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Twenty-first century economists, financial actors and regulators blithely talked of the “risk-free debt” of governments, and European bank regulators set a zero-capital requirement on the debt of their governments. The manifold proof of their error is that banks and other investors are now taking huge credit losses on their Greek government bonds.
“Can you enforce your rights to such collateral if a powerful government decides not to pay? You can’t.” — Alex Pollock
The only question is why anybody would be surprised by this. The governments of country after country defaulted on their debt in the 1980s, a mere generation ago. In a longer view, Carmen Reinhart and Kenneth Rogoff count 250 defaults on government debt from 1800 to the early 2000s. As Max Winkler wrote in his instructive 1933 book, “Foreign Bonds: An Autopsy”: “The history of government loans is really a history of government defaults.”
Winkler chronicled many examples of government defaults and repudiations of debts up to 1933, including those of Austria, Bolivia, Brazil, Bulgaria, Canada, Chile, Ecuador, Costa Rica, Germany, Greece, Guatemala, Latvia, Mexico, Peru, Romania, Russia, Turkey and Yugoslavia—as well as those of a dozen U.S. states.
Among the financial history lessons now forgotten is the European sovereign debt crisis of the 1920s. The losers of World War I were flat broke. But the winners, principally the governments of Britain and France, had vast debts they could not pay.
Simply put, the theory of the Versailles Peace Treaty at the end of the war was that Germany would be forced to pay reparations, a form of debt, so that France could pay its debt to Britain and the United States, and Britain could pay its debt to the United States. There was a slight problem, of course: Germany probably could not, and certainly would not, make the payments as decreed by the treaty, so no one could pay off their debt.
By the mid-1920s, it was obvious that the expected repayments were not happening and could not happen. The debt crisis gave rise to complex international negotiations and an agreement that included the restructuring of German obligations, along with new lending to Germany. This was considered at the time a landmark success. The similarity to the recent fevered negotiations in Europe is clear.
The 1920s negotiations were carried out by the international Dawes Committee, resulting in the then-famous Dawes Plan of 1924. The effort was chaired by Charles Dawes, who was elected U.S. vice president later that year and was awarded the Nobel Peace Prize in 1925 for the plan.
Under the Dawes Plan, German payments were reduced and restructured. The French military occupation of part of Germany, part of a plan to enforce payments, would end. Foreign creditors were to have oversight of the Reichsbank, Germany’s central bank—and the creditors were to have as collateral German customs duties, taxes on tobacco, beer and sugar, and revenue from alcoholic spirits.
But can you enforce your rights to such collateral if a powerful government decides not to pay? You can’t.
New loans from the U.S. would make Germany’s planned payments possible. Americans would lend Germany money, so it could pay France and Britain, so they could pay the U.S. One might imagine that this pattern of making new loans to pay old obligations was not sustainable, and it wasn’t.
But the German External Loan of 1924 that followed to implement the Dawes Plan was considered by many to be “a brilliant success.” As late as 1930, with 19 years left to maturity, these 7% Dawes loan bonds traded above their face value, at 109. “The Dawes Loan opened the eyes of American investors to the romance of buying foreign securities,” wrote Charles Kindleberger and Robert Aliber in their classic “Manias, Panics and Crashes.” Foreign government bonds became popular in the new financial capital of the world, New York City.
But it was a disappointed romance. In 1934, the German government announced it was no longer paying on Dawes bonds. By 1936, 35% of the sovereign bonds floated in New York in the 1920s were in default—an experience similar to defaults on subprime mortgages in our own time. The vast majority of the sovereign debt that had been created by World War I also defaulted.
In 1933, Winkler predicted that “All will at last be forgotten. New foreign loans will again be offered, and bought as eagerly as ever.” And then: “Investors will once again be found gazing sadly and drearily on foreign promises to pay.” A brilliant forecast.
As European banks and other investors today gaze sadly on government promises to pay, it is essential to ask: Who promotes loans to governments?
The answer is that governments promote loans to governments. They have an obvious self-interest in promoting loans to themselves and to other governments they wish to help or influence. Banks are extremely vulnerable to pressure from governments—the more regulated they are, the more vulnerable. Employees of government bureaucracies have an incentive to encourage loans to their political employers—an inherent conflict of interest.
In addition to promoting their own debt to all possible buyers at all times, governments promoted the World War I loans to the Allies; loans to Germany in the 1920s; loans to developing countries in the 1970s, which defaulted in the 1980s; loans to Fannie Mae and Freddie Mac until they failed; and loans to fellow governments in the European Union up to today.
Because governments always promote government debt and can induce or pressure banks into buying it, future sovereign debt crises are inevitable.
Alex Pollock is a resident fellow at AEI.
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