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Antebellum Banking in the United States

Howard Bodenhorn, Lafayette College

The first legitimate commercial bank in the United States was the Bank of North America founded in 1781. Encouraged by Alexander Hamilton, Robert Morris persuaded the Continental Congress to charter the bank, which loaned to the cash-strapped Revolutionary government as well as private citizens, mostly Philadelphia merchants. The possibilities of commercial banking had been widely recognized by many colonists, but British law forbade the establishment of commercial, limited-liability banks in the colonies. Given that many of the colonists’ grievances against Parliament centered on economic and monetary issues, it is not surprising that one of the earliest acts of the Continental Congress was the establishment of a bank.

The introduction of banking to the U.S. was viewed as an important first step in forming an independent nation because banks supplied a medium of exchange (banknotes1 and deposits) in an economy perpetually strangled by shortages of specie money and credit, because they animated industry, and because they fostered wealth creation and promoted well-being. In the last case, contemporaries typically viewed banks as an integral part of a wider system of government-sponsored commercial infrastructure. Like schools, bridges, road, canals, river clearing and harbor improvements, the benefits of banks were expected to accrue to everyone even if dividends accrued only to shareholders.

Financial Sector Growth

By 1800 each major U.S. port city had at least one commercial bank serving the local mercantile community. As city banks proved themselves, banking spread into smaller cities and towns and expanded their clientele. Although most banks specialized in mercantile lending, others served artisans and farmers. In 1820 there were 327 commercial banks and several mutual savings banks that promoted thrift among the poor. Thus, at the onset of the antebellum period (defined here as the period between 1820 and 1860), urban residents were familiar with the intermediary function of banks and used bank-supplied currencies (deposits and banknotes) for most transactions. Table 1 reports the number of banks and the value of loans outstanding at year end between 1820 and 1860. During the era, the number of banks increased from 327 to 1,562 and total loans increased from just over $55.1 million to $691.9 million. Bank-supplied credit in the U.S. economy increased at a remarkable annual average rate of 6.3 percent. Growth in the financial sector, then outpaced growth in aggregate economic activity. Nominal gross domestic product increased an average annual rate of about 4.3 percent over the same interval. This essay discusses how regional regulatory structures evolved as the banking sector grew and radiated out from northeastern cities to the hinterlands.

Table 1
Number of Banks and Total Loans, 1820-1860

Year Banks Loans ($ millions)
1820 327 55.1
1821 273 71.9
1822 267 56.0
1823 274 75.9
1824 300 73.8
1825 330 88.7
1826 331 104.8
1827 333 90.5
1828 355 100.3
1829 369 103.0
1830 381 115.3
1831 424 149.0
1832 464 152.5
1833 517 222.9
1834 506 324.1
1835 704 365.1
1836 713 457.5
1837 788 525.1
1838 829 485.6
1839 840 492.3
1840 901 462.9
1841 784 386.5
1842 692 324.0
1843 691 254.5
1844 696 264.9
1845 707 288.6
1846 707 312.1
1847 715 310.3
1848 751 344.5
1849 782 332.3
1850 824 364.2
1851 879 413.8
1852 913 429.8
1853 750 408.9
1854 1208 557.4
1855 1307 576.1
1856 1398 634.2
1857 1416 684.5
1858 1422 583.2
1859 1476 657.2
1860 1562 691.9

Sources: Fenstermaker (1965); U.S. Comptroller of the Currency (1931).

Adaptability

As important as early American banks were in the process of capital accumulation, perhaps their most notable feature was their adaptability. Kuznets (1958) argues that one measure of the financial sector’s value is how and to what extent it evolves with changing economic conditions. Put in place to perform certain functions under one set of economic circumstances, how did it alter its behavior and service the needs of borrowers as circumstances changed. One benefit of the federalist U.S. political system was that states were given the freedom to establish systems reflecting local needs and preferences. While the political structure deserves credit in promoting regional adaptations, North (1994) credits the adaptability of America’s formal rules and informal constraints that rewarded adventurism in the economic, as well as the noneconomic, sphere. Differences in geography, climate, crop mix, manufacturing activity, population density and a host of other variables were reflected in different state banking systems. Rhode Island’s banks bore little resemblance to those in far away Louisiana or Missouri, or even those in neighboring Connecticut. Each state’s banks took a different form, but their purpose was the same; namely, to provide the state’s citizens with monetary and intermediary services and to promote the general economic welfare. This section provides a sketch of regional differences. A more detailed discussion can be found in Bodenhorn (2002).

State Banking in New England

New England’s banks most resemble the common conception of the antebellum bank. They were relatively small, unit banks; their stock was closely held; they granted loans to local farmers, merchants and artisans with whom the bank’s managers had more than a passing familiarity; and the state took little direct interest in their daily operations.

Of the banking systems put in place in the antebellum era, New England’s is typically viewed as the most stable and conservative. Friedman and Schwartz (1986) attribute their stability to an Old World concern with business reputations, familial ties, and personal legacies. New England was long settled, its society well established, and its business community mature and respected throughout the Atlantic trading network. Wealthy businessmen and bankers with strong ties to the community — like the Browns of Providence or the Bowdoins of Boston — emphasized stability not just because doing so benefited and reflected well on them, but because they realized that bad banking was bad for everyone’s business.

Besides their reputation for soundness, the two defining characteristics of New England’s early banks were their insider nature and their small size. The typical New England bank was small compared to banks in other regions. Table 2 shows that in 1820 the average Massachusetts country bank was about the same size as a Pennsylvania country bank, but both were only about half the size of a Virginia bank. A Rhode Island bank was about one-third the size of a Massachusetts or Pennsylvania bank and a mere one-sixth as large as Virginia’s banks. By 1850 the average Massachusetts bank declined relatively, operating on about two-thirds the paid-in capital of a Pennsylvania country bank. Rhode Island’s banks also shrank relative to Pennsylvania’s and were tiny compared to the large branch banks in the South and West.

Table 2
Average Bank Size by Capital and Lending in 1820 and 1850 Selected States and Cities
(in $ thousands)

1820
Capital
Loans 1850 Capital Loans
Massachusetts $374.5 $480.4 $293.5 $494.0
except Boston 176.6 230.8 170.3 281.9
Rhode Island 95.7 103.2 186.0 246.2
except Providence 60.6 72.0 79.5 108.5
New York na na 246.8 516.3
except NYC na na 126.7 240.1
Pennsylvania 221.8 262.9 340.2 674.6
except Philadelphia 162.6 195.2 246.0 420.7
Virginia1,2 351.5 340.0 270.3 504.5
South Carolina2 na na 938.5 1,471.5
Kentucky2 na na 439.4 727.3

Notes: 1 Virginia figures for 1822. 2 Figures represent branch averages.

Source: Bodenhorn (2002).

Explanations for New England Banks’ Relatively Small Size

Several explanations have been offered for the relatively small size of New England’s banks. Contemporaries attributed it to the New England states’ propensity to tax bank capital, which was thought to work to the detriment of large banks. They argued that large banks circulated fewer banknotes per dollar of capital. The result was a progressive tax that fell disproportionately on large banks. Data compiled from Massachusetts’s bank reports suggest that large banks were not disadvantaged by the capital tax. It was a fact, as contemporaries believed, that large banks paid higher taxes per dollar of circulating banknotes, but a potentially better benchmark is the tax to loan ratio because large banks made more use of deposits than small banks. The tax to loan ratio was remarkably constant across both bank size and time, averaging just 0.6 percent between 1834 and 1855. Moreover, there is evidence of constant to modestly increasing returns to scale in New England banking. Large banks were generally at least as profitable as small banks in all years between 1834 and 1860, and slightly more so in many.

Lamoreaux (1993) offers a different explanation for the modest size of the region’s banks. New England’s banks, she argues, were not impersonal financial intermediaries. Rather, they acted as the financial arms of extended kinship trading networks. Throughout the antebellum era banks catered to insiders: directors, officers, shareholders, or business partners and kin of directors, officers, shareholders and business partners. Such preferences toward insiders represented the perpetuation of the eighteenth-century custom of pooling capital to finance family enterprises. In the nineteenth century the practice continued under corporate auspices. The corporate form, in fact, facilitated raising capital in greater amounts than the family unit could raise on its own. But because the banks kept their loans within a relatively small circle of business connections, it was not until the late nineteenth century that bank size increased.2

Once the kinship orientation of the region’s banks was established it perpetuated itself. When outsiders could not obtain loans from existing insider organizations, they formed their own insider bank. In doing so the promoters assured themselves of a steady supply of credit and created engines of economic mobility for kinship networks formerly closed off from many sources of credit. State legislatures accommodated the practice through their liberal chartering policies. By 1860, Rhode Island had 91 banks, Maine had 68, New Hampshire 51, Vermont 44, Connecticut 74 and Massachusetts 178.

The Suffolk System

One of the most commented on characteristic of New England’s banking system was its unique regional banknote redemption and clearing mechanism. Established by the Suffolk Bank of Boston in the early 1820s, the system became known as the Suffolk System. With so many banks in New England, each issuing it own form of currency, it was sometimes difficult for merchants, farmers, artisans, and even other bankers, to discriminate between real and bogus banknotes, or to discriminate between good and bad bankers. Moreover, the rural-urban terms of trade pulled most banknotes toward the region’s port cities. Because country merchants and farmers were typically indebted to city merchants, country banknotes tended to flow toward the cities, Boston more so than any other. By the second decade of the nineteenth century, country banknotes became a constant irritant for city bankers. City bankers believed that country issues displaced Boston banknotes in local transactions. More irritating though was the constant demand by the city banks’ customers to accept country banknotes on deposit, which placed the burden of interbank clearing on the city banks.3

In 1803 the city banks embarked on a first attempt to deal with country banknotes. They joined together, bought up a large quantity of country banknotes, and returned them to the country banks for redemption into specie. This effort to reduce country banknote circulation encountered so many obstacles that it was quickly abandoned. Several other schemes were hatched in the next two decades, but none proved any more successful than the 1803 plan.

The Suffolk Bank was chartered in 1818 and within a year embarked on a novel scheme to deal with the influx of country banknotes. The Suffolk sponsored a consortium of Boston bank in which each member appointed the Suffolk as its lone agent in the collection and redemption of country banknotes. In addition, each city bank contributed to a fund used to purchase and redeem country banknotes. When the Suffolk collected a large quantity of a country bank’s notes, it presented them for immediate redemption with an ultimatum: Join in a regular and organized redemption system or be subject to further unannounced redemption calls.4 Country banks objected to the Suffolk’s proposal, because it required them to keep noninterest-earning assets on deposit with the Suffolk in amounts equal to their average weekly redemptions at the city banks. Most country banks initially refused to join the redemption network, but after the Suffolk made good on a few redemption threats, the system achieved near universal membership.

Early interpretations of the Suffolk system, like those of Redlich (1949) and Hammond (1957), portray the Suffolk as a proto-central bank, which acted as a restraining influence that exercised some control over the region’s banking system and money supply. Recent studies are less quick to pronounce the Suffolk a successful experiment in early central banking. Mullineaux (1987) argues that the Suffolk’s redemption system was actually self-defeating. Instead of making country banknotes less desirable in Boston, the fact that they became readily redeemable there made them perfect substitutes for banknotes issued by Boston’s prestigious banks. This policy made country banknotes more desirable, which made it more, not less, difficult for Boston’s banks to keep their own notes in circulation.

Fenstermaker and Filer (1986) also contest the long-held view that the Suffolk exercised control over the region’s money supply (banknotes and deposits). Indeed, the Suffolk’s system was self-defeating in this regard as well. By increasing confidence in the value of a randomly encountered banknote, people were willing to hold increases in banknotes issues. In an interesting twist on the traditional interpretation, a possible outcome of the Suffolk system is that New England may have grown increasingly financial backward as a direct result of the region’s unique clearing system. Because banknotes were viewed as relatively safe and easily redeemed, the next big financial innovation — deposit banking — in New England lagged far behind other regions. With such wide acceptance of banknotes, there was no reason for banks to encourage the use of deposits and little reason for consumers to switch over.

Summary: New England Banks

New England’s banking system can be summarized as follows: Small unit banks predominated; many banks catered to small groups of capitalists bound by personal and familial ties; banking was becoming increasingly interconnected with other lines of business, such as insurance, shipping and manufacturing; the state took little direct interest in the daily operations of the banks and its supervisory role amounted to little more than a demand that every bank submit an unaudited balance sheet at year’s end; and that the Suffolk developed an interbank clearing system that facilitated the use of banknotes throughout the region, but had little effective control over the region’s money supply.

Banking in the Middle Atlantic Region

Pennsylvania

After 1810 or so, many bank charters were granted in New England, but not because of the presumption that the bank would promote the commonweal. Charters were granted for the personal gain of the promoter and the shareholders and in proportion to the personal, political and economic influence of the bank’s founders. No New England state took a significant financial stake in its banks. In both respects, New England differed markedly from states in other regions. From the beginning of state-chartered commercial banking in Pennsylvania, the state took a direct interest in the operations and profits of its banks. The Bank of North America was the obvious case: chartered to provide support to the colonial belligerents and the fledgling nation. Because the bank was popularly perceived to be dominated by Philadelphia’s Federalist merchants, who rarely loaned to outsiders, support for the bank waned.5 After a pitched political battle in which the Bank of North America’s charter was revoked and reinstated, the legislature chartered the Bank of Pennsylvania in 1793. As its name implies, this bank became the financial arm of the state. Pennsylvania subscribed $1 million of the bank’s capital, giving it the right to appoint six of thirteen directors and a $500,000 line of credit. The bank benefited by becoming the state’s fiscal agent, which guaranteed a constant inflow of deposits from regular treasury operations as well as western land sales.

