Maintenance
of a national debt by the U.S. government began in earnest after the Civil War. This was in the mistaken belief that the
currency had to be backed with government debt, and that if the government paid
down its debt, there would be no money.
Reliance on government debt, however, ensured that the people who most
needed access to credit were denied that access.
It happened like this. The disparity between small and large investment from 1862 when the Homestead Act was passed, and 1913 when the Federal Reserve was established caused two major financial panics and depressions, 1873-1878, and 1893-1898. The small farmer and businessman was restricted to a depleted base of existing savings and a deflated Greenback currency to finance development, while the large industrial and commercial interests, particularly the railroads, could create money at will by offering bills of exchange to one another or at the state and National banks, that also served as commercial banks. This caused consumption power to lag behind productive capacity, triggering the panics and depressions.
By 1913, the government-issued money supply accounted for approximately 20-25% of GDP, according to Harold Moulton, up from less than 1% during the 1830s. Many people thought this was a dangerously high level of debt. (Cf. Henry C. Adams, Public Debts: An Essay in the Science of Finance, 1898.) The Federal Reserve was, in part, established to get rid of all government debt-backed currency (the National Bank Notes of 1863-1913 and the Treasury Notes of 1890), and replace them, ultimately, with private sector asset-backed Federal Reserve Notes, thereby making the government debt-free again. Moulton noted that the federal government could have been debt-free several times during the latter half of the 19th century, but maintained an outstanding debt in the mistaken belief it was needed to back the currency.
The decision to finance World War I using debt rather than taxes (Chase made the same mistake during the Civil War) caused the Federal Reserve to be “hijacked” through a loophole from its primary mission to establish a stable, uniform, elastic, asset-backed currency, and back the currency with government debt. This was being repaid during the 1920s, but then came the Great Depression. Instead of listening to people like Moulton, who insisted that government spending was not the answer (nor was it), FDR listened to Keynes, devalued the currency, expanded government power, and ran up the debt.