How the U.S. Economy Works

The U.S. Economy:
A Brief History

Small Business and the Corporation

Stocks, Commodities, and Markets

The Role of the Government in the Economy

Monetary and Fiscal Policy

American Agriculture:
Its Changing Significance

Labor in America:
The Worker's Role

Foreign Trade and Global Economic Policies

Afterword:
Beyond Economics

Glossary

  The Role of
Government
     in the
    Economy

Laissez-faire Versus Government Intervention
Historically, the U.S. government policy toward business was summed up by the French term laissez-faire -- "leave it alone." The concept came from the economic theories of Adam Smith, the 18th-century Scot whose writings greatly influenced the growth of American capitalism. Smith believed that private interests should have a free rein. As long as markets were free and competitive, he said, the actions of private individuals, motivated by self-interest, would work together for the greater good of society. Smith did favor some forms of government intervention, mainly to establish the ground rules for free enterprise. But it was his advocacy of laissez-faire practices that earned him favor in America, a country built on faith in the individual and distrust of authority.
     Laissez-faire practices have not prevented private interests from turning to the government for help on numerous occasions, however. Railroad companies accepted grants of land and public subsidies in the 19th century. Industries facing strong competition from abroad have long appealed for protections through trade policy. American agriculture, almost totally in private hands, has benefited from government assistance. Many other industries also have sought and received aid ranging from tax breaks to outright subsidies from the government.
     Government regulation of private industry can be divided into two categories -- economic regulation and social regulation. Economic regulation seeks, primarily, to control prices. Designed in theory to protect consumers and certain companies (usually small businesses) from more powerful companies, it often is justified on the grounds that fully competitive market conditions do not exist and therefore cannot provide such protections themselves. In many cases, however, economic regulations were developed to protect companies from what they described as destructive competition with each other. Social regulation, on the other hand, promotes objectives that are not economic -- such as safer workplaces or a cleaner environment. Social regulations seek to discourage or prohibit harmful corporate behavior or to encourage behavior deemed socially desirable. The government controls smokestack emissions from factories, for instance, and it provides tax breaks to companies that offer their employees health and retirement benefits that meet certain standards.
     American history has seen the pendulum swing repeatedly between laissez-faire principles and demands for government regulation of both types. For the last 25 years, liberals and conservatives alike have sought to reduce or eliminate some categories of economic regulation, agreeing that the regulations wrongly protected companies from competition at the expense of consumers. Political leaders have had much sharper differences over social regulation, however. Liberals have been much more likely to favor government intervention that promotes a variety of non-economic objectives, while conservatives have been more likely to see it as an intrusion that makes businesses less competitive and less efficient.

Growth of Government Intervention
In the early days of the United States, government leaders largely refrained from regulating business. As the 20th century approached, however, the consolidation of U.S. industry into increasingly powerful corporations spurred government intervention to protect small businesses and consumers. In 1890, Congress enacted the Sherman Antitrust Act, a law designed to restore competition and free enterprise by breaking up monopolies. In 1906, it passed laws to ensure that food and drugs were correctly labeled and that meat was inspected before being sold. In 1913, the government established a new federal banking system, the Federal Reserve, to regulate the nation's money supply and to place some controls on banking activities.
     The largest changes in the government's role occurred during the "New Deal," President Franklin D. Roosevelt's response to the Great Depression. During this period in the 1930s, the United States endured the worst business crisis and the highest rate of unemployment in its history. Many Americans concluded that unfettered capitalism had failed. So they looked to government to ease hardships and reduce what appeared to be self-destructive competition. Roosevelt and the Congress enacted a host of new laws that gave government the power to intervene in the economy. Among other things, these laws regulated sales of stock, recognized the right of workers to form unions, set rules for wages and hours, provided cash benefits to the unemployed and retirement income for the elderly, established farm subsidies, insured bank deposits, and created a massive regional development authority in the Tennessee Valley.
     Many more laws and regulations have been enacted since the 1930s to protect workers and consumers further. It is against the law for employers to discriminate in hiring on the basis of age, sex, race, or religious belief. Child labor generally is prohibited. Independent labor unions are guaranteed the right to organize, bargain, and strike. The government issues and enforces workplace safety and health codes. Nearly every product sold in the United States is affected by some kind of government regulation: food manufacturers must tell exactly what is in a can or box or jar; no drug can be sold until it is thoroughly tested; automobiles must be built according to safety standards and must meet pollution standards; prices for goods must be clearly marked; and advertisers cannot mislead consumers.
     By the early 1990s, Congress had created more than 100 federal regulatory agencies in fields ranging from trade to communications, from nuclear energy to product safety, and from medicines to employment opportunity. Among the newer ones are the Federal Aviation Administration, which was established in 1966 and enforces safety rules governing airlines, and the National Highway Traffic Safety Administration (NHSTA), which was created in 1971 and oversees automobile and driver safety. Both are part of the federal Department of Transportation.
     Many regulatory agencies are structured so as to be insulated from the president and, in theory, from political pressures. They are run by independent boards whose members are appointed by the president and must be confirmed by the Senate. By law, these boards must include commissioners from both political parties who serve for fixed terms, usually of five to seven years. Each agency has a staff, often more than 1,000 persons. Congress appropriates funds to the agencies and oversees their operations. In some ways, regulatory agencies work like courts. They hold hearings that resemble court trials, and their rulings are subject to review by federal courts.
     Despite the official independence of regulatory agencies, members of Congress often seek to influence commissioners on behalf of their constituents. Some critics charge that businesses at times have gained undue influence over the agencies that regulate them; agency officials often acquire intimate knowledge of the businesses they regulate, and many are offered high-paying jobs in those industries once their tenure as regulators ends. Companies have their own complaints, however. Among other things, some corporate critics complain that government regulations dealing with business often become obsolete as soon as they are written because business conditions change rapidly.

