The Third Pillar

by Raghuram Rajan

  Seen in this light, Adam Smith was pro-market, not pro-business. Indeed, he was no fan of the businessmen of his time because of their cartelizing tendencies. In arguing against guilds and monopoly corporations, he wrote, “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.”2 About businessmen’s suggestions for regulation, he emphasized that these should be “carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.”3 Smith was no starry-eyed forerunner of Ayn Rand, convinced of the heroism of the business class. Instead, he pushed for eliminating anticompetitive privileges, such as those enjoyed by the monopolist corporations of his time.4

  He was equally scathing about mercantilism. He dismissed the notion that an accumulation of gold would make a country more powerful and able to wage war—for a country like Great Britain, any feasible accumulation of gold would be too small given the huge costs of war. What was needed to sustain a long war was greater domestic productive capacity. To give domestic producers a monopoly by levying high import tariffs or prohibiting imports was therefore either “useless or . . . hurtful.” If the local product could be made and sold as cheaply as the foreign product, the prohibition was useless for domestic production would be competitive on its own. If local production was not competitive, the tariff was harmful for it raised domestic prices of the product, and diverted precious domestic productive capacity toward its making. Smith wrote:

  “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor . . . What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”5

  Therefore, Smith pushed hard for freeing the domestic market from the hold of guilds and monopolists, while bringing down the barriers to foreign trade erected by the mercantilists. In the spirit of laissez-faire, Smith thought little of a government that tried to direct production or investment by the businessman from afar, for “every individual, it is evident, can in his local situation judge much better than any statesman or lawgiver can do for him.” Indeed, Smith believed the government had only three essential duties: “First, the duty of protecting the society from . . . invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, . . . and, thirdly, the duty of erecting and maintaining certain public works, and certain public institutions, which it can never be for the interest of any individual, or small number of individuals to erect and maintain.”6

  A PHILOSOPHY FOR THE MARKET

  It was a short step from Adam Smith’s work to the manifesto for individualism and the free market, On Liberty, written by British economist John Stuart Mill. It was published in 1859, soon after the death of his wife Harriet, whom he acknowledged had influenced the work greatly.7 Mill defended individual thinking and speech against the tyranny of the majority. He argued that the views of the community tended to be the views of the powerful or the majority, and there were good reasons to subject that view to challenge, including the obvious possibility that the majority view could turn out to be wrong.

  Mill saw all individual actions as permissible that did not hurt the interests of others. Apart from this, he saw an individual’s duty to society as sharing in “the labors and sacrifices incurred for defending the society and its members from injury and molestation.” Society had no call on the individual beyond this. He argued he was not advocating selfish indifference to the community, but voluntary engagement. Not only would an individual’s engagement on his own terms improve social enterprise, he believed “the free development of individuality is one of the leading essentials of well-being.” Individuality should be valued in its own right and not just as a means to a societal end.

  Mill thus sought to restore free will’s role in the vibrancy and variety of human existence that Calvin had rejected. Calvinism emphasized obedience—“You have no choice; thus you must do, and not otherwise: ‘whatever is not a duty, is a sin.’ Human nature being radically corrupt, there is no redemption for anyone until human nature is killed within him.” Instead, Mill argued that “Pagan self-assertion” is as much an element of human worth as “Christian self-denial,” that it is “not by wearing down into uniformity all that is individual in themselves, but by cultivating it, and calling it forth, within the limits imposed by the rights and interests of others, that human beings become a noble and beautiful object of contemplation,” and “in proportion to the development of individuality, each person becomes more valuable to himself, and therefore capable of being more valuable to others.” He declared that “genius can only breathe freely in an atmosphere of freedom,” for “the general tendency of things throughout the world is to render mediocrity the ascendant power among mankind.”

  Mill’s was thus an attack on the stultifying effects of the community, the “despotism of custom.” He viewed the freedom of trade, contracts, and markets as consistent with his beliefs on liberty. This also meant limits on the state, for “where everything is done through the bureaucracy, nothing to which the bureaucracy is really adverse can be done at all.” Instead, the state should be an “active circulator and diffusor, of the experience resulting from many trials . . . [enabling] each experimentalist to benefit by the experiments of others; instead of tolerating no experiments but its own.”

  The state and the market had grown together from the crumbling edifice of feudalism. The constitutional limitations on the state that we traced in the last chapter did not shrink the state. Instead it helped the state build out its military and fiscal capabilities as it gained access to finance. Once the state had created a framework to ensure security and protect property rights, the proponents of laissez-faire started questioning how much more it should do. Smith and Mill were not rabidly antigovernment. Smith, for example, accepted a role for the state in education, as well as other services that would not be privately provided. For these reasons, he argued that the state in a civilized country would be larger than in a barbaric one.8 Yet these nuances were ignored, as were his asides on the perfidy of businessmen if they were entrusted with their own regulation. Instead, public debate became focused on steadily eliminating any restraints on business practice, as well as any protections to labor.

