The (rail)road to Lochner :

reproduction cost and the Gilded Age controversy on rate regulation

Nicola Giocoli

University of Pisa

nicola.giocoli@unipi.it

https://pisa.academia.edu/NicolaGiocoli

http://ssrn.com/author=92886

The controversy over railroad rates regulation represented a fundamental component of the jurisprudential trajectory

that, culminating in Lochner v. New York, led to the era of so-called laissez faire constitutionalism. Constitutional

protection of property required that regulation be such as to preserve the value of the regulated business. The paper

builds on Siegel 1984 to argue that, by indicating in Smyth v. Ames (1898) reproduction cost as the correct technique

to calculate the value of a railways, the Supreme Court retained its allegiance to the fundamental tenets of classical

political economy even in a period of massive economic transformations, when classical economics was increasingly

viewed as unable to capture the new reality of American industrial life.

Keywords: reproduction cost, historic cost, business valuation, railways economics, Lochner, laissez faire

constitutionalism, regulation, Gilded Age

JEL Codes: B13, K23, L51, M21

Word Length: 14,800 (approx.)

This version: April 2015

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The (rail)road to Lochner :

reproduction cost and the Gilded Age controversy on rate regulation

§1. Introduction

By the term laissez faire constitutionalism (LFC) it is meant a phase in the history of American

constitutional law that spanned from the late 19th century to the first decades of the 20th century. Most

historians recognize LFC’s chronological extremes in Allgeyer v. Louisiana (1897) and West Coast Hotel v.

Parrish (1937), and the pivotal case in the arch-famous Lochner v. New York (1905) – hence the alternative

name, Lochner era, often used to identify the period.1 In the most succinct terms, LFC may be summarized

as the forty years during which the Supreme Court substantively applied the due process clauses of the

Fifth and Fourteenth Amendments of the American Constitution to strike down various state and federal

laws that infringed the constitutional rights to property and liberty of contract. Thousands of pages have

been written by law historians about Lochner, its origins and its aftermath. While everybody agrees that

economic ideas played a fundamental role during LFC, a significant debate exists about to what this role

actually was, as well as about the exact nature of Lochner’s economics.2 Was it classical or neoclassical? A

broad philosophy or a specific set of analytical results? This paper contributes to this literature from a

different viewpoint, that of the history of economic thought, and by focusing on a seemingly lateral issue,

rate regulation.

In a landmark 1984 essay, De Paul University law professor Stephen Siegel has explained how the legal

controversies of the Lochner era involved both substantive values and methodological issues. The former

concerned the validity of the traditional distinction between property and privilege; the latter explored the

limits of judges’ discretional decision-making. Siegel’s main thesis is that both kinds of controversies

stemmed from the transformation of the American economy from one based on small-scale, decentralized,

individual businesses to one where large-scale, concentrated, corporate enterprises prevailed (Siegel 1984,

188). This thesis, and the rest of Siegel’s essay, inspired the present paper and will be our guiding light.

The constitutional doctrine of government regulation was among the areas of American law where the

above-mentioned transformation had the amplest effect. The legitimacy of state and federal interferences

1 Allgeyer v. Louisiana, 165 U.S. 578 (1897); West Coast Hotel v. Parrish, 300 U.S. 379 (1937); Lochner v. New York, 198 U.S. 45 (1905). 2 See, among many others, Benedict 1985; Hovenkamp 1988; Gillman 1993; Kens 1998; Strauss 2003; Frankel Paul 2005; Ely 2006; Bernstein 2011; Epstein 2014.

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with the economy – themselves made necessary by the new industrial conditions – was the subject of an

intense scholarly debate that involved jurists and economists alike. One of the hottest issue was how to

evaluate a business in the presence of rate regulation; this in order to avoid the regulated rates being an

unconstitutional taking of the business’s property. Given the constitutional protection of private property,

only if government fixed rates that guaranteed business owners a “fair” return over their investment could

regulation pass constitutional muster. Before establishing what “fair” meant, how should such investment

be evaluated in the first place?

Valuing a business has never been easy, then like today. After flirting with other techniques, the US

Supreme Court eventually reached a consensus upon the reproduction cost method, namely, the idea that

the value of a business (like that of any other thing) is equal to what it would cost to reproduce it today.

This doctrine, established with the famous Smyth v. Ames decision,3 would hold sway for the next five

decades, thereby substantially overlapping with the Lochner era. The story of how and why the Supreme

Court converged to this solution and of the controversies that accompanied it is the subject of this paper.

It will be argued that the Smyth doctrine represented an essential component of LFC,4 in that it embodied

exactly the same economic worldview of, say, Allgeyer or Lochner. This worldview was, in a nutshell, that of

classical political economy, as distinguished from classical economics.5 Indeed, the Justices unanimously

agreed on the reproduction cost method precisely because the technique was grounded on the idea of a

businessman’s free choice in a freely competitive market, viz., on the true hallmark of the classical

approach that retained its validity even in a transformed economic landscape where other analytical pillars

of classical economics, such as the profit equalization theorem, could not hold anymore.

§2. The property v. privilege dilemma

Traditionally, property denoted only those valuables whose acquisition was open to everybody, typically

through work and saving. In this sense, Siegel observed (ibid., 190), property stood in contrast to privilege,

which identified “those assets that only specially designated individuals could acquire, characteristically

3 Smyth v. Ames, 169 U.S. 466 (1898). 4 This also in a purely quantitative sense. As demonstrated by Phillips (1998), rate regulation cases represented a significant share of LFC jurisprudence and an even bigger one of the decisions actually endorsing LFC principles. 5 By political economy it is meant here a specific view on the relation between individuals and society, the market and the state, which draws upon fields as diverse as economics, political science, philosophy and sociology. As Joseph Schumpeter called it, a system of political economy is “an economics that includes an adequate analysis of government action and of the mechanisms and prevailing philosophies of political life”, “an exposition of a comprehensive set of economic policies” that are advocated “on the strength of certain unifying normative principles” (Schumpeter 1986 [1954], 22, 38).

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through special governmental act”. Privilege endangered equality, harmony, freedom, and the overall

economic and political liberty that property itself helped establish. In particular, privilege corrupted

government away from the pursuit of general good towards that of individual self-interest. The conflict

over the implications of what, borrowing from Siegel (ibid.), we may call the “property v. privilege”

dichotomy was central to 19th-century political debates. Both liberal reformers and conservative defenders

of vested rights praised property and condemned privilege in general. Both identified the source of

property in market forces and that of privilege – in the form of, say, monopoly grants – in government

power. However reformers thought of privileges as a necessary evil, to be used only when policy goals

could be met by no other means and requiring close public supervision and control. Conservatives, on the

other hand, perceived fewer types of wealth as privilege, found more occasions that properly called for the

grant of a privilege and were equally concerned with the vested rights of the individuals who received

privileges vis-à-vis the government power of control and regulation (ibid., 191).

The standard dichotomy was seriously questioned by the post-Civil War advent of large-scale business, a

phenomenon that took place thanks to, rather than against, market forces. Now economic privilege, i.e.,

monopoly, did not necessarily stem from government intervention. New economic conditions allowed the

achievement of market dominance through private market activity rather than government grants – what in

the jurisprudential jargon of the time were called “virtual monopolies”. The dilemma arose about what to

do with the free play of market forces.

The usual recipe – do nothing at all – could even appear counter-productive. In a shocking reversal,

government was now invoked by powerless individuals as a curb against rising monopoly power. To the

eyes of a late 19th-century, reform-oriented commentator, it looked like revenge: “Feeling […] his

impotence [against monopolies] the individualist turns to the State, and invokes its assistance as against an

enemy that is sapping the foundations of the national existence. […] the doctrine of Munn v. Illinois may be

regarded rather as an effort of individualism to stem the rising tide of combination, than as socialistic; a

stand made by the individual rather than a move forward of socialism” (Foster 1895, 77).

Foster’s account was only partial, though. On the one hand, his remark that, market forces being

impotent against big businesses, government remained the only possible defense was quite on target. On

the other, he failed to recognize that allowing government to prevail over these large-scale enterprises

could lead to undue political domination over the economy and, through the economy, the whole society.

Aware of the multiple and complex sides of the regulatory dilemma, American jurists, whether liberal or

conservative, endeavored to handle it by redefining no less than the substance of constitutional law. One

way or the other, Siegel argued (1984, 260), their privileged response was to constitutionalize the free market.

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The above reference to Munn v. Illinois was not casual. That landmark decision – where the Supreme

Court had famously established that state regulation was constitutionally legitimate for every “business

affected with the public interest” – had triggered a double controversy in constitutional law.6 By

legitimizing rate regulation, the Court had not only put the “property v. privilege” theme at center stage,

but had also sanctioned the existence of an unreviewable legislative control over prices. Again in Foster’s

words: “the principle that really received the sanction of the [Munn] Supreme Court was the right of the

government to interfere with all private property, with its use and enjoyment, whenever it considers it

necessary for the public good to do so” (Foster 1895, 71). According to him, Munn could now be read as

an instrument to protect the classical liberal principles of individualism and competition against “the rising

tide” of monopoly. However, many jurists had attacked Munn on both fronts. They rejected the Court’s

doctrine that all businesses “affected with the public interest” be subject to rate regulation. They also

discarded the narrower view that at least “virtual monopolies” might properly be regulated.