Federal Efforts to Control Monopoly
Monopolies were among the first business entities the U.S. government attempted to regulate in the public interest. Consolidation of smaller companies into bigger ones enabled some very large corporations to escape market discipline by "fixing" prices or undercutting competitors. Reformers argued that these practices ultimately saddled consumers with higher prices or restricted choices. The Sherman Antitrust Act, passed in 1890, declared that no person or business could monopolize trade or could combine or conspire with someone else to restrict trade. In the early 1900s, the government used the act to break up John D. Rockefeller's Standard Oil Company and several other large firms that it said had abused their economic power.
     In 1914, Congress passed two more laws designed to bolster the Sherman Antitrust Act: the Clayton Antitrust Act and the Federal Trade Commission Act. The Clayton Antitrust Act defined more clearly what constituted illegal restraint of trade. The act outlawed price discrimination that gave certain buyers an advantage over others; forbade agreements in which manufacturers sell only to dealers who agree not to sell a rival manufacturer's products; and prohibited some types of mergers and other acts that could decrease competition. The Federal Trade Commission Act established a government commission aimed at preventing unfair and anti-competitive business practices.
     Critics believed that even these new anti-monopoly tools were not fully effective. In 1912, the United States Steel Corporation, which controlled more than half of all the steel production in the United States, was accused of being a monopoly. Legal action against the corporation dragged on until 1920 when, in a landmark decision, the Supreme Court ruled that U.S. Steel was not a monopoly because it did not engage in "unreasonable" restraint of trade. The court drew a careful distinction between bigness and monopoly, and suggested that corporate bigness is not necessarily bad.
     The government has continued to pursue antitrust prosecutions since World War II. The Federal Trade Commission and the Antitrust Division of the Justice Department watch for potential monopolies or act to prevent mergers that threaten to reduce competition so severely that consumers could suffer. Four cases show the scope of these efforts:

• In 1945, in a case involving the Aluminum Company of America, a federal appeals court considered how large a market share a firm could hold before it should be scrutinized for monopolistic practices. The court settled on 90 percent, noting "it is doubtful whether sixty or sixty-five percent would be enough, and certainly thirty-three percent is not."
  
• In 1961, a number of companies in the electrical equipment industry were found guilty of fixing prices in restraint of competition. The companies agreed to pay extensive damages to consumers, and some corporate executives went to prison.
  
• In 1963, the U.S. Supreme Court held that a combination of firms with large market shares could be presumed to be anti-competitive. The case involved Philadelphia National Bank. The court ruled that if a merger would cause a company to control an undue share of the market, and if there was no evidence the merger would not be harmful, then the merger could not take place.
  
• In 1997, a federal court concluded that even though retailing is generally unconcentrated, certain retailers such as office supply "superstores" compete in distinct economic markets. In those markets, merger of two substantial firms would be anti-competitive, the court said. The case involved a home office supply company, Staples, and a building supply company, Home Depot. The planned merger was dropped.

