The Defaults of 1933, 1862, ... and 2013?

Pundits tell us that the US government has “never” defaulted on its debts. However, this generalization overlooks the very significant defaults of 1933 and 1862.

Prior to 1933, US Treasury bonds were promises to pay gold at $20.67/oz. Yet one of the first acts of the Franklin D. Roosevelt administration was to revoke this promise. After 1935, foreigners were paid in paper dollars they could redeem for gold at $35 an ounce, but American creditors did not even get that diluted option.

The government did not just default on its own Treasury obligations, but took the entire US economy down with it by imposing a similar default on private borrowers and banks, including the Federal Reserve System. I’d argue that taking the dollar off gold at that point was pointless, misguided and disruptive, but however one feels about that, this was clearly a default on the part of the US government.

During the Civil War, the Federal government financed many of its expenses with “United States Notes,” or “Greenbacks” as they were known. These were, like private banknotes, promises to pay lawful money on demand, which initially meant gold at $20.67 an ounce or silver at $1.293 an ounce, at the government’s discretion. Since gold was a little cheaper at the time, in practice this meant gold.

Throughout 1861, the Treasury kept its promise to pay gold on demand. However, at the end of 1861, it announced it would suspend redemption effective Jan. 1, 1862. Greenbacks began to circulate at a discount relative to gold, and were made legal tender for private debts the following month. Government bonds continued to be paid in gold, but holders of greenbacks never got their promised specie until 1879.

One could argue that greenbacks issued after February 1862 were merely promises to pay specie at the government’s earliest convenience, so that they were not technically in default, even if no one realized at the time that resumption would take 17 years. However, the greenbacks issued during 1861 clearly defaulted.

Although a Treasury default next week would therefore not be unprecedented, it would clearly be detrimental to the Treasury’s credit rating. With a national debt in excess of $16 trillion, each 100 basis points extra the Treasury has to pay to attract lenders will add $160 billion per year to its annual deficit. Congress should therefore make every effort not to default.

Several Republican member of Congress have claimed that the Administration has the power to cut spending sufficiently to prevent a default even without an increase in the national debt ceiling. I hope this is true, but any national debt ceiling, whether legislative or constitutional, should explicitly empower and require the President to impound whatever spending is necessary and expedient to stay within the limit, well in advance of the stroke of midnight. The President was understood to have this power prior to the Impoundment Control Act of 1974.

In a front page article yesterday entitled “Many in G.O.P. Offer Theory: Default Wouldn’t Be That Bad,” the New York Times quoted four Republican members of Congress to the effect that a default would not be necessary, and one (freshman Ted Yoho of Florida) to the effect that it wouldn’t be all that bad. The Times headline was clearly deceptive in light of the actual content of the article.

Governments often effectively default on their debts through inflation. Under a fiat money regime, they can always print enough legal tender money to pay off their debts. The only catch is that the money will not be worth as much as it was before. If it tries to cover too much deficit spending in this manner, more than a few percent of GDP, the inevitable result is hyperinflation in which money quickly becomes virtually worthless.

Disastrous though an explicit Treasury default would be, bringing down the entire economy with a hyperinflation or even a partial inflationary default would be even worse. But if we keep charging current deficits to future taxpayers at our current rate, the inevitable result will be a revolt in which they either explicitly repudiate all or part of the debt, or, worse yet, inflate it away.

The only solution to runaway deficit spending appears to be an effective Balanced Budget Amendment, such as I provide in my article, “An Improved Balanced Budget Amendment,” The Independent Review, Sept. 2012. However, I argue that the Republican BBA proposals to date would unfortunately be worse than no BBA at all. See also my Beacon blog post on the subject.

J. Huston McCulloch is Professor Emeritus of Economics and Finance at the Ohio State University, and Adjunct Professor of Economics, New York University.
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