“Imperial Finance: A History of Empires”
It’s finally here. The second Investor Amnesia course has launched… and wow is it exciting. This course offers more than eight hours of world class lectures taught by an incredible lineup of speakers. Highlights include:
- Marc Andreessen on anti-trust, Robber Barons & Golden Age of Piracy.
- Niall Ferguson reveals which financial innovations produce empires.
- Tracy Alloway explains how political chaos impacts investors.
- Mike Green uncovers episodes of monetary debasement and inflation.
- Kim Oosterlinck studies the history of sovereign defaults.
Enroll in Course for $99
Yes, yes, I know… I am breaking my promise from last weekend that the Panic Series would resume today. However, after a week dominated by one major story (the debt ceiling & potential default), it felt like not providing historical context would be a disservice to Investor Amnesia readers.
The Politics of Debt
Michael Scott, Scranton, PA paper supply magnate, once stated:
“Business is always personal. It’s the most personal thing in the world.”
After this week, you could convincingly argue:
“Debt is always political. It’s the most political thing in the world.”
There are many ways in which politics pervades the world of debt:
- A means of control & influence
- Funding government operations
- Political posturing
Debt As A Means of Control & Influence
Throughout history, states and sovereign entities have utilized debt as a mechanism for control and influence, wielding the financial instrument like another weapon in their arsenal. In fact, President William Taft’s foreign policy of ‘Dollar Diplomacy’ explicitly referenced the interchangeability of traditional weapons and debt. In his 1912 State of the Union Address, Taft explained that his foreign policy was to “substitute dollars for bullets”.
“Taft used the threat of American economic clout to coerce countries into agreements to benefit the United States…
several Central American nations still owed to various countries in Europe. Fearing that the debt holders might use the monies owed as leverage to use military intervention in the Western Hemisphere, Taft moved quickly to pay off these debts with U.S. dollars. Of course, this move made the Central American countries indebted to the United States…” (Lumen)
This approach is still practiced today, albeit in different forms. Although some question the legitimacy of this argument, past administrations have called China’s foreign policy one of “debt-trap diplomacy”, particularly within African. Proponents argue that this policy includes China granting loans to developing nations knowing that they will be unable to pay, allowing China to wrest control of a nation’s key assets and infrastructure.
Funding Government Operations
The most obvious intersection of politics and debt is funding government operations; the simple process of sovereign states raising funds by issuing government bonds. While this process is fairly simple today, this was not always the case. As we learned in the first Panic Series installment, Alexander Hamilton faced a difficult task as Treasury Secretary in constructing a feasible system for funding government operations via federal debt. Making matters worse, he faced the country’s first financial crisis in 1792.
When Hamilton assumed this new role, the country’s financial situation was dire:
“Before 1790, the government was effectively bankrupt. Without tax revenues until late in 1789—after the newly created Treasury Department opened in September of that year, it managed to collect by year end a grand total of $162,200 in custom duties—the U.S. government was in default on almost all of its large domestic debts left over from the Revolution, as well as on most of its foreign debts incurred in the struggle. The new nation lacked a national currency, a national bank, a banking system, and regularly functioning securities markets.” (Sylla, 2010)
It was in the Panic of 1792 that the now all-too-familiar signs of political partisanship over national finances emerged, which brings us to the other important role that debt unfortunately plays: political posturing.
Americans prefer to think of our founding fathers as perfect individuals that would never favor party over country, or play politics during crises. However, this is inaccurate. During the Panic of 1792, for example, Thomas Jefferson engaged in partisan politics while Alexander Hamilton tried to navigate the nation’s first financial crisis.
To calm the volatile bond market, Hamilton required authorization from his “Sinking Fund” commissioners to execute open-market purchases of US debt, which were intended to support prices and inject liquidity. Despite the national crisis, as a Sinking Fund commissioner, Thomas Jefferson “dragged his feet” on authorizing these purchases, to put it mildly.
“Jefferson still objected [to Hamilton’s open-market purchases of federal 6% and 3% bonds], and would object again when the Sinking Fund commissioners on April 4, based on Jay’s opinion, authorized purchases of 3s at 60 percent of par and deferreds at 62.5 percent of par. Jefferson behaved irresponsibly and maliciously, according to Forrest Donald, who writes that Jefferson was “scarcely able to contain his glee over the catastrophe.
The political rivalry of Jefferson and Hamilton was a year old by the spring of 1792, and it would become much more intense over the next few months. Jefferson wrote that his dissents from the Sinking Fund open-market purchase authorizations of March and April 1792 were based on his opinion that the “true values” of 3s and deferreds were lower than their market prices.
