Resolving an Enormous Debt Crisis

January 5, 2012

Thomas Jefferson might rightly be called the greatest American. His Declaration of Independence established the United States as the only nation in history founded on moral principles. His purchase of the Louisiana Territory was the shrewdest real estate deal in history—doubling the size of the United States at $.15 an acre.

This is what Jefferson had to say about an enormous national debt:

I sincerely believe…that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.

And:

It is incumbent on every generation to pay its own debts as it goes. A principle, which if acted on, would save one-half the wars of the world.

He also said:

I wish it were possible to obtain a single amendment to our Constitution. I would be willing to depend on that alone for the reduction of the administration of our government, an additional article taking from the Federal Government the power of borrowing. I now deny their power of making paper money or anything else a legal tender. I know that to pay all proper expenses within the year would, in case of war, be hard on us. But not so hard as ten wars instead of one. Wars would be reduced in that proportion.

In other words, Jefferson believed in a balanced budget amendment to the Constitution. He believed in a sound currency. He also believed that the ability of a government to borrow money was a major reason why governments enter so lightly into wars, such as Iraq, Afghanistan, and Libya.

Alexander Hamilton was Jefferson’s great rival—not enemy, but rival. Both men were greatly admired by George Washington. In his first cabinet, Washington made Jefferson Secretary of State and Alexander Hamilton Secretary of the Treasury. Ah, if only we had two such minds today in those positions.

However, Hamilton and Jefferson differed on fundamental principles—Jefferson was born a Virginian and believed deeply in states’ rights and in limited government and low taxes.

Hamilton was born in the West Indies. He believed that the states should be abolished. At the Constitutional Convention, Hamilton argued for an indirectly elected president, who would serve for life—in other words, a king. But he also had an astute financial mind and worked closely with the finest financial minds in the country at that time, such as Robert Morris. Hamilton believed that the United States would endure if the wealthy and well-educated played the dominant role in the politics of the nation.

The most critical issue facing that first Congress, meeting from 1789 to 1791, was how to solve a debt crisis of enormous proportions, and as Secretary of the Treasury, that is what he set out to do.

Adam Smith stated that once a nation had incurred an enormous debt, there were only two ways out: the nation could repudiate the debt, or the nation could inflate its currency and ruin its citizens. I ask if we are smart enough today to come up with a third alternative, a salutary alternative. I don’t know about today’s politicians, but Alexander Hamilton was smart enough.

The new Constitution of 1787 was itself a response to the debt crisis. During the course of the Revolutionary War, from 1775 to 1783, enormous debts had been run up by the individual American states, by the Congress, and by individual merchants, and by 1786 the debt situation had reached crisis proportions. Large numbers of revolutionary soldiers had been paid in paper money issued by their states or by the Continental Congress. All the states had borrowed large sums of money and were deeply in debt. The Continental Congress was deeply in debt. When general stores refused to accept this scrip money, these Revolutionary War soldiers, who had just defeated the greatest superpower of the day—Great Britain—decided to take those same muskets and overthrow this new country.

In western Massachusetts, in the fall of 1786, that is what threatened to happen. Capt. Daniel Shays, a Revolutionary War hero, mustered a large number of troops and proceeded to march upon Boston and demand that their paper money be accepted. The Boston bankers raised a militia and put down the revolt. But thoughtful men all over this new country were alarmed. This was the specter of democracy run amok. Just as Plato and Aristotle warned, a democracy would end in fiscal chaos and the rise of a tyrant.

Thus, in May of 1787, George Washington, Benjamin Franklin, James Madison, Alexander Hamilton, and others came to Philadelphia with the pressing need to find a new Constitution that could create financial, as well as political, security.

To us, today, it seems amazing that in one summer these delegates drafted a constitution which, when ratified by their fellow citizens, still gives Americans liberty under law almost 225 years later. There is no constitution in history so successful and so long-lived as the Constitution of the United States.

The real question, however, was would this Constitution work? In the ratifying conventions in the various states, that was the major argument against the Constitution. It would not work. Practical men like Alexander Hamilton, George Washington, and Benjamin Franklin said “let’s give it a try.”

Everything the new president, George Washington, did set a precedent. That is why he is our greatest president. Everything that Alexander Hamilton did as Secretary of Treasury set a precedent. Together the new administration had to present to Congress, and present quickly, a set of proposals to end this debt crisis.

