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Wednesday, August 25, 2010

Alexander Hamilton and the Perils of State Capitalism

Historians have long praised Alexander Hamilton’s activist government promotion of capitalism. Hamilton’s “financial revolution” brought secure government debt, fluid securities markets, and a modern banking system to the United States. Most scholars believe these factors were responsible for the amazing growth of the U.S. economy in the subsequent 200 years. Thus while George Washington is commonly known as father of his country, Hamilton is lauded as the father of American capitalism.

Hamilton may indeed be worthy of this title; but lest we give him and his economic ideas undue credit, we should pause to consider exactly what kind of “capitalism” Hamilton and his Federalist allies bestowed on the U.S. economy. Capitalism can mean different things to different people. Economic prosperity requires a legal system that protects individuals and secures their property from expropriation, whether it be private theft or political predation. Advocates of this system of rules often call it “capitalism.” We’ll call it “free-market capitalism.” And it’s a good thing for government to let this kind of capitalism develop by protecting private property, sanctity of contract, and consensual exchange. This ensures individual freedom of choice—and not coincidentally, it is the only known recipe for economic prosperity.

Another line of argument claims that governments should actively create and promote the products, organizations, and institutions of capitalism. Let’s call this “state capitalism.” Advocates of state capitalism argue that the institutions of capitalism should be forcefully imposed even if they are unwanted. The theory is that this will make the nation wealthier and so it should be done regardless of any objections.

It is by no means certain that the forceful imposition of the mere institutional trappings of an advanced capitalist economy actually promotes economic growth. Under the legal framework of free-market capitalism, individuals save, invest, trade, and set up markets as they see fit. Intricate patterns of interaction emerge, including some of today’s complex institutional forms of finance, industry, and commerce. Focusing on creating these institutions instead of the framework that lets them grow puts the cart before the horse. It means constructing the byproducts of progress instead of the mainspring that makes such progress possible.

Thus the statist approach to capitalist development is backward and unlikely to create wealth, even if the constructed institutions are industrial or financial. Constructivism—the idea that government can design economies to ensure growth—doesn’t work because central planning cannot substitute for the knowledge generated by the trial and error of the market process. Even the best-intentioned government officials cannot replicate the competition of market participants guided by profit and loss. Moreover, it defies human nature to assume that those who would implement state capitalism would promote solely the general welfare, without any bias toward shaping these institutions to benefit themselves or the special interests they represent.

The Early U.S. Economy

Proponents of state capitalism point to the historical development of American financial institutions as their strongest supporting evidence. In particular, Hamilton and his “financial revolution” embody the ideas of government leadership in building up a nation’s financial infrastructure. Fans of the finance-led growth hypothesis like to trumpet Hamilton’s achievements, which include a well-funded government debt, active securities markets (a stock exchange), a large and vibrant banking sector, and an enlarged money supply.

Thus many historians argue that with this infrastructure in place the financial means were created for corporate development and the growth of large-scale industry. They contend that Hamilton’s policies set the stage for the industrial revolution in America and that this experience should be replicated everywhere today.

But is government design really necessary for free-market capitalism to flourish? A closer investigation of early U.S. economic performance challenges that hypothesis.

At the close of the American Revolution, the United States was economically “underdeveloped.” In 1790 about 90 percent of the nation’s four million people were farmers. There were few large cities, and the population was clustered on the coast and near larger rivers. Poor roads impeded communication and commerce with the sparsely populated interior regions.

As for money, the United States was on a specie standard, with foreign silver and gold coinage forming the basis of the money supply. As of early 1791 there were three banks in the country, one each in Boston, New York, and Philadelphia. All issued banknotes representing claims on specie money. Although the bank notes were reportedly safe and reliable, they did not circulate widely, and there were constant complaints of a “scarcity of money.” While actual money—in both coin and note form—was present and fueling transactions in the commercial centers, in the remote farming regions barter was still commonplace.

Like banks, securities markets were rare. In 1792 only five domestic securities were quoted in New York. There were irregular and economically insignificant transactions in domestic and foreign equities. However, a larger, more continuous securities market was arising due to speculation in state and Continental Congress bonds issued during the Revolutionary War.

Grand Financial Scheme

When Hamilton became the first secretary of the Treasury under the Constitution in 1789, he surveyed a U.S. economy that was significantly less financially developed than England’s. Yet he also saw an opportunity to use his new office to spur the development of financial institutions and thereby give mercantile interests a helping hand. In the political climate of the early 1790s he was able to use the outstanding war debts as a tool to overhaul America’s financial system.

Hamilton laid out his grand financial scheme in four reports to Congress from 1790 to 1791. According to historian Frank Bourgin, Hamilton’s reports “constituted a unified and integrated program of planning on such a grand scale that even today it would appear as a magnificent conception of an economy directed and controlled toward socially chosen objectives.”

Hamilton used the public debt to implement an economic program that provided the impetus for the country’s first continuous securities market and also for its first brush with central banking. The first plank of his program was to secure the government’s credit by honoring the pre-constitutional war debt. Congress obliged in 1790, authorizing over $60 million in new U.S. bond issues to take responsibility, at face value, for all revolution-era debts.

The second plank in Hamilton’s program called for the creation of a national bank. Northern merchants largely supported the proposal, pointing to the advantages it would procure for their economic interests and for strengthening the position of the central government. Agrarian southerners were mostly opposed, arguing that such a bank would be unconstitutional and interfere with states’ rights. President Washington was eventually convinced by Hamilton’s broad interpretation of Congress’s constitutional powers and signed the Bank Bill into law on April 25, 1791.

