Committee on Homeland Security and Governmental Affairs demanding that the practice of “index speculation” be banned because of the massive impact on the price of oil that results.  Alas, the only thing truly spectacular about this testimony is the magnitude of the errors in the supposed analysis.

Note that, in the scenario mentioned above, the average price of the commodity over time remains completely unchanged.  All other things being equal, the impact of speculation is that the price of the commodity rises earlier by a given amount and is reduced at a later time by a like amount.  The ultimate price of the commodity is still determined in its entirety by supply and demand.  How is that different in the oil futures market?  It isn’t.  In fact, it is even less likely that speculators in the oil futures market can materially impact price than in any number of other commodity markets.

Say you choose to invest in gold.  This is a common practice and many people own shares in “inflation hedge” instruments.  As an individual investor, you can actually remove from circulation an amount of gold and place it in a vault somewhere.  So long as that gold is locked away, the available supply is reduced by a like amount.  At the same time, the investor gains no return on that investment until such time as he returns it to the marketplace.  There is still ultimately no impact on the long term average price (again, all other things being equal), but the time horizon is such that it may be several years before the return to circulation of that commodity impacts the market price.

With oil, such a scenario is essentially unheard of.  None of the speculators in the marketplace are actually taking ownership of Texas tea no matter how sweet the crude might be.  The only players in the marketplace actually removing significant quantities of product from the market are government entities.  The US government has socked away 705 million barrels of in the Strategic Petroleum Reserve.  Japan has the second largest reserve with a capacity of nearly 580 million barrels.  All that is being traded in the futures markets is the ownership of a commodity to be delivered on a specific date.  Thus, when the illustrious Mr. Masters uses the wheat futures market as an example of speculators run amok and tells us, “the current Wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years!” he is neglecting the obvious fact that no actual wheat is owned by such speculators at all.  For that matter, just how likely is it that speculators would remove wheat from the marketplace, presumably until it spoils, guaranteeing a loss of their investment?  The whole premise is absurd.

Oil futures contracts can go out years but the reality is that the trading of such contracts is overwhelmingly concentrated in the short term.  More than 90% of trading today (July 14) in oil futures contracts is concentrated in those due for redemption within the current year.  Further, when Mr. Masters breathlessly announces that index speculators “roll their positions by buying calendar spreads. They never sell (emphasis in original)”, he is misstating the fact that such rollover activities exchange one short-term contract for another and represents a sale in and of itself.  Still no change in the supply or consumption of oil takes place.

Finally, to get a handle on just how much of an impact speculators have on the oil market as a whole, consider:

Much has been made of the increase in the futures market.  To stick with the figures used in congressional testimony, the amount of unrefined oil traded on the futures market jumped from 147 million barrels (1/1/03) to 830 million barrels (3/12/08), a 465% increase.  But to assess the magnitude of such an investment, one must compare it not to the supply of oil from a single supply source over some short delivery period, but to the global marketplace over the total long term period of production.  Current world oil production exceeds 86 million barrels per day so the amount traded in the futures markets amounts to a no more than 2.6% of annual production, but, again, that’s just the production within a single year.  If you consider that nearly 277 billion barrels of oil were produced worldwide over the decade ending in 2005, the impact of speculation on long term oil prices can be put into real perspective.  So much for the theory that $40-$70/bbl of the current price is due to speculation.

The story goes that it is “unfair” that the oil companies are “gouging” consumers at the pump while reaping record profits. As one reporter argued, “If ExxonMobil were a country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank’s economic rankings.” The oil industry argues that looking at nominal profits is meaningless. What matters, they say, is profit margin, which is materially lower for oil companies than for other major industries. Recently, a third view has surfaced – in no small part as a response to the oil company position - asserting that the key measure is return on equity and “the oil industry as a whole earned a 27 return on equity [in 2007] and that this was 10 points higher than other industries”. Whose view is correct?

Let’s take them one at a time. As one might expect, it is the position taken by the politicians that is completely wrong. As has been made clear in countless articles and columns by competent analysts and economists, looking at nominal profits in a vacuum is of no value whatsoever in assessing the real profitability of a company or industry. I will not rehash the reasoning behind this obvious point here.