The rationale for distinguishing between permissible and impermissible rate regulation resided in the

“property v. privilege” dichotomy. In a dissenting opinion given as a New York judge, the future author of

Lochner, would-be Justice Rufus Peckham, refused the Munn doctrine.7 The roots of Peckham’s argument

lay in classical economic theory – specifically, in the categorical distinction between de jure and de facto

monopolies. He argued that only wealth obtainable by government privilege (de jure monopolies) was under

the discretionary control of public power because government “could condition its grants of privileges as it

wished, just as the common law grantor of property could insert restrictions upon its use” (Siegel 1984,

203). But the boundary of property obtainable by market means could never be overstepped: that kind of

property had to remain immune from regulation. Nor was regulation necessary in those circumstances.

Market forces, Peckham (and classical economists with him) guaranteed, would always suffice to eliminate

de facto monopolies.

This solution – dictated as it was by the principles of classical economics – met serious troubles when

faced with the self-sustaining rise of large-scale industrial concerns that characterized the American

economy of the Gilded Age. Rather than dissolving them, market forces now favored the rise of de facto

monopolies. Still, the Munn’s category of “virtual monopoly” seemed too discretionary to suit many jurists’

tastes. Contrary to the “property v. privilege” distinction, which turned upon such notorious facts as the

enactment of special legislation, a finding of “virtual monopoly” was so intangible and debatable – relying,

as it did, on a vague, unscientific notion of market power – that it invited either uncontrollable legislative

6 Munn v. Illinois, 94 U.S. 113 (1876). On both controversies, see Siegel 1984, 199-209. 7 People v. Budd, 117 N.Y. 1 (1889). This case, like Munn, involved legislative efforts to regulate the rates charged by an allegedly monopolistic grain storage and handling facility.

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abuse or excessive judicial discretion. In other words, much like every business could be declared as being

“affected with the public interest”, so almost everything could be dubbed a “virtual monopoly”. Even a

supporter of regulation had to concede that, when “the injury to the public, by which the exercise of the

Police Power is justified, is one more of opinion than fact”,8 individual liberty was in jeopardy: “If the final

word as to what is or what is not within the scope of the Police Power be left to a legislative majority, all

security to the citizen is gone; all he has, all he does, would be subject to the veto or the regulation of the

omnipotent half plus one” (Foster 1895, 57). Where to draw the line between excessive discretion and

excessive reliance on market forces?

§3. Value is like title and possession

Historians of law and economics know well that an answer to the previous question was found in the

efforts to control monopoly with the Sherman Act. Another solution would prove more directly conducive

to the Lochner era, though. One could well admit that, under the traditional classification of monopolies, the

prices charged for grain elevator services in Munn or Budd were clearly beyond legitimate regulation. Just as

obviously, however, one would recognize other businesses as falling within the bounds. Everybody for

instance agreed that railroads were specially privileged enterprises: they exercised the sovereign power of

eminent domain and received generous government grants in exchange for their performance of a vital

public function. As a result, it was perfectly possible to claim that the Constitution forbade regulation of

grain elevator services and accept the legitimacy of that very regulation in the case of railroad rates.9

Railroads were of course the issue, as far as regulation was concerned. Already by the 1860s, they

represented the most important business in America in terms of employees, capitalization and social

influence. No surprise, then, that the first comprehensive regulatory measure passed by Congress, the 1887

Interstate Commerce Act, addressed the railroad industry, via the institution of the Interstate Commerce

Commission (ICC). Indeed, by the time of its enactment, states had already been regulating railroads for

the previous half century and courts had been called to adjudicate law several times in regulatory conflicts

between the states, the railroads and the other subjects having an interest in railway services.

Even classical economists could approve such a circumscribed use of regulation. In offering the earliest

complete analysis of natural monopolies – those, as he wrote, “which are created by circumstances, and not

8 Police power was the name given to the constitutional doctrine according to which state governments had the authority to protect the health, safety, morals and general welfare of their citizens by appropriate laws. To perform their task, these laws might even restrain individual rights of liberty or property. Rate regulation’s legitimacy rested on such power. 9 See Siegel 1984, 205-6.

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by law” (Mill, Principles, II.15.9)10 – John Stuart Mill had already explained that, in “the case of a road, a

canal, or a railway”, which are “always, in a great degree, practical monopolies”, the government, by

granting “such monopoly unreservedly to a private company, does much the same thing as if it allowed an

individual or an association to levy any tax they chose, for their own benefit, on all the malt produced in

the country, or on all the cotton imported into it”. For this reason, he continued, “To make the concession

for a limited time is generally justifiable, on the principle which justifies patents for invention: but the state

should either reserve to itself a reversionary property in such public works, or should retain, and freely exercise, the right of

fixing a maximum of fares and charges, and, from time to time, varying that maximum” (ibid., V.11.36; emphasis

added). The classical school thus admitted railways regulation at least since 1848.

Classical liberals would have little to object either. Free resource mobility – the analytical core of classical

economics – was obviously out of question in the case of railways or similar industries. Hence, the “right

of exit” – the possibility of opting out of a certain regulatory framework by moving business somewhere

else – offered no defense against misguided regulation. Moreover, protection of the national market against

the risk of excessive fragmentation caused by excessive state control over business was a traditional

concern for those who wanted to “constitutionalize the free market”. Finally, efficiency required that

network industries, such as railways, be managed at a national level. Combining these features together,

even classical liberals could endorse a limited form of federal regulation as the lesser evil – surely superior,

as a regulatory solution, to state-based regulation that would likely undermine both nation-wide networks

and the national market.11

Alas, railroad regulation was no easy task either. During the Gilded Age, the problem had at least two

facets: how should the railroads be regulated and who, between the states or the federal government,

should regulate them. The latter prong was as delicate as the former – possibly more, in that it touched the

constitutionally sensible issue of the division of power between Washington and the states. The stakes were

so high, both economically and constitutionally, that the jurisprudential answers given to both prongs of

the railroad regulation problem would eventually shape all the other areas of regulatory activity in the US.

To understand what this might entail, consider that admitting regulatory power over rates meant granting

legislatures full control over the value of property. No surprise then that even when everybody recognized

the legitimacy of such power, as in the case of railroads and other privileged businesses, many jurists still

balked at the idea of placing vast amounts of private wealth, accumulated in the nation’s most significant

enterprises, at the mercy of state legislators. The Munn Court had expressly rejected the counsel’s argument

10 “There are many cases in which the agency, of whatever nature, by which a service is performed, is certain, from the nature of the case, to be virtually single; in which a practical monopoly, with all the power it confers of taxing the community, cannot be prevented from existing” (Mill, Principles, V.11.36). On Mill’s analysis of natural monopoly, see Mosca 2008. 11 See Epstein 2014, 152-3.

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that the value of property – viz., its profitability – should receive the same degree of constitutional

protection as the title and possession. Siegel underlines how this aspect of the majority opinion was clearly

anachronistic. By the late 19th century, non-landed wealth had achieved a significance it could not have in

the early decades of the Republic, when the main form of property was land and the constitutional

protection over title and possession sufficed to guarantee individual freedom from external interference. In

modern economies, largely based upon immaterial wealth, value had to be recognized as an essential

element of the constitutional concept of property.12

Long before Allgeyer and Lochner, the Justices would recognize the problem and renege on this side of

Munn. In the so-called Railroad Commission Cases (1886), the Court made a first move in this direction. The

opinion read: “it is not to be inferred that this power of limitation or regulation is itself without limit. This

power to regulate is not a power to destroy, and limitation is not the equivalent of confiscation. Under pretense of

regulating fares and freights, the state cannot require a railroad corporation to carry persons or property

without reward; neither can it do that which in law amounts to a taking of private property for public use

without just compensation or without due process of law”.13 Four more years and, in another railroad rate

regulation case, the Court finally ruled that the Constitution mandated judicial review of the

“reasonableness” of regulated rates. Writing for a 6-to-3 majority, Justice Samuel Blatchford declared in

Chicago, Milwaukee & St. Paul Railway that: “The question of the reasonableness of a rate of charge for

transportation by a railroad company, involving as it does the element of reasonableness both as regards

the company and as regards the public, is eminently a question for judicial investigation, requiring due

process of law for its determination”.14

The 1890 decision marked a turning point in American constitutional jurisprudence on economic

matters. In a complete overturn of Munn, the Court now recognized that regulation was not beyond judicial

review: the Constitution both allowed legislative control of the charges of privileged enterprises and required

courts to substantially protect from spoliation the private wealth invested in them.15 The new doctrine did

not just affect regulatory case law. At the price of expanding the boundaries of judicial discretion, it

established the reasonableness scrutiny over all applications of the police power. Every contemporary

commentator recognized that “[i]f ‘reasonableness’ was essentially a judicial question and therefore

reviewable in the rate regulation context, it was in theory, and immediately became in fact, reviewable in

12 See Siegel 1984, 210. 13 Stone v. Farmers’ Loan & Trust Co., 116 U.S. 307 (1886), at 331, emphasis added. See Smalley 1906, 27-8. 14 Chicago, Milwaukee & St. Paul Railway Co. v. Minnesota, 134 U.S. 418 (1890), at 458. See Smalley 1906, 32-8. 15 See Propositions I and IIA in Matthews & Thompson 1901, 250, 254. On the doctrine of judicial review of regulated rates, also see Smalley 1906, esp. 79-80. A former regulator at the ICC, Smalley lamented that the doctrine marked “a notable triumph achieved by the principle of individual interest over that of the public welfare. […] a movement against the current of the times” (ibid., 109).

