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Hamilton’s Revolutionary Financial System

“A national debt, if it is not excessive, will be to us a national blessing.”
                                     —Alexander Hamilton

At George Washington’s invitation, Hamilton eagerly accepted office as the nation’s first treasury secretary. Though only 34 years old, he had long considered the severe economic and financial problems facing the country. He had corresponded actively with the few prominent financiers and finance theorists of the time and had some years earlier outlined the nation’s difficulties in a widely read essay, “The Constitutionalist.” Because New York was then the capital, the government had located the Treasury office on Broadway just south of Trinity Church. When he first entered it on September 11, 1789, he had already begun his official work. The Saturday before he had arranged an emergency $50,000 loan for the federal government from the Bank of New York, one of the few in the country at the time and one that he had helped organize. That was no small amount either, even though such numbers today rate as petty cash in Washington.

Though Hamilton had clearly thought matters through, he used his small staff to clarify the details. He determined that the new government faced a debt burden of some $50 million. This seems like a tiny number by today’s standards, where billions and even trillions prevail in matters of government finance, but in the late eighteenth century, it was a crippling sum. The federal debt outstanding exceeded the government’s annual revenue by a factor of 300.  The 6 percent interest due on that debt each year exceeded government revenues by a factor of almost 20. National income figures from 1789 are sketchy to say the least, but estimates put the debt at just under $12 for each of the country’s four million citizens. That, too, seems small, but in 1789 the average American earned about $162 a year.

Obligations facing the country came in all shapes and sizes. The government owed some $10 million overseas: $4.4 million to France; $1.8 million to Dutch bankers, guaranteed by France; an additional $3.6 million to those same Dutch bankers without a French guarantee; and $175,000 to the Spanish government. In addition to the 6 percent annual interest on this debt, the United States also had an obligation to pay down part of its outstanding principal each year. Domestic debt, though it mostly carried a 6 percent rate of interest as well, was not subject to a schedule for repayment. According to most of its covenants, Congress had discretion over how much to pay back and when. These domestic obligations amounted to $40 million and consisted of some $11 million in so-called “loan certificates,” direct borrowing by Congress under the wartime government and the Articles of Confederation; $16 million in promissory notes the army issued during the war for supply; and, because the government in the past had borrowed to pay interest on existing debt, an additional $13 million in so-called “indents” or “certificates of interest.”

The treasury staff also tallied state debts. These they estimated at some $21–25 million. Though not officially a federal obligation, Hamilton knew that they nonetheless affected the nation’s credit worthiness and so deserved his office’s consideration. Besides, the previous government under the Articles of Confederation had acknowledged its obligation on some state debts (those that had supported the war effort). That government had begun an audit in the early 1780s to determine where those obligations resided. Its efforts produced more dispute than conclusions. Virginia, for instance, had issued debt to support George Rogers Clark’s activities in Ohio but that effort, many contended, aimed less at fighting the British than gaining territory for Virginia. Others questioned the obligations Massachusetts had incurred to support its military adventures in Maine, for similar reasons. Matters were so convoluted that the audit commission took five years just to reach a compromise on the number of commissioners and was still debating when the new Constitution came into effect and Hamilton took office.

Even without considering state debts, the government faced an unsupportable predicament. At best, the addition of new taxes could gather some $2.8 million in revenues over the coming year. From this amount, the treasury needed $600,000 to run the government, leaving a maximum of $2.2 million for debt service. The 6 percent interest on the foreign debt alone amounted to $600,000 a year. The required $489,000 in annual principal payments put the foreign obligation over $1.0 million a year. Interest on $40 million of domestic debt would then leave the Treasury $1.2 million a year short on its debt service obligation, and that ugly fact did not even take into account state debts.

What is more, the budgetary impasse only captured one of the problems facing the new government. The country’s entire system of payments had long since collapsed. People had lost confidence in the government’s ability to make good on the $200 million in paper money issued during the war, the “continental.” That paper was all but worthless; no one would take continentals in payment. Because of what had happened to them, new issuances of paper money were out of the question. Gold and silver, the medium of exchange common in Europe and in which all had confidence, could not substitute. Most of it had gone abroad to service the government’s foreign debt obligations and continued to flow abroad for that purpose. Meanwhile, the government’s poor record of debt repayment had depressed the market price of its domestic bonds to one-fifth of its original face amount. And because its value kept slipping, few stood ready to hold this paper for very long, rendering it a poor substitute for money and an equally poor support for commerce. By 1790, the country completely lacked a national medium of exchange; everyday business relied on some 50 different foreign coinages and paper, as well as some private issues.

