October 9, 2011


Debt and Dumb: As a young artillery captain in the Revolutionary War, Alexander Hamilton learned a crucial lesson: Good credit, based on the power to tax, is essential to a nation's security. As the first U.S. Treasury secretary, he built America's fiscal policy on that principle. Will the Tea Party destroy his legacy? (Simon Johnson and James Kwak, October 2011, Vanity Fair)

At the beginning of the 18th century, France, not Great Britain, had been the most powerful state in Europe. Louis XIV, the Sun King, was the Continent's most powerful monarch. France had Europe's largest population, its largest economy, its largest armies, and even for a time its largest navy.

Throughout the 18th century, Europe was locked in an episodic series of wars, often to contain French power. While alliances shifted, France's constant enemy was Great Britain. On paper, Britain began as the lightweight. It had less than half of France's population and a small fraction of its army. Its economy was only half as large. And Britain was coming off a century of political turmoil that had seen the execution of King Charles I, the restoration of King Charles II, and finally the overthrow of King James II. Yet Great Britain proved to be more than France's match on the world stage. The two powers fought to a standstill on the Continent, while Britain seized most of France's overseas colonies in the Seven Years' War, from 1756 to 1763 (known here as the French and Indian War).

The secret to Great Britain's power was boring: fiscal policy, or the way its government raised and managed money. In 18th-century warfare, access to cash meant the difference between victory and defeat, and here Britain reigned supreme. Taxes in Great Britain were collected by a modern, centralized bureaucracy, while in France, the tax collectors were often corrupt. But taxes could never buy enough ships, mercenaries, and supplies in wartime, so governments were forced to borrow money. And here, Great Britain's secret weapon was ... democracy. Since 1688, Parliament had had control over taxation and spending policy: decisions were in the hands of the people whose money was being spent. This legitimized government policies and ensured Britain's exceptional credit. And as Robinson Crusoe author Daniel Defoe wrote, "Credit makes war, and makes peace; raises armies, fits out navies, fights battles, besieges towns; and, in a word, it is more justly called the sinews of war than the money itself."

In France, the Estates General (the closest approximation to Parliament) had not met since 1614. Debts were incurred by the monarchy, which relied on an unstable tax-collection system to bring in revenues, and absolute monarchs' habit of stiffing creditors meant that the government had to pay high interest rates to borrow money. The problems with this system became clear after the American Revolutionary War, which forced both Great Britain and France to borrow large amounts of money. Great Britain emerged from the war with a national debt as large as France's but paid half as much in interest, thanks to its good credit. In France, by contrast, efforts to raise taxes met with increasing resistance, and finally King Louis XVI was forced to call the Estates General, which rapidly transformed itself into the National Assembly--the first step in the French Revolution. (The Revolution and the rise of Napoleon led to another 20 years of war--in which Great Britain ultimately prevailed again, thanks in part to its superior ability to raise money.)

In modern geopolitics--since 1688, at least--credit matters. And good credit requires more than just a strong economy, because, in order to raise money, it's essential to have a political system that people believe in. In words familiar to all Americans, there can be no taxation without representation (except in the District of Columbia). And without the ability to tax effectively, no government's debt will be credible.

The lessons of the British-French rivalry were clear to Alexander Hamilton and the other founders of our nation. After all, it was our Revolutionary War that pushed the French monarchy to the brink of collapse. And a major question for the American government, taking office in 1789 under the new Constitution, was what its fiscal policy should be.
The Decision

The most pressing issue was what to do about the new nation's debt. Both the Continental Congress and the individual states had accumulated massive debts during the Revolutionary War--close to $80 million, an enormous amount in those days. Hamilton--now secretary of the Treasury under his old boss, now President Washington--wanted the new federal government to assume the states' debt and pay them back in full. Since the government did not have enough cash to pay off those debts, he proposed to borrow new money by issuing Treasury bonds--and to pay off those bonds with new taxes on liquor, tea, and coffee. On the other side, Thomas Jefferson and James Madison feared that the plan would give too much power to the federal government, setting the precedent for further borrowing. But ultimately they agreed--in exchange for Hamilton's support in relocating the nation's capital to the shores of the Potomac River, in a new city called Washington.

Hamilton's plan was an economic success: the federal government quickly established a solid credit rating, consolidated its debts at low interest rates, and began paying them down rapidly. His plan also led to the new nation's first anti-tax rebellion. In western states, farmers refused to pay the new tax on whiskey (which was sometimes used as a medium of exchange), leading to armed rebellion in Pennsylvania. In 1794, President Washington raised a federal militia and dispatched it to western Pennsylvania. The Whiskey Rebellion collapsed, cementing the federal government's power to levy and collect taxes.

In just five years, Hamilton--with Washington's support--had laid the foundation of American fiscal policy. The federal government would always honor its debt. After the War of 1812, the Civil War, World War I, and World War II, this principle remained unquestioned. By the late 19th century, the government could raise large amounts of money on short notice--which made possible, among other things, rapid mobilizations to fight two World Wars.

Government bonds also became a crucial part of the financial system--the paradigmatic global risk-free asset, the universally accepted collateral on which everything else depends. What makes those bonds as good as cash is that the federal government has the power to levy and collect taxes in order to pay them off.
Our debt is only now approaching the annual GDP number after we defeated Communism and Islamicism.  When the Brits finished off Napoleonism theirs hit 250% of GDP and they've proceeded to dominate the next couple centuries.

Posted by at October 9, 2011 8:39 AM

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