Ethics and Politics: The Public and Their Utilities

AN investigation of the electric power companies of the United States was begun in April before the Federal Trade Commission at the initiative of several eminent popular leaders who had for some time been firing broadsides at the ‘Power Trust’ without any very noticeable effect, and who were apparently running short of ammunition. The investigation opened with an inquiry into the activities of the National Electric Light Association in its campaign to improve the public relations of the operating companies belonging to the Association, and from the very outset the word ‘propaganda’ was applied to all of them. It was a skillful move. All men who have had experience with casuistry know that if you allow your opponent to use his own terms, and to define them, he will run you up a tree and out on a limb. The term ‘ propaganda ’ has come to have an ominous sound to us because of the methods used by the Government in selling its political programme to the voters and to investors during the late war, so that now the use of it always implies some concealed and improper motive. When you disagree with a man, or disapprove of his activities, to call them propaganda is a knock-down argument. Thus we have lost a useful term, for, if properly used, it should mean merely a campaign to make public the ideas in which you believe. Every religious revival has made use of propaganda as its best weapon, and if propaganda were prohibited all human communication would have to stop because of our inability to draw a dead line. But now, when used in a political campaign such as that at present in progress before the Federal Trade Commission against the electric power companies, it raises in the public mind a vision of the methods used by an organized minority to put the Prohibition Amendment on the statute books, and goes far to decide the issue against the companies in advance.

No official report on this phase of the proceeding has yet been made public, but the scarcity of ammunition already referred to was so acute that its promoters demanded from the Commission weekly reports of the evidence with which to serve their guns, and these reports have provided them with many useful arguments to discredit the management of the privately owned power companies and to facilitate a movement toward government ownership. This is an issue in which the nation is deeply interested, and it will be prudent to await the publication of the full report before passing judgment. But this can now be safely said. The American people are overwhelmingly opposed to government interference in business. We are whole-hearted individualists, and we have had experience with government operation in the case of railroads and ships. The promoters of the investigation appear to assume, however, that the report will be so unfavorable to the companies that the public will clamor for more rigid control of them or even for a great extension of government ownership. In this they may be disappointed. Many politicians, and a few private managers who have mismanaged their companies, would profit by government ownership, but the nation would not; and if the Government enters the electric power business, as advocated by Governor Smith in his Acceptance Speech, this extension of its functions will have to be forced upon a reluctant majority by tactics similar to those which saddled us with the Eighteenth Amendment. Surely the genial Governor is getting into strange company.

Though the first stage of the Federal Trade Commission investigation is not yet complete, it has started upon the second — a study of the mechanism and methods of the holding companies by which many of the electric power companies are controlled. This is probably the part of the proceeding from which the politicians hope to gain the most, and perhaps they may; but before they build their hopes too high they will do well to consider whether it is the electric power companies and the men who manage them or the Federal Trade Commission and those who have set this piece of machinery in motion who are really on trial. When this Commission was first created, we had high hopes of what it might accomplish in establishing new and better standards of business ethics; but we have been sorely disillusioned, for as yet we have little or nothing of this sort to show for it. We may even find that we have less than nothing; harm may prove to have been done, for the most obvious result of its labors to date has been to create suspicion in the public mind. Few poisons are more deadly to a highly integrated industrial civilization like ours. Confidence is the foundation upon which it rests, and a court of inquisition, which is what the Federal Trade Commission has proved to be, is a menacing instrument of government, to which the temper of this people is strongly opposed. Sooner or later, and perhaps as a result of the present investigation, the public will see this, and it may be that the engineers who have loaded it will be hoist with their own petard. This aspect of the problem of the electric power companies, however, is mainly political and temporary, and is important only as an example of the confusion which seems inevitable in a democracy when economic problems get into politics.

I

There are really two separate problems connected with these holding companies which are in urgent need of intelligent consideration, but which have become so deeply entangled in politics that there is small hope of their getting it. They are, first, the danger that monopoly in electric power supply will enable the producers to earn an excessive profit; and second, the danger that profits legitimately earned may be diverted into the wrong hands by manipulation within the holding companies themselves. In current political discussion it is fashionable to mix the two so that neither can be clearly seen.

The first problem — namely, the danger of monopoly of the electric power supply — has been for years a target for political marksmen, and although there is really no cause for alarm the public has been told so often that the danger is serious that many are beginning to believe it. The war cry of the politicians is the ‘Power Trust,’ adopted apparently for the purpose of foreclosing the issue by deciding it in advance. Perhaps it is from the lack of any other that this issue has claimed so much attention. Certainly it is a very poor one, for, to anyone familiar with the principles of public utility regulation in the United States, it is obviously a jack-o’-lantern useful to frighten the children on Halloween but not to be taken seriously by grown-ups. However, as the man in the street seems to have been misled, it is time that the hoax was exposed.

