What We Can Learn from Hamilton & Another “Bail Out”

Our economic crisis of 2008, rooted in the over-borrowing and over-lending of bad mortgages which resulted in a credit crisis after various financial institutions failed, has led to a rancorous debate centered largely on whether and how to “bail out” Wall Street. American history is chock full of events that might shed light on the current crisis or help us to better comprehend where we stand today. There is, for instance, the 1920s issues of First World War debt, reparations, and the 1929 stock market crash; there is the financial panic of 1907 and the bail out single-handedly arranged by financier J. P. Morgan (there was no central bank at the time); and there is the late 19th Century and one economic depression, or “panic,” atop another. What I think is enlightening, however, is an economic crisis involving debt, what could be regarded as a “bail out,” a fierce political debate, and the end results. While it might not be a perfect match for today — history actually never does repeat itself so much as it rhymes — the economic issues addressed by our first treasury secretary, Alexander Hamilton, and our first federal government might inform our 21st century perspective.

Immediately following the American Revolution, the fledgling United States, led by an impotent central government defined by the Article of Confederation, faced a monumental debt problem. Specifically, in addition to massive national war debt, each state faced its own war debt problems. While several states managed to pay off their debts (namely Virginia and New York) others, like Massachusetts, experienced open rebellion. In an attempt to eliminate its debt, the Massachusetts government drastically raised property taxes by as much as 60 % during the 1780s with the unintended result being many citizens in western Massachusetts losing their farms in foreclosure. These desperate farmers, led by former Revolutionary War soldier Daniel Shays, petitioned the state for help, and being denied, first shut down the county court house then threatened to march on the capital. The insurrection was only stopped when the state’s armed forces intervened.

One result of Shays Rebellion was the development of political momentum leading to the reorganization of the national government resulting, over time, in our current federal system. Once in place, the first treasury secretary resolved to ensure the new republic’s future, to stabilize a crippled economy, and to prevent future rebellions by creating a strong national economy buttressed by a strong federal government. And topping Hamilton’s economic laundry list was an enormous debt — the same war debt that had resulted in Shays Rebellion. The federal government owed $54 million plus interest to domestic and foreign creditors, while the thirteen states owed, collectively, $25 million. Complicating matters was the fact that American currency was valueless and that foreign countries regarded the U.S. as a bad credit risk, and this meant there were no sources of foreign capital to sustain an economy teetering on disaster.

The situation was actually even more complex than this. Because the government under the Articles had no way of raising revenue to extinguish debts — it had no power of taxation — those holding government IOUs such as soldiers, farmers, and merchants often sold their debt certificates to financial speculators at a fraction of their face values. The speculators, doing what speculators do best, in turn sold this debt (today we might regard it as “bad debt”) to other speculators and so on, and so on. Hamilton resolved to remedy this problem in 1790 by fully funding the combined state and national debts together at face value, which the new, more powerful, federal government had the ability to do. His bold proposal was for the federal government to buy up the debt — which they called the “assumption” of it — re-issue it in the form of interest-earning bonds that, as they were sold and resold, would pump millions of dollars into the country’s weak economy and relieve a credit crisis by establishing good US credit in order to secure foreign loans. As Hamilton famously characterized it: “A national debt if not excessive will be to us a national blessing; it will be a powerful cement of our union.” Actually, the debt was excessive but Hamilton knew that if the people, themselves, had a vested financial interest in their government that it would help ensure the future stability of the country.

Just as we’ve seen with today’s economic crisis, wherein Treasury Secretary Henry Paulson called for the assumption of $700 billion worth of bad mortgage debt to stem a looming credit crunch, there was/is fierce debate and much criticism. Critics charged in 1790, like today, that the scheme was too expensive, that it was unfair, and that it would give unwarranted powers to the executive branch. Absent in the debate, largely like today, was the president. George Washington wanted to appear nonpartisan then took ill; George Bush has problems of trust. A leading critic in 1790, though, was the Republican (not like today’s) James Madison who regarded Hamilton’s program as benefitting only the fat-cat speculators at the expense of the original holders of the debt who, seeing no options, sold it off. Madison, therefore, resolved to pay both the original holders of the debt and the speculators a portion of its value. Hamilton scoffed, arguing, again much like today, that it would be impossible for the federal government to trace the selling of debt from original owner to speculator to the next because no one kept track.

Moreover, and also similar to today, Congress in 1790 failed to pass a timely debt-resolution bill and, instead, descended into a long (six months) debate. Madison and his supporters didn’t see why some states should have to help pay the debt of others. He also argued that the huge debt would only lead to higher taxes. In the end, with careful negotiation famously over dinner, Hamilton, Madison, and host Thomas Jefferson hammered out a deal whereby opposition to debt assumption was quieted, the bill passed, and the capital city of the country would henceforth be located in the south — where the states with less debt were to be found and forever separating the physical location of the capital from the country’s financial capital.

More importantly, Hamilton’s massive debt assumption plan worked. With the state debt relieved, the gargantuan national debt funded, foreign investors regarded the United States — now — as a good credit risk. In short, Hamilton had successfully established the country’s credit, solved a national financial credit crunch, which all resulted in huge amounts of liquidity being pumped into the American economy from abroad.

Yet there are obvious difference between 1790 and 2008. In 1790, Hamilton sorted out America’s debt problem to establish good credit for the country and sought to help pay off the debt, responsibly, with sometimes unpopular tax increases. Today, however, the United States is engaged in excessive borrowing — from China and Japan — to finance a significant trade deficit and to pay for wars in Iraq and Afghanistan (they are not being paid with traditional domestic war bonds or higher taxes). Making matters worse we need to recognize that in addition to the trade deficit the U.S. government has its own large deficit. At the same time, we are not responsibly trying to pay down this debt via taxes but adhering to the Reagan-Bush philosophy of tax cuts and making up the difference, and compounding our problems, by borrowing and spending more. Like ancient Rome (to draw in another historical example), is the U.S. now drastically over-extending itself? Will our country’s bad economic policies devastate the value of the dollar and snuff out the federal government’s good credit leading foreign investors to flee and not fund our debt, which will not allow us to buy cheap imports, and result in further domestic and international economic collapse? Perhaps Americans should focus less on issues of Wall Street fat cats, outmoded philosophies of government involvement and the “free market,” and political power grabs and focus more on explaining our situation and solidifying our economic foundations and adopting sound policies to ensure a prosperous and stable future for everyone in 2008, as we eventually did in 1790.