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History of Food and Drug Regulation in the United States

Marc T. Law, University of Vermont

Throughout history, governments have regulated food and drug products. In general, the focus of this regulation has been on ensuring the quality and safety of food and drugs. Food and drug regulation as we know it today in the United States had its roots in the late nineteenth century when state and local governments began to enact food and drug regulations in earnest. Federal regulation of the industry began on a large scale in the early twentieth century when Congress enacted the Pure Food and Drugs Act of 1906. The regulatory agency spawned by this law – the U.S. Food and Drug Administration (FDA) – now directly regulates between one-fifth and one-quarter of U.S. gross domestic product (GDP) and possesses significant power over product entry, the ways in which food and drugs are marketed to consumers, and the manufacturing practices of food and drug firms. This article will focus on the evolution of food and drug regulation in the United States from the middle of the nineteenth century until the present day.1

General Issues in Food and Drug Regulation

Perhaps the most enduring problem in the food and drug industry has been the issue of “adulteration” – the cheapening of products through the addition of impure or inferior ingredients. Since ancient times, producers of food and drug products have attempted to alter their wares in an effort to obtain dear prices for cheaper goods. For instance, water has often been added to wine, the cream skimmed from milk, and chalk added to bread. Hence, regulations governing what could or could not be added to food and drug products have been very common, as have regulations that require the use of official weights and measures. Because the adulteration of food and drugs may pose both economic and health risks to consumers, the stated public interest motivation for food and drug regulation has generally been to protect consumers from fraudulent and/or unsafe food and drug products.

From an economic perspective, regulations like these may be justified in markets where producers know more about product quality than consumers. As Akerlof (1970) demonstrates, when consumers have less information about product quality than producers, lower quality products (which are generally cheaper to produce) may drive out higher quality products. Asymmetric information about product quality may thus result in lower quality products – the so-called “lemons” – dominating the market. To the extent that regulators are better informed about quality than consumers, regulation that punishes firms that cheat on quality or that requires firms to disclose information about product quality can improve efficiency. Thus, regulations governing what can or cannot be added to products, how products are labeled, and whether certain products can be safely sold to consumers, can be justified in the public interest if consumers do not possess the information to accurately discern these aspects of product quality on their own. Regulations that solve the asymmetric information problem benefit consumers who desire better information about product quality, as well as producers of higher quality products, who desire to segment the market for their wares.

For certain products, it may be relatively easy for consumers to know whether or not they have been deceived into purchasing a low quality product after consuming it. For such goods, sometimes called “experience goods,” market mechanisms like branding or repeat purchase may be adequate to solve the asymmetric information problem. Consumers can “punish” firms that cheat on quality by taking their business elsewhere (Klein and Leffler 1981). Hence, as long as consumers are able to identify whether or not they have been cheated, regulation may not be needed to solve the asymmetric information problem. However, for those products where quality is not easily ascertained by consumers even after consuming the product, market mechanisms are unlikely to be adequate since it is impossible for consumers to punish cheaters if they cannot determine whether or not they have in fact been cheated (Darby and Karni 1973; McCluskey 2000). For such “credence goods,” market mechanisms may therefore be insufficient to ensure that the right level of quality is delivered. Like all goods, food and drugs are multidimensional in terms of product quality. Some dimensions of quality (for instance, flavor or texture) are experience goods because they can be easily determined upon consumption. Other dimensions (for instance, the ingredients contained in certain foods, the caloric content of foods, whether or not an item is “organic,” or the therapeutic merits of medicines) are better characterized as credence goods since it may not be obvious to even a sophisticated consumer whether or not he has been cheated. Hence, there are a priori reasons to believe that market forces will not be adequate to solve the asymmetric information problem that plagues many dimensions of food and drug quality.

Economists have long recognized that regulation is not always enacted to improve efficiency and advance the public interest. Indeed, since Stigler (1971) and Peltzman (1976), it has often been argued that regulation is sought by specific industry groups in order to tilt the competitive playing field to their advantage. For instance, by functioning as an entry barrier, regulation may raise the profits of incumbent firms by precluding the entry of new firms and new products. In these instances of “regulatory capture,” regulation harms efficiency by limiting the extent of competition and innovation in the market. In the context of product quality regulations like those applying to food and drugs, regulation may help incumbent producers by making it more costly for newer products to enter the market. Indeed, regulations that require producers to meet certain minimum standards or that ban the use of certain additives may benefit incumbent producers at the expense of producers of cheaper substitutes. Such regulations may also harm consumers, whose needs may be better met by these new prohibited products. The observation that select producer interests are often among the most vocal proponents of regulation is consistent with this regulatory capture explanation for regulation. Indeed, as we will see, a desire to shift the competitive playing field in favor of the producers of certain products has historically been an important motivation for food and drug regulation.

The fact that producer groups are often among the most important political constituencies in favor of regulation need not, however, imply that regulation necessarily advances the interests of these producers at the expense of efficiency. As noted earlier, to the extent that regulation reduces informational asymmetries about product quality, regulation may benefit producers of higher quality items as well as the consumers of such goods. Indeed, such efficiency-enhancing regulation may be particularly desirable for those producers whose goods are least amenable to market-based solutions to the asymmetric information problem (i.e., credence goods) precisely because it helps these producers expand the market for their wares and increase their profits. Hence, because it is possible for regulation that benefits certain producers to also improve welfare, producer support for regulation should not be taken as prima facie evidence of Stiglerian regulation.

United States’ Experience with Food and Drug Regulation

From colonial times until the mid to late nineteenth century, most food and drug regulation in America was enacted at the state and local level. Additionally, these regulations were generally targeted toward specific food products (Hutt and Hutt 1984). For instance, in 1641 Massachusetts introduced its first food adulteration law, which required the official inspection of beef, pork and fish; this was followed in the 1650s with legislation that regulated the quality of bread. Meanwhile, Virginia in the 1600s enacted laws to regulate weights and measures for corn and to outlaw the sale of adulterated wines.

During the latter half of the nineteenth century, the scale and scope of state level food regulation expanded considerably. Several factors contributed to this growth in legislation. For instance:

  • Specialization and urbanization made households more dependent on food purchased in impersonal markets. While these forces increased the variety of foods available, it also increased uncertainty about quality, since the more specialized and urbanized consumers became, the less they knew about the quality of products purchased from others (Wallis and North 1986).
  • Technological change in food manufacturing gave rise to new products and increased product complexity. The late nineteenth century witnessed the introduction of several new food products including alum-based baking powders, oleomargarine (the first viable substitute for butter), glucose, canned foods, “dressed” (i.e. refrigerated) beef, blended whiskey, chemical preservatives, and so on (Strasser 1989; Young 1989; Goodwin 1999). Unfamiliarity with these new products generated consumer concerns about food safety and food adulteration. Moreover, because many of these new products directly challenged the dominant position enjoyed by more traditional foods, these developments also give rise to demands for regulation on the part of traditional food producers who desired regulation to disadvantage these new competitors (Wood 1986).
  • Related to the previous point, the rise of analytic chemistry facilitated the “cheapening” of food in ways that were difficult for consumers to detect. For instance, the introduction of preservatives made it possible for food manufacturers to mask food deterioration. Additionally, the development of glucose as a cheap alternative to sugar facilitated deception on the part of producers of high priced products like maple syrup. Hence, concerns about adulteration were increasingly felt. Curiously, however, the rise of analytic chemistry also improved the ability of experts to detect these more subtle forms of food adulteration.
  • Because food adulteration became more difficult to detect, market mechanisms that relied on the ability of consumers to detect cheating ex post became less effective in solving the food adulteration problem. Hence, there was a growing perception that regulation by experts was necessary.2

Given this environment, it is perhaps unsurprising that a mixture of incentives gave rise to food regulation in the late nineteenth century. General pure food and dairy laws that required producers to properly label their products to indicate whether mixtures or impurities were added were likely enacted to help reduce asymmetric information about product quality (Law 2003). While producers of “pure” items also played a role in demanding these regulations, consumer groups – specifically women’s groups and leaders of the fledgling home economics movement – were also an important constituency in favor of regulation because they desired better information about food ingredients (Young 1989; Goodwin 1999). In contrast, narrow producer interest motivations seem to have been more important in generating a demand for more specific food regulations. For instance, state and federal oleomargarine restrictions were clearly enacted at the behest of dairy producing interests, who wanted to limit the availability of oleomargarine (Dupré 1999). Additionally, state and federal meat inspection laws were introduced to placate local butchers and local slaughterhouses in eastern markets who desired to reduce the competitive threat posed by the large mid-western meat packers (Yeager 1981; Libecap 1992).

Federal regulation of the food and drug industry was mostly piecemeal until the early 1900s. In 1848, Congress enacted the Drug Importation Act to curb the import of adulterated medicines. The 1886 oleomargarine tax required margarine manufacturers to stamp their product in various ways, imposed an internal revenue tax of 2 cents per pound on all oleomargarine produced in the United States, and levied a fee of $600 per year on oleomargarine producers, $480 per year on oleomargarine wholesalers, and $48 per year on oleomargarine retailers (Lee 1973; Dupré 1999). The 1891 Meat Inspection Act mandated the inspection of all live cattle for export as well as for all live cattle that were to be slaughtered and the meat exported. In 1897 the Tea Importation Act was passed which required Customs inspection of tea imported into the United States. Finally, in 1902 Congress enacted the Biologics Control Act to regulate the safety of vaccinations and serums used to prevent diseases in humans.

The 1906 Pure Food and Drugs Act and the 1906 Meat Inspection Act

The first general pure food and drug law at the federal level was not enacted until 1906 with the passage of the Pure Food and Drugs Act. While interest in federal regulation arose contemporaneously with interest in state regulation, conflict among competing interest groups regarding the provisions of a federal law made it difficult to build an effective political constituency in favor of federal regulation (Anderson 1958; Young 1989; Law and Libecap 2004). The law that emerged from this long legislative battle was similar in character to the state pure food laws that preceded it in that its focus was on accurate product labeling: it outlawed interstate trade in “adulterated” and “misbranded” foods, and required producers to indicate the presence of mixtures and/or impurities on product labels. Unlike earlier state legislation, however, the adulteration and misbranding provisions of this law also applied to drugs. Additionally, drugs listed in the United States Pharmacopoeia (USP) and the National Formulary (NF) were required to conform to USP and NF standards. Congress enacted the Pure Food and Drug Act along with the 1906 Meat Inspection Act, which tightened the USDA’s oversight of meat production. This new meat inspection law mandated ante and post mortem inspection of livestock, established sanitary standards for slaughterhouses and processing plants, and required continuous USDA inspection of meat processing and packaging. While the desire to create more uniform national food regulations was an important underlying motivation for regulation, it is noteworthy that both of these laws were enacted following a flurry of investigative journalism about the quality of meat and patent medicines. Specifically, the publication of Upton Sinclair’s The Jungle, with its vivid description of the conditions of the meat packing industry, as well as a series of articles by Samuel Hopkins Adams published in Collier’s Weekly about the dangers associated with patent medicine use, played a key role in provoking legislators to enact federal regulation of food and drugs (Wood 1986; Young 1989; Carpenter 2001; Law and Libecap 2004).3

Responsibility for enforcing the Pure Food and Drugs Act fell to the Bureau of Chemistry, a division within the USDA, which conducted some of the earliest studies of food adulteration within the United States. The Bureau of Chemistry was renamed the Food, Drug, and Insecticide Administration in 1927. In 1931 the name was shortened to the Food and Drug Administration (FDA). In 1940 the FDA was transferred from the USDA to the Federal Security Agency, which, in 1953, was renamed the Department of Health, Education and Welfare.

Whether the 1906 Pure Food and Drugs Act was enacted to advance special interests or to improve efficiency is a subject of some debate. Kolko (1967), for instance, suggests that the law reflected regulatory capture by large, national food manufacturers, who wanted to use federal legislation to disadvantage smaller, local firms. Coppin and High (1999) argue that rent-seeking on the part of bureaucrats within the government – specifically, Dr. Harvey Wiley, chief of the Bureau of Chemistry – was a critical factor in the emergence of this law. According to Coppin and High, Wiley was a “bureaucratic entrepreneur” who sought to ensure the future of his agency. By building ties with pro-regulation interest groups and lobbying in favor of a federal food and drug law, Wiley secured a lasting policy area for his organization. Law and Libecap (2004) argue that a mixture of bureaucratic, producer and consumer interests were in favor of federal food and drugs regulation, but that the last-minute onset of consumer interest in regulation (provoked by muckraking journalism about food and drug quality) played a key role in influencing the timing of regulation.

Enforcement of the Pure Food and Drugs Act met with mixed success. Indeed, the evidence from the enforcement of this law suggests that neither the pure industry capture nor public interest hypotheses provide an adequate account for regulation. On the one hand, some evidence suggests that the fledgling FDA’s enforcement work helped raise standards and reduce informational asymmetries about food quality. For instance, under the Net Weight Amendment of 1919, food and drug packages shipped in interstate commerce were required to be “plainly and conspicuously marked to show the quantity of contents in terms of weight, measure, and numerical count” (Weber 1928, p. 28). Similarly, under the Seafood Amendment of 1934, Gulf coast shrimp packaged under FDA supervision was required to be stamped with a label stating “Production supervised by the U.S. Food and Drug Administration” as a mechanism for ensuring quality and freshness. Additionally, during this period, investigators from the FDA played a key role in helping manufacturers improve the quality and reliability of processed foods, poultry products, food colorings, and canned items (Robinson 1900; Young 1992; Law 2003). On the other hand, the FDA’s efforts to regulate the patent medicine industry – specifically, to regulate the therapeutic claims that patent medicine firms made about their products – were largely unsuccessful. In U.S. vs. Johnson (1911), the Supreme Court ruled that therapeutic claims were essentially subjective and hence beyond the reach of this law. This situation was partially alleviated by the Sherley Amendment of 1912, which made it possible for the government to prosecute patent medicine producers who intended to defraud consumers. Effective regulation of pharmaceuticals was generally not possible, however, because under this amendment the government needed to prove fraud in order to successfully prosecute a patent medicine firm for making false therapeutic claims about its products (Young 1967). Hence, until new legislation was enacted in 1938, the patent medicine industry continued to escape effective federal control.

The 1938 Food, Drugs and Cosmetics Act

Like the law it replaced (the 1906 Pure Food and Drugs Act), the Food, Drugs and Cosmetics Act of 1938 was enacted following a protracted legislative battle. In the early 1930s, the FDA and its Congressional supporters began to lobby in favor of replacing the Pure Food and Drugs Act with stronger legislation that would give the agency greater authority to regulate the patent medicine industry. These efforts were successfully challenged by the patent medicine industry and its Congressional allies until 1938, when the so-called “Elixir Sulfanilamide tragedy” made it impossible for Congress to continue to ignore demands for tighter regulation. The story behind the Elixir Sulfanilamide tragedy is as follows. In 1937, Massengill, a Tennessee drug company, began to market a liquid sulfa drug called Elixir Sulfanilamide. Unfortunately, the solvent in this drug was a highly toxic variant of antifreeze; as a result, over 100 people died from taking this drug. Public outcry over this tragedy was critical in breaking the Congressional deadlock over tighter regulation (Young 1967; Jackson 1970; Carpenter and Sin 2002).

Under the 1938 law, the FDA was given considerably greater authority over the food and drug industry. The FDA was granted the power to regulate the therapeutic claims drug manufacturers printed on their product labels; authority over drug advertising, however, rested with the Federal Trade Commission (FTC) under the Wheeler-Lea Act of 1938. Additionally, the new law required that drugs be marketed with adequate directions for safe use, and FDA authority was extended to include medical devices and cosmetics. Perhaps the most striking and novel feature of the 1938 law was that it introduced mandatory pre-market approval for new drugs. Under this new law, drug manufacturers were required to demonstrate to the FDA that a new drug was safe before it could be released to the market. This feature of the legislation was clearly a reaction to the Elixir Sulfanilamide incident; food and drug bills introduced in Congress prior to 1938 did not include provisions requiring mandatory pre-market approval of new drugs.

Within a short period of time, the FDA began to deem some drugs to be so dangerous that no adequate directions could be written for direct use by patients. As a consequence, the FDA created a new class of drugs which would only be available with a physician’s prescription. Ambiguity over whether certain medicines – specifically, amphetamines and barbiturates – could be safely marketed directly to consumers or required a physician’s prescription led to disagreements between physicians, pharmacists, drug companies, and the FDA (Temin 1980). The political response to these conflicts was the Humphrey-Durham Amendment in 1951, which permitted a drug to be sold directly to patients “unless, because of its toxicity or other potential for harmful effect or because the method of collateral measures necessary to its use, it may safely be sold and used only under the supervision of a practitioner.”

The most significant expansion in FDA authority over drugs in the post World War II period occurred when Congress enacted the 1962 Drug Amendments (also known as the Kefauver-Harris Amendments) to the Food, Drugs and Cosmetics Act. Like the 1938 law, the 1962 Drug Amendments were passed in response to a therapeutic crisis – in this instance, the discovery that the use of thalidomide (a sedative that was marketed to combat the symptoms associated with morning sickness) by pregnant women caused birth deformities in thousands of babies in Europe.4 As a result of these amendments, drug companies were required to establish that drugs were both safe and effective prior to market release (the 1938 law only required proof of safety) and the FDA was granted greater authority to oversee clinical trials for new drugs. Under the 1962 Drug Amendments, responsibility for regulating prescription drug advertising was transferred from the FTC to the FDA; furthermore, the FDA was given the authority to establish good manufacturing practices in the drug industry and the power to access company records to monitor these practices. As a result of these amendments, the United States today has among the toughest drug approval regimes in the developed world.

A large and growing body of scholarship has been devoted to analyzing the economics and politics of the drug approval process. Early work has focused on the extent to which the FDA’s pre-market approval process has affected the rate of innovation and the availability of new pharmaceuticals.5 Peltzman (1973), among others, argues that 1962 Drug Amendments significantly reduced the flow of new drugs onto the market and imposed large welfare losses on society. These views have been challenged by Temin (1980) who maintains that much of the decline in new drug introductions occurred prior to the 1962 Drug Amendments. More recent work, however, suggests that the FDA’s pre-market approval process has indeed reduced the availability of new medicines (Wiggins 1981). In international comparisons, scholars have also found that new medicines generally become available more quickly in Europe than in America, suggesting that tighter regulation in the U.S. has induced a drug-lag (Wardell and Lasagna 1975; Grabowsky and Vernon 1983; Kaitin and Brown 1995). Some critics believe that the costs of this drug lag are large relative to the benefits because delay in the introduction of new drugs prevents patients from accessing new and more effective medicines. Gieringer (1985), for instance, estimates that the number of deaths that can be attributed to the drug lag far exceeds the number of lives saved by extra caution on the part of the FDA. Hence, according to these authors, the 1962 Drug Amendments may have had adverse consequences for overall welfare.

Other scholarship has examined the pattern of drug approval times in the post 1962 period. It is commonly observed that larger pharmaceutical firms receive faster drug approvals than smaller firms. One interpretation of this fact is that larger firms have “captured” the drug approval process and use the process to disadvantage their smaller competitors. Empirical work by Olson (1997) and Carpenter (2002), however, casts some doubt on this Stiglerian interpretation.6 These authors find that while larger firms do generally receive quicker drug approvals, drug approval times are also responsive to several other factors, including the specific disease at which a drug is directed, the number of applications submitted by the drug company, and the existence of a disease-specific interest group. Indeed, in other work, Carpenter (2004a) demonstrates that a regulator that seeks to maximize its reputation for protecting consumer safety may approve new drugs in ways that appear to benefit large firms.7 Hence, the fact that large pharmaceutical firms obtain faster drug approvals than small firms need not imply that the FDA has been “captured” by these corporations.

Food and Drug Regulation since the 1960s

Since the passage of the 1962 Drug Amendments, federal food and drug regulation in the United States has evolved along several lines. In some cases, regulation has strengthened the government’s authority over various aspects of the food and drug trade. For instance, the 1976 Medical Device Amendments required medical device manufacturers to register with the FDA and to follow quality control guideline. These amendments also established pre-market approval guidelines for medical devices. Along similar lines, the 1990 Nutrition Labeling and Education Act required all packaged foods to contain standardized nutritional information and standardized information on serving sizes.8

In other cases, regulations have been enacted to streamline the pre-market approval process for new drugs. Concerns that mandatory pre-market approval of new drugs may have reduced the rate at which new pharmaceuticals become available to consumers prompted the FDA to issue new rules in 1991 to accelerate the review of drugs for life-threatening diseases. Similar concerns also motivated Congress to enact the Prescription Drug User Fee Act of 1992 which required drug manufacturers to pay fees to the FDA to review drug approval applications and required the FDA to use these fees to pay for more reviewers to assess these new drug applications.9 Speedier drug approval times have not, however, come without costs. Evidence presented by Olson (2002) suggests that faster drug approval times have also contributed to a higher incidence of adverse drug reactions from new pharmaceuticals.

Finally, in a few instances, legislation has weakened government’s authority over food and drug products. For example, the 1976 Vitamins and Minerals Amendments precluded the FDA from establishing standards that limited the potency of vitamins and minerals added to foods. Similarly, the 1994 Dietary Supplements and Nutritional Labeling Act weakened the FDA’s ability to regulate dietary supplements by classifying them as foods rather than drugs. In these cases, the consumers and producers of “natural” or “herbal” remedies played a key role in pushing Congress to limit the FDA’s authority.

References

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Carpenter, Daniel P. “Groups, the Media, Agency Waiting Costs, and FDA Drug Approval.” American Journal of Political Science 46, no. 2 (2002):490-505

Carpenter, Daniel P. “Protection without Capture: Drug Approval by a Political Responsive, Bayesian Regulator.” American Political Science Review, (2004a), Forthcoming.

Carpenter, Daniel P. “The Political Economy of FDA Drug Review: Processing, Politics, and Lessons for Policy.” Health Affairs 23, no. 1 (2004b):52-63.

Carpenter, Daniel P. and Gisela Sin. “Crisis and the Emergence of Economic Regulation: The Food, Drug and Cosmetics Act of 1938.” University of Michigan, Department of Political Science, unpublished manuscript, 2002.

Comanor, William S. “The Political Economy of the Pharmaceutical Industry.” Journal of Economic Literature 24, no. 3 (1986): 1178-1217.

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1 See Hutt and Hutt (1984) for an excellent survey of the history of food regulation in earlier times. French and Phillips (2000) discuss the development of food regulation in the United Kingdom.

2 This rationale for regulation was articulated by a member of the 49th Congress (1885):

In ordinary cases the consumer may be left to his own intelligence to protect himself against impositions. By the exercise of a reasonable degree of caution, he can protect himself from frauds in under-weight and in under-measure. If he can not detect a paper-soled shoe on inspection he detects it in the wearing of it, and in one way or another he can impose a penalty upon the fraudulent vendor. As a general rule the doctrine of laissez faire can be applied. Not so with many of the adulterations of food. Scientific inspection is needed to detect the fraud, and scientific inspection is beyond the reach of the ordinary consumer. In such cases, the Government should intervene (Congressional Record, 49th Congress, 1st Session, pp. 5040-41).

3 It is noteworthy that in writing The Jungle, Sinclair’s motivation was not to obtain federal meat inspection legislation, but rather, to provoke public outrage over industrial working conditions. “I aimed at the public’s heart,” he later wrote, “and by accident I hit it in the stomach.” (Quoted in Kolko 1967, p. 103.)

4 Thalidomide was not approved for sale in the U.S. The fact that an FDA official – Dr. Frances Kelsey, an FDA drug examiner – played a key role in blocking its availability in the United States gave even more legitimacy to the view that the FDA’s authority over pharmaceuticals needed to be strengthened. See Temin (1980, pp. 123-24). Ironically, Dr. Kelsey’s efforts to block the introduction of thalidomide in the United States stemmed not from knowledge about the fact that thalidomide caused birth defects, but rather, from concerns that thalidomide might cause neuropathy (a disease of the nervous system) in some of its users. Indeed, the association between thalidomide and birth defects was discovered by researchers in Europe, not by drug investigators at the FDA. Hence, the FDA may not in fact have deserved the credit it was given in preventing the thalidomide tragedy from spreading to the U.S. (Harris 1992).

5 See Comanor (1986) for a summary of this literature.

6 Along these lines, Olson (1995, 1996a, 1996b) also finds that other aspects of the FDA’s enforcement work from the 1970s until the present are generally responsive to pressures from multiple interest groups including firms, consumer groups, the media, and Congress.

7 For a very readable discussion of this perspective see Carpenter (2004b).

8 See Mathios (2000) and Ippolito and Pappalardo (2002) for analyses of the effects of this law on food consumption choices.

9 See Olson (2000) for analysis of the effects of these user fees on approval times.

Citation: Law, Marc. “History of Food and Drug Regulation in the United States”. EH.Net Encyclopedia, edited by Robert Whaples. October 11, 2004. URL http://eh.net/encyclopedia/history-of-food-and-drug-regulation-in-the-united-states/

History of Workplace Safety in the United States, 1880-1970

Mark Aldrich, Smith College

The dangers of work are usually measured by the number of injuries or fatalities occurring to a group of workers, usually over a period of one year. 1 Over the past century such measures reveal a striking improvement in the safety of work in all the advanced countries. In part this has been the result of the gradual shift of jobs from relatively dangerous goods production such as farming, fishing, logging, mining, and manufacturing into such comparatively safe work as retail trade and services. But even the dangerous trades are now far safer than they were in 1900. To take but one example, mining today remains a comparatively risky activity. Its annual fatality rate is about nine for every one hundred thousand miners employed. A century ago in 1900 about three hundred out of every one hundred thousand miners were killed on the job each year. 2

The Nineteenth Century

Before the late nineteenth century we know little about the safety of American workplaces because contemporaries cared little about it. As a result, only fragmentary information exists prior to the 1880s. Pre-industrial laborers faced risks from animals and hand tools, ladders and stairs. Industrialization substituted steam engines for animals, machines for hand tools, and elevators for ladders. But whether these new technologies generally worsened the dangers of work is unclear. What is clear is that nowhere was the new work associated with the industrial revolution more dangerous than in America.

US Was Unusually Dangerous

Americans modified the path of industrialization that had been pioneered in Britain to fit the particular geographic and economic circumstances of the American continent. Reflecting the high wages and vast natural resources of a new continent, this American system encouraged use of labor saving machines and processes. These developments occurred within a legal and regulatory climate that diminished employer’s interest in safety. As a result, Americans developed production methods that were both highly productive and often very dangerous. 3

Accidents Were “Cheap”

While workers injured on the job or their heirs might sue employers for damages, winning proved difficult. Where employers could show that the worker had assumed the risk, or had been injured by the actions of a fellow employee, or had himself been partly at fault, courts would usually deny liability. A number or surveys taken about 1900 showed that only about half of all workers fatally injured recovered anything and their average compensation only amounted to about half a year’s pay. Because accidents were so cheap, American industrial methods developed with little reference to their safety. 4

Mining

Nowhere was the American system more dangerous than in early mining. In Britain, coal seams were deep and coal expensive. As a result, British mines used mining methods that recovered nearly all of the coal because they used waste rock to hold up the roof. British methods also concentrated the working, making supervision easy, and required little blasting. American coal deposits by contrast, were both vast and near the surface; they could be tapped cheaply using techniques known as “room and pillar” mining. Such methods used coal pillars and timber to hold up the roof, because timber and coal were cheap. Since miners worked in separate rooms, labor supervision was difficult and much blasting was required to bring down the coal. Miners themselves were by no means blameless; most were paid by the ton, and when safety interfered with production, safety often took a back seat. For such reasons, American methods yielded more coal per worker than did European techniques, but they were far more dangerous, and toward the end of the nineteenth century, the dangers worsened (see Table 1).5

Table 1
British and American Mine Safety, 1890 -1904
(Fatality rates per Thousand Workers per Year)

Years American Anthracite American Bituminous Great Britain
1890-1894 3.29 2.52 1.61
1900-1904 3.13 3.53 1.28

Source: British data from Great Britain, General Report. Other data from Aldrich, Safety First.

Railroads

Nineteenth century American railroads were also comparatively dangerous to their workers – and their passengers as well – and for similar reasons. Vast North American distances and low population density turned American carriers into predominantly freight haulers – and freight was far more dangerous to workers than passenger traffic, for men had to go in between moving cars for coupling and uncoupling and ride the cars to work brakes. The thin traffic and high wages also forced American carriers to economize on both capital and labor. Accordingly, American carriers were poorly built and used few signals, both of which resulted in many derailments and collisions. Such conditions made American railroad work far more dangerous than that in Britain (see Table 2).6

Table 2
Comparative Safety of British and American Railroad Workers, 1889 – 1901
(Fatality Rates per Thousand Workers per Year)

1889 1895 1901
British railroad workers
All causes
1.14 0.95 0.89
British trainmena
All causes
4.26 3.22 2.21
Coupling 0.94 0.83 0.74
American Railroad workers
All causes
2.67 2.31 2.50
American trainmen
All causes
8.52 6.45 7.35
Coupling 1.73c 1.20 0.78
Brakingb 3.25c 2.44 2.03

Source: Aldrich, Safety First, Table 1 and Great Britain Board of Trade, General Report.

1

Note: Death rates are per thousand employees.
a. Guards, brakemen, and shunters.
b. Deaths from falls from cars and striking overhead obstructions.

Manufacturing

American manufacturing also developed in a distinctively American fashion that substituted power and machinery for labor and manufactured products with interchangeable arts for ease in mass production. Whether American methods were less safe than those in Europe is unclear but by 1900 they were extraordinarily risky by modern standards, for machines and power sources were largely unguarded. And while competition encouraged factory managers to strive for ever-increased output, they showed little interest in improving safety.7

Worker and Employer Responses

Workers and firms responded to these dangers in a number of ways. Some workers simply left jobs they felt were too dangerous, and risky jobs may have had to offer higher pay to attract workers. After the Civil War life and accident insurance companies expanded, and some workers purchased insurance or set aside savings to offset the income risks from death or injury. Some unions and fraternal organizations also offered their members insurance. Railroads and some mines also developed hospital and insurance plans to care for injured workers while many carriers provided jobs for all their injured men. 8

Improving safety, 1910-1939

Public efforts to improve safety date from the very beginnings of industrialization. States established railroad regulatory commissions as early as the 1840s. But while most of the commissions were intended to improve safety, they had few powers and were rarely able to exert much influence on working conditions. Similarly, the first state mining commission began in Pennsylvania in 1869, and other states soon followed. Yet most of the early commissions were ineffectual and as noted safety actually deteriorated after the Civil War. Factory commissions also dated from but most were understaffed and they too had little power.9

Railroads

The most successful effort to improve work safety during the nineteenth century began on the railroads in the 1880s as a small band of railroad regulators, workers, and managers began to campaign for the development of better brakes and couplers for freight cars. In response George Westinghouse modified his passenger train air brake in about 1887 so it would work on long freights, while at roughly the same time Ely Janney developed an automatic car coupler. For the railroads such equipment meant not only better safety, but also higher productivity and after 1888 they began to deploy it. The process was given a boost in 1889-1890 when the newly-formed Interstate Commerce Commission (ICC) published its first accident statistics. They demonstrated conclusively the extraordinary risks to trainmen from coupling and riding freight (Table 2). In 1893 Congress responded, passing the Safety Appliance Act, which mandated use of such equipment. It was the first federal law intended primarily to improve work safety, and by 1900 when the new equipment was widely diffused, risks to trainmen had fallen dramatically.10

Federal Safety Regulation

In the years between 1900 and World War I, a rather strange band of Progressive reformers, muckraking journalists, businessmen, and labor unions pressed for changes in many areas of American life. These years saw the founding of the Federal Food and Drug Administration, the Federal Reserve System and much else. Work safety also became of increased public concern and the first important developments came once again on the railroads. Unions representing trainmen had been impressed by the safety appliance act of 1893 and after 1900 they campaigned for more of the same. In response Congress passed a host of regulations governing the safety of locomotives and freight cars. While most of these specific regulations were probably modestly beneficial, collectively their impact was small because unlike the rules governing automatic couplers and air brakes they addressed rather minor risks.11

In 1910 Congress also established the Bureau of Mines in response to a series of disastrous and increasingly frequent explosions. The Bureau was to be a scientific, not a regulatory body and it was intended to discover and disseminate new knowledge on ways to improve mine safety.12

Workers’ Compensation Laws Enacted

Far more important were new laws that raised the cost of accidents to employers. In 1908 Congress passed a federal employers’ liability law that applied to railroad workers in interstate commerce and sharply limited defenses an employer could claim. Worker fatalities that had once cost the railroads perhaps $200 now cost $2,000. Two years later in 1910, New York became the first state to pass a workmen’s compensation law. This was a European idea. Instead of requiring injured workers to sue for damages in court and prove the employer was negligent, the new law automatically compensated all injuries at a fixed rate. Compensation appealed to businesses because it made costs more predictable and reduced labor strife. To reformers and unions it promised greater and more certain benefits. Samuel Gompers, leader of the American Federation of Labor had studied the effects of compensation in Germany. He was impressed with how it stimulated business interest in safety, he said. Between 1911 and 1921 forty-four states passed compensation laws.13

Employers Become Interested in Safety

The sharp rise in accident costs that resulted from compensation laws and tighter employers’ liability initiated the modern concern with work safety and initiated the long-term decline in work accidents and injuries. Large firms in railroading, mining, manufacturing and elsewhere suddenly became interested in safety. Companies began to guard machines and power sources while machinery makers developed safer designs. Managers began to look for hidden dangers at work, and to require that workers wear hard hats and safety glasses. They also set up safety departments run by engineers and safety committees that included both workers and managers. In 1913 companies founded the National Safety Council to pool information. Government agencies such as the Bureau of Mines and National Bureau of Standards provided scientific support while universities also researched safety problems for firms and industries14

Accident Rates Begin to Fall Steadily

During the years between World War I and World War II the combination of higher accident costs along with the institutionalization of safety concerns in large firms began to show results. Railroad employee fatality rates declined steadily after 1910 and at some large companies such as DuPont and whole industries such as steel making (see Table 3) safety also improved dramatically. Largely independent changes in technology and labor markets also contributed to safety as well. The decline in labor turnover meant fewer new employees who were relatively likely to get hurt, while the spread of factory electrification not only improved lighting but reduced the dangers from power transmission as well. In coal mining the shift from underground work to strip mining also improved safety. Collectively these long-term forces reduced manufacturing injury rates about 38 percent between 1926 and 1939 (see Table 4).15

Table 3
Steel Industry fatality and Injury rates, 1910-1939
(Rates are per million manhours)

Period Fatality rate Injury Rate
1910-1913 0.40 44.1
1937-1939 0.13 11.7

Pattern of Improvement Was Uneven

Yet the pattern of improvement was uneven, both over time and among firms and industries. Safety still deteriorated in times of economic boon when factories mines and railroads were worked to the limit and labor turnover rose. Nor were small companies as successful in reducing risks, for they paid essentially the same compensation insurance premium irrespective of their accident rate, and so the new laws had little effect there. Underground coal mining accidents also showed only modest improvement. Safety was also expensive in coal and many firms were small and saw little payoff from a lower accident rate. The one source of danger that did decline was mine explosions, which diminished in response to technologies developed by the Bureau of Mines. Ironically, however, in 1940 six disastrous blasts that killed 276 men finally led to federal mine inspection in 1941.16

Table 4
Work Injury Rates, Manufacturing and Coal Mining, 1926-1970
(Per Million Manhours)

.

Year Manufacturing Coal Mining
1926 24.2
1931 18.9 89.9
1939 14.9 69.5
1945 18.6 60.7
1950 14.7 53.3
1960 12.0 43.4
1970 15.2 42.6

Source: U.S. Department of Commerce Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970 (Washington, 1975), Series D-1029 and D-1031.

Postwar Trends, 1945-1970

The economic boon and associated labor turnover during World War II worsened work safety in nearly all areas of the economy, but after 1945 accidents again declined as long-term forces reasserted themselves (Table 4). In addition, after World War II newly powerful labor unions played an increasingly important role in work safety. In the 1960s however economic expansion again led to rising injury rates and the resulting political pressures led Congress to establish the Occupational Safety and Health Administration (OSHA) and the Mine Safety and Health Administration in 1970. The continuing problem of mine explosions also led to the foundation of the Mine Safety and Health Administration (MSHA) that same year. The work of these agencies had been controversial but on balance they have contributed to the continuing reductions in work injuries after 1970.17

References and Further Reading

Aldrich, Mark. Safety First: Technology, Labor and Business in the Building of Work Safety, 1870-1939. Baltimore: Johns Hopkins University Press, 1997.

Aldrich, Mark. “Preventing ‘The Needless Peril of the Coal Mine’: the Bureau of Mines and the Campaign Against Coal Mine Explosions, 1910-1940.” Technology and Culture 36, no. 3 (1995): 483-518.