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the police power context” (Siegel 1984, 214, fn.122). The Chicago, Milwaukee & St. Paul Railway decision

thus represented a milestone in the journey to substantive due process and, from there, to LFC, of no

lesser importance than the cases typically mentioned in more traditional accounts of the Lochner era.

Nothing could be more substantive than establishing that the rule of reason was to control the police

power doctrine. As it turns out, economic theory had a lot to say about such a rule.

§4. What is “reasonable” regulation?

The difficulty implicit in the new standard was apparent. No test existed that clearly bounded the limits of

“reasonable” regulation. Although the constitutional notion of property now included its value, it was hard

to pin down what “value” meant. Guaranteeing the absolute intangibility of value would effectively bar all

rate regulation. But a wholly discretionary analysis of the relationship between regulated rates and declared

public policy ends would not do either, because it would give too much leeway to judicial opinion vis-à-vis

legislative motives. Identifying a fact-based, non-discretionary notion of value that could determine, both

theoretically and practically, the boundary separating regulation from confiscation: this was the tough

challenge facing American courts. It was here that Justice David Josiah Brewer left his mark.

4.1 Brewer’s test and its critics

In a series of cases in the late 1880s and early 1890s,16 Brewer proposed a clever solution based on the

notion of “just compensation”, itself drawn from the standard doctrine of takings and eminent domain.

His analysis took private, not public, ownership as the natural starting point; as a consequence, any

regulation was fundamentally confiscatory – an infringement of sacred individual rights. That government

should not take property without “just compensation” was an established constitutional principle and the

first substantive due process right from which all others (including contractual freedom) stemmed.

Brewer’s idea was to extend this doctrine to prevent rate regulation from “work[ing] a practical destruction

to rights of property” (Reagan, at 410). He argued that the takings clause necessarily protected shareholders’

property against rates set so low that they did not cover operating expenses and other compulsory

16 Among which, Chicago & North Western Railway v. Dey, 35 F. 866 (C.C.S.D. Iowa 1888); Ames v. Union Pacific Railway, 64 F. 165 (C.C.D. Neb. 1894); Reagan v. Farmers’ Loan & Trust Co., 154 U.S. 362 (1894). Brewer’s doctrine on this theme was mainly developed outside the Supreme Court. As a judge for the Eight Circuit, he gave in Dey the first clear enunciation of the legitimacy of judicial review of regulated rates, anticipating Justice Blatchford’s 1890 statement. Later, as a Justice, Brewer sat in various occasions on the Eight Circuit Court of Appeals, which happened to cover the most active states on regulatory matters. For more details on these cases and Brewer’s role, see Smalley 1906, esp. Chs. II-III-IV; Siegel 1984, 215-20.

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payments, like the service of debt.17 This was a smart way to distinguish permissible from impermissible

rate regulations because it envisaged a clear, fact-based test as a direct offspring of traditional eminent

domain doctrine. The boundary of confiscation was objectively determined by the total of operating

expenses plus necessary charges: a rate that failed to cover this amount entailed an unconstitutional taking

of shareholders’ property.

Brewer’s test had three remarkable features. First, and most significantly on jurisprudential grounds, it

shifted the rate regulation problem from the police power to the takings doctrine, that is to say, from being

a public welfare concern to being a property rights issue.18 The move thus placed the problem firmly within

the realm of classical liberalism and classical political economy – the realm, that is, where protecting

property was, as in Adam Smith’s jurisprudence, first of all a matter of natural justice and equality, beyond

and before than an instrument to maximize social wealth.

Second, the test referred constitutional protection of the “just compensation” value of property to an

array of observable economic values, like operating costs and interest expenditures. This marked the

definitive recognition of the constitutional protection of property as a mutable economic value, rather than

as a static vested right. The test, note well, achieved that result by simply enlarging the category of what

constituted property. It was again an affirmation of classical political economy, in that it guaranteed

substantial – and categorical – defense to property as a sheer matter of justice.

Third, the protection offered by the test did not cover profits, in the form of shareholders’ dividends.

Notwithstanding his conservative inclination, Brewer apparently believed that a difference existed between

bonds and shares.19 In the case of privileged businesses that, like railroads or public utilities, owed their

existence to government permission, the extent of dividends was a discretionary policy issue, involving the

legislator’s estimations of what profit would attract further capital and whether further capital ought to be

attracted. In short, dividends were a matter of privilege that lay entirely within the province of the

legislature. Accordingly, shareholders of a privileged business were only entitled to their ownership rights,

not to any pre-established profit. Bonds were, on the contrary, a pure matter of property. They were “a

creature of the common law, a form of wealth and investment available to all as a matter of right” (Siegel

1984, 218). The contract clause of the Constitution ensured protection from state interference to all kinds

of contracts, including those between a company and its bondholders. While Brewer’s distinction between

stock and debt sounded anachronistic in view of the separation between ownership and control that

already characterized late 19th-century Corporate America, it did represent a proper closure to his brilliant

17 Due to the massive initial investments, debt burdens were a major part of a railroad’s balance sheets. 18 A critic like Smalley deemed the change a “fundamental error” that “vitiated the whole process” of judicial review of rate regulation (Smalley 1906, 89). 19 See Siegel 1984, 217-8.

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solution. Once again, the “property v. privilege dichotomy” had been the key to apply established legal

doctrines to the development of a reasonableness test of regulatory interventions grounded upon non-

discretionary data.

Brewer’s test attracted critiques from all camps. Classical liberals attacked the idea that the return on

capital could be a matter of discretionary policy. Markets, rather than legislators, determined profit as much

as interest. Reasonable regulated prices should therefore include at least a market return on capital, lest

capitals would shun the regulated industry and fly elsewhere. This critique did not especially trouble

Brewer. His test could easily encompass the notion that, as California highest court put it, “no distinction

can be made between those who construct the works with their own money and those who do so with

money borrowed from others”.20 The takings clause could well entitle both to the competitive rate of

return existing at the time of their investment. The final version of Brewer’s test thus set the boundary between

regulation and confiscation at the level of operating expenses plus a competitive rate of return on all

invested capital, evaluated at historical cost.21 Once again, all ingredients in the calculation were objectively

quantifiable by a court. Moreover, in order to avoid easy abuses or sanctioning waste and mismanagement,

expenditures could only be included in the calculation conditionally on their having been “prudentially

incurred”22 – hence the name of prudent investment rule that came to identify the test.

Progressive critics had much to complain about it. The main drawback was that the conditions of late

19th-century American economy made the test excessively favorable to regulated industries, first of all

railways. The reason was the dramatic fall in railroad construction costs since the 1870s.23 Deflation made

the historical cost of investment a high hurdle for regulators to overcome in order to satisfy the prudent

investment rule. The bottom line was that regulated rates could not be significantly lower than current (i.e.,

monopoly) ones. A different benchmark was needed if regulation were to bite, as progressive jurists

desired. Brewer himself gave them an opening.

Writing for the Supreme Court in a 1893 takings case, and called to determine the exact value of just

compensation for condemned property, he had proclaimed the following criterion: “The value of property,

20 San Diego Water Co. v. City of San Diego, 118 Cal. 556 (1897), at 570. 21 What is modernly called rate-of-return, or cost-plus, regulation. See Viscusi et al. 2005, 429-36. 22 “We do not wish to be understood as laying down as an absolute rule, that in every case a failure to produce some profit to those who have invested their money in the building of a road is conclusive that the tariff is unjust and unreasonable”, Brewer wrote in Reagan. “There may have been extravagance, and a needless expenditure of money. There may be waste in the management of the road, enormous salaries, unjust discrimination as between individual shippers, resulting in general loss. The construction may have been at a time when material and labor were at the highest price, so that the actual cost far exceeds the present value. The road may have been unwisely built, in localities where there is no sufficient business to sustain a road” (Reagan, at 412). 23 The general price index fell from a high of 129 in 1864 to a low of 71 in 1894. As to single materials, the wholesale price of pig iron fell by about two-thirds and refined petroleum by over 90 percent. The production cost of steel rails dropped by 88 percent from the early 1870s to he late 1880s; that of aluminum by 96 percent, in the same period. See Perelman 2006, 71.

