How did the United States change from a

nearly bankrupt country with no

financial system to become the center of

world financial markets?

The Founding of the American Financial System

---Hamiltonian Finance---

Articles of Confederation

• Extremely weak central government. Ratified 1777-1781

• Taxation: Power to tax left to states• Borrowing: Federal Government defaults

on internal debts. Can’t borrow.• Money: Many states still printing money---

and no one will hold a “continental.”

External Challenges• After 1783, Britain and other countries enact

laws that limit American ability to compete in foreign markets.– British ban American ships and goods from West

Indies – Set high duties on U.S. exports. – Cut off from British credit.

• 1784 Spain closes lower Mississippi River to American traffic.

• France restricts American trade

• RESULT? Larger trade deficits and Lower national income.

• Depression in U.S. port cities.

Internal Challenges• TRADE

– Individual states set own external tariffs and retaliate against British.

– States set own protective tariffs against other states. Protect state industries.

– Effects of tariffs?

• DEBT AND MONEY: – Debt and monetary problems of the states

and central government.

States v. the Federal Government

• Multiple Currencies • Except for Delaware which links up with

Pennsylvania, each state had its own money. Seven continue to issue paper money after 1781

• No “federal” dollar?• State failure to send taxes to federal

government. Two Reasons:– Resentment: They are jointly liable for the debt—

owed on basis of wealth not population, but only information on latter, poorer states resentful.

– Strategic: There might be some debt repudiation after first pay.

Debt and Taxes• 13 States recognize their debts and some of

federal debt owed to their citizens• Taxes raised. States paid interest and even

interest in arrears. Moving towards eliminating debt by 1790s.

• Federal government has NO revenue cannot service its debt.

• Federalists like Morris, Hamilton and Madison worry that states will assume the federal obligations owned by their citizens. 8 states begin this process.

• Consequence: no role for federal government and fear for safety of nation with parochial, self-interested states

The Constitution

• Trade (tariffs) and other economic conflicts lead states to send delegates to Philadelphia in 1787—ignore charge to amend Articles of Confederation and start from scratch.

• Finished in 4 months. Delaware ratifies December 7, 1787 and 9th vote New Hampshire on June 21, 1788---then others rush to vote.

• Congress declares Constitution in effect March 4, 1789 and in 1791 Bill of Rights passed and put into effect.

U.S. Constitution: a federal economic system• Federal power to tax---can pay debts. After default,

U.S. can honor its debts.• Central government has sole right to mint coin and

create money. – During Revolution and Articles of Confederation period,

people turned against paper money. – Constitution prohibits states from issuing “bills of credit” or

paper money but states retain right to create banks.– Congress has the exclusive right to “coin money” and

“establish the value thereof” – Result a monetary union based on specie.

• Commerce Clause---no internal tariff barriers---one national market.

• Forbids export duties, but allows tariffs and federal government power to negotiate

Constitution=one national market• Due process, no seizure of property without

compensation.• Maintain army, navy, post office, roads, fix weights

and measures, uniform bankruptcy laws, patents.• Contract clause—each state must recognize laws

and court orders of other states. • Census (1790) to determine population for

representation in House of Representatives• Implicit powers: Powers not delegated to federal

government or forbidden to states are reserved to states---licensing, zoning, regulation of business

• Common law retained. (Power of judicial review established---later.)

The New Federal Government

• 1789 Congress Opens. Washington—President (Adams, Vice President, but excluded from decision making): His cabinet:– Alexander Hamilton, Secretary of the

Treasury– Henry Knox, Secretary of War– Thomas Jefferson, Secretary of State– Edmund Randolph, Attorney General– Samuel Osgood, Postmaster General

Alexander HamiltonFirst Secretary of the Treasury

1789-1795

1755-1804

July 11, 1804, Weehauken, NJ

Four Pillars of Hamiltonian Finance

I. Monetary Systema bimetallic monetary regime with long-term price stability

II. Taxes and Tax Collectionrevenue for the federal government

III. Management of the National Debtrecovery from bankruptcy and long-term borrowing for federal government

IV. A National Bank (proto-Central Bank)foundation for financial system and short-term borrowing for federal government

I. The Monetary System

• What kind of monetary system will promote price stability and economic growth?

