Distinguishing Free-Market and Crony Capitalism

The distinction between free market capitalism and crony capitalism is crucial to the public understanding of the economy. Free market capitalism consists of voluntary exchanges from which participants expect to benefit. These generally lead to improving living standards for all. Crony capitalism consists of involuntary “exchanges” that use government to take from some (against their wills and often without their knowledge) and transfer it to politically connected others. These generally benefit the latter at the expense of the former.

To the extent the public understands “capitalism” to be free-market capitalism, they’ll generally support it, as they should. To the extent the public understands “capitalism” to be crony capitalism, they’ll generally oppose it, as they should. The trouble arises when they lump both together in their minds as “capitalism,” and oppose the good along with the bad, because they don’t see the difference.

Respected writers should keep this distinction clear. Indeed, they should carefully point it out.

Hence it’s sad to see James Surowiecki, in his column, “Do the Hustle,” in the January 13, 2014 edition of The New Yorker (HT: Don Boudreaux), muddy the distinction with respect to a notorious piece of American economic history. “In the nineteenth century especially,” he says, “the line between crook and businessman was fuzzy.” Yes, Mr. Surowiecki. Now explain that that was because crony capitalism gave businessmen access to what Frederic Bastiat called “legal plunder”—money taken from taxpayers.

He doesn’t. He writes,

Take the building of the American railroads, which both spurred industrialization and laid the foundation for a truly national economy. When the Central Pacific Railroad (the western spur of the transcontinental railroad) was built, the four men who started it, including Leland Stanford, set up an outside construction company in which they were the sole shareholders, and used that company to milk the Central Pacific for tens of millions of dollars in excess construction costs.

“Now wait a second,” the thoughtful reader will think, “how could The Big Four, as they were known, possibly profit by having their construction company milk their railroad?” There must be something missing here. Who were the investors in the railroad whose millions were the milk? Was it the Big Four themselves? No, they wouldn’t milk themselves and couldn’t do so profitably. So was it outside investors? If so, why didn’t those investors pay attention to what was happening to their millions? How could this happen in free-market capitalism?

It couldn’t.

The Central Pacific Railroad was not a free-market capitalist enterprise, as Surowiecki should emphasize. The “investors” in the Central Pacific were those creatures in Congress, and they were investing other people’s money. According to the enabling legislation (legislation, not contract; there’s a huge difference), Congress loaned the Central Pacific “$16,000 for each mile of track of flat prairie land, $32,000 per mile for hilly terrain, and $48,000 per mile in the mountains.”*

Where did Congress get the money it loaned the railroad, money that private investors would not loan? From the taxpayers, ultimately, of course. And how strong an incentive did each member of Congress have to make sure the money was carefully spent? How much would each lose if the Central Pacific went bankrupt, as it almost did, and evidently would have, had not Leland Stanford (yes, that Stanford), achieved a legal monopoly for the Central Pacific on the entire state of California, a monopoly that allowed him to raise its rates above the levels that would have obtained in a free market.**

Surowiecki continues, about the other player in the first trans-continental railroad,

The building of the Union Pacific Railroad led to the same kind of self-dealing and pocket-lining and reckless overbuilding, while railroad financiers like Jay Gould made enormous sums via stock schemes and dubious takeovers. The result was one of the biggest cons the country has ever seen, with huge losses for investors and huge fortunes for the moguls.

He does not tell us that the Union Pacific, too, was a crony capitalist enterprise, with all its fraud and waste (the UP did go bankrupt in 1893) made possible by the same kind of reckless government subsidies. Nor does he stress that the main “investors” were taxpayers who never chose to make an investment.

Surowiecki also confuses things by suggesting that the crony capitalist Central Pacific and Union Pacific were necessary to “spur… industrialization and [lay] the foundation for a truly national economy.” In good time, as soon as there was enough freight and passenger traffic to support the building of transcontinental railroads, private investors and entrepreneurs—free-market capitalists—would built them. J.J. Hill soon built one called the Great Northern. He did so profitably, with no subsidies. If Surowiecki were to tell that story, too, “the line between crook and businessman” would not appear so fuzzy.


* American History: From Revolution to Reconstruction and beyond, “The Central Pacific and the Union Pacific Railroads

** American History: From Revolution to Reconstruction and beyond, “After the Celebration

 See also Burton Folsom’s The Myth of the Robber Barons.

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