

HMS SHannon leading the captured American frigate USS Chesapeake into Halifax, Nova Scotia (1813)
Source: Library and Archives Canada








Oh. Wait. That’s not what happened at all.



The new western banks bought government securities with the bank notes, which the United States government used to fund the way. Much of this wound up in New England, of course, since that was where much of industrial goods needed for fighting the war were manufactured. When the conservative New England banks attempted to redeem the bank notes from the banks that had purchased the government securities, the federal and state governments reacted by permitting the western banks to remain in business, even after they suspended redemption.

By undertaking a credit expansion to finance its war, the United States government was merely mimicking what the British had done. Again, from Rothbard’s "Mystery of Banking":

In 1797, there were 280 country banks in England and Wales. By 1813, the total number of banks was over 900. These banks pyramided on top of a swiftly rising total of Bank of England notes. Total bank notes outstanding in 1797 were £11 million. By 1816, the total had more than doubled, to £24 million.

In other words, the source of the British and the American war funds was simply credit creation. The government allowed banks to expand credit, the new credit created new deposits, these deposits were used to purchase US government securities, which were used to finance the purchase of supplies and pay the soldiers and sailors necessary for the war effort.

Even in the banking system of the early 19th century, there never was any real danger of the United States running out of buyers for our debt, or running out of purchasing power to buy domestically produced goods necessary for the war. Credit expansion created new deposits and the war years saw a giant expansion of productive capacity.

This isn’t to say that the War of 1812 was not disastrous for the United States and might better have been avoided—or that the credit expansion did not set off a dangerous business cycle. But it certainly shows that the very respectable anti-debt mythology embodied in Johnson and Kwak’s history is made much more complicated by the possibility of credit expansion, non-redeemable currency and a government willing to bail out the financial system’s weaker links.

But if Kwak’s and Johnson’s history is a bit off, the lesson they draw for today is even more bizarre.


Today, of course, we live with a financial system that makes the War of 1812 banking innovations pale in comparison. The entire system runs on floating rate, non-redeemable, fiat currency created with keystrokes. Banks can create new money, only constrained by regulatory reserve requirements (which they can meet by borrowing from other banks or the Federal Reserve).

If the United States could find lenders willing to fund our government even as the White House, the Capitol and the Treasury burned at the hands of the British—we’re hardly likely to run out of creditors in modern circumstances. As we’ve seen during the past four years, the Fed balance sheet can expand as far as it needs.

The real constraint on government spending is not the size of the debt, it’s the size of government spending relative to the economy. If the government is using up too many of our resources, the private sector may find itself starved of real assets. If the government pays for those real assets by taking money from the private sector through tax policy, the economy slumps. If it pays for them with new money, inflation results.

The key factor, then, is getting the size of government spending right. All the talk by responsible people about taxes and debt is mostly a distraction.






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