Aldrich, Mark. “The Peril of the Broken Rail: the Carriers, the Steel Companies, and Rail Technology, 1900-1945.” Technology and Culture 40, no. 2 (1999): 263-291

Aldrich, Mark. “Train Wrecks to Typhoid Fever: The Development of Railroad Medicine Organizations, 1850 -World War I.” Bulletin of the History of Medicine, 75, no. 2 (Summer 2001): 254-89.

Derickson Alan. “Participative Regulation of Hazardous Working Conditions: Safety Committees of the United Mine Workers of America,” Labor Studies Journal 18, no. 2 (1993): 25-38.

Dix, Keith. Work Relations in the Coal Industry: The Hand Loading Era. Morgantown: University of West Virginia Press, 1977. The best discussion of coalmine work for this period.

Dix, Keith. What’s a Coal Miner to Do? Pittsburgh: University of Pittsburgh Press, 1988. The best discussion of coal mine labor during the era of mechanization.

Fairris, David. “From Exit to Voice in Shopfloor Governance: The Case of Company Unions.” Business History Review 69, no. 4 (1995): 494-529.

Fairris, David. “Institutional Change in Shopfloor Governance and the Trajectory of Postwar Injury Rates in U.S. Manufacturing, 1946-1970.” Industrial and Labor Relations Review 51, no. 2 (1998): 187-203.

Fishback, Price. Soft Coal Hard Choices: The Economic Welfare of Bituminous Coal Miners, 1890-1930. New York: Oxford University Press, 1992. The best economic analysis of the labor market for coalmine workers.

Fishback, Price and Shawn Kantor. A Prelude to the Welfare State: The Origins of Workers’ Compensation. Chicago: University of Chicago Press, 2000. The best discussions of how employers’ liability rules worked.

Graebner, William. Coal Mining Safety in the Progressive Period. Lexington: University of Kentucky Press, 1976.

Great Britain Board of Trade. General Report upon the Accidents that Have Occurred on Railways of the United Kingdom during the Year 1901. London, HMSO, 1902.

Great Britain Home Office Chief Inspector of Mines. General Report with Statistics for 1914, Part I. London: HMSO, 1915.

Hounshell, David. From the American System to Mass Production, 1800-1932: The Development of Manufacturing Technology in the United States. Baltimore: Johns Hopkins University Press, 1984.

Humphrey, H. B. “Historical Summary of Coal-Mine Explosions in the United States — 1810-1958.” United States Bureau of Mines Bulletin 586 (1960).

Kirkland, Edward. Men, Cities, and Transportation. 2 vols. Cambridge: Harvard University Press, 1948, Discusses railroad regulation and safety in New England.

Lankton, Larry. Cradle to Grave: Life, Work, and Death in Michigan Copper Mines. New York: Oxford University Press, 1991.

Licht, Walter. Working for the Railroad. Princeton: Princeton University Press, 1983.

Long, Priscilla. Where the Sun Never Shines. New York: Paragon, 1989. Covers coal mine safety at the end of the nineteenth century.

Mendeloff, John. Regulating Safety: An Economic and Political Analysis of Occupational Safety and Health Policy. Cambridge: MIT Press, 1979. An accessible modern discussion of safety under OSHA.

National Academy of Sciences. Toward Safer Underground Coal Mines. Washington, DC: NAS, 1982.

Rogers, Donald. “From Common Law to Factory Laws: The Transformation of Workplace Safety Law in Wisconsin before Progressivism.” American Journal of Legal History (1995): 177-213.

Root, Norman and Daley, Judy. “Are Women Safer Workers? A New Look at the Data.” Monthly Labor Review 103, no. 9 (1980): 3-10.

Rosenberg, Nathan. Technology and American Economic Growth. New York: Harper and Row, 1972. Analyzes the forces shaping American technology.

Rosner, David and Gerald Markowity, editors. Dying for Work. Blomington: Indiana University Press, 1987.

Shaw, Robert. Down Brakes: A History of Railroad Accidents, Safety Precautions, and Operating Practices in the United States of America. London: P. R. Macmillan. 1961.

Trachenberg, Alexander. The History of Legislation for the Protection of Coal Miners in Pennsylvania, 1824 – 1915. New York: International Publishers. 1942.

U.S. Department of Commerce, Bureau of the Census. Historical Statistics of the United States, Colonial Times to 1970. Washington, DC, 1975.

Usselman, Steven. “Air Brakes for Freight Trains: Technological Innovation in the American Railroad Industry, 1869-1900.” Business History Review 58 (1984): 30-50.

Viscusi, W. Kip. Risk By Choice: Regulating Health and Safety in the Workplace. Cambridge: Harvard University Press, 1983. The most readable treatment of modern safety issues by a leading scholar.

Wallace, Anthony. Saint Clair. New York: Alfred A. Knopf, 1987. Provides a superb discussion of early anthracite mining and safety.

Whaples, Robert and David Buffum. “Fraternalism, Paternalism, the Family and the Market: Insurance a Century Ago.” Social Science History 15 (1991): 97-122.

White, John. The American Railroad Freight Car. Baltimore: Johns Hopkins University Press, 1993. The definitive history of freight car technology.

Whiteside, James. Regulating Danger: The Struggle for Mine Safety in the Rocky Mountain Coal Industry. Lincoln: University of Nebraska Press, 1990.

Wokutch, Richard. Worker Protection Japanese Style: Occupational Safety and Health in the Auto Industry. Ithaca, NY: ILR, 1992

Worrall, John, editor. Safety and the Work Force: Incentives and Disincentives in Workers’ Compensation. Ithaca, NY: ILR Press, 1983.

1 Injuries or fatalities are expressed as rates. For example, if ten workers are injured out of 450 workers during a year, the rate would be .006666. For readability it might be expressed as 6.67 per thousand or 666.7 per hundred thousand workers. Rates may also be expressed per million workhours. Thus if the average work year is 2000 hours, ten injuries in 450 workers results in [10/450×2000]x1,000,000 = 11.1 injuries per million hours worked.

2 For statistics on work injuries from 1922-1970 see U.S. Department of Commerce, Historical Statistics, Series 1029-1036. For earlier data are in Aldrich, Safety First, Appendix 1-3.

3 Hounshell, American System. Rosenberg, Technology,. Aldrich, Safety First.

4 On the workings of the employers’ liability system see Fishback and Kantor, A Prelude, chapter 2

5 Dix, Work Relations, and his What’s a Coal Miner to Do? Wallace, Saint Clair, is a superb discussion of early anthracite mining and safety. Long, Where the Sun, Fishback, Soft Coal, chapters 1, 2, and 7. Humphrey, “Historical Summary.” Aldrich, Safety First, chapter 2.

6 Aldrich, Safety First chapter 1.

7 Aldrich, Safety First chapter 3

8 Fishback and Kantor, A Prelude, chapter 3, discusses higher pay for risky jobs as well as worker savings and accident insurance See also Whaples and Buffum, “Fraternalism, Paternalism.” Aldrich, ” Train Wrecks to Typhoid Fever.”

9Kirkland, Men, Cities. Trachenberg, The History of Legislation Whiteside, Regulating Danger. An early discussion of factory legislation is in Susan Kingsbury, ed.,xxxxx. Rogers,” From Common Law.”

10 On the evolution of freight car technology see White, American Railroad Freight Car, Usselman “Air Brakes for Freight trains,” and Aldrich, Safety First, chapter 1. Shaw, Down Brakes, discusses causes of train accidents.

11 Details of these regulations may be found in Aldrich, Safety First, chapter 5.

12 Graebner, Coal-Mining Safety, Aldrich, “‘The Needless Peril.”

13 On the origins of these laws see Fishback and Kantor, A Prelude, and the sources cited therein.

14 For assessments of the impact of early compensation laws see Aldrich, Safety First, chapter 5 and Fishback and Kantor, A Prelude, chapter 3. Compensation in the modern economy is discussed in Worrall, Safety and the Work Force. Government and other scientific work that promoted safety on railroads and in coal mining are discussed in Aldrich, “‘The Needless Peril’,” and “The Broken Rail.”

15 Farris, “From Exit to Voice.”

16 Aldrich, “‘Needless Peril,” and Humphrey

17 Derickson, “Participative Regulation” and Fairris, “Institutional Change,” also emphasize the role of union and shop floor issues in shaping safety during these years. Much of the modern literature on safety is highly quantitative. For readable discussions see Mendeloff, Regulating Safety (Cambridge: MIT Press, 1979), and Viscusi, Risk by Choice

History of Workplace Safety in the United States, 1880-1970

Mark Aldrich, Smith College

The dangers of work are usually measured by the number of injuries or fatalities occurring to a group of workers, usually over a period of one year. 1 Over the past century such measures reveal a striking improvement in the safety of work in all the advanced countries. In part this has been the result of the gradual shift of jobs from relatively dangerous goods production such as farming, fishing, logging, mining, and manufacturing into such comparatively safe work as retail trade and services. But even the dangerous trades are now far safer than they were in 1900. To take but one example, mining today remains a comparatively risky activity. Its annual fatality rate is about nine for every one hundred thousand miners employed. A century ago in 1900 about three hundred out of every one hundred thousand miners were killed on the job each year. 2

The Nineteenth Century

Before the late nineteenth century we know little about the safety of American workplaces because contemporaries cared little about it. As a result, only fragmentary information exists prior to the 1880s. Pre-industrial laborers faced risks from animals and hand tools, ladders and stairs. Industrialization substituted steam engines for animals, machines for hand tools, and elevators for ladders. But whether these new technologies generally worsened the dangers of work is unclear. What is clear is that nowhere was the new work associated with the industrial revolution more dangerous than in America.

US Was Unusually Dangerous

Americans modified the path of industrialization that had been pioneered in Britain to fit the particular geographic and economic circumstances of the American continent. Reflecting the high wages and vast natural resources of a new continent, this American system encouraged use of labor saving machines and processes. These developments occurred within a legal and regulatory climate that diminished employer’s interest in safety. As a result, Americans developed production methods that were both highly productive and often very dangerous. 3

Accidents Were “Cheap”

While workers injured on the job or their heirs might sue employers for damages, winning proved difficult. Where employers could show that the worker had assumed the risk, or had been injured by the actions of a fellow employee, or had himself been partly at fault, courts would usually deny liability. A number or surveys taken about 1900 showed that only about half of all workers fatally injured recovered anything and their average compensation only amounted to about half a year’s pay. Because accidents were so cheap, American industrial methods developed with little reference to their safety. 4

Mining

Nowhere was the American system more dangerous than in early mining. In Britain, coal seams were deep and coal expensive. As a result, British mines used mining methods that recovered nearly all of the coal because they used waste rock to hold up the roof. British methods also concentrated the working, making supervision easy, and required little blasting. American coal deposits by contrast, were both vast and near the surface; they could be tapped cheaply using techniques known as “room and pillar” mining. Such methods used coal pillars and timber to hold up the roof, because timber and coal were cheap. Since miners worked in separate rooms, labor supervision was difficult and much blasting was required to bring down the coal. Miners themselves were by no means blameless; most were paid by the ton, and when safety interfered with production, safety often took a back seat. For such reasons, American methods yielded more coal per worker than did European techniques, but they were far more dangerous, and toward the end of the nineteenth century, the dangers worsened (see Table 1).5

Table 1
British and American Mine Safety, 1890 -1904
(Fatality rates per Thousand Workers per Year)

Years American Anthracite American Bituminous Great Britain
1890-1894 3.29 2.52 1.61
1900-1904 3.13 3.53 1.28

Source: British data from Great Britain, General Report. Other data from Aldrich, Safety First.

Railroads

Nineteenth century American railroads were also comparatively dangerous to their workers – and their passengers as well – and for similar reasons. Vast North American distances and low population density turned American carriers into predominantly freight haulers – and freight was far more dangerous to workers than passenger traffic, for men had to go in between moving cars for coupling and uncoupling and ride the cars to work brakes. The thin traffic and high wages also forced American carriers to economize on both capital and labor. Accordingly, American carriers were poorly built and used few signals, both of which resulted in many derailments and collisions. Such conditions made American railroad work far more dangerous than that in Britain (see Table 2).6

Table 2
Comparative Safety of British and American Railroad Workers, 1889 – 1901
(Fatality Rates per Thousand Workers per Year)

1889 1895 1901
British railroad workers
All causes
1.14 0.95 0.89
British trainmena
All causes
4.26 3.22 2.21
Coupling 0.94 0.83 0.74
American Railroad workers
All causes
2.67 2.31 2.50
American trainmen
All causes
8.52 6.45 7.35
Coupling 1.73c 1.20 0.78
Brakingb 3.25c 2.44 2.03

Source: Aldrich, Safety First, Table 1 and Great Britain Board of Trade, General Report.

1

Note: Death rates are per thousand employees.
a. Guards, brakemen, and shunters.
b. Deaths from falls from cars and striking overhead obstructions.

Manufacturing

American manufacturing also developed in a distinctively American fashion that substituted power and machinery for labor and manufactured products with interchangeable arts for ease in mass production. Whether American methods were less safe than those in Europe is unclear but by 1900 they were extraordinarily risky by modern standards, for machines and power sources were largely unguarded. And while competition encouraged factory managers to strive for ever-increased output, they showed little interest in improving safety.7

Worker and Employer Responses

Workers and firms responded to these dangers in a number of ways. Some workers simply left jobs they felt were too dangerous, and risky jobs may have had to offer higher pay to attract workers. After the Civil War life and accident insurance companies expanded, and some workers purchased insurance or set aside savings to offset the income risks from death or injury. Some unions and fraternal organizations also offered their members insurance. Railroads and some mines also developed hospital and insurance plans to care for injured workers while many carriers provided jobs for all their injured men. 8

Improving safety, 1910-1939

Public efforts to improve safety date from the very beginnings of industrialization. States established railroad regulatory commissions as early as the 1840s. But while most of the commissions were intended to improve safety, they had few powers and were rarely able to exert much influence on working conditions. Similarly, the first state mining commission began in Pennsylvania in 1869, and other states soon followed. Yet most of the early commissions were ineffectual and as noted safety actually deteriorated after the Civil War. Factory commissions also dated from but most were understaffed and they too had little power.9

Railroads

The most successful effort to improve work safety during the nineteenth century began on the railroads in the 1880s as a small band of railroad regulators, workers, and managers began to campaign for the development of better brakes and couplers for freight cars. In response George Westinghouse modified his passenger train air brake in about 1887 so it would work on long freights, while at roughly the same time Ely Janney developed an automatic car coupler. For the railroads such equipment meant not only better safety, but also higher productivity and after 1888 they began to deploy it. The process was given a boost in 1889-1890 when the newly-formed Interstate Commerce Commission (ICC) published its first accident statistics. They demonstrated conclusively the extraordinary risks to trainmen from coupling and riding freight (Table 2). In 1893 Congress responded, passing the Safety Appliance Act, which mandated use of such equipment. It was the first federal law intended primarily to improve work safety, and by 1900 when the new equipment was widely diffused, risks to trainmen had fallen dramatically.10

Federal Safety Regulation

In the years between 1900 and World War I, a rather strange band of Progressive reformers, muckraking journalists, businessmen, and labor unions pressed for changes in many areas of American life. These years saw the founding of the Federal Food and Drug Administration, the Federal Reserve System and much else. Work safety also became of increased public concern and the first important developments came once again on the railroads. Unions representing trainmen had been impressed by the safety appliance act of 1893 and after 1900 they campaigned for more of the same. In response Congress passed a host of regulations governing the safety of locomotives and freight cars. While most of these specific regulations were probably modestly beneficial, collectively their impact was small because unlike the rules governing automatic couplers and air brakes they addressed rather minor risks.11

In 1910 Congress also established the Bureau of Mines in response to a series of disastrous and increasingly frequent explosions. The Bureau was to be a scientific, not a regulatory body and it was intended to discover and disseminate new knowledge on ways to improve mine safety.12

Workers’ Compensation Laws Enacted

Far more important were new laws that raised the cost of accidents to employers. In 1908 Congress passed a federal employers’ liability law that applied to railroad workers in interstate commerce and sharply limited defenses an employee could claim. Worker fatalities that had once cost the railroads perhaps $200 now cost $2,000. Two years later in 1910, New York became the first state to pass a workmen’s compensation law. This was a European idea. Instead of requiring injured workers to sue for damages in court and prove the employer was negligent, the new law automatically compensated all injuries at a fixed rate. Compensation appealed to businesses because it made costs more predictable and reduced labor strife. To reformers and unions it promised greater and more certain benefits. Samuel Gompers, leader of the American Federation of Labor had studied the effects of compensation in Germany. He was impressed with how it stimulated business interest in safety, he said. Between 1911 and 1921 forty-four states passed compensation laws.13

Employers Become Interested in Safety

The sharp rise in accident costs that resulted from compensation laws and tighter employers’ liability initiated the modern concern with work safety and initiated the long-term decline in work accidents and injuries. Large firms in railroading, mining, manufacturing and elsewhere suddenly became interested in safety. Companies began to guard machines and power sources while machinery makers developed safer designs. Managers began to look for hidden dangers at work, and to require that workers wear hard hats and safety glasses. They also set up safety departments run by engineers and safety committees that included both workers and managers. In 1913 companies founded the National Safety Council to pool information. Government agencies such as the Bureau of Mines and National Bureau of Standards provided scientific support while universities also researched safety problems for firms and industries14

Accident Rates Begin to Fall Steadily

During the years between World War I and World War II the combination of higher accident costs along with the institutionalization of safety concerns in large firms began to show results. Railroad employee fatality rates declined steadily after 1910 and at some large companies such as DuPont and whole industries such as steel making (see Table 3) safety also improved dramatically. Largely independent changes in technology and labor markets also contributed to safety as well. The decline in labor turnover meant fewer new employees who were relatively likely to get hurt, while the spread of factory electrification not only improved lighting but reduced the dangers from power transmission as well. In coal mining the shift from underground work to strip mining also improved safety. Collectively these long-term forces reduced manufacturing injury rates about 38 percent between 1926 and 1939 (see Table 4).15

Table 3
Steel Industry fatality and Injury rates, 1910-1939
(Rates are per million manhours)

Period Fatality rate Injury Rate
1910-1913 0.40 44.1
1937-1939 0.13 11.7

Pattern of Improvement Was Uneven

Yet the pattern of improvement was uneven, both over time and among firms and industries. Safety still deteriorated in times of economic boon when factories mines and railroads were worked to the limit and labor turnover rose. Nor were small companies as successful in reducing risks, for they paid essentially the same compensation insurance premium irrespective of their accident rate, and so the new laws had little effect there. Underground coal mining accidents also showed only modest improvement. Safety was also expensive in coal and many firms were small and saw little payoff from a lower accident rate. The one source of danger that did decline was mine explosions, which diminished in response to technologies developed by the Bureau of Mines. Ironically, however, in 1940 six disastrous blasts that killed 276 men finally led to federal mine inspection in 1941.16

Table 4
Work Injury Rates, Manufacturing and Coal Mining, 1926-1970
(Per Million Manhours)

.

Year Manufacturing Coal Mining
1926 24.2
1931 18.9 89.9
1939 14.9 69.5
1945 18.6 60.7
1950 14.7 53.3
1960 12.0 43.4
1970 15.2 42.6

Source: U.S. Department of Commerce Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970 (Washington, 1975), Series D-1029 and D-1031.

Postwar Trends, 1945-1970

The economic boon and associated labor turnover during World War II worsened work safety in nearly all areas of the economy, but after 1945 accidents again declined as long-term forces reasserted themselves (Table 4). In addition, after World War II newly powerful labor unions played an increasingly important role in work safety. In the 1960s however economic expansion again led to rising injury rates and the resulting political pressures led Congress to establish the Occupational Safety and Health Administration (OSHA) and the Mine Safety and Health Administration in 1970. The continuing problem of mine explosions also led to the foundation of the Mine Safety and Health Administration (MSHA) that same year. The work of these agencies had been controversial but on balance they have contributed to the continuing reductions in work injuries after 1970.17

References and Further Reading

Aldrich, Mark. Safety First: Technology, Labor and Business in the Building of Work Safety, 1870-1939. Baltimore: Johns Hopkins University Press, 1997.

Aldrich, Mark. “Preventing ‘The Needless Peril of the Coal Mine’: the Bureau of Mines and the Campaign Against Coal Mine Explosions, 1910-1940.” Technology and Culture 36, no. 3 (1995): 483-518.

Aldrich, Mark. “The Peril of the Broken Rail: the Carriers, the Steel Companies, and Rail Technology, 1900-1945.” Technology and Culture 40, no. 2 (1999): 263-291

Aldrich, Mark. “Train Wrecks to Typhoid Fever: The Development of Railroad Medicine Organizations, 1850 -World War I.” Bulletin of the History of Medicine, 75, no. 2 (Summer 2001): 254-89.

Derickson Alan. “Participative Regulation of Hazardous Working Conditions: Safety Committees of the United Mine Workers of America,” Labor Studies Journal 18, no. 2 (1993): 25-38.

Dix, Keith. Work Relations in the Coal Industry: The Hand Loading Era. Morgantown: University of West Virginia Press, 1977. The best discussion of coalmine work for this period.

Dix, Keith. What’s a Coal Miner to Do? Pittsburgh: University of Pittsburgh Press, 1988. The best discussion of coal mine labor during the era of mechanization.

Fairris, David. “From Exit to Voice in Shopfloor Governance: The Case of Company Unions.” Business History Review 69, no. 4 (1995): 494-529.

Fairris, David. “Institutional Change in Shopfloor Governance and the Trajectory of Postwar Injury Rates in U.S. Manufacturing, 1946-1970.” Industrial and Labor Relations Review 51, no. 2 (1998): 187-203.

Fishback, Price. Soft Coal Hard Choices: The Economic Welfare of Bituminous Coal Miners, 1890-1930. New York: Oxford University Press, 1992. The best economic analysis of the labor market for coalmine workers.

Fishback, Price and Shawn Kantor. A Prelude to the Welfare State: The Origins of Workers’ Compensation. Chicago: University of Chicago Press, 2000. The best discussions of how employers’ liability rules worked.

Graebner, William. Coal Mining Safety in the Progressive Period. Lexington: University of Kentucky Press, 1976.

Great Britain Board of Trade. General Report upon the Accidents that Have Occurred on Railways of the United Kingdom during the Year 1901. London, HMSO, 1902.

Great Britain Home Office Chief Inspector of Mines. General Report with Statistics for 1914, Part I. London: HMSO, 1915.

Hounshell, David. From the American System to Mass Production, 1800-1932: The Development of Manufacturing Technology in the United States. Baltimore: Johns Hopkins University Press, 1984.

Humphrey, H. B. “Historical Summary of Coal-Mine Explosions in the United States — 1810-1958.” United States Bureau of Mines Bulletin 586 (1960).

Kirkland, Edward. Men, Cities, and Transportation. 2 vols. Cambridge: Harvard University Press, 1948, Discusses railroad regulation and safety in New England.

Lankton, Larry. Cradle to Grave: Life, Work, and Death in Michigan Copper Mines. New York: Oxford University Press, 1991.

Licht, Walter. Working for the Railroad. Princeton: Princeton University Press, 1983.

Long, Priscilla. Where the Sun Never Shines. New York: Paragon, 1989. Covers coal mine safety at the end of the nineteenth century.

Mendeloff, John. Regulating Safety: An Economic and Political Analysis of Occupational Safety and Health Policy. Cambridge: MIT Press, 1979. An accessible modern discussion of safety under OSHA.

National Academy of Sciences. Toward Safer Underground Coal Mines. Washington, DC: NAS, 1982.

Rogers, Donald. “From Common Law to Factory Laws: The Transformation of Workplace Safety Law in Wisconsin before Progressivism.” American Journal of Legal History (1995): 177-213.

Root, Norman and Daley, Judy. “Are Women Safer Workers? A New Look at the Data.” Monthly Labor Review 103, no. 9 (1980): 3-10.

Rosenberg, Nathan. Technology and American Economic Growth. New York: Harper and Row, 1972. Analyzes the forces shaping American technology.

Rosner, David and Gerald Markowity, editors. Dying for Work. Blomington: Indiana University Press, 1987.

Shaw, Robert. Down Brakes: A History of Railroad Accidents, Safety Precautions, and Operating Practices in the United States of America. London: P. R. Macmillan. 1961.

Trachenberg, Alexander. The History of Legislation for the Protection of Coal Miners in Pennsylvania, 1824 – 1915. New York: International Publishers. 1942.

U.S. Department of Commerce, Bureau of the Census. Historical Statistics of the United States, Colonial Times to 1970. Washington, DC, 1975.

Usselman, Steven. “Air Brakes for Freight Trains: Technological Innovation in the American Railroad Industry, 1869-1900.” Business History Review 58 (1984): 30-50.

Viscusi, W. Kip. Risk By Choice: Regulating Health and Safety in the Workplace. Cambridge: Harvard University Press, 1983. The most readable treatment of modern safety issues by a leading scholar.

Wallace, Anthony. Saint Clair. New York: Alfred A. Knopf, 1987. Provides a superb discussion of early anthracite mining and safety.

Whaples, Robert and David Buffum. “Fraternalism, Paternalism, the Family and the Market: Insurance a Century Ago.” Social Science History 15 (1991): 97-122.

White, John. The American Railroad Freight Car. Baltimore: Johns Hopkins University Press, 1993. The definitive history of freight car technology.

Whiteside, James. Regulating Danger: The Struggle for Mine Safety in the Rocky Mountain Coal Industry. Lincoln: University of Nebraska Press, 1990.

Wokutch, Richard. Worker Protection Japanese Style: Occupational Safety and Health in the Auto Industry. Ithaca, NY: ILR, 1992

Worrall, John, editor. Safety and the Work Force: Incentives and Disincentives in Workers’ Compensation. Ithaca, NY: ILR Press, 1983.

1 Injuries or fatalities are expressed as rates. For example, if ten workers are injured out of 450 workers during a year, the rate would be .006666. For readability it might be expressed as 6.67 per thousand or 666.7 per hundred thousand workers. Rates may also be expressed per million workhours. Thus if the average work year is 2000 hours, ten injuries in 450 workers results in [10/450×2000]x1,000,000 = 11.1 injuries per million hours worked.

2 For statistics on work injuries from 1922-1970 see U.S. Department of Commerce, Historical Statistics, Series 1029-1036. For earlier data are in Aldrich, Safety First, Appendix 1-3.

3 Hounshell, American System. Rosenberg, Technology,. Aldrich, Safety First.

4 On the workings of the employers’ liability system see Fishback and Kantor, A Prelude, chapter 2

5 Dix, Work Relations, and his What’s a Coal Miner to Do? Wallace, Saint Clair, is a superb discussion of early anthracite mining and safety. Long, Where the Sun, Fishback, Soft Coal, chapters 1, 2, and 7. Humphrey, “Historical Summary.” Aldrich, Safety First, chapter 2.

6 Aldrich, Safety First chapter 1.

7 Aldrich, Safety First chapter 3

8 Fishback and Kantor, A Prelude, chapter 3, discusses higher pay for risky jobs as well as worker savings and accident insurance See also Whaples and Buffum, “Fraternalism, Paternalism.” Aldrich, ” Train Wrecks to Typhoid Fever.”

9Kirkland, Men, Cities. Trachenberg, The History of Legislation Whiteside, Regulating Danger. An early discussion of factory legislation is in Susan Kingsbury, ed.,xxxxx. Rogers,” From Common Law.”

10 On the evolution of freight car technology see White, American Railroad Freight Car, Usselman “Air Brakes for Freight trains,” and Aldrich, Safety First, chapter 1. Shaw, Down Brakes, discusses causes of train accidents.

11 Details of these regulations may be found in Aldrich, Safety First, chapter 5.

12 Graebner, Coal-Mining Safety, Aldrich, “‘The Needless Peril.”

13 On the origins of these laws see Fishback and Kantor, A Prelude, and the sources cited therein.

14 For assessments of the impact of early compensation laws see Aldrich, Safety First, chapter 5 and Fishback and Kantor, A Prelude, chapter 3. Compensation in the modern economy is discussed in Worrall, Safety and the Work Force. Government and other scientific work that promoted safety on railroads and in coal mining are discussed in Aldrich, “‘The Needless Peril’,” and “The Broken Rail.”

15 Farris, “From Exit to Voice.”

16 Aldrich, “‘Needless Peril,” and Humphrey

17 Derickson, “Participative Regulation” and Fairris, “Institutional Change,” also emphasize the role of union and shop floor issues in shaping safety during these years. Much of the modern literature on safety is highly quantitative. For readable discussions see Mendeloff, Regulating Safety (Cambridge: MIT Press, 1979), and

Citation: Aldrich, Mark. “History of Workplace Safety in the United States, 1880-1970”. EH.Net Encyclopedia, edited by Robert Whaples. August 14, 2001. URL http://eh.net/encyclopedia/history-of-workplace-safety-in-the-united-states-1880-1970/

A History of Futures Trading in the United States

Joseph Santos, South Dakota State University

Many contemporary [nineteenth century] critics were suspicious of a form of business in which one man sold what he did not own to another who did not want it… Morton Rothstein (1966)

Anatomy of a Futures Market

The Futures Contract

A futures contract is a standardized agreement between a buyer and a seller to exchange an amount and grade of an item at a specific price and future date. The item or underlying asset may be an agricultural commodity, a metal, mineral or energy commodity, a financial instrument or a foreign currency. Because futures contracts are derived from these underlying assets, they belong to a family of financial instruments called derivatives.

Traders buy and sell futures contracts on an exchange – a marketplace that is operated by a voluntary association of members. The exchange provides buyers and sellers the infrastructure (trading pits or their electronic equivalent), legal framework (trading rules, arbitration mechanisms), contract specifications (grades, standards, time and method of delivery, terms of payment) and clearing mechanisms (see section titled The Clearinghouse) necessary to facilitate futures trading. Only exchange members are allowed to trade on the exchange. Nonmembers trade through commission merchants – exchange members who service nonmember trades and accounts for a fee.

The September 2004 light sweet crude oil contract is an example of a petroleum (mineral) future. It trades on the New York Mercantile exchange (NYM). The contract is standardized – every one is an agreement to trade 1,000 barrels of grade light sweet crude in September, on a day of the seller’s choosing. As of May 25, 2004 the contract sold for $40,120=$40.12x1000 and debits Member S’s margin account the same amount.

The Clearinghouse

The clearinghouse is the counterparty to every trade – its members buy every contract that traders sell on the exchange and sell every contract that traders buy on the exchange. Absent a clearinghouse, traders would interact directly, and this would introduce two problems. First, traders. concerns about their counterparty’s credibility would impede trading. For example, Trader A might refuse to sell to Trader B, who is supposedly untrustworthy.

Second, traders would lose track of their counterparties. This would occur because traders typically settle their contractual obligations by offset – traders buy/sell the contracts that they sold/bought earlier. For example, Trader A sells a contract to Trader B, who sells a contract to Trader C to offset her position, and so on.

The clearinghouse eliminates both of these problems. First, it is a guarantor of all trades. If a trader defaults on a futures contract, the clearinghouse absorbs the loss. Second, clearinghouse members, and not outside traders, reconcile offsets at the end of trading each day. Margin accounts and a process called marking-to-market all but assure the clearinghouse’s solvency.

A margin account is a balance that a trader maintains with a commission merchant in order to offset the trader’s daily unrealized loses in the futures markets. Commission merchants also maintain margins with clearinghouse members, who maintain them with the clearinghouse. The margin account begins as an initial lump sum deposit, or original margin.

To understand the mechanics and merits of marking-to-market, consider that the values of the long and short positions of an existing futures contract change daily, even though futures trading is a zero-sum game – a buyer’s gain/loss equals a seller’s loss/gain. So, the clearinghouse breaks even on every trade, while its individual members. positions change in value daily.

With this in mind, suppose Trader B buys a 5,000 bushel soybean contract for $9.70 from Trader S. Technically, Trader B buys the contract from Clearinghouse Member S and Trader S sells the contract to Clearinghouse Member B. Now, suppose that at the end of the day the contract is priced at $9.71. That evening the clearinghouse marks-to-market each member’s account. That is to say, the clearinghouse credits Member B’s margin account $50 and debits Member S’s margin account the same amount.

Member B is now in a position to draw on the clearinghouse $50, while Member S must pay the clearinghouse a $50 variation margin – incremental margin equal to the difference between a contract’s price and its current market value. In turn, clearinghouse members debit and credit accordingly the margin accounts of their commission merchants, who do the same to the margin accounts of their clients (i.e., traders). This iterative process all but assures the clearinghouse a sound financial footing. In the unlikely event that a trader defaults, the clearinghouse closes out the position and loses, at most, the trader’s one day loss.

Active Futures Markets

Futures exchanges create futures contracts. And, because futures exchanges compete for traders, they must create contracts that appeal to the financial community. For example, the New York Mercantile Exchange created its light sweet crude oil contract in order to fill an unexploited niche in the financial marketplace.

Not all contracts are successful and those that are may, at times, be inactive – the contract exists, but traders are not trading it. For example, of all contracts introduced by U.S. exchanges between 1960 and 1977, only 32% traded in 1980 (Stein 1986, 7). Consequently, entire exchanges can become active – e.g., the New York Futures Exchange opened in 1980 – or inactive – e.g., the New Orleans Exchange closed in 1983 (Leuthold 1989, 18). Government price supports or other such regulation can also render trading inactive (see Carlton 1984, 245).

Futures contracts succeed or fail for many reasons, but successful contracts do share certain basic characteristics (see for example, Baer and Saxon 1949, 110-25; Hieronymus 1977, 19-22). To wit, the underlying asset is homogeneous, reasonably durable, and standardized (easily describable); its supply and demand is ample, its price is unfettered, and all relevant information is available to all traders. For example, futures contracts have never derived from, say, artwork (heterogeneous and not standardized) or rent-controlled housing rights (supply, and hence price is fettered by regulation).

Purposes and Functions

Futures markets have three fundamental purposes. The first is to enable hedgers to shift price risk – asset price volatility – to speculators in return for basis risk – changes in the difference between a futures price and the cash, or current spot price of the underlying asset. Because basis risk is typically less than asset price risk, the financial community views hedging as a form of risk management and speculating as a form of risk taking.

Generally speaking, to hedge is to take opposing positions in the futures and cash markets. Hedgers include (but are not restricted to) farmers, feedlot operators, grain elevator operators, merchants, millers, utilities, export and import firms, refiners, lenders, and hedge fund managers (see Peck 1985, 13-21). Meanwhile, to speculate is to take a position in the futures market with no counter-position in the cash market. Speculators may not be affiliated with the underlying cash markets.

To demonstrate how a hedge works, assume Hedger A buys, or longs, 5,000 bushels of corn, which is currently worth $2.40 per bushel, or $12,000=$2.40×5000; the date is May 1st and Hedger A wishes to preserve the value of his corn inventory until he sells it on June 1st. To do so, he takes a position in the futures market that is exactly opposite his position in the spot – current cash – market. For example, Hedger A sells, or shorts, a July futures contract for 5,000 bushels of corn at a price of $2.50 per bushel; put differently, Hedger A commits to sell in July 5,000 bushels of corn for $12,500=$2.50×5000. Recall that to sell (buy) a futures contract means to commit to sell (buy) an amount and grade of an item at a specific price and future date.

Absent basis risk, Hedger A’s spot and futures markets positions will preserve the value of the 5,000 bushels of corn that he owns, because a fall in the spot price of corn will be matched penny for penny by a fall in the futures price of corn. For example, suppose that by June 1st the spot price of corn has fallen five cents to $2.35 per bushel. Absent basis risk, the July futures price of corn has also fallen five cents to $2.45 per bushel.

So, on June 1st, Hedger A sells his 5,000 bushels of corn and loses $250=($2.35-$2.40)x5000 in the spot market. At the same time, he buys a July futures contract for 5,000 bushels of corn and gains $250=($2.50-$2.45)x5000 in the futures market. Notice, because Hedger A has both sold and bought a July futures contract for 5,000 bushels of corn, he has offset his commitment in the futures market.

This example of a textbook hedge – one that eliminates price risk entirely – is instructive but it is also a bit misleading because: basis risk exists; hedgers may choose to hedge more or less than 100% of their cash positions; and hedgers may cross hedge – trade futures contracts whose underlying assets are not the same as the assets that the hedger owns. So, in reality hedgers cannot immunize entirely their cash positions from market fluctuations and in some cases they may not wish to do so. Again, the purpose of a hedge is not to avoid risk, but rather to manage or even profit from it.

The second fundamental purpose of a futures market is to facilitate firms’ acquisitions of operating capital – short term loans that finance firms’ purchases of intermediate goods such as inventories of grain or petroleum. For example, lenders are relatively more likely to finance, at or near prime lending rates, hedged (versus non-hedged) inventories. The futures contact is an efficient form of collateral because it costs only a fraction of the inventory’s value, or the margin on a short position in the futures market.