The BUS Bubble

The Bank of the United States (BUS) was not technically a central bank in the modern sense; it was not granted a monopoly of note issue, nor did it regulate the commercial banking system. It was, however, granted important legal privileges: It was the only bank exempt from an otherwise nationwide restriction on branch banking, and its banknotes were accepted in payment of customs duties. This privilege provided the bank with a strong advantage over its competitors. The BUS charter called for an initial capitalization of $10 million—an enormous sum at the time. Three-quarters of it, however, was to consist of the new government bonds. Thus Hamilton used the bank to boost the market for government debt, making the bank and the government codependent. The size, scope, and privileged position of the BUS ensured that its actions would exert a titanic influence on the money supply and credit conditions in the United States.

Hamilton also introduced other measures to round out the overhaul of the financial system. Thanks to his prodding, a bimetallic currency was introduced to enlarge the money supply. The federal government began to recognize gold as legal tender in addition to the Spanish-based silver dollar at a 15:1 silver-to-gold ratio. And finally, Hamilton ushered in a policy of activist industrial promotion and protectionism in the form of tariffs, subsidies, and “public-private partnerships” designed to foster large-scale industry. The entire Hamiltonian program—the BUS in particular—was, in the words of David Cowen, designed to “stimulate the economy [and] enhance the shaky credit of the government.”

The Funding Act and Bank Bill brought about massive speculation in government debt and BUS stock. Although only five securities—three U.S. bonds and two bank stocks—were publicly quoted in 1792, public interest in them was intense and widespread, ranging from millionaire financiers to day laborers and widows. When the BUS opened, it began pumping vast amounts of credit into the economy. A substantial portion of BUS loans went to stock speculators in the form of “accommodation loans,” or unsecured debt, similar to modern-day margin accounts. A classic asset bubble ensued as the intense demand for these issues led to higher and higher prices. But this stock mania was soon revealed to be unsustainable. An abrupt contraction of credit by the BUS in February 1792 led to a massive selloff in securities markets—the first stock market bust in American history. Many of the speculators were heavily leveraged, expecting to repay the accommodation loans with the sale proceeds of ever-appreciating stocks and bonds. When the short-term loans came due and the banks refused to extend further credit for fear of being drained of their specie reserves, leveraged investors had no other choice but to settle their debts by liquidating their securities portfolios.

The crash piled up unprecedented losses and left several prominent speculators in debtors’ prison. Many economic historians laud Hamilton for successfully managing this crisis by using government funds to support bond prices and steady the nerves of the market. But government involvement in money and banking caused the panic in the first place. Furthermore, the events of 1792 did not signal the resolution of the BUS credit expansion. Over and above the securities panic, the inflationary practices of the BUS set into motion an unsustainable investment boom and consequent bust that would play out over the entire decade.

The BUS engaged in monetary overexpansion through the early 1790s, causing price inflation and disorder in the intertemporal structure of production along the lines theorized by capital-based macroeconomics. This expansion also pushed down real interest rates by making banks far more eager—and able—to lend. The resulting distortion of marginal returns to investment and saving led entrepreneurs to make malinvestments in transportation improvements, manufacturing, and other capital-intensive projects. Furthermore, the expectation of inflation induced individuals to bet on continued price increases by borrowing money to purchase real estate. Thus the atmosphere of easy money created by the bank also channeled resources into western land speculation and fueled local real estate bubbles.

Eventually a correction to the credit overexpansion occurred, but it took time and required a painful monetary contraction. Initially, as the newly injected bank credit worked its way through the economy, it created a disparity in international prices. Steep inflation within the United States made American exports relatively more costly abroad and foreign imports into the country relatively cheaper for Americans, leading to a reduction in net exports. By 1795 specie was flowing out of the country to pay for the increased imports, and the growth rate of bank-issued money tapered off. As a result, the money supply and price level began to fall, causing the real interest rate to rise sharply. In the ensuing credit crunch businesses that counted on rolling over short-term debt for their financing were rendered unsustainable. At this point many investments that had appeared reasonable when they were undertaken were revealed to be errors, and a wave of business failures ensued.

The long-run consequences of the Hamiltonian financial revolution were a crushingly large central government and a burdensome government debt. According to advocates of state capitalism, this last aspect was actually a good thing—they portray government debt as a blessing because it allowed for a strong central government. But contrary to their mercantilist interpretation, a bloated central government is not a blessing. As Thomas DiLorenzo’s book Hamilton’s Curse demonstrates, the strong central government, built on Hamiltonian policies, enabled unnecessary military spending, unjustified wealth transfers, and a slew of ever-expanding governmental programs and activities down to the present day.

Despite Hamilton

Hamilton’s schemes impregnated the U.S. economy with the institutions of a financially advanced, capitalist economy. But the accelerated development of securities markets and the banking industry was premature. The truly beneficial aspects of these markets would have developed in due time through the natural course of economic growth. Hamilton’s reforms merely induced a precursory period of unproductive trading in government debt instruments and credit-fueled speculation. More important, the centralized banking system created by Hamilton’s nationalist party destabilized the American economy. The new banking system immediately created a sequence of financial panic, deep-seated malinvestment, and a delayed recession.

Hamilton’s expansionary program did no better over the long run. Primarily, it left the United States with an economy prone to central bank-induced business cycles and a squandering of economic resources on redistributive polices and wars, financed by the accumulation of a burdensome debt. On net the Hamiltonian revolution was not a blessing for the U.S. economy. The United States became the world’s leading economy despite the legacy of Alexander Hamilton, not because of it.

  • Tyler Watts is an assistant professor of economics at East Texas Baptist University.

  • Nicholas Curott is an assistant professor of economics at Ball State University.