By 1803 the demand for loans outstripped the existing banks’ supply and a plan for a new bank, the Philadelphia Bank, was hatched and its promoters petitioned the legislature for a charter. The existing banks lobbied against the charter, and nearly sank the new bank’s chances until it established a precedent that lasted throughout the antebellum era. Its promoters bribed the legislature with a payment of $135,000 in return for the charter, handed over one-sixth of its shares, and opened a line of credit for the state.

Between 1803 and 1814, the only other bank chartered in Pennsylvania was the Farmers and Mechanics Bank of Philadelphia, which established a second substantive precedent that persisted throughout the era. Existing banks followed a strict real-bills lending policy, restricting lending to merchants at very short terms of 30 to 90 days.6 Their adherence to a real-bills philosophy left a growing community of artisans, manufacturers and farmers on the outside looking in. The Farmers and Mechanics Bank was chartered to serve excluded groups. At least seven of its thirteen directors had to be farmers, artisans or manufacturers and the bank was required to lend the equivalent of 10 percent of its capital to farmers on mortgage for at least one year. In later years, banks were established to provide services to even more narrowly defined groups. Within a decade or two, most substantial port cities had banks with names like Merchants Bank, Planters Bank, Farmers Bank, and Mechanics Bank. By 1860 it was common to find banks with names like Leather Manufacturers Bank, Grocers Bank, Drovers Bank, and Importers Bank. Indeed, the Emigrant Savings Bank in New York City served Irish immigrants almost exclusively. In the other instances, it is not known how much of a bank’s lending was directed toward the occupational group included in its name. The adoption of such names may have been marketing ploys as much as mission statements. Only further research will reveal the answer.

New York

State-chartered banking in New York arrived less auspiciously than it had in Philadelphia or Boston. The Bank of New York opened in 1784, but operated without a charter and in open violation of state law until 1791 when the legislature finally sanctioned it. The city’s second bank obtained its charter surreptitiously. Alexander Hamilton was one of the driving forces behind the Bank of New York, and his long-time nemesis, Aaron Burr, was determined to establish a competing bank. Unable to get a charter from a Federalist legislature, Burr and his colleagues petitioned to incorporate a company to supply fresh water to the inhabitants of Manhattan Island. Burr tucked a clause into the charter of the Manhattan Company (the predecessor to today’s Chase Manhattan Bank) granting the water company the right to employ any excess capital in financial transactions. Once chartered, the company’s directors announced that $500,000 of its capital would be invested in banking.7 Thereafter, banking grew more quickly in New York than in Philadelphia, so that by 1812 New York had seven banks compared to the three operating in Philadelphia.

Deposit Insurance

Despite its inauspicious banking beginnings, New York introduced two innovations that influenced American banking down to the present. The Safety Fund system, introduced in 1829, was the nation’s first experiment in bank liability insurance (similar to that provided by the Federal Deposit Insurance Corporation today). The 1829 act authorized the appointment of bank regulators charged with regular inspections of member banks. An equally novel aspect was that it established an insurance fund insuring holders of banknotes and deposits against loss from bank failure. Ultimately, the insurance fund was insufficient to protect all bank creditors from loss during the panic of 1837 when eleven failures in rapid succession all but bankrupted the insurance fund, which delayed noteholder and depositor recoveries for months, even years. Even though the Safety Fund failed to provide its promised protections, it was an important episode in the subsequent evolution of American banking. Several Midwestern states instituted deposit insurance in the early twentieth century, and the federal government adopted it after the banking panics in the 1930s resulted in the failure of thousands of banks in which millions of depositors lost money.

“Free Banking”

Although the Safety Fund was nearly bankrupted in the late 1830s, it continued to insure a number of banks up to the mid 1860s when it was finally closed. No new banks joined the Safety Fund system after 1838 with the introduction of free banking — New York’s second significant banking innovation. Free banking represented a compromise between those most concerned with the underlying safety and stability of the currency and those most concerned with competition and freeing the country’s entrepreneurs from unduly harsh and anticompetitive restraints. Under free banking, a prospective banker could start a bank anywhere he saw fit, provided he met a few regulatory requirements. Each free bank’s capital was invested in state or federal bonds that were turned over to the state’s treasurer. If a bank failed to redeem even a single note into specie, the treasurer initiated bankruptcy proceedings and banknote holders were reimbursed from the sale of the bonds.

Actually Michigan preempted New York’s claim to be the first free-banking state, but Michigan’s 1837 law was modeled closely after a bill then under debate in New York’s legislature. Ultimately, New York’s influence was profound in this as well, because free banking became one of the century’s most widely copied financial innovations. By 1860 eighteen states adopted free banking laws closely resembling New York’s law. Three other states introduced watered-down variants. Eventually, the post-Civil War system of national banking adopted many of the substantive provisions of New York’s 1838 act.

Both the Safety Fund system and free banking were attempts to protect society from losses resulting from bank failures and to entice people to hold financial assets. Banks and bank-supplied currency were novel developments in the hinterlands in the early nineteenth century and many rural inhabitants were skeptical about the value of small pieces of paper. They were more familiar with gold and silver. Getting them to exchange one for the other was a slow process, and one that relied heavily on trust. But trust was built slowly and destroyed quickly. The failure of a single bank could, in a week, destroy the confidence in a system built up over a decade. New York’s experiments were designed to mitigate, if not eliminate, the negative consequences of bank failures. New York’s Safety Fund, then, differed in the details but not in intent, from New England’s Suffolk system. Bankers and legislators in each region grappled with the difficult issue of protecting a fragile but vital sector of the economy. Each region responded to the problem differently. The South and West settled on yet another solution.

Banking in the South and West

One distinguishing characteristic of southern and western banks was their extensive branch networks. Pennsylvania provided for branch banking in the early nineteenth century and two banks jointly opened about ten branches. In both instances, however, the branches became a net liability. The Philadelphia Bank opened four branches in 1809 and by 1811 was forced to pass on its semi-annual dividends because losses at the branches offset profits at the Philadelphia office. At bottom, branch losses resulted from a combination of ineffective central office oversight and unrealistic expectations about the scale and scope of hinterland lending. Philadelphia’s bank directors instructed branch managers to invest in high-grade commercial paper or real bills. Rural banks found a limited number of such lending opportunities and quickly turned to mortgage-based lending. Many of these loans fell into arrears and were ultimately written when land sales faltered.

Branch Banking

Unlike Pennsylvania, where branch banking failed, branch banks throughout the South and West thrived. The Bank of Virginia, founded in 1804, was the first state-chartered branch bank and up to the Civil War branch banks served the state’s financial needs. Several small, independent banks were chartered in the 1850s, but they never threatened the dominance of Virginia’s “Big Six” banks. Virginia’s branch banks, unlike Pennsylvania’s, were profitable. In 1821, for example, the net return to capital at the Farmers Bank of Virginia’s home office in Richmond was 5.4 percent. Returns at its branches ranged from a low of 3 percent at Norfolk (which was consistently the low-profit branch) to 9 percent in Winchester. In 1835, the last year the bank reported separate branch statistics, net returns to capital at the Farmers Bank’s branches ranged from 2.9 and 11.7 percent, with an average of 7.9 percent.

The low profits at the Norfolk branch represent a net subsidy from the state’s banking sector to the political system, which was not immune to the same kind of infrastructure boosterism that erupted in New York, Pennsylvania, Maryland and elsewhere. In the immediate post-Revolutionary era, the value of exports shipped from Virginia’s ports (Norfolk and Alexandria) slightly exceeded the value shipped from Baltimore. In the 1790s the numbers turned sharply in Baltimore’s favor and Virginia entered the internal-improvements craze and the battle for western shipments. Banks represented the first phase of the state’s internal improvements plan in that many believed that Baltimore’s new-found advantage resulted from easier credit supplied by the city’s banks. If Norfolk, with one of the best natural harbors on the North American Atlantic coast, was to compete with other port cities, it needed banks and the state required three of the state’s Big Six branch banks to operate branches there. Despite its natural advantages, Norfolk never became an important entrepot and it probably had more bank capital than it required. This pattern was repeated elsewhere. Other states required their branch banks to serve markets such as Memphis, Louisville, Natchez and Mobile that might, with the proper infrastructure grow into important ports.

State Involvement and Intervention in Banking

The second distinguishing characteristic of southern and western banking was sweeping state involvement and intervention. Virginia, for example, interjected the state into the banking system by taking significant stakes in its first chartered banks (providing an implicit subsidy) and by requiring them, once they established themselves, to subsidize the state’s continuing internal improvements programs of the 1820s and 1830s. Indiana followed such a strategy. So, too, did Kentucky, Louisiana, Mississippi, Illinois, Kentucky, Tennessee and Georgia in different degrees. South Carolina followed a wholly different strategy. On one hand, it chartered several banks in which it took no financial interest. On the other, it chartered the Bank of the State of South Carolina, a bank wholly owned by the state and designed to lend to planters and farmers who complained constantly that the state’s existing banks served only the urban mercantile community. The state-owned bank eventually divided its lending between merchants, farmers and artisans and dominated South Carolina’s financial sector.

The 1820s and 1830s witnessed a deluge of new banks in the South and West, with a corresponding increase in state involvement. No state matched Louisiana’s breadth of involvement in the 1830s when it chartered three distinct types of banks: commercial banks that served merchants and manufacturers; improvement banks that financed various internal improvements projects; and property banks that extended long-term mortgage credit to planters and other property holders. Louisiana’s improvement banks included the New Orleans Canal and Banking Company that built a canal connecting Lake Ponchartrain to the Mississippi River. The Exchange and Banking Company and the New Orleans Improvement and Banking Company were required to build and operate hotels. The New Orleans Gas Light and Banking Company constructed and operated gas streetlights in New Orleans and five other cities. Finally, the Carrollton Railroad and Banking Company and the Atchafalaya Railroad and Banking Company were rail construction companies whose bank subsidiaries subsidized railroad construction.

“Commonwealth Ideal” and Inflationary Banking

Louisiana’s 1830s banking exuberance reflected what some historians label the “commonwealth ideal” of banking; that is, the promotion of the general welfare through the promotion of banks. Legislatures in the South and West, however, never demonstrated a greater commitment to the commonwealth ideal than during the tough times of the early 1820s. With the collapse of the post-war land boom in 1819, a political coalition of debt-strapped landowners lobbied legislatures throughout the region for relief and its focus was banking. Relief advocates lobbied for inflationary banking that would reduce the real burden of debts taken on during prior flush times.

Several western states responded to these calls and chartered state-subsidized and state-managed banks designed to reinflate their embattled economies. Chartered in 1821, the Bank of the Commonwealth of Kentucky loaned on mortgages at longer than customary periods and all Kentucky landowners were eligible for $1,000 loans. The loans allowed landowners to discharge their existing debts without being forced to liquidate their property at ruinously low prices. Although the bank’s notes were not redeemable into specie, they were given currency in two ways. First, they were accepted at the state treasury in tax payments. Second, the state passed a law that forced creditors to accept the notes in payment of existing debts or agree to delay collection for two years.

The commonwealth ideal was not unique to Kentucky. During the depression of the 1820s, Tennessee chartered the State Bank of Tennessee, Illinois chartered the State Bank of Illinois and Louisiana chartered the Louisiana State Bank. Although they took slightly different forms, they all had the same intent; namely, to relieve distressed and embarrassed farmers, planters and land owners. What all these banks shared in common was the notion that the state should promote the general welfare and economic growth. In this instance, and again during the depression of the 1840s, state-owned banks were organized to minimize the transfer of property when economic conditions demanded wholesale liquidation. Such liquidation would have been inefficient and imposed unnecessary hardship on a large fraction of the population. To the extent that hastily chartered relief banks forestalled inefficient liquidation, they served their purpose. Although most of these banks eventually became insolvent, requiring taxpayer bailouts, we cannot label them unsuccessful. They reinflated economies and allowed for an orderly disposal of property. Determining if the net benefits were positive or negative requires more research, but for the moment we are forced to accept the possibility that the region’s state-owned banks of the 1820s and 1840s advanced the commonweal.

Conclusion: Banks and Economic Growth

Despite notable differences in the specific form and structure of each region’s banking system, they were all aimed squarely at a common goal; namely, realizing that region’s economic potential. Banks helped achieve the goal in two ways. First, banks monetized economies, which reduced the costs of transacting and helped smooth consumption and production across time. It was no longer necessary for every farm family to inventory their entire harvest. They could sell most of it, and expend the proceeds on consumption goods as the need arose until the next harvest brought a new cash infusion. Crop and livestock inventories are prone to substantial losses and an increased use of money reduced them significantly. Second, banks provided credit, which unleashed entrepreneurial spirits and talents. A complete appreciation of early American banking recognizes the banks’ contribution to antebellum America’s economic growth.

Bibliographic Essay

Because of the large number of sources used to construct the essay, the essay was more readable and less cluttered by including a brief bibliographic essay. A full bibliography is included at the end.

Good general histories of antebellum banking include Dewey (1910), Fenstermaker (1965), Gouge (1833), Hammond (1957), Knox (1903), Redlich (1949), and Trescott (1963). If only one book is read on antebellum banking, Hammond’s (1957) Pulitzer-Prize winning book remains the best choice.

