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Why was the Federal government's assumption of state debt so significant?

Why was the Federal government's assumption of state debt so significant?



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Alexander Hamilton advocated for the assumption of the states' debts by the Federal government. Why was this so significant? The reasons Chernow gives in his book are:

  • the wealthy bond holders would have a stake in preserving a government that owed them money

  • if the government didn't assume states' debts, states might take import duties which would clash with federal import duties

This all makes sense, but these reasons don't seem as significant if this is just a one-time assumption? I say one-time because today states can take out debt. The only reasons I can think that Hamilton would give up the capital for this assumption was because:

  • the state debt was so significant and wouldn't be paid off by the most debt-burdened states

  • something to do with the fact that it was debt from the revolutionary war

  • the legislation was not a one-time assumption but a permanent assumption which was later changed in other legislation


The significance of this act was its importance in the Hamilton-Jefferson debate. Basically, Hamilton's idea was that of a large, strong, federal government. Jefferson and his supporters favored a weaker, de-centralized, and (in most cases) a state based government. Hamilton won this round by "federalizing" what had been Revolutionary war (and subsequent) debt.

The assumption of the states' debt meant that there would be one large centralized "national" debt, instead of 13 smaller ones. It was much easier for lenders, foreign as well as domestic, to monitor and deal with one federal debt, which had earlier been incurred by the states mainly to fight the Revolution, and to operate until the "United States" got going.

Yes, the states later incurred their own state debts, but for local matters, (usually) funded by "local" citizens. These debts were much smaller than the "national" debt that had been undertaken to fight the Revolution. By repaying the national debt promptly and in full, America established the credit it needed to fight future wars and to deal with other national emergencies.

There was one other thing. The federal responsibility to pay off the central debt was accompanied its control over most revenue sources, mainly tariffs and excise taxes (income taxes were permanently established in 1913, over a century later).


Why was the Federal government's assumption of state debt so significant? - History

In September 1789, ten days after Hamilton became Secretary of Treasury, the House of Representatives asked him to create a plan to meet the national debt. Hamilton estimated it to be $54,124,464.56, including interest. The general assumption was that the debt would be reduced somewhat, and that U.S. citizens would receive only partial repayment. Most domestic debt certificates were held by speculators and merchants who had purchased them at drastically discounted prices from Revolutionary War soldiers and patriots. Thus, many Americans felt that it was unnecessary to pay the speculators the full price of the debt, since they had obtained the certificates at a discount.

Some of Hamilton's recommendations, as presented to Congress in 1790, were, thus, something of a surprise. Few Congressmen objected to his suggestion to pay the foreign debt in full, since repayment of debt was important in establishing the new nation's credibility. There was much controversy over his proposal to pay back the domestic debt in full. Hamilton asserted that the current holders of the bonds, whether they were speculators or not, should be paid in full. Although some members of Congress protested the unfairness of rewarding speculators without paying anything to the soldiers and others who had originally held the bonds.

Another contentious proposal was that the federal government should assume state debts. Northern states tended to have larger debts than southern states, so those in the north supported the proposal, while southern Congressmen opposed it as an unfair burden to the nation. A compromise was finally reached, which allowed the federal government to assume responsibility for state war debts, provided that the national capital be built in the South.

The nation clearly did not have the money to pay back the debt immediately. Congress had established customs duties on all imports and a tonnage duty on all shipping, arranged to levy high duties on foreign ships, and low duties on American vessels. These customs revenues were funneled into the Treasury, from which the nation's war debts were to be settled. Hamilton suggested that the debt be funded by reissuing bonds to be paid back in full after 15 or 20 years. Thus, rather than eliminating the debt, Hamilton's plan created a large, permanent public debt, issuing new bonds as old ones were paid off. Congress approved this proposal.

In addition to ideas on how to fund the debt, Hamilton made four other sets of proposals: establishing a national bank creating an American coinage system establishing an excise tax and creating protective tariffs for American industry. Hamilton felt that the new nation needed to establish a National Bank to act as a safe depository for federal tax revenue facilitate public and private borrowing and create a ut put into circulation.

Nevertheless, the federal government lacked the funds needed to meet their operating and debt-repayment expenses. The 1789 tariff act, putting duties on certain imports, had not raised enough money to meet the government's expenses. Hamilton recommended that a tariff be levied on foreign imports to protect domestic industries and discourage imports, as well as raise government revenue. This was the only major Hamilton proposal to be rejected by Congress. In 1791, however, Hamilton was able to convince Congress to pass an excise tax on whiskey. (An excise tax is one placed on goods produced or services performed within the country.)niform and stable American currency by issuing sound paper money. After significant debate (see A National Bank), Washington signed the National Bank Bill into law.


What Happens in Debt Crisis

A true debt crisis occurs when a country is in danger of not meeting its debt obligations. The first sign is when the country finds that it cannot get a low-interest rate from lenders.

Investors become concerned the country cannot afford to pay the bonds and that it might default on its debt. That happened to Iceland in 2008 and threw the country into bankruptcy. Debt default has also bankrupted Argentina, Russia, and Mexico, in modern times. While Greece was bailed out of its crisis by the European Union in 2010 to stave off a greater effect, it has since repaid only a fraction of its loan.


Forms of Government Borrowing

Government borrowing which adds to the national debt shortfall can take other forms. Governments can issue financial securities or even borrow from international organizations like the World Bank or private financial institutions.     Since it is borrowing at a governmental or national level, it is termed national debt. To keep things interesting, other terms for this obligation include government debt, federal debt, or public debt.

