When the United States began as a nation under the Constitution in 1789, it faced the handling of Revolutionary War debt incurred from 1775 to 1783 by individual states and the Continental Congress. Under a plan devised by Alexander Hamilton in 1790, the United States agreed to assume these debts. Hamilton issued new Treasury bonds to pay off the Revolutionary War debt and financed the new bonds with tariffs, which also protected infant U.S. industries against U.K. competition. These new bonds marked the beginning of the U.S. Treasury securities market. With U.S. credit now established, Hamilton and his successors issued new bonds to pay off maturing bonds, in effect rolling over the debt.
Starting with the election of John Adams, the second president, until the beginning of the Madison administration, the U.S. ran budget surpluses in fourteen of sixteen years from 1796 to 1811. Adams held public debt constant at $83 million, while Jefferson reduced the debt to $65 million during his two terms, despite borrowing to finance the Louisiana Purchase. Adams and Jefferson did not eliminate the national debt, yet they kept it manageable, and gave the United States a higher credit rating than any country in Europe. Jefferson also established the first of two pillars of prudent U.S. debt management—debt declined in a time of peace.
In the last two years of Madison’s administration, during the War of 1812, the nation exhibited the second of two pillars of U.S. debt management—debt increased in a time of war. Public debt almost doubled from $65 million to $127 million under Madison. Jefferson and Madison together established the signal attributes of U.S. national debt. The debt does not go up continuously; debt rises in war and declines in peace. Budget surpluses achieved during peace, even if they do not eliminate debt entirely, serve as a rainy-day fund so the United States has ample borrowing capacity during war. Borrowing capacity is financial dry powder, no different in purpose than gunpowder or ammunition stockpiled for unforeseen yet inevitable strife.
The administrations of James Monroe (1817–25), and John Quincy Adams (1825–29) continued this accordionlike pattern. Together they reduced the national debt from $127 million to $67.5 million, an almost 50-percent decline. John Quincy Adams’s successor, President Andrew Jackson (1829–37), took this pattern to its logical conclusion by eliminating the national debt entirely. The United States was practically debt-free in 1836. Jackson also eliminated the Second Bank of the United States, which acted as the central bank. Jackson’s last year in office was the only time the United States was debt-free in its history. Coincidentally, starting with Jackson, the United States did not have a central bank for seventy-seven years, until the creation of the Federal Reserve in 1913. Jackson’s legacy was no debt and no central bank.
The national debt soon returned. Debt was $4 million at the end of Martin Van Buren’s term (1837–41), and rose steadily to $65 million by the time of Abraham Lincoln’s election in 1860. The most notable increase in this period was a rise from $33 million to $47 million during the single term of James Knox Polk (1845–49). Most of this debt arose in connection with the Mexican-American War (1846–48) waged by Polk. These war costs were money well spent, since the United States acquired all or part of present-day California, Nevada, Utah, Wyoming, Colorado, and Arizona. Texas previously agreed to annexation by the United States in 1845, yet the borders with Mexico were not settled. Texas definitively became part of the United States as a result of Polk’s war. Despite war spending, national debt by the end of James Buchanan’s term (1857–61) was $65 million, exactly where it was when Jefferson left office in 1811, a half century earlier. The United States had no increase in its debt in fifty years despite two major wars, the War of 1812 and the Mexican-American War, and numerous lesser conflicts. This was the result of budget surpluses and prudent spending in times of peace.
Abraham Lincoln’s single full term—he was assassinated six weeks into a second term—saw both America’s bloodiest war, measured in total casualties, until the Second World War, and the first exponential increase in America’s national debt. During the Civil War (1861–65), national debt rose from $65 million to $2.7 billion, a 4,000-percent increase. This increase is in keeping with the history of debt during existential wartime crises. If the borrower loses the war, debt is irrelevant; it is repudiated or extinguished, perhaps replaced with reparations. If the borrower wins the war, there is enough gain through havoc or reconstruction to reduce the debt. Either way, citizens in general and domestic financers in particular rarely question a government’s need to borrow during war—creditors stand or fall with the nation itself.
