Collectively, we are drowning in a sea of debt: personal debt, credit cards, automobile loans, student loans, municipal debt, bank debt, state debt, federal debt, international debt. Debt went on increasing in the last decades of the 20th century, but then debt levels soared at even faster rates as we passed over into the new millennium. What drove that acceleration was a surge of international and cross-border debt that allowed nearly everyone, nearly everywhere, to borrow as much as they wanted. Europe has become the epicenter of the new crisis of government debt, but Europeans are not alone in their problems; they are just more vulnerable as a consequence of the constraints imposed by the adoption of a single currency, which means both that individual countries cannot inflate their way out of debt, and that the European Central Bank, by virtue of its founding principles, won’t do it for them.
The world’s overflowing reservoir of credit was worldwide in scope. From 2000 to 2008, the global average annual growth rate of cross-border deposits and loans in dollar terms was over 20 percent. In retrospect, it looks as if the turning point, when a mere party turned into an orgy, came in 2004. By a unanimous vote, the U.S. Securities and Exchange Commission lifted leverage controls on brokers. Although the measure received little attention at the time, it allowed firms like Goldman Sachs to increase their already stellar earnings by borrowing more and increased competitive pressures on other firms to do the same.
There then followed, as it always does, a sharp and painful lesson. Since 2007, we have learned that public and private debt are not as easily separable as we had supposed. First, bank problems in almost every country required massive injections of public capital, and then the direction of crisis causality ran in the opposite direction, with poor public finances leading to banking problems. Finally, the causality runs both ways, in a diabolical spiral of propagation or contagion of crises, with sell-offs of government debt of a widening range of countries spreading bank misery ever further. This conjunction is threatening a financial shock of a much larger magnitude than even that caused by the Lehman Brothers collapse of 2008, with a real prospect of the world plunging into a new version of the Great Depression.
The debt explosion and the subsequent painful lessons of 2007–08 have produced a deep frustration. Confronted by hopeless levels of indebtedness, with bankruptcy staring many in the face, there must surely be someone out there to help. The banks? But the banks are being pushed to run down their exposure. The government? But public finances are also in a fragile condition. So maybe there is some convenient deus ex machina, perhaps some international agency? A Vatican publication has endorsed the idea of an international superbank or monetary authority to help people and countries out; it depicts the innovation as one of the “first steps in view of a public Authority with universal jurisdiction; as a first stage in a longer effort by the global community to steer its institutions towards achieving the common good.” Cynics may be forgiven for wondering what will happen first, the arrival of such an Authority or the Second Coming.
Clearly, more realistic solutions are urgently needed. It is thus not at all undesirable that European interest in American precedents for Federal finance has been whetted. Specifically, the way that Alexander Hamilton negotiated the very new U.S. Federal government’s assumption of high levels of state debt in 1790 in the aftermath of the American War of Independence looks like a tempting model for those European states with unbearable debt burdens.1
The sudden interest of various and sundry Continentals in Alexander Hamilton strikes some as insightful, others as quaint, still others as delusional. As one Warsaw-based analyst commented after a closed-door session on the crisis in Prague in late October, “I had to listen to talk about ‘the Jeffersonian-Hamiltonian moment in Europe’, as if the Greek bailout deal was comparable to the ratification of the U.S. Constitution.” The question is, will such investigations help in any practical way? To get an answer, we must first review some pertinent history, some of it even preceding Mr. Hamilton. But first, a grounding in some basics on the politics of debt.
For Whom the Debt Bell Tolls
Historical experience suggests that the identity of a state’s creditor makes an enormous difference when it comes to expectations of whether debt will be regularly and promptly serviced. The frequent and spectacular early modern bankruptcies of the French and Spanish monarchies concerned for the most part debt owed to foreigners. The 16th-century Habsburgs borrowed—at very high interest rates—from Florentine, Genovese and Augsburg merchants; their bankruptcies amounted to a conversion to much lower interest rates. But for a time at least, lenders lent because they saw in the very high initial rates enough compensation for the possible non-repayment of the principal. They also lent because the Spanish crown seemed to have a secure, though not necessarily constant, stream of revenue from New World silver. In the end, however, military costs exceeded available revenues, and the powerful merchant houses were dragged down by their dependence on Spanish debt. Ancien régime France developed a similar pattern, borrowing in Amsterdam or Geneva in order to fight wars against Spain in the 16th and 17th centuries, and against Britain in the 18th.