The total amount of money that can be borrowed by the government without further authorization by Congress is known as the "total public debt subject to limit." Any amount to be borrowed above this level has to receive additional approval from the legislative branch.

The public debt is calculated daily. After receiving end-of-day reports from about 50 different sources, such as Federal Reserve Bank branches, regarding the number of securities sold and redeemed that day, the U.S. Treasury calculates the total public debt outstanding, which is released the following morning.   It represents the total marketable and non-marketable principal amount of securities outstanding (i.e., not including interest).

The national debt can only be reduced through five mechanisms: increased taxation, reduced spending, debt restructuring, monetization of the debt, or outright default.   The federal budget process directly deals with taxation and spending levels and can create recommendations for restructuring or possible default.


Why was the Federal government's assumption of state debt so significant? - History

Alexander Hamilton saw America’s future as a metropolitan, commercial, industrial society, in contrast to Thomas Jefferson’s nation of small farmers. While both men had the ear of President Washington, Hamilton’s vision proved most appealing and enduring. John Trumbull, Portrait of Alexander Hamilton, 1806. Wikimedia.

Meanwhile, during George Washington’s presidency, political trouble was already brewing. Washington’s cabinet choices reflected continuing tension between politicians who wanted and who feared a powerful national government. The vice president was John Adams, and Washington chose Alexander Hamilton to be his secretary of the treasury. Both men wanted an active government that would promote prosperity by supporting American industry. However, Washington chose Thomas Jefferson to be his secretary of state, and Jefferson was committed to restricting federal power and preserving an economy based on agriculture. From almost the beginning, Washington struggled to reconcile the “Federalist” and “Republican” (or Democratic-Republican) factions within his own administration.

Alexander Hamilton believed that self-interest was the “most powerful incentive of human actions.” Self-interest drove humans to accumulate property, and that effort created commerce and industry. According to Hamilton, government had important roles to play in this process. First, the state should protect private property from theft. Second, according to Hamilton, the state should use human “passions” and “make them subservient to the public good.” In other words, a wise government would harness its citizens’ desire for property so that both private individuals and the state would benefit.

Hamilton, like many of his contemporary statesmen, did not believe the state should ensure an equal distribution of property. Inequality was “the great & fundamental distinction in Society,” and Hamilton saw no reason to change this reality. Instead, Hamilton wanted to tie the economic interests of wealthy Americans, or “monied men,” to the federal government’s financial health. If the rich needed the government, then they would direct their energies to making sure it remained solvent.

Hamilton, therefore, believed that the federal government must be “a Repository of the Rights of the wealthy.” As the nation’s first secretary of the treasury, he proposed an ambitious financial plan to achieve that.

The first part of Hamilton’s plan involved federal “assumption” of state debts, which were mostly left over from the Revolutionary War. The federal government would assume responsibility for the states’ unpaid debts, which totaled about $25 million. Second, Hamilton wanted Congress to create a bank—a Bank of the United States.

The goal of these proposals was to link federal power and the country’s economic vitality. Under the assumption proposal, the states’ creditors (people who owned state bonds or promissory notes) would turn their old notes in to the Treasury and receive new federal notes of the same face value. Hamilton foresaw that these bonds would circulate like money, acting as “an engine of business, and instrument of industry and commerce.” This part of his plan, however, was controversial for two reasons.

First, many taxpayers objected to paying the full face value on old notes, which had fallen in market value. Often the current holders had purchased them from the original creditors for pennies on the dollar. To pay them at full face value, therefore, would mean rewarding speculators at taxpayer expense. Hamilton countered that government debts must be honored in full, or else citizens would lose all trust in the government. Second, many southerners objected that they had already paid their outstanding state debts, so federal assumption would mean forcing them to pay again for the debts of New Englanders. Nevertheless, President Washington and Congress both accepted Hamilton’s argument. By the end of 1794, 98 percent of the country’s domestic debt had been converted into new federal bonds.

Hamilton’s plan for a Bank of the United States, similarly, won congressional approval despite strong opposition. Thomas Jefferson and other Republicans argued that the plan was unconstitutional the Constitution did not authorize Congress to create a bank. Hamilton, however, argued that the bank was not only constitutional but also important for the country’s prosperity. The Bank of the United States would fulfill several needs. It would act as a convenient depository for federal funds. It would print paper banknotes backed by specie (gold or silver). Its agents would also help control inflation by periodically taking state bank notes to their banks of origin and demanding specie in exchange, limiting the amount of notes the state banks printed. Furthermore, it would give wealthy people a vested interest in the federal government’s finances. The government would control just twenty percent of the bank’s stock the other eighty percent would be owned by private investors. Thus, an “intimate connexion” between the government and wealthy men would benefit both, and this connection would promote American commerce.

In 1791, therefore, Congress approved a twenty-year charter for the Bank of the United States. The bank’s stocks, together with federal bonds, created over $70 million in new financial instruments. These spurred the formation of securities markets, which allowed the federal government to borrow more money and underwrote the rapid spread of state-charted banks and other private business corporations in the 1790s. For Federalists, this was one of the major purposes of the federal government. For opponents who wanted a more limited role for industry, however, or who lived on the frontier and lacked access to capital, Hamilton’s system seemed to reinforce class boundaries and give the rich inordinate power over the federal government.

