July 22, 2011

What Would Alexander Hamilton Do?

The founder’s financial wisdom holds lessons for today’s debt crisis.

We often forget that the main reason the Constitutional Convention met in 1787 was to resolve a financial crisis—one more serious even than ours of today.

In the wake of the successful American Revolution, the United States government was flat broke. We owed $11.7 million—real money, in those days—to European creditors (mostly the French government and Dutch bankers), $40.4 million to creditors in the United States, and an additional $25 million in state debts incurred during the war. The interest alone was over seven times the annual operating budget of the then-United States government.

Hamilton and public finance
Illustration by Barbara Kelley

This is the stuff of national disaster. More than any other single objective, the United States Constitution was designed to provide long-term institutional solutions to the young nation’s fiscal woes.

The central problem in 1787 was that the United States government, under the Articles of Confederation, had power to borrow, but not to tax. That is a nasty combination. Federal revenues slowed to a trickle. The United States was out of money.

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Alexander Hamilton, truly a remarkable young man, was penniless and family-less when he immigrated to New York in 1772 from the West Indies. John Adams called him the "bastard brat of a Scotch peddler."

At the age of 26, while serving full time as an artillery officer and aide-de-camp to General George Washington, in the midst of the war for independence, which was not going well at the time, Hamilton wrote two letters.

One was to his friend James Duane, a delegate to the Congress. It presented a proposal for a new Constitution of the United States—six years before the Constitutional Convention even met. The second letter was to the newly appointed Superintendent of Finance, Robert Morris, which suggested an economic plan for the new government. There is no better way to grasp the connection between constitutional design and financial reform than to examine these two letters.

Hamilton recognized that solving the fiscal crisis was central to winning independence, and that constitutional reform was essential to solving the fiscal crisis. In his letter to Morris, he wrote that, "Tis by introducing order into our finances – by restoring public credit—not by gaining battles, that we are finally to gain our object."

Hamilton recognized that solving the fiscal crisis was central to winning independence.

In this, Hamilton was ahead of his time. Today, economic and military historians look back on the long series of wars between England and France—France having three times the population, two and a half times the GDP, a better climate, more fertile land, and significant advantages in science and culture—and conclude that England’s military advantage was, purely and simply, its superior financial system and thus its ability to finance war.

Hamilton perceived this, and wanted to bring that advantage to America.

But Hamilton’s plans were even more ambitious than that. In the depths of the war, he was planning for the subsequent peace, and he wanted it to be a peace of strength and prosperity. Hamilton realized that if the new nation could put its public credit on a proper footing, this would not only avert fiscal meltdown in the short run, but it would bring huge commercial, military, and political benefits to the new nation for the future.

A properly funded national debt, Hamilton wrote, "if not excessive, will be to us a national blessing."

An added advantage, Hamilton realized, was that if the nation provided proper funding for the interest on the debt, it would not be necessary to repay the principal. Creditors would be more than happy to roll over their investments in stable and profitable government securities.

Moreover—and this was Hamilton’s visionary insight—if the interest were paid regularly, and everyone knew it would be paid, then the underlying securities would gain stable value. They would become a kind of liquid capital—a "blessing" in a world where gold and silver was costly to transport and use for transactions.

Hamilton thus wished to bring what economic historians call "the Financial Revolution" to America.

At this time, in most of Europe, kings and princes borrowed on their own credit, mostly for personal luxuries, wars, and foreign adventures. And they were none too scrupulous about paying it back. Instead, they dealt with their debts through defaults and depreciations, which were usually accompanied by attacks on the greedy speculators who held the royal securities. France, for example, defaulted on its royal debt in 1634, 1648, 1661, 1708, 1720, and 1770, and in intervening years debauched the currency, which is nothing but default in small increments.

These shenanigans naturally made creditors unwilling to lend to governments.

