Debt and Deficit 101

Debt and Deficit 101

We will undoubtedly, over the next months,  hear and read a plethora of “wise old men” (and women) schooling us on the meaning and implication of the national debt and the seemingly unending string of deficits which fuel it. The background of “the debt” is, as are many family budgets, a matter of periodic “cash flow” problems stretching all the way back to the post-Revolutionary war era. The government under the Articles of Confederation was a very different and much weaker animal than that created by the Constitution.

        Under the Articles, the states, but not the Continental Congress, had the power to tax. Congress could raise money only by asking the states for funds, borrowing from foreign governments, or selling western lands. In addition, Congress could not draft soldiers or regulate trade. There was no provision for national courts. There were actually 6 separate drafts written with various differences, but the general gist of all of them was that the states would retain sovereignty. Benjamin Franklin wrote the first and presented it to Congress in July 1775.

        A final version was approved, after much debate between July 1776 and November 1777, more than a year later, with the newly declared nation already at war, by the Second Continental Congress on November 15, 1777, and sent to the states for ratification. It wouldn’t be ratified by all 13 states until 1881. At this point, it had become obvious to some that trying to fund a war and pay an army was difficult when the organization running the war was reliant on voluntary donations from the states. Added to this was the fact that much of the war in the early years was fought in the Northeast and impacted those states far more than their Southern compatriots until the last year or so of the war. During those early years, many Northern states had run up significant debt to their own people, selling bonds to outfit army regiments.

        If this sounds somewhat unworkable, that’s because it was. The Articles of Confederation held the new United States together long enough for it to prevail in the Revolutionary War, but once the war was over the league of friends quickly became a league of impoverished quibblers. The men who met in Philadelphia in wartime had been so concerned with making sure the central government couldn’t become too powerful that they neglected to make it powerful enough to solve the issues facing a new nation. As the Confederation Congress attempted to govern the continually growing American states, delegates discovered that the limitations placed upon the central government rendered it ineffective at doing so. Eventually the government's weaknesses became apparent, especially after Shays' Rebellion, which was primarily fueled by Massachusetts’ attempts to raise funds to repay the war loan debts they owed their wealthier citizens by taxing all their citizens.  

       Some prominent political thinkers in the fledgling union, led by men like James Madison and Alexander Hamilton, and several others, began urging changes to the Articles.

        Their hope and initial objective was to create a stronger government. Initially, some states had convened meetings to deal with their mutual trade and economic problems. However, as more states became interested in meeting to change the Articles, a meeting was set in Philadelphia on May 25, 1787. This became the Constitutional Convention. It was quickly agreed that as structured, changes would not work, and instead the entire Articles needed to be replaced.

        I have always been somewhat amused by the fact that while the folks back home had sent delegates to revise, once in Philadelphia, they concluded (without further consultation) that replacement was better!  There was not universal accord among the states or even within the states regarding this proposed shift to centralized power and authority. Hamilton and Madison, with contributions by John Jay, were the most outspoken (and literate) advocate for this radical power shift, Their series of newspaper essays, under the collective name The Federalist Papers, were instrumental in gaining sufficient support for ratification of this new model of government under the Constitution.

           In 1789, the government under the Articles was replaced with a federal government under the Constitution. The new Constitution provided for a much stronger federal government by establishing a chief executive (the President), courts, and taxing powers. During the first Washington administration there was significant debate regarding those significant war loan debts owed by several states (primarily northern) to their citizens. An underlying issue was that, as long as the wealthy northeastern merchant class was owed money by their state governments, their loyalties would almost certainly “follow the money.”

        Treasury Secretary, Alexander Hamilton, recognizing this, proposed that the Federal Government assume the states war debts. This was met with a predictable lack of enthusiasm by those states with little or no remaining war debt. Called “the Assumption Controversy,” this was a serious threat to national harmony almost as soon as Washington took office.

        Massachusetts had serious outstanding war debt while Virginia had none, for example. In a series of negotiations which would give Lin-Manuel Miranda the basis for a great song, (The Room Where it Happened) Hamilton (primarily) negotiated a compromise, often referred to by historians as the Compromise of 1790, which moved the national capitol from New York City to Philadelphia until a new capitol could be built on the current site of Washington, DC. This somewhat mollified southerners who had viewed a NYC capitol as signifying Northern dominance. In return, it was agreed that the national government would assume all outstanding state war debts. Hamilton saw this as shifting wealthy creditors’ allegiance from states to federal authority.

        Hamilton also, in a “Report on Manufactures” encouraged Congress to enact Excise Taxes, or taxes on domestic production (leading to the Whiskey rebellion) and more importantly, tariffs on foreign imported goods. These tariffs would be, until the Civil War and beyond, the primary source of funding Government operations. It is estimated that in some years during the 19th Century, the tariff provided as much as 95% of the revenue for the federal government.  

        To reduce the national debt, from 1796 to 1811 there were 14 budget surpluses (high tariff receipts from European manufactured imports) and 2 deficits. There was a sharp increase in the debt as a result of the War of 1812. In the 20 years following that war, there were 18 surpluses. In 1835, Andrew Jackson paid off the entire national debt, the only time in U.S. history that has been accomplished. In 1833, Jackson had retaliated against the Bank of the United States by removing federal government deposits and placing them in "pet" state banks. Jackson had vetoed a bill to re-charter the Second Bank in July 1832 by arguing that in the form presented to him it was incompatible with “justice,” “sound policy” and the Constitution.  Jackson then ordered the Specie Circular, which required all payments for government lands to be paid in gold or silver.... When combined with loose state banking practices and a credit contraction, a major economic crisis was brewing and came to the boil, when Martin Van Buren took office as president in March 1837.  No longer debt free!