Hamilton’s plan, furthermore, had another highly controversial element. In order to pay what it owed on the new bonds, the federal government needed reliable sources of tax revenue. In 1791, Hamilton proposed a federal excise tax on the production, sale, and consumption of a number of goods, including whiskey.


How the United States’ High Debt Will Weaken the Economy and Hurt Americans

U.S. federal spending in 2013, combined with depressed receipts from a weak economy, is on track to result in a deficit of $850 billion.

The major entitlements and interest on the debt are on track to devour all tax revenues in less than one generation.

As U.S. debt is quickly approaching economically damaging debt levels, U.S. lawmakers should delay no more.

Growing federal debt also would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage the budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would…probably have a very significant negative impact on the country.

-Congressional Budget Office, 2012 Long-Term Budget Outlook

U.S. federal spending in 2013, combined with depressed receipts from a weak economy, is on track to result in a deficit of $850 billion. Publicly held debt in the United States will exceed 76 percent of gross domestic product (GDP) in 2013, and chronic deficits are projected to push U.S. debt to 87 percent of the economy in 10 years.[1] Debt is projected to grow even more rapidly after 2023. Recent economic research, especially the work of Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, confirms that federal debt at such high levels puts the United States at risk for a number of harmful economic consequences, including slower economic growth, a weakened ability to respond to unexpected challenges, and quite possibly a debt-driven financial crisis.[2]

The federal government is quickly exhausting its ability to manage its bills, with debt having already reached the statutory debt ceiling. The resulting debate should focus on the need to reduce federal spending immediately and over the long term by making necessary and prudent reforms to the nation’s major entitlement programs, and thus reduce the continued buildup of debt and the expected harmful consequences increasingly confirmed by academic research.

Vulnerable Budget Path

In the contentious 2011 debate over the U.S. debt limit, President Barack Obama and Congress agreed to raise the debt ceiling by $2.1 trillion in exchange for specified spending reductions over 10 years. The Budget Control Act allowed the President to raise the limit in three increments from $14.29 trillion to $16.39 trillion.[3] At the time, the United States lost its seemingly permanent AAA rating from Standard & Poor’s, starkly affirming the risk arising from the nation’s budget path.[4] America’s budget problems are twofold: (1) spending and debt are dangerously high today, and (2) future spending and debt are on track to rise even higher.

As dangerous as these trends are, the long-term unfunded obligations in the nation’s major entitlement programs loom like an even darker cloud over the U.S. economy. Demographic and economic factors are expected to combine to drive spending in Medicare and Social Security to unsustainable heights. The major entitlements and interest on the debt are on track to devour all tax revenues by in less than one generation.[5]

While tax revenues are expected to return to their historically average levels of 18.5 percent, total federal spending driven in large part by entitlements is projected to hover well above the historical level of about 20 percent in the near term.[6] In a mere 25 years, federal spending under current policy is projected to consume as much as 36 percent of GDP.[7]

America’s entitlement programs, by definition, span generations. It is vital in assessing their sustainability to consider their long-term implications. Over the 75-year long-term horizon, the combined unfunded obligations arising from promised benefits in Medicare and Social Security alone exceed $48 trillion.[8] The federal unfunded obligations arising from Medicaid and even from veterans’ benefits are unknown, but would likely add many trillions more to this figure.

The International Monetary Fund,[9] the intergovernmental organization of 188 member states that seeks to ensure the stability of the international monetary system, warned that the U.S. lacks a “credible strategy” to stabilize its mounting public debt.[10] Such a strategy must begin with putting entitlement spending on a more sustainable long-term path. The sooner policymakers act, the less severe and the more gradual the necessary policy changes can be. Policymakers should not delay, since the economic consequences, particularly the impact on individuals in or planning retirement, would be pronounced and severe.

Research Confirms Danger of High Government Debt

Recent research confirms the dangers posed by high levels of government debt. Reinhart, Reinhart, and Rogoff examined over 110 years of economic data to conclude that advanced economies whose debt levels reach 90 percent of GDP face much slower economic growth.[11]

In 2009, Carmen Reinhart and Rogoff wrote This Time Is Different, a book The Economist called “a magisterial work on the causes and consequences of crises stretching back 800 years.”[12] Their conclusions were based on a vast new accumulation of cross-country data, covering 66 countries across all regions of the world and spanning eight centuries. This dataset made it possible to study country debt episodes and crises much more comprehensively. Reinhart, Reinhart, and Rogoff’s recent work on the impact of high public debt on growth and interest rates is based on this groundbreaking dataset.

The economists follow a descriptive approach, comparing economic variables for different countries as averages for debt-to-GDP ratios below and above 90 percent of GDP. Measures of comparison include averages for real GDP growth, real (inflation-adjusted) short-term interest rates, and real long-term interest rates. Public debt overhang episodes are analyzed for the causes of the debt, whether from specific wars, financial crises and economic depression, domestic turmoil, or other factors. The researchers refer to sustained periods of gross country debt persisting above 90 percent of GDP for five years or more as “public debt overhang episodes.” Identifying 26 such episodes, of which 20 lasted for more than a decade, the research shows that even if such episodes begin with short-lived dramatic events, such as war or a financial crisis, the negative impact from high debt on growth lasts far beyond such events.

