Legal Commentary

In these troubled fiscal times, it would be fitting to remember President Martin Van Buren who presided over the nation during a similar economic crisis. Like President Obama, Van Buren came to the Presidency right at the onset of a financial panic due to the bursting of a real estate bubble (the Panic of 1837). When this panic turned into a prolonged depression (by 1840), states' toll revenue from their internal improvements -- canals, roads, etc -- plummeted, and states faced a budgetary crisis. The states begged for federal assistance to avoid default on their bonds used to build those improvements (bonds held mostly by British creditors). Van Buren and the Democratic Party refused to bail the states out (the Whigs wanted the feds to assume the debt), and eventually nine states defaulted in part or in whole. (The default by Pennsylvania inspired Wordsworth, infuriated at his losses from investing in Pennsylvania bonds, to pen the only romantic poem about the bond market of which I am aware, decrying the Pennsylvanians for their perfidy).

Should Obama follow Van Buren's example and let California, Illinois, and other deeply indebted states twist in the wind without federal aid? The history of the 1840s suggests one benefit of such tough love: By forcing states to decide how to accommodate or resist their bondholders, the 1840s Democrats also forced the states' citizens to take responsibility for the spending incurred in their name. Maybe the 2010 Democrats could induce the citizens of California, Illinois, and New York to act with similar maturity.

New York's 1842 "Stop and Tax" law, for instance, imposed a one-mill levy to pay off the debt but also enacted a state constitutional amendment banning further expenditures for canals. Other states amended their constitutions during the 1840s to limit or ban aid to private corporations or subject bond issues to referenda. Some states avoided taxation by insulting their British creditors with nationalistic rhetoric ("slap John Bull in the face" said one Mississippi politician), but, as Jay Sexton's history, Debtor Diplomacy explains, those states eventually backed down after they were thereby foreclosed from further borrowing in London. "You can tell your government," said James de Rothschild to an American envoy, "that they cannot borrow one dollar, not a dollar"). The reputational costs of thumbing one's nose at the international bond market proved higher than the political benefits of xenophobic political posturing.

According to Jonathan Rodden, Stanford political scientist and author of Hamilton?s Paradox, the federal government's refusal to bail out defaulting states sent a credible signal to bondbuyers to monitor states' fiscal, legal, and political decisions carefully and set interest rates by the default risk of individual states. Those interest rates served as a wake-up call for citizens who were otherwise inclined to engage in infantile populism -- insult the British, sell short-term notes for systemic expenses, etc. In short, by treating the states as grown-ups, the feds induced the states' citizens to act with a modicum of political maturity, accepting responsibility for their spending choices by either curtailing the spending or raising revenue.

Is there a moral here for us Americans today? Consider this hypothesis (which I will state with perhaps exaggerated starkness for clarity's sake): In debt-swamped states like California, New York, and Illinois, the two major parties represent two streaks of political infantilism. The Republicans cater to suburban homeowners who resist all tax increases without any credible plan to cut spending; The Democrats cater to public employees who resist any practical productivity measures or any realistic cut in unsustainable labor -- especially pension -- costs without any credible plan to raise revenue. Both sides engage in petulant gestures rather than meaningful negotiation.

Perhaps they both need a shove from bondholders to jolt them out of their complacently intransigent rhetoric. If default really loomed, then perhaps we would see the modern equivalent of New York's 1842 "stop and tax" laws that (a) raised revenue through visible and broadly applicable taxes but (b) forced future spending obligations like collective bargaining agreements to be subject to processes that would make them equally visible -- fiscal notes, referenda, genuine and accesible up-front review. In short, We the People could act like grownups who take responsibility for our spending decisions, either by raising revenue or monitoring spending.

It happened in the 1840s: Why not today?