Debt Compromises

by Elaine Schwartz    •    Jul 23, 2011    •    717 Views

This story is about a country that had massive debt. A recent war had been expensive and the economy had big problems. Still though, powerful political leaders opposed the solution that the Secretary of the Treasury proposed.

Yes, the country is the United States but the year is 1790. Because of the Revolutionary War, the U.S. owed French and Dutch bankers $11,710,378. From citizens at home it had borrowed $42,414,085. Using calculations from historian John Steele Gordon, the U.S. Revolutionary War debt was close to $19 trillion in today’s dollars–$5 trillion more than we currently owe. Behind on interest payments, a worthless currency (“not worth a continental”), a huge national debt, rampant inflation, we faced debilitating obligations. What to do?

To manage the debt, Alexander Hamilton first had to solve 2 problems.

Problem 1: Who legally owns U.S. bonds?

Revolutionary war bonds were primarily held by wealthy merchants and unscrupulous speculators who had purchased the securities when they were virtually worthless from loyal patriots. Enraged, James Madison said that the present bondholders should get a partial repayment and the original holders should get the balance. Opposed also, John Adams was said not to understand the connection between funding a national debt and economic prosperity.

By contrast, Hamilton realized that for the economy to grow from a sound foundation, contractual obligations had to be preserved. When a bond was sold, the new owner, whether a widow or a shady speculator, had to be recognized in the eyes of the law. 

The final vote in the House, supporting the Hamiltonian plan, was 36-13. Hamilton’s father-in-law, who owned government securities, said that the opposition’s comments “made his hair stand ‘on end as if the Indians had fired at him.'”

Problem 2: Should the federal government assume the states’ war debts?

Some states like Virginia had repaid their debts while others, including Massachusetts, had not. On this issue, Jefferson was Hamilton’s main adversary. Hamilton said the U.S. was responsible for all existing debts; Jefferson said Virginia should not have to pay “twice.”

To secure a compromise, Hamilton invited Jefferson to dinner. Accompanied by Madison, Jefferson agreed to support the assumption plan if the new capital would move from New York to the “muddy and fever-ridden banks of the Potomac.” (p. 31)

So, you can see that our Congress has always been divided on debt issues. And, when it really mattered, they voted, they compromised and they made a wise decision.

Here, in American Heritarge Magazine, you can read more about Hamilton’s proposals, the opposition, and the resolution through which European and domestic bondholders were repaid. In Hamilton’s Blessing, historian John Steele Gordon provides a more detailed history of the U.S. debt through 1995.

The Economic Lesson

With good credit, for relatively low interest rates, a nation can borrow money from creditors at home and abroad. According to scholars Kenneth Rogoff and Carmen Reinhart, the tipping point at which debt becomes excessive and unmanageable for most nations appears to be 90% of GDP. In 2010, the U.S. debt was close to 90% of its GDP.

An Economic Question: Referring to funding and how it is used, explain how sovereign debt relates to economic growth.

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