How the US handled its debt problem?
Let us look at the experience of the largest and
the most powerful country and its experience with debt. The united states
was born in debt having had to raise resources for its war of independence.
The enemy that it was fighting* The British government* had a large advantage
with its well-established nat*ional debt and its efficient tax system.
It could borrow easily
and it certainly did, forcing the fledgling US to borrow as well.
Newly formed governments in rebellion against a Great Power are poor credit risks for two reasons: debt recovery in the case of a defeat is impossible and, in the midst of a rebellion such governments do not have tax base. And the new Continental Congress, established in 1775, had none at all. The US was able to borrow from the French government and Dutch bankers and both the Congress and the states sold bonds to wealthy patriots who were willing to risk the loss of their capital for the cause. In addition, money was printed with inflationary consequences to raise revenues for the war.
The result was that independence was finally achieved
on September 3rd, 1783, and acknowledged American independence, the United
States, while free, was in a state of utter fiscal chaos. The Congress
was defaulting on both domestic and foreign debt. The new congress
inherited about $ 80 million debt which was about 26 times their revenues,
and about 40 % of GDP. The fiscal deficit was about 50 percent of
revenues. The deteriorating financial
situation had led to the development of a new constitution and a new government.
In 1789, a new Constitution was adopted giving Congress exclusive
power over foreign and interstate commerce and power "to lay and correct
Taxes, Duties, Impose Excises.* One of the most important new government
executive departments was certain to be the Treasury; soon it had forty
employees to the State
Department's mere five.
And its tasks were as clear as they were monumental:
a) the de*partment would have to devise a system of taxation to finance
the new government; b) a monetary system would have to be developed to
further the country's commerce and industry; c) the national debt needed
to be refunded and rationalized; d) the Customs Service bad to be organized;
e) the public credit had to be established so that the government could
borrow as necessary; f) all this was to be brilliantly accomplished in
the first two years of the new government. It was, almost entirely, the
work of the first Secretary of Treasury, Alexander
Hamilton. For this he is viewed as, *among the Founding Fathers, Hamilton,
because of his financial genius and despite never holding elective office,
would have an impact on the future of the US that only Washington, Madison
and Jefferson equaled.*
Under the direction of Hamilton, Congress's
set about devising a federal tax system; it passed the first Tariff Act
on July 4, 1789, largely written by Hamilton, and hence*forth import duties
would usually provide the bulk of the federal government's revenues until
the First World War. For additional revenues, Congress, also passed
excise taxes on consumption
items of the rich as well.
A revenue stream in place,
Hamilton quickly turned to refunding the debt incurred in the Revolution
and by the old national government. The argument was over who should benefit
from this re*funding. Much of the debt, in the form of bonds, requisi*tion
IOUs, and continentals had fallen into the hands of wealthy merchants in
the major cities, who had
acquired it at far below par (its nominal face value), some for as
little as 10 percent of that face value.
On January 14th, 1790, Hamilton submitted his first "Report on the Public Credit," which called for redeeming the old national debt on generous terms and issuing new bonds to pay for it, backed by the revenue from tariff. The plan immediately became public knowledge in New York City and speculators started to take advantage of the situation. They bought as many of the old bonds as they could, raising the price from 20-25 percent of par to about 40-45 percent. Speculation: Should the government intervene?
There was an immediate outcry
that these speculators should not be allowed to profit at the expense of
those who had patriotically taken the old government's paper at par and
then sold it for much less in despair or from ne*cessity. Schemes were
proposed by several important politicians including Madison for not only
curtailing speculation but also punishing the
speculators. For example, it was proposed that the current holders
of the old bonds be paid only the present market value and that the origi*nal
bondholders be paid the difference between market value and face value.
Practically it would be very difficult to identify the original holders
and fraud would have abounded. Moreover, it would establish the precedent
of the government, rather than the market determining the validity of a
market transaction.
Hamilton*s view was that government cannot base policy
purely on grounds of restricting speculation and that while speculation
may be on the rise now, the only way to prevent its adverse future effect
is to give the public funds a degree of stability as soon as possible.
He also realized that any attempt to nullify market transactions through
government intervention
would have greatly impaired any future free market in U.S. government
securities and thus greatly restricted the ability of the new government
to borrow in the future. The reason was simple. If the government
of the moment could de*cide, on its own, to whom it owed past debts, any
government in the future would have a precedent to do the same. Politics
would control the
situation, and politics is always uncertain. There is nothing
that markets hate more than uncertainty, and they weigh the value of stocks
and bonds accordingly. Hamilton seemed to know well what economists have
understood in this age that maintaining the credibility of a good borrower
was extremely important for a poor country that needed to borrow for its
development.