The authors’ results should serve as a sobering wake-up call for policymakers. Reinhart, Reinhart, and Rogoff discovered that the average growth rate in countries experiencing public debt overhang is 1.2 percentage points lower than in periods with debt below 90 percent of GDP.[13] These public debt overhang episodes last an average of about 23 years. Thus, the cumulative effect of lower growth by one percentage point or more means that national income at the end of the period would be lower by roughly one-fourth. The growth rate of countries with exceptionally high levels of debt—more than 120 percent of the economy—drops even lower, by an average of 2.3 percentage points, which is roughly two-thirds.

These figures indicate just how dire the U.S. situation could become: According to the Congressional Budget Office baseline economic forecast, U.S. GDP is projected to be $25.9 trillion in fiscal year 2023. U.S. publicly held debt is projected to reach nearly 90 percent of GDP that year. Assuming a 2.2 percent growth rate over 23 years, U.S. GDP would reach $42.7 trillion in 2046 if there was no impact from the debt overhang. Applying the crude assumption that GDP would be reduced by 1.2 percentage points, in each year of the assumed 23-year debt overhang period, U.S. GDP growth would be slashed by more than half to a mere 1 percent. This would reduce U.S. GDP by more than $10 trillion, to only $32.6 trillion in 2046. The cumulative effect from the debt overhang would result in a level of GDP lower by nearly one-quarter at the end of the period.

The researchers also note that in addition to vast amounts of public debt, other measures of country debt, such as levels of state and local government debt, private debt, external debt (government and private debt owed to foreigners), and the unfunded obligations from retirement and medical care programs, have risen to unprecedented heights in advanced economies, including the United States.

In the U.S., the total amount of debt held by all 50 state governments combined amounted to $4.17 trillion in 2012. If one adds state debt to the U.S. gross national debt of $16.4 trillion, the combined state and federal debt exceeds $20.5 trillion. Moreover, the long-term unfunded obligations for Social Security and Medicare totaled $48 trillion in 2012—three times the current U.S. gross national debt. Even this measure does not include other federal obligations in the form of Medicaid or veterans’ benefits, for example. While data across countries of these debt measures is difficult to obtain, other government debt certainly adds to the risks faced by countries with high public debt levels.

A Significant and Prolonged Drag on Economic Growth

Debt overhang reduces economic growth significantly and for a prolonged period of time in three main ways.

1. Higher Interest Rates. Creditors may lose confidence in the country’s ability to service its debt and demand higher interest rates to offset the additional risk. Or, interest rates may rise simply because the government is attempting to sell more debt than private bondholders are willing to buy at current prices. Either way, higher interest rates raise the cost of the debt, and the government must then either tax its citizens more, which would reduce economic activity reduce government spending in other areas or take on even more debt, which could cause a debt spiral.

Higher interest rates on government bonds also lead to higher rates for other domestic investments, including mortgages, credit cards, consumer loans, and business loans. Higher interest rates on mortgages, car loans, and other loans would make it more costly for families to borrow money. Families may then have to delay purchasing their first home and other means of building financial security. For many Americans, the dream of starting a business would no longer be in reach. Higher interest rates have a real and pronounced impact on the lives of ordinary citizens and translate into less investment and thus slow growth in the rest of the economy. A weaker economy in turn would provide fewer career opportunities and lower wages and salaries for workers.

However, higher interest rates do not always materialize in countries suffering a debt overhang. According to Reinhart, Reinhart, and Rogoff, in 11 of the 26 cases where public debt was above 90 percent of GDP, real interest rates were either lower, or about the same, as during years of lower debt ratios. Soaring debt matters for economic growth even when market actors are willing to absorb it at low interest.[14]

Interpreted another way, in more than half of debt overhang cases, interest rates rose. In the case of the U.S., the Federal Reserve’s policy of repeated quantitative easing has contributed to interest rates dropping to historical lows. Interest rates will likely rise at some point over the next several years. The Congressional Budget Office predicts that interest costs on the debt will more than double before the end of the decade, rising from 1.4 percent of GDP in 2013 to 2.9 percent as early as 2020.[15] High levels of U.S. public debt could push interest rates even higher with severe impacts for the American economy.

2. Higher Inflation. The United States has, as do other countries with independent currencies, an additional option to monetize its debts: replacing a substantial portion of outstanding debt with another form of federal liability—currency. The government could, through the Federal Reserve, inflate the money supply. The resulting increase in the rate of price inflation would devalue the principal of the remaining public debt. The resulting inflation would also destabilize the private economy, increase uncertainty, increase real interest rates, and slow economic growth markedly.

Inflation is particularly harmful for those Americans on fixed incomes, such as the elderly who rely on Social Security checks, pensions, and their own savings in retirement. By raising the cost of essential goods and services, like food and medical care, inflation can push seniors into poverty. Inflation and longer life expectancies can mean that some seniors run out of their savings sooner than anticipated, then becoming completely dependent on Social Security. Inflation inflicts the most pain on the poor and middle class by reducing the purchasing power of the cash savings of American families. Inflation also means that everyone has to pay more for goods and services, including essentials like food and clothing.

Moreover, severe inflation could dethrone the U.S. dollar as the world’s primary reserve currency. Thus far, a major saving grace for the U.S. government has been that, in comparison with other advanced nations with major currencies, such as Europe and China, the U.S. dollar has retained its status as the best currency option for finance and commerce.[16] If Washington policies continue on their current path of ever-higher sovereign debt and a risky Federal Reserve policy, both of which lack a credible crisis coping strategy, confidence in the U.S. economy and monetary policy regime could erode. Such a development would be unprecedented in size and magnitude and the impact on Americans and the economy would be massive and severe.