This was bad economics, but it may have been good politics. Delaying action to counter the financial crisis might have made it more embarrassing to Hamilton and the Federalist administration, thus promoting the interests of the opposition Republican political party that Jefferson and his allies were then forming.” (Sylla, 2006)
This example illustrates that American leaders have engaged in brinksmanship and partisan politics over national debt since the very founding of our nation.
Brief History of the The Debt Limit (Ceiling)
Before getting any further, let’s quickly review what the debt ceiling is….
“The debt ceiling is the legal cap that Congress sets on the amount that the Treasury can borrow. It does not authorize any new spending; it simply lets the government pay for what Congress has approved. The debt ceiling came into being in 1917; before then, Congress tended to authorize borrowing for specific purposes. But when raising money to support America’s entry into the first world war, Congress granted the Treasury more flexibility, eventually setting a comprehensive debt ceiling in 1935.” (The Economist)
Interestingly, before the 1917 shift in policy, Congress authorized the Treasury to issue securities for specific uses like war financing or infrastructure projects. Between 1776-1920 Congress authorized some 200 of these securities, ranging between 0-8 new securities annually. Importantly, there were limits on how much of a specific securities could be issued. That is to say, Congress might authorize Treasury to issue $200M of ‘War Bond A’, and $100M of ‘Panama Canal Bond C’. Limits were placed on the individual security Congress had authorized.
However, this changed with the onset of World War I, and the introduction of Liberty Loans.
“World War I was a conflict with unknowable costs, making targeted legislation difficult. At first Congress established a $5 billion limit on new issues of bonds, along with the immediate issuance of $2 billion in one-year certificates of indebtedness, in the First Liberty Loan Act of 1917.
But very quickly another law was needed — the Second Liberty Bond Act of 1917 — in which Congress set a general limit on borrowing: $9.5 billion in Treasury bonds and $4 billion in one-year certificates. This freed the Treasury secretary to begin to figure out the best mix of securities to issue, without nearly as much congressional oversight as before.” (Washington Post)
Eventually, in 1939, Congress ditched the limits on individual debt securities, and placed an overall aggregate limit on the national debt. So it was in 1939 that the debt limit (ceiling) we know today, was born.
The Recent Debt Ceiling Crisis
This introduction has obviously been building towards this week’s chaotic attempts to resolve the debt ceiling crisis and avoid an embarrassing default. I’ll avoid summarizing the events and negotiations that have been covered ad nauseam in news outlets, but thankfully Congress straightened up just enough to reach an agreement that will avoid default until at least December 3rd, when this very same issue will come to the fore again. However, this scare prompted many investors to consider the previously unthinkable scenario: what if America defaulted on its debts? That said, today’s post will analyze the history of sovereign defaults, debt and other important issues surrounding the debt ceiling crisis.
Previous American Defaults: The War of 1812
Despite what pundits and politicians might say, America has actually defaulted on its debts before, notably during the War of 1812, when it could not even afford to pay its own troops. Since Congress had not re-authorized the National Bank of the United States in 1811, America was financing a costly war against the British with no central banking institution to help regulate and implement monetary policy. Due to a proliferation of “state banks” that printed their own currencies unchecked, which eventually harmed the Treasury Department’s ability to meet its obligations. Ultimately, the Treasury had to suspend specie payments in 1814.
“Alexander J. Dallas, who became Treasury Secretary in October 1814, soon complained that Treasury “was suffering from every kind of embarrassment” and that “the dividend on the funded debt has not been punctually paid; a large amount of treasury notes has already been dishonored.” For instance, interest federal debt due to Boston investors on October 1, 1814, could not be paid and those investors refused to accept Treasury notes as payment rather than specie, thus providing a clear example of default.” (D. Andrew Austin, 2016)
Today’s post will provide a more accurate history of sovereign defaults than you’ll hear from politicians.
Final Thoughts: Minting the Coin & Episodes of Sovereign Default
Before getting into the Sunday Reads, I just want to make one point on this “Mint the Coin” movement.
If you think that minting a $1 Trillion coin to solve a government debt crisis is crazy, consider this: In the 13th century, Emperor Baldwin II paid off his imperial debts by ‘redeeming’ the Christian ‘Crown of Thorns’ relic to King Louis IX of France. In exchange, Louis IX paid off Baldwin II’s debts.
Finally, if you enjoy today’s Sunday Reads or reading in general about sovereign debt, defaults and more… I highly encourage you to check out my new financial history course. The course includes lectures by Niall Ferguson on the importance of Britain’s debt market for financing growth, Tracy Alloway on antique Chinese debt / Russian default during the 1917 Bolshevik Revolution, and Kim Oosterlinck on many episodes of sovereign defaults, odious debts, repudiations and more. Enter ‘HISTORYRHYMES’ at checkout for 10% off.
Now let’s dive in to the history of sovereign defaults, debt and more!
Has the US Government Ever Defaulted?
