The U.S. is Playing a Dangerous Game of Debt Roulette
The Severe Consequences of a Debt Default
“Exigencies are to be expected to occur, in the affairs of nations, in which there will be a necessity for borrowing…And as on the one hand, the necessity for borrowing in particular emergencies cannot be doubted, so on the other, it is equally evident, that to be able to borrow on good terms, it is essential that the credit of a nation should be well established.”
U.S. Secretary of the Treasury (January 11, 1790)
The Origin of America’s Pristine Credit
On June 21, 1788, the United States of America was formed when New Hampshire became the ninth state to sign the Constitution, but the future of the nation was far from secure. The most pressing problem was its poor credit. U.S. government bonds were far from “risk free” in 1790. In fact, outstanding federal and state government bonds regularly traded as low as $0.10 to $0.20 on the dollar. Foreign investors’ aversion to U.S. debt securities was hardly unjustified. Congress had suspended interest payments, and many Congressmen wished to renegotiate the principal or even default entirely. Even among those who were committed to honoring the nation’s debts, many wished to compensate the original bond holders, rather than the actual bond holders (which consisted mostly of foreigners and northern speculators). They reasoned that the patriots who funded the war deserved to be rewarded, as opposed to speculators who stood to profit by buying bonds at distressed prices.
The nation’s first Secretary of the Treasury, Alexander Hamilton, saw things differently. He argued against such proposals, and instead detailed the benefits of honoring the nation’s obligations to current bond holders. Hamilton carefully framed his argument around the benefits to U.S. citizens rather than more abstract moral principles. For example, he emphasized that sound credit was critical to national defense, stating “loans in times of public danger, especially from foreign war, are found an indispensable resource, even to the wealthiest of them.” Hamilton understood that it was impossible to fight a war without financing it first. He concluded his proposal by promoting the somewhat radical concept of assumption, which meant that all debt (both federal and state) would be consolidated and paid in full by the federal government. Despite vicious opposition, the proposal passed, all war debts were assumed by the federal government, and interest and principal payments have been made in full and on time for 233 years.
The Price of a Debt Default
“Now, the Americans have cut themselves off from all resources of credit. Having been as dishonest as they can be, they are prevented from being as foolish as they wish to be. In the whole habitable globe, they cannot borrow a guinea, and they cannot draw the sword because they have not money to buy it.”
Reverend Sydney Smith
British Investor in Pennsylvania Government Bonds (March 8, 1844)
On July 10, 1832, President Andrew Jackson vetoed legislation to renew the 20-year charter of the Second Bank of the United States. The Second Bank was America’s second iteration of a central bank, and its disappearance reignited the spread of lightly regulated state-chartered banks. Reckless lending and speculation created a real estate bubble in the Mid-West, and when it collapsed in the Panic of 1837, the U.S. experienced a Great Depression-level event.
The depression not only ruined the credit of individuals and businesses, but it also forced several states to default on their debts. Many had borrowed heavily from European investors to fund canals, turnpikes, and railroads. Between 1836 and 1838 alone, states borrowed more than $100 million, which exceeded the combined debt of Russia, Prussia, and the Netherlands. In July 1841, the State of Michigan became the first casualty, and it was soon followed by the states of Indiana, Maryland, Pennsylvania, Arkansas, Illinois, Louisiana, Mississippi, and the Territory of Florida. In total, the eight states and one territory had issued two-thirds of the nation's outstanding state debt.
In contrast to the states, the federal government was on sound footing. Prior to the Panic of 1837, the federal debt was almost fully repaid in large part due to a flood of income from federal land sales. Nevertheless, European investors refused to differentiate federal and state debts. This became problematic when a severe economic contraction followed the Panic of 1837, which forced the United States into deficit spending. After the U.S. attempted to sell bonds to Europeans in 1842, James de Rothschild, head of the family’s bank in Paris, stated “You may tell your government that you have seen the man who is at the head of the finances in Europe, and that he has told you that you cannot borrow a dollar, not a dollar.”
The Hard Times of the 1840s may not have matched the economic devastation of the Great Depression, but it was close. American standards of living plummeted, and the nation’s cities devolved into dystopian versions of the ones that existed only 10 years earlier. Soup kitchens, bread lines, and overpopulated alms houses were prevalent. The depression was also accompanied by a frightening break down of law and order, as Americans desperately competed for scarce resources. Violent uprisings, crime, and even outright insurrections erupted throughout the states in the early 1840s.
A Game of American Roulette
After the Great Crash in October 1929, the famed stock operator, William C. Durant, lamented “We may as well tell the truth and put the blame where it belongs. It’s up to Washington now. We have stepped aside. Eventually, we will take control again.” The age of Wall Street’s stock operators had ended, and the Securities Act of 1933 and Securities Exchange Act of 1934 ensured they would never return in full force. In April 2008, John Mack, CEO of Morgan Stanley, lamented Wall Street’s role in the unfolding Global Financial Crisis, stating “Greed, leverage, and lax investment standards. We took conditions for granted, and we as an industry lost discipline.”
The most dangerous situations in financial history are those in which the major actors have forgotten the consequences of the catastrophe that they risk inviting. There is not a single American alive today who has experienced the consequence of a U.S. debt default. Alexander Hamilton understood the consequences in 1790. In the 1840s, many politicians forgot Hamilton’s lessons, and the subsequent state debt defaults extended and deepened the depression even though the federal government itself never defaulted. In 2023, I hope that politicians, regardless of party, realize that the consequences of debt default cannot be taken lightly.
In fairness, there are serious issues that must be addressed regarding the nation’s debt. Expressed as a percentage of GDP, the national debt now exceeds levels reached after the conclusion of World War II. But the post-World War II years provided a highly favorable economic environment for the United States because the nation possessed the only industrial infrastructure that remained intact, and the entire world was experiencing a prolonged period of exceptional productivity growth. Neither of these conditions is present today, which means the United States cannot grow its way out of its debt. This is a real problem – and it is not getting the attention it deserves.
The U.S. has now raised the debt ceiling 74 times and, each time, it has avoided default. The odds are very low that politicians will allow a default in 2023 – but the odds are not zero – and even a small chance of default is not a risk worth taking. Americans need to find a way to manage the unsustainability of their spending habits without prematurely suffering a self-inflicted wound. Neither the debt increases nor the standoffs on the debt ceiling are sustainable.
Hamilton, Alexander. The First Report on the Public Credit. (January 14, 1790).
Goetzmann, William N. and Rouwenhorst, K. Geert (2005). The Origins of Value. New York: Oxford University Press.
Hamilton, Alexander. The First Report on the Public Credit. (January 14, 1790).
Roberts, Alasdair (2012). America’s First Great Depression. Ithaca: Cornell University Press.
Sobel, Robert (1968). The Great Bull Market: Wall Street in the 1920s. New York: W.W. Norton & Company, Inc.
Paulson, Hank Jr. (2010). On the Brink. New York: Hatchett Book Group.