2011-11 "Debt and Dumb" by Simon Johnson and James Kwak from "Vanity Fair" magazine
As a young artillery captain in the Revolutionary War, Alexander Hamilton learned a crucial lesson: Good credit, based on the power to tax, is essential to a nation’s security. As the ﬁrst U.S. Treasury secretary, he built America’s ﬁscal policy on that principle. Will the Tea Party destroy his legacy?
Rick Perry, Mitt Romney, Michele Bachmann, and the rest of the Republican candidates are running for president on the idea that today’s federal government is far out of line with the original intent of the Founding Fathers. The Constitution, in Perry’s view, permits only a narrow and specific list of activities to be run out of Washington—and Social Security and Medicare are definitely not on this list. As they vie for the support of the Tea Party faithful, the candidates compete to enumerate the ways in which they are, in the title of Perry’s recent book, Fed Up!
They say this is the Boston Tea Party redux. But that tea party was about the American colonists’ objection to being taxed by the British Parliament, in which they had no representation—not the scope of a national government or the power of a duly elected legislature to tax its citizens. With their steadfast resistance to taxes, their hostility toward central government, and their willingness to risk a national default, today’s Republican candidates tap into a different American tradition—one that begins not with tea but with whiskey: the Whiskey Rebellion of 1794.
To understand that rebellion and why President George Washington was willing to send troops to put it down, go back to the early days of the Revolution and look at what really motivated the founders.
In September 1776 a young artillery captain named Alexander Hamilton struggled to cross the woods of northern Manhattan. With the British at his heels, he was one of the last American officers to reach safety. Political considerations had required George Washington to defend New York, but with their fleet and large numbers of mercenaries the British had easily surrounded and repeatedly overwhelmed the patriot forces.
This lesson was drubbed into the artillery captain’s head again and again over the next seven years as he rose to become Washington’s close aide. The British had an empire and a larger population, to be sure. But the American colonies also had great resources and over two million people. What the British had, more than anything, was money—money in the hands of the government that could be used to equip ships, pay troops, and send them halfway around the world to suppress rebellions as needed.
The United States of America, which had proclaimed its independence so grandly in 1776, had trouble keeping 10,000 men in the field. The British routinely had 15,000 to 25,000 experienced troops available for battle. George Washington struggled to keep the British at bay for a simple reason: there was no tax revenue to back him, and without the assured prospect of future income there was no way for the Continental Congress to borrow sufficient funds.
The man who learned this lesson better than anyone—and who thought more about what it meant—was Hamilton.
Modern Americans have long ago lost track of the challenges that our new country faced when fighting Europe’s leading power: our soldiers had to suffer with little food, poor shoes, and derisory accommodation during harsh winters and couldn’t even get paid on time. We proudly remember Valley Forge, forgetting that some 2,500 men starved, froze, and died of disease in the winter of 1777–78. We never think of the Pennsylvania Mutiny of 1783, in which destitute Continental soldiers hounded Congress out of Philadelphia.
The young United States got lucky. Although it was a poor credit risk, the Netherlands and France lent it money to spite the British, and the French provided troops and ships that helped tip the balance. But what Hamilton learned, as Washington’s indispensable liaison officer, was that the new country could not really be independent unless the world’s powers backed off. And whatever you might like to believe, such powers never respect anyone without the ability to make war. Hamilton’s conclusion was simple: You cannot run a prosperous and secure independent country without the ability to finance the sudden surge in spending called for by a national emergency—which requires borrowing large amounts of money quickly.
It was Hamilton who laid the foundations of the system of public finance that propelled the United States to economic prosperity and global prominence. But it was the experience of 18th-century warfare that gave him the motivation for his ideas.
Hamilton’s Homework -
At the beginning of the 18th century, France, not Great Britain, had been the most powerful state in Europe. Louis XIV, the Sun King, was the Continent’s most powerful monarch. France had Europe’s largest population, its largest economy, its largest armies, and even for a time its largest navy.
Throughout the 18th century, Europe was locked in an episodic series of wars, often to contain French power. While alliances shifted, France’s constant enemy was Great Britain. On paper, Britain began as the lightweight. It had less than half of France’s population and a small fraction of its army. Its economy was only half as large. And Britain was coming off a century of political turmoil that had seen the execution of King Charles I, the restoration of King Charles II, and finally the overthrow of King James II. Yet Great Britain proved to be more than France’s match on the world stage. The two powers fought to a standstill on the Continent, while Britain seized most of France’s overseas colonies in the Seven Years’ War, from 1756 to 1763 (known here as the French and Indian War).