The literature on New England banking is not particularly large, and the more important historical interpretations of state-wide systems include Chadbourne (1936), Hasse (1946, 1957), Simonton (1971), Spencer (1949), and Stokes (1902). Gras (1937) does an excellent job of placing the history of a single bank within the larger regional and national context. In a recent book and a number of articles Lamoreaux (1994 and sources therein) provides a compelling and eminently readable reinterpretation of the region’s banking structure. Nathan Appleton (1831, 1856) provides a contemporary observer’s interpretation, while Walker (1857) provides an entertaining if perverse and satirical history of a fictional New England bank. Martin (1969) provides details of bank share prices and dividend payments from the establishment of the first banks in Boston through the end of the nineteenth century. Less technical studies of the Suffolk system include Lake (1947), Trivoli (1979) and Whitney (1878); more technical interpretations include Calomiris and Kahn (1996), Mullineaux (1987), and Rolnick, Smith and Weber (1998).

The literature on Middle Atlantic banking is huge, but the better state-level histories include Bryan (1899), Daniels (1976), and Holdsworth (1928). The better studies of individual banks include Adams (1978), Lewis (1882), Nevins (1934), and Wainwright (1953). Chaddock (1910) provides a general history of the Safety Fund system. Golembe (1960) places it in the context of modern deposit insurance, while Bodenhorn (1996) and Calomiris (1989) provide modern analyses. A recent revival of interest in free banking has brought about a veritable explosion in the number of studies on the subject, but the better introductory ones remain Rockoff (1974, 1985), Rolnick and Weber (1982, 1983), and Dwyer (1996).

The literature on southern and western banking is large and of highly variable quality, but I have found the following to be the most readable and useful general sources: Caldwell (1935), Duke (1895), Esary (1912), Golembe (1978), Huntington (1915), Green (1972), Lesesne (1970), Royalty (1979), Schweikart (1987) and Starnes (1931).

References and Further Reading

Adams, Donald R., Jr. Finance and Enterprise in Early America: A Study of Stephen Girard’s Bank, 1812-1831. Philadelphia: University of Pennsylvania Press, 1978.

Alter, George, Claudia Goldin and Elyce Rotella. “The Savings of Ordinary Americans: The Philadelphia Saving Fund Society in the Mid-Nineteenth-Century.” Journal of Economic History 54, no. 4 (December 1994): 735-67.

Appleton, Nathan. A Defence of Country Banks: Being a Reply to a Pamphlet Entitled ‘An Examination of the Banking System of Massachusetts, in Reference to the Renewal of the Bank Charters.’ Boston: Stimpson & Clapp, 1831.

Appleton, Nathan. Bank Bills or Paper Currency and the Banking System of Massachusetts with Remarks on Present High Prices. Boston: Little, Brown and Company, 1856.

Berry, Thomas Senior. Revised Annual Estimates of American Gross National Product: Preliminary Estimates of Four Major Components of Demand, 1789-1889. Richmond: University of Richmond Bostwick Paper No. 3, 1978.

Bodenhorn, Howard. “Zombie Banks and the Demise of New York’s Safety Fund.” Eastern Economic Journal 22, no. 1 (1996): 21-34.

Bodenhorn, Howard. “Private Banking in Antebellum Virginia: Thomas Branch & Sons of Petersburg.” Business History Review 71, no. 4 (1997): 513-42.

Bodenhorn, Howard. A History of Banking in Antebellum America: Financial Markets and Economic Development in an Era of Nation-Building. Cambridge and New York: Cambridge University Press, 2000.

Bodenhorn, Howard. State Banking in Early America: A New Economic History. New York: Oxford University Press, 2002.

Bryan, Alfred C. A History of State Banking in Maryland. Baltimore: Johns Hopkins University Press, 1899.

Caldwell, Stephen A. A Banking History of Louisiana. Baton Rouge: Louisiana State University Press, 1935.

Calomiris, Charles W. “Deposit Insurance: Lessons from the Record.” Federal Reserve Bank of Chicago Economic Perspectives 13 (1989): 10-30.

Calomiris, Charles W., and Charles Kahn. “The Efficiency of Self-Regulated Payments Systems: Learnings from the Suffolk System.” Journal of Money, Credit, and Banking 28, no. 4 (1996): 766-97.

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1 Banknotes were small demonination IOUs printed by banks and circulated as currency. Modern U.S. money are simply banknotes issued by the Federal Reserve Bank, which has a monopoly privilege in the issue of legal tender currency. In antebellum American, when a bank made a loan, the borrower was typically handed banknotes with a face value equal to the dollar value of the loan. The borrower then spent these banknotes in purchasing goods and services, putting them into circulation. Contemporary law held that banks were required to redeem banknotes into gold and silver legal tender on demand. Banks found it profitable to issue notes because they typically held about 30 percent of the total value of banknotes in circulation as reserves. Thus, banks were able to leverage $30 in gold and silver into $100 in loans that returned about 7 percent interest on average.

2 Paul Lockard (2000) challenges Lamoreaux’s interpretation. In a study of 4 banks in the Connecticut River valley, Lockard finds that insiders did not dominate these banks’ resources. As provocative as Lockard’s findings are, he draws conclusions from a small and unrepresentative sample. Two of his four sample banks were savings banks, which were designed as quasi-charitable organizations designed to encourage savings by the working classes and provide small loans. Thus, Lockard’s sample is effectively reduced to two banks. At these two banks, he identifies about 10 percent of loans as insider loans, but readily admits that he cannot always distinguish between insiders and outsiders. For a recent study of how early Americans used savings banks, see Alter, Goldin and Rotella (1994). The literature on savings banks is so large that it cannot be be given its due here.

3 Interbank clearing involves the settling of balances between banks. Modern banks cash checks drawn on other banks and credit the funds to the depositor. The Federal Reserve system provides clearing services between banks. The accepting bank sends the checks to the Federal Reserve, who credits the sending bank’s accounts and sends the checks back to the bank on which they were drawn for reimbursement. In the antebellum era, interbank clearing involved sending banknotes back to issuing banks. Because New England had so many small and scattered banks, the costs of returning banknotes to their issuers were large and sometimes avoided by recirculating notes of distant banks rather than returning them. Regular clearings and redemptions served an important purpose, however, because they kept banks in touch with the current market conditions. A massive redemption of notes was indicative of a declining demand for money and credit. Because the bank’s reserves were drawn down with the redemptions, it was forced to reduce its volume of loans in accord with changing demand conditions.

4 The law held that banknotes were redeemable on demand into gold or silver coin or bullion. If a bank refused to redeem even a single $1 banknote, the banknote holder could have the bank closed and liquidated to recover his or her claim against it.

5 Rappaport (1996) found that the bank’s loans were about equally divided between insiders (shareholders and shareholders’ family and business associates) and outsiders, but nonshareholders received loans about 30 percent smaller than shareholders. The issue remains about whether this bank was an “insider” bank, and depends largely on one’s definition. Any modern bank which made half of its loans to shareholders and their families would be viewed as an “insider” bank. It is less clear where the line can be usefully drawn for antebellum banks.

6 Real-bills lending followed from a nineteenth-century banking philosophy, which held that bank lending should be used to finance the warehousing or wholesaling of already-produced goods. Loans made on these bases were thought to be self-liquidating in that the loan was made against readily sold collateral actually in the hands of a merchant. Under the real-bills doctrine, the banks’ proper functions were to bridge the gap between production and retail sale of goods. A strict adherence to real-bills tenets excluded loans on property (mortgages), loans on goods in process (trade credit), or loans to start-up firms (venture capital). Thus, real-bills lending prescribed a limited role for banks and bank credit. Few banks were strict adherents to the doctrine, but many followed it in large part.

7 Robert E. Wright (1998) offers a different interpretation, but notes that Burr pushed the bill through at the end of a busy legislative session so that many legislators voted on the bill without having read it thoroughly

Citation: Bodenhorn, Howard. “Antebellum Banking in the United States”. EH.Net Encyclopedia, edited by Robert Whaples. March 26, 2008. URL http://eh.net/encyclopedia/antebellum-banking-in-the-united-states/

The Economic History of Australia from 1788: An Introduction

Bernard Attard, University of Leicester

Introduction

The economic benefits of establishing a British colony in Australia in 1788 were not immediately obvious. The Government’s motives have been debated but the settlement’s early character and prospects were dominated by its original function as a jail. Colonization nevertheless began a radical change in the pattern of human activity and resource use in that part of the world, and by the 1890s a highly successful settler economy had been established on the basis of a favorable climate in large parts of the southeast (including Tasmania ) and the southwest corner; the suitability of land for European pastoralism and agriculture; an abundance of mineral wealth; and the ease with which these resources were appropriated from the indigenous population. This article will focus on the creation of a colonial economy from 1788 and its structural change during the twentieth century. To simplify, it will divide Australian economic history into four periods, two of which overlap. These are defined by the foundation of the ‘bridgehead economy’ before 1820; the growth of a colonial economy between 1820 and 1930; the rise of manufacturing and the protectionist state between 1891 and 1973; and the experience of liberalization and structural change since 1973. The article will conclude by suggesting briefly some of the similarities between Australia and other comparable settler economies, as well as the ways in which it has differed from them.

The Bridgehead Economy, 1788-1820

The description ‘bridgehead economy’ was used by one of Australia’s foremost economic historians, N. G. Butlin to refer to the earliest decades of British occupation when the colony was essentially a penal institution. The main settlements were at Port Jackson (modern Sydney, 1788) in New South Wales and Hobart (1804) in what was then Van Diemen’s Land (modern Tasmania). The colony barely survived its first years and was largely neglected for much of the following quarter-century while the British government was preoccupied by the war with France. An important beginning was nevertheless made in the creation of a private economy to support the penal regime. Above all, agriculture was established on the basis of land grants to senior officials and emancipated convicts, and limited freedoms were allowed to convicts to supply a range of goods and services. Although economic life depended heavily on the government Commissariat as a supplier of goods, money and foreign exchange, individual rights in property and labor were recognized, and private markets for both started to function. In 1808, the recall of the New South Wales Corps, whose officers had benefited most from access to land and imported goods (thus hopelessly entangling public and private interests), coupled with the appointment of a new governor, Lachlan Macquarie, in the following year, brought about a greater separation of the private economy from the activities and interests of the colonial government. With a significant increase in the numbers transported after 1810, New South Wales’ future became more secure. As laborers, craftsmen, clerks and tradesmen, many convicts possessed the skills required in the new settlements. As their terms expired, they also added permanently to the free population. Over time, this would inevitably change the colony’s character.

Natural Resources and the Colonial Economy, 1820-1930

Pastoral and Rural Expansion

For Butlin, the developments around 1810 were a turning point in the creation of a ‘colonial’ economy. Many historians have preferred to view those during the 1820s as more significant. From that decade, economic growth was based increasingly upon the production of fine wool and other rural commodities for markets in Britain and the industrializing economies of northwestern Europe. This growth was interrupted by two major depressions during the 1840s and 1890s and stimulated in complex ways by the rich gold discoveries in Victoria in 1851, but the underlying dynamics were essentially unchanged. At different times, the extraction of natural resources, whether maritime before the 1840s or later gold and other minerals, was also important. Agriculture, local manufacturing and construction industries expanded to meet the immediate needs of growing populations, which concentrated increasingly in the main urban centers. The colonial economy’s structure, growth of population and significance of urbanization are illustrated in tables 1 and 2. The opportunities for large profits in pastoralism and mining attracted considerable amounts of British capital, while expansion generally was supported by enormous government outlays for transport, communication and urban infrastructures, which also depended heavily on British finance. As the economy expanded, large-scale immigration became necessary to satisfy the growing demand for workers, especially after the end of convict transportation to the eastern mainland in 1840. The costs of immigration were subsidized by colonial governments, with settlers coming predominantly from the United Kingdom and bringing skills that contributed enormously to the economy’s growth. All this provided the foundation for the establishment of free colonial societies. In turn, the institutions associated with these — including the rule of law, secure property rights, and stable and democratic political systems — created conditions that, on balance, fostered growth. In addition to New South Wales, four other British colonies were established on the mainland: Western Australia (1829), South Australia (1836), Victoria (1851) and Queensland (1859). Van Diemen’s Land (Tasmania after 1856) became a separate colony in 1825. From the 1850s, these colonies acquired responsible government. In 1901, they federated, creating the Commonwealth of Australia.

Table 1
The Colonial Economy: Percentage Shares of GDP, 1891 Prices, 1861-1911

Pastoral Other rural Mining Manuf. Building Services Rent
1861 9.3 13.0 17.5 14.2 8.4 28.8 8.6
1891 16.1 12.4 6.7 16.6 8.5 29.2 10.3
1911 14.8 16.7 9.0 17.1 5.3 28.7 8.3

Source: Haig (2001), Table A1. Totals do not sum to 100 because of rounding.

Table 2
Colonial Populations (thousands), 1851-1911

Australia Colonies Cities
NSW Victoria Sydney Melbourne
1851 257 100 46 54 29
1861 669 198 328 96 125
1891 1,704 608 598 400 473
1911 2,313 858 656 648 593

Source: McCarty (1974), p. 21; Vamplew (1987), POP 26-34.

