In 1887, Congress created the first federal regulatory agency by enacting the Interstate Commerce Act. As has often been the case since that time, the act was a response to the problems created by previous government interventions.
Under the Pacific Railway Act, enacted in 1862, the federal government was to provide land and low-interest loans to facilitate the construction of railroads from the Missouri River to the Pacific Ocean.
The Pacific Railway Act awarded railroads land for a right-of-way to construct the rail lines, as well as land adjacent to completed lines. The adjacent land was to be sold to settlers as a source of revenue. The act also authorized the federal government to purchase 30-year bonds from the railroads with an interest rate of 6 percent. The effect of these two acts was massive migration to the west and the fulfillment of Manifest Destiny.
Prior to the Pacific Railway Act, the railroads had regarded construction of rail lines in the west as economically unjustifiable. The sparse population and difficult terrain simply made no sense economically. This however, did not fit with the federal government’s plans, and so it responded by essentially bribing the railroads to engage in activities that they would have otherwise avoided.
This government intervention had predictable consequences. Government intervention invariably distorts markets, as it causes individuals to act differently than they would without the intervention. The most obvious examples are those involving prohibitions—these directly prevent individuals from acting according to their own judgment. Less obvious, and perhaps more insidious, are interventions that involve incentives. This was the case in regard to the railroads.
The railroads had concluded that they could not make money building lines in the west, and so they did what any prudent business would do—they didn’t build. But federal subsidies suddenly made such construction feasible, even though other market conditions—such as an adequate market for profitable operations—had not changed. In other words, federal intervention provided incentives to act in a manner that was previously regarded as irrational.
Government intervention forces or encourages individuals to act contrary to their own rational judgment. While that intervention may encourage or discourage certain actions, it does not change the underlying motivation for action—the values and interests held by those individuals. When the intervention involves prohibitions, individuals will continue to seek ways to attain the desired values. When the intervention involves incentives, individuals pursue values that have no rational basis in reality.
Frederic Bastiat, the French economist, often wrote of the distinction between the “seen” and the “unseen”: “There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” The politicians of the time did not concern themselves with what had to be foreseen; they concerned themselves solely with the expediency of the moment. The consequences of their intervention, while predictable, remained unidentified.
All of the companies who received federal aid eventually went bankrupt. The small, isolated markets and great distances to travel simply could not support the railroads. In short the railroads had been correct—the market did not justify building in the west.
A further consequence of the intervention, and one that would soon have a significant impact on American politics, were the rates charged by the railroads. In an attempt to attain profitability, they charged high rates. For the western farmers, who had no other options for getting their crops to market, these rates were devastating. Neither the farmers nor the railroads could operate profitably.
Without the government’s intervention in encouraging the construction of western rail lines, this issue would not have arisen. Western expansion would have occurred when it was deemed prudent. Railroads would have built when it made financial sense to do so.
The Pacific Railway Act essentially created a demand where none existed. It provided the railroads with an incentive to build, not because of market conditions, but because of government policies. Government intervention distorted the market, and when problems arose, further intervention—the Interstate Commerce Act—was advocated as the solution.