     As these examples demonstrate, it is not always easy to define when a violation of antitrust laws occurs. Interpretations of the laws have varied, and analysts often disagree in assessing whether companies have gained so much power that they can interfere with the workings of the market. What's more, conditions change, and corporate arrangements that appear to pose antitrust threats in one era may appear less threatening in another. Concerns about the enormous power of the Standard Oil monopoly in the early 1900s, for instance, led to the breakup of Rockefeller's petroleum empire into numerous companies, including the companies that became the Exxon and Mobil petroleum companies. But in the late 1990s, when Exxon and Mobil announced that they planned to merge, there was hardly a whimper of public concern, although the government required some concessions before approving the combination. Gas prices were low, and other, powerful oil companies seemed strong enough to ensure competition.

Deregulating Transportation
While antitrust law may have been intended to increase competition, much other regulation had the opposite effect. As Americans grew more concerned about inflation in the 1970s, regulation that reduced price competition came under renewed scrutiny. In a number of cases, government decided to ease controls in cases where regulation shielded companies from market pressures.
     Transportation was the first target of deregulation. Under President Jimmy Carter (1977-1981), Congress enacted a series of laws that removed most of the regulatory shields around aviation, trucking, and railroads. Companies were allowed to compete by utilizing any air, road, or rail route they chose, while more freely setting the rates for their services. In the process of transportation deregulation, Congress eventually abolished two major economic regulators: the 109-year-old Interstate Commerce Commission and the 45-year-old Civil Aeronautics Board.
     Although the exact impact of deregulation is difficult to assess, it clearly created enormous upheaval in affected industries. Consider airlines. After government controls were lifted, airline companies scrambled to find their way in a new, far less certain environment. New competitors emerged, often employing lower-wage nonunion pilots and workers and offering cheap, "no-frills" services. Large companies, which had grown accustomed to government-set fares that guaranteed they could cover all their costs, found themselves hard-pressed to meet the competition. Some -- including Pan American World Airways, which to many Americans was synonymous with the era of passenger airline travel, and Eastern Airlines, which carried more passengers per year than any other American airline -- failed. United Airlines, the nation's largest single airline, ran into trouble and was rescued when its own workers agreed to buy it.
     Customers also were affected. Many found the emergence of new companies and new service options bewildering. Changes in fares also were confusing -- and not always to the liking of some customers. Monopolies and regulated companies generally set rates to ensure that they meet their overall revenue needs, without worrying much about whether each individual service recovers enough revenue to pay for itself. When airlines were regulated, rates for cross-country and other long-distance routes, and for service to large metropolitan areas, generally were set considerably higher than the actual cost of flying those routes, while rates for costlier shorter-distance routes and for flights to less-populated regions were set below the cost of providing the service. With deregulation, such rate schemes fell apart, as small competitors realized they could win business by concentrating on the more lucrative high-volume markets, where rates were artificially high.
     As established airlines cut fares to meet this challenge, they often decided to cut back or even drop service to smaller, less-profitable markets. Some of this service later was restored as new "commuter" airlines, often divisions of larger carriers, sprang up. These smaller airlines may have offered less frequent and less convenient service (using older propeller planes instead of jets), but for the most part, markets that feared loss of airline service altogether still had at least some service.
     Most transportation companies initially opposed deregulation, but they later came to accept, if not favor, it. For consumers, the record has been mixed. Many of the low-cost airlines that emerged in the early days of deregulation have disappeared, and a wave of mergers among other airlines may have decreased competition in certain markets. Nevertheless, analysts generally agree that air fares are lower than they would have been had regulation continued. And airline travel is booming. In 1978, the year airline deregulation began, passengers flew a total of 226,800 million miles (362,800 million kilometers) on U.S. airlines. By 1997, that figure had nearly tripled, to 605,400 million passenger miles (968,640 kilometers).