Speculators make the hedge possible because they absorb the inventory’s price risk; for example, the ultimate counterparty to the inventory dealer’s short position is a speculator. In the absence of futures markets, hedgers could only engage in forward contracts – unique agreements between private parties, who operate independently of an exchange or clearinghouse. Hence, the collateral value of a forward contract is less than that of a futures contract.3

The third fundamental purpose of a futures market is to provide information to decision makers regarding the market’s expectations of future economic events. So long as a futures market is efficient – the market forms expectations by taking into proper consideration all available information – its forecasts of future economic events are relatively more reliable than an individual’s. Forecast errors are expensive, and well informed, highly competitive, profit-seeking traders have a relatively greater incentive to minimize them.

The Evolution of Futures Trading in the U.S.

Early Nineteenth Century Grain Production and Marketing

Into the early nineteenth century, the vast majority of American grains – wheat, corn, barley, rye and oats – were produced throughout the hinterlands of the United States by producers who acted primarily as subsistence farmers – agricultural producers whose primary objective was to feed themselves and their families. Although many of these farmers sold their surplus production on the market, most lacked access to large markets, as well as the incentive, affordable labor supply, and myriad technologies necessary to practice commercial agriculture – the large scale production and marketing of surplus agricultural commodities.

At this time, the principal trade route to the Atlantic seaboard was by river through New Orleans4; though the South was also home to terminal markets – markets of final destination – for corn, provisions and flour. Smaller local grain markets existed along the tributaries of the Ohio and Mississippi Rivers and east-west overland routes. The latter were used primarily to transport manufactured (high valued and nonperishable) goods west.

Most farmers, and particularly those in the East North Central States – the region consisting today of Illinois, Indiana, Michigan, Ohio and Wisconsin – could not ship bulk grains to market profitably (Clark 1966, 4, 15).5 Instead, most converted grains into relatively high value flour, livestock, provisions and whiskies or malt liquors and shipped them south or, in the case of livestock, drove them east (14).6 Oats traded locally, if at all; their low value-to-weight ratios made their shipment, in bulk or otherwise, prohibitive (15n).

The Great Lakes provided a natural water route east to Buffalo but, in order to ship grain this way, producers in the interior East North Central region needed local ports to receive their production. Although the Erie Canal connected Lake Erie to the port of New York by 1825, water routes that connected local interior ports throughout northern Ohio to the Canal were not operational prior to the mid-1830s. Indeed, initially the Erie aided the development of the Old Northwest, not because it facilitated eastward grain shipments, but rather because it allowed immigrants and manufactured goods easy access to the West (Clark 1966, 53).

By 1835 the mouths of rivers and streams throughout the East North Central States had become the hubs, or port cities, from which farmers shipped grain east via the Erie. By this time, shippers could also opt to go south on the Ohio River and then upriver to Pittsburgh and ultimately to Philadelphia, or north on the Ohio Canal to Cleveland, Buffalo and ultimately, via the Welland Canal, to Lake Ontario and Montreal (19).

By 1836 shippers carried more grain north on the Great Lakes and through Buffalo, than south on the Mississippi through New Orleans (Odle 1964, 441). Though, as late as 1840 Ohio was the only state/region who participated significantly in the Great Lakes trade. Illinois, Indiana, Michigan, and the region of modern day Wisconsin either produced for their respective local markets or relied upon Southern demand. As of 1837 only 4,107 residents populated the “village” of Chicago, which became an official city in that year (Hieronymus 1977, 72).7

Antebellum Grain Trade Finance in the Old Northwest

Before the mid-1860s, a network of banks, grain dealers, merchants, millers and commission houses – buying and selling agents located in the central commodity markets – employed an acceptance system to finance the U.S. grain trade (see Clark 1966, 119; Odle 1964, 442). For example, a miller who required grain would instruct an agent in, say, New York to establish, on the miller’s behalf, a line of credit with a merchant there. The merchant extended this line of credit in the form of sight drafts, which the merchant made payable, in sixty or ninety days, up to the amount of the line of credit.

With this credit line established, commission agents in the hinterland would arrange with grain dealers to acquire the necessary grain. The commission agent would obtain warehouse receipts – dealer certified negotiable titles to specific lots and quantities of grain in store – from dealers, attach these to drafts that he drew on the merchant’s line of credit, and discount these drafts at his local bank in return for banknotes; the local bank would forward these drafts on to the New York merchant’s bank for redemption. The commission agents would use these banknotes to advance – lend – grain dealers roughly three quarters of the current market value of the grain. The commission agent would pay dealers the remainder (minus finance and commission fees) when the grain was finally sold in the East. That is, commission agents and grain dealers entered into consignment contracts.

Unfortunately, this approach linked banks, grain dealers, merchants, millers and commission agents such that the “entire procedure was attended by considerable risk and speculation, which was assumed by both the consignee and consignor” (Clark 1966, 120). The system was reasonably adequate if grain prices went unchanged between the time the miller procured the credit and the time the grain (bulk or converted) was sold in the East, but this was rarely the case. The fundamental problem with this system of finance was that commission agents were effectively asking banks to lend them money to purchase as yet unsold grain. To be sure, this inadequacy was most apparent during financial panics, when many banks refused to discount these drafts (Odle 1964, 447).

Grain Trade Finance in Transition: Forward Contracts and Commodity Exchanges

In 1848 the Illinois-Michigan Canal connected the Illinois River to Lake Michigan. The canal enabled farmers in the hinterlands along the Illinois River to ship their produce to merchants located along the river. These merchants accumulated, stored and then shipped grain to Chicago, Milwaukee and Racine. At first, shippers tagged deliverables according to producer and region, while purchasers inspected and chose these tagged bundles upon delivery. Commercial activity at the three grain ports grew throughout the 1850s. Chicago emerged as a dominant grain (primarily corn) hub later that decade (Pierce 1957, 66).8

Amidst this growth of Lake Michigan commerce, a confluence of innovations transformed the grain trade and its method of finance. By the 1840s, grain elevators and railroads facilitated high volume grain storage and shipment, respectively. Consequently, country merchants and their Chicago counterparts required greater financing in order to store and ship this higher volume of grain.9 And, high volume grain storage and shipment required that inventoried grains be fungible – of such a nature that one part or quantity could be replaced by another equal part or quantity in the satisfaction of an obligation. For example, because a bushel of grade No. 2 Spring Wheat was fungible, its price did not depend on whether it came from Farmer A, Farmer B, Grain Elevator C, or Train Car D.

Merchants could secure these larger loans more easily and at relatively lower rates if they obtained firm price and quantity commitments from their buyers. So, merchants began to engage in forward (not futures) contracts. According to Hieronymus (1977), the first such “time contract” on record was made on March 13, 1851. It specified that 3,000 bushels of corn were to be delivered to Chicago in June at a price of one cent below the March 13th cash market price (74).10

Meanwhile, commodity exchanges serviced the trade’s need for fungible grain. In the 1840s and 1850s these exchanges emerged as associations for dealing with local issues such as harbor infrastructure and commercial arbitration (e.g., Detroit in 1847, Buffalo, Cleveland and Chicago in 1848 and Milwaukee in 1849) (see Odle 1964). By the 1850s they established a system of staple grades, standards and inspections, all of which rendered inventory grain fungible (Baer and Saxon 1949, 10; Chandler 1977, 211). As collection points for grain, cotton, and provisions, they weighed, inspected and classified commodity shipments that passed from west to east. They also facilitated organized trading in spot and forward markets (Chandler 1977, 211; Odle 1964, 439).11

The largest and most prominent of these exchanges was the Board of Trade of the City of Chicago, a grain and provisions exchange established in 1848 by a State of Illinois corporate charter (Boyle 1920, 38; Lurie 1979, 27); the exchange is known today as the Chicago Board of Trade (CBT). For at least its first decade, the CBT functioned as a meeting place for merchants to resolve contract disputes and discuss commercial matters of mutual concern. Participation was part-time at best. The Board’s first directorate of 25 members included “a druggist, a bookseller, a tanner, a grocer, a coal dealer, a hardware merchant, and a banker” and attendance was often encouraged by free lunches (Lurie 1979, 25).

However, in 1859 the CBT became a state- (of Illinois) chartered private association. As such, the exchange requested and received from the Illinois legislature sanction to establish rules “for the management of their business and the mode in which it shall be transacted, as they may think proper;” to arbitrate over and settle disputes with the authority as “if it were a judgment rendered in the Circuit Court;” and to inspect, weigh and certify grain and grain trades such that these certifications would be binding upon all CBT members (Lurie 1979, 27).

Nineteenth Century Futures Trading

By the 1850s traders sold and resold forward contracts prior to actual delivery (Hieronymus 1977, 75). A trader could not offset, in the futures market sense of the term, a forward contact. Nonetheless, the existence of a secondary market – market for extant, as opposed to newly issued securities – in forward contracts suggests, if nothing else, speculators were active in these early time contracts.

On March 27, 1863, the Chicago Board of Trade adopted its first rules and procedures for trade in forwards on the exchange (Hieronymus 1977, 76). The rules addressed contract settlement, which was (and still is) the fundamental challenge associated with a forward contract – finding a trader who was willing to take a position in a forward contract was relatively easy to do; finding that trader at the time of contract settlement was not.

The CBT began to transform actively traded and reasonably homogeneous forward contracts into futures contracts in May, 1865. At this time, the CBT: restricted trade in time contracts to exchange members; standardized contract specifications; required traders to deposit margins; and specified formally contract settlement, including payments and deliveries, and grievance procedures (Hieronymus 1977, 76).

The inception of organized futures trading is difficult to date. This is due, in part, to semantic ambiguities – e.g., was a “to arrive” contract a forward contract or a futures contract or neither? However, most grain trade historians agree that storage (grain elevators), shipment (railroad), and communication (telegraph) technologies, a system of staple grades and standards, and the impetus to speculation provided by the Crimean and U.S. Civil Wars enabled futures trading to ripen by about 1874, at which time the CBT was the U.S.’s premier organized commodities (grain and provisions) futures exchange (Baer and Saxon 1949, 87; Chandler 1977, 212; CBT 1936, 18; Clark 1966, 120; Dies 1925, 15; Hoffman 1932, 29; Irwin 1954, 77, 82; Rothstein 1966, 67).

Nonetheless, futures exchanges in the mid-1870s lacked modern clearinghouses, with which most exchanges began to experiment only in the mid-1880s. For example, the CBT’s clearinghouse got its start in 1884, and a complete and mandatory clearing system was in place at the CBT by 1925 (Hoffman 1932, 199; Williams 1982, 306). The earliest formal clearing and offset procedures were established by the Minneapolis Grain Exchange in 1891 (Peck 1985, 6).

Even so, rudiments of a clearing system – one that freed traders from dealing directly with one another – were in place by the 1870s (Hoffman 1920, 189). That is to say, brokers assumed the counter-position to every trade, much as clearinghouse members would do decades later. Brokers settled offsets between one another, though in the absence of a formal clearing procedure these settlements were difficult to accomplish.

Direct settlements were simple enough. Here, two brokers would settle in cash their offsetting positions between one another only. Nonetheless, direct settlements were relatively uncommon because offsetting purchases and sales between brokers rarely balanced with respect to quantity. For example, B1 might buy a 5,000 bushel corn future from B2, who then might buy a 6,000 bushel corn future from B1; in this example, 1,000 bushels of corn remain unsettled between B1 and B2. Of course, the two brokers could offset the remaining 1,000 bushel contract if B2 sold a 1,000 bushel corn future to B1. But what if B2 had already sold a 1,000 bushel corn future to B3, who had sold a 1,000 bushel corn future to B1? In this case, each broker’s net futures market position is offset, but all three must meet in order to settle their respective positions. Brokers referred to such a meeting as a ring settlement. Finally, if, in this example, B1 and B3 did not have positions with each other, B2 could settle her position if she transferred her commitment (which she has with B1) to B3. Brokers referred to this method as a transfer settlement. In either ring or transfer settlements, brokers had to find other brokers who held and wished to settle open counter-positions. Often brokers used runners to search literally the offices and corridors for the requisite counter-parties (see Hoffman 1932, 185-200).

Finally, the transformation in Chicago grain markets from forward to futures trading occurred almost simultaneously in New York cotton markets. Forward contracts for cotton traded in New York (and Liverpool, England) by the 1850s. And, like Chicago, organized trading in cotton futures began on the New York Cotton Exchange in about 1870; rules and procedures formalized the practice in 1872. Futures trading on the New Orleans Cotton Exchange began around 1882 (Hieronymus 1977, 77).

Other successful nineteenth century futures exchanges include the New York Produce Exchange, the Milwaukee Chamber of Commerce, the Merchant’s Exchange of St. Louis, the Chicago Open Board of Trade, the Duluth Board of Trade, and the Kansas City Board of Trade (Hoffman 1920, 33; see Peck 1985, 9).

Early Futures Market Performance

Volume

Data on grain futures volume prior to the 1880s are not available (Hoffman 1932, 30). Though in the 1870s “[CBT] officials openly admitted that there was no actual delivery of grain in more than ninety percent of contracts” (Lurie 1979, 59). Indeed, Chart 1 demonstrates that trading was relatively voluminous in the nineteenth century.

An annual average of 23,600 million bushels of grain futures traded between 1884 and 1888, or eight times the annual average amount of crops produced during that period. By comparison, an annual average of 25,803 million bushels of grain futures traded between 1966 and 1970, or four times the annual average amount of crops produced during that period. In 2002, futures volume outnumbered crop production by a factor of eleven.

The comparable data for cotton futures are presented in Chart 2. Again here, trading in the nineteenth century was significant. To wit, by 1879 futures volume had outnumbered production by a factor of five, and by 1896 this factor had reached eight.

Price of Storage

Nineteenth century observers of early U.S. futures markets either credited them for stabilizing food prices, or discredited them for wagering on, and intensifying, the economic hardships of Americans (Baer and Saxon 1949, 12-20, 56; Chandler 1977, 212; Ferris 1988, 88; Hoffman 1932, 5; Lurie 1979, 53, 115). To be sure, the performance of early futures markets remains relatively unexplored. The extant research on the subject has generally examined this performance in the context of two perspectives on the theory of efficiency: the price of storage and futures price efficiency more generally.

Holbrook Working pioneered research into the price of storage – the relationship, at a point in time, between prices (of storable agricultural commodities) applicable to different future dates (Working 1949, 1254).12 For example, what is the relationship between the current spot price of wheat and the current September 2004 futures price of wheat? Or, what is the relationship between the current September 2004 futures price of wheat and the current May 2005 futures price of wheat?

Working reasoned that these prices could not differ because of events that were expected to occur between these dates. For example, if the May 2004 wheat futures price is less than the September 2004 price, this cannot be due to, say, the expectation of a small harvest between May 2004 and September 2004. On the contrary, traders should factor such an expectation into both May and September prices. And, assuming that they do, then this difference can only reflect the cost of carrying – storing – these commodities over time.13 Though this strict interpretation has since been modified somewhat (see Peck 1985, 44).

So, for example, the September 2004 price equals the May 2004 price plus the cost of storing wheat between May 2004 and September 2004. If the difference between these prices is greater or less than the cost of storage, and the market is efficient, arbitrage will bring the difference back to the cost of storage – e.g., if the difference in prices exceeds the cost of storage, then traders can profit if they buy the May 2004 contract, sell the September 2004 contract, take delivery in May and store the wheat until September. Working (1953) demonstrated empirically that the theory of the price of storage could explain quite satisfactorily these inter-temporal differences in wheat futures prices at the CBT as early as the late 1880s (Working 1953, 556).

Futures Price Efficiency

Many contemporary economists tend to focus on futures price efficiency more generally (for example, Beck 1994; Kahl and Tomek 1986; Kofi 1973; McKenzie, et al. 2002; Tomek and Gray, 1970). That is to say, do futures prices shadow consistently (but not necessarily equal) traders’ rational expectations of future spot prices? Here, the research focuses on the relationship between, say, the cash price of wheat in September 2004 and the September 2004 futures price of wheat quoted two months earlier in July 2004.

Figure 1illustrates the behavior of corn futures prices and their corresponding spot prices between 1877 and 1890. The data consist of the average month t futures price in the last full week of month t-2 and the average cash price in the first full week of month t.

The futures price and its corresponding spot price need not be equal; futures price efficiency does not mean that the futures market is clairvoyant. But, a difference between the two series should exist only because of an unpredictable forecast error and a risk premium – futures prices may be, say, consistently below the expected future spot price if long speculators require an inducement, or premium, to enter the futures market. Recent work finds strong evidence that these early corn (and corresponding wheat) futures prices are, in the long run, efficient estimates of their underlying spot prices (Santos 2002, 35). Although these results and Working’s empirical studies on the price of storage support, to some extent, the notion that early U.S. futures markets were efficient, this question remains largely unexplored by economic historians.

The Struggle for Legitimacy

Nineteenth century America was both fascinated and appalled by futures trading. This is apparent from the litigation and many public debates surrounding its legitimacy (Baer and Saxon 1949, 55; Buck 1913, 131, 271; Hoffman 1932, 29, 351; Irwin 1954, 80; Lurie 1979, 53, 106). Many agricultural producers, the lay community and, at times, legislatures and the courts, believed trading in futures was tantamount to gambling. The difference between the latter and speculating, which required the purchase or sale of a futures contract but not the shipment or delivery of the commodity, was ostensibly lost on most Americans (Baer and Saxon 1949, 56; Ferris 1988, 88; Hoffman 1932, 5; Lurie 1979, 53, 115).

Many Americans believed that futures traders frequently manipulated prices. From the end of the Civil War until 1879 alone, corners – control of enough of the available supply of a commodity to manipulate its price – allegedly occurred with varying degrees of success in wheat (1868, 1871, 1878/9), corn (1868), oats (1868, 1871, 1874), rye (1868) and pork (1868) (Boyle 1920, 64-65). This manipulation continued throughout the century and culminated in the Three Big Corners – the Hutchinson (1888), the Leiter (1898), and the Patten (1909). The Patten corner was later debunked (Boyle 1920, 67-74), while the Leiter corner was the inspiration for Frank Norris’s classic The Pit: A Story of Chicago (Norris 1903; Rothstein 1982, 60).14 In any case, reports of market corners on America’s early futures exchanges were likely exaggerated (Boyle 1920, 62-74; Hieronymus 1977, 84), as were their long term effects on prices and hence consumer welfare (Rothstein 1982, 60).

By 1892 thousands of petitions to Congress called for the prohibition of “speculative gambling in grain” (Lurie, 1979, 109). And, attacks from state legislatures were seemingly unrelenting: in 1812 a New York act made short sales illegal (the act was repealed in 1858); in 1841 a Pennsylvania law made short sales, where the position was not covered in five days, a misdemeanor (the law was repealed in 1862); in 1882 an Ohio law and a similar one in Illinois tried unsuccessfully to restrict cash settlement of futures contracts; in 1867 the Illinois constitution forbade dealing in futures contracts (this was repealed by 1869); in 1879 California’s constitution invalidated futures contracts (this was effectively repealed in 1908); and, in 1882, 1883 and 1885, Mississippi, Arkansas, and Texas, respectively, passed laws that equated futures trading with gambling, thus making the former a misdemeanor (Peterson 1933, 68-69).

Two nineteenth century challenges to futures trading are particularly noteworthy. The first was the so-called Anti-Option movement. According to Lurie (1979), the movement was fueled by agrarians and their sympathizers in Congress who wanted to end what they perceived as wanton speculative abuses in futures trading (109). Although options were (are) not futures contracts, and were nonetheless already outlawed on most exchanges by the 1890s, the legislation did not distinguish between the two instruments and effectively sought to outlaw both (Lurie 1979, 109).

In 1890 the Butterworth Anti-Option Bill was introduced in Congress but never came to a vote. However, in 1892 the Hatch (and Washburn) Anti-Option bills passed both houses of Congress, and failed only on technicalities during reconciliation between the two houses. Had either bill become law, it would have effectively ended options and futures trading in the United States (Lurie 1979, 110).

A second notable challenge was the bucket shop controversy, which challenged the legitimacy of the CBT in particular. A bucket shop was essentially an association of gamblers who met outside the CBT and wagered on the direction of futures prices. These associations had legitimate-sounding names such as the Christie Grain and Stock Company and the Public Grain Exchange. To most Americans, these “exchanges” were no less legitimate than the CBT. That some CBT members were guilty of “bucket shopping” only made matters worse!

The bucket shop controversy was protracted and colorful (see Lurie 1979, 138-167). Between 1884 and 1887 Illinois, Iowa, Missouri and Ohio passed anti-bucket shop laws (Lurie 1979, 95). The CBT believed these laws entitled them to restrict bucket shops access to CBT price quotes, without which the bucket shops could not exist. Bucket shops argued that they were competing exchanges, and hence immune to extant anti-bucket shop laws. As such, they sued the CBT for access to these price quotes.15

The two sides and the telegraph companies fought in the courts for decades over access to these price quotes; the CBT’s very survival hung in the balance. After roughly twenty years of litigation, the Supreme Court of the U.S. effectively ruled in favor of the Chicago Board of Trade and against bucket shops (Board of Trade of the City of Chicago v. Christie Grain & Stock Co., 198 U.S. 236, 25 Sup. Ct. (1905)). Bucket shops disappeared completely by 1915 (Hieronymus 1977, 90).

Regulation

The anti-option movement, the bucket shop controversy and the American public’s discontent with speculation masks an ironic reality of futures trading: it escaped government regulation until after the First World War; though early exchanges did practice self-regulation or administrative law.16 The absence of any formal governmental oversight was due in large part to two factors. First, prior to 1895, the opposition tried unsuccessfully to outlaw rather than regulate futures trading. Second, strong agricultural commodity prices between 1895 and 1920 weakened the opposition, who blamed futures markets for low agricultural commodity prices (Hieronymus 1977, 313).

Grain prices fell significantly by the end of the First World War, and opposition to futures trading grew once again (Hieronymus 1977, 313). In 1922 the U.S. Congress enacted the Grain Futures Act, which required exchanges to be licensed, limited market manipulation and publicized trading information (Leuthold 1989, 369).17 However, regulators could rarely enforce the act because it enabled them to discipline exchanges, rather than individual traders. To discipline an exchange was essentially to suspend it, a punishment unfit (too harsh) for most exchange-related infractions.

The Commodity Exchange Act of 1936 enabled the government to deal directly with traders rather than exchanges. It established the Commodity Exchange Authority (CEA), a bureau of the U.S. Department of Agriculture, to monitor and investigate trading activities and prosecute price manipulation as a criminal offense. The act also: limited speculators’ trading activities and the sizes of their positions; regulated futures commission merchants; banned options trading on domestic agricultural commodities; and restricted futures trading – designated which commodities were to be traded on which licensed exchanges (see Hieronymus 1977; Leuthold, et al. 1989).

Although Congress amended the Commodity Exchange Act in 1968 in order to increase the regulatory powers of the Commodity Exchange Authority, the latter was ill-equipped to handle the explosive growth in futures trading in the 1960s and 1970s. So, in 1974 Congress passed the Commodity Futures Trading Act, which created far-reaching federal oversight of U.S. futures trading and established the Commodity Futures Trading Commission (CFTC).

Like the futures legislation before it, the Commodity Futures Trading Act seeks “to ensure proper execution of customer orders and to prevent unlawful manipulation, price distortion, fraud, cheating, fictitious trades, and misuse of customer funds” (Leuthold, et al. 1989, 34). Unlike the CEA, the CFTC was given broad regulator powers over all futures trading and related exchange activities throughout the U.S. The CFTC oversees and approves modifications to extant contracts and the creation and introduction of new contracts. The CFTC consists of five presidential appointees who are confirmed by the U.S. Senate.

The Futures Trading Act of 1982 amended the Commodity Futures Trading Act of 1974. The 1982 act legalized options trading on agricultural commodities and identified more clearly the jurisdictions of the CFTC and Securities and Exchange Commission (SEC). The regulatory overlap between the two organizations arose because of the explosive popularity during the 1970s of financial futures contracts. Today, the CFTC regulates all futures contracts and options on futures contracts traded on U.S. futures exchanges; the SEC regulates all financial instrument cash markets as well as all other options markets.

Finally, in 2000 Congress passed the Commodity Futures Modernization Act, which reauthorized the Commodity Futures Trading Commission for five years and repealed an 18-year old ban on trading single stock futures. The bill also sought to increase competition and “reduce systematic risk in markets for futures and over-the-counter derivatives” (H.R. 5660, 106th Congress 2nd Session).

Modern Futures Markets

The growth in futures trading has been explosive in recent years (Chart 3).

Futures trading extended beyond physical commodities in the 1970s and 1980s – currency futures in 1972; interest rate futures in 1975; and stock index futures in 1982 (Silber 1985, 83). The enormous growth of financial futures at this time was likely because of the breakdown of the Bretton Woods exchange rate regime, which essentially fixed the relative values of industrial economies’ exchange rates to the American dollar (see Bordo and Eichengreen 1993), and relatively high inflation from the late 1960s to the early 1980s. Flexible exchange rates and inflation introduced, respectively, exchange and interest rate risks, which hedgers sought to mitigate through the use of financial futures. Finally, although futures contracts on agricultural commodities remain popular, financial futures and options dominate trading today. Trading volume in metals, minerals and energy remains relatively small.

Trading volume in agricultural futures contracts first dropped below 50% in 1982. By 1985 this volume had dropped to less than one fourth all trading. In the same year the volume of futures trading in the U.S. Treasury bond contract alone exceeded trading volume in all agricultural commodities combined (Leuthold et al. 1989, 2). Today exchanges in the U.S. actively trade contracts on several underlying assets (Table 1). These range from the traditional – e.g., agriculture and metals – to the truly innovative – e.g. the weather. The latter’s payoff varies with the number of degree-days by which the temperature in a particular region deviates from 65 degrees Fahrenheit.

Table 1: Select Futures Contracts Traded as of 2002

Agriculture Currencies Equity Indexes Interest Rates Metals & Energy
Corn British pound S&P 500 index Eurodollars Copper
Oats Canadian dollar Dow Jones Industrials Euroyen Aluminum
Soybeans Japanese yen S&P Midcap 400 Euro-denominated bond Gold
Soybean meal Euro Nasdaq 100 Euroswiss Platinum
Soybean oil Swiss franc NYSE index Sterling Palladium
Wheat Australian dollar Russell 2000 index British gov. bond (gilt) Silver
Barley Mexican peso Nikkei 225 German gov. bond Crude oil
Flaxseed Brazilian real FTSE index Italian gov. bond Heating oil
Canola CAC-40 Canadian gov. bond Gas oil
Rye DAX-30 Treasury bonds Natural gas
Cattle All ordinary Treasury notes Gasoline
Hogs Toronto 35 Treasury bills Propane
Pork bellies Dow Jones Euro STOXX 50 LIBOR CRB index
Cocoa EURIBOR Electricity
Coffee Municipal bond index Weather
Cotton Federal funds rate
Milk Bankers’ acceptance
Orange juice
Sugar
Lumber
Rice

Source: Bodie, Kane and Marcus (2005), p. 796.

Table 2 provides a list of today’s major futures exchanges.

Table 2: Select Futures Exchanges as of 2002

Exchange Exchange
Chicago Board of Trade CBT Montreal Exchange ME
Chicago Mercantile Exchange CME Minneapolis Grain Exchange MPLS
Coffee, Sugar & Cocoa Exchange, New York CSCE Unit of Euronext.liffe NQLX
COMEX, a division of the NYME CMX New York Cotton Exchange NYCE
European Exchange EUREX New York Futures Exchange NYFE
Financial Exchange, a division of the NYCE FINEX New York Mercantile Exchange NYME
International Petroleum Exchange IPE OneChicago ONE
Kansas City Board of Trade KC Sydney Futures Exchange SFE
London International Financial Futures Exchange LIFFE Singapore Exchange Ltd. SGX
Marche a Terme International de France MATIF

Source: Wall Street Journal, 5/12/2004, C16.

Modern trading differs from its nineteenth century counterpart in other respects as well. First, the popularity of open outcry trading is waning. For example, today the CBT executes roughly half of all trades electronically. And, electronic trading is the rule, rather than the exception throughout Europe. Second, today roughly 99% of all futures contracts are settled prior to maturity. Third, in 1982 the Commodity Futures Trading Commission approved cash settlement – delivery that takes the form of a cash balance – on financial index and Eurodollar futures, whose underlying assets are not deliverable, as well as on several non-financial contracts including lean hog, feeder cattle and weather (Carlton 1984, 253). And finally, on Dec. 6, 2002, the Chicago Mercantile Exchange became the first publicly traded financial exchange in the U.S.

References and Further Reading

Baer, Julius B. and Olin. G. Saxon. Commodity Exchanges and Futures Trading. New York: Harper & Brothers, 1949.

Bodie, Zvi, Alex Kane and Alan J. Marcus. Investments. New York: McGraw-Hill/Irwin, 2005.

Bordo, Michael D. and Barry Eichengreen, editors. A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. Chicago: University of Chicago Press, 1993.

Boyle, James. E. Speculation and the Chicago Board of Trade. New York: MacMillan Company, 1920.

Buck, Solon. J. The Granger Movement: A Study of Agricultural Organization and Its Political,

Carlton, Dennis W. “Futures Markets: Their Purpose, Their History, Their Growth, Their Successes and Failures.” Journal of Futures Markets 4, no. 3 (1984): 237-271.

Chicago Board of Trade Bulletin. The Development of the Chicago Board of Trade. Chicago: Chicago Board of Trade, 1936.

Chandler, Alfred. D. The Visible Hand: The Managerial Revolution in American Business. Cambridge: Harvard University Press, 1977.

Clark, John. G. The Grain Trade in the Old Northwest. Urbana: University of Illinois Press, 1966.

Commodity Futures Trading Commission. Annual Report. Washington, D.C. 2003.

Dies, Edward. J. The Wheat Pit. Chicago: The Argyle Press, 1925.

Ferris, William. G. The Grain Traders: The Story of the Chicago Board of Trade. East Lansing, MI: Michigan State University Press, 1988.

Hieronymus, Thomas A. Economics of Futures Trading for Commercial and Personal Profit. New York: Commodity Research Bureau, Inc., 1977.

Hoffman, George W. Futures Trading upon Organized Commodity Markets in the United States. Philadelphia: University of Pennsylvania Press, 1932.

Irwin, Harold. S. Evolution of Futures Trading. Madison, WI: Mimir Publishers, Inc., 1954

Leuthold, Raymond M., Joan C. Junkus and Jean E. Cordier. The Theory and Practice of Futures Markets. Champaign, IL: Stipes Publishing L.L.C., 1989.

Lurie, Jonathan. The Chicago Board of Trade 1859-1905. Urbana: University of Illinois Press, 1979.

National Agricultural Statistics Service. “Historical Track Records.” Agricultural Statistics Board, U.S. Department of Agriculture, Washington, D.C. April 2004.

Norris, Frank. The Pit: A Story of Chicago. New York, NY: Penguin Group, 1903.

Odle, Thomas. “Entrepreneurial Cooperation on the Great Lakes: The Origin of the Methods of American Grain Marketing.” Business History Review 38, (1964): 439-55.

Peck, Anne E., editor. Futures Markets: Their Economic Role. Washington D.C.: American Enterprise Institute for Public Policy Research, 1985.

Peterson, Arthur G. “Futures Trading with Particular Reference to Agricultural Commodities.” Agricultural History 8, (1933): 68-80.

Pierce, Bessie L. A History of Chicago: Volume III, the Rise of a Modern City. New York: Alfred A. Knopf, 1957.

Rothstein, Morton. “The International Market for Agricultural Commodities, 1850-1873.” In Economic Change in the Civil War Era, edited by David. T. Gilchrist and W. David Lewis, 62-71. Greenville DE: Eleutherian Mills-Hagley Foundation, 1966.

Rothstein, Morton. “Frank Norris and Popular Perceptions of the Market.” Agricultural History 56, (1982): 50-66.

Santos, Joseph. “Did Futures Markets Stabilize U.S. Grain Prices?” Journal of Agricultural Economics 53, no. 1 (2002): 25-36.

Silber, William L. “The Economic Role of Financial Futures.” In Futures Markets: Their Economic Role, edited by Anne E. Peck, 83-114. Washington D.C.: American Enterprise Institute for Public Policy Research, 1985.

Stein, Jerome L. The Economics of Futures Markets. Oxford: Basil Blackwell Ltd, 1986.

Taylor, Charles. H. History of the Board of Trade of the City of Chicago. Chicago: R. O. Law, 1917.

Werner, Walter and Steven T. Smith. Wall Street. New York: Columbia University Press, 1991.

Williams, Jeffrey C. “The Origin of Futures Markets.” Agricultural History 56, (1982): 306-16.

Working, Holbrook. “The Theory of the Price of Storage.” American Economic Review 39, (1949): 1254-62.

Working, Holbrook. “Hedging Reconsidered.” Journal of Farm Economics 35, (1953): 544-61.

1 The clearinghouse is typically a corporation owned by a subset of exchange members. For details regarding the clearing arrangements of a specific exchange, go to www.cftc.gov and click on “Clearing Organizations.”

2 The vast majority of contracts are offset. Outright delivery occurs when the buyer receives from, or the seller “delivers” to the exchange a title of ownership, and not the actual commodity or financial security – the urban legend of the trader who neglected to settle his long position and consequently “woke up one morning to find several car loads of a commodity dumped on his front yard” is indeed apocryphal (Hieronymus 1977, 37)!

3 Nevertheless, forward contracts remain popular today (see Peck 1985, 9-12).

4 The importance of New Orleans as a point of departure for U.S. grain and provisions prior to the Civil War is unquestionable. According to Clark (1966), “New Orleans was the leading export center in the nation in terms of dollar volume of domestic exports, except for 1847 and a few years during the 1850s, when New York’s domestic exports exceeded those of the Crescent City” (36).

5 This area was responsible for roughly half of U.S. wheat production and a third of U.S. corn production just prior to 1860. Southern planters dominated corn output during the early to mid- 1800s.

6 Millers milled wheat into flour; pork producers fed corn to pigs, which producers slaughtered for provisions; distillers and brewers converted rye and barley into whiskey and malt liquors, respectively; and ranchers fed grains and grasses to cattle, which were then driven to eastern markets.

7 Significant advances in transportation made the grain trade’s eastward expansion possible, but the strong and growing demand for grain in the East made the trade profitable. The growth in domestic grain demand during the early to mid-nineteenth century reflected the strong growth in eastern urban populations. Between 1820 and 1860, the populations of Baltimore, Boston, New York and Philadelphia increased by over 500% (Clark 1966, 54). Moreover, as the 1840’s approached, foreign demand for U.S. grain grew. Between 1845 and 1847, U.S. exports of wheat and flour rose from 6.3 million bushels to 26.3 million bushels and corn exports grew from 840,000 bushels to 16.3 million bushels (Clark 1966, 55).

8 Wheat production was shifting to the trans-Mississippi West, which produced 65% of the nation’s wheat by 1899 and 90% by 1909, and railroads based in the Lake Michigan port cities intercepted the Mississippi River trade that would otherwise have headed to St. Louis (Clark 1966, 95). Lake Michigan port cities also benefited from a growing concentration of corn production in the West North Central region – Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota and South Dakota, which by 1899 produced 40% percent of the country’s corn (Clark 1966, 4).

9 Corn had to be dried immediately after it was harvested and could only be shipped profitably by water to Chicago, but only after rivers and lakes had thawed; so, country merchants stored large quantities of corn. On the other hand, wheat was more valuable relative to its weight, and it could be shipped to Chicago by rail or road immediately after it was harvested; so, Chicago merchants stored large quantities of wheat.

10 This is consistent with Odle (1964), who adds that “the creators of the new system of marketing [forward contracts] were the grain merchants of the Great Lakes” (439). However, Williams (1982) presents evidence of such contracts between Buffalo and New York City as early as 1847 (309). To be sure, Williams proffers an intriguing case that forward and, in effect, future trading was active and quite sophisticated throughout New York by the late 1840s. Moreover, he argues that this trading grew not out of activity in Chicago, whose trading activities were quite primitive at this early date, but rather trading in London and ultimately Amsterdam. Indeed, “time bargains” were common in London and New York securities markets in the mid- and late 1700s, respectively. A time bargain was essentially a cash-settled financial forward contract that was unenforceable by law, and as such “each party was forced to rely on the integrity and credit of the other” (Werner and Smith 1991, 31). According to Werner and Smith, “time bargains prevailed on Wall Street until 1840, and were gradually replaced by margin trading by 1860” (68). They add that, “margin trading … had an advantage over time bargains, in which there was little protection against default beyond the word of another broker. Time bargains also technically violated the law as wagering contracts; margin trading did not” (135). Between 1818 and 1840 these contracts comprised anywhere from 0.7% (49-day average in 1830) to 34.6% (78-day average in 1819) of daily exchange volume on the New York Stock & Exchange Board (Werner and Smith 1991, 174).

11 Of course, forward markets could and indeed did exist in the absence of both grading standards and formal exchanges, though to what extent they existed is unclear (see Williams 1982).

