Past & Present: Alexander Hamilton and the Start of the National Debt

On Sept. 18, 1789, the new secretary of the treasury, Alexander Hamilton, entered into negotiations for a temporary loan with the Bank of New York and the Bank of North America—the only two banks in the country at that time. The following February, the deal went through and the government borrowed $19,608.81. It was the start of the American national debt under the new Constitution.

American statesman Alexander Hamilton (1757 - 1804)

The United States was not exactly a good credit risk at that time, so the government was, perhaps, fortunate to get the loan. (Hamilton had helped found the Bank of New York, which probably helped.) It already owed millions, but no one knew exactly how much, for the government's books were, to be charitable, a mess. The Constitution required the new government to assume the debts of the old one under the Articles of Confederation. To win the Revolution, the Continental Congress had borrowed heavily from the French government and from Dutch bankers and had stopped paying both principal and interest on those debts in 1786.

It had also issued millions in fiat money, called continentals, that had sunk to a few pennies on the dollar in the inflation that it inevitably caused. The phrase "not worth a continental" would be part of the American lexicon for a century afterward.

So it was not surprising that the Treasury was the largest department of the new government, with 39 employees versus just five for the State Department under Thomas Jefferson.

Hamilton, deeply read in economic theory and politics, understood how useful an instrument a national debt could be in asserting national power. Britain had founded the Bank of England in 1694 and its government bonds traded freely in the marketplace. Thus it was able to borrow at much lower cost than France and repeatedly defeat its much larger and theoretically more powerful rival in the endless wars that punctuated the 18th century. Hamilton firmly believed that a similar type of national debt, "if it is not excessive, will be to us a national blessing."

To achieve it, Hamilton sent to Congress on Jan. 14, 1790, his "Report on the Public Credit." In it, he proposed three things. First, he wanted to redeem the old debt on generous terms by issuing new bonds that would be backed by the revenues from the tariff, the main source of the federal government's income. The old bonds had been trading in a range of 20 to 25 percent of par and speculators in New York, where the federal capital was then located, quickly pushed the price up to 40 to 45 percent. Many thought that these speculators should not benefit from their recent purchases. James Madison thought that the current bondholders should get only what they had paid for the bonds and the original purchasers should get the difference.

This was hopelessly impractical, as identifying the original holders would have been a nightmare. Further, if a government can pick and choose as to whom it owes a debt, investors would be much more reluctant to buy later issues of government bonds. The government's ability to borrow in the future would thus be greatly impaired.

The second part of Hamilton's plan was to assume the state debts incurred in the Revolution. This was much more controversial because some states, notably Virginia, had paid off their revolutionary debts, while other states, such as those in New England, had not. Hamilton, and many others, thought that since the surest source of funds to pay these debts, the tariff, was now exclusively a federal revenue, that the debts should follow the revenue.

Hamilton also wanted to help cement the still fragile union by making the state debt holders federal debt holders, thus giving them a stake in the success of the Union. Only when Hamilton made a deal with Madison and Jefferson, trading away New York City's status as the national capital in favor of a site on the Potomac, did his state-funding proposal pass Congress.

Hamilton's final proposal was to create a Bank of the United States, modeled on the Bank of England, to act as the government's fiscal agent, provide a sound paper money supply, and be a source of loans for the government. Thomas Jefferson and his political allies thought it nothing but a scheme to enrich the rich. They also thought it patently unconstitutional, as the Constitution does not explicitly give the federal government the power to create corporations.