George Hall on the History of the U.S. National Debt and Government Financing

George Hall is a professor of economics at Brandeis University, and was formerly an economist at the Chicago Federal Reserve Bank. George has written widely on the history of U.S. public finance, and he joins Macro Musings to talk about the history of the U.S. national debt, including the most recent surge resulting from the pandemic. David and George also discuss how a government goes about funding itself, two different models of expenditure financing, the Revolutionary War and Civil War as case studies, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: George, welcome to the show.

George Hall: Oh, thanks for having me. It's great to be here.

Beckworth: Well, it's great to have you on. And about this time last year, George, I saw you present a paper that you and Tom Sargent had written, and it was at the Hoover Monetary Policy Conference and it was titled, *Financing Big U.S. Federal Expenditure Surges: COVID-19, and Earlier US Wars.* And it was really fascinating because you compared these big surges in federal expenditures usually surrounding wars and pandemics, you could view it as a public health war of sorts, and how did we pay for it, how was it financed? And then I went back and looked at your vitae and your webpage, and you had a whole slew of papers that you and Tom have written on this. And moreover, you have an amazing dataset that's available to the public. You have monthly data, par value, market value, U.S. treasuries going all the way back to when?

Hall: 1776. So, the very start of the financing of the U.S. Revolution.

Beckworth: That is just remarkable. So, that must have been a labor of love there going out and collecting all that data and make it available to the rest of us.

Hall: Well, you'll see that there's a gap on my CV when I was doing it, but it was a lot of fun. I feel like I'm getting paid to do my hobby, which is to study financial history.

Beckworth: Fantastic. So, you've been working with Tom Sargent on public finance, the history of it in the U.S., for some time. I saw a paper as far back as 2010, but maybe walk us through it. How did you get into this area and what kind of sparked this journey?

Getting Into the History of U.S. Public Finance

Hall: Sure. So, I first started working on this actually in the early 1990s when I was a graduate student at Chicago and Tom Sargent was my advisor. He said, would I like to be a research assistant on a project that he was working on, creating a sort of second set of accounts for the U.S. Treasury. So, the U.S. Treasury measures its debt at its par value and measures its interest payments on the debt essentially by summing up the coupon payments. So, it uses an accounting measure to measure its debt and its interest payments. But that's not the measure that we use as a macroeconomist in our government budget constraints and in our theories. The theories that we have about public finance measure debt at its market value and measure interest payments using the holding period returns. So, what the returns… the actual ex post returns that investors receive.

Hall: And he said, "Would you be interested in creating some accounts for this?" And I said, "Sure." And so, we worked on that and wrote a paper that then went into the Chicago Fed, I was working also at the Chicago Fed at the time, economic perspectives, where we documented the low returns that bond holders received in the '70s and then the high returns that bond holders received after Volcker brought down inflation. And it was a nice little paper, but if you remember in the 1990s, the big issue was actually about paying down the debt, and there was a [inaudible] that the debt was going to get paid down. And it didn't seem like making a career out of studying U.S. debt when it was going to go away, there wasn't much to it. So, we stopped working on that. I went off and did my own thing, Tom did his own thing.

Hall: And then 2008 rolled around, and lo and behold the debt hadn't gone away. It was back. And the question a little bit about how we were going to pay for the 2007, 2008 crisis came around. And Tom gave me a call and said, "Would you like to restart that project?" Thinking about the market value of the debt and the holding period returns. And I'm happy to go work with Tom. So I said, "Sure." And we again wrote a paper, did a little better a job now measuring both the market value of the debt, and holding period returns. And that eventually turned into a 2011 paper in the AEJ Macro. But while presenting that paper, Mike Bordo came up to us and said, "You guys are studying the post-World War II period. That's all fine and good, but really the most exciting periods and where these issues, these differences between how economists measure debt and returns, and how accountants, let's say the Treasury, measure debt and returns, are going to really be different in key episodes in U.S. history. The Hamilton refinancing of the 1790s, the Civil War, World War I, it's going to be a big thing." And so, I started digging into this and realized that Mike was exactly right, and I got the bug. And so, I was a generic macroeconomist and decided I should go do financial history. And luckily I had tenure at the time.

Beckworth: And the rest is history.

Hall: Yeah, the rest is history. Exactly. Yeah, that's how I got into it.

Beckworth: ... quite the resume of papers that you've written over the past decade. So, the other thing that was interesting is that you're working on this project and then the pandemic happens, and it's just another great data point. You couldn't ask for a better development. I mean, awful development for humanity, but great development for your research agenda.

Hall: As Tom and I have often pointed out, what's good for the country ... Because during times of stability, there's not a big difference between this accounting framework and our framework, but it's during times of fiscal stress where these differences matter and are really important. And so, what's good for the country is not necessarily good for our research agenda. But we looked at COVID and said, "It looks an awful lot like a war." And we see these basic patterns over and over again in various wars, and we might expect to see many of the same patterns during COVID. In particular, after many wars, particularly after World War I and World War II, bond holders have not done terribly well. They paid a big chunk. Also, after every war the size of government grows. And you see lots of indications that those patterns will also continue.

Beckworth: Yeah, this ratcheting up of government expenditures doesn't return. But let me go back to the point you just raised, how economists look at the market value of public debt, and a lot of the popular press, I dare say the IMF, World Bank, they report that kind of the par value, face value, it’s more of an accounting measure. And George, as you know I recently wrote a piece in Barron's where I invoked the market value, which has fallen a lot dramatically. So, if you look at the market value as a percentage of GDP, it’s come down quite a bit. Now, I got a lot of flak, a lot of pushback on Twitter and other places. And I was told, "Beckworth, you're the only person who puts market value in the numerator. You're an oddball. The IMF doesn't do it, the World Bank doesn't do it. And they think about these issues all the time. So, who do you think you are?"  I was like, "But wait, it's in the literature." Like, "Hush up, Beckworth. Move along." So, help me understand this, and was I correct in taking that approach?

