Although Congress has managed to put off the question of raising the debt ceiling and possible default for another 3 months, the next episode of frayed nerves and fear in the markets, over the same issue, is on its way. Widely circulated statements in the mass media allege that if America defaults on its debt, it would be the first time in history. Historians know better. America has a comparatively good record of paying bills, but it has defaulted in the past. In fact, it is easy to identify at least 3 prior American debt defaults. Understanding what happened afterward will help investors understand what to do when it happens again.
I DO NOT endorse default. Failing to pay debt is a dishonorable act. I discuss this topic first, because it is interesting, and, second, because to avoid losing their shirts, investors must know the truth. If America defaults again, it will be the 4th major American debt default, NOT the 1st. It will present opportunities for investors. It will not be "the end" for the USA. This is borne out by historical experience. For example, in the mid 1860s, after the first major American default, some investors bought so-called "greenback bonds" at 30 cents on the "gold dollar." They ended up tripling their money in less than 10 years, when the government agreed to redeem greenbacks for gold. So, let's start with that first default.
The American Civil War began on April 12, 1861. In that day and age, the vast majority of legal scholars believed that the Constitution prohibited issuance of paper currency not backed by an equal amount of gold or silver coinage. This was the "pure" gold specie standard, prior to the time, later on, when it became acceptable to partially back the dollar with gold. The federal government was expected to keep a number of gold coins exactly equal to the actual value of paper dollars, (a bank note then known as the "US demand note").
Anyone who owned a US demand note had the theoretical right to "demand" a one ounce ($20) gold piece for every $20 worth of paper money. But, in 1861, government revenue sources were very limited. Neither personal nor corporate income tax yet existed. In fact, prior to a 1913 constitutional amendment, income taxes were held unconstitutional. The central government relied, instead, on collecting taxes from imports and exports. The largest single source of export duties were cotton and other agricultural exports. The largest single source of import duties were from importation of manufactured products from Europe, into the South.
With the formation of the Confederacy, the Union government in Washington DC was cut off from a large part of its funding. In fact, the Confederacy, with some justification, reasonably believed that, even if it could not win the war by force of arms, it could effectively "starve" the Union government into submission. Against this, to fund itself, the Union issued Treasury bonds, the terms of which required payment, not in paper dollars, but in gold or silver coins.
In 1861, war expenses quickly mounted. Government contractors, soldiers and civil servants all expected wages in either gold or silver coin, or in demand notes readily redeemable in gold or silver coin. Financiers expected their interest payment in gold coins. Yet, there wasn't enough gold to pay everyone. The Union government quickly became dependent upon a small cadre of NYC banks, willing to buy "gold bonds" with gold coins. The bonds required payment of interest in gold, so, some of the money was used to pay the interest, and the rest was used to fund the government.
Unfortunately, in the first year of the Civil War, the Confederate States made considerable gains on the battlefield. Incompetent Union generals lost battles. In spite of this, and in spite of the government's revenue problems, NYC financiers were confident that the central government would defeat the Confederacy. They knew that the South had few factories and little ability to supply manufactured goods. They also knew that, in "modern warfare," guns, cannon and so on, all of which required a strong manufacturing base, were the key to a successful prosecution of any war.
So, for almost the first year, NYC banks lent freely to the Union government. Enormous quantities of gold flowed from New York to Washington DC. But, in early December of 1861, a series of rumors began spreading on Wall Street. England's mills had once been almost totally dependent upon cheap cotton from the southern states. The UK economy was suffering severely, as a result of the war, and the Union's attempt to stop imports and exports to the South was infuriating businessmen in London.
Anyone with common sense would have known that, regardless of the economic consequences created by war, it was politically impossible for England to enter on the side of South. Britain had a very vocal anti-slavery movement both inside and outside government circles. Entering on the side of the Confederacy, regardless of deep trade ties, would have been an endorsement of black slavery, something the British government could never have gotten away with. American slavery had been condemned, time and time again, by important commentators, politicians, and various members of England's ruling elite.
But, when rumors fly, logic, common sense and even the rule of reason quickly departs, especially on Wall Street, when large sums of money are involved. And, so the rumors spread like wildfire, regardless of their falsity. England was going to war against the Union, on the side of the South! Or, if it wasn't going to war, the British Navy would force safe delivery of war materials to Confederate ports. If the rumors had been true, such an intervention would have tipped the balance of power, and likely caused the Union to lose. Potentially, the gold supplied by NYC bankers... might never be repaid...
In the wake of this rumor, and with some new Union battlefield setbacks, on December 16, 1861, most major NYC banks abruptly stopped buying Union Treasury bonds. The US Treasury was cut off from its main supply of gold. Its ability to redeem paper for gold, and to continue making interest payments on bonds, in gold, came under intense pressure. By early January 1862, the Treasury suspended gold redemption, and refused to deliver gold in exchange for United States "Demand" Notes. This suspension was a violation of law, and most legal scholars also viewed it as a direct violation of the provisions of the US Constitution.
Soon afterwards, a new currency, known as the so-called "greenback," from which our current "Federal Reserve Notes" have inherited their color, was printed and circulated in replacement of gold. Greenbacks were an admitted fiat currency, the first in US history. They were overtly NOT backed by gold, but were issued and declared "legal tender" for all purposes, by the government. They were legal tender for every purpose except for payment of import and export duties. The government required that these taxes be paid in gold coin.
A lot of controversy was stirred. Until that time, it had been thought that paper money was unconstitutional. The issuance of the greenback was widely condemned in the financial community. Even though most people believed that the government would eventually redeem the greenback notes in gold, people began hoarding gold coins. The circulating currency became the ever-depreciating paper greenback, and both gold and silver coins were progressively withdrawn by the population.
By mid-summer of 1862, gold coins circulated at a 15% premium over paper. A $20 gold piece was readily exchangeable for $23 worth of greenback paper dollars. But, that was not the end. As time went on, the value of gold coins continued to rise, and the value of greenbacks continued to fall. At the lowest point, an American greenback fell to a value of about 1/3rd of a Canadian dollar, or about 25% of value of an American gold coin of identical face value denomination.
The seemingly endless devaluation of the greenback inspired Congress to pass what is now known as the "Anti-Gold Futures Act of 1864" (13 Stat. 132) on June 17, 1864. This was an ill-fated attempt to bolster the value of the paper money. Back then, no one really knew how to manipulate futures markets. So, Congress just wanted them to go away. The Act prohibited the trading of promises to deliver more than 10 days in the future. But, unfortunately for a helpless Congress, the beleaguered greenback did not rise, but, instead, it dropped more sharply than ever.
Meanwhile, anti-fiat money forces had filed suit against the government, and were progressively bringing the actions up through the appellate courts. These lawsuits became known as the "Legal Tender Cases" and they arose out of the "Legal Tender Act" that had created the fiat greenback. By 1870, eight years after the issuance of the first fiat money, the US Supreme Court eventually held, consistent with precedent, in Hepburn v. Griswold, that the issuance of fiat money greenbacks was unconstitutional. This infuriated then-President Ulysses S. Grant, who proceeded to "stack" the Court with two new justices, picked for the sole reason that they were known to be strong fiat money advocates.
Accordingly, in the subsequent 1871 case of Knox v. Lee and Parker v. Davis, the two new justices created a new majority of the Court, which partially reversed the previous decision. Finally, in 1872, the new majority completely reversed the original decision. In Juillard v. Greenman, the court held that the constitutional prohibition against the issuance of paper fiat money extended only to the states, and not to the federal government.
Thus, like subsequent American debt defaults, this first one came in two-pronged form. First, the government suspended the convertibility of US demand notes into gold. Second, it suspended payment in gold on Treasury bonds, even though the language of the bonds required payment in gold, and NOT in paper money. These acts were violations of written contracts, and well accepted law. The suspension of gold convertibility and interest payments lasted until the end of the Civil War. In short, they constituted a very large default on the debt of the USA.
