A Suggestion of Bankruptcy, Part II

IN PART I of this article, I revisited the early days of the American republic. I discussed the importance of hard money (meaning gold and silver), unpaid debt, and the development of bankruptcy law in post-Colonial America in the early 1800s up through the time of the California Gold Rush. In an overview of half a century of U.S. history, I reviewed the balance of debts and credits in the context of the monetary situation of the nation in the early 19th century.

How Will It End? How Did It Begin?

In those long-ago days, money was scarce in the best of times. There was not much money to lose to deadbeat debtors no matter how sad the story behind the loss. When there is not much in the way of margin for absorbing a loss, the qualities of mercy are necessarily strained. Yet this being America, I discussed how the concept of frontier populism crept into bankruptcy law through the allowance of “discharge” of debt via legal process.

In this second article, I want to amplify some of the philosophical underpinnings of bankruptcy in the U.S. My goal in all of this is to help you think about the history of credit and debt in the U.S., about collection and nonpayment of debt, about some basic concepts of federalism and constitutional law. Eventually, we will discuss how the U.S. has transitioned from being historically a nation of thrift, savings, and internal investment to become the largest debtor nation in the history of mankind. Where can the U.S. go from here? How will it end? First, I want to go back to the beginning.

Fraud via Federalism

The first two federal bankruptcy laws in the U.S. (1800-1803 and 1841-1843) were temporary responses to bad economic conditions. The Bankruptcy Act of 1800 was passed in consequence of and response to the need for the nation to deal with immense debts run up through land speculation on the Western frontiers in the 1790s. This land speculation was the cause of one of the nation’s first financial “panics,” that of 1797.

During and after the Panic of 1797, many prominent businessmen, numerous state officials, several members of the U.S Congress, and even Justice James Wilson of the U.S. Supreme Court found themselves being hounded by creditors. The unfortunate and impecunious Supreme Court justice actually spent some time in debtor’s prison, and was forced to flee from Pennsylvania to the relative safety of Maryland at one point to escape his pursuing creditors. Thus, there was an impetus among the highest levels of the political class to pass some sort of federal law to help to alleviate the effects of the recent 1797 Panic: Their own hides were on the line.

The 1800 act allowed for only a minimal discharge of debt. However, the 1800 law also ushered in a significant amount of bankruptcy fraud by both debtors and creditors. That is, many debtors colluded with their creditors, or even retained family and friends to make false claims and file unsubstantiated liens in order the better to avail themselves of the bankruptcy laws. The colluding creditors would then file “sympathetic” bankruptcy actions against their debtor co-conspirators. The unscrupulous debtors would add up all of the “debt” owed to creditors, including the phantom debt claims filed by the collaborators. Then, via bankruptcy proceedings, the debtor would pay each creditor a small fraction of what was owed. The result, which included the illegitimate claims as part of the payout calculation, was that many legitimate creditors were grossly cheated.

Under the 1800 act, one common result of bankruptcy proceedings was that there were relatively minor recoveries by creditors. Thus, bankruptcy did not really “pay” the creditors, the class whom it was supposed to benefit. And many of the debtors who received discharges were just high-rolling speculators, who went through bankruptcy proceedings and then started their illicit operations anew. So the legal process did not even tend to cause people to improve their bad business behavior, let alone merit the grant of a “fresh start” in life.

In addition, bankruptcy proceedings were held in federal courts, most of which were located in cities on the Eastern coast. Hence, it was difficult for many people in the interior of the country to travel to and attend the proceedings. In a situation that was a harbinger of much future political conflict within the U.S., the agricultural interests that tended to be debtors were outraged at the perceived favoritism of the federal courts toward the creditor merchant groups. Thus the 1800 Bankruptcy Act rapidly fell from favor, even among the creditor classes it was supposed to benefit, and was repealed in 1803.

Profound Issues of Federalism

These preceding items were what one might call the immediate practical, if not “political,” reasons, for the demise of the 1800 Bankruptcy Act. But there were also profound philosophical issues of federalism that undermined the idea of, and support for, a federal bankruptcy law. These issues bear discussion because they are still present in current political assumptions, in the world’s most indebted nation, about whether and when and where and how debt ought to be repaid.

At the U.S. Constitutional Convention, held in Philadelphia in 1787, bankruptcy arose within the context of a discussion of what is called “full faith and credit.” The earlier, post-Revolutionary War Articles of Confederation had provided that each state give “full faith and credit” to the judicial decisions of the courts of each other state. Thus, a court judgment or decision in one state would, if transferred to the court in another state, be entitled to the same level of enforcement and effect (“full faith and credit”), as if the courts of that other state had issued the result. By way of concrete example, a money judgment from a court in Massachusetts could therefore be transferred to and enforced in, say, Virginia or South Carolina. A Yankee creditor could cause a Southern debtor to go to jail for nonpayment of a debt, and vice versa. This was something of a culture shock in those days.

