by John Hood

Templeton Foundation Press – 2001 – 308 pages – $24.95

Reviewed by David L. Littmann

What better way to strengthen the roots of capitalism than to give its participants a stake in the system! But how? This is the question John Hood addresses in Investor Politics. In a world filled with envy, largely reflecting hatred of capitalism’s wealth-building capabilities, it is refreshing to read the author’s optimism about what’s leading us away from the socialist trends of the past century and a half.

One might think of Hood’s thesis as trendy. After all, the past two decades have vindicated significant portions of his main theme: that most households are favorably disposed toward politicians whose proposals strengthen individual ownership and freedom to manage their own assets.

Starting with a wonderfully prescient quote from Thomas Jefferson, the author does the reader a great service by tracing the historical forces and individuals most responsible for the rise of America’s welfare state. He emphasizes the powerful political movements that arose in response to migrations of citizens from a largely agrarian economy to a dense, more specialized, and predominately urban society. As farmers on their own land and as entrepreneurial merchants in small towns, Americans lived rather self-reliantly, owning most of their capital and labor resources. But as technology and investment capital flowed into agriculture, productivity and output rose, rendering much farm labor redundant.

Hood contrasts the land- and home-ownership situation of a farmer with the condition of a worker facing weekly or monthly rent payments required for living in rapidly growing industrial cities during the second half of the nineteenth century. The psychology and politics diverge sharply, based on such factors as self-employment versus employee status, and ownership of one’s own land and tools versus paying a landlord and leasing tools and equipment owned by a capitalist banker or shareholder.

The author dates the hatching of America’s cradle-to-grave welfarism with the writings of Edward Bellamy, the influential American journalist who wrote the utopian novel Looking Backward. But Hood is careful to chronicle the ways in which the foundations for America’s welfare state had already been excavated by the time Bellamy achieved national notoriety in the late 1880s. Hood is at his best when organizing for readers the political threads that coalesced to give us today’s welfarism.

Ironically from our current perspective, the Progressives were urban and voted for the Republican Party and the Populists were rural and voted for the Democrats. Hood explains how, by 1912, all political parties stood for increased government intervention in the economy. Proliferation of immense federal programs in the New Deal era marked a natural outgrowth of these earlier statist movements and the financial and employment insecurities exacerbated by the Great Depression.

Again, one testimony to the excellence of Hood’s book is its historical continuity. He recapitulates for readers the squalor of congressional pandering to the "envy lobby" of a bygone decade. However, note that the pandering to envy described here occurred 40 years before the Depression. Specifically, Hood points to Populist calls in the early 1890s for a peacetime corporate income tax not to raise revenues, but to redistribute income, and the 1894 congressional enactment of the first personal income tax since the Civil War.

As coherent and helpful as the historical developments presented by Hood are, his chief mission in writing the book is captured in its subtitle, which might be paraphrased: "Ways to restore American self-reliance, responsibility, and limited government." From the introduction of 401(k) plans in the 1980s to welfare reform in the 1990s to early 21st-century momentum aimed at restructuring and circumventing the public-school monopoly, Hood is convinced that the public has made a profound course change. Aided by economic growth and prosperity in the 1990s, the author sees a growing segment of the public becoming increasingly insistent on controlling their own financial affairs and increasingly

disaffected by government’s relentless assault on household incomes, assets, and private decision-making.

Hood is simultaneously convincing and entertaining: authoritative and educational in his proposals for generating permanent reform through greater individual asset ownership, and entertaining in how he uses history and empiricism to defrock political and economic charlatans. Citing the wisdom of Aristotle as his premise-"Great is the good fortune of a state in which the citizens have a moderate and sufficient property"-Hood details the virtues of individually owned medical and educational savings accounts, privatization of Social Security, elimination of income taxation, and more welfare and unemployment-related reform.

The author harbors no illusions that converting our entitlement mindset into an investor mindset will be quick or easy, especially with entrenched bureaucracies and constituencies. But he sees favorable trends.

In a hard-hitting "war room" segment, Hood outlines a six-point strategy for undermining the welfare state. The key it seems to me is the author’s call to reformers to "clearly challenge the underlying immorality of writing envy into law."

David Littmann is senior vice president and chief economist with Comerica Bank in Detroit, Michigan.

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2. Book Review: The Political Racket: Deceit, Self-Interest and Corruption in American Politics by Martin L. Gross
3. Book Review: The American Economy in the Twentieth Century by Gene Smiley

On some books you feast. On others you nibble. Jim Powell’s The Triumph of Liberty is one of the latter. A fascinating collection of brief biographical sketches of those who have championed human freedom throughout history, Powell’s work is a seemingly inexhaustible source of information, insight, and inspiration. To sit down and read it cover to cover would be not to give Powell his due. His stories deserve to be savored, re-read, and retold. (Readers of this magazine may remember that a number of Powell’s sketches first appeared in these pages.)

Powell begins with Cicero and ends with Martin Luther King Jr. This reflects the breadth of his vision, blending names traditionally associated with free-market economics and classical liberal thought—such as John Locke, John Stuart Mill, Ludwig von Mises, Milton Friedman, and Ayn Rand—with champions of religious, social, and cultural liberation as varied as Mary Wollstonecraft, Susan B. Anthony, Louis L’Amour, Mark Twain, and Robert Heinlein.

One of my favorite accounts is of the life of Desiderius Erasmus, prolific author and contemporary of Martin Luther in fifteenth- and sixteenth-century Europe. I had only a passing familiarity with Erasmus, and so was delighted to learn about his defense of free will and religious toleration in an era of persecution by both the Catholic Church and Luther’s Protestant followers. Erasmus, we further learn, wrote a response to Machiavelli’s The Prince urging European leaders to favor peace and freedom over power and plunder. “I am a lover of liberty,” he wrote, and Powell supposes that he “must have been uneasy about his friend Thomas More’s Utopia, which described an ideal society where ‘everything’s under state control.’”

Powell dutifully provides those just learning the tenets of the freedom philosophy an excellent introduction through the lives of major eighteenth-, nineteenth-, and twentieth-century economists, philosophers, and politicians. But then he throws some curve balls. He profiles William S. Gilbert, whose comic operas ridiculed the governing establishment of his day. H.M.S. Pinafore, or the Lass That Loved a Sailor apparently drove Tory prime minister Benjamin Disraeli up the wall, which alone justifies Gilbert’s inclusion in The Triumph of Liberty. Another work created with Sir Arthur Sullivan, The Mikado, is a clever take on the dangers of meddlesome government and the hypocrisy it so often creates.

Another gem is Powell’s profile of Victor Hugo, whose Les Misérables has itself been revived as a popular and powerful musical in recent years. I had forgotten that it was Hugo who famously declared that “nothing is so powerful as an idea whose time has come.”

I am indebted to Powell for giving me a new appreciation of Thomas Babington Macaulay. Powell leads off his treatment of Macaulay by making the sweeping claim that the English essayist and historian “ranks among the most eloquent of all authors on liberty” and “in terms of the sheer quantity and range of eloquence, perhaps only Thomas Jefferson soared to such breathtaking heights.” Macaulay was an abolitionist, advocate of religious freedom and equality for women, and critic of “profuse expenditures, heavy taxation, absurd commercial restrictions, corrupt tribunals, disastrous wars” and other government perfidy. He wrote that private property is “that great institution to which we owe all knowledge, all commerce, all industry, all civilization.”

The Triumph of Liberty provides a unique perspective on such pivotal world events as the fall of the Roman Republic, the Reformation, the American Revolution, the Holocaust, and social movements for abolition, women’s suffrage, and civil rights. A major theme is how much it can cost to stand up for basic human freedom. Twelve of the 65 men and women he profiles were imprisoned for their beliefs, and 15 were exiled from their home countries. Three were killed. Many of Powell’s heroes were poor for much of their lives, sacrificing material comfort as they fought for their principles. Often they did not live to see the fruits of their labors.

In today’s intellectual climate, the kind of history that Powell has written is decidedly out of fashion. His is a book about heroes whose actions altered the course of human development. It is a refutation of the notion that only impersonal social and economic forces can explain the evolution of societies. If, for example, John Lilburne had not spent much of his life in English prisons, protesting the injustices of the Star Chamber and championing the rights of the individual, English history from the seventeenth century to the present might have been far different.

I feel compelled to conclude by quoting one of the blurbs on the back of The Triumph of Liberty. I do so only because I can’t imagine any better way to put it. “A generation of American children are being taught that Malcolm X, Ralph Nader, Gloria Steinem, and William Kunstler are heroes,” author P. J. O’Rourke wrote. “Please read The Triumph of Liberty to your kids. Or go to their school and hit a teacher over the head with it.”

John Hood is president of the John Locke Foundation, a public-policy think tank in North Carolina, and author of the forthcoming Investor Politics.

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In traditional discussions of the rise of free-market capitalism, great attention is paid to changes in institutions, technologies, and ideologies. We read the great philosophers and classical economists. We study the legal and political systems of England and Holland, which limited the power of government and promoted trade and economic freedom. We trace the history of kings and statesmen. But serious students of this fortunate event in human history should examine another factor with a far more ancient pedigree: the discovery of the number zero.

Our story begins in the cradle of human civilization, Mesopotamia. Historians are learning more and more about the inhabitants of this land (modern-day Iraq). Civilization began in the region not only because of farming opportunities that the Tigris and Euphrates rivers created, but because the Sumerians, Babylonians, and Akkadians were an industrious and inventive lot. They came up with a variety of agricultural, military, and cultural innovations. New archaeological discoveries suggest that their success was also due to the growth of trade and commerce, which were in many cases surprisingly sophisticated.

Primitive people had, of course, engaged in trade far back into prehistory. But merchants in Mesopotamian towns such as Uruk and Urappear to have pioneered such crucial tools as business partnerships and interest-bearing loans in the centuries before 2000 B.C. The lending of breeding stock was most likely the origin of the latter innovation. Indeed, the intimate connection between lending and livestock is easily seen in language. The ancient Sumerian word mash, which archaeologists identify as “interest,” was also the word for “calf.” The ancient Greek word for “interest,” tokos, had the original meaning “calf” too. The Latin root of the modern “pecuniary” is pecus, meaning “flock.” And the ancient Egyptian word for “interest” doubled as “to give birth.” Perhaps the rate of interest in early contracts referred to the number of calves or lambs owed the owner of a stud. Later the concept of rate of return in breeding contracts came to be applied to other business arrangements.

Certainly by the time of Hammurabi’s reign in Babylonia, in the 1700s B.C., lending must have been commonplace. Historians know this because surviving tables chronicle government regulations on the interest rate; a cap of 20 percent was frequently specified but just as frequently evaded by manipulating loan length and terms. Other records dating to the same period from Ur, the Biblical Abraham’s hometown, reveal the existence of a financial district, a sort of ancient Wall Street, where lenders congregated to make deals, compete, and finance long-range trade. These early financiers apparently experimented not only with lending at interest but also with business forms distinct from the traditional family proprietorship.^[1]

One tablet tells the story of Ea-Nasir, a merchant from Ur who assembled a group of 51 investors who provided either silver or trade goods, particularly baskets. Ea-Nasir conducted trade missions southward to Persian Gulf ports, where he traded for copper, precious stones, and spices. Ea-Nasir’s business appears to be a rudimentary form of the limited-liability partnership. Investors were liable only for the money or goods they contributed up front. Losses beyond the capital investment were apparently swallowed by Ea-Nasir, as were the bulk of the profits to compensate him for this risk. In addition, the investors were compensated not strictly with interest but with a share of profits earned from Ea-Nasir’s trips south. In other words, they were equity investors—and not all large ones. Records show that ordinary citizens, investing a bracelet or two, could participate, anticipating the idea of mutual funds of small investors. “The effect of this business structure upon personal fortunes was profound,” writes Yale University historian William Goetzmann. “People were able to ‘insure’ themselves against personal failure—if their own venture collapsed, then the investment in Ea-Nasir’s might carry them through hard times.”

