Can we learn from previous instances of fiscal prioritisation? This column surveys the US Treasury’s response to three wars – the Revolutionary War, The War of 1812 and the Civil War. Contemporary advocates of engaging in fiscal discrimination might ponder the actions of previous US Presidents Madison and Grant, who honoured all existing federal obligations despite challenging fiscal conditions.
With the temporary suspension on the US Treasury’s statutory debt limit set to expire in late May, Republicans in the US House of Representatives have advanced the idea of debt prioritisation. This proposal, put forward in the Full Faith and Credit Act (HR 807), would “require that the government prioritise all obligations on the debt held by the public in the event that the debt limit is reached”. Specifically, as an alternative to increasing the debt limit, the Secretary of the Treasury would be instructed to pay the principal and interest on Treasury securities held by public and the Social Security trust fund before paying the government’s other obligations. Hence the government would honour some of its promises (e.g. those to its bond holders) while threatening to break some of its promises to others (e.g. those to veterans and Medicare recipients expecting payments).
This is hardly the first time that the US government has faced the question of whether it should discriminate among its different promises (see Hall and Sargent 2013). In 1868, immediately following the Civil War, the US faced what seemed a crushing debt burden with outstanding Treasury obligations exceeding 35% of GDP. While this may seem low by today’s standards, tax receipts as a share of GDP at the height of the war barely exceed 5% and fell to 3% immediately after war. Hence, debt was roughly ten times tax receipts. Today, the quantity of debt held by the public is between four and five times tax receipts.
In order to create sufficient fiscal space to allow the government to rebuild the war-torn South and to honour the long-term pension obligations to Union soldiers and their families, many advocated discriminating across different classes of government creditors. None other than the president at the time, Andrew Johnson, stated in his 1868 Annual Message to Congress:
“Various plans have been proposed for the payment of the public debt. However they may have varied as to the time and mode in which it should be redeemed, there seems to be a general concurrence as to the propriety and justness of a reduction in the present rate of interest. … The lessons of the past admonish the lender that it is not well to be over-anxious in exacting from the borrower rigid compliance to the letter of the bond”.
‘Lessons of the past’
What were these ’lessons of the past’ that might suggest less than rigid compliance to previous promises? Prior to the Civil War, the US had fought three major wars. Two of these wars, the Revolutionary War and The War of 1812, had also led to fiscal crises.
In 1790, during the US’ first fiscal crisis, then Secretary of the Treasury Alexander Hamilton crafted a plan to restructure the Continental and state debts incurred in the course of the Revolutionary War. Under this plan, Hamilton gave first priority to foreign creditors, paying off Dutch creditors in full (see Table 9 of Garber 1991). Hamilton then reduced the promised interest payments to domestic bondholders while preserving their promised principal payments. This reduction in the interest rate was a form of repudiation, though perhaps Hamilton repudiated less than had been expected during the 1780s, earning him substantial gratitude from 1780s speculators. But not all government creditors fared so well. Holders of Continental Dollars received only 1% of their face value.
Clearly Hamilton’s plan enhanced the credit of the new nation, but it was not until the resolution of the second US fiscal crisis that government debt would consistently trade at par. And it would not be for another 70 years that the Treasury could credibly issue paper money.
Fast forward 25 years and the Federal government faced a second fiscal crisis during the War of 1812. During this conflict, the value of US Treasury bonds fell to 75 cents on the dollar as many creditors were unwilling to support an unpopular war and saw the nation’s capital burned to the ground. Despite this difficultly in borrowing, President James Madison resisted resorting to the mainstay of the American Revolution – an inflation tax – in financing the war and, in years following the war, awarded outsized positive returns to all holders of US debt.
Late 1860s advocates of `lowering ex post interest rates’ to be paid to Union creditors might legitimately appeal to Alexander Hamilton as an example; but they could not appeal to the precedent set by the Madison administration and its successors.
While President Johnson advocated prioritising government obligations so that bond holders would receive less then was promised, the 1868 Republican presidential candidate and former Union general Ulysses S Grant argued that to protect the nation’s honour, every dollar of government indebtedness should be paid in full. After winning the presidency, Grant stated: “no repudiator of one farthing of our public debt will be trusted in public place”. And as its very first act following the inauguration, the Congress passed ‘An Act to Strengthen the Public Credit’ committing the Treasury not to discriminate among different classes of creditors.
The fact that the US government honoured in full all of its obligations after the War of 1812 – including those to British creditors – established precedents that led President Grant and the Congress to preside over a period of post-Civil War deflation. This deflation had the effect of rewarding people who held Union obligations throughout the war, and by 1879, people trusted US government nominal promises to be ‘as good as gold’ for the first time in the country’s history.
Alexander Hamilton discriminated among different classes of federal obligations – paying some in full while partially repudiating others. After Hamilton’s restructuring, Treasury debt traded at a discount relative to its par value for nearly 30 years.
Contemporary advocates of engaging in fiscal discrimination might ponder the actions of Presidents Madison and Grant, who honoured all existing federal obligations despite challenging fiscal conditions.
Garber, Peter (1991), “Alexander Hamilton’s Market Based Debt Reduction Plan”, Carnegie-Rochester Conference Series on Public Policy 35, 79–104.
Hall, George J and Thomas J Sargent (2013), “Fiscal Discriminations in Three Wars“, NBER Working Papers 19008, National Bureau of Economic Research, Inc.