July

incomes and improving mortality rates indicates that 279 A Reviewer's Notebook the industrial revolution raised John Chamberlain the standard of living of the "How the West Grew Rich," working class. by Nathan Rosenberg and L. E. Birdzell, Jr., finds that capitalism has been the key to prosperity and growth.

THEFREEMAN IDEAS ON LIBERTY Published by The Foundation for Economic Education Irvington-on-Hudson, NY 10533 President of the Board: Robert D. Love Vice President of Operations: Robert G. Anderson Senior Editors: Beth A. Hoffman Brian Summers Editorial Adviser: Paul L. Poirot Book Review Editor: Edmund A. Opitz Contributing Editors: Howard Baetjer Jr. Bettina Bien Greaves Gregory F. Rehmke Joan Kennedy Taylor The Freeman is published monthly by The Foundation for Economic Education, Inc., Irvington-on-Hudson, New York 10533. (914) 591-7230. FEE is a nonpolitical, non profit, educational champion of private prop erty, the free market, and limited government. The costs of Foundation projects and services are met through donations. Donations are in vited in any amount. Subscriptions to The Freeman are available to any interested per son in the United States for the asking. Single copies $1.00; 10 or more, 50 cents each. For foreign delivery, a donation of $10.00 is re quired to cover direct mailing costs.

Copyright © 1986 by The Foundation for Economic Education, Inc. Printed in U.S.A. Permission is granted to reprint any article in this issue, except "Taxes and Unemploy ment," provided appropriate credit is given and two copies of the reprinted material are sent to The Foundation. Bound volumes of The Freeman are available from the Foundation for calendar years 1969 to date. Earlier volumes as well as current is sues are available on microfilm from Univer sity Microfilms, 300 North Zeeb Road, Ann Arbor, MI 48106. The Freeman considers unsolicited editorial submissions, but they must be accompanied by a stamped, self-addressed envelope. Our author's guide is available on request. PERSPECTIVE On Savings Men can produce very little with physical labor alone. Only when they begin to use their minds to make tools does their labor become more pro ductive. And the development of tools starts with "rainy-day savings," that is, by consuming less than is produced and setting aside some food, clothing, and shelter to tide the toolmaker over while he invents and produces.

Improving production is a very slow process. However, the productivity increasing tools of inventors make it somewhat easier to consume less than is produced. Little by little producers were able to increase their savings. In stead of accumulating only' 'rainy-day savings," such as excess supplies of food, clothing, and shelter, they be gan in time to produce capitalist sav ings-extra tools and machines to be used later in production. In this way our ancestors created the vast accu mulations of capitalist savings on which we all rely: huge power proj ects, automobile plants, coal and iron mines, oil tankers and pipelines, care fully cultivated farmland, textile mills, and so on. Most of our material wel fare is the outcome of the ingenuity and thrift of our ancestors. -From Bettina Greaves' Economics II course at the New York Institute oj Credit TangledWeb "0, what a tangled web we weave, when first we practice to deceive." In Marmion, Walter Scott wasn't writing about economics. Nevertheless, deceit in market pricing has certainly led to "a tangled web" of waste and mal production.

I The modern economy is rife with examples of production gone awry when market prices are artificially held down o'r artificially supported. Wartime price controls led to empty grocery shelves and black markets. Tenants in rent-controlled apartments enjoy housing and a privileged posi tion, while would-be tenants face a se vere shortage of apartments. Price supports, on the other hand, lead to the production of unwanted commodities. For example, the Swiss and Austrian governments pay farm ers to grow -wheat on the slopes of the Alps for esthetic reasons. The wheat never matures in that cold environ ment, but presumably tourists enjoy the fields of waving grain. In this country, we support the production of commodities that cannot be sold at the subsidized prices. Recently, when sur plus dairy products became an em barrassment, our government began slaughtering 1.6 million dairy cattle.

Among the latest disclosures of an ar tificially subsidized surplus was a wheat glut in Saudi Arabia, where the government has been paying wheat farmers almost five times the world price. If production were left for entre preneurs to plan, to serve consumers on the basis of free market prices, supply and demand would always tend to balance. There would then be no serious shortages of rental housing or gluts of wheat or dairy products. Those who try to deceive the pricing system fail to appreciate the valuable knowledge to be gained from freely fluctuating market prices. -BBG Air TrafficControl Economic Outlook, published by the Chamber of Commerce of the United States, offers an interesting comparison of private versus public management of air traffic control: "Air traffic control in the U.S. is provided by both the Federal Aviation Administration (FAA) and by private contractors at smaller airports. For the smallest FAA tower authoriza tion, the FAA spends about $1 million to install and about $275,000 a year to operate and maintain a tower. Private firms provide the same services for about $120,000 per year, including amortization of their original capital investment. When a private operator assumed the responsibility for oper ating the Farmington, New Mexico, tower, its contract was for $99,000 per year compared to the $287,000 that it had cost the FAA."

For further insights into private versus public management, see Dale M. Haywood's article on page 274 and Tibor R. Machan's article on page 270. FEE Columns Freeman articles are reaching a growing audience of newspaper read ers around the country. John W. Som mer's "Disasters Unlimited" (April Freeman) has been reprinted by the Houston Chronicle, The Washington Times, and the Waterbury (Connect icut) American. An adaptation of Dennis Bechara's "The Continuing Plight of Agriculture" (May Free man) has appeared in the Waterbury Republican and Pacific Business News. In Brazil, interviews and stories about FEE are becoming almost a regular feature in the popular news magazine, Visao. Latest to appear is a reprinting of William S. Kern's "Catholic Social Teaching and the U.S. Economy" (December 1985 Freeman). As FEE expands its publishing pro gram, we would appreciate it if you would call our attention to any of our articles you may see. We would es pecially appreciate it if you would send us a elipping.

ReprintsAvailable We are pleased to offer reprints of James L. Payne's "It's Not Our Money," which appeared on page 213 in our June issue. Prices are 50¢ each or 25¢ each on orders for 10 or more. PERSPECTIVE 244 THEFREEMAN IDEAS ON LIBERTY The PoliticalEconomy ofEducational Vouchers Publicfinancing of education means political control. by Dwight R. Lee Dr. Lee is a professor of economics at the University of Georgia, where he holds the Ramsey Chair of Private Enterprise. T he crisis in public education is real. As judged by any rea sonable measure, the quality of public education is declining as the cost of public education is increasing. The desire for reform in public education is genuine. Parents want a good education for their children, and taxpayers want an honest return for their dollars. Unfortunately, a realistic appraisal of why meaningful reform in public education is so badly needed also points to why mean ingful reform is so unlikely to occur.

The underlying problem with public education is, quite simply, that it is public. As long as education is provided publicly, it will be con trolled by, and for the benefit of, public education professionals. The reason for this is straightforward. As opposed to market decisions where each consumer exerts direct and decisive control over the services he chooses to purchase, no one individual has decisive control over the political decisions which de termine the publicly provided services all consumers are required to "purchase." Seeing no advantage in becoming informed and active in pursuit of objectives over which he has no direct control, the typical citizen-consumer quite rationally devotes little effort to influence pub lic education policy. In contrast, suppliers of public education have significant political influence over public education policy by virtue of the fact that they are organized through professional associations, have a concentrated interest in decisions affecting public education, and are widely perceived as education experts. The political dominance of supplier interests over consumer interests gives public education professionals the opportunity to control the policy of the public schools. The special interests that comprise the public school lobby have taken full advantage of this opportunity to promote their private purposes while neglecting the public's desire for the efficient provision of quality education.