Still another tablet chronicles the use of interest rates to teach mathematics to young scholars, illustrating the close connection between business and numbers. The Babylonian system of counting was based on 60, rather than the decimal system we use today, and was expressed in a form of writing called cuneiform that is clumsy by today’s standards. Yet the system was sufficient to allow the Babylonians to chart the heavens, survey their property, conduct their businesses, and collect their taxes. It is likely that difficulties in charting the increasing amount of trade led the Babylonians around the third century B.C. to invent a “placeholder” number so they could calculate large quantities. But they didn’t actually come up with the concept of zero as a mathematical quantity. Nor did other ancient mathematicians.

For all its intriguing innovations, the Mesopotamian economic system lacked theconcept of economic independence that fully free markets require. Most of the lending, for example, was for “emergency needs” rather than profitable investment, and the emergencies almost always involved taxes or temple requisitions, which were really the same things. More generally, Mesopotamian society simply did not allow for much large-scale economic activity outside of government, which officially owned large segments of the arable land and lorded over tenant farmers in ways more despotic than Europe’s feudal barons ever dreamed.

Individualistic Greeks

The individualistic, landowning ancient Greeks, particularly in Athens, built on the Mesopotamians’ early commercial innovations. The Greek economy, more so than in the Near East, featured long-term investment in such products as olives and wine. Stable private property rights and the decentralized, participatory government they engendered fostered long-term investment and made possible true private-sector banking, albeit on a relatively small scale. Athenian lenders invested in overseas trade, providing maritime loans as well as opportunities for equity investment. Banks accepted deposits of money from natives as well as out-of-town merchants. One successful banker was Pasion, a former slave who lived in Athens in the fourth century. His masters were bankers, too, from whom he learned the trade. At his death, his was the largest bank of at least seven operating in the city.^[2]

Still, it is difficult to separate ancient investment from government, since the same lenders financing international trade were also frequently government creditors, public officials, or a hated “tax farmer.” The latter, known in Jesus’s day as “publicans,” were contractors who bought the right to collect taxes in a particular neighborhood or town, then profited by charging a higher rate, loaning money to debt-strapped farmers without other means of paying taxes, and in many cases by hiring goons to confiscate property on the flimsiest of pretenses. The ravages of the tax farmers and the financial insiders associated with rapacious governments who profited from public works and the sale of military supplies, coupled with the envy that lenders and investors have always seemed to engender in their fellow countrymen, gave ancient financiers a bad name and paved the way for much government meddling.

In both Mesopotamia and Greece, governments periodically issued debt amnesties and tried to regulate interest rates. Prophets and philosophers railed against the wealthy bankers. Socrates called government debt relief the tool of the “demagogue,” but he wasn’t above comparing moneylenders to wasps and parasites. Rome typifies the blended nature of ancient finance. By early imperial days, Rome had developed a fairly sophisticated financial sector, complete with lending, banking, (quasi-) limited-liability enterprises, and the sale of “stock” in such enterprises among Roman nobles. Unfortunately, much of this financial activity revolved around lucrative tax-farming contracts in Asia Minor and other Eastern provinces.

Even those nascent forms of monetary investment might have evolved into something more closely approaching international capitalism if the empire itself had not grown in size and cost. As economist Lawrence Reed tells the story, swelling bureaucracies and armies led emperors to attempt ever more desperate ways of financing the government and paying debts. These included hiking existing tax rates, inventing new forms of taxation, inflating the money supply, and confiscation. Ultimately, the money economy itself was driven out of the West, not to return for several hundred years. When it did, ironically enough in Italy, one of the catalysts was the zero.

Medieval Business Innovations

The first glimmers of the re-emergence of large-scale private commerce can be seen in the eleventh century. It began with an innovation that makes few millennial history lists but, small as it may seem, set the stage for capitalism itself. Double-entry bookkeeping, developed by Italian merchants in the eleventh century based on concepts borrowed from Arabic traders, wasn’t the result of some esoteric pursuit of truth. It was a practical solution to a common problem—bookkeeping errors. Particularly before the widespread use of Arabic numerals, maintaining accurate records of any large-scale operation, business or not, was a major challenge. Imagine having to keep books with Roman numerals. Commerce existed, of course, but it was inherently limited. Nor was it possible for merchants of different cultures to find common ways of valuing their enterprises and developing long-term relationships.

Here’s where mathematics re-enters the picture. While the Babylonians (and, independently, the Mayans across the sea in present-day Central America) had come up with a “placeholder” zero, Indian scholars in the sixth or seventh centuries introduced the idea that zero represented “nothing.” It sounds banal, but it had revolutionary implications, particularly after the concept was introduced into the dynamic and adventuresome Islamic culture by famed mathematician Al-Khwarizmi in the ninth century. Al-Khwarizmi himself acknowledged that his interest in Indian numeration systems based on zero arose from the need for people to solve practical problems related to inheritances, wills, purchase and sales contracts, surveying, and tax collection. As what we now call Arabic numerals began to spread throughout the Islamic world in the ninth and tenth centuries, the traditional small-scale partnerships that characterized commerce early in Islamic history—a business form in which the Prophet Mohammed had himself participated—gave way to large-scale trading companies in which investors owned the equivalent of stock and around which a system of banking and credit evolved.

Unfortunately, Islam’s early trading institutions, though elaborate and the source of tremendous wealth, never developed into capitalism of a European sort. As was previously the case in ancient Mediterranean societies, Islam’s rulers were heavily involved in business enterprises, rarely paid their own debts, and imposed excessive costs in the form of taxes, regulations, wars, and outright confiscation. Neither Islamic law nor Islamic rulers recognized the independence of trading cities or the enterprises that populated them. And as historian Subhi Y. Labib has noted, other basic concepts such as commercial insurance “remained practically outside the scope of Islamic economic thought” during the period.^[3]

Double-Entry Bookkeeping

But Arabic innovations, particularly in mathematics and bookkeeping, would find fertile ground across the sea by the eleventh century. As merchant families from Venice and other Italian trading cities began to resuscitate long-range trade in the Mediterranean after the interruptions of the Dark Ages, someone armed with the new Arabic numerals hit on a bright idea. To detect accounting errors in his business, he would enter all transactions twice, once as a debit and once as a credit. For example, the purchase of a new scale would require the entry of an asset (the value of the scale) and a liability (the cash withdrawal or debt incurred to purchase it). At the end of any recording period, typically a month, the merchant would total all debits and credits. If the two totals didn’t match, he would know to look for a flawed entry.

Double-entry bookkeeping became far more than an error-detection device, however. For the first time, it allowed managers to determine accurately the net worth of their businesses at any point. But more important, it created a conceptual doorway to what we now know as modern industrial capitalism. Here’s how. The only way for assets to equal liabilities is if the equity stake is itself considered a liability—an obligation to the owner. Double-entry bookkeeping, in other words, is based on the concept that a business is distinct and separate from its owner(s). In an eleventh-century world of family businesses, this was revolutionary, to say the least. Such separation was necessary for the future development of limited-liability partnerships and corporations, the building blocks of a modern capitalist economy. Economic historian Werner Sombart summed it up well: “One cannot imagine what capitalism would be without double-entry bookkeeping.”^[4]

One further effect of this innovation was to make possible the creation of a system ofinternational business finance far surpassing anything developed by the Mesopotamians, Greeks, Romans, or Muslims. After all, lenders in these societies had a major handicap. Outside their own circle of family and business acquaintances there were huge transaction costs in extending credit. Independent information about prospective borrowers was nearly impossible to derive. Double-entry bookkeeping gave lenders a common accounting language and a useful means of distinguishing the appearance of prosperity from the reality. The practice, write Nathan Rosenberg and L. E. Birdzell, Jr., “grew into an agreed-upon procedure for recording all economic events in a measurable and therefore calculable way. In a very real sense, economic reality became that which could be expressed in numerical terms in the books.”^[5]

The Financial Revolution

Double-entry bookkeeping was followed closely by a succession of other innovations and institutions that formed the building blocks of capitalism. Armed with the ability to calculate business values accurately, merchants developed a body of commercial law to provide predictability in a world of petty tyrants, a patchwork of fiefdoms, and the ever-present threat of piracy. The ancient Greeks had pioneered the use of maritime loans to underwrite long-range trade, but by the twelfth century Italian merchants had invented more formal insurance contracts that guaranteed a trading mission against loss in return for a stated premium. Later, insurance markets in Italy, Amsterdam, and London differentiated maritime insurance, a risky product covering acts of piracy or God on the high seas, from more marketable commercial insurance, which covered the profitability of the subsequent sales. “The division between specialists in maritime risks and specialists in market risks greatly facilitated the growth of maritime trade,” Rosenberg and Birdzell write.^[6]

Bills of exchange, in existence by the thirteenth century, permitted merchants to transfer the amounts they owed each other without having to exchange coin or goods directly. These early checks were themselves traded among far-flung traders, giving rise to a private system of paper money based on the credibility of the merchant families against whom the bills of exchange were drawn. Deposit banking was the next logical development, as lesser merchants deposited funds with prominent trading families whose drafts were credible money in faraway lands. The creditors found that they need not maintain the entire face value of their circulating notes and could use some of their deposits to buy other bills of exchange at discount—“that is, for lending money at interest despite the prohibition of usury.”^[7]

Also in the thirteenth century, some governments began a tentative, but inexorable movement away from arbitrary taxation to a more predictable system for collecting revenue, controlled in England and later in Holland by the merchant class sitting in council rather than by kings or tax farmers. Kings put up with their diminution of the direct power to tax in exchange for a steady flow of revenue. One result in both England and Holland was that real capital assets such as vessels and trading stations could be owned and operated by private enterprises without fear of arbitrary seizure by sovereigns, a right that continental merchants—and, indeed, most of their counterparts in the Islamic world, India, and China—simply could not take for granted. This made large-scale private investment possible for the first time in markets previously the province only of governments or small-scale merchants.^[8]

The final innovation needed to pave the way for the Mercantile and Industrial Revolutions of the latter half of the millennium was the development of truly private property rights and institutions. In England and other regionsof Western Europe, increasing population pressures in the thirteenth century led to robust competition for arable land and pastures, increasing enclosure of range land, and the evolution of laws governing alienation and transfers of land. States took over the administration of private property claims from feudal barons. At the same time, kings began to give exclusive franchises to private entities to operate certain economic enterprises or monopolize certain trade routes. While hardly free-market in nature, these franchises weren’t tax farms in the Roman or Muslim sense. They were honest-to-goodness trading enterprises that allowed private merchants to build up physical capital (ships and equipment) and human capital (skilled labor and knowledge of routes and markets) without as much fear of interference or confiscation of their ships or workers by governments.^[9]

It is no exaggeration to say that these innovations, setting the stage for the birth of capitalism, followed directly from the discovery of zero and its introduction into European commerce. No king subsidized its invention, and no government program mandated its acceptance. Common folks, of many nationalities, had simply come up with a tool that helped them solve their problems. From such a lowly beginning, human freedom and progress took giant leaps forward.

