the birth of america’s bond market -- 7/29/24

29 Jul 2024

the birth of america’s bond market -- 7/29/24

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Today's selection-- from Alexander Hamilton: The Illustrated Biography by Richard Sylla. In the 1780s, Americans—primarily wealthy Americans—held $79 million in war debt, the debt that Congress and the states had incurred to fight the war. About $25 million of that was state-issued debt. These citizens were not receiving any interest on this debt, which was a huge problem in and of itself, and because of that the value of the debt itself had plunged to around 30% of its face value. It was a double whammy. As a percent of GDP, in today’s terms, it was the equivalent of $5 trillion—a massive amount. Since the Articles of Confederation did not give Congress the authority to impose the taxes necessary to pay interest on that debt, a Constitutional Convention was called in Philadelphia in 1787 to create a constitution that would give Congress that missing power. The wealthy holders of this debt wanted robust payment on their state debt in addition to their congressional debt, so Hamilton proposed that the central government assume that debt too. It took a famous “Dinner Table Bargain” to make that happen:

“Washington appointed Hamilton secretary of the Department of the Treasury on September 11, 1789. From the old Confederation, the young man inherited an empty Treasury. Ten days later, the House of Representatives directed him to prepare a plan ‘for the support of the public credit, as a matter of high importance to the national honor and prosperity.’ He delivered his ‘Report on Public Credit’ in January 1790.

“He estimated the country's debts at $54 million, a fifth of that owed to foreign governments and investors and the rest to domestic creditors. State debts, mostly incurred during the war, ran to about $25 million. Hamilton argued that the federal government should assume those state debts because those debts had supported independence and assumption would strengthen the Union. That put total government debt at roughly $79 million. This, Hamilton said, was ‘the price of liberty,’ and he proposed to pay it in full over time as soon as Congress enacted the necessary legislation. For a finance minister with no cash in hand, that was a bold gamble.

“If America paid the interest according to the original borrowing terms, annual interest would come to $4.5 million. How could a government with practically nonexistent revenues afford operating expenses—around $0.6 million by his calculation—as well as huge annual interest payments? Survival required ‘the extension of taxation to a degree, and to objects, which the true interest of public creditors forbids.’

“Americans hate paying taxes, then as now, so he recommended paying the interest on the foreign debt in full but asking domestic creditors to agree to having their debts funded by a new loan at a reduced rate. That plan would reduce annual interest on the domestic debt from $4 million to around $2.7 million. Much more manageable. In turn, future government revenues would go toward regular interest payments, a tactic never undertaken before Hamilton. It was the beginning of the modern American government debt market, now the largest in the world for the debt of a single issuer.

“To convince domestic creditors, Hamilton offered them call protection, meaning that the government could retire only a small amount of the debt each year even if market interest rates declined, which he confidently predicted they would. He recommended that no more than 1 percent of the debt be ‘called’ each year, but Congress doubled that to 2 percent in the approved legislation.

“To give the creditors further assurances, Hamilton proposed a federally administered sinking fund to apply surplus revenues and money borrowed at home or abroad to open-market purchases of public debt ‘until the whole of the debt shall be discharged.’ That way, investors could count on the government not just to pay interest on its debt but to redeem it. In turn, the government gained the ability to conduct open-market purchases to support debt prices. That benefit proved more than useful when the market for U.S. debt tanked in 1791 and more seriously in the Panic of 1792, the first of many financial crises.

The Bank of The United States on Third Street in Philadelphia, 1799.

“Hamilton wanted to establish public credit so that in the future the government could borrow money easily, say, in times of war. After all, that ability had propelled the Italian city-states, the Dutch Republic, and Britain to success in their various rivalries. But public credit, once established, might tempt governments to run up debts that eventually they couldn't pay. To avoid that end, Hamilton ardently wanted ‘to see incorporated, as a fundamental maxim, in the system of public credit in the United States, that the creation of debt should always be accompanied with the means of its extinguishment.’ In other words, a fiscally responsible government should match borrowing to taxation.

“Half a year of protracted debates took place along with side deals to garner votes. One of the early debates in February took up the topic of discrimination. Hamilton opposed this tactic, which proposed to pay current debt holders, identified as speculators, only the highest value that their securities had obtained in the market and to pay the difference between that value and face value to the original parties. When the government had no money to pay what it owed during the 1780s, its debts declined in market value to fractions of face value, and many original creditors had sold their securities at those depressed market values. It seemed only fair to give the original holders a share in the rise of the value of securities.

“Many southerners didn't like Hamilton's overall plan for a variety of reasons. Madison, Hamilton's old ally and Federalist coauthor, surprised him and many others by arguing for discrimination, apparently to please the Virginians who had elected him to Congress. The main problem with discrimination is that it violated the terms of the original debt, which made the securities negotiable and thus more attractive by giving the owner rights to all future payments. Discrimination essentially allowed Congress to rewrite its debt contracts after the fact, which would have destroyed all confidence in public credit. Common sense prevailed, however, and the House defeated discrimination later that month.

“The most important side deal that happened at the time involved the federal assumption of state debts, a crucial move that was going nowhere. Thomas Jefferson, then secretary of State, wrote about a conversation he had on the subject with Hamilton, who stressed ‘the necessity of it in the general fiscal arrangements and it's indispensable necessity toward a preservation of the union: and particularly of the New England states.’ Most southern congressmen opposed assumption because their states had paid much of their debts, and assumption implied that they had to pay other states' debts—and because assumption increased the power and scope of the federal government.

“Jefferson agreed to host a dinner for Hamilton and Madison, at which Hamilton convinced the southerners of the wisdom of the plan. Madison agreed to twist the arms of those congressman in return for Hamilton’s help moving the national capital from New York City, through Philadelphia for ten years (to secure Pennsylvania’s support for the deal), to a new city on the Potomac River. Washington, D.C., stands as America’s capital today because the federal government shouldered state debts

“The Dinner Table Bargain cleared the way for enacting the recommendations of Hamilton’s ‘Report on Public Credit.’ New loans, secured primarily through Dutch bankers, allowed for rolling over and discharging the foreign debts—mostly to France—by 1795. The timing of those payments meant that America helped finance the French Revolution, just as the French had helped finance the American Revolution."