The implication here appears to be clear. Achieving genuine edu cational reform would seem to require a policy which shifted control of education from suppliers of education to consumers of education. It is this view of the crisis in public education that has motivated the call for educational vouchers.! The idea behind educational vouchers is straightforward. Instead of government financing education by ac tually supplying educational services, publicly funded vouchers would be given to the parents of school-age children to spend at the school of their choice (as long as the choice is approved by government). As envisioned by its proponents, this voucher system would transfer con trol to the consumers of education. Educators would be forced to compete for the consumers' educational vouchers and therefore cater to the consumers' educational demands. Only those schools providing quality education, as determined by the consumer, at low cost would survive. It is also predicted that the variety of educational approaches would increase to reflect the range of educational preferences among the public. Also, with diversity replacing uniformity in education, market choice would replace political combat as the means of ex pressing educational preferences. 2 T his case for educational vouchers would be sound if it were indeed true that the root of the problem lay in the control . of public school policy by professional educators. But this is not the case. Educator control of public education policy is a symptom of a more fundamental problem: the public funding of education. The flaw with the voucher system is that it attacks the symptom of the problem without addressing the source of the prob lem. Under the voucher system public education remains public ed ucation, and nothing fundamental has changed.

Proponents of educational vouchers have assumed a benign political setting for their proposal-one which if it indeed existed would largely eliminate the need for vouchers in the first place. Once vouchers were issued by government, consumers would supposedly be in complete control, as the public school lobby would somehow have been polit ically neutered. The only political influence that would be in evidence is the restriction that vouchers be used to purchase education only from approved schools. And presumably this influence would be ex ercised in a politically impartial way. The political arena would sud denly become a setting in which the education consumer is in control; the public school lobby is dormant; and quality education is provided efficiently because it is in the public interest to do so. Obviously in such a political setting educational vouchers would perform as advertised.

The prognosis for vouchers is completely different, however, when a realistic view of politics is accepted. As long as education is funded publicly, decisions on educational policy will be made politically. As long as decisions on educational policy are made politically, the in terests of consumers will remain diffused and unorganized, and dom inated by the focused and organized interests of the public school professionals. Given this fact of political life there are only two pos sibilities for educational vouchers. The first possibility is that edu cational vouchers will be benign because they never will be considered seriously. The second possibility is that educational vouchers will be- . come politically acceptable-in which case they will be no better, and probably worse, than the educational approach they replace. - Consider a voucher proposal which, if enacted, would indeed be in the best interest of the public as consumers of education. In other words, the voucher proposal would accomplish exactly what propoEducational Vouchersand Political Realism 245 246 THE FREEMAN JULY 1986 The Response of the Public SchoolLobby nents of educational vouchers envision: the transfer of control over education to consumers from suppliers. One does not have to be clair voyant to predict how the public school lobby would respond to such a proposal. They would oppose it for the obvious reason that their power and privileges would be undermined by a voucher system which worked the way it is supposed to work. This opposition is sure to be effective for the same reason that lies behind the case being made for vouchers-the ability of education professionals to control education policy when that policy is determined through the political process.

What the voucher proponents have not yet recognized is that they are confronted with a Catch-22. They want an effective voucher system for the very reason that it is impossible to have one. Unfortunately, this is not the end of the story. If it were, the idea of educational vouchers would be a rather harmless one. The problem is that there is a real danger that educational vouchers will become politically acceptable. How will vouchers become politically acceptable if they pose such a threat to the professional educators who control the political agenda on educational policy? It has to be recognized that the public school lobby faces a second threat. That threat is public education's inferi ority to the private education alternative, but this is a threat that the public school lobby can neutralize with the creative use of educational vouchers. Compelling evidence of the inferiority of the public schools is found in the fact that private schools, charging full price for their services, are competing successfully against the fully subsidized public schools.

And the number of parents who remove their children from the public school system is likely to increase. The public schools are surely not going to get better, and are very likely to get worse. The recent call for "reform" and the political rhetoric about "excellence in educa tion" will do nothing to improve public education. Indeed, the pre tense of reform has satisfied the political demand that something be done while leaving such educationally destructive forces as the Na tional Education Association with more control than ever. On the other hand, the private demand that something be done will continue to find expression in parents' rejection of public schools. This rejection will surely increase as per capita incomes increase, even if the decline in the quality of public education is somehow arrested. 3 T he public school lobby will respond to this threat of con sumer rejection, but how? It will not, indeed cannot, re spond by improving the quality of education and becoming competitive with private schools. This is not to be taken as a criticism of the individuals who teach in our public schools. Many of these individuals are competent, hard working, and personally ded icated to educational excellence. The problem is one of the flawed incentive structure that plagues the provision of all publicly financed goods and services.

If suppliers are to direct their efforts efficiently and persistently to the satisfaction of consumer demands, they require accurate infor mation on what those demands are, and compelling motivation to respond to this information. There is only one arrangement whereby this information and motivation can be provided. That arrangement "As long as education is funded publicly, decisions on educational policy will be made politically. " 247 is the private market where consumers, by virtue of the fact that they are spending their own money as they see fit, communicate their pref erences through changes in pric;esand patronage in a way that conveys wealth gains to those suppliers who respond appropriately, and im poses wealth losses on those who do not. By breaking the connection between the demand for education and the ability of consumers to control their own money in expressing that demand, public education has made it impossible for the public schools to provide quality ed ucation efficiently.

But the public school lobby does not have to concern itself with providing better education at lower costs in order to beat back the threat it faces from the private school option. If the move to purely private schools begins to accelerate, the public school lobby can, and surely will, protect its privileged position against this competition by embracing educational vouchers. As strange as it will sound to ad vocates of educational vouchers, if the voucher approach to education ever becomes a serious political possibility, it will be as a means of reducing competition in education, not increasing it. 4 The advantage the public school lobby will see in educational vouch ers comes from the ability of vouchers to entice students back into publicly financed education. Consider the situation in which a large number of parents have taken their children out of the public schools. These parents will have the control over their children's education that can come only from private education, but they will be paying dearly for the privilege; paying for both the private education they have cho sen and the public education they have rejected. Given this burden, parents of children in private schools will be susceptible to a proposal for educational vouchers. As presented by the advocates of vouchers, which will now include public school professionals, the promise will be continued freedom of choice in education without the obligation to pay twice. Such a voucher proposal will also sound appealing to the proprietors of private schools, who will mistakenly see it as a way of expanding the demand for their product by eliminating the dis criminatory financial burden being placed on their customers.

Unfortunately, the reality of educational vouchers will be far dif ferent from their promise. Vouchers or no vouchers, as long as edu cation is financed publicly, control over education will be exerted through political power, not through consumer choice. Educational vouchers may, for a time, give the appearance-that consumers are ex ercising genuine choice. But consumer choice can, and will, be cir cumscribed by restrictions on the vouchers; restrictions that will reflect the interests of the politically organized public school lobby, not the interests of the politically unorganized public. One can predict with confidence that the choices educational consumers will have under any voucher system that is politically acceptable will in no way threaten the privileged position of the public school establishment.

