Questions surrounding the power to tax and spend have hugely influenced world and American history, dating to the country's founding, Nobel Prize-winning economist Thomas Sargent of New York University explained on May 16 at the Federal Reserve Bank of Atlanta's headquarters.
Speaking at a Public Affairs Forum held during the Workshop on Monetary and Financial History, Sargent described how conflicting interests in fiscal policy—primarily tensions between government bond holders wishing to be repaid and taxpayers who must finance those bonds—have shaped alliances, constitutions, and even revolutions. The workshop was organized by the Atlanta Fed and Emory and Rutgers universities.
Fiscal questions helped form the nation
In the United States, fiscal issues had profound consequences from the beginning. Specifically, a formative debate concerned whether the federal government should backstop state governments' debts, or vice versa.
"There was an intellectual war going on in the 1780s by very smart people who represented different interests," Sargent said.
This battle of ideas pitted those who thought the separate states, not the national government, should hold the power to tax and spend against nationalists who believed in federal power to tax, spend, and borrow. The nationalist views of George Washington and Alexander Hamilton prevailed, but not until after the signing of the Constitution in 1787. The nation's original framing document, the Articles of Confederation of 1781, restricted to the 13 states the power to levy taxes and regulate commerce.
The Constitution established federal fiscal powers, but the disputes did not end. For instance, the nation went on an infrastructure building spree in the 1820s and '30s. Political leaders of the day argued about who should finance it—states or the national government. President Andrew Jackson, who served from 1829 to 1837, believed the federal government should have no part in paying for railroads, canals, and banks. He and his new party, the Democratic Republicans, or Democrats, won the debate. So the states borrowed heavily, mainly from Great Britain, to finance "internal improvements," Sargent related.
Trouble soon emerged. Two financial crises during the 1830s left many states unable to repay their creditors. Fearing defaults, British lenders and their government demanded that the U.S. Congress step in and repay the states' debts. However, Jackson and the Democrats blocked a federal bailout of the states. So for the next 20 years, the U.S. government was considered a bad credit risk and essentially was cut off from European capital, Sargent explained.
Many American taxpayers welcomed a bad credit rating. They figured it would rein in future government spending. But if more U.S. citizens held their government's bonds, Sargent noted, they likely would have favored repayment. This episode, he pointed out, highlights the importance of who owns public debt, and where they live.
Sargent's talk was largely a collection of stories. One of the more compelling described the role that public debt—and particularly the violent means creditor nations sometimes employed to collect it—played in European conquests and the two world wars.
Sargent recalled the American economist Henry Carter Adams, who in 1887 warned that the U.S. policy of isolationism of that day would be threatened if New York were to become an important lender to foreign governments, as London and Paris already were. Adams, Sargent said, observed that the British essentially used their military as debt collectors in taking over Egypt in the 1880s, and France did the same in Tunisia around the same time and in Algeria 50 years earlier.
Similar financial forces helped bring about the two world wars, Sargent said. Wealthy American citizens lent to Germany early in World War I. The desire to collect on those loans was one reason America joined the war in 1917, he explained. Subsequently, the United States made huge loans to Britain and France, which helped lead the allied powers to impose large reparations on the defeated Germans after World War I. The disorderly process of writing down those German debts, and the frustration of many Germans facing what they viewed as a national humiliation, helped give rise to Hitler and World War II.
"That's a tragic story," Sargent said.