Many expenses incurred in the American Revolution by the colonists were borne by colonial governments rather than the Continental Congress. These debts went unpaid for years and came to be worth little after the war. In the late 1780s though, a new Constitution was drafted that gave the central government new powers. At the same time, an argument was being put forward that the new federal government should assume state debts and consolidate these amounts with a new bond issuance. Confidence in public credit was quickly restored but the maneuver was not without its controversy.
State Debts and New Government
In January 1790, the total federal government debt of the United States, across both foreign and domestic loans, was $54 million and, in addition, there was around $25 million in outstanding state debts. This included interest in arrears as debts went unpaid for a long time. This borrowing was not all raised in voluntary loans; in fact, there were many unwilling creditors of the United States. During the American Revolution, many soldiers were paid in various forms of debt certificates. As so much time had passed without payment, some state debts were trading hands at as little as fifteen cents on the dollar.
These debts were incurred largely during the War of Independence or in the next few years by the government of the United States before the Constitution was ratified. Unfortunately, a weak federal government had too little power to implement a convincing plan to resume payments on this debt.
This particular issue was resolved when the new Constitution was ratified in 1789. So, it is not surprising that speculators were buying depreciated debts. They expected the delivery of a report by the country’s first Treasury Secretary, Alexander Hamilton, which would recommend assumption of state debts by the federal government and devise a means of repaying it all. Prices of public bonds were surging higher in anticipation. Market prices on defaulted public debts rose by one-third between January and November 1789 and another 50% between November 1789 and January 1790 when Hamilton’s report was delivered to the House of Representatives.
Report on the Public Credit
Hamilton’s report began with a simple explanation of the benefits of sound public credit. He points out that borrowing is inevitable, particularly in times of war, and strong credit lowers borrowing costs. A few more benefits, including supporting asset values, creating a new money supply in the form of readily-accepted public securities, and restoring public order were rattled off as well. His ‘Report Relative to a Provision for the Support of Public Credit’ goes on to stress the importance of adhering to contracts as part of strengthening public credit. It seems obvious enough, but it was a segue to a controversial proposal.
“To justify and preserve their confidence; to promote the encreasing respectability of the American name; to answer the calls of justice; to restore landed property to its due value; to furnish new resources both to agriculture and commerce; to cement more closely the union of the states; to add to their security against foreign attack; to establish public order on the basis of an upright and liberal policy. These are the great and invaluable ends to be secured, by a proper and adequate provision, at the present period, for the support of public credit.” – Report Relative to a Provision for the Support of Public Credit, Treasury Department, January 9, 1790
The report proposed that the federal government assume state debts. The advantage of doing this was that a single national debt could be serviced by a uniform tax system. By contrast, if left to individual states to manage, the tax systems of different states could conflict in such a way as to move industry from some states to others or lead to shortages of some taxed goods in some places and surpluses in others.
There was a political consideration too. A single national debt would make the interests of creditors uniform everywhere. This would give more support to the fiscal system than a system where individual states are competing for a tax base on which to support their individual tax burdens. The latter would make the interests of creditors to different states at odds with one another and their political causes more adversarial.
While the consolidation of state debts by the federal government was particularly controversial, besides the assumption of state debts, the report covered other topics. It addressed the going rate of interest in the debt markets both in the United States and in Europe and devised various types of bond issues, including life annuities. One of its more exotic suggestions proposed making the debt partially redeemable for federal government owned land in the western part of the country.
Nonetheless, the new federal debt would largely be repaid by uniform federal taxes. Hamilton enumerated various specific import duties in his report: “Upon every gallon of Sherry, twenty-five cents … Upon every pound of Bohea Tea, twelve cents … Upon every pound of Coffee, five cents” etc. Hamilton also briefly hints at his idea for a national bank, which he would submit a plan for in a subsequent report.
Opposition
Hamilton’s project was not well received by most. The prominent opponents, at least initially, included future presidents Thomas Jefferson and James Madison. There were many others, particularly in the South, who argued their states shouldered larger burdens in the war than was commonly understood and they thought their states would be short-changed by an assumption. By contrast, members of Congress from the North were more supportive of federal assumption of state debts. Still, the contentiousness meant that the first vote on the assumption bill failed in the House of Representative, in a 31-to-29 vote.
One question at the heart of much of the controversy was whether speculators who bought state debts at very low prices should profit from their purchases. To the critics, this seemed like the prioritization of financial interests over taxpayers or over those citizens who had sold their claims on state governments for little. So, many argued in favor of paying only those who still held the original bonds in full and paying those who bought later at the price they paid plus interest and nothing more.