248 THE FREEMAN JULY 1986 . Conclusion This conclusion is based on more than just idle theorizing. We have experience with Federally funded educational vouchers at the exper imental level. The Federally funded voucher experiment that ran the longest and has been deemed most successful was conducted in Alum Rock, California. As one would predict, restrictions were plafed on these vouchers which minimized the competitive pressures they im posed o,n public school professionals, and which attempted to promote social objectives that had little to do with education. Teachers, for example, did not have to worry about loss of income if their enroll ments declined. They were given priority in teaching jobs at other schools and were paid for makeshift 'work until such jobs became available. On the other hand, teachers who succeeded in attracting additional students were not rewarded with higher salaries. Those schools which parents preferred were not able to expand to meet the extra demand. Those students who did not get their first choice were simply assigned to other schools. A local employee certification coun cil required that any private school had to satisfy a host of standards on such things as teacher education requirements, pay and fringe ben efits, and faculty-student ratios. This control over entry was used to make it effectively impossible for any private school to enter into com petition for the vouchers. The Alum Rock vouchers did nothing to threaten the suppliers of public education by passing genuine control to the consumers of education.

If educational vouchers become politically viable it will be because they can be used to reverse the expansion in genuinely private edu cation. The public school lobby will see educational vouchers as the means to entice those who are attending private schools back into a public education system that will be no better than the one which they have rejected. T he special interests that comprise the public school lobby have been able to subvert educational policy to their narrow advantages with the same political influence that will be used to frustrate any reform that threatens those advantages. These special interests would be emasculated by a system of educa tional vouchers that worked in the way envisioned by the advocates of vouchers. It is for this reason that we will never get a voucher system that is worth having. If educational vouchers are in our future it will be because the public school lobby will see them as the best vehicle for maintaining or enlarging their special interest advantages. Edu cational vouchers will never serve to increase the range of freedom in education, and may do much to restrict it. D 1. For the purpose of this paper there is no ad vantage in distinguishing between educational vouchers and educational tax credits, and hence forth we will refer only to vouchers.

2. Milton Friedman, the leading proponent of educational vouchers, first made the case for vouchers in "The Role of Government in Ed ucation," in Robert Solow, ed. Education and the Public Interest, New Brunswick: Rutgers University Press, 1955. 3. It should not go unnoticed that increased wealth represents a major threat to the public education establishment. The wealthier parents become, the greater their demand for quality ed ucation for their children, i.e., private education for their children. The NEA's advocacy of eco nomic policies calling for economically stifling regulations and taxes is not completely irrational from their perspective. 4. This point was first recognized by Gary North in his article, "Educational Vouchers: The Dou ble Tax," The Freeman, (May 1976): 259-75.

Taxesand Unemployment T ax exactions, in recent decades, have risen to heights that would have seemed incredible to our forebears. They have become a big, often the biggest, item of a family budget. To business, taxes now are an important determinant of deci sion making; they circumscribe the production process, specify the nature of business activity, direct its location, and signal failure or success. In the U.S., total tax exactions now exceed one trillion dollars in a three-trillion dollar economy. It is inevitable that, in such mag nitude, taxes vitally affect many aspects of our economic, social, and political lives. A tax is a compulsory payment by individuals to government. It differs from all other payments in its basic characteristics: (1) com pulsion, (2) apportionment without close reference to individual ben efits, (3) use of the proceeds by politicians and government officials.

The intent of a tax levy may be fiscal, to raise revenue and defray the expenses and expenditures of politicians and officials, or it may be economic, to effect economic changes. It may be to effect changes in consumption patterns, stimulate business spending, provide jobs for the unemployed, redistribute income and wealth, or even reshape the economic system. But no matter what the intent may be, all taxes have economic effects; there are no neutral taxes. Every tax that touches business tends to "regulate" business. Every business tax-whether it is a corporate income tax, a supplementary tax on undistributed corporate income, a capital stock tax, an excess profits tax, a severance tax, an unincorporated business tax, or a prop erty tax-affects business activity~ Similarly, personal taxes, such as payroll taxes, poll taxes, gift taxes, death taxes, commodity taxes, transfer taxes, sales taxes, motor vehicle taxes, fuel taxes, or taxes on imports, all leavetheirmarkson economicproductionand distribution.

Under the influence of popular economic thought, governments now raise or lower taxes in order to prevent inflation, check business reces sions, and promote economic activity and growth. When economic output is approaching the limits of capacity and people want to spend more than is offered at stable prices, taxes are supposed to exert a powerful restraining force and close the "inflationary gap." In the opposite situation, when a recession is threatening to paralyze eco nomic activity and unemployment is descending on many labor mar249 How do rising levels of taxationaffect the rate of unemployment? by Hans F. Sennholz Dr. Sennholz heads the Department of Economics at Grove City College in Pennsylvania. He is a noted writer and lecturer on economic, political, and monetary affairs. This essay is a chapter from his forthcoming book on unemployment.

250 THE FREEMAN JULY 1986 Improper Means to DubiousEnds kets, government is supposed to lower taxes while maintaining or even increasing spending. Government is to create deficits and finance them by borrowing, which is said to add to the people's disposable income and propensity to consume. In short, taxation together with deficit spending anq credit expansion are supposed to be a powerful force for full employment. Economic reality differs radically from such crude notions of taxing and spending. Ever since governments the world over sought to close the "inflationary gap" and practiced contracyclical policies, the rates of inflation have soared and the cyclical movements of business have become more numerous and severe. Taxation obviously cannot alle viate inflation as long as government engages in money creation and credit expansion; but it may aggravate the rise in prices by exacting and consuming business capital and thereby reducing the supply of available goods.

Similarly, taxation is utterly incapable of alleviating the business cycle. Once economic production is disoriented and maladjusted due to inflation and credit expansion, the readjustment, which is the reces sion, must run its course. To prescribe tax boosts in such situations is to make matters worse. To increase government spending and suffer yet larger deficits is to deprive business of urgently needed capital, prolong the recession, and cause more unemployment. P ew legislators are knowledgeable in economic matters, which explains why tax legislation may bring forth more uninten tional than desired effects. A levy may fall far short in rev enue or surpass all expectations. It may be designed to equal ize income and wealth, but actually create more inequality. It may seek to provide equal opportunities, but actually prevent changes and bar opportunity. A tax may be imposed to improve the economic condi tions of working people, but actually make them worse. It may be intended to fight inflation, but actually aggravate it, to overcome the business cycle, only to exacerbate it. It may be inflicted to alleviate poverty, but actually worsen it. It may be foisted on business in order to stimulate activity and employment, but actually bring forth eco nomic stagnation and unemployment.

Surely, there is no tax purposely and willfully designed to cause economic stagnation or unemployment. But whatever their objectives may be, the levies imposed rarely are the proper means for the chosen ends. In particular, taxes imposed for the purpose of economic stim ulation and full employment actually bring about stagnation and unemployment. Students of labor and labor markets judge a particular levy ac cording to its effect on the demand for and supply of labor. A tax levy, or changes thereof, may affect the demand for labor, influence the quantity and quality offered, or act on both. Like any other ob stacle to production it may cause economic stagnation and breed un employment. Taxation has such consequences whenever it renders hu man labor uneconomical. It may do so by raising the cost of labor above its marginal productivity, that is, above the addition to output attributable to the last worker employed whose cost equals the value ofhis output. Above this point, the loss incurred from the employment of labor forces employers to discharge workers.