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generally speaking, is determined by its productiveness – the profits which its use brings to the owner.

Various elements enter into this matter of value. […] The value […] is not determined by the mere cost of

construction, but more by what the completed structure brings in the way of earnings to its owner. For

each separate use of one’s property by others the owner is entitled to a reasonable compensation, and the

number and amount of such uses determines the productiveness and the earnings of the property, and

therefore largely its value”.24 This was nothing but the modern idea that the value of a business is equal to

the present value of its future net earnings. Progressive jurists exploited this notion to build an alternative

benchmark to historical cost for assessing regulated rates.

4.2 Present value and reproduction cost

Present value was itself an ambiguous concept when applied to regulatory issues. What did present value

mean, exactly? If it meant the value of an unregulated business, which by definition included its ability to gain

supra-competitive profits, the whole purpose of regulation would have been defeated. Neither could it

mean its regulated value, that is, the value resulting by employing regulated rates in the calculation of future

earnings. In such a case the constitutional protection of shareholders would have been clearly infringed by

basing the permissible rates on the rates already set by legislators.25 Only one solution seemingly existed.

The proper present value of a business could be no other than the value set by the competitive market. In

other words, rate regulation was confiscatory only when it reduced the overall return of the regulated

business below that obtainable from an investment of comparable size and risk made in a competitive

environment. Needless to say, using competitive markets as a benchmark for “just compensation” rested

upon the solid foundations of classical political economy. Both conservative and progressive jurists could

invoke the authority of Adam Smith and his system of natural liberty to defend the choice as morally, as

well as economically, grounded. How could anyone accuse a court of having exercised excessive

discretionary power if its decision had followed the just light of classical thought? Courts did not miss the

chance to avail themselves in so controversial an issue of a welcome inflow of external authoritativeness.

Under the doctrine of competitive present value, the judicial task was to determine what the value of a

railroad or public utility would have been if operated in a competitive environment. That was again a hard

task, were it not for the help coming from business and engineering valuation techniques. The notion of

reproduction cost provided the answer. While the notion had been theoretically developed by leading

American economist Henry Charles Carey in his Principles of Political Economy,26 it is very likely that late 19th-

24 Monongahela Navigation Co. v. United States, 148 U.S. 312 (1893), at 328. 25 See Siegel 1984, 221. 26 See Carey 1837, 9-12.

12

century courts borrowed the idea of reproduction, or replacement, cost from more mundane sources. For

example, the 1886 volume of the Transactions of the American Society of Mechanical Engineers hosted a paper by a

New Jersey engineer named Oberlin Smith about “Inventory evaluation of machinery plant”. There Smith

discussed the evaluation techniques a business should apply for cost accounting. The problem was to find

out “the true value of property kept account of” (Smith 1886, 433). The only correct answer, he declared,

was reproduction cost: “The grand principle which lies at the root of correct evaluation, and which should

govern the appraised throughout all his work, is, that any article is worth not what it did cost, but what it

would cost to replace it to-day” (ibid., 436, original emphasis).

As a further example, consider a 1886 paper by Brooklyn economist Paul Davis that dealt with the big

national controversy about the outstanding debt of the Union Pacific Railway Co. towards the United

States. One solution being debated was to foreclose the government lien on at least part of the Union

Pacific debt and proceed with selling the railroad lines to anyone willing to pay for them an amount equal

to the sum of the prior lien plus an additional figure determined by the Congress to reach the fair value of

the government claim. The issue was of course to assess the actual profitability of this solution. The

government could not expect to get more than the difference between the value of the properties and the

amount of the prior liens. But, how was the value of Union Pacific properties to be determined? Here

came Davis’s contribution. He suggested to make recourse to the cost of reproduction principle, invoking

the authority of civil engineer and renown expert in railway matters, Richard P. Morgan, who had already

adopted this evaluation technique for the same railway company a few years before (Davis 1886, 68-70).

In a sort of mutually enforcing feedback, the notion of replacement cost owes a lot to the history of

regulation itself. For instance, the concept was employed as back as the 1840s in controversies raised

against the British Railway Commission about the evaluation of capital improvements.27 Accounting

historian Germain Boer confirms that the earliest arguments about replacement cost in the US had no

theoretical foundation or origin, but stemmed from rate cases involving public utilities and heard before

regulatory agencies: “It was in the hearings before these commissions that replacement cost first received

prominence in America” (Boer 1966, 92). In short, railroad regulators used reproduction cost because

engineers and accountants did; engineers and accountants in turn used it because some regulators had.

27 See Pollins 1956, 353.

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§5. The Smyth doctrine

By the last two decades of the 19th-century engineers, accountants and even a few regulators had agreed

that the present value of a business was equivalent to the funds a potential buyer of the whole business

would have to expend to construct anew that specific enterprise, i.e., to the business’s reproduction cost.

This technique rested on the more or less implicit assumption that in a free market buyers always had the

option of building, rather than buying, and should bear the full consequences of their own choice. Once

again, the reference to free – that is, competitive – markets proved crucial in the technique’s success.28 As

Siegel (1984, 222) remarked, under the reproduction cost approach, a businessman in a regulated industry

would reap the fruits, positive or negative, of his own ability: if he had built his enterprise at less than its

current reproduction cost, even regulated rates would guarantee him an extra profit; on the contrary, if he

had spent too much, he would suffer from his bad choices. This was exactly what would happen in the

unregulated market, given that the reproduction cost always identified the exact value of his business.

Of course, calculating the reproduction cost of a railroad or public utility was no simple task, but still no

harder than determining the historic cost, as required by the prudent investment rule. Moreover, it was

again a matter of factual inquiry, rather than mere judicial opinion. This catered to the courts’ needs of

avoiding excessive discretion. In 1898 a unanimous Supreme Court established the reproduction cost rule

in the landmark Smyth v. Ames case.29 Despite mounting criticism (especially after WWI), and a considerable

degree of ambiguity in the Court’s own wording, the rule would remain valid for the next forty years,30

helping judges at all levels to separate rate regulation from confiscation. Owing to its apparent foundations

in classical political economy, the rule thus represented one of those instances of LFC’s influence and

persistence we mentioned at the end of the previous chapter.

The case involved Nebraska’s 1893 railroad rate legislation. With an opinion written by Justice Harlan,

the Court found the rate regulation unconstitutional: state rates that were too low to permit the railroads a

28 This was for instance Columbia economist Robert Lee Hale’s explanation: “there is some reason to suppose that new competitors will keep out unless they expect to be able to earn as much as a fair return on the cost of building a factory as efficient as the one in question. […] If, however, there is nothing to prevent the buyer of the [existing] plant from putting up and operating his own factory, without buying this one, then of course he would pay no more than the replacement cost for this one; whatever earnings might be thought at first to give it a value above this are not likely to persist in the face of exposure to competition, and are not likely to enter into the capitalization. Replacement cost is thus a highly important bit of evidence bearing on the earning capacity of a plant subject to competition” (Hale 1921, 714-5). These words came in a critical essay Hale wrote against the technique and its jurisprudential use. 29 Smyth v. Ames, 169 U.S. 466 (1898). One year earlier, the Supreme Court of Minnesota had already stated that: “the material question is not what the railroad cost originally, but what it would now cost to reproduce it. […] the burden is on the railroad company to show that the rates fixed by the commission are unreasonable, and for this purpose the original cost of the road, the amount of its present fixed charges, and its history, are material only so far as they show what it would now cost to reproduce the railroad” (Steenerson v. Great Northern Railway Co., 69 Minn. 353, 1897, at 374-5). Judges invoked no authority, either economic or legal, for their use of the reproduction cost method. It looked as if they considered the technique pretty standard stuff. 30 Smyth will be formally overruled only in Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944).

14

reasonable return amounted to an unconstitutional taking of private property without due process of law.

Factual analysis would have sufficed to reach this conclusion in the specific case, because the rates

established by Nebraska legislators brought insufficient revenues for the railroads under any possible

definition of “reasonable return”. However, the Court hinted at a preferred approach to the notion. In the

key passage of his opinion, Harlan wrote: “the basis of all calculations as to the reasonableness of rates to

be charged by a corporation maintaining a highway under legislative sanction must be the fair value of the

property being used by it for the convenience of the public. And in order to ascertain that value, the

original cost of construction, the amount expended in permanent improvements, the amount and market

value of its bonds and stock, the present as compared with the original cost of construction, the probable earning

capacity of the property under particular rates prescribed by statute, and the sum required to meet

operating expenses are all matters for consideration, and are to be given such weight as may be just and

right in each case. […] What the company is entitled to ask is a fair return upon the value of that which it

employs for the public convenience” (Smyth, at 546-7, emphasis added).