I. Monetary System:Coinage Act of 1792

Bimetallism

• Decision to abandon British system of one pound = 20 shillings = 240 pencefor decimal system

• Coinage Act of 1792---Spanish silver dollar for silver content of U.S. dollar) and gold coins.

• Gold was approximately 15 times more valuable than silver. Mint Ratio 15:1

• Dollars would have 371.25 grains of fine silver and 44.75 grains of copper alloy. Gold $10 (eagles) would have 347.5 grains of gold and 22.5 grains of alloy.

Bimetallism• A bimetallic standard or a gold standard are

forms of a specie standard.• Maintain long-term price stability, but have short-

term price variability.• Welcome relief after inflation of the Revolution.

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1793 1794 1795 1796 1797 1798 1799 1800 1801 1802 1803 1804 1805 1806 1807 1808 1809 1810 1811

Price Index--GDP Deflator

II. Taxes and Tax Collection

• What is a sufficient level of taxation?

• Does the Federal Government need a tax collection bureaucracy?

• Does it need to act coercively?

II. Taxes and Tax Collection:“A Huge Bureaucracy”

• Initially, Hamilton’s Department of the Treasury had 39 employees (5 in State, 1 in War).

• Hamilton devised basic bookkeeping, checking and auditing for Treasury.

• Hamilton created a customs service—to collect revenue, which could be paid in specie or notes from Bank of New York or Bank of North America.

• Gets fleet of revenue cutters to patrol offshore waters, become the Coast Guard in 1790.

• Hamilton demands exact figures from all customs collectors plus ship manifest to ascertain cargo traded, and reports from port wardens, lighthouses, beacons and buoys.

• By 1791, Treasury had grown until occupies a whole city block with 85 employees to handle auditing, records, plus 122 customs collectors and surveyors around country.

• For opponents it was a monster, fear it was Hamilton’s spy force and militia—but it collected the taxes.

The Tonnage and Tariff Acts of 1789

• Revenue!!!!

• Tonnage Act levies duties on ships entering American ports.

• Tariff Act taxes imports of some goods.

• Revenue for the central government!!!!

• Enough to pay for current expenses but not for servicing of the debt.

The Fiscal Dilemma• Tonnage and Tariff Acts of 1789 provide enough

revenue for current expenses but not for servicing the debt.

• Income from sales of federal land in the West not enough.

• What to do?• Hamilton proposes and Madison (leader of the

House) supports an excise tax on whiskey, wine, coffee, etc. and other distilled spirits.

• Measure loathed in rural areas that thrived on moonshine. Requires large number of inspectors.

• Tax put into effect in July 1791---Whiskey Rebellion results.

The Whiskey Rebellion• Tax on whiskey 7 to 18 cents per gallon. • Western farmers with excess grain often converted grain

to whiskey---easier to transport with poor They bitterly opposed the tax. Protest meetings held that were reminiscent of the opposition to the Stamp Act of 1765.

• From Pennsylvania to Georgia, farmers in the western counties harassed federal tax collectors with often violent protests.

• By 1794, protests became an armed rebellion near Pittsburgh. Loosely organized resistance, robbery and threaten assault on the city.

• Washington and Hamilton remembered Shays’ Rebellion in Massachusetts eight years before. They decide to make an example of the rebels. Washington invokes martial law and summons the state militias to form an army of 13,000. March on Western Pennsylvania. Protestors scatter and 20 are arrested.

Sources of Federal Revenue

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Federal Revenue and Expenditures 1791-1820

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III. Managing the National Debt

• Is a large national debt good or bad for the economy?

• Does it promote financial stability and growth?

or

• Does it create instability, corruption and ultimately disaster?

III. Management of the National Debt: Default of the Continental Congress

• Alexander Hamilton: “A national debt, if it is not excessive, will be to us a national blessing. It will be a powerful cement of our union.”

• Debt is good?!?• Based on view: (1) Need strong federal

government to pay debt (2) British national debt a key to development of capital market.

• Thomas Jefferson against a national debt. Letter from Jefferson to Washington (1792) “I wish the debt paid tomorrow; he (Hamilton) wishes it never to be paid, but always to be a thing with to corrupt & manage the legislature.”