This failure of domestic finance hamstrung the economy. People effectively had to engage in foreign exchange transactions just to make daily purchases. Because no financial medium held its value, no one would lend for fear that repayment would have no value in the future, if it even arrived at all. Since gold and silver were scarce, writing loan contracts in either of those metals was hardly feasible. Farmers could not borrow to buy seed for planting. Wholesalers and retailers lacked credit to finance inventories. Shelves were bare, and sales suffered accordingly. Investment and development suffered especially. Because these activities require longer-term commitments, lenders saw even more risk in supporting them than in loans for planting or inventories. No credit was available.

If these difficulties were not crushing enough, Mr. Hamilton and America faced a still more fundamental economic problem. As a colony, it had prospered within Britain’s imperial system. Its output of exclusively agricultural products and raw materials had a favored place on the mother country’s markets and those of its other colonies, the rich West Indies in particular. In that system, America also had privileged access to Britain’s manufacturing might. With independence, however, the new country had lost all that. Britain’s system gave its empire priority when it bought and when it sold. Britain further insisted that all exports and imports travel on British ships. U.S. goods and needs came second at best, while its shipping did not count at all. France, Spain, and Portugal offered no alternatives. These empires had similar colonial trade systems. The United States was effectively shut out of world markets, as either a seller or a buyer, except as a last resort.

Though many in the country had long since felt the economic pinch, few understood the source of pain. Having prospered with agriculture and raw materials before independence, most people expected that the old prosperity would return once the geopolitical situation stabilized. Confidence in the old, agrarian structure got further support from a Jeffersonian interpretation of John Locke. Jefferson’s followers were suspicious of commerce and saw independent farmers as the only assurance of the liberties for which the country had fought. Unusual circumstances in 1789 gave false hopes in the old system’s ultimate ability to support prosperity.  Crop failures in Europe had brought scores of European buyers to U.S. markets, all carrying bills of exchange. Their buying boosted agriculture while the credit they offered substituted, at least partially, for the utter inadequacies of domestic finance. This, however, was hardly a long-term solution. The country could not rest its economic and financial future on European agricultural failure.

Restructuring U.S. Debt

Confronted with this phalanx of troubles, Hamilton no doubt felt the temptation for an easy fix. And there was one, at least where the debt was concerned. Because the low esteem in which the world held this country’s credit had depressed the debt’s market value to only 20 percent of the original face amount, Hamilton could easily have floated a loan to buy it all back cheaply, all $50 million, in fact, for only $10 million or less. If he were less responsible and farsighted, he might well have gone this route. He could then retire the old debt and declare the problem solved. With only modest tax increases, federal revenues could have serviced the $10 million loan involved in such a maneuver, even if it carried interest rates of 7 or 8 percent. By severely haircutting the contracted amount owed to creditors, this maneuver, in purely financial terms, would have been quite a coup. Hamilton could have made himself look very good, a clever man of finance.

Indeed, shortly before Hamilton took office, Gouverneur Morris, a delegate to the Constitutional Convention and chair of the document’s drafting committee, succumbed to something very much like this temptation. He and a syndicate of similarly wealthy Americans had in 1787 made just such a bid for a portion of the country’s outstanding debt. They focused on the paper held by the French treasury. Because France was then near bankruptcy, and its debt, like America’s, sold at a very deep discount, Morris and his associates proposed to buy French bonds cheaply and swap them back to the French treasury for its American holdings. France could gain by retiring some of its debt. The United States would gain because the transaction would have turned some of its foreign debt into a domestic obligation where the U.S. Treasury would have had more options. If the U.S government paid off only a portion of what it owed, Morris and his friends would also have turned a handsome profit.