For all these reasons, the Federal Reserve and central banks of all industrialized countries have adopted a policy favoring low and stable inflation, though the means by which they pursue this policy can vary substantially and their success is often spotty. Reversing this policy in favor of a policy of debt monetization and high inflation would be a radical departure in policy and practice. It would be the economic equivalent of a scorched earth policy, and its adoption is thus extremely unlikely.

How High U.S. Debt Levels Would Hurt Americans

  • Higher interest rates on mortgages, car loans, and other loans would make it more costly for families to borrow
    money.
  • Families may have to delay purchasing their first home and other means of building financial security.
  • For many Americans, the dream of starting a business would no longer be in reach.
  • Inflation reduces the purchasing power of the cash savings of American families, inflicting the most pain on the
    poor and middle class by eroding the value of their rainy day fund.
  • Inflation raises the prices on essential goods and services, like food, clothing, and medical care, and is particularly
    harmful for the poor and those on fixed incomes, like the elderly.
  • Higher inflation and longer life expectancies together can mean that some seniors run out of their savings sooner
    than anticipated, leaving them completely dependent on Social Security. Some may even end up in poverty.

Crowding Out Private Investment

  • Government deficit spending and its associated debt subtracts from the amount of private saving available for private
    investment, leading to slower economic growth.
  • Less economic growth means fewer jobs, lower wages and salaries, and fewer opportunities for career
    advancement.
  • Less private investment means fewer opportunities for innovation and the creation of productivity enhancing technologies,
    putting the U.S. at a disadvantage with competing trading nations.

U.S. debt is quickly approaching economically damaging debt levels. U.S. lawmakers should delay no more. Congress and the President should take firm and immediate steps to balance the budget within 10 years, by cutting spending and reforming the entitlements.

3. Crowding Out Private Investment. Economic growth, especially increasing per capita income, depends on the proper functioning of prices to signal and markets to respond, but it also depends fundamentally on increasing the amount and quality of productive capital available to the workforce. The amount of capital employed in the economy needs to increase at least to keep pace with the growth in the labor force to maintain current living standards, and must grow even faster—to increase the amount of capital per worker—to raise worker productivity and thus wages and salaries.

Government deficit spending and its associated debt subtracts from the amount of private saving available for private investment, leading to slower economic growth. Unlike what staunch believers of government spending for economic stimulus claim, government stimulus spending does the opposite of growing the economy. Less economic growth caused by high government spending and debt results in fewer available jobs, lower wages and salaries, and fewer opportunities for career advancement.

Prolonged debt overhang in the United States, even at low interest rates, would be a massive drag on economic growth, leading to significantly reduced prosperity for Americans. In the words of Reinhart, Reinhart, and Rogoff: “This debt-without-drama scenario is reminiscent for us of T. S. Eliot’s (1925) lines in The Hollow Men: ‘This is the way the world ends / Not with a bang but a whimper.’”[17]

Europe’s Fiscal Crisis: Precursor for the United States?

Europe is experiencing an extended fiscal and economic crisis with no end in sight. In addition to adopting a common currency regime lacking most of the institutional trappings necessary for its survival, many countries in Europe have lived beyond their means for many years. Many racked up massive government debts while benefiting from artificially low interest rates, as the euro signaled to markets that all European debts were alike. The poster child for this behavior, of course, is Greece. Greece racked up a debt-to-GDP ratio of 145 percent in 2010 and 165 percent in 2011.[18] Not surprisingly, investors eventually lost confidence in Greece’s ability to service its debts. European lawmakers responded in early 2011 with a combination of a bailout and fiscal austerity. Nevertheless, Greece defaulted on its debts to the detriment of investors and other European taxpayers.

Many other European countries also amassed public debts beyond 90 percent of their economies—for instance Italy (100 percent) and Portugal (97 percent) in 2011—and are now undergoing wrenching austerity and prolonged recessions. In addition to disastrous currency policy, these countries also have a fiscal policy culprit in common: high levels of government spending on entitlements—a fiscal situation by no means foreign to the U.S. government.

Avoiding Japan’s “Lost Decades” for America

Not all countries that build debt mountains suffer from a lack in investor confidence and go into default. Japan is arguably the world’s most indebted major economy, with net public debt at 126 percent of GDP, and yet creditors continue to lend to the Japanese government. Japan amassed this public debt to a large extent in the midst of its “lost decades”—1991 to 2010—while falling again and again for the wishful thinking that government deficits stimulate economic growth. History and economic fundamentals have shown this thinking to be wrong. This misguided policy is standing in the way of a Japanese recovery. As The Heritage Foundation’s Derek Scissors and J. D. Foster explain:

Japan’s debt is almost entirely domestically financed, which means gigantic sums are shifted from the private sector to the public sector, where the social return on investment is almost nil and the yields paid on the debt are only slightly better. The huge debt and oversized government has sapped Japan’s domestic sources of growth.[19]

Japan is experiencing a prolonged debt overhang episode with, as yet, no debt crisis drama because Japanese citizens are prodigious savers. The Japanese mostly owe their debt to themselves as Japanese citizens have been willing to forgo consumption and have been buying government bonds for a long time, enabling the Japanese government to accumulate gross debt levels more than twice the size of the Japanese economy. Instead, the country suffers from persistently weak economic growth.

