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! The!Success!and!Failures!of!! American!Capitalism!
________________________________________! Spring!Semester!2013! Cody!Moreland! ! ! ! ! ! ! ! ! ! ! ! ! !

! Hydraulic!Fracturing:!


! !

The Success and Failures of American Capitalism ____________________________

Recommendations to the Nation for Regulating and Enabling Hydraulic Fracturing

Name: Cody Moreland Date: May 2, 2013 Class: POSC 4341 Instructor: Dr. Prout

Table of Contents
2 3 4 4 5 6 7 9 9 11 12 13 15 17 20 Introduction Economist Perspectives Adam Smith Joseph Schumpeter Todays Economy Government Enabling Business Government Regulating Business Fracking/Oil Production Oil Industry History Why we need Energy Independence Fracking Boom or Bust? Environment Sustainable Production Moving Forward - Recommendations Conclusion

In every economy, companies bring together resources, labor, and technology to produce and distribute goods to consumers. The way these different components of an economy are structured and used, also mirrors a countries political ideologies and culture. In America we are considered to have a culture of capitalism. Our economy is considered a "mixed", because the government plays a significant role along side the private sector. In this capitalist system the central component is the market, which is regulated and protected by the government. The market helps allocate scarce resources and allows people to create value. Without the ability to grow value by risking capital, the real engine of capitalism grinds to a halt. American politics has long debated the role the government should play when it comes to regulating and enabling our economy. We have entered an age where the need to find the perfect the role of government is essential to our prosperity, because the global economy we have today is not immune to crisis. We are now faced with the question of whether it is more efficient to move away from the individual capitalist system we have today, or if we should incorporate a state-capitalism system like the BRICS. It is a rather complex question, and before it can be answered we must analyze whether our current brand of American capitalism in itself has been a

success, or failure. In regards to the success, and failures of American capitalism this report will review whether government intervention has helped or hurt the economy. Over the course of our history the government didnt create the most powerful economy in the world through extensive regulation, however, government policies that enabled our businesses to grow and citizens prosper, did create our status of economic superpower. With that being said, the mixed economy we have today will not last forever if our governments inefficiencies in market intervention continue. Going forward we need to have a pro growth agenda that allows sustainable outcomes. This can be achieved if the government strikes a healthy balance between regulating business on one hand, and enabling business on the other. This balance can be achieved by weighing the negative and positive externalities of enabling and regulating capitalism.


Economist Perspectives
In America, we now see two dividing ideologies when it comes to the role of government intervention in the market. On one side we have Jeffersonian principles, which argue the government intervention has not been main reason of our successes. And on the other side we have those with Hamiltonian principles that argue the contrary, saying that strong national government has been the constant enabler of our growth since the founding. Before there was government, man was born free, but was everywhere in chains. During this time everyone had unlimited natural freedoms, including the "right to all things" and thus the freedom of no regulation. This led to an endless "war of all against all". In the state of nature there were no social goods such as education, technology or industry, because the social cooperation needed to produce them did not exist. To avoid the state of nature, savage men contracted with each other to establish a civil society through a social contract in which they all gained security in return for subjecting themselves to a government. When man entered the social contact he gave up his personal economic freedoms of no government intervention, however, the contract allowed for government to enable and regulate the social goods of society at a sustainable level, which in return helped man and society develop. We have seen the tension between economic freedom and the broader welfare of the community arise from the social contract and still define the relationship between our government and business today.

Adam Smith
Adam Smith also subscribed to this prevailing Enlightenment notion of natural rights and then looked to define what the social contract meant for the relationship

! between government and the individual. While Smith argued for a minimalist government role, and believed the multitude of exchanges and transactions were indeed


governed by an invisible hand. Smith also understood that men have always been selfinterested and since man is self-interested, he will tend to create externalities in the market and may indeed need regulation. He did however, also suggest that man may feel sympathy for his fellow man, and indeed would often act in accordance with how an impartial spectator might view himself. Smiths Theory of Moral Sentiments thus laid important groundwork for ensuring that capitalism would not ignore its externalities.