Notes

1. William N. Goetzmann, Financing Civilization, forthcoming.
2. Richard Pipes, Property and Freedom (New York: Alfred A. Knopf, 1999), pp. 98-99.
3. Subhi Y. Labib, “Capitalism in Medieval Islam,” The Journal of Economic History, March 1969, pp. 93-95.
4. Quoted in Nathan Rosenberg and L. E. Birdzell, Jr., How the West Grew Rich: The Economic Transaction of the Industrial World (New York: Basic Books, 1986), p. 127.
5. Ibid.
6. Ibid., p. 118.
7. Ibid., p. 117.
8. Douglass C. North, Structure and Change in Economic History (New York: W. W. Norton & Co., 1981), p. 141.
9. Ibid., p. 133.

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“An ounce of prevention is worth a pound of cure,” or so the old saying goes. For the past three decades, politicians and policymakers attempting to close the gaps in educational achievement and social well-being among American children have taken this sentiment to heart. From the creation of Head Start in 1965 to various preschool and child-care programs today, government at all levels has attempted to ameliorate or eliminate social problems such as poverty, illiteracy, crime, drug abuse, out-of-wedlock births, and welfare dependency by “investing” in early childhood education. The case for such programs has been seductive. Why not inoculate youngsters against these social pathologies with a preschool program, much as public-health departments inoculate youngsters against viral or bacterial pathologies?

In reality, the public-health model has little relevance for early childhood development. The wide range of influences on young minds has proven resistant and sometimes impervious to government alteration. Head Start and other preschool programs aren’t “miracle drugs” that can overcome the effects of poor parenting, poverty, and educational malpractice in the public schools.

Nor is an institutional setting the preferred means of caring for preschoolers in most American families. Census data show that nearly three-quarters of all preschoolers are still cared for by parents or relatives at home, rather than in the day-care centers that benefit most from the new government initiatives. It is, in other words, impossible for preschool models, day-care subsidies, provider training, and new regulations to improve the early childhood development of the many children who will never set foot in a day-care center or preschool. What they and other children need are not new government programs but tax relief to allow families to keep more of what they earn and to make their own investments in their children’s development.

Head Start

The granddaddy of the government preschool movement is Head Start, a federal program that provides educational, medical, and social services to disadvantaged preschool children. The program originated in 1965 as an eight-week summer program of the U.S. Office of Economic Opportunity. Over the next three decades, it grew into a $4 billion year-round program providing grants to local organizations to operate programs for about 800,000 poor preschoolers.

There are four major components to Head Start: (1) education, (2) health care, (3) parent education, and (4) social services. Local programs provide these services in surprisingly different ways and levels of quality. Indeed, reports by the Inspector General’s Office in the U.S. Department of Health and Human Services have found that many programs fail to deliver the services for which they are paid. Many children fail to receive scheduled immunizations despite spending two or more years in Head Start.

Even given the spotty nature of local Head Start performance, few analysts dispute that children who leave Head Start and enter elementary school exhibit some advantages over their non-Head Start peers in academic and socio-emotional measures. Unfortunately, these benefits do not last long. By the third grade, according to the federal government’s own analysis of Head Start studies, the benefits “fade out.” That is, disadvantaged youngsters with Head Start experience become indistinguishable from disadvantaged youngsters without such experience. Whatever Head Start is, it does not qualify as inoculation against educational or social maladies later in life.

Still, defenders of Head Start and similar government programs continue to argue that an early taxpayer investment can save significant costs in the future. They base their case not on Head Start itself but studies of a handful of university experiments. The most famous of these is probably the Perry Preschool in Ypsilanti, Michigan. In 1962 the preschool selected 123 poor children. Half the group was given two years of preschool instruction and services, two-and-a-half hours a day, five days a week. The other half took part in no preschool program. Both groups of children were then tracked throughout their academic careers and into adulthood. The Perry students demonstrated not only significant short-term gains, as do typical Head Start participants, but also long-term gains. About two-thirds of the Perry group graduated from high school, compared to 50 percent of the control group. Similarly, while 51 percent of the control group had been arrested by age 19 for some crime, fewer than a third of Perry graduates had.

When the Perry results were first reported in the mid-1980s, they made a huge public relations splash. Child advocates began arguing that a dollar spent on preschool would save taxpayers $5 in future economic, education, welfare, and crime costs—all based on the Perry experiment. Even as pressure mounted to expand Head Start, and several states began their own early childhood initiatives, few bothered to ask why the Perry results differed so radically from those of Head Start programs themselves.

In fact, studies of the Perry Preschool and a couple of other university experiments don’t offer much guidance about the probable efficacy of government preschool. “These programs were conducted under ideal circumstances,” wrote Congressional staffer Ron Haskins in a seminal article in The American Psychologist. “They had skilled researchers, capable staffs with lots of training, ample budgets. . . . It seems unwise to claim that the benefits produced by such exemplary programs would necessarily be produced by ordinary preschool programs conducted in communities across the United States.”

Another major difference between Perry and Head Start is obvious: studies of the Perry project and a few similar projects track only a relative handful of students, a few hundred, through their academic and early adult lives. Studies of Head Start, on the other hand, involve hundreds of preschool programs and thousands of children. When dealing with complex issues such as child development, researchers and policymakers must do better than hype a few best cases.

Smart Start and Success by Six

Fueled by Head Start’s public-relations successes in the mid and late 1980s, several states began designing their own early childhood development initiatives in the early 1990s. With names such as “Smart Start” and “Success by Six,” these programs mixed a variety of approaches to assisting families with preschoolers, including grants to local service providers, day-care subsidies, home visitation by nurses or social workers, child-care referral activities, and parent-education efforts. In a 1998 report, Columbia University identified eight states as having the most “comprehensive” initiatives in the early childhood area. They included Colorado, Georgia, Minnesota, North Carolina, Ohio, Oregon, Vermont, and West Virginia. The Smart Start program, created by North Carolina Governor Jim Hunt in 1993, serves as a useful case study for how these programs have developed and what impact they have on children’s lives.

Hunt made Smart Start the centerpiece of his election campaign in 1992. He promised not a traditional entitlement program but a public-private partnership to link preschool children with service providers in local communities. Very quickly, however, it became clear that Smart Start was in fact a government program paid for almost entirely by taxpayers and routing most dollars to service providers rather than parents. When fully funded, the program is expected to cost nearly $350 million a year—larger than entire departments of North Carolina’s state government. Just to put that in perspective: Smart Start will consume more resources than the state’s law enforcement budget and almost as much as the state’s entire judiciary.

Smart Start may well be the most successful public-policy initiative ever hatched in North Carolina—if one defines success as getting good press. Not just in North Carolina but nationally, the program has received lavish praise for making an investment in the future of the state. Most recently, the program was the recipient of the 1998 Innovation in American Government Award from Harvard University and the Ford Foundation. “North Carolina is making an effort for early childhood education that includes county by county, group after group, and business after business, and is making significant headway,” said selection committee chairman David Gergen, former Clinton aide and editor-at-large for U.S. News & World Report. Other kudos for Smart Start have come from national magazines such as Working Mother and Good Housekeeping.

After such heady praise, many state leaders seem to have conveniently forgotten the purpose of Smart Start—to make a long-term impact on the education and social development of children. With only four years of operation under its belt, Smart Start cannot yet be judged conclusively on this criterion. Indeed, it is striking how many plaudits the program has received without a shred of evidence that it is achieving its stated goals. Like Head Start, Smart Start has been successful on a political level without establishing a demonstrable record of success.

The Early Evidence

Unfortunately for its boosters, the early evidence that does exist does not bear out Smart Start’s reputation. Two studies, neither conducted by critics of the program, have found it not to be the public-private partnership Hunt promised in 1993, nor is it likely to be a successful “investment” in early childhood development.

In August 1998, North Carolina State Auditor Ralph Campbell released a “Special Report on the Smart Start Program,” which included financial data for FY 1995–96 and 1996–97. While Campbell’s office found some areas of improvement, particularly in the number of management problems at local partnerships, it concluded that Smart Start still operates without a uniform fund accounting system, without a uniform contract management and monitoring system, and without sufficient oversight by its nonprofit parent, the N.C. Partnership for Children.

Perhaps most significantly, the audit found that Smart Start continues to fail to meet its private fundraising goals. For 1996–97, the program received $3.9 million in cash and in-kind contributions, far less than the $6.7 million in private funds required by the state legislature in exchange for past increases in taxpayer support. Even this standard wasn’t particularly high; the legislature mandated only that Smart Start raise $1 in private funds for every $10 in taxpayer funds. Given the early rhetoric about Smart Start not being a government entitlement program and instead being a public-private partnership, the failure to meet the legislature’s low fundraising target represents a major disappointment. Indeed, the N.C. Partnership for Children says it has exceeded the fundraising goal for 1997–98—but only after liberalizing the definition of fundraising to include gifts made directly to day-care centers, not to Smart Start itself. How much private support would flow to the centers anyway? It is impossible to tell.

With regard to the benefits of the program, only one study provides any useful information. It was conducted by the Charlotte-Mecklenburg Public Schools and Smart Start of Mecklenburg County and was released in July 1998 by the N.C. Partnership for Children. In examining the educational impact of Smart Start on kindergartners in Mecklenburg County, the state’s most populous county, it surveyed 5,715 parents. It used different assessments to provide educational data. One, the Kindergarten Awareness Profile (KAP), is given to incoming students to identify potential learning difficulties. The other, the Kindergarten Assessment in Reading and Mathematics (KARM), is a periodic observation of academic achievement given by classroom teachers. The results are combined at the end of the year and serve as a measurement of student achievement.

In brief, no statistically significant relationship was found between the KAP and KARM results, on the one hand, and participation in the Smart Start program for fewer than three years, on the other. That is, preschoolers who spent a single year in a Smart Start-supported day-care center or simply received a Smart Start-sponsored vision or hearing screening did not perform any better on the KAP screening or the KARM achievement assessment than preschoolers who did not. For those who spent three years in a Smart Start-supported center, the study did find a statistically significant—but small—difference. On the KAP screening, long-term Smart Start kids scored an average of 93.35 (on a scale of 0-102) versus 91.05 for kids without that experience. On the KARM, the point difference was similar: 32.18 versus 29.83.

Smart Start proponents trumpeted that last result as evidence of the effectiveness of the program. “Smart Start is working in Mecklenburg County and this study proves it,” said Ashley Thrift, chairman of the N.C. Partnership for Children. He is mistaken. The Head Start experience shows that the difference between participating and nonparticipating preschoolers will shrink as both groups go through the same schools. A large gain in early educational outcomes for participants might be sustained over time, but a tiny one—two points on a test—is unlikely to persist. It is certainly not a worthwhile return on the huge investment that North Carolina taxpayers have made in the Smart Start program since 1993.

