As became abundantly clear during the course of the Revolutionary War, the national government was simply incapable of raising the kind of money needed to win a war against another civilized nation, particularly one like Great Britain with the most advanced system of public finance in the world. The lack of money might not have posed such a serious problem in pre-modern war, but America’s financial situation became so desperate during the Revolution that Hamilton would go so far as to reverse the traditional priority of arms over money as the sinews of war: “Tis by introducing order into our finances—by restoreing public credit—not by gaining battles, that we are finally to gain our object.” (Sylla 34)Hamilton’s Funding SystemThese problems in public finance, in part, prompted the Constitutional Convention, and led Hamilton to create his funding system once he was installed as the nation’s first Treasury secretary. The major features of Hamilton’s funding system included: abandoning the system of requisitions in favor of an unlimited power to tax individuals, an unlimited power to borrow, full funding of the accumulated debt at par (but at a reduced interest rate) with no discrimination between the debt’s original and subsequent holders, assumption of the $25 million worth of remaining state debts, the incorporation of a new and better capitalized national bank, and the creation of a modest sinking fund to retire the debt. (Gordon 47) With respect to the requirements of national defense, Hamilton believed that the most important characteristic of his funding system was that it maximized the potential resources of the government: “A complete power, therefore, to procure a regular and adequate supply of revenue, as far as the resources of the community will permit, may be regarded as an indispensable ingredient in every constitution.
” (Federalist 156)Obviously, the unlimited power to tax and borrow, and the creation of a bank would help to do this. Funding the debt at par with no discrimination and assumption would keep the national government in the good graces of current creditors and potential future lenders. A sinking fund would create a public commitment to reducing the debt to manageable proportions).
Hamilton warned that a failure to observe any of the “maxims of public credit” would guarantee that future loans “would be made upon the same principles that usurers commonly lend to bankrupt and fraudulent debtors—with a sparing hand and at enormous premiums.” (Hamilton 160)But what about the potential abuses of the funding system? Hamilton conceded that “abuses of a thing intrinsically good” were indeed possible, but that is true of virtually all good things. (Hamilton 51) Wealth, power, liberty, and learning can lead to extravagance, pride, ambition, dissipation, effeminacy, etc., but Hamilton asks, “shall we on this account forego every advantage which we are fitted to enjoy?” (Hamilton XII 52-3) A nation armed with a funding system might be tempted to wage unnecessary or unjust war, but a funding system was both necessary to defend of war and useful to deter other nations from initiating war in the first place. A funding system could also contribute to the “advancement of the nation’s interests” (Hamilton XII 53) After weighing such considerations, Hamilton simply concluded that the benefits of a funding system greatly outweighed its potential evils.BanksAmerica then had only a half dozen banks, and most loans were directed toward either short and medium term financing for merchants and farmers, or land speculation. (Hamilton XII 58) This system was hardly adequate to finance the plethora of new industrial enterprises that Hamilton hoped to see created.
To help remedy this deficiency, Hamilton proposed the creation of a new national bank with a capitalization of $10 million, or three times the combined capitalization of the extant banks in the country. (Hamilton XII 52-3) In deference to public opinion, which is the “ultimate arbiter of every measure of Government,” and which was (and continues to be) generally backward when it came to matters of finance, Hamilton began his case for the creation of national bank with some preliminary reflections about the usefulness of banks. (Perkins 167-8)Hamilton observed that “public banks have found admission and patronage among the principal and most enlightened commercial nations,” including Italy, Germany, Holland, England, France, and America. The “experience of centuries” established beyond a doubt the usefulness of banks, and both “theorists and men of business unite in acknowledgment of it.” (Sylla 36) The usefulness of banks stems from their ability to provide an important aid to trade and industry as well as the government. Hamilton noted in particular that the U.S.
government during “the most critical junctures of the late war” and during the peace following, “received assistance from those established among us, with which it could not have dispensed.” (Hamilton X 230)With this evidence, one might expect “a perfect union of opinions” in favor of banks. “Yet doubts have been entertained,” and “jealousies and prejudices have circulated” which prevented such a concurrence of opinions. To allay those doubts and to combat those prejudices, Hamilton laid out the three principal advantages of banks: the augmentation of the active or productive capital of country, the greater facility to the government in obtaining pecuniary aids, especially in sudden emergencies, and the facilitation of the payment of taxes.
(Gordon)Hamilton observed that because of the financial problems and abuses that occurred during the Revolutionary War, much of the paper currency in circulation “was in a great measure destroyed, by being discredited, and the same events had destroyed a large portion of the monied and mercantile capital of the country.” (Bruchey 311) As a consequence, people increasingly resorted to direct barter which contributed to economic stagnation. Moreover, the situation was not likely to improve in the near term because Hamilton believed that the progressive settlement of vacant lands would further drain what little specie the country possessed as “settlers not only furnish no surplus for exportation, but they consume a part of that which is produced by the labor of others.” (Walling 203) A well-capitalized national bank was therefore indispensable to help put back into circulation the large sums of money needed to oil the wheels of commerce.
Money loomed quite large in Hamilton’s overall thinking about economic matters. Hamilton called money “the vital principle of the body politic; as that which sustains its life and motion and enables it to perform its most essential functions” (Federalist 30) For “enlightened statesmen,” the widespread circulation of money offers one of the principal means to rouse men from their natural state of lethargic indolence and make them industrious. By introducing a plentiful supply of money, Hamilton would create a powerful incentive for Americans, particularly the quarrelsome and contentious farmers on the frontier, to become rational and industrious.
