James Macdonald on US sovereign default

January 17, 2011
blogged Greg Ip's post on the dangers of a US debt default if the debt ceiling isn't raised, it became clear that we were very much lacking an expert take on the matter. " data-share-img="" data-share="twitter,facebook,linkedin,reddit,google,mail" data-share-count="false">

After I blogged Greg Ip’s post on the dangers of a US debt default if the debt ceiling isn’t raised, it became clear that we were very much lacking an expert take on the matter. So I asked James Macdonald, author of my favorite book about sovereign debt, if he might weigh in. Here’s what he replied:

Constitutional issues:

In the event of a refusal by Congress to raise the debt ceiling, would public debts have precedence over other government obligations? Some commentators have referred to the Fourteenth Amendment, passed in the aftermath of the Civil War, which states that “the validity of the public debt… shall not be questioned.” Is the public debt of the United States constitutionally sacrosanct in ways that its other obligations are not?

The Fourteenth Amendment was needed because, as the ex-Confederate states rejoined the Union after the Civil War, they were likely to hold a great deal of power in Congress, just as they had before 1860. In fact southern whites had been over-represented thanks to the extraordinary provision of the original Constitution that States could count 60% of their slave populations towards their seat allocations in Congress even though slaves had no rights. The main purpose of the amendment was to ensure that emancipated slaves could not be deprived of the right to vote, and as an additional weapon the amendment stated that States would only be entitled to seats in Congress in proportion to their voting populations.

The clause on public debt was the amendment’s final provision, and reads:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.”

There are a number of issues raised here. As the southern states regained power in Congress they might have refused to honour war pensions to Union veterans unless an equivalent provision was made for Confederate soldiers. Or they might have demanded equivalent treatment for the war debt of both sides. The amendment put exiting debts, agreed while the Confederate states were not in the Union, out of bounds of discussion. The most striking aspect of the clause may be the second sentence. It rode roughshod over States’ rights by prohibiting them from paying any Confederate war debts, even if they wanted to. It also set aside the protection of property rights enshrined in the Fifth Amendment (“nor shall private property be taken for public use without just compensation”) by making it illegal to compensate slave owners for the loss of their property, even those in States that had not joined the Confederacy. It is perfectly possible that without the Fourteenth Amendment, slave owners could have taken to government to the Supreme Court on the basis of the Fifth Amendment.

What implications are there for the present situation? Prior to the Fourteenth Amendment, the main constitutional protection for public creditors was the Fifth Amendment. It is not clear just how much the Fourteenth Amendment added to that protection in the case of debt securities, which, as a form of property, are protected by the Fifth Amendment anyway. Where the Fourteenth Amendment might have some implications is in the case of state pensions, and by extension Social Security benefits, which could be deemed to be protected in the same way as post-Civil War veterans’ pensions. The Amendment also has a bearing on any attempt by the government to default on some debts while honoring others. (What happens to Chinese holdings of US Treasuries if China invades Taiwan triggering economic war between the two superpowers?)

Neither the Fifth nor the Fourteenth Amendments protected creditors in 1934, when the US declared that, as part of removing gold from circulation, it would no longer honor the “gold clause” that required the government to pay its bonds in gold coin of a fixed standard. The matter went to the Supreme Court, which found for the government on the basis that section 8 of the Constitution allowed Congress to determine what constituted money; so if it wanted to demonetize gold, it could. This, of course, did not mean the the government had not defaulted, merely that the Constitution allowed it to default under certain circumstances.

Since the Constitution gives the government the power to redefine money at will, it could be argued that the government might find a way around the debt ceiling by some monetary sleight of hand. However, the Constitution would not help in this instance, since the power is vested in Congress, not the administration.

Historical precedents:

The power of the debt ceiling can be very effective. The closest historical analogy to the present situation – other than the shutdown of government under Clinton in 1995 – is the run-up to the French Revolution. The French government was running a chronic deficit, although nothing like so large as the present US deficit in relation to GDP. There was no elected assembly in France, but registration of government loans by the Parlement of Paris, an unelected body of lawyers, was required to give them the force of law. In 1788 the Parlement refused to register the loan needed to cover the annual deficit unless the Estates General was reconvened. The government responded by disbanding the Parlement and imprisoning its leaders, but its access to the credit markets was frozen. In the end it was forced to summon the Estates General in 1789, and the rest, as they say, is history.

Thoughts on the present situation:

Clearly the US does not have to default just because the debt ceiling is reached – for the reasons outlined in this blog and elsewhere. It can temporarily cut back, or delay, its expenses. There is very unlikely to be a problem covering interest on this basis, since the interest on the market debt is only running at $16bn per month and only represents 5% of spending.

The problems could occur for other reasons:

– Given a budget deficit of $1,500 billion per year, new debt has to be issued at a average rate of $130 billion per month. The government would therefore have to reduce/delay spending by $145 billion per month to cover interest and avoid increasing its debt. This is a far more serious problem than finding a mere $16 billion per month, and represents 44% of total spending.

– The market could take fright and refuse to refinance existing debt as it matures, leading to default. Since, quite apart from bond maturities, there are around $2 trillion of T-bills outstanding, the government is on a very short leash when it comes to its credit standing. However, I do not take this risk seriously, since the Fed will simply lend the government the money to roll over the debt if the market refuses to do so.

Given that the the prices of government bonds have not collapsed, the market clearly assumes that that Congress will blink first and there will be no crisis. Personally, I am pretty confident that the market is right. However, there is a risk that, precisely because the only thing that the government can do legally to avoid default is to reduce spending, which is what the Republican right wants, there is an incentive for the Republicans to continue with the game of chicken until it is arguably too late.

At that point, even if the government does avoid default, the battle may be such a “damn close run thing” that the markets may decide that American politics is in so parlous a state that the risk premium on government bonds needs to rise sharply.

PS. Diverting the Social Security surplus (as per your blog) is not an option. Because of the recession, the program is currently running at a deficit, although it is supposed to return to surplus as employment increases.


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