These words have been subjected to careful scrutiny in the following four decades.31 Taken literally, they

merely offered a list of evaluation criteria that eschewed any commitment to a specific determination of the

vague concepts of “fair return” and “fair value”. So Harlan’s statement has been considered ambiguous at

best and useless at worst.32 According to Siegel, though, this was not how most contemporary courts and

commentators understood it. At the time it was widely recognized that the Court had endorsed the

reproduction cost approach to rate regulation.33 Indeed, all subsequent decisions on rate regulations took it

for granted that the “fair return” to which a regulated company was entitled was the competitive dividend and

that the “fair value” upon which that return had to be calculated was the present reproduction value of the

company’s assets, as required by the reproduction cost method, and not their original cost, as required by

Brewer’s test.

One year later, in San Diego Land & Town, Harlan himself clarified the Court’s endorsement of

reproduction cost, calling for a “fair return upon the reasonable value of the property at the time it is being

31 Given that the “fair return on fair value” mantra underlies all forms of cost-plus regulation, one may legitimately argue that the debate raised by Smyth still goes on today. 32 “This ample list of all possible standards of value is indeed imposing”, Harvard economist William Z. Ripley wrote of Harlan’s words, “but, after all, matters in detail were still left about as much in the air as before” (Ripley 1915, 319). 33 Siegel 1984, 227. Textual corroboration did exist. Reproduction cost had been explicitly employed by counsel for the appellant State of Nebraska, famous agrarian leader William Jennings Bryan, with the goal of demonstrating that no right to profit existed for the railroads (Smyth, at 489-91). Moreover, Harlan’s opinion quoted from an 1891 official report of the Nebraska Board of Transportation that, in admitting that freight rates could be lowered no further (as the 1893 legislation would instead do) without “doing violence” to the railroads, underlined that such conclusion had been reached “not by taking the cost of construction and equipments, nor the amount of stock and bonds issued per mile, but by making our computations upon the basis of what it would cost to duplicate the property at the present time” (ibid., at 549). The Court plainly approved this method of evaluating the railroads’ “fair value”, the one more favorable to regulators in a deflationary period, and still voided the law as an undue deprivation of property.

15

used for the public” as the measure of just compensation, while rejecting the appellant’s request based on the

original cost.34 Even more significantly, the next rate regulation cases – where the Court consistently

applied the new method – were all decided unanimously, with opinions written by Justices as diverse as

conservative Peckham and progressive Oliver Wendell Holmes.35 In 1903 the latter quoted Harlan’s words

from San Diego Land & Town to proclaim that “[i]t no longer is open to dispute that under the constitution”

evaluation for regulatory reasons should be based on reproduction cost. “That is decided”, Holmes wrote,

“and is decided as against the contention that you are to take the actual cost of the plant, annual

depreciation, etc., and to allow a fair profit on that footing over the above expenses”.36 By the time of

Lochner, reproduction cost looked like settled law.37

As we said, the logical underpinnings of the reproduction cost principle resided in the notion of

competitive markets. Fairness (of values and returns) was expressly translated in terms of the outcomes of

classical competition. Smyth thus constitutionalized competitive values and returns as the fair yardsticks for

measuring property and for protecting it against unconstitutional takings.38 Classical competition gave

substantive content to all those vague ethical or political attributes – justice, reasonableness, fairness – a

regulated rate should satisfy. Indeed, its outcomes were themselves just, reasonable and fair. Under

competitive conditions, the public would pay no more for a product or service than what would grant a

competitive return to a freely entering rival – viz., the equilibrium rate of profit. The Court recognized that

this was also the amount the Constitution should guarantee to railroad and utility shareholders.

Competitive market returns, and only them, represented the morally justified profits that even privileged

businesses like railroads and utilities were entitled to gain. Judicial determination of reasonable rates thus

suffered of no arbitrariness: competition, not the judge’s idiosyncratic will, drew the constitutional (and

categorical) boundary between regulation and confiscation. Courts should just establish by factual analysis

what the competitive return on the present market value of a given enterprise would be and compare it

with that implied by the regulated rates.

Remarkably, the kind of competition the unanimous Court had in mind in Smyth and later decisions was

still the classical one. As classical economists envisaged, competition was the dynamic process leveling the

profit rate and canceling any monopolistic rent unsupported by legal privilege. Competitive markets were

34 San Diego Land & Town Co. v. City of National City, 174 U.S. 739 (1899), at 757 (emphasis added). 35 On these cases, see Whitten 1912, 26-8; Siegel 1984, 226-8. Peckham and Holmes will famously clash in Lochner. 36 San Diego Land & Town Co. v. Jasper, 189 U. S. 439 (1903), 442. 37 Treatise writer Robert Harvey Whitten had to concede that (Whitten 1912, 69-71), although he himself rejected reproduction cost and believed the Smyth Court had left the door open for alternative criteria: “The whole subject of valuation is still in a developmental stage. The Supreme Court of the United States has wisely refrained from laying down a hard and fast rule that might have to be reversed when all the factors of the problem have been more clearly disclosed” (ibid., 71; 1914, 419). The same concession to seemingly settled law was made by another critic of reproduction cost: see Ripley 1915, 346. 38 See Siegel 1984, 231-2.

16

simply those where this process worked unhampered. Proof of their effective functioning rested in the

tendency itself to the equalization of returns – the analytical core of classical economics. It was the process

that mattered, not the firms’ size or the structure of the market. The Court’s jurisprudence on rate

regulation did not constitutionalize the neoclassical notion of competition as a market structure made of

small enterprises devoid of monopoly power.

In sum, by 1898 the Court had fully and unanimously endorsed the strong connection between

competition and property that lay at the core of classical political economy. The former provided no less

than the measure of the latter, because free markets were the one and the only place where the value of

property was determined. This free market value was, according to the Court, also the value protected by

the American Constitution. One could not separate competition and property without violating the

Constitution – and classical economic principles, too.

The Smyth doctrine had momentous consequences that went beyond rate regulation. The

constitutionalization of competitive markets affected LFC as a whole. “The Lochner era began”, Siegel

wrote, “when American jurists decided that the constitutional notion of property included its free market

value” (Siegel 1984, 260). First settled in the railroad regulation context, the latter idea was soon

generalized. All citizens were entitled, like railroads, to the free market value of their property. In Siegel’s

account, even the central doctrine of the Lochner era, liberty of contract, emerged as a corollary of the

constitutional protection of the competitive value of property (ibid.). Free market value is in fact nothing

but exchange value; the latter, in turn, depends upon the possibility of trading property with the utmost

liberty. Hence, liberty of contract may also be constructed as a necessary implication of the Court’s

interpretation of the “just compensation” principle of rate regulation in terms of the reproduction cost rule

– that is to say, of the ironclad connection between classical competition and the constitutional protection

of property rights. The road to Lochner was not unique, after all.

§6. Smyth besieged

In the years after Smyth, federal courts were busy with rate regulation cases. Under the new doctrine,

railroad companies could ask for injunctions against the enforcement of state-fixed rates. Federal courts of

equity granted several such injunctions, thereby significantly restricting state rate-making authority. A

reaction came on both legal and economic fronts.

Legally speaking, some states resorted to their legislative powers to attempt restraining the railroads’

rights to pursue courtroom relief. States began to append to their regulatory acts provisions punishing

17

violations of rate regulations with severe criminal penalties and large fines. The goal was to intimidate

railroads and prevent their testing the constitutional validity of regulated rates in a federal court. It was in

this context that Justice Peckham had the opportunity to leave his mark even in regulatory jurisprudence.

In the seminal case of Ex Parte Young (1908), the Supreme Court deemed unconstitutional the draconian

penalty provisions contained in a Minnesota statute regulating railroad rates, in that they effectively denied

access to federal courts to determine the adequacy of imposed rates.39 While the case pivoted on the

controversial interpretation of the Eleventh Amendment of the Constitution, no doubt exists that in

writing for the Court Peckham was influenced by his skepticism about state regulations and his desire to

protect the carriers’ property rights from confiscatory rates. The core of his opinion was indeed the

principle that railroads should not be forced to suffer huge losses, and risk even more severe penalties, in

order to obtain judicial review of state-imposed rates.40

A second line of attack against Smyth originated in economics. The reproduction cost method was

criticized on both pragmatic and theoretical grounds. Scores of economists, engineers and legal scholars

joined the debate. The intense controversy, which would last until the demise of the Smyth doctrine in the

1940s, began in the wake of the passing of the Hepburn Act, viz., exactly when Lochner was decided. The

1906 Act strengthened the power of the ICC, establishing, among other things, the Commission’s authority

to fix maximum railroad rates. Economists took an active part to the discussions that surrounded its

enactment. For example, in December 1904 the Seventeenth Annual Meeting of the American Economic

Association (AEA) hosted a session, jointly organized with the American Political Science Association,

about “Corporations and Railways”. The following December, another session, this time on “The

Regulation of Railway Rates”, took place during the AEA’s Eighteenth Meeting. Beyond publishing the

material from the two conferences, the AEA also dedicated one of its monographs to a long essay on

“Railroad rate control in its legal aspects” by Michigan economist and former ICC member Harrison

Standish Smalley. Overall, railways economics occupied more than 250 pages of the Publications of the AEA

– the forerunner of the American Economic Review – between May 1905 and May 1906.41

By so late a date, the classical faith in the market’s self-policing ability had almost vanished in the

profession. Hence, the economists’ take on the issue focused on the allocative function rate regulation

should accomplish, downplaying the classical themes of justice and equality. Everybody agreed that free

markets would determine “normal price” as the long run equilibrium value of railway services and that this

39 Ex Parte Young, 209 U.S. 123 (1908). 40 Young, at 163. See Ely 2009, 617-9. 41 It may be worthwhile to remark that by that date the AEA had long ceased to be the exclusive domain of the radical economists of the “new school” who had founded it in 1885. Rapprochement with the more conservative branch of the profession had been completed as early as 1890: see Yonay 1998, 42-3; Dorfman 1949, 208-9.