First the New Provinces (the Netherlands, as it later became known) and then Britain followed a different path. They depended much less on foreign creditors than on domestic lenders, even though their domestic financiers sometimes drew upon foreign sources of capital. The Dutch model was exported in 1688 with a political revolution that deposed the Catholic Stuart King and put the Netherlands Protestant William of Orange on the English throne. The political revolution made for a revolution in finance, too. In particular, the recognition of the rights of parliament—of a representative assembly—ensured that the representatives of the creditor classes would have permanent control of the budgetary process. Appropriations and spending decisions needed a vote in the States-General or the House of Commons. The parliamentarians could thus guarantee—also on behalf of other creditors—that the state’s finances were solid and that debts would be paid. A constitutional approach limited the scope for wasteful spending on luxurious court life (as well as on military adventure) that had been the hallmark of early modern autocratic monarchy.
The fiscal revolution didn’t stop state spending. A rapid consequence of the new reliability of debt was a dramatic reduction in the price of financing. Then the state soon discovered that it could do more things, including having a more ambitious foreign policy and seizing more territories outside Europe. The amazing feature of the British financial system was that it could sustain very high levels of debt at times of national emergency because there was a confidence that the political order ensured that there would not be a default. The state became more powerful—and what is really important, more powerful than its peer competitors—as a result of well managed debt.
The converse of increased state power was the building of prosperity among citizens, notably the then-burgeoning middle classes. Prosperity and well-managed public debt are actually two sides of the same coin. Indeed, an increase in prosperity logically requires a building up of claims against others: in other words, of debt. Both the lenders and the borrowers are thus as if by magic better off—by the magic of behaving well. As Alexander Hamilton noted, “States, like individuals, who observe their engagements, are respected and trusted: while the reverse is the fate of those, who pursue an opposite conduct.”2
The question at the end of the 18th century was: Could this Dutch and then British and then American model be transferred to other countries? The answer turned out to be “yes”, and the result is the key to the evolution of the modern world. The financial revolution of the modern era was built on a political order based on representative legislatures and in time representative government, which preceded a full transition to genuine democracy in a good many countries, in which creditors formed a significant part of the political class along with big landowners, owners of large merchant houses, industrialists and others.
By the 20th century, there were signs that the compromise between legislatures composed of creditors and state authorities who wanted to spend was breaking down. People who wanted to spend more moved into parliaments. Consequently, the main areas of state spending shifted to the satisfaction of domestic demands and the appeasement of increasingly organized domestic interests and lobbying groups. With that move, the magic of responsible government faded.
The experience of inflations in wartime and postwar periods (as in early Weimar Germany), used to produce de facto defaults in the 20th century, subsequently made the theme of responsible finance a crucial part of a new republican and democratic European consensus. One of the foundations of the European integration process was recognition of the importance of a stable currency to political legitimacy. In particular, the conviction that political order in a democracy depended on the security of debt cemented the critical French-German axis of the European Union. The Germans saw the expropriation of two generations of middle-class bond holders as the outcome of the Kaiser’s war, and then of Hitler’s war—in other words, as the outcome of democratic failure. After inflation and unstable government, Charles de Gaulle rebuilt the French political system, as well as the idea of the French nation, by championing currency stability. He explicitly went back to the legacy of Napoleon in arguing that France could only be stable with a strong currency.
Going Abroad, Finding Monsters
In the post-1945 period, government finance was also overwhelmingly national, and the assumptions of the 1688 Orangist revolution still held good. But with the opening up of global financial markets in the 1970s, vast foreign sources of credit became available. In the mid-1980s, the United States switched from being a net creditor to a net borrower. In some phases (notably in the 1990s), inflows of foreign money coursed mostly to the private sector in the form of FDI or portfolio investment; in other phases (especially during the 2000s), inflows ran more to the public sector. In both cases, though, the driving force was the same: Foreigners wanted a share of American stability and security, and they were willing to pay a price in terms of lower yields to get that additional safety.
As long as there is confidence that the debt is sustainable, this trade of lower yields for higher security looks like a good bargain for the foreign investor. U.S. citizens, too, benefited from lower interest rates, and cheap credit allowed them to enjoy higher standards of material living by means of the consumption of foreign goods, whose lower prices also dampened the inflationary pressures that might otherwise have attended so much spending. It also allowed American government at the local, state and Federal levels to run up enormous deficits without apparently paying much of a cost.
The European tragedy is that the old Continent tried to follow exactly the same path without realizing where it would eventually end up on both sides of the Atlantic. Since the 1960s, Europeans wanted to imitate the financial superpower on the other side of the Atlantic. The euro was driven by a kind of dollar-envy. But beyond that, part of the promise of the new push to European integration in the 1980s was that it would make borrowing easier. The main attraction of monetary union by the 1990s for Italian and Spanish politicians was that the commitment to the new currency would bring down interest rates and make foreign money available for the cheap financing of government debt.