Joseph Schumpeter
While Smith argued that domestic markets were robust and thus inclined to grow on their own without government intervention, another economist, Joseph Schumpeter held a similar view, in that the free flow of capital to investments, that can either succeed or fail, leads to a creative destruction, or constant reinvention of an innovation fueled economy [1]. Schumpeter believed capitalism could only be understood as an evolutionary process of continuous innovation and 'creative destruction'. Currently, we are witnessing our own creative destruction with the drilling technology of the oil and natural gas industry. We now have the reinvention that Schumpeter said would fuel our innovation-based economy. The reinvention of technology is with hydraulic fracturing, which has allowed companies to reach and extract shale oil that was once deemed inaccessible. The way the government regulates and enables this new technology will be a momentous policy decision going forward. The government needs to be efficient, because as Schumpeter argued, government creates scarcity. He also believed that when


consumers want more of something, businesses will find ways to fuel the demand. In the mid 2000s, we saw an example of this consumer-business relationship when the global demand for oil increased and caused domestic oil prices to rise drastically. To combat the rising prices and increased consumer demand, innovators reinvented the hydraulic fracturing technology, allowing them access to shale oil that was once deemed unreachable, as well as allowing them to supply the increasing demand. This, as Schumpeter would agree, is the new technology that will fuel the worlds capitalist growth in the area of energy consumption. This technology, if handled properly through efficient government enabling and regulating, may allow us to achieve the goal of energy independence by 2030.

Todays Economy
Today there are two distinct views of how the government and the economys relationship should work. One theory is that a good economy is one in which the government enables business. Its a system where businesses establish a partnership with the government that enables them to grow. This view believes the government should not intervene or intrude upon the businesses economic freedoms, but instead should enable them to grow and be competitive. The second theory believes that a good economy is one in which the government regulates businesses. Those who follow this theory believe that society should worry about the collective wellbeing. Most members of this ideology view this as not only a good moral view, but also as a path for future sustainability. Currently, we are facing an inescapable dilemma in regards to global capitalism. As the global population continues to grow rapidly and developing nations continue to

! modernize, energy consumption around the world will also continue to rise at a staggering pace. The International Energy Agency predicts a 70 percent increase in


global energy use by 2050 [32]. Will the increase in global demand for energy cause us to sacrifice our economic freedoms for the collective well-being? With a large amount of nations developing, we could, in just few decades see the use of our fossil fuels begin to severely affect the earth's climate and our daily lives. It is clear we now live in a world of global imbalances. Sustainability, or the capacity to endure, will require us to meets the needs of the present without compromising the ability of future generations to meet their own needs. Sustainability may not be the most desired political issue, but achieving it has become one of the greatest challenges to capitalisms survival. To ensure sustainable outcomes, the government will need to strike a healthy balance between regulator and enabler.

Government Enabling Business

The government has always played a very big role in terms of enabling business in American Capitalism. From Henry Clays American System that focused on a strong national government, to the Homestead Act of 1862 that distributed 270,000,000 acres of federal land for private ownership, then followed by the Minerals Depletion Allowance of 1958 and the Telecommunications Act of 1996, the government has consistently enabled American business by granting licenses, copyrights, and patents; issuing land and low rents; and by providing subsidies. This challenges the view of Hayek and Friedman that government should essentially stay out of the way of the market. The Laissez Faire, or free market system that Adam Smith was a proponent of reemerged throughout the United States in the 1970s and 1980s [2]. During a Laissez

! Faire government, transactions between private parties are free from government


restrictions, tariffs, and subsidies, with only enough regulations to protect property rights [3]. Most actions taken by government in a Laissez Faire system are not to constrain business, but to enable its further development. Even those government actions aimed at ending the dominance of the trust, such as the Sherman Anti-trust Act, were seldom administered.

