Tuesday, January 4, 2011

WSJ: "When States Default"

There was an article in the WSJ today making the analogy with current fiscal troubles and the state defaults in the 1840s.

See also this Murray Rothbard piece on state defaults:

Although largely forgotten by historians and by the public, repudiation of public debt is a solid part of the American tradition. The first wave of repudiation of state debt came during the 1840's, after the panics of 1837 and 1839. Those panics were the consequence of a massive inflationary boom fueled by the Whig-run Second Bank of the United States. Riding the wave of inflationary credit, numerous state governments, largely those run by the Whigs, floated an enormous amount of debt, most of which went into wasteful public works (euphemistically called "internal improvements"), and into the creation of inflationary banks. Outstanding public debt by state governments rose from $26 million to $170 million during the decade of the 1830's. Most of these securities were financed by British and Dutch investors.

During the deflationary 1840's succeeding the panics, state governments faced repayment of their debt in dollars that were now more valuable than the ones they had borrowed. Many states, now largely in Democratic hands, met the crisis by repudiating these debts, either totally or partially by scaling down the amount in "readjustments." Specifically, of the 28 American states in the 1840's, nine were in the glorious position of having no public debt, and one (Missouri's) was negligible; of the 18 remaining, nine paid the interest on their public debt without interruption, while another nine (Maryland, Pennsylvania, Indiana, Illinois, Michigan, Arkansas, Louisiana, Mississippi, and Florida) repudiated part or all of their liabilities. Of these states, four defaulted for several years in their interest payments, whereas the other five (Michigan, Mississippi, Arkansas, Louisiana, and Florida) totally and permanently repudiated their entire outstanding public debt.
Also, read this amazing New York Times article from April 1876 regarding another debt catastrophe (this one involving state guarantees of railroad debt) that quotes the Alabama state auditor's warning in 1869 about these practices:
"While I fully concur in all legislation favoring the development... by giving credit in aid of material improvements... yet I am constrained to call your attention to the following facts: The total value of railroads in the State as per assessment returns made to this office, including right of way, main and side track, rolling stock, and other property, is less than $13,000 per mile. When it is remembered that these items include all of value that can be embraced in 'first mortgage bonds' upon any railroad... it will be readily seen that the State cannot be safe in the indorsement of railroad bonds to the amount of $16,000 per mile, nor would she be free from loss should default be made by the railroads in payment of interest or principal of said bonds."
The article regards Alabama's offer to pay about 30 cents on the dollar, on average, to bondholders, with some receiving less, and some of the railroad bondholders to receive nothing despite the state's guarantee.

I am not so sure that any of the states will default this time (and not because the states are solvent). I think it is fair to question whether Congress would bail out California by writing checks (e.g. a fiscal bailout).

But, what will stop Bernanke from buying California bonds? At this point, I wouldn't bet against it.


eahilf said...

Good post.

But, what will stop Bernanke from buying California bonds?

It would not be easy for him to do that. But it would be a sort of logical next step.

At this point, I wouldn't bet against it.

Nor would I.

CP said...

On the other hand, there are no consequences for states that default, so maybe they'll just do that.

If California repudiated its debt, Goldman Sachs would be there the next morning to lend money all over again.