But what about the debt?http://money.cnn.com/2009/06/05/retirement/next_crisis_americas_debt.fortune/

• A VIEW FROM CNN• The next great crisis: America's debt 2009• At this rate, your share of the load will be $155,000 in a decade. How

chronic deficits are putting the country on a path to fiscal collapse.• (Fortune Magazine) -- Normally Paul Krugman, the liberal pundit and Nobel

laureate in economics, and Paul Ryan, a conservative Republican congressman from Wisconsin, share little in common except their first names and a scorching passion for views they champion from opposite political poles. So when the two combatants agree on a fundamental threat to the U.S. economy, Americans should heed this alarm as the real thing. What's worrying both Krugman and Ryan is the rapid increase in the federal debt - not so much the stimulus-driven rise to mountainous levels in the next few years, but the huge structural deficits that, under all projections, keep building the burden far into the future to unsustainable, ruinous heights. "The long-term outlook remains worrying," warned Krugman in his New York Times column. Krugman strongly supports President Obama's spending plans but bemoans the shortfall in taxes to pay for them.

• WHAT WOULD HAMILTON DO?

Hamilton, Report of Public Credit (1790)• Debt is the “price of liberty” and a

“blessing” A “permanent” debt?• “States, like individuals, who observe

their engagements are respected and trusted, while the reverse is the fate of those who pursue an opposite conduct.”

• Manage the debt by setting aside revenue at regular intervals to service interest and slowly pay off principal. Benefit will permit lower interest rates.

• Trust in government is a key: “In nothing are appearances of greater moment than in whatever regards credit. Opinion is the soul of it and this is affected by appearances as well as realities.”

• Public relations and confidence building are key for the Secretary of the Treasury.

Ending the Federal Government’s Default:

Three Issues1. “Full Payment” ---Should all or part

of the debt be paid? Default? Why?2. “Discrimination”---Should the

current or original holders of debt be paid? Why?

3. “Assumption” ---Should the federal government assume the state governments’ debts? Why?

Full Payment?• Huge burden of wartime debt. Belief that it is

impossible to raise taxes sufficiently to pay interest and principal.

• Decision: – Foreign Debt (originally at 4 or 5%) to be Paid in full – Domestic Debt (originally at 6%) would be partially

repudiated.• Hamilton gambled that creditors would accept

lower rates for rock-solid guarantee of repayment. But why treat foreign and domestic differently?

• Europe had long-established capital markets, unlikely to be forgiving. Dubious title of some domestic debt.

Full Payment?• A One Time Default on Domestic Debt: Offers

voluntary refunding scheme with many options– Partial payment at 6% plus some land in West– Lower interest rate stretched over longer period– 6% on 4/9 of total, 3% on 3/9, and 6% on 2/9

beginning in 1800– Almost all is exchanged for new debt.

• Most of the debt becomes perpetual bonds, like British consols

• Paid with pledged taxes---the excises on wine, whiskey, coffee, and tea---”sin taxes”

The “Discrimination Issue”• During war, many citizens buy bonds, get

paid for supplies with certificates and war veterans get script.

• Bond prices all tumble under Confederation. Fear no repayment and sell securities to speculators for as little at 15 cents on the dollar.

• Government now promised payment and prices of securities soared. Seemed to some to be unfair. Who should benefit---speculators or upright patriots?

The “Discrimination Issue”• Decision: Current holders of debt will be paid not

original• Hamilton: “discrimination” in favor of former debt

holders would be “ruinous to public credit.”– An administrative nightmare to track down original

owners.– They had showed little faith in the government– Speculators hazarded their money– Securities are freely transferable and buyers assume

rights to profits or losses----a question of property rights

– Hamilton worries that discrimination would discourage European investors

The “Assumption Issue”• Decision: Hamilton decided that the federal

government should assume the states’ debts.• Why?

– The war was a joint effort.– Bondholders would have a stake in preserving a

(federal) government that owed them money.– Federal government had exclusive right to collect

import duties---a key source of revenue. If states had debts they might contest this right, re-creating chaos of Confederation. Eliminate incentive for states to compete with federal government.

Hamilton: on the Three Issues

• Full Payment: Only pay in full on Foreign Debt, partial payment on Domestic Debt

• Discrimination: Only pay current not original owners.

• Assumption: Federal Government should assume debts of states

• Result: Large Federal Debt that remains outstanding.

