“The revenue of the state is the state.” Edmund Burke
The rise of the modern nation state in the 1600s was founded upon monarchies securing independent sources of revenue to pay for the royal armies that secured their dynasties. Jacques Colbert, Louis XIV’s minister of finance, designed a system of state monopolies, internal free trade districts, tariffs and internal taxes to support the wars of his sovereign. Later in the eighteenth century, the French and Indian War resulted in a British victory in large part due to the rise of deficit spending (and the national debt which makes it possible) which funded the British war machine in this first of global wars. Crucial to any scheme of deficit spending is the development of a symbiotic relationship between the financiers who purchase government debt and the state which comes to depend upon the funds of these financiers. In Great Britain, the lender of last resort to the government was the Bank of England, so if British bonds could not catch a bid in the loanable funds market, the Bank of England could come to the rescue.
The American colonies before and during the Revolution, and the Continental Congress during the Revolution, pursued a mixture of financing schemes. These schemes broke down into two different camps. The first of these was direct borrowing from financial institutions, foreign governments, or other creditors via bond sales. The second was the issue of paper currency in the form of bills of credit that governments used for purchases then took out of circulation via taxes. The emission of bills of credit often caused inflation in the colonial and Revolutionary periods; “not worth a continental” became the byword for worthless paper currency. Not all financial schemes miscarried during the American Revolution. North Carolina acted responsibly and had retired its debt from the Revolution. Also, the Americans won; the system, though deeply flawed, did contribute to the American victory over the world’s foremost military and financial power of the day. Nevertheless the adoption of the English system of finance became a point of fierce debate among Americans to the present day.
The debate entered its first stage at the Philadelphia convention, where the convention voted to deny federal government the power of chartering a national bank. Under the inspiration of Alexander Hamilton, the Federalist dominated congress went ahead and chartered a national bank anyway, leading to the first constitutional crisis of the new government. George Washington tasked his Secretary of State Thomas Jefferson and his Secretary of treasury Alexander Hamilton with presenting to him arguments in favor of and opposed to the bank’s establishment. After reading, Thomas Jefferson’s brief in opposition to the bank and Hamilton’s in support. From the arguments of these two men were born the strict construction and loose construction schools of constitutional interpretation. What is perhaps more telling is the financial debate that surrounded the BUS’ establishment. Hamilton and his compatriots argued for the bank as a necessity to bail the federal government out of in time of financial emergency by forging a close relationship between financiers and the federal state, and as a necessary check against reckless currency emissions via loans by state banks. This last function requires a bit of explanation.
Before the Federal Reserve Bank was created, banks mad loans issued in their own currency or bank notes. These bank notes were debt instruments which could be redeemed in silver or gold coin. These same banks held deposits of their clients; these deposits could be made in either bank notes or silver and /or gold coin. Banks recognized that depositors did not all come to the bank to close their accounts and withdraw their notes and coin from the bank at the same time. Therefore, a bank assumed that it could issue more bank notes as loans than the bank had in silver and gold coin to redeem the new issues, until of course the depositors found out and began to descend upon the ban to demand their money back. This was known as a run on the banks. The theory was that a national bank who held the notes of other banks could enforce a certain amount of fiscal discipline upon these banks by either presenting notes for redemption or threatening to do so. The hope was that the threat of such action on the part of national bank would curb the greed of banks and keep them from lending out too much currency.
The Jeffersonians dismissed Hamilton’s worship of the financiers of the state. The most astute critic of the Hamilton system of public finance was John Taylor of Caroline. Taylor’s critique was simple. The system of Yankee finance capitalism proposed by Hamilton and his minions was a rigged game. The government would expand its activities and its abilities to grant favors, subsidies, and tariffs from the revenue collected via bond sales to the new Bank for the United States and other wealthy creditors. The federal government’s creditors would then have the tax revenues collected from ordinary citizens, and during Taylor’s time this meant farmers, transferred to their pockets as payment for the principal and interest on the loans given to the federal government. Thus one class of citizens, predominately farmers, had their wealth transferred to another class of citizens, the financiers. Taylor also speculated that if foreign capitalists became creditors to the federal government, foreign influence in the counsels of the union became a real possibility.
The Jeffersonian alternative to the Hamiltonian system was currency finance. To the initiated, currency finance conjures up such slogans as, “not worth a continental,” and such images as profligate governments printing currency and igniting the wild fires of inflation. Currency finance was much more complex than all of that, and during the American Revolution the states often supplemented currency finance with the selling of government bonds. Government emissions of notes did maintain their face value with respect to gold and silver as long as the notes carried an interest rate and could be used for the payment of taxes. In the War of 1812, Treasury notes the government issued to pay for war supplies which paid interest held their value quite well against gold and silver and other debt notes in the market. When President Andrew Jackson killed the second bank of the United States, ultimately the United States opted for a system of currency finance via the emission of Treasury notes which were payable by the government in gold and silver. The Treasury notes could also be used for the payment of federal taxes. Thus the federal government acted as its own banker and was divorced from the direct influence of creditors, national banks, and state banks. More importantly, the federal government had to follow a strict fiscal discipline lest it suspend the gold and silver redemption of its notes and thereby lose the confidence of the people. This system of currency finance endured successfully, with some modest modification, until the establishment of the federal reserve system in the twentieth century.