Looking at the Market Value of Government Debt

Hall: So let me just say, I think you're exactly right. I think it's the right way to look at things. I mean, just like the way we think about companies, both in book value and market value, when we think about companies, we want to be looking at the book value or the par value of the debt and the market value as well. And I'll just say that, I think that for good reasons the U.S. Treasury and the Office of Management and Budget have to use these accounting measures. Some of the debt is not marketable so you have to mark to a model. And so, some judgment is involved and you want to be careful about that.

Hall: And so, there's good reasons why this Congressional Budget Office or the Treasury have to report these accounting measures, and good reason. And so, we're very familiar, I think everyone's familiar with the par value and it's easy to understand. Actually, as soon as you say interest payments on the debt is basically just summing up the coupon payments, everybody in finance goes and says, "Why would you do that?" But that's the measure everyone's familiar with. It gets on the cover of CBO reports. So, people just aren't that familiar with it. But I will say the Dallas Fed reports on market value of the debt, and it's up on FRED. We have our measure that goes back a little further. It's quite similar to the Dallas Fed measure. So, we're not the only ones out there. And I think people who are within the academic world, people are a little more familiar with it and a little more comfortable with it.

Hall: I mean, again, during times of fiscal calm, there's not a big difference between the market value and the par value. And that's partly the way… the Treasury deliberately, when it sets its coupon rates on its bonds, tries to keep the market value and the par value close so that the difference between the accounting measure and the economic measure are minimized. So, if I give this talk in 2014 people are going to say, "Not a big deal," but it's at times of fiscal crisis or fiscal stress like the ones we're in, where those differences matter. And what you identified in your Barron's essay is the big transfer from bond holders to taxpayers. And that transfer gets obscured when you look at the accounting measure. But it becomes very clear when you look at the market values and the holding period returns.

Hall: I mean, just to think about it, bond holder's last year, I mean, anybody who has them in their retirement account knows that bond funds lost 10%, 20% probably there. Those losses went somewhere. And the question is where did they go? If you look at the par value, you're not going to see those big losses. And if you look at the accounting measure, you'd say, "Oh, bond holders received 2% or 3% on their investment last year," because if you take interest payments over debt, over the par value of the debt that's what you would get. But look at anybody's retirement account and it's down. And where did it go? Well, it was a transfer from bond holders to taxpayers.

Beckworth: And your research shows this historically, this is not something new.

Hall: Well, there are big, big transfers. That's what you see is in every one of these crises. You look at 1790, you look at wars, you look at the 1920s, you look at the '30s, in every war there are big transfers between taxpayers and bond holders. And this question about who pays... And the debate we're in right now is who's going to pay for COVID? We spent four or five trillion dollars on COVID, depends how you count it. And the question is who's going to pay? And it's either going to be recipients of government expenditures. So, either we're going to cut spending on Social Security, Medicare, Medicaid, or defense, it's going to be we're going to increase taxpayers, or we're going to deliver low returns to bond holders. And again, the newspapers are very comfortable talking about the first two, cutting spending or raising taxes.

Hall: Without looking at the market value of the debt, it's very hard to observe the low returns that we’ll deliver to the bond holders. And so, when you write the article in Barron's saying, "Hey, that's part of how we're paying for COVID is by delivering low returns," people say, "What? Huh? Where's that?" But it's obscured by the accounting measures. And often what people see is free lunches. People running around saying, "Oh, there's this free lunch with government this or that, and the other thing." And it appears to be a free lunch because you're looking at an accounting measure. Once you look at the market value, you see that either bond holders are doing very well or they're doing very poorly. And that's what explains some of these differences.

Beckworth: Yeah, and we're going to get into your papers here in a minute. And they're really great because they provide a decomposition of how all the big expenditures, usually surrounding wars, are funded and they have to be funded. Somehow real resources have to go to pay for these endeavors we take on, whether it's a war, the pandemic, and either taxpayers, as you said, bond holders, someone's going to have to pay the bill somehow, there's no free lunch. So, that's what I love about your work and you provide historical context. And yes, I felt validated reading your papers. I wasn't off out in left field saying something really ... If you and Tom Sargent say it's okay, I feel really good about it. But let's get going then and let's talk about a framework or an approach in dealing with this. And we've kind of touched on it already, but let me ask a very basic question, and probably most of our listeners know this, but how does a government fund itself? What are the various tools or options at its disposal?

How Does a Government Fund Itself?

Hall: So, Keynes has a beautiful explanation of this, and let me paraphrase him. He argues that government finances itself by taking real resources from the public and then handing the public one of three pieces of paper. So, as the government, take real resources from the public, and then hand you a tax receipt. And you take that tax receipt and you crinkle it up and you throw it in the trash. Or I might take those receipts and say, "I'm borrowing those receipts and I'm going to hand you a beautiful piece of paper, a bond, and it's going to be an IOU. And you're going to take that piece of paper and you're going to put it in your safety deposit box.” Or, what I'm going to do is print up green pieces of paper with dead presidents on them, and go out and buy those things, and it's going to be money, and we're going to put that in your wallet. At the end of the day, to pay for a war, to pay for COVID, we're going to need real resources moving from the public into the government. And it's a question of what piece of paper are we going to hand them in return? And then the question is, what's the value of those pieces of paper? Does the value of money go up or down? And how much does it fall? And when does a bond turn into a tax receipt?