18

“normal price” would conform to production cost. At the same time, almost42 everybody recognized that

in the case of monopoly railroads competitive forces would fail to exercise sufficient pressure to push the

prices down to production cost and that there lay the rationale for rate regulation. Robert Harvey Whitten,

a city planner who uniquely combined legal expertise and economic literacy, explained this rationale most

effectively: “In the case of unregulated virtual monopoly the force that tends to limit prices charged to the

cost of production is lacking. This creates the necessity for public regulation of the rates of charge of

public service companies. The aim of public regulation is to accomplish what in other industries is assumed

to be accomplished automatically by free competition, that is, to limit the price charged to the normal cost

of production” (Whitten 1914, 422).

The regulator’s task was therefore to determine a rate that corresponded exactly to the “normal price”,

which, in turn, should equate the “normal cost of production”. Whitten defined the latter as “the amount

which in the long run it is necessary to pay to secure the utilities demanded by the public. It is the amount

that will secure an equilibrium between demand and supply”, and the former as “the amount which in the

long run it is necessary to pay to secure the utilities demanded by the public. It is the amount which

constitutes an adequate inducement for investment” (ibid., 422, 424). The allocative viewpoint was

apparent: rate regulation should aim at generating sufficient profits to attract the capital necessary for

future investment in railways, exactly like competitive markets would have done. The question was whether

the reproduction cost method devised by the Smyth Court could actually perform this task, without

triggering either under- or over-investment.43

Several economists gave a negative answer on purely practical grounds. Reproduction cost was unable to

fulfill its allocative role because of huge administrative problems. The valuation of present reproduction

cost was a time-consuming process, largely based upon conjectural estimations and, above all, incapable by

definition of providing a stable basis for fixing rates.44 Compulsory reference to current prices of inputs in

the production process of railway services made the results exceedingly sensitive to changes in the price

level. In particular, the inflationary process of the early 20th century turned the method into a boon for

railroads, by generating reproduction values that far exceeded the original outlays to build the lines.

42 The almost refers to no less than the father of modern railway economics, Arthur Twining Hadley, who – as we will learn below – remained optimist about the effectiveness of competition to curb monopoly power in the railroad industry, at least in the long run. At the bottom of this view, which Hadley held from his first major work (Hadley 1885, 101-5) until the end (e.g. Hadley 1928), lay his pioneering intuition about the absence of any necessary relation between the structure of a market and the effectiveness of competition. 43 Alternatively, but still within a functional approach to the subject, regulators could be charged with “the duty of advancing the public welfare”. This was for instance the viewpoint of Smalley (1906, 86), who accordingly placed rate regulation within the realm of police power rather than eminent domain (ibid., 89-92). 44 Administrative complexity – the hallmark of so much of Harvard-style economic analysis of the law (see Giocoli 2015a) – is also mentioned as the main reason for the abandonment of replacement cost in Breyer 1982, 38.

19

One of the fiercest critic of reproduction cost was Harvard economics professor (and renowned racial

taxonomist) William Zebina Ripley. In his oft-quoted treatise Railroads Finance and Organization, Ripley

borrowed from the practical wisdom of railways commissioners to dismiss the method. “The ‘reproduction

theory’ contemplates an imaginary community in which an imaginary corporation makes imaginary

estimates of the cost of an imaginary railroad”, he wrote, “The actual, efficient sacrifice of the investor, as

revealed in accounting and other historical studies, supplemented by engineering advice as to the

adaptability and present condition of properties for the purpose intended, will count far more than the

estimates of engineers as to what it will cost to buy land that will never be bought again, to duplicate

property that will never have to be duplicated, and to build up a business that will never again have to be

developed” (Ripley 1915, 356; quoting from Bemis E.W., Proceedings of the National Association of Railway

Commissioners, 1913). The passage reveals not only Ripley’s distaste for the conjectural character of

reproduction cost, but also his favor for the historical cost method, as embodied by Justice Brewer’s

prudent investment rule.45 The favor was shared by most economists involved in the post-Smyth debate.

Practical difficulties also occupied center stage in Whitten’s analysis.46 He was especially concerned of the

instability of incentives stemming from regulated rates when the latter were grounded upon reproduction

cost. Stability, and the ensuing provision of correct incentives to invest, would per force require a

continuous adjustment of the rate of return applied to the outcome of the evaluation method, but this was

clearly a cumbersome solution: “The fair rate of return could be altered so as in a measure to offset the

appreciation or depreciation of the base to which such rate of return is applied. With declining prices the

risk of depreciation in reproduction cost would be offset by an increase in rate of return, and with

advancing prices the probability of appreciation would be offset by a decrease in the rate of return. This,

however, is but a poor method of accomplishing what can be more fairly and logically effected by directly

basing the rate of return on actual capital cost. Any method that is permanently fair to both parties must

get back to actual capital cost as the base for actual as distinct from nominal profits” (Whitten 1914, 425).

The final sentences show that even Whitten preferred a method based upon historical cost. What he

called the “actual capital cost” had an edge not only as a guiding light for railroads’ investment plans, but

also with respect to railways customers, who would themselves benefit from rate stability: “The normal

actual capital cost as a basis for rate determination, moreover, has a distinct advantage from the standpoint

of public policy. It is desirable that rate schedules should have stability and should not fluctuate with the

price of iron pipe or copper wire or with real-estate activity or reactions” (ibid.).

45 See Ripley 1915, Ch. XI for a comparison of the two methods. 46 Chapter IV of his 1912 treatise Valuation of Public Service Corporations (Whitten 1912) discussed the method at length. He summarized the argument in Whitten 1914, which also took into account the important 1913 decision by the Supreme Court in Minnesota Rate Case, on which see next §.

20

Troubles in administering the reproduction cost method could get even worse whenever one wished to

apply the technique in a truly rigorous way, that is, by following the so-called “value of service rendered”

approach. This meant neglecting the value of property and aiming instead at that of the service provided.

The difference could be huge in terms of depreciation allowances because a given level of service could be

rendered even with an obsolete capital. “As justifying the reproduction method”, Whitten explained, “it

may be argued that the public is always entitled to secure service under present conditions as to cost of production.

It is entitled to secure service at a rate of charge sufficient only to cover cost of operation, interest, and

profits of a substitute plant of the most modern approved design, capable of performing the same service as

the existing plant. The company assumes the risk and enjoys the profit, if any, incident to this arrangement.

This method involves a reproduction of the service rather than a reproduction of the plant. If the old plant

were wiped out, what would it cost at present to construct and operate a plant capable of performing the

service now performed by the old plant?” (Whitten 1914, 426, emphasis added).

Both Whitten and Ripley acknowledged that focusing on the service rather than the plant was the proper

way of reasoning from the theoretical viewpoint. Yet, they also remarked that the approach would then

clash with existing accounting techniques (ibid., 429; Ripley 1915, 357) and, above all, suffer from

insurmountable administrative complexity. In Whitten’s words: “As thus stated, the reproduction method

has so many difficulties that it is practically never employed. The reproduction of the service involves not

only the determination of the cost of the most efficient substitute plant, but the determination of the

present cost of reproducing the business […] The engineering costs of such survey and estimates would

be enormous” (Whitten 1914, 427). How could the evaluator ever know all the details necessary to

reproduce a company’s whole business?