12 In the parlance of modern financial futures, the term cost of carry is used instead of the term storage. For example, the cost of carrying a bond is comprised of the cost of acquiring and holding (or storing) it until delivery minus the return earned during the carry period.

13 More specifically, the price of storage is comprised of three components: (1) physical costs such as warehouse and insurance; (2) financial costs such as borrowing rates of interest; and (3) the convenience yield – the return that the merchant, who stores the commodity, derives from maintaining an inventory in the commodity. The marginal costs of (1) and (2) are increasing functions of the amount stored; the more the merchant stores, the greater the marginal costs of warehouse use, insurance and financing. Whereas the marginal benefit of (3) is a decreasing function of the amount stored; put differently, the smaller the merchant’s inventory, the more valuable each additional unit of inventory becomes. Working used this convenience yield to explain a negative price of storage – the nearby contract is priced higher than the faraway contract; an event that is likely to occur when supplies are exceptionally low. In this instance, there is little for inventory dealers to store. Hence, dealers face extremely low physical and financial storage costs, but extremely high convenience yields. The price of storage turns negative; essentially, inventory dealers are willing to pay to store the commodity.

14 Norris’ protagonist, Curtis Jadwin, is a wheat speculator emotionally consumed and ultimately destroyed, while the welfare of producers and consumers hang in the balance, when a nineteenth century CBT wheat futures corner backfires on him.

15 One particularly colorful incident in the controversy came when the Supreme Court of Illinois ruled that the CBT had to either make price quotes public or restrict access to everyone. When the Board opted for the latter, it found it needed to “prevent its members from running (often literally) between the [CBT and a bucket shop next door], but with minimal success. Board officials at first tried to lock the doors to the exchange…However, after one member literally battered down the door to the east side of the building, the directors abandoned this policy as impracticable if not destructive” (Lurie 1979, 140).

16 Administrative law is “a body of rules and doctrines which deals with the powers and actions of administrative agencies” that are organizations other than the judiciary or legislature. These organizations affect the rights of private parties “through either adjudication, rulemaking, investigating, prosecuting, negotiating, settling, or informally acting” (Lurie 1979, 9).

17 In 1921 Congress passed The Futures Trading Act, which was declared unconstitutional.

Citation: Santos, Joseph. “A History of Futures Trading in the United States”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/a-history-of-futures-trading-in-the-united-states/

The U.S. Economy in the 1920s

Gene Smiley, Marquette University

Introduction

The interwar period in the United States, and in the rest of the world, is a most interesting era. The decade of the 1930s marks the most severe depression in our history and ushered in sweeping changes in the role of government. Economists and historians have rightly given much attention to that decade. However, with all of this concern about the growing and developing role of government in economic activity in the 1930s, the decade of the 1920s often tends to get overlooked. This is unfortunate because the 1920s are a period of vigorous, vital economic growth. It marks the first truly modern decade and dramatic economic developments are found in those years. There is a rapid adoption of the automobile to the detriment of passenger rail travel. Though suburbs had been growing since the late nineteenth century their growth had been tied to rail or trolley access and this was limited to the largest cities. The flexibility of car access changed this and the growth of suburbs began to accelerate. The demands of trucks and cars led to a rapid growth in the construction of all-weather surfaced roads to facilitate their movement. The rapidly expanding electric utility networks led to new consumer appliances and new types of lighting and heating for homes and businesses. The introduction of the radio, radio stations, and commercial radio networks began to break up rural isolation, as did the expansion of local and long-distance telephone communications. Recreational activities such as traveling, going to movies, and professional sports became major businesses. The period saw major innovations in business organization and manufacturing technology. The Federal Reserve System first tested its powers and the United States moved to a dominant position in international trade and global business. These things make the 1920s a period of considerable importance independent of what happened in the 1930s.

National Product and Income and Prices

We begin the survey of the 1920s with an examination of the overall production in the economy, GNP, the most comprehensive measure of aggregate economic activity. Real GNP growth during the 1920s was relatively rapid, 4.2 percent a year from 1920 to 1929 according to the most widely used estimates. (Historical Statistics of the United States, or HSUS, 1976) Real GNP per capita grew 2.7 percent per year between 1920 and 1929. By both nineteenth and twentieth century standards these were relatively rapid rates of real economic growth and they would be considered rapid even today.

There were several interruptions to this growth. In mid-1920 the American economy began to contract and the 1920-1921 depression lasted about a year, but a rapid recovery reestablished full-employment by 1923. As will be discussed below, the Federal Reserve System’s monetary policy was a major factor in initiating the 1920-1921 depression. From 1923 through 1929 growth was much smoother. There was a very mild recession in 1924 and another mild recession in 1927 both of which may be related to oil price shocks (McMillin and Parker, 1994). The 1927 recession was also associated with Henry Ford’s shut-down of all his factories for six months in order to changeover from the Model T to the new Model A automobile. Though the Model T’s market share was declining after 1924, in 1926 Ford’s Model T still made up nearly 40 percent of all the new cars produced and sold in the United States. The Great Depression began in the summer of 1929, possibly as early as June. The initial downturn was relatively mild but the contraction accelerated after the crash of the stock market at the end of October. Real total GNP fell 10.2 percent from 1929 to 1930 while real GNP per capita fell 11.5 percent from 1929 to 1930.

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Price changes during the 1920s are shown in Figure 2. The Consumer Price Index, CPI, is a better measure of changes in the prices of commodities and services that a typical consumer would purchase, while the Wholesale Price Index, WPI, is a better measure in the changes in the cost of inputs for businesses. As the figure shows the 1920-1921 depression was marked by extraordinarily large price decreases. Consumer prices fell 11.3 percent from 1920 to 1921 and fell another 6.6 percent from 1921 to 1922. After that consumer prices were relatively constant and actually fell slightly from 1926 to 1927 and from 1927 to 1928. Wholesale prices show greater variation. The 1920-1921 depression hit farmers very hard. Prices had been bid up with the increasing foreign demand during the First World War. As European production began to recover after the war prices began to fall. Though the prices of agricultural products fell from 1919 to 1920, the depression brought on dramatic declines in the prices of raw agricultural produce as well as many other inputs that firms employ. In the scramble to beat price increases during 1919 firms had built up large inventories of raw materials and purchased inputs and this temporary increase in demand led to even larger price increases. With the depression firms began to draw down those inventories. The result was that the prices of raw materials and manufactured inputs fell rapidly along with the prices of agricultural produce—the WPI dropped 45.9 percent between 1920 and 1921. The price changes probably tend to overstate the severity of the 1920-1921 depression. Romer’s recent work (1988) suggests that prices changed much more easily in that depression reducing the drop in production and employment. Wholesale prices in the rest of the 1920s were relatively stable though they were more likely to fall than to rise.

Economic Growth in the 1920s

Despite the 1920-1921 depression and the minor interruptions in 1924 and 1927, the American economy exhibited impressive economic growth during the 1920s. Though some commentators in later years thought that the existence of some slow growing or declining sectors in the twenties suggested weaknesses that might have helped bring on the Great Depression, few now argue this. Economic growth never occurs in all sectors at the same time and at the same rate. Growth reallocates resources from declining or slower growing sectors to the more rapidly expanding sectors in accordance with new technologies, new products and services, and changing consumer tastes.

Economic growth in the 1920s was impressive. Ownership of cars, new household appliances, and housing was spread widely through the population. New products and processes of producing those products drove this growth. The combination of the widening use of electricity in production and the growing adoption of the moving assembly line in manufacturing combined to bring on a continuing rise in the productivity of labor and capital. Though the average workweek in most manufacturing remained essentially constant throughout the 1920s, in a few industries, such as railroads and coal production, it declined. (Whaples 2001) New products and services created new markets such as the markets for radios, electric iceboxes, electric irons, fans, electric lighting, vacuum cleaners, and other laborsaving household appliances. This electricity was distributed by the growing electric utilities. The stocks of those companies helped create the stock market boom of the late twenties. RCA, one of the glamour stocks of the era, paid no dividends but its value appreciated because of expectations for the new company. Like the Internet boom of the late 1990s, the electricity boom of the 1920s fed a rapid expansion in the stock market.

Fed by continuing productivity advances and new products and services and facilitated by an environment of stable prices that encouraged production and risk taking, the American economy embarked on a sustained expansion in the 1920s.

Population and Labor in the 1920s

At the same time that overall production was growing, population growth was declining. As can be seen in Figure 3, from an annual rate of increase of 1.85 and 1.93 percent in 1920 and 1921, respectively, population growth rates fell to 1.23 percent in 1928 and 1.04 percent in 1929.

These changes in the overall growth rate were linked to the birth and death rates of the resident population and a decrease in foreign immigration. Though the crude death rate changed little during the period, the crude birth rate fell sharply into the early 1930s. (Figure 4) There are several explanations for the decline in the birth rate during this period. First, there was an accelerated rural-to-urban migration. Urban families have tended to have fewer children than rural families because urban children do not augment family incomes through their work as unpaid workers as rural children do. Second, the period also saw continued improvement in women’s job opportunities and a rise in their labor force participation rates.

Immigration also fell sharply. In 1917 the federal government began to limit immigration and in 1921 an immigration act limited the number of prospective citizens of any nationality entering the United States each year to no more than 3 percent of that nationality’s resident population as of the 1910 census. A new act in 1924 lowered this to 2 percent of the resident population at the 1890 census and more firmly blocked entry for people from central, southern, and eastern European nations. The limits were relaxed slightly in 1929.

The American population also continued to move during the interwar period. Two regions experienced the largest losses in population shares, New England and the Plains. For New England this was a continuation of a long-term trend. The population share for the Plains region had been rising through the nineteenth century. In the interwar period its agricultural base, combined with the continuing shift from agriculture to industry, led to a sharp decline in its share. The regions gaining population were the Southwest and, particularly, the far West.— California began its rapid growth at this time.

 Real Average Weekly or Daily Earnings for Selected=During the 1920s the labor force grew at a more rapid rate than population. This somewhat more rapid growth came from the declining share of the population less than 14 years old and therefore not in the labor force. In contrast, the labor force participation rates, or fraction of the population aged 14 and over that was in the labor force, declined during the twenties from 57.7 percent to 56.3 percent. This was entirely due to a fall in the male labor force participation rate from 89.6 percent to 86.8 percent as the female labor force participation rate rose from 24.3 percent to 25.1 percent. The primary source of the fall in male labor force participation rates was a rising retirement rate. Employment rates for males who were 65 or older fell from 60.1 percent in 1920 to 58.0 percent in 1930.

With the depression of 1920-1921 the unemployment rate rose rapidly from 5.2 to 8.7 percent. The recovery reduced unemployment to an average rate of 4.8 percent in 1923. The unemployment rate rose to 5.8 percent in the recession of 1924 and to 5.0 percent with the slowdown in 1927. Otherwise unemployment remained relatively low. The onset of the Great Depression from the summer of 1929 on brought the unemployment rate from 4.6 percent in 1929 to 8.9 percent in 1930. (Figure 5)

Earnings for laborers varied during the twenties. Table 1 presents average weekly earnings for 25 manufacturing industries. For these industries male skilled and semi-skilled laborers generally commanded a premium of 35 percent over the earnings of unskilled male laborers in the twenties. Unskilled males received on average 35 percent more than females during the twenties. Real average weekly earnings for these 25 manufacturing industries rose somewhat during the 1920s. For skilled and semi-skilled male workers real average weekly earnings rose 5.3 percent between 1923 and 1929, while real average weekly earnings for unskilled males rose 8.7 percent between 1923 and 1929. Real average weekly earnings for females rose on 1.7 percent between 1923 and 1929. Real weekly earnings for bituminous and lignite coal miners fell as the coal industry encountered difficult times in the late twenties and the real daily wage rate for farmworkers in the twenties, reflecting the ongoing difficulties in agriculture, fell after the recovery from the 1920-1921 depression.

The 1920s were not kind to labor unions even though the First World War had solidified the dominance of the American Federation of Labor among labor unions in the United States. The rapid growth in union membership fostered by federal government policies during the war ended in 1919. A committee of AFL craft unions undertook a successful membership drive in the steel industry in that year. When U.S. Steel refused to bargain, the committee called a strike, the failure of which was a sharp blow to the unionization drive. (Brody, 1965) In the same year, the United Mine Workers undertook a large strike and also lost. These two lost strikes and the 1920-21 depression took the impetus out of the union movement and led to severe membership losses that continued through the twenties. (Figure 6)

Under Samuel Gompers’s leadership, the AFL’s “business unionism” had attempted to promote the union and collective bargaining as the primary answer to the workers’ concerns with wages, hours, and working conditions. The AFL officially opposed any government actions that would have diminished worker attachment to unions by providing competing benefits, such as government sponsored unemployment insurance, minimum wage proposals, maximum hours proposals and social security programs. As Lloyd Ulman (1961) points out, the AFL, under Gompers’ direction, differentiated on the basis of whether the statute would or would not aid collective bargaining. After Gompers’ death, William Green led the AFL in a policy change as the AFL promoted the idea of union-management cooperation to improve output and promote greater employer acceptance of unions. But Irving Bernstein (1965) concludes that, on the whole, union-management cooperation in the twenties was a failure.

To combat the appeal of unions in the twenties, firms used the “yellow-dog” contract requiring employees to swear they were not union members and would not join one; the “American Plan” promoting the open shop and contending that the closed shop was un-American; and welfare capitalism. The most common aspects of welfare capitalism included personnel management to handle employment issues and problems, the doctrine of “high wages,” company group life insurance, old-age pension plans, stock-purchase plans, and more. Some firms formed company unions to thwart independent unionization and the number of company-controlled unions grew from 145 to 432 between 1919 and 1926.

Until the late thirties the AFL was a voluntary association of independent national craft unions. Craft unions relied upon the particular skills the workers had acquired (their craft) to distinguish the workers and provide barriers to the entry of other workers. Most craft unions required a period of apprenticeship before a worker was fully accepted as a journeyman worker. The skills, and often lengthy apprenticeship, constituted the entry barrier that gave the union its bargaining power. There were only a few unions that were closer to today’s industrial unions where the required skills were much less (or nonexistent) making the entry of new workers much easier. The most important of these industrial unions was the United Mine Workers, UMW.

The AFL had been created on two principles: the autonomy of the national unions and the exclusive jurisdiction of the national union.—Individual union members were not, in fact, members of the AFL; rather, they were members of the local and national union, and the national was a member of the AFL. Representation in the AFL gave dominance to the national unions, and, as a result, the AFL had little effective power over them. The craft lines, however, had never been distinct and increasingly became blurred. The AFL was constantly mediating jurisdictional disputes between member national unions. Because the AFL and its individual unions were not set up to appeal to and work for the relatively less skilled industrial workers, union organizing and growth lagged in the twenties.

Agriculture

The onset of the First World War in Europe brought unprecedented prosperity to American farmers. As agricultural production in Europe declined, the demand for American agricultural exports rose, leading to rising farm product prices and incomes. In response to this, American farmers expanded production by moving onto marginal farmland, such as Wisconsin cutover property on the edge of the woods and hilly terrain in the Ozark and Appalachian regions. They also increased output by purchasing more machinery, such as tractors, plows, mowers, and threshers. The price of farmland, particularly marginal farmland, rose in response to the increased demand, and the debt of American farmers increased substantially.

This expansion of American agriculture continued past the end of the First World War as farm exports to Europe and farm prices initially remained high. However, agricultural production in Europe recovered much faster than most observers had anticipated. Even before the onset of the short depression in 1920, farm exports and farm product prices had begun to fall. During the depression, farm prices virtually collapsed. From 1920 to 1921, the consumer price index fell 11.3 percent, the wholesale price index fell 45.9 percent, and the farm products price index fell 53.3 percent. (HSUS, Series E40, E42, and E135)

Real average net income per farm fell over 72.6 percent between 1920 and 1921 and, though rising in the twenties, never recovered the relative levels of 1918 and 1919. (Figure 7) Farm mortgage foreclosures rose and stayed at historically high levels for the entire decade of the 1920s. (Figure 8) The value of farmland and buildings fell throughout the twenties and, for the first time in American history, the number of cultivated acres actually declined as farmers pulled back from the marginal farmland brought into production during the war. Rather than indicators of a general depression in agriculture in the twenties, these were the results of the financial commitments made by overoptimistic American farmers during and directly after the war. The foreclosures were generally on second mortgages rather than on first mortgages as they were in the early 1930s. (Johnson, 1973; Alston, 1983)

A Declining Sector

A major difficulty in analyzing the interwar agricultural sector lies in separating the effects of the 1920-21 and 1929-33 depressions from those that arose because agriculture was declining relative to the other sectors. A relatively very slow growing demand for basic agricultural products and significant increases in the productivity of labor, land, and machinery in agricultural production combined with a much more rapid extensive economic growth in the nonagricultural sectors of the economy required a shift of resources, particularly labor, out of agriculture. (Figure 9) The market induces labor to voluntarily move from one sector to another through income differentials, suggesting that even in the absence of the effects of the depressions, farm incomes would have been lower than nonfarm incomes so as to bring about this migration.

The continuous substitution of tractor power for horse and mule power released hay and oats acreage to grow crops for human consumption. Though cotton and tobacco continued as the primary crops in the south, the relative production of cotton continued to shift to the west as production in Arkansas, Missouri, Oklahoma, Texas, New Mexico, Arizona, and California increased. As quotas reduced immigration and incomes rose, the demand for cereal grains grew slowly—more slowly than the supply—and the demand for fruits, vegetables, and dairy products grew. Refrigeration and faster freight shipments expanded the milk sheds further from metropolitan areas. Wisconsin and other North Central states began to ship cream and cheeses to the Atlantic Coast. Due to transportation improvements, specialized truck farms and the citrus industry became more important in California and Florida. (Parker, 1972; Soule, 1947)

The relative decline of the agricultural sector in this period was closely related to the highly inelastic income elasticity of demand for many farm products, particularly cereal grains, pork, and cotton. As incomes grew, the demand for these staples grew much more slowly. At the same time, rising land and labor productivity were increasing the supplies of staples, causing real prices to fall.

Table 3 presents selected agricultural productivity statistics for these years. Those data indicate that there were greater gains in labor productivity than in land productivity (or per acre yields). Per acre yields in wheat and hay actually decreased between 1915-19 and 1935-39. These productivity increases, which released resources from the agricultural sector, were the result of technological improvements in agriculture.

Technological Improvements In Agricultural Production

In many ways the adoption of the tractor in the interwar period symbolizes the technological changes that occurred in the agricultural sector. This changeover in the power source that farmers used had far-reaching consequences and altered the organization of the farm and the farmers’ lifestyle. The adoption of the tractor was land saving (by releasing acreage previously used to produce crops for workstock) and labor saving. At the same time it increased the risks of farming because farmers were now much more exposed to the marketplace. They could not produce their own fuel for tractors as they had for the workstock. Rather, this had to be purchased from other suppliers. Repair and replacement parts also had to be purchased, and sometimes the repairs had to be undertaken by specialized mechanics. The purchase of a tractor also commonly required the purchase of new complementary machines; therefore, the decision to purchase a tractor was not an isolated one. (White, 2001; Ankli, 1980; Ankli and Olmstead, 1981; Musoke, 1981; Whatley, 1987). These changes resulted in more and more farmers purchasing and using tractors, but the rate of adoption varied sharply across the United States.

Technological innovations in plants and animals also raised productivity. Hybrid seed corn increased yields from an average of 40 bushels per acre to 100 to 120 bushels per acre. New varieties of wheat were developed from the hardy Russian and Turkish wheat varieties which had been imported. The U.S. Department of Agriculture’s Experiment Stations took the lead in developing wheat varieties for different regions. For example, in the Columbia River Basin new varieties raised yields from an average of 19.1 bushels per acre in 1913-22 to 23.1 bushels per acre in 1933-42. (Shepherd, 1980) New hog breeds produced more meat and new methods of swine sanitation sharply increased the survival rate of piglets. An effective serum for hog cholera was developed, and the federal government led the way in the testing and eradication of bovine tuberculosis and brucellosis. Prior to the Second World War, a number of pesticides to control animal disease were developed, including cattle dips and disinfectants. By the mid-1920s a vaccine for “blackleg,” an infectious, usually fatal disease that particularly struck young cattle, was completed. The cattle tick, which carried Texas Fever, was largely controlled through inspections. (Schlebecker, 1975; Bogue, 1983; Wood, 1980)

Federal Agricultural Programs in the 1920s

Though there was substantial agricultural discontent in the period from the Civil War to late 1890s, the period from then to the onset of the First World War was relatively free from overt farmers’ complaints. In later years farmers dubbed the 1910-14 period as agriculture’s “golden years” and used the prices of farm crops and farm inputs in that period as a standard by which to judge crop and input prices in later years. The problems that arose in the agricultural sector during the twenties once again led to insistent demands by farmers for government to alleviate their distress.

Though there were increasing calls for direct federal government intervention to limit production and raise farm prices, this was not used until Roosevelt took office. Rather, there was a reliance upon the traditional method to aid injured groups—tariffs, and upon the “sanctioning and promotion of cooperative marketing associations.” In 1921 Congress attempted to control the grain exchanges and compel merchants and stockyards to charge “reasonable rates,” with the Packers and Stockyards Act and the Grain Futures Act. In 1922 Congress passed the Capper-Volstead Act to promote agricultural cooperatives and the Fordney-McCumber Tariff to impose high duties on most agricultural imports.—The Cooperative Marketing Act of 1924 did not bolster failing cooperatives as it was supposed to do. (Hoffman and Liebcap, 1991)

Twice between 1924 and 1928 Congress passed “McNary-Haugan” bills, but President Calvin Coolidge vetoed both. The McNary-Haugan bills proposed to establish “fair” exchange values (based on the 1910-14 period) for each product and to maintain them through tariffs and a private corporation that would be chartered by the government and could buy enough of each commodity to keep its price up to the computed fair level. The revenues were to come from taxes imposed on farmers. The Hoover administration passed the Hawley-Smoot tariff in 1930 and an Agricultural Marketing Act in 1929. This act committed the federal government to a policy of stabilizing farm prices through several nongovernment institutions but these failed during the depression. Federal intervention in the agricultural sector really came of age during the New Deal era of the 1930s.

Manufacturing

Agriculture was not the only sector experiencing difficulties in the twenties. Other industries, such as textiles, boots and shoes, and coal mining, also experienced trying times. However, at the same time that these industries were declining, other industries, such as electrical appliances, automobiles, and construction, were growing rapidly. The simultaneous existence of growing and declining industries has been common to all eras because economic growth and technological progress never affect all sectors in the same way. In general, in manufacturing there was a rapid rate of growth of productivity during the twenties. The rise of real wages due to immigration restrictions and the slower growth of the resident population spurred this. Transportation improvements and communications advances were also responsible. These developments brought about differential growth in the various manufacturing sectors in the United States in the 1920s.

Because of the historic pattern of economic development in the United States, the northeast was the first area to really develop a manufacturing base. By the mid-nineteenth century the East North Central region was creating a manufacturing base and the other regions began to create manufacturing bases in the last half of the nineteenth century resulting in a relative westward and southern shift of manufacturing activity. This trend continued in the 1920s as the New England and Middle Atlantic regions’ shares of manufacturing employment fell while all of the other regions—excluding the West North Central region—gained. There was considerable variation in the growth of the industries and shifts in their ranking during the decade. The largest broadly defined industries were, not surprisingly, food and kindred products; textile mill products; those producing and fabricating primary metals; machinery production; and chemicals. When industries are more narrowly defined, the automobile industry, which ranked third in manufacturing value added in 1919, ranked first by the mid-1920s.

Productivity Developments

Gavin Wright (1990) has argued that one of the underappreciated characteristics of American industrial history has been its reliance on mineral resources. Wright argues that the growing American strength in industrial exports and industrialization in general relied on an increasing intensity in nonreproducible natural resources. The large American market was knit together as one large market without internal barriers through the development of widespread low-cost transportation. Many distinctively American developments, such as continuous-process, mass-production methods were associated with the “high throughput” of fuel and raw materials relative to labor and capital inputs. As a result the United States became the dominant industrial force in the world 1920s and 1930s. According to Wright, after World War II “the process by which the United States became a unified ‘economy’ in the nineteenth century has been extended to the world as a whole. To a degree, natural resources have become commodities rather than part of the ‘factor endowment’ of individual countries.” (Wright, 1990)

In addition to this growing intensity in the use of nonreproducible natural resources as a source of productivity gains in American manufacturing, other technological changes during the twenties and thirties tended to raise the productivity of the existing capital through the replacement of critical types of capital equipment with superior equipment and through changes in management methods. (Soule, 1947; Lorant, 1967; Devine, 1983; Oshima, 1984) Some changes, such as the standardization of parts and processes and the reduction of the number of styles and designs, raised the productivity of both capital and labor. Modern management techniques, first introduced by Frederick W. Taylor, were introduced on a wider scale.

One of the important forces contributing to mass production and increased productivity was the transfer to electric power. (Devine, 1983) By 1929 about 70 percent of manufacturing activity relied on electricity, compared to roughly 30 percent in 1914. Steam provided 80 percent of the mechanical drive capacity in manufacturing in 1900, but electricity provided over 50 percent by 1920 and 78 percent by 1929. An increasing number of factories were buying their power from electric utilities. In 1909, 64 percent of the electric motor capacity in manufacturing establishments used electricity generated on the factory site; by 1919, 57 percent of the electricity used in manufacturing was purchased from independent electric utilities.

The shift from coal to oil and natural gas and from raw unprocessed energy in the forms of coal and waterpower to processed energy in the form of internal combustion fuel and electricity increased thermal efficiency. After the First World War energy consumption relative to GNP fell, there was a sharp increase in the growth rate of output per labor-hour, and the output per unit of capital input once again began rising. These trends can be seen in the data in Table 3. Labor productivity grew much more rapidly during the 1920s than in the previous or following decade. Capital productivity had declined in the decade previous to the 1920s while it also increased sharply during the twenties and continued to rise in the following decade. Alexander Field (2003) has argued that the 1930s were the most technologically progressive decade of the twentieth century basing his argument on the growth of multi-factor productivity as well as the impressive array of technological developments during the thirties. However, the twenties also saw impressive increases in labor and capital productivity as, particularly, developments in energy and transportation accelerated.

 Average Annual Rates of Labor Productivity and Capital Productivity Growth.

Warren Devine, Jr. (1983) reports that in the twenties the most important result of the adoption of electricity was that it would be an indirect “lever to increase production.” There were a number of ways in which this occurred. Electricity brought about an increased flow of production by allowing new flexibility in the design of buildings and the arrangement of machines. In this way it maximized throughput. Electric cranes were an “inestimable boon” to production because with adequate headroom they could operate anywhere in a plant, something that mechanical power transmission to overhead cranes did not allow. Electricity made possible the use of portable power tools that could be taken anywhere in the factory. Electricity brought about improved illumination, ventilation, and cleanliness in the plants, dramatically improving working conditions. It improved the control of machines since there was no longer belt slippage with overhead line shafts and belt transmission, and there were less limitations on the operating speeds of machines. Finally, it made plant expansion much easier than when overhead shafts and belts had been relied upon for operating power.

The mechanization of American manufacturing accelerated in the 1920s, and this led to a much more rapid growth of productivity in manufacturing compared to earlier decades and to other sectors at that time. There were several forces that promoted mechanization. One was the rapidly expanding aggregate demand during the prosperous twenties. Another was the technological developments in new machines and processes, of which electrification played an important part. Finally, Harry Jerome (1934) and, later, Harry Oshima (1984) both suggest that the price of unskilled labor began to rise as immigration sharply declined with new immigration laws and falling population growth. This accelerated the mechanization of the nation’s factories.

Technological changes during this period can be documented for a number of individual industries. In bituminous coal mining, labor productivity rose when mechanical loading devices reduced the labor required from 24 to 50 percent. The burst of paved road construction in the twenties led to the development of a finishing machine to smooth the surface of cement highways, and this reduced the labor requirement from 40 to 60 percent. Mechanical pavers that spread centrally mixed materials further increased productivity in road construction. These replaced the roadside dump and wheelbarrow methods of spreading the cement. Jerome (1934) reports that the glass in electric light bulbs was made by new machines that cut the number of labor-hours required for their manufacture by nearly half. New machines to produce cigarettes and cigars, for warp-tying in textile production, and for pressing clothes in clothing shops also cut labor-hours. The Banbury mixer reduced the labor input in the production of automobile tires by half, and output per worker of inner tubes increased about four times with a new production method. However, as Daniel Nelson (1987) points out, the continuing advances were the “cumulative process resulting from a vast number of successive small changes.” Because of these continuing advances in the quality of the tires and in the manufacturing of tires, between 1910 and 1930 “tire costs per thousand miles of driving fell from $9.39 to $0.65.”

John Lorant (1967) has documented other technological advances that occurred in American manufacturing during the twenties. For example, the organic chemical industry developed rapidly due to the introduction of the Weizman fermentation process. In a similar fashion, nearly half of the productivity advances in the paper industry were due to the “increasingly sophisticated applications of electric power and paper manufacturing processes,” especially the fourdrinier paper-making machines. As Avi Cohen (1984) has shown, the continuing advances in these machines were the result of evolutionary changes to the basic machine. Mechanization in many types of mass-production industries raised the productivity of labor and capital. In the glass industry, automatic feeding and other types of fully automatic production raised the efficiency of the production of glass containers, window glass, and pressed glass. Giedion (1948) reported that the production of bread was “automatized” in all stages during the 1920s.

Though not directly bringing about productivity increases in manufacturing processes, developments in the management of manufacturing firms, particularly the largest ones, also significantly affected their structure and operation. Alfred D. Chandler, Jr. (1962) has argued that the structure of a firm must follow its strategy. Until the First World War most industrial firms were centralized, single-division firms even when becoming vertically integrated. When this began to change the management of the large industrial firms had to change accordingly.

Because of these changes in the size and structure of the firm during the First World War, E. I. du Pont de Nemours and Company was led to adopt a strategy of diversifying into the production of largely unrelated product lines. The firm found that the centralized, divisional structure that had served it so well was not suited to this strategy, and its poor business performance led its executives to develop between 1919 and 1921 a decentralized, multidivisional structure that boosted it to the first rank among American industrial firms.

General Motors had a somewhat different problem. By 1920 it was already decentralized into separate divisions. In fact, there was so much decentralization that those divisions essentially remained separate companies and there was little coordination between the operating divisions. A financial crisis at the end of 1920 ousted W. C. Durant and brought in the du Ponts and Alfred Sloan. Sloan, who had seen the problems at GM but had been unable to convince Durant to make changes, began reorganizing the management of the company. Over the next several years Sloan and other GM executives developed the general office for a decentralized, multidivisional firm.

Though facing related problems at nearly the same time, GM and du Pont developed their decentralized, multidivisional organizations separately. As other manufacturing firms began to diversify, GM and du Pont became the models for reorganizing the management of the firms. In many industrial firms these reorganizations were not completed until well after the Second World War.

Competition, Monopoly, and the Government

The rise of big businesses, which accelerated in the postbellum period and particularly during the first great turn-of-the-century merger wave, continued in the interwar period. Between 1925 and 1939 the share of manufacturing assets held by the 100 largest corporations rose from 34.5 to 41.9 percent. (Niemi, 1980) As a public policy, the concern with monopolies diminished in the 1920s even though firms were growing larger. But the growing size of businesses was one of the convenient scapegoats upon which to blame the Great Depression.

However, the rise of large manufacturing firms in the interwar period is not so easily interpreted as an attempt to monopolize their industries. Some of the growth came about through vertical integration by the more successful manufacturing firms. Backward integration was generally an attempt to ensure a smooth supply of raw materials where that supply was not plentiful and was dispersed and firms “feared that raw materials might become controlled by competitors or independent suppliers.” (Livesay and Porter, 1969) Forward integration was an offensive tactic employed when manufacturers found that the existing distribution network proved inadequate. Livesay and Porter suggested a number of reasons why firms chose to integrate forward. In some cases they had to provide the mass distribution facilities to handle their much larger outputs; especially when the product was a new one. The complexity of some new products required technical expertise that the existing distribution system could not provide. In other cases “the high unit costs of products required consumer credit which exceeded financial capabilities of independent distributors.” Forward integration into wholesaling was more common than forward integration into retailing. The producers of automobiles, petroleum, typewriters, sewing machines, and harvesters were typical of those manufacturers that integrated all the way into retailing.

In some cases, increases in industry concentration arose as a natural process of industrial maturation. In the automobile industry, Henry Ford’s invention in 1913 of the moving assembly line—a technological innovation that changed most manufacturing—lent itself to larger factories and firms. Of the several thousand companies that had produced cars prior to 1920, 120 were still doing so then, but Ford and General Motors were the clear leaders, together producing nearly 70 percent of the cars. During the twenties, several other companies, such as Durant, Willys, and Studebaker, missed their opportunity to become more important producers, and Chrysler, formed in early 1925, became the third most important producer by 1930. Many went out of business and by 1929 only 44 companies were still producing cars. The Great Depression decimated the industry. Dozens of minor firms went out of business. Ford struggled through by relying on its huge stockpile of cash accumulated prior to the mid-1920s, while Chrysler actually grew. By 1940, only eight companies still produced cars—GM, Ford, and Chrysler had about 85 percent of the market, while Willys, Studebaker, Nash, Hudson, and Packard shared the remainder. The rising concentration in this industry was not due to attempts to monopolize. As the industry matured, growing economies of scale in factory production and vertical integration, as well as the advantages of a widespread dealer network, led to a dramatic decrease in the number of viable firms. (Chandler, 1962 and 1964; Rae, 1984; Bernstein, 1987)

It was a similar story in the tire industry. The increasing concentration and growth of firms was driven by scale economies in production and retailing and by the devastating effects of the depression in the thirties. Although there were 190 firms in 1919, 5 firms dominated the industry—Goodyear, B. F. Goodrich, Firestone, U.S. Rubber, and Fisk, followed by Miller Rubber, General Tire and Rubber, and Kelly-Springfield. During the twenties, 166 firms left the industry while 66 entered. The share of the 5 largest firms rose from 50 percent in 1921 to 75 percent in 1937. During the depressed thirties, there was fierce price competition, and many firms exited the industry. By 1937 there were 30 firms, but the average employment per factory was 4.41 times as large as in 1921, and the average factory produced 6.87 times as many tires as in 1921. (French, 1986 and 1991; Nelson, 1987; Fricke, 1982)

The steel industry was already highly concentrated by 1920 as U.S. Steel had around 50 percent of the market. But U. S. Steel’s market share declined through the twenties and thirties as several smaller firms competed and grew to become known as Little Steel, the next six largest integrated producers after U. S. Steel. Jonathan Baker (1989) has argued that the evidence is consistent with “the assumption that competition was a dominant strategy for steel manufacturers” until the depression. However, the initiation of the National Recovery Administration (NRA) codes in 1933 required the firms to cooperate rather than compete, and Baker argues that this constituted a training period leading firms to cooperate in price and output policies after 1935. (McCraw and Reinhardt, 1989; Weiss, 1980; Adams, 1977)

Mergers

A number of the larger firms grew by merger during this period, and the second great merger wave in American industry occurred during the last half of the 1920s. Figure 10 shows two series on mergers during the interwar period. The FTC series included many of the smaller mergers. The series constructed by Carl Eis (1969) only includes the larger mergers and ends in 1930.

This second great merger wave coincided with the stock market boom of the twenties and has been called “merger for oligopoly” rather than merger for monopoly. (Stigler, 1950) This merger wave created many larger firms that ranked below the industry leaders. Much of the activity in occurred in the banking and public utilities industries. (Markham, 1955) In manufacturing and mining, the effects on industrial structure were less striking. Eis (1969) found that while mergers took place in almost all industries, they were concentrated in a smaller number of them, particularly petroleum, primary metals, and food products.

The federal government’s antitrust policies toward business varied sharply during the interwar period. In the 1920s there was relatively little activity by the Justice Department, but after the Great Depression the New Dealers tried to take advantage of big business to make business exempt from the antitrust laws and cartelize industries under government supervision.

With the passage of the FTC and Clayton Acts in 1914 to supplement the 1890 Sherman Act, the cornerstones of American antitrust law were complete. Though minor amendments were later enacted, the primary changes after that came in the enforcement of the laws and in swings in judicial decisions. Their two primary areas of application were in the areas of overt behavior, such as horizontal and vertical price-fixing, and in market structure, such as mergers and dominant firms. Horizontal price-fixing involves firms that would normally be competitors getting together to agree on stable and higher prices for their products. As long as most of the important competitors agree on the new, higher prices, substitution between products is eliminated and the demand becomes much less elastic. Thus, increasing the price increases the revenues and the profits of the firms who are fixing prices. Vertical price-fixing involves firms setting the prices of intermediate products purchased at different stages of production. It also tends to eliminate substitutes and makes the demand less elastic.