The process of colonial growth began with two related developments. First, in 1820, Macquarie responded to land pressure in the districts immediately surrounding Sydney by relaxing restrictions on settlement. Soon the outward movement of herdsmen seeking new pastures became uncontrollable. From the 1820s, the British authorities also encouraged private enterprise by the wholesale assignment of convicts to private employers and easy access to land. In 1831, the principles of systematic colonization popularized by Edward Gibbon Wakefield (1796-1862) were put into practice in New South Wales with the substitution of land sales for grants in order to finance immigration. This, however, did not affect the continued outward movement of pastoralists who simply occupied land where could find it beyond the official limits of settlement. By 1840, they had claimed a vast swathe of territory two hundred miles in depth running from Moreton Bay in the north (the site of modern Brisbane) through the Port Phillip District (the future colony of Victoria, whose capital Melbourne was marked out in 1837) to Adelaide in South Australia. The absence of any legal title meant that these intruders became known as ‘squatters’ and the terms of their tenure were not finally settled until 1846 after a prolonged political struggle with the Governor of New South Wales, Sir George Gipps.

The impact of the original penal settlements on the indigenous population had been enormous. The consequences of squatting after 1820 were equally devastating as the land and natural resources upon which indigenous hunter-gathering activities and environmental management depended were appropriated on a massive scale. Aboriginal populations collapsed in the face of disease, violence and forced removal until they survived only on the margins of the new pastoral economy, on government reserves, or in the arid parts of the continent least touched by white settlement. The process would be repeated again in northern Australia during the second half of the century.

For the colonists this could happen because Australia was considered terra nullius, vacant land freely available for occupation and exploitation. The encouragement of private enterprise, the reception of Wakefieldian ideas, and the wholesale spread of white settlement were all part of a profound transformation in official and private perceptions of Australia’s prospects and economic value as a British colony. Millennia of fire-stick management to assist hunter-gathering had created inland grasslands in the southeast that were ideally suited to the production of fine wool. Both the physical environment and the official incentives just described raised expectations of considerable profits to be made in pastoral enterprise and attracted a growing stream of British capital in the form of organizations like the Australian Agricultural Company (1824); new corporate settlements in Western Australia (1829) and South Australia (1836); and, from the 1830s, British banks and mortgage companies formed to operate in the colonies. By the 1830s, wool had overtaken whale oil as the colony’s most important export, and by 1850 New South Wales had displaced Germany as the main overseas supplier to British industry (see table 3). Allowing for the colonial economy’s growing complexity, the cycle of growth based upon land settlement, exports and British capital would be repeated twice. The first pastoral boom ended in a depression which was at its worst during 1842-43. Although output continued to grow during the 1840s, the best land had been occupied in the absence of substantial investment in fencing and water supplies. Without further geographical expansion, opportunities for high profits were reduced and the flow of British capital dried up, contributing to a wider downturn caused by drought and mercantile failure.

Table 3
Imports of Wool into Britain (thousands of bales), 1830-50

German Australian
1830 74.5 8.0
1840 63.3 41.0
1850 30.5 137.2

Source: Sinclair (1976), p. 46

When pastoral growth revived during the 1860s, borrowed funds were used to fence properties and secure access to water. This in turn allowed a further extension of pastoral production into the more environmentally fragile semi-arid interior districts of New South Wales, particularly during the 1880s. As the mobs of sheep moved further inland, colonial governments increased the scale of their railway construction programs, some competing to capture the freight to ports. Technical innovation and government sponsorship of land settlement brought greater diversity to the rural economy (see table 4). Exports of South Australian wheat started in the 1870s. The development of drought resistant grain varieties from the turn of the century led to an enormous expansion of sown acreage in both the southeast and southwest. From the 1880s, sugar production increased in Queensland, although mainly for the domestic market. From the 1890s, refrigeration made it possible to export meat, dairy products and fruit.

Table 4
Australian Exports (percentages of total value of exports), 1881-1928/29

Wool Minerals Wheat,flour Butter Meat Fruit
1881-90 54.1 27.2 5.3 0.1 1.2 0.2
1891-1900 43.5 33.1 2.9 2.4 4.1 0.3
1901-13 34.3 35.4 9.7 4.1 5.1 0.5
1920/21-1928/29 42.9 8.8 20.5 5.6 4.6 2.2

Source: Sinclair (1976), p. 166

Gold and Its Consequences

Alongside rural growth and diversification, the remarkable gold discoveries in central Victoria in 1851 brought increased complexity to the process of economic development. The news sparked an immediate surge of gold seekers into the colony, which was soon reinforced by a flood of overseas migrants. Until the 1870s, gold displaced wool as Australia’s most valuable export. Rural industries either expanded output (wheat in South Australia) or, in the case of pastoralists, switched production to meat and tallow, to supply a much larger domestic market. Minerals had been extracted since earliest settlement and, while yields on the Victorian gold fields soon declined, rich mineral deposits continued to be found. During the 1880s alone these included silver, lead and zinc at Broken Hill in New South Wales; copper at Mount Lyell in Tasmania; and gold at Charters Towers and Mount Morgan in Queensland. From 1893, what eventually became the richest goldfields in Australia were discovered at Coolgardie in Western Australia. The mining industry’s overall contribution to output and exports is illustrated in tables 1 and 4.

In Victoria, the deposits of easily extracted alluvial gold were soon exhausted and mining was taken over by companies that could command the financial and organizational resources needed to work the deep lodes. But the enormous permanent addition to the colonial population caused by the gold rush had profound effects throughout eastern Australia, dramatically accelerating the growth of the local market and workforce, and deeply disturbing the social balance that had emerged during the decade before. Between 1851 and 1861, the Australian population more than doubled. In Victoria it increased sevenfold; Melbourne outgrew Sydney, Chicago and San Francisco (see table 2). Significantly enlarged populations required social infrastructure, political representation, employment and land; and the new colonial legislatures were compelled to respond. The way this was played out varied between colonies but the common outcomes were the introduction of manhood suffrage, access to land through ‘free selection’ of small holdings, and, in the Victorian case, the introduction of a protectionist tariff in 1865. The particular age structure of the migrants of the 1850s also had long-term effects on the building cycle, notably in Victoria. The demand for housing accelerated during the 1880s, as the children of the gold generation matured and established their own households. With pastoral expansion and public investment also nearing their peaks, the colony experienced a speculative boom which added to the imbalances already being caused by falling export prices and rising overseas debt. The boom ended with the wholesale collapse of building companies, mortgage banks and other financial institutions during 1891-92 and the stoppage of much of the banking system during 1893.

The depression of the 1890s was worst in Victoria. Its impact on employment was softened by the Western Australian gold discoveries, which drew population away, but the colonial economy had grown to such an extent since the 1850s that the stimulus provided by the earlier gold finds could not be repeated. Severe drought in eastern Australia from the mid-1890s until 1903 caused the pastoral industry to contract. Yet, as we have seen, technological innovation also created opportunities for other rural producers, who were now heavily supported by government with little direct involvement by foreign investors. The final phase of rural expansion, with its associated public investment in rural (and increasingly urban) infrastructure continued until the end of the 1920s. Yields declined, however, as farmers moved onto the most marginal land. The terms of trade also deteriorated with the oversupply of several commodities in world markets after the First World War. As a result, the burden of servicing foreign debt rose once again. Australia’s position as a capital importer and exporter of natural resources meant that the Great Depression arrived early. From late 1929, the closure of overseas capital markets and collapse of export prices forced the Federal Government to take drastic measures to protect the balance of payments. The falls in investment and income transmitted the contraction to the rest of the economy. By 1932, average monthly unemployment amongst trade union members was over 22 percent. Although natural resource industries continued to have enduring importance as earners of foreign exchange, the Depression finally ended the long period in which land settlement and technical innovation had together provided a secure foundation for economic growth.

Manufacturing and the Protected Economy, 1891-1973

The ‘Australian Settlement’

There is a considerable chronological overlap between the previous section, which surveyed the growth of a colonial economy during the nineteenth century based on the exploitation of natural resources, and this one because it is a convenient way of approaching the two most important developments in Australian economic history between Federation and the 1970s: the enormous increase in government regulation after 1901 and, closely linked to this, the expansion of domestic manufacturing, which from the Second World War became the most dynamic part of the Australian economy.

The creation of the Commonwealth of Australia on 1 January 1901 broadened the opportunities for public intervention in private markets. The new Federal Government was given clearly-defined but limited powers over obviously ‘national’ matters like customs duties. The rest, including many affecting economic development and social welfare, remained with the states. The most immediate economic consequence was the abolition of inter-colonial tariffs and the establishment of a single Australian market. But the Commonwealth also soon set about transferring to the national level several institutions that different the colonies had experimented with during the 1890s. These included arrangements for the compulsory arbitration of industrial disputes by government tribunals, which also had the power to fix wages, and a discriminatory ‘white Australia’ immigration policy designed to exclude non-Europeans from the labor market. Both were partly responses to organized labor’s electoral success during the 1890s. Urban business and professional interests had always been represented in colonial legislatures; during the 1910s, rural producers also formed their own political parties. Subsequently, state and federal governments were typically formed by the either Australian Labor Party or coalitions of urban conservatives and the Country Party. The constituencies they each represented were thus able to influence the regulatory structure to protect themselves against the full impact of market outcomes, whether in the form of import competition, volatile commodity prices or uncertain employment conditions. The institutional arrangements they created have been described as the ‘Australian settlement’ because they balanced competing producer interests and arguably provided a stable framework for economic development until the 1970s, despite the inevitable costs.

The Growth of Manufacturing

An important part of the ‘Australian settlement’ was the imposition of a uniform federal tariff and its eventual elaboration into a system of ‘protection all round’. The original intended beneficiaries were manufacturers and their employees; indeed, when the first protectionist tariff was introduced in 1907, its operation was linked to the requirement that employers pay their workers ‘fair and reasonable wages’. Manufacturing’s actual contribution to economic growth before Federation has been controversial. The population influx of the 1850s widened opportunities for import-substitution but the best evidence suggests that manufacturing grew slowly as the industrial workforce increased (see table 1). Production was small-scale and confined largely to the processing of rural products and raw materials; assembly and repair-work; or the manufacture of goods for immediate consumption (e.g. soap and candle-making, brewing and distilling). Clothing and textile output was limited to a few lines. For all manufacturing, growth was restrained by the market’s small size and the limited opportunities for technical change it afforded.

After Federation, production was stimulated by several factors: rural expansion, the increasing use of agricultural machinery and refrigeration equipment, and the growing propensity of farm incomes to be spent locally. The removal of inter-colonial tariffs may also have helped. The statistical evidence indicates that between 1901 and the outbreak of the First World War manufacturing grew faster than the economy as a whole, while output per worker increased. But manufacturers also aspired mainly to supply the domestic market and expended increasing energy on retaining privileged access. Tariffs rose considerably between the two world wars. Some sectors became more capital intensive, particularly with the establishment of a local steel industry, the beginnings of automobile manufacture, and the greater use of electricity. But, except during the first half of the 1920s, there was little increase in labor productivity and the inter-war expansion of textile manufacturing reflected the heavy bias towards import substitution. Not until the Second World War and after did manufacturing growth accelerate and extend to those sectors most characteristic of an advance industrial economy (table 5). Amongst these were automobiles, chemicals, electrical and electronic equipment, and iron-and-steel. Growth was sustained during 1950s by similar factors to those operating in other countries during the ‘long boom’, including a growing stream of American direct investment, access to new and better technology, and stable conditions of full employment.

Table 5
Manufacturing and the Australian Economy, 1913-1949

1938-39 prices
Manufacturing share of GDP % Manufacturing annual rate of growth % GDP, annual rate of growth %
1913/14 21.9
1928/29 23.6 2.6 2.1
1948/49 29.8 3.4 2.2

Calculated from Haig (2001), Table A2. Rates of change are average annual changes since the previous year in the first column.

Manufacturing peaked in the mid-1960s at about 28 percent of national output (measured in 1968-69 prices) but natural resource industries remained the most important suppliers of exports. Since the 1920s, over-supply in world markets and the need to compensate farmers for manufacturing protection, had meant that virtually all rural industries, with the exception of wool, had been drawn into a complicated system of subsidies, price controls and market interventions at both federal and state levels. The post-war boom in the world economy increased demand for commodities, benefiting rural producers but also creating new opportunities for Australian miners. Most important of all, the first surge of breakneck growth in East Asia opened a vast new market for iron ore, coal and other mining products. Britain’s significance as a trading partner had declined markedly since the 1950s. By the end of the 1960s, Japan overtook it as Australia’s largest customer, while the United States was now the main provider of imports.

The mining bonanza contributed to the boom conditions experienced generally after 1950. The Federal Government played its part by using the full range of macroeconomic policies that were also increasingly familiar in similar western countries to secure stability and full employment. It encouraged high immigration, relaxing the entry criteria to allow in large numbers of southern Europeans, who added directly to the workforce, but also brought knowledge and experience. With state governments, the Commonwealth increased expenditure on education significantly, effectively entering the field for the first time after 1945. Access to secondary education was widened with the abandonment of fees in government schools and federal finance secured an enormous expansion of university places, especially after 1960. Some weaknesses remained. Enrolment rates after primary school were below those in many industrial countries and funding for technical education was poor. Despite this, the Australian population’s rising levels of education and skill continued to be important additional sources of growth. Finally, although government advisers expressed misgivings, industry policy remained determinedly interventionist. While state governments competed to attract manufacturing investment with tax and other incentives, by the 1960s protection had reached its highest level, with Australia playing virtually no part in the General Agreement on Tariffs and Trade (GATT), despite being an original signatory. The effects of rising tariffs since 1900 were evident in the considerable decline in Australia’s openness to trade (Table 6). Yet, as the post-war boom approached its end, the country still relied upon commodity exports and foreign investment to purchase the manufactures it was unable to produce itself. The impossibility of sustaining growth in this way was already becoming clear, even though the full implications would only be felt during the decades to come.

