Collapse of Utilities in 1929 Portends Financial Collapse in 2008

While going through my PhD thesis, I came across the following section written in 2005, which describes how the utilities helped plunge the US (and the world) into the Great Depression. It reads just like it happened now, but in the financial sector.

Do two things while reading this. Replace 'utilities' with 'financial firms and mortgage brokers' and you'll find out, how through the gaps in the regulatory process crisis occurs.

...This tight government regulation at the higher ‘state’ scale did not mean the private utilities lost out (public utilities stayed mainly within their municipal boundaries). In fact, as Samual Insull, one of the founding moguls of private electricity in America, remarked in 1913, “there is one great advantage that must follow regulation, and that advantage is protection” (Hirsh 1999: 30). There are a number of different reasons that the state enacted regulations over the industry forming a new consensus between government institutions and chiefly private electricity companies.

As a key element of the utility consensus, regulation [agreement by all parties for existence of a ‘natural monopoly’ and its regulation] constituted a social experiment typical of other reforms of the Progressive era. In drafting legislation that established state commissions, elite groups recognized the need to curtail abuses of large, technology-based companies that offered vital public services. At the same time, they realized that these companies could provide great value to society as a result of their size and technological prowess. The laws therefore reinforced the truth that companies were natural monopolies, and they outlined the commissioners’ responsibilities to enforce the obligations and maintain the rights of utilities (Hirsh 1999: 30).

By the early 1920s, two-thirds of states had established public utility commissions, in addition to the existing municipal authorities. Ever since, this division of powers in the US has come to play an important part in states maintaining regulatory control over electric companies.

States are closer to the electricity customers, sensitive to local economic and environmental concerns, the source of electric company franchises and rights of way, and… staffed sufficiently to regulate hundreds of electric companies (Kelly 1995: 127).

While there are advantages in this proximity of regulators and companies, there are also disadvantageous that involve the bounded geographic reach of states. At the same time that states erected regulatory commissions, the owners of electric companies continued their spatial-scale expansion throughout America, by establishing a complex maze of private holding companies with numerous local electricity companies.

Holding companies were initially created in the late 1800s to help smaller electrical companies purchase and operate the expensive equipment to generate electricity. In return for the equipment manufacturers (such as General Electric or Westinghouse Electric) or financial firms would receive bonds or stocks, and thus a stake in the new electricity companies. As these stocks were often bundled into one company, such as the Electric Bond and Share Company, these became known as ‘holding companies’(Hirsh 1999: 35), thereby financed against the capital investment of a company and not its projected income.

Involvement in a holding company, for smaller companies, held advantages. The larger holding companies would provide management and technical expertise that the smaller firms would not be able to afford on their own.

However, if two holding companies were merged and new securities issued the securitized value of the new holding company (and the stocks issued) could exceed the total capitalization of the operating firms. Despite this risk (and the harm it would later cause) investment bankers on Wall Street focused on the benefits for the smaller electrical companies. For GE and Westinghouse, they benefited from selling their products and through their investments. “Put simply, as more parties benefited from the existing structure of the utility system, they helped create substantial momentum” (Hirsh 1999: 37).

Eventually holding companies became known for their abuses, including the artificial inflation of stocks and the subsidization of rates in one state or region to allow lower rates in more competitive markets.

State regulatory agencies failed in efforts to track costs and profits that could be shifted across state lines, or into a blur of bookkeeping transactions between affiliated companies. [Companies] found that the largest profits were not to be made in the operation of power companies, but in padding out charges for financing, engineering, fuel and equipment services (Ridley 1996: 18).

A constant financial shell game developed between states so that by 1928, 16 major electric companies controlled 85 percent of the electricity produced in the US (Ridley 1996: 17). The utility entrepreneur Insull who pushed for state regulation to ensure monopoly status had also made another (short-term) winning assumption.
In the dizzying stock market climb of the late 1920s, speculation on utility stock ran wild. Some of the holding companies would trade stock back and forth between subsidiaries, inflating its value with each exchange. Based on rampant speculation, Insull’s personal fortune increased from $5 million in 1927 to $150 million in 1929. (Ridley 1996: 18)

The jurisdictional limit of state regulators was thus exposed. The establishment of state commissions had been seen as an effective way to regulate expanding utilities, but the continued scaling up of utilities and the development of national financial markets, exposed the jurisdictional limits of state regulators.

The financial and market shenanigans of private utilities, despite the oversight of state regulatory authorities, finally led to the federal government stepping in to fill the regulatory gap, triggered by the spectacular crash of utility companies at the start of the Great Depression. This put society on skid row, politicians up a tree and the economy in the gutter.