Price-fixing continued to be considered illegal throughout the period, but there was no major judicial activity regarding it in the 1920s other than the Trenton Potteries decision in 1927. In that decision 20 individuals and 23 corporations were found guilty of conspiring to fix the prices of bathroom bowls. The evidence in the case suggested that the firms were not very successful at doing so, but the court found that they were guilty nevertheless; their success, or lack thereof, was not held to be a factor in the decision. (Scherer and Ross, 1990) Though criticized by some, the decision was precedent setting in that it prohibited explicit pricing conspiracies per se.

The Justice Department had achieved success in dismantling Standard Oil and American Tobacco in 1911 through decisions that the firms had unreasonably restrained trade. These were essentially the same points used in court decisions against the Powder Trust in 1911, the thread trust in 1913, Eastman Kodak in 1915, the glucose and cornstarch trust in 1916, and the anthracite railroads in 1920. The criterion of an unreasonable restraint of trade was used in the 1916 and 1918 decisions that found the American Can Company and the United Shoe Machinery Company innocent of violating the Sherman Act; it was also clearly enunciated in the 1920 U. S. Steel decision. This became known as the rule of reason standard in antitrust policy.

Merger policy had been defined in the 1914 Clayton Act to prohibit only the acquisition of one corporation’s stock by another corporation. Firms then shifted to the outright purchase of a competitor’s assets. A series of court decisions in the twenties and thirties further reduced the possibilities of Justice Department actions against mergers. “Only fifteen mergers were ordered dissolved through antitrust actions between 1914 and 1950, and ten of the orders were accomplished under the Sherman Act rather than Clayton Act proceedings.”

Energy

The search for energy and new ways to translate it into heat, light, and motion has been one of the unending themes in history. From whale oil to coal oil to kerosene to electricity, the search for better and less costly ways to light our lives, heat our homes, and move our machines has consumed much time and effort. The energy industries responded to those demands and the consumption of energy materials (coal, oil, gas, and fuel wood) as a percent of GNP rose from about 2 percent in the latter part of the nineteenth century to about 3 percent in the twentieth.

Changes in the energy markets that had begun in the nineteenth century continued. Processed energy in the forms of petroleum derivatives and electricity continued to become more important than “raw” energy, such as that available from coal and water. The evolution of energy sources for lighting continued; at the end of the nineteenth century, natural gas and electricity, rather than liquid fuels began to provide more lighting for streets, businesses, and homes.

In the twentieth century the continuing shift to electricity and internal combustion fuels increased the efficiency with which the American economy used energy. These processed forms of energy resulted in a more rapid increase in the productivity of labor and capital in American manufacturing. From 1899 to 1919, output per labor-hour increased at an average annual rate of 1.2 percent, whereas from 1919 to 1937 the increase was 3.5 percent per year. The productivity of capital had fallen at an average annual rate of 1.8 percent per year in the 20 years prior to 1919, but it rose 3.1 percent a year in the 18 years after 1919. As discussed above, the adoption of electricity in American manufacturing initiated a rapid evolution in the organization of plants and rapid increases in productivity in all types of manufacturing.

The change in transportation was even more remarkable. Internal combustion engines running on gasoline or diesel fuel revolutionized transportation. Cars quickly grabbed the lion’s share of local and regional travel and began to eat into long distance passenger travel, just as the railroads had done to passenger traffic by water in the 1830s. Even before the First World War cities had begun passing laws to regulate and limit “jitney” services and to protect the investments in urban rail mass transit. Trucking began eating into the freight carried by the railroads.

These developments brought about changes in the energy industries. Coal mining became a declining industry. As Figure 11 shows, in 1925 the share of petroleum in the value of coal, gas, and petroleum output exceeded bituminous coal, and it continued to rise. Anthracite coal’s share was much smaller and it declined while natural gas and LP (or liquefied petroleum) gas were relatively unimportant. These changes, especially the declining coal industry, were the source of considerable worry in the twenties.

Coal

One of the industries considered to be “sick” in the twenties was coal, particularly bituminous, or soft, coal. Income in the industry declined, and bankruptcies were frequent. Strikes frequently interrupted production. The majority of the miners “lived in squalid and unsanitary houses, and the incidence of accidents and diseases was high.” (Soule, 1947) The number of operating bituminous coal mines declined sharply from 1923 through 1932. Anthracite (or hard) coal output was much smaller during the twenties. Real coal prices rose from 1919 to 1922, and bituminous coal prices fell sharply from then to 1925. (Figure 12) Coal mining employment plummeted during the twenties. Annual earnings, especially in bituminous coal mining, also fell because of dwindling hourly earnings and, from 1929 on, a shrinking workweek. (Figure 13)

The sources of these changes are to be found in the increasing supply due to productivity advances in coal production and in the decreasing demand for coal. The demand fell as industries began turning from coal to electricity and because of productivity advances in the use of coal to create energy in steel, railroads, and electric utilities. (Keller, 1973) In the generation of electricity, larger steam plants employing higher temperatures and steam pressures continued to reduce coal consumption per kilowatt hour. Similar reductions were found in the production of coke from coal for iron and steel production and in the use of coal by the steam railroad engines. (Rezneck, 1951) All of these factors reduced the demand for coal.

Productivity advances in coal mining tended to be labor saving. Mechanical cutting accounted for 60.7 percent of the coal mined in 1920 and 78.4 percent in 1929. By the middle of the twenties, the mechanical loading of coal began to be introduced. Between 1929 and 1939, output per labor-hour rose nearly one third in bituminous coal mining and nearly four fifths in anthracite as more mines adopted machine mining and mechanical loading and strip mining expanded.

The increasing supply and falling demand for coal led to the closure of mines that were too costly to operate. A mine could simply cease operations, let the equipment stand idle, and lay off employees. When bankruptcies occurred, the mines generally just turned up under new ownership with lower capital charges. When demand increased or strikes reduced the supply of coal, idle mines simply resumed production. As a result, the easily expanded supply largely eliminated economic profits.

The average daily employment in coal mining dropped by over 208,000 from its peak in 1923, but the sharply falling real wages suggests that the supply of labor did not fall as rapidly as the demand for labor. Soule (1947) notes that when employment fell in coal mining, it meant fewer days of work for the same number of men. Social and cultural characteristics tended to tie many to their home region. The local alternatives were few, and ignorance of alternatives outside the Appalachian rural areas, where most bituminous coal was mined, made it very costly to transfer out.

Petroleum

In contrast to the coal industry, the petroleum industry was growing throughout the interwar period. By the thirties, crude petroleum dominated the real value of the production of energy materials. As Figure 14 shows, the production of crude petroleum increased sharply between 1920 and 1930, while real petroleum prices, though highly variable, tended to decline.

The growing demand for petroleum was driven by the growth in demand for gasoline as America became a motorized society. The production of gasoline surpassed kerosene production in 1915. Kerosene’s market continued to contract as electric lighting replaced kerosene lighting. The development of oil burners in the twenties began a switch from coal toward fuel oil for home heating, and this further increased the growing demand for petroleum. The growth in the demand for fuel oil and diesel fuel for ship engines also increased petroleum demand. But it was the growth in the demand for gasoline that drove the petroleum market.

The decline in real prices in the latter part of the twenties shows that supply was growing even faster than demand. The discovery of new fields in the early twenties increased the supply of petroleum and led to falling prices as production capacity grew. The Santa Fe Springs, California strike in 1919 initiated a supply shock as did the discovery of the Long Beach, California field in 1921. New discoveries in Powell, Texas and Smackover Arkansas further increased the supply of petroleum in 1921. New supply increases occurred in 1926 to 1928 with petroleum strikes in Seminole, Oklahoma and Hendricks, Texas. The supply of oil increased sharply in 1930 to 1931 with new discoveries in Oklahoma City and East Texas. Each new discovery pushed down real oil prices, and the prices of petroleum derivatives, and the growing production capacity led to a general declining trend in petroleum prices. McMillin and Parker (1994) argue that supply shocks generated by these new discoveries were a factor in the business cycles during the 1920s.

The supply of gasoline increased more than the supply of crude petroleum. In 1913 a chemist at Standard Oil of Indiana introduced the cracking process to refine crude petroleum; until that time it had been refined by distillation or unpressurized heating. In the heating process, various refined products such as kerosene, gasoline, naphtha, and lubricating oils were produced at different temperatures. It was difficult to vary the amount of the different refined products produced from a barrel of crude. The cracking process used pressurized heating to break heavier components down into lighter crude derivatives; with cracking, it was possible to increase the amount of gasoline obtained from a barrel of crude from 15 to 45 percent. In the early twenties, chemists at Standard Oil of New Jersey improved the cracking process, and by 1927 it was possible to obtain twice as much gasoline from a barrel of crude petroleum as in 1917.

The petroleum companies also developed new ways to distribute gasoline to motorists that made it more convenient to purchase gasoline. Prior to the First World War, gasoline was commonly purchased in one- or five-gallon cans and the purchaser used a funnel to pour the gasoline from the can into the car. Then “filling stations” appeared, which specialized in filling cars’ tanks with gasoline. These spread rapidly, and by 1919 gasoline companies werebeginning to introduce their own filling stations or contract with independent stations to exclusively distribute their gasoline. Increasing competition and falling profits led filling station operators to expand into other activities such as oil changes and other mechanical repairs. The general name attached to such stations gradually changed to “service stations” to reflect these new functions.

Though the petroleum firms tended to be large, they were highly competitive, trying to pump as much petroleum as possible to increase their share of the fields. This, combined with the development of new fields, led to an industry with highly volatile prices and output. Firms desperately wanted to stabilize and reduce the production of crude petroleum so as to stabilize and raise the prices of crude petroleum and refined products. Unable to obtain voluntary agreement on output limitations by the firms and producers, governments began stepping in. Led by Texas, which created the Texas Railroad Commission in 1891, oil-producing states began to intervene to regulate production. Such laws were usually termed prorationing laws and were quotas designed to limit each well’s output to some fraction of its potential. The purpose was as much to stabilize and reduce production and raise prices as anything else, although generally such laws were passed under the guise of conservation. Although the federal government supported such attempts, not until the New Deal were federal laws passed to assist this.

Electricity

By the mid 1890s the debate over the method by which electricity was to be transmitted had been won by those who advocated alternating current. The reduced power losses and greater distance over which electricity could be transmitted more than offset the necessity for transforming the current back to direct current for general use. Widespread adoption of machines and appliances by industry and consumers then rested on an increase in the array of products using electricity as the source of power, heat, or light and the development of an efficient, lower cost method of generating electricity.

General Electric, Westinghouse, and other firms began producing the electrical appliances for homes and an increasing number of machines based on electricity began to appear in industry. The problem of lower cost production was solved by the introduction of centralized generating facilities that distributed the electric power through lines to many consumers and business firms.

Though initially several firms competed in generating and selling electricity to consumers and firms in a city or area, by the First World War many states and communities were awarding exclusive franchises to one firm to generate and distribute electricity to the customers in the franchise area. (Bright, 1947; Passer, 1953) The electric utility industry became an important growth industry and, as Figure 15 shows, electricity production and use grew rapidly.

The electric utilities increasingly were regulated by state commissions that were charged with setting rates so that the utilities could receive a “fair return” on their investments. Disagreements over what constituted a “fair return” and the calculation of the rate base led to a steady stream of cases before the commissions and a continuing series of court appeals. Generally these court decisions favored the reproduction cost basis. Because of the difficulty and cost in making these calculations, rates tended to be in the hands of the electric utilities that, it has been suggested, did not lower rates adequately to reflect the rising productivity and lowered costs of production. The utilities argued that a more rapid lowering of rates would have jeopardized their profits. Whether or not this increased their monopoly power is still an open question, but it should be noted, that electric utilities were hardly price-taking industries prior to regulation. (Mercer, 1973) In fact, as Figure 16 shows, the electric utilities began to systematically practice market segmentation charging users with less elastic demands, higher prices per kilowatt-hour.

Energy in the American Economy of the 1920s

The changes in the energy industries had far-reaching consequences. The coal industry faced a continuing decline in demand. Even in the growing petroleum industry, the periodic surges in the supply of petroleum caused great instability. In manufacturing, as described above, electrification contributed to a remarkable rise in productivity. The transportation revolution brought about by the rise of gasoline-powered trucks and cars changed the way businesses received their supplies and distributed their production as well as where they were located. The suburbanization of America and the beginnings of urban sprawl were largely brought about by the introduction of low-priced gasoline for cars.

Transportation

The American economy was forever altered by the dramatic changes in transportation after 1900. Following Henry Ford’s introduction of the moving assembly production line in 1914, automobile prices plummeted, and by the end of the 1920s about 60 percent of American families owned an automobile. The advent of low-cost personal transportation led to an accelerating movement of population out of the crowded cities to more spacious homes in the suburbs and the automobile set off a decline in intracity public passenger transportation that has yet to end. Massive road-building programs facilitated the intercity movement of people and goods. Trucks increasingly took over the movement of freight in competition with the railroads. New industries, such as gasoline service stations, motor hotels, and the rubber tire industry, arose to service the automobile and truck traffic. These developments were complicated by the turmoil caused by changes in the federal government’s policies toward transportation in the United States.

With the end of the First World War, a debate began as to whether the railroads, which had been taken over by the government, should be returned to private ownership or nationalized. The voices calling for a return to private ownership were much stronger, but doing so fomented great controversy. Many in Congress believed that careful planning and consolidation could restore the railroads and make them more efficient. There was continued concern about the near monopoly that the railroads had on the nation’s intercity freight and passenger transportation. The result of these deliberations was the Transportation Act of 1920, which was premised on the continued domination of the nation’s transportation by the railroads—an erroneous presumption.

The Transportation Act of 1920 presented a marked change in the Interstate Commerce Commission’s ability to control railroads. The ICC was allowed to prescribe exact rates that were to be set so as to allow the railroads to earn a fair return, defined as 5.5 percent, on the fair value of their property. The ICC was authorized to make an accounting of the fair value of each regulated railroad’s property; however, this was not completed until well into the 1930s, by which time the accounting and rate rules were out of date. To maintain fair competition between railroads in a region, all roads were to have the same rates for the same goods over the same distance. With the same rates, low-cost roads should have been able to earn higher rates of return than high-cost roads. To handle this, a recapture clause was inserted: any railroad earning a return of more than 6 percent on the fair value of its property was to turn the excess over to the ICC, which would place half of the money in a contingency fund for the railroad when it encountered financial problems and the other half in a contingency fund to provide loans to other railroads in need of assistance.

In order to address the problem of weak and strong railroads and to bring better coordination to the movement of rail traffic in the United States, the act was directed to encourage railroad consolidation, but little came of this in the 1920s. In order to facilitate its control of the railroads, the ICC was given two additional powers. The first was the control over the issuance or purchase of securities by railroads, and the second was the power to control changes in railroad service through the control of car supply and the extension and abandonment of track. The control of the supply of rail cars was turned over to the Association of American Railroads. Few extensions of track were proposed, but as time passed, abandonment requests grew. The ICC, however, trying to mediate between the conflicting demands of shippers, communities and railroads, generally refused to grant abandonments, and this became an extremely sensitive issue in the 1930s.

As indicated above, the premises of the Transportation Act of 1920 were wrong. Railroads experienced increasing competition during the 1920s, and both freight and passenger traffic were drawn off to competing transport forms. Passenger traffic exited from the railroads much more quickly. As the network of all weather surfaced roads increased, people quickly turned from the train to the car. Harmed even more by the move to automobile traffic were the electric interurban railways that had grown rapidly just prior to the First World War. (Hilton-Due, 1960) Not surprisingly, during the 1920s few railroads earned profits in excess of the fair rate of return.

The use of trucks to deliver freight began shortly after the turn of the century. Before the outbreak of war in Europe, White and Mack were producing trucks with as much as 7.5 tons of carrying capacity. Most of the truck freight was carried on a local basis, and it largely supplemented the longer distance freight transportation provided by the railroads. However, truck size was growing. In 1915 Trailmobile introduced the first four-wheel trailer designed to be pulled by a truck tractor unit. During the First World War, thousands of trucks were constructed for military purposes, and truck convoys showed that long distance truck travel was feasible and economical. The use of trucks to haul freight had been growing by over 18 percent per year since 1925, so that by 1929 intercity trucking accounted for more than one percent of the ton-miles of freight hauled.

The railroads argued that the trucks and buses provided “unfair” competition and believed that if they were also regulated, then the regulation could equalize the conditions under which they competed. As early as 1925, the National Association of Railroad and Utilities Commissioners issued a call for the regulation of motor carriers in general. In 1928 the ICC called for federal regulation of buses and in 1932 extended this call to federal regulation of trucks.

Most states had began regulating buses at the beginning of the 1920s in an attempt to reduce the diversion of urban passenger traffic from the electric trolley and railway systems. However, most of the regulation did not aim to control intercity passenger traffic by buses. As the network of surfaced roads expanded during the twenties, so did the routes of the intercity buses. In 1929 a number of smaller bus companies were incorporated in the Greyhound Buslines, the carrier that has since dominated intercity bus transportation. (Walsh, 2000)

A complaint of the railroads was that interstate trucking competition was unfair because it was subsidized while railroads were not. All railroad property was privately owned and subject to property taxes, whereas truckers used the existing road system and therefore neither had to bear the costs of creating the road system nor pay taxes upon it. Beginning with the Federal Road-Aid Act of 1916, small amounts of money were provided as an incentive for states to construct rural post roads. (Dearing-Owen, 1949) However, through the First World War most of the funds for highway construction came from a combination of levies on the adjacent property owners and county and state taxes. The monies raised by the counties were commonly 60 percent of the total funds allocated, and these primarily came from property taxes. In 1919 Oregon pioneered the state gasoline tax, which then began to be adopted by more and more states. A highway system financed by property taxes and other levies can be construed as a subsidization of motor vehicles, and one study for the period up to 1920 found evidence of substantial subsidization of trucking. (Herbst-Wu, 1973) However, the use of gasoline taxes moved closer to the goal of users paying the costs of the highways. Neither did the trucks have to pay for all of the highway construction because automobiles jointly used the highways. Highways had to be constructed in more costly ways in order to accommodate the larger and heavier trucks. Ideally the gasoline taxes collected from trucks should have covered the extra (or marginal) costs of highway construction incurred because of the truck traffic. Gasoline taxes tended to do this.

The American economy occupies a vast geographic region. Because economic activity occurs over most of the country, falling transportation costs have been crucial to knitting American firms and consumers into a unified market. Throughout the nineteenth century the railroads played this crucial role. Because of the size of the railroad companies and their importance in the economic life of Americans, the federal government began to regulate them. But, by 1917 it appeared that the railroad system had achieved some stability, and it was generally assumed that the post-First World War era would be an extension of the era from 1900 to 1917. Nothing could have been further from the truth. Spurred by public investments in highways, cars and trucks voraciously ate into the railroad’s market, and, though the regulators failed to understand this at the time, the railroad’s monopoly on transportation quickly disappeared.

Communications

Communications had joined with transportation developments in the nineteenth century to tie the American economy together more completely. The telegraph had benefited by using the railroads’ right-of-ways, and the railroads used the telegraph to coordinate and organize their far-flung activities. As the cost of communications fell and information transfers sped, the development of firms with multiple plants at distant locations was facilitated. The interwar era saw a continuation of these developments as the telephone continued to supplant the telegraph and the new medium of radio arose to transmit news and provide a new entertainment source.

Telegraph domination of business and personal communications had given way to the telephone as long distance telephone calls between the east and west coasts with the new electronic amplifiers became possible in 1915. The number of telegraph messages handled grew 60.4 percent in the twenties. The number of local telephone conversations grew 46.8 percent between 1920 and 1930, while the number of long distance conversations grew 71.8 percent over the same period. There were 5 times as many long distance telephone calls as telegraph messages handled in 1920, and 5.7 times as many in 1930.

The twenties were a prosperous period for AT&T and its 18 major operating companies. (Brooks, 1975; Temin, 1987; Garnet, 1985; Lipartito, 1989) Telephone usage rose and, as Figure 19 shows, the share of all households with a telephone rose from 35 percent to nearly 42 percent. In cities across the nation, AT&T consolidated its system, gained control of many operating companies, and virtually eliminated its competitors. It was able to do this because in 1921 Congress passed the Graham Act exempting AT&T from the Sherman Act in consolidating competing telephone companies. By 1940, the non-Bell operating companies were all small relative to the Bell operating companies.

Surprisingly there was a decline in telephone use on the farms during the twenties. (Hadwiger-Cochran, 1984; Fischer 1987) Rising telephone rates explain part of the decline in rural use. The imposition of connection fees during the First World War made it more costly for new farmers to hook up. As AT&T gained control of more and more operating systems, telephone rates were increased. AT&T also began requiring, as a condition of interconnection, that independent companies upgrade their systems to meet AT&T standards. Most of the small mutual companies that had provided service to farmers had operated on a shoestring—wires were often strung along fenceposts, and phones were inexpensive “whoop and holler” magneto units. Upgrading to AT&T’s standards raised costs, forcing these companies to raise rates.

However, it also seems likely that during the 1920s there was a general decline in the rural demand for telephone services. One important factor in this was the dramatic decline in farm incomes in the early twenties. The second reason was a change in the farmers’ environment. Prior to the First World War, the telephone eased farm isolation and provided news and weather information that was otherwise hard to obtain. After 1920 automobiles, surfaced roads, movies, and the radio loosened the isolation and the telephone was no longer as crucial.

Othmar Merganthaler’s development of the linotype machine in the late nineteenth century had irrevocably altered printing and publishing. This machine, which quickly created a line of soft, lead-based metal type that could be printed, melted down and then recast as a new line of type, dramatically lowered the costs of printing. Previously, all type had to be painstakingly set by hand, with individual cast letter matrices picked out from compartments in drawers to construct words, lines, and paragraphs. After printing, each line of type on the page had to be broken down and each individual letter matrix placed back into its compartment in its drawer for use in the next printing job. Newspapers often were not published every day and did not contain many pages, resulting in many newspapers in most cities. In contrast to this laborious process, the linotype used a keyboard upon which the operator typed the words in one of the lines in a news column. Matrices for each letter dropped down from a magazine of matrices as the operator typed each letter and were assembled into a line of type with automatic spacers to justify the line (fill out the column width). When the line was completed the machine mechanically cast the line of matrices into a line of lead type. The line of lead type was ejected into a tray and the letter matrices mechanically returned to the magazine while the operator continued typing the next line in the news story. The first Merganthaler linotype machine was installed in the New York Tribune in 1886. The linotype machine dramatically lowered the costs of printing newspapers (as well as books and magazines). Prior to the linotype a typical newspaper averaged no more than 11 pages and many were published only a few times a week. The linotype machine allowed newspapers to grow in size and they began to be published more regularly. A process of consolidation of daily and Sunday newspapers began that continues to this day. Many have termed the Merganthaler linotype machine the most significant printing invention since the introduction of movable type 400 years earlier.

For city families as well as farm families, radio became the new source of news and entertainment. (Barnouw, 1966; Rosen, 1980 and 1987; Chester-Garrison, 1950) It soon took over as the prime advertising medium and in the process revolutionized advertising. By 1930 more homes had radio sets than had telephones. The radio networks sent news and entertainment broadcasts all over the country. The isolation of rural life, particularly in many areas of the plains, was forever broken by the intrusion of the “black box,” as radio receivers were often called. The radio began a process of breaking down regionalism and creating a common culture in the United States.

The potential demand for radio became clear with the first regular broadcast of Westinghouse’s KDKA in Pittsburgh in the fall of 1920. Because the Department of Commerce could not deny a license application there was an explosion of stations all broadcasting at the same frequency and signal jamming and interference became a serious problem. By 1923 the Department of Commerce had gained control of radio from the Post Office and the Navy and began to arbitrarily disperse stations on the radio dial and deny licenses creating the first market in commercial broadcast licenses. In 1926 a U.S. District Court decided that under the Radio Law of 1912 Herbert Hoover, the secretary of commerce, did not have this power. New stations appeared and the logjam and interference of signals worsened. A Radio Act was passed in January of 1927 creating the Federal Radio Commission (FRC) as a temporary licensing authority. Licenses were to be issued in the public interest, convenience, and necessity. A number of broadcasting licenses were revoked; stations were assigned frequencies, dial locations, and power levels. The FRC created 24 clear-channel stations with as much as 50,000 watts of broadcasting power, of which 21 ended up being affiliated with the new national radio networks. The Communications Act of 1934 essentially repeated the 1927 act except that it created a permanent, seven-person Federal Communications Commission (FCC).

Local stations initially created and broadcast the radio programs. The expenses were modest, and stores and companies operating radio stations wrote this off as indirect, goodwill advertising. Several forces changed all this. In 1922, AT&T opened up a radio station in New York City, WEAF (later to become WNBC). AT&T envisioned this station as the center of a radio toll system where individuals could purchase time to broadcast a message transmitted to other stations in the toll network using AT&T’s long distance lines and an August 1922 broadcast by a Long Island realty company became the first conscious use of direct advertising.

Though advertising continued to be condemned, the fiscal pressures on radio stations to accept advertising began rising. In 1923 the American Society of Composers and Publishers (ASCAP), began demanding a performance fee anytime ASCAP-copyrighted music was performed on the radio, either live or on record. By 1924 the issue was settled, and most stations began paying performance fees to ASCAP. AT&T decided that all stations broadcasting with non AT&T transmitters were violating their patent rights and began asking for annual fees from such stations based on the station’s power. By the end of 1924, most stations were paying the fees. All of this drained the coffers of the radio stations, and more and more of them began discreetly accepting advertising.

RCA became upset at AT&T’s creation of a chain of radio stations and set up its own toll network using the inferior lines of Western Union and Postal Telegraph, because AT&T, not surprisingly, did not allow any toll (or network) broadcasting on its lines except by its own stations. AT&T began to worry that its actions might threaten its federal monopoly in long distance telephone communications. In 1926 a new firm was created, the National Broadcasting Company (NBC), which took over all broadcasting activities from AT&T and RCA as AT&T left broadcasting. When NBC debuted in November of 1926, it had two networks: the Red, which was the old AT&T network, and the Blue, which was the old RCA network. Radio networks allowed advertisers to direct advertising at a national audience at a lower cost. Network programs allowed local stations to broadcast superior programs that captured a larger listening audience and in return received a share of the fees the national advertiser paid to the network. In 1927 a new network, the Columbia Broadcasting System (CBS) financed by the Paley family began operation and other new networks entered or tried to enter the industry in the 1930s.

Communications developments in the interwar era present something of a mixed picture. By 1920 long distance telephone service was in place, but rising rates slowed the rate of adoption in the period, and telephone use in rural areas declined sharply. Though direct dialing was first tried in the twenties, its general implementation would not come until the postwar era, when other changes, such as microwave transmission of signals and touch-tone dialing, would also appear. Though the number of newspapers declined, newspaper circulation generally held up. The number of competing newspapers in larger cities began declining, a trend that also would accelerate in the postwar American economy.

Banking and Securities Markets

In the twenties commercial banks became “department stores of finance.”— Banks opened up installment (or personal) loan departments, expanded their mortgage lending, opened up trust departments, undertook securities underwriting activities, and offered safe deposit boxes. These changes were a response to growing competition from other financial intermediaries. Businesses, stung by bankers’ control and reduced lending during the 1920-21 depression, began relying more on retained earnings and stock and bond issues to raise investment and, sometimes, working capital. This reduced loan demand. The thrift institutions also experienced good growth in the twenties as they helped fuel the housing construction boom of the decade. The securities markets boomed in the twenties only to see a dramatic crash of the stock market in late 1929.

There were two broad classes of commercial banks; those that were nationally chartered and those that were chartered by the states. Only the national banks were required to be members of the Federal Reserve System. (Figure 21) Most banks were unit banks because national regulators and most state regulators prohibited branching. However, in the twenties a few states began to permit limited branching; California even allowed statewide branching.—The Federal Reserve member banks held the bulk of the assets of all commercial banks, even though most banks were not members. A high bank failure rate in the 1920s has usually been explained by “overbanking” or too many banks located in an area, but H. Thomas Johnson (1973-74) makes a strong argument against this. (Figure 22)— If there were overbanking, on average each bank would have been underutilized resulting in intense competition for deposits and higher costs and lower earnings. One common reason would have been the free entry of banks as long as they achieved the minimum requirements then in force. However, the twenties saw changes that led to the demise of many smaller rural banks that would likely have been profitable if these changes had not occurred. Improved transportation led to a movement of business activities, including banking, into the larger towns and cities. Rural banks that relied on loans to farmers suffered just as farmers did during the twenties, especially in the first half of the twenties. The number of bank suspensions and the suspension rate fell after 1926. The sharp rise in bank suspensions in 1930 occurred because of the first banking crisis during the Great Depression.

Prior to the twenties, the main assets of commercial banks were short-term business loans, made by creating a demand deposit or increasing an existing one for a borrowing firm. As business lending declined in the 1920s commercial banks vigorously moved into new types of financial activities. As banks purchased more securities for their earning asset portfolios and gained expertise in the securities markets, larger ones established investment departments and by the late twenties were an important force in the underwriting of new securities issued by nonfinancial corporations.

The securities market exhibited perhaps the most dramatic growth of the noncommercial bank financial intermediaries during the twenties, but others also grew rapidly. (Figure 23) The assets of life insurance companies increased by 10 percent a year from 1921 to 1929; by the late twenties they were a very important source of funds for construction investment. Mutual savings banks and savings and loan associations (thrifts) operated in essentially the same types of markets. The Mutual savings banks were concentrated in the northeastern United States. As incomes rose, personal savings increased, and housing construction expanded in the twenties, there was an increasing demand for the thrifts’ interest earning time deposits and mortgage lending.

But the dramatic expansion in the financial sector came in new corporate securities issues in the twenties—especially common and preferred stock—and in the trading of existing shares of those securities. (Figure 24) The late twenties boom in the American economy was rapid, highly visible, and dramatic. Skyscrapers were being erected in most major cities, the automobile manufacturers produced over four and a half million new cars in 1929; and the stock market, like a barometer of this prosperity, was on a dizzying ride to higher and higher prices. “Playing the market” seemed to become a national pastime.

The Dow-Jones index hit its peak of 381 on September 3 and then slid to 320 on October 21. In the following week the stock market “crashed,” with a record number of shares being traded on several days. At the end of Tuesday, October, 29th, the index stood at 230, 96 points less than one week before. On November 13, 1929, the Dow-Jones index reached its lowest point for the year at 198—183 points less than the September 3 peak.

The path of the stock market boom of the twenties can be seen in Figure 25. Sharp price breaks occurred several times during the boom, and each of these gave rise to dark predictions of the end of the bull market and speculation. Until late October of 1929, these predictions turned out to be wrong. Between those price breaks and prior to the October crash, stock prices continued to surge upward. In March of 1928, 3,875,910 shares were traded in one day, establishing a record. By late 1928, five million shares being traded in a day was a common occurrence.

New securities, from rising merger activity and the formation of holding companies, were issued to take advantage of the rising stock prices.—Stock pools, which were not illegal until the 1934 Securities and Exchange Act, took advantage of the boom to temporarily drive up the price of selected stocks and reap large gains for the members of the pool. In stock pools a group of speculators would pool large amounts of their funds and then begin purchasing large amounts of shares of a stock. This increased demand led to rising prices for that stock. Frequently pool insiders would “churn” the stock by repeatedly buying and selling the same shares among themselves, but at rising prices. Outsiders, seeing the price rising, would decide to purchase the stock whose price was rising. At a predetermined higher price the pool members would, within a short period, sell their shares and pull out of the market for that stock. Without the additional demand from the pool, the stock’s price usually fell quickly bringing large losses for the unsuspecting outside investors while reaping large gains for the pool insiders.

Another factor commonly used to explain both the speculative boom and the October crash was the purchase of stocks on small margins. However, contrary to popular perception, margin requirements through most of the twenties were essentially the same as in previous decades. Brokers, recognizing the problems with margin lending in the rapidly changing market, began raising margin requirements in late 1928, and by the fall of 1929, margin requirements were the highest in the history of the New York Stock Exchange. In the 1920s, as was the case for decades prior to that, the usual margin requirements were 10 to 15 percent of the purchase price, and, apparently, more often around 10 percent. There were increases in this percentage by 1928 and by the fall of 1928, well before the crash and at the urging of a special New York Clearinghouse committee, margin requirements had been raised to some of the highest levels in New York Stock Exchange history. One brokerage house required the following of its clients. Securities with a selling price below $10 could only be purchased for cash. Securities with a selling price of $10 to $20 had to have a 50 percent margin; for securities of $20 to $30 a margin requirement of 40 percent; and, for securities with a price above $30 the margin was 30 percent of the purchase price. In the first half of 1929 margin requirements on customers’ accounts averaged a 40 percent margin, and some houses raised their margins to 50 percent a few months before the crash. These were, historically, very high margin requirements. (Smiley and Keehn, 1988)—Even so, during the crash when additional margin calls were issued, those investors who could not provide additional margin saw the brokers’ sell their stock at whatever the market price was at the time and these forced sales helped drive prices even lower.

The crash began on Monday, October 21, as the index of stock prices fell 3 points on the third-largest volume in the history of the New York Stock Exchange. After a slight rally on Tuesday, prices began declining on Wednesday and fell 21 points by the end of the day bringing on the third call for more margin in that week. On Black Thursday, October 24, prices initially fell sharply, but rallied somewhat in the afternoon so that the net loss was only 7 points, but the volume of thirteen million shares set a NYSE record. Friday brought a small gain that was wiped out on Saturday. On Monday, October 28, the Dow Jones index fell 38 points on a volume of nine million shares—three million in the final hour of trading. Black Tuesday, October 29, brought declines in virtually every stock price. Manufacturing firms, which had been lending large sums to brokers for margin loans, had been calling in these loans and this accelerated on Monday and Tuesday. The big Wall Street banks increased their lending on call loans to offset some of this loss of loanable funds. The Dow Jones Index fell 30 points on a record volume of nearly sixteen and a half million shares exchanged. Black Thursday and Black Tuesday wiped out entire fortunes.

Though the worst was over, prices continued to decline until November 13, 1929, as brokers cleaned up their accounts and sold off the stocks of clients who could not supply additional margin. After that, prices began to slowly rise and by April of 1930 had increased 96 points from the low of November 13,— “only” 87 points less than the peak of September 3, 1929. From that point, stock prices resumed their depressing decline until the low point was reached in the summer of 1932.

 

—There is a long tradition that insists that the Great Bull Market of the late twenties was an orgy of speculation that bid the prices of stocks far above any sustainable or economically justifiable level creating a bubble in the stock market. John Kenneth Galbraith (1954) observed, “The collapse in the stock market in the autumn of 1929 was implicit in the speculation that went before.”—But not everyone has agreed with this.

In 1930 Irving Fisher argued that the stock prices of 1928 and 1929 were based on fundamental expectations that future corporate earnings would be high.— More recently, Murray Rothbard (1963), Gerald Gunderson (1976), and Jude Wanniski (1978) have argued that stock prices were not too high prior to the crash.—Gunderson suggested that prior to 1929, stock prices were where they should have been and that when corporate profits in the summer and fall of 1929 failed to meet expectations, stock prices were written down.— Wanniski argued that political events brought on the crash. The market broke each time news arrived of advances in congressional consideration of the Hawley-Smoot tariff. However, the virtually perfect foresight that Wanniski’s explanation requires is unrealistic.— Charles Kindleberger (1973) and Peter Temin (1976) examined common stock yields and price-earnings ratios and found that the relative constancy did not suggest that stock prices were bid up unrealistically high in the late twenties.—Gary Santoni and Gerald Dwyer (1990) also failed to find evidence of a bubble in stock prices in 1928 and 1929.—Gerald Sirkin (1975) found that the implied growth rates of dividends required to justify stock prices in 1928 and 1929 were quite conservative and lower than post-Second World War dividend growth rates.

However, examination of after-the-fact common stock yields and price-earning ratios can do no more than provide some ex post justification for suggesting that there was not excessive speculation during the Great Bull Market.— Each individual investor was motivated by that person’s subjective expectations of each firm’s future earnings and dividends and the future prices of shares of each firm’s stock. Because of this element of subjectivity, not only can we never accurately know those values, but also we can never know how they varied among individuals. The market price we observe will be the end result of all of the actions of the market participants, and the observed price may be different from the price almost all of the participants expected.

In fact, there are some indications that there were differences in 1928 and 1929. Yields on common stocks were somewhat lower in 1928 and 1929. In October of 1928, brokers generally began raising margin requirements, and by the beginning of the fall of 1929, margin requirements were, on average, the highest in the history of the New York Stock Exchange. Though the discount and commercial paper rates had moved closely with the call and time rates on brokers’ loans through 1927, the rates on brokers’ loans increased much more sharply in 1928 and 1929.— This pulled in funds from corporations, private investors, and foreign banks as New York City banks sharply reduced their lending. These facts suggest that brokers and New York City bankers may have come to believe that stock prices had been bid above a sustainable level by late 1928 and early 1929. White (1990) created a quarterly index of dividends for firms in the Dow-Jones index and related this to the DJI. Through 1927 the two track closely, but in 1928 and 1929 the index of stock prices grows much more rapidly than the index of dividends.