Subject to still more debate was the question of how to settle the assumption of state debts between states. How could this be done fairly if states had different debts? There were complexities to assumption. For example, some state obligations bore no interest; if the federal government issued bonds to take these on, it would be replacing a non-interest-bearing debt with an interest-bearing one. Would this make sense? Another complexity was introduced by the fact that many debts were in the form of certificates issued to soldiers in lieu of cash payment and some states paid their soldiers more than others during the War of Independence. Was an assumption unfair to states that paid their soldiers less. Lastly, making matters worse, there were reports of widespread counterfeiting of securities. Simply put, this was not going to be a simple task.
The strongest opponents, including James Madison, thought their states were being short-changed. The initial opponents on these grounds were largely from New Hampshire and the southern states of Maryland, Virginia, North Carolina, and Georgia. Madison proposed a delay to consolidation until the debts in question could be adequately tabulated, a modest request that was accepted, but also that debts already paid by state governments be reimbursed by the federal government.
Counterarguments and Compromise
As for these questions, Hamilton and the supporters of assumption had counterarguments but they also needed to make some compromises. As for the speculators, Hamilton insisted in making creditors whole no-matter how they acquired their bonds or certificates, even if this meant allowing a speculator to profit. Anything short of this, he argued, would be a violation of a contract and damaging to public credit. Hamilton argued that if an original holder was forced by desperation to sell at a depressed price, it was the fault of the government this was so because the government’s inability to honor its debts (or make convincing plans to honor them in the future) made the securities worth little. To reduce payment to the later purchasers would be an act of a government trying to benefit from its past negligence.
Hamilton provided no shortage of examples to illustrate the injustice of such a plan that would discriminate among debtholders based on how they acquired their claims. As just one example, he compared two people who bought their claims on the secondary market at steep discounts; one later sold when the market price rose over 1789 and the other continued holding his bond. The former would make his full profit but the latter, who arguably showed a stronger faith in the government by continuing to hold the claims, if a proposal was announced to repay secondary-market purchasers at a major discount, would make almost no profit by contrast.
As for how to implement a fair assumption of the state debts with respect to the different debt burdens of states, Hamilton’s report suggested that in addition to acquiring state debts from holders, states be ‘credited for all monies paid and articles furnished to the United States, and for all other expenditures during the war’ among other items, and the balances cancelled out. For example, if the federal government acquired $1 million in debts each from two states during the consolidation and one was judged to have contributed $1 million to the war effort and the other only $500,000, then the former could have the full $1 million cancelled whereas the latter would be relieved of only $500,000 of its debt burden.
This is a simplified summary of Hamilton’s plan, but it illustrates its logic and how it achieves the end result of relieving states of a large burden by offsetting their state debts, which were recognized by all, against a newly calculated figure of what states contributed to the war effort. In the end, backers of assumption in Congress agreed to a more fleshed out appraisal of states’ claims in order to overcome skepticism by many opponents.
On this basis and because of his concern for national unity, James Madison, who then sat in the House of Representatives, accepted the plan in April 1790. To win over some others, the assumption of state debts was paired with a proposal to establish a permanent capital city for the United States in the South. This paved the way for assumption and the House of Representatives passed the bill assuming state debts on July 26, 1790.
Funding Act of 1790
The bill, titled the Funding Act of 1790, also authorized new borrowing to refinance foreign debts. Besides that, a loan was arranged for the consolidation of state debts by the federal government. Subscribers in the new loan were able to pay for their bonds in various forms of loans or certificates issued by the states and the Congress of the Confederation, the pre-Constitution government under the Articles of Confederation. Caps were set on the amount of each state’s debt that was to be assumed by the federal government. These ranged from $200,000 each for debts of Delaware and Rhode Island to $4 million each for paper issued by South Carolina and Massachusetts.
Lesson
Some of the largest challenges to public credit are not quantitative. The case of France and Britain in the 18th century offers a famous example. Britain’s debts were larger in comparison to the size of its economy but the French were plagued by debt problems of greater severity. The early United States offers more evidence of the same fact. Here too, measuring the strength of public credit largely involved reaching a political verdict rather than calculating some credit metric.
In 1789-90, nothing changed about the size of the American economy; there was no windfall. Yet, the prospect for repayment of the public debt was transformed. What changed was the victory of those advocating for protecting all creditors, despite political inconvenience, and those who demanded the government be given the means to repay debts.
More from the Tontine Coffee-House
Read about the way war spending was funded during the American Revolution, inflation-linked notes issued by Massachusetts, and Alexander Hamilton’s handling of the Panic of 1792. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. An Act Making Provision for the Debt of the United States. 4 Aug. 1790.
2. Hamilton, Alexander. Report Relative to a Provision for the Support of Public Credit. National Archives, 9 Jan. 1790.
3. Kuehl, John W. “Justice, Republican Energy, and the Search for Middle Ground: James Madison and the Assumption of State Debts.” The Virginia Magazine of History and Biography, vol. 103, no. 3, July 1995, pp. 321–38.
4. Sloan, Robert. “The Great Debate Hamilton, Jefferson and the Fight Over Assumption.” Financial History, Winter 2010, pp. 28–39.
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