## _wp14183

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---

### Global Financial Crisis and euro area sovereign crises
- Two defining moments: September 2008 and April 2010.
- September 2008: Lehman’s bankruptcy triggered threatened bankruptcies (AIG) and evaporation of market liquidity; systemically-important money market mutual funds were affected, starting with Reserve Primary Fund.
- Market panic produced desperate demand for liquidity and safe assets; policy lessons invoked:
  - Central bank should lend freely in a panic to preserve orderly financial market conditions.
  - Expansionary monetary policy stabilizes economic activity and employment when recession spirals threaten.
  - Expansionary fiscal policy complements monetary policy, especially when monetary policy hits operational constraints like the zero lower bound on nominal interest rates.
- International cooperation cited:
  - October 10, 2008: G-7 agreement to stabilize financial markets.
  - Mid-November 2008: first G-20 summit in Washington.
  - December 2008: European Economic Recovery Plan approved.
- April 2010–July 2012: euro area crisis featured financial fragmentation, sovereign credit risk for Greece, Ireland, Portugal, Spain, Cyprus; Italy’s debt markets were also affected.
- Key political and ECB actions:
  - European Council, June 2012: political commitment to deeper integration.
  - September 2012: ECB announced the Outright Monetary Transactions Program.
  - By September 2013 the prospect of euro area fragmentation was no longer driving international investors’ decisions.

### Policy and macro-financial linkages
- Sovereign risk and banking risk created “diabolical loop” dynamics (Brunnermeier et al., 2011).
- Financial divergence caused divergent macroeconomic developments across euro area countries.
- Macro-systemic feedback loops and cross-country contagion threatened euro area integrity and investor confidence.
- Key lesson: changing policy outcomes requires changing political rules and incentives; public finance and the financial system are embedded in political institutions.

### Focus and scope of the paper
- Narrow focus: late 1789 to early 1795 U.S. episode examining how public credit and financial stability were established under Alexander Hamilton.
- Central questions examined:
  - Why honor public credit rather than repudiate debt?
  - By what means can public credit be maintained and a smooth transition promoted?
  - How to restore financial stability in the face of financial panic?
- Emphasis: answers are fundamentally political; institutional design must align political incentives with macroeconomic stability and financial integration.
- Organization (as presented):
  - Section I: Why pay for public debt?
  - Section II: By what means can public credit be maintained?
  - Section III: How to restore stability in the face of financial panic?
  - Section IV: Lessons for the euro area and its member states.
  - Section V: References

### Hamilton’s core claim and historical confirmation
- Hamilton: public credit is fundamental for political stability and state capacity; recent research (Sargent and Velde (1995)) reaffirms this.
- French example: Louis XVI’s pledge to honor Crown debt; revolutionary government defaulted on two-thirds of government debt in 1797—almost ten years after 1789—illustrating how disorderly public finances can fuel political upheaval.
- U.S. example (Shays’ Rebellion, 1786–1787): indebted farmers, currency and credit scarcity, and harsh taxation contributed to insurrection; Hamilton attributed the insurrection largely to tax pressure and indebtedness.

### Strategic and governance arguments for public credit
- Hamilton’s wartime strategic argument: public credit confers advantage in prolonged international competition and war.
  - Quote preserved: “It is so immense a power in the affairs of war that a nation without credit would be in great danger of falling a victim in the first war with a power possessing a vigorous and flourishing credit.” — Alexander Hamilton, July 1795.
- Robert Morris (Superintendent of Finance, 1781–1784) actions:
  - Proposed a 5 percent federal tax on imports in 1782; 12 of 13 States approved but Rhode Island blocked it.
  - Obtained a loan of specie from France (mid-1781) to finance Yorktown (October 1781).
  - Proposed the Bank of North America (BNA), chartered end of 1781, instrumental in public finance in 1782–1783.
- Hamilton’s governance claim (The First Report on the Public Credit, 1790): public credit is “the true desideratum toward relief from individual and national embarrassments” and materially affects individual and aggregate prosperity and good government.
- Adam Smith connection: administration of justice, property security, and contract enforcement underpin commerce and the willingness of merchants and manufacturers to lend to government.

### Summary of Hamilton’s narrower economic and financial arguments
- Public credit:
  1. Ensures enduring access of the federal government to internal and international debt markets;
  2. Contributes to the international financing of the U.S. through the provision of a liquid (and safe) asset for international investors;
  3. Contributes to the development of domestic financial organizations and markets by providing the ultimate safe asset.