Beckworth: Good question. Yes.

Hall: And then there's some continuum. In Argentina, bonds turned into tax receipts.

Beckworth: Pretty quickly.

Hall: And throw them in the trash. Yeah, exactly. But that's the choice is, you're going to need the resources. Which one of these pieces of paper, what mix of the piece of paper are you going to turn over to the public in exchange for the real resources that are coming?

Beckworth: So, you've noted taxes, bonds, money, let me throw out a couple of other unconventional ones, which I know don't amount to much, just to be thorough. How about asset sales? So, the government sells its stock of forestry or gold holdings. I mean, I guess we don't look at those because they're not very big, one, and they're at best a one-time pop. Is that right?

Hall: Okay, yeah. I mean, yes, the government does hold assets. I mean, one way the U.S. government funding itself… if you think about the U.S. Revolution, one thing we picked up was we basically picked up a third of a continent and we were able to sort of sell off Ohio, sell off Kentucky, things like that in order to get revenue. Now, so we do do it, and actually, we generally under-price these things as a government. We sell them off too cheaply. But yes, we can raise revenue that way as well. There are these other means we can do.

Beckworth: But they're not ones you can rely on, on a consistent basis, right? They're a one time fix.

Hall: Eventually we sold off all of the West.

Beckworth: Right, and also the other one that you mentioned, the Revolutionary War, didn't George Washington also go and seize assets? "I'm taking your pig. I'm taking your corn." I mean, that's another tried and true approach in many developing countries.

Hall: Well, that's the great question. Again, thinking about how we financed the revolution is when they took that pig, so the army would come up to a farmhouse and say, "We need supplies, we need your cows, we need your pigs." And they would hand them a piece of paper and they would say, "This paper is a bond, we're going to repay you." Which many of the farmers said, "No, this is a tax receipt."

Beckworth: Okay. So, they were using one of the first three mechanisms, but they were effectively seizing real resources.

Hall: So, I wouldn’t say seizing real resources, I would put it under the tax receipt category.

Beckworth: Yeah, that makes sense. I see that.

Hall: Throw that one away.

Beckworth: Okay, well let's move on to one other kind of tool to help us think through this. In your work, you mentioned two basic, or two benchmark models, I should say, that helps you think through the different historical episodes, which by themselves are fascinating. But it's good to have some model in your mind to help you sort through all the facts. So maybe you can walk us through, but you have the Barro model from 1979 and then the Lucas and Stokey model, and walk us through those two approaches and how they help inform this history.

Two Models of Government Expenditure Financing

Hall: Sure. So, it's really two different models about who bears the risk when there's a large government expenditure shock. So, just assume in both models, basically what they suggest is that permanent expenditures, what you might think is the baseline government that you know you're going to pay year, after year, after year, peacetime army, Medicaid, Medicare… that you should tax finance. So, you should basically balance that budget. But then how do you pay for a large, sudden, unexpected surge in expenditures? And what the Barro model says is… So, government spending's given, so you can't cut spending elsewhere in either of these models. What the Barro model says is that what you should do is essentially debt finance those expenditures, and then raise taxes sufficiently to cover the interest payments on the debt. And you might want to raise them a little bit more to pay down the debt over time.

Hall: But essentially taxpayers… bond holders are going to always be paid in full, and taxpayers are going to absorb the risk, and the risk is going to be spread out over time. So, basically if there's a large increase in government spending, taxpayers take the hit, taxes go up, but in a smooth way. In Lucas and Stokey, what you do is you have a stock of debt outstanding, again, same basic thing, the long term debt or long term expenditures, long term expenditures are covered with taxes. But now you have this unexpected shock to government spending. What you do is you impose a loss on your bond holders during the war. And so, bond holders take losses during the war, and then once the war is over you have to deliver abnormally large returns to compensate them for those losses and to make them whole. But there, what it is, is basically the taxpayers are protected and the bond holders absorb the risk and absorb the shock.

Hall: So, in some sense bond holders offer an insurance contract to the government. They say, "During times of fiscal stress, we'll take low returns. But when we go back to good times, we'll get high returns." And this is actually the way the gold standard operated. So, if you think about the U.S. Civil War when we were on the gold standard, so we're on the gold standard prior to the war. The war breaks out, we go off the gold standard, and we run into inflation, one big inflation during the Civil War. Bond holders don't do well. And then after the war, what we do is we say, "Well, we're going to go back to the gold standard, we're going to go back to the old par. It's going to take us a while, it's going to take us 15 more years to do it, but during that time we're going to run a deflation. And by running a deflation, we're going to deliver high returns to the bond holders and go back to the old par."  So, that's a state contingency aspect of debt there. But in one model it's the taxpayer who absorbs all the risk, and in the Lucas and Stokey model it's the bond holders who absorb essentially all the risk. And probably the real world is somewhere in between there. Taxpayers are going to absorb some-

Beckworth: Some combination they equally share.

Hall: Some combination. Yeah.

Beckworth: But the Barro model, I think is useful and interesting, when you think like World War II, you mentioned ... Well, we'll get to World War II because some of it was inflated away, some of it was real growth. But you can think of, at least think of a war, maybe a generic war, and maybe you don't want to impose all those taxes on the people also fighting the war. They're going to lose family members. So, you smooth taxes over so future generations pay little… you know, we secured the piece for the next generation, so, the tax smoothing makes a lot of sense-

Hall: In both models, you don't want to tax finance large sudden expenditures.

