Alexander Hamilton (61 page)

In preparing his report, Hamilton was eclectic in his sources. He had clearly plumbed David Hume’s
Political Discourses,
which admitted that public debt could vitalize business activity. Montesquieu had stressed that states should honor financial obligations, “as a breach in the public faith cannot be made on a certain number of subjects without seeming to be made on all.”
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Thomas Hobbes had emphasized the sacredness of contracts in transfers of securities, arguing that people entered into such transactions voluntarily and must accept all the consequences—a seemingly arcane point that shortly had explosive consequences for Hamilton’s career. During the Revolution, Hamilton had stuffed Malachy Postlethwayt’s
Universal Dictionary of Trade and Commerce
into his satchel, and now he used it once again. Postlethwayt stressed that no country could borrow money at attractive interest rates unless creditors could freely buy and sell its bonds: “Such is the nature of public credit, that nobody would lend their money to the support of the state, under the most pressing emergencies, unless they could have the privilege of buying and selling their property in the public funds, when their occasions required.”
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Inviolable property rights lay at the heart of the capitalist culture that Hamilton wished to enshrine in America.

As he toiled over the report, Hamilton queried several contemporaries, including John Witherspoon, the Princeton president who had rebuffed his request for accelerated study. Hamilton must have been amused by the educator’s deferential reply: “It is very flattering to me that you suppose I can render any assistance by advice in the important duties of your present station.”
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Aware that the American Revolution had produced a nation averse to taxes, Hamilton asked Madison, “What further taxes will be
least
unpopular?”
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At this point, Hamilton and Madison still shared a sense of political camaraderie. One lady remembered seeing them together that summer “turn and laugh and play with a monkey that was climbing in a neighbor’s yard.”
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But the letter that Madison now wrote to Hamilton gave the first preview of a fateful schism between them. Madison did not want a long-term government debt, fearing that such securities would fall into foreign hands: “As they have more money than the Americans and less productive ways of laying it out, they can and will pretty generally buy out the Americans.”
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When Madison registered this muted dissent, Hamilton had no idea that such differences of opinion were soon to demolish their friendship.

Had Hamilton stuck to dry financial matters, his
Report on Public Credit
would never have attained such historic renown. Instead, he presented a detailed blueprint of the government’s fiscal machinery, wrapped in a broad political and economic vision. From the opening pages, Hamilton reminded readers that the government’s debt was the “price of liberty” inherited from the Revolution and had special claims on the public purse.
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The states had balked at taxing citizens during a revolt against onerous taxes, and Congress had lacked the power to levy taxes, leaving borrowing as the only solution. The outstanding debt was now enormous: $54 million in national debt, coupled with $25 million in state debt, for a total of $79 million.

Hamilton argued that the security of liberty and property were inseparable and that governments should honor their debts because contracts formed the basis of public and private morality: “States, like individuals, who observe their engagements are respected and trusted, while the reverse is the fate of those who pursue an opposite conduct.”
²³
The proper handling of government debt would permit America to borrow at affordable interest rates and would also act as a tonic to the economy. Used as loan collateral, government bonds could function as money—and it was the scarcity of money, Hamilton observed, that had crippled the economy and resulted in severe deflation in the value of land. America was a young country rich in opportunity. It lacked only liquid capital, and government debt could supply that gaping deficiency.

The secret of managing government debt was to fund it properly by setting aside revenues at regular intervals to service interest and pay off principal. Hamilton refuted charges that his funding scheme would feed speculation. Quite the contrary: if investors knew for sure that government bonds would be paid off, the prices would not fluctuate wildly, depriving speculators of opportunities to exploit. What mattered was that people
trusted
the government to make good on repayment: “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.”
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Hamilton intuited that public relations and confidence building were to be the special burdens of every future treasury secretary.

How exactly the debt should be funded was to be the most inflammatory political issue. During the Revolution, many affluent citizens had invested in bonds, and many war veterans had been paid with IOUs that then plummeted in price under the confederation. In many cases, these upright patriots, either needing cash or convinced they would never be repaid, had sold their securities to speculators for as little as fifteen cents on the dollar. Under the influence of his funding scheme, with government repayment guaranteed, Hamilton expected these bonds to soar from their depressed levels and regain their full face value.

This pleasing prospect, however, presented a political quandary. If the bonds appreciated, should speculators pocket the windfall? Or should the money go to the original holders—many of them brave soldiers—who had sold their depressed government paper years earlier? The answer to this perplexing question, Hamilton knew, would define the future character of American capital markets. Doubtless taking a deep breath, he wrote that “after the most mature reflection” about whether to reward original holders and punish current speculators, he had decided against this approach as “ruinous to public credit.”
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The problem was partly that such “discrimination” in favor of former debt holders was unworkable. The government would have to track them down, ascertain their sale prices, then trace all intermediate investors who had held the debt before it was bought by the current owners—an administrative nightmare.

Hamilton could have left it at that, ducking the political issue and taking refuge in technical jargon. Instead, he shifted the terms of the debate. He said that the first holders were not simply noble victims, nor were the current buyers simply predatory speculators. The original investors had gotten cash when they wanted it and had shown little faith in the country’s future. Speculators, meanwhile, had hazarded their money and should be rewarded for the risk. In this manner, Hamilton stole the moral high ground from opponents and established the legal and moral basis for securities trading in America: the notion that securities are freely transferable and that buyers assume all rights to profit or loss in transactions. The knowledge that government could not interfere retroactively with a financial transaction was so vital, Hamilton thought, as to outweigh any short-term expediency. To establish the concept of the “security of transfer,” Hamilton was willing, if necessary, to reward mercenary scoundrels and penalize patriotic citizens. With this huge gamble, Hamilton laid the foundations for America’s future financial preeminence.