Government Regulating Business

In terms of regulating the market, the government has applied many regulations over the course of our history to allow for our long-term growth rate to be sustainable. In the 1819 case of Dartmouth v Woodward the court settled the issue of private charters [4]. As a result of the landmark case the American corporation and the free enterprise system were born. From this point on in history American corporations enjoyed a protected status and by the turn of the nineteenth century morphed into large vertically and horizontally integrated trusts with massive economic and political power. Yet beginning with the progressive reforms of Republican Teddy Roosevelts New Nationalism through the New Deal and Great Society reforms, the latitude American corporations could exercise in the marketplace was redefined. While we often want the government to enable business, at times our country has looked to the government to regulate companies that create market failures. We have seen the government address market externalities that the free market economy overlooks, such as the environmental concerns we see in our current debate over fracking. Even with a strong sentiment for the free hand of the market, throughout our history we have still

! relied on the government to grow developing industries, and at times apply protectionist measures for American industries, beginning with the Report on Manufactures in 1791. During the remainder of the 20th century and now into the 21st, government regulation of financial activity has exponentially increased. Yet with each successive wave of regulation beginning with the New Deal and recently concluding with Dodd-


Frank, there seems to be no way to prevent white collar criminals and corporations from finding new ways to bypass regulation and take advantage of innocent consumers with financial activities such as derivatives. Whenever a regulation is created, there will always be someone or some company trying to evade it. With the fracking example, we have seen companies easily evade regulations. Since hydraulic fracturing typically introduces a mixture of potentially toxic chemicals into the ground, it is supposed to be regulated by the EPA under the Safe Drinking Water Act [5]. But due to another federal law enacted in 2005, the EPA does not currently have the authority to regulate the underground injection of chemicals during the hydraulic fracturing process. This prohibition is a result of provisions within the 2005 National Energy Act, which was enacted by Congress and signed into law by President George W. Bush. The prohibition has been called the Halliburton Loophole, because it came from recommendations made in 2001 by a Special Energy Policy Task Force headed by then United States Vice President Richard B. Cheney, who had served as Chief Executive Officer of the Halliburton Corporation, a leading energy company in Texas that initially developed the modern hydraulic fracturing process [6]. Fracking companies evade regulations by using this Halliburton Loopholewhich frees the fracking practice from regulation of the EPA and allows them to circumvent the Safe Drinking Water Act.

Also amended in the 2005 Energy Policy Act was the Clean Water Act. Congress

enacted the Clean Water Act back in 1972 as a way to regulate discharges into the countrys rivers and streams [7]. The Clean Water Act was amended in 1987 to include storm water run-off. But now oil and gas production are exempted from those regulations. And in the 2005 Energy Policy Act, those exemptions included oil and gas fracking sites [8]. Environmentalists have worried about run-off from well pads, pipelines and construction sites. With all of these exemptions we see how part of federal government wants to enable the fracking industry, while on the other hand part of the government works to regulate the industry. Going forward we need to strike a healthy balance between regulating and enabling the industry.

Fracking/Oil Production
The history of our oil industry started during the Gilded Age of American industry, when John D. Rockefeller founded what was to become Standard Oil in 1860. Rockefeller's innovative and competitive approach led Standard Oil to own upwards of 90 percent of the oil refining market but also dramatically lowered the price to consumers from 58 cents to eight cents a gallon [9]. By the 1920s, oil prices had peaked causing many to believe that oil would soon run out. This prompted Congress to put in place generous tax allowances for producers, which prompted further investments and ultimately led to the discovery of large, new oil reserves [10]. But then, with prices dropping, demands for price supports and restricted competition emerged. Consequently, President Roosevelt, in 1933, created the "Petroleum Code", allowing the government vast powers to fix prices, dictate wages and

! hours, limit production, and control the importation of oil. The Code enabled the government, through local agencies, to restrict production. With production heavily regulated, prices rose again [11].


Meanwhile, oil production elsewhere, particularly in the Middle East, took off. A combination of high demand and rising domestic oil costs ushered in a willingness to purchase oil from outside the United States: In 1948 the U.S. officially became a net importer of oil [12]. As imports of lower cost oil surged, domestic producers lobbied Congress to impose oil import quotas, which President Dwight Eisenhower established in 1959 [13]. The government quotas dictated how much crude oil and refined products would gain entry into the country and gave preference to imports from Canada and Mexico. Excluding the oil producing states of the Persian Gulf from a free market exchange depressed Middle Eastern oil prices. As a response to the U.S. import regulation, four Persian Gulf countriesIran, Iraq, Kuwait, and Saudi Arabiaalong with Venezuela, founded the Organization of Petroleum Exporting Countries (OPEC) in 1960. In 1973 the world experienced an oil crisis when OPEC caused a sharp increase in oil prices by reducing the crude oil output in order to raise profits. In essence, this has been OPEC's agenda ever since [14].