Beckworth: Okay. So, in both approaches.

Hall: In both approaches there, yeah.

Beckworth: Then the key insight there is who's bearing most of the burden, taxpayers or bond holders?

Hall: Who ultimately pays?

Beckworth: Okay. Well, we can invoke this as we move along. Let's proceed. And I do want to note one thing, and it goes with what you just mentioned about effectively turning these bonds into state contingent contracts. Well, let me actually mention your papers I'm going to be pulling from, so we'll have links to these in the show notes. So listeners, I'd encourage you to check them out. But you have a paper titled, *Debt and Taxes in Eight U.S. Wars and Two Insurrections: The Handbook of Historical Economics,* 2021. Really fascinating. So, you've got 10 different experiences there. The other paper is, *Financing Big U.S. Federal Expenditure Surges: COVID-19 and Earlier US Wars.* This is the Hoover paper I mentioned as 2023, came out this year. And then one other I'll mention, *Three World Wars: Fiscal-Monetary Consequences,* Proceedings of the National Academy of Sciences, 2022.

Beckworth: And there's the host of other papers you have, but those three are the ones that I've read, I drew from. And again, very fascinating. But I want to go back to this idea that the government, if it wants, can turn these bonds of state contingent contracts, or contracts contingent on some state of the world. And you write here on page 11 in the *Debt and Taxes in Eight Wars and Two Insurrections,* you say, "Most debt issued by the U.S. Treasury was not explicitly state contingent debt, but by accepting or engineering changes in price levels, capital tax rates, and interest rates, a government can deliver, ex post, state contingent returns on debt." And you go on to say, "Until World War II, the U.S. government encouraged money and bond holding in the face of wartime inflation by promising post-war deflations." So, they effectively created the outcome that bond holders wanted.

Beckworth: So, let me ask this kind of a question to motivate us to move into the history, but that long run there, if you look at the price level from the beginning of the country up until really right, maybe, after World War I, from a step back and look, it's a straight line. There's ups and downs during wars, but it's literally a straight line. And then since then it's been this upward ascending price level. Are you suggesting that that accomplishment, that feat, was in part motivated by a desire to keep bond holders happy and money holders happy? Were they explicitly thinking this, or was there just the deeper societal commitment to price stability as a civilization norm?

The History of U.S. Government Expenditure Finance

Hall: I think there was a recognition that if you want people to buy your bonds, particularly during times of fiscal stress when you don't have the resources to deliver high returns to them, because you're fighting a war, you have to say, "After this war, I will pay you high returns, and I'm committed to that." And there's a recognition that this will not be the last war we fight, and we’ll have to go back to bond markets. And if we honor our commitments to deliver high returns during this war, we can go back in the next war and deliver high returns. And bond markets, particularly international bond markets, have long memories. And you've got to come through on your promises. And we can talk about that some more-

Beckworth: Yeah, well this is fascinating-

Hall: ... when the U.S. has come through on its promises and when it hasn't. Yeah.

Beckworth: So, you outlined some trends. Again, I want to get to each war specifically, but just kind of a broad view here, trends that you note, as you put in some of these tables in your paper, one big trend is that over time, with the exception of the pandemic we just went through, that we see more tax financing, less bond financing over time. So, bonds become less important as a way to pay for the real resource. Is this because we do move away from that stable price level? Or is that a sign-

Hall: Yeah, part of it is, well, we now have the income tax. So, prior to the income tax our main source of revenue was tariffs and customs revenue. And the problem with wars is they cut off your customs revenue, because trade goes down. And now the income tax is very, for better or for worse, is a very effective way to raise revenue. And so, we're just better at raising revenue than we were in terms of in tax revenue. And then some of it is, the U.S. is no longer a developing country. The dollar is the global currency, and people have to hold it. They have to hold it for other reasons. We can get away with-

Beckworth: That's true.

Hall: ... paying lower returns than we might otherwise get away with. Or particularly in the 19th century we couldn't get away with that.

Beckworth: I've been a big proponent of dollar dominance and this exorbitant privilege, and that's what you're speaking to. So, it's a very different dynamic. But this does raise questions historically of the gold standard or commodity standard, we had bimetallism for part of the period, as to its value or use in creating that price stability. Many people will look back, "Oh, we need to return to the classical gold standard to get price stability." But maybe the gold standard itself was an outcome of a deeper desire to preserve bond holders' wealth, to preserve bond holders' return. In other words, by itself it was just something reflecting a deeper norm in society.

Hall: Yeah. Well, it's a way of establishing credibility. When you're fighting a war where you're under fiscal stress, that's when you need credibility the most. And the gold standard was a way of tying yourself and committing yourself to honoring these promises. And not only committing yourself, but committing the next Secretary of the Treasury, and the next president, and the next Congress, to these promises. And ultimately World War I essentially breaks the gold standard, because again the same dynamic happens, and the war breaks out, everybody goes off the gold standard, there's a big inflation, and then after the war everyone says, "Okay, let's go back to the gold standard, and let's go back at the old par." Actually, I argue that they should have looked at the U.S. Civil War where after the Civil War it takes us 15 years to go back to the old par.  Britain says, "Oh, we're going to do it in five." And they're much too poor. I mean, the war has wiped them out and they're much too poor. And so, they try to do it and it basically throws the economy into a deep recession, depression, and then they back off and they never come up with a credible plan to go back, I think partly because they're just too anxious. And when you look at the United States after the Civil War, they say, "Okay, it's going to take 15 years," but it's a credible plan. And bondholders believe them.