Inevitably, the reproduction cost method had to be applied less than rigorously: “The cost of

reproduction in practice, therefore, instead of meaning the cost of a substitute plant of the most modern

approved design, capable of performing the same service as the existing plant, has come to mean the cost

of a substantially identical reproduction of the existing plant. This is the usual method. It involves,

however, a partial abandonment of the reproduction of the service theory” (ibid.). Intrinsic imperfection in

actual applications undermined the main argument in favor of the method itself, namely, its being a more

rigorous evaluation technique – that is to say, one less dependent on the regulator’s or the judge’s arbitrary

assessment – than the rough estimates of the prudent investment rule. “Rather than providing the definite,

21

clear, and simple rule called for by a functional analysis”, Siegel noted, “the Smyth v. Ames rule was an

administrative nightmare and an inaccurate one at that” (Siegel 1984, 236).47

Many economists thus preferred the actual cost approach. On the one side, it was administratively easier

to apply; on the other, it could be tailored to meet contingent necessities, such as the need to attract new

capital in some parts of the railroad industry. In his 1912 treatise, Whitten praised the approach as the best

way to obey the prescriptions arising from judicial decisions: “Actual cost properly considered is the most

natural and in many respects the fairest single basis for the determination of fair value for rate purposes”

(Whitten 1912, 83). “A fundamental principle of public service regulation”, he explained, “is that as the

public service corporation devotes its property to a public use it may consequently be required to render

the service at reasonable rates of charge. Rates of charge to be reasonable may not be in excess of the fair

value of the service and may not be higher than necessary to produce a fair return on the property devoted

to a public use. The measure of the property devoted to a public use is undoubtedly in the first instance, at

least, the money that the company has actually and necessarily invested, i.e., the actual cost” (ibid.).48 As to

the traditional charges that the method suffered from technical obscurities, these were, to Whitten’s view,

“largely the result of a somewhat confused conception of actual cost”. When properly considered, that is,

as equivalent to the first cost of the identical units currently in use, actual cost “may in a great majority of

cases be determined with much greater accuracy than reproduction cost” (Whitten 1914, 429).

Actual cost had the further advantage that “it eliminates or minimizes, through compensation, the

changes of valuation arising from fluctuations in the level of prices in general” (Ripley 1915, 349). This

remark touched a sensible chord, of which all early 20th-century commentators were perfectly aware.

Opting for one method or the other was hardly neutral: “If it were generally true that public utility

properties could now be reproduced at less than actual cost, the argument for the acceptance of actual cost

as a normal standard for fair value would appeal very strongly to the public utility interests. As, however,

prices of land, labor, and material have in general advanced enormously since 1896, most utility enterprises

can only be reproduced to-day at a cost considerably in excess of the actual necessary cost. It is natural,

therefore, that public utility interests should incline strongly toward the reproduction method” (Whitten 1914, 433,

emphasis added).

The numbers were indeed staggering. Between 1913 and 1920 the price level rose almost 150%. Under

inflationary conditions, the reproduction cost method effectively meant green light for railroads to charge

47 Borrowing from Porter (2006, 1280), we may say that the method was indeed fairly precise – because it did not (or not so much) depended upon the evaluator’s subjective assessment – but not accurate – in that it did not determine the “true” cost required for reproducing the railroad service. 48 Chapter V of Whitten (1912) offers a thoroughly discussion of the criterion. Ripley agreed that “despite its insecure legal footing, [actual cost] seems to be not only the most natural but in many respects the fairest single basis for the determination of reasonableness of rates” (Ripley 1915, 347).

22

what the market would bear, and a practical constitutional ban on government’s regulatory activities. The

situation was the opposite than at the time of Smyth, which came at the end of a period of sharp deflation.

Falling prices meant that the method subjected regulated businesses to the risk of losing on their capital

outlays, like any other private firm. Accordingly, late 19th-century enemies of regulation had shunned

reproduction cost, while pro-regulation interpreters had embraced it. Wartime inflation changed

everything: now present costs were much higher than historic ones, so reproduction cost was very

favorable to railroads and other public utilities.

Scholars could not fail to notice that. “During the generation to 1900”, Ripley recalled, “the steady fall in

commodity prices worked disadvantageously to the railroads in any appraisal of property. The greater the

fall in unit costs, the narrower the basis upon which they might claim a return in rates. After that time the

equally marked enhancement of prices enabled them by means of an up-to-date inventory to justify heavier

charges for service rendered” (Ripley 1915, 349). The shocking reversal also raised serious equity concerns.

“In either case, so far as property long ago acquired is concerned”, Ripley continued, “this change in the

rate basis was merely fortuitous, totally disconnected with the matter in hand. It would certainly appear

more equitable that the rights and obligations of the companies should rest upon the amount of the

investment honestly and fairly, that is to say, ‘actually created and placed in the public service’” (ibid., 349-

50). In short, the criterion of actual cost – Brewer’s prudent investment rule – appeared clearly superior to

achieve both the allocative and the justice goals of railroad regulation. Whitten could therefore conclude

that: “If normal actual capital cost were adopted as the rule for the future, accounting methods and rate

regulation would be much simplified and the relations between the utilities and the public placed on a

much more equitable and dependable basis” (Whitten 1914, 436).

The superiority of actual cost was not merely practical, but also theoretical. A parallel stream of critiques

focused on a major theoretical flaw in the argument supporting the reproduction cost method. As we

know, the approach found its rationale in the equivalence between the market value of a business and its

reproduction cost – an equivalence that was guaranteed by the opportunity for every entrant in a free

market to choose between starting a business anew or taking over an existing one. Underlying all that was

the principle of perfect capital mobility among alternative uses, a pillar of classical economics. The problem

was that – as Yale economist Arthur Hadley had explained as early as 1885 – railroads were a business like

no other in the past. The provision of railroad services required enormous investments in fixed capital that

could not be withdrawn. Hence, railroads could go on for a long time pricing their services at so low a level

that it barely covered operating expenses. Their rates thus bear no necessary relation to their capital

investment: “the rate at which it pays [for capital] to come in is much higher than the rate at which it pays

to go out”, as he famously put it (Hadley 1886, 223). This meant that observable market conditions could

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in no way provide a benchmark for assessing what it would cost to reproduce the infrastructure necessary

for providing the service.

By the second decade of the 20th century, Hadley’s analysis was common wisdom. “The real cost of

transportation”, Whitten observed, “can only be determined by recognizing the only process by which

transportation service can be supplied, that is, by devoting capital permanently to the enterprise” (Whitten

1914, 424). In short, perfect capital mobility – and the attached profit equalization theorem – could not

hold in the railway industry. Against classical claims, the entry/exit mechanism failed to bring either the

market price or the return on capital to their “normal” level. The equivalence between the market value of

a business and its reproduction cost was consequently lost. Or, as Whitten put it: “Cost of production

determined by the reproduction method is largely hypothetical. It is not based on the actual conditions that limit

the production of the utility” (ibid., 423; emphasis added). The critique seemed definitive. Still, the Smyth

doctrine managed to survive.

§7. Smyth defended

Though embraced by a majority of scholars, both the pragmatic and the theoretical critiques met no

universal consensus. Some authors still defended the reproduction cost method and rejected the prudent

investment rule. For example, New York lawyer Edward Cashman Bailly remarked that “As engineering

skill and experience increase, and the courts become more intimate with the valuation problem, the

measure of present value afforded by the cost of present construction meets with more favor. […] After

all, this is the only effective means of determining the present value to a community of a complicated and

extensive plant, with tangible and intangible properties, which it has taken years to develop” (Bailly 1911,

545). Remarkably, engineers were the group more consistently in favor of employing reproduction cost.49

The circumstance lent credit to the approach and represented the best reply to the pragmatic critique. “As

for its accuracy and expediency”, Bailly underlined, “the fact that [reproduction cost] has been approved as

the best means of determining present value by nearly all the great public service commissions in the

United States, that it has been repeatedly approved by the Interstate Commerce Commission, […] that it is

given practically controlling effect in the more recent decisions of at least the federal courts of inferior

jurisdiction, is answer enough” (ibid., 546). His conclusion was orthogonal to Whitten’s and Ripley’s: “It

49 For an example in this sense, see Ford 1911.

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can hardly be conceived to-day that a valuation would be undertaken without great weight being given to

the cost of reproduction” (ibid., 547).

This declaration of faith in reproduction cost was supported by the continued allegiance to the method

by American federal judges. The best example is a 1913 decision by the Supreme Court that,

notwithstanding the Justices’ refusal to apply it in the specific case, did reiterate the centrality of

reproduction cost for regulatory matters. Writing for a unanimous Court in Minnesota Rate Case, Justice

Charles Evans Hughes defined the outcomes of the reproduction cost method as “mere speculation” and

“mere conjecture”; unsurprisingly, he declined to endorse them.50 Yet, the denial only applied to the

peculiar application of the method railroad stockholders had invoked in the case. Stockholders had argued

that, in assessing the reasonableness of the regulated rates, allowance should be made for the fact that the

“right of way” (viz., the right to use land for a railway line) cost more than the land’s market value. This

because the purchaser of the right, the railroad company, would find itself locked-in (in modern economic

jargon) in its bargaining with landowners on account of its specific railways investment and massive sunk

capital. The argument’s goal was of course to inflate the reproduction cost and, therefore, get higher rates

from Minnesota regulators.

The Court dismissed the thesis on two grounds. First, railroads had been granted eminent domain power

over landowners precisely to escape these lock-in situations (Minnesota Rate, at 451). Hence, a railroad

enjoyed a privilege over the land that already compensated it for the potential loss of bargaining power.

