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Excerpt from Simon Johnson and James Kwak's book "White House Burning"

Chapter OneImmortal Credit ardently wishes to see it incorporated, as a fundamental maxim in the system of public credit of the United States, that the creation
Excerpt from Simon Johnson and James Kwak's book \"White House Burning\"
Excerpt from Simon Johnson and James Kwak's book \"White House Burning\"

Chapter One

Immortal Credit

[The treasury secretary] ardently wishes to see it incorporated, as a fundamental maxim in the system of public credit of the United States, that the creation of debt should always be accompanied with the means of extinguishment.—-Treasury Secretary Alexander Hamilton, January 17901

On April 30, 1789, when George Washington was inaugurated as the first president of the United States, the country he would lead was a fiscal basket case. Less than six years after the Treaty of Paris ended the American Revolutionary War, the new nation was deeply in debt and already in default. The United States had missed interest payments owed to France for several years in succession, as well as principal payments due in 1787 and 1788.2 The country’s credit was so poor in the 1780s that some claims on the central government could be bought for less than 15 cents on the dollar.3 In 1790, when Alexander Hamilton, Washington’s first treasury secretary, added up the nation’s debts, the federal government owed $54 million, almost $12 million to foreigners; on top of that, he estimated individual states had debts that added up to $25 million.4 To put this in perspective, from 1784 to 1789, the Continental Congress was able to bring in only $4.6 -million—-and half of that was borrowed money.5

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These debts were the price of fighting the Revolutionary -War—-the “price of liberty,” in Hamilton’s words.6 In 1776, the North American colonies proclaimed their independence from Great Britain, then one of the most powerful countries in the world. For the next five years, lacking both the authority to collect taxes and the good credit necessary to borrow money, the Continental Congress struggled to keep an army of 10,000 men in the field. The British, by contrast, routinely had 15,000 to 25,000 experienced -front--line troops available for battle and had numerical superiority in most confrontations.7 The British could deploy so many troops because they had the financial resources to mobilize -them—-or to hire them from other European states, as was the case for the Hessians defeated in the Battle of Trenton.

General Washington, by contrast, struggled to keep the British at bay because there was little money available to mobilize, equip, and pay the Continental Army. The Continental Congress lacked both the power and the infrastructure to levy and collect taxes; without the assured prospect of future income (or even survival), the new government had trouble borrowing money. Most central government payments were made with -“continentals”—-paper money issued by the government.8 Benjamin Franklin was initially impressed by this financing solution: “The whole is a mystery even to the

politicians, how we have been able to continue a war four years without money, and how we could pay with paper that had no previously fixed fund appropriated specifically to redeem it.”9 But as the government issued more and more paper money with nothing to back it, the currency fell in value, leading Washington to complain in October 1779 that “a wagon load of money will scarcely purchase a wagon load of provisions.”10 Insufficient funds meant that American soldiers had to suffer with little food, poor shoes, and derisory accommodations during harsh winters; in the winter of 1777–1778, 2,500 men died at Valley Forge. Anger over irregular pay in a depreciating currency would later contribute to the Pennsylvania Mutiny of 1783, which prompted Congress to relocate from Philadelphia to Princeton, New Jersey.

The new nation was fortunate, however. France, Britain’s traditional enemy, was willing to loan money to the Continental Congress  despite the high risk of not being paid back, and the United States was also able to borrow money in Spain and the Netherlands.11 In addition, the French provided troops and ships that helped tip the military balance, particularly at the decisive Battle of Yorktown in 1781, which helped convince the British that the war was no longer worth fighting. But it was clear that the United States could not truly be independent unless the world’s powers were persuaded that the new country could defend itself, which required money. And to raise the money to fight an -eighteenth--century war, nothing was more valuable than good credit. This was a lesson that -Washington—-and Hamilton, his wartime aide12—-learned firsthand from the British, the masters of the subject.

War, Debt, and Taxes

During the eighteenth century, Great Britain and France were locked in a struggle for political supremacy in Europe. At first glance, everything seemed to favor France. It had twice as many people as Great Britain (19 million versus 9 million in 1700), an advantage it maintained throughout most of the century. Its army was several times as large (350,000 troops to 75,000 in 1710); even its fleet was larger in the late seventeenth century, although the British navy would take the lead in the eighteenth century.13 Its overseas possessions were the equal of Great Britain’s. Yet throughout the century, Great Britain was more than France’s match on the world stage: the two powers fought to a standstill on the Continent, while Great Britain seized most of France’s overseas colonies in the Seven Years’ War (known in the American colonies as the French and Indian War).

The reason was not economic superiority. In 1700, France’s economy was the largest in Europe, nearly twice as big as Great Britain’s.14 The reason was the British government’s fiscal superiority: its ability to raise money through both taxation and borrowing. To begin with, Great Britain had a more efficient administrative system for collecting taxes in the form of a modern centralized bureaucracy.15 In France, taxes were collected by “tax farmers” who leased the right to collect taxes, other officials who bought their positions, and various traditional corporate bodies. Many of these intermediaries took their share of tax proceeds before passing them on to the government (and sometimes more than their share).16 Still, no country could afford to fight the wars of the eighteenth century solely with tax revenue, and so the crucial factor was a government’s ability to borrow money. Here Great Britain had two major advantages. The first was its superior ability to raise taxes, which gave lenders confidence that the loans they advanced during wartime could be paid back by taxes in peacetime.17 The second, and more important, was that government debts had to be approved by Parliament, which also had the power to raise taxes.