Beckworth: Yeah. But tie this back into this point you just mentioned about the income tax becoming a very important source of revenue. So, take that observation, number one, take the second observation, which is an important trend you show in your paper that bond financing becomes less important over these big expenditures, these wars, except for the pandemic, things changed. But you see this decreasing reliance on bonds and you see this increase in reliance on taxes, particularly after the income tax, World War I, World War II, is a big jump, almost like a discontinuous jump, which again, to me, at a minimum, it complicates the picture of the gold standard because it says we don't necessarily need the gold standard to reassure the bond holders who are going to pay a big part of the bill.

Hall: I would put in one thing also… So, after the U.S. Civil War, bond holders received very good, fantastic returns. And I'll just note that all those bond holders are in the north, and the tax base includes both the north and the south. So, it's a nice transfer of wealth from the south up to the north. I mean, so essentially is we get to World War I and they promise high after war returns, and then they aren't able to deliver on them. And one of the people, we tell this little story in the PNAS paper, but one of those bond holders is Captain Harry Truman, who takes his government pay and buys bonds with it. And then he all of a sudden finds 20% of his bond value wiped out.  And he remembers this, and he's quite angry about it. He's quite angry that he thinks, "I lent the government $100? I should be able to get $100 back. The bond prices should not fall." He doesn't understand that bond prices can go up and down. But then we get into World War II, and what's funny about it is they want to make sure that the Lucas Stokey ... I mean, not everything is always right. They want to make sure the Lucas Stokey dynamic doesn't happen. So, they set up price controls during the war, and they also fix interest rates so that there's no way to impose losses on bond holders during the war. And then they strongly encourage… instead of taxing people, what they're going to do is say, "Take your paycheck and buy U.S. bonds with it."

Hall: So, there's a lot of payroll deduction of bonds. And then the question is, is this is a tax or is this debt? But so, most Americans, if you're working in a factory, you're going to have bonds deducted from your paycheck and they're going to buy these bonds. The war ends, and the government immediately releases the price controls and releases the interest rate controls, and that imposes big losses on the bond holders. And it's the exact flip of Lucas and Stokey. So, Lucas and Stokey says, "Give low returns during the war, high returns after the war." And what they do in World War II is they deliver constant returns during the war. And then after the war, they basically run two years of 10% inflation, and bond holders take it in the shorts. And you see a big drop in the debt to GDP ratio right there.

Hall: And it's because we've inflated the debt away. Fast-forward to Korea, and all of a sudden you now have Harry Truman as president, and he's got to fight the Korean War. And he says two things. One is, he says, "I remember being a bond holder and taking those losses, and I don't think that's right." And also he goes to the bond market and he has to finance a war. And the bond holders say, "Wait a minute, we just took it in the shorts in 1947, 1948, when you imposed big losses on us. We don't have much interest in loaning to you to finance another war." And so, Korea has to basically be financed on a balanced budget. So, if you look at Korea, there's no debt financing, it's all tax financed. And that's a consequence of this breakdown, and the gold standard enforced these promises that you would pay back well after the war. And with the breakdown of the gold standard, high post-war returns breaks down, and it does change the dynamic of how you will finance wars.

Beckworth: Yeah, in your paper, you note this trend, this increase in finance, and you mentioned the story of Harry Truman, the Korean War, and it continues even in the Vietnam War. They raised a lot of tax revenue to help pay for the Vietnam War and less on bonds. And you detail this story, and I'm going to read a quote from your paper that includes this Harry Truman story, but it's a broader one. So, it speaks to this institutional memory that people had and they try to veer course. And this makes me wonder if there's going to be any lessons or memories from the current situation we're in moving forward. But let me just read a brief excerpt here.

Beckworth: You and Tom Sargent note, "Memories of how the continental currency that had financed the War of Independence from Great Britain had eventually depreciated to one penny on the dollar prompted war of 1812 decision makers to take steps to avoid that outcome. Non-callable federal bonds issued to pay for the Mexican war appreciated in value after the war when interest rates fell, creating ex post regress that the bonds had not been bundled with call options, something that the union would do early in the Civil War. Rising nominal interest rates after World War I delivered nominal capital losses to owners of liberty bonds that had been used to finance the war, teaching Captain Harry Truman a lesson that he would remember when as president. He insisted that the Treasury and Federal Reserve manage interest rates after World War II to prevent that from happening again. We recount many other instances later statesmen learning from what came to be recognized as mistakes during past wars.” So, there's a pattern here that goes on, and we're swinging from one side to the other.

Hall: I think what makes studying financial history so much fun is at some level there are these principles and there's these theories that, clearly, policymakers are aware of. I mean, what's interesting is Albert Gallatin, he has sentences in his reports that basically read off equations of Robert Barro's 1979 paper. So, he understands Barro tax smoothing, clearly. But what's funny is that when you get into the war, all of a sudden then the politics gets involved and nobody wants to pay. I mean, they always want somebody else to pay for it. And there's this mix of expedience, of politics, there's often some incompetence thrown in there, and there's brilliance, incompetence, high mindedness, greed, and you get these interesting mixes. And they draw lessons from the past war, and sometimes they draw the wrong ones.