Why We Need Energy Independence

Today, the same concerns we faced in the Gilded Age over the role oil should play in the U.S. economy continue. The Left focuses mainly on the environmental consequences of abundant use of and continued demand for oil, the rising profits from oil to producers, the role of speculators, and the price increases to consumers. The Right

! warns of the security risk associated with purchasing oil from politically unstable or outright hostile regimes and thus pushes for relaxation of domestic drilling restrictions.


Both views assert that oil's heyday as a cheap and plentiful fuel has ended, as the earth's natural oil supply is running out and rising economies across the world ramp up their oil demands. As developing nations of the world are seeing huge increases in energy consumption, the rate of global capitalism also continues to rise. The needed global spare capacity, which is a safeguard supply against oil market disruptions, could continue to rise sharply alongside the devolving world and exceed 8 million barrels by 2030 based on EIA estimates. The current global share capacity as of 2013 is 2.4 mbd [15]. This huge gap in the global share capacity illustrates how the increasing demand will affect our future. This gap also provides our business and government with an adequate reason to develop our fracking technology, increase oil/gas production, and become energy independent. Going forward, we need to become energy independent so that a disruption in the supply wont force us rely on spare capacity, because doing so could have devastating effects to our own economy. We saw how close we can come to a disruption in the supply when Iran threated to close the Strait of Hormuz, which is the most strategic oil choke point in the world. Our dependence on volatile foreign oil market has been the thorn in our side since we became a net importer in 1948. Unless the U.S. gains a large share of the oil market, OPEC will continue to have the ability to increase prices and control the flow of oil at the tip of their fingers. As of now there is no global spare supply outside that of the OPECs, however, there is a strong possibility that if the U.S. government enables oil and natural gas production, it would allow the industry to grow

! and would cause OPEC to lose price control. By allowing crude oil prices to collapse, it would cause a major blow to the political power of OPEC. It will remain an important strategy to take energy independence seriously, because if we fail to do so it will have devastating effects to our national, human, and economic security going forward.


Fracking Boom or Bust

In the last five years the United States has seen a boom in oil and natural gas production. This boom has taken place because of technological advancements in the fracking process and new government policies that focus on energy independence. The path to energy independence allows the government to enable energy production through various investments and policies. Over the next 15-20 years the DOE estimates that demand for energy will rise sharply by almost 50 percentlargely in response to the capitalist economic growth in the developing world [16]. To keep up with the rising demand, the private sector and government will need to work together. On one hand, energy companies will need to increase production efforts, and on the other hand government will need to ensure the flow of oil to consumers. As Joseph Schumpeter would agree, capitalism and economic growth caused by the developments in fracking technology essentially benefit those at the bottom by providing them with goods and services that they previously would not have been able to afford. And perhaps more importantly, it does this without coercion, force, or central authority to direct it. There is still much to learn form hydraulic fracturing, as it is still a rather new technology. There is a learning curve for all new innovations as Schumpeter argued, and going forward we must understand this concept with Fracking.

While it is clear that government wants to enable the fracking industry, they also

have a compelling interest to regulate the environmental damages caused by fracking. The regulation of businesses that harm the environment has been a rising trend in our political system since the 1960s. This environmental regulation trend is a good example of how government intervention can protect the future sustainability of capitalism. If the government does not regulate the environment, capitalism will run its course and dry up every resource the environment has to offer. Going forward, it is important that the government has oversight over production levels so that it is done at a sustainable rate. A sustainable long-term supply that can avoid price shocks and environmental damages will be a vital aspect of our growth. There can be a mutually beneficial relationship between the government and the oil/natural gas industry if the two sides work together. The next two sections will evaluate the regulatory process on the environment in terms of fracking and whether or not increasing production is sustainable policy.

