Read an Excerpt

Captive Audience

YALE UNIVERSITY PRESS

Chapter One

AT THE BEGINNING OF THE TWENTIETH century, Theodore Roosevelt received complaints from all parts of the country about the depredations of the railroad moguls, a problem that had been decades in the making. Beginning in the 1820s, states and local communities had provided extensive direct aid to railway entrepreneurs in the form of land grants, loans, and outright cash donations hoping to attract routes that would serve their citizens and boost economic growth. By the 1860s, states and localities had provided at least half the capital for the early railways. But all this boosterism was unaccompanied by oversight. Many of the railroad operators of the time were actually groups of companies that had combined in order to get access to land grants whose value they hoped to increase by opening a railway. The general sentiment in the country was for states to provide inducements but no regulation that would intrude into the private affairs of firms—carrots but no sticks. The result: rampant fraud and scandals, as railway executives from the 1830s through the 1850s watered their stock, absconded with public funds, built lines that had no chance of financial success, and freely handed out bribes to short-term state and local public officials. State and local aid to privately held railroads in several states came to an abrupt end in the 1860s with the passage of laws and constitutional provisions outlawing the practice.

But the nation still needed railroad lines crossing the country, and no single state could support rail development across sparsely settled western territories. In the 1850s, the idea of a federally funded national railroad was briefly discussed, but the nation's lack of an expert and disinterested civil service that could carry out such a project scuttled the notion. In the end, Congress followed much the same path the states had, authorizing land grants and federal loan guarantees to the Union Pacific and Central Pacific Railroads to build a line between Sacramento and Omaha. The Pacific Railway Act of 1862 hewed to the line the states had established by providing incentives accompanied by little regulatory authority. Just sixteen federal-level administrators were tasked with administering the grants under the act, and ten of these were part-time and unpaid.

Predictably, scandal followed. The Union Pacific bribed federal officials to ensure that the line would receive massively favorable public assistance—twice the original land grants under the act and guaranteed bonds—and the line's directors (including federal employees) paid themselves generously. In what became known as the Crédit Mobilier scandal, government appointees to the board of the organization formed to allocate profits from the Union Pacific transcontinental construction project took bribes during the early 1860s in the form of stock. Other board members enjoyed cash distributions before the line was completed.

All this turmoil gave a bad name to government promotion of private infrastructure investment by way of land grants and loan guarantees. The entire idea of industrial policy became tainted for Americans; the exercise of state power seemed to engender corruption. As the sociologist Frank Dobbin puts it in Forging Industrial Policy, "Americans were certain that their governments had overstepped their bounds in offering aid to railroads, and forswore future government aid to enterprise."

Meanwhile, bolstered by the massive loans and government assistance needed to build new lines, railroad construction grew fivefold between 1860 and 1890. A financial crisis for the railways followed in the 1870s amid the scandalous revelations of fraud and corruption; as much as a third of the trackage in the country at the time was controlled by companies that went bankrupt under their debt burdens. Following these upheavals, the railways went through a period of astonishing consolidation during the 1870s and 1880s, as bankers and bondholders worked to rein in the railroads with "voting trusts" that would run the lines and avoid ruinous competition among systems. By 1905 most of the country's 164,000 railway miles were held by six huge communities of interest—sets of corporations linked by common ownership—allowing entities controlled by J. P. Morgan, Vanderbilt, Harriman-Kuhn-Loeb, Gould, and Rockefeller to wield enormous power. The voting trusts were often groups of Morgan friends who were determined that the railroads be carefully run.

These large regional monopolies flagrantly favored large shippers—manufacturers and middlemen—over small. Farmers were charged exorbitant rates for shipping their agricultural wares, but favored customers like Standard Oil and Andrew Carnegie's steel operations received secret rebates and drawbacks. Drawbacks were particularly alarming to small shippers because they required the railroad to pay a favored customer if the railroad shipped a competitor's products. Small farmers were angry as well at collusion between different regional systems aimed at keeping prices uniform; during the 1860s and 1870s, agreements among systems setting prices and providing shared resources (trains and track) were common. Big shippers routinely paid less for sending goods long distances between major transit hubs than small shippers paid to send their products shorter distances to smaller destinations. As a result of these economic disparities and other factors, independent farmers had a difficult time staying in business at the end of the nineteenth century: millions became tenant farmers or moved to cities as the farmers' share of the country's gross domestic product plummeted from 38 percent in the 1870s to 24 percent in the 1890s.