As it turned out, the deal fell through. When Morris approached the French treasury, Finance Minister Jacques Necker explained that he needed cash. Profit prospects from the trade were so good that Morris and his friends were willing to make half the exchange in cash and the rest in French government debt. Necker showed a good deal of interest in this proposal, but shortly thereafter, pricing turned against the trade. Tension between Britain and the Netherlands had sent Dutch bankers in search of substitutes for their British investments. They seized, accurately it turned out, on the adoption of the Constitution as a good sign for American public finance. Led by the great Amsterdam bank, Willinks, Van Staphorsts, and Hubbard, they raised money to buy the most deeply discounted part of U.S. debt in Europe, the overdue portion of American bonds held by France. In a short time, Dutch buying had increased the European price of this paper enough to render Morris’s venture impractical. France was better off selling its American paper to the Dutch in what was a completely cash deal.

Though Hamilton might well have felt a measure of sympathy for his friend Morris, he surely welcomed the Dutch buying. Though it precluded the easy fix of buying up some, if not all U.S. paper cheaply, Hamilton never seriously considered this option. It would have fallen far short of the country’s needs, and what Hamilton surely saw as his official duty as treasury secretary. He needed more than a clever maneuver to restore the nation’s public credit so that the United States could borrow easily in the future, as he knew the needs of the government would surely demand. To meet this goal, he needed to demonstrate unequivocally that the United States would always honor its obligations as originally contracted. The country’s other needs, he subsequently made clear, impelled him to go still further. More than a clever financial fix or even the reestablishment of the country’s credit standing, the new government under the new Constitution required that its treasury secretary also find ways to repair the country’s domestic payments and financial systems as well as set the economy on a path to cope with independence. Hamilton’s willingness to deal with all these challenges speaks to his character and energy. His ultimate success speaks to genius.

He laid out his plans and the analysis behind them an immense communication to Congress, his Report Relative to a Provision for the Support of Public Credit. There he made clear how a solution to any part of the country’s separate economic and financial problems would reinforce the solutions to the others. A restoration of public credit would help to improve domestic finance, which in turn would help the economy, raising government revenues and so improving the country’s public credit and its financial system still more. It showed the breadth of his vision and his character that in all he did, even in the inevitable cut and thrust of politics, he never shrank from or compromised on these larger goals.

The debt solution, the most purely financial aspect of the plan, actually constituted its most straightforward part. He refused to repudiate any of the debt, as some in Congress and the administration wanted. That would have destroyed the nation’s credit for years, possibly decades to come. But because he lacked the resources to meet the terms of the original contracts he had to ask creditors for concessions. He proposed that the nation postpone payments to France in order to dedicate what resources it had to becoming current with the Dutch bankers. Based on these on-time payments, he planned to float a loan in Amsterdam large enough to substitute for the existing debt. That new paper, Hamilton knew, had to carry a lower interest rate than the debt it replaced. He focused on 4 percent because, even after raising taxes, likely treasury revenues available to service the $50 million outstanding came to roughly 4 percent of that figure. That was as low as he dared go. Even at that, he could have retired none of the debt, which, it turned out, he used to serve another of the country’s needs.

As in many such cases since, the creditors readily gave up the 6 percent to take 4. They did so less out of a desire to help than from irrefutably practical reasoning. They knew that at 6 percent the United States would fail to pay, and 4 percent of something is always better than 6 percent of nothing. Still, he sought to bolster the nation’s credit as much as possible by making it appear as if the country had met all its original obligations. Holders, he suggested, should have the choice to stay with the 6 percent bonds. He would promise them that the United States would eventually honor those obligations but would make clear that the new debt was senior, so those who held onto the old paper would have to accept a lower priority should problems arise and receive repayment only according to Congress’s annual appropriations. He also would give creditors the option to take paper that paid 6 percent interest but that postponed the payment of interest, if not its accrual, for some years. He reckoned that he could manage the additional expense at a later date after the economy and federal revenues had time to grow.

To further encourage buyers of the new paper, the new debt had two other appealing characteristics. Interest payments would be made entirely in gold and silver, which was not the case for the old debt. He would also seek to inspire confidence by establishing a sinking fund modeled on the one Britain used some years before to encourage buying of its government bonds. He would use $5 million from the new Dutch loan to seed the fund and earmark $100,000 a year for it from the post office’s surplus (it had one at the time) up to an accumulation of $1.0 million. With these monies, the sinking fund could, at its discretion, gradually retire the outstanding debt (“sink” it in financial jargon).