Why This is Relevant:
Whenever it comes time for Congress to debate the debt ceiling, politicians are always quick to point out the dangers of United States defaulting for the “first” time in history. However, this is historically inaccurate. In fact, this paper details three instances of default in American history: 1814, 1933, 1979.
“This report examines three episodes in the federal government’s fiscal history when some have questioned the public credit of the U.S. government. During the War of 1812, the federal government eventually became unable to meet its obligations… In March 1933, newly inaugurated President Franklin Roosevelt soon took steps to suspend the gold standard… the cancellation of gold clauses in federal bond contracts amounted to a restructuring of debt… the U.S. Treasury failed to make timely payments to some small investors in the spring of 1979, some dubbed the incident a ‘mini-default’.“
Sovereign Default & Repudiation: The Emerging-Market Debt Crisis in U.S. States (1839-1843)
Why This is Relevant:
There has been a warranted focus on the dangers of a national default in the United States, but this paper analyzes the fallout of the Panic of 1837, in which eight states defaulted on their sovereign debts.
“In 1841 and 1842, eight states and the Territory of Florida defaulted on their sovereign debts. Traditional histories of the default crisis have stressed the causal role of the depression that began with the Panic of 1837, unexpected revenue shortfalls from canal and bank investments as a result of the depression, and an unwillingness of states to raise tax rates. This paper shows that none of these stylized facts fits the experience of states at all well. The majority of state debts in default in 1842 were contracted after the Panic of 1837; most states did not expect canal investments to return substantial revenues by 1841 and so could not experience unexpected shortfalls in those revenues; and, finally, most states were willing to raise tax rates substantially. The relationship between land sales and land values explains much of the timing of state borrowing and the default experience of western and southern states. Pennsylvania and Maryland defaulted because they postponed the imposition of a state property until it was too late.”
Evolution of Sovereign Debt Default: From the 13th Century to the Modern Era
Why This is Relevant:
This paper chronicles the evolution of sovereign debt over hundreds of years, providing an insightful look at repeating patterns and themes for government debt and defaults. This is a fantastic history of sovereign defaults.
“A key feature of the full sovereign default record from 1294-2008 is that serial default is far rarer than the much-ballyhooed 1980s experience suggests. The only mass default in Europe’s long record, dating back to 1294, occurs during the Napoleonic Wars (1800-1815). The majority of the serial defaults occurred only after 1975, primarily in Africa, Asia, and Latin America, and were heavily concentrated in the 1980s. These countries’ multiple defaults, in common with some earlier default waves in Latin America, reflect the experiences of newer nation states. These defaults also occurred in conjunction with the inherent vulnerability of countries on the periphery to events in the much longer-established major financial centers. This was quite distinct from the earlier defaults seen in Europe and largely represent an aberration when taken in context of the overall historical record both before and after.”
Sovereign Debt Defaults: Insights from History
Why This is Relevant:
Kim Oosterlinck is one of the world’s foremost experts on sovereign debt and the history of sovereign defaults. In this paper he analyzes the long history of sovereign defaults in order to better understand the present.
“History provides many insights to address the issue of sovereign debt defaults. This article first presents a detailed account of defaults in historical perspective. It then discusses the solution devised in the past to address sovereign debt crises and sets these into perspective with today’s answers when crises occur. Finally, the paper stresses the role of history when events under study don’t occur frequently and when archival data may add a new light to understand the process of crises resolution. The impact of odious debts declarations, of state succession, and of international relations on sovereign defaults and on their settlement is thus also addressed.”
The Debt Limit: History and Recent Increases
Why This is Relevant:
This paper provides an excellent history on the historical origins of the American debt limit, which helps us better understand the chaos surrounding debt ceiling crises in modern times.
“Congress has always restricted federal debt. The Second Liberty Bond Act of 1917 included an aggregate limit on federal debt as well as limits on specific debt issues. Through the 1920s and 1930s, Congress altered the form of those restrictions to give the U.S. Treasury more flexibility in debt management and to allow modernization of federal financing. In 1939, a general limit was placed on federal debt. Federal debt accumulates when the government sells debt to the public to finance budget deficits and to meet federal obligations or when it issues debt to government accounts, such as the Social Security, Medicare, and Transportation trust funds. Total federal debt is the sum of debt held by the public and debt held by government accounts. Debt also increases when the portfolio of federal loans expands.”
A History of U.S. Debt Limits
Why This is Relevant:
While the official debt limit was instituted in 1939 by Congress, limits on the amount of money that America’s government could borrow stretch right back to 1776.
“Congress first imposed an aggregate debt limit in 1939 when it delegated decisions about designing US debt instruments to the Treasury. Before World War I, Congress designed each bond and specified a maximum amount of each bond that the Treasury could issue. It usually specified purposes for which proceeds could be spent. We construct and interpret a Federal debt limit before 1939.”
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