Telecommunications
Until the 1980s in the United States, the term "telephone company" was synonymous with American Telephone & Telegraph. AT&T controlled nearly all aspects of the telephone business. Its regional subsidiaries, known as "Baby Bells," were regulated monopolies, holding exclusive rights to operate in specific areas. The Federal Communications Commission regulated rates on long-distance calls between states, while state regulators had to approve rates for local and in-state long-distance calls.
     Government regulation was justified on the theory that telephone companies, like electric utilities, were natural monopolies. Competition, which was assumed to require stringing multiple wires across the countryside, was seen as wasteful and inefficient. That thinking changed beginning around the 1970s, as sweeping technological developments promised rapid advances in telecommunications. Independent companies asserted that they could, indeed, compete with AT&T. But they said the telephone monopoly effectively shut them out by refusing to allow them to interconnect with its massive network.
     Telecommunications deregulation came in two sweeping stages. In 1984, a court effectively ended AT&T's telephone monopoly, forcing the giant to spin off its regional subsidiaries. AT&T continued to hold a substantial share of the long-distance telephone business, but vigorous competitors such as MCI Communications and Sprint Communications won some of the business, showing in the process that competition could bring lower prices and improved service.
     A decade later, pressure grew to break up the Baby Bells' monopoly over local telephone service. New technologies -- including cable television, cellular (or wireless) service, the Internet, and possibly others -- offered alternatives to local telephone companies. But economists said the enormous power of the regional monopolies inhibited the development of these alternatives. In particular, they said, competitors would have no chance of surviving unless they could connect, at least temporarily, to the established companies' networks -- something the Baby Bells resisted in numerous ways.
     In 1996, Congress responded by passing the Telecommunications Act of 1996. The law allowed long-distance telephone companies such as AT&T, as well as cable television and other start-up companies, to begin entering the local telephone business. It said the regional monopolies had to allow new competitors to link with their networks. To encourage the regional firms to welcome competition, the law said they could enter the long-distance business once new competition was established in their domains.
     At the end of the 1990s, it was still too early to assess the impact of the new law. There were some positive signs. Numerous smaller companies had begun offering local telephone service, especially in urban areas where they could reach large numbers of customers at low cost. The number of cellular telephone subscribers soared. Countless Internet service providers sprung up to link households to the Internet. But there also were developments that Congress had not anticipated or intended. A great number of telephone companies merged, and the Baby Bells mounted numerous barriers to thwart competition. The regional firms, accordingly, were slow to expand into long-distance service. Meanwhile, for some consumers -- especially residential telephone users and people in rural areas whose service previously had been subsidized by business and urban customers -- deregulation was bringing higher, not lower, prices.

