There's a Philosophical Rot In the Modern Economy

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In 1853, George Bissell traveled to Western Pennsylvania and caught a glimpse of the nascent oil industry and the technological standards through which it operated at the time. He observed as workers used blankets to skim "surface oil", wringing them into barrels for collection. While it served its purpose, there were stories of larger quantities of "rock oil" underground, scattered throughout the countryside. There were limited uses at the time, but oil had potential for anyone bold enough to see it.

Along with his law partner, Jonathan Eveleth, Bissell formed the Pennsylvania Rock Oil Company in 1854. Initially they focused on land around Titusville, using trenches and other mining techniques to skim small quantities in labor-intensive work. For the most part, the company was simply focused on finding and exploiting oil springs, the natural process where the substance would bubble to the surface on its own. After seeing derricks being used in salt mining, however, Bissell saw parallels in getting after that rock oil.

After Bissell and Eveleth split with other partners in 1858, their newly formed Seneca Oil Company hired Edwin Drake to investigate the feasibility of large-scale extraction around an oil spring near Titusville. After spending large amounts of money and being subjected to much local ridicule, Drake was let go by Seneca Oil, though he kept at it. By August 27, 1859, his drill rig, run by steam engine added to the innovation of using a pipe in the borehole, had run down about 70 feet when crude finally began to bubble to the surface. It was collected in a bathtub and a brand new industry was born.

As oil production expanded through Drake's innovation and other advancements in chemistry that contributed to the distillation process, oil uses grew exponentially. The scaling of crude production meant a lower selling point was possible, making it adaptable to a wide market. That was the beauty of disruptive technology in birthing new industries and advancing the cause of society simultaneously. Enormous economic activity and advancement would be built upon these foundational achievements, layer upon layer once the direction was established and the critical mass of business and finance was achieved.

Taking advantage of that nexus after the Civil War was John D. Rockefeller. Before the war, Rockefeller had been in the grain business where he had come into contact with Henry Flagler. In the mid-1860's, Rockefeller left the grain business to start an oil refinery in Cleveland. He petitioned Flagler for an equity investment of $100,000. Flagler borrowed it from his father-in-law, and in conjunction with chemist Samuel Andrews, the Rockefeller, Andrews & Flagler partnership was formed.

It was Henry Flagler who suggested incorporation to his partners, and in 1870 the Standard Oil Company was chartered in Ohio. Innovations in the refining and extraction of crude developed by, and added to, the Standard Oil business allowed the company to grow and eventually acquire other stand-alone refineries and oil businesses throughout Ohio and Pennsylvania, eventually extending nationally. The result of this national corporation was a tangled mess of regulations and state rules that did not easily lend themselves to the dawning era of big business.

At that time, Ohio corporate regulations forbade Ohio corporations from owning stock in another company and owning property in another state. This was not an impediment unique to Ohio; indeed it was standard in all the states of the Union. As Standard Oil sought expansion outside Ohio, it was Flagler that solved the regulatory riddle. He would, as corporate secretary, name himself as the sole trustee for the benefit of Standard Oil shareholders to hold stock in subsidiaries outside Ohio. The trust-type of organization had been legally sanctioned and used for hundreds of years, simply as a means to convey or share legal rights or to establish mutual benefits.

As expansion drew in more properties and acquired businesses, this trust form was refined until there were only three trustees for all Standard Oil properties outside Ohio. By 1882, company attorney Samuel C.T. Dodd had created a new organizational trust where separate corporations were established in each state with the properties belonging to Standard Oil. The trust would appoint a separate board of directors for each corporation, with the shares of each in the hands of trustees. The trustees then issued "certificates of interest" to the Standard Oil stockholders, allowing them to receive dividends while maintaining organizational control.

This new "trust" business proved to be alluring to other industries and quickly spread, along with growing public ire and alarm. Most of this new drive toward national conglomeration drew attention to the consolidation and fragmentation in the railroads. Often due to geography, single railroad lines served as de facto monopolies. This was particularly true around Pittsburgh in the 1860's and 1870's. Only the Pennsylvania Railroad was accessible to the Pittsburgh refineries, meaning they were subject to the full abuse of monopoly pricing terms. Despite their close proximity to the oil fields, the Pittsburgh refineries were actually at a disadvantage because of the railroad monopoly.

Standard Oil, on the other hand, had more transportation alternatives in Cleveland, including the use of the Erie Canal through Buffalo during the summer months. Because of this and its growing volumes, it exerted great influence on the railroads. Standard Oil negotiated and extracted rebates from railroads, a common business practice that Rockefeller had used in his own oil and grain business experience, and even, at times, forced the railroads to pay Standard Oil a rebate for shipping other refiners' products.

These pricing practices and other business anomalies began to seep into not only popular consciousness, but regulatory awareness. In April 1889, for example, the Trans-Missouri Freight Association was formed as an organization to, "establish rates, rules, and regulations on the traffic subject to this association, and to consider changes therein, and makes rules for meeting the competition of outside lines." Ostensibly, it was a means of controlling natural competition inside its agreed geography.