Hall: It's funny that way. I mean, sometimes they get the right ones, but sometimes they get the wrong one. And so, you see this, looking across wars, we see that there are these lessons that you get running across wars. And so, that's why we think it's useful if you want to think about how COVID is going to get resolved… Well, it's interesting to look at how past wars got resolved, and what the choices are that policymakers had to make after, post-wars, and what lessons they decided to draw and bring forward. It's been a while since we have fought of a large war. So, some of these lessons may seem to have been forgotten and we want to bring them back

Beckworth: And your papers help us remember these lessons. Well, let's jump into some of the wars. We can't do all of them. There's a lot of wars in your paper, from the Revolutionary War up to the present, including the Spanish American War, Mexican war. So, lots of neat stuff, we're going to have to skip a bunch of them. But let's start with the Revolutionary War, because everyone loves the Revolutionary War, and I know you call it an insurrection in your paper. But let's touch on that because it's well known, at least among Americans, and there's this famous saying, "Not worth a continental." That was the currency. So, talk about that experience, and maybe what tie-in did Alexander Hamilton have? Was this a legacy of him? What connections are there to his program?

The Revolutionary War and Alexander Hamilton

Hall: Sure. Many people appeal to the lessons of the Revolutionary War and Alexander Hamilton when thinking about these issues going forward. So, you think about, you want to start a revolution, you don't have a tax base so taxes are off the table. And so, what are you left with? You're left with debt and money. And so, they start by issuing bonds to finance the war, but essentially bond sales are insufficient to cover the expenses. So, then they start printing up money, these continental dollars, and they have to print so many, and there's really no taxes to back them that they eventually go worthless and become not worth a continental. And then they have to go to what you mentioned, to expropriation, where the army start going up to farm houses and to, they call it foraging was the polite term, and basically at gunpoint, take resources from farmers, from metal workers, from there, and hand them IOUs.

Hall: Now, they did hand IOUs off to these folks and said, "We will pay you back after the war is over." But of course, that's all contingent on the U.S. winning. Okay, so the war ends and there's all of these pieces of paper out there floating around, all of these IOUs saying, "We're going to pay you this and pay you that." And they all basically promised to pay 6% interest on it. That was the going rate. The central government, it wasn't it the federal government yet, but the central government has no ability to tax, all the tariff revenue belongs to the states. And so, where the brilliance of George Washington and Alexander Hamilton come in, particularly Alexander Hamilton, is they're going to engineer ... So, what you have is a classic debt crisis.

Hall: So, you have all of these IOUs, all of this debt outstanding, and it's trading at 25 cents on the dollar. So, the market value of the debt is 25% of the par value of the debt. So, a big, big, big difference between market values and par values, debt crisis. What Hamilton does, is he engineers a restructuring of the debt and gets us out of this debt crisis. And he's going to do it two ways. One is we're going to rewrite the U.S. Constitution so that the taxing authority moves from the states to the federal government. So, the federal government's going to get some new revenue, and then he's going to nationalize all of these debts, all of these IOUs that are outstanding, he's going to make to be federal obligations, and he's going to convert them into three new securities. And you say, "Well, why three securities? Why not one security?" And the reason he is going to do three is he's not going to pay the bond holders back everything they were promised.

Hall: He says, "The value was 25 cents on the dollar. I'm going to pay you back 85 cents on the dollar, but you'll take 85 cents on the dollar better than 25 cents on the dollar, and it's more than 100% rate of return. So, very close to 200% rate of return on the bonds. So, I'm going to pay you handsomely and this will stabilize the debt crisis." And in doing so, he stabilizes U.S. markets. The debt, it doesn't trade at par for 20 more years. We'll get into that in a second. But he reestablishes debt markets. We then get access to new borrowing. He's going to do two other things. One is, he's going to default completely on the money holders. So, he bails out the bond holders, but he's not going to bail out anybody who's holding a continental dollar because he doesn't believe in fiat currency. He wants, basically, the government to only use taxes and bonds to raise revenue and not to do fiat currency. So, he's going to default to ruin the reputation of money hold, of issuing fiat currency.

Hall: He's also going to then turn around, he says, "Oh, I'm only going to use this tax revenue to pay back the bond holders." But of course he then takes that tax revenue and builds an army, and that army's going to help enforce tax revenue collection and things like that. So, he's going to increase the size of government. So, the question about, what's the legacy of Hamilton a little bit is we now say, "Oh, he pays back the bond holders in full and honors our debts." But when you look at it again, when you look and do the accounting properly, and he's actually pretty clear about this, he says, "No, I'm not going to pay the bond holders back in full. They should take some of the hit. The taxpayers shouldn't be on the hook for everything. The bond holders are going to take some of the hit, some of the fiscal risk will be borne by bond holders, some of it will be borne by taxpayers." And I think that, the idea that he protected the bond holders, that's not entirely right there.

Beckworth: How does he make the bond holders take somewhat of a hit? What's his solution?

Hall: Remember that they're promised 6% on their bonds. And what he's going to do is he's going to create three securities, one of which is going to pay 6%, and one of which is not going to pay 6% until 10 years from now. And one's only going to pay 3%. And then he gives people various combinations of these things. But by giving you a combination of these two bonds, particularly the one that pays 6% and the one that doesn't pay anything for 10 years, what he's able to do is lower the interest rate to 4%. He's handing you a bond with the same face value, but instead of paying a 6% coupon, he's paying you a 4% coupon or a 3% coupon. So, he's exchanging you face value for face value, but they promise a lower stream of payments than they did before. And these things trade at 80 or 85 cents on the dollar relative to their face value, because interest rates back then were about 6%. And he's effectively issuing a bond with a coupon rate of 3% or 4% depending on the deal that you got.

