US Government Debt Different - Finance Department - University of ...

8 U.S. Government Debt Has Always Been Different!For the first century and a half of U.S. history, from the 1780s to the1930s, the prevailing sentiment was that national debt ought to bepaid down whenever possible. The debt rose mostly in times of war,and was paid down in times of peace. The driving force, however,was less the sentiment that debts should be paid and more the rapidgrowth of the U.S. economy which swelled federal revenues, makingdebt reduction possible. Debt reduction probably added to capitalformation, making the country grow even faster than it would havewithout paying down the national debt. In real terms, more waspaid back at low prices in times of peace than was borrowed whenprices were high in times of war. But debt reduction may itself haveadded to financial instabilities by creating credit booms and busts.4. U.S. Debt as Backing for U.S. currencyThe U.S. national debt served as backing for a large part of U.S. currencyfrom the 1860s to the 1930s. Civil War legislation in 1863 and1864 created the National Banking System and related legislation in1865 taxed currency issued by state banks out of existence. The U.S.finally had a national currency issued either by the Treasury in theform of U.S. notes (greenbacks) or by national banks in the form ofnational bank notes. Both were liabilities of the federal government.National bank notes were printed by the government, but stampedwith the names of national banks that to issue notes had to buy governmentbonds and deposit them with a federal office, the Comptrollerof the Currency, as collateral backing the notes. Then, if abank failed, the holders of its notes would suffer no loss because thecollateral would be liquidated and the proceeds would be used to payoff the note holders.In principle, this was a good system for making the paper currency ofthe country safer than it had been when it was issued by thousandsof independent banks before 1863. In fact, it was copied (althoughsoon abandoned) by other countries such as Japan and Argentina.In the U.S., however, the policy of backing national bank notes withgovernment bonds clashed with the policy of redeeming the nationaldebt, which reduced the amount of collateral available for banks to