A Reviewer's Notebook - 1979/5

In the now distant Nineteen Thirties Senator Joe O’Mahoney of Wyoming carried on a one-man crusade for the federal chartering of corporations. I remember his expounding on his favorite thesis that the corporation was a special creature of the state, a fictitious entity with no inherent rights of its own. He hoped a federal incorporation law would help the work of that other fractious Wyoming native, the trust-busting Thurman Arnold, in prosecuting alleged monopolies.

Creatures of the state, said O’Mahoney, should obviously be subject to license by the state. True enough, the majority of big American corporations seemed to be incorporated already in the state of Delaware, so why the need for federal chartering? O’Mahoney’s logical answer was that the normal corporation was set up to do business on a continental scale, so it was to the federal government that it should apply for the right to exist.

O’Mahoney’s crusade, a casualty of World War II, has been pretty much forgotten, but now Ralph Nader has picked it out of the dustbin of history without much concern about giving his predecessor credit for it. The new life that Nader has pumped into the O’Mahoney theory has provoked Robert Hessen, an authority on the steel industry, into joining issue with Nader and all his anti-corporate raiders. Hessen’s own trail-blazing book on corporate theory, In Defense of the Corporation (Hoover Institution Press, Stanford, California 94305, 127 pp., $7.95 hardcover) is an eye-opener to me, for I had always considered that the one issue of corporate limited liability did involve a special state dispensation. Mr. Hessen now tells me that I have been wrong, and he puts up a strong historical and legal argument for his case.

The notion that the corporation is a creature of the state is deeply embedded in the common law. The reason for this, says Hessen, is that in feudal England, when the common law evolved, only the king had the power to endow groups of individuals with special rights—really permissions—to do anything. Guilds, with royal charters, were empowered to establish their own price and wage controls. The medieval church, a corporation, held its lands in feudal tenure. Every association, from a university to a hospital, was in or of the system set up by William the Conqueror to insure that nobody should have an inalienable right of his own. In the late seventeenth century, parliament cut itself in on the deal, assuming its responsibility for protecting "English liberties," but it was never conceded in England that any right was "inalienable." It took the Virginian, Thomas Jefferson, to assert inalienability for the American colonials.

Unfortunately, that other Virginian, Chief Justice John Marshall, who was steeped in the legal commentaries of Sir William Blackstone, chose to paraphrase English authorities going back to Lord Chief Justice Coke when, in the Dartmouth College case of 1819, he declared that "a corporation is an artificial being, invisible, intangible, and existing only in contemplation of law." Marshall’s opinion has ruled ever since. But why, so Hessen asks, should precedents evolved by the courts to apply to medieval feudal institutions be extended to business corporations created centuries later to expand the inalienable idea of freedom of association to the marketplace?

Matters of Contract

Against the medieval Nader idea that the corporate features of "entity status, perpetual life and limited liability" are state-created privileges, Hessen poses his own "inherence theory." To do this he has to break down the distinctions ordinarily made between partnerships and corporations. In Nader theory, which derives from tradition, a partnership is an aggregate, an association of individuals acting together to pursue such things as the making of a profit. Unlike a corporation, it does not have a legal being that exists independently of its owners. The proprietors of a partnership incur unlimited personal liability for business debts. They can be sued for all they own. But if a corporation cannot meet its obligations, shareholders can’t be assessed to cover deficits.

This is the theory of the matter, but Mr. Hessen finds it deficient. Looking at actual business practice, Mr. Hessen says that "entity status, perpetual duration and limited liability" are all contractual matters. Partnerships can avail themselves of them, too. Entity status happens to be an optional feature available to unincorporated businesses including partnerships (owners can designate trustees to represent them in lawsuits, for example). Partners can make their enterprise perpetual by adopting a continuity agreement specifying that the firm will not be liquidated if one of the partners dies or withdraws.

As for limited liability, how is it to be explained by contractual theory in contrast to state-created privilege? Mr. Hessen says limited liability is actually the result of an implied contract between corporate owners and their creditors. It is a freely accepted and negotiated market transaction. You do business with a corporation on the understanding that your "right of recovery" (the phrase is Adolph Berle’s) is limited to what is in the corporation’s common fund. As for partners in a partnership, they may safeguard themselves by purchasing liability insurance. This amounts in practice to a limitation on their liability. Corporations use liability insurance, too.

So, if Hessen’s line of reasoning is to be followed, there is no real difference between partnerships and corporations when it comes to the rights of individuals making use of them to do business. Mr. Hessen speaks of the rights of individuals to pursue goals. No matter what form of voluntary venture they choose, they neither gain nor lose any of these rights. Regardless of the type of organization a person selects, it can only acquire those rights which its members possess as individuals.

No Special Privilege

The English legal historian, Frederick Maitland, noted in 1900 that the description of a business association as a corporation was "a mere labour-saving device, like stenography or the mathematician’s symbols." The use of the symbol should not be to obscure the individual rights of its members, whether they are shareholders, directors or officers. At every stage of growth, a corporation is still a voluntary association based on contract. At no stage is it dependent on state-created privileges.

In history many corporations have evolved out of partnerships. They do this when the proprietors, finding it inconvenient to operate as so many individuals possessing agency powers, decide to choose one or a few of them as managing partners and remove agency powers from all the others. From here on the way to reorganization as a corporation, with the partners becoming the original shareholders, is an easy one. Mr. Hessen asks a single question: at what point in the continuum from partnerships to corporations do individuals lose their rights? At what point does an enterprise become a "creature of the state"?