### Empirical evidence on costs and benefits of debt repudiation/restructuring
- Cruces and Trebesch (2013): database of 180 restructurings (1970–2010); episodes classified by duration of negotiations, debtor attitude, and magnitude of creditor loss.
- Main findings:
  - Duration of negotiations and debtor attitude strongly correlate with weak institutions and political instability.
  - Costs for the debtor economy are considerable, widespread, and correlate with the size of haircuts.
  - Costs measured by length of exclusion from international bond markets and financing effects on domestic banks, large nonfinancial corporations, bank-dependent SMEs, and households.
  - Long shadow of debt restructuring provides a strong reputational incentive to repay public debt.
- Trebesch (2011) chapter 3: delays in restructuring linked to weaker political institutions, higher political risk and instability, and debtor country economic/financial characteristics.
- Conclusion: strong case for protecting public credit given political, economic and financial ramifications.

### Government budget constraint, solvency, and political determinants
- Current value of debt equals compounded past primary plus compounded past debt; solvency requires current debt to equal present discounted value of future primary surpluses (Sargent and Wallace (1981); Sargent and Velde (1995); Sargent (2013)).
- Primary surpluses are politically determined (expenditures excluding interest minus revenues).
- Endogenous fiscal policy approaches (Bi and Leeper (2013)) derive sustainable debt limits from maximum tax capacity via an empirical Laffer curve, constrained by political frictions.
- Default modeled as a strategic decision (Eaton and Gersovitz (1981); Arellano (2008)) but such models do not fully explain cross-country vulnerability differences.

### Expectations, multiple equilibria, and financial stability
- Intertemporal budget constraint allows expectations to determine equilibrium; multiple self-fulfilling equilibria possible (Calvo (1988); Cole and Kehoe (2000); Basseto (2005); Roch and Uhlig (2012); Uhlig (2013)).
- Good equilibrium: creditors assume safety → low interest rates → government can generate required primary surpluses.
- Bad equilibrium: creditors expect unsustainability → high risk premia → financing costs preclude required surpluses → expectations validated.
- Banking-sector analogy: Diamond and Dibvig (1983) bank-run vs no-run equilibria justify lender-of-last-resort interventions.
- Fiscal reaction estimates (Goshi et al. (2011)) require sufficiently strong primary responses to debt for sustainability; such methods have limits under institutional change.

### Constitutional solution and Hamilton’s market-based strategy (1789–1795)
- 1780s: Federal Government effectively bankrupt; large war debts; power to tax resided with States under Articles of Confederation.
- Hamilton (Federalist 30) critiqued the Articles’ incompatibility with public credit.
- Constitutional reform outcome: U.S. Constitution strengthened federal taxation power (article 1, section 8, clause one).
- 1789–1790 federal finance magnitudes and constraints:
  - Total federal debt estimated at $54.1 million, of which $11.7 was foreign-owned (includes interest arrears).
  - Total state debt (including arrears) estimated at about $25 million.
  - Aggregate debt close to $80 million, about 40 percent of estimates of U.S. GDP for 1790.
  - Under contractual interest terms, annual interest payments would be almost $4.6 million.
  - Hamilton’s estimate of government operating expenditures: $0.6 million; first full fiscal year outturn: $0.829 million.
  - Interest payments on total debt near almost 85 percent of total expenditures.
  - Total federal tax revenues for fiscal year 1790: $1.640 million; debt service about 2.8 times the tax revenue available in 1790.
  - March 1790: Treasury lacked funds to meet current expenditures and interest on Dutch loans; authorization sought and granted for a new $100,000 loan.
  - Hamilton characterized the government as operating under a binding cash constraint in 1790.

### Funding Act of August 1790 and market conversions
- Funding Act converted domestic debt into new instruments:
  - 6 percent coupon bonds (the 6s);
  - 6 percent coupon bonds with interest deferred 10 years (the deferred);
  - 3 percent coupon bonds (3s).
- Conversion terms:
  - Principal: conversion at par into two-thirds 6s and one-third deferred.
  - Interest arrears: conversion at par into 3s.
  - New bonds paid interest quarterly.
- Market effects and uptake:
  - Interest payments reduced from about $4.6 million to $3.6 million.
  - By September 1791, $31.8 million of the new instruments had been subscribed.
  - By the end of 1794, 98 percent of domestic debt had been voluntarily converted into the new instruments.
  - Garber documents the market value of the offer was significantly below par, implying substantial reduction in the net present value of Treasury liabilities.