The secret to Great Britain’s power was boring: fiscal policy, or the way its government raised and managed money. In 18th-century warfare, access to cash meant the difference between victory and defeat, and here Britain reigned supreme. Taxes in Great Britain were collected by a modern, centralized bureaucracy, while in France, the tax collectors were often corrupt. But taxes could never buy enough ships, mercenaries, and supplies in wartime, so governments were forced to borrow money. And here, Great Britain’s secret weapon was … democracy. Since 1688, Parliament had had control over taxation and spending policy: decisions were in the hands of the people whose money was being spent. This legitimized government policies and ensured Britain’s exceptional credit. And as Robinson Crusoe author Daniel Defoe wrote, “Credit makes war, and makes peace; raises armies, fits out navies, fights battles, besieges towns; and, in a word, it is more justly called the sinews of war than the money itself.”
In France, the Estates General (the closest approximation to Parliament) had not met since 1614. Debts were incurred by the monarchy, which relied on an unstable tax-collection system to bring in revenues, and absolute monarchs’ habit of stiffing creditors meant that the government had to pay high interest rates to borrow money. The problems with this system became clear after the American Revolutionary War, which forced both Great Britain and France to borrow large amounts of money. Great Britain emerged from the war with a national debt as large as France’s but paid half as much in interest, thanks to its good credit. In France, by contrast, efforts to raise taxes met with increasing resistance, and finally King Louis XVI was forced to call the Estates General, which rapidly transformed itself into the National Assembly—the first step in the French Revolution. (The Revolution and the rise of Napoleon led to another 20 years of war—in which Great Britain ultimately prevailed again, thanks in part to its superior ability to raise money.)
In modern geopolitics—since 1688, at least—credit matters. And good credit requires more than just a strong economy, because, in order to raise money, it’s essential to have a political system that people believe in. In words familiar to all Americans, there can be no taxation without representation (except in the District of Columbia). And without the ability to tax effectively, no government’s debt will be credible.
The lessons of the British-French rivalry were clear to Alexander Hamilton and the other founders of our nation. After all, it was our Revolutionary War that pushed the French monarchy to the brink of collapse. And a major question for the American government, taking office in 1789 under the new Constitution, was what its fiscal policy should be.
The Decision -
The most pressing issue was what to do about the new nation’s debt. Both the Continental Congress and the individual states had accumulated massive debts during the Revolutionary War—close to $80 million, an enormous amount in those days. Hamilton—now secretary of the Treasury under his old boss, now President Washington—wanted the new federal government to assume the states’ debt and pay them back in full. Since the government did not have enough cash to pay off those debts, he proposed to borrow new money by issuing Treasury bonds—and to pay off those bonds with new taxes on liquor, tea, and coffee. On the other side, Thomas Jefferson and James Madison feared that the plan would give too much power to the federal government, setting the precedent for further borrowing. But ultimately they agreed—in exchange for Hamilton’s support in relocating the nation’s capital to the shores of the Potomac River, in a new city called Washington.
Hamilton’s plan was an economic success: the federal government quickly established a solid credit rating, consolidated its debts at low interest rates, and began paying them down rapidly. His plan also led to the new nation’s first anti-tax rebellion. In western states, farmers refused to pay the new tax on whiskey (which was sometimes used as a medium of exchange), leading to armed rebellion in Pennsylvania. In 1794, President Washington raised a federal militia and dispatched it to western Pennsylvania. The Whiskey Rebellion collapsed, cementing the federal government’s power to levy and collect taxes.
In just five years, Hamilton—with Washington’s support—had laid the foundation of American fiscal policy. The federal government would always honor its debt. After the War of 1812, the Civil War, World War I, and World War II, this principle remained unquestioned. By the late 19th century, the government could raise large amounts of money on short notice—which made possible, among other things, rapid mobilizations to fight two World Wars.
Government bonds also became a crucial part of the financial system—the paradigmatic global risk-free asset, the universally accepted collateral on which everything else depends. What makes those bonds as good as cash is that the federal government has the power to levy and collect taxes in order to pay them off.
Hamilton’s scheme has succeeded at a scale unimaginable in 1790. Elsewhere, we have questioned Hamilton’s affection for large, powerful banks, but his contribution to American fiscal policy is undisputed. The good credit of the federal government has allowed us to amass trillions of dollars of debt, run the largest peacetime deficits in history, and still borrow money at historically low interest rates. But that has not made everyone happy.
Undermining Hamilton -
In August, the credit-rating agency Standard & Poor’s downgraded the federal government, claiming that our leaders no longer showed the ability or resolve to reduce large budget deficits. At first glance, this might seem to support the claims of Republican leaders like House Speaker John Boehner, who said the federal government was “broke,” and Tea Party heroes like presidential candidate Ron Paul, who said the country was “bankrupt.” Their position, which has been accepted as dogma by Republicans in Congress, is that the government has been overspending for decades, and only major spending cuts can rescue our creditworthiness.