Compounding the novelty of “full faith and credit,” in many respects, it did not matter by what legal process the courts of one state had reached the final determination. A judgment was a judgment, and the state to which it was transferred was proscribed from inquiring into the underlying merits of the decision. (Today, a final state judgment may be challenged on certain grounds relating to notice and fundamental due process, to include jurisdiction, but there are still very few ways to challenge an out-of-state judgment in another state. So don’t get sued in other states, and if you do get sued, you had better defend the case.) This rather novel legal doctrine was supposed to be a key element in promoting commerce across state lines, and fostering the creation and enforcement of contracts.

When the framers of the Constitution examined and debated the concepts of both bankruptcy and “full faith and credit,” they did so within just a few days of one another. In fact, both the “Bankruptcy Clause” of the Constitution and the “full faith and credit” clause were voted on literally one after the other (although they are located in different sections of the final version of the U.S. Constitution). This was quite a significant ordering of events.

“Full faith and credit” effectively bound the courts of each state to the judicial determinations of the courts of all the other states. In other words, the Constitution established “full faith and credit” as an allowable invasion of the sovereignty of one state by another. This was a remarkable philosophical, federalist concept at a time when the different states had decidedly different, if not distinct, cultures. Decades later, it would matter quite a bit when someone wanted to use the “fugitive slave laws” of one state to obtain the return of an escaped slave in another state. But this is another discussion for another time.

Now think of “full faith and credit,” allowing one state to invade the sovereignty of another in the same context of subordinating all states’ commercial interests to the supremacy of a federal bankruptcy law. By permitting a national-level and federal bankruptcy process to grant relief, and even to discharge debtors from repaying debts, states were surrendering a significant measure of control over their own commercial interests. One commentator referred to a national bankruptcy power as reducing state commercial laws and judicial results to the level of “municipal regulation.”

The creditor class liked the idea of “full faith and credit” because it meant that a debtor could be hunted down in any state of the union and summarily tossed into jail for nonpayment of debt. But it came as quite a shock to many creditors that a national-level “bankruptcy” discharge might also serve to eliminate that otherwise useful threat of the jailhouse to prompt a debtor to pay up.

So the constitutional clauses concerning “full faith and credit” and bankruptcies are two sides of the same coin. Both concepts entail states ceding some elements of their sovereignty to the courts of other states. “Full faith and credit” binds state legal processes to the final judgments of courts of other states, and federal bankruptcy binds state legal processes to federal discharges of debt.

The truly astonishing vision of the framers of the Constitution in all of this was that they recognized that credit, like commerce, could not be contained within traditional state boundaries. This laid the foundation for the rise of the U.S. as a great commercial and industrial power. But this vision also laid a national policy foundation for the federal government to exert more and more control over the “credit” of the nation, most notably in the on-again, off-again establishment of a national bank in the 19th century. In our own time, this vision has led to the creation of an American central bank, known as the Federal Reserve, in the 20th century.

Thomas Jefferson, Bankruptcy, and State Sovereignty

One keen observer who recognized the immense powers and significance of the Bankruptcy Clause of the Constitution was Thomas Jefferson. He saw the extent to which a national-level bankruptcy law would invade and curtail traditional state sovereignty. At a practical level, Jefferson was concerned that, in a land where distances were vast and transportation and communication relatively slow and problematic, distant creditors, as well as debtors, could abuse federal bankruptcy process and wrongly usurp the commercial regulation and judicial processes of other states.

In addition, Jefferson foresaw the creation of a federal legal process that could seize and sell the assets of debtors outside of the protections offered under state laws. This was an imminent federal trespass on what Jefferson considered to be state prerogative. According to Jefferson, it would set the stage for a struggle for power “between the general (i.e., federal) and state legislatures.” To one correspondent, Jefferson wrote, “Hitherto, we had imagined the general (federal) government could not meddle with title to lands.” Note the rather dismissive word “meddle,” as if to say that “title to lands” was exclusively a matter for regulation by states. Thus, Jefferson perceived that a national-level bankruptcy law had more profound implications than just ensuring a uniformity of legal processes across state boundaries.

Throughout the 1790s, Jefferson lobbied against passage of a federal bankruptcy law. Primarily, he knew that it would strengthen the national government at the expense of state powers. No one questioned the constitutional authority for Congress to pass a bankruptcy law, just whether or not such a law was really required. And no one doubted that a national-level law would promote a federalist agenda, meaning uniformity of laws and promoting federal control over commerce generally.

To the extent that anti-federalists supported a national act, part of their agenda was to establish federal court districts in the interior of the country, with judges and judicial seats somewhat removed from the Eastern urban centers. The distance from the frontier and a perception of judicial arrogance by many citizens “beyond the Alleghenies” in the early days of the republic is hard to overstate. It took the Whiskey Rebellion in 1794, in no small measure based on the outrage of frontier settlers at highhanded injustices issuing from the federal court in far-off Philadelphia, to prompt the national government to set up a “Western District” federal court in Pittsburgh. (I discussed this in an article in Whiskey & Gunpowder entitled “Whiskey Taxes: The Real Thing,” published on Dec. 17, 2004.)