There is a contrast, however, between the experience of the 1990s and the 2000s. In the former decade, highly indebted European countries (especially in southern Europe) made great efforts at fiscal stabilization in order to qualify under the Maastricht criteria (renamed the Stability and Growth Pact) for membership in the eurozone. Once in, their efforts flagged. European fiscal performance deteriorated in the 2000s, well before the financial crisis. For a time, the global bubble made the fiscal picture look better than was really warranted in light of the underlying imbalances. And then, as it always does, the bubble burst, and reality became depressingly clear.
Modern Europe has produced some dangerous incentives for governments to build up excessive foreign-owned debt. In the wake of the transition to monetary union, debt holding became internationalized. By contrast, most usually consider Japan very stable despite a horrendously high proportion of debt to GDP because the lenders (debt holders) are domestic, as well as aging and thus need to hold investments to pay for their retirement. Up to the late 1990s and the advent of monetary union, most EU government debt was also domestically held: In 1998, the overall ratio of foreign-owned debt was a fifth. It then climbed rapidly in the aftermath of the introduction of the euro, in part because the advent of the euro facilitated the expansion of European banking activity both in size and scope. In 2008, on the eve of the financial crisis, three-quarters of Portuguese debt, and half of Spanish and Greek debt, as well as more than two-fifths of Italian debt, was held by foreigners. Foreign banks held a significant proportion of this debt, especially in the case of Greece, Portugal and Italy.
In retrospect, we can see the moment the fatal blow fell for Europe. It came when France and Germany ignored the Stability and Growth Pact, suspending it in November 2003 as a counter to a (as it proved, spurious) threat of recession. Italy’s Romano Prodi, who ought to have had a powerful interest in enforcing the system’s rules, instead called the Pact “stupid.” Smaller EU countries were outraged by the Franco-German action. Not surprisingly, the behavior of the Big Two (perhaps the Bad Two) had a corrosive effect on other countries.
This was not just a European phenomenon. The same trajectory occurred in the United States, from relative fiscal responsibility in the 1990s (under Clinton) to persistent and high deficits in the 2000s under George W. Bush. Indeed, perhaps it was the United States that provided the worst bad example. More plausibly, perhaps the markets were apparently willing to finance almost limitless amounts of government debt since they perceived the debt of industrial countries to be an entirely risk-free asset. Bank regulators, pushed by governments desperate for cheap financing, gradually embedded this conventional wisdom in their regulatory codes.
Then the older lessons of history kicked in as they generally do. As the ledgers of economic history attest, when the level of debt reaches a psychological tipping point, the costs of borrowing suddenly soar. First Greece, then Portugal, then Spain and now Italy are seeing a sudden surge of risk premia. With an increase in the foreign share of debt, the political incentives to impose the costs of debt on foreigners increase. Why not just take the money and never repay it, especially if the alternative is to have the voters throw you out of office or even put you in jail?
In the 1930s during the Great Depression there were many defaults on internationally held debt. Some occurred in Europe, where even the French government defaulted (in December 1932) on government debt from World War I (Inter-allied Debt). Other examples came from Latin America. There was a strong feeling that the creditors were illegitimate and unethical bloodsuckers, and that the restrictive policies of creditor countries (such as the United States, with its highly protectionist Smoot-Hawley tariff) made it hard or even impossible to repay by essentially sterilizing their capacity to export. Amazingly, this feeling was shared by some political figures in creditor countries. In the wake of powerful populist criticism of the lending behavior of the Wall Street banks, President Franklin Roosevelt jovially slapped his thigh when he heard that Nazi Germany was defaulting on its external debt, including that owned by American banks, and exclaimed, “Serve the bankers right!” It is possible to envisage some time in the not-so-distant future when an American President will cheerfully embark on the expropriation of Chinese or other foreign holders of U.S. government debt by declaring a default after “quantitative easing” tranches three, four, five and six do not work.
Enter Mr. Hamilton
The economists’ answer to the European problem, namely that a monetary union demands a fiscal union, is only part of a much deeper truth about debt and obligation. Debt among nations is rarely sustainable without some sense of communal or collective responsibility for it. That is the mechanism that reduces the incentives to expropriate the creditor and makes debt both secure to the lender and cheap for the borrower.
This is the calculation that is now pushing some Europeans to consider the American experience. Alexander Hamilton in 1790 successfully argued, against James Madison and Thomas Jefferson, that the debt accumulated by the states in the War of Independence should be assumed by the new federation. One of his most appealing arguments was that this would provide greater security and thus reduce interest rates, from the 6 percent at which the states funded their debt to 4 percent.