More generally, money engenders a greater disposition among men to be forward looking, or to use Hamilton’s term, “sagacious.” Admittedly, sagacity and industry come at price because money encourages avarice as well, but this only goes to show that money is a mixed blessing. (Walling 177-9)Hamilton’s bank possessed many of the features of a modern central bank, but this view of the national bank tends to underestimate Hamilton’s broader goal of employing banks to promote investment and economic growth. (Bruchey) To see this distinction more clearly, it is helpful to contrast Hamilton’s view of banks with Adam Smith’s. According to Adam Smith, the reduction in the need for specie and the short term loans made to merchants (or what economists today would refer to as reducing transaction costs) are what make banks truly useful.
(Bruchey) As such, banks do not really increase the amount of capital in a nation except indirectly: “It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than otherwise would be so, that the most judicious operations of banking can increase the industry of the country.” (Hamilton X 287) Hamilton, however, went beyond Smith’s view of the role of banks, and saw them as having the additional role of what economists would today call financial intermediaries. Banks accept deposits from some individuals in the private sector and use the funds to make loans to other individuals in the private sector. Rather than lending the money directly to each other, these individuals use banks to intermediate between them in the loan. (Perkins)For all intents and purposes of trade and industry, this represents “an absolute increase of capital.” (Hamilton, X 289) With a fractional reserve system, banks—through what economists call the “money multiplier”—can increase the amount of money and capital in circulation by several times the bank’s capitalization; Hamilton himself estimated this multiplier “at the proportions of two and three to one.
” (Hamilton, X 289) In economic terms, banks lower the rate of interest, and thus promote investment far beyond merely freeing up specie. For the interest rate to be reduced appreciably, however, “their capitals must be completely equal to all the demands of business,” which is one of the reasons why Hamilton sought to create a bank with such a large capitalization. (Hamilton, X 290) In essence, Hamilton saw banks as a powerful mechanism to extend and to vivify America’s fledgling capital market. Banks “enable honest and industrious men, of small or perhaps no capital to undertake and prosecute business, with advantage to themselves and to the community.
” (Bruchey 314) More importantly, banks enable more substantial men of business not only to meet the short-term demands of everyday trade but also to create new enterprises.Public Credit and TaxesThe keystone of Hamilton’s financial program was the establishment of public credit. Without it, Hamilton’s grand design of constructing a secure, prosperous, just and glorious nation almost certainly would have been frustrated.
In his words, “the individual and aggregate prosperity of the citizens of the United States; their relief from the embarrassments they now experience; their character as a People; the cause of good government” were all dependent on a “due observance” of the “maxims that uphold public credit.” (Hamilton X 252) Much to Hamilton’s chagrin, the neglect of those maxims during the Revolutionary War had left the nation’s public credit in tatters. His first and most important task as Treasury secretary was therefore to create “a proper plan for the support of the Public Credit.” (Hamilton X 272) The plan Hamilton devised called for funding of the domestic and foreign debt at par, but with a reduction in the interest rate from six to four percent, and with no discrimination between original and current holders of the debt. Initially, tax revenue would only be sufficient to service the interest on the debt. To retire the principal, Hamilton proposed the creation of a sinking fund which would be funded with profits from the post office.
(Hamilton X 251) Hamilton defended full funding of the debt on grounds of both policy and justice.Besides making it possible to borrow money in the future for nation’s defense and keeping those future borrowing costs reasonable, the most important policy reason for fully funding the debt was that it would operate in much the same manner as banks, serving as both money and capital. Hamilton claimed “it is a well know fact, that in countries in which the national debt is properly funded, and an object of established confidence, it answers most of the purposes of money.” (Hamilton X 271) As such, it reduces transaction costs and makes more specie available. It also serves to increase the amount of active capital in much the same way that bank credit does, which Hamilton regarded as an artificial rather than real increase of capital.
Fully funding the debt left Hamilton with no choice but to raise additional taxes. He did, however, have a choice in deciding precisely which taxes to raise. Although he could have opted to raise taxes in the most economically efficient manner, such an approach to tax policy was too narrow. Instead, Hamilton calibrated his tax measure to raise the needed revenue so as to achieve the following political and economic ends: promote industry, discourage vicious luxury, insinuate the federal government into the daily lives of citizens, and maximize the potential revenue of the federal government. Hamilton’s tax proposal included higher tariffs on imported alcohol, tea, and coffee, and most controversially, the imposition of an excise duty on domestically distilled spirits. (Perkins)Though it may sound odd to contemporary ears, Hamilton claimed that one of the blessings of a national debt was that it would “create a necessity for keeping up taxation to a degree which without being oppressive, will be a spur to industry.
While Hamilton believed a tax increase would tend to force people to work more, he was not utterly indifferent to the plight of the poor. Hamilton deliberately avoided increasing taxes on “the necessaries of life,” and instead chose to increase taxes on alcohol, tea, and coffee because he regarded them as “luxuries—the greatest part of them foreign luxuries; some of them in the excess in which they are used, pernicious luxuries.” (Gordon 47)ConclusionBy all accounts Hamilton was an untiring proponent of the advanced commercial republic. As America’s first Secretary of the Treasury, Hamilton’s various reports on supporting public credit, establishing a national bank, and promoting manufactures all point to the development of the kind of industrial capitalist economy which the United States has become. Hamilton’s commercialism would of course eventually prevail over Founders’ times. As George Will puts it, “if you seek Hamilton’s monument, look around.
You are living it. We honor Jefferson but live in Hamilton’s country, a mighty industrial nation with a strong central government.” (www.hamiltonsociety.org) Indeed, Hamilton no doubt would have been deeply gratified to see America grow from a “Hercules in the cradle” into a mature Hercules whose strength is so great that America is no longer called merely a superpower but a “hyperpower.” But does Hamilton’s financial genius have any relevance for us today? Certainly in the realm of national defense and foreign policy, historical experience has made Hamilton’s arguments even more compelling today than they were in the late eighteenth century.