Hamilton then explained how the government could secure greater revenues to support the new loan. Tariffs stood as his only substantive option. Direct levies on income and property were out of the question. These, the thinking of the time held, belonged to the states. Indeed, federal income tax ultimately required a Constitutional amendment, the sixteenth in the early twentieth century. Excise taxes, too, belonged to the states. Only the urgent need for revenue pushed Hamilton into this area. He sought such taxes on luxuries, tobacco, and notably liquor. Even though such a move infringed little on state prerogatives, the notion of an intergovernmental competition for revenues so distressed all in government at the time that it, among other things, prompted Hamilton to seek to compensate the states by absorbing their debts into the federal obligation. Ensuring that state obligations were paid also served his broader goal of establishing the country’s credit with lenders at home and abroad.

Accordingly, he asked Congress to raise import duties to between 5 and 10 percent, and 10 percent above that if the cargo arrived in a foreign ship. This, he no doubt reasoned, would invite little retaliation by the country’s trading partners, since his plans basically mimicked the imperial systems that the European powers had long had in place. By 1790, the average tariff had risen to 20 percent. He reasoned that 20 percent was about as far as he could push matters. Beyond that, the tariffs would raise the cost of living for the average American enough to prompt pushback. For today’s professional economists, it is sobering indeed to realize that Hamilton considered matters of optimal taxation almost two centuries before it occurred to the theoreticians.

Rebuilding the Economy

From these first steps, Hamilton’s report turned to the repair of the country’s economy and its financial system. In this, his insight showed most clearly, for he not only explained the needs but also laid out a novel and ingenious way to deal with both simultaneously. In doing so, this eighteenth century document offers a remarkable insight into the ephemeral nature of finance and how economic health depends on that unavoidably vague base. It is an insight from which today’s journalists, academics, policy makers, civil servants, and politicians might well gain.

The economic challenge of independence lay at the base of these efforts. Hamilton was acutely aware of this country’s economic disadvantages. No doubt his early education in an import-export office on the Caribbean island of Nevis made him especially sensitive to the benefits and shortcomings of Britain’s imperial system, benefits that this country enjoyed as a part of it but that became disadvantages once it exited. Because Europe’s imperial systems denied the independent United States ready, viable markets anywhere in the world in which to sell its agricultural surplus and raw materials or buy manufacturers, the country’s only option, Hamilton concluded, was to broaden its economy from its existing colonial structures, to develop prowess in manufacturing and commerce as well as in agricultural and raw materials. That way, America could absorb more of its own agricultural surplus and raw materials even as it supplied its own manufacturing and commercial needs.

To some extent, tariff hikes served these objectives. By raising the cost of foreign goods—by no small amount either—these levies fostered the development of a domestic answer and so encouraged a shift, at least at the margin, in economic effort from agriculture toward commerce and industry. To be sure, this “infant industry” rationale for tariffs flies in the face of most modern economic thought, which holds that free trade serves the country’s needs best. It is hardly surprising, however, that Hamilton nowhere defends his tariffs from such thinking. When he introduced them, the seminal work advocating free trade, by the British economist David Ricardo, was still decades in the future. Even if Hamilton had been aware of such thinking, he surely would have countered with the argument that Europe’s imperial systems precluded the option of free trade. But whatever tariffs might have done to help the economic shift, it was a minor consideration. Their main purpose was to raise needed federal revenues. Hamilton’s primary and most insightful effort to foster the economic change came through his management of a broad domestic financial solution.

More robust domestic finance, he argued, would not only remove impediments to daily business, but, by facilitating domestic borrowing and lending, it would also promote the growth of manufacturing and commerce. At the very least, the country needed a uniform system for daily transactions and strong enough finance to provide capital for businesses’ everyday borrowing needs, something that British capital had provided when it was a colony. The United States would need still more robust capital support if it was to develop its own manufacturing. Building factories, ships, ports, roads, and everything involved in making and shipping goods would require large amounts of lending over long periods. He hardly needed to point out that the ensuing economic growth would benefit the public as well as federal revenues, answering both the economy’s needs and those of debt service.