Fiscal theory distinguishes between two modes of taxation bringing forth unemployment: (1) Taxes, levies and fees that directly raise the cost of labor, such as Social Security payroll taxes, unemployment compensation taxes, workman's compensation assessments, and so on. They are called "employment taxes." 2) Taxes, levies and fees that lower the productivity of labor by preventing capital formation or consuming capital outright, such as steeply progressive corporate and personal income taxes, capital stock taxes, business license taxes, death and gift taxes, and other levies on capital. We may call them "business taxes." For a tax to bring forth unemployment it must raise the cost of labor above the value of its productive contribution. If, for any reason, it fails to do so because other factors oppose and offset it, the unem ployment may not materialize. Inflation, for instance, may tempo rarily erode real wages while eager legislators are adding costs. Ram pant inflation throughout the 1970s facilitated prompt downward readjustments of real wages, at least in nonunionized industries, al though government was continually boosting employment taxes. 1 In unionized industries, inflation usually triggers additional wage de mands that prevent the offsetting adjustment. The boosts in employ ment taxes together with new demands for higher pay and less work bring about mass unemployment.

In a free society institutional unemployment is an alien, unnatural phenomenon. The market order, which forces capital and labor to adjust continually to consumer demand, offers employment oppor tunities to everyone willing to work. Free prices, which reflect con sumer values and choices, guide the adjustment process. At the free market rate of labor there can be neither surplus nor shortage of labor. Chronic unemployment always indicates extraneous intervention that makes labor uneconomical. It hints at permanent barriers such as min imum wage legislation, union wage rates and work rules, government rules and regulations, and last but not least, prohibitive taxation. Both government and labor unions are laboring diligently to maintain and even raise the barriers. T o hel.p finance Social Security benefits, the federal gover.n ment imposes a series of payroll taxes that now yield almost $300 billion a year. Taxes in such magnitude obviously are an important element in the cost of labor affecting the de mand for labor. They usually consist of two sets of levies-one claims a share of employee income, the other a share of employer profits.

The former is deducted from a worker's pay and remitted by the em ployer to the Internal Revenue Service, which credits it to his account. It reduces a worker's take-home pay and net income; it is a part of labor cost borne directly by the worker. The employer's share, too, constitutes a part of labor cost, but differs from employee withholding in that a boost directly and immediately raises total labor costs and thus exerts an influence on the demand for labor. To the employer levy must be added the employer's cost of collection, remission, and compliance. Every employer report on earnings in covered employ ment, every labor questionnaire, adds to labor cost. 251 TAXES AND UNEMPLOYMENT Employment Taxes 252 THE FREEMAN JULY 1986 The Impact of Benefit Mandates Many politicians and officials are ever anxious to boost employee benefits and increase employer obligations. To analyze their motives is to reach into the haze of politics. Some lawmakers may actually believe that they, in Congress assembled, wield the power to exact income and benefits from employers and bestow them on workers.

They depend on tax collectors, judges, juries, and police to enforce the laws they devise. Other politicians whose paramount concern is re-election, usually promise anything and everything the electorate may want to hear. But no matter what the motivation may be, every new levy raises the cost of labor and causes some unemployment. The magnitude of the unemployment depends on the size of the exaction and the adaptability of labor. A quick downward adjustment of other labor costs-wages, fringes, or both-offsetting the new ex action, may keep unemployment at a minimum. To resist the adjust ment, however, is to let the consequences run their course. The loss inflicting submarginal labor is laid off, suffers the pain and agony of joblessness, and in time searches for other employment. The competition of the unemployed creates a tendency for wage rates to decline to the point where the reduction offsets the new ex action. In the end, the worker pays for every penny of fringe benefit exaction no matter how it is labeled or packaged. When seen in this light, the Social Security system and' all the other labor benefit systems merely are mandated schemes of wage redistribution that permit pol iticiansand government officials to manage and redistribute labor in come. The workers bear all costs of wage withholding, accounting, and remission to the Social Security Administration.

I na labor-intensive industry in which labor costs comprise a large share of production"cost, the impact of benefit mandates is likely to be painful and severe. If labor costs are made to rise by one per cent, unemployment may rise by two or three per cent. In a capital-intensive industry in which the payroll represents a small share of production cost, the effect of a benefit boost will be less pro nounced. A one per cent rise may boost production costs by a small fraction of one per cent and unemployment by a lesser amount. In every case, labor is rendered unemployable whenever its cost is boosted forcibly above its productivity rate. Unemployment compensation taxes by both federal and state gov ernments are classic examples. When general business activity declines, unemployment benefits, which are state expenditures, tend to increase automatically. State governments promptly react by boosting em ployer exactions, which in turn boost the unemployment rates.' More over, unemployment compensation undoubtedly affects the supply of labor as any subsidy sustains that which it subsidizes. Higher benefits tend to reduce incentives to effort; since some states have removed most restrictions on benefits to strikers, the benefits invite and en courage strikes, which raise labor costs and create more unemploy ment. The strongholds of labor unions are the centers of unem ployment.

Labor is rendered unemployable whenever government forcibly raises its cost. The Occupational Safety and Health Act of 1970 (OSHA) is estimated to have added tens of billions of dollars to the cost of labor. It contributed significantly not only to rising unemployment, but also to the economic stagnation of the 1970s, the visible decline in American ability to compete in world markets, and the ex traordinary rise in goods prices. Similarly, the Employee Retirement Income Security Act of 1974 (ERISA), which made it easier to qualify for pensions, substantially raised the costs of private pension plans. The Equal Employment Opportunity legislation of 1964 and 1967, which forced employers to engage workers according to racial criteria rather than considerations of suitability and productivity, raised the cost of some labor. In every case the new legislation brought some unemployment to the very labor it meant to benefit.

T he Federal tax system relies primarily on payroll and income taxes. Boosts in payroll taxes bring forth unemployment di rectly and immediately, provided other cost reduction does not mitigate the tax boosts. Income taxes have similar results whenever they consume savings and prevent capital formation. In par ticular, steeply progressive rates retard economic development and produce unemployment by discouraging saving, investment in business expansion, and work effort, especially on the part of capitalists and entrepreneurs. In 1986 income taxes paid by individuals and corpo rations are estimated at $433 billion, or 54.5 per cent of estimated budget receipts. Social insurance taxes consisting primarily of payroll taxes levied on wages and salaries are estimated to yield some $289.4 billion, or 36.5 per cent of total income. Excise taxes on products and services are expected to provide $35 billion, or 4.4 per cent of the total, and estate and gift taxes, customs duties and miscellaneous receipts $36.3 billion, the remaining 4.6 per cent of budget receipts (Budget of the United States Government, Fiscal Year 1986, p. 4-3).

For many Americans steep tax progression is a maxim of "social justice" that renders to every man his due. Although men are by nature unequal in talent, labor, and virtue, many dream about equality of economic and social conditions. They would, in the name of social justice, reduce society to an average level, using the political process and government, the apparatus of force. Fiscal and budgetary objec tives take second place to social and economic considerations that make government apportion its levies according to the principle of "ability to pay" and allocate the benefits according to political need and merit. Government seizes income and wealth from individuals who own and earn more than the average, from taxpayers known to save and invest their savings. Unfortunately, government consumption of the funds reduces the amount of capital invested per worker employed, lowers the productivity of labor and depresses wage rates. Workers resisting the reduction face disemployment. They may encounter yet greater difficulties if taxpayers, instead of meekly suffering the confiscatory levies, decide to enjoy and consume their capital. The consumption breeds waste and invites mismanagement-dissipating more capital, depressing wage rates further, and causing more unemployment.

