Obama Says We Must Never Default, But Would It Really Hurt Us If We Did?
After defaulting on their debts in the 1840s, state governments, like Pennsylvania’s, learned to disallow budget shortfalls. This is the lesson that we should learn from history and never repeat. Photo by Flickr user Brendan Lynch.
Paul Solman: President Obama says America must never default. Maybe that’s because he remembers what happened when Pennsylvania did. And Illinois. And Maryland. And Mississippi still hasn’t paid its debts from 1842. Law professor Alasdair Roberts recounts how states decided they could no longer operate with budget deficits.
Alasdair Roberts: In last night’s State of the Union Address, President Barack Obama asked Congress to promise that the United States would never default on its debt. “Let’s agree,” Obama said, “to keep the people’s government open, pay our bills on time, and always uphold the full faith and credit of the United States of America.”
It’s incredible that the leader of an economic superpower should feel obliged to say anything about the need to honor the country’s debts. But there’s no doubt that default would cause enormous damage to America’s reputation abroad. We already have the evidence, provided by one of the most humiliating moments in America’s economic history.
The humiliation came in 1842. But the real cause of American embarrassment arose several years earlier.
In the mid-1830s, the American economy was booming. Cotton exports to the United Kingdom were growing rapidly, British investors were pouring capital into the United States, and lightly-regulated American banks were lending generously. Land speculation was rampant.
State governments wanted in on the action. Voters were pleading for new infrastructure — canals, railroads and turnpikes — as well as more access to loans to speculate in real estate. Legislators believed they could meet those demands easily. States could establish government-owned banks that borrowed at 3 percent in London and lent at 6 percent at home. Or they could repay infrastructure loans from the tolls and fees that were sure to come from new roads, railways and canals.
It seemed like a riskless proposition, and states borrowed massively. Within three years, from 1836 to 1838, U.S. states incurred obligations equal to the combined national debt of Russia, Prussia, and the Netherlands.
Then the bubble burst.
A series of crises hit the U.S. financial sector, which finally collapsed in the autumn of 1839. The country slid into a deep depression. Revenues from infrastructure projects evaporated, and loans issued by state-owned banks went bad. Few states had other sources of revenue. They had no money to pay their overseas creditors.
Michigan and Indiana were the first states to default, in July 1841. They were followed in October 1841 by Arkansas, Illinois and Maryland. Then Florida and Mississippi defaulted in March 1842, and Pennsylvania in August 1842, and Louisiana in January 1843. Nine governments, responsible for two-thirds of all American government debt in private hands, were delinquent on their loans.
The outrage in London was immediate and intense. British investors had been assured by statesmen such as Daniel Webster that state bonds were a safe bet. No state, Webster said in London in 1839, would risk “dishonor and disgrace” by defaulting.
Americans visiting London were barred from clubs, snubbed at dinner parties, and mocked in the newspapers. “Great bitterness of feeling is very naturally felt,” the American ambassador wrote home. “Many have by their investments lost all the earning of active life and the fund on which they relied for their support in old age.”
The low point might have been the summer of 1842. The federal government itself went to London to sell its bonds. This should have been easy: the United States had completely paid off its debt six years earlier. But investors refused to touch anything from the far side of the Atlantic.
“You may tell your government,” James de Rothschild told the U.S. agents, “that you have seen the man who is at the head of the finances of Europe, and that he has told you that you cannot borrow a dollar, not a dollar.”
Anger over the defaults permeated every aspect of Anglo-American relations. The British poet William Wordsworth confided to an American friend that his elderly relatives had lost much of their savings because of the default. He was indignant that Pennsylvania — “one of the richest countries in the world” — had chosen to evade its creditors.
In 1845 Wordsworth, now poet laureate of the United Kingdom, wrote a poem lambasting the Pennsylvanians:
All who revere the memory of Penn
Grieve for the land on whose wild woods his name
Was fondly grafted with a virtuous aim
Renounced, abandoned by degenerate Men
For state-dishonour black as ever came
To upper air from Mammon’s loathsome den.
Another literary heavyweight, Sydney Smith, “the wittiest man in England,” also entered the fray. He wrote that Americans were “guilty of a fraud as enormous as ever disgraced the worst king of the most degraded nation of Europe.” Americans were outraged by Smith’s rhetoric. “My bomb has fallen very successfully in America,” Smith wrote privately in 1843. “I have several quires of paper sent me every day, calling me monster, thief, atheist, deist, etc.”
The default crisis even affected foreign policy. In the early 1840s, the United States and United Kingdom were jostling for territory and markets. As goodwill deteriorated, these conflicts became harder to manage. The two countries came close to war. But the British knew that the cash-strapped American states would find it difficult to fight. Americans “cannot draw the sword,” Smith taunted, “because they have not the money to buy it.”
The British investors’ rage was stoked by the lack of any immediate remedies. The doctrine of sovereign immunity precluded any resort to American courts. The administration of President John Tyler refused to put pressure on defaulting states. And the British government also refused to intervene on the side of creditors.
What is remarkable about this story is what happened next. The defaulting states were free to choose their own course. They could repudiate their debt if they wished. And at first it seemed that many states would follow this path. “The doctrine of repudiating state debts is spreading rapidly,” a prominent Philadelphia merchant lamented in late 1841. “It is spoken of openly and boldly defended by many presses and leading politicians.”
Indeed, many Americans were outraged at the idea that they should have to bear extra burdens, in the depths of a depression, to honor commitments to overseas financiers. Mississippi governor Alexander McNutt promised that the people of his state would never provide relief to “the Baron Rothschild…the blood of Judas and Shylock flows in his veins. It is for this people to say whether he shall have a mortgage upon our cotton fields and make serfs of our children.”
Eventually, though, most states did not repudiate. Mississippi and Florida were the exceptions. Moreover, many states — including those that had never defaulted at all — began amending their constitutions to prevent a recurrence of the humiliation of 1842. The now-familiar no-deficit restrictions on state government borrowing were born.
This was hardly an easy transformation in state policy. Honoring state debt meant establishing new taxes, as well as new capacities for collecting those taxes. This was bitterly resisted by many citizens, especially when times were so tough.
And constitutional restrictions were also resisted. The new rules didn’t just prohibit borrowing. Often, they limited the capacity of state governments to engage in infrastructure or banking projects. In other words, they strictly curtailed activist government.
For many Americans this was a bitter pill to swallow. The Age of Jackson, which witnessed the extension of voting rights, had barely ended. The ideal of popular sovereignty was widely celebrated. “We have an abiding faith in the virtue, intelligence, and full capacity for self-government, of the great mass of the people,” one Democratic magazine said in 1838. “We are opposed to all restraints on the free action of popular opinion.”
The wave of defaults compelled Americans to rethink this sunny view of democratic rule. The crisis seemed to show its darker side. Democratically elected legislatures could be swayed by popular passions or compromised by logrolling and corruption. Some kind of check seemed necessary. “We have not that perfect confidence in ourselves,” said one legislator in the late 1840s. “And we take our cool and calm moments to protect ourselves against the sudden and dangerous impulses of passion and prejudice.”
British banks hired agents to press their case in state capitals, and the first reports from those agents were grim. Complaints about the “corrupt morals” of state legislators were commonplace. But profound changes did eventually come. And perhaps because it came mainly from within — through the slow grinding of democratic processes, rather than by imposition from any external power — those changes proved durable. We are still living with them today.
Alasdair Roberts is the Rappaport Professor of Law and Public Policy at Suffolk University Law School in Boston. His book, “America’s First Great Depression: Economic Crisis and Political Disorder After the Panic of 1837,” has just been published in paperback by Cornell University Press.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions