America's Fiscal Constitution (19 page)

P
APER
M
ONEY AND
T
AXES
, 1861–1862

Salmon Chase, whom Lincoln had asked to serve as Secretary of the Treasury, inherited from Cobb a federal budget in shambles. For the fiscal year ending on June 30, 1861, the United States borrowed $25 million to finance $66 million in spending.
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President Lincoln asked Congress to authorize a budget that would “make this contest a short and decisive one.” Secretary Chase requested a budget of $320 million in the next fiscal year.
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Chase asked Congress to raise taxes to pay for a quarter of that amount and authorize debt to pay for the rest. The entire US money supply at the beginning of the war consisted of $414 million in gold coin and circulating bank notes.
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Secretary Chase hoped that a show of Union resolve would lead to prompt reunification. General George McClellan assembled a large army in the hopes of forcing the Confederate capital, Richmond, to surrender.

In July 1861 Congress authorized $250 million in debt, imposed new taxes on domestic sales, and increased some import taxes.
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As Senator
Stephen A. Douglas had predicted, these import revenues could not cover much of the war’s cost. Congressman Justin Morrill concluded that the nation needed a new tax on incomes to help finance the war effort. Congressman Thaddeus Stevens of Pennsylvania rammed Morrill’s income tax bill through the House, while Senators John Sherman and William Fessenden guided it through the Senate. Since Chase’s Treasury Department lacked the organizational capacity required to collect federal taxes on incomes, collection was delayed until the summer of 1862.

By December 1861 Chase had raised the projected cost of the war’s first year to $543 million and lowered projections of tax revenues from $80 million to $35 million.
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Chase met in New York with the nation’s leading bankers, who agreed to make three consecutive $50 million loans in late 1861.
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Chase insisted that banks loan the full amount in gold, not bank notes, a request tantamount to transferring to the Treasury all gold then held as bank reserves. James Gallatin, son of former treasury secretary Albert Gallatin and spokesman for the New York bankers, respectfully declined Chase’s request. Chase questioned the patriotism of those bankers, who felt that a loss of all gold reserves would cripple their ability to finance needed international trade. Their disagreement paralleled the dispute between Albert Gallatin and the Van Buren administration more than two decades earlier, when Van Buren weakened commercial banking by building the Treasury’s gold reserves. Those episodes offer a lesson with contemporary relevance: large federal borrowing can reduce funds needed for commercial activity unless accompanied by an overall expansion of credit.

By the end of 1861, commercial banks and the Treasury had to suspend payments in gold. Chase’s Jacksonian fealty to the ideal of a gold standard yielded to the extraordinary reality of wartime finances. The federal government had not even been able to borrow the full $250 million Congress had authorized; the US Treasury ran out of money. Senator Sherman summarized the dilemma: “At the beginning of the year 1862 we were physically strong but financially weak. . . . There was great wealth in the country but how could it be promptly utilized?”
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Lincoln delegated wartime budgets to Chase, though the secretary preferred to spend his time conferring with the cabinet and Congress on broader issues of wartime strategy. Strong congressional leaders—Senators John Sherman and William Fessenden and Representatives Justin Morrill
and Thaddeus Stevens—filled the vacuum of budget leadership. Though they usually worked as an effective team, they disagreed on how to proceed once Chase’s Treasury had exhausted currency reserves and bank credit in the winter of 1861–1862.

Sherman and Stevens saw no alternative to issuing some paper money with the status of legal tender. The Treasury had already circulated non–interest-bearing demand notes, but so far in the nation’s history only metal coins had served as legal tender—a status that required people to accept money at face value in payment for amounts owed. Today one still finds on American paper money the words: “This note is legal tender for all debts, public and private.” Sherman and Stevens worried about “debts public.” Sherman argued that the hoarding of coins during wartime artificially restricted the supply of hand-to-hand currency. He also invoked the authority of Jefferson, who had urged President Madison to issue Treasury notes backed by future taxes during the War of 1812 to finance deficits.

The concept of paying bills with paper money ran counter to deeply held beliefs. Democrats associated paper notes with the type of hardships experienced when bank notes became worthless during downturns, while many former Whigs—including Fessenden and Morrill—believed that printed legal tender opened the door to inflation. Sherman urged them to minimize these risks by making a national commitment to redeem the paper money in gold after the war’s end. Stevens and Sherman prevailed on the issue because of the lack of any viable alternative for paying the mountain of military bills accumulating in 1862. In early 1862 Congress authorized $150 million in green paper dollars, or “greenbacks.” By March 1863 Congress had raised the total amount of authorized paper money to $450 million.
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During the Civil War, Secretary of Treasury Chase welcomed the paper money and even put his picture on the bills. Chase returned to his Jacksonian opposition to paper money after the war and declared, as chief justice of the United States, that it was unconstitutional to require their acceptance as legal tender.

In 1862 and early 1863 greenbacks temporarily helped close the gap between revenues and spending. They ultimately financed about 15 percent of total federal war expenses. Though the new currency did create sharp double-digit increases in prices, the Union avoided the ruinous price inflation that haunted the Confederacy, which relied far more heavily on
currency and short-term notes. The use of greenbacks bought time for the federal government to develop a new system of bond financing.

In early 1862 Chase hired financier Jay Cooke, then thirty-one, to develop new markets for federal bonds.
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Cooke’s brother Harry, Ohio’s leading Republican newspaper publisher, was one of Chase’s most loyal political supporters. The younger Cooke turned out to be a marketing genius. He hired over 2,500 salesmen to create the world’s largest retail brokerage firm and used patriotic appeals to sell $500 million in bonds bearing 6 percent interest. The sheer quantity of new federal notes and bonds overwhelmed private printers, prompting Congress to federalize the printing function by creating the Bureau of Printing and Engraving.

Secretary Chase boasted after the war that he had avoided dependence on foreign creditors, though in reality he had had no choice. At the war’s outset he had asked Augustus Belmont, the chief representative of the Rothschild family’s banking interests, about the prospects of foreign borrowing. “Not a chance,” Belmont replied.
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Confederate financial leaders could not overcome their states’ ideological resistance to taxation. That resistance was one of the grievances some used to justify the rebellion. Confederate vice president Alexander Stephens of Georgia argued that Republican opposition to secession rested more on fiscal interests than on moral opposition to slavery. If Northern leaders objected to the extension of slavery in US territory, Stephens asked, why should they oppose the departure of slave states? Why did many Northerners resist the annexation of Texas as a slave state and then oppose its secession? Republicans, concluded Stephens, sought only “one object, and that is a collection of taxes, raised by slave labor, to swell the fund necessary to meet their heavy appropriations.”
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Stephens advocated the use of loans rather than taxes to finance the Confederate military.

Frustrated Confederate leaders such as President Jefferson Davis and Treasury Secretary Christopher Memminger understood that tax revenues would eventually be needed in order to show the capacity to repay loans.
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“Cotton certificates” were used to obtain goods from Great Britain early in the war but had limited value after the Union’s naval embargo of cotton exports. Smugglers who successfully evaded the embargo on imports and exports rarely complied with tax laws. The struggle of the Confederacy to finance the war illustrates the plight of any nation that spends far more than its available tax revenues. In order to supply the war effort, the
“conservative” Confederate government began confiscating agricultural produce in exchange for paper notes.

N
EW
T
AXES AND
B
ANKS
, 1863–1865

Congress raised taxes throughout the war, leading some to joke that it “taxed everything except coffins.” A congressman warned against repeating that phrase to Morrill, who might just respond by passing a coffin tax. Imports were taxed at an average rate of 47 percent of their total value.
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Congress also taxed sales of domestic manufactured goods, raw materials, railroad services, dividends, legal transactions, occupations, and licenses.

In July 1861 Morrill proposed a 3 percent tax rate on personal incomes above a standard exemption of $800, which was about the average household income.
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In the debate over the nation’s first income tax bill, he asked his colleagues: “Ought not men . . . with large incomes . . . pay more in proportion to what they have than those with limited means, who live by the work of their own hands, or that of their families?”
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By the war’s end, Congress had raised this rate to 5 percent of incomes between $600 and $5,000 and 10 percent of incomes above $5,000.
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Since most taxpayers with high incomes lived in a small number of commercial hubs, the residents of just three states—New York, Massachusetts, and Pennsylvania—paid about 60 cents of each dollar of federal revenues generated by the Civil War income tax.
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In 1865 income taxes produced more revenue than import taxes and yielded a quarter of the total federal revenues during the war.

Wartime internal revenue—that is, revenue exclusive of import taxes—peaked in the fiscal year ending on June 30, 1866, at $309 million, an amount five times greater than the entire prewar federal budget and more than all Confederate tax revenues collected during the entire war.
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Tax revenue had also peaked in the last year of the War of 1812 and would do so again in the final years of World War I, World War II, and the Korean War. Taxes during the Civil War’s last year covered about 40 percent of its total cost, almost the same percentage as in the last years of World War I and World War II.

By the end of 1862 Jay Cooke had exhausted his ability to sell bonds to existing businesses and banks. He needed a broader market for federal debt. Treasury Secretary Chase, once an opponent of national banking, asked Congress to create a new system of federal banks that would be
capable of buying more debt. Since those banks could accumulate more of the nation’s wealth by attracting deposits and equity investment, their investment in federal bonds would absorb some purchasing power, thereby moderating wartime inflation.

In early 1863 the exigency of Civil War financing forced a resolution of the national banking issue that had been debated since early in the Washington administration. Some state-chartered banks continued to lobby against new competition, and Northern Democrats had not forgotten Jackson’s storied battle with the national bank. Jackson disciple and Polk secretary of the treasury Robert Walker eventually implemented a “subtreasury” system as the Democratic alternative to a national bank. The Lincoln administration, therefore, welcomed help from Walker in overcoming Democratic opposition to a new national banking system.
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Walker warned Northern Democrats that federal debt would continue to rise by at least half a billion dollars a year for the duration of the war. He saw no alternative to chartering well-regulated banks that issued notes in exchange for federal debt that could be held as a form of reserve.

Sherman confided to his wife in early 1863 that he could “scarcely sleep” until he passed the National Bank Act, which he described as “indispensable to create a demand for our bonds.”
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It took Sherman only a week to pass the bill that March. The National Bank Act created an enduring new banking system, initially with a three-tier structure of “country,” regional, and New York City banks. Country and regional banks could satisfy reserve requirements with deposits in New York City banks, thereby elevating Wall Street’s status as the nation’s financial center.

Cooke sold much of the Treasury debt to the newly chartered national banks. State banks continued to exist, though by 1866 the federal government had taxed their notes out of existence. The fate of the nation’s credit system after the war would depend on the ability of the federal government to maintain the value of bank reserves by repaying its debts with a dollar of roughly equivalent value.

The war effectively ended with General Robert E. Lee’s surrender of the Army of Northern Virginia in April 1865. The war’s human and economic costs persisted long afterwards. In just four fiscal years—July 1861 through June 1865—the federal government spent over $3.3 billion on the military, almost double the total of all federal outlays since President Washington’s inauguration.
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About $2 billion was funded with outstanding interest-bearing bonds or notes.
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