As his report progressed, Hamilton tiptoed through a field seeded thickly with deadly political traps. The next incendiary issue was that some debt was owed by the thirteen states, some by the federal government. Hamilton decided to consolidate all the debt into a single form: federal debt. He wrote, “The Secretary, after mature reflection on this point, entertains a full conviction that an assumption of the debts of the particular states by the union and a like provision for them as for those of the union will be a measure of sound policy and substantial justice.”
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The repercussions of this decision were as pervasive as anything Alexander Hamilton ever did to fortify the U.S. government.

Why was this assumption of state debts by the federal government so crucial? For starters, it would be more efficient, since there would be one overarching scheme for settling debt instead of many small, competing schemes. It also reflected a profound political logic. Hamilton knew that bondholders would feel a stake in preserving any government that owed them money. If the federal government, not the states, was owed the money, creditors would shift their main allegiance to the central government. Hamilton’s interest was not in enriching creditors or cultivating the privileged class so much as in insuring the government’s stability and survival. Walter Lippmann later said of Hamilton, “He used the rich for a purpose that was greater than their riches.”
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On the other hand, he was naïve in thinking that the rich would always have a broader sense of public duty and would somehow be devoid of self-interest, instead of being captives to an even larger set of interests.

There was a further advantage to the assumption of state debt. The Constitution had granted the federal government an exclusive right to collect import duties. If states had to pay off debts, too, they might contest that monopoly and try to skim off money from their import duties, re-creating the chaos under the Articles of Confederation. Under his scheme, Hamilton believed, the states would lose incentive to compete with the federal government for major revenue sources.

Hamilton now had to decide whether state debt should be paid off at the original interest rates. He knew this would be impossible to accomplish without stiff taxes, which might precipitate a rebellion or impoverish the country. He also did not want to give
too
bountiful a reward to speculators who had rounded up state debt at cheap prices from small investors. So he decided that foreign debt, which bore interest rates of only 4 or 5 percent, was to be paid in full. Domestic debt, with a 6 percent interest rate, posed a greater dilemma.

To relieve financial pressure on the government, Hamilton decided on a partial repudiation of the domestic debt, though he certainly did not phrase it that way. He gambled that creditors would accept lower interest rates in exchange for rock-solid securities that could not be redeemed by the government if interest rates fell (in modern parlance, noncallable bonds). To entice domestic creditors, he offered a long list of voluntary options, only some of which were enacted. They could receive, for instance, part of their payment at the original 6 percent interest rate and part in western land, enabling them to participate in the appreciation of frontier property. Or they could take payment at a lower interest rate but stretched over a longer period. To enhance such choices, investors would be paid quarterly, not annually. Most significantly, creditors would be paid with taxes pledged for that express purpose. Hamilton’s supporters praised the byzantine brilliance of this program; for his foes, it smacked of impenetrable mumbo jumbo, designed to hoodwink the public.

To make good on payments, Hamilton knew he would have to raise a substantial loan abroad and boost domestic taxes beyond the import duties now at his disposal. He proposed taxes on wines and spirits distilled within the United States as well as on tea and coffee. Of these first “sin taxes,” the secretary observed that the products taxed are “all of them in reality luxuries, the greatest part of them foreign luxuries; some of them, in the excess in which they are used, pernicious luxuries.”
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Such taxation might dampen consumption and reduce revenues, Hamilton acknowledged, but he doubted this would happen, because “luxuries of every kind lay the strongest hold on the attachments of mankind, which, especially when confirmed by habit, are not easily alienated from them.”
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In the report’s final section, Hamilton reiterated that a well-funded debt would be a “national blessing” that would protect American prosperity. He feared this statement would be misconstrued as a call for a
perpetual
public debt—and that is exactly what happened. For the rest of his life, he was to express dismay at what he saw as a deliberate distortion of his views. His opponents, he claimed, neglected a critical passage of his report in which he wrote that he “ardently wishes to see it incorporated as a fundamental maxim in the system of public credit of the United States that the creation of debt should always be accompanied with the means of extinguishment.” The secretary regarded this “as the true secret for rendering public credit immortal.”
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Three years later, Hamilton testily reminded the public that he had advocated extinguishing the debt “in the
very first
communication” which he “ever made on the subject of the public debt, in that
very report
which contains the expressions [now] tortured into an advocation [
sic
] of the doctrine that public debts are public blessings.”
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Indeed, in Hamilton’s writings his warnings about oppressive debt
vastly
outnumber his paeans to public debt as a source of liquid capital. Five years after his first report, still fuming, he warned that progressive accumulation of debt “is perhaps the NATURAL DISEASE of all Governments. And it is not easy to conceive anything more likely than this to lead to great and convulsive revolutions of Empire.”
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To make sure the debt was extinguished over time, Hamilton proposed the creation of a sinking fund, financed by post-office revenues and manned by the government’s chief officers. (A sinking fund is a repository, set up apart from the general budget, for revenues to pay off debt.) It would sequester revenues from the sudden whims of grasping politicians who might want to raid the Treasury for short-term gain. The sinking fund would retire about 5 percent of the debt each year until it was paid off. Because outstanding bonds currently traded below their original face value, such purchases would benefit the government as the securities rose in price. Thus, the government would profit from rising prices alongside private investors. Hamilton concluded, “In the opinion of the Secretary…it ought to be the policy of the government to raise the value of stock to its true standard as fast as possible.”
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Little did he know how quickly he was to succeed or how much trouble this success was to bring in its wake.