Bitter Money Fights Shaped U.S History (Part 1): JohnsonSimon Johnson and James Kwak
March 26 (Bloomberg) -- On June 1, 1812, President James Madison asked Congress to consider a declaration of war against Britain. The Democratic-Republican majority was happy to oblige.
Britain’s insults to the U.S. ranged from seizing its ships and forcing its sailors into the Royal Navy to supporting American Indian attacks along the Western frontier.
With war approaching, it fell to Treasury Secretary Albert Gallatin to figure out a way to pay for it. Gallatin hoped to borrow the money, but he wanted to raise taxes to cover the interest on the new debt. He worried that, otherwise, bond investors would be unwilling to lend large amounts of money to a young country. But the war hawks were ideologically and politically opposed to taxes -- particularly the excise (internal trade) taxes that Gallatin favored.
As the party of small government, the Democratic-Republicans believed that higher federal taxes were a threat to individual and states’ rights. They also feared that raising taxes could hurt them at the ballot box. Congress did increase some tariffs (taxes on external trade) in the run-up to war, but failed to approve internal taxes while still expecting Gallatin to find funds to borrow. As Gallatin feared, there weren’t enough investors willing to lend the amount needed. The government was forced to print money.
By 1813, with the war in full swing and the government weeks away from running out of money, Gallatin convinced Philadelphia banker Stephen Girard to underwrite a huge loan. Later in the year, with the U.S. military unable to achieve any of its major objectives, Congress finally agreed to impose excise taxes. But it was too late to build a world-class military.
After a decade of tight budgets, the U.S. Navy had begun the war with all of 17 ships. The Royal Navy commanded more than 1,000 ships. Even with many of them committed elsewhere, Britain was still able to blockade America’s Eastern shoreline and raid the coast. Chesapeake Bay, the broad waterway leading to both Washington and Baltimore, was defended by a collection of barges and gunboats outclassed by the British navy and soon trapped in the Patuxent River.
In August 1814, British ground forces landed in Benedict, Maryland, less than 40 miles from the U.S. capital. The soldiers marched overland from Benedict, defeated an American militia at the Battle of Bladensburg, and eventually reached Washington, where they encountered little resistance. On the night of Aug. 24, they burned the Capitol, the Treasury Building and the White House, after eating the dinner that had been set for that evening.
What the British had, more than anything else, was money. By contrast, without a stable source of tax revenue, the U.S. struggled to attract lenders willing to bet on the country’s unproven armed forces. This deep fiscal crisis had its roots in a bitter, decades-long political battle.
Beginning in 1790, Treasury Secretary Alexander Hamilton had pushed through controversial fiscal policies that included a restructuring of the national debt, federal government assumption of state debts, a national bank and excise taxes. Opposition to Hamilton’s policies led Thomas Jefferson and James Madison to found the Democratic-Republican Party (often known simply as the Republican Party), which faced off against Hamilton’s Federalists.
No New Taxes
The small-government, anti-tax Republicans swept the elections of 1800, with Jefferson defeating Federalist incumbent President John Adams, and proceeded to reverse many of Hamilton’s policies, including his excise taxes. To pay for these tax cuts, the Republicans cut defense spending. It was this battle over taxes and spending that led to the country’s fiscal weakness in 1812.
Ironically, the Republicans, who voted for war but not for the taxes to pay for it, were the political victors of the War of 1812. The Federalists’ opposition to the war, which extended to attempts to undermine the Treasury Department’s fundraising efforts, made the party appear unpatriotic, and it never again gained national power.
At the same time, the war vindicated the principles laid out by Hamilton two decades earlier. Both Federalists and Republicans had always been “fiscally responsible” in the shallow sense that they believed the country should make required payments on its debts. But there is a deeper meaning of fiscal responsibility: the recognition that if you want something, you have to pay for it, either now or in the future. If a government cannot demonstrate that type of fiscal responsibility -- through the willingness and capacity to levy taxes when necessary -- it will have trouble borrowing money in a time of crisis. This was missing in the Congress of 1812.