The qualitative evidence for a bubble in the stock market in 1928 and 1929 that White assembled was strengthened by the findings of J. Bradford De Long and Andre Shleifer (1991). They examined closed-end mutual funds, a type of fund where investors wishing to liquidate must sell their shares to other individual investors allowing its fundamental value to be exactly measurable.— Using evidence from these funds, De Long and Shleifer estimated that in the summer of 1929, the Standard and Poor’s composite stock price index was overvalued about 30 percent due to excessive investor optimism. Rappoport and White (1993 and 1994) found other evidence that supported a bubble in the stock market in 1928 and 1929. There was a sharp divergence between the growth of stock prices and dividends; there were increasing premiums on call and time brokers’ loans in 1928 and 1929; margin requirements rose; and stock market volatility rose in the wake of the 1929 stock market crash.

There are several reasons for the creation of such a bubble. First, the fundamental values of earnings and dividends become difficult to assess when there are major industrial changes, such as the rapid changes in the automobile industry, the new electric utilities, and the new radio industry.— Eugene White (1990) suggests that “While investors had every reason to expect earnings to grow, they lacked the means to evaluate easily the future path of dividends.” As a result investors bid up prices as they were swept up in the ongoing stock market boom. Second, participation in the stock market widened noticeably in the twenties. The new investors were relatively unsophisticated, and they were more likely to be caught up in the euphoria of the boom and bid prices upward.— New, inexperienced commission sales personnel were hired to sell stocks and they promised glowing returns on stocks they knew little about.

These observations were strengthened by the experimental work of economist Vernon Smith. (Bishop, 1987) In a number of experiments over a three-year period using students and Tucson businessmen and businesswomen, bubbles developed as inexperienced investors valued stocks differently and engaged in price speculation. As these investors in the experiments began to realize that speculative profits were unsustainable and uncertain, their dividend expectations changed, the market crashed, and ultimately stocks began trading at their fundamental dividend values. These bubbles and crashes occurred repeatedly, leading Smith to conjecture that there are few regulatory steps that can be taken to prevent a crash.

Though the bubble of 1928 and 1929 made some downward adjustment in stock prices inevitable, as Barsky and De Long have shown, changes in fundamentals govern the overall movements. And the end of the long bull market was almost certainly governed by this. In late 1928 and early 1929 there was a striking rise in economic activity, but a decline began somewhere between May and July of that year and was clearly evident by August of 1929. By the middle of August, the rise in stock prices had slowed down as better information on the contraction was received. There were repeated statements by leading figures that stocks were “overpriced” and the Federal Reserve System sharply increased the discount rate in August 1929 was well as continuing its call for banks to reduce their margin lending. As this information was assessed, the number of speculators selling stocks increased, and the number buying decreased. With the decreased demand, stock prices began to fall, and as more accurate information on the nature and extent of the decline was received, stock prices fell more. The late October crash made the decline occur much more rapidly, and the margin purchases and consequent forced selling of many of those stocks contributed to a more severe price fall. The recovery of stock prices from November 13 into April of 1930 suggests that stock prices may have been driven somewhat too low during the crash.

There is now widespread agreement that the 1929 stock market crash did not cause the Great Depression. Instead, the initial downturn in economic activity was a primary determinant of the ending of the 1928-29 stock market bubble. The stock market crash did make the downturn become more severe beginning in November 1929. It reduced discretionary consumption spending (Romer, 1990) and created greater income uncertainty helping to bring on the contraction (Flacco and Parker, 1992). Though stock market prices reached a bottom and began to recover following November 13, 1929, the continuing decline in economic activity took its toll and by May 1930 stock prices resumed their decline and continued to fall through the summer of 1932.

Domestic Trade

In the nineteenth century, a complex array of wholesalers, jobbers, and retailers had developed, but changes in the postbellum period reduced the role of the wholesalers and jobbers and strengthened the importance of the retailers in domestic trade. (Cochran, 1977; Chandler, 1977; Marburg, 1951; Clewett, 1951) The appearance of the department store in the major cities and the rise of mail order firms in the postbellum period changed the retailing market.

Department Stores

A department store is a combination of specialty stores organized as departments within one general store. A. T. Stewart’s huge 1846 dry goods store in New York City is often referred to as the first department store. (Resseguie, 1965; Sobel-Sicilia, 1986) R. H. Macy started his dry goods store in 1858 and Wanamaker’s in Philadelphia opened in 1876. By the end of the nineteenth century, every city of any size had at least one major department store. (Appel, 1930; Benson, 1986; Hendrickson, 1979; Hower, 1946; Sobel, 1974) Until the late twenties, the department store field was dominated by independent stores, though some department stores in the largest cities had opened a few suburban branches and stores in other cities. In the interwar period department stores accounted for about 8 percent of retail sales.

The department stores relied on a “one-price” policy, which Stewart is credited with beginning. In the antebellum period and into the postbellum period, it was common not to post a specific price on an item; rather, each purchaser haggled with a sales clerk over what the price would be. Stewart posted fixed prices on the various dry goods sold, and the customer could either decide to buy or not buy at the fixed price. The policy dramatically lowered transactions costs for both the retailer and the purchaser. Prices were reduced with a smaller markup over the wholesale price, and a large sales volume and a quicker turnover of the store’s inventory generated profits.

Mail Order Firms

What changed the department store field in the twenties was the entrance of Sears Roebuck and Montgomery Ward, the two dominant mail order firms in the United States. (Emmet-Jeuck, 1950; Chandler, 1962, 1977) Both firms had begun in the late nineteenth century and by 1914 the younger Sears Roebuck had surpassed Montgomery Ward. Both located in Chicago due to its central location in the nation’s rail network and both had benefited from the advent of Rural Free Delivery in 1896 and low cost Parcel Post Service in 1912.

In 1924 Sears hired Robert C. Wood, who was able to convince Sears Roebuck to open retail stores. Wood believed that the declining rural population and the growing urban population forecast the gradual demise of the mail order business; survival of the mail order firms required a move into retail sales. By 1925 Sears Roebuck had opened 8 retail stores, and by 1929 it had 324 stores. Montgomery Ward quickly followed suit. Rather than locating these in the central business district (CBD), Wood located many on major streets closer to the residential areas. These moves of Sears Roebuck and Montgomery Ward expanded department store retailing and provided a new type of chain store.

Chain Stores

Though chain stores grew rapidly in the first two decades of the twentieth century, they date back to the 1860s when George F. Gilman and George Huntington Hartford opened a string of New York City A&P (Atlantic and Pacific) stores exclusively to sell tea. (Beckman-Nolen, 1938; Lebhar, 1963; Bullock, 1933) Stores were opened in other regions and in 1912 their first “cash-and-carry” full-range grocery was opened. Soon they were opening 50 of these stores each week and by the 1920s A&P had 14,000 stores. They then phased out the small stores to reduce the chain to 4,000 full-range, supermarket-type stores. A&P’s success led to new grocery store chains such as Kroger, Jewel Tea, and Safeway.

Prior to A&P’s cash-and-carry policy, it was common for grocery stores, produce (or green) grocers, and meat markets to provide home delivery and credit, both of which were costly. As a result, retail prices were generally marked up well above the wholesale prices. In cash-and-carry stores, items were sold only for cash; no credit was extended, and no expensive home deliveries were provided. Markups on prices could be much lower because other costs were much lower. Consumers liked the lower prices and were willing to pay cash and carry their groceries, and the policy became common by the twenties.

Chains also developed in other retail product lines. In 1879 Frank W. Woolworth developed a “5 and 10 Cent Store,” or dime store, and there were over 1,000 F. W. Woolworth stores by the mid-1920s. (Winkler, 1940) Other firms such as Kresge, Kress, and McCrory successfully imitated Woolworth’s dime store chain. J.C. Penney’s dry goods chain store began in 1901 (Beasley, 1948), Walgreen’s drug store chain began in 1909, and shoes, jewelry, cigars, and other lines of merchandise also began to be sold through chain stores.

Self-Service Policies

In 1916 Clarence Saunders, a grocer in Memphis, Tennessee, built upon the one-price policy and began offering self-service at his Piggly Wiggly store. Previously, customers handed a clerk a list or asked for the items desired, which the clerk then collected and the customer paid for. With self-service, items for sale were placed on open shelves among which the customers could walk, carrying a shopping bag or pushing a shopping cart. Each customer could then browse as he or she pleased, picking out whatever was desired. Saunders and other retailers who adopted the self-service method of retail selling found that customers often purchased more because of exposure to the array of products on the shelves; as well, self-service lowered the labor required for retail sales and therefore lowered costs.

Shopping Centers

Shopping Centers, another innovation in retailing that began in the twenties, was not destined to become a major force in retail development until after the Second World War. The ultimate cause of this innovation was the widening ownership and use of the automobile. By the 1920s, as the ownership and use of the car began expanding, population began to move out of the crowded central cities toward the more open suburbs. When General Robert Wood set Sears off on its development of urban stores, he located these not in the central business district, CBD, but as free-standing stores on major arteries away from the CBD with sufficient space for parking.

At about the same time, a few entrepreneurs began to develop shopping centers. Yehoshua Cohen (1972) says, “The owner of such a center was responsible for maintenance of the center, its parking lot, as well as other services to consumers and retailers in the center.” Perhaps the earliest such shopping center was the Country Club Plaza built in 1922 by the J. C. Nichols Company in Kansas City, Missouri. Other early shopping centers appeared in Baltimore and Dallas. By the mid-1930s the concept of a planned shopping center was well known and was expected to be the means to capture the trade of the growing number of suburban consumers.

International Trade and Finance

In the twenties a gold exchange standard was developed to replace the gold standard of the prewar world. Under a gold standard, each country’s currency carried a fixed exchange rate with gold, and the currency had to be backed up by gold. As a result, all countries on the gold standard had fixed exchange rates with all other countries. Adjustments to balance international trade flows were made by gold flows. If a country had a deficit in its trade balance, gold would leave the country, forcing the money stock to decline and prices to fall. Falling prices made the deficit countries’ exports more attractive and imports more costly, reducing the deficit. Countries with a surplus imported gold, which increased the money stock and caused prices to rise. This made the surplus countries’ exports less attractive and imports more attractive, decreasing the surplus. Most economists who have studied the prewar gold standard contend that it did not work as the conventional textbook model says, because capital flows frequently reduced or eliminated the need for gold flows for long periods of time. However, there is no consensus on whether fortuitous circumstances, rather than the gold standard, saved the international economy from periodic convulsions or whether the gold standard as it did work was sufficient to promote stability and growth in international transactions.

After the First World War it was argued that there was a “shortage” of fluid monetary gold to use for the gold standard, so some method of “economizing” on gold had to be found. To do this, two basic changes were made. First, most nations, other than the United States, stopped domestic circulation of gold. Second, the “gold exchange” system was created. Most countries held their international reserves in the form of U.S. dollars or British pounds and international transactions used dollars or pounds, as long as the United States and Great Britain stood ready to exchange their currencies for gold at fixed exchange rates. However, the overvaluation of the pound and the undervaluation of the franc threatened these arrangements. The British trade deficit led to a capital outflow, higher interest rates, and a weak economy. In the late twenties, the French trade surplus led to the importation of gold that they did not allow to expand the money supply.

Economizing on gold by no longer allowing its domestic circulation and by using key currencies as international monetary reserves was really an attempt to place the domestic economies under the control of the nations’ politicians and make them independent of international events. Unfortunately, in doing this politicians eliminated the equilibrating mechanism of the gold standard but had nothing with which to replace it. The new international monetary arrangements of the twenties were potentially destabilizing because they were not allowed to operate as a price mechanism promoting equilibrating adjustments.

There were other problems with international economic activity in the twenties. Because of the war, the United States was abruptly transformed from a debtor to a creditor on international accounts. Though the United States did not want reparations payments from Germany, it did insist that Allied governments repay American loans. The Allied governments then insisted on war reparations from Germany. These initial reparations assessments were quite large. The Allied Reparations Commission collected the charges by supervising Germany’s foreign trade and by internal controls on the German economy, and it was authorized to increase the reparations if it was felt that Germany could pay more. The treaty allowed France to occupy the Ruhr after Germany defaulted in 1923.

Ultimately, this tangled web of debts and reparations, which was a major factor in the course of international trade, depended upon two principal actions. First, the United States had to run an import surplus or, on net, export capital out of the United States to provide a pool of dollars overseas. Germany then had either to have an export surplus or else import American capital so as to build up dollar reserves—that is, the dollars the United States was exporting. In effect, these dollars were paid by Germany to Great Britain, France, and other countries that then shipped them back to the United States as payment on their U.S. debts. If these conditions did not occur, (and note that the “new” gold standard of the twenties had lost its flexibility because the price adjustment mechanism had been eliminated) disruption in international activity could easily occur and be transmitted to the domestic economies.

In the wake of the 1920-21 depression Congress passed the Emergency Tariff Act, which raised tariffs, particularly on manufactured goods. (Figures 26 and 27) The Fordney-McCumber Tariff of 1922 continued the Emergency Tariff of 1921, and its protection on many items was extremely high, ranging from 60 to 100 percent ad valorem (or as a percent of the price of the item). The increases in the Fordney-McCumber tariff were as large and sometimes larger than the more famous (or “infamous”) Smoot-Hawley tariff of 1930. As farm product prices fell at the end of the decade presidential candidate Herbert Hoover proposed, as part of his platform, tariff increases and other changes to aid the farmers. In January 1929, after Hoover’s election, but before he took office, a tariff bill was introduced into Congress. Special interests succeeded in gaining additional (or new) protection for most domestically produced commodities and the goal of greater protection for the farmers tended to get lost in the increased protection for multitudes of American manufactured products. In spite of widespread condemnation by economists, President Hoover signed the Smoot-Hawley Tariff in June 1930 and rates rose sharply.

Following the First World War, the U.S. government actively promoted American exports, and in each of the postwar years through 1929, the United States recorded a surplus in its balance of trade. (Figure 28) However, the surplus declined in the 1930s as both exports and imports fell sharply after 1929. From the mid-1920s on finished manufactures were the most important exports, while agricultural products dominated American imports.

The majority of the funds that allowed Germany to make its reparations payments to France and Great Britain and hence allowed those countries to pay their debts to the United States came from the net flow of capital out of the United States in the form of direct investment in real assets and investments in long- and short-term foreign financial assets. After the devastating German hyperinflation of 1922 and 1923, the Dawes Plan reformed the German economy and currency and accelerated the U.S. capital outflow. American investors began to actively and aggressively pursue foreign investments, particularly loans (Lewis, 1938) and in the late twenties there was a marked deterioration in the quality of foreign bonds sold in the United States. (Mintz, 1951)

The system, then, worked well as long as there was a net outflow of American capital, but this did not continue. In the middle of 1928, the flow of short-term capital began to decline. In 1928 the flow of “other long-term” capital out of the United States was 752 million dollars, but in 1929 it was only 34 million dollars. Though arguments now exist as to whether the booming stock market in the United States was to blame for this, it had far-reaching effects on the international economic system and the various domestic economies.

The Start of the Depression

The United States had the majority of the world’s monetary gold, about 40 percent, by 1920. In the latter part of the twenties, France also began accumulating gold as its share of the world’s monetary gold rose from 9 percent in 1927 to 17 percent in 1929 and 22 percent by 1931. In 1927 the Federal Reserve System had reduced discount rates (the interest rate at which they lent reserves to member commercial banks) and engaged in open market purchases (purchasing U.S. government securities on the open market to increase the reserves of the banking system) to push down interest rates and assist Great Britain in staying on the gold standard. By early 1928 the Federal Reserve System was worried about its loss of gold due to this policy as well as the ongoing boom in the stock market. It began to raise the discount rate to stop these outflows. Gold was also entering the United States so that foreigners could obtain dollars to invest in stocks and bonds. As the United States and France accumulated more and more of the world’s monetary gold, other countries’ central banks took contractionary steps to stem the loss of gold. In country after country these deflationary strategies began contracting economic activity and by 1928 some countries in Europe, Asia, and South America had entered into a depression. More countries’ economies began to decline in 1929, including the United States, and by 1930 a depression was in force for almost all of the world’s market economies. (Temin, 1989; Eichengreen, 1992)

Monetary and Fiscal Policies in the 1920s

Fiscal Policies

As a tool to promote stability in aggregate economic activity, fiscal policy is largely a post-Second World War phenomenon. Prior to 1930 the federal government’s spending and taxing decisions were largely, but not completely, based on the perceived “need” for government-provided public goods and services.

Though the fiscal policy concept had not been developed, this does not mean that during the twenties no concept of the government’s role in stimulating economic activity existed. Herbert Stein (1990) points out that in the twenties Herbert Hoover and some of his contemporaries shared two ideas about the proper role of the federal government. The first was that federal spending on public works could be an important force in reducin Smiley and Keehn, 1995.  investment. Both concepts fit the ideas held by Hoover and others of his persuasion that the U.S. economy of the twenties was not the result of laissez-faire workings but of “deliberate social engineering.”

The federal personal income tax was enacted in 1913. Though mildly progressive, its rates were low and topped out at 7 percent on taxable income in excess of $750,000. (Table 4) As the United States prepared for war in 1916, rates were increased and reached a maximum marginal rate of 12 percent. With the onset of the First World War, the rates were dramatically increased. To obtain additional revenue in 1918, marginal rates were again increased. The share of federal revenue generated by income taxes rose from 11 percent in 1914 to 69 percent in 1920. The tax rates had been extended downward so that more than 30 percent of the nation’s income recipients were subject to income taxes by 1918. However, through the purchase of tax exempt state and local securities and through steps taken by corporations to avoid the cash distribution of profits, the number of high income taxpayers and their share of total taxes paid declined as Congress kept increasing the tax rates. The normal (or base) tax rate was reduced slightly for 1919 but the surtax rates, which made the income tax highly progressive, were retained. (Smiley-Keehn, 1995)

President Harding’s new Secretary of the Treasury, Andrew Mellon, proposed cutting the tax rates, arguing that the rates in the higher brackets had “passed the point of productivity” and rates in excess of 70 percent simply could not be collected. Though most agreed that the rates were too high, there was sharp disagreement on how the rates should be cut. Democrats and  Smiley and Keehn, 1995.  Progressive Republicans argued for rate cuts targeted for the lower income taxpayers while maintaining most of the steep progressivity of the tax rates. They believed that remedies could be found to change the tax laws to stop the legal avoidance of federal income taxes. Republicans argued for sharper cuts that reduced the progressivity of the rates. Mellon proposed a maximum rate of 25 percent.

Though the federal income tax rates were reduced and made less progressive, it took three tax rate cuts in 1921, 1924, and 1925 before Mellon’s goal was finally achieved. The highest marginal tax rate was reduced from 73 percent to 58 percent to 46 percent and finally to 25 percent for the 1925 tax year. All of the other rates were also reduced and exemptions increased. By 1926, only about the top 10 percent of income recipients were subject to federal income taxes. As tax rates were reduced, the number of high income tax returns increased and the share of total federal personal income taxes paid rose. (Tables 5 and 6) Even with the dramatic income tax rate cuts and reductions in the number of low income taxpayers, federal personal income tax revenue continued to rise during the 1920s. Though early estimates of the distribution of personal income showed sharp increases in income inequality during the 1920s (Kuznets, 1953; Holt, 1977), more recent estimates have found that the increases in inequality were considerably less and these appear largely to be related to the sharp rise in capital gains due to the booming stock market in the late twenties. (Smiley, 1998 and 2000)

Each year in the twenties the federal government generated a surplus, in some years as much as 1 percent of GNP. The surpluses were used to reduce the federal deficit and it declined by 25 percent between 1920 and 1930. Contrary to simple macroeconomic models that argue a federal government budget surplus must be contractionary and tend to stop an economy from reaching full employment, the American economy operated at full-employment or close to it throughout the twenties and saw significant economic growth. In this case, the surpluses were not contractionary because the dollars were circulated back into the economy through the purchase of outstanding federal debt rather than pulled out as currency and held in a vault somewhere.

Monetary Policies

In 1913 fear of the “money trust” and their monopoly power led Congress to create 12 central banks when they created the Federal Reserve System. The new central banks were to control money and credit and act as lenders of last resort to end banking panics. The role of the Federal Reserve Board, located in Washington, D.C., was to coordinate the policies of the 12 district banks; it was composed of five presidential appointees and the current secretary of the treasury and comptroller of the currency. All national banks had to become members of the Federal Reserve System, the Fed, and any state bank meeting the qualifications could elect to do so.

The act specified fixed reserve requirements on demand and time deposits, all of which had to be on deposit in the district bank. Commercial banks were allowed to rediscount commercial paper and given Federal Reserve currency. Initially, each district bank set its own rediscount rate. To provide additional income when there was little rediscounting, the district banks were allowed to engage in open market operations that involved the purchasing and selling of federal government securities, short-term securities of state and local governments issued in anticipation of taxes, foreign exchange, and domestic bills of exchange. The district banks were also designated to act as fiscal agents for the federal government. Finally, the Federal Reserve System provided a central check clearinghouse for the entire banking system.

When the Federal Reserve System was originally set up, it was believed that its primary role was to be a lender of last resort to prevent banking panics and become a check-clearing mechanism for the nation’s banks. Both the Federal Reserve Board and the Governors of the District Banks were bodies established to jointly exercise these activities. The division of functions was not clear, and a struggle for power ensued, mainly between the New York Federal Reserve Bank, which was led by J. P. Morgan’s protege, Benjamin Strong, through 1928, and the Federal Reserve Board. By the thirties the Federal Reserve Board had achieved dominance.

There were really two conflicting criteria upon which monetary actions were ostensibly based: the Gold Standard and the Real Bills Doctrine. The Gold Standard was supposed to be quasi-automatic, with an effective limit to the quantity of money. However, the Real Bills Doctrine (which required that all loans be made on short-term, self-liquidating commercial paper) had no effective limit on the quantity of money. The rediscounting of eligible commercial paper was supposed to lead to the required “elasticity” of the stock of money to “accommodate” the needs of industry and business. Actually the rediscounting of commercial paper, open market purchases, and gold inflows all had the same effects on the money stock.

The 1920-21 Depression

During the First World War, the Fed kept discount rates low and granted discounts on banks’ customer loans used to purchase V-bonds in order to help finance the war. The final Victory Loan had not been floated when the Armistice was signed in November of 1918: in fact, it took until October of 1919 for the government to fully sell this last loan issue. The Treasury, with the secretary of the treasury sitting on the Federal Reserve Board, persuaded the Federal Reserve System to maintain low interest rates and discount the Victory bonds necessary to keep bond prices high until this last issue had been floated. As a result, during this period the money supply grew rapidly and prices rose sharply.

A shift from a federal deficit to a surplus and supply disruptions due to steel and coal strikes in 1919 and a railroad strike in early 1920 contributed to the end of the boom. But the most—common view is that the Fed’s monetary policy was the main determinant of the end of the expansion and inflation and the beginning of the subsequent contraction and severe deflation. When the Fed was released from its informal agreement with the Treasury in November of 1919, it raised the discount rate from 4 to 4.75 percent. Benjamin Strong (the governor of the New York bank) was beginning to believe that the time for strong action was past and that the Federal Reserve System’s actions should be moderate. However, with Strong out of the country, the Federal Reserve Board increased the discount rate from 4.75 to 6 percent in late January of 1920 and to 7 percent on June 1, 1920. By the middle of 1920, economic activity and employment were rapidly falling, and prices had begun their downward spiral in one of the sharpest price declines in American history. The Federal Reserve System kept the discount rate at 7 percent until May 5, 1921, when it was lowered to 6.5 percent. By June of 1922, the rate had been lowered yet again to 4 percent. (Friedman and Schwartz, 1963)

The Federal Reserve System authorities received considerable criticism then and later for their actions. Milton Friedman and Anna Schwartz (1963) contend that the discount rate was raised too much too late and then kept too high for too long, causing the decline to be more severe and the price deflation to be greater. In their opinion the Fed acted in this manner due to the necessity of meeting the legal reserve requirement with a safe margin of gold reserves. Elmus Wicker (1966), however, argues that the gold reserve ratio was not the main factor determining the Federal Reserve policy in the episode. Rather, the Fed knowingly pursued a deflationary policy because it felt that the money supply was simply too large and prices too high. To return to the prewar parity for gold required lowering the price level, and there was an excessive stock of money because the additional money had been used to finance the war, not to produce consumer goods. Finally, the outstanding indebtedness was too large due to the creation of Fed credit.

Whether statutory gold reserve requirements to maintain the gold standard or domestic credit conditions were the most important determinant of Fed policy is still an open question, though both certainly had some influence. Regardless of the answer to that question, the Federal Reserve System’s first major undertaking in the years immediately following the First World War demonstrated poor policy formulation.

Federal Reserve Policies from 1922 to 1930

By 1921 the district banks began to recognize that their open market purchases had effects on interest rates, the money stock, and economic activity. For the next several years, economists in the Federal Reserve System discussed how this worked and how it could be related to discounting by member banks. A committee was created to coordinate the open market purchases of the district banks.

The recovery from the 1920-1921 depression had proceeded smoothly with moderate price increases. In early 1923 the Fed sold some securities and increased the discount rate from 4 percent as they believed the recovery was too rapid. However, by the fall of 1923 there were some signs of a business slump. McMillin and Parker (1994) argue that this contraction, as well as the 1927 contraction, were related to oil price shocks. By October of 1923 Benjamin Strong was advocating securities purchases to counter this. Between then and September 1924 the Federal Reserve System increased its securities holdings by over $500 million. Between April and August of 1924 the Fed reduced the discount rate to 3 percent in a series of three separate steps. In addition to moderating the mild business slump, the expansionary policy was also intended to reduce American interest rates relative to British interest rates. This reversed the gold flow back toward Great Britain allowing Britain to return to the gold standard in 1925. At the time it appeared that the Fed’s monetary policy had successfully accomplished its goals.

By the summer of 1924 the business slump was over and the economy again began to grow rapidly. By the mid-1920s real estate speculation had arisen in many urban areas in the United States and especially in Southeastern Florida. Land prices were rising sharply. Stock market prices had also begun rising more rapidly. The Fed expressed some worry about these developments and in 1926 sold some securities to gently slow the real estate and stock market boom. Amid hurricanes and supply bottlenecks the Florida real estate boom collapsed but the stock market boom continued.

The American economy entered into another mild business recession in the fall of 1926 that lasted until the fall of 1927. One of the factors in this was Henry’s Ford’s shut down of all of his factories to changeover from the Model T to the Model A. His employees were left without a job and without income for over six months. International concerns also reappeared. France, which was preparing to return to the gold standard, had begun accumulating gold and gold continued to flow into the United States. Some of this gold came from Great Britain making it difficult for the British to remain on the gold standard. This occasioned a new experiment in central bank cooperation. In July 1927 Benjamin Strong arranged a conference with Governor Montagu Norman of the Bank of England, Governor Hjalmar Schacht of the Reichsbank, and Deputy Governor Charles Ritt of the Bank of France in an attempt to promote cooperation among the world’s central bankers. By the time the conference began the Fed had already taken steps to counteract the business slump and reduce the gold inflow. In early 1927 the Fed reduced discount rates and made large securities purchases. One result of this was that the gold stock fell from $4.3 billion in mid-1927 to $3.8 billion in mid-1928. Some of the gold exports went to France and France returned to the gold standard with its undervalued currency. The loss of gold from Britain eased allowing it to maintain the gold standard.

By early 1928 the Fed was again becoming worried. Stock market prices were rising even faster and the apparent speculative bubble in the stock market was of some concern to Fed authorities. The Fed was also concerned about the loss of gold and wanted to bring that to an end. To do this they sold securities and, in three steps, raised the discount rate to 5 percent by July 1928. To this point the Federal Reserve Board had largely agreed with district Bank policy changes. However, problems began to develop.

During the stock market boom of the late 1920s the Federal Reserve Board preferred to use “moral suasion” rather than increases in discount rates to lessen member bank borrowing. The New York City bank insisted that moral suasion would not work unless backed up by literal credit rationing on a bank by bank basis which they, and the other district banks, were unwilling to do. They insisted that discount rates had to be increased. The Federal Reserve Board countered that this general policy change would slow down economic activity in general rather than be specifically targeted to stock market speculation. The result was that little was done for a year. Rates were not raised but no open market purchases were undertaken. Rates were finally raised to 6 percent in August of 1929. By that time the contraction had already begun. In late October the stock market crashed, and America slid into the Great Depression.

In November, following the stock market crash the Fed reduced discount rates to 4.5 percent. In January they again decreased discount rates and began a series of discount rate decreases until the rate reached 2.5 percent at the end of 1930. No further open market operations were undertaken for the next six months. As banks reduced their discounting in 1930, the stock of money declined. There was a banking crisis in the southeast in November and December of 1930, and in its wake the public’s holding of currency relative to deposits and banks’ reserve ratios began to rise and continued to do so through the end of the Great Depression.

Conclusion

Though some disagree, there is growing evidence that the behavior of the American economy in the 1920s did not cause the Great Depression. The depressed 1930s were not “retribution” for the exuberant growth of the 1920s. The weakness of a few economic sectors in the 1920s did not forecast the contraction from 1929 to 1933. Rather it was the depression of the 1930s and the Second World War that interrupted the economic growth begun in the 1920s and resumed after the Second World War. Just as the construction of skyscrapers that began in the 1920s resumed in the 1950s, so did real economic growth and progress resume. In retrospect we can see that the introduction and expansion of new technologies and industries in the 1920s, such as autos, household electric appliances, radio, and electric utilities, are echoed in the 1990s in the effects of the expanding use and development of the personal computer and the rise of the internet. The 1920s have much to teach us about the growth and development of the American economy.

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Smiley, Gene. “A Note on New Estimates of the Distribution of Income in the 1920s.” The Journal of Economic History 60, no. 4 (2000): 1120-1128.

Smiley, Gene. Rethinking the Great Depression: A New View of Its Causes and Consequences. Chicago: Ivan R. Dee, 2002.

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Citation: Smiley, Gene. “US Economy in the 1920s”. EH.Net Encyclopedia, edited by Robert Whaples. June 29, 2004. URL http://eh.net/encyclopedia/the-u-s-economy-in-the-1920s/

Alcohol Prohibition

Jeffrey A. Miron, Boston University

The prohibition of alcohol, 1920-1933, is one of the most interesting policy experiments in U.S. history. Temperance movements waxed and waned in the U.S. from early in the nineteenth century, and these movements produced numerous state prohibitions. Many of these prohibitions were subsequently repealed, however, and those that persisted were widely regarded as ineffective. Amid the atmosphere created by World War I, support for national prohibition reached critical mass, and the country ratified the 18th Amendment to the Constitution in January, 1919.1 Under this amendment and the Volstead Act, which provided for the enforcement of Prohibition, the manufacture, transportation, and sale of alcohol were prohibited by federal law.2 The Amendment was popular for many years, but beginning in the late 1920s support began to erode.3 In 1933 the 21st Amendment repealed the 18th, ending Prohibition.

This article provides a brief economic history of Alcohol Prohibition. The first section discusses the major effects one should expect from policies like Prohibition and mentions evidence consistent with these effects. The second and third sections then consider more detailed evidence on two keys issues: Prohibition’s effect on the quantity and price of alcohol, and Prohibition’s effect on violent crime.

The Effects of Prohibitions

The most direct effects of prohibitions are on the supply and demand for the prohibited commodity.4 Prohibitions raise supply costs because black market suppliers face legal punishments for manufacturing, distributing, and selling. Conditional on operating in secret, however, black market suppliers face low marginal costs of evading government regulations and taxes (Miron 2001), which provides a partial offset to the increased costs due to prohibition.5 Prohibitions reduce demand by creating legal penalties for possession and by increasing uncertainty about product quality.6 Prohibitions also reduce demand if consumers exhibit “respect for the law.” At the same time, prohibitions can increase demand through a “forbidden fruit” effect, meaning a tendency for consumers to desire that which has been forbidden to them. Thus, the effect of prohibitions on price and even quantity are ambiguous a priori and must be determined empirically.

In addition to affecting price and quantity, prohibitions potentially increase violent and non-violent crime. Participants in an illegal trade cannot use the legal and judicial system to resolve disputes, so they seek other methods such as violence. Enforcement of prohibitions means reduced resources for enforcement of non-prohibition laws, which implies reduced deterrence of crime generally. Prohibitions can increase income-generating crime, such as theft or prostitution, by raising prices if consumers finance consumption of the prohibited commodity from such crime. And prohibitions give black market suppliers an incentive to corrupt law enforcement officials and politicians. Despite these tendencies to increase crime, the net effect of prohibitions on crime can be negative if prohibitions discourage consumption of the prohibited good and if such consumption encourages criminal activity. Thus, the net effect of prohibitions on crime can only be determined empirically.

Two other effects of prohibitions are the effects on overdoses and accidental poisonings. Because suppliers in a prohibited market must hide their activities from the authorities, they have a strong incentive to produce and ship the good in the most concentrated and hence most easily concealed form (Thornton 1998). This implies that prohibitions help make the potent forms of a good more readily available or even help create more potent forms of a prohibited substance. By itself this effect does not necessarily change the manner in which consumption takes place; consumers can potentially redilute the commodity in question to achieve their desired degree of potency. But in practice such redilution is imperfect, suggesting increased overdoses under prohibitions.7

Consumers in a prohibited market cannot sue the manufacturers of faulty goods or complain to government agencies without incriminating themselves. In addition, the costs of advertising are high in a prohibited market, so producers cannot easily develop a reputation for quality in order to generate repeat business. Thus, uncertainty about quality is likely to be greater in a prohibited market. Combined with the greater existence of high potency products, this further suggests the possibility of increased overdoses, as well as accidental poisonings, under prohibition.8

Alcohol Consumption and Prices under Prohibition

The evidence on alcohol consumption during Prohibition is incomplete, since standard data sources are not available for the Prohibition period. Thus, most analyses of Prohibition’s effect use the cirrhosis death rate as a proxy. Figures 1 and 2 present data on alcohol consumption and cirrhosis, respectively.9 The figures suggests a strong correlation between alcohol consumption and cirrhosis. Both series decline noticeably just before the onset of Prohibition and increase gradually for the first three decades after repeal of Prohibition. Both series then increase more rapidly from the mid-1960’s to the mid-1970’s and decline from 1980 to the present. The correlation is not perfect; alcohol consumption exhibits a noticeable spike relative to cirrhosis in the 1940’s, and cirrhosis starts declining several years earlier than alcohol consumption during the 1970’s. But the figure suggests that cirrhosis is a reasonable proxy for alcohol consumption, and the evidence summarized in Dills and Miron (2001) confirms this impression.

The fact that cirrhosis was substantially lower on average during Prohibition than before or after might suggest that Prohibition played a substantial role in reducing cirrhosis, but further examination suggests this conclusion is premature. First, there have been substantial fluctuations in cirrhosis outside the Prohibition period, indicating that other factors are important determinants and must be accounted for in analyzing whether Prohibition caused the low level of cirrhosis during Prohibition. Second, there is no obvious jump in cirrhosis upon repeal. This fact does not prove that Prohibition had no effect, since the lags between consumption and cirrhosis mean the effect of increased consumption might not have shown up immediately. Nevertheless, the behavior of cirrhosis after repeal fails to suggest a large effect of Prohibition. Third, cirrhosis began declining from its pre-1920 peak by as early as 1908, and it had already attained its lowest level over the sample in 1920, the year in which constitutional prohibition took effect.

This last fact is the most problematic for the claim that Prohibition reduced alcohol consumption. One possible explanation for the large pre-1920 decline in cirrhosis is that state prohibition laws were becoming increasingly widespread during the 1910-1920 period. Dills and Miron (2001) use state-level data, however, to show the declines in cirrhosis during this period were typically as large or larger in wet states as in states that adopted prohibition laws. More formally, they estimate a fixed-effects regression using state-level cirrhosis data to show that, once aggregate effects are accounted for, there is little effect of state prohibitions on cirrhosis.

A different possible explanation for the large decline in cirrhosis is pre-1920 federal anti-alcohol policies. In February 1913, Congress adopted the Webb-Kenyon Law, which prohibited shipments of liquor from wet states into dry states if such shipments were in violation of the dry state law. This did not prohibit all shipments into dry states, since some dry states allowed importation (Merz 1930, p. 14). In February 1917, Congress passed the Reed bone-dry amendment, which forbade interstate shipment of liquor into states that prohibited manufacture and sale, even if the state allowed importation. (Merz 1930, p. 20). In August 1917, Congress adopted the Food Control Law, which forbade the manufacture of distilled spirits from any form of foodstuff and closed the distilleries (Merz 1930, pp. 26-27, 40-41). In September 1918, it closed the breweries as well (Merz 1930, p. 41). Also in September 1918, Congress approved wartime prohibition, although this did not take effect until July 1, 1919 (Merz 1930, p. 41). Wartime prohibition contained the first general restriction on sale, providing that after June 30, 1919, no liquor could be sold for beverage purposes except for export (Schmeckebier 1929, pp. 4-5).