Inflating the land’s value by recognizing its higher “railway value” would unconstitutionally sanction a

railroad’s right to enjoy privilege-based, supra-competitive profits. Second, Hughes found it impossible to

evaluate what the value of “right of way” through a certain land would have been in the absence of the

railroad already built upon it: “it is manifest that an attempt to estimate what would be the actual cost of

acquiring the right of way if the railroad were not there is to indulge in mere speculation. The railroad has

long been established. […] The assumption of its nonexistence, and at the same time that the values that

rest upon it remain unchanged, is impossible and cannot be entertained. The conditions of ownership of

the property and the amounts which would have to be paid in acquiring the right of way, supposing the

railroad to be removed, are wholly beyond reach of any process of rational determination” (at 452). The

existing railroad could not be “obliterated” in order to recalculate the “railway value” of the land. Hence,

the reproduction cost method could not be applied in that specific circumstance.

Ripley did not miss the chance to jump at Hughes’s statements and conclude that Minnesota Rate had

buried reproduction cost for good (Ripley 1915, 355-6). Yet, this conclusion was way too optimist. The

50 Minnesota Rate Case, 230 U.S. 352 (1913), at 452.

25

Court had actually proclaimed that: “The ‘cost of reproduction’ method is of service in ascertaining the

present value of the plant, when it is reasonably applied and when the cost of reproducing the property

may be ascertained with a proper degree of certainty” (Minnesota Rate, at 452). Clearly, the Justices had no

problem with the method itself, provided it was based upon demonstrable facts (at 453). Their decision

simply meant the method could not be applied when grounded upon mere conjectures or, worse, when its

use would imply granting constitutional protection to the profits generated by railroad’s privileges.51

Minnesota Rate was just one among a score of cases where courts confirmed their allegiance to the Smyth

doctrine. In the early 1920s, another LFC champion, Justice Pierce Butler, even got close to affirming

something the Smyth Court never explicitly held, namely, that reproduction cost was the only factor to be

consulted in determining a railroad’s, or other public utility’s, present value.52 Keeping into account the

inconclusive results reached by the economics of valuation, it is therefore unsurprising that the debate

between friends and foes of the reproduction cost method went on throughout that decade and the next.

Clearly, no definitive answer could come from purely theoretical, or practical, arguments. As Siegel (1984,

242) remarked, commitments to values other than purely economic motivated the supporters of each

approach, reproduction or actual cost. A broader issue was at stake under the surface of a seemingly

technical matter. Under the Munn doctrine, government regulation had the potential of spreading across

several branches of economic activity. The “public interest” notion was so vague and over-reaching that it

could be stretched up to the establishment of some general forms of public control over the economy.

Justice Brewer’s smart jurisprudence had managed to move rate regulation from the public welfare to the

property rights territory. The shift had significantly reduced the Munn-related risks of excessive government

interference. Still, competing conceptions of private property versus public welfare came back to the fore

under the guise of the apparently neutral choice between historic and reproduction cost. Rate regulation

thus remained a key battleground in the war between LFC and Progressive approaches to constitutional

law – a war that, as everybody knows, only ended with the so-called “revolution” of 1937. Indeed, Smyth

would last seven extra years, being formally overruled only in 1944.

51 See Siegel 1984, 229. Using the terminology of footnote 46@, the Court had rejected the method partly because, in that specific case, it was not even “precise” (viz., too conjectural). 52 Reversing a decision by the Supreme Court of Appeals of West Virginia in Bluefield Water Works v. Public Service Commission, 262 U.S. 679 (1923), Butler chastised the lower court for failing “to give proper consideration to the higher cost of construction in 1920 over that in 1915 and before the war” and “to give weight to cost of reproduction less depreciation on the basis of 1920 prices, or to the testimony of the company's valuation engineer, based on present and past costs of construction”. As a consequence of these mistakes, that court had reached “a valuation considerably and materially less than would have been reached by a fair and just consideration of all the facts. The valuation cannot be sustained. Other objections to the valuation need not be considered” (at 692).

26

§8. Conclusion: property and privilege

As a formal proposition, classical laissez faire – the thesis that government interference with the economy

should never trespass the bounds of the so-called “night watchman state” – rested upon analytical

foundations, like perfect factor mobility and the gravitational model of market prices. Yet, the limitations

LFC courts placed upon the regulatory power of the states were based first and foremost on the idea that

certain kinds of legislation violated constitutionally protected individual rights. This a was a legal, not an

economic, notion. “The Lochner Court, though generally sympathetic with the market system”, wrote David

Bernstein (2003, 34), “did not attempt to enforce anything remotely resembling the night watchman state

usually associated with the phrase laissez-faire”.

Bernstein’s statement is correct only if referred to classical economics, where laissez faire had a precise

analytical content, but not with respect to the broader notion of laissez faire as synonymous with Adam

Smith’s system of natural liberty. Classical political economy did share with Lochner era jurisprudence a

presumption in favor of the individual, a sacred respect of his economic rights, a strong commitment to

justice and equality, and the ideal of an atomistic, privilege-free economy. Indeed, both groups, classical

economists and LFC judges, had common roots in the 18th-century classical liberal tradition – the tradition

the Founding Fathers had inscribed in the American Constitution.53 Separating the analytical part of

economic thought from the more general vision about the place of individuals and government in society,

or about the ethical superiority of a certain organization of economic affairs over all others – the vision

most classical economists entertained – is crucial for a correct understanding of the relationship between

economic ideas and LFC.

Nowhere is this better demonstrated than in the regulatory jurisprudence of the Gilded Age. This was a

rare instance of an area of the law where the Supreme Court did endorse a specific economics. The

reproduction cost principle dwelled on the profit equalization theorem, a mainstay of classical analysis. In

this specific case, the laissez faire, anti-regulation standard had both an analytical and a philosophical basis.

Hence, at least in one quantitatively important area of the law, the Court did apply “a particular economic

theory”, as Justice Holmes would complain in his famous Lochner dissent.54 Yet, it is a testimony to the

much greater sway classical political economy had over the Court than classical economics that the latter’s

dismissal, in the wake of the new world of corporate giants and massive fixed investments, did not lead the

Justices to lose their confidence in reproduction cost. For decades the technique remained at center stage

of regulatory jurisprudence because it perfectly harmonized with the classical system of natural liberty,

53 See Epstein 2014. 54 Lochner, at 198.

27

namely, with an idealized economy where property rights and contractual freedom were the utmost values

and where competition was always at work, regardless of business size and temporary entry barriers.

Another important message descends from railroad regulation of the Gilded Age. Its jurisprudence was

peculiar in that a perfect overlap existed, at least in the early stages, between the economics and the

political economy underlying it. Elsewhere, when broader freedoms, such as the liberty of pursuing lawful

callings or of selling one’s own products, were at stake, the harmony between the two was neither a given

nor a constant. Although classical economics embodied the theoretical side of classical political economy

to form a coherent whole, the respective key concepts lived independent lives. Free market itself was a case

in point.

Making market freedom a constitutional principle meant to incorporate in American law the norms of a

vanishing society, characterized by small-scale businesses, free entry and a fair approximation to perfect

competition. One of those norms was the abhorrence of monopoly power. The economy of the Gilded

Age was a wholly different world, though. Large-scale enterprises, with their enormous sunk costs,

fundamentally altered the working of the free market. The economics of the period acknowledged the change,

dropping several classical postulates and results, and making room for scale economies, ruinous

competition and persistent monopolies. While the smartest economists, like Hadley or, say, John Bates

Clark, realized that the transformation did not necessarily mean that competitive forces were not at play

anymore, everybody shared an undeniable conclusion: the free working of the market now entailed the

possibility of monopolistic power. How to reconcile free market and monopoly became the main

theoretical puzzle of the era.

Unsurprisingly, political economy was slower to adapt to the new economic conditions. Systems of thought

are more difficult to update than specific analytical principles. The jurists’ adaptation was especially

difficult. While it may be relatively easy for lawyers and judges to embrace a new economic theory – the

main obstacle being letting them get in touch with it55 – it is much harder to modify one’s own (implicit)

political economy, usually matured as a young student of the law and, in that specific case, even

overlapping with key constitutional principles. Yet, the reality facing LFC courts was inescapable.

Borrowing again from Siegel, in the new world property and privilege were inextricably intertwined. This

meant that, for instance, no free-market measure of railroad value existed that did not include at least some

monopolistic effects; hence, the Smyth doctrine was simply bad economics.

Alas, the problem went much beyond rate regulation. Classical political economy had no room for the

property and privilege mix. Other areas of the law existed where the inconsistency between new industrial

55 A barrier that was at the time, when “elite lawyers and political economists wrote for, and read, the same journals and were concerned with the same kinds of policy issues” (Hovenkamp 1988, 401), much lower than in later periods.

28

conditions, novel economic ideas and the time-honored classical worldview was bound to explode. By the

time Smyth was decided, anyone involved in antitrust debates and litigations – from judges to politicians,

from lawyers and economists to the public opinion – already knew that pretty well. But that’s another story

for another paper.

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