Fast forward to 2011. Once again, Washington is embroiled in a bitter partisan fight over taxes and spending. On Aug. 2, 2011, political squabbling brought the nation within a few days of defaulting on the national debt.
Because of the debt ceiling -- a legal limit on the total national debt -- the Treasury Department could no longer borrow new money and was in danger of running out of cash to pay the country’s bills. Republicans demanded that any increase in the debt ceiling be accompanied by dollar-for-dollar reductions in spending. Democrats insisted either that the debt ceiling be increased without conditions or that any deal to reduce the deficit also increase taxes. (Both sides declined to mention that they had just months before collaborated on a major tax cut that increased the national debt by almost $860 billion.)
This latest battle was provoked by record federal government budget deficits, which in 2009 and 2010 exceeded $1 trillion for the first and second times in history. These deficits were primarily due to the 2007-2009 financial crisis, which triggered a severe recession, reduced tax revenues and increased spending. The second-most important cause of those deficits was major tax cuts in 2001 and 2003 that, unlike the 1802 tax cut, were not offset by spending reductions. But the real debate is over future spending.
In 1812, some Republicans opposed the war because they didn’t want higher spending or higher taxes. But the majority of Republicans wanted war without the necessary tax increases. Today, the central debate is over increasing federal spending on retirement, disability and health-care programs such as Social Security, Medicare and Medicaid, which threaten to outstrip growth in tax revenue.
One possibility, favored by most Republicans, is to scale back those programs to avoid the need for higher taxes. Another possibility, favored by many Democrats, is to maintain those spending commitments while raising taxes to pay for them. A compromise position -- some spending reductions and some tax increases -- is also conceivable. But our highly polarized political system is on the course set by the 1812 Congress: higher spending without higher taxes. This inability to make any fiscally responsible choice is how a dysfunctional political system could cause a true fiscal crisis in one of the richest, most powerful nations in the history of the world.
The specter of national deficits has been a fixture of American politics for most of the three decades since 1980, when Ronald Reagan won the presidency by promising higher defense spending, lower taxes and lower deficits. Reagan oversaw what were, at the time, the largest peacetime deficits in history, caused largely by a huge 1981 tax cut.
Since then, inflated rhetoric about the national debt has mainly served as a tool that politicians use to argue for unrelated policy objectives, which as often as not increase the debt.
But we should not be too quick to place all the blame on politicians. Ordinary people, at least as measured by opinion polls, are also deeply divided -- within themselves. In early 2011, 64 percent of Americans worried a great deal about “federal spending and the budget deficit” (second only to the “economy”).
No Program Cuts
In one survey, 95 percent of respondents supported reducing the deficit by cutting government spending (on its own or in conjunction with tax increases). At the same time, 78 percent opposed cuts in Medicare spending, 69 percent opposed cuts in Medicaid spending, and 56 percent opposed cuts in military spending.
Politicians behave accordingly. During the health-care debate of 2009, Republicans positioned themselves as defenders of Medicare spending by opposing cuts proposed by the Obama administration (remember, people like Medicare). On Dec. 6, the Senate Republican leader, Mitch McConnell of Kentucky, issued a news release titled “Cutting Medicare Is Not What Americans Want.” But the next day, responding to a Democratic proposal to allow people ages 55 to 64 to buy into Medicare, McConnell played the deficit card with another news release, “Expanding Medicare ‘A Plan for Financial Ruin.’”
Although it is possible to reconcile both positions, the politics are quite simple: Oppose any effort to expand popular programs on the grounds that they are fiscally unsustainable, while simultaneously attacking any effort to make those programs sustainable as a cut in benefits (or an increase in taxes).
As a nation, we will have to make a choice, one way or another. If the national debt grows faster than the economy for long enough, investors could lose their appetite for Treasury bonds, making it impossible for the government to borrow money at any price -- as almost happened in 1813.
(Simon Johnson and James Kwak are authors of “13 Bankers” and co-founders of The Baseline Scenario, a blog on economic and public policy. Johnson is also a Bloomberg View columnist. This is the first of three excerpts from their new book, “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You,” to be published by the Knopf Doubleday Group on April 3. The opinions expressed are their own.)
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