Global Macro Monitor

One of the most pervasive myths about the United States is that the federal government has never defaulted on its debts. There’s just one problem: it’s not true, and while few people remember the “gold clause cases” of the 1930s, that episode holds valuable lessons for leaders today. – Sebastian Edwards, Project Syndicate,  May 21, 2018

My friend, UCLA professor,  Sebastian Edwards, is out with a must-read summer book, American Default: The Untold Story of FDR, the Supreme Court, and the Battle over Gold.

Sebastian has also published an excellent synopsis of the the book, Learning from America’s Forgotten Default, on the Project Syndicate (PS) website.   It is an excellent introduction to the subject material but only scratches the surface and should not be a substitute or excuse for not purchasing the book.

Money quotes from the Project Syndicate  piece:  

• There was a time, decades ago, when the US behaved more like a “banana republic” than an advanced economy, restructuring debts unilaterally and retroactively
• In April 1933, in an effort to help the US escape the Great Depression, President Franklin Roosevelt announced plans to take the US off the gold standard and devalue the dollar. 
• …this would not be as easy as FDR calculated. Most debt contracts at the time included a “gold clause,” which stated that the debtor must pay in “gold coin” or “gold equivalent.” 
• These clauses were introduced during the Civil War as a way to protect investors against a possible inflationary surge.
• …the gold clause was an obstacle to devaluation. If the currency were devalued without addressing the contractual issue, the dollar value of debts would automatically increase to offset the weaker exchange rate, resulting in massive bankruptcies and huge increases in public debt.
• Congress passed a joint resolution on June 5, 1933, annulling all gold clauses in past and future contracts.
• Republicans were dismayed that the country’s reputation was being put at risk, while the Roosevelt administration argued that the resolution didn’t amount to “a repudiation of contracts.”
• On January 30, 1934, the dollar was officially devalued. The price of gold went from $20.67 an ounce – a price in effect since 1834 – to $35 an ounce.
• …those holding securities protected by the gold clause claimed that the abrogation was unconstitutional. 
• Lawsuits were filed, and four of them eventually reached the Supreme Court; in January 1935, justices heard two cases that referred to private debts, and two concerning government obligations.
• On February 18, 1935, the Supreme Court announced its decisions. In each case, justices ruled 5-4 in favor of the government – and against investors seeking compensation. 
• Justice James Clark McReynolds… wrote the dissenting opinion – one for all four cases… He ended his presentation with strong words: “Shame and humiliation are upon us now. Moral and financial chaos may be confidently expected.”
• …the 1935 ruling is invoked [today] when attorneys are defending countries in default (like Venezuela). And, as more governments face down new debt-related dangers – such as unfunded liabilities associated with pension and health-care obligations – we may see the argument surface even more frequently.
• …the US government’s unfunded liabilities are a staggering 260% of GDP – and that does not include conventional federal debt and unfunded state and local government liabilities.
• A key question, then, is whether governments seeking to adjust contracts retroactively may once again invoke the legal argument of “necessity.”
• The US Supreme Court agreed with the “necessity” argument once before. It is not far-fetched to think that it may happen again.  – Sebastian Edwards

A Roadmap? 

There you have it, folks.

The good professor lays it all out, which may or may not be the roadmap for how the U.S. and other highly indebted governments resolve their ,massive and almost impossible to fulfill contractual obligations to both creditors and its citizens.   The Supremes have already ruled in favor of the government under the “necessity” argument.

Modern Monetary Theory (MMT)

Sebastian’s material gives us much ammunition in arguing with the Modern Monetary Theory crowd, who believe a sovereign government cannot and will never default on its local currency obligations if it has an independent central bank.    Of course, they will argue that FDR and the U.S. didn’t have an independent monetary policy because of its link to the gold standard.

Russia 1998

When we bring up Russia’s 1998 default on local currency GKO debt (David Tepper’s worst trade, BTW) the MMTs argue “special case.”

It seems to us the MMT crowd believe that because a government has an independent central bank and can always print money to payoff debt, they will never, ever experience rollover risk.  Complete nonsense.

Can you say Venezuela?

When a government experiences financing problems through a sudden stop in funding, the leaders must make a political decision on whom to inflict the pain.

Either default, which hurts their creditors, and who be predominantly consists of foreigners, as was the case in Russia in 1998; and is the case with the U.S. federal government marketable debt in 2018;  or monetizing the rollover, resulting in hyperinflation and wiping out domestic residents.

We have the first-hand experience of the latter and have written about it in many posts over the years,

We’ll also never forget being in the Bulgarian central bank in 1996 just before some very large maturities of treasury bills were coming due.  The market had lost confidence in the government and a high ranking central bank official looked us straight in the eye and said “we will not let the government default.”

We knew instantly a massive amount of liquidity was about to hit the local markets, the demand for the currency was going to collapse, and the country was headed for hyperinflation.   Rioting broke out, the government fell, and the country eventually implemented a currency board, not too dissimilar from  that of the Euro, in order to enforce fiscal discipline upon the government. – GMM, November 2011

We suspect when the day of reckoning comes for the United States to pay for its debt profligacy, it won’t be such a simple binary choice. There will be many and various types of public sector obligations in the queue to be paid, which may require differential treatment.

Sebastian’s example of the U.S. government default in the 1930’s is a combination of both.  The default on the contractual gold clause and the inflating away of much of the debt through devaluation.

This is tantamount to an emerging market government unilaterally and retroactively converting its foreign currency debt into local currency and then monetizing it, and supported by the legal system.

How would that work out for, say,  Venezuela dollar denominated bond holders?

Let’s hope our political leaders and policy makers come to their senses before that dreadful day is upon us.

Now take the few minutes to read the full article and go buy the book for some excellent beach reading. .