America's Fiscal Constitution (27 page)

Bryan’s booming voice unexpectedly challenged the convention’s leadership on the first, largely ceremonial order of business: the designation of a temporary presiding officer. He narrowly lost that vote but made his presence felt as he greeted delegates—most of whom he knew personally—while seated in the convention’s front row as he fanned himself with a
large palm leaf. Though it became apparent only in hindsight, the battle for the direction of the Democratic Party for most of the twentieth century would be decided in that sweltering convention hall.

Large delegations from states dominated by urban organizations—New York, Illinois, and Massachusetts—sought to maximize their strength by supporting minor candidates and then switching that support to create momentum for a candidate who would subsequently be in their debt. On the tenth ballot the large New York delegation controlled by Tammany Hall chief Charles Murphy swung its votes to the front-runner Clark, giving him a clear majority. Clark delegates began a long demonstration to celebrate their anticipated victory. McAdoo persuaded Wilson not to send a prepared telegram conceding defeat, since party rules still required a nomination by a two-thirds majority.

Then Bryan announced to the delegates that he could not back Clark, since Bryan interpreted New York’s support as a sign that Clark might be a candidate beholden to Wall Street. Support for Clark slipped away over numerous ballots until the delegates finally nominated Wilson on the forty-sixth ballot. A professor with barely eighteen months experience in public office had become the presidential nominee of the world’s oldest political party.

Roosevelt’s platform—the “Contract with the People”—called for “a modern industrial society” with minimum wages, the abolition of child labor, and a social insurance that could mitigate the “hazards of sickness, accident, invalidism, involuntary unemployment, and old age.”
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Wilson endorsed many of Roosevelt’s proposed policies, although he expressed that support in language that also conveyed a Jeffersonian skepticism of federal power. The aloof Democratic nominee agonized privately over his failure to match Roosevelt’s magnetism on the campaign trail. After being shot at close range three weeks before the election, the former president proceeded to give an hour-long speech with a bullet lodged an inch from his heart.

Roosevelt’s stamina and popularity were not sufficient to overcome the strength of a two-party system that had become embedded in the nation’s unwritten constitution. This system was every bit as powerful as traditional limits on debt. The defection of Roosevelt progressives from the Republican Party gave Wilson an easy victory in the Electoral College. Taft received only 23 percent of the national popular vote. In several states the incumbent president trailed the Socialist candidate, Eugene Debs.

The 1912 election completed the thirty-year ascendency of populist and progressive reformers. Roosevelt returned to the Republican Party, which in turn realized it needed to bring many of the former president’s supporters back into the fold. Wilson made the urban reformer McAdoo his secretary of the treasury and the rural populist Bryan his secretary of state.

Wilson trusted McAdoo’s economic and political judgment, and the two became even closer after McAdoo married one of Wilson’s daughters. Assisted by a talented staff, McAdoo became the most powerful treasury secretary since John Sherman.

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The Democratic platform in 1912 explicitly opposed the “Aldrich plan” for a central bank. During the election, McAdoo and Wilson’s largest donor, the moderate Republican Cleveland Dodge, quietly assured Wall Street firms that Bryan’s rural populists would not control the monetary policy of a Wilson administration.

Carter Glass, a fiscally conservative Democrat from Virginia, chaired the House Banking Committee. He had concluded that the nation needed a central bank. Glass traveled to the president-elect’s New Jersey home to learn Wilson’s views on the controversial issue. Wilson, who had studied the history of American banking and monetary policy, agreed with Glass. In the following months they worked as a team to overcome opposition from Democratic populists led by Bryan, regional bankers who resisted central control, and other bankers who insisted that a central bank be controlled only by bankers.

Glass’s initial bill merely created regional associations. As Glass anticipated, many bankers came forward to make the case for at least some measure of central authority. In order to rebut Bryan’s claim that a central bank would allow private bankers too much influence, Wilson told Glass to amend his bill to give obligations of the new central bank the backing of the full faith and credit of the federal government. Glass argued that would be unnecessary because the proposed reserve system pooled most of the nation’s commercial banking reserves. Wilson persuaded Glass by turning the argument around: if federal credit was redundant, then a federal guaranty would do no harm and might reassure populists that the
federal government would control a central bank that exercised a constitutional power ultimately derived from Congress.

Wilson understood that Democratic opposition to a central bank had always rested more on distrust of bankers than of federal authority. Wilson and Glass eventually agreed to Bryan’s demand that the president be given the power to select the members of the national governing board. By giving board members staggered, fourteen-year terms, they sought to preserve the central bank’s independence from any particular administration. After passage by the House, 287 to 85, and the Senate, in a closer vote, Wilson signed the Federal Reserve Act into law on December 23, 1913. The perennial controversy over “paper money” faded into history. The Federal Reserve’s green paper notes became the nation’s principal hand-to-hand currency and paper money no longer appeared as debt on the national balance sheet.
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American history before the Federal Reserve yields a straightforward answer to the question of whether the federal government had “printed money” to cover budget deficits. The United States printed $450 million during the Civil War to pay its bills.
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Between the Civil War and the creation of the Federal Reserve, the Treasury issued bonds—instead of currency—to refinance Civil War debt and to fund debt incurred during the Panic of 1893, the Spanish-American War, and the construction of the Panama Canal.

The new Federal Reserve did, of course, have the authority to use cash—that is, Federal Reserve notes or credits—to purchase federal debt from the Treasury or in the open market. The Federal Reserve ordinarily has monetized debt as a means of expanding the money supply in order to provide liquidity and accommodate growth. When the Federal Reserve was created, no one anticipated how quickly it would be called on to monetize debt used to finance World War I.