Business taxes are rising continuously. The windfall oil profit tax of 1980, the largest single tax ever imposed on an industry, is estimated to yield $5 billion in 1986.2 Boosts in excise taxes on airport and airway users and telephone service are estimated to yield $2.4 billion. A 5 cent per gallon increase in the excise tax on gasoline and diesel fuel, and other provisions of the Highway Revenue Act of 1982 are expected to 253 BusinessTaxes 254 THE FREEMAN JULY 1986 FiscalJustice raise business costs by more than $6 billion (Budget of the United States, Fiscal Year 1986, p. 4-18). Federal estate and gift taxes are estimated to yield $5.3 billion dol lars in 1986. There are few taxes that are more destructive to labor income and employment than such levies. They expropriate economic wealth that is employed almost exclusively in the production of goods and services for the people, giving them· employment and consumer products. Death duties force the heirs to sell parts or all of the tes tator's estate. Of course, the business they must sell or the stock they must liquidate are not consumed; they merely change ownership. But the liquid capital received for the property is surrendered to tax col lectors and consumed by government. The consumption reduces the amount of capital invested per worker, lowers the productivity of labor and depresses wage rates. If the workers resist the necessary wage ad justment they face unemployment. 3 M ost Americans applaud the new levies on business. They look upon business capital as evidence of unearned per sonal wealth that should be seized and distributed. Why should anyone be richer than the average wage earner~ Viewing business capital with unveiled envy, they do not understand that capital is a requisite of all production, a tool that renders human labor more productive.

They do not know that capital is not a gift of nature, but the product of individual saving and investing. To seize it and consume it is to impair labor productivity, reduce wage rates, and destroy jobs. To distribute it among workers or hand it to politicians and government officials amounts to the same. And yet in politics, envy that covets another's income and hates the wealth it cannot reach, is setting society on fire and destroying the people it possesses. The common cry of "social justice" is but the smoke of envy; it pollutes the moral fiber of society. It is difficult to argue about justice in fiscal matters, for it is doubt ful that any exaction that depends on brute force, that apportions without reference to individual benefits and that delivers the proceeds to politicians and government officials, can ever be morally right and equitable. Justice consists in doing no injury to men. How can a con fiscatory income tax or estate tax be called "just" when it inflicts great injury on taxpayers? Justice is depicted as blind; taxes exact income and wealth from some people for the benefit of others. Legislators aim their levies at certain groups and classes of taxpayers. They target their levies at producers, distributors, banks, chain stores, and many other classes of taxpayers. Surely, neither a corporate income tax nor a "windfall profits tax" on petroleum production can be said to be blind. The essence of justice is impartiality; the substance of taxation is partiality and partisanship. Justice gives to every man his own; tax ation takes from some to give to others.

Taxation is a simple business. Anyone can devise new levies and add to the old. He may receive support from lobbyists who would use the instruments of government to promote their own interests by ham pering and hurting others. Lobbyists for independent retailers argue for higher taxes on chain stores, coal miners plead for higher taxes on oil producers, American oil men for higher taxes on foreign producers, and so on. The tax boosters in turn depend on the support of the reformers who wax eloquent on equality and justice. Oppression and rebellion are never far apart. When the burdens reach confiscatory levels the public may unite and demand tax re ductions. As long as the number of taxpayers exceeds the number of tax boosters, and taxpayers organize as effectively as the boosters nor mally do, a tax rebellion may succeed in lowering particular levies. Most of the time, however, the public is divided on the issues. The tax boosters thus may turn a tax rebellion into a tax reform movement.

They may divide the public and turn its attention from the oppression to the distribution of the burden. They may succeed in turning a re bellion against government into a taxpayer feud that must be settled by government. In short, the people are persuaded to seek "new jus tice" by assigning "fair shares" and "closing loopholes." The tax reform battle is akin to the entitlement battle. Springing from the same ideological and philosophical roots, both signal the growing role of government in our lives. Taxation and unemployment are painful symptoms of this role. D 255 TAXES AND UNEMPLOYMENT 1. Maximum Social Security levies on employ ers since 1970 ($): Source: William H. Hoffman, Jr. and Eugene Willis, eds., West's Federal Taxation: Compre hensive Volume, 1986 Annual Edition (New York: West Publishing, 1986), p. 1-18; also Bud get of the United States Government, Fiscal Year 1986, p. 4-16.

2. Although the tax is called a "windfall profits 1970 - 374 1971 - 405 1972 - 468 1973 - 632 1974 - 772 1975 - 825 1976 - 895 1977 - 965 1978 - 1,071 1979 - 1,404 1980 - 1,588 1981 - 1,975 1982 - 2,171 1983 - 2,392 1984 - 2,532 1985 - 2,792 tax" the exaction actually applies to the price increases above the 1979 controlled prices, not to profits. For many years Federal controls kept oil prices far below market prices. When oil pro duction and distribution came to grief, sinking into stagnation and shortages, the controls were lifted reluctantly and markets were permitted to function again. But the difference between the controlled price and the free market price was expropriated by the windfall profits tax. If there were truth in politics, the tax would probably be called "a double-header exaction," at first by controls and then by taxation. 3. Cf. Sennholz, Death and Taxes, 2nd ed. (Ce dar Falls, Iowa: Center For Futures Education, 1982), p. 48 et seq.

Money and Freedom by Hans F. Sennholz Money and Freedom is a remarkable study of money and some fateful errors of popular monetary doctrines. Profes sor Sennholz argues forcefully and convincingly that such control, which amounts to a money monopoly, causes mon etary destruction. Money and Freedom is published by Libertarian Press and is also available from The Foundation for Economic Education. 102 pages, paperback $6.00 Order from: The Foundation for Economic Education Irvington-on-Hudson, New York 10533 256 The Industrial Revolution:Working ClassPovertyor Prosperity? How the industrial revolution raisedthe qualityof life for workersand their families. by John Majewski John Majewski is an economics major at the University of Texas at Austin. He is currently serving as a summer intern with the Institute for Humane Studies. Following graduation in 1988, John hopes to pursue a Ph.D. in economics. This paper was awarded second prize, college division, in FEE's Freedom Essay Contest.

S ince it began approximately two centuries ago, the industrial revolution has captured the minds of an endless number of historians and economists. An era of relatively laissez faire economics, the period between 1760-1850 is for many academics the key to unlocking the secrets of economic growth, tech nological change, and economic development. But, for defenders of the classical liberal tradition of free enterprise, the industrial revo lution is important for more insidious reasons. Writers such as Dick ens, Engels, and the Hammonds have made the terms industrial rev olution and capitalism synonymous with degradation of the working class. Pessimistic interpretations of the industrial revolution have led to the popular acceptance of what R.M. Hartwell terms the "theory of immiseration" -a belief that unrestrained capitalism was making the rich richer and the poor poorer during the industrial revolution (Hartwell, 1974). For the general public, the horrors of the industrial revolution prove the horrors of capitalism.

But it is not only laymen who perceive the industrial revolution in terms of "dark, satanic mills." A brief glance at almost any university history or English textbook. reveals that most academics who do not specifically study the industrial revolution accept without reservation the view that capitalism led to a deterioration of living conditions for the working class. For example, a text commonly used in college Brit ish literature classes describes the industrial revolution in these terms: For the great majority of the laboring class the results of the policy (of laissez faire) were inadequate wages, long hours of work under sordid conditions, and the large-scale employment of women and children for tasks which destroy body and soul. Reports from investigating committees on coal mines found male and female children ten or even five years of age harnessed to heavy coal sledges which they dragged crawling on their hands and knees ...

