If you believe the doomsayers, fiscal Armageddon is just around the corner. "Let's get real," economist Laurence Kotlikoff warned in 2010. "The U.S. is bankrupt." Unless lawmakers act quickly, the nation will face a range of unpleasant realities, including higher taxes, soaring prices, and a dramatic increase in poverty, he wrote.
"This is an awful, downhill road to follow," Kotlikoff wrote, "but it's the one we are on. And bond traders will kick us miles down our road once they wake up and realize the U.S. is in worse fiscal shape than Greece."
Those bond traders haunt even less dire assessments of the nation's fiscal health. "When it comes to a sovereign debt crisis, it is no longer possible to say 'it can't happen here,'" George Mason University economist Tyler Cowen wrote earlier this year.
If a full-blown debt crisis still seems unlikely -- after all, the federal government continues to borrow at rock-bottom rates -- it's worth recalling that such crises are not unprecedented in American history. In fact, we're currently celebrating the bicentennial of one of them, otherwise known as the War of 1812.
Debt and Security
America's first sovereign debt crisis actually came in the 1780s. The Articles of Confederation, adopted by Congress in 1777 and fully ratified by the states in 1781, denied the new national government an independent power to tax. Instead, Congress was reduced to the status of a groveling supplicant, begging the states for money through a series of requisitions.
The states responded predictably. Between 1781 and 1786, they coughed up 37 percent of the total amount requested by Congress. And then things got worse. Between October 1786 and March 1787, the treasury collected a grand total of $663. Even adjusted for a few hundred years of inflation, that's not much money.
Anemic tax revenue made borrowing difficult. Initially, domestic lenders were willing to finance the new government, but failure to stay current with interest payments soon dried up their enthusiasm. Foreign governments were a bit more flexible, in large part because they had geopolitical motives for propping up the new American nation. But failure to keep current with those payments made further borrowing problematic after the mid-1780s.
Lacking cash from taxes or loans, Congress was unable to support a decent military. At one point, the army dwindled to just 625 soldiers, leaving the nation vulnerable to foreign aggressors, of which there were many. European powers quickly realized they could push the young nation around, and several -- including Great Britain and Spain -- did exactly that, trespassing on U.S. territory and interfering with trade and commercial activity.
That combination of tax and security concerns propelled the drive for a new charter of national government. As eventually ratified, the Constitution gave Congress the taxing power it lacked under the Articles of Confederation, and nationalist leaders moved to shore up the nation's finances. As the nation's first Treasury secretary, Alexander Hamilton pushed through a dramatic and controversial plan to have the federal government assume state debts left over from the Revolution. At the same time, Hamilton insisted on raising enough tax revenue to fund repayment of the consolidated debt.
Hamilton's plan went a long way to restoring American credit. In 1787 the yield on government debt in the United States ranged from 26 percent to 40 percent, according to Simon Johnson and James Kwak in their fine new history of American governmental borrowing, White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You. Just four years later, that yield had fallen to 9 percent.
Most political leaders were grateful for the improvement, but arguments over debt and taxes continued to rage. The new Federalist Party, led by Hamilton and Vice President John Adams, was committed to building a robust fiscal state, including a strong power to tax and a reasonable willingness to borrow. By contrast, the Democratic-Republicans (usually called simply the Republicans and led by Thomas Jefferson and James Madison) were more interested in limiting national power, especially on fiscal issues.
For the Republicans, taxes and debt were necessary, especially for reasons of national security. "Though I am an enemy of the system of borrowing, I feel strongly the necessity of preserving the power to borrow," Jefferson wrote. "Without that, we may be overwhelmed by another nation merely by the force of its power to borrow." Indeed, Jefferson would go on to borrow quite a bit of money on the nation's behalf, including more than $11 million for the Louisiana Purchase.
But Republicans considered taxes -- and the debt they made possible -- a serious threat to liberty. For the Republicans, "borrowing and the taxes it necessitated provided the cash that enabled governments to centralize power and to fight wars -- both of which were bad," Johnson and Kwak write. As Madison himself put it:
War is the parent of armies; from these proceed debts and taxes; and armies, and debts, and taxes are the known instruments for bringing the many under the domination of the few.
In terms of tax policy, the Federalist-Republican divide was crystallized in arguments over internal taxes. The Federalists insisted that the new government exercise its broad taxing power, including the authority to levy excise taxes on domestic goods. Republicans, on the other hand, preferred to rely solely on tariff duties, which were generally less controversial and reasonably well tolerated by the general public.
