A Free Nation Deep in Debt: The Financial Roots of Democracy

Published by EH.NET (May 2006)

James Macdonald, A Free Nation Deep in Debt: The Financial Roots of Democracy. Princeton: Princeton University Press, 2006. ix + 564 pp. $20 (paperback), ISBN: 0-691-12632-1.

Reviewed for EH.NET by Robert E. Wright, Stern School of Business, New York University.

Storied trade publishing house Farrar, Straus and Giroux (FSG) published A Free Nation Deep in Debt in cloth in 2003 but did not see fit to send a copy to EH.Net for review. Princeton University Press, the publisher of the new paperback edition technically reviewed here, is taking closer aim at the scholarly market. That is likely a good call. Though ably written, this book is closer in tone, density, and substance to a scholarly tome than a bookstore blockbuster. Likely, FSG was attracted to the book’s Niall Ferguson-esque Big Thesis: Democracies eventually defeat autocracies because “countries with representative institutions are able to borrow more cheaply than those with autocratic governments” (p. 4). Bond markets also strengthen democracies internally by giving citizens some of the proverbial power of the purse and by aligning their interests with those of their governments. Heady, important stuff.

To prove his thesis, James Macdonald, a British investment banker and independent scholar, has written a wide-ranging survey of the co-evolution of representative governments and public debt markets. He starts with the Old Testament, which he uses as a primary source to explicate the transition of societies from a Lockean state of nature to autocracy. Small family groups that highly valued leisure were subsumed or slaughtered by larger and more powerfully organized autocracies that forced their subjects through taxation to create economic surpluses. Autocracies soon came to control much of the ancient world but found it impossible to control the vast expanses of Asia, the forests and fjords of Northern Europe, or the jungles of Africa. A few small city states, often strengthened by alliances with other nearby cities, also managed to hold off the imperial advance for a time.

The ancient autocracies financed wars from savings, their legendary “treasure troves,” and equity contracts that divided the spoils of war. The democratic city states, by contrast, borrowed to fund resistance to imperial encroachments. “The picture that emerges,” however, was “not of a regular system of public finance, but of a series of improvised reactions to fiscal emergencies” (p. 36). The ancient Greeks, for example, moved toward modern public credit but never explicitly connected “the principle of voluntary contribution to the public funds and the principle of distribution of surplus assets” (p. 36). The result was a dizzying array of debt instruments, some forced and some voluntary, some paying interest and others not, most short-term but some in the form of life annuities. The Greeks sometimes found it difficult to honor their obligations but the extant documentation is too sparse to say anything more definitive about their creditworthiness.

Modern public finance had to await the emergence of a different group of city states some 1,500 years later in the northern Italian peninsula. There emerged, for the first time since the fall of Carthage, a group of states run by merchants instead of soldiers. Desperate to maintain their freedom from regional despots, the representative governments of Venice, Florence, and Genoa hit upon the notion of repayable taxes, levies upon which interest would be paid if the government’s finances allowed. To evade the Church’s then stringent usury prohibition, repayment of the principal sum was left at the pleasure of the government. The Venetians circumvented that inconvenience by making the right to receive the tax repayments transferable to third parties, which quickly led to the creation of a secondary market. “They had invented the bond market” (p. 77) as Macdonald writes, but the Italian city states did not regularly pay interest on their repayable taxes, the market prices of which spiraled downward. City states in northern Europe eventually improved upon the Italian model by avoiding forced loans and repayable taxes and religiously servicing their debts. The Dutch Republic was the major innovator here.

Medieval and Early Modern European autocrats also borrowed but almost invariably eventually defaulted. Unsurprisingly, they could not borrow as much or as cheaply as the Dutch, who won their independence by wearing down the once mighty Hapsburg Empire. By the end of the 80-year struggle, a majority of Dutch households were creditors to their government. Default, rebellion, or large scale tax evasion became unthinkable because the interests of the government and the citizenry were thoroughly intertwined.

After revolutions of their own in 1688 and 1776, the British and the Americans adopted Dutch-style finance, funding their wars in large measure by selling bonds to citizen creditors rather than resorting to punitive levels of taxation, ruinous inflation, or physical coercion. The democracies thrived, while autocracies in France, Germany, Russia, and elsewhere lost wars and rebellions. By World War II, however, government wartime financial techniques, including financial repression, rationing, and payroll deduction, had become so powerful that the great patriotic bond drives of earlier wars lost much of their importance. The wartime financial system of that greatest of autocrats, Adolf Hitler, looked eerily similar to that of the United States.

If Macdonald is right — and there is more than a little truth in this book — then adherents of the English “Country” and American Jeffersonian Republican traditions exaggerated the negative aspects of national debts. Far from endangering democracies, national debts bolstered them by enabling them to defeat powerful external and internal foes. Eternal interest was as much the price of liberty as eternal vigilance.

Authors who dare proffer such a Big Thesis confront numerous tradeoffs, the most important of which is that between depth and breadth. A twenty-page bibliography is always impressive, but less so for a book that covers several millennia of finance, government, and politics. Specialists will likely be disappointed with the treatment of their areas of expertise. (I cringed at several points in his discussion of the early U.S. monetary and financial systems.) But readers should concentrate on the forest rather than the trees and judge this ambitious and important book on its panoramic vision.

Robert E. Wright teaches business, economic, and financial history at the Stern School of Business, New York University. His most recent books include The First Wall Street: Chestnut Street, Philadelphia, and the Birth of American Finance (Chicago, 2005) and Financial Founding Fathers: The Men Who Made America Rich (Chicago, 2006, with David J. Cowen). He is currently working on a book tentatively titled Financing Freedom that will describe how the entire financial system, not just the government securities market, enabled America to vanquish its most dangerous enemies at home and abroad.