Beginning in the late 1960s and early 1970s, the world, and specifically the U.S. saw a growing trend in concerns for environmental issues caused by rapid industrial growth [17]. The powerful social movement behind the trend argued that economic growth caused environmental decline and could not be sustained forever. At the time there was a vast amount of pollution from the increasing amount of cars, as well as from the many companies who were dumping harmful waste. The pollution was creating what we refer to as externality a cost the responsible party can escape, but that society as a whole must bear. With the free market forces unable to correct these externalities, a large amount of environmentalists argued that, the government has a moral obligation to

! protect the environment - even if doing so requires some economic growth to be


sacrificed [18]. A vast amount of new regulations were created by the government: from the 1963 Clean Air Act, to the 1974 Safe Drinking Water Act, these regulations were all designed to control the wide range of environmental damage. This current debate over fracking is an example of these long-standing tensions between enabling business on one hand, and protecting the environment on the other. The major obstacle that fracking will need to tackle if it wants to reach its full potential is the public concern that it will negatively impact the environment through water contamination, seismic inducement, and methane emissions [19]. The fear of contamination of surface water and groundwater during operation and the risk to water resources for all users in the area are the primary environmental concerns of government regulators. Public concern over fracking rose dramatically after many environmental experts argued that drinking water can be affected by the hydraulic fracturing process. However, in response the EPA did extensive research on the effects fracking has on drinking water. The results of their 2004 study showed no connection between contaminated drinking water and fracking [20]. These are all examples of the long-standing tensions between the environmental lobby, (which prefer more government regulation), and business (which prefer a more enabling government approach), in terms of government intervention. It is clear that the government and the fracking industry must work together going forward. Whether it is from new technologies that allow them to increase their presence in the natural gas or oil market, or whether government funded research allows the company to create new technologies, the private sector and government must collectively work together to form

! a solution to fracking that poses less of a threat to the environment. Schumpeter would


agree, that innovation of the fracking process, by making it more environmental friendly, is essential to fueling our capitalistic growth.

Sustainable Production
While the previous section viewed the environmental factors, this section will view why how the government can enable the industry, but at the same time have sustainable production rates. Increased production has its merits, but the government needs to know the limitations of the market. We now know that there is enough recoverable oil in the U.S. to last us the next 200 years [21], but instead of drilling strategically we have tried to maximize profits without a long-term vision. You cannot over saturate any market to quickly without causing a market imbalance in the supply. The government regulators need to realize this market failure and improve regulations that allow for sustainable outcomes. Gas producers have been able to take advantage of the Halliburton loophole and drilled too many wells too quickly, which in turn caused the price of gas to drop below the cost of production. While many argue that the recent surge in production was originally driven by new drilling technologies, many oil and natural gas companies argue it was due to the high prices at the pumps, which reduced consumer confidence in the market. In the case of oil and gas the demand for the goods had been increasing but the supply was dwindling. With a limited future supply, the companies only way to make profits was by driving down production costs and becoming more competitive. From the years 2005 through 2008, as conventional gas supplies dried up due to depletion, prices for natural


gas soared to record highs - $13 per million BTU [22]. In the 1990s the price for natural gas was around $2 per million BTU. It was these record high prices that gave businesses an incentive to invest in expensive new technologies that could access resources once thought of as unreachable. For example, many oil companies flocked to the Haynesville shale formation in Texas, bought up mineral rights, and drilled thousands of wells in short order [23]. Many of these companies did not think of over producing because they were blinded by the potential profits. High per-well decline rates and high production costs were masked by the vast amount of new production. With companies having a surplus of supplies, gas prices fell below $3 per million BTU, which was actually less than the cost of production for most companies [24]. This dilemma forced U.S. oil and gas companies to find a way to draw additional investment capital just to sustain their cash flows. The CEO of Exon Mobil was quoted saying, We are all losing our shirts todaywere making no money. Its all in the red. It was obvious that the gas producers drilled too many wells to quickly and created a market imbalance. This is where government intervention in the market can help businesses going forward, so that sustainable production rates are the norm and that market imbalances are minimized.