Thus he wrote in his report: "It (the lack of credibility and its associated uncertainty of repayment) renders property in the funds less valuable, consequently induces lenders to demand a higher premium for what they lend, and produces every other inconvenience of a bad state of public credit." The importance of maintaining credibility
Hamilton was anxious to establish the ability of the U.S. government to borrow when necessary. But he was also anxious to establish a well-funded and secure national debt for other reasons, for he was fully aware of the British experience with its national debt. Perhaps the greatest problem of the American economy at this time was a lack of liquid capital, which is to say, capital available for in*vestment. Hamilton wanted to use the national debt to create a larger and more flexible money supply. Banks holding government bonds, he argued, could issue bank notes backed by them. He knew also that government bonds could serve as collateral for bank loans by multiplying the available capital, and that they would attract still more capital from Europe. Hamilton's reasoning eventually prevailed and the House passed Hamilton's funding proposals in 1792.
The second major part of Hamilton's program was for
the new federal government to assume the debts that the individual states
had incurred during the Revolu*tionary War. These debts were estimated
to be about $ 20 million. Again, opinion was sharply divided. Those
states, such as Virginia, that had redeemed most of their bonds were adamantly
opposed to assumption. Needless to say, those states, like the New
England ones, that had not were all in favor of it. Virginians who
had nearly liquidated their state's bonded indebtedness, to pay all over
again for the debts incurred by other states that had not.
Financial speculators, hoping for a rise to par of bonds they
had bought at deep discount, also fa*vored the federal government
assuming the state debts. But land speculators were opposed because
many states allowed public lands to be purchased with state bonds at face
value, even when the bonds were selling in the open market for much less.
Hamilton also recognized that for the unity of a diverse and large
federation, a centralized approach to debt-management with a creditworthy
federal government was likely to be very important. He therefore
tied funding of the old national debt and the assumption of the state debt
into one bill. Many thought that the state debt issue was "a millstone
about the neck of
the whole system which must finally sink it." Despite repeated Congressional
votes against the proposal, Hamilton was able to get his way and obtained
his funding bill.
The impact of Hamilton*s program Hamilton's financial
program quickly transformed the country's financial future. In the 1780s
the United States had been a financial basket case. By 1794 it had
the highest credit rating in Europe, and some of its bonds were selling
at l0 percent over par-- not an exceptional premium for a country recovering
from a default. Talleyrand, who later became the French foreign minister,
explained why. The United States bonds, he said, were safe and free
from
reverses: they have been funded in such a sound manner and the prosperity
of this country is growing so rapidly that there can be no doubt
of their solvency. By 1801 Europeans held $33 million in U.S. securities,
and European capital was helping mightily to build the American economy.
Less than two years after Hamilton's funding bill be*came law, trading in state and federal bonds had become so brisk in New York that brokers who specialized in them got together and formed an organization to facilitate trad*ing. This organization would evolve into the New York Stock Exchange, and within a little more than 100 years it would be the largest such exchange in the world, eclipsing London's.
Daniel Webster, with typical
grandiloquence, later summarized the achievements of Hamilton thus: "the
whole country perceived with delight, and the world saw with admiration.
He smote the rock of the national resources, and abundant streams gushed
forth. He touched the dead corpse of the public credit, and it sprung
to its feet. The fabled birth of Minerva from
the brain of Jove was hardly more sudden or more perfect than the financial
system of the United States as it burst forth from the conception of Alexander
Hamilton." In 1792, after Hamilton*s program had been enacted, the
national debt amounted to about 80 million, as about 40 % of GDP.
After some fiscal consolidation, from 1795 to about 1811 the government
only ran two years in deficit. As a result, the debt was shrunk rapidly.
By 1811 the total debt was only a little more than half of what it had
been in 1795 and as percentage of GDP it was less that 15%.
***
It is interesting that, in contrast to our esteemed
economists, Hamilton had recognized in 1790 the following principles on
which economic policy must be based:
That default presents some short run temptations but has large long run costs. Government financial managers are trustees of the financial system and cannot indulge in debt confiscation. Should they do so, the long run consequences of the action will be huge.
That policy must be based on credible market-based solutions. Markets may not always be in consonance with government objectives, such as redistribution, but ultimately they are both a barometer of government performance and are necessary for economic development. Good policy will develop markets bad policy based on temporary expediency will inhibit market development.
Sound market development as well as ready access
to international markets are two important determinants of economic development
and growth. This story of how a credible and comprehensive plan of
fiscal management is important to
economic development must be repeated to our esteemed economists, policymakers
and of course, our current and aspiring prime ministers. Our famous economists
are always looking for ways to place more money in the hands of the government,
supposedly for development that never takes place. To them credibility
of proper debt management and fiscal discipline is not as important as
the possibility of increased government resources even if through confiscation.
But then why should they be different? Like everyone else they also
expect to drink off the government trough or at least be close to it. Perhaps,
you and I, those who do not benefit from the government, can learn from
this history?