Beckworth: So George, John Steele Gordon has a book called Hamilton's Blessing. And in it, he argues Hamilton left a blessing for us in the form of this national debt, which as we alluded to earlier, it has this exorbitant privilege. People are around the world want to hold. It creates deep financial markets in the U.S. And so, his argument is this is actually a good thing that Hamilton did largely protect the bond holders. Not completely, as you noted, but largely. Do you agree with that assessment?

Hall: Yes, I do. I mean, by taking all of these various forms of debt and consolidating them into three securities, and Hamilton knows this, he's very clear that he's going to do two things. One is, it's going to create deep and liquid markets in three easy to recognize securities, which is going to facilitate the trading of these securities. Furthermore, the politics, is that now nobody has state debts anymore. All of those are gone. And so, everyone now has federal debts. Now everyone, particularly the moneyed men, as they were just called back then, now have a political interest in supporting a strong federal government with a strong tax base, because a strong federal government with a strong tax base will ensure repayment.  And so, it's going to move the political center of power away from the states and to the federal government, which is something Hamilton very much wants to do in strengthening the federal government relative to the power of the state governments. And he argues that this is going to bind the nation together. And so, we're not just a collection of 13 separate countries loosely tied by a treaty, but we're a single country with with single financial markets. And I do think it really has helped develop U.S. financial markets, quickly accelerated.

Beckworth: And that's why if you visit the U.S. Treasury Department building, you'll see his statue out front. And then on the backside you have Albert Gallatin, two important people in shaping U.S. Treasury markets.

Hall: I mean, what’s funny is, while he did very well for the bond holders, what's interesting is, and here's kind of again where the looking at the market value versus the par value matters is that he gives them 85 cents on the dollar, which is far better than 25 cents on the dollar. So, they get very high returns. And if you read history, or even if you go to just the musical, Hamilton, what you realize is that Jefferson and Madison are very much opposed to this plan because they say this is a big giveaway to the bond holders at the expense of the taxpayer. It's a big transfer from taxpayers to bond holders, and kind of undeservingly. The war's over and we shouldn't be paying these guys back. Ultimately, Hamilton wins this debate. They move the capitol from New York to DC and things like that to get it to happen. But what's interesting is that you go 20 years later, 25 years later, and now Madison is president and he's fighting the war of 1812. And he's fighting the war against the U.S.' main trading partner, Britain. So, our tariff revenue collapses and he has no tax revenue. 

Hall: He can't issue paper currency because Hamilton has poisoned that reputation. So, he's dependent on the bond market. And so, he's dependent on very wealthy people who were in the north and aren't very much in favor of the war. And he has to promise them 30% rates of return in order to get them to lend the money to win the war. And again, if you look at just the par value, those rates of return are going to be obscured. They're very clear once you look at the market value. And what's interesting is after the war, Madison repays bond holders dollar for dollar, and when you look at it, he gives the bond holders an even better rate of return and even treats them better than Hamilton did. Hamilton said, "Well, you should pay for part of the war." Madison says, "The taxpayer is going to pay all the war and we're going to deliver the bond holders fantastic rates of return."

Beckworth: The irony is rich, for sure.

Hall: The irony is rich. Yeah, exactly.

Beckworth: Well, let me go back to the Revolutionary War real briefly here. So, we touch on the continentals, because part of what you do in these papers is you decompose how you pay for the wars or big federal government expenditures, Revolutionary War being the first big one. I once read someone make the statement that the U.S. rode the wave of hyperinflation into existence. So, I'm going to ask you about this claim. Would we have been able to win the Revolutionary War had we not relied on that money financing?

Hall: Great counterfactual. In the end we did, we issued a lot of paper and we then defaulted completely on that. We ran a hyperinflation and ultimately defaulted explicitly on our money holding. Even after the hyperinflation, we still had three more years of the war to fight, and really, we had to resort to expropriation. So, I think the question would be, so if we hadn't done money finance I think we'd have had to go to expropriation just that much earlier. Now, what that would've had for hearts and minds... Again, it's you're paying with money that then becomes a tax receipt, or whether you pay with an IOU that sort of looks like a bond, but then becomes a tax receipt.

Beckworth: I mean, right. At a deeper level, you're seizing assets one way or the other.

Hall: Yeah, and they're fighting a war.

Beckworth: Yeah. Okay, well let's move on to the Civil War and then we'll do World War II and wrap things up. But I want to go to the Civil War. We've already touched on it a little bit, but I'm going to go to the Secretary of the Treasury, Salmon Chase, because he's a fascinating character. Maybe you walk us through this. So, my understanding is in addition to the securities that he issued, the debt, he also issued the greenbacks. And then later, he became a Supreme Court Justice and actually ruled that they were unconstitutional, which is another rich irony in the history of U.S. public finance. But maybe you can walk us through that story.

The Civil War and Salmon Chase

Hall: Yeah. So, just to continue after the war of 1812, the U.S. government says it's not going to be in the infrastructure business. And so, state governments take over the business of infrastructure and they finance canals and banks, and all of these various states take on all of this debt. And so, the U.S. government pays off its debt by 1830, but the state governments have a huge amount of debt. And they actually… a lot of those states start to go bankrupt. They can't pay it. Pennsylvania can't pay, Mississippi can't pay. A bunch of these states can't pay. And they've lent largely to the Europeans. And so, the Europeans say, "Okay, we'd like to be repaid." The States say, "We can't pay." So, they go to the federal government and say, "Well, you're all one country. Hamilton nationalized all the debts, you're responsible for the state debts."

