US Has Defaulted Before
Thursday, July 28th, 2011 by George Bragues posted in Economics, History, Politics.
The idea that the US cannot possibly default, at least in the sense of not being able to pay its debt obligations, is universally held. It helps explain why yields on US government bonds are so low despite its public debt having reached an eye-popping 96% of GDP. But is it true that the US cannot really default?
According to Richard Salsman, president of InterMarket Forecasting, it’s not. One key reason why not is America’s track record. The US has effectively defaulted before. The operative word here is “effectively”, as the US has never formally declared that it was defaulting on its debt. But if a country’s government takes steps to dramatically reduce the value of its currency and then use this cheapened money to pay the nominal amounts it owes, it has ”effectively” defaulted. Creditors end up with less purchasing power than they originally lent.
As excerpted in the op-ed page of today’s Financial Post, such inflationary restructuring of debt has occurred at least three times in US history:
1. The 1861-1865 Civil War during which greenbacks were issued.
2. In 1933, when the Roosevelt administration passed an executive order that revoked clauses in bond contracts allowing creditors to demand payment in gold.
3. The coup de grace that US President Nixon gave to Bretton Woods when he broke the last tie between the US dollar and gold. This allowed the US government to freely print money. The consequence, as Salsman points out, is that the rate of return on US bonds was -56% from 1965 to 1981.
That negative performance is something to think about if one happens to be pondering an investment in US government bonds.
Has the United States Ever Defaulted on Its Debt?
Excerpt:
Reinhart and Rogoff give four examples of US defaults/restructurings.
Let’s run through each of them.
The 1790 Default. Shortly after the formation of the first United States federal government under the Constitution of 1787, Congress passed and President Washington signed the Funding Act of 1790. This act directed the Secretary of the Treasury, Alexander Hamilton, to assume the Revolutionary War debts of the states, allowing creditors to exchange the state-backed war debt with bonds issued by the US Treasury. The interest on the bonds was deferred until 1801. A total of $21.5 million dollars was assumed.
Prior to the passage of the Funding Act, much of the debt was expected to default. It traded at deep discounts to face value. Once the act was passed, the value of the debt skyrocketed—because bondholders were sure they would be repaid by the new federal government. In fact, quite a lot of money was made by people who bought the state debt in anticipation of the Funding Act or with early notice that it had passed. Even at the time of the Founding, traders were profiting from informational asymmetries.
The Act also provided that the debt securities issued by the Confederation government that existed prior to the federal government would be converted into new federal bonds. The interest on one third of the value of the converted bonds was deferred until 1801.
So why is this described as a default by Reinhart and Rogoff? It’s pretty clear that the federal government was not defaulting on its own obligations. Instead, it was modifying obligations incurred by the states—either directly or through the Confederation—and assuming them.
This was almost the opposite of a default, since it made payment much more likely. That’s why the bonds rallied after the passage of the act.
The 1841-1842 Defaults. This was actually a series of defaults by nine state governments, including three states that repudiated their debt altogether. The federal government was not involved.
The 1873-1884 Defaults. Another series of defaults by states and cities. In total 10 states defaulted. West Virginia, the worst of the state financial basket cases, was still working out its debt with creditors by 1918. There wasn’t a federal government default, however.
The 1933 Default. In the summer of 1933, Congress passed the “Joint Resolution to Assure Uniform Value to the Coins and Currencies of the United States” which declared invalid and provisions of obligations of the federal government which were “purported” to give the creditor the right to require repayment in gold. The Roosevelt administration wanted to depreciate the paper currency, and thought the “gold clauses” contained in various bonds were an obstacle.
This is arguably the closest the US government came to defaulting. But this is more like monetizing debt than defaulting. It is closer to having the Federal Reserve inflate our way out of debt than what Rep. Ryan is proposing.
So no history of defaults?
To be fair to Reinhart and Rogoff, they don’t describe these as pure defaults—but as instances of defaults and restructuring. In this paper, they give more details on them.
It’s just not correct to say that the US is a serial defaulter—or to imply that we can predict the consequences of a default now based on past defaults. We just don’t have any historical data to tell us what would happen.