The operating companies which produce electric power are required by law to be local monopolies under the control of a state regulating commission. Their status as monopolies has been fixed by law, because we have found after years of experience that through the method of regulated monopoly the customers get a better service at a lower price than direct competition can provide. The standard method is to place each local monopoly under the regulation of a state commission charged with the duty of seeing that the service is adequate and that the prices are just and reasonable, so that, unless the state commissions fail in their duty, it is utterly impossible for these operating units to demand, or receive, an excessive price or to earn a monopoly profit. The function of the holding companies is to group these local operating companies and direct their management through stock control, and if they were managed by Machiavelli himself it would be impossible for the holding companies to oppress the customers of the local companies, because they have no contact with them. They are powerless to do them harm, but they can do them much good by creating administrative units of sufficient size to command the services of men able to operate them, and to raise in an efficient manner the capital which must flow into them in a continuous stream. These are not ideals, but conditions actually achieved; the splendid development of electric power production and use, in which we lead the world, being due in no small degree to this grouping of operating companies under holding-company control. It would be impossible to charge the purchasers of electric light and power more than the prices fixed by the state regulating commissions as just and reasonable, even if all the operating units in the country were controlled by one holding company; and therefore from the customer’s point of view a Power Trust, instead of being a menace, would be a benefit, provided the size of it did not exceed the capacity of our ablest administrators. It is devoutly to be wished that the present movement toward enlarging the size of the holding companies and reducing their number will go considerably further. The customers have everything to gain and nothing to lose, provided that the state regulating commissions are honest and competent. This is the point on which attention should be concentrated.

It may seem that I have put the case too strongly in claiming that a Power Trust, if one existed, would not be an injury to the customer, but a blessing. The Power Trust has been held up to the public for years as a menace. Where there is so much smoke, there should be some fire. There is fire; if you search, you will find it. But those who are berating the holding companies are leading the public away from it. The fire is not in the corporation offices in Wall Street, but in the offices of the state regulating commissions. The problem which really needs searching investigation is whether the regulation of rates by the state commissions is being intelligently and skillfully done. This is a dark corner into which I shall try to throw some light.

Just at the moment the public seems more interested in the second problem — namely, whether these holding companies are engaged in extracting improper, because unearned, profits for their stockholders from the operating companies; profits which either should be cut off at the source by lowering rates to customers or should go to stockholders of the operating companies or into a reserve account for their protection. This is the tangle which the Federal Trade Commission has been set to unravel, and there appears to be a very general belief that when the job is done it will appear that there is ‘something rotten in the State of Denmark.’ As evidence of the suspicions which are burrowing in the public mind, there is an interesting paper by Maurice R. Scharff in the September Atlantic Monthly. He is described as ‘a consulting engineer with a long experience in the very business he discusses’ — namely, ‘the finance, engineering, and management of public utility corporations,’ and the picture which he draws is dismal enough. After opening with an imaginary example showing that it is clearly within the power of these holdingcompany managers to pay their stockholders enormous profits on a trivial capital investment, and that, as things now stand, the regulating commissions are helpless to prevent it because the financial structures are of so labyrinthine a character that only the insiders can find their way through them, he proceeds to show that because strong temptation exists it is to be presumed that many, if not most, of those tempted will fall. This point of view shows a surprising family likeness to Calvinism, with its doctrine of original sin and the fall of man.

Now I should be the last to deny that Calvinism has been a powerful, perhaps a controlling, economic force among Western nations during the last two or three centuries. The doctrine of original sin and the doctrine of election by the Almighty have done yeoman service in the economic as well as in the theological field; but, like all human inventions, they have outgrown their usefulness, and although they are still used as a pious gesture by many worthy people no one now thinks of applying them to himself, and the time has come when they should be given a decent Christian burial. But with Mr. Scharff and many other earnest men they seem to have undergone a sort of transmigration and now inhabit those useful, but artificial, bodies which we call corporations. Their life in this body, however, if they ever have any, will be short, for corporations are nothing but the groups of men who work through them, and what has been found untrue for men is untrue, and therefore misleading, when applied to corporations also.