### Sinking Fund, lender-of-last-resort actions, and crisis tools
- Sinking Fund design:
  - Funded by Post Office net product; First Report estimate of current Post Office revenue: $100,000.
  - Net Post Office product up to “one million of dollars” to be vested in commissioners (Vice‑President or President of the Senate, Speaker of the House, Chief Justice, Secretary of the Treasury, Attorney‑General) to apply funds to discharge public debt by market purchases or principal payments.
  - Commissioners authorized, with presidential approbation, to borrow on their credit a sum “not exceeding twelve millions of dollars.”
  - Intended roles: anchor expectations about funded Treasuries, accelerate bond-price transition to “true standard,” provide market stabilization in disturbances (used in panics of 1791 and 1792).
- Hamilton as early lender of last resort (1792):
  - Monitored speculative excesses and market threats to public credit (letters, January 18, 1792; March 25, 1792).
  - External financing: Amsterdam loan of “three millions of florins at four per cent” provided cash buffer.
  - Tactical guidance (March 25, 1792): purchase of 6s at par up to $50,000 if 6s sank below par; covert or auction purchases as appropriate.
  - Reported near $1,000,000 in cash after paying current quarter’s interest and another $1,000,000 in bonds from duties of prior year.
  - Anticipated lender‑of‑last‑resort doctrine: advocated large liquidity supply ($1,000,000), acceptance of good collateral, and lending at penalty rates (7 percent referenced as penalty/usury ceiling).
  - Proposed collateral haircuts:
    - 6s accepted as collateral at par;
    - 3s accepted at 50 percent of nominal value;
    - Deferred accepted at 60 percent of nominal value.
  - Hamilton’s Sinking Fund purchases and acceptance of Treasuries as collateral helped position U.S. Treasuries as the ultimate safe asset and showed system resilience.

### Key technical facts and magnitudes (preserved)
- Debt and revenue magnitudes and ratios:
  - $54.1 million federal debt; $11.7 million foreign‑owned; $25 million state debt; roughly $80 million total debt; 40 percent of GDP estimate for 1790.
  - almost $4.6 million interest payments; $0.6 million Hamilton operating expenditures estimate; $0.829 million actual first full fiscal year expenditures; interest ≈ almost 85 percent of expenditures.
  - $1.640 million federal tax revenue in 1790; debt service ≈ 2.8 times tax revenue.
  - $31.8 million subscribed by September 1791; 98 percent voluntary conversion by end‑1794.
  - Post Office current revenue $100,000; net Post Office product vesting up to one million of dollars; authority to borrow not exceeding twelve millions of dollars.
  - External loan: three millions of florins at four per cent (Amsterdam).
  - Collateral haircuts: 6s at par; 3s at 50 percent; deferred at 60 percent.
  - Reference discount/valuation rates: 4 percent (Dutch loan), 5 percent (discount reference), 7 percent (penalty/usury ceiling reference).
  - Liquidity provision magnitude in crisis response: $1,000,000.

### Lessons and policy recommendations for the euro area and member states
- Integrate fiscal policy, finance, and politics: solutions must be viable across fiscal, financial, and political dimensions; systemic crises require systemic solutions.
- Prioritize public credit: strong case to pay public debt based on political legitimacy, public finance, macro‑financial stability, and institutional quality.
- Ensure fiscal sustainability through binding rules and national implementation: EU fiscal governance (Six Pack, Two Pack, Fiscal Compact) aims to internalize constraints into national frameworks; effective national responsibility is essential given the primacy of the national political dimension.
- Manage transitions actively and credibly: perceptions and expectations matter; quick, credible, market‑based measures (debt restructuring, credible funding sources, market operations) can prevent perverse equilibria.
- Build robust institutions and financial backstops: banking union, Single Supervisory and Single Resolution Mechanisms, and adequate financial backstops are priorities to break sovereign–bank feedback loops and ensure integration stability.
- Recognize distributional and political constraints: legacy assets, burden sharing, and unemployment create political obstacles requiring feasible solutions.
- Design contingency instruments and market‑stabilizing tools: instruments analogous to the Sinking Fund and explicit lender‑of‑last‑resort arrangements, combined with credible collateral policies, strengthen the safe‑asset role of sovereign liabilities and system resilience.

*Source: _wp14183*

### Introduction ...........................................................................................................

