Hamilton's 1791 Monetary Reform
STIMULATING THE IMPORT OF
FOREIGN INVESTMENT CAPITAL
[written February 4, 1991]
Few economists today are aware of the monetary reform technique employed by Treasury Secretary Alexander Hamilton in 1791 to prevent the financial collapse of the new government of the United States.
The United States at that time was a small underdeveloped country, deeply in debt to foreign creditors, with a weak government, a monetary system in collapse, no effective system of direct taxation, and a government debt entirely either in arrears or default when the Federal government took over from the Confederation. The total debt was not particularly large by Mexican or Brazilian standards — it was just $74.6 million, but that is still a sizable sum for a predominantly agricultural economy of only 4 million people.
The government’s debt was accumulated to finance the Revolutionary War, but lending to the government had exhausted the domestic savings of Americans, and the power to borrow abroad was jeopardized by the problem of inflation. Not only were Dutch and French bondholders losing confidence in the new American republic, there was danger of domestic insurrection. Shay’s rebellion had just been suppressed in Massachusetts.
Yet, to succeed the new Federal government needed to stimulate its economy and a way had to be found to do this while maintaining monetary and fiscal austerity. The government did not impose income or wealth taxes, but rather adopted measures to attract foreign capital and restore a local capital market — to create the framework for economic growth.
A trade surplus and balanced budget were not the economic measures adopted: total government debt rose by $8 million over the next 10 years and an increase in the trade deficit was actually encouraged as part of the capital-inflow strategy. The U.S. used a revenue tariff as its major source of finance to service its bonds, so Hamilton was able to skim off a small percentage of the capital inflow (foreign direct investment) his monetary reform caused.
The story of Alexander Hamilton’s success is, quite simply, the opposite of current orthodox “development theory.” He made use of supply-side economic tools. He saw the problem as a shortage of liquid working capital for business; the public debt had absorbed it, and the former Confederation government’s default had choked the private capital markets into illiquidity.
In particular, the bonds held by the American public were circulating, by endorsement, in a secondary market at well below par value. This bond market was, effectively, the “money supply” of the United States (there was no central bank, nor mint, at the time). By restoring the bonds to par value, the money supply of the United States was rapidly expanded without inflation.
To attract foreign capital, Hamilton introduced a simple monetary reform: he asked Congress to enact a fixed exchange rate between the [silver] dollar and gold. The European currencies in which the U.S. had to borrow were gold currencies. This reassured the European bankers who wanted to deal only in gold. But his fixed exchange rate (15:1 by weight) put a 3.3 percent foreign exchange (gold) premium on U.S. government bonds, which were payable in dollars (it was a silver currency until 1900). The market ratio in Europe at that time was 31:2 by weight.
About 60 percent of the U.S. government debt in 1790 was owed to local people. Hamilton was able to borrow in Europe and repay local bondholders, who could use the capital for expanding business, agriculture, and new investments. As a result of significant bond redemptions, interest rates in dollars fell, and the fixed exchange rate committed the government to a hard currency policy assuring no future inflation.
In the first five years, the government’s external debt actually increased from $13.3 million to over $20 million, and at the end of ten years it had grown to over $33 million, but in the same period the government reduced its debt to domestic bond holders by $12 million. Its monetary and fiscal reforms enabled the government to roll its domestic debt over, putting investment capital into the private sector, and into the hands of businessmen who put it to work for growth.
The application of the same principles in today’s international financial environment would involve either (1) the fixing of local currency to U.S. dollars, Japanese yen, or German marks (or to all three, in a multi-currency blend) — the equivalent today of gold — at a small premium, and maintaining the premium by appropriate exchange rate policy actions. This premium would make local currency relatively “cheap” to foreign investors.
Eventually, of course, supply and demand will equalize prices in the local currency, but it will happen through increased incomes and employment in the short run; Keynes says so.
Government bonds could be denominated in local currency, therefore, instead of dollars, marks, or yen. This would be the equivalent of offering bonds at a discount to those who bought them with hard currency. But identical bonds could be sold (or donated, to buy political support) to local citizens, and local holders could trade the same bond offerings to foreigners for capital goods imports.
An alternative monetary reform, which would have the same effect, would be (2) for the developing nation to establish not a fixed exchange rate with the dollar/yen/euro âgold standardâ? but a âparallelâ? standard, declaring the dollar, yen, and euro as legal tender within the nation and permitting banking and financial services, and collecting taxes, in those hard currencies as well as in the legal tender of the sovereign.