The specter haunting Washington (and the United States) these days is not communism — at least, not outright abolition of private property, as Karl Marx summed up the theory of the communists in his Communist Manifesto. Rather, the politicians are worrying about whether the deteriorating situation over the spending of our children's future faster than it can be produced will have a detrimental effect on the credit rating of the United States. As reported in "It's Not the Default, It's the Downgrade," Carrie Budoff Brown and Ben White of Politico on the Yahoo! News Service give one view of the looming disaster. The analysis increases the fright factor by stating that the faith and credit of the United States have never been questioned, and never downgraded.
That's not exactly true. During and following the Revolution, for example, the credit of the new country couldn't have been lower. You've heard the old joke about somebody whose credit was so bad even his money wasn't accepted? It wasn't a joke. You actually had debtors chasing creditors down the street trying to pay off their debts with the badly inflated Continental Currency instead of hard money or negotiable instruments backed with the present value of existing or future marketable goods and services.
During "Hard Times" of the late 1830s, after Andrew Jackson issued the Specie Circular (and left it for Martin van Buren to enforce) that forbade the federal government from accepting payment for land (the chief source of revenue) and duties and taxes in any form other than gold or silver coin, nobody wanted U.S. government bonds. Why accept government paper when the government wouldn't accept yours?
What about following the Civil War? Treasury Secretary Salmon P. Chase had financed the Union war effort using debt-backed greenbacks. As a result, gold, silver, even copper money disappeared from circulation and commanded a substantial premium over the inflated paper. By 1863 Chase found he could no longer issue substantial amounts of debt and was forced to use direct taxation rather than the indirect tax of inflation. Following the war, the government's credit was so low that Andrew Johnson instituted an official policy of deflation to try and restore parity of the paper money (and U.S. government debt) with gold.
The policy was officially a failure and abandoned in 1868. Unofficially the policy continued through two financial panics (1873 and 1893) and the ensuing depressions. Restoring parity of gold, silver and paper drained the country of circulating media in the form of coin and currency for consumers at the same time that credit was easily available in the form of bills of exchange for the corporations to finance new capital formation. This decreased consumer power at critical times and made the new capital being formed at an incredible rate less financially feasible. This inspired the demand for increased federal debt and "free silver" to inflate the currency, raise prices, and erode the faith and credit of the United States. Government bureaucrats, many of whom had served in the war, remembered the inflation and the harm it had done. Consequently, nothing was done until the Panic of 1907 revealed to even the most intransigent that there were serious flaws in the financial system.
The problem was that supply and demand were out of sync. Money creation for new capital formation on a large scale — "supply" — was readily available by drawing and discounting and rediscounting private sector bills of exchange. Money for ordinary consumer demand (which drives the economy), however, was not only not being created, it was disappearing as a result of the unofficial policy of deflation. With the inelastic National Bank Note, United States Note and Treasury Note currencies with the amount fixed by law, supplemented by inadequate gold and silver coin, there wasn't enough money in circulation to sustain demand and, worse, it was not tied in any way to supply. Bureaucrats made decisions as to how much currency they thought should be in circulation to maintain the full faith and credit of the United States and, at the same time, provide sufficient effective demand to ensure the financial feasibility of new and existing capital investment. As you might expect, that worked about as well as every other means of centrally controlling a market.
In response to the Panic of 1907 and the demand for reform the Federal Reserve System was established in conjunction with the Internal Revenue Service. Seen as a Populist triumph — Secretary of State William Jennings Bryan and Representative Carter Glass of Virginia congratulated each other on the difficult feat they had accomplished — the Federal Reserve was viewed (in the words of one financial historian) as combining "Jacksonian hopes" with "financial responsibility." A balance had finally been achieved between a circulating currency for consumption, and financing for new capital formation by discounting and rediscounting bills of exchange. The solution? Use private sector bills of exchange to back the currency, thereby tying effective demand directly to productive capacity instead of relying on bureaucratic guessing games, phase out all debt-backed National Bank Notes and Treasury Notes, replace them with asset-backed Federal Reserve Notes, and limit the government to borrowing out of existing accumulations of savings instead of emitting bills of credit.
Rather than back the currency with a fixed amount of government debt on deposit in the individual National Banks and raise funds for government by emitting bills of credit backed by future tax collections, the country now had the possibility of backing not just the private sector money supply (around 80% of the total money supply at that time), but the official government currency with private sector bills of exchange drawn on hard assets representing the present value of existing and future marketable goods and services — not future tax collections that might or might not materialize. This had the potential to balance supply and demand (restoring Say's Law of Markets), provide the country with a non-inflationary yet "elastic" currency sufficient to meet the needs of agriculture, commerce and industry, rebuild the tax base, and replace the possibly unconstitutional bills of credit as well as property taxes as the main source of government revenue, with a direct tax on income.
As a side note, it is important to realize that an income tax was never unconstitutional. The Congress has always had the power to levy taxes in any form. The question was whether an income tax is a direct tax, or an indirect tax on persons. If indirect, then an income tax could be levied without regard to apportionment. If direct, however, the tax must, under the Constitution, be apportioned among the states on the basis of population. A state with few people, most of whom were rich, would pay far less in taxes than a state with a large number of people, most of whom were poor. That would, obviously, not be fair. The 16th Amendment did not make the income tax constitutional — it had always been that — but (if you read it carefully) made a direct tax constitutional without apportionment to accommodate the decision by the U.S. Supreme Court in the Pollack case in 1895.
Unfortunately for the new system, the United States entered the First World War — and made the same mistake that had been made in the Civil War. Politicians decided to finance the war using debt instead of taxes, and figured out a way to circumvent the intent of the Federal Reserve Act of 1913 to prevent the government from using the system to finance its deficits. Rediscounting of private sector bills of exchange decreased in favor of government bills of credit purchased on the "open market," and to all intents and purposes ceased entirely by the mid-1930s.
Keynesian economic policies dictated that the currency be backed exclusively by government debt instead of private sector assets. The only effective change from the old National Bank system was to change the debt-backed currency from a carefully regulated fixed amount, to an elastic, debt-backed currency that responded to the government's increasing demands for cash provided in a way that rendered the government unaccountable to the citizens through the tax system. In consequence, the effective systemic check on money creation provided by only using private sector bills of exchange representing the present value of existing and future marketable goods and services to back the currency was removed. In its place was government debt backed by a bureaucratic guess as to how much could be borrowed before creditors finally got fed up and started demanding repayment, causing a default or a lowering of the national credit rating.
This, then, is the problem we face today. The amount of currency that can be created backed by the present value of existing and future marketable goods and services is strictly limited by the properly vetted present value of those marketable goods and services. The amount of currency that can be created backed by a politician's optimism or desperation is, effectively, limited only by what he or she can get away with, and has no discernible link to the ability of the private sector to produce enough marketable goods and services to tax to make good on the promises the government has made with a lavish hand.
The only feasible way for the United States to restore its full faith and credit — again — and (at the same time) provide the country with sufficient liquidity for the needs of agriculture, industry and commerce, is to implement the reforms detailed in Capital Homesteading at the earliest possible date.