America joined the first rank of nations in early March 1797, when for the first time in history U.S. government bonds traded at higher prices than comparable British government bonds did in London. The inversion occurred because British investors feared invasion; the French had botched an incursion into Wales in late February but remained a potent threat to the Home Islands. Frightened investors from London to Liverpool swapped their own government’s bonds for those issued by the U.S. government, which since the early 1790s had proven itself highly creditworthy. Prices soon again reversed but the differential between British and American bonds remained close through the next century and more of peace and war, exhilaration and depression, prosperity and recession, a tribute to both the Mother Country and her upstart offspring. A nation’s greatness, after all, is usually directly proportional to its credit. Those with superior credit, like Holland, Great Britain, and the United States, long reigned as world super powers. Tiny Holland defeated the Hapsburg Empire because it could borrow large sums for long periods at low interest. The sunny British Empire was likewise built on the backs of bonds issued by a government that investors knew would pay its obligations punctually. And the U.S.A. won the Civil War, both World Wars, and the Cold War by borrowing sums so vast that its enemies could not hope to compete.
The close historical connection between credit and geopolitical might is why some observers were alarmed by the mid-March 2010 announcement that Moody’s, one of the largest, hoariest, and most respected credit ratings agencies, might downgrade its rating of U.S. Treasuries. With its bonds long accorded the highest rating, Aaa, the U.S. government has been able to borrow as much as it wanted from investors worldwide at the lowest rates available. If its rating was downgraded, the federal government would find itself in a position analogous to that of an individual with a credit score of 800+ who ran up credit card debt at low rates only to be hit suddenly with a much lower score and consequently much higher interest rate payments. A downgrade would negatively impact every American, from newborns to centenarians, unskilled workers to professionals, homemakers to home builders, prisoners to pensioners, students to teachers, and voters to politicians. Collectively, American taxpayers owe bondholders almost $13 trillion and much of that needs to be repaid or refinanced within the next 5 years. Interest rates are currently low, so “only” about 10 percent of the federal budget goes to pay interest on that debt. If budget deficits (which of course entail additional borrowing) stay high and interest rates rise, however, a larger percentage of the federal budget will have to be paid out in interest. That means that American tax dollars increasingly will go to China, Japan, and other bondholders instead of into education, transportation infrastructure, research, Homeland Security and the armed forces, and conceivably even Social Security and healthcare. Or, taxes will have to increase, perhaps considerably.
Barring a politically-motivated budget impasse like that of 1995, the U.S. Treasury will not outright default on its obligations. The government’s bonds are denominated in dollars, after all, and the government via the Federal Reserve can create dollars at will. More likely therefore is a “soft” default whereby the government meets its obligations by creating so much money that inflation results, as it did during the 1970s. (Oil embargoes didn’t help, but most of the rise in prices that decade was due to loose monetary policy.) Interest rates rise during inflationary periods because investors buy bonds in order to reap real returns, or in other words to increase their purchasing power, not to see it eroded by ever higher prices. Inflation also tends to weaken the dollar in international markets, causing foreign bondholders to seek higher interest rates as well. If the dollar weakens too much, the U.S. government may have to begin borrowing in foreign currencies like the euro, yen, or yuan, which could ultimately lead to a “hard” default, much like those in Argentina in 2001 and Russia in 1998.
America’s fiscal situation at present looks more dire than a wolf but the nation might be able to learn something from the experience of its founding generation, which faced a much more pressing fiscal problem but eventually found a politically palatable solution that worked wonders for the economy. The United States was born bankrupt. Even after the end of the Revolutionary War, its national and state governments could not find the means to repay the enormous debts they had racked up fighting for independence. (In fact, had the British not gone so far into debt fighting the French over the course of the eighteenth century, the rebels would not have prevailed and may never have rebelled in the first place. But that’s a different story.) Fearful that the young republic could disintegrate into warring factions or perhaps again be colonized by a European power, a small group of reformers pushed for the creation of a benign but relatively powerful national government. The story of how they wrote and ratified a new frame of government has been oft and well told. That the reformers followed up by establishing the new government’s credit is less well understood and often recounted, when discussed at all, through the lens of partisan politics. In fact, partisan differences were relatively unimportant compared to the broad consensus that the United States had to repay its debts and grow its economy. Squabbles there were, but mostly over details.