The Special Case of Banking
Banks are a special case when it comes to regulation. On one hand, they are private businesses just like toy manufacturers and steel companies. But they also play a central role in the economy and therefore affect the well-being of everybody, not just their own consumers. Since the 1930s, Americans have devised regulations designed to recognize the unique position banks hold.
     One of the most important of these regulations is deposit insurance. During the Great Depression, America's economic decline was seriously aggravated when vast numbers of depositors, concerned that the banks where they had deposited their savings would fail, sought to withdraw their funds all at the same time. In the resulting "runs" on banks, depositors often lined up on the streets in a panicky attempt to get their money. Many banks, including ones that were operated prudently, collapsed because they could not convert all their assets to cash quickly enough to satisfy depositors. As a result, the supply of funds banks could lend to business and industrial enterprise shrank, contributing to the economy's decline.
     Deposit insurance was designed to prevent such runs on banks. The government said it would stand behind deposits up to a certain level -- $100,000 currently. Now, if a bank appears to be in financial trouble, depositors no longer have to worry. The government's bank-insurance agency, known as the Federal Deposit Insurance Corporation, pays off the depositors, using funds collected as insurance premiums from the banks themselves. If necessary, the government also will use general tax revenues to protect depositors from losses. To protect the government from undue financial risk, regulators supervise banks and order corrective action if the banks are found to be taking undue risks.
     The New Deal of the 1930s era also gave rise to rules preventing banks from engaging in the securities and insurance businesses. Prior to the Depression, many banks ran into trouble because they took excessive risks in the stock market or provided loans to industrial companies in which bank directors or officers had personal investments. Determined to prevent that from happening again, Depression-era politicians enacted the Glass-Steagall Act, which prohibited the mixing of banking, securities, and insurance businesses. Such regulation grew controversial in the 1970s, however, as banks complained that they would lose customers to other financial companies unless they could offer a wider variety of financial services.
     The government responded by giving banks greater freedom to offer consumers new types of financial services. Then, in late 1999, Congress enacted the Financial Services Modernization Act of 1999, which repealed the Glass-Steagall Act. The new law went beyond the considerable freedom that banks already were enjoying to offer everything from consumer banking to underwriting securities. It allowed banks, securities, and insurance firms to form financial conglomerates that could market a range of financial products including mutual funds, stocks and bonds, insurance, and automobile loans. As with laws deregulating transportation, telecommunications, and other industries, the new law was expected to generate a wave of mergers among financial institutions.
     Generally, the New Deal legislation was successful, and the American banking system returned to health in the years following World War II. But it ran into difficulties again in the 1980s and 1990s -- in part because of social regulation. After the war, the government had been eager to foster home ownership, so it helped create a new banking sector -- the "savings and loan" (S&L) industry -- to concentrate on making long-term home loans, known as mortgages. Savings and loans faced one major problem: mortgages typically ran for 30 years and carried fixed interest rates, while most deposits have much shorter terms. When short-term interest rates rise above the rate on long-term mortgages, savings and loans can lose money. To protect savings and loan associations and banks against this eventuality, regulators decided to control interest rates on deposits.
     For a while, the system worked well. In the 1960s and 1970s, almost all Americans got S&L financing for buying their homes. Interest rates paid on deposits at S&Ls were kept low, but millions of Americans put their money in them because deposit insurance made them an extremely safe place to invest. Starting in the 1960s, however, general interest rate levels began rising with inflation. By the 1980s, many depositors started seeking higher returns by putting their savings into money market funds and other non-bank assets. This put banks and savings and loans in a dire financial squeeze, unable to attract new deposits to cover their large portfolios of long-term loans.
     Responding to their problems, the government in the 1980s began a gradual phasing out of interest rate ceilings on bank and S&L deposits. But while this helped the institutions attract deposits again, it produced large and widespread losses on S&Ls' mortgage portfolios, which were for the most part earning lower interest rates than S&Ls now were paying depositors. Again responding to complaints, Congress relaxed restrictions on lending so that S&Ls could make higher-earning investments. In particular, Congress allowed S&Ls to engage in consumer, business, and commercial real estate lending. They also liberalized some regulatory procedures governing how much capital S&Ls would have to hold.
     Fearful of becoming obsolete, S&Ls expanded into highly risky activities such as speculative real estate ventures. In many cases, these ventures proved to be unprofitable, especially when economic conditions turned unfavorable. Indeed, some S&Ls were taken over by unsavory people who plundered them. Many S&Ls ran up huge losses. Government was slow to detect the unfolding crisis because budgetary stringency and political pressures combined to shrink regulators' staffs.
     The S&L crisis in a few years mushroomed into the biggest national financial scandal in American history. By the end of the decade, large numbers of S&Ls had tumbled into insolvency; about half of the S&Ls that had been in business in 1970 no longer existed in 1989. The Federal Savings and Loan Insurance Corporation, which insured depositors' money, itself became insolvent. In 1989, Congress and the president agreed on a taxpayer-financed bailout measure known as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). This act provided $50 billion to close failed S&Ls, totally changed the regulatory apparatus for savings institutions, and imposed new portfolio constraints. A new government agency called the Resolution Trust Corporation (RTC) was set up to liquidate insolvent institutions. In March 1990, another $78,000 million was pumped into the RTC. But estimates of the total cost of the S&L cleanup continued to mount, topping the $200,000 million mark.
     Americans have taken a number of lessons away from the post-war experience with banking regulation. First, government deposit insurance protects small savers and helps maintain the stability of the banking system by reducing the danger of runs on banks. Second, interest rate controls do not work. Third, government should not direct what investments banks should make; rather, investments should be determined on the basis of market forces and economic merit. Fourth, bank lending to insiders or to companies affiliated with insiders should be closely watched and limited. Fifth, when banks do become insolvent, they should be closed as quickly as possible, their depositors paid off, and their loans transferred to other, healthier lenders. Keeping insolvent institutions in operation merely freezes lending and can stifle economic activity.
     Finally, while banks generally should be allowed to fail when they become insolvent, Americans believe that the government has a continuing responsibility to supervise them and prevent them from engaging in unnecessarily risky lending that could damage the entire economy. In addition to direct supervision, regulators increasingly emphasize the importance of requiring banks to raise a substantial amount of their own capital. Besides giving banks funds that can be used to absorb losses, capital requirements encourage bank owners to operate responsibly since they will lose these funds in the event their banks fail. Regulators also stress the importance of requiring banks to disclose their financial status; banks are likely to behave more responsibly if their activities and conditions are publicly known.