  Perhaps more than anyone else, the Reverend Thomas Robert Malthus epitomized the heartless side of liberalism, when taken to its extreme. In the various editions of his Essay on the Principles of Population published in 1798, he emphasized the tendency of man to reproduce faster than food supply. Man could restrain himself through self-imposed checks like delayed marriage or sexual abstinence, but Malthus did not believe these would work. Instead, disease, war, and famine would be the natural checks on mankind’s lack of self-control. No wonder historian Thomas Carlyle termed economics “the dismal science”! Malthus was wrong. Humans do not have an uncontrollable urge to reproduce. Indeed, prosperity has been a powerful contraceptive, with people becoming less willing to have children, even as they can afford more of them. Fertility rates for women are now below population replacement rates, not just in rich countries but in a number of emerging markets. Nevertheless, his views offered those who opposed even humanitarian government aid a theoretical rationale. Any relief schemes f
or the unemployed or the poor only encouraged them to reproduce more, and thwarted natural checks and balances. The indigent should be left free to starve, for only through a market-induced cull would succeeding generations have a better life.

  Even if such callous theorizing was never actually translated into action, it did help harden policies toward the poor and the destitute. As the eminent historian and sociologist Karl Polanyi pointed out, the Poor Law in England, which mandated parish support for the indigent, was made harsher in 1834, especially for able-bodied males. This was just as difficult economic times and the new machines of the Industrial Revolution were putting thousands out of work.9 Some tried to put a better light on these policies, arguing they placed the community back in charge of any voluntary support, others claimed rich farmers were misusing Poor Law subsidies. There was some truth to these explanations. It was also true that Parliament was dominated by the propertied well-to-do, who had been complaining about the high taxes they had to pay before the Poor Law was reformed. Clearly, they were also voting for their pecuniary interests.

  With the demise of feudal institutions, the powerful no longer had an obligation to the weak in the community, while market fluctuations and automation left workers, especially those who had left their traditional communities, utterly exposed. Something between the extreme individualism of unregulated markets and the enforced collectivism of an authoritarian, overweening state had to be rebuilt on the ashes of feudalism. Before getting to that, though, what did a market freed from all restraint look like?

  THE UNBRIDLED MARKET

  Initially, it resembled the perfect competition of textbooks, with producers competing with one another to give the consumer the best deal, but this did not last. For as Adam Smith recognized, competition drove down profits, making any producer’s life greatly uncertain. The inexorable political tendency of a free, unfettered, unregulated market was for the producers, after experiencing the rigors of competition, to attempt cartelization.

  John D. Rockefeller, the richest man in the world in his time, made his money in rock oil or petroleum, in the early days of the industry when oil’s primary uses were for fueling lamps and lubricating steam engines. Rockefeller was not attracted to the risky business of prospecting for oil. Not only was unscientific drilling more likely to unearth dry wells than oil, excess production whenever oil was found in a locality could bankrupt producers as prices plunged.10 Rockefeller wanted a more stable business, and he found it in oil refining in Cleveland, the urban portal to Oil Creek, Pennsylvania, where oil had been discovered first. As Rockefeller worked to make his refinery the lowest-cost producer—at one point reducing the number of drops of solder on the tin cans used to carry kerosene from forty to thirty-nine after checking that any further reduction would cause the can to leak—he managed to drive out the truly incompetent and gained market share.11 Yet many, having sunk money in their investments, and having debts to pay, refused to quit, and kept the price of refined products low—so long as the price was a little more than their incremental cost of refining, the zombie producers staggered on. At one point in the 1870s, refining capacity was three times greater than demand.12

  Rockefeller wanted to bring order to refining, and his first target was the twenty-six remaining independent Cleveland refiners. In 1872, as Ron Chernow details in his biography of Rockefeller, Rockefeller struck a deal with the railroads serving Cleveland, whereby Rockefeller and his cartel would get discounts (from the posted transport price) for the crude and refined oil they shipped. More egregious, the railways agreed to pay the cartel for every barrel shipped by the competing independent non-cartel refiners. Effectively, this meant the railways would face a higher cost to transport non-cartel products, and thus would have to charge the cartel’s competitors more.13 In addition, the cartel was to get full information about the oil shipped by competitors. In exchange, the three participating railroads each got a fixed share of the oil that the cartel shipped, and fixed transport fees, thereby eliminating the cutthroat competition they otherwise engaged in. The arrangement would bring stability to their revenues. Rockefeller’s keen business sense helped him recognize that both refiners and railroads might want to cartelize, and the combination would be deadly to those not in the cartel.