At the moment these dogmas display a somewhat artificial vitality under the stimulation of frequent investigations by the Federal Trade Commission, by committees of Congress and committees of state legislatures. These are sowing suspicion broadcast with both hands, and a man — even a trained engineer like Mr. Scharff — may well be pardoned if he despairs of finding an honest corporation manager. But, if he will look behind the scenes, he may find that the politicians who get up and use these investigations are not quite so disinterested as they appear. The doctrine of salvation for the elect, — that is, for the elected, for those chosen by votes which can sometimes be hired, in a pinch, like a taxicab, — if used to sweep the country into an experiment with government ownership of public utilities, or, failing that, into the creation of new administrative commissions for their rigid control, will provide a great number of well-paid sinecures for the faithful.

The danger is serious, but we need not despair. The doctrine of the fall of man is false; most men are honest, and small harm would result if all men were presumed to be so. Experience has shown us that all men are as honest as they can afford to be; they sin because they are tempted beyond their strength and many men who have done dishonest things become trustworthy when they arc trusted. Before condemning men, we do well to consider whether we have not ourselves led them into temptation and whether the sin is not more ours than theirs. Before concluding that public utility managers are dishonest men, ask yourself how they have been tempted and whether they have been fairly treated. In my judgment, to say that these men are more often dishonest than men in other industries is a lie, and to follow the track of this lie is well worth the effort.

Mr. Scharff, and others of his ilk, assume that there is widespread dishonesty among the managers of public utility holding companies; that the Federal Trade Commission will show them up, and that they had better make haste to put their places of business in order before they are raided by the police. He is trying, as it were, to give the owners of the ‘ speak-easies’ a friendly tip in advance.

As a method of putting things in order and keeping them so he recommends a dictator for the whole public utility industry, who would have full inquisitorial powers and, by means of the weapon of publicity, could compel wrongdoers to mend their ways or suffer public execution. But the wisdom of such a course may well be doubted. Its purpose is to reëstablish public confidence in an industry already accused of seeking illegal monopoly, and it is highly improbable that confidence would be restored by making it a monopoly in fact under the rule of a beneficent tyrant. This is what the proposition means, for a dictator who had the power and the means to investigate and divulge the inner workings of every operating unit and every holding company in the electric industry would hold them all in the hollow of his hand.

This seems to me an important practical objection to the remedy which Mr. Scharff puts forward. But what is more important is that in basing it upon an outworn religious dogma he has committed himself to a principle which is false. He assumes that all men who act dishonestly are dishonest, but as a matter of fact many honest men will act dishonestly under compulsion, and especially when they feel that they have been unfairly treated. In the last twenty years I have known many of the men who manage these holding companies. As a class they are far above the average of intelligence and integrity, and yet I do not doubt that some have been driven into devious courses by the methods of regulation used by state regulating commissions.

Practically all the states have statutes establishing commissions for the purpose of regulating rates and the quality of the service of all public utilities doing business within their jurisdiction. Their most important task is to determine whether the rates charged are just and reasonable. So far as rates are concerned, this is their whole duty. No commission in the land is directed to regulate profit; rates and rates alone are to be regulated. The statutes creating the commissions did not aim to declare any new principle of law, but merely to set up new machinery for administering principles which are older than the common law. The principle that prices shall be just and reasonable is very ancient, and it was for the purpose of establishing such rates that the price-fixing powers of the state commissions were given them.

But the commissions have gradually slipped away from this position, and instead of regulating prices so that they shall be just and reasonable they now more commonly regulate profits. Although this deviation from their true course has already done great damage and will do more, it has passed almost unnoticed because it is assumed that the only way to regulate prices is by regulating profits, although in all competitive markets profits are regulated in the most satisfactory manner through the regulation of price. Because monopoly has been established in the field of local electric supply, it is assumed that competitive prices cannot be found and that there is therefore no way to establish just and reasonable prices except by regulating the profits of the operating companies. This assumption is false, and to it can be traced the major ills of this industry.

Those who are interested in the origin of this principle of rate regulation should consult the famous case of Smyth v. Ames, decided in 1898, in which a rule was laid down by which a court could determine whether a rate, or price, fixed by a state commission was so unjust and unreasonable as to constitute a taking of property without due process of law. This rule followed the ancient economic doctrine that price is determined by the cost of production, and indicated a method for valuing the property of the railroads involved in the case and for estimating a fair rate of return on the value thus found; by adding this sum to the operating expenses, a figure for the gross income which the railroads should be allowed to earn was built up. Just and reasonable rates were defined to be such rates as would produce this gross income.