The IMF warned the United States and Japan against a further buildup of risk by failing to lower their debt levels. U.S. policymakers should not allow themselves to be lulled into complacency by low interest rates. Policymakers must act now to allow an orderly and controlled mechanism to reduce public debt—not wait for a sovereign debt crisis to force their hands.[20]

A full-fledged fiscal crisis hits a country with the same force as a patient suffering severe trauma. However, a no-drama debt overhang that reduces growth slowly drains the life from the patient, like a long-term disease. The U.S. should not delay adopting a credible strategy to resolve chronic deficits and debt, lest it find itself on the stretcher.

A Credible Strategy

Federal budget deficits and debt are massive today—and future spending and debt projections are far worse if Congress and the President fail to act. Federal spending was about 23 percent of GDP in 2012—far above the historical average of 20.2 percent. It is projected to surge to nearly 36 percent in less than one generation. This spending is the cause of the chronic deficits that are driving the debt higher yet. Public debt is projected to reach 87 percent of GDP by 2023 and rise sharply in later years.

Two programs in particular—Social Security and Medicare—are taking over a quickly expanding share of federal spending. In addition, they suffer from programmatic weaknesses. Social Security and Medicare provide an important safety net for seniors, but in their current form the programs are unsustainable over the medium term and long term. These programs take up 39 percent of the budget today and are projected to grow to 44 percent of federal spending in just 10 years. At $48 trillion in net-present value, their unfunded obligations are triple the size of the entire gross U.S. national debt.

There are numerous reforms to help shore up financing for these programs that garner bipartisan support and that can be implemented quickly. These include raising the Social Security eligibility age to match increases in longevity and correcting the cost-of-living adjustment (COLA) to more accurately measure the impact of inflation on beneficiaries. In Medicare, raising the eligibility age to match Social Security makes common sense. Seniors with high incomes already pay a higher share of their own Medicare costs, and the remaining subsidy should be pared back even further.

Beyond resolving immediate financing challenges, there are bolder reforms to resolve many of the programs’ inherent weaknesses. The goal should be to arrive at a strengthened social safety net for those seniors who need it. Doing so in an affordable manner means turning Social Security and Medicare into true insurance against poverty in retirement.

For Social Security, benefits should be phased out for upper-income retirees. Consolidating Medicare’s three distinct components—Parts A, B, and D—and collecting a combined higher premium would save money and simplify the program. Lawmakers should begin pursuing a credible strategy on reining in massive budget deficits and debt by implementing proposals such as outlined here.[21]

The Time to Act Is Now

By neglecting the regular budget order—the institutional schedule to assess government spending and allocate taxpayer dollars with prudence—Congress and the President are increasingly failing to govern. Congress has only budgeted when forced to do so. Reaching the debt ceiling should be such an occasion, and Congress should not delay the decision again on necessary reforms and spending reductions. The President’s and Congress’s failure to establish a credible strategy for reining in massive deficits and debts in 2011 led Standard & Poor’s to downgrade the U.S. credit rating,[22] Moody’s, another major rating agency, warned Congress early in 2013 that failure to provide a basis for meaningful improvement in the government’s debt ratios over the medium term could “affect the rating negatively.”[23] Ratings agencies provide important signals to investors about the risks associated with investing in government bonds. Further downgrades of the U.S. debt and demand by capital markets will eventually lead to higher interest rates, whose costs would drive up federal spending and debt even more. As U.S. debt is quickly approaching economically damaging debt levels, U.S. lawmakers should delay no more. The time to act is now.

—Romina Boccia is Research Coordinator in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

[1] Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023, Alternative Fiscal Scenario, February 5, 2013, http://www.cbo.gov/publication/43907 (accessed on February 6, 2013).

[2] Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol. 26 No. 3 (Summer 2012), pp. 69–86, http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.26.3.69 (accessed February 6, 2013). Kenneth Rogoff served as economist for the International Monetary Fund (IMF) and at the Board of Governors of the Federal Reserve System. Carmen Reinhart of Harvard University delivered a keynote address on “Lessons from Sovereign Crises” at a recent IMF conference on the global debt crisis.

[3] “Rising Deficits Drive U.S. Debt Limit Higher, Faster,” Heritage Foundation Federal Budget in Pictures, 2012, http://www.heritage.org/federalbudget/increases-us-debt-limit.

[5] Alison Acosta Fraser et al., Federal Spending by the Numbers 2012, Heritage Foundation Special Report No. 121, October 16, 2012, http://www.heritage.org/research/reports/2012/10/federal-spending-by-the-numbers-2012.

[6] Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023, Alternative Fiscal Scenario.

[7] Fraser et al., Federal Spending by the Numbers 2012.

[8] Romina Boccia, “CBO Report Echoes Trustees on Medicare, Social Security,” Heritage Foundation Issue Brief No. 3638, June 14, 2012, http://www.heritage.org/research/reports/2012/06/cbo-long-term-budget-outlook-on-the-nations-fiscal-future.

[9] International Monetary Fund, “The IMF at a Glance,” August 22, 2012, http://www.imf.org/external/np/exr/facts/glance.htm (accessed December 28, 2012).

[10] Chris Giles and James Politi, “US Lacks Credibility on Debt, Says IMF,” The Financial Times, April 13, 2011, http://www.ft.com/cms/s/0/dc1aadea-652e-11e0-b150-00144feab49a.html#axzz2GHbf8ouW (accessed February 6, 2013).