As any similar perceived violations would today, the 1861 debt default provoked intense debate. Dire warnings were issued in the media. The Union, it was said, would collapse as a result of the default. But, the Union did not collapse. Instead, it went on to win the Civil War. By the 1870s, in spite of finally receiving an 1872 Supreme Court opinion upholding the constitutionality of paper money, the federal government agreed to redeem greenbacks for gold. Amazingly, upon the mere making of this promise, a near 1 to 1 relationship, between paper dollars and gold coin dollars, was almost immediately restored. Investors who bought greenback bonds, and those who had held onto the greenbacks, rather than selling them cheaply, were richly rewarded.
The second US government default happened in 1933. During the 1920s, the newly opened Federal Reserve System produced more Federal Reserve Notes than it had gold coins to redeem them with. This stimulated a boom now known as the "Roaring 20s." It ended, of course, in the same manner as all liquidity booms end… in a very large bust. According to Benjamin Bernanke, now Chairman of the Federal Reserve, an attempt was made, in the early 1930s, to reduce the size of the Fed balance sheet by withdrawing some of the liquidity that had been issued in the 1920s. This ill-timed withdrawal, according to him, caused the most serious economic downturn in the nation's history, known as the "Great Depression."
President Herbert Hoover and the Republicans were in power at the start of the decline. Naturally, therefore, they were thrown out of office and in the next election Franklin D. Roosevelt became President. His administration blamed the Great Depression, not on the Federal Reserve, but upon the alleged "hoarding of gold." According to the Roosevelt administration, hoarding was causing the "disappearance of money" and the downturn. Roosevelt signed the infamous Executive Order 6102, "forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States."
The United States proceeded to seize all gold within its territorial boundaries, both from its own citizens and foreign nationals, with the exception of jewelry and other limited and specified forms. After the seizure, the Roosevelt administration unilaterally revalued gold from $20.67 to $35.00 per ounce, thereby allowing more paper dollars to be printed. Accordingly, those who were forced to trade gold for fiat dollars suffered financial loss. The act of seizing gold without full compensation, alone, is a default. But, the default was about to become more classical.
On October 24, 1918, to fund World War I, the United States government had issued debt instruments known as "Liberty Bonds." These were purchased by financial institutions and patriotic individuals and bore interest at 4.25%, with a maturity date of October 15, 1933. By their written terms and conditions, they were repayable ONLY in gold. The Treasury decided to redeem the bonds early "calling" them. About $7 billion worth were taken back. After adjustment to the current price of gold, that equals over $400 billion worth, in today's dollars, using $1,300 as the per ounce price of gold.
The terms of these Liberty Bonds included the following clause, written in plain English:
"The principal and interest hereof are payable in United States gold coin of the present standard of value."
Note that the language specifically required payment in "gold coin of the present standard of value" at the time the bonds were issued. It doesn't take a lawyer to realize that this clause should have protected the bond holders. It was a typical "gold clause," written specifically with the possibility that the government might, someday, attempt to debase the currency. It was written to protect bond buyers from exactly the type of dollar devaluation, against gold, that had happened in 1933.
Gold clause or not, however, on April 15, 1934, the US Treasury "called" the bonds, "paying them off" in US dollars. Bondholders cried foul! and demanded payment in gold. The Treasury responded that it could not redeem in gold because gold ownership was now illegal. The bondholders countered that they would accept payment in paper dollars, but in an amount that would equal $20.67 per ounce of gold. The Treasury refused.
With that refusal, more than 20 million bond holders suddenly lost over 40% of the principal that the written terms and conditions of the bonds were supposed to protect. That is a net loss equal to approximately $175 billion in today's dollars, if we value gold at $1,300 per ounce. Naturally, unhappy about the loss, the bondholders filed a lawsuit. They challenged the seizure of their assets, at the trial level, all the way up through the US Supreme Court level.
The eventual opinion sided with bondholders, but only in theory. The Court held that the Roosevelt administration had unconstitutionally seized property without just compensation. But, then, (Perry v. the United States), the Supreme Court further held that in spite of the unconstitutionality of the seizure, it could not award damages, illogically claiming that it was impossible to quantify bondholder losses. After the 1872 decision in the "legal tender cases," the government eventually did the right thing by curing the previous default. But, the Roosevelt administration refused to cure the default. Indeed, no subsequent American administration, whether Republican or Democrat, has cured this second major American debt default.