### Introduction

### Global Financial Crisis and euro area sovereign crises
- Two defining moments in the Crisis: September 2008 and April 2010.
- September 2008: Lehman’s bankruptcy triggered threatened bankruptcies (AIG) and evaporation of market liquidity; systemically-important money market mutual funds were affected, starting with Reserve Primary Fund.
- Financial panic led market participants to desperately seek access to liquidity and safe assets; financial market conditions threatened to spin out of control.
- Policy responses drew on lessons from the Great Depression and from the emerging discipline of Macroeconomics:
  - In a financial panic the central bank should lend freely to ease the panic and preserve orderly financial market conditions.
  - When a recession spiral threatens, expansionary monetary policy contributes to stabilize economic activity and employment.
  - Expansionary fiscal policy complements and supports monetary policy, especially when monetary policy hits operational constraints like the zero lower bound on nominal interest rates.
- International cooperation in late 2008 and 2009:
  - October 10, 2008: the G-7 agreed to work together to stabilize financial markets.
  - Mid-November 2008: first G-20 summit held in Washington.
  - December 2008: European Council approved the European Economic Recovery Plan.
- April 2010–July 2012: the euro area was at the center of the Global Crisis; from 2009 financial fragmentation replaced integration, credit risk considerations affected previously safe sovereign debt, and Greece, Ireland, Portugal, Spain and Cyprus required financial assistance; Italian debt markets were also rocked.
- Political commitment and ECB action:
  - European Council of June 2012: political commitment to deeper integration.
  - September 2012: ECB announced the Outright Monetary Transactions Program.
  - One year after September 2012 the prospect of euro area fragmentation was no longer driving international investors’ decisions.

### Policy and macro-financial linkages
- Sovereign risk and banking risk became strongly linked, producing “diabolical loop” dynamics (term origin: Brunnermeier et al., 2011).
- Financial divergence drove divergent macroeconomic developments across euro area countries.
- Macro-systemic feedback loops and cross-country contagion threatened the euro area’s integrity and investor confidence.
- Key policy lesson: changing policy outcomes systematically requires changing the rules and incentives of politics; public finance and the financial system are embedded in political institutions.

### Historical comparison: U.S. early financial politics and Hamilton’s reforms
- The U.S. Federal Government began 1789 bankrupt; by 1795 U.S. Bonds enjoyed safe asset status domestically and were well accepted by European investors.
- Alexander Hamilton (Secretary of the U.S. Treasury, 1789–1795) managed the transition from a bankrupt Federal Government to an issuer of safe assets and laid foundations for a modern financial system.
- Hamilton’s major writings and reports mentioned:
  - Letters in the early 1780s: two letters (1780 and April 1781) to William Morris and one (September 1780) to James Duane.
  - Reports: On Public Credit (1790, 1795); On the Establishment of a National Bank (1790); On the Establishment of a Mint (1791); On the Establishment of Manufactures (1791).
- Constitutional change was central: the Constitution of 1788 replaced the Articles of the Confederation (ratified in 1781), enabling institutional transformation necessary for credible public finance.
- Historical parallels: North and Weingast (1989) document how constitutional change after the English Glorious Revolution supported financial development and government bond markets; creation of the Bank of England in 1694 was part of that transformation.

### Focus and scope of the paper
- Inspired by Thomas Sargent’s Nobel Lecture (Sargent, 2013) and related literature (James, 2014; Kincaid, 2014; Sylla, 2014), the paper concentrates on a specific U.S. episode: late 1789 to early 1795, examining in detail how public credit and financial stability were established.
- The paper’s narrow focus allows detailed examination of the political and institutional mechanisms Hamilton used to build credibility and the financial system.
- The paper centers on answers to three core questions Hamilton posed:
  - Why is it important to honor public credit? Why not repudiate debt?
  - By what means can public credit be maintained? How to ensure public credit? How to promote a smooth and quick transition?
  - How to restore financial stability in the face of financial panic?
- Emphasis: the answers are fundamentally political; institutions shape incentives and feasible outcomes. For Europe, the crucial question is how to design institutions to align political incentives with macroeconomic stability and financial integration.

### Organization of the paper (as presented)
- Section I: Why pay for public debt?
- Section II: By what means can public credit be maintained? (includes A. The U.S. Constitution; B. U.S. Federal Budget and Treasury Finance)
- Section III: How to restore stability in the face of financial panic?
- Section IV: Lessons for the euro area and its member states.
- Section V: References

*Source: _wp14183 - Introduction*

### 1789. Hamilton’s assessment is confirmed by recent research. Sargent and Velde (1995)

### _wp14183 - 1789. Hamilton’s assessment is confirmed by recent research. Sargent and Velde (1995)

### Hamilton’s core claim and historical confirmation
- Hamilton’s view that public credit is fundamental for political stability and state capacity is reaffirmed by recent research (Sargent and Velde (1995)).
- Historical narrative:
  - Louis XVI acceded to the throne in 1774 and pledged to honor the Crown’s debt.
  - Debt accumulated largely from unsuccessful warfare; peacetime expenditures in 18th century France were dominated by interest payments.
  - The Estates General was convened to accelerate public finance transformation and became a focal point for political discontent; the French Revolution took place in 1789.
  - The revolutionary government initially continued to honor public debt amid turmoil; the government defaulted on two-thirds of the government debt only in 1797, almost ten years later.
- Political implication: disorderly public finances and public debt management provided fertile ground for disruptive political events; public credit underpins political stability.