Even the small jump in scores for long-term Smart Start participants may be suspect. After all, it is difficult if not impossible to rule out “selection bias” in such a study. That is, parents with other characteristics likely to improve student performance are probably more likely to get their children involved in Smart Start-type programs than are their peers. This effect may be small, but it would not take much to eradicate the small outcome differences the study found.

A Different Approach

There is no great mystery as to why government programs like Head Start and Smart Start don’t provide the long-term benefits they promise. Two or three years of preschool are unlikely to make an indelible impact on children who will spend far more time with their parents and in what are often mediocre (or worse) government schools. There is no magic wand that can wish away the effects of poverty, family breakup, and educational malpractice. There are no shortcuts in tackling these problems, nor are many of them amenable to government solutions at all.

On this point, the comments of four academic researchers who support Head Start are particularly salient:

If we wish to “close the gap” between advantaged and disadvantaged children, educational services need to go beyond the provision of short-term interventions. Policy decisions that support the expansion of preschool programs without addressing the more fundamental question of trying to alter what happens to disadvantaged children in our nation’s public schools are shortsighted. (Valerie Lee, et al., “Are Head Start Effects Sustained?,” Child Development. vol. 61, 1990, p. 505)

Furthermore, there is no reason to believe that government involvement or oversight of preschool and child-care arrangements will improve their quality. It is not obvious, for example, what specific factors make an early childhood program effective, so governments have little to go on in trying to mandate improvements. As the National Research Council stated in 1996, researchers do not know what constitutes the “basic ingredients” of high-quality child care. The council observed that “what is developmentally beneficial for one child may not be so beneficial for another.”

The few studies that do exist suggest that the impact of day care and preschool, positive or negative, on a child’s readiness to learn is difficult to demonstrate. Only 1.3 to 3.6 percent of differences among children in cognitive and language performance has been significantly linked to child-care factors; the vast majority of such differences among students when they enter school can be linked to factors such as family income, mother’s vocabulary, and family environment.

If policymakers really want to help all children grow and develop, the most important task is to alleviate the tax burden on families.

Related posts:

1. Book Review ~ Ask the Children: What Americas Children Really Think About Working Parents by Ellen Galinsky
2. A Matter of Principle: The Real Enemy of Liberty
3. Why Children Are Dying in the Nation’s Capital

John Hood is president of the John Locke Foundation in Raleigh, North Carolina.

Perhaps the most critical chapter of CancerScam, a slim but effective exposé of the politicization of America’s health-care charities, begins with this famous quotation from Thomas Jefferson: “To compel a man to furnish contributions of money for the propagation of opinions which he disbelieves is sinful and tyrannical.” This statement has properly been used to criticize taxpayer funding of political campaigns, of obscene art, and of various advocacy groups and lobbies.

In CancerScam, economists James Bennett and Thomas DiLorenzo apply Jefferson’s maxim to critique the phenomenon of major health charities, such as the American Cancer Society, using taxpayer money to lobby for laws or ballot initiatives restricting the freedom of tobacco smokers. A case in point was the 1988 passage of a California initiative raising cigarette taxes and using some of the proceeds to subsidize tobacco control, research, and “public education” (read: lobbying) programs run by these very charities.

The American Cancer Society, the American Lung Association, and the American Heart Association all spent time and money pushing for approval of the initiative. They were rewarded by receiving at least $8 million a year from the cigarette tax increase to promote anti-tobacco education programs.

Bennett and DiLorenzo quote one journalist sympathetic to the tobacco-control movement, who wrote that the formerly “‘starved for funds’ movement . . . found itself awash in California gold.”

The money-grubbing aspect of the health charities’ involvement was underscored by the legislative history of the initiative. A cigarette tax hike would likely have been passed by the California legislature in 1988, but because of a constitutional spending limit, much of the proceeds from the tax would have had to be refunded to taxpayers. Instead of pushing for the tax hike legislatively—which would have accomplished the anti-smoking activists’ purported goal of raising the price of cigarettes and thus discouraging smoking—the activists pushed for and got a tax hike written into the state constitution. This may have been a bizarre way to raise a tax, but it was the only way to route the new revenues to the charities themselves.

This story is replicated several times as Bennett and DiLorenzo chronicle the growing involvement of anti-smoking health charities in the political process. The book, not surprisingly, spends a fair amount of time rebutting claims made by these anti-smoking forces on such issues as the risks of secondhand smoke, the impact of smoking on government budgets, and how smokers perceive the risks of their habit.

There’s little new here to a reader already familiar with the debate, but it will help other readers put into perspective the pervasive sense of moral rectitude that the anti-smoking zealots exhibit when criticized about their taxpayer-funded lobbying efforts.

Bennett and DiLorenzo don’t focus only on the smoking issue. They argue that the corruption of charitable institutions—their seduction onto the government dole and into the political game—is a trend with far-reaching negative consequences. A free society is based, in part, on drawing clear lines between various social institutions, be they businesses, governments, families, or charities. Governments have a unique role to play in our lives, as do the other institutions. Corruption sets in when businesses act like governments (for example, the Mafia), governments act like businesses (for example, providing rail transportation), governments act like families (for example, giving food stamps and subsidized day care), and so on.

CancerScam tells a cautionary tale. To pervert government public health spending—which in any event should be limited to combating communicable diseases and other immediate threats to innocent bystanders—into a means of supporting political causes is to erase the lines that protect individual liberty and the market process. Jefferson understood this. He would see no justification for forcing anyone to finance campaigns against the right of smokers to do what they want with their own lives and property, and neither do Jim Bennett and Tom DiLorenzo.

Related posts:

1. Book Review: Destroying Democracy: How Government Funds Partisan Politics by James T. Bennett and Thomas J. DiLorenzo
2. Book Review ~ From Pathology to Politics: Public Health in America by James T. Bennett and Thomas J. DiLorenzo
3. Book Review: Official Lies: How Washington Misleads Us by James T. Bennett and Thomas J. DiLorenzo

It’s a constant refrain among politicians and the news media: America has a low savings rate. This, it is said, has dire consequences for the long-term health of the economy. Some analysts put the personal savings rate—the percentage of disposable income that isn’t consumed in a given year—as low as 2.1 percent in 1997, a 63-year low. Although this undercounts the real amount of American savings and investment, there is no doubt that the private savings rate is near an all-time low.

Why is this? Are Americans simply irresponsible? Should government force households to save more money for a rainy day, as some doomsayers have suggested?

On the contrary. America’s savings crisis is almost totally manufactured by government itself. Through punitive taxation and the growth of the welfare state, big government has legislated against the habits of thrift and delayed gratification on which human progress is based. The decline in the savings rate over the course of the twentieth century isn’t just a minor economic trend. It represents the threat that government expansion poses to the principles on which successful human civilization rests.

What Is Savings?

It’s worth pausing to consider the definition and origin of savings. After all, economists aren’t talking simply about a bank account, or even an investment in stocks or bonds, when they address the issue of savings. For example, one’s home is a form of savings, in that the value of the home usually appreciates even as one uses the home for current consumption (shelter).

Indeed, the official savings rates don’t factor in the appreciating value of assets. They reflect the difference between reported income and reported expenditures. The Commerce Department, which generated the 2.1 percent rate cited above, doesn’t actually track inflows and outflows of wealth. It doesn’t include the rise in the value of investments in individual retirement accounts, 401(k) plans, real estate appreciation, or the rise in value of mutual funds or corporate stock. It doesn’t count the implicit wealth people accumulate in pension plans. The Federal Reserve computes an alternative measure incorporating some of these factors and estimated that the 1997 savings rate was actually 7.1 percent of disposable income. Still, that’s pretty small compared with the savings rates of other countries. In Asia, rates reach as high as 20 percent.

The reason the issue of savings is so important is that deferring consumption—which is probably the best definition of savings—is essential to human happiness. That statement may seem paradoxical. How can forgoing current pleasure or satisfaction by choosing not to buy a good or service today increase one’s happiness? To answer that question, it’s important to look at how four closely related economic behaviors—savings, insurance, investment, and specialization—arose among prehistoric human cultures.

A Short Economic Prehistory

The earliest societies historians can identify are the nomadic hunter-gatherers who inhabited various regions of Africa, Asia, Europe, and the Americas. Throughout most of their history, these hunter-gatherers traveled in small groups of 20 to 30 related individuals—a patriarch and matriarch, their children and grandchildren, mates from neighboring groups, and other assorted relatives. They worked together both to hunt animals for meat and to gather fruits, vegetables, nuts, simple tools, and other useful objects. Because these groups were constantly on the move, their housing consisted of either portable shelters (tents, or yurts) or structures they found or could construct quickly (caves, lean-tos).

In this earliest of human societies, the line separating political, economic, and spiritual institutions was blurred or nonexistent. Few of the tools future civilizations would use to draw such lines were available to the hunter-gatherers. Their nomadic lifestyle, for example, provided little opportunity to develop or enforce private property rights, not only over land but over the products that land might produce. Private property rights are indispensable if societies are to separate the public from the private, the sphere of human activity over which political power is freely wielded and the sphere over which it is limited or excluded.

Furthermore, the small size of these societies necessarily reduced the extent to which differences in knowledge or talent resulted in the development of markets or a division of labor beyond the most rudimentary one. Finally, because they lacked any practical means of saving and transporting food of more than limited quantities, these earliest human societies provided little reward or incentive for hard work. All that was hunted or gathered was consumed relatively quickly. An individual who was exceptionally talented as a hunter or gatherer had no reason to invest much of his time performing those tasks.

Stages of Economic Discovery

Even under these conditions, however, developments occurred in economic exchange and institutions. The earliest hunting and gathering humans cooperated with each other to derive sustenance from a sometimes-forbidding environment. They had to develop terms of trade and rules of work and reward in order to put members of the clan or band to productive use. A simple division of labor did evolve, based on age, sex, and physical prowess (or infirmity). We know that these small societies, while primitive and sometimes brutal, also gave opportunities for those with different natural talents and skills. And while the invention of money was far in the future, these early humans engaged in mutually beneficial trade in valuable goods that sometimes spanned surprising distances.

Archaeologists and anthropologists divide human prehistory before metallurgy into three periods: Paleolithic (Old Stone Age), Mesolithic (Middle Stone Age), and Neolithic (New Stone Age). The names suggest a categorization based on stone technology, but the real dividing lines among these periods involve changes in geography and corresponding changes in economic technology and organization.

For the purposes of understanding economic history, the Paleolithic Period is critical. It lasted from 2.5 million years ago until about 10,000 B.C. Humans during this period include Homo erectus and archaic Homo sapiens. Early in the period, humans used simple tools made either of the core of a stone after pieces had been flaked off, or the flakes themselves. They used fire (discovered sometime between 1 million and 500,000 years ago) to drive or prod animals, to prepare food, and of course to keep warm.

Later, in the so-called Middle Paleolithic Period, flake tools were developed into a wide array of scrapers, borers, and points used to manipulate animal kills and other materials. This was the period of Neanderthal Homo sapiens in Europe and some humans even closer in appearance to modern humans. Their tools may have improved their hunting but, more important, there is evidence of extensive social cooperation not only in hunting but in storing and exchanging food. As one writer has noted, hunting is not just about killing animals. Killing animals is the easy part, whether it is by using weapons, by trapping, or by driving prey over cliffs. The difficult part lies in the organization of personnel so that they are in the right place at the right time and with the right gear to ensure a better-than-average chance of success.

