Appendix I: The Debt Assumption Issue

This question of whether or not the federal government should take over (assume) each individual state’s war debts was complex but crucial. The very intricacy of the debt funding and assumption issues became part of the issues, with opponents claiming that Alexander Hamilton’s policies were imitations of England’s overcomplicated fiscal system.

However, Hamilton’s proposal regarding the funding of the national debt, approved by congress in 1790, was less expensive as well as less complicated than James Madison’s rejected scheme of discriminating between original and subsequent holders of the debt certificates in the case of domestic creditors. This was because Hamilton was content to have the debt funded at 4% rather than at the 6% rate originally contracted. He justified this lowering of the interest rate that the government would be paying to its creditors by arguing that market interest rates for any future government borrowing were bound to fall during the life of current debt, in fact very soon, because the government’s credit rating would rise, and the supply of loan capital available in the United States would increase. In other words, Hamilton boldly but wisely built into his project the assumption that it would succeed.

Hamilton’s reason for wanting to lower the cost of funding the national debt in this way was to make it more feasible for the United States to assume responsibility also for the debts that the individual states had incurred during the Revolution. One of Madison’s reasons for proposing his more expensive funding scheme was probably that it would have ruled out this federal assumption of the states’ debts, which the majority of Virginians opposed.

Hamilton was keen for the state debts to become federal debts because he did not want the state governments to compete with the federal government either for creditors’ attention and dependence or for sources of revenue required to service government debts. Federalizing the states’ debts was also a way of honoring the Revolutionary commitment to treat the war as a responsibility of the whole country, not of the individual states. However, the question was complicated by the different situations of various states: some had spent more than others and were now desperate for the federal government to take over, some had now repaid much, some simply had less complete records than others. Virginia politicians in particular felt that a thorough and final reckoning of this complex of credits and debits should precede any assumption of the states’ debts, otherwise states like Virginia, which had already repaid much of its war debt, risked being out of pocket, because the federal government, with tax revenues from Virginians as well as from residents of other states, would pay out money to some states now that it might not be able to get refunded by those states if the final reckoning later showed that refunds were owed.

When the issue was first discussed by the House of Representatives (in the spring of 1790), the opponents of assumption, among them the Virginian James Madison, narrowly won, removing the assumption proposal from the funding legislation by a vote of 31 to 29. However, that was not the end of the matter. Madison himself began to have doubts about the wisdom of letting this decision stand when he witnessed the extreme reactions by the losing side in this vote; his opponents began to predict that if the debts of the states were not assumed, the union would not hold together. Madison soon began to fear that he had underestimated the desperation of the advocates of assumption, so he was ready for the “compromise of 1790.”

Although this “compromise” was later condemned by Jefferson and other Republicans as a bad bargain because of its political effect of entrenching Hamilton’s “corrupting” fiscal system, in the financial terms that were used in the debate in 1790 it was actually less a compromise than a victory for Madison and the south. The agreements that constituted the “compromise” reversed the decision not to assume the states’ debts, but in turn not only gave Virginia and other southern states the promise that the capital city would be located on the Potomac, but also gave Virginia a guarantee that assumption would be managed in such a way that that state would not be out of pocket in the way Madison and other Virginians had feared it would be. Without such management of the numbers, Madison had estimated that Virginia would probably lose to the tune of $2 million.)