Having defaulted on its debts in the 1930s, America ran into a spat of economic good luck. World War II was coming. The war inflicted terrible human suffering on the world. But by the late 1930s, England's large stock of gold was slowly but surely making its way across the Atlantic. The British were required to pay "cash," meaning gold, for the enormous deliveries of lend-lease military equipment they were getting from the States.
By the end WW II, not only the British, but most of the sovereign gold of the entire continent of Europe found its way to America. It had been used to purchase war material and had been transferred for "safe storage" against the ravages of the Nazis. But, one way or another, it was sitting in North America. By 1945, the victorious United States, which had been a downtrodden debtor in 1933/34 that had unconstitutionally seized private property (according to its own Supreme Court) now owned over half of the entire world's gold reserve!
After the war, as the victor, which "saved Europe from the Nazis," the USA held enormous prestige, power and moral authority. Most important, however, tremendous quantities of gold were now the property of the USA. The major nations of Europe, poverty stricken and bereft of power and gold, signed what would become known as the Bretton-Woods Agreement. This treaty established the US dollar as the base of the world's financial system. Although the US did not reestablish the right of private citizens to exchange dollars for gold, all dollars were to be convertible to gold if requested by a sovereign state. The rate of exchange was set at the rate that the dollar had previously been devalued to... or $35 per troy ounce.
Things went smoothly for over a decade. But, eventually, just as before, the United States got itself into financial trouble. By the late 1960s and early 1970s, the boom that had arisen out of possession of most of the world's gold, and the establishment of the US dollar as the world reserve currency, was bust. Germany, mindful of its experience during the Weimar hyperinflation of the early 1920s, was unwilling to debase the German Mark to artificially prop up the dollar system. It was the first to withdraw from the Bretton-Woods Agreement.
Other foreign nations, most notably France and Switzerland, pointed out that America had printed too many US dollars to redeem them in gold. They demanded their physical gold immediately, and France sent a warship to pick up their share. The ship was loaded with Franch-owned gold in the Port of New York, and it sailed back to France. The run on America's gold reserve had begun. As America's gold supplies dwindled, the unsustainable drain eventually culminated in the "Nixon Shock." This was a series of measures, announced in the afternoon of Friday, Aug. 13, 1971, unilaterally suspending the convertibility of the dollar into gold, freezing wages and prices for 90 days to combat the inflationary effects of this act, and imposing an import surcharge of 10 percent.
The unilateral actions of the US government were, of course, in direct violation of the Bretton-Woods treaty, which it had agreed to and signed. It was a major default. US Secretary Connally, Nixon's right hand man, however, was one of the most clever men of his day. By the time he and the President were finished presenting the facts about the third major American debt default, and had given their respective speeches on the subject, America was applauding. Everyone believed that Nixon had "taken charge" of the situation. The next day, the NYSE index went up by more, in one day, than it ever had gone up before.
Like a private debtor who serially defaults, declares Chapter 7 bankruptcy, and then gets new credit cards, the USA has been back at the same game, time and time again. Major defaults occurred in 1861, in 1933/34, and, yet, again, in 1971. None of these episodes of "debt relief" resulted in a nation with the political will to control spending, or raise sufficient taxes to pay for it. The supposed "temporary" suspension of the convertibility of dollars into gold continues to this day, 42 years later, and this is very important, as we will discuss in a moment.
Because all three prior debt defaults had been caused by a lack of gold, it was thought that having a fiat currency, readily printable and easily debased, would always allow default to be avoided in the future. We now learn that this is not necessarily true. America has a fiat currency it can print with abandon. It is not linked to gold anymore. Yet, in spite of that, the nation is in deep trouble, yet again! The issue of the self-imposed "debt limit" keeps coming up, and each time, politicians seem to bring us to the precipice of what the media paints as total destruction of the US economy.
Fortunately, for defaulting debtors, a vast majority of creditors have very short memories. In the case of the United States, memories are so weak that a majority of otherwise intelligent people are convinced that the USA has never defaulted. This mirrors the foolishness of creditors in the private realm. In my years as an attorney, I have seen numerous individuals go bankrupt, and, then, a few months after they get a bankruptcy discharge, they get showered with credit card offers. They take the cards, charge them up, and, eventually, as soon as the law allowed, they were back in my office, forced to declare bankruptcy again. The same seems to be true for nations.