Irritation mounted among the smaller shippers about the restraints on trade enforced by the giant regional railroad combinations, as well as about the railroads' common practice of giving free tickets to influential people, including officials and newspaper editors, to avoid any suggestions of oversight. Protests erupted; fear of monopolistic and unfair behavior by the railroads grew; legislatures began to work.

The first regulatory response to the regional railroad cartels took place in New England in the 1860s. States set up commissions that could adjudicate disputes between shippers and railroads but could not set prices or punish misbehaving railroads. Massachusetts, for example, passed a law in 1871 making short haul–long haul discrimination illegal and requiring that railroads be subject to an adjudicative procedure before the commission if shippers complained. In the Midwest and the South, the long haul–short haul problem was met with a sterner response: farmer-led "Granger" efforts triggered the establishment of state commissions in the 1870s and 1880s that regulated rates.

But the Granger commissions, as popular as they were, were ineffective. The railroads simply ignored their mandates. Weaker state commissions in the East had little authority to enforce their proclamations; stronger commissions in the Midwest, West, and South had rate-setting ability but no power to carry out structural reforms that would have addressed rate-cutting by carriers in favor of favored customers. Perceiving that these state-level regulatory attempts were not working, small businesses and other interested parties applied mounting pressure in the 1870s and 1880s for a federal solution to the abusive behavior of the railroads. In 1876 federal legislation designed to avoid the domination of transport was introduced, but it failed to pass. So did more than a hundred other railway-constraining efforts debated by Congress during the 1870s and early 1880s. The railroad lawyers—forty thousand strong at the height of their powers—testified before commissions and legislators and used every trick they could find to undermine the effect of any potentially destructive legislation. Railroad lawyers were some of America's first lobbyists, and they argued strenuously that state intervention in the private workings of businesses would be a threat to the American way of life; government power would lead to tyranny and corruption, as the land-grant experience had shown, and was unconstitutional to boot because it would exceed the grant of authority to regulate "commerce." The railroaders maintained that railways were common carriers, not commerce itself.

Despite these arguments, public outrage over the concentrated economic power of the railroads—and the huge companies that controlled them—continued to build. The Supreme Court ruled in the Wabash cases that only the federal government—and not the states—could regulate interstate commerce. This put the state commissions out of business and prompted the first successful concrete reaction by the federal government to the widespread anguish of small farmers and others: the Interstate Commerce Act of 1887. The act created the first regulatory commission in America, the Interstate Commerce Commission (ICC). Officially, the act prohibited the railroads from charging unreasonable rates, discriminating between persons, or charging less for a long haul than for a short one included within it where the two trips operated "under substantially similar circumstances."

But the tension between fear of concentration of power in the trusts and of concentration of power in government was managed by limiting the power of the Interstate Commerce Commission to intervene in the railroads' private affairs. The ICC itself was the product of a long list of compromises. And so the short haul–long haul antidiscrimination provision of the act was weak, the "unreasonable rates" provision said nothing about how to define reasonable, and the Commission would have to resort to courts to enforce its decisions if a railroad refused to comply. The constitutional claims made by the railroads did not prevail, but concerns over the scope of government entanglement curbed the power of the ICC.

Enforcement, as a result, became nearly impossible. Virtually all the ICC's decisions were referred to the courts and the Commission kept losing; between 1887 and 1905 the Supreme Court ruled against the ICC in fifteen of the sixteen rate-setting cases that came before it. In effect, conservative courts were persuaded by lawyers representing the combinations that the language of the new statute gave power to the government to set aside rates that were unreasonable (a negative power) but no affirmative power to fix rates. The power to set rates was special, the Supreme Court found, and not one that Congress should be considered to have granted absent express language saying so. Canny litigation over the meaning of "substantially similar" went on for years; the railroad lawyers convinced judges that their clients faced competition at the distant points of their lines that made the statute inapplicable to short-haul routes. If no long haul could ever be compared to any short-haul route on an apples-to-apples basis, there could never be a successful claim that an operator had unfairly hiked the price for the short-haul section. Conservative judicial interpretation of the Interstate Commerce Act, coupled with a lack of clarity as to the Commission's powers, impeded the efforts of the nation's first regulatory agency. The attempt to regulate railroads by the ICC had collapsed by 1900, but public demands for reform continued.

Enter Theodore Roosevelt. Consolidation by the railway owners (even after the nation slid into the severe depression of 1893) made their operations more efficient, but these benefits were not being passed along in the form of lower prices for farmers and intermediary merchants forced to deal with the single railway operator in their territory. As the Omaha platform adopted by the Populist Party had put it in 1892: "We believe that the time has come when the railroad corporations will either own the people or the people must own the railroads." By the time Roosevelt became president in 1901, farmers had been agitating for twenty years for a regulator and even for public ownership of the railroads. Rapid consolidation had made these pleas sharper.