(Norton Anthology, p. 3). Such harsh interpretation of the industrial revolution has directly affected public policy. The industrial revolution has become a suc cessful battle cry for detractors of capitalism. The specter of workingclass poverty and misery during the industrial revolution has been and still remains an important justification for government intervention into social and economic affairs. A vast amount of legislation, from minimum wage to antitrust laws, owes its existence to the anticapitalist mentality created by pessimistic views of the industrial revolution. As Nobel laureate F.A. Hayek pointedly argues, the industrial revolution portrayed by the pessimists is the "one supreme myth which more than any other has served to discredit the economic system to which we owe our modern day civilization" (Hayek, pp. 9-10). This paper will attempt to show that the pessimistic interpretations, however popular, are unfounded. It will be argued that the quanti tative (material) standard of living improved as real wages rose, while falling mortality rates indicate that the qualitative (sociological) stan dard of living also improved. Although there was considerable social and economic disruption throughout the revolution, this paper will try to show that these problems were caused by various government in terventions, especially the Napoleonic Wars. Far from being a cause of misery and despair, this essay concludes, capitalism in the early nineteenth century improved the standard of living and set the stage for the modern comforts that we enjoy today.

A s noted above, the pessimistic case is widely accepted by both the general public and academia. However, it is fair to say that the majority of modern economic historians who study the industrial revolution believe that at least a slight increase in the material standard of living occurred. Since the introduction of reliable statistical evidence in Sir John Clapham's An Economic History of Modern Britain in 1926, it has become increas ingly obvious that real wages rose. The evidence is now so conclusive that one historian has confidently declared that "unless new errors are discovered, the debate over real wages in the early nineteenth cen tury is over: the average worker was much better off in any decade from the 1830s on than any decade before 1820" (Williamson, p. 18). The evidence vindicates such confidence. Although money wages remained stable, the prices of manufactured and agricultural goods plummeted as entrepreneurs struggled to deliver consumers low-priced goods and services (Hartwell, 1971, pp. 326-27). Although the extent of the increase in real wages is hotly debated, the most recent evidence suggests that blue-collar real wages doubled between 1810 and 1850 (Williamson, p. 18). McCloskey, although emphasizing a much longer period of time, also concludes that real wages increased significantly.

He argues that real wages rose from an average of £11 per capita in 1780 to £28 per capita in 1860 (McCloskey, p. 108). As one can imagine, the increase in real wages resulted in significant improvements in the standard of living. An excellent example is the changes in diet that occurred. Per capita consumption of meat, sugar, tea, beer, and eggs all increased. An even better indication of the rising affluence was the great increase of imported foods. Per capita con sumption of foreign cocoa, cheese, coffee, rice, sugar, and tobacco increased. Meanwhile, meat, vegetables, and fruits, long considered luxuries, were by 1850 eaten regularly (Hartwell, 1971, pp. 328-29). In fact, the average weekly English diet of 1850-five ounces of butter, thirty ounces of meat, fifty-six ounces·of potatoes, and sixteen ounces An Increase in Real Wages 257 258 THE FREEMAN JULY 1986 Untenable Arguments of fruits and vegetables-is quite similar to the English diet of today (Hartwell, 1971, p. 330).

Although such improvements obviously are important, they take on added significance when considering the large population increase that took place during the industrial revolution. Because of a fall in the death rate, the population of England and Wales rose 1.25 per cent per year between 1780 and 1860, an annual expansion that translates into an unprecedented threefold increase (McCloskey, pp. 105-108). Rising real wages (and consequent increases in food consumption) cou pled· with a rapidly rising population was a first in European history. The Malthusian trap of geometrically increasing populations out stripping arithmetically increasing food supplies had finally been bro ken. Whereas more people invariably resulted in less food per person throughout earlier European history, the industrial revolution pro vided more food per person. Breaking the bonds of Malthus is perhaps the crowning accomplishment of capitalism in general and the indus trial revolution in particular.

C onsidering the preponderance of evidence indicating sub stantial improvement in real wages, it is clear that the ar guments of early pessimists, such as Engels, have become untenable. Clearly, the material standard of living did not plummet. With the advent of reliable statistical evidence supporting real wage increases, sophisticated pessimists began to emphasize the qualitative effects of industrialization. Openly admitting that the working class enjoyed higher wages, more food, and better clothing, these pessimists argue that the cost for such gains in material wealth was dear. They contend that the evils of child labor, sordid working conditions, increased pollution, and various other discomforts out weighed any progress due to increasing real wages. E.P. Thompson, in his influential book The Making oj the English Working Class, succinctly summarizes this new pessimistic position, arguing that, "By 1840 most people were 'better off' than their forerunners, but they suffered and continued to suffer this slight improvement as a catas trophic experience" (Rude, p. 67-68).

The pessimistic quantitative versus qualitative position is open to considerable criticism. For example, many of the poor conditions cited by the pessimists existed well before the industrial revolution. Pre industrial society was very static and often cruel---':"'childlabor, dirty living conditions, long working hours, and a host of other ills asso ciated with nineteenth century capitalism were just as prevalent before the industrial revolution. Although by today's standard conditions were indeed poor, they were no worse than living conditions before the revolution (Hartwell, 1971, pp. 339-341). A second general problem with the new pessimistic position is that it fails to take into account the significant improvement in life ex pectancy that took place. The great population explosion that hap pened during the industrial revolution was fueled by a steep fall in death rates. Even in cities, where living conditions are said to have been the worst, mortality rates improved somewhat (McCloskey, pp.

105-106). Deteriorating living conditions and longer life spans are dif ficult positions to reconcile. Clearly, improving mortality rates indi cate that the standard of living rose during the industrial revolution.

Besides the two general arguments outlined above, the qualitative pessimistic position can be refuted by a close look at its specific charges. Technological unemployment and underemployment. It has been long held by many pessimists that the wage increases of the industrial revolution were eroded away by extremely high unemployment and underemployment rates caused by the introduction of labor-saving technology. Although there were some pockets of technological un employment, the calculations of Williamson suggest that the unem ployment rate was at most eight per cent per year, and was probably far lower (Williamson, p. 22). Furthermore, the stable money wages between 1820 and 1850 indicate that there was little competition from unemployed workers that would have lowered wages (Hartwell, 1971, pp. 318-319). As for underemployment, the tremendous shift from agriculture, which provided only seasonal employment, to the more stable manufacturing sector, led to decreasing underemployment (Hartwell 1971, p. 323).

Pollution and Urban Conditions. Another popular argument of the pessimists is that the real wage increases were merely "bribes" to workers forced to endure polluted and unsanitary urban conditions. According to this line of reasoning, the gain in real wages was simply a means of luring workers to the horrid working conditions of the cities, and did not constitute a net gain in wealth. Although it is cer tainly true that urban conditions during the industrial revolution were appalling, the aforementioned improvement in mortality rates indi cates that conditions were not bad enough to grievously affect the health of the city dwellers. Secondly, the workers voluntarily moved into urban areas, suggesting that the "opportunity cost" of pollution and various other urban discomforts did not outweigh the gains in real wages. Child Labor. Another qualitative argument brought forth by the pessimists is that children were forced to endure long hours of work in unhealthy conditions. Although the existence of child labor cannot be denied, it is clear that most pessimists have overstated both its mag nitude and the effects on the health of the children involved. In fact, much of the evidence for the pessimist's case comes from the very famous, yet very inaccurate, reports from the government committees investigating the factory system. Almost all of the' 'condition of Eng land" novels by Dickens, as well as the works of Engels and the Ham monds, have been in large part based on these committee reports (Jef ferson, p. 189). Politically motivated and seriously defective, the evidence in these reports is marred by the fact that the doctors who testified against child labor in the factories had not even been in a factory and refused to testify under oath (Hutt, pp. 161-167). More over, the great improvement in mortality rates seems to indicate that either child labor was not extensive as before or was less harmfuL Indeed, it was the great improvement in productivity instigated by the industrial revolution that has enabled Western societies to banish child labor.