To accomplish all this, he needed a reliable basis for currency and finance, something that people could confidently rely on to hold its value over time, something as good as gold. Of course, had the country enjoyed a good base of gold and silver, his job would have been easier. People had confidence that these metals would hold their value and so would use them as a basis for the borrowing and lending necessary to support commerce and development. But because the country’s already meager supply of precious metals went abroad at regular intervals to pay interest on the government’s debt, Hamilton needed a substitute. The continentals were worthless and the public would understandably suspect any new paper currency. With remarkable insight, he tied his solution back to the debt restructuring.

His thinking on this score relied on a small bit of history, which he took the time to explain to Congress. When in the Middle Ages gold was the only acceptable medium of exchange, those fretting over the security of their holdings sought out respectable goldsmiths for its safekeeping. The smiths gave gold depositors paper receipts for the weight of gold left with them. People soon discovered that merchants and business associates would readily accept the receipts of trustworthy smiths as if they were gold. But since receipts for all the gold a person had were a cumbersome means for exchange, people asked the smiths to issue receipts in smaller, standardized denominations. In time the goldsmiths noticed that no one ever came for the gold. They realized they could make receipts for more gold than they actually held, and as long as they avoided excessive writing, they could use these receipts for their own buying and for lending. As the smiths became bankers in this way, the resulting expansion of trade and credit fostered greater levels of economic activity and development than the gold ever could have.

Hamilton used this reference to bring home the critical lesson about money and finance: It matters not what lies behind the system just so long as people have confidence that it will hold its value. Even gold is only worth what people believe it is: it has no intrinsic value. If, therefore, he could convince people that the United States would always pay its debts, the government’s bonds would retain a stable price over time. As people gained confidence in this stability, they would willingly accept the debt, or paper money backed by it, in payment for goods and services. The United States would acquire a uniform currency for daily transactions. The debt would also provide a standard on which to base short- and long-term lending that, in their turn, would promote an expansion of trade and the development of the economy’s manufacturing and commercial side. In the jargon of economists, he would “monetize” the debt. He had evidence that it could work. In both Britain and the Netherlands, reliable government obligations had substituted for gold and silver in all ways. His debt restructuring would form a base for a domestic monetary and financial system that, in time, would secure economic growth, development, and economic independence from Europe. In doing so, it would also provide the government with additional revenues that would further reinforce people’s confidence in the debt.

His plans, of course, demanded that the debt remain outstanding. Repaying it would steal the stuff he needed to replace gold in the nation’s monetary-financial system. Thus Hamilton talked publicly of repaying the debt. The sinking fund seemed to stand as an agent of that purpose. Such talk built confidence in the reliability of the debt and its ability to hold value. And indeed, the structure he created aimed at repaying any individual holder. Otherwise, the system required that the treasury, rather than pay off the debt, seek only to fund it securely. Even the sinking fund, unlike its British model, could never commit to a schedule for paying down the debt. In Hamilton’s scheme, the fund, rather than do that, would became a manager of its market value, keeping it constant by buying when for some reason prices slipped, and cease buying then they rose again. Presumably, he meant for the fund to sell bonds into the market should the their price rise, though he never explicitly mentioned such an intention.

It was precisely in this context—as backing for currency and as a basis of an expansion of credit and so development and economic growth—that he described the “national debt” as a “national blessing.” To facilitate the process, Hamilton sought two additional pieces of legislation, one to create a national mint that would strike coins and bills to replace the cumbersome mélange of currencies circulating at the time and to serve as a kind of emblem of public confidence. Second, he also pushed to establish a national bank, the First Bank of the United States, a public-private partnership that would serve as the government’s bank and set the tone for extending credit based on the security of the government’s promises. It, like the sinking fund, could act in the market, buying and selling U.S. government bonds to stabilize their value.

Obstacles and Triumphs

The legislative effort to get this massive plan into law demanded herculean effort. Powerful interests lay on all sides. In favor were the original owners of the debt, the merchants who had taken the paper in payment for goods and services, and the speculators who began accumulating U.S. government debt on the initial rumors of Hamilton’s plans. On the other side were many in government who objected to any hint that speculators might make gains, especially with paper bought at a discount from the original holders. Hamilton had to show the impossibility of these people’s mind-bogglingly complex schemes to find the original buyers and see to it that they got full value. He also had to explain that such efforts, morally attractive as they were, would undermine the nation’s public credit which would only gain when the government showed an unalloyed willingness to honor all contracts from all comers. Also opposing Hamilton’s plan were a powerful group of land speculators. They were making fortunes by purchasing deeply discounted paper and presenting it at state and federal land sales where the authorities valued it at par. There were others, too. Jefferson and many of his political allies, including Madison and the Revolutionary War hero, Henry Lee, opposed anything that might shift the nature of the economy away from agriculture.