Look at Argentina… a nation, which overtly defaulted on its debts back in 2000, and defaults every 10-15 years, on a regular basis. Yet, it is now the proud sponsor of a public debt that foreign banks are, amazingly enough, once again buying! In fact, Argentina recently argued, in a New York courtroom, that if the court forced it to pay pre-2000 debts, it would default on newer debt, owed to other American financial institutions.
How stupid can creditors be? The answer is VERY stupid. In spite of defaulting on tens of billions of dollars worth of debt, back in year 2000, Argentina has been able to borrow tens of billions more from witless creditors who learned nothing from past experience. Why, then, should we be worried about the United States? America has only defaulted 3 times in all its prior history and, with respect to the 1861 event, the default was eventually cured.
In fact, the new prospective default, which would almost certainly revolve around a failure to raise the debt ceiling, would be cured far more quickly than the 15 years required back in 1861. The next default will almost surely be cured within a few weeks or months. Possibly, it could be cured within a few days. Accordingly, if America does delay payments on its debt, it won't be the end of the world. The default will result in short-term economic consequences, just as it did in the past. As soon as the debt is paid (as after the Civil War), even if the payments are very late, the default will be forgotten, and all will be as it was before.
In fact, even with respect to defaults NEVER cured, such as in the defaults of 1933/34 and 1971, creditors still resumed lending. It is a sounder strategy, therefore, to default at a time of our choosing, while everyone believes the debt will be paid, rather than at a time when it is forced upon us from the outside. The reality is that every knowledgeable American creditor already knows that they will be repaid in devalued dollars. The simple fact that they will be paid, in something that resembles the current dollar, as weak as that promise may be, keeps them buying the debt, partly because it is the only game in town when it comes to large quantities of money.
It would obviously be better for America to become a sober handler of money. That does not seem to be in the cards, and if the alternative is to endlessly raise our debt limit, or eliminate having a debt limit altogether, then the unsustainable debt problem will simply continue to build. The bigger the American debt bubble becomes, the more severe the eventual economic consequences. A default would eventually be forced by external factors. At some point in the future, Congress is likely to realize this, and no agreement to further raise the debt ceiling will be possible. The 4th American debt default will become a reality.
Unfortunately, the widespread propaganda about this being our "first" debt default will create a much more severe initial short-term reaction than would otherwise be the case. Markets will be "shocked" by the default, because most investors will not realize that it is an event that we have recovered from many times in the past. Only a few thousand will read this article compared to the millions who follow CNBC, MarketWatch, the Wall Street Journal, etc. If Treasuries decline dramatically, it could provide the best opportunity to buy them in over 150 years (since 1861). That is because, after a few days, weeks or months of suspended payments, the bonds will be fully paid.
Once the initial shock is over, purchasing Treasuries might be a much more profitable investment than buying the stock market (NYSEARCA:SPY) (NYSEARCA:DIA) (NASDAQ:QQQ). It might be wise to wait for the inevitable decline of both stocks and bond prices. Treasuries should eventually rise, even if the stock market continues to fall, once it becomes clear that the default is going to be cured. When Treasuries fall enough, they should be bought. Then, when they subsequently rise, sell them promptly.
Success in this trade depends upon two factors. The first is the number of people who read articles like this one, or to otherwise learn the truth. If too many people learn that there have been many previous debt defaults and none of them have collapsed the nation, the fear factor will leave, and there will be no wholesale Treasury sell-off. The trade would then become worthless, because, like all opportunities, it relies upon market inefficiencies to be successful.
The second factor is the willingness of the buyer of treasuries to promptly get rid of them. Remember, we are no longer on a gold standard, and the Federal Reserve Note is a fiat currency. The US Treasury will NEVER redeem treasuries for gold coins as it redeemed Civil War greenback bonds. Dollar debasement policies, like quantitative easing, will slowly but surely erode the inherent buying power value of the Federal Reserve Note version of the dollar. Thus, getting rid of the US treasuries, on a timely basis, will be almost as important as buying them at temporary deep discount.