Table 6
Trade (Exports Plus Imports)
as a Share of GDP, Current Prices, %

1900/1 44.9
1928/29 36.9
1938/38 32.7
1964/65 33.3
1972/73 29.5

Calculated from Vamplew (1987), ANA 119-129.

Liberalization and Structural Change, 1973-2005

From the beginning of the 1970s, instability in the world economy and weakness at home ended Australia’s experience of the post-war boom. During the following decades, manufacturing’s share in output (table 7) and employment fell, while the long-term relative decline of commodity prices meant that natural resources could no longer be relied on to cover the cost of imports, let alone the long-standing deficits in payments for services, migrant remittances and interest on foreign debt. Until the early 1990s, Australia also suffered from persistent inflation and rising unemployment (which remained permanently higher, see chart 1). As a consequence, per capita incomes fluctuated during the 1970s, and the economy contracted in absolute terms during 1982-83 and 1990-91.

Even before the 1970s, new sources of growth and rising living standards had been needed, but the opportunities for economic change were restricted by the elaborate regulatory structure that had evolved since Federation. During that decade itself, policy and outlook were essentially defensive and backward looking, despite calls for reform and some willingness to alter the tariff. Governments sought to protect employment in established industries, while dependence on mineral exports actually increased as a result of the commodity booms at the decade’s beginning and end. By the 1980s, however, it was clear that the country’s existing institutions were failing and fundamental reform was required.

Table 7
The Australian Economy, 1974-2004

A. Percentage shares of value-added, constant prices

1974 1984 1994 2002
Agriculture 4.4 4.3 3.0 2.7
Manufacturing 18.1 15.2 13.3 11.8
Other industry, inc. mining 14.2 14.0 14.6 14.4
Services 63.4 66.4 69.1 71.1

B. Per capita GDP, annual average rate of growth %, constant prices

1973-84 1.2
1984-94 1.7
1994-2004 2.5

Calculated from World Bank, World Development Indicators (Sept. 2005).

Figure 1
Unemployment, 1971-2005, percent

Unemployment, 1971-2005, percent

Source: Reserve Bank of Australia (1988); Reserve Bank of Australia, G07Hist.xls. Survey data at August. The method of data collection changed in 1978.

The catalyst was the resumption of the relative fall of commodity prices since the Second World War which meant that the cost of purchasing manufactured goods inexorably rose for primary producers. The decline had been temporarily reversed by the oil shocks of the 1970s but, from the 1980/81 financial year until the decade’s end, the value of Australia’s merchandise imports exceeded that of merchandise exports in every year but two. The overall deficit on current account measured as a proportion of GDP also moved became permanently higher, averaging around 4.7 percent. During the 1930s, deflation had been followed by the further closing of the Australian economy. There was no longer much scope for this. Manufacturing had stagnated since the 1960s, suffering especially from the inflation of wage and other costs during the 1970s. It was particularly badly affected by the recession of 1982-83, when unemployment rose to almost ten percent, its highest level since the Great Depression. In 1983, a new federal Labor Government led by Bob Hawke sought to engineer a recovery through an ‘Accord’ with the trade union movement which aimed at creating employment by holding down real wages. But under Hawke and his Treasurer, Paul Keating — who warned colorfully that otherwise the country risked becoming a ‘banana republic’ — Labor also started to introduce broader reforms to increase the efficiency of Australian firms by improving their access to foreign finance and exposing them to greater competition. Costs would fall and exports of more profitable manufactures increase, reducing the economy’s dependence on commodities. During the 1980s and 1990s, the reforms deepened and widened, extending to state governments and continuing with the election of a conservative Liberal-National Party government under John Howard in 1996, as each act of deregulation invited further measures to consolidate them and increase their effectiveness. Key reforms included the floating of the Australian dollar and the deregulation of the financial system; the progressive removal of protection of most manufacturing and agriculture; the dismantling of the centralized system of wage-fixing; taxation reform; and the promotion of greater competition and better resource use through privatization and the restructuring of publicly-owned corporations, the elimination of government monopolies, and the deregulation of sectors like transport and telecommunications. In contrast with the 1930s, the prospects of further domestic reform were improved by an increasingly favorable international climate. Australia contributed by joining other nations in the Cairns Group to negotiate reductions of agricultural protection during the Uruguay round of GATT negotiations and by promoting regional liberalization through the Asia Pacific Economic Cooperation (APEC) forum.

Table 8
Exports and Openness, 1983-2004

Shares of total exports, % Shares of GDP: exports + imports, %
Goods Services
Rural Resource Manuf. Other
1983 30 34 9 3 24 26
1989 23 37 11 5 24 27
1999 20 34 17 4 24 37
2004 18 33 19 6 23 39

Calculated from: Reserve Bank of Australia, G10Hist.xls and H03Hist.xls; World Bank, World Development Indicators (Sept. 2005). Chain volume measures, except shares of GDP, 1983, which are at current prices.

The extent to which institutional reform had successfully brought about long-term structural change was still not clear at the end of the century. Recovery from the 1982-83 recession was based upon a strong revival of employment. By contrast, the uninterrupted growth experienced since 1992 arose from increases in the combined productivity of workers and capital. If this persisted, it was a historic change in the sources of growth from reliance on the accumulation of capital and the increase of the workforce to improvements in the efficiency of both. From the 1990s, the Australian economy also became more open (table 8). Manufactured goods increased their share of exports, while rural products continued to decline. Yet, although growth was more broadly-based, rapid and sustained (table 7), the country continued to experience large trade and current account deficits, which were augmented by the considerable increase of foreign debt after financial deregulation during the 1980s. Unemployment also failed to return to its pre-1974 level of around 2 percent, although much of the permanent rise occurred during the mid to late 1970s. In 2005, it remained 5 percent (Figure 1). Institutional reform clearly contributed to these changes in economic structure and performance but they were also influenced by other factors, including falling transport costs, the communications and information revolutions, the greater openness of the international economy, and the remarkable burst of economic growth during the century’s final decades in southeast and east Asia, above all China. Reform was also complemented by policies to provide the skills needed in a technologically-sophisticated, increasingly service-oriented economy. Retention rates in the last years of secondary education doubled during the 1980s, followed by a sharp increase of enrolments in technical colleges and universities. By 2002, total expenditure on education as a proportion of national income had caught up with the average of member countries of the OECD (Table 9). Shortages were nevertheless beginning to be experienced in the engineering and other skilled trades, raising questions about some priorities and the diminishing relative financial contribution of government to tertiary education.

Table 9
Tertiary Enrolments and Education Expenditure, 2002

Tertiary enrolments, gross percent Education expenditure as a proportion of GDP, percent
Australia 63.22 6.0
OECD 61.68 5.8
United States 70.67 7.2

Source: World Bank, World Development Indicators (Sept. 2005); OECD (2005). Gross enrolments are total enrolments, regardless of age, as a proportion of the population in the relevant official age group. OECD enrolments are for fifteen high-income members only.

Summing Up: The Australian Economy in a Wider Context

Virtually since the beginning of European occupation, the Australian economy had provided the original British colonizers, generations of migrants, and the descendants of both with a remarkably high standard of living. Towards the end of the nineteenth century, this was by all measures the highest in the world (see table 10). After 1900, national income per member of the population slipped behind that of several countries, but continued to compare favorably with most. In 2004, Australia was ranked behind only Norway and Sweden in the United Nation’s Human Development Index. Economic historians have differed over the sources of growth that made this possible. Butlin emphasized the significance of local factors like the unusually high rate of urbanization and the expansion of domestic manufacturing. In important respects, however, Australia was subject to the same forces as other European settler societies in New Zealand and Latin America, and its development bore striking similarities to theirs. From the 1820s, its economy grew as one frontier of an expanding western capitalism. With its close institutional ties to, and complementarities with, the most dynamic parts of the world economy, it drew capital and migrants from them, supplied them with commodities, and shared the benefits of their growth. Like other settler societies, it sought population growth as an end in itself and, from the turn of the nineteenth century, aspired to the creation of a national manufacturing base. Finally, when openness to the world economy appeared to threaten growth and living standards, governments intervened to regulate and protect with broader social objectives in mind. But there were also striking contrasts with other settler economies, notably those in Latin America like Argentina, with which it has been frequently compared. In particular, Australia responded to successive challenges to growth by finding new opportunities for wealth creation with a minimum of political disturbance, social conflict or economic instability, while sharing a rising national income as widely as possible.

Table 10
Per capita GDP in Australia, United States and Argentina
(1990 international dollars)

Australia United States Argentina
1870 3,641 2,457 1,311
1890 4,433 3,396 2,152
1950 7,493 9,561 4,987
1998 20,390 27,331 9,219

Sources: Australia: GDP, Haig (2001) as converted in Maddison (2003); all other data Maddison (1995) and (2001)

From the mid-twentieth century, Australia’s experience also resembled that of many advanced western countries. This included the post-war willingness to use macroeconomic policy to maintain growth and full employment; and, after the 1970s, the abandonment of much government intervention in private markets while at the same time retaining strong social services and seeking to improve education and training. Australia also experienced a similar relative decline of manufacturing, permanent rise of unemployment, and transition to a more service-based economy typical of high income countries. By the beginning of the new millennium, services accounted for over 70 percent of national income (table 7). Australia remained vulnerable as an exporter of commodities and importer of capital but its endowment of natural resources and the skills of its population were also creating opportunities. The country was again favorably positioned to take advantage of growth in the most dynamic parts of the world economy, particularly China. With the final abandonment of the White Australia policy during the 1970s, it had also started to integrate more closely with its region. This was further evidence of the capacity to change that allowed Australians to face the future with confidence.

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http://eh.net/encyclopedia/the-economic-history-of-australia-from-1788-an-introduction/

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/

History and Financial Crises: Lessons from the 20th Century

Reviewer(s):Moen, Jon

Published by EH.Net (August 2013)

Christopher Kobrak and Mira Wilkins, editors, History and Financial Crises: Lessons from the 20th Century.? New York: Routledge, 2013. x + 138 pp. $140 (cloth), ISBN: 978-0-415-62297-4.

Reviewed for EH.Net by Jon Moen, Department of Economics, University of Mississippi.

This book is a collection of six papers that were originally published as a special issue of Business History (Volume 53, Issue 2, April 2011).? It includes a new summary chapter on the use of history in understanding modern financial crises.? Two themes tied the original collection together: the roles of globalization and regulation in financial crises.? Because of the five papers chosen, the collection focuses on the 1920s and 30s.? The papers cover the experiences of the German, Swedish, British, Canadian, and U.S. financial and banking sectors just before and during the Great Depression.? Individually, the five papers draw useful lessons from historical episodes of financial crises, and I enjoyed reading them.? Because they were subject to careful peer-review, I will not review them individually.? Instead, I will review the effectiveness of the collection as a whole.

The original introductory essay and the new concluding essay distract from the five papers; they do not clearly make a case for why I should read them as a collection.? The introductory essay by Christopher Kobrak and Mira Wilkins starts with an extended discussion on the definition of a financial crisis.? It acknowledges Charles Kindleberger?s (2011) self-confessed inability to define a crisis and notes attempts to define a crisis on the basis of sudden movements in interest rates or the money supply.? Yet it ends quite unsatisfyingly with ?no absolute definition of either financial or economic crisis? (p. 5).? Later the essay apologizes for ultimately choosing a set of papers that are limited to the twentieth century, with an emphasis on the Great Depression (p. 10).? That is not bad, but the apology diminishes what the five essays do offer, as noted carefully in the next few pages.? One important point that the essay points out, however, is that not all crises covered in the special issue resulted in a collapse in demand and prices (p. 15).? Why crises do not inevitably lead to recessions or worse could be examined more.

The new, concluding essay by Christopher Kobrak is problematic.? As a stand-alone essay, I found it to be a potentially compelling survey of the relationship between financial and banking panics and the perils of making casual historical comparisons.? In particular, highlighting the relevance of the banking crises of the early 1930s rather than the spectacular stock market crash of 1929 helps in making historical comparisons with the crisis that started in 2008.? But then the essay veers off into topics that are again distracting, like musing on the loss of governmental discipline from the collapse of the Bretton Woods Agreement (p. 119).? This is odd, as the introductory essay indicates that the paper by Mark Billings and Forrest Capie emphasizes the benefits of flexible exchange rates.? The author then regrets not having an essay or more discussion of the Bank Panic of 1907, stating that it gets ?little press in financial histories? (p. 120) and then proceeds to write several pages on the Panic.? I have found quite a bit about 1907 in financial histories by Milton Friedman and Anna Schwartz (1963), Gary Gorton (2010), Richard Timberlake (1993), and Elmus Wicker (2000), just to name a few.? I may have contributed something myself.? The section on regulation (p. 123) starts out well, noting how historically regulation has always been trying to play catch-up to financial innovation.? But the subsequent discussion of the breakdown in Bretton Woods again doesn?t seem closely related to the papers of the special issue.? The discussion of ?Good Financial Crises? argues that crises that were successfully averted rarely get examined.? Wicker clearly points out that the New York Clearing House successfully dealt with the Panic of 1873, and he refers to the reactions to the Panics of 1884 and 1890 as success stories from the point of view of the Clearing House.? I mention this because there is a lot of historical analysis of specific panics out there that could have been tied into this essay.