Even more difficult is the task of coping with failure, weather, and the decline of animal stocks. Remember that these societies lacked effective technologies for storing food, and a diet of nuts, berries, and other gathered foods was of insufficient quantity or nutritional value to tide families and clans over in the event of a seasonal decline of game.

Humans Beings Invent Savings

It is here, in the Middle Paleolithic populated by humans whose language skills were limited or nonexistent, that economic institutions extending beyond kinship probably developed. More specifically, these Middle Paleolithic people pioneered the crucial economic behavior of managing risk—in this case, the risk of starvation. They did it with two innovations: savings and group insurance. In the former case, they learned to put stores of food in secure places in their hunting and gathering territory, and then budget them to cover subsistence needs over the lean times. In the latter, nearby small kinship groups established social networks through alliance, intermarriage, visiting, and feasting that served as regional insurance policies. A group facing a decline in game (or lack of success in hunting) could make claims on the food stores of neighbors with whom they had previously invested time, attention, or their own food. This served to spread the risk of starvation over a broader number of hunters and gatherers, thus improving the chances of survival for all.

The concepts of savings and insurance are closely related; indeed, one might think of insurance as a way of realizing the benefits of savings without 1) having to develop technologies for saving food over a long period and 2) having to wait until a stock of savings is sufficiently large to tide a family or group over during hard times. Insurance-type arrangements, if they are of large enough breadth for their members to escape simultaneous misfortunes, represent a reasonable technique for coping with risk under difficult technological conditions.

The Upper Paleolithic, beginning about 50,000 years ago in various regions, represented the appearance of humans roughly identical to us today. It also brought two additional economic innovations of critical importance: specialization and investment. The Cro-Magnon and other advanced Homo sapiens of the Upper Paleolithic, unlike their predecessors, seem to have specialized in the hunting or gathering of specific species, rather than being purely opportunistic and pursuing whatever was visible in their range areas. Like savings and insurance, specialization was a form of risk management in the sense that it usually involved careful study of particular animals with the goal of predicting their behavior—and thus increasing the likelihood of catching them. Specialization took some of the risk out of hunting and gathering by allowing for the accumulation of knowledge with which small human societies could ensure a more stable and predictable food supply. It not only required study of animal habits and movements, but also a more detailed understanding of the climate and topography of their range areas.

Accumulating such knowledge had a cost. It took a great deal of time and effort, which earlier human societies had probably devoted to less taxing and more recreational activities. Indeed, many people assume that economic progress throughout history has meant a progressive increase in leisure time, but until recently the opposite has been true. In earlier Paleolithic groups, there was little to be gained by spending more time on hunting and gathering activities rather than on leisure activities. Hunting and gathering was such a hit or miss process that increased time and effort invested in it wouldn’t have yielded much more in the way of results.

But with the introduction of specialization, increased time and effort devoted to the study of quarry and environment could pay off in higher returns. So the more sophisticated hunters and gatherers of the Upper Paleolithic discovered the value of investment—forgoing consumption or leisure in the short run for greater material benefit in the long run. Until it became practical to store information (through better language skills and specialization in a relatively narrow field of inquiry) investment would have had paltry returns.

This revolution in hunting and gathering had repercussions beyond improvements in the food supply. It was also associated with the development of larger, multi-family groups. For one thing, specialization and investment made population growth much more desirable. Additional people meant additional opportunities to gather useful information and carry out the more complex strategies required to catch more game. At the same time, the improved food supply made it possible to support larger populations. Specialization and the increased scale of human populations led to larger and more permanent settlements, and the beginnings of a territoriality that would eventually lead to concepts of private property. And both the larger populations and the increased productivity of hunting and gathering made possible a greater division of labor within the groups, allowing some individuals the option of specializing in tasks other than hunting and gathering.

Savings and Investment Create Trade

Finally, the development of larger groups with a higher level of specialization created the conditions required to inaugurate trade among unrelated groups. After all, if one group chooses to specialize in a particular form of hunting and gathering, then the occasional acquisition of game or artifacts outside the specialty becomes more attractive. It represents variety and diversion. A coastal group specializing in catching fish and gathering shellfish would have something of value to offer an inland group specializing in hunting deer, horses, or other big game. This increased value of trade would apply not only to foodstuffs but also to other goods. In both western and central Europe of the Upper Paleolithic, for example, there is evidence that several species of seashells were traded or exchanged over hundreds of miles. Similarly, there is evidence of relatively long distance trade in high-quality flints and other raw materials.

The Upper Paleolithic Period ended with the end of the last Ice Age and the impact of global warming on the environment. The initial stages of this warming can be traced back to about 11,000 B.C., and affected different parts of the Old and New Worlds at different times. The oceans rose as ice melted, forests expanded over the expanses left behind by the retreating glaciers, and portions of the globe saw climate change of cold to temperate or temperate to hot. These changes led either to human migration or to significant changes in the way humans lived in their home areas. One further note about the end of the Upper Paleolithic is that it coincides with the final settlement of every habitable continent.

The key point for our purposes is that the development of multi-family societies, and later towns and cities, was based on the invention of economic practices involving delayed gratification, or savings. The habit of savings and investment paid its greatest returns once human settlements developed around new notions of private property. Once families could work their own land or tend their own herds, the economic value of hard work soared. After all, at a very basic level, agriculture and animal husbandry were the epitome of savings and investment. Rather than literally “eating the seed corn,” farmers planted it in the ground, tended it for months (perhaps nearly starving the whole time), and then reaped a far greater bounty at harvest time. With herders, delaying gratification meant feeding scarce grains and water to stock animals rather than to their own families. It meant tending, not eating, the stock. Those who could learn to do this would, in the long run, be far better off that those hunter-gatherers who worried only about today’s meal.

If one considers the broad sweep of human history, this radical revolution in how human beings live has occurred only recently. The passage of time from the last Ice Age and early human settlements to the modern day is, geologically speaking, a blink of the eye. Yet consider how radically different our lives are compared with our hunter-gatherer ancestors.

The Savings-Rate Decline

Although no data exist on the personal savings rate per se throughout recorded history, one can safely say that it was extremely high. Even as recently as the nineteenth century, most Americans still lived and worked on farms. They spent most of their waking hours saving and investing—working the land for the promise of future return. Few could afford luxury items, vacations, or other forms of current consumption.

The Industrial Revolution changed all that. Mass production, first of clothes and later of other goods, significantly reduced their cost and thus reduced the amount of time and effort consumers had to save and invest in order to afford them. Advances in transportation technology came next, facilitating trade and thus the comparative advantages in price and quality of purchasing goods from others rather than making them oneself. Finally, dramatic advances in agricultural technology and practices so increased the productivity of farming that prices fell, far more food and fiber could be produced per person, and farmers gradually found their time and effort more profitably invested elsewhere.

The purpose of savings and investment changed from acquiring basic necessities to addressing “quality of life” goals. As workers moved to cities, then to suburbs, in the new industrial economy, savings and investment became a means of purchasing a new automobile, buying a nice home, sending children to college, affording higher levels of health care, dealing with sudden disability or unemployment, and providing for a comfortable retirement.

Unfortunately, the advent of the New Deal in the 1930s, followed by the Great Society programs of the 1960s, began to suggest to Americans that these big-ticket items in their lives might be paid for by someone else. Roosevelt’s Social Security and unemployment insurance promised income in case of sudden loss of employment, disability, or old age. Johnson’s Medicare and Medicaid promised families that they wouldn’t have to save and invest to take care of elderly relatives who needed lots of medical attention or institutional care.

At the same time, these expansions of government spending required increasing amounts of revenue. The government got this revenue in large part by taxing private savings and investment. The first permanent income taxes arose in the early 1900s. Marginal rates soared during World War I and then rose again during the New Deal and World War II. Payroll taxes were added to fund entitlement programs, taking money that families would otherwise have saved for their own needs. Today, the income tax code is strongly biased in favor of current consumption and against long-term savings. For example, a worker who earns $1,000 will pay income and payroll taxes only once on that money if he chooses to spend it immediately. If he invests it in corporate stock, however, he will likely pay income tax on the money three or more additional times, as the corporation pays taxes on earnings, the worker pays taxes on his dividends, and then pays again if he leaves the investment to his heirs.

Is it any wonder that the rise of the welfare state has coincided with what many observers, of varying political persuasions, call a new ethic of instant gratification and self-indulgence? Public opinion polls show that Americans have become convinced that government will help them through the big expenses they will face in their lives, be it unemployment, education, health care, home-buying, disability, or retirement.

This is a mirage, of course. If one thinks of the money taxed out of families and “invested” by government for these future needs as the real rate of personal savings, then it’s not being invested very well. Everyone knows the crisis that faces Social Security in the long run, as Baby Boomers retire and base their expectations of a comfortable old age on the prospect of government transfer payments from a smaller cohort of working Americans. But the problem isn’t just limited to retirement. Medicare will go broke far earlier, perhaps in the next decade. Medicaid—increasingly a program of nursing-home payments for the middle-class elderly instead of an anti-poverty program—will collapse next. Unemployment insurance is already an awful deal for most workers, who are eligible to draw money only if they are terminated without cause, and even then they get paltry returns. The money Americans are forced to save and invest in education also gets poor returns, as the mediocre test scores of American schoolchildren and the declining academic standards of American universities illustrate.

So even if one defines the savings rate in the most expansive manner—as not only private savings but also the amount of money government “saves” on your behalf—there remains a savings crisis. Too little of our seed corn is being invested in long-term productive enterprise, with a promise of future harvests. Instead, government is feeding this seed corn to current beneficiaries of entitlement programs. Americans have lost the impulse that industrious human beings throughout history have maintained to work and save for the future.

This is the real savings crisis. It isn’t just one of dollars and cents, but of thrift and self-reliance. The solutions are clear: end the tax code’s bias against private savings and investment, and end government’s false promise of saving and investing on our behalf. There is no more serious challenge facing American society and American freedom.

(For further background, see Barry Cunliffe, The Oxford Illustrated Prehistory of Europe (Oxford: Oxford University Press, 1994) and Mark Kishlansky, Civilization in the West, Volume 1 (New York: HarperCollins Publishers, 1991).

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2. Savings, Tools, and Production
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Businesses are accustomed to being criticized for neglecting their responsibilities to society. Complaints that private enterprise puts profit before people have long provided reliable applause lines for politicians and assorted activists, and material for the briefs of crusading public-interest attorneys. But in the past few years, the concept of corporate social responsibility—increasingly part of the curriculum in America’s schools of business and management—has established itself as a political and social force to be reckoned with. This can be seen in recent proposals in Congress and elsewhere to offer tax breaks or regulate differently firms that shoulder their “social responsibilities.”

Another sign of the increasing prominence of the idea was the formation of Business for Social Responsibility (BSR) in Washington, D.C., in 1992. The 54 founding members of BSR—including Ben & Jerry’s Homemade, Inc., The Body Shop, Stride Rite Corp., and Working Assets—were well known as advocates of environmentalism and economic “fairness.” The organization said it intended, through lobbying and public relations, to make “social equity,” “environmental responsibility,” and “developing a sustainable economy” integral to corporate decision-making. BSR now has more than 800 members and affiliates, including AT&T, Federal Express, Hallmark, and Time Warner.