[11] Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs.” The authors analyze central government gross debt, excluding debt by states and municipalities. For most of the countries analyzed, gross debt does not include significant amounts of intragovernmental debt and is a roughly equivalent measure to debt held by the public in the U.S. In the U.S., however, gross debt includes significant amounts of intragovernmental debt such as money the government borrowed from the Social Security trust fund. For the United States, publicly held debt is the more economically relevant debt measure and is the one considered in this paper when interpreting the Reinhart, Reinhart, and Rogoff results for implications for the United States.

[12] “The Best Books: The Economist’s US Finance Editor on Books About Folly and Promise on Wall Street,” The Economist, April 26, 2010, http://www.economist.com/node/15993737?story_id=15993737 (accessed February 6, 2013).

[13] Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs.”

[15] Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023, Alternative Fiscal Scenario.


Creating a new government on paper was difficult. The framers of the constitutional convention fought long and hard over the format and function of our government. Putting it in practice was difficult as well. In 1790 Madison wrote " We are in a wilderness, without a single footstep to guide us. " As our founding fathers walked through the wilderness of democratic government, alone and without a real model, many obstacles would have to be overcome and many precedents would be set.

A. What precedents did Washington set as the nation's first President?

1. Washington wanted a formal presidency and thus set precedent by establishing Presidential protocol. He held regular morning receptions as well as formal evening dances and dinners. He had servants in uniforms and always dressed properly. Critics thought that these occasions seemed to cold but George felt that they were necessary for the dignity of the office. Washington realized that a formal presidency lent a degree of leadership the nation needed.

2. As the first President Washington recognized the need for advisors. He therefore created the first cabinet . He appointed Alexander Hamilton Secretary of the Treasury, John Jay Secretary of State until Thomas Jefferson returned from Europe and Henry Knox was made Secretary of War. John Adams was the Vice President.

3. Washington refused to take a third term of office. In doping so he set a the two term limit prcedent. This precedent was not broken until the mid 1900's.

4. Upon leaving the Presidency Washington issued what became known as the "Farewell Address." In it he urged America to "build commercial relations," and the "steer clear of permanent alliances." In short, he orged a policy of neutrality .


Some Background

Budget projections are inevitably uncertain. COVID-19 has pushed deficits far above expectations, for example. On the other hand, interest rates have fallen substantially in recent decades, limiting the debt service costs of rising debt. Despite these and other changes, long-run budget projections consistently show that, under existing policies, the public debt will likely continue to grow faster than the economy.

The Congressional Budget Office (CBO) has been making periodic long-run budget projections since the 1990s. Since then, policies have changed—as have the economic and demographic assumptions underlying the analysis. But the lesson from these projections has remained the same: the United States is on an unsustainable fiscal path. That is to say, if policies are not reformed, the public debt will likely continue to grow faster than the economy.

Causes of rising public debt

The most important underlying cause of our rising public debt is population aging. The result is pressure on Social Security, the largest program in the budget, and on Medicare and Medicaid, the largest health insurance programs. Life expectancy has typically increased steadily over time (interrupted by unfortunate declines in the mid-2010s), and current age demographics are well known. More difficult to forecast are birth rates and growth of the taxpaying population, but birth rates have remained low for a long time with no surprises.

Per person health costs have risen faster than incomes, after adjusting for the population aging that has driven the projected rise in total spending. But this “excess cost growth” is difficult to forecast. After constituting most total health cost growth for decades, excess cost growth slowed abruptly in the 2000s. And no one knows whether the slowdown will last or will be a one-time phenomenon.

Structural changes in the delivery of health care may hold down cost growth in the long run. On the other hand, excess cost growth might resume at historically familiar rates. In recent long-run projections, CBO has assumed that excess cost growth will indeed resume, but at a rate lower than the historical average.

Major disruptions to the growth rate of public debt

With Social Security and major health programs expected to grow faster than the economy and tax revenues, the deficit and public debt are expected to grow faster as well. Interest on the debt would become a growing part of the budget if interest rates stabilize or increase. Over the twenty or so years that CBO has been making long-term budget projections, this basic story has held true. But four major surprises have caused the debt-GDP ratio to rise more slowly than predicted in some periods and faster in others.

The most important surprise slowing the growth of the debt-GDP ratio has been interest rates falling dramatically during and after the Great Recession. Despite a rise in the debt-GDP ratio from 39 percent in 2008 to 74 percent in 2014, interest payments on the debt actually fell! As of mid-2020, 10-year Treasury rates were near record lows. If they persist, such low rates will limit growth of interest payment in coming years. The second surprise involved a surge in revenues related to the dot-com boom of the 1990s. It caused the debt-GDP ratio to fall from the mid-1990s to 2001, when the ratio was supposed to rise according to all long-term projections. The third surprise was the Great Recession that caused the debt-GDP ratio to rise far faster than could be explained by the increase in Social Security and health programs. Finally, the economic hit from the COVID-19 crisis and associated policy responses in 2020 led to an enormous increase in debt relative to GDP.

Despite the two big surprises that made the long-term outlook appear better than expected and the two surprises that made it look worse, the fundamentals of long-term projections have held true. Social Security and health programs have been on a strong upward trend propelled by aging and health costs, and there is little reason to expect this trend to evaporate. Absent policy changes, increased spending on those programs will likely push up the debt faster than the economy in coming years.