The conclusion to the essay left me a bit puzzled.? Certainly financial markets are much more complicated today than, say, in 1907.? But is this the result of an increasing lack of social responsibility on the part of financiers today?? We are asked to compare today?s leaders with those of 1907, who ?stepped in to save a system from problems they themselves had created? (p. 131).? Whatever those problems were, I have a hard time imagining that saving his own skin was not first and foremost in J.P. Morgan?s mind, an incentive that just happened to be compatible with that of New York?s financial market in general.? Nevertheless, read the special issue or the book for the all of the essays.? Just do not expect to find a lot of lessons.

References:

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, NJ: University Press, 1963.

Gorton, Gary.? Slapped by the Invisible Hand: The Panic of 2007.? Oxford: Oxford University Press, 2010.

Kindleberger, Charles.? Manias, Panics, and Crashes: A History of Financial Crises, 6th edition. New York: Palgrave Macmillan, 2011.

Timberlake, Richard.? Monetary Policy in the United States: An Intellectual and Institutional History. Chicago: University of Chicago Press, 1993.

Wicker, Elmus.? Banking Panics of the Gilded Age.? Cambridge: Cambridge University Press, 2000.
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Jon Moen is an Associate Professor in the Department of Economics at the University of Mississippi.? He has studied retirement in the United States in addition to his research on the Panic of 1907.? He is currently working on a project with Ellis Tallman of Oberlin College and the Cleveland Federal Reserve Bank on the effectiveness of the New York Clearing House in the late nineteenth and early twentieth centuries.??
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Copyright (c) 2013 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (August 2013). All EH.Net reviews are archived at http://www.eh.net/BookReview

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):Europe
North America
Time Period(s):20th Century: Pre WWII

Money over Two Centuries: Selected Topics in British Monetary History

Author(s):Capie, Forrest
Wood, Geoffrey
Reviewer(s):Wood, John H.

Published by EH.Net (December 2012)

Forrest Capie and Geoffrey Wood, Money over Two Centuries: Selected Topics in British Monetary History. Oxford: Oxford University Press, 2012. x + 367 pp. $125 (hardcover), ISBN: 978-0-19-965512-0.

Reviewed for EH.Net by John H. Wood, Department of Economics, Wake Forest University.

Two eminent professors emeriti of economic history at City University London have collected some of their published work over three decades into a convenient and useful analytical account of British monetary experiences the last two centuries.? Competing hypotheses of connections between money, inflation, central banking, and financial stability are examined to help us understand twenty-first-century events as well as the past.? The authors say in the introduction that they began with the goal of a monetary history of the United Kingdom similar to Friedman and Schwartz?s Monetary History of the United States.? An insurmountable obstacle, however, was the openness of the British economy.? For an economy with a third of national income engaged in foreign trade, domestic policies are only part of the story.? It can hardly be said, for example, that because wage changes are moderate there are no inflation dangers.? Nor are other closed-economy models imported from the United States helpful.? An ?output gap? derived from a domestically measured ?supply potential? of an economy open to the world is a meaningless concept (pp. 1-2).? This would also explain why the NBER?s cyclical domestic measures at the center of Friedman and Schwartz?s study are less useful to the analysis of more open economies.? The book and the rest of this review are divided into three parts that treat (i) the causes and effects of money, 1870-1939, (ii) financial crises, 1914-1949, and (iii) international problems and policies since World War II.?
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Chapter 2 applies an ARIMA analysis to the distinction between two explanations of the Great Depression (which should probably be renamed ?The Great Price Fall?) of 1873-96 in Britain ? money and excess agricultural supply ? and finds in favor of the former; in particular, the international gold standard under which the quantity of money is outside the control of the authorities and the price level is determined internationally by gold production. (This reviewer would have said the relative cost of gold, but it comes to the same thing.)? The demand for money was also stable, helped by remarkable monetary stability (Chapter 3), which also explains why the post-1929 depression was less severe in Britain than the United States (Chapter 4).? Whatever monetary problems Britain had, including the return to gold in 1925 and the suspension of 1931, the authors conjecture that the stability of money contributed to general economic stability.? ?Institutions were crucial to the contrast in monetary stability between Britain and the rest of the world? (p. 99).? They were at least part of the reason why the deflations of 1873-96 and the interwar period had no important real effects, at least compared with the rest of the world.? The predictability of prices leads to the rejection of Keynes?s and Fisher?s theories of adverse effects of deflation on output in Britain (Chapter 5).?

Chapters 6 and 7 examine devaluations.? British monetary policies left much to be desired during the interwar period, but its institutions managed to get through what might have been crises without severe damage to the economy.? Although suspension of the gold convertibility of the pound in 1931 was a surprise, it was not associated with any of the shocks present in Minsky?s or Kindleberger?s accounts of crises.? There was no major boom and bust, bank run, reserve loss, or large government deficit.? Public and policy responses were mainly sighs of relief, and the suspension was treated as part of a considered adjustment to international events, forced in this case by the breakdown of the gold standard.? The 1949 devaluation was planned, on the other hand, but was similar to 1931 in being a response to conditions.? Both were ?beneficial? though feared beforehand (p. 203).
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The third part is historical with interesting implications for the present.? Chapter 11 notes that apparently significant technological and institutional innovations have not ?threatened to move us from a money-using society to one which transacts by some other means,? so that their ?implications for monetary policy have … been, in theory at least, trivial? (p. 235).? A strategic market game implies that as long as transactions costs exist there will be fiat money (p. 249).? To the question, ?Can the EMU Survive?? (Chapter 12), the history of monetary unions suggests: not without more fiscal and political union.? The history of central banks and inflation (Chapter 13) suggests that the distinction between dependent and independent central banks has been overdrawn.? The choice has always depended on the government?s preference.? The history of the IMF in Chapter 14 finds no redeeming qualities.? The institution?s purpose as originally envisioned ? a flexible international order ? was not realized, and its self-anointed role as crisis manager, consisting largely of indefensible bailouts, has not been surprising in ?unelected officials who are not accountable for their actions,? quoting Anna Schwartz (p. 323).? In ?Financial Crises from 1803 to 2009: The Crescendo of Moral Hazard? (Chapter 15), we see government regulation deteriorate from reinforcing market solutions by providing lender-of-last facilities to their opposite, i.e., impeding rather than helping market incentives.? Those who would understand the development of British monetary policies, and appreciate how we got where we are, can do no better than begin with this book.

John H. Wood, Reynolds Professor of Economics, Wake Forest University, is co-author (with Sandeep Mazumder) of ?The Great Recession of 1929-33: It (Almost) Had to Happen,? forthcoming in the Journal of Economic History.

Copyright (c) 2012 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (December 2012). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):Europe
Time Period(s):19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII

Monetary and Banking History: Essays in Honour of Forrest Capie

Author(s):Wood, Geoffrey
Mills, Terence C.
Crafts, Nicholas
Reviewer(s):Neal, Larry

Published by EH.Net (November 2012)

Geoffrey Wood, Terence C. Mills and Nicholas Crafts, editors, Monetary and Banking History: Essays in Honour of Forrest Capie. Abingdon, UK: Routledge, 2011. xxii + 316 pp.? $140 (cloth), ISBN: 978-0-415-45146-8.

Reviewed for EH.Net by Larry Neal, Department of Economics, University of Illinois.

As Forrest Capie was wrapping up his official history of the Bank of England covering the period 1950s to 1979, a book already a classic in the literature, he was honored at a conference held at the Bank of England organized by his friend, frequent co-author, and former colleague at the Cass Business School in the City University, Geoffrey Wood.? Geoffrey solicited papers from a wide range of fellow monetary and financial historians, even including the present reviewer, and most responded with excellent papers, each of which deserves reading on its own merits.? Alas for this reviewer and potential readers, however, the papers as a group do not cohere with each other in any obvious way.? Reflecting the variety of topics Forrest has dealt with over his career and the number of friends and admirers he has acquired, the papers cover a variety of subjects with a mix of methodologies, which range from time series analysis to narrative accounts of previous Bank of England histories.? Recognizing the problem, the editors have organized the contributions into categories pertinent to the corpus of Forrest?s scholarly work.

Part I, ?Writing History,? has Charles Goodhart disparaging previous histories of the Bank while setting a high bar for Forrest?s then unpublished history (update: Forrest met the bar and then some, see my jacket blurb) and Barry Eichengreen reviewing the literature of ?The New Monetary and Financial History,? that combines analysis of monetary disturbances with due attention to financial innovations and crises.? Goodhart provides a helpful guide to past histories of the Bank of England, while Eichengreen gives a masterly overview of the recent contributions to monetary and financial history covering the period from mid-nineteenth century on.

Part II, ?Crisis Management,? has Mae Baker and Michael Collins evaluating the information exchanges between Bank of England officials and private bank managers before and during the financial crisis of 1836; Eugene N. White arguing that the Banque de France did apply Bagehot?s rule effectively even in financial crises caused by miscalculations in the derivatives markets in Paris in the 1880s; and Charles Calomiris insisting that the Bank of England got the lender of last resort role right by 1856, while the U.S. financial system was repeatedly waylaid by misguided regulation.? Baker and Collins demonstrate how intense were personal communications between bankers and regulators dealing with the vicissitudes of impersonal and international money markets at the outset of global financial markets.? White elucidates how Bagehot?s rule depended on the role of collateral, but it took independent experts to assess the quality of collateral.? Calomiris highlights the problems of inadequate information and capital that plagued the fragmented American unit banking system as contrasted with both the British and Canadian systems of concentrated branch banking.

Part III, ?Money and Interest Rates,? presents three analyses of new financial and monetary time series to show: 1) that a true ?liquidity trap? did not exist even in the depths of Great Depression in the U.S. (Peter Basile, John Landon-Lane and Hugh Rockoff) as shown by the junk bond market of the time; 2) that the separate monetary regimes created in Britain over two-and-a-half centuries created different interactions between inflation and nominal interest rates so that Gibson?s famous paradox of a positive relationships between the price level and the nominal interest rate existed only during the gold standard periods (Terence C. Mills and Geoffrey Wood); and 3) that creating a consistent broad measure of the money supply, M4 retail, over the period of rapid monetary innovation of the 1970s and 1980s allows a stable money demand function to re-emerge despite the Bank of England?s decision to target exchange rates rather than money supply at the end of the 1980s (Alec Chrystal and Paul Mizen).??

Part IV, ?Implications of Economic Integration,? puts together two papers dealing with the flawed design of the euro, first from a comparative historical perspective that briefly surveys four successful monetary unions and two disasters leaving this reviewer convinced that the disaster examples of Argentina and Brazil are most relevant despite the authors? attempt to be optimistic (Michael Bordo, Lars Jonung, and Agnieszka Markiewcz); and then from an inside look at the turf battles between central bank governors and finance ministers that led to the eventual creation of the euro without, however, resolving the issue of bank regulation (Harold D. James).? These are followed by two papers that show how the progressive lowering of tariffs by the United Kingdom after World War II and then the reforms undertaken during the Thatcher era did improve Britain’s productivity significantly and permanently (?Openness, Protectionism and Britain?s Productivity Performance over the Long Run,? by Stephen Broadberry and Nicholas Crafts; and ?The Price-cost Markup in the UK: A Long-run Perspective,? by Nicholas Crafts and Terence C. Mills).? Neither contribution gives much credit to the removal of capital controls or the financial innovations that were key to the Thatcher reforms.

Overall, each reader can decide on the basis of his/her own interests which of these contributions is worth checking in the university library?s copy, but will probably not find it worthwhile to pay the $140 retail price for a personal copy.? They will, nevertheless, be well-advised to go directly to Forrest Capie, The Bank of England: 1950s to 1979, New York: Cambridge University Press, 2011, the completion of which was the occasion for the conference volume.

Larry Neal is professor emeritus of economics, University of Illinois at Urbana-Champaign, research associate of the National Bureau of Economic Research, and visiting professor at the London School of Economics.?? His books include The Rise of Financial Capitalism: International Capital Markets in the Age of Reason (1990) and ?I Am Not Master of Events?: The Speculations of John Law and Lord Londonderry in the Mississippi and South Sea Bubbles (2012).

Copyright (c) 2012 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (November 2012). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):General, International, or Comparative
Time Period(s):18th Century
19th Century
20th Century: Pre WWII
20th Century: WWII and post-WWII

A Europe Made of Money: The Emergence of the European Monetary System

Author(s):Mourlon-Druol, Emmanuel
Reviewer(s):Mushin, Jerry

Published by EH.Net (November 2012)

Emmanuel Mourlon-Druol, A Europe Made of Money: The Emergence of the European Monetary System.? Ithaca: NY: Cornell University Press, 2012. viii + 359 pp. $55 (hardcover), ISBN: 978-0-8014-5083-9.

Reviewed for EH.Net by Jerry Mushin, School of Economics and Finance, Victoria University of Wellington, New Zealand.

At a time when the problems in the euro zone are frequently in the news, it is wise to consider the nature and origins of its immediate predecessor. Emmanuel Mourlon-Druol, of the University of Glasgow and the London School of Economics, has written a thorough description and analysis of the political and economic developments that led to the establishment, in 1979, of the European Monetary System [EMS].