America’s Civil War debt was extinguished in stages. From $2.7 billion at the end of the Civil War, the national debt dropped to $1.6 billion by 1893, a 41-percent reduction by the end of President Benjamin Harrison’s single term (1889–93). Since the period from 1865 to 1893 was one of enormous economic growth in the United States, the debt-to-GDP ratio dropped even more dramatically than the debt itself. Debt increased again during William McKinley’s term in office (1897–1901) to $2.1 billion because of the Spanish-American War (1898), another illustration of the yin and yang of U.S. debt and the dogs of war.
This pattern continued in the twentieth century. The U.S. national debt rose modestly from $2.1 billion to $2.9 billion during the combined administrations of Theodore Roosevelt (1901–9) and William Howard Taft (1909–13), despite Roosevelt’s robust big-stick diplomacy and $50 million spent to acquire land and rights for the construction of the Panama Canal, a transaction in which J. P. Morgan acted as fiscal agent for the U.S. Treasury.
The second exponential increase in U.S. debt after the Civil War occurred during the Woodrow Wilson administration (1913–21) in connection with financing U.S. participation in the First World War (1917–18). National debt exploded from $2.9 billion to $27.4 billion, an increase of 845 percent. This debt was partly financed by the issuance of Liberty Bonds to the general public. Previous wars were financed by wealthy private financers beginning with Philadelphians Robert Morris (Revolutionary War), Stephen Girard (War of 1812), Nicholas Biddle and Jay Cooke (Civil War), and later New Yorkers J. P. Morgan (“Pierpont”), and his son, Jack Morgan (First World War). Salmon P. Chase, secretary of the treasury during the Civil War, financed the Civil War in part with a popular issuance of small denomination, non-interest-bearing demand notes initially exchangeable for specie, although redemption was later suspended. These notes, called greenbacks because they were printed with green ink on the reverse, were more like proto-money than true securities and circulated as legal tender. Liberty Bonds issued in the First World War marked an innovation in war finance—they were U.S. Treasury debt. For millions of Americans, a Liberty Bond purchase was their first experience investing in securities. Liberty Bonds made the linkage between patriotism and war finance explicit in the minds of everyday American citizens.
Following the U.S. and Allied victory in 1918, the national debt once again declined. The Harding and Coolidge administrations produced eight consecutive surpluses from 1921 to 1929, reducing the national debt to $17.6 billion, a 36-percent decline from the postwar spike. The national debt increased only slightly under Herbert Hoover (1929–33), despite the demands of the worst years of the Great Depression. When Hoover left office, the national debt was $19 billion, still 31 percent below where it stood when Wilson left office twelve years earlier. The pattern of expanding then contracting debt that prevailed since 1787 remained intact.
The first two terms of Franklin D. Roosevelt’s administration, 1933–1937, and 1937–1941, marked a decisive turning away from the then nearly 150-year old pattern of expanding debt only in time of war. FDR did indeed expand the national debt from $19 billion to $42 billion, a 120-percent increase. Still, there was no war. Instead there was a continuation of Hoover’s Great Depression, including a severe technical recession in 1937–1938. In his first two terms, FDR was not fighting a war against a foreign enemy; he was fighting a “war” at home against unemployment, malnutrition, deflation, and rural underdevelopment. Federal def
icits were enlisted in this war in part on the advice of the U.K.’s John Maynard Keynes. Yet FDR’s impact on the national debt in his first two terms goes far beyond typical increased spending in peacetime. His response to the exigencies of the Great Depression ended the small government era forever. It was in 1935 that FDR and Congress enacted Social Security, one of the earliest and still the largest entitlement program, which created off-budget contingent liabilities in the form of promises to retirees. The political sales pitch that Social Security is “insurance paid for with payroll tax contributions” was false in 1935 and remains false today. Social security has always been a pay-as-you-go scheme in which younger workers pay retiree benefits, with no particular lifetime relationship between payments and benefits, as with true insurance. The difference between then and now is that Social Security was cash-flow positive for decades as the postwar baby-boom generation grew and entered the work force beginning in the 1960s. Today, Social Security is cash-flow negative as the boomers hit retirement age beginning in 2008. The fault cannot be laid at FDR’s feet, since entitlement programs have been mismanaged by Congress and the White House in recent decades. Still, the fuse on today’s fiscal time bomb was lit in 1935.