Social responsibility isn’t expected only of large corporations. If commercial activities are perceived to be unethical or destructive, it doesn’t matter what type of business enterprise engages in them. However, publicly traded corporations are the target of most discussion about social responsibility because of how they are created and managed.

Corporate social-responsibility advocates note that since corporations are “fictitious persons,” created by law and sustained by government grants of limited liability for individual shareholders, they have obligations to society that surpass those of sole proprietorships or partnerships. One such scholar, business professor Thomas M. Jones of the University of Washington in Seattle, explained that “the corporation which acts in a responsible manner may simply be paying society back for the social costs of doing business, costs for which the firms rarely receive an invoice.”

This view is hardly new. In fact, it was accepted doctrine in the United States and other Western societies until the nineteenth century that the right to conduct business in the corporate form was a matter of royal or state prerogative, not of private economic interest. Monarchs issued charters to public-stock corporations that promised public benefits, such as exploration and colonization of the New World. Individuals could own shares of the corporation, and sell them (with some limitations), but the purpose was not merely to serve the interests of stockholders. In the American colonies, the earliest business corporations established during the eighteenth century were founded to perform such services as building transportation infrastructure, supplying water, fighting fires, and providing insurance. These early corporations were rare and closely regulated in size, scope, and property holdings.

Self-Incorporation Permitted

After the break from England, however, American states began to pass charters that allowed self-incorporation rather than incorporation by special legislative act. At first, these corporations could be created only for religious, charitable, or municipal functions. The first private incorporation statute, passed by the North Carolina state legislature in 1795, applied only to canal builders, and the canals had to pass to state ownership. Later, however, states broadened the scope of self-incorporation to the point where firms began to arise throughout the economy for the clear purpose of conducting private business.

At the turn of the century, the implicit assumption underlying state corporate law was that the corporation existed to make money for its shareholders. This consensus was rarely challenged. The first important legal test of the responsibilities of corporate directors came in the influential 1919 case of Dodge v. Ford. Despite its name, the case had nothing to do with competition between automakers. Instead, it had to do with the intended largess of Henry Ford, president and controlling shareholder of the Ford Motor Company. In August 1916 Ford owned 58 percent of company stock. John and Horace Dodge owned 10 percent. Rather than pay regular and special dividends, as the company had done in previous years, Ford announced that only regular dividends would be paid. The remaining profits would be used to expand production capacity, increase wages, and offset losses expected from his cutting the price of cars.

Many analysts have interpreted Henry Ford’s strategy as an astute business decision calculated to increase profits in the longer run. But that wasn’t his stated purpose. Ford proclaimed broader social goals: “to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes.” The Dodge brothers sued, claiming that Ford was using shareholder equity to pursue his own personal philanthropic goals. The Michigan Supreme Court, while professing to respect Ford’s business judgment, agreed with the Dodges. It stated that a corporation exists to benefit its stockholders and that corporate directors have discretion only in the means to achieve that goal. It may not use profits for “other purposes.”

The court went on to say that corporate behavior such as charitable giving could pass legal scrutiny as long as it had a legitimate relationship to corporate profits. Other state courts codified this standard by upholding corporate expenditures such as gifts to local training schools, community chests, recreational facilities, hospitals, and even churches. Expenditures designed to attract customers and advance corporate interests by obtaining “good will and prestige” also passed muster.

As a practical matter, then, Dodge v. Ford and similar cases throughout the early twentieth century gave corporate managers great discretion. Nevertheless, the case did establish in the minds of corporate managers and others the notion that corporations had direct responsibilities only to shareholders.

Principle Under Fire

After the Great Depression hit and throughout the war years, this notion came under fire from several fronts. First, a number of scholars and observers of business came to advance the proposition that corporations, far from being owned and thus controlled by their shareholders, were really accountable to no one but their managers. Adolf Berle and Gardiner Means, in their influential work, The Modern Corporation and Private Property, argued that shareholders were passive owners at best; they effectively exercised only the power to sell their shares if dissatisfied with corporate policies or performance. “By surrendering control and responsibility,” Berle and Means wrote, shareholders had “surrendered the right that the corporation should be operated in their sole interest.” Their book, published the same month Franklin Roosevelt was elected, helped justify the economic regulations imposed in the early New Deal.

Another argument advanced was that corporations had grown so large and amassed so much power over society that previous formulations of their social responsibilities had simply become outdated. This view was stated by the New Jersey Supreme Court in A.P. Smith Manufacturing Co. v. Barlow, the 1953 case that helped redefine the purpose of corporations in the minds of many executives, judges, and scholars. In 1951, the board of directors of A.P. Smith, a manufacturer of valves and fire hydrants, adopted a resolution to contribute $1,500 to Princeton University. Corporate shareholders challenged the donation as being outside the proper scope of corporate expenditure. The court disagreed and upheld the contribution. Harking back to the royal charters, the court said that the shareholders, “whose private interests rest entirely upon the well-being of the corporation, ought not to be permitted to close their eyes to present-day realities and thwart the long-visioned corporate action in recognizing and voluntarily discharging its high obligations as a constituent of our modern social structure.”

Around the same time, other court decisions and new state statutes recognized the power of corporations to make donations to the public welfare or for charitable, scientific, or educational purposes. Advocates of corporate social responsibility began to argue that if philanthropy was a legitimate corporate activity, then perhaps other activities that placed social goals over shareholder returns were also legitimate, such as abandoning profitable but (in their view) socially or environmentally destructive product lines. The actual legal status of corporate social responsibility probably did not change a great deal between Dodge v. Ford and Smith v. Barlow, since managers had always enjoyed a substantial amount of discretion in how to serve what they perceived to be the economic interest of the corporation. But in Smith, the court, along with other legal and academic commentators, suggested that the corporate interest itself had changed. Because they controlled institutions of economic power and social influence, responsible corporate managers (as well as government regulators), according to this outlook, should consider a host of goals other than profit maximization.

Reaction and Counteraction

Many business leaders and academics viewed the corporate social responsibility movement with alarm. To them, it went hand in hand with increased government control over private economic decisions. The most famous critic is Nobel laureate Milton Friedman, author of Capitalism and Freedom. Friedman, while teaching at the University of Chicago, wrote perhaps the most widely cited—and criticized—essay on corporate social responsibility in the past 30 years: “The Social Responsibility of Business Is to Increase Its Profits.” In that modest five-page article in the September 13, 1970, issue of the New York Times Magazine, Friedman sought to clarify the legal and ethical issues involved in the debate by noting that businesses are simply groups of people and that only people have responsibilities. If a corporation makes a donation to charity without the shareholders’ authorization, wrote Friedman, the managers are deciding how to spend other people’s money. It would be better to return the money to shareholders as dividends or capital gains and let them decide which charities to support.

In Friedman’s view, the purpose of the corporation is clear: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”

It is no exaggeration to say that, with very few exceptions, every major article on or analysis of corporate social responsibility since the publication of Friedman’s article has cited, mentioned, or challenged it. Some critics maintain that Friedman’s understanding of corporate ownership is badly dated. Since shareholders are passive or even unknowing investors in particular companies (through pension or mutual funds), they don’t exercise the type of control that real owners of property do. “With the dissolution of ownership in the traditional sense,” wrote Michigan State University legal scholar Jeffrey Nesteruk in the Cincinnati Law Review, “the dichotomy between shareholder and societal member must be reconsidered.” Another argument lodged against Friedman’s view is that dividing profit-seeking business activity from the larger world of political, legal, and social decision-making is impossible. “Role specialization, which perhaps is desirable, does not and cannot exist in our modern industrial economy,” Thomas Jones stated. “Corporations play a political role; governments play an economic role. Profit alone no longer implies preferred behavior. . . . Corporations are social institutions and as such must live up to society’s standards; society has changed the standards for corporations, as it has every right to do.”

Friedman has responded that social changes have not invalidated the distinction between corporations and other institutions. Nor is the relationship between shareholder and corporate manager anything but an owner-employee, or principal-agent, relationship. To suggest otherwise is merely to substitute one’s own judgment for the judgment of shareholders, who, after all, voluntarily decide whether or not to invest their funds. They (or their agents among money managers) will sell the stock of companies from which they no longer expect competitive returns. Indeed, the proliferation of stock ownership through institutional investors has merely reinforced the responsibility of corporate managers to focus like a laser beam on profit as an objective. Advocates of corporate social responsibility may not like the implications of this trend, but that does not justify their attempts to second-guess shareholders in their wish for an economic return.

Shifting the Debate

The debate over corporate social responsibility has focused on such issues as the nature of corporate ownership in America today and the legal or fiduciary responsibilities of corporate managers in business transactions such as takeovers and mergers. But there remain a couple of points from Friedman’s discussion that are unappreciated.

One is the important notion that corporations do not exist in physical reality. This has implications beyond Friedman’s contention that corporations, as artificial persons, cannot really have social responsibilities. Consider that corporations consist of more than simply their land, plants, machinery, inventory, and products. The value of a corporation—at least in the minds of those who buy, hold, or sell its stock—is based on both tangible and intangible assets. A company with few assets today but a great idea for a new product may dominate the marketplace tomorrow, while a company with millions of dollars in assets and a large market share in a soon-to-be obsolete industry may be destined for failure. Hard-to-quantify characteristics, such as worker morale, management style, systems for promoting internal innovation, and an ability to foresee future trends, determine the expected value of corporate stock.

Can individual shareholders really be viewed as “owners” of such corporate assets as the brainpower and work ethic of employees, or the goodwill and confidence of consumers? A more meaningful way to think about corporations may be that they are bundles of ever-changing and variably valuable private agreements between individual persons. Coca-Cola, for example, might be reasonably thought of as a set of bilateral and multilateral agreements between such groups as farmers, factory workers, plastic designers, bauxite miners, graphic artists, bankers, bond buyers, managers, retailers, soda drinkers, and celebrity spokesmen. All these individuals (and many others) enter into contracts with Coca-Cola in which they agree to provide something of value in exchange for something else of value.

Stockholders are no different; they agree to risk their wealth as equity owners of the corporation in exchange for a shot at a profitable return on their investment. There is nothing socially undesirable about this emphasis on profit. Many American families rely on investments in stocks or mutual funds to make the down payment on their first home, to send their kids to college, or to live decently in retirement. Shareholders of U.S. corporations seek profit in the same way that other groups of Americans seek higher wages as workers, higher interest rates as lenders, lower interest rates as borrowers, and lower prices as consumers. Corporations serve as the venue where these sometimes compatible, sometimes competing interests are accommodated in ever-changing, but always mutually satisfactory ways.

Stephen Bainbridge of the University of Illinois College of Law has suggested that this “nexus of contracts” view of corporations establishes a firmer defense of profit as the goal of corporations than the traditional understanding of shareholder “ownership” that Friedman employs. After all, shareholders of publicly traded companies differ from, say, homeowners in some easily recognizable ways. Someone who buys a few shares in Coca-Cola and is subsequently caught breaking into a bottling plant cannot defend himself by proclaiming that since he is an “owner” of Coca-Cola, he has a perfect right to enter.