But there’s a big problem with this story. After the S&P downgrade, the prices of government securities went up, not down. Interest rates for the federal government kept falling, reaching their lowest level in 60 years. This was the opposite of what recently happened in countries like Greece and Italy when markets became nervous about their government debt.
The S&P downgrade proved that Hamilton was still relevant. Treasury bonds retain their place in the hearts of investors as the ultimate safe place to park their rainy-day funds. This lowers our interest rates and helps keep our economy in better shape than it would otherwise be.
The federal government’s sturdy credit has confounded anti-government conservatives, who for decades have been counting on large deficits to force the federal government to shrink. This is the essence of the “starve the beast” strategy spearheaded by elite conservative groups such as the Club for Growth and Grover Norquist’s Americans for Tax Reform: cut taxes at every opportunity and eventually the government will have to get smaller. But after both the Reagan tax cut of 1981 and the Bush tax cuts of 2001 and 2003, spending only grew, and the Treasury Department was easily able to borrow enough money to make up the difference.
The Tea Party is the latest face of this modern tax revolt. Despite the myth that it spontaneously sprang into being in 2009, the Tea Party has been largely backed by experienced Republican operatives and funded by wealthy businessmen. And its foot soldiers come from the same pool of white, religious social conservatives who have pulled the Republican Party rightward in recent decades.
This time, instead of merely singing the praises of free enterprise, the Tea Party is intent on undermining the federal government itself. Its leaders claim that the federal government is illegitimate or unconstitutional, a view popularized by media star Glenn Beck and now brandished by the torchbearers of the Republican Party. Whether it’s the Affordable Care Act requiring people to have health insurance or the Federal Reserve “printing money,” the rallying cry is that the federal government is violating its fundamental pact with the people—even prompting Rick Perry to threaten Federal Reserve chair Ben Bernanke with a Texas-style whuppin’ if he attempted to help the economy before next year’s elections.
Tea Party–backed politicians were at the vanguard of the attempt to force the federal government to default in this summer’s debt-ceiling crisis—which really would have violated the government’s fundamental pact with its creditors and citizens. Representative Michele Bachmann pledged unconditionally to vote against any increase in the debt ceiling. Ron Paul argued that defaulting on the national debt would actually be a good thing. Respect for the Tea Party—or fear of it—led every leading Republican presidential candidate to oppose the debt-ceiling deal.
This is no fringe ideology. While increasingly unpopular, the Tea Party still enjoys the support of one in four people, and a large majority of Americans believe that the federal government should be smaller. (It’s not clear whether they realize what this would mean: more than 40 percent of all Americans who have benefited from Social Security, subsidized student loans, or unemployment insurance do not understand that these are government social programs.)
A bare majority of the Tea Party caucus in the House eventually voted for the debt-ceiling increase, but that was because they had achieved their primary goal: a bill that was all spending cuts and no tax increases. “Don’t tread on me” may be the rallying cry, but the real issue is taxes. Congressional Republicans have successfully held the line against any tax increases—even against closing tax loopholes, like the break for corporate-jet owners—and every Republican presidential candidate said they would reject the idea of reducing the deficit with $10 in spending cuts for every $1 in tax increases.
Today’s tax revolt may not be taking up arms against the federal government, but that’s because it is far stronger than a motley collection of western-Pennsylvania farmers. Virtually every Republican in Congress, including an overall majority of the House, has signed a pledge to oppose any bill that would increase tax revenues. This makes it almost impossible for any Treasury secretary today to do what Alexander Hamilton did (and what Great Britain routinely did in the 18th century): raise taxes to pay down the national debt. The Tea Party’s preference for default over higher taxes could effectively break open the deal struck by Hamilton, Jefferson, and Madison—and backed up with force by Washington—more than 200 years ago.
As presidents, Jefferson and especially Madison both came to realize the value of being able to sell a great deal of marketable government debt quickly. Jefferson struggled to get financing for the Louisiana Purchase, one of the best real-estate investments of all time. Madison had an even ruder awakening. In the War of 1812, the British burned the White House while the federal government had trouble scraping together enough money to build a few frigates. Treasury Secretary Albert Gallatin was forced to go cap in hand to beg money from individual financiers. Gallatin had supported the Whiskey Rebellion (as a moderate who helped negotiate a peaceful stand-down) and opposed Hamilton’s vision of federal fiscal power. After 1812 he got the point and even re-introduced the same taxes he had opposed in the 1790s. And today Gallatin’s statue—not Hamilton’s—stands in front of the Treasury Building.
Good credit made the United States the dominant world power of the 20th century. Whether it will ever force the federal government to default or not, the Tea Party and the conservative tax revolt behind it are chipping away at the fiscal foundations built by Hamilton at the dawn of the Republic. Ultimately, this could make us less like 18th-century Great Britain and more like 18th-century France: a country where the people no longer believe in their government and refuse to pay taxes, destroying the sound credit that is still vital to national prosperity and power.