### Domestic political instability: Shays’ Rebellion and U.S. experience
- Hamilton’s examples from American history:
  - Shays’ Rebellion occurred in 1786 and 1787 in post-War of Independence contraction; indebted farmers faced currency scarcity, credit scarcity, and harsh tax measures aimed at ensuring state solvency.
  - Hamilton in The Federalist and later in Defense attributed the insurrection largely to tax pressure and indebtedness:
    - “if Shays had not been a desperate debtor, it is much to be doubted whether Massachusetts would have plunged into civil war.”
    - “In Massachusetts taxation was carried still further, even to a degree too burdensome for the comfortable condition of the citizens. ... The insurrection was in a great degree the offspring of this pressure.” — Alexander Hamilton, July 1795.
- Lesson: taxation and debt management can push political systems to breaking points; stability in public credit reconciles political stability with financial development.

### Strategic advantage in international competition
- Hamilton’s strategic argument: public credit confers advantage in prolonged international competition and war.
  - “It is so immense a power in the affairs of war that a nation without credit would be in great danger of falling a victim in the first war with a power possessing a vigorous and flourishing credit.” — Alexander Hamilton, July 1795.
- Supporting modern research: Schulz and Weingast (2003) emphasize financial power in prolonged competition, illustrating France–England competition from 1689 to 1815; public credit became decisive for the sinews of power in the modern age.
- Hamilton’s wartime urgency:
  - “It is by introducing order in our finances–by restoring public credit–not by winning battles that we are finally to gain our object. It is by putting ourselves in a condition to continue the war—not by temporary, violent and unnatural efforts to bring it to a decisive issue, that we shall, in reality, bring it to a speedy and successful one.” — Alexander Hamilton, Letter to Robert Morris, April 1781.

### Role of finance and institutions in the War of Independence
- Robert Morris as Superintendent of Finance (1781 to 1784):
  - Congress’ finances were dismal; Continental dollars were over-issued and became worthless; in 1780 Congress stopped issuing Continental dollars.
  - Congress lacked direct taxation power under the Articles of Confederation; national taxation required unanimous agreement of all States.
  - In 1782 Morris proposed a 5 percent federal tax on imports; at year-end 12 of the 13 States approved the measure but Rhode Island blocked it.
- Morris’s actions and institution-building:
  - Morris obtained a timely loan of specie from France (mid-1781) to finance the Yorktown campaign; Yorktown (October 1781) was the decisive turning point.
  - In May 1781 Morris proposed the Bank of North America (BNA), chartered at the end of 1781; BNA was the first modern bank in the U.S. and instrumental in obtaining public finance in 1782 and 1783.
  - Morris also financed government through his own notes; distinction between private and public interests was blurred, but his actions were crucial to sustaining the American army.

### Public credit as indicator of governance and implications for development
- Hamilton’s governance argument (The First Report on the Public Credit, 1790):
  - Public credit established on a satisfactory provision for the public debt is “the true desideratum toward relief from individual and national embarrassments.”
  - Failure to uphold public credit augments the long-run expenses of a nation and harms the whole system of the social economy.
  - “From [due observance of the maxims that uphold public credit] materially depend[s] ... the individual and aggregate prosperity of the citizens of the United States; their relief from the embarrassments they now experience; their character as a people; the cause of good government.” — Alexander Hamilton, The First Report on the Public Credit, 1790.
- Adam Smith’s related argument (Wealth of Nations, 1776):
  - Commerce and manufactures flourish where administration of justice, property security, and enforcement of contracts exist; confidence in government induces both ordinary trust in property protection and extraordinary trust to lend to government.
  - Full quotation preserved in source emphasizing the link between rule of law, confidence in government, and willingness of merchants and manufacturers to lend and invest.

### Summary of Hamilton’s narrower economic and financial arguments
- Public credit:
  1. Ensures enduring access of the federal government to internal and international debt markets;
  2. Contributes to the international financing of the U.S. through the provision of a liquid (and safe) asset for international investors;
  3. Contributes to the development of domestic financial organizations and markets by providing the ultimate safe asset.