The Politics of the Debt• A “Perpetual Debt”: Interest paid out of general

revenues. Slow retirement of principal by the sinking fund supplied with Post-Office revenues.

• Bonds appear to be rock solid—perfectly safe. Induces speculative craze---huge change in expectations! Price of debt soars from 15-20% to near “par.”

• Worsens North-South division as many original holders of debt are from the South and they sold it to speculators in the North.

• Enemies called it a “villainous business” They claimed that it corrupted Congressmen and helped New York speculators.

The Politics of the Debt:Discrimination Issue

• James Madison, Hamilton’s co-author of the Federalist Papers assailed the plan. Madison, leader of House of Representatives, demands windfall go to original owners—”true” patriots.

• But, in Congress Hamilton wins. Hamilton furious that Madison joined Jefferson’s opposition.

• Madison opposed assumption because he believed Virginia and other Southern states had paid off most of wartime debts. Wrong “to contribute to those states [i.e. NY, NJ] who have not equally done their duty.”

• But no one knows the true position of each state

Politics of the Debt:Assumption Issue

• Hamilton argued that debt was generated by the Revolution and all had benefited and that all should assume collective responsibility for the debts.

• If state debts were unequal so were the sacrifices made during fighting.

• Hamilton initially loses this argument in Congress in June 1790 bill.

• Hamilton trades passage of assumption with the Residence Act (July 1790), designating the capital to be permanently on the Potomac with Philadelphia as interim capital although Hamilton had wanted New York.

State Debts assumed but Hamilton equalizes the Burden of the Debt

A. By 1786, congressional clerks had identified claims of every individual. Now look at question of each state’s relative contribution to the military effort.

B. Calculates the total expenditure by 13 states to be $114 million. Federal advances to the states deducted ---net balance of $76.6 million of common expenses.

C. Each state assessed its share of total on a per capita basis.

D. From each state’s assessment, its contributions were deducted.

E. Zero sum game—6 debtor states owe $3.5 million to 7 creditor states.

F. Treasury to compensate creditors with U.S. Bonds.

Example• New Jersey spent $3,816,000 for the war

out of total war cost of $76.8 million.• Based on its share of population, NJ’s

share is 4% of $76.8m or $3.1m ($3.072m).

• Spent $3,816,000 – Share $3,072,000 = net credit of $744,000.

• It has state debt of $659,000---these are assumed by federal government---so balance owed to New Jersey is $744,000-$695,000 = $49,000, paid in new US bonds.

Items B & C

Items D & E

•Upper limit of $4 million per state!

The Political Economy of the Debt• Three large debtors—Delaware, New York and

North Carolina• Four big creditors—Massachusetts, Connecticut,

Rhode Island and South Carolina.• Their positions were unclear at time of

ratification of Constitution– NC anti-federalists fight ratification partly because

they fear the cost– MA makes determined efforts (a huge tax increase) to

reduce its debts unaware of its net creditor position----helps to provoke Shays’ Rebellion.

What Debt is the Federal Government Left With?

The Debt---the details

The Federal Debt and the Assumption of the State Debts---

something any 21st century investment banker could admire• January 1, 1790

– Domestic Debt and Arrears $40.3 million– Foreign Debt and Arrears $11.8 million

• Federal Assumption of State Debts $18.3 million• Total Federal Debt now $70 million.• Hamilton’s goals

– Military expenditures 1775-1783 were common. Federal government to assume ALL unpaid debts—federal and state-----reverse trend of states denationalizing the debt

– Inclusion of state debts would increase initial size of capital market

– If federal government meets interest payments on total its credit will receive a big boost.

– Increases federalist support for federal taxes

How to pay for the debt?• But it is rising!! Aggregate debt in 1792: $80.4

million (rising to $83 million in 1795). • Hamilton needs about $5 million per year (2% of

GDP) in revenue (interest expenditure is 70% of budget or $3.5 million)

• Tariff rates too low, not enough revenue, raised so that in 1793 yield $4.3 million.

• Excise tax on alcohol (about $500,000),and other small excises—just enough.

• 1794 Whiskey rebellion in Western PA to vigorous efforts to collect revenue—suppressed.

• By 1796, first substantial federal surplus.

Hamilton’s Achievement

Are you a Jeffersonian or a Hamiltonian?

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Hamilton’s Achievement—Risk Premium

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What would Hamilton do?

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