The historical case looks like an attractive precedent for the Europeans of today. Hamilton emphasized the importance of a commitment to sound finance:
For when the credit of a country is in any degree questionable, it never fails to give an extravagant premium, in one shape or another, upon all the loans it has occasion to make. Nor does the evil end here; the same disadvantage must be sustained upon whatever is to be bought on terms of future payment. From this constant necessity of borrowing and buying dear, it is easy to conceive how immensely the expences of a nation, in a course of time, will be augmented by an unsound state of the public credit.3
Hamilton also provided a stronger reason for following good principles than merely the pursuit of expediency:
While the observance of that good faith, which is the basis of public credit, is recommended by the strongest inducements of political expediency, it is enforced by considerations of still greater authority. There are arguments for it, which rest on the immutable principles of moral obligation. And in proportion as the mind is disposed to contemplate, in the order of Providence, an intimate connection between public virtue and public happiness, will be its repugnancy to a violation of those principles.
It was those principles that made the fiscal union what he called “the powerful cement of our union.”
The condition for success was that the Union raised its own revenue, initially mostly through federally administered customs houses. That is also a logic that applies in modern Europe, where a reformed fiscal system might include a common administration of value added tax, or a Hamiltonian customs system of some sort.
In the American case, Union was bought at a price to creditors. The potential exposure to the common liability of Virginia, the most politically powerful state in the union, was limited with a ceiling. Only this inducement moved Madison to drop his opposition and agree to the proposal. This compromise, which also involved the capital being moved to the new site of Washington, DC, on the border of Virginia and Maryland, may be a precedent for limiting German liabilities in the case of the creation of a common European bond, or Eurobond.
Other reasons intervened to make this experiment in federalized finance ultimately unsuccessful, at least during what historians often call the first American republic. Two important parts of Hamilton’s financial architecture were not realized or realized only imperfectly. First, he proposed a model of joint stock banking on a national scale, which ran into immediate opposition (and which, curiously, was much more influential in Canada than in the United States). Second, his proposal for a national central bank was eventually blocked by political opposition. The charter of the First Bank of the United States was allowed to lapse in 1811; then, a generation later, Andrew Jackson successfully opposed the charter of the Second Bank of the United States in 1836.
For these reasons the Hamiltonian scheme of Federal finance could not guarantee a peaceful commonwealth. The partly erected fiscal union proved to be explosive rather than cementing. The country was torn apart by the Civil War in the 1860s partly as the result of a dispute about states’ rights and the character of financial burdens, in particular for payments to correct an abuse that was practice only in some states. In attempting to end the immoral practice of slavery, Abraham Lincoln originally proposed that slave owners should be compensated by the public purse for the loss of their property. At more or less the same time, the Russian government ended serfdom and paid compensation out of taxes. But what was possible in an autocracy was unacceptably expensive in a republic. So in the end, the Union expropriated Virginians and the rest of the South—at least that is the way the Southerners saw things. And, indeed, Lincoln then came to regard the war at least in part as a divinely enforced property transaction: God, he said, “gives to both North and South this terrible war . . . until all the wealth piled by the bond-man’s two hundred and fifty years of unrequited toil shall be sunk, and until every drop of blood drawn by the lash, shall be paid by another drawn with the sword.”
The Hamiltonian assumption was not and could not be on its own a guarantor of political order. The perspective that debt required a common foundation of morality was central to Hamilton’s approach, but it foundered on the differences between different states’ conception of morality.
What, then, can Europe learn from Alexander Hamilton? A collective European burden-sharing responsibility is in the long run the only non-catastrophic way out of the current crisis. Such generalized European burden-sharing requires a substantially greater dimension of political accountability and control on a pan-European level. That in turn requires a deeper degree not only of political but also moral consensus. If that consensus cannot be found, symbolized and politically ratified, no amount of tinkering or temporizing or bailing out can save the eurozone and the Union behind it. Is it already too late for a Hamiltonian solution to save the euro and the Union for which it has come to stand? Time will tell.
1See, for example, Marta Dassu, “Le colonie Usa e la lezione sul debito”, LaStampa.it, September 17, 2011; Hans von der Hagen, “Europa vs. USA—‘Kuhhandel braucht Kühe’ (interview with Irwin Collier’)”, Suddeutsche.de, March 1, 2011; Joëlle Kuntz, “L’Europe a ses Jeffersons. Où sont ses Hamiltons?” Le Temps, March 6, 2010; Clément Pimor, “La crise de l’eurozone, les États-Unis et l’introuvable M. Hamilton”, LeMonde.fr, December 13, 2010.
2Hamilton, “First Report on Public Credit” (1790).
3The Papers of Alexander Hamilton, edited by Harold C. Syrett et al., (Columbia University Press, 1961–79), Papers 6:67–72.