*Italic source: _wp14183 - 1789. Hamilton’s assessment is confirmed by recent research. Sargent and Velde (1995), source PDF: _wp14183 - 1789. Hamilton’s assessment is confirmed by recent research. Sargent and Velde (1995).*

### 4. Benefits agricultural, industrial and commercial development since it

### 4. Benefits agricultural, industrial and commercial development since it

### Empirical evidence on the costs and benefits of debt repudiation and restructuring
- Cruces and Trebesch (2013) use a database with 180 debt restructurings from 1970 to 2010.
- They classify restructuring episodes along three dimensions:
  - duration of negotiations with creditors;
  - attitude of the debtor nation towards creditors;
  - magnitude of the loss suffered by the creditors.
- Main findings documented:
  - The duration of negotiations and the attitude towards creditors is strongly correlated to weakness of institutions and political instability.
  - Costs for the debtor economy are considerable, widespread, and correlate with the size of the haircuts imposed on creditors.
  - Costs are measured in terms of the length of the exclusion of the Treasury from international bond markets.
  - Costs are also calculated for financing of domestic banks; domestic large nonfinancial corporations; and bank-dependent small and medium-sized enterprises and households.
  - The long shadow of debt restructuring provides a strong incentive to repay public debt—a reputational mechanism supporting repayment.

- Trebesch (2011) (Ph.D. dissertation) chapter 3:
  - Finds delays in debt restructuring are linked to debtor country characteristics.
  - Delays are greater the weaker political institutions and the greater political risk and instability.
  - Results also show correlation with economic and financial characteristics of the debtor country.
  - Challenges literature that attributes main obstacles to creditor coordination.

- Trebesch and co-authors (e.g., Trebesch, 2011 and Cruces and Trebesch, 2013) document broader costs from debt restructuring than earlier literature.
  - Earlier literature (see Panizza et al., 2009 for a survey) finds little or no evidence for reputational costs; Trebesch attributes this to disregarding crucial characteristics of restructuring processes.
  - Link between restructuring-process characteristics, politics and political institutions highlights the politics of public credit in the tradition of Adam Smith and Alexander Hamilton.

- Conclusion drawn:
  - Strong case for protecting public credit based on broad political, economic and financial ramifications.
  - Failure to protect public credit undermines access of the national economy to international financing and hampers access to finance by resident households and private corporations—financial and nonfinancial.

### The government budget constraint, solvency, and political determinants
- The conditions for maintenance of public credit follow from the arithmetic of the government budget constraint.
- Central references: Sargent and Wallace (1981), Sargent and Velde (1995) and Sargent (2013).
- Key insights:
  - From the government’s budget constraint the current value of the debt stock equals the compounded value of past primary plus the compounded value of the debt stock at some given past period.
  - To guarantee solvency, the current value of the stock of debt must equal the present discounted value of future primary surpluses.
  - Sargent (2013) emphasizes the present discounted value of future primary surpluses valuation equation for public debt: the ultimate fundamental value of public debt is determined by the revenue flows allocated to its service and repayment.

- Political economy of primary surpluses:
  - Primary surpluses = government’s expenditures in current and capital goods and services—excluding interest payments—minus government’s revenues—from taxation and other sources.
  - Determination of expenditures and revenues is the outcome of a political process.

- Endogenous fiscal policy approaches:
  - Bi and Leeper (2013) approach limits to sustainable debt as deriving from maximum tax capacity—as obtained from an empirical Laffer curve—constrained by additional frictions from the political process.
  - Advantage: natural framework to analyze institutional change.

- Default as strategic decision models:
  - Eaton and Gersovitz (1981) and Arellano (2008) model default decisions as strategic choices by an optimizing government under stochastic shocks.
  - Such models, in conjunction with real business cycle models, can mimic stylized facts of business cycles in developing countries but do not fully explain cross-country differences in vulnerability.

### Expectations, multiple equilibria, and financial stability
- Intertemporal nature of the government’s budget constraint allows expectations to play a key role and opens the possibility of multiple self-fulfilling equilibria.
- Relevant contributions: Calvo (1988), Cole and Kehoe (2000), Basseto (2005), Roch and Uhlig (2012), and Uhlig (2013).
- Intuition for multiple equilibria:
  - If creditors assume public debt is safe → Treasury rolls over debt at low interest rates → government can generate required primary surpluses (good equilibrium).
  - If investors believe debt is not sustainable → they demand a high credit risk premium → elevated financing costs prevent government from generating required surpluses → investors’ expectations are validated (bad equilibrium).

- Banking-sector analogy:
  - Diamond and Dibvig (1983): closed-economy bank model without lender of last resort exhibits at least two equilibria—bank run (bad) and no run (good); lender of last resort justified to avoid bad equilibrium.