Hall: And President Tyler says, "No we're not, states are separate." And a bunch of the states default on the Europeans, on their debt, and they complain bitterly. In A Christmas Carol, there's a snide remark about U.S. securities and things like that, about the defaults. But a lot of the States default on the Europeans. So, that's in the 1840s. 1860s roll around, we've got to finance a war, we go back to Britain and Europe to try to borrow because we need a lot of money to finance this war. And Europeans say, "Well, you didn't pay us back in the 1840s." And they say, "Well, that was the states." And they say, "We don't care. You all look the same to us." One thing to keep in mind is we can't go to foreign markets anymore because we've got this reputation of having defaulted. And it's because the states defaulted, not the federal government that defaulted. Okay, but Chase has this war to finance and he tries to issue it, he tries to borrow, he can't borrow abroad, he tries to borrow abroad, can't do it.

Hall: He tries to borrow from the big banks and the rich people in the United States, and there's not enough of it. There's not enough of money in the big banks to do it. They don't have it. So, they go off the gold standard, they're forced to, and they start printing up these greenbacks. And what's fascinating is we now have two things that are called a dollar. We have greenbacks that just promise ... they don't really promise anything. And then we have claims that we have dollars that promise gold. And these two things start to trade… But when you say, "I want to get paid in the dollar," you have to decide is it a gold dollar or a greenback dollar? So, there's two things, and then there's bonds that pay back in greenbacks, and bonds that pay back in gold. So, there's two currencies floating around. And what they end up doing, since they can't borrow from the banks what they realize is that they've got to go to ordinary Americans. And they start selling bonds to ordinary Americans and they start marketing bonds to ordinary Americans. And Roger Lowenstein has got a great book on this, and it's thinking about how you turn the U.S. into an investor nation is they have to sell these bonds and get people to become investors. And so, they sell bonds far and wide in small denominations out across the entire union. And then they successfully finance the war. The war ends, and then they have to decide ...

Hall: You've got two things that are called a dollar. You've got gold dollars that are worth a lot, and you've got greenback dollars that are worth very little. And the question is, what's going to become the new dollar? Is it going to be the crappy dollar that pays, or is it going to become the good dollar? And are you going to pay the debt back in good dollars or in bad dollars? And so, this is a question about who's going to bear the risk. Now, the southern states are all going to soon join the union back, and they say, "Oh." Well, they say two things. So they say, one is, "We're Hamiltonian. We should nationalize all the state debts. We had this war, you should nationalize our debts and take our debts on. And if you're not going to do that, then you should go back below currency, at the greenback." And this gets decided in the election of 1868 where the Democratic Party says, "Well, we paid the soldiers in the bad currency, and if we paid the soldiers in the bad currency, why are we paying the bond holders in the good currency? We should pay the bond holders in the bad currency and keep our taxes low, and the bond holders should take the hit." But part of the selling these bonds far and wide was now you had this large political constituency that wanted high returns. And so, they want to be paid back in the good currency. And Grant says, "The bond holders will be paid back in gold, everything will be paid back in gold, and we will go back to the gold standard and bond holders will get high returns."

Hall: Now, they're worried that when the Confederacy rejoins the union, they're going to try to undo this. So, if you look at the 14th Amendment and the statement about the debt, it's that you cannot default on U.S. debt. The U.S. debt will be repaid. So, you can't come in and then undermine that. And that two, we're not going to pay back any of the southern debts. You can't nationalize any of the southern debts. And everyone says, “they also wrapped themselves in Hamilton,” and Andrew Johnson says, "Well, Hamilton didn't pay back everybody in full, so why should we pay back everyone in full?" And the Southerners are saying, "We're Hamiltonian. We should all nationalize all of these debts. We're all one big nation, we shouldn't be thinking of ourselves as two different nations," all of that. And so, it's interesting, but what ultimately does happen is we bring the value of the poor, low quality currency up to the value of gold by running this deflation, takes us 15 years to do it but we do it. Bond holders receive very high returns after the war, and it does help create this nation of investors. And it also is a case where the tax base is the entire country, the bond holders are all on the north, and it's that transfer from taxpayers to bond holders. And so, therefore, a transfer from the citizens of southern states to the citizens of northern states. So, in a way they paid reparations in that way.

Beckworth: So, we have deflation until we can go back on the gold standard, 1879, if I remember correctly, and go back to the original exchange rate. But just briefly, Secretary Salmon Chase becomes Justice Chase, and he rules the greenbacks unconstitutional as a way to get rid of fiat currency. Is that the story?

Hall: Yeah. Well, so if you look at the Constitution, it's clear that the states cannot issue fiat currency, so it is explicit about that, that the states may not do this, issue fiat currency. But it doesn't explicitly rule out whether the federal government can issue fiat currency. And it says the federal government has the power to coin money, and then the debates on what the verb “to coin” means. Hamilton was worried that the constitution allowed the government to issue fiat currency. And so, he said, "Well, I'll take care of that by defaulting on fiat currency, and then no one will ever accept it again. And whether it's legal or not legal, I'll just close the door on that option.” And then with Chase, so he does issue a fiat currency and then says, "Well, nope. Unconstitutional," later.

Beckworth: It's an interesting story.

Hall: It's kind of comical that he rules… It's a funny story, but at that point we've already done it and-

Beckworth: Yeah, the horse is out of the barn at that point.

Hall: Exactly. The horse is out of the barn.

Beckworth: Well listeners, we are out of time but I am going to keep talking to George. We'll provide a bonus segment that'll be released on Wednesday. But we're going to wrap things up here for today's show. It's been an hour. George, thank you so much for coming on the podcast.

Hall: Oh, thanks so much for having me. It's been great fun.

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