  With no alternative methods of transport, the angry oil drillers along Oil Creek decided to boycott the cartel and sell only to local independent refiners. Protesters attacked the railroads, emptied oil cars and spilled their contents on the ground, and ripped up tracks. Even as the industry was in turmoil, though, Rockefeller bought up twenty-two of his twenty-six Cleveland competitors. As an owner recounted, “There was a pressure brought . . . that if we did not sell out we should be crushed out . . . It was said they had a contract with the railroads by which they could run us into the ground if they pleased.”14

  In the face of prolonged public protests, legislators eventually withdrew the charter for the shell company at the center of Rockefeller’s cartel, while Congress started investigations. The railroads, who were much more dependent on government favor and public opinion for their activities, backed down, and instituted uniform rates for all shippers once again. In the meantime, Rockefeller had created a refining monopoly in Cleveland, as well as a strategy that would serve him well going forward—cost efficiency was good, but monopoly on top of it was even better. Five years after what became known as the Cleveland Massacre, Rockefeller’s company, Standard Oil, controlled 90 percent of oil refined in the United States. There were about a hundred struggling small independent refiners still in existence at that time in the United States, which allowed Rockefeller to maintain the pretense of competition in the refining industry.

  In Rockefeller’s mind, he had only helped his inefficient competitors end their misery by taking them over—in many cases, he closed their plants.15 The surviving refiners would enjoy greater economies of scale and more stable prices, their workers would be more secure in their jobs, and customers would benefit in the long run. This argument for cooperation among producers—coordinated by Rockefeller—instead of competition, while not entirely implausible, was entirely self-serving. Competition was the only guarantee in a free market that a producer would be solicitous to customers, whether through innovation, better customer service, or low prices. Faced with a refiner monopoly, customers were dependent on Rockefeller’s benevolence. How much could it be trusted?

  Rockefeller was a superbly efficient businessman in the Calvinist mode; he saw his work as his calling. His confidence in his own capabilities blinded him to alternative paths. He saw unfettered competition as greed, causing unnecessary booms and busts, and impoverishing the entire industry. What he tried to restore were cooperative structures such as trusts, pools, and monopolies that brought order to markets—and he had no hesitation in bribing entire legislatures or misleading public hearings with fake testimonials to get his way.16 Manipulating government was just another means to business success. Many successful businessmen of the time thought similarly—Rockefeller was just more successful at executing plans. Many at the receiving end saw the kind of order he brought, which was spreading to a number of industries in the United States such as railroads and steel, as monopoly capitalism, perhaps the worst form of calculated greed. For essentially, the capitalists at the center of these cartels insisted that they, not the free market, knew what was best for the public.

  The free market was not perfect. Bouts of euphoria, fueled by easy money, undoubtedly led to overexpansion and industry hangovers. However, eliminating these wasteful and volatile episodes would also eliminate the innovation, dynamism, and creative destruction of the free market. What the cartels called waste was in fact the constant experimentation fostered by the market, energized by competition. In a sense, the magnates of the late-nineteenth-century Gilded Age in the United States wanted to restore the aristocracy, where they decided what was best for the public, but without the explicit responsibilities of the feudal manor. />
  In many ways, Rockefeller’s personal life was exemplary. He lived in the Gilded Age but was not of it. In the latter part of his life, he did take public responsibility seriously, figuring out how to spend his enormous fortune on the well-being of society. Among the extraordinarily successful institutions he founded are the University of Chicago, where I teach. His dismal view of competition had less resonance with Adam Smith, though, than with another insightful economist, Karl Marx.

  THE MARXIST RESPONSE

  The Industrial Revolution that started in Britain in the late eighteenth century created tremendous new possibilities as well as widespread despair. I have already referred to workers displaced by new machines like the power loom. In addition, though, the promise of new technologies, as well as new lands, especially in the Americas, made accessible by railways and the steamship, prompted waves of euphoria fueled by finance. The business cycle, with its production booms and busts, emerged in many industrializing countries, as did the financial cycle, with sustained booms in lending and euphoric rises in land and stock prices, followed by crashes. In the United States, there were serious financial panics about once every twenty years between 1819 and the start of the Great Depression in 1929. Among these were the Long Depression, a series of global downturns between 1873 and 1896, bookended by financial crises. The seventy years or so of relative financial calm between the bank failures of the Great Depression and the Global Financial Crisis in 2007–2008 were an aberration, not the norm.

  Barring a few at the top of the societal pyramid, people in preindustrial times had experienced collective poverty. While industrialization, transmitted through the competitive market, lifted average living standards steadily over generations, what was also new was great dispersion in incomes across society at any particular point in time, and great volatility over time. The market offered bountiful rewards and merciless punishment, which was both its greatest economic strength and its greatest political weakness. Economic security, not physical security, was now the primary public concern in industrializing countries.