- Fiscal reaction functions and sustainability:
  - Goshi et al. (2011) follow Bohn (1998) estimating fiscal policy reaction functions where the primary responds to the debt level; response must be strong enough for debt sustainability.
  - Such approaches are inappropriate to predict outcomes under political and institutional change.

### Historical perspective: Alexander Hamilton and the U.S. constitutional solution
- In the 1780s the Federal Government was effectively bankrupt: large debts from the War of Independence and power to tax rested with separate States.
- Paper currency issued to finance the war was dramatically debased; bonds traded at deep discounts for both Congress and States’ debt.
- Under the Articles of Confederation no viable solution existed because revenues were to be collected under the “authority and direction” of the states.

- Alexander Hamilton (Federalist 30) critique:
  - Quoted passage emphasizes incompatibility of the Articles of Confederation with foundations of public credit and problems arising from dependence on states to furnish required sums.

- Article VIII of the Articles of Confederation (quoted):
  - “All charges of war, and all other expenses that shall be incurred for the common defense or general welfare, and allowed by the united states in congress assembled, shall be defrayed out of a common treasury, which shall be supplied by the several states in proportion to the value of all land within each state.... The taxes for paying that proportion shall be laid and levied by the authority and the direction of the legislatures of the several states within the time agreed upon by the united states in congress assembled.”

- Constitutional reform outcome:
  - A Constitutional solution was called for because practical collection of revenues by states proved impossible under the Articles.
  - The U.S. Constitution strengthened the ability of the federal government to tax (article 1, section 8, clause one: the power to impose and to collect taxes and duties).

*Source: _wp14183 - 4. Benefits agricultural, industrial and commercial development since it*

### 2. Gave the central government exclusive competence to regulate external trade

### _wp14183 - 2. Gave the central government exclusive competence to regulate external trade

### Hamilton’s constitutional rationale and the commerce competence
- Hamilton argued that “All imposts upon commerce ought to be laid by Congress, and appropriated to their use,” linking control over external trade to durable federal revenues and solvency.
- Hamilton advocated “complete sovereignty” for Congress in matters “that relates to war, peace, trade, finance; and to the management of foreign affairs,” explicitly including “laying prohibitions on all the articles of export or import; imposing duties; granting bounties and premiums” (Letter to James Duane, September 1780).
- The commerce clause (article 1, section 8, clause three) gave the U.S. Federal Government the institutional means to ensure solvency and to create future revenue sources.

### U.S. federal budget and Treasury finance in 1789–1790: magnitudes and constraints
- Total federal debt estimated at $54.1 million, of which $11.7 was foreign-owned (includes interest arrears).
- Total state debt (including arrears) estimated at about $25 million.
- Aggregate debt close to $80 million, about 40 percent of estimates of U.S. GDP for 1790.
- Under contractual interest terms, annual interest payments would be almost $4.6 million.
- Hamilton’s estimate of government operating expenditures: $0.6 million; first full fiscal year outturn: $0.829 million.
- Interest payments on total debt near almost 85 percent of total expenditures.
- Total federal tax revenues for fiscal year 1790: $1.640 million; debt service about 2.8 times the tax revenue available in 1790.
- March 1790: Treasury lacked funds to meet current expenditures and interest on Dutch loans; authorization sought and granted for a new $100,000 loan.
- Hamilton characterized the government as operating under a binding cash constraint in 1790.

### Hamilton’s market-based debt strategy and Funding Act measures
- Hamilton sought voluntary, market-based modification of creditors’ claims to restore public credit and reduce interest burden while avoiding coercive legal changes.
- Funding Act of August 1790 converted domestic debt into new instruments:
  - 6 percent coupon bonds (the 6s);
  - 6 percent coupon bonds with interest deferred 10 years (the deferred);
  - 3 percent coupon bonds (3s).
- Conversion terms:
  - Principal: conversion at par into two-thirds 6s and one-third deferred.
  - Interest arrears: conversion at par into 3s.
  - New bonds paid interest quarterly.
- Market effects and take-up:
  - Interest payments reduced from about $4.6 million to $3.6 million.
  - By September 1791, $31.8 million of the new instruments had been subscribed.
  - By the end of 1794, 98 percent of domestic debt had been voluntarily converted into the new instruments.
  - Garber documents the market value of the offer was significantly below par, implying a substantial reduction in the net present value of Treasury liabilities.