Although this rule was never intended as a formula for rate-making by a regulating commission, it has been remodeled into a dogma which is almost universally used for this purpose. The underlying assumptions are, first, that public utilities are monopolies, and that therefore price cannot be fixed by competition; second, that, price being determined by cost, the cost (usually called the value) of the property of the public utility used in producing the service is the predominating element of cost which requires determination. This is the dogma on which modern rate regulation rests. Now I approve of dogmatism, provided I am allowed to select the dog; but as I regard this as a dog of uncertain parentage, long since dead, and urgently in need of burial, I decline to choose him.

The dogma on which I pin my faith would read somewhat as follows: —

First, public utilities are not monopolies so far as the price of their service is concerned. When the case of Smyth v. Ames was decided the railroads affected were monopolies, but to-day the utilities with which we are concerned have little more monopoly control of price than the manufacturers of shoes. Each power company has a monopoly of the sale of its product in its local field, but, with the exception of the trivial part of it used for lighting, the product must be sold in competition not only with other power produced by the potential customers for their own use, but also with an almost infinite variety of substitutes. In former times we were accustomed to think of competition as the rivalry of like with like, but nowadays every merchant has learned that his real rivals are substitutes which satisfy other wants of his customers and thus deprive them of the wherewithal to buy his goods. This is often called the new competition, although it is by no means new. I repeat that electric power companies have very little monopoly power over price, and that price can and should be determined by the competitive method of price comparison. This can be done without direct competition.

Second, cost does not determine price except under static conditions such as do not now exist in the electric power industry in America. On the contrary, price determines cost, and therefore no amount of information as to the cost of production will enable a regulating commission to determine the just and reasonable price for any specific kind of service.

Third, profit is the spur to private initiative; without it ambition and progress are destroyed, and therefore profit regulation as a method of price regulation is vicious. The present tendency of regulating commissions to determine net income, or profit, and to regulate that is wholly opposed to the best interests of the customers. They are interested only in the prices they have to pay, the aggregate of which is the gross income; and the method of profit regulation is defective because it deals directly with only about a quarter of the gross income, the other three quarters consisting mainly of operating expenses over which the control of regulating commissions is now very feeble. As a result the investor is pampered, while the consumer, whose interest should be paramount, is neglected. It is entirely possible to regulate gross income — that is, prices — directly, and if this is skillfully done profit will be effectively and justly regulated. To-day this is not done. Profits are not regulated — they are confiscated. This is unjust and shortsighted. For profits are the source of all our wealth. When they are confiscated, property is confiscated, because in the last analysis the value of industrial property is mainly the capitalized expectation of profit, and to protect property you must protect profit. To tamper with a profit justly earned — that is, a competitive profit — is to apply the axe to the tree of wealth. If the competitive method of price regulation were substituted for the present method of profit regulation, this grave danger would be avoided. In my opinion it can be done.

I am aware that to assert these propositions without proof is rank dogmatism, but the reasoning by which they can be sustained is technical and would lead me far away from my present subject, which is to indicate some of the grave evils resulting from the methods of regulation now in use. At another time and place I shall be glad to break a lance with any man in their defense, but I hope he will not choose the select and cultured readers of the Atlantic Monthly as the jury. They might simply regard the combat as an unseemly brawl and call in the police.

II

Returning now to the managers of the holding companies whose methods are under investigation, it is quite generally believed, and often said, that their standards of business ethics are low. But let us call a spade a spade. What the promoters of the investigation really believe is that these men are guilty of theft, and they expect to prove it. Perhaps they may; but if by theft we mean taking property which belongs to someone else, I make bold to assert that the Government has forced them into it by the methods of profit regulation now in use. If stealing is going on, the Government began it. Even honest men will rebel against unjust treatment. When profits are regulated instead of prices, the temptation to carelessness, or even crookedness, in the handling of operating expenses and capital charges is very great. A man who has worked hard to earn a profit in a competitive field like the electric power business may be pardoned if he uses every weapon within his reach when he sees that profit threatened. This is the position into which the regulating commissions have driven the public utility managers by applying old economic theories to new conditions. The old dogma that the value of the use — that is, the price — can be determined from the cost of the tool has resulted in practice in the regulation of net income and the neglect of the other elements which really determine price. In consequence we have developed a highly complicated game of hide and seek in which the managers try to conceal or divert the real profits so that they shall not appear in the net income, which is the figure most closely scrutinized. Some attention is given by regulating commissions to operating expenses, but it cannot be searching, because under private ownership it is the right of the managers to control these items. These are the major items of cost, and when the price schedules have been approved by the regulating commissions it is the business of the managers to select and bring into existence those costs which they think will benefit them most. This is the true function of all management. But when, as now, the profits resulting from this selection are subject to regulation, the managers are tempted to devise some way of manipulating these operating costs so as to get a profit out of them. This is the charge now brought against the holding companies, and there is no denying that there are many ways of doing it which are quite impossible for regulation to detect.

