What Would Hamilton Do?

Wednesday, October 12, 2011

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

This is the stuff of national disaster. More than any other single objective, the 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.

MAKING DEBT A “BLESSING”

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 twenty-six, while serving full time as an artillery officer and aide-de-camp to General George Washington amid 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 it was “by introducing order into our finances—by restoring public credit—not by gaining battles, that we are finally to gain our object.”

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 bring huge commercial, military, and political benefits to the new nation in 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.

Alexander Hamilton, anticipating independence, wrote that it was “by introducing order into our finances—by restoring public credit—not by gaining battles, that we are finally to gain our object.”

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.

AND THEN THE REVOLUTION

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.

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 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.

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 bring huge commercial, military, and political benefits.

Upon publication of the new Constitution, even before ratification, speculators in New York and abroad began buying up United States securities. In March 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 were 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 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.

In the list of powers given to Congress, the very first one says Congress shall have the power “to lay and collect taxes . . . to pay the debts of the United States.”

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 had 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.

A twenty-first-century view

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 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.

Strangely, just as Hamiltonian finance has begun to crumble, neo- Hamiltonianism in governance has resurged.

And what about the public debt? In the past two years, the national debt as a percentage of GDP has been higher than ever before, other than during World War II. Our debt will double in 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, neo-Hamiltonianism in governance has resurged. 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 would be if Hamilton’s dream of a national blessing were restored by the very democratic, unruly politics that he thought incapable of fulfilling it.