The author explains that, especially from the early 1970s, there were several processes, which were often conflicting. Two were of particular importance. There was a cooperative, transnational monetary elite of technocrats, which was especially interested in the macroeconomic and operational benefits of monetary integration. In addition, from 1974, regular meetings of heads of government at the European Council ensured that this issue remained current. The politicians were often more interested in the importance of monetary stability in the establishment of a European identity. Despite the difficulties, there was a hesitant transition from emphasis on European cooperation to emphasis on European integration.

Although it deals with economic issues, this book is principally a political and diplomatic history, and not an economic history, of the founding of the EMS. It is part of the publisher?s Political Science series. The author has shown that the eventual outcome was reached by a tortuous process that was influenced by recent history and by traditional rivalries. The intermittent progress and regress of negotiations depended on the interaction of a small number of strong and idealistic personalities. Economic arguments were tempered by political pressures and vice versa. Political pressures frequently dominated the economic arguments.

Mourlon-Druol places the negotiations of the 1970s in their proper context. He refers to economic and political events in individual countries, including election results and national policies against inflation. He also shows the significance of world developments, including the perceived increasing weakness of the United States dollar. However, it is curious that the Sterling Area does not merit much attention. In the 1960s, the role of the UK in the Sterling Area was frequently seen, especially by France, as an obstacle in the British application to join the European Economic Community. The author also refers to the theoretical basis of monetary integration, including optimum currency area theory, and to the development of transnational and supranational institutions in Europe.

The negotiations occurred during the existence of the Snake, a cooperative exchange rate arrangement that dated from 1972. There were serious problems in this system. Membership was unstable; the United Kingdom and the Irish Republic withdrew after less than one month, and only the German Federal Republic remained a member for the whole of its existence. Other countries withdrew and rejoined and some, including France, did this more than once. The structure and processes that were eventually agreed for the EMS were an attempt to learn from the experience of the Snake. This was a lengthy process in which the dominant issues included the nature of the parity grid, the role of gold and of the SDR, the width of margins, the increased freedom of capital movements, and the precise obligations of members. The intention was that benefits and obligations would be symmetrical between larger and smaller members. The outcome was the establishment of the EMS, from which, in 1999, the euro zone could evolve.

Although Mourlon-Druol is a fluent and engaging writer, the volume of detail is likely to be overwhelming to all but the most committed specialists. This indicates one of the strengths of this book. It is based on extensive use of primary sources (including the archives of central banks). For this reason, it should be purchased by university libraries. However, it also indicates a weakness. An excess of detail means that this book is unlikely to be accessible to a wide readership.

Although this book should be purchased, as a research resource, by university libraries, it is unlikely to be included on undergraduate reading lists.

Jerry Mushin?s most recent book is Interest Rates, Prices, and the Economy, Scientific Publishers [India], Jodhpur, 2009. jerry.mushin@vuw.ac.nz

Copyright (c) 2012 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (November 2012). All EH.Net reviews are archived at http://www.eh.net/BookReview.

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Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):Europe
Time Period(s):20th Century: WWII and post-WWII

Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System

Author(s):Eichengreen, Barry
Reviewer(s):Toniolo, Gianni

Published by EH.NET (August 2011)

Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. New York: Oxford University Press, 2011. iii + 215 pp. $28 (cloth), ISBN: 978-0-19-975378-9.

Reviewed for EH.Net by Gianni Toniolo, Departments of Economics and History, Duke University.

?We are seeing the government of a global sport (cricket) passing from west to east for the first time. The shift is unique and irreversible. The east can now take something western and make the west a supplicant. We had better get used to it? (M. Bose, Financial Times, 7/21/2011, p.11).? How long will it take before the main reserve currency will be added to the list of ?something western? passing east?? The main tenet of Barry Eichengreen?s book is that it will take a long time before the dollar follows the fate of cricket, not so much because of the dollar?s strength but because of the weakness of the alternatives.

The book, written for the general public, is useful and pleasant to read also by the so-called professionals. Those used to Eichengreen?s clear and fluent prose will find here a particularly light touch obtained by dropping here and there a good dose of anecdotal hints to lessen the weight of serious history and rigorous economics: this is particularly appreciated by those like me who write on monetary history and know how heavy a meal it is to digest — both by undergraduates and the educated public.

A brief introduction sketches the main argument of the book, namely that there is a ?fallacy behind the notion that the dollar is engaged in a death race with its rivals? (p. 9): rather than getting used to money moving, with cricket, from west to east we should prepare to a world ?in which several international currencies coexist,? as they did for most of the past two centuries.

Chapter 2 traces a brief history of the dollar, from its humble and foreign origin (it even got its name by assonance with the silver thaler coming from the south) to the turning point of the 1930s.? The main question here is why the dollar didn?t become the leading international currency by the end of the nineteenth century when American economy and trade were already larger than Britain?s, the producer of the most important among the international currencies of the day. The answer, for Eichengreen, is to be found in the underdevelopment of the U.S. money market vis ? vis Britain?s.? As long as acceptances were more efficiently traded in the liquid London market, the dollar could not aspire to the status of international currency. Had Jackson not vetoed the renewal of the Second Bank of the United States, things might have been different; as it was, the international rise of the dollar was checked by the absence of a central bank. Things changed after 1919 when the pound remained inconvertible and the United States became the main lender to Europe: by 1925, when London resumed convertibility, the dollar had already overtaken the sterling in the reserve portfolios of the world?s central banks. One might add that, had the Congress ratified the Versailles Peace Treaty, giving America a more decisive role in European affairs, by 1930 the dollar?s weight as international currency might have been more decisive.

Chapter 3 deals with the time when ?the dollar reigned supreme,? much to De Gaulle?s chagrin (hence the title of the book). Everything of course began at Bretton Woods where Keynes?s bancor never stood a chance. Brains or no brains, industrial might and military power had already decided in favor of the American currency. The history of the rise and fall of the Bretton Woods system has been told so many time, including by Eichengreen, that relatively few pages are devoted to the quarter-century following 1945. There were, of course, good reasons for the continued dominance of the dollar much beyond the demise of Bretton Woods: Eichengreen stresses both the strength of the American economy and the lack of alternatives.

Chapter 4 outlines the history of the euro, potentially the only credible rival to the dollar. An outstanding expert on European monetary history and economics, Eichengreen provides a lively account of the long gestation of the single currency from the road leading to the Warren Report of 1970, up to the present. The chapter will be my suggested reading to those in need a short briefing on the politics of European monetary union, an object still largely misunderstood not only by the American public and press but by academic experts as well. Eichengreen?s conclusion is that the euro would have made a formidable rival to the dollar had the UK opted in. This may be true from a technical point of view but, as Eichengreen knows only too well, for good or bad, Continental ways are not British ways. British participation has arguably weakened the progress towards a more politically integrated Europe (a prerequisite for the health of the euro in the long run) and one may wonder how British and German cultures would be integrated in running the ECB.

Chapter 5 provides a masterful user?s manual for the crisis that began in 2007. Interestingly, in fact, each chapter of this book can be read in its own right as a synopsis for relevant international monetary issues, regardless of their bearing on the book?s theme: the future of the dollar. The manuscript was given to the publisher when the Great Recession (the terminology might look awkward a few years hence) was on its way to being slowly overcome. The events of Summer 2011, unfolding while I write this review, might oblige at least a partial change the overall interpretation of the past eventful years. They might also impact on the prospects of the dollar-euro relation. It is, however, impossible to say to what extent this will be the case. Economic history stops at the end of the cycle previous to the one when it is written: economic historians need the perspective of the full cycle in order to explain both its origins and consequences.

Chapters 6 and 7 can be read together: they discuss the end of the dollar?s monopoly as reserve currency and ask whether the dollar will (relatively) soon crash or just slowly lose weight, sharing its reserve currency role with other means of international payment. History shows ? and this is one of the themes of the book ? that the ?normal? case is one where several reserve currencies coexist, with one of them in more or less dominant but not monopolistic position. Monopoly, in the post- Second World War years, was an exception due to both economic and geopolitical reasons. We are now back to ?normal? times but, for all the economic and political weakness of the United States, we shall not witness a precocious move away from the dollar. For one thing, the American economy is still the world?s largest and, at market exchange rates, it is destined to remain such for another while.? For the rest, alternatives don?t look very promising: the euro has problems of its own, the renminbi is not convertible, the Swiss franc is backed by too small an economy, the Indian and Brazilian currencies might in the future qualify for limited diversification but are no match to the dollar, gold is not used for current transactions, timber is illiquid, and so on. International trade is still largely invoiced in dollars and this is a powerful incentive for central banks to hold dollar reserves. All these conditions may, and probably will, change: the future will look like the early twentieth century when a number of reserve currencies coexisted with the leading one. What we saw after the publication of this book tends to reinforce its conclusions: the demand for T Bonds and other dollar-denominated assets increased in spite of Standard & Poor?s.

As I said, this is a book aimed to a large audience of non-specialists. Its chapters make superb assignments to undergraduate classes (most economics Ph.D. students would hugely benefit from reading it but I doubt that many of them ever will.). It contains a lot of details that will interest specialists as well. There is only one question the reader, specialist or otherwise, finds unanswered: what about geopolitical factors? Eichengreen brings them explicitly to the fore in discussing, with a wealth of details, the impact of the unfortunate Anglo-Franco expedition to Egypt in 1956. For the rest, there are here and there hints that politics matters for the international status of leading currencies and Eichengreen states that the leading world power also tends to own the leading currency but one remains a bit unsatisfied by the relative paucity of elaboration on this theme, particularly regarding future scenarios. Jeffrey Sachs recently stated the obvious when writing: ?For at least two decades the U.S. has been unable to provide monetary stability, financial regulation and fiscal rectitude? (Financial Times, May 31, 2011). Are we, in this respect, back to the interwar years? Eichengreen seems to agree that similarities exist. If so, will weak international leadership have no impact on the dollar?s status in any plausible scenario? The dollar might even get stronger in cases of looming international military or political crises, as it did in the late 1930s: by bringing geopolitical considerations more to the fore Eichengreen would have probably strengthened his own conclusions.

Gianni Toniolo is Research Professor of Economics and History, Duke University, Contract Professor of Political Science at the Libera Universit? delle Scienze Sociali (Roma) and Research Fellow at CEPR, London

Copyright (c) 2011 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (August 2011). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):General, International, or Comparative
North America
Time Period(s):20th Century: Pre WWII
20th Century: WWII and post-WWII

Inside the Fed: Monetary Policy and Its Management, Martin through Greenspan to Bernanke

Author(s):Axilrod, Stephen H.
Reviewer(s):Wood, John H.

Published by EH.NET (August 2011)

Stephen H. Axilrod, Inside the Fed: Monetary Policy and Its Management, Martin through Greenspan to Bernanke (revised edition). Cambridge, MA: MIT Press, 2011. viii + 225 pp.? $25 (cloth), ISBN: 978-0-262-01562-2.

Reviewed for EH.Net by John H. Wood, Department of Economics, Wake Forest University.