To establish its credit, Federalists (the party of George Washington and Alexander Hamilton) and Democratic-Republicans (the party of Thomas Jefferson and James Madison) agreed, the national government’s revenues had to exceed its expenditures. Federalists wanted a somewhat bigger government than the Democratic-Republicans sought but both sides believed that the government’s proper scope was extremely limited. Both thought that tariffs (taxes on imported goods) and tonnage duties (taxes on international trading ships) should be the national government’s major sources of revenue but they bickered a bit over technical issues like tariff levels on specific goods and subsidiary sources of revenue, including excise taxes on whiskey, which the Federalists thought necessary lest the tariff on foreign spirits do nothing more than encourage domestic whiskey production and consumption.
Because the national government laid exclusive claim to the tariff, traditionally a major source of revenue for the states, the Federalists thought it necessary to assume responsibility for the state’s wartime debts as well. To ensure that the national government could borrow large sums quickly if it ever faced a revenue shortfall, the Federalists also wanted to establish the Bank of the United States. The Democratic-Republicans pushed back on both assumption and the bank using the rhetoric of states’ rights and strict limitation of the national government’s powers under the Constitution but conceded both issues in exchange for locating the permanent capital on the Potomac.
The Democratic-Republicans also made a loud ruckus about who should receive the new government bonds created by Hamilton’s funding system, the original holders of IOUs issued during the war -- typically represented as soldiers, farmers, and patriots -- or the current holders -- usually described as grasping speculators. It’s an old canard that Hamilton and his Federalist minions wanted a large, perpetual national debt while Jefferson and his virtuous Democratic-Republican followers sought the opposite. Yet the plan espoused by Madison to discriminate against current holders of the debt would have actually increased the national debt in no small measure. Moreover, Hamilton believed that the national debt would be a blessing only if it wasn’t “excessive,” or too large a proportion of the total economy (gross domestic product or GDP in modern parlance). Hamilton therefore wanted to pay the debt off slowly so as not to jeopardize economic growth by burdening innovators with high taxes.
Jefferson and many of his followers accused Hamilton of merely copying British institutions, a bad omen in their Anglophobe eyes. In fact, Hamilton created the perception of European fiscal orthodoxy while simultaneously innovating around the edges, adapting Dutch and British precedents to American circumstances. The Bank of the United States, for example, was more sophisticated than the Bank of England because it had numerous district banks (called “branches”) and engaged in lender of last resort activities (a type of “bailout”) in March 1792, at least a year before its British predecessor did. Hamilton also innovated by building into some U.S. government bonds an option that allowed the government to repay up to 2 percent of the principal annually, much like a modern amortized mortgage. Finally, Hamilton realized before most that ownership of government bonds wedded prominent citizens to the new government. Only a small percentage of the population owned government bonds at any given moment, but holders were spread pretty widely geographically and tended to be local civic and business leaders.
Hamilton’s financial program established the new government’s credit as its bonds rose in price from a few pence on the pound to over 100 cents on the dollar and soon rivaled British bonds in Amsterdam and, as noted above, even in London. The Bank of the United States also proved a rousing success. Parts of Hamilton’s tax program caused political difficulties but his tariffs provided ample revenue in most years and were as popular as taxes can be. (Numerous uninformed claims to the contrary, he did not implement a protective tariff. That he wanted to is based on a misreading of his Report on Manufactures.)
Despite playing politics at times, Jefferson also helped to establish the nation’s creditworthiness. His administration tweaked the tax code but left Hamilton’s bank and funding system in place, allowing it to purchase the Louisiana Territory by selling bonds, something unthinkable just 15 years before. Until recently, subsequent administrations were also careful to maintain the national government’s creditworthiness. Time again, as the accompanying graphic shows, the debt to GDP ratio increased only during wars and recessions but quickly receded in the face of budget surpluses and economic growth.
One of Jefferson’s worst fears, a runaway national debt, may now be upon us, however. Politicians face an unquenchable urge to borrow and spend and of late have been unable to slake that thirst. During the administrations of George W. Bush and Barack Obama, the national debt has rapidly outgrown the economy, forcing the debt to GDP ratio towards 100 percent, a level achieved only once before, while fighting a two-front world war on the heels of the worst economic debacle in the world’s history. Two minor wars and sharp but short recessions in 2001 and 2008 have been used to cloud the trend, but voters appear to be catching on. Unfortunately, politicians have turned to accounting legerdemain designed to put off the pain until after the next election. Such tactics may work for a time but in the end bondholders and credit rating agencies will not be denied. What America needs now is the same as it needed in 1790, economic statesmanship, budget controls, and a vibrant economy.
Robert E. Wright has authored Fubarnomics, One Nation Under Debt, and 10 other books on U.S. business, economic, and financial history and holds the Nef Family Chair of Political Economy at Augustana College, SD.