        During the Civil War, Federal tariff income slipped, as such European imports as slipped through Union blockades into southern ports were no longer taxed. Added to this was the cost of mobilizing a huge army while major southern tariff ports (New Orleans, Charlestown, Mobile) were generating no revenue to fund it. The result was an income tax. On August 5, 1861, President Lincoln imposed the first federal income tax by signing the Revenue Act. Strapped for cash with which to pursue the Civil War, Lincoln and Congress agreed to impose a 3 percent tax on annual incomes over $800.

       In 1860, the year before the American Civil War started, the U.S. Government debt was $64.8 million. In current terms that would be a national debt of just $864 million. However, once war began, national debt grew quickly. The financial cost of the war was significant, totaling an estimated $5.2 billion. By the end of the Civil War, the USA had financed about two-thirds of its $3.4 billion in direct costs by selling War Bonds, increasing National debt by a factor of 50! The debt was just $65 million in 1860 but passed $1 billion in 1863 and reached $2.7 billion by the end of the war.

        During the following 47 years, there were 36 surpluses and 11 deficits. During this period 55% of the national debt was paid off.       It could have been more, maybe all, but a succession of Republican Presidents politically catering to Union Army Veterans, their families and their children, intensely lobbied by the almost overwhelmingly Republican vote producing veteran’s association, the GAR (Grand Army of the Republic). This US Union vets pension system was the biggest welfare system in the world at that point; at its height it accounted for one third of the federal government’s budget. It wasn’t until this year, 2020, that the last Civil war “child of a soldier” pensioner died at the age of 90. The war ended in 1865, her father died in 1938, and she drew a check for the next 82 years!

       What is “money?”  The “gold standard” is (was) a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. The United States, though formally on a bimetallic (gold and silver) standard, switched to gold, de facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. To the layman, this meant there weas a dollar’s worth of gold somewhere (Fort Knox) for every paper dollar in circulation. It also meant to some extent that the price of gold was determined, not by market forces, but by someone’s arbitrary decision.  

         This has led during the last years of the 19^th century to “panics” at times when inflation drove the face value of money above the gold reserves of the nation.  During the Panic of 1893, JP Morgan Used $60 Million in Bonds to Bail Out the United States Government. because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. It would take a book to discuss all the nuances and arguments related to the gold standard, which Nixon ended in 1973 for the USA. What is fact is that regardless of what standard (if any) is used barring a monstrous gold rush which is on US soil, gold is “iffy.” After the Gold rushes of CA and AK  in the 19th centuries, gold supplies remained relatively stable and prices pegged to it remained somewhat flat while prices for imports and other tangibles rose, hammering US Agriculture as farm prices remained low while cost to produce grew.

        Regardless of currency foundation or lack of same, there are factors which, in the modern, cannot be solved by gold. WWI, the Great Depression, WWII, and the Great Recession are all exemplary of events which have driven national debt. All these however are also atypical events (no I don’t want to get into a Marxian discussion here, although it relates to a significant degree, especially in 2007-8.  The first three events were largely externally driven, but the 2008 Housing Bubble collapse and subsequent recession are self-inflicted wounds.  Historically, and unsurprisingly, the US public debt as a share of gross domestic product (GDP) has increased during wars and recessions, and subsequently declined. It should surprise no one that spending during WWI the Great Depression and WWII all led to deficit ridden budgets and accordingly increasing debt.

        Economists tend to look at a nation’s financial stability by comparing the amount of the Federal Debt to the Gross Domestic Product (GDP) for the same year. GDP is a measure of the total size and output of the economy. This measure of the “debt burden” is its size relative to GDP, called the "debt-to-GDP ratio."  A low debt-to-GDP ratio indicates an economy that produces and sells goods and services sufficient to pay back debts without incurring further debt. One might expect that absent a war or recession, the deficit would decrease. Someone naive enough might actually expect the deficit to go to zero.  Don’t hold your breath. The last time the deficit was even in single digits of billions was 1974 when it was $6 billion, that is, until the second Clinton administration actually had 4 consecutive multi-billion-dollar surplus years from 1998-2001!

        The problem with the debt is that the more you owe, the more interest you pay. Anyone who’s ever had a home mortgage knows that feeling in the first years when interest is such a huge chunk of the payment, The same is true for federal debt also, in fact in 2019, the interest, alone, on the federal debt was $375 billion.  The recent large increases in total debt due to increases in the deficit reflect several discrete factors. In my opinion they are/were:

 The housing bubble collapse and aftermath (TARP, extended unemployment, tax revenue decrease due to bankruptcies and foreclosures. Hopefully non-repeating, although Trump has attempted to gut Dodd-Frank which attempts to preclude a repetition.

War on terror involvement in Iraq. They didn’t attack us, Saudi’s funded it. We’re still there.

Prior to Covid in a strong economy: from 2013-2015 during the Obama recovery from the worst economic downturn since the depression, deficits were too high but lower than 3% of GDP.

From 2016 to 2020 (Not factoring in CoVid which will, predictably, push the deficit to a record peacetime high which while possibly higher than it might have been, is still understandable) which Trump has proclaimed “the greatest economy ever”, we have seen 4 straight deficits of more than 3% of GDP. In fact, 2019 and 2020 (as submitted without accounting for any CoVid spending) are more than 4.5% of GDP and both at or over $1 trillion.    

So, what drives these deficits?  What can be done about it? What should be done about it?

              Stay tuned for (a much shorter) part two