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Did a Tax-Budget Battle Almost Kill the US in 1812?

HMS SHannon leading the captured American frigate USS Chesapeake into Halifax, Nova Scotia (1813)
Source: Library and Archives Canada
HMS SHannon leading the captured American frigate USS Chesapeake into Halifax, Nova Scotia (1813)

The myth that the United States government is—or soon will be—desperately short of tax revenues got a new airing over the weekend, in the form of a history lesson from Simon Johnson and James Kwak.

Johnson and Kwak, writing in a Bloomberg Op-Ed, argue that the failure of the federal government to raise taxes before and during the War of 1812 left us economically and financially weak.

Both dominant political parties were opposed to raising taxes to pay for the war against Britain. In New England, which had strong pro-British affinities as well as most of the capital and industrial capacity of the nation, the leading Federalists opposed the war altogether. The Jeffersonian Democratic-Republicans, who favored the war, opposed raising taxes to fund the war.

“Treasury Secretary Albert Gallatin borrowed the money, but he wanted to raise taxes to cover the interest on the new debt. He worried that, otherwise, bond investors would be unwilling to lend large amounts of money to a young country. But the war hawks were ideologically and politically opposed to taxes — particularly the excise (internal trade) taxes that Gallatin favored,” Johnson and Kwak write.

Another difficulty with borrowing the money was that the Federalist-led New England banks did not want to finance the war by purchasing government bonds, either.

“What the British had, more than anything else, was money. By contrast, without a stable source of tax revenue, the U.S. struggled to attract lenders willing to bet on the country’s unproven armed forces,” Johnson and Kwak write.

And this is why the United States lost its independence to Great Britain and has been a colony ever since.

Oh. Wait. That’s not what happened at all.

What happened, in fact, is that the United States government encouraged what economist Murray Rothbard describes in his book “The Mystery of Banking” as “an enormous expansion in the number of banks and in bank notes and deposits to purchase the growing war debt.”

In 1811, there were just 117 banks in the United States. By 1815, the number had risen to 246. The aggregate of bank notes and deposits rose from $42.2 million in 1811 to $79 million four years later, an increase of 87.2 percent. This expansion occurred even while the amount of gold and silver backing the notes shrunk.

The new western banks bought government securities with the bank notes, which the United States government used to fund the way. Much of this wound up in New England, of course, since that was where much of industrial goods needed for fighting the war were manufactured. When the conservative New England banks attempted to redeem the bank notes from the banks that had purchased the government securities, the federal and state governments reacted by permitting the western banks to remain in business, even after they suspended redemption.

By undertaking a credit expansion to finance its war, the United States government was merely mimicking what the British had done. Again, from Rothbard’s "Mystery of Banking":

In 1797, there were 280 country banks in England and Wales. By 1813, the total number of banks was over 900. These banks pyramided on top of a swiftly rising total of Bank of England notes. Total bank notes outstanding in 1797 were £11 million. By 1816, the total had more than doubled, to £24 million.

In other words, the source of the British and the American war funds was simply credit creation. The government allowed banks to expand credit, the new credit created new deposits, these deposits were used to purchase US government securities, which were used to finance the purchase of supplies and pay the soldiers and sailors necessary for the war effort.

Even in the banking system of the early 19th century, there never was any real danger of the United States running out of buyers for our debt, or running out of purchasing power to buy domestically produced goods necessary for the war. Credit expansion created new deposits and the war years saw a giant expansion of productive capacity.

This isn’t to say that the War of 1812 was not disastrous for the United States and might better have been avoided—or that the credit expansion did not set off a dangerous business cycle. But it certainly shows that the very respectable anti-debt mythology embodied in Johnson and Kwak’s history is made much more complicated by the possibility of credit expansion, non-redeemable currency and a government willing to bail out the financial system’s weaker links.

But if Kwak’s and Johnson’s history is a bit off, the lesson they draw for today is even more bizarre.

As a nation, we will have to make a choice, one way or another. If the national debt grows faster than the economy for long enough, investors could lose their appetite for Treasury bonds, making it impossible for the government to borrow money at any price — as almost happened in 1813.

Today, of course, we live with a financial system that makes the War of 1812 banking innovations pale in comparison. The entire system runs on floating rate, non-redeemable, fiat currency created with keystrokes. Banks can create new money, only constrained by regulatory reserve requirements (which they can meet by borrowing from other banks or the Federal Reserve).

If the United States could find lenders willing to fund our government even as the White House, the Capitol and the Treasury burned at the hands of the British—we’re hardly likely to run out of creditors in modern circumstances. As we’ve seen during the past four years, the Fed balance sheet can expand as far as it needs.

The real constraint on government spending is not the size of the debt, it’s the size of government spending relative to the economy. If the government is using up too many of our resources, the private sector may find itself starved of real assets. If the government pays for those real assets by taking money from the private sector through tax policy, the economy slumps. If it pays for them with new money, inflation results.

The key factor, then, is getting the size of government spending right. All the talk by responsible people about taxes and debt is mostly a distraction.

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