There are a number of reasons to doubt that these policies were major factors in causing the pre-1920 declines in cirrhosis. First, cirrhosis had been declining since 1908, well before any of these policies took effect. Second, all these policies except war-time prohibition (which did not take effect until July, 1919) were weak; they did not restrict production until August 1917, and none outlawed importation or consumption of existing stocks. Moreover, Congress made no appropriation for the enforcement of any of these laws. In addition, there are other factors that potentially explain a decline in alcohol consumption or cirrhosis. Patriotism might have encouraged temperance, since food was considered vital to the War effort and beer production was associated with Germany. And the high morality rate in Word War I combined with the flu epidemic of 1918 might have removed many persons from the population at risk who would otherwise have died from cirrhosis.

Beyond the results presented here, additional results in Dills and Miron (2001)—which account for the effects of state prohibitions, pre-1920 federal anti-alcohol policies, alcoholic beverage taxes, income and other factors—demonstrate consistently that Prohibition had a small, statistically insignificant, and possibly even a positive effect on cirrhosis. Given the evidence that cirrhosis is a reasonable proxy for alcohol consumption, this implies Prohibition had little impact on the path of alcohol consumption.

The question raised by this result is why consumption did not fall more significantly, since conventional accounts suggest that alcohol prices rose by several hundred percent on average (Warburton (1932), Fisher (1928)). One possibility is that the conventional view is overstated.

The first problem with the calculations presented by Warburton or Fisher is that they neglect the behavior of the overall price level. Warburton’s data compare prices between 1911-1915 and 1926-1930, while Fisher’s compare prices between 1916 and 1928. Both authors examine the behavior of nominal prices, yet the price level increased by approximately 75 percent between these two periods (Bureau of the Census (1975), p.211). Thus, at a minimum, the raw data presented by Warburton and Fisher overstate the increase in the relative price of alcohol.

In addition, Warburton presents a broad range of prices for the Prohibition period, and the lowest prices reported suggest that, even ignoring inflation, some alcoholic beverage prices fell relative to the pre-Prohibition period. This does not prove that consumers paid less, on average, for alcohol, but they certainly faced an incentive to buy at the lowest prices and then stockpile the quantities purchased at these prices. The available data do not allow computation of the average price actually paid, and the extremely high prices reported in many cases by both Warburton and Fisher allow for the possibility that the average price paid in fact rose. But the magnitude of this rise is undoubtedly less than they asserted, and it is at least possible prices failed to rise substantially overall. If prices did not increase very much, there is no puzzle in the failure of consumption to fall substantially.

Alcohol Prohibition and Crime

The evidence on Prohibition and crime focuses on the homicide rate, since this is the only type of crime for which data are reported consistently both before, during, and after Prohibition.10 Figure 3 presents the homicide rate in the United States (measured as homicides per 100,000 population) for the period 1900-1995. Starting from around 1906, the homicide rate rises steadily through 1933-1934, when it begins a general decline until approximately 1960, interrupted by a spike during World War II. Beginning in the early 1960’s the homicide rate rises steadily until the early 1970’s—to a level slightly above the previous peak in 1933-1934—and then fluctuates around a relatively high value for the remainder of the sample.

Roughly speaking, therefore, there have been two periods with high homicide rates in U.S. history, the 1920-1934 period and the 1970-1990 period (Friedman 1991). Both before the first episode and between these two episodes, homicide rates were relatively low or clearly declining. Prima facie, this pattern is consistent with the hypothesis that alcohol prohibition increased violent crime: homicide rates are high in the 1920-1933 period, when constitutional prohibition of alcohol was in effect; the homicide rate drops quickly after 1933, when Prohibition was repealed; and the homicide rate remains low for a substantial period thereafter. Further, the homicide rate is low during the 1950s and early 1960s, when drug prohibition was in existence but not vigorously enforced, but high in the 1970-1990 period, when drug prohibition was enforced to a relatively stringent degree (Miron 1999).

To see this more carefully, consider Figure 4, which plots real per capita expenditure by the federal government for enforcement of alcohol and drug prohibition over this same period. As discussed in Miron (1999, 2001), the effect of prohibition on violence depends not just on the existence of a prohibition but on the degree to which it is enforced. Increased enforcement narrows the scope of legal exceptions to the prohibition (e.g., medical uses), thereby increasing the size of the black market, and increased enforcement destroys reputations and implicit property rights within the black market. Both effects increase the use of violence.

Real per Capita Expenditures for Enforcement of Alcohol and Drug Prohibition

Note: Vertical axis is measured in 1992 dollars.

The data in Figure 4 combined with the data in Figure 3 show that expenditure climbs along with the homicide rate during Alcohol Prohibition and then falls at the end of this prohibition, as does the homicide rate. The relation is not perfect; other factors undoubtedly play a role. For example, the homicide rate begins rising about a decade before constitutional Prohibition takes effect, a fact that potentially reflects demographics (the enormous levels of immigration during the early part of this century), the violence-inducing effects of World War I, or perhaps merely changes in the sample of states used to compute homicide rates (Miron 1999). Regression analysis in Miron (1999) considers this more formally and confirms that enforcement of alcohol prohibition played a central role in causing the increasing and decreasing homicide rates during this period.

Conclusions

Prohibition represents one of the most dramatic policy experiments in U.S. history, with implications for a broad range of economic, historical, and political issues. This summary has focused narrowly on the most basic economic effects of Prohibition. The analysis shows that the evidence is consistent with the predictions of standard economic theory about the effects of prohibitions.

References

Clark, Norman H. Deliver Us From Evil: An Interpretation of American Prohibition. New York: W.W. Norton and Company, 1976.

Dills, Angela and Jeffrey A. Miron. “Alcohol Prohibition, Alcohol Consumption, and Cirrhosis.” Manuscript, Boston University, 2001.

Fisher, Irving. Prohibition Still at Its Worst. New York: Alcohol Information Committee, 1928.

Friedman, Milton. “The War We Are Losing.” In Searching for Alternatives: Drug-Control Policy in the United States, edited by M. B. Krauss and E. P. Lazear, 53-67. Stanford, CA: Hoover Institution, 1991.

Levine, Harry G. and Craig Reinarman. “From Prohibition to Regulation: Lessons from Alcohol Policy for Drug Policy.” The Milbank Quarterly 69 (1991): 1-43.

Merz, Charles. The Dry Decade. Garden City, NY: Doubleday, Doran and Co., 1930.

Miron, Jeffrey A. “Some Estimates of Annual Alcohol Consumption Per Capita, 1870-1991,” ISP Discussion Paper #69, Department of Economics, Boston University, 1996.

Miron, Jeffrey A. “The Effect of Alcohol Prohibition on Alcohol Consumption.” NBER Working Paper No. 7130, 1997.

Miron, Jeffrey A. “Violence and the U.S. Prohibitions of Drugs and Alcohol,” American Law and Economics Review 1-2 (1999): 78-114.

Miron, Jeffrey A. “Violence, Guns, and Drugs: A Cross-Country Analysis.” Manuscript, Boston University, 2001.

Miron, Jeffrey A. and Jeffrey Zwiebel. “Alcohol Consumption During Prohibition.” American Economic Review 81, no. 2 (1991): 242-247.

Miron, Jeffrey A. and Jeffrey Zwiebel. “The Economic Case against Drug Prohibition.” Journal of Economic Perspectives, 9, no. 4 (1995): 175-192.

Sinclair, Andrew. Prohibition: The Era of Excess. London: Faber and Faber, 1962.

Schmeckebier, Laurence F. The Bureau of Prohibition: Its History, Activities, and Organization. Brookings Institution: Washington, 1929.

Thornton, Mark. The Economics of Prohibition. Salt Lake City: University of Utah Press, 1991.

Thornton, Mark. “The Potency of Illegal Drugs.” Journal of Drug Issues 28, no. 3 (1998): 725-740.

Warburton, Clark. The Economic Results of Prohibition. New York: Columbia University Press, 1932.

1 Historical accounts cite a range of factors as finally tipping sentiment in favor of national prohibition. One was the huge number of immigrants during the first decade and a half of the 20th century, since popular wisdom held that immigrants were heavy drinkers. A second factor was increasing urbanization, which made the presence of the hard drinking, saloon frequenting, urban poor more visible (Clark, 1976). U.S. involvement in World War I may also have played a significant role, by legitimizing the view that turning grain into alcohol was wasteful (Merz 1930), by creating an air of moral certainty that facilitated passage of prohibition (Sinclair 1962), and by producing a distaste for anything German (i.e., beer).

2 Most states adopted similar laws, but the severity and enforcement of these varied widely (Merz 1930).

3 The two key factors usually credited with precipitating Prohibition’s demise (Levine and Reinarman 1991) are the Great Depression, which invalidated dry claims that Prohibition promoted prosperity and produced a need for tax revenue, and the increasing violence associated with Prohibition.

4 The analysis in this section is based on Miron and Zwiebel (1995).

5 For example, black market suppliers during Prohibition evaded the high alcohol taxes enacted during World War I.

6 The federal prohibition of alcohol did not include any penalties for possession per se, although “possession” of large amounts could be prosecuted as “intent to distribute.”

7 Evidence from Warburton (1932) suggests a substantial substitution of hard liquor for beer consumption during Prohibition, presumably because of this effect.

8 Miron and Zwiebel (1991) show that deaths due to alcoholism, which probably included deaths from overdoses or accidental poisonings, soared during Prohibition relative to other proxies.

9The data on alcohol consumption are estimates of the per capita consumption of pure alcohol, measured in gallons, computed as a weighted sum of separate estimates for beer, spirits, and wine, assuming a particular pure alcohol content for each component. The cirrhosis death rate is measured as the number of deaths per 100,000. Miron (1996, 1997) and Dills and Miron (2001) provides details of the construction of these series.

10 The discussion here is based on Miron (1999).

Citation: Miron, Jeffrey. “Alcohol Prohibition”. EH.Net Encyclopedia, edited by Robert Whaples. September 24, 2001. URL http://eh.net/encyclopedia/alcohol-prohibition/

Advertising Bans in the United States

Jon P. Nelson, Pennsylvania State University

Freedom of expression has always ranked high on the American scale of values and fundamental rights. This essay addresses regulation of “commercial speech,” which is defined as speech or messages that propose a commercial transaction. Regulation of commercial advertising occurs in several forms, but it is often controversial. In 1938, the Federal Trade Commission (FTC) was given the authority to regulate “unfair or deceptive” advertising. Congressional hearings were first held in 1939 on proposals to ban radio advertising of alcohol beverages (Russell 1940; U.S. Congress 1939, 1952). Actions by the FTC during 1964-69 led to the 1971 ban of radio and television advertising of cigarettes. In 1997, the distilled spirits industry reversed a six decade-old policy and began using cable television advertising. Numerous groups immediately called for removal of the ads, and Rep. Joseph Kennedy II (D, MA) introduced a “Just Say No” bill that would have banned all alcohol advertisements from the airways. In 1998, the Master Settlement Agreement between that state attorneys general and the tobacco industry put an end to billboard advertising of cigarettes. Do these regulations make any difference for the demand for alcohol or cigarettes? When will an advertising ban increase consumer welfare? What legal standards apply to commercial speech that affect the extent and manner in which governments can restrict advertising?

For many years, the Supreme Court held that the broad powers of government to regulate commerce included the “lesser power” to restrict commercial speech.1 In Valentine (1942), the Court held that the First Amendment does not protect “purely commercial advertising.” This view was applied when the courts upheld the ban of broadcast advertising of cigarettes, 333 F. Supp 582 (1971), affirmed per curiam, 405 U.S. 1000 (1972). However, in the mid-1970s this view began to change as the Court invalidated several state regulations affecting advertising of services and products such as abortion providers and pharmaceutical drugs. In Virginia State Board of Pharmacy (1976), the Court struck down a Virginia law that prohibited the advertising of prices for prescription drugs, and held that the First Amendment protects the right to receive information as well as the right to speak. Responding to the claim that advertising bans improved the public image of pharmacists, Justice Blackmun wrote that “an alternative [exists] to this highly paternalistic approach . . . people will perceive their own best interests if only they are well enough informed, and the best means to that end is to open the channels of communication rather than to close them” (425 U.S. 748, at 770). In support of its change in direction, the Court asserted two main arguments: (1) truthful advertising coveys information that consumers need to make informed choices in a free enterprise economy; and (2) such information is indispensable as to how the economic system should be regulated or governed. In Central Hudson Gas & Electric (1980), the Court refined its approach and laid out a four-prong test for “intermediate” scrutiny of restrictions on commercial speech. First, the message content cannot be misleading and must be concerned with a lawful activity or product. Second, the government’s interest in regulating the speech in question must be substantial. Third, the regulation must directly and materially advance that interest. Fourth, the regulation must be no more extensive than necessary to achieve its goal. That is, there must be a “reasonable fit” between means and ends, with the means narrowly tailored to achieve the desired objective. Applying the third and fourth-prongs, in 44 Liquormart (1996) the Court struck down a Rhode Island law that banned retail price advertising of beverage alcohol. In doing so, the Court made clear that the state’s power to ban alcohol entirely did not include the lesser power to restrict advertising. More recently, in Lorillard Tobacco (2001) the Supreme Court invalidated a state regulation on placement of outdoor and in-store tobacco displays. In summary, Central Hudson requires the use of a “balancing” test to examine censorship of commercial speech. The test weighs the government’s obligations toward freedom of expression with its interest in limiting the content of some advertisements. Reasonable constraints on time, place, and manner are tolerated, and false advertising remains illegal.

This article provides a brief economic history of advertising bans, and uses the basic framework contained in the Central Hudson decision. The first section discusses the economics of advertising and addresses the economic effects that might be expected from regulations that prohibit or restrict advertising. Applying the Central Hudson test, the second section reviews the history and empirical evidence on advertising bans for alcohol beverages. The third section reviews bans of cigarette advertising and discusses the regulatory powers that reside with the Federal Trade Commission as the main government agency with the authority to regulate unfair or deceptive advertising claims.

The Economics of Advertising

Judged by the magnitude of exposures and expenditures, advertising is a vital and important activity. A rule of thumb in the advertising industry is that the average American is exposed to more than 1,000 advertising messages every day, but actively notices fewer than 80 ads. According to Advertising Age (http://www.adage.com), advertising expenditures in 2002 in all media totaled $237 billion, including $115 billion in 13 measured media. Ads in newspapers accounted for 19.2% of measured spending, followed by network TV (17.3%), magazines (15.6%), spot TV (14.0%), yellow pages (11.9%), and cable/syndicated TV (11.9%). Internet advertising now accounts for about 5.0% of spending. By product category, automobile producers were the largest advertisers ($16 billion of measured media), followed by retailing ($13.5 billion), movies and media ($6 billion), and food, beverages, and candies ($6.0 billion). Beverage alcohol producers ranked 17th ($1.7 billion) and tobacco producers ranked 23rd ($284 million). Among the top 100 advertisers, Anheuser-Busch occupied the 38th spot and Altria Group (which includes Philip Morris) ranked 17th. Total advertising expenditures in 2002 were about 2.3% of U.S. gross domestic product (GDP). Ad spending tends to vary directly with general economy activity as illustrated by spending reductions during the 2000-2001 recession (Wall Street Journal, Aug. 14, 2001; Nov. 28, 2001; Dec. 12, 2001; Apr. 25, 2002). This pro-cyclical feature is contrary to Galbraith’s view that business firms use advertising to control or manage aggregate consumer demand.

National advertising of branded products developed in the early 1900s as increased urbanization and improvements in communication, transportation, and packaging permitted the development of mass markets for branded products (Chandler 1977). In 1900, the advertising-to-GDP ratio was about 3.1% (Simon 1970). The ratio stayed around 3% until 1929, but declined to 2% during the 1930s and has fluctuated around that value since then. The growth of major national industries was associated with increased promotion, although other economic changes often preceded the use of mass media advertising. For example, refrigeration of railroad cars in the late 1870s resulted in national advertising by meat packers in the 1890s (Pope 1983). Around the turn-of-the-century, Sears Roebuck and Montgomery Ward utilized low-cost transportation and mail-order catalogs to develop efficient systems of national distribution of necessities. By 1920 more Americans were living in urban areas than in rural areas. The location of retailers began to change, with a shift first to downtown shopping districts and later to suburban shopping malls. Commercial radio began in 1922, and advertising expenditures grew from $113 million in 1935 to $625 million in 1952. Commercial television was introduced in 1941, but wartime delayed the diffusion of televison. By 1954, half of the households in the U.S. had at least one television set. Expenditures on TV advertising grew rapidly from $454 million in 1952 to $2.5 billion in 1965 (Backman 1968). These changes affected the development of markets — for instance, new products could be introduced more rapidly and the available range of products was enhanced (Borden 1942).

Market Failure: Incomplete and Asymmetric Information

Because it is costly to acquire and process, the information held by buyers and sellers is necessarily incomplete and possibly unequal as well. However, full or “perfect” information is one of the analytical requirements for the proper functioning of competitive markets — so what happens when information is imperfect or unequal? Suppose, for example, that firms charge different prices for identical products, but some consumers (tourists) are ignorant of the dispersion of prices available in the marketplace. For many years, this question was largely ignored by economists, but two contributions sparked a revolution in economic thinking. Stigler (1961) showed that because information is costly to acquire, consumer search for lower prices will be less than complete. As a result, a dispersion of prices can persist and the “law of one price” is violated. The dispersion will be less if the product represents a large expenditure (e.g., autos), since more individual search is supported and suppliers have an extra incentive to promote the product. Because information has public good characteristics, imperfect information provides a rationale for government intervention, but profit-seeking firms also have reasons to reduce search costs through advertising and brand names. Akerlof (1970) took the analysis a step further by focusing on material aspects of a product that are known to the seller, but not by potential buyers. In Akerlof’s “lemons model,” the seller of a used car has private knowledge of defects, but potential buyers have difficulty distinguishing between good used cars (“creampuffs”) and bad used cars (“lemons”). Under these circumstances, Akerlof showed that a market may not exist or only lower-quality products are offered for sale. Hence, asymmetric information can result in market failure, but a reputation for quality can reduce the uncertainty that consumers face due to hidden defects (Akerlof 1970; Richardson 2000; Stigler 1961).

Under some conditions, branding and advertising of products, including targeting of customer groups, can help reduce market imperfections. Because advertising has several purposes or functions, there is always uncertainty regarding its effects. First, advertising may help inform consumers of the existence of products and brands, better inform them about price and quality dimensions, or better match customers and brands (Nelson 1975). Indeed, the basic message in many advertisements is simply that the brand is available. Consumer valuations can reflect a joint product, which is the product itself and the information about it. However, advertising tends to focus on only the positive aspects of a product, and ignores the negatives. In various ways, advertisers sometimes inform consumers that their brand is “less bad” (Calfee 1997b). An advertisement that announces a particular automobile is more crash resistant also is a reminder that all cars are less than perfectly safe. Second, persuasive or “combative” advertising can serve to differentiate one firm’s brand from those of its rivals. As a consequence, a successful advertiser may gain some discretion over the price it charges (“market power”). Furthermore, reactions by rivals may drive industry advertising to excessive levels or beyond the point where net social benefits of advertising are maximized. In other words, excessive advertising may result from the inability of each firm to reduce advertising without similar reductions by its rivals. Because it illustrates a breakdown of desirable coordination, this outcome is an example of the “prisoners’ dilemma game.” Third, the costs of advertising and promotion by existing or incumbent firms can make it more difficult for new firms to enter a market and compete successfully due to an advertising-cost barrier to entry. Investments in customer loyalty or intangible brand equity are largely sunk costs. Smaller incumbents also may be at a disadvantage relative to their larger rivals, and consequently face a “barrier to mobility” within the industry. However, banning advertising can have much the same effect by making it more difficult for smaller firms and entrants to inform customers of the existence of their brands and products. For example, Russian cigarette producers were successful in banning television advertising by new western rivals. Given multiple effects, systematic empirical evidence is needed to help resolve the uncertainties regarding the effects of advertising (Bagwell 2005).

Substantial empirical evidence demonstrates that advertising of prices increases competition and lowers the average market price and variance of prices. Conversely, banning price advertising can have the opposite effect, but consumers might derive information from other sources — such as direct observation and word-of-mouth — or firms can compete more on quality (Kwoka 1984). Bans of price advertising also affect product quality indirectly by making it difficult to inform consumers of price-quality tradeoffs. Products for which empirical evidence demonstrates that advertising reduces the average price include toys, drugs, eyeglasses, optometric services, gasoline, and grocery products. Thus, for relatively homogeneous goods, banning price advertising is expected to increase average prices and make entry more difficult. A partial offset occurs if significant costs of advertising increases product prices.

The effects of a ban of persuasive advertising also are uncertain. In a differentiated product industry, it is possible that advertising expenditures are so large that an advertising ban reduces costs and product prices, thereby offsetting or defeating the purpose of the ban. For products that are well known to consumers (“mature” products), the presumption is that advertising primarily affects brand shares and has little impact on primary demand (Dekimpe and Hanssens 1995; Scherer and Ross 1990). Advertising bans tend to solidify market shares. Furthermore, most advertising bans are less than complete, such as the ban of broadcast advertising of cigarettes. Producers can substitute other media or use other forms of promotion, such as discount coupons, articles of apparel, and event sponsorship. Thus, government limitations on commercial speech for one product or media often lead to additional efforts to limit other promotions. This “slippery slope” effect is illustrated by the Federal Communications Commission’s fairness doctrine for advertising of cigarettes (discussed below).

The Industry Advertising-Sales Response Function

The effect of a given ban on market demand depends importantly on the nature of the relationship between advertising expenditures and aggregate sales. This relationship is referred to as the industry advertising-sales response function. Two questions regarding this function have been debated. First, it is not clear that a well-defined function exists at the industry level, since persuasive advertising primarily affects brand shares. The issue is the spillover, if any, from brand advertising to aggregate (primary) market demand. Two studies of successful brand advertising in the alcohol industry failed to reveal a spillover effect on market demand (Gius 1996; Nelson 2001). Second, if an industry-level response function exists, it should be subject to diminishing marginal returns, but it is unclear where diminishing returns begin (the inflection point) or the magnitude of this effect. Some analysts argue that diminishing returns only begin at high levels of industry advertising, and sharply increasing returns exist at moderate to low levels (Saffer 1993). According to this view, comprehensive bans of advertising will reduce market demand importantly. However, this argument is at odds with empirical evidence for a variety of mature products, which demonstrates diminishing returns over a broad range of outlays (Assmus et al. 1984; Tellis 2004). Simon and Arndt (1980) found that diminishing returns began immediately for a majority of 100-plus products. Furthermore, average advertising elasticities for most mature products are only about 0.1 in magnitude (Sethuraman and Tellis 1991). As a result, limited bans of advertising will not reduce sales of mature products or the effect is likely to be extremely small in magnitude. It is unlikely that elasticities this small could support the third prong of the Central Hudson test.

Suppose that advertising for a particular product convinces some consumers to use Brand X, and this results in more sales of the brand at a higher price. Are consumers better or worse off as a consequence? A shift in consumer preferences toward a fortified brand of breakfast cereal might be described as either a “shift in tastes,” an increase in demand for nutrition, or an increase in joint demand for the cereal and information. Because it concerns individual utility, it is not clear whether a “shift in tastes” reduces or increases consumer satisfaction. Social commentators usually respond that consumers just think they are better off or the demand effect is spurious in nature. Much of the social criticism of advertising is concerned with its pernicious effect on consumer beliefs, tastes, and desires. Vance Packard’s, The Hidden Persuaders (1957), was an early, but possibly misguided, effort along these lines (Rogers 1992). Packard wrote that advertisers can “channel our unthinking habits, our purchasing decisions, and our thought processes by the use of insights gleaned from psychiatry and the social sciences.” Of course, once a “hidden secret” is revealed, such manipulation is less effective in the marketplace for products due to cynicism toward advertisers or outright rejection of the advertising claims.

Dixit and Norman (1978) argued that because profit-maximizing firms tend to over-advertise, small decreases in advertising will raise consumer welfare. In their analysis, this result holds regardless of the change in tastes or what product features are being advertised. Becker and Murphy (1993) responded that advertising is usually a complement to products, so it is unclear that equilibrium prices will always be higher as advertising increases. Further, it does not follow that social welfare is higher without any advertising. Targeting by advertisers also helps to increase the efficiency of advertising and reduces the tendency to waste advertising dollars on uninterested consumers through redundant ads. Nevertheless, this common practice also is criticized by social commentators and regulatory agencies. In summary, the evaluation of advertising bans requires empirical evidence. Much of the evidence on advertising bans is econometric and most of it concerns two products, alcohol beverages and cigarettes.

Advertising Bans: Beverage Alcohol

In an interesting way, the history of alcohol consumption follows the laws of supply and demand. The consumption of ethyl alcohol as a beverage began some 10,000 years ago. Due to the uncertainties of contaminated water supplies in the West, alcohol is believed to have been the most popular and safe daily beverage for centuries (Valle 1998). In the East, boiled water in the form of teas solved the problem of potable beverages. Throughout the Middle Ages, beer and ale were drunk by common folk and wine by the affluent. Following the decline of the Roman Empire, the Catholic Church entered the profitable production of wines. Distillation of alcohol was developed in the Arab world in 700 A.D. and gradually spread to Europe, where distilled spirits were used ineffectively as a cure for plague in the 14th century. During the 17th century, several non-alcohol beverages became popular, including coffee, tea, and cocoa. In the late eighteenth century, religious sentiment turned against alcohol and temperance activity figured prominently in the concerns of the Baptist, Friends, Methodist, Mormon, Presbyterian, and Unitarian churches. It was not until the late nineteenth century that filtration and treatment made safe drinking water supplies more widely available.

During the colonial period, retail alcohol sellers were licensed by states, local courts, or town councils (Byse 1940). Some colonies fixed the number of licenses or bonded the retailer. Fixing of maximum prices by legislatures and the courts encouraged adulteration and misbranding by retailers. In 1829, the state of Maine passed the first local option law and in 1844, the territory of Oregon enacted a general prohibition law. Experimentation with statewide monopoly of the retail sale of alcohol began in 1893 in South Carolina. As early as 1897, federal regulation of labeling was enacted through the Bottling in Bond Act. Following the repeal of Prohibition in 1933, the Federal Alcohol Control Administration was created by executive order (O’Neill 1940). The Administration immediately set about creating “fair trade codes” that governed false and misleading advertising, unfair trade practices, and prices that were “oppressively high or destructively low.” These codes discouraged price and advertising competition, and encouraged shipping expansion by the major midwestern brewers (McGahan 1991). The Administration ceased to function in 1935 when the National Industrial Recovery Act was declared unconstitutional. The passage of Federal Alcohol Administration Act in 1935 created the Federal Alcohol Administration (FAA) within the Treasury Department, which regulated trade practices and enforced the producer permit system required by the Act. In 1939, the FAA was abolished and its duties were transferred to the Alcohol Tax Unit of the Internal Revenue Service (later named the Bureau of Alcohol, Tobacco, and Firearms). The ATF presently administers a broad range of provisions regarding the formulation, labeling, and advertising of alcohol beverages.

Alcohol Advertising: Analytical Methods

Three types of econometric studies examine the effects of advertising on the market demand for beverage alcohol. First, time-series studies examine the relationship between alcohol consumption and annual or quarterly advertising expenditures. Recent examples of such studies include Calfee and Scheraga (1994), Coulson et al. (2001), Duffy (1995, 2001), Lariviere et al. (2000), Lee and Tremblay (1992), and Nelson (1999). All of these studies find that advertising has no effect on total alcohol consumption and small or nonexistent effects on beverage demand (Nelson 2001). This result is not affected by disaggregating advertising to account for different effects by media (Nelson 1999). Second, cross-sectional and panel studies examine the relationship between alcohol consumption and state regulations, such as state bans of billboards. Panel studies combine cross-sectional (e.g., all 50 states) and time-series information (50 states for the period 1980-2000), which alters the amount of variation in the data. Third, cross-national studies examine the relationship between alcohol consumption and advertising bans for a panel of countries. This essay discusses results obtained in the second and third types of studies.

Background: State Regulation of Billboard Advertising

In the United States, the distribution and retail sale of alcohol beverages is regulated by the individual states. The Twenty-First Amendment, passed in 1933, repealed Prohibition and granted the states legal powers over the sale of alcohol, thereby resolving the conflicting interests of “wets” and “drys” (Goff and Anderson 1994; Munger and Schaller 1997; Shipman 1940; Strumpf and Oberholzer-Gee 2000). As a result, alcohol laws vary importantly by state, and these differences represent a natural experiment with regard to the economic effects of regulation. Long-standing differences in state laws potentially affect the organization of the industry and alcohol demand, reflecting incentives that alter or shape individual behaviors. State laws also differ by beverage, suggesting that substitution among beverages is one possible consequence of regulation. For example, state laws for distilled spirits typically are more stringent than similar laws applied to beer and wine. While each state has adopted its own unique regulatory system, several broad categories can be identified. Following repeal, eighteen states adopted public monopoly control of the distribution of distilled spirits. Thirteen of these states operate off-premise retail stores for the sale of spirits, and two states also control retail sales of table wine. In five states, only the wholesale distribution of distilled spirits is controlled. No state has monopolized beer sales, but laws in three states provide for restrictions on private beer sales by alcohol content. In the private license states, an Alcohol Beverage Control (ABC) agency determines the number and type of retail licenses, subject to local wet-dry options. Because monopoly states have broad authority to restrict the marketing of alcohol, the presumption is that total alcohol consumption will be lower in the control states compared to the license states. Monopoly control also raises search costs by restricting outlet numbers, hours of operation, and product variety. Because beer and wine are substitutes or complements for spirits, state monopoly control can increase or decrease total alcohol use, or the net effect may be zero (Benson et al. 1997; Nelson 1990, 2003a).

A second broad experiment includes state regulations banning advertising of alcohol beverages or which restrict the advertising of prices. Following repeal, fourteen states banned billboard advertising of distilled spirits, including seven of the license states. Because the bans have been in existence for many years and change infrequently over time, these regulations provide evidence on the long-term effectiveness of advertising bans. It is often argued that billboards have an important effect on youth behaviors, and this belief has been a basis for municipal ordinances banning billboard advertising of tobacco and alcohol. Given long-standing bans, it might be expected that youth alcohol behaviors will show up as cross-state differences in adult per capita consumption. Indeed, these two variables are highly correlated (Cook and Moore 2000, 2001). Further, fifteen states banned price advertising by retailers using billboards, newspapers, and visible store displays. In general, a ban of price advertising reduces retail competition and increases search costs of consumers. However, these regulations were not intended to advance temperance, but rather were anti-competitive measures obtained by alcohol retailers (McGahan 1995). For example, in 44 Liquormart (1996) the lower court noted that Rhode Island’s ban of price advertising was designed to protect smaller retailers from in-state and out-of-state competition, and was closely monitored by the liquor retailers association. A price advertising ban could reduce alcohol consumption by elevating full prices (search costs plus monetary prices). Because many states banned only price advertising of spirits, substitution among beverages also is a possible outcome.

Table 1 illustrates historical changes since 1935 in alcohol consumption in the United States and three individual states. Also, Table 1 shows nominal and real advertising expenditures for the U.S. After peaking in the early 1980s, per capita alcohol consumption is now at roughly the level experienced in the early 1960s. Nationally, the decline in alcohol consumption from 1980 to 2000 was 21.0%. This decline has occurred despite continued high levels of advertising and promotion. At the state-level, the percentage changes in consumption are Illinois, -25.3%; Ohio, -15.5%; and Pennsylvania, -20.5%. Pennsylvania is a state monopoly for spirits and wines and also banned price advertising of alcohol, including beer, prior to 1997. However, the change in per capita consumption in Pennsylvania parallels what has occurred nationally.

Econometric Results: State-Level Studies of Billboard Bans

Seven econometric studies estimate the relationship between state billboard bans and alcohol consumption: Hoadley et al. (1984), Nelson (1990, 2003a), Ornstein and Hanssens (1985), Schweitzer et al. (1983), and Wilkinson (1985, 1987). Two studies used a single year, but the other five employed panel data covering five to 25 years. Two studies estimated demand functions for beer or distilled spirits only, which ignores substitution. None of the studies obtained a statistically significant reduction in total alcohol consumption due to bans of billboards. In several studies, billboard bans increased spirits consumption significantly. A positive effect of a ban is contrary to general expectations, but consistent with various forms of substitution. The study by Nelson (2003a) covered 45 states for the time period 1982-1997. In contrast to earlier studies, Nelson (2003a) focused on substitution among alcohol beverages and the resulting net effect on total ethanol consumption. Several subsamples were examined, including all 45 states, ABC-license states, and two time periods, 1982-1988 and 1989-1997. A number of other variables also were considered, including prices, income, tourism, age demographics, and the minimum drinking age. During both time periods, state billboard bans increased consumption of wine and spirits, and reduced consumption of beer. The net effect on total ethanol consumption was significantly positive during 1982-1988, and insignificant thereafter. During both time periods, bans of price advertising of spirits were associated with lower consumption of spirits, higher consumption of beer, and no effect on wine or total alcohol consumption. The results in this study demonstrate that advertising regulations have different effects by beverage, indicating the importance of substitution. Public policy statements that suggest that limited bans have a singular effect are ignoring market realities. The empirical results in Nelson (2003a) and other studies are consistent with the historic use of billboard bans as a device to suppress competition, with little or no effect on temperance.

Econometric Results: Cross-National Studies of Broadcast Bans

Many Western nations have restrictions on radio and television advertising of alcohol beverages, especially distilled spirits. These controls range from time-of-day restrictions and content guidelines to outright bans of broadcast advertising of all alcohol beverages. Until quite recently, the trend in most countries has been toward stricter rather than more lenient controls. Following repeal, U.S. producers of distilled spirits adopted a voluntary Code of Good Practice that barred radio advertising after 1936 and television advertising after 1948. When this voluntary agreement ended in late 1996, cable television stations began carrying ads for distilled spirits. The major TV networks continued to refuse such commercials. Voluntary or self-regulatory codes also have existed in a number of other countries, including Australia, Belgium, Germany, Italy, and Netherlands. By the end of the 1980s, a number of countries had banned broadcast advertising of spirits, including Austria, Canada, Denmark, Finland, France, Ireland, Norway, Spain, Sweden, and United Kingdom (Brewers Association of Canada 1997).

Table 1
Advertising and Alcohol Consumption (gallons of ethanol per capita, 14+ yrs)

Illinois Ohio Pennsylvania U.S. Alcohol Ads Real Ads Real Ads Percent
Year (gal. p.c.) (gal. p.c.) (gal. p.c.) (gal. p.c.) (mil. $) (mil. 96$) per capita Broadcast
1935 1.20
1940 1.56
1945 2.25
1950 2.04
1955 2.00
1960 2.07
1965 2.27 242.2 1018.5 7.50 38.7
1970 2.82 2.22 2.28 2.52 278.4 958.0 6.41 34.7
1975 2.99 2.21 2.35 2.69 395.6 979.9 5.99 44.0
1980 3.00 2.33 2.39 2.76 906.9 1580.5 8.83 55.1
1981 2.91 2.25 2.37 2.76 1014.9 1618.7 8.91 56.6
1982 2.83 2.28 2.36 2.72 1108.7 1667.0 9.07 58.1
1983 2.80 2.22 2.29 2.69 1182.9 1708.4 9.18 62.0
1984 2.77 2.26 2.25 2.65 1284.4 1788.9 9.50 66.0
1985 2.72 2.20 2.22 2.62 1293.0 1746.1 9.16 68.2
1986 2.68 2.17 2.23 2.58 1400.2 1850.6 9.61 73.5
1987 2.66 2.17 2.20 2.54 1374.7 1766.1 9.09 73.5
1988 2.64 2.11 2.11 2.48 1319.4 1639.8 8.37 74.4
1989 2.56 2.07 2.10 2.42 1200.4 1436.6 7.27 68.2
1990 2.62 2.09 2.15 2.45 1050.4 1209.7 6.10 64.8
1991 2.48 2.03 2.05 2.30 1119.5 1247.2 6.22 66.4
1992 2.43 1.98 1.99 2.30 1074.7 1172.0 5.78 68.5
1993 2.38 1.95 1.96 2.23 970.7 1030.9 5.04 70.4
1994 2.35 1.85 1.93 2.18 1000.9 1041.1 5.03 69.4
1995 2.29 1.90 1.86 2.15 1027.5 1046.4 5.00 68.2
1996 2.30 1.93 1.86 2.16 1008.8 1008.8 4.77 68.5
1997 2.26 1.91 1.84 2.14 1087.0 1069.2 5.01 66.5
1998 2.25 1.97 1.86 2.14 1187.6 1154.6 5.36 66.3
1999 2.27 2.00 1.87 2.16 1242.2 1189.5 5.45 64.2
2000 2.24 1.97 1.90 2.18 1422.6 1330.8 5.89 62.8

Sources: 1965-70 ad data from Adams-Jobson Handbooks; 1975-91 data from Impact; and 1992-2000 data from LNA/Competitive Media. Nominal data deflated by the GDP implicit price deflator (1996 = 100). Alcohol data from National Institute on Alcohol Abuse and Alcoholism, U.S. Apparent Consumption of Alcoholic Beverages (1997) and 2003 supplement. Real advertising per capita is for ages 14+ based on NIAAA and author’s population estimates.