By January 1892, the Atchison, Topeka & Santa Fe Railroad Company and some 17 other railroad companies of the Association were charged by the US Attorney for the District of Kansas:

"...the defendants not being content with the usual rates and prices for which they and others were accustomed to move, carry, and transport property, freight, and commodities in the trade and commerce aforesaid, and in their said business and occupation, but contriving and intending unjustly and oppressively to increase and augment the said rates and prices, and to counteract the effect of free competition on the facilities and prices of transportation, and to establish and maintain arbitrary rates, and to prevent any one of said defendants from reducing such arbitrary rates, and thereby exact and procure great sums of money from the people of the said states and territories aforesaid, and from the people engaged in the interstate commerce, trade, and traffic within the region of country aforesaid, and from all persons having goods, wares and merchandise to be transported by said railroads, and intending to monopolize the trade, traffic, and commerce among and between the states and territories aforesaid, did combine, conspire, confederate, and unlawfully agree together, and did then and there enter into a written contract, combination, agreement, and compact, known as a memorandum of agreement of the Trans-Missouri Freight Association, which was signed by each of said above-named defendants."

It would become a test case under the new Sherman Anti-Trust Act. Senator John Sherman of Ohio was its chief sponsor, despite previous business history with Rockefeller in Cleveland. It passed the Senate with only one "nay", and passed the House without opposition. President Harrison would sign the bill in April 1890, a year after the Trans-Missouri formation.

The court case wound its way through the justice system, with the railroad companies arguing that their association was legal under various state statutes and that the Sherman Act did not apply to railroads. In March 1897, the Supreme Court held that the Sherman Act's prohibitions would be widely interpreted and inclusive, meaning that railroad combinations and associations fell under its scope.

While this legal wrangling took place not only in Washington, but all over the nation as it wrestled with the transformations of the "Gilded Age", the pace of business continued to find its own innovations toward larger scales. In addition to Rockefeller and Flagler, JP Morgan was using the trust organization in the railroad space to consolidate his control and territories.

By 1896, Morgan had gained control through stock ownership and trusts over the Northern Pacific Railroad. A parallel line, the Great Northern Railroad, was under the control, but not ownership, of Morgan associate James Hill. Later in 1896, Hill's Great Northern proposed to purchase more than half the capital stock in Northern Pacific while guaranteeing the bonds, but the state of Minnesota objected.

The two railroads were successful in 1901 with a joint bid for the Chicago, Burlington and Quincy Railroad with 8,000 miles of track from Colorado to Missouri. Spending about $216 million on the purchase, floated through joint bonds, the idea was to reduce transportation costs for lumber and heavy resources coming from the West since rail cars could be loaded with goods from the Missouri Valley heading back - saving shippers from having empty rail cars on the return trip. Because of the proposed business combination, these kinds of efficiencies and cost savings would be durable.

Seeing a threat through this combination, the Union Pacific Railroad tried to "raid" Northern Pacific, ending up with a large proportion of preferred shares, which were subject to early retirement. JP Morgan spent a huge sum retiring the preferred stock in defense of his interest, now wary to the danger from Union Pacific. Since there were "hostile" competitors seeking to restrict growth activities and business opportunities, from the Morgan/Hill perspective, it became "necessary" to find some combination for the two rail lines (Great Northern & Northern Pacific).

In November 1901, the Northern Securities Corporation was established in New Jersey, owing in no small part to New Jersey's embrace of the corporate structure and new laws allowing corporations to own stock in other corporations - the holding company model. Within a few months, Northern Securities had acquired 76% of Great Northern shares (with JP Morgan owning substantially the rest) and 96% of Northern Pacific.

In response, a conference of Governors and Attorneys-General from the states in the Northern Securities territories was held in Helena, Montana, in December 1901. It was decided that Minnesota would again object, this time bringing suit against Northern Securities. In anticipation of an adverse judgment that state courts in Minnesota had no standing jurisdiction, a suit was also filed in Federal Court.

Four judges from the Eighth Circuit heard the case on an expedited basis, owing to the urgency given anti-trust cases at the time, in February 1903. They rendered a unanimous verdict in April 1903, stating that the acquisition of the two railroads by Northern Securities Corporation was tantamount to a "combination or conspiracy in restraint of trade among the states."

Northern Securities had argued that it was not a conspiracy, but a simple purchase and sale contract. Further, they asserted that the motive for the combination was not to suppress competition, but to protect the assets and business from the hostile intentions of competitors.

However, most of the argument in favor of Northern Securities rested on the evidence against restraint of trade. The company argued, quite successfully, that its combination had the opposite effect, where trade was expanding in lumber and other goods from the West. It offered evidence that flour traveling from the Mississippi Valley to China could do so at 80 cents per barrel, a distance of 8,000 miles, while the same flour cost 55 cents per barrel to ship to New York City, only 1,500 miles. In other words, the combination of railroads through Northern Securities had been a great benefit to trade.