This book is truly from ?inside the Fed.?? The author served the Board of Governors from 1952 to 1986, nearly half the time as senior advisor for monetary policy to chairmen Arthur Burns (1970-78), G. William Miller (1978-79), and Paul Volcker (1979-87).? He also observed William McChesney Martin, Jr. (1951-70) in action as chairman of the Federal Open Market Committee, and has kept in touch with the making of monetary policy under Alan Greenspan (1987-2006) and Ben Bernanke (since 2006).? Axilrod?s accounts of policymaking as seen from inside the Fed are interesting and informative, as are the ?anecdotes,? as he calls them, which reveal the personalities and methods of Fed chairmen, including their working relationships with advisors, fellow governors, and other central bankers.
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Axilrod doesn?t deny that theory influences policy, but he suggests that the personal characteristics of chairmen and their sensitivities to the public and political circumstances are also important.? Burns, for example, was unable to deal effectively with the Great Inflation of the 1970s for several reasons.? Although he had been a student of the consistencies embodied in business cycles, he seemed to see ?each cyclical episode as embodying a unique set of events,? of which money was only one.? Rising inflation during 1974-77, when the real fed funds rate turned negative, caused the market to perceive ?that the Fed was doing too little to contain money growth to a pace that would significantly restrain inflation, and the institution?s anti-inflation credibility substantially eroded.?
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Although Burns possessed substantial persuasive powers in small groups, aided by an explosive temper, his effectiveness as inflation-fighter was hampered by his inability even ?to attempt to exercise powers of persuasion and logic dramatically and compellingly enough in public speeches and congressional testimony so as to evoke the public support that might have made it easier for the Fed itself to pursue a stronger anti-inflationary policy.?? Such a ?task may seem too Herculean,? but it should be remembered that Volcker?s shift was only a year or two in the future, and Burns had a president in Gerald Ford who probably would have supported a genuine attack on inflation (which the Whip Inflation Now ? WIN ? campaign against greed was not).? Burns was further limited by his lack of a potentially persuasive policy, of something more than a maneuver ?inside the box.?
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Paul Volcker, on the other hand, ?combined great sensitivity to shifting trends in political economy (he could see what the country would now accept) with a willingness to take dramatic action,? and see it through.? When a New York Fed official said ?the Fed was in the process of ?experimenting? with a new approach to policy [as it shifted from interest-rate to money targeting], Volcker … went ballistic …. The idea of an ?experiment? was anathema to him because it suggested a lack of conviction at the Fed and would most certainly not help us regain market credibility.?? Some of this might be hindsight on Axilrod?s part, but he had no difficulty finding concerns for credibility among successful Fed chairman such as Martin, Volcker, and the early Greenspan before it became a part of economic models.
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He does not give high grades to Bernanke or the later Greenspan in this respect.? He shares what might be the consensus belief that the Fed contributed to the recent crisis.? Its opposition to inflation seemed half-hearted after 1998, and belief in the Greenspan-put — that the Fed would underwrite the large risks being taken — contributed to its loss of credibility, Axilrod believes.
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Bernanke inherited a difficult situation and didn?t improve on it.? The Fed seemed unaware of speculative and inflationary pressures, and the real fed funds rate became negative before the Fed belatedly shifted to tight money.? Its reactions to the crisis were unusual, and how it will deal with its gargantuan balance sheet is unknown.? There may ?be no very significant technical difficulties in either reining in the monetary base or at least minimizing the extent to which some larger than normal monetary base can be transformed into excess public liquidity.? But the Fed?s ability to undertake effective monetary policies in so complicated and uncertain a transition requires more than technical capacity.? It also requires from its chairmen … a public stature that enables him to perform effectively on the national stage, [which] does not yet seem to be firmly within Bernanke?s grasp.????
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?My experiences at the Fed suggest that a great leader for monetary policy is differentiated not especially by economic sophistication, but by his or her ability to perceive when social and political limits can and should be placed to make space for a significant, paradigmatic change in the approach to policy should it be required, as well as by the courage and bureaucratic moxie to pull it off.?? ?Native good judgment and plain old common sense,? as well as ?an intuitive feel for markets,? are also important.
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He gives no formal ranking of the chairmen, but there is no doubt that Volcker would be at the top of his list, probably with Martin second, although the latter had no ?powerful, dramatic crises to deal with.?
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Unsurprising in a ?lifer,? Axilrod?s stories of people and policies at the Fed reveal institutional beliefs that might improve our understanding of American monetary policy.? One belief that has often found expression among the governors and the staff is that the Fed is fighting inflation, which is hard to swallow when we know that inflation is fully explained by the Fed?s injections of reserves.? Statements to this effect possess the characteristics of a state of denial in an organization that has caused the greatest inflation in U.S. history, and make sense only if it means that the fight is against other, primarily political, interests for the independence to conduct a stable price policy.? There is even less reason, in light of his delivery of inflation leading up to the 1972 election, to call Burns ?unfortunate in the particular decade, the 1970s, where fate placed him as chairman … in years of quite strong inflationary winds.?? The relatively stable conditions in Martin?s term might not have been all luck. ???
One reason why the governors and senior staff have resisted academic influence is the Fed?s immersion in the money markets that are barely evident in economic theories.? The groups have different models for different interests.? There has been a circle-the-wagons reaction to the nearly universal academic disapproval of monetary policy during most of the postwar period.? Axilrod?s recollections in this area are ambivalent.? In the early 1960s, he believed that monetarist Karl Brunner?s description of the Fed?s control of the money stock ?was telling us nothing that we didn?t already know.?? However, Axilrod?s account of the Fed?s growing interest in money seemed to reflect a similar development among economists.?

Whatever the intellectual causes and effects between academia and the Fed — I believe each underrates the other — Axilrod?s bilingual discussion of the development of monetary policy over time, particularly the logical and empirical connections between money and credit, is a genuine contribution to our understanding of monetary policy and the institution that makes it.?

This book by a uniquely placed participant is an interesting and informative read on its own, but those who would like to learn more about Axilrod and his times are advised to read some of the many writings that offer different perspectives of the same events, for example, Allan Meltzer, who confirms Axilrod?s warnings about lagged reserve accounting when it was adopted (A History of the Federal Reserve); the Bank of England?s Charles Goodhart, who gives Axilrod an almost equal share with Volcker for the 1979 policy shift and calls him the second most important person at the Fed, (?Review,? Economica, Jan. 2011); and William Greider, who wrote that Chairman Miller?s lack of expertise made Axilrod ?an extraordinarily powerful bureaucrat.? Axilrod contradicts this by saying that the staff tended to have ?more influence when the chairman was strong than when he was not. … I always had the feeling that in Miller?s time … my views? were received ?with a bit less intensity.?? An author and defender of the modified monetarist model that replaced interest targeting in 1979, Axilrod finds no sense in the statements ?by a policymaker or two [that] the new policy was simply a cover so that the Fed could raise interest rates while ducking direct responsibility.?? It should be noted that one of the offending parties was Volcker (Volcker and Tyoo Gyohten, Changing Fortunes).

John H. Wood, Reynolds Professor of Economics, Wake Forest University, jw@wfu.edu, is the author of A History of Central Banking in Great Britain and the United States (Cambridge University Press, 2005) and A History of Macroeconomic Policy in the United States (Routledge, 2009). A current research project connects the economics and politics of William McChesney Martin, Jr. at the Fed and as president of the New York Stock Exchange. His Federal Reserve experience has been as a fellowship student at the Federal Reserve Bank of Chicago for two summers, an economist at the Board for three years and the Federal Reserve Bank of Dallas for two years, and further visits at the Federal Reserve Banks of Dallas, Chicago and Philadelphia.? He remembers looking down enviously from his window in the Flow-of-Funds section at the noon tennis match of which Axilrod writes, although he eventually got a chance with the afternoon group formed by Dewey Daane when he joined the Board.

Copyright (c) 2011 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (August 2011). All EH.Net reviews are archived at http://www.eh.net/BookReview.

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

The Plans That Failed: An Economic History of the GDR

Author(s):Steiner, André
Reviewer(s):Polyakova, Maria

Published by EH.NET (April 2011)

Andr? Steiner, The Plans That Failed: An Economic History of the GDR. (Translated from German by Ewald Osers.) New York: Berghahn Books, 2010. xiii + 228 pp. $60 (hardback), ISBN: 978-1-84545-748-8.

Reviewed for EH.Net by Maria Polyakova, Department of Economics, M.I.T.

In 1945, the Third Reich unconditionally surrendered to the Allied forces of Great Britain, France, the United States and the Soviet Union. The Allies occupied Germany in the same year, splitting the country and its capital into four Zones of Occupation. The northeastern part of modern Germany became the Soviet Occupation Zone governed by the Soviet Military Administration. In 1949, four years after the end of the War, the Socialist Unity Party of Germany (SED) proclaimed the foundation of the German Democratic Republic (GDR), also known as East Germany, in place of the Soviet Zone. The political history of East Germany has had a number of academic and broad audience publications devoted to it. Detailed analysis of its economic history, on the other hand, has been surprisingly scarce in comparison.

Andr? Steiner, Research Director for the Department of Economic and Social History at the Center for Contemporary History Potsdam (ZZF) and professor of economic and social history at the University of Potsdam, attempts to reduce this gap. The study is meant primarily to provide an analytical summary of the existing research on the topic (both by Steiner himself and other scholars) and accomplishes its goal well.? In about 200 pages of condensed prose, Steiner presents a detailed, yet concise, overview of the key economic decisions and policies — and their consequences — that characterized the socialist German state from 1945 to 1990. In his account, Steiner relies on a number of primary and secondary sources that include published collections of documents, archival materials, and scholarly writings. Among these sources are diverse protocols from the political discussions of the time, contemporary legal and regulatory publications, as well as analytical books and articles written in the midst of the historical developments.

Steiner?s main questions are ?why things happened the way they happened and, above all, what alternatives were available and why they were not chosen? (p. 1) as well as ?how was it possible … that the system survived for forty years? (p. 7). Steiner rightfully claims that, just by observing the end result of the economic development in the GDR, we cannot be confident that the system of the centrally planned economy, in and of itself, was the key reason for the failure of East Germany.? To get closer to the heart of the matters, Steiner lays out the details of the economic development of the GDR in six chapters. In each chapter, he considers both the political economy of the policies and the daily experience of the GDR?s population during different ?political caesuras? (p. 8) of the GDR?s economic history. The hard work of organizing and explaining the often chaotic and controversial economic events (as well as their academic accounts) in East Germany, allows Steiner to conclude that, indeed, ?the crucial negative element was the planned-economy system? (p. 1). This conclusion will hardly surprise the readers familiar with East German history. The merit of the book, however, lies in its well-structured account of the events and the relevant primary sources. These serve to convince readers of the non-dogmatic objectivity of the book?s conclusion.??

Steiner devotes the first two chapters of the book to the discussion of the immediate post-war situation in the Soviet Zone and the first five years of the GDR?s existence. Steiner shows that the area of the Soviet Occupation was highly industrialized and produced a sizeable agricultural surplus. Its industry, however, critically depended on the supplies of raw materials from the Western territories — a fact that would later cause much trouble for the GDR?s government.? Steiner provides evidence that the Zone?s wartime destruction was lower than in its Western neighbor and should not have been inhibitive for the economic reconstruction.? The controversial attempts to nationalize agriculture, restore the production of consumer goods, and, at the same time, develop heavy industry, as instructed by the Soviet Union, were, however, inhibitive.

The Soviet dismantling of plants and the reorganization of the industrial structures had a severe effect on the capacities of the GDR?s industry. The book further accounts for the complications that the GDR?s new political leadership faced in trying to restart production and stabilize employment, monetary exchange, and the supply of consumer goods and food.? Harvest failures and the collectivization reforms of agriculture resulted in severe food shortages.? Dismantling, reparations and incentive mismatch in the manufacturing resulted in the escape of more than 4,000 producers to the West, while the remaining ones struggled to provide desirable quantity and quality. The difficult situation led to the strike of June 17, 1953 that was forcefully resolved with Soviet tanks.

In the third chapter, Steiner discusses the economic situation during the second decade after the end of the War. He characterizes this period as a time that experienced rapid growth from the post-war production level. At the same time, there were consumption shortages, severe underinvestment into the production of consumer goods and big waves of emigration to the West. It was also a period of further deep structural changes in all sectors of the economy. Steiner emphasizes the dependency of the young German state upon the Soviet command and its struggle of keeping up with its Western neighbor, which by this time clearly offered a much more attractive environment for the consumers and firms of the East. The chapter culminates with the request of the East German government to the Soviet Union to allow for the construction of the Berlin Wall to shut off emigration from the country.

Although the official justification for the construction of the Wall was political, Steiner argues that the real reason (and the one that East German policy-makers stressed in their internal discussions) was economic. In the next two chapters, Steiner discusses how the forceful hold of the population and firms within the country allowed the GDR?s government to pursue the economic reforms it desired. The SED still advertised that the goal of the GDR was to ?overtake? the living standards of the Western neighbor, but now it didn?t have to worry about the extensive emigration that was the consequence of the obvious failures in the past. Over the course of these two decades, the GDR?s government implemented an array of reforms that tied it closer to the Eastern bloc and were supposed to convince its citizens of the merits of the socialist system. Steiner argues that the reforms of the ?New Economic System?? and the ?Overtake without Catching Up? programs were often undermined by structural inconsistencies that followed the attempt ?to simulate market mechanisms without, however, introducing the foundations of a market economy? (p. 111).? The standard of living and the industrial output showed improvement in the sixties and seventies.? Consumer demand continued to be dictated by the government, however, rather than by the consumers themselves. That is, there was no way for the economy to signal its needs to the planners.
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Lastly, Steiner discusses another big problem, namely the indebtedness of the different parts of the system and its reliance on support from the Soviet Union. The country was severely indebted to both the East and the West. Within the country, companies relied heavily on subsidies from the state. East German exports were not competitive and the economy was not self-sustainable, relying to a considerable extent on the imports. The political events of the following decades led to a termination of the credit line from the West. At this point, as Steiner skillfully puts it ?reality caught up with the GDR: it was in an indebtedness trap? (p. 142). The last decade before the fall of the Berlin Wall saw the country struggling with debt, rising prices for raw material imports, the growing demands of the population, shortages, declining investments and productivity and, finally, renewed emigration to the West. The economic crisis and the dramatic changes in the political circumstances in the Eastern bloc eventually led to the fall of the Wall and the GDR in 1989.

As Steiner sums up, ?the socialist economic system?s immanent incapacity to produce structural and technological or innovatory change was the decisive cause of the GDR?s economic weakness in its final decade? (p. 193)

The 2004 German edition of the book with the original title Von Plan zu Plan: Eine Wirtschaftsgeschichte der DDR became a popular read in Germany. This is, of course, not surprising, given the low number of good systematic accounts of economic life in East Germany and the slowly fading heritage of the GDR?s economy and society in modern Germany. The audience for the English translation of the book might be harder to define. While it is unlikely to arouse a lot of interest among the non-German casual readers, it is at the same time too general for specialized researchers of East Germany?s economic history, who would probably prefer to use the German edition anyway. On the other hand, it would provide an excellent introduction for students and researchers who are just starting their work in the area of East Germany?s history, or for the researchers of state-owned enterprises and planned economies, who are interested in an overview of the historical precedent. Furthermore, Steiner?s bibliography presents an impressive scholarly reference to a large subset of primary and secondary sources that are available on the topic.

Maria Polyakova is a graduate student at the Department of Economics of the Massachusetts Institute of Technology.? One of her current research projects concerns the organization of the German industry in the first decade after World War II.

Copyright (c) 2011 by EH.Net. All rights reserved. This work may be copied for non-profit educational uses if proper credit is given to the author and the list. For other permission, please contact the EH.Net Administrator (administrator@eh.net). Published by EH.Net (April 2011). All EH.Net reviews are archived at http://www.eh.net/BookReview.

Subject(s):Economic Planning and Policy
Economywide Country Studies and Comparative History
Geographic Area(s):Europe
Time Period(s):20th Century: WWII and post-WWII