Needless to say, the politics to secure passage got rough. Unsavory deals secured elements of the plan, the details of which might dispel any romantic notion that the founders always rose above narrow interest. These ugly arrangements often involved some otherwise admirable figures, such as Thomas Jefferson and James Madison. But that discussion, rich and diverting as it would be, would go beyond the economic and financial focus here. The important thing in this matter is that Congress eventually passed the substance of Hamilton’s marvelously insightful plan. Many of the ultimate details differed. Congress, true to its by now well-established nature, added levels of infinite complexity. Still, the law committed the United States to reschedule outstanding debt at manageable rates of interest, establish a sinking fund as well as a mint, and found the First Bank of the United States. The country funded rather than repaid the debt and so stabilized its value. The United States in pretty short order embraced a uniform payments system based on the debt. It supported a financial system that provided ample credit for both day-to-day business as well as more fundamental longer-term development. The economy broadened and grew, very rapidly indeed.

What few statistics exist for the time speak loudly to the plan’s success. Federal revenues, a reasonable proxy in this case for national income, soared. In 1789, before Hamilton’s plans went into effect, federal receipts amounted to some $162,000. Five years later in 1794, and only four years after Hamilton secured his legislation, federal revenues verged on $5.4 million, a yearly growth rate of over 100 percent. Treasury revenues went from less than one-three-hundredth of the country’s outstanding debt to one-fifteenth of a slightly larger pool of debt. The United States was realizing its potential for everyone who lived in it, providing new jobs, incomes, and gaining independence from Europe’s imperial systems, which, incidentally, became still more exclusive as the wars of the French Revolution intensified.

And at bottom, the country continues to follow the outlines of Hamilton’s system. To be sure, the United States, at least until recently, turned against tariffs in favor of free trade. It did this less in contradiction to Hamilton’s reasoning in the 1790s than because such an approach became viable as Europe abandoned its mercantile imperial systems, world trade broadened, and the U.S. economy became more competitive, especially during the decades immediately after World War II. Besides, the government over time developed sources of income other than import duties.

As for finance, it still stands as Hamilton established it. At times when gold and silver were relatively plentiful, the United States declared itself on a gold standard. But even then, the money in circulation and the country’s financial and credit systems have always found their base in the government’s commitment to pay interest and principal as contracted on its debt. As long as the treasury, in Hamilton’s words, avoided “excessive” amounts of debt, it has remained just the “blessing” he claimed it would be. Indeed, when for a brief period in the 1990s the government ran a budget surplus and talk of paying down the debt became prominent, then Chairman of the Federal Reserve Alan Greenspan warned how such an effort, if it went beyond the margins, would threaten the basis of the country’s entire financial system, confirming the wisdom of Hamilton’s structure.

The accomplishment is nothing short of miraculous. With none of the theory and practical support available to modern policy makers, Hamilton recognized the essence of economics and finance. In the face of tremendous pressure, he devised a plan that not only answered the country’s immediate needs but did nothing less than build a basis for domestic finance that has answered the economy’s needs since. That system, despite its many unavoidable problems and occasional failures, still projects a robust health for the foreseeable future. Hamilton and his thought even now, some 230 years later, can guide anyone who would deal with this economy and its financial markets, whether they are a policy maker, commentator, theoretician, or practitioner. What is more, he accomplished it all with a staff of 39 and no computers.

Perhaps Hamilton’s greatest tribute came from the French statesman, Charles Maurice de Talleyrand, who managed to serve the pre-revolution French monarch, the revolution itself, Napoleon, and then the post-Napoleon government. This remarkable man said of Hamilton: “I consider Napoleon, Fox, and Hamilton the three greatest men of our epoch, and if I were forced to decide between the three, I would give without hesitation the first place to Hamilton.”

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