“An Objection to the Constitution Itself”

The bankruptcy law that was proposed in every session of Congress throughout the 1790s made it perfectly clear that the new federal government was going to usurp many traditional state powers. Any federal law would undermine state attachment laws, subject property everywhere to seizure and sale by federal agents, give powers of arrest to federal officials, and give those federal officials power to imprison people for nonpayment or to use the federal writ of habeas corpus to gain the freedom of other people. These new federal powers would also interfere with, if not entirely override, similar state powers. But this is what any bankruptcy law was intended to do under the original constitutional wording and construction.

Opponents argued that any federal bankruptcy law was a raw grab for centralized power in the young nation, reminiscent of the tyranny of the former British masters. During the 1790s, the proponents of a bankruptcy law announced that administering the proposed system would require all of 250 new judges and court personnel. Many skeptics viewed this number as a small army of federal patronage, and indeed, it was in some respects the equivalent of an army, because 250 new souls on the federal payroll was near to the number of active duty officers in the entire U.S. Army at the time. But as Chief Justice John Marshall summed it up, to object to a bankruptcy law “is an objection to the Constitution itself. The mischief suggested, so far as it can readily happen, is the necessary consequence of the supremacy of the laws of the United States on all subjects to which the legislative power of Congress extends.”

By 1800, in the wake of the financial collapse precipitated by the Panic of 1797, the nation’s first bankruptcy act passed by one vote in the House, and was signed into law by the federalist-oriented President John Adams. As I discussed above, the implementation of the law was poor toward both debtors (well, honest debtors) and creditors, and the new act rapidly lost its political support. The U.S. was, at the time, a nation without great reserves of wealth or stores of capital. The new country could not afford, either figuratively or literally, to engage in public policy that not only did not work in practice but that actually interfered with and harmed the growth of commerce. By 1803, the rather anti-federalist President Jefferson gladly signed the repeal of the Bankruptcy Act of 1800.

“The Fearsome Hardship of Perpetual Debt”

After the repeal of the first federal bankruptcy law, the states continued to regulate dealings between debtors and creditors, and to oversee limited actions in bankruptcy and insolvency. While this may have been satisfactory in matters concerning only small or local markets, it was impractical for commerce that covered extensive distances. In many important respects, state relief over interstate commercial disputes was unavailable.

In 1819, the Supreme Court, in Sturges v. Crowninshield, held that states could not constitutionally discharge pre-existing debts. This decision was quite untimely, because the Panic of 1819-1820 was then causing an extreme economic contraction in the U.S. But this time, unlike in the aftermath of the Panic of 1797, there was no federal bankruptcy law by which debtors could be relieved. After the Sturges holding, it was not possible to obtain state relief from pre-existing debts. So people and businesses were forced to live with what one commentator called, “the fearsome hardship of perpetual debt.”

And in 1827, the Supreme Court, in Ogden v. Saunders, held that states could not discharge the debts due a citizen of another state. So between the two cases, the Supreme Court established that neither in-state debt nor out-of-state debt could be discharged. Thus did the Supreme Court severely hamstring the ability of debtors to avoid their creditors and of creditors to regain some semblance of their money or goods extended on credit.

In the meantime, the era of using imprisonment as a remedy for unpaid debt was ending. The practice of imprisonment for debt was abolished at the federal level in 1833, and many states followed suit in the 1830s and 1840s. Even though debtors were no longer under threat of going to prison for not paying their debts, between 1803-1841, they lacked any means to discharge pre-existing debts. But this legal arrangement did not necessarily serve the promotion of commerce, either. Debtors could not pay, and therefore were unlikely to obtain access to new sources of capital. And creditors could not collect, and hence had less capital to invest in novel enterprises.

How was the economy going to develop with such dead weight working against the wheels of commerce? In particular, the development of the steam engine was creating the need for quite a bit of new capital investment, which had to be done on borrowed money. Steamboats and railway lines were, after all, not cheap to construct and promised a payback only over a period of many years.

It took the Panic of 1837, one of the most profound economic collapses in U.S. history, to prompt a political consensus for passing the second national bankruptcy law in the U.S. That second bankruptcy act was passed in 1841. One of the first entities to file under the new act was the remnant of Nicholas Biddle’s “Second Bank of the United States,” in some respects the forerunner of the modern central bank called the Federal Reserve.

And on that note, I will end this article for now. There is, of course, more to say on the subject of how the U.S. came to be the most indebted nation in the history of mankind. And there is more to say on where the nation might go from here. So if you keep on reading Whiskey & Gunpowder, I will continue to write about it. Thank you for your interest.

Until we meet again…

Byron W. King
September 6, 2006

The Daily Reckoning