Here, for example, is a situation which often occurs. After years of work and anxiety the managers of a holding company may have worked out for one of their operating units a schedule of prices which suit the customers so well that they will buy the service in such quantity as to show a handsome profit, and to this schedule of prices the managers have obtained the approval of the regulating commission. But, as things are now, their profit may be taken away from them if it happens to exceed what the commission regards as fair. Confronted with this dilemma, can you blame a manager if he seeks some way to camouflage the position by introducing some intercompany profit into the operating expenses which, while increasing them and reducing the apparent profit, will in fact keep the profit of the holding company intact? No one can justify such a proceeding by any ethical standard, but before we condemn those who resort to it we should consider who led them into temptation. ‘ Call a dog a bad name and he will bite you.’ Tamper with a man’s hard-won profits and you may drive him into sin. If it is shown that some of the managers of these holding companies have been driven into devious courses, it is the Government which should hang its head. It has led them into temptation. Whatever the outcome of the present investigation, this thing should be stopped, because, if it goes on, we shall have a fine crop of sinners. Honest and able men will be driven from the field, and only those who are willing to resort to the use of devious methods will remain.

If prices have been properly determined by the competitive method, the profits, whatever they may be, belong to the owners — that is, to the stockholders. Under extraordinarily able management profits will be above the average; under a stupid or incompetent one they may approach the vanishing point. But the customers need not worry in either case, because they may be sure that a business which has shown such stability will always be carried on. An incompetent management may not be able to earn a profit at competitive — that is, reasonable — prices and the company may temporarily require the protecting hand of a receiver. This is bad for the stockholders, but that is their lookout. The customers need not worry; a more capable management can easily be found, and the business will surely go on without interruption.

There are many cases on record where the customers have allowed themselves to be stampeded, by threats of the impairment or interruption of the service, into rescuing the stockholders from the fate which they have brought upon themselves, and in so doing the customers have imposed upon themselves a needless burden. The Boston Elevated Railway Company Control Act is an example. Such weak-mindedness is damaging to all concerned in the long run. If stockholders are allowed to reap what they have sown, they will learn wisdom by experience, and the industry will be kept in healthy condition.

There seem to be many persons who believe that it is the duty of the State in its regulation of public utilities to protect not only the customers but the stockholders against their own managements. Under the present methods of profit regulation, where minute supervision of security issues by regulating commissions is the common practice, this may be true. It is another of the unfortunate results of the erroneous theory that cost determines price. When the type of securities to be sold to the public and the price of issue are fixed by commissions, they can hardly shirk some responsibility for the consequences, although investors in the securities of the New England railroads have reason to know that they do. But if price instead of profit were regulated the State need not concern itself with what becomes of the profits of public utility companies any more than of other corporations. The stockholders are the owners; they elect the directors who supervise the management, and, so far as most stockholders are concerned, it is a sheer impertinence to put them under the guardianship of public officials who commonly know less about how the business should be carried on than they do.

We have a right to expect our Government to protect us against fraud in the purchase of a bond or a share of stock as well as in the purchase of a horse, and in exactly the same manner. But beyond this protection should not go. We demand the right to make our own mistakes; they are commonly better teachers than success. The right to lose is as sacred as the right to win; in fact, it is the bottom of it, and you cannot slice off the right to win so thin as to leave it bottomless. Cut off the right to lose, and the right to win is gone. This is a fact of nature which our lawmakers will do well to heed.

Those who exhibit so much apprehension at the possible misdeeds of the managers, engineers, and financiers of the public utility holding companies may find their fears somewhat allayed and may see their course more clearly if they will ponder upon these three propositions: —

1. ‘Don’t try to make a silk purse out of a sow’s ear.’ The material of which rate regulation is now fashioned is old and so full of holes that it does not protect the customer from the east wind. Try a new piece, and most of the evils which now plague us will disappear. Those that remain can then be clearly seen and can be dealt with.

2. Don’t expect more of public utility managers than you expect of yourself. They also are men.

3. Don’t overprotect the stockholder. You may injure him, and he will not thank you.