Notwithstanding FDR’s two-term deficit without war prior to 1941, FDR or his successors might have reduced the deficit based on an anticipated economic recovery in subsequent years. This vision was shattered by the instigation of a real war—the Second World War—and America’s involvement from 1941 to 1945.
Roosevelt was elected to a fourth term in 1944, but died on April 12, 1945, less than three months after being sworn in. Roosevelt’s third term (1941–45) overlapped America’s fighting in the Second World War, which saw an unprecedented expansion of the U.S. national debt in the face of an existential threat to U.S. national security from Nazi Germany and the Empire of Japan. In Roosevelt’s third term, the U.S. national debt grew from $42 billion to $245 billion. Over the same four-year period, the U.S. debt-to-GDP ratio grew from 50 percent to almost 120 percent, the highest in U.S. history. This $203 billion increase in the national debt from 1941 to 1945 dwarfed the $23 billion increase in FDR’s first two terms. FDR’s fiscal policy ran parallel to that of his predecessors since 1789. America expands its debt as needed to win wars, and then mitigates the debt postwar. America’s bloodiest war in history, measured in casualties, required the greatest expansion of the U.S. national debt in history, measured in dollars. This debt expansion in time of war was consistent with U.S. fiscal policy since the founding.
The next four administrations, Truman, Eisenhower, Kennedy, and Johnson, in cooperation with Congress and with explicit and implicit assistance from the Federal Reserve, engineered an extraordinary reduction in the U.S. debt-to-GDP ratio from 120 percent at the end of the Roosevelt administration to 38.6 percent in January 1969, the end of Johnson’s term. This was accomplished through a combination of occasional budget surpluses (1947–49, 1951, 1956–57, and 1969), strong real growth (after a prolonged postwar recession from 1945–47, the economy had a series of outstanding growth years, including 8.7 percent in 1950, 8.1 percent in 1951, 7.1 percent in 1955, 6.5 percent in 1965, and 6.6 percent in 1966; an analyst need only compare those growth rates to annual average real growth of only 2.2 percent for the nine years from June 2009 to June 2018 to see why strong real growth is the best cure for high debt-to-GDP ratios), and the Federal Reserve’s financial repression policy (holding nominal interest rates slightly below inflation for extended periods to reduce the real value of nominal debt). There were two major U.S. wars during this period—Korea and Vietnam—yet the debt-to-GDP continued to decline because the Korean War was paid for with tax increases and the Vietnam War was made affordable by the strong real growth of the Kennedy-Johnson years.
The steady melting away of the postwar debt-to-GDP ratio continued through the Nixon, Ford, and Carter years (1969–81) for different reasons. Real growth was not nearly as strong in the 1970s as the 1960s (there were recessions in 1974–75 and in 1980), yet high inflation especially after 1976 had the same impact as financial repression in the 1950s. Inflation ran ahead of interest-rate increases until Paul Volcker slammed on the brakes with 20 percent interest rates in 1980. As long as nominal GDP increases faster than the deficit plus interest expense, the debt-to-GDP ratio declines even if real GDP growth is weak.
A parlay of design in the 1950s, good fortune in the 1960s, and inflation in the 1970s ultimately reduced the U.S. debt-to-GDP ratio to 32.5 percent when President Jimmy Carter left office in January 1981, about the same ratio as in 1790 during George Washington’s first term and the lowest ratio since the 1930s. Through seven presidential administrations, from 1945 to 1981, Democrat and Republican, the looming tower of postwar debt was whittled down to a sustainable, even enviable, level. It was a moment for fiscal hawks to savor, yet it was fleeting. The debt-to-GDP ratio would never be that low again.