Capitalism and "the spirit of the age. " Perhaps the most common yet most difficult to define charge made against capitalism and the industrial revolution is that the working class was filled with' 'spiri259 THE INDUSTRIAL REVOLUTION 260 THE FREEMAN JULY 1986 Government Intervenes tual" loss. According to this argument, rural farm workers were torn from their roots and thrust into the industrial towns and cities, thus losing sense of their heritage and individualism. However, the very fact that workers moved voluntarily from rural to urban areas once again suggests that the advantages of more material wealth outweighed the "opportunity cost" incurred from the move. Moreover, many friendly societies, workers' societies, and voluntary organizations de veloped during this time, throwing the whole notion of "isolation of the individual" into dispute (Ashton, p. 137). Any sociological costs endured during the industrial revolution must be counterbalanced against the many sociological benefits. For the first time, there was a sense of hope and optimism. The industrial revolution spawned the attitude that progress could be made and prob lems could be solved. Perhaps it is worth quoting Hartwell at length on this point: The new attitude to social problems that emerged with the in dustrial revolution was that ills should be identified, examined, analyzed, publicized, and remedied, either by voluntary or leg islative action. Thus evils that had long existed-child labor, for instance-and had long been accepted as inevitable, were re garded as new ills to be remedied rather than old ills to be endured (Hartwell, 1971, p. 343).

A s the above analysis demonstrates, the industrial revolution resulted in a significant improvement in the quality of life for the working class. However, progress was slow, un even, and sometimes nonexistent during many periods. For example, in the early stages of the revolution growth was minimal, resulting in little or no improvement for the working class (William son, p. 162). Is capitalism to blame for this slow rate of progress? To the contrary, it was the many forms of government intervention, not capitalism, which slowed British economic growth during the indus trial revolution. Perhaps the most important of these many interventions that hin dered progress was the long period of intense war during the early years of the revolution. From 1760 to 1815, Britain was constantly engaged in war, either against France or the American Colonies. In fact, between 1780 and 1810, England was in the midst of a massive military buildup that was unmatched until World War I (Williamson, p. 163). Early commentators were quick to recognize the debilitating effects of this military buildup on the English economy. The historian J .E. Thorold Rogers, for instance, observed that the cost of the Na poleonic Wars was high indeed: Thousands of homes were starved in order to find the means for the great war ... the resources on which the struggle was based, and without which it would have speedily collapsed, were the stint and starvation of labor, the overtaxed and underfed toils of child hood, and the underpayed and uncertain unemployment of men (Rogers, 1891, quoted in Hartwell, 1971, p. 326).

Modern statistical evidence and economic theory lends support to such observations. Government war spending and borrowing in creased interest rates, thus "crowding out" private investors who desperately needed capital to construct new factories, build better canals, and design new inventions. Growth was present during the war, but it was excruciatingly small. In the long run, this meant fewer jobs and lower wages for the working class. But, for the common man, the war had more painful and immediate consequences than slowing the rate of economic growth. Various gov ernment schemes to finance the war debt led to monetary instability and uncertainty. This monetary instability, coupled with severe harvest failures, led to rapidly increasing food prices throughout the Napo leonic Wars (Redford, pp. 89-93). In fact, food prices soared upward by more than twenty-five per cent (Williamson, p. 187). Considering that the British working class then only earned on the average little more than £11 per year, it is no wonder how these developments led to hardships and deprivation that invariably resulted in social unrest.

Although decidedly the most important, war was not the only form of government intervention that decreased the quality of life. Gov ernment monopolies, such as the East India Company and Cutler's Company, served to lessen economic efficiency and growth. The entire area of foreign commerce and trade was forced to contend with mas sive government regulation (Ashton, pp. 138-39). Notwithstanding the popularity of pessimistic interpretations, the evidence of increasing real incomes and improving mortality rates in dicates that significant improvement took place in the standard of living of the working class. These factors and other evidence also sug gest that most qualitative aspects of the quality of life at least remained stable, and probably improved. This progress took place despite con stant warfare and other counterproductive forms of government in tervention that significantly hindered .improvement.

While these immediate effects should not be overlooked, the real benefits of the industrial revolution are enjoyed by those living in to day's world of comparative luxury and splendor. The industrial rev olution was the "great discontinuity" that built the foundations for our modern society (Hartwell, 1971). It has led us into an age without the famines, epidemics, and other disasters that continually plagued preindustrial societies. Perhaps the only way to fully appreciate the impact of the industrial revolution is to look at those in the modern world who have yet to undergo industrialization. The fate of the hun gry and disease-ridden peasants in such areas as Africa and India is perhaps the most forceful and convincing argument in favor of cap italism's industrial revolution. 0 261 Ashton, T.S., The Industrial Revolution 1760 1830 (London: Methuen and Co., 1957). Hartwell, R.M., "Capitalism and the Histori ans," Essays on Hayek (New York: New York University Press, 1976).

Hartwell, R.M., "History and Ideology," Mod ern Age, Vol. 18, No.4, Fall, 1974. Hartwell, R.M., The Industrial Revolution and Economic Growth (London: Methuen and Co., 1971). Hayek, EA., Capitalism and the Historians (London, Routledge and Kegan Paul, 1954). Hutt, W.H., "The Factory System of the Early Nineteenth Century," Capitalism and the His torians EA. Hayek, editor, (London: Rout ledge and Kegan Paul, 1954). Jefferson, J.M., "Industrialization and Pov erty: in Fact and Fiction," The Long Debate on Poverty (London: Institute of Economic Affairs, 1972). McCloskey, Donald, "The Industrial Revolu tion 1780-1860: A Survey," The Economic History of Britain Since 1700 (Cambridge: Cambridge University Press, 1981). North, Douglass, Structure and Change in Eco nomic History (New York: Norton, 1981). The Norton Anthology of English Literature, Vol. 2 (London: Norton and Co., 1979). . Redford, Arthur, The Economic History of En gland (/760-1860) (London: Longmans, Green, and Co., 1931).

Rude, George, Debate on Europe 1815-1850 (New York: Harper and Row, 1972). Williamson, Jeffrey, Did British Capitalism Breed Inequality? (Boston: Allen and Unwin, 1985).