Then came the Financial Revolution. After the Glorious Revolution in 1688, the English Parliament chartered the Bank of England. Sir Robert Walpole, as Prime Minister and First Lord of the Treasury, embarked on a solid and predictable policy of full payment of interest and gradual retirement of principal, over the screams of many who thought he was favoring the fat cats and speculators. By the mid-1730s, the Crown was able to borrow money, long-term, for as little as 3 percent.

Hamilton wanted to bring the English funding system to America. To do that, the Articles of Confederation had to be scrapped, and a new Constitution adopted that would enable the federal government to raise revenue and service its debts.

The properly funded public debt indeed turned out to be a national blessing, as Hamilton predicted.

Seven years later, Hamilton got his wish. In the list of powers given to Congress, which appears in Article I, Section 8, the very first item says that Congress shall have the power "To lay and collect taxes . . . to pay the debts of the United States."

The Constitution assigns to the federal government the exclusive right to the most lucrative source of public revenue in early America: taxes on imports, and a supervening claim on the second most lucrative, excise taxes. Beyond giving the federal government the nation’s most valuable physical asset—the western lands—the Constitution also gives the federal government control over the currency, interstate and foreign commerce, and bankruptcy. These are the ingredients for a common market and a modern commercial republic.

Upon publication of the new Constitution, even before ratification, speculators in New York and abroad began buying up United States securities. In March of 1788, a leading Dutch banker bought $200,000 in American securities at 37.5 cents on the dollar. In August he increased his order to a million dollars worth, and by early 1789 Dutch investors had purchased about $4 million—and the price of continental securities was soaring toward par.

Later, as Treasury Secretary, Hamilton put into place the economic plan he had outlined in his 1781 letter to Morris, and toward which the Constitution had pointed. His public finance program had three key elements and two important effects.

First, he created a national bank, controlled by private investors, on the model of the Bank of England. The structure of the bank is a point of some interest, in light of recent events.

Hamilton insisted that private investors control the bank; the United States government was merely a minority shareholder. He explained that investors would not trust the bank if it were controlled by politicians. But he realized incentives are important. The bank would be required to redeem its notes and deposits in silver or gold, which means that the bank’s owners would lose money if they allowed the bank’s credit to slip.

Moreover, he gave the Treasury Secretary (himself) power to inspect the books and to receive weekly reports on the bank’s activities. Note what this accomplishes. The government becomes a guarantor of the transparency and integrity of the bank’s books, but leaves the bank’s investment decisions to private hands, under conditions where investors will lose money if they fail to maintain sound practices.

Second, Hamilton set tax rates at a manageable level, which would not inhibit trade and production. He realized that excessive tax rates would both hurt the economy and bring in less revenue.

Third, he dedicated certain revenue sources to repayment of the debt, with priority over other spending. This removed debt service from the politics of annual appropriations.

So much for Hamiltonian economics: our national debt is ballooning out of control.

Hamilton’s program worked amazingly quickly. By 1792, the interest rates on federal debt had crawled down first to 6 percent, then to 5.25 percent, then 4.25 percent. By 1797, for a brief period, American securities carried a lower risk premium even than British securities. The properly funded public debt indeed turned out to be a national blessing, as Hamilton predicted, enabling the United States to borrow money at the lowest interest rates in the world, and making the dollar the reserve currency of the world.

So, how are we doing today?

Let’s first consider the banking system. Today, if private investors make decisions that are unsound enough, the federal taxpayers will bear some or all of the loss. Think of Freddie and Fannie, and the banks that are too big to fail.

Second, the recent financial reform bill is not about the transparency and integrity of financial books. Instead it gives a new government agency the power to second-guess investment decisions about risk. The two changes are essentially the reverse of Hamilton’s theory that we should get the incentives right and then rely on private management.

And what about the public debt? In the last two years, the national debt as a percentage of GDP has been higher than it has even been in our history, other than during World War II. Our debt will double in about five short years. We are beginning to hear a worldwide chorus of concern that the national debt is ballooning out of control.