During the presidencies of Washington and John Adams, the Federalists went ahead and levied excise taxes, including one on distilled liquor that prompted the famous Whiskey Rebellion. But after Jefferson won the bitter election of 1800, he and his fellow Republicans repealed the excises for both ideological and political reasons. As explained by Jefferson's Treasury secretary, Albert Gallatin, the new administration wanted "to strike at the root of the evil and arrest the danger of encroaching taxes, encroaching government, temptations to offensive wars, etc."
War of 1812
The Republican antipathy toward internal taxes would become a problem when the United States found itself fighting another war with Great Britain. In the run-up to hostilities, Republican lawmakers tried to impose economic pressure on the British through a variety of trade restrictions. Those were notably ineffective in changing British behavior but quite effective in decimating federal revenue. By curtailing trade, the various import restrictions (including the Embargo Act of 1807 and the Non-Intercourse Act of 1809) hobbled the nation's principal revenue tool. Tariff revenue fell from $17.1 million in 1808 to just $7.8 million in 1809.
Republican political leaders -- now firmly in control of national politics -- were aware that tariffs would be unable to raise enough money for war with Britain. Gallatin conceived a plan to borrow war funds and impose new taxes adequate to repay interest on the loans.
Gallatin ran into bitter opposition from some of his more bellicose Republican colleagues, known collectively as the War Hawks. Those pro-war, antitax lawmakers were determined to head off any revival of the Federalist excise regime, no matter how attenuated. They rejected Gallatin's attempt to raise taxes and instead forced further reliance on short-term governmental debt.
Once war broke out, spending soared but tax revenues remained flat. "This gap could only be closed by borrowing, but there was relatively little appetite to invest in a country at war with the world's richest country and most powerful navy," Johnson and Kwak write.
The refusal to raise new taxes made matters considerably worse. In 1813 Gallatin had to ask Philadelphia banker Stephen Girard to underwrite a loan, "because, at that point, Girard's credit was better than the government's," Johnson and Kwak write. Indeed, federal bonds were proving a tough sell in financial markets, as lenders grew increasingly doubtful about the government's political capacity to make good on its debts.
The United States, in other words, was on the brink of another sovereign debt crisis. The problem wasn't the nation's economic capacity to repay debt, but its political capacity to make it happen. And taxes were at the center of those worries. With lawmakers so reluctant to raise money -- but more than willing to spend it -- the popularity of federal debt instruments continued to plummet. "Without a stable source of tax revenue, the United States struggled to attract lenders willing to bet on the country's unproven armed forces," according to Johnson and Kwak.
Eventually, the Republicans faced reality. After a series of increasingly dire reports from Treasury, Congress agreed to raise taxes in 1813 and then again in 1814. By most accounts, both were half measures, hardly adequate to the task of rescuing the national credit. But luckily, the war came to an end before the nation's fiscal weakness caused any more damage.
The Moral of the Story
Johnson and Kwak use the War of 1812 as a parable of sorts. It's a redemption story, with spendthrift lawmakers gradually coming to grips with economic reality. The Republicans of 1812 never completely abandoned notions of fiscal responsibility, they write. The party accepted, in general terms, the idea that federal debt had to be repaid, not repudiated.
But that sort of fiscal responsibility was hardly worthy of the name. "There is a deeper meaning of fiscal responsibility," Johnson and Kwak write. "The recognition that if you want something, you have to pay for it, either now or in the future. If a government cannot demonstrate that type of fiscal responsibility -- through the willingness and capacity to levy and collect taxes when necessary -- it will have trouble borrowing money in a time of crisis."
And therein lies the lesson for today's policymakers. Like their 19th-century counterparts, they are happy to spend money, and more than willing to proclaim their devotion to fiscal rectitude. But when push comes to shove, they are notably unwilling to turn the rhetoric of responsibility into the reality of higher taxes (or genuinely lower spending in the form of smaller government).
In 1814 the hard realities of war brought an end to political dysfunction. When the British burned Washington that year, they drove home the dangers of fighting a war that you aren't willing to pay for.
But that raises a question: What will prompt a similar acceptance of reality in today's world? The United States seems unlikely to face the kind of existential threat represented by the burning of Washington. Will some other crisis eventually prompt lawmakers to do the right thing, make the hard choices, and put the nation's fiscal house in order? Or will the slow-motion nature of the looming entitlement and tax crisis induce them to wait too long?
The outlook is gloomy.