262 TowardFree Banking Movingtoward a fully deregulated financialsystem. by Donald R. Wells and L.S. Scruggs Dr. Wells teaches in the Department of Economics and Dr. Scruggs in the Department of Finance at Memphis State University, Memphis, Tennessee. This article is based on a paper presented to the Southwestern Economics Association in San Antonio, Texas, on March 20, 1986. M ost economists consider money to be a special good that should be controlled by the national government. But advocates of free banking consider money a private good which, as any other good, must meet the market test of acceptability. Let us consider the advantages of free banking, and see how such a system might be implemented in the United States. Under free banking, no government agency would grant a charter to allow a bank to operate. Banks would be free to begin operations as they saw fit, just as other businesses. They could acquire funds from any source: equity, deposits, banknotes, or other liabilities such as debentures; and pay whatever market conditions dictated on these sources. They could then use these funds in the manner most profitable to the bank as long as they avoided deception or fraud. They would hold whatever reserve they wanted-cash, securities or claims on a clearinghouse-wherever they wanted to hold it. Loans and securities would not be subjected to interest controls, nor would investment in any particular industry be mandated or forbidden. If so desired, banks could even acquire equity positions in other firms. The only role for government would be to prosecute fraud and enforce contracts, in cluding settling disputes in court. Banks would not be subjected to government audits or made to pay any special taxes not levied on other businesses.

Money did not originate through some governmental body author izing its use, but rather by the public and the market deciding what was mutually acceptable. Free banks could continue to offer to ex change their recognized and highly tradeable liabilities for the less well known and less marketable liabilities of others. Traditionally, banks have persuaded the public to use banknotes and checkable deposits as money. The right to issue these notes and deposits was never a gov ernment prerogative, but the common right of all (Breckenridge 1895, p. 196). In the quasi-free-banking systems of the past, banknotes and deposits were normally convertible; that is, redeemable on demand in some reserve asset that the bank could not create, such as gold or silver. Central banks entered the picture and eventually monopolized the is suance of currency, leaving deposit creation to commercial banks.

Since currency became an outside money which banks could no longer issue, they could not exchange one liability for another-de posits for banknotes-as the public desired, but instead were forced to use up reserves or borrow from the central bank to placate public demand for currency. The ability to issue their own notes permitted banks to ease public fears about bank runs and to reduce funds tied up in till money, since unissued banknotes were not a liability on the bank's balance sheet, but were instantly available. This was especially helpful to Canadian and Scottish banks in minimizing the cost of op erating branch offices (Breckenridge, p. 387; Beckhart 1929, p. 377; White 1984, p. 40). Banks in an unregulated system would be free to open and close branches wherever they wanted. Branching allows banks to diversify their loans geographically and industrially, since banks would be in a position to acquire loan customers all over the country. An increased need for banking services in a particular area of a nation is met more readily by a new branch of an existing bank than by a new unit bank, which requires new directors and managers. Furthermore, within a given financial center, reserves can be moved among branches of one institution more quickly and cheaply than among institutions.

Branching would not be required, of course, but would face the test of the market. Experience from both Scotland and Canada shows that unit banks found it difficult to compete with larger branch banks and were frequently absorbed by them (Breckenridge, p. 146; White 1984, p. 36). Many specialized thrift institutions, such as savings banks, savings and loan associations, credit unions, and trust companies, originated because commercial banks were legally barred from, or voluntarily eschewed, a particular field of lending. Free banking implies no re strictions on bank lending or investing; hence specialized thrifts would be necessary only for loan categories systematically shunned by banks. U nlike the current arrangement, whereby the central bank controls the ultimate expansion of the money supply through its control of the money base, bank loan expan sion under free banking would be controlled by the ex change of notes and deposits through clearinghouses. Banks that ex panded their lending more rapidly than others would face adverse clearings and would be forced to curtail their lending unless they pos sessed more cash reserves than their rivals. These reserve assets could be deposits in the clearinghouse, gold, silver or some other "outside"

money, such as Federal Reserve Notes (FRNs), which would be frozen in supply as were Greenbacks after the Civil War. If the Federal Re serve (Fed) were abolished, existing FRNs could serve as base money in a free banking system. An individual bank could increase its reserves by a lending policy more restrictive than that of its rivals. The expanding bank would find its notes and deposits presented for redemption in reserve money; the more restrictive bank would gain reserves, as a smaller volume of its liabilities would be presented, by other banks, for payment through the clearinghouse. However, the reserve base in an entirely free banking system could expand only if new reserve money entered from the outside. Since no 263 Limit on Credit Expansion 264 THE FREEMAN JULY 1986 Transitionto a Free Banking System FRNs would ever again be printed, the only avenue open would be an influx of gold or silver from other areas or from mining. But no central bank could expand the money base at will, imparting monetary dis turbances to the economy.

Since no bank would be legally required to maintain any specific reserves, each bank would hold only the amount of the reserve assets indicated by its experience and liquidity preferences. Thus, if all banks in the system were to expand their lending by the same percentage, the check on them would not be adverse clearings, since each would be receiving from every other roughly the same amount of notes and deposits. Instead the expansion would be checked by each bank's de sired holding of reserves plus the public's desired ratio of base money to notes and deposits. If the public trusted banks it would be unlikely to convert notes and deposits to specie or FRNs, but such a conversion would act as a brake on bank expansion. White (1984, p. 44n) found that Scottish banks, during the late 1700s and early 1800s, were able to reduce their average gold reserves fr~m 10 per cent and higher to 3.2 per cent as these banks gained more public confidence. In any case, credit expansion is limited in a free banking system, since the public will hold only a finite amount of any issuer's distinctive notes and deposits. But under our current system, there is no limit to expansion by the central bank, because the supply of its monopoly money will create its own demand, as the public has no choice but to hold whatever amount is created to support a higher level of nominal income and prices (Yeager, p. 42).

T he first step to achieve a free banking system is to remove , all legal obstacles to the production ,Of "outside" base money plus all restrictions on private banking. The legal impedi ments to the production of outside money, according to White (1984a, pp. 297-98), include: (1) a prohibition on the minting of private coins; (2) a sales tax on the purchase of commodity monies'; (3) a capital-gains tax on the holding of non-dollar currencies; and (4) uncertainty regarding the upholding by courts of the payment of a contract in anything but dollars, even when gold is specified. Removal of these barriers would signify that the field is open to any type of innovation that might seem profitable to undertake. Simultaneously, Congress would have to abolish the Fed, freeing the existing supply of FRNs (the Bureau of Engraving can replace worn bills). The Fed would dispose of its assets, after buying back its stock from the member banks. Termination of the Fed could proceed as follows: (1) cease open-market operations and discounting; (2) require the Fed to buy back its stock from member banks by crediting their reserve accounts; (3) send all government securities and gold certifi cates to the Treasury for cancellation; (4) move the Treasury account to the commercial banking system; (5) let foreign central banks move their accounts wherever they wish; (6) phase out the Fed's check-clear ing system, perhaps over one year, as deregulated commercial banks establish branches nationwide and assume the clearing function.

Private Banking. Equally important, however, would be total de regulation of private banking, concurrent with dismantling of the Fed. The immediate steps should be: (1) allow free entry with no charter needed from any governmental agency; (2) grant freedom to branch anywhere; (3) abolish reserve requirements; (4) remove restrictions on the type of assets held; (5) abolish limits on interest rates paid or charged; and (6) allow -banks to issue distinctive banknotes or even fractional token coins. The freedom to enter without charter should reduce the forced dif ference between banks and thrift institutions. The unlimited branching will further erode this distinction as mergers occur between banks and thrifts. In addition, unrestricted branching will expedite the replace ment of Fed check-clearing with private clearing. Unlimited branching will also lead to the end of correspondent relationships among banks and the holding of interbank deposits, a feature peculiar to the unit banking system. When allowed to branch, as in Canada and Scotland, banks hold insignificant amounts of the liabilities of other banks, and are insulated from contagious bank runs.