The possible effects of broadcast bans are examined in four studies: Nelson and Young (2001), Saffer (1991), Saffer and Dave (2002), and Young (1993). Because alcohol behavior or “cultural sentiment” varies by country, it is important that the social setting is considered. In particular, the level of alcohol consumption in the wine-drinking countries is substantially greater. In France, Italy, Luxembourg, Portugal, and Spain, alcohol consumption is about one-third greater than average (Nelson and Young 2001). Further, 20 to 25% of consumption in the Scandinavian countries is systematically under-reported due to cross-border purchases, smuggling, and home production. In contrast to other studies, Nelson and Young (2001) accounted for these differences. The study examined alcohol demand and related behaviors in a sample of 17 OECD countries (western Europe, Canada, and the U.S.) for the period 1977 to 1995. Control variables included prices, income, tourism, age demographics, unemployment, and drinking sentiment. The results indicated that bans of broadcast advertising of spirits did not decrease per capita alcohol consumption. During the sample period, five countries adopted broadcast bans of all alcohol beverage advertisements, apart from light beer (Denmark, Finland, France, Norway, Sweden). The regression estimates for complete bans were insignificantly positive. The results indicated that bans of broadcast advertising had no effect on alcohol consumption relative to countries that did not ban broadcast advertising. For the U.S., the cross-country results are consistent with studies of successful brands, studies of billboard bans, and studies of advertising expenditures (Nelson 2001). The results are inconsistent with an advertising-response function with a well-defined inflection point.

Advertising Bans: Cigarettes

Prior to 1920, consumption of tobacco in the U.S. was mainly in the form of cigars, pipe tobacco, chewing tobacco, and snuff. It was not until 1923 that cigarette consumption by weight surpassed that of cigars (Forey et al. 2002). Several early developments contributed to the rise of the cigarette (Borden 1942). First, the Bonsak cigarette-making machine was patented in 1880 and perfected in 1884 by James Duke. Second, the federal excise tax on cigarettes, instituted to help pay for the Civil War, was reduced in 1883 from $1.75 to 50 cents a thousand pieces. Third, during World War I, cigarette consumption by soldiers was encouraged by ease of use and low cost. Fourth, the taboo against public smoking by women began to wane, although participation by women remained substantially below that of men. By 1935, about 50% of men smoked compared to only 20% of women. Fifth, advertising has been credited with expanding the market for lighter-blends of tobacco, although evidence in support of this claim is lacking (Tennant 1950). Some early advertising claims were linked to health, such as a 1928 ad for Lucky Strike that emphasized, “No Throat Irritation — No Cough.” During this time, the FTC banned numerous health claims by de-nicotine products and devices, e.g., 10 FTC 465 (1925).

Cigarette advertising has been especially controversial since the early 1950s, reflecting known health risks associated with smoking and the belief that advertising is a causal factor in smoking behaviors. Warning labels on cigarette packages were first proposed in 1955, following new health reports by the American Cancer Society, the British Medical Research Council, and Reader’s Digest (1952). Regulation of cigarette advertising and marketing, especially by the FTC, increased over the years to include content restrictions (1942, 1950-52); advertising guidelines (1955, 1960, 1966); package warning labels (1965, 1970, 1984); product testing and labeling (1967, 1970); public reporting on advertising trends (1964, 1967, 1981); warning messages in advertisements (1970); and advertising bans (1971, 1998). The history of these regulations is discussed below.

Background: Cigarette Prohibition and Early Health Reports

During the 17th century, several of the northern colonies banned public smoking. In 1638, the Plymouth colony passed a law forbidding smoking in the streets and, in 1798, Boston banned the carrying of a lighted pipe or cigar in public. Beginning around 1850, a number of anti-tobacco groups were formed (U.S. Surgeon General 2000), including the American Anti-Tobacco Society in 1849, American Health and Temperance Association (1878), Anti-Cigarette League (1899), Non-Smokers Protective League (1911), and the Department of Narcotics of the Women’s Christian Temperance Union (1883). The WCTU was a force behind the cigarette prohibition movement in Canada and the U.S. During the Progressive Era, fifteen states passed laws prohibiting the sale of cigarettes to adults and another twenty-one states considered such laws (Alston et al. 2002). North Dakota and Iowa were the first states to adopt smoking bans in 1896 and 1897, respectively. In West Virginia, cigarettes were taxed so heavily that they were de facto prohibited. In 1920, Lucy Page Gaston of the WCTU made a bid for the Republican nomination for president on an anti-tobacco platform. However, the movement waned as the laws were largely unenforceable. By 1928, cigarettes were again legal for sale to adults in every state.

As the popularity of cigarette smoking spread, so too did concerns about its health consequences. As a result, the hazards of smoking have long been common knowledge. A number of physicians took early notice of a tobacco-cancer relationship in their patients. In 1912, Isaac Adler published a book on lung cancer that implicated smoking. In 1928, adverse health effects of smoking were reported in the New England Journal of Medicine. A Scientific American report in 1933 tentatively linked cigarette “tars” to lung cancer. Writing in Science in 1938, Raymond Pearl of Johns Hopkins University demonstrated a statistical relationship between smoking and longevity (Pearl 1938). The addictive properties of nicotine were reported in 1942 in the British medical journal, The Lancet. These and other reports attracted little attention from the popular press, although Reader’s Digest (1924, 1941) was an early crusader against smoking. In 1950, three classic scientific papers appeared that linked smoking and lung cancer. Shortly thereafter, major prospective studies began to appear in 1953-54. At this time, the research findings were more widely reported in the popular press (e.g., Time 1953). In 1957, the Public Health Service accepted a causal relationship between smoking and lung cancer (Burney 1959; Joint Report 1957). Between 1950 and 1963, researchers published more than 3,000 articles on the health effects of smoking.

Cigarette Advertising: Analytical Methods

Given the rising concern about the health effects of smoking, it is not surprising that cigarette advertising would come under fire. The ability of advertising to stimulate primary demand is not debated by public health officials, since in their eyes cigarette advertising is inherently deceptive. The econometric evidence is much less clear. Three methods are used to assess the relationship between cigarette consumption and advertising. First, time-series studies examine the relationship between cigarette consumption and annual or quarterly advertising expenditures. These studies have been reviewed several times, including comprehensive surveys by Cameron (1998), Duffy (1996), Lancaster and Lancaster (2003), and Simonich (1991). Most time-series studies find little or no effect of advertising on primary demand for cigarettes. For example, Duffy (1996) concluded that “advertising restrictions (including bans) have had little or no effect upon aggregate consumption of cigarettes.” A meta-analysis by Andrews and Franke (1991) found that the average elasticity of cigarette consumption with respect to advertising expenditure was only 0.142 during 1964-1970, and declined to -0.007 thereafter. Second, cross-national studies examine the relationship between per capita cigarette consumption and advertising bans for a panel of countries. Third, several time-series studies examine the effects of health scares and the 1971 ban of broadcast advertising. This essay discusses results obtained in the second and third types of econometric studies.

Econometric Results: Cross-National Studies of Broadcast Bans

Systematic tests of the effect of advertising bans are provided by four cross-national panel studies that examine annual per capita cigarette consumption among OECD countries: Laugesen and Meads (1991); Stewart (1993); Saffer and Chaloupka (2000); and Nelson (2003b). Results in the first three studies are less than convincing for several reasons. First, advertising bans might be endogenously determined together with cigarette consumption, but earlier studies treated advertising bans as exogenous. In order to avoid the potential bias associated with endogenous regressors, Nelson (2003b) estimated a structural equation for the enabling legislation that restricts advertising. Second, annual data on cigarette consumption contain pronounced negative trends, and the data series in levels are unlikely to be stationary. Nelson (2003b) tested for unit roots and used consumption growth rates (log first-differences) to obtain stationary data series for a sample of 20 OECD countries. Third, the study also tested for structural change in the smoking-advertising relationship. The motivation was based on the following set of observations: by the mid-1960s the risks associated with smoking were well known and cigarette consumption began to decline in most countries. For example, per capita consumption in the United States increased to an all-time high in 1963 and declined modestly until about 1978. Between 1978 and 1995, cigarette consumption in the U.S. declined on average by -2.44% per year. Further, the decline in consumption was accompanied by reductions in smoking prevalence. In the U.S., male smoking prevalence declined from 52% of the population in 1965 to 33% in 1985 and 27% in 1995 (Forey et al. 2002). Smoking also is increasingly concentrated among individuals with lower incomes or lower levels of education (U.S. Public Health Service 1994). Changes in prevalence suggest that the sample of smokers will not be homogeneous over time, which implies that empirical estimates may not be robust across different time periods.

Nelson (2003b) focused on total cigarettes, defined as the sum of manufactured and hand-rolled cigarettes for 1970-1995. Data on cigarette and tobacco consumption were obtained from International Smoking Statistics (Forey et al. 2002). This comprehensive source includes estimates of sales in OECD countries for manufactured cigarettes, hand-rolled cigarettes, and total consumption by weight of all tobacco products. The data series begin around 1948 and extend to 1995. Regulatory information on advertising bans and health warnings were obtained from Health New Zealand’s International Tobacco Control Database and the World Health Organization’s International Digest of Health Legislation. For each country and year, HNZ reports the media in which cigarette advertising are banned. Nine media are covered, including television, radio, cinema, outdoor, newspapers, magazines, shop ads, sponsorships, and indirect advertising such as brand names on non-tobacco products. Based on these data, three dummy variables were defined: TV-RADIO (= 1 if only television and radio are banned, zero otherwise); MODERATE (= 1 if 3 or 4 media are banned); and STRONG (= 1 if 5 or more media are banned). On average, 4 to 5 media were banned in the 1990s compared to only 1 or 2 in the 1970s. Except for Austria, Japan and Spain, all OECD countries by 1995 had enacted moderate or strong bans of cigarette advertising. In 1995, there were 9 countries in the strong category compared to 5 in 1990, 4 in 1985, and only 3 countries in 1980 and earlier. Additional control variables in the study included prices, income, warning labels, unemployment rates, percent filter cigarettes, and demographics.

The results in Nelson (2003b) indicate that cigarette consumption is determined importantly by prices, income, and exogenous country-specific factors. The dummy variables for advertising bans were never significantly negative. The income elasticity was significantly positive and the price elasticity was significantly negative. The price elasticity estimate of -0.39 is identical to the consensus estimate of -0.4 for aggregate data (Chaloupka and Warner 2000). Beginning about 1985, the decline in smoking prevalence resulted in a shift in price and income elasticities. There also was a change in the political climate favoring additional restrictions on advertising that followed rather than caused reductions in smoking and smoking prevalence, which is “reverse causality.” Thus, advertising bans had no demonstrated influence on cigarette demand in the OECD countries, including the U.S. The advertising-response model that motivates past studies is not supported by these results. Data and estimation procedures used in three previous studies are picking-up the substantial declines in consumption that began in the late-1970s, which were unrelated to major changes in advertising restrictions.

Background: Regulation of Cigarettes by the Federal Trade Commission

At the urging of President Wilson, the Federal Trade Commission (FTC) was created by Congress in 1914. The Commission was given the broad mandate to prevent “unfair methods of competition.” From the very beginning, this mandate was interpreted to include false and deceptive advertising, even though advertising per se was not an antitrust issue. Indeed, the first cease-and-desist order issued by the FTC concerned false advertising, 1 FTC 13 (1916). It was the age of the patent medicines and health-claims devices. As early as 1925, FTC orders against false and misleading advertising constituted 75 percent of all orders issued each year. However, in Raladam (1931) the Supreme Court held that false advertising could be prevented only in situations where injury to a competitor could be demonstrated. The Wheeler-Lea Act of 1938 added a prohibition of “unfair or deceptive acts or practices” in or affecting commerce. This amendment broadened Section 5 of the FTC Act to include consumer interests as well as business concerns. The FTC could thereafter proceed against unfair and deceptive methods without regard to alleged effects on competitors.

As an independent regulatory agency, the FTC has rulemaking and adjudicatory authorities (Fritschler and Hoefler 1996). Its rulemaking powers are quasi-legislative, including the authority to hold hearings and trade practice conferences, subpoena witnesses, conduct investigations, and issue industry guidelines and proposals for legislation. Its adjudicatory powers are quasi-judicial, including the authority to issue cease-and-desist orders, consent decrees, injunctions, trade regulation rules, affirmative disclosure and substantiation orders, corrective advertising orders, and advisory opinions. Administrative complaints are adjudicated before an administrative law judge in trial-like proceedings. Rulemaking by the FTC is characterized by broad applicability to all firms in an industry, whereas judicial policy is based on a single case and affects directly only those named in the suit. Of course, once a precedent is established, it may affect other firms in the same situation. Lacking a well-defined constituency, except possibly small business, the FTC’s use of its manifest powers has always been controversial (Clarkson and Muris 1981; Hasin 1987; Miller 1989; Posner 1969, 1973; Stone 1977).

Beginning in 1938, the FTC used its authority to issue “unfair and deceptive” advertising complaints against the major cigarette companies. These actions, known collectively as the “health claims cases,” resulted in consent decrees or cease-and-desist orders involving several major brands during the 1940s and early 1950s. As several cases neared the final judgment phase, in September 1954 the FTC sent a letter to all companies proposing a seven-point list of advertising standards in light of “scientific developments with regard to the [health] effects of cigarette smoking.” A year later, the FTC issued its Cigarette Advertising Guides, which forbade any reference to physical effects of smoking and representations that a brand of cigarette is low in nicotine or tars that “has not been established by a competent scientific proof.” Following several articles in Reader’s Digest, cigarette advertising in 1957-1959 shifted to emphasis on tar and nicotine reduction during the “tar derby.” The FTC initially tolerated these ads if based on tests conducted by Reader’s Digest or Consumer Reports. In 1958, the FTC hosted a two-day conference on tar and nicotine testing, and in 1960 it negotiated a trade practice agreement that “all representations of low or reduced tar or nicotine, whether by filtration or otherwise, will be construed as health claims.” This action was blamed for halting a trend toward increased consumption of lower-tar cigarettes (Calfee 1997a; Neuberger 1963). The FTC vacated this agreement in 1966 when it informed the companies that it would no longer consider advertising that contained “a factual statement of tar and nicotine content” a violation of its Advertising Guides.

On January 11, 1964, the Surgeon General’s Advisory Committee on Smoking and Health issued its famous report on Smoking and Health (U.S. Surgeon General 1964). One week after the report’s release, the FTC initiated proceedings “for promulgation of trade regulation rules regarding unfair and deceptive acts or practices in the advertising and labeling of cigarettes” (notice, 29 Fed Reg 530, January 22, 1964; final rule, 29 Fed Reg 8325, July 2, 1964). The proposed Rule required that all cigarette packages and advertisements disclose prominently the statement, “Caution: Cigarette smoking is dangerous to health [and] may cause death from cancer and other diseases.” Failure to include the warning would be regarded as a violation of the FTC Act. The industry challenged the Rule on grounds that the FTC lacked the statutory authority to issue industry-wide trade rules, absent congressional guidance. The major companies also established their own Cigarette Advertising Code, which prohibited advertising aimed at minors, health-related claims, and celebrity endorsements.

The FTC’s Rule resulted in several congressional bills that culminated in the Federal Cigarette Labeling and Advertising Act of 1965 (P.L. 89-92, effective Jan. 1, 1966). The Labeling Act required each cigarette package to contain the statement, “Caution: Cigarette Smoking May Be Hazardous to Your Health.” According to the Act’s declaration of policy, the warnings were required so that “the public may be adequately informed that cigarette smoking may be hazardous to the health.” The Act also required the FTC to report annually to Congress concerning (a) the effectiveness of cigarette labeling, (b) current practices and methods of cigarette advertising and promotion, and (c) such recommendations for legislation as it may deem appropriate. Beginning in 1967, the FTC commenced its annual reporting to Congress on advertising of cigarettes. It recommended that health warning be extended to advertising and strengthened to conform to its original proposal, and it called for research on less-hazardous cigarettes. These recommendations were repeated in 1968 and 1969, and a recommendation was added that advertising on television and radio should be banned.

Several other important regulatory actions also took place in 1967-1970. First, the FTC established a laboratory to conduct standardized testing of tar and nicotine content for each brand. In November 1967, the FTC commenced public reporting of tar and nicotine levels by brand, together with reports of overall trends in smoking behaviors. Second, in June of 1967, the Federal Communications Commission (FCC) ruled that the “fairness doctrine” was applicable to cigarette advertising, which resulted in numerous free anti-smoking commercials by the American Cancer Society and other groups during July 1967 to December 1970.2 Third, in early 1969 the FCC issued a notice of proposed rulemaking to ban broadcast advertising of cigarettes (34 Fed Reg 1959, Feb. 11, 1969). The proposal was endorsed by the Television Code Review Board of the National Association of Broadcasters, and its enactment was anticipated by some industry observers. Following the FCC’s proposal, the FTC issued a notice of proposed rulemaking (34 Fed Reg 7917, May 20, 1969) to require more forceful statements on packages and extend the warnings to all advertising as a modification of its 1964 Rule in the “absence of contrary congressional direction.” Congress again superseded the FTC’s actions, and passed the Public Health Smoking Act of 1969 (P.L. 91-222, effective Nov. 1, 1970), which banned broadcast advertising after January 1, 1971 and modified the package label to read, “Warning: The Surgeon General Has Determined that Cigarette Smoking Is Dangerous to Your Health.” In 1970, the FTC negotiated agreements with the major companies to (1) disclose tar and nicotine levels in cigarette advertising using the FTC Test Method, and (2) include the health warning in advertising. By 1972, the FTC believed that it had achieved the recommendations in its initial reports to Congress.3

In summary, the FTC has engaged in continuous surveillance of cigarette advertising and marketing practices. Industry-wide regulation began in the early 1940s. As a result, the advertising of cigarettes in the U.S. is more restricted than other lawful consumer products. Some regulations are primarily informational (warning labels), while others affect advertising levels directly (broadcast ban). During a six-decade period, the FTC regulated the overall direction of cigarette marketing, including advertising content and placement, warning labels, and product development. Through its testing program, it has influenced the types of cigarettes produced and consumed. The FTC engaged in continuous monitoring of cigarette advertising practices and prepared in-depth reports on these practices; it held hearings on cigarette testing, advertising, and labeling; and it issued consumer advisories on smoking. Directly or indirectly, the FTC has initiated or influenced promotional and product developments in the cigarette industry. However, it remains to be shown that these actions had an important or noticeable effect on cigarette consumption and/or industry advertising expenditures. Is there empirical evidence that federal regulation has affected aggregate cigarette consumption or advertising? If the answer is negative or the effects are limited in magnitude, it suggests that the Congressional and FTC actions after 1964 did not add materially to information already in the marketplace or these actions were otherwise misguided.4

Table 2 displays information on smoking prevalence, cigarette consumption, and advertising. Smoking prevalence has declined considerably compared to the 1950s and 1960s. Consumption per capita reached an all-time high in 1963 (4,345 cigarettes per capita) and began a steep decline around 1978. By 1985, consumption was below the level experienced in 1947. Cigarette promotion has changed greatly over the years as producers substituted away from traditional advertising media. As reported by the FTC, the category of non-price promotions includes expenditures on point-of-sale displays, promotional allowances, samples, specialty items, public entertainment, direct mail, endorsements and testimonials, internet, and audio-visual ads. The shift away from media advertising reflects the broadcast and billboard bans as well as the controversies that surround advertising of cigarettes. As a result, spending on traditional media now amounts to only $356 million, or about 7% of the total marketing outlay of $5.0 billion. Clearly, regulation has affected the type of promotion, but not the overall expenditure.

Econometric Results: U.S. Time-Series Studies of the 1971 Advertising Ban

Several econometric studies examine the effects of the 1971 broadcast ban on cigarette demand, including Franke (1994), Gallet (1999), Ippolito et al. (1979), Kao and Tremblay (1988), and Simonich (1991). None of these studies found that the 1971 broadcast ban had a noticeable effect on cigarette demand. The studies by Franke and Simonich employed quarterly data on cigarette sales. The study by Ippolito et al. covered an extended time period from 1926 to 1975. The studies by Gallet and Kao and Tremblay employed simultaneous-equations methods, but each study concluded that the broadcast advertising ban did not have a significant effect on cigarette demand. Although health reports in 1953 and 1964 may have reduced the demand for tobacco, the results do not support a negative effect of the 1971 Congressional broadcast ban. By 1964 or earlier, the adverse effects of smoking appear to have been incorporated in consumers’ decisions regarding smoking. Hence, the advertising restrictions did not contribute to consumer information and therefore did not affect cigarette consumption.

Conclusions

The First Amendment protects commercial speech, although the degree of protection afforded is less than political speech. Commercial speech jurisprudence has changed profoundly since Congress passed a flat ban on broadcast advertising of cigarettes in 1971. The courts have recognized the vital need for consumers to be informed about market conditions — an environment that is conducive to operation of competitive markets. The Central Hudson test requires the courts and agencies to balance the benefits and costs of censorship. The third-prong of the test requires that censorship must directly and materially advance a substantial goal. This essay has discussed the difficulty of establishing a material effect of limited and comprehensive bans of alcohol and cigarette advertisements.

Sales per cap. 5-media Non-Price Total per cap.

Table 2
Advertising and Cigarette Consumption

Prevalence: Total Cig Sales Cigs
per cap.
Ad Spending:
5-media
Promotion:
Non-Price
Real Total Real Total
per cap.
Male Female
Year (%) (%) (bil.) (ages 18+) (mil. $) (mil. $) (mil 96$) (ages 18+)
1920 44.6 665
1925 79.8 1,085
1930 119.3 1,485 26.0 213.1
1935 53 18 134.4 1,564 29.2 286.3
1940 181.9 1,976 25.3 245.6
1947 345.4 3,416 44.1 269.7 2.70
1950 54 33 369.8 3,552 65.5 375.4 3.61
1955 50 24 396.4 3,597 104.6 528.8 4.83
1960 47 27 484.4 4,171 193.1 870.2 7.53
1965 52 34 528.8 4,258 249.9 1050.9 8.49
1970 44 31 536.5 3,985 296.6 64.4 1242.3 9.26
1975 39 29 607.2 4,122 330.8 160.5 1227.3 8.28
1980 38 29 631.5 3,849 790.1 452.2 2177.9 13.29
1985 33 28 594.0 3,370 932.0 1544.4 3360.6 19.09
1986 583.8 3,274 796.3 1586.1 3163.5 17.78
1987 32 27 575.0 3,197 719.2 1861.3 3326.2 18.49
1988 31 26 562.5 3,096 824.5 1576.3 2993.1 16.44
1989 540.0 2,926 868.3 1788.7 3190.8 17.35
1990 28 23 525.0 2,817 835.2 1973.0 3246.1 17.52
1991 28 24 510.0 2,713 772.6 2054.6 3153.2 16.86
1992 28 25 500.0 2,640 621.5 2435.0 3328.1 17.62
1993 28 23 485.0 2,539 542.1 2933.9 3695.9 19.38
1994 28 23 486.0 2,524 545.1 3039.5 3733.6 19.41
1995 27 23 487.0 2,505 564.2 2982.6 3615.5 18.62
1996 487.0 2,482 578.2 3220.8 3799.0 19.37
1997 28 22 480.0 2,423 575.7 3561.4 4058.0 20.47
1998 26 22 465.0 2,320 645.6 3908.0 4412.4 22.03
1999 26 22 435.0 2,136 487.7 4659.0 4918.0 24.29
2000 26 21 430.0 2,092 355.8 5015.0 5043.0 24.53
Sources: Smoking prevalence and cigarette sales from Forey et al (2002) and U.S. Public Health Service (1994). Data on advertising compiled by the author from FTC Reports to Congress (various issues); 1930-1940 data derived from Borden (1942). Nominal data deflated by the GDP implicit price deflator (1996=100). Advertising expenditures include TV, radio, newspapers, magazine, outdoor and transit ads. Promotions exclude price-promotions using discount coupons and retail value-added offers (“buy one, get one free”). Real total includes advertising and non-price promotions.

Law Cases

44 Liquormart, Inc., et al. v. Rhode Island and Rhode Island Liquor Stores Assoc., 517 U.S. 484 (1996).

Central Hudson Gas & Electric Corp. v. Public Service Commission of New York, 447 U.S. 557 (1980).

Federal Trade Commission v. Raladam Co., 283 U.S. 643 (1931).

Food and Drug Administration, et al. v. Brown & Williamson Tobacco Corp., et al., 529 U.S. 120 (2000).

Lorillard Tobacco Co., et al. v. Thomas F. Reilly, Attorney General of Massachusetts, et al., 533 U.S. 525 (2001).

Red Lion Broadcasting Co. Inc., et al. v. Federal Communications Commission, et al., 395 U.S. 367 (1969).

Valentine, Police Commissioner of the City of New York v. Chrestensen, 316 U.S. 52 (1942).

Virginia State Board of Pharmacy, et al. v. Virginia Citizens Consumer Council, Inc., et al., 425 U.S. 748 (1976).

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Endnotes

1. See, for example, Packer Corp. v. Utah, 285 U.S. 105 (1932); Breard v. Alexandria, 341 U.S. 622 (1951); E.F. Drew v. FTC, 235 F.2d 735 (1956), cert. denied, 352 U.S. 969 (1957).

2. In 1963, the Federal Communications Commission (FCC) notified broadcast stations that they would be required to give “fair coverage” to controversial public issues (40 FCC 571). The Fairness Doctrine ruling was upheld by the Supreme Court in Red Lion Broadcasting (1969). At the request of John Banzhaf, the FCC in 1967 applied the Fairness Doctrine to cigarette advertising (8 FCC 2d 381). The FCC opined that the cigarette advertising was a “unique situation” and extension to other products “would be rare,” but Commissioner Loevinger warned that the FCC would have difficulty distinguishing cigarettes from other products (9 FCC 2d 921). The FCC’s ruling was upheld by the D.C. Circuit Court, which argued that First Amendment rights were not violated because advertising was “marginal speech” (405 F.2d 1082). During the period 1967-70, broadcasters were required to include free antismoking messages as part of their programming. In February 1969, the FCC issued a notice of proposed rulemaking to ban broadcast advertising of cigarettes, absent voluntary action by cigarette producers (16 FCC 2d 284). In December 1969, Congress passed the Smoking Act of 1969, which contained the broadcast ban (effective Jan. 1, 1971). With regard to the Fairness Doctrine, Commissioner Loevinger’s “slippery slope” fears were soon realized. During 1969-1974, the FCC received thousands of petitions for free counter-advertising for diverse products, such as nuclear power, Alaskan oil development, gasoline additives, strip mining, electric power rates, clearcutting of forests, phosphate-based detergents, trash compactors, military recruitment, children’s toys, airbags, snowmobiles, toothpaste tubes, pet food, and the United Way. In 1974, the FCC began an inquiry into the Fairness Doctrine, which concluded that “standard product commercials, such as the old cigarette ads, make no meaningful contribution toward informing the public on any side of an issue . . . the precedent is not at all in keeping with the basic purposes of the fairness doctrine” (48 FCC 2d 1, at 24). After numerous inquires and considerations, the FCC finally announced in 1987 that the Fairness Doctrine had a “chilling effect,” on speech generally, and could no longer be sustained as an effective public policy (2 FCC Rcd 5043). Thus ended the FCC’s experiment with regulatory enforcement of a “right to be heard” (Hazlett 1989; Simmons 1978).

3. During the remainder of the 1970s, the FTC concentrated on enforcement of its advertising regulations. It issued consent orders for unfair and deceptive advertising to force companies to include health warnings “clearly and conspicuously in all cigarette advertising.” It required 260 newspapers and 40 magazines to submit information on cigarette advertisements, and established a task force with the Department of Health, Education and Welfare to determine if newspaper ads were deceptive. In 1976, the FTC announced that it was again investigating “whether there may be deception and unfairness in the advertising and promotion of cigarettes.” It subpoenaed documents from 28 cigarette manufacturers, advertising agencies, and other organizations, including copy tests, consumer surveys, and marketing plans. Five years later, it submitted to Congress the results of this investigation in its Staff Report on Cigarette Investigation (FTC 1981). The report proposed a system of stronger rotating warnings and covered issues that had emerged regarding low-tar cigarettes, including compensatory behaviors by smokers and the adequacy of the FTC’s Test Method for determining tar and nicotine content. In 1984, President Reagan signed the Comprehensive Smoking Education Act (P.L. 98-474, effective Oct.12, 1985), which required four rotating health warnings for packages and advertising. Also, in 1984, the FTC revised its definition of deceptive advertising (103 FTC 110). In 2000, the FTC finally acknowledged the shortcoming of its tar and nicotine test method.

4. The Food and Drug Administration (FDA) has jurisdiction over cigarettes as drugs in cases involving health claims for tobacco, additives, and smoking devices. Under Dr. David Kessler, the FDA in 1996 unsuccessfully attempted to regulate all cigarettes as addictive drugs and impose advertising and other restrictions designed to reduce the appeal and use of tobacco by children (notice, 60 Fed Reg 41313, Aug. 11, 1995; final rule, 61 Fed Reg 44395, Aug. 28, 1996); vacated by FDA v. Brown & Williamson Tobacco Corporation, et al., 529 U.S. 120 (2000)

Citation: Nelson, Jon. “Advertising Bans, US”. EH.Net Encyclopedia, edited by Robert Whaples. May 20, 2004. URL http://eh.net/encyclopedia/nelson-adbans/

Corruption and Reform: Lessons from America’s Economic History

Author(s):Glaeser, Edward L.
Goldin, Claudia
Reviewer(s):Cain, Louis P.

Published by EH.NET (August 2006)

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Edward L. Glaeser and Claudia Goldin, editors, Corruption and Reform: Lessons from America’s Economic History. Chicago: University of Chicago Press, 2006. ix + 386 pp. $75 (cloth), ISBN: 0-226-29957-0.

Reviewed for EH.NET by Louis P. Cain, Loyola University Chicago, Northwestern University, and the University of Chicago.

Corruption and Reform is a stimulating set of eleven essays that follow an instructive introduction by the editors, both of whom are Professors of Economics at Harvard. The authors, stalwarts of the National Bureau of Economic Research’s Development of the American Economy program directed by Claudia Goldin, first presented their papers at a July 2004 conference. Edward Glaeser, in collaboration with Andrei Shleifer, wrote what is perhaps the work most frequently cited in this collection, “The Rise of the Regulatory State,” which appeared in the June 2003 Journal of Economic Literature. Glaeser and Shleifer use economic history to argue that the strategy a society chooses to enforce its laws depends on each alternative’s vulnerability to subversion by affected interests. Given their research interests, it is logical that these authors address the issues raised by Glaeser and Shleifer’s hypotheses. It is logical that this book focuses on the Progressive Era which, after all, “was dedicated to the elimination of corruption” (p. 4). And, while it is unfortunate the total social costs of corruption are probably unknowable in any time or place, it is clear the reforms discussed in this collection were cost reducing.

The volume is organized into four parts; the first consists of the editors’ introduction and three essays under the heading of “Corruption and Reform: Definitions and Historical Trends.” The introduction and the first essay by John Joseph Wallis attempt to define what is meant by corruption. As the editors note, it is essential to have a consistent definition in order to do time series work, but there are many possible definitions, and Wallis’ article is particularly good in articulating the sometimes subtle differences. The definitions adopted in the other essays, while they differ slightly one from another, generally are consistent with what Wallis terms “venal corruption,” a situation where economics corrupts politics, as opposed to “systematic corruption” where the reverse is true. The editors present three series to establish a “time path of corruption in the United States” (pp. 12-18). That path appears to have rather large cycles around a relatively horizontal trend between 1815 and 1890, a downward trend between 1890 and 1930 (the Progressive Era), and much smaller cycles around a relatively horizontal trend between 1930 and 1975. This is consistent with Glaeser and Shleifer who find that regulation became the increasingly efficient enforcement strategy in the Progressive Era. One reason for the smaller cycles is that, over the twentieth century, the price paid by corrupt politicians has significantly increased. The final two essays establish time paths consistent with those of the editors. Rebecca Menes’ essay makes use of information on corrupt mayors and urban administrations, while that of Stanley Engerman and Kenneth Sokoloff examines cost overruns on major public works, beginning with the Erie Canal System and continuing into the twenty-first century.

The second section, “Consequences of Corruption,” consists of two essays. The first, by Naomi Lamoreaux and Jean-Laurent Rosenthal, discusses how the rise of corporations diminished the protection afforded minority stockholders, a particular problem given the mergers and combinations of the Progressive Era. They note the major movement toward reform here did not develop until the stock market crashed in 1929. The second, by David Cutler and Grant Miller, looks at the development of urban water systems in the Progressive Era, a time when municipalities’ access to capital was substantially increasing. This essay does not confront corruption as directly as others in the volume, in part because they find “corruption-based explanations” for these municipal improvements are not supported. This, in turn, makes the useful point that corruption generally did not interfere with the creation of public goods.

The third section consists of three essays concerning “The Road to Reform.” The two editors and Matthew Gentzkow examine the role of the media is providing a check against corruption. Their essay contrasts two eras, the first characterized by the Credit Mobilier scandal of 1870 and the second by the Teapot Dome scandal of 1922. In the first, the media was largely “partisan,” but in the second it was primarily “informative.” They attribute this change to increasing financial returns to the sale of newspapers (as production costs fell, circulation, advertising revenues, and the number of newspapers increased). They simply comment, without attribution of causality, that this contributed to reform by providing supportive news coverage. Howard Bodenhorn, looks at the development of free banking in New York, one of the first reform movements in the United States. He argues it resulted from the self-interest of one political party attempting to limit the rents of corruption accruing to the other, what Wallis terms a “classic case” of systematic corruption. He sees reform as a result of parallel forces dating from early in the century that were moving toward greater economic and political self-determination. In the third essay, Werner Troesken conjoins his knowledge of the ownership structure of utilities with a definition of corruption stressing the illicit sale of political influence to explain why there was a movement toward public ownership in the early years of the twentieth century and a movement away from it seventy-five years later. His investigation reaches the conclusion that “corruption, and the necessity to eliminate corruption when it gets too costly, accounts for the efficacy of regime change” (p. 278); the direction of change is less important than the removal of corrupt elements.

The three essays in the final section, “Reform and Regulation,” look at safety reform in the workplace (Price Fishback), the Pure Food and Drugs Act of 1906 (Marc Law and Gary Libecap), and relief legislation during the New Deal (Wallis, Fishback, and Shawn Kantor). Fishback notes that labor generally supported safety regulations in mining and manufacturing, while management generally opposed them. Mining laws were targeted to a single industry (devoid of women) often located in isolated areas where managers and owners were likely to have a disproportionate amount of political power. Manufacturing regulations were applied to a broad range of industries and raised the costs of small firms much more than those of large firms, thus the latter’s managers often favored the regulations. Law and Libecap note that the Food and Drug Administration resulted from a combination of consumers concerned about quality (concerns often attributable to muckraking journalists) and producers interested in calming those concerns. After presenting three views of Progressive Era reform (regulatory capture, public interest, and rent seeking), they argue the evidence supports a “nuanced combination” of all three. Wallis, Fishback, and Kantor argue that the move to federal provision of relief, particularly welfare and unemployment compensation, significantly reduced the corruption that had been endemic in local provision, and Roosevelt recognized the incentive he had to maintain the good will generated by the new system. Although a portion of relief provision remained under local administration, the federal government controlled the distribution of funds and required that local administration be fair and impartial.

All in all, this is a first rate collection on a topic that will always be relevant, at least from the perspective of one who lives in Cook County, Illinois. A short review such as this can not do justice to the contributions each of these essays makes on a number of different margins. Even though many are still available as NBER working papers, the intersections between them make the whole more valuable than the parts.

Louis P. Cain is Professor of Economics at Loyola University Chicago, Adjunct Professor of Economics at Northwestern University, and Visiting Professor at the University of Chicago’s Graduate School of Business where he is serving as Visiting Co-Director of the Center for Population Economics. With the late Jonathan Hughes, he is author of American Economic History, soon to appear in its seventh edition.

Subject(s):Markets and Institutions
Geographic Area(s):North America
Time Period(s):20th Century: WWII and post-WWII