Hamilton taught us that a properly funded national debt, if not excessive, can be a national blessing. In 2010, the federal debt had grown to 62 percent of GDP, and is growing rapidly.

So much for Hamiltonian economics. What about Hamilton’s ideas of constitutional design?

Hamilton was skeptical of the ability of politicians facing frequent elections to make the long-term sacrifices necessary for the common good. At the Constitutional Convention, Hamilton went so far as to suggest that the President and senators serve life terms, insulating them from popular demands for shortsighted policies, like spending today and paying tomorrow. Barring that, he wanted administrative officials in the executive to serve for lengthy periods, across presidencies, so that they could bring a long-term perspective to their jobs. For the most part, these ideas were rejected, in favor of a more democratic and accountable system of governance.

Strangely, just as Hamiltonian finance has begun to crumble, there has been a resurgence of neo-Hamiltonianism in governance. The federal government relies more and more on unelected and unaccountable regulatory bodies to control our economic life: presidentially-appointed "czars," independent agencies, and the autonomous Federal Reserve. But here is the irony. The current unelected and long-termed federal officers, aided and abetted by members of Congress (who often act as if they are entitled to hold office for life), are the very people who have given us the current financial mess.

Meanwhile, it is the placard-waving, Jeffersonian common horde, flocking to town halls and filling town squares, who have become the champions of Hamiltonian prudence. Stop spending money we do not have on things we do not need, they say. Stop piling debt on the shoulders of future generations, they say. Bring back the Hamiltonian dream, where penniless bastards out of nowhere can rise by the sheer force of intellect, hard work, and audacity to succeed in an America that prefers opportunity to entitlement, that lets losing businesses fail and winning businesses make some serious money.

Do they really mean it, these oddly foresighted populists? Will they stick to their principles when budget cutting starts to pinch?

How ironic it will be if Hamilton’s dream of a national blessing were restored by the very democratic, unruly politics that he thought incapable of it.


Michael W. McConnell is a senior fellow at the Hoover Institution and the Richard and Frances Mallery Professor and director of the Constitutional Law Center at Stanford Law School. From 2002 to the summer of 2009, he served as a circuit judge on the United States Court of Appeals for the Tenth Circuit. Before his appointment to the bench, McConnell was the Presidential Professor at the S.J. Quinney College of Law at the University of Utah; before that he was the William B. Graham Professor of Law at the University of Chicago. He has also been a frequent visiting professor at Harvard Law School.

In his academic work, McConnell has written widely on such subjects as freedom of religion, segregation, unenumerated rights, and constitutional history and theory. He is coeditor of Religion and the Law (Aspen Publishing, 2002) and Christian Perspectives on Legal Thought (Yale University Press 2002).

McConnell was born in Louisville, Kentucky, on May 18, 1955. He graduated from Michigan State University (BA, 1976) and the University of Chicago Law School (JD, 1979). Before entering teaching, he served as law clerk to Chief Judge J. Skelly Wright on the United States Court of Appeals for the D.C. Circuit and for Associate Justice William J. Brennan Jr. on the United States Supreme Court, as assistant general counsel of the Office of Management and Budget, and as assistant to the solicitor general of the United States.

McConnell has argued eleven cases in the Supreme Court and served as chair of the Constitutional Law Section of the Association of American Law Schools, cochair of the Emergency Committee to Defend the First Amendment, member of the President’s Intelligence Oversight Board, and special counsel to Mayer, Brown, Rowe & Maw. In 1996, he was elected a fellow of the American Academy of Arts and Sciences.


Letters to the editor

Hamilton, the Indispensable Founder

Hamilton has always been my favorite founder as he created the financial system that allowed ordinary citizens economic and, thus, personal freedom. Your article explains it very well. Even though de Tocqueville designated Jefferson the arbiter of all questions about democracy, I believe that without Hamilton the fate of the average citizen in America would have been quite different.

--Richard L. Spencer


Letters to the editor may be sent to definingideas@stanford.edu. Editors reserve the right to reject or publish (and edit) letters.