### The Sinking Fund: design, objectives, and powers
- Sinking Fund funded by Post Office net product; First Report estimate of current Post Office revenue: $100,000.
- Proposed vesting of net Post Office product up to “one million of dollars” in commissioners (Vice‑President or President of the Senate, Speaker of the House, Chief Justice, Secretary of the Treasury, Attorney‑General) to apply funds to discharge public debt by market purchases or principal payments.
- Commissioners authorized, with presidential approbation, to borrow on their credit a sum “not exceeding twelve millions of dollars.”
- Intended roles of the Sinking Fund:
  - Anchor expectations on appropriately funded Treasuries.
  - Accelerate transition of bond prices to their “true standard.”
  - Provide an instrument for bond-market stabilization in disturbances (explicitly used during panics of 1791 and 1792).

### Hamilton as lender of last resort and the financial panic of 1792
- Hamilton monitored speculative excesses and perceived threat to public credit (letters to William Seton, January 18, 1792 and March 25, 1792).
- External financing: Amsterdam loan of “three millions of florins at four per cent” provided a sizeable cash buffer.
- Tactical market intervention guidance (March 25, 1792):
  - Purchase of 6s at par up to $50,000 if 6s sank below par (purchases to be covert or by auction as appropriate).
  - Hamilton reported near $1,000,000 in cash after paying the current quarter’s interest and another $1,000,000 in bonds from duties of the prior year.
- Anticipation of classical lender‑of‑last‑resort doctrine:
  - Hamilton advocated large liquidity supply ($1,000,000), acceptance of good collateral, and lending at penalty rates — specifically mentioning 7 percent as a reference rate.
  - Eligible collateral and haircuts Hamilton proposed:
    - 6s accepted as collateral at par;
    - 3s accepted at 50 percent of nominal value;
    - Deferred accepted at 60 percent of nominal value.
- Hamilton’s interventions (Sinking Fund purchases and explicit acceptance of Treasuries as collateral) helped position U.S. Treasuries as the ultimate safe asset and demonstrated the new system’s resilience.

### Key technical points and numerical facts preserved from the record
- Debt and revenue magnitudes: $54.1 million federal debt; $11.7 million foreign‑owned; $25 million state debt; roughly $80 million total debt; 40 percent of GDP estimate for 1790.
- Fiscal flows and ratios: almost $4.6 million interest payments; $0.6 million Hamilton’s operating expenditures estimate; $0.829 million actual first full fiscal year expenditures; interest ≈ almost 85 percent of expenditures.
- Revenues and conversion uptake: $1.640 million federal tax revenue in 1790; debt service ≈ 2.8 times tax revenue; $31.8 million subscribed by September 1791; 98 percent voluntary conversion by end‑1794.
- Sinking Fund and borrowing authorities: Post Office current revenue $100,000; net Post Office product up to one million of dollars to be vested; authority to borrow not exceeding twelve millions of dollars.
- External loan cited: three millions of florins at four per cent (Amsterdam).
- Collateral haircuts: 6s at par; 3s at 50 percent; deferred at 60 percent.
- Discount/valuation reference rates mentioned: 4 percent (Dutch loan), 5 percent (discount reference), 7 percent (penalty/usury ceiling reference).
- Liquidity provision magnitude in crisis response: $1,000,000.

### Lessons and policy recommendations for the euro area and member states
- Integrate fiscal policy, finance, and politics: policy solutions must be viable simultaneously in fiscal, financial, and political dimensions; systemic crises require systemic solutions.
- Prioritize public credit: strong case to pay public debt based on political legitimacy, public finance, macro-financial stability, and institutional quality.
- Ensure fiscal sustainability through binding rules and national implementation: EU fiscal governance (Six Pack, Two Pack, Fiscal Compact) aims to internalize constraints into national frameworks; effective national responsibility is essential given the primacy of the national political dimension.
- Manage transitions actively and skillfully: perceptions and expectations matter; quick, credible, market‑based measures (debt restructuring, credible funding sources, market operations) can prevent perverse equilibria.
- Build robust, resilient institutions and financial backstops: banking union, Single Supervisory and Single Resolution Mechanisms, and adequate financial backstops are priorities to break sovereign–bank feedback loops and ensure integration stability.
- Recognize distributional and political constraints: distributional conflicts (legacy assets, burden sharing, unemployment) are central political obstacles and require politically feasible solutions.
- Design contingency instruments and market‑stabilizing tools: instruments analogous to the Sinking Fund and explicit lender‑of‑last‑resort arrangements, combined with credible collateral policies, strengthen the safe‑asset role of sovereign liabilities and the system’s resilience.

*Source: _wp14183 - 2. Gave the central government exclusive competence to regulate external trade*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14183.pdf_