Thinking of the responsibility of managers to stockholders as stemming from a contract with a specified goal—the maximization of the return on investment—might be more helpful than thinking about property ownership per se. By embracing the contractual definition of a corporation, Bainbridge is able to argue that state laws allowing incorporation are not special public favors to shareholders, justifying imposition of social obligations. Instead, they are merely “default rules” for establishing contracts between buyers and sellers of equity that would come about in the marketplace anyway, but at a high transaction cost. Rather than having every corporation and potential shareholder negotiate and sign contracts, the law recognizes a baseline corporate contract that everyone is presumed to agree to unless otherwise specified. “Refusing to hold shareholders personally liable for firm debts thus is the precise equivalent of enforcing a standard form sales contract, nothing more and nothing less,” Bainbridge contends.

Profit and the Common Good

Another of Friedman’s points that deserve greater attention is his suggestion that “the people who preach the doctrine of social responsibility are concealing something: the great virtue of the private enterprise system is precisely that by maximizing corporate profits, corporate executives contribute far more to the social welfare than they do by spending stockholders’ money on what they as individuals regard as worthwhile activity.” Here is the crux of the matter. The assumption that profit is inconsistent with the common good is predicated on a perceived tension between making money and serving one’s fellow man. But as Adam Smith said centuries ago, if the pursuit of profit really does act as “an invisible hand” guiding human action toward socially beneficial endeavors, then surely to abandon that pursuit is to lose the social benefits that would otherwise exist.

In other words, perhaps commercial activity—as distinguished from other forms of behavior, such as personal philanthropy or government action—confers unique benefits on society. Realistically, all sorts of problems in society can be viewed as within the purview of corporate activity. But in Friedman’s view, the response of corporations to these problems will and must be different because of the nature of profit-seeking business. “The crucial question for a corporation is not whether some action is in the interest of the corporation, but whether it is enough in its interest to justify the money spent,” he wrote. Companies, then, bring a search for efficiency and economy to the task of solving problems. This search represents a fundamentally different way of addressing social problems from the means employed by governments, charities, churches, or families. To erase the distinctions between corporations and other institutions is potentially to lose the unique problem-solving opportunities that free enterprise creates. In effect, private business is fulfilling its “social responsibility” if, and only if, it tries to make a profit.

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Do racial minorities, women, and other groups need the government to protect them against prejudice and discrimination? To hear some prominent social commentators tell it, American business has a shameful record on social equality. Corporate boards lack significant minority representation. Minority consumers are underserved, and minority and female workers are underpaid. Minorities and women can’t get financing to start their own businesses. “In most fields, there is a level beyond which people of color cannot rise,” said Stephen Carter, the well-known author and law professor.^[1] Similar complaints about the economic prospects of women have been popularized in recent years by such authors as Susan Faludi and Gloria Steinem.

This picture of the private sector as an arena of continued discrimination, inequality, and despair for everyone in society except white men is often repeated, presumed accurate by reporters and politicians, used to defend government affirmative action programs—and completely wrong. Not only is there great news to report for the economic accomplishments and prospects of previously downtrodden groups in America, but this good news is due almost totally to the triumph of commercial values over alternative values that have in the past put fear, racism, and insularity ahead of business success and profit.

The cornucopia of good news about social equality and American business overflows with little-noticed facts about our recent economic past. For example:

• American women were forming small businesses at twice the rate of men in the early 1990s. Businesses owned by women now employ more people than do all the firms in the Fortune 500 combined.^[2] If the trends of the 1980s and early 1990s continue, women will own half of all U.S. businesses by the year 2000.^[3] Similarly, the number of businesses owned by members of racial and ethnic minorities more than doubled from 1982 to 1994.^[4]
• Before the Second World War, only 5 percent of American blacks had middle-class incomes. Today, the figure is about 60 percent.^[5] From 1981 to 1991, the total income of blacks grew 38 percent, faster than the growth rate for the incomes of the white population. Almost half of all black households own their own homes.^[6]
• Measured correctly, there is no evidence of significant discrimination in bank lending against prospective minority homebuyers.^[7]
• Among full-time, college-educated workers, about the same percentage of blacks and whites have executive, administrative, or managerial jobs.^[8]

Naturally, racial stereotypes, invidious discrimination, and animus still exist in America. But it is important to understand the role profit-seeking businesses play in combating these lingering problems. For corporate managers, excluding potential workers or customers because of race, gender, or other group characteristics means sacrificing future productivity and sales. It simply stands to reason that the wider you cast your net for employees or consumers, the better off you will be. To do anything less is to fail in your responsibility to the owners or shareholders.

Gary Becker, Nobel laureate in economics and a professor at the University of Chicago, pointed out the anti-discrimination effect of free enterprise in 1957, and has been restating his conclusion ever since. The key, he says, is competition. Screening out job applicants because of their group means reducing the chances of hiring the best worker, who may well go to work for a competing firm. Similarly, screening out whole groups of consumers means giving up sales to competitors. “Competition forces people to face costs, and therefore reduce the amount of discrimination when compared with monopolistic situations,” Becker said.^[9] So racism and discrimination are, over time, much more likely to persist in monopolistic institutions (like governments themselves) rather than in businesses.

Indeed, one might argue that without the largely unconscious pressure of the business sector on social attitudes, there would be a great deal more racism and social inequality. For governments, charged with protecting societies from their external or internal enemies, loyalty to one’s group and the distrust of others is a virtue. It maximizes the physical safety of the society and protects its land from encroachment. But for traders the greatest rewards lie in trusting strangers, who are the source of new products and new ideas. That means seeking out and embracing people who are different from you—the more different they are, the more likely they are to have something of value to you. The social benefits of trade—of breaking down barriers between groups in the interest of mutual economic gain—have been enjoyed by every group in American society. Past immigrants, recent immigrants, racial minorities, religious minorities, and many others have sought and obtained in the marketplace what they did not have and could not achieve through politics or social activism.

Race, Gender, and Entrepreneurship

As mentioned, the number of businesses owned by racial minorities and women has been increasing rapidly in recent decades. Not only has the number of firms grown, but their share in the national economy has, too. Just from 1991 to 1995, for example, the combined revenue of the Black Enterprise 100 for industrial/service companies and auto dealers grew by 63 percent to $11.7 billion.^[10] A third of the roughly 6.5 million enterprises with fewer than 500 employees were owned or controlled by women in 1994.^[11]

Entrepreneurship has been a traditional route out of poverty for American minority groups of all sorts. Jewish, Greek, Cuban, and Japanese immigrants, for example, overcame prejudice and social barriers by entering occupations and markets ignored by native-born Americans, making themselves indispensable to the growth and development of the economy. As generations of immigrants gained economic success, their children and grandchildren pursued higher education, befriended and married individuals outside their own groups, and gradually obtained social tolerance and acceptance.^[12]

Even within the artificially restricted markets left to them by Jim Crow segregation, some American blacks of the late nineteenth and early twentieth centuries were able to find opportunities for economic success. Arthur G. Gaston was born in 1892 in a log cabin his grandparents, former slaves, built in rural Marengo County, Alabama. After the early death of her husband, Gaston’s mother moved to Birmingham in 1900 to be a cook for A.B. and Minnie Loveman, founders of what would later become the state’s largest department store chain. Young Gaston, an admirer of Booker T. Washington, worked a number of odd jobs, including selling subscriptions for the local black newspaper. Later, he moved to Mobile and became a bellhop. After serving in the army during World War I, Gaston came home and took a job at the Tennessee Coal and Iron Co. Always looking for opportunities, he began selling box lunches (prepared by his mother) and peanuts and lending money to workers at the TCI plant. He started a burial society for the workers, too, which eventually acquired a mortuary and became Smith and Gaston Funeral Directors. In 1932, the burial society was incorporated as Booker T. Washington Insurance Co.^[13]

New ventures followed. Gaston started a business college for black clerical workers in 1939, bought a cemetery in 1947, opened the Gaston Motel in 1954, and started the Citizens Federal Savings Bank in 1957 to lend money to blacks excluded from lending markets by segregation. Active in the civil rights movement and numerous civic and community organizations, Gaston kept adding to his business holdings during the 1960s, 1970s, and 1980s, buying radio stations and opening his own construction company. In 1994, Black Enterprise named A.G. Gaston, then 102 years old, as the magazine’s Entrepreneur of the Century. In Gaston’s view, his business success has enabled him to advance the cause of racial equality just as his hero Booker T. Washington had predicted. “Money has no color,” Gaston said. “If you can build a better mousetrap, it won’t matter whether you’re black or white, people will buy it.”^[14]

Color-Blind Customers and Employers

The entrepreneurial explosion among women and members of minorities in the past few years has demonstrated that consumers, both households and businesses, will generally buy from anyone who can supply a high-quality product or service at a low price. The same might be said about American employers, who have discovered that businesses that want to compete effectively cannot afford to discriminate against workers because of race, sex, or other such characteristics. Indeed, having a workforce of people who meet high standards of quality and performance and bring differing backgrounds and perspectives to their jobs is often a recipe for success.

Vigorous political debates about such subjects as affirmative action and comparable worth obscure what is actually occurring in the American economy today: the gradual elimination of discriminatory hiring and firing practices, as well as rising levels of compensation and respect for minority and female workers. According to economist Howard R. Bloch of George Mason University, 70 to 85 percent of observed differences in income and employment among American racial and ethnic groups disappear when you adjust the numbers for factors such as age, education, and experience. “That’s been shown by studies dating back to the mid-1960s,” Bloch said. “And you can’t even be sure that the residual gap is due to discrimination. It could be due to factors we haven’t controlled for.”^[15]

In measurements of accumulated household wealth, as contrasted with annual income, minorities have also made tremendous gains. A Federal Reserve Bank of St. Louis study in 1989 found that observed differences between whites and minorities were no longer statistically significant once age and education were taken into account. “Members of minority groups are typically younger than whites, and therefore have had less time to accumulate assets,” noted the author, John C. Weicher of the Hudson Institute.^[16]

Similarly, apparent pay gaps between men and women don’t prove the lack of “equal pay for equal work,” as many critics allege. June O’Neal, head of the Congressional Budget Office, noted that when earnings comparisons are restricted to men and women with similar experience and life situations, the differences are small, particularly among today’s young people. Among people 27 to 33 who have never had a child, the earnings of women are close to 98 percent of men’s.^[17] Even for broader groups of men and women, today’s pay gaps mostly reflect the impact of such factors as women’s shorter average working week and women’s choice of careers that allow for greater flexibility should they wish to bear and rear children later on. Full-time working women also have, on average, less work experience than comparable males, again affecting their value to firms and thus their compensation.^[18]

Progress toward more equal treatment of workers began long before the state and federal governments passed laws governing hiring. Thomas Sowell, a senior fellow at the Hoover Institution and the author of numerous books on affirmative action, notes that the number of blacks in higher-paying, professional occupations was increasing rapidly before the passage of the 1964 Civil Rights Act.^[19] Several studies have found that the convergence of economic opportunities for blacks and whites, and men and women, began before World War II.^[20] Harvard economist Richard Freeman has found that blacks and whites with similar backgrounds and education had essentially achieved pay equity by 1969.^[21]

Many explanations for the pay convergence among American workers lie in the social changes wrought by an innovative business sector. Technological innovation in our economy, for example, has not only made us all collectively better off but also had the side effect of promoting greater pay equality. The substitution of machinery for human labor has reduced the value of physical strength and increased the value of mental acuity and social skills—which are distributed more evenly between sexes. At the same time, labor-saving devices in the home have given married women more freedom to pursue education and employment. Household chores that previously consumed hours of tedious work are now performed in whole or in part by electrical appliances or by outside contractors.^[22] The result has been a revolution in time and family responsibility that is difficult to overstate.