The Federal Reserve was not the only innovation in 1913 that forever altered the management of federal debt and budgets. That year, after state ratification of the sixteenth amendment to the Constitution, Congress enacted a personal income tax applicable to individuals with the highest incomes. The tax was included in eight pages of an import tax bill totaling more than eight hundred pages. Congress taxed 1 percent of all “gains, profits, and income” for people with incomes above a $3,000 standard deduction and an extra $1,000 deduction for a married taxpayer. Higher
rates, then called surtaxes, were applied to those in higher income brackets. Annual taxable income of over $500,000 was taxed at the maximum rate of 7 percent. The bill excluded from taxation all interest on state and local bonds and allowed taxpayers to deduct “necessary” business expenses, including tax and interest payments. In its first years, only 2 percent of American households paid the federal income tax.
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Wilson’s early legislative agenda consisted of regulatory and tax reforms rather than large new spending programs. The budget was in surplus. For the first time in years, postal service was paid for entirely with dedicated user fees.

The triumph of rural populists and urban progressives did not alter the power of the nation’s unwritten fiscal constitution. From 1902 through 1915, the level of federal interest-bearing debt was stable for longer than at any other time in the nation’s history, before or since. Debt in this period began at $931 million and ended at $962 million.
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In fact, in 1915 the total debt differed little from when Grover Cleveland had taken office in 1884, even though national income had quadrupled. Two-thirds of the debt in 1915 represented refinanced Civil War debt, while the remainder consisted of bonds used to finance either the Panama Canal or the Spanish-American War. Congress authorized each issue of debt, and the public could easily identify precisely why the federal government had borrowed.

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INANCING A
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1916–1928: Years when deficits exceeded debt service = 2 (1917–1918, World War I)

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President Wilson went to bed on election night in 1916 believing that he had lost. His narrow margin of victory, despite the strong economy, reflected the close partisan balance that existed once Theodore Roosevelt returned to the GOP. The war in Europe cast a shadow over the election. Wilson had kept the United States out of Europe’s tragic conflict, but found—as had Jefferson and Madison—that it was difficult to navigate a policy of neutrality in the perilous waters of trade embargoes, particularly after the advent of submarine warfare.

The war actually seemed to help the US economy after an initial financial panic in 1914. American products replaced European exports to Asia and Latin America. Gold flowed in as exports flowed out, and New York City displaced London as the center of global finance.

The red ink of European debt rose in tandem with the river of blood flowing from a generation of European soldiers. In contrast, the federal government ran a surplus in the fiscal year ending June 30, 1916. Though Congress had enacted an income tax, consumption taxes—the traditional staple of federal taxation—accounted for 80 percent of federal revenues.
Taxes on alcohol and tobacco alone generated more revenue than did the new personal income tax, which was paid in 1916 by only 437,000 wealthy American families out of a total population of about 100 million.
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That mix of tax revenue would soon change forever.

Democratic Ways and Means Committee Chairman Claude Kitchin opposed calls for higher military spending in response to the German submarine threat. Kitchin, who also served as the Democratic majority leader in 1915, largely controlled federal tax policy. He could count on help from his home state ally, Furnifold Simmons of North Carolina, then chairman of the Senate Finance Committee. An audience often filled the galleries in the House when the eloquent Kitchin, a master of budget detail, engaged in debate.

Kitchin’s political heritage and views on World War I shed light on the sudden and irrevocable emergence of a federal tax system based largely on the ability to pay. His family had helped lead the wing of North Carolina’s Democratic Party that had emerged from the Farmers Alliance in the 1890s. North Carolina Democrats channeled agrarian populism into a mainstream program of reforms. Kitchin had supported the Wilson administration until he disagreed with the president’s request for more battleships in the wake of a German submarine attack on the ocean liner
Lusitania
in 1915. Majority Leader Kitchin thought the purchase of new battleships would be more effective in raising the profits of steelmakers than sinking submarines. Congress nonetheless increased naval funding, prompting the forty-seven-year-old Kitchin to complain to William Jennings Bryan about the influence of “the jingoes and war traffickers.”
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The American Fiscal Tradition was so strong that no mainstream American leader in 1915 argued that debt rather than taxes should fund this military buildup. Chairman Kitchin succeeded in doubling—from 1 to 2 percent—the basic tax rate applied to incomes above a standard exemption. That exemption was set at a level higher than the incomes of a vast majority of households. Graduated rates of up to 13 percent applied to the highest incomes.
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Like Jefferson in the 1790s, Kitchin hoped that the burden of taxation would dampen enthusiasm for war, which ran especially strong in financial centers with commercial ties to Great Britain. He anticipated that “when the New York people are thoroughly convinced that the income tax will have to pay for the increases in the army and navy . . . preparedness will not be so popular with them as it now is.”
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After his reelection the professorial Wilson asked each warring European nation to give a written description of its goals in continuing war. The war cabinets in London, Paris, and Berlin dreamed that victory would enable them to acquire territory and force their enemy to pay reparations. Yet the government of each belligerent power was reluctant to admit those objectives in a war justified to citizens as a matter of national survival.

By 1916 the war had taken a horrific turn. More than two million soldiers had died during failed offensives intended by each side to obtain a decisive victory on the Western Front. At the beginning of 1917, Allied and Central leaders had become desperate. They faced the potential loss of an entire generation of young men while their civilian populations grew restless and experienced economic hardships.