Roosevelt had no interest in nationalizing the railroads, but he was convinced that the interests of the railways needed to be balanced with those of the public: "The railway," he said in 1901, "is a public servant. Its rates should be just to and open to all shippers alike. The government should see to it that within its jurisdiction this is so and should provide a speedy, inexpensive, and effective remedy to that end." He recognized the benefits the railroads were bringing to America: "At the same time it must not be forgotten that our railways are the arteries through which the commercial life-blood of this Nation flows. Nothing could be more foolish than the enactment of legislation which would unnecessarily interfere with the development of these commercial agencies." Roosevelt's aim was to establish stronger oversight in the form of explicit rate-setting rules that would ensure that railroads served the public interest. And in a series of bills passed between 1903 and 1910, legislative language that appeared to create this power was put into place.

The problem was that enforcing market competition did not, in the end, constrain the power of the railroads. Without a strategic, positive effort by the federal government aimed at addressing the fundamental questions posed by a privately run transportation system—how should service best be extended to all Americans?—the railroad companies were able to evade the weak legislation by overwhelming the agency that was supposed to regulate them and litigating over niceties in its language for years.

And because they were natural monopoly businesses, railroads were not constrained by the operation of antitrust law either. The Sherman Antitrust Act of 1890, passed in response to populist concern about the role of titans in business, outlawed "every contract, combination or conspiracy in restraint of trade" and treated violations as crimes. But the act represented a compromise written in ambiguous language that provided no guidance as to how it should be applied, and it was little used during the first decade of its existence, despite the tremendous wave of mergers that took place at about that time. Collaboration that squashed rivalry was clearly different from cooperation that promoted growth and advantages of scale and scope. Many courts and economists took the view during the early years of the Sherman Act that unconstrained competition might actually endanger industries with high fixed costs and low marginal costs, like railroads and other utilities.

Even when the Roosevelt administration wielded the Sherman Act in attempts to enforce railway competition it had little effect. A referee enforcing the rules of competition is very different from a manager, and it is difficult to imagine a railway that is not a consolidated, collaborating entity. Policing and facilitating the choices made by private natural monopoly entities operating physical infrastructure used for transportation and communications will not address deep-rooted structural shortcomings in the market economy. Besides, because the Sherman Act is and was interpreted one step at a time by courts, large natural monopoly entities aiming to retain their economies of scale and price-setting power could always keep the fight running for another day.

With his enormous red nose and his shy, imperious demeanor, J. P. Morgan effectively ran U.S. economic policy for decades. Lonely, anxious to please his dead father, and possessed of a strong sense that what was good for his bank was good for America, he advised presidents, wrestled down entire industries, and mastered the art of the holding company. He fervently believed in order and found great satisfaction in the rituals of the Episcopal Church. He believed that unfettered competition in industries (such as railroads) characterized by high initial investment costs was destructive and unnecessary, because the industries' attempts to under-price one another so as to grab a greater share of a given regional market would systematically destroy any hope of lower average costs for their fixed-price operations and eventually drive all the competitors out of business.

Morgan knew that his businesses' monopolistic practices caused great public anger. But to him, as to most of the Gilded Age barons, such a response was naive: the railroads, the web that linked America's great cities together, could function only with the substantial support for investment that protection from price wars provided. Without collaboration and organization of transportation resources, the country would remain a preindustrial backwater.

From Morgan's perspective, pure competition was impossible. True competitors would have to cut workers' wages in order to service debt, making their businesses unsustainable. At the same time, giant shippers were forcing the railroads to grant rebates and give preference to their distribution needs. In Morgan's view, the railroads had no choice but to operate under unregulated extralegal arrangements supporting both cooperation and rebates.

Under his strong guidance, the railroad barons formed trusts—corporate forms that allowed one entity to serve as an umbrella for formerly competing companies through an arrangement by which stockholders in several companies transferred their shares to a single set of trustees. The first true trust had been created in the 1870s by John D. Rockefeller's Standard Oil in an effort to combine companies acquired by Standard under the same management. As Standard Oil had done, the railroad trust company trustees—usually a handful of Morgan's cronies—handed stockholders holding company certificates.

(Continues...)

---

Excerpted from Captive Audience by SUSAN CRAWFORD Copyright © 2013 by Susan Crawford. Excerpted by permission of YALE UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---