Naturally, this means that the oil companies have a much more tenable position when they argue that profit margins examine profitability in context. The oil industry earned about 7.6% of revenues in the fourth quarter of 2007. For comparison purposes, all of US manufacturing (excluding auto manufacturing which took a dive as gas prices rose) earned approximately 9.2% of revenues in the same quarter. These are figures concede even by the industry’s detractors.

One must be careful when looking at such numbers. One quarter does not a trend make and there are those on both sides who will point at specific industries who performed better or worse (depending upon the point of view) in order to make a point. The banking industry, for example, has taken a bath since then (roughly since I took up my current position with a regional bank), but banking has long been an industry that generates higher margins than the average. That’s the point: over the long haul, the oil industry earns profit margins generally lower than most other industries, including other manufacturing industries.

But the response to the emphasis on profit margins – that return on equity (ROE) is a viable indicator of company profitability – has some merit. The question is whether or not such a measure is materially superior to a comparison of profit margins and, further, whether or not such a measurement can indicate whether or not the industry has reaped a “windfall”. The answer to both questions is: no.

First of all, while the dismissal of nominal profits as unrelated to underlying investment has merit, the dismissal of profit margin on the same grounds does not. While looking at nominal revenue growth would be equally useless, the profit margin, by extension, reflects the outlay (expenses) necessary to generate those profits. While expense outlays are a step removed from shareholder investment, the connection between spending and profits is far more immediate than between capital holdings and earnings in any particular period.

Nor is the use of ROE as a measure without problems. One must remember that these are accounting measures that are designed to represent, as well as possible, real world conditions. Understanding those real world conditions is so important that literally dozens of alternative measures have been developed to refine the concept (ROA, ROCE, ROGIC, RAROC, etc.).

Then, of course is the (deliberate) distortions in the use of these measures. The statement about the oil industry being “10 points above” all other industries is factually wrong. For the period (a point I’ll come back to), the oil industry’s return was 10 points higher than all other manufacturing industries. Further, the manufacturing figure included the automotive industry whose returns were so poor during the quarter that its losses depressed the profit margins for the entire US manufacturing sector from the 9.2% mentioned above to a mere 5.8%.

The argument is then made that these ROE figures have been higher during the period of rising prices, just as they were when prices rose in the early 1980s. Rather than demonstrating a “windfall”, however, this merely demonstrates a material flaw in using ROE as measure of assessing profitability over the short run. It should hardly come as a surprise to anyone that periods of rapidly rising prices can easily outstrip the pace at which a company can attract capital. The differential is not some wonderful bonus for the company but an indication of how much more a company must spend to acquire additional capital. That is, because funds must be obtained more rapidly in comparison to other investment alternatives, a premium must be paid to investors to attract needed capital away from those alternatives. Such conditions are particularly prevalent in industries that a particularly capital intensive – and you’d be hard pressed to find many more so than the oil industry – and have historically low profit margins because thinner margins mean greater investment risk.

In the final analysis, higher returns on equity during a period when costs, and thus dependent prices, are rising rapidly are not evidence of a windfall, but nothing less than an informed observer should expect.

In such an environment, assessing a windfall profits tax is particularly foolhardy. Not only is it attempting to recoup a benefit that does not exist – and “recoup” is a further misnomer as there is never any intent to return it to those consumers supposedly harmed when it can, instead, simply be added to the public treasury to buy still further votes – but it reduced capital in an industry that, for reasons that should now be obvious, is in desperate need of additional capital to finance the greater expense burden. The inevitable result of such a move is to increase the cost of funds to the industry and place further upward pressure on prices and downward pressure on production. The results of the original “windfall profits tax” signed by Jimmy Carter was no fluke. Prices surged still further and the problem was simply made worse.

It was up to Ronald Reagan, who as his first official act deregulated oil prices, to return sanity to the energy market and allow prices to fall to the point that the real price of a gallon of gas didn’t return to similar levels for more than a quarter century.