Updated May 2020

Congressional Budget Office. 2019. The 2019 Long-Term Budget Outlook. Washington, DC: Congressional Budget Office.

Penner, Rudolph G. 2016. “The Reliability of Long-Term Budget Projections.” In Fixing Fiscal Myopia, 43–57. Washington, DC: Bipartisan Policy Center.


Hamilton&aposs Childhood in the Caribbean 

Hamilton was born in either 1755 or 1757 on the Caribbean island of Nevis. His father, the Scottish trader James Hamilton, and mother, Rachel Faucette Lavien, weren’t married. Rachel was still married to another man at the time of Hamilton’s birth, but had left her husband after he spent much of her family fortune and had her imprisoned for adultery.

Hamilton’s father abandoned the family in 1766 and his mother died two years later. Hired as a clerk in a trading company on St. Croix when he was just 11, Hamilton gained wider attention after he published an eloquent letter describing a hurricane that had hit the island in 1772. Locals helped raise money to send him to America to study, and he arrived in New York in late 1772, just as the colonies were gearing up for a war for independence from Great Britain. 

Did you know? Alexander Hamilton&aposs beloved first-born son, Philip, was killed in a duel in 1801 while attempting to defend his father&aposs honor against attacks by New York lawyer George Eacker. Philip&aposs death devastated the Hamiltons, and many historians believe it led to Hamilton&aposs own reluctance to fire directly at Aaron Burr during their legendary duel just three years later.


Some Background

What does it mean for a government program to be off-budget?

The two Social Security trust funds and the postal service are “off-budget”—their spending and receipts are walled off from the rest of the budget. Putting Social Security and the post office off-budget shields them from some pressures, but policymakers often focus on the unified budget that includes them. A few other agencies are excluded because of their independence (e.g., the Federal Reserve) or private character (e.g., government-sponsored, privately owned entities and funds managed for private citizens).

Off-Budget versus On-Budget Accounting

The budget brings together the spending and receipts of virtually all federal activities, from paying doctors who treat Medicare patients to financing the Environmental Protection Agency to collecting income taxes to selling oil leases on federal land. In two cases, however, Congress has separated programs from the rest of the budget. The Postal Service Fund and the disability and retirement trust funds in Social Security are formally designated “off-budget,” even though their spending and revenues are included in the unified budget.

Lawmakers created this special accounting to try to wall off these programs. For the postal service, the intent was to free the agency to pursue more efficient practices than the conventional budget process allows. But that has not helped the postal service avoid financial difficulties.

With Social Security, the intent was to protect any surpluses from being diverted into other programs. The two Social Security trust funds have accumulated large surpluses since 1983. Those will eventually be drawn down to pay benefits. Advocates therefore argued that those surpluses should be separated from budgeting for the rest of government. Congress hoped that this separation would induce greater fiscal discipline in the rest of the government.

RESULTS

This accounting has had mixed results. Congressional budget rules prevent spending reductions or revenue increases in Social Security from being explicitly used to pay for spending increases or tax cuts elsewhere. In that sense, off-budget accounting has protected the program. But high-level budget discussions focus on the unified budget deficit and thus ignore the off-budget versus on-budget distinction. As a result, Social Security surpluses have effectively helped finance deficits elsewhere in the government. Just how much is unclear, but in the almost three decades that Social Security has been off-budget, the rest of government has run a surplus in only two years (1999 and 2000).

In any case, these arguments have less relevance today. Annual Social Security expenditures have exceeded noninterest income since 2010. The combined trust funds still run surpluses through 2019 because of interest payments from the Treasury, but these payments are simply transfers from one government office to another and therefore do not affect the unified deficit. Trust fund balances may begin to decline in 2020.

The Federal Reserve System

The Federal Reserve System (the Fed) is part of the federal government but is explicitly excluded from the budget to shield monetary policymakers from political pressure. Other developed nations do the same. The Fed thus sets its own spending and finances itself from earnings on lending to banks and its financial assets. The Fed remits its profits to the Treasury each year, which the budget records as receipts, but the agency otherwise operates outside the budget.

OTHER ACTIVITIES OUTSIDE THE BUDGET

Some federal activities are outside the budget because the government plays a limited role in what is otherwise a private activity. The government manages various funds whose assets belong to Indian tribes, federal employees, copyright holders, and other private individuals. Spending from and receipts to those funds are generally not included in the budget.

Government-sponsored enterprises, such as the Federal Home Loan Banks, also fall outside the budget because they are privately owned and their debt does not bear the full faith and credit of the US government. However, most observers assume their close ties to the government would lead to a bailout if they got into financial trouble.

That assumption proved accurate for Fannie Mae and Freddie Mac, the giant mortgage finance enterprises. During the 2008 financial crisis, they received substantial financial assistance and were put into federal conservatorship. This has led to a dispute regarding their status. The Office of Management and Budget believes Fannie Mae and Freddie Mac are still sufficiently private to fall outside the budget. The Congressional Budget Office believes federal control is now so strong that the two entities are effectively federal agencies and their spending and receipts should be in the budget.

Updated May 2020

Congressional Budget Office. 2010. “CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac.” Washington, DC: Congressional Budget Office.

Office of Management and Budget. 2015. “Coverage of the Budget.” In Analytical Perspectives, Budget of the United States Government, Fiscal Year 2016, 115–19. Washington, DC: Office of Management and Budget.


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