With this economic history in mind, we turn to the story of the past four decades, during which spending became unmoored from national security or existential threats and the sequential expansion and contraction of national debt was replaced by one long expansion, to the point of national humiliation.
The Breaking of America from Reagan to Trump
Absent higher growth, which is elusive due to demographics and declines in productivity, the only ways to escape America’s new debt dilemma are default, inflation, asset sales, an IMF world money bailout, or some combination. Default imposes immediate losses on unpaid government bondholders and mark-to-market losses on other bondholders as interest rates spike to account for increased default risk. Inflation mitigates the government’s debt burden by spreading losses indiscriminately to holders of all forms of fixed-dollar claims, including bank deposits, money market funds, annuities, insurance policies, pensions, and long-term contracts. Asset sales are a humiliation, as Greeks would attest after their sovereign debt crisis from 2010 to 2015. American assets such as parks and highways are worth little to foreign investors, since they cannot be removed, exploited, or used to generate cash-on-cash returns. An IMF bailout requires the United States to give up partial control of its economy to an unaccountable globalist institution, a politically unpopular prospect. It would also result in unforeseen consequences, including displacement of the dollar by the IMF’s special drawing right, or SDR, as the benchmark global reserve currency, at China’s insistence.
At least one of these dire outcomes is inevitable. To see why, begin with consideration of the U.S. debt-to-GDP ratio. Debt itself cannot be analyzed in isolation; it must be compared to the income available to support that debt. Comparing debt and income is no different for a country than for an individual. If you owe $25,000 on a MasterCard that may or may not be a problem depending on your income. If you earn $20,000 per year, the $25,000 credit card debt overwhelms you with interest payments and penalties, possibly causing you to file for bankruptcy. On the other hand, if you earn $500,000 per year, you can probably pay off the credit card debt with ease, using the cash in your bank account. The point is, you cannot determine whether $25,000 is a high or low debt load without looking at the income available to service the debt.
Countries are the same. The United States today has $22 trillion in national debt. Is that high or low? If U.S. GDP were $60 trillion, analysts would treat the $22 trillion in debt as low and easily manageable. The U.S. debt-to-GDP ratio would be 37 percent ($22 trillion ÷ $60 trillion = 0.37), about where it was in 1790 and 1981. Conversely, if GDP were only $21 trillion, then the debt-to-GDP ratio would be 105 percent ($22 trillion ÷ $21 trillion = 1.05). Of course, the United States is in the latter situation. The debt-to-GDP ratio is 105 percent, a dangerous and nonstable level. To see how America came to this pass, one needs to review almost forty years of fiscal policy under presidents Reagan, Bush 41, Clinton, Bush 43, Obama, and Trump. Fiscal policy for the period 1981 to 2019 can be summed up in a curious phrase: Feed-the-beast, starve-the-beast.
The beast is t
he U.S. government with its voracious appetite for taxpayer funds. Feeding the beast refers to huge deficits to support expanded spending. Starving the beast refers to spending cuts and fiscal prudence. These alternating bouts of spending increases and spending cuts amplified by tax increases or tax cuts make deficits larger or smaller than they would be based on baseline spending alone. The problem is that feed-the-beast, starve-the-beast strategies were used by successive administrations to tie the hands of their successors, with ruinous results. This recurring and destructive dynamic combined with the simple math of growth and deficits has led the United States to the dolorous debt condition it finds itself in today.
When Ronald Reagan was sworn in as fortieth president of the United States in January 1981, the U.S. debt-to-GDP ratio was 32.5 percent, a level last seen in the 1930s. Reagan faced other challenges when he assumed office, including 20 percent interest rates, 15 percent inflation, and a major recession, the worst since the Great Depression, which consumed his first two years in office. Still, the debt level was low and American credit was sound.
Aftermath Page 7