In 1789, when the first Congress got under way, the debt of the United States stood at $73,000,000. To us, accustomed to speaking of trillions of dollars, this seems a paltry sum. In fact, adjusted for inflation and given the ability of a nation in 1789 to raise money, this $73,000,000 is comparable to the debt of the United States today.

The debt fell into three parts. Some $14,000,000 was owed to foreign countries—France and Holland—who had bankrolled the American Revolution. The second part was owed by the Continental Congress for purchases made during the war. The third, and largest, part was owed by the individual states’ governments for purchases made during the Revolutionary War. There were many in the country who wanted simply to repudiate that debt. A gross inflation was already under way to get rid of that debt.

Hamilton’s proposal was to pay the debt in hard currency. His goal was simple—to establish the new nation on a rock-solid foundation of fiscal responsibility and for its credit rating to be as high as possible with every government of Europe.

The first part of his proposal was to pay France and Holland in hard currency. This measure passed with little dissent. These congressmen were men of honor and this was a debt of honor.

Much more difficult was the question of paying off the debt owed by the Continental Congress. Most of those bonds had been bought up by speculators. In other words, I had loaned the Continental Congress $1,000, I believed I would never get the money back, so I sold it to you for $100, and you sold it to a third party for $.10. The question was, should you, the third party, be paid $1,000 for what you had bought at $.10? Many congressmen thought this was wrong, but with the force of George Washington behind Hamilton, the measure was carried that the current owner of the bond would be paid its full face value, plus interest. This ensured that the bonds of the United States government would be taken seriously by investors.

The third part was the most difficult. This was the debt owed by individual states. Some states, such as Massachusetts and South Carolina, were spendthrifts and had heavy loads of debt, which they had not paid off. Other states, like Virginia, when Thomas Jefferson had been its governor, were frugal. Those states had paid off their debts. Why should they, the fiscally responsible states, have to help pay off the debts of spendthrifts?

Congress reached an absolute impasse. The impasse was as complete as what exists in the United States Congress today. The difference was that then the United States had a leader, George Washington. He sat down with Thomas Jefferson, his Secretary of State, and with Alexander Hamilton, his Secretary of Treasury, and said, “Gentlemen, I want this issue settled. I want it settled today. I want it settled with the states all agreeing to pay their debts. I want you to walk up and down outside my study window until you have settled it.”

Jefferson was pessimistic. “There is no way I can get the Virginia congressmen to vote to pay these debts.”

Hamilton said, “What if we can make a compromise? What if I could tell you that I can swing the Pennsylvania delegates to vote to have the new federal capital established on the banks of the Potomac?”

“But,” Jefferson said, “it’s clearly supposed to be either Philadelphia or New York.”

“Ah,” said Hamilton, “that can all be arranged.”

Politics as we would recognize it today. Scratch my back and I’ll scratch yours. But it worked, and it worked for the good of the country.

The rest of Hamilton’s proposals were carried. A sound currency was established. A national bank was established to facilitate funding the debt. In fact, Hamilton believed that a huge debt was ruinous, but a small debt might be useful in gaining the support of the wealthy, commercial citizens of the United States. He also believed in tariffs to promote the development of industries in the new nation.

Did it work? Yes. In that same year of 1789, the French Revolution broke out in Europe. The finances of Europe were swept into chaos. There was no place in Europe for a wealthy investor to place his money. Thus the eyes of European investors turned to the United States, which had proven its fiscal responsibility. Enormous sums of money were poured into the United States, laying the foundation for a century of prosperity.
So, that is what political wisdom can achieve. Certainly Alexander Hamilton and the congressmen who voted for his proposals lacked all of our technology and lacked all of the accumulated financial wisdom of the last two centuries.

What Hamilton and these congressmen did have was patriotism and common sense. Both are sadly lacking in the parliaments of Europe today and in the Congress of the United States.

J. Rufus Fears (Ph.D., Harvard University) is a classics professor at the University of Oklahoma, where he holds the G.T. and Libby Blankenship Chair in the History of Liberty. He also serves as the Dr. David and Ann Brown Distinguished Fellow for Freedom Enhancement at OCPA.