If the logic of business success works against unfair and capricious treatment of workers on the basis of race or sex, then it virtually mandates that companies with the desire to maximize revenue not discriminate against potential customers. The fact that some businesses have done so, and continue to do so, reflects only that they are run by people who put their own personal biases above profit. Flagstar Cos., Inc., which operates Denny’s and Hardee’s restaurants throughout the south and west, is clearly not one of these businesses, despite some well-publicized cases of discrimination in the early 1990s.

In 1991, reports began to trickle in to Flagstar CEO Jerry Richardson of racial discrimination at some of his Denny’s restaurants in California. Some black customers charged that they were denied service, while others said they were forced to prepay for food unlike white customers. Richardson immediately fired managers who had discriminated, apologized to offended customers, and instituted programs to train managers and workers with respect to racism. In a restaurant chain with thousands of employees across many states, it would have been impossible not to inadvertently hire some racists. The key issue was how company management saw its responsibility to correct problems as they arose. “It makes no sense that we would condone racism,” said Richardson. “Denny’s needs all the customers it can get.”^[23]

The Redlining Controversy

The efforts of corporations to cultivate regular customers among minority groups has been largely obscured in the public mind by the lingering controversy over “redlining” by banks, insurers, real estate agents, and similar types of businesses. Discussion of redlining is complicated by the fact that historically, some lenders and insurers were clearly willing to forgo the business of blacks and others to reinforce a social consensus of segregation in their communities. But this despicable—and economically unwise—practice would seem to be extremely rare today, despite incessant claims by activists and the media that redlining remains the rule.

The problem is that studies purporting to show discrimination in bank lending or insurance focus almost exclusively on rejection rates for loans and policies. These rejection rates often do, indeed, differ significantly among racial groups in studies. But these studies ignore many important factors that provide a more plausible explanation for the apparent disparity than does racism.^[24] Sometimes the studies promoted so widely by the mass media, like the celebrated 1992 Federal Reserve Board of Boston study purporting to show higher black rejection rates than those of whites with similar incomes, are simply invalid; that study contained transcription and mathematical errors, inappropriate generalizations, and the skewing of average results by a few exceptional cases.^[25]

Ironically, higher rejection rates are often found for those very institutions, including minority-owned banks, that are trying to extend credit in inner-city and minority neighborhoods, since banks in predominantly white areas are more likely to receive applicants from a smaller, more select group of minorities with better-than-average financial resources, work histories, or business prospects. When a bank opens a branch in a minority community, it will necessarily reject more minority applications than before.^[26]

It is the personal characteristics of loan applicants—the items in their financial history likely to communicate to potential lenders the likelihood that their loans will be repaid—that explain virtually all racial or ethnic disparities. The most important measure of discrimination is not rejection rates, which are affected by a host of racially neutral factors, but instead the rates at which customers of different races or communities default on their loans. If households or businesses in black areas tend to default at lower rates than those in white areas, that would be evidence of discrimination, since blacks would seem to have to meet higher credit standards than whites do to get loans. On the other hand, if the default rates of blacks are higher, that would suggest discrimination in favor of them. In reality, the available evidence on default rates suggests that there is no significant difference between households and businesses of predominantly white and predominantly minority communities, suggesting that the latter are not being “redlined.”^[27] Other studies that have tried to identify actual racial discrimination by interviewing loan applicants have often failed to find any significant evidence of it.^[28]

It is important to understand the role of profit-seeking business in eliminating disparities in income and economic opportunity that are based on racism and sexism. For groups kept from realizing the American dream by the prejudices and failures of the past, the best hope for progress in the future is an economy populated with companies whose managers put performance and profitability first.

Notes

1. Stephen Carter, “The Glass Ceiling for Blacks Is All Too Real,” Fortune, November 2, 1992, p. 124.
2. “Women Entrepreneurs: ‘A Pretty Big Game,’” Nation’s Business, August 1992, p. 53.
3. E. Holly Butler, “Female Entrepreneurs: How Far Have They Come?” Business Horizons, March/April 1993, p. 59.
4. James Overstreet, “Minority businesses riding a wave of success,” USA Today, October 25, 1994, p. 4B.
5. Peter Drucker, “The Age of Social Transformation,” The Atlantic Monthly, April 1994, p. 62. Of course, this increase in income potential isn’t due solely to the actions of firms, since minority workers are employed by government and nonprofits as well as by businesses.
6. Paul Klebnikov, “Showing Big Daddy the Door,” Forbes, November 9, 1992, p. 150.
7. Benjamin Zycher and Timothy A. Wolfe, “Mortgage Lending, Discrimination, and Taxation by Regulation,” Regulation, vol. 17, no. 2, 1994, pp. 61–71.
8. John Leo, “Our Addiction to Bad News,” U.S. News and World Report, June 5, 1995, p. 20.
9. Peter Brimelow and Leslie Spencer, “When Quotas Replace Merit, Everybody Suffers,” Forbes, February 15, 1993, p. 80.
10. Angela G. King, “Black-Owned Businesses: Lean But Healthy,” USA Today, May 10, 1995, p. 4B.
11. Wendy Zellner, “Women Entrepreneurs,” Business Week, April 18, 1994, pp. 104–105.
12. John Sibley Butler, Entrepreneurship and Self-Help Among Black Americans: A Reconsideration of Race and Economics (Albany, N.Y.: State University of New York Press, 1991), pp. 1–33.
13. Harold Jackson, “True Grit,” Black Enterprise, June 1994, pp. 230–34.
14. Ibid.
15. Brimelow and Spencer, p. 86.
16. John C. Weicher, “Getting Richer (at Different Rates),” The Wall Street Journal, June 14, 1995, p. 10A.
17. June Ellenoff O’Neill, “The Shrinking Pay Gap,” The Wall Street Journal, October 7, 1994, p. 12A.
18. Christina Hoff Sommers, “Figuring Out Feminism,” National Review, June 27, 1994, p. 34.
19. Elizabeth Wright, “Preferential Policies: An International Perspective,” Associates Memo, Manhattan Institute for Policy Research, August 2, 1990, p. 3.
20. See, for example, Mary C. King, “Occupational Segregation by Race and Sex, 1940–88,” Monthly Labor Review, April 1992, pp. 30–36.
21. Brimelow and Spencer, p. 86.
22. These Are the Good Old Days, 1993 Annual Report, Federal Reserve Bank of Dallas, 1994, pp. 7–8.
23. Andrew E. Serwer, “What To Do When Race Charges Fly,” Fortune, July 12, 1993, p. 95. Allegations of discrimination continue, however, according to reports published in May of this year.
24. Zycher and Wolfe.
25. Stan Liebowitz, “A Study That Deserves No Credit,” The Wall Street Journal, September 1, 1993, p. A14.; see also Joseph Blalock, “Testing Fair Lending,” Savings and Community Banker, June 1994, pp. 44–48.
26. See Jeff Taylor, “Ratings Present Misleading Picture,” Consumers’ Research, October 1992, p. 23; and Tim W. Ferguson, “The Next Lender Wave: Mortgage Bias,” The Wall Street Journal, May 25, 1993, p. A15.
27. Jonathan R. Macey, “Banking By Quota,” The Wall Street Journal, September 7, 1994, p. A14.
28. See George J. Benston and Dan Horsky, “The Relationship Between the Demand and Supply of Home Financing and Neighborhood Characteristics: An Empirical Study of Mortgage Redlining,” Journal of Financial Services Research.

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2. The Economics and Politics of Discrimination
3. Discrimination and Liberty

John Hood is president of the John Locke Foundation, a nonprofit think tank based in Raleigh, North Carolina, and author of The Heroic Enterprise.

The Corporation, as we know it-and we know it from every aspect of our liveswas invented; it did not come to be of itself." With those words from Oscar Handlin begins Michael Novak’s latest work, The Fire of Invention: Civil Society and the Future of the Corporation. The quotation sums up neatly the two main thrusts of Novak’s short and readable book: the moral and social importance of the corporation, and the role that invention and patent laws play in a free society.

The Fire of Invention is based on three lectures Novak gave at the American Enterprise Institute in Washington. The first deals with the history and future of the corporation. Novak points out that while the publicly held corporation has become a worldwide phenomenon, the people of the United States are primarily responsible for "inventing" it as a basic social institution.

They did so first by suggesting that they as citizens, not as merely the subjects of a sovereign, could form corporations. The citizens of Massachusetts, for example, made up a charter of incorporation for Harvard University in 1636, shocking the monarchy back in England. By 1800 the United States, populated by only about 5 million people, had more business corporations than all of Europe.

The difference between America and Europe went beyond the extent of incorporation to the nature of civil society itself. Instead of pleasing states and sovereigns, would-be American incorporators would have to please customers and stockholders. "[The corporation] brought to civil society not only independence from the state but also unparalleled social flexibility and a zest for risk and dare," Novak argues.

The second lecture in the book details another of America’s unique social institutions: its patent system. Without a system for "intellectual property," the Founders believed, America’s experiment with freedom would fail. That is why providing for patents and copyrights, Novak maintains, is among the few enumerated powers of the federal government in the U.S. Constitution. And he does students of economic history a great service by uncovering Abraham Lincoln’s longforgotten celebration of the Founders’ wisdom about patents. Before patents, Lincoln wrote, inventors had no way of protecting their practical ideas and thus lacked the incentives to develop and use them. "The patent system changed this," Lincoln continued. "[Patents] secured to the inventor, for a limited time, the exclusive use of his invention; and thereby added the fuel of interest to the fire of genius, in the discovery and production of new and useful things." The title of Novak’s book is a paraphrase of this classic passage.

Corporations and patents were necessary to the explosion of American know-how throughout the nineteenth century. Even innovations originating elsewhere, such as the railroad, were implemented far more quickly in the fertile soil of the United States. Many economists and historians have tossed around various explanations for this fact, but Novak is onto the truth when he spotlights the role that social institutions play in guiding human endeavor.

The last of Novak’s lectures is on corporate governance. This is an important issue, given the insistence by latter-day socialists that "stakeholders" (outside interests affected by corporate decisions) deserve representation in corporate governance equal to the stockholders. Some argue that stockholders don’t deserve priority treatment because they are mostly passive, with little or no interest in the management of the firm. The author shows the hazards of this thinking.

Excellent as the book is, I wish that Novak had covered more ground. One dangerous argument that critics make is that corporations have duties to society. But Novak says little about this. He observes that the growth of pension funds means both broader stock ownership throughout society and stronger pressure on behalf of shareholders to keep managers in line. It is not enough to argue, however, that the interests of society in general and those of stockholders are converging because of the growth of stock ownership. One must challenge the basic assumption that the limited-liability corporation is a government intervention in the free market.

Although Novak doesn’t weigh in on all the issues and arguments, his book remains one of the best introductions to the subject of the morality of the corporation that one can find. Its brevity is an asset, not a liability; it makes The Fire of Invention a perfect gift for that busy corporate executive you know who needs to understand more clearly why what he does is socially beneficial and morally just.

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2. Book Review: Business as a Calling: Work and the Examined Life by Michael Novak
3. Book Review: The Catholic Ethic and the Spirit of Capitalism by Michael Novak