Parliamentary control over spending and taxation was a -long--term consequence of the Glorious Revolution of 1688, in which the Catholic King James II was deposed in favor of the Protestant King William III and Queen Mary II. The Revolution led to heightened competition between Whigs (associated with commercial and financial interests) and Tories (representing traditional landowners). William III relied on Whig support to fight on the Continent against King Louis XIV of France; the Tories, by contrast, preferred to withdraw from the Continent and rely on the navy to protect Great Britain.18 The need for new taxes and borrowing to fight the War of the League of Augsburg (1689–1697) and the War of the Spanish Succession (1702–1713) increased the power of Parliament relative to the monarchy, making fiscal and economic policy more dependent on public support.19 Parliamentary oversight and the perception that the tax system was basically fair were also major reasons why British society was willing to endure unprecedented levels of taxation.20

In the three decades that followed the Glorious Revolution, the British government was able to borrow vast sums of money to fight the French, its national debt growing from £1 million to £54 million.21 That borrowing was supported by taxes that tripled between the 1670s and 1715.22 Still, it was only the advent of Whig dominance in 1715 that ensured Great Britain’s good credit; a large Whig -majority—-representing the nation’s creditors, among other -groups—-provided confidence that the government would continue to pay its debts by raising taxes if necessary, allowing it to borrow money at relatively low interest rates.23 By the time Whig control of Parliament ended in 1760, the idea that servicing the national debt was a crucial priority had become far less controversial.24 And this was the secret to winning wars in the eighteenth century. As Daniel Defoe (of Robinson Crusoe fame) wrote, “Credit makes war, and makes peace; raises armies, fits out navies, fights battles, besieges towns; and, in a word, it is more justly called the sinews of war than the money itself.”25

France, by contrast, was in a near constant state of financial crisis.26 The Estates General (a representative assembly that was France’s closest approximation to Parliament) had not met since 1614, debts were incurred by the monarchy, and taxes were based on the monarchy’s traditional rights and privileges or imposed without consent by the king.27 The haphazard tax collection system made it difficult to bring in revenues reliably.28 The sale of -offices—-bureaucratic or professional positions, sometimes carrying social -distinction—-was a major source of revenue, but also meant that the government had to pay “interest” in the form of salaries to officeholders.29 The difficulty of raising adequate revenues through taxation meant that wars periodically led to escalating debts;30 the government often responded by defaulting or unilaterally rescheduling debt repayments, as occurred in 1715, 1722, 1759, 1763, and 1772.(31)

Without the assurance of future revenues to back it up, government debt can quickly become worthless paper. And unlike in Great Britain, creditors had little political power and hence no reason to trust the government to make good on its debts.32 As a result, France had to pay interest rates that not only were higher than those paid by Britain but also were higher than those paid by the private sector in France.33

The difference between the two countries became clear after the American Revolutionary War. At first glance, Great Britain seemed to come out of the war in worse shape, and not just because it lost. Britain had financed the war entirely by new borrowing, and it ended the war with a larger national debt than France (and a much smaller population); in 1782, 70 percent of all British government expenditures went to interest on the debt.34 (In the United States today, the corresponding figure is 6 percent.)35 But Britain benefited from lower interest rates, thanks to its good credit, and, more importantly, was able to raise taxes in the 1780s, bringing its debt under control.36 While France’s debt was smaller than Britain’s, it was unable to raise taxes due to the weak legitimacy of the monarchy, and so it had to resort to even more borrowing even after the war ended; by 1789, interest payments were consuming 68 percent of all government spending and growing each year.37 Finally, King Louis XVI was forced to call the Estates General, which convened on May 5, 1789, leading rapidly to the French Revolution and the overthrow of the monarchy. At the time, effective tax rates in Britain were nearly twice as high as in France, leading historian Kathryn Norberg to conclude, “More than any other factor, the inability to tax brought down the French treasury and with it the absolute monarchy.”38

Even then, some things did not change. The Revolution and the rise of Napoleon Bonaparte led to another twenty years of war, and Great Britain continued to enjoy a vast fiscal advantage, raising more in taxes than France, which helped fund the coalition that would eventually defeat Napoleon.39 By this time, the Industrial Revolution was well under way in -En-gland, and Great Britain would be the dominant world power for the next century.

What was the main difference between Great Britain and France? It -wasn’t the size of their national debts: at the time of the French Revolution, Great Britain’s debt per person was much larger than France’s. The difference was politics. In Great Britain, the political system was dominated by elected representatives who supported an activist government and were willing to endorse the taxes necessary to pay for its resulting debts. In France, the government did not have the legitimacy necessary to raise the money to service its smaller debts. And although its tax rates were lower than Britain’s, the problem of taxation without representation was an important cause of the Revolution.40

Surprising facts in WHITE HOUSE BURNING

  • 44% of Social Security recipients say they do not use a government program, as do 40% of Medicare recipients and 43% of unemployment benefit recipients.
  • Americans believe government spending is out of control, but our federal government spending is only 37% of GDP, the second-lowest figure among 27 advanced economies.
  • 40% of Americans are “angry” about the level of federal income taxes they pay, but individual income taxes have fallen over the past 30 years.
  • Our current and long-terms deficit problems are largely a product of the financial sector.
  • The amount of the national debt would not matter if we did not have to pay interest in it each year (and the bigger the debt, the greater the interest).
  • The federal budget should not be treated like a household’s budget, despite what some politicians claim. There are good reasons for the U.S. to carry debt and have a deficit—but they must be kept stable.
  • We are not broke as a nation (despite what was said during the standoff over the debt ceiling in the summer of 2011) and the national debt and the federal deficit do not impact the future livelihoods of our children and grandchildren.
  • The vast majority of Americans depend on the federal government for their basic livelihood, either now or in the future.
  • Tax increases are no better than spending cuts to reduce the deficit, and in fact there is some evidence that spending cuts affect the economy more.

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