Because of the expedition of anti-trust cases, all appeals were sent directly to the Supreme Court. In December 1903, the Court heard the case, rendering a 5-4 verdict affirming the lower court decision in March 1904. The reasoning for that affirmation made the Northern Securities case a landmark ruling in the age of "trust busting", setting the legal foundation for action against the monopolistic impulse of business.

In essence, Northern Securities, by demonstrating great benefits to trade across its business territory, was arguing that the acquisition of monopoly power was not in itself illegal as it was not necessarily equivalent to the restraint of trade, as charged in the Sherman Act. A monopolistic combination could, as Northern Securities showed at some length, actually do the opposite. And for the most part the government agreed, as did the courts.

What set this apart was the legal prohibition against the acquisition of the potential to restrain trade. There was no distinction between businesses that actually restrain trade and businesses that possess the ability to restrain trade; the mere act of combination or engineering legal authority was enough of a violation. In other words, the acquisition of power was legally the same as its use, and should thus be denied. Justice John Marshall Harlan wrote in the majority opinion, "the mere existence of such a combination constitutes a menace."

The Court essentially affirmed in business and trade what was supposed to be standing sense in government - that there should never be any kind of accumulation of power without some balance. In this case, the government itself was deemed insufficient to balance the power of business monopoly and thus had to appeal to none other than splitting up Northern Securities due solely to its "mere existence". Monopoly power was to be abhorred simply because of the dangerous potential, regardless of even established intent.

For Northern Securities, it was not enough to show that it held no such risible and illegal intentions. No matter how much it benefited trade today, the potential for future abuse was too much to bear and unfit to be permitted under any circumstances. While it would be the case brought against Standard Oil that remains a symbol of the period, the framework of understanding was laid throughout the earlier decades, particularly as it culminated in the legal theory of the Northern Securities case.

Even though that concept was both applied and set aside, notably in the case of "natural monopolies" like AT&T, it remains embedded in not only legal precedence but political philosophy - at least as it applies to corporate structures and business in general. It seems lost as a universal principle in the expanding scope of government activities.

Not only has government acquired monopoly power in so many undertakings, including the above-mentioned sanctioning of business monopolies where it sees a "natural" place, it holds monopoly power over money in the aftermath of the Emergency Banking Relief Act of 1933 (which provided the statutory authority for Executive Order 6102). From the perspective of business and trade, given all that has happened in the 21st century, could not a case be made that such monopoly authority has restrained trade? Yet there remains no direct redress to such abuse of power, particularly since both political parties have now fully embraced the statist impulses of monetarism, central banking and soft central planning.

And where this fundamental mistrust of power in the hands of business is rightfully affirmed, it is discarded the moment it gains favor in government. I have no legal opinion about Edward Snowden and his activities, for example, but I believe we would be wise to consider the NSA's activities against the "settled wisdom" of Northern Securities - just because the NSA's actions have been a net benefit so far does not mean such power should rest unchecked. Indeed, the mere presence of such ability is, like Northern Securities, abhorrent to our decentralized and restrained system.

This extends into legally sanctioned ideas such as "too big to fail" and the cartel of Wall Street banks (and their global, London-based mega-bank cousins). Where the government deems beneficial interests, such activities and accumulation of power is not only allowed, it is officially and explicitly condoned. In that important sense, there is no daylight between the banks and policy, they are one conjoined monopoly. JP Morgan could only dream of the amount of power accumulated on Wall Street today, particularly in the bank that bears his name (see tri-party repo, Lehman margin calls, MF Global, etc.).

What the Supreme Court decided in 1904 was that there was no water's edge to the acquisition of such power in business; it was always and everywhere an illegal act regardless of intent. The question we have now, in terms of money and the Federal Reserve or the government's ability to track and use private data streams, is why such wisdom apparently only applies to business and corporations. The flawed nature of humans is dangerous gaining power through business or power through government. I would argue strenuously that the latter is a far worse case; elected officials can be just as tyrannical as absolute monarchs (does the Education Department really need a SWAT team, and would they have one if government debt weren't so cheaply and easily attained?). The key against autocracy lies in applying the 1904 judgment and insights on monopolies liberally and broadly.

In a capitalist system, there will always be a tendency toward cartel and monopoly. Competition produces winners; those who can produce at lower price points then their competition can stay alive. Standard Oil won and earned its place because it was a net benefit to society, making oil ubiquitous along the way. Despite that, the government was right to rebuke the company and remove its monopoly. There is no deference to stability in that sentiment, only the appeal of true public interest against potential abuse.

The current government monopoly on money through the quasi-private business of the Federal Reserve is the opposite, since monetary policy seeks to foster the appearance of "stability", using abuse (interventions) as its tools also in the name of public interest. Markets tried to put Wall Street out of business, or at least scale back their operations to the point of more reasonable influence and risk, but were fully rebuffed by the money monopoly (armed with Monopoly money).

This goes way beyond simple conflicts of interest, it gets at a philosophical rot in the modern system; namely that stability is the entrenchment of powerful interests, to be guarded above all else. If stability is the primary goal, there is and never will be an effective limit to the accumulation of power. Thus the worst parts of history get repeated because we refuse to learn.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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