Moving Forward- Recommendations

In the future, finding sustainable production rates and minimizing market imbalances will call for government intervention in the market. While Joseph Schumpeter argued government intervention in the market tends to slow down innovation and prevent growth, I think he would also realize that an efficient government regulation could actually create growth, as well as be protective of the collective good and private

! sector. An example, and possible recommendation for how the government can regulate to create growth in fracking is by regulating the type of equipment they use. The government can regulate the equipment and production process so that it is


environmental friendly, while at the same time enabling business through government research. This regulation can clearly be balanced if the government enables business by increasing funding in research of: efficient equipment, environmental friendly production, and cost effective ways of fracking. This relationship between business and government will be essential for our capitalist system going forward. While the core of previous recommendation called for the government to regulate equipment and the production process, I believe we can still create policies that encourage production. As long as the production process meets the environmental and sustainability requirements, the government can continue to enable the industry. If the environmental standards trend becomes the new norm, then government should look to incentivize companies for meeting these standards. Obviously these companies currently do not follow all regulations, so incentivizing will help the private sector become more efficient and eco-friendly. We want the industry to grow responsibly, because it will benefit our economy in the long run by creating jobs and reducing environmental damage. The U.S. will have enough natural gas and oil to meet the domestic demand and generate potential global exports for the next century only if the government continues enabling production at a sustainable rate. The sustainable rate has been a core argument of this report because it is essential to our long-term growth. If we do indeed increase production at a sustainable level, we will reduce our foreign oil

! imports and will cause a substantial reduction in the U.S. net trade balance, thus leading to faster economic expansion. Going forward, if the government can enable fracking, while at the same time keep the environmental lobby happy, it would allow for bipartisan cooperation in


Congress. The goal of energy independence set in place by our last two presidents could be momentous opportunity for bi-partisan support. The cooperation between both sides of Congress on the issue would allow for other realms of politics to be handled bi-partisanly and could eventually lift us from the political gridlock problem we see in American capitalism today. This recommendation will not be an easy process, as both the environmental lobby and oil lobby respectively hold a lot of congressional bargaining power. It is clear that, in order to achieve the goal of energy independence by 2030, the government will need to invest more in the research of safer fracking methods that guarantee protection of the environment. This research could be done through a race to the top initiative, which would create more competition to innovate. The government can help enable the competition needed to promote a sustainable and efficient growth rate. In terms of production to achieve energy independence, the government can intervene by allowing each company a certain percentage of wells, based of how well they follow regulations. This is turn would force companies to comply with regulations. While the government could also step aside and let the free hand of the market work itself out, I would argue that intervening would allow for the distribution of resources to spread out among the market. This would be a true way for the government to enable small business, which is the backbone of the American economy.

As you can see it is very easy for oil companies and the government to say, drill

baby drill, but as Adam Smith would agree, there will always be externalities, or loose rocks that companies overlook as they climb the mountain of potential profits. This is the defining reason why it is so important for the government to play an efficient role when regulating oil and gas companies. While environmental regulation may in fact slow down growth, it will remain an important factor for our long-term survival. If society keeps up the tragedy of the commons strategy, we will eventually rid the entire earth of its resources. Government after all is the main allocator of these scarce resources and if the government can get those resources to the maximum amount of people at an affordable cost, then society will become more efficient as a whole.

Over the course of this report I have argued for increased efforts of government-funded research in fracking that will allow the private sector to take new technologies and develop them further into products for the marketplace. Technology advancements can sufficiently boost economic productivity to prevent a long-term slowdown. Going forward, this prevention of a long-term slowdown will enable us to invent alternative fuel sources such as water or algae that are easily renewable. A renewable energy source will slow down the consumption of scare resources and allow society to progress more rapidly. If we are to ever address serious issues like climate change or other pressing environmental concerns, and, at the same time, ensure energy access and security for the American people without overburdening the U.S. economy, alternative sources of energy must be developed, energy conservation must be encouraged, and advanced technologies must be developed and deployed. I remain a strong believer that the U.S. can see an economic turnaround due advancements in technologies that enable our businesses to grow.

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