Galbraith, before Nader, is responsible for the theory that corporations are actually huge "private governments." But this, says Hessen, obliterates the distinction between politics and economics. Governments can compel obedience to their laws and forcibly collect taxes. Businesses, on the other hand, can only succeed by offering something of value in an uncoerced exchange. To force a merger of state and corporation, which Nader wants to bring about, would scramble everything. It is what Fascism tried to do, and it did not work.

THE NEW PROTECTIONISM: THE WELFARE STATE AND INTERNATIONAL TRADE by Melvyn B. Krauss

An International Center for Economic Policy Studies Book (New York University Press, Washington Square, New York, N.Y. 10018, 1978)

114 Pages

Reviewed by Amy Mann

Superstition dies hard. Over two hundred years ago, Adam Smith exposed the fallacies inherent in the protectionist practices of England (and other nations) at that time. Trade between nations was scarcely free. Today we can pick up any newspaper and read the latest demands of a myriad of industries and special interest groups—e.g., the steel producers, shoe manufacturers, sugar growers, labor unions—all seeking protection from "unfair" foreign competition.

Protectionism has been with us for a long time. How, then, does the "new" protectionism of the title differ from the "old" protectionism? Economist Melvyn Krauss, of New York University, answers this question admirably. There is, he says, not only an increase in the amount of protection, but, more important, a difference in its form. He considers a number of factors responsible for this situation, and traces most of them to the growth of the welfare state.

Welfare state policies have definite effects on international trade. The growth of the new protectionism in the Western nations parallels the growth of welfare or interventionist economies at the expense of market economies. The author’s "new protectionism" takes into account all forms of government intervention into the private economy.

The system of world commerce set up by GATT (the General Agreement on Tariffs and Trade) after World War II envisioned international trade as free from domestic intervention and protection as possible. The rationale for the GATT agreements was that free trade increases consumption alternatives for everyone, and the economy as a whole benefits. Free traders fear that protection of special interests can increase the role of government in society, which can in turn lead to more centralization and thus jeopardize the autonomy and freedom of markets. Protectionists, however, argue that economic benefits for special interest groups (usually their own) are more important than the general benefits to the whole of society.

If there must be some form of protection, free traders would choose tariffs over quotas or other non-tariff barriers to trade. Tariffs distort prices, consumption levels, and resource allocation, but they are still more compatible with the free market system than non-tariff interventions, which do not work through the price mechanism and cannot always be recognized for the harm that they do.

Professor Krauss discusses at some length the effects of the numerous non-tariff restrictions on free trade. A partial list of these would include domestic subsidies, export subsidies, cartels, environmental measures, government procurement policies, and adjustment assistance payments to workers and managers. He also analyzes the effects of massive income redistribution on "capital flight," "guest workers" (migrant labor), and the volume and terms of trade between nations.

One form of protection which is relatively new is protection of the environment. The rallying cry of environmentalists is that we all have the "right" to a clean and safe environment. Further, it is the duty of government to bring this about. What is often accomplished instead, however, is protection of domestic industry. Take automobile safety standards, ostensibly designed to clean up the air, or to prevent accidents. In effect, these regulations keep out of the United States certain very popular and reasonably priced foreign cars such as the Fiat 500 and 600 models. The intent of the regulations may or may not be to keep out the imports, but that is the result. Motive here is unimportant.

In explaining the mentality which leads to welfare and protectionist measures, Krauss quotes Daniel Bell, who has spoken of "the revolution of rising entitlements." Welfare statists insist that every person has a right to economic security, a right to the job of his choice in the place of his choice, and almost at the salary of his choice. Again, citizens have the right to be shielded from changes which may bring them economic adversity, or force them to find other employment. Whole industries also—as well as private citizens—claim the right to be protected from economic dislocations.

But at what price to the individual consumer? Industries receiving protection are the weak, inefficient ones. Wages rise too high relative to productivity. Consumers are forced to pay higher prices, often for inferior goods,. and consumption opportunities are reduced. Disincentives to produce run rampant. Why work hard? A government committed to "cradle to grave" security will presumably bail out any firm or industry, regardless of economic performance. Over-regulation and high taxation stifle investment and production.

While taxes rise to pay for new programs, people do everything possible to avoid paying them. Workers and professionals take a higher proportion of their income in the form of leisure time. Barter, a growing form of tax avoidance, reduces the efficiency of the economy. Finally, a hidden purpose of so many of the protectionist programs comes clear: to redistribute income from savers and producers to nonproductive individuals. Egalitarianism is touted, while the competitive spirit and work ethic are undermined.

An economy can be likened to a living organism which, if it is to grow and thrive, must be able to adapt to the demands of a changing environment and must receive adequate sustenance (capital). High rates of social welfare expenditure keep the economy from adjusting to change and impede capital formation. Stagnation inevitably results. Or, as Professor Krauss concludes: ". . . the welfare state is self-destructive. It both depends upon economic growth and destroys it. In the long run, the demand for a secure economic income at a given level or rate of increase, regardless of the changes that are being wrought elsewhere, proves illusory because the attempt to attain secure income reduces the ability of the economy to produce it."

The New Protectionism is highly recommended. Economists and laymen alike can learn much about the consequences of interventionist policies on international trade and investment. Considering the recent experience of England, American legislators who vote for such measures would be well advised to read this book.