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In the foibles and adventures of lending and borrowing, at least one constant law holds: loans that cannot be repaid will not be repaid, whether they are to governments or to anybody else. History shows us that sovereign governments often default on their loans, particularly in times of war or economic upheaval. Europe finds itself in this situation now and would do well to examine past sovereign debt crises—particularly, the European sovereign debt crisis of the 1920s—for lessons.
Key points in this Outlook:
In his instructive 1933 book, Foreign Bonds: An Autopsy, Max Winkler states a central irony: “Governments have long been considered preferred credit risks, in spite of the fact that they may, with comparative impunity, suspend payments.” Although our language often obscures the distinction, it is essential to remember that each sovereign loan is a loan to a government, not to the country itself.
As the governments of country after country defaulted on their debt in the 1980s, the US banking system suffered massive economic losses. Citibank had been a leader in making big loans to these sovereign borrowers, and other banks had joined in. “I remember how the bankers tried to corner me at conferences to offer me loans,” said one former Latin American finance minister. These loans were at the time widely praised by politicians and economists as successful so-called “petrodollar recycling”—until the cascading defaults started.
After the defaults, critics smugly laughed at Citibank’s former chairman, Walter Wriston, for having pronounced, “Countries don’t go bankrupt.” It was indeed a foolish thing to say, going down in financial lore with gems like the 1929 predictions of permanently high stock prices and the more recent idea that house prices would never fall.
Yet a mere generation later, twenty-first-century economists, financial actors, and regulators blithely talked of the “risk-free debt” of governments and the “risk-free” interest rate. Europe and its banks must now face up to recognizing huge losses on government debt, and banking regulators are suffering the intense embarrassment of having assigned zero capital requirements to such “risk-free” assets. Here we are again, historically speaking, with yet another sovereign debt crisis.
But why is anybody surprised? Carmen Reinhart and Kenneth Rogoff count 250 defaults on government debt from 1800 to the early 2000s. As Winkler wrote, “The history of government loans is really a history of government defaults.”
Winkler chronicled many contemporary and historical examples of governments’ defaults and repudiations of debts, including “the famous decree of December, 1917, providing for the repudiation of all [Russian government] debts.”
Winkler provided summaries of the historical defaults on their debt up to 1933 by the governments of Argentina, Austria, Bolivia, Brazil, Bulgaria, Canada, Chile, China, Ecuador, Costa Rica, Germany, Greece, Guatemala, Latvia, Mexico, Peru, Romania, Russia, Turkey, and Yugoslavia. For good measure, he added the history of defaults within the United States by the governments of Alabama, Arkansas, Florida, Georgia, Louisiana, Michigan, Minnesota, Mississippi, North Carolina, South Carolina, Tennessee, Virginia, and West Virginia.
The European Sovereign Debt Crisis of the 1920s and ‘30s
Among the history now forgotten in the midst of today’s European sovereign debt crisis is the European sovereign debt crisis of the 1920s, which distracted the finances and politics of that time before ending in huge defaults.
As former British prime minister David Lloyd George wrote, “The World War, prolonged over four years on a more intense and destructive scale than human imagination had ever previously conceived possible, left all the belligerent nations at its close deeply impoverished, burdened with immense debts.”
“Europe and its banks must now face up to recognizing huge losses on government debt.”Borrowing money to spend on destruction is even worse than borrowing money to buy things at high prices that later collapse. After the Great War, what assets were left to service the debt? This was especially true for the losers, but also true for the winners—except for the United States, which emerged from that war the principal creditor of all the others.
Emanuel Derman, a physicist who also plied his mathematical skills on Wall Street, offers instructive historical insight on government debt: “In the long run . . . governments collapse, countries disappear, empires fall, and things hold their value much better than paper does.”
“The extensive liabilities incurred by the Southern States of the U.S.A. to British investors for War Loans during the American Civil War have never been paid at all,” Lloyd George observed. A lesson in war finance: do not lend to the side that is going to lose.
But even the winners of 1918, principally the governments of France and Britain, had vast debts they could not pay. Put simply, the theory of the Treaty of Versailles 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. Of course there was a slight problem: Germany probably could not, and certainly would not, pay the reparations as decreed by the treaty, so no one could pay off their debt. This was the famous “economic consequence of the peace” as predicted by Keynes.
There can be political consequences as well: governments cannot necessarily remain in power when broke. A new sovereign government may take over and refuse to pay the old obligations of former regimes, as in Germany in 1934 and Russia in 1917.
During the 1920s, European and American governments struggled mightily to come up with ways to address the huge problems of European government debts. Naturally, it occurred to the debtor governments that the whole problem could be solved in cutting-the-Gordian-knot fashion if everyone agreed to cancel all the debts arising from the Great War.
Lloyd George made a desperate plea in favor of this solution. “The people of the United States are no better off . . . that their customers throughout the world cannot afford to buy their goods,” or that Germany was being driven “to a bankruptcy in a vain effort to get more than she can pay,” he argued. Keynes weighed in, noting that if “the United States exacts payment of the Allied debts, the position will be intolerable.”
Financial debates recur with financial cycles, and modern economists, in response to the current European debt crisis, have again argued that “debt must be forgiven . . . to restore any hope of growth.” This echoes Lloyd George’s peroration from 1932: “It would be a commercially sound business proceeding to wipe out these debts.”
In retrospect, this was probably correct, but of course the idea sounded less good to the creditor. From the viewpoint of the United States, William G. McAdoo sourly observed, “Although small payments on this stupendous debt have been made by some of the debtor nations since the war, it has not diminished, but has actually increased, owning to the accumulation of unpaid interest.” McAdoo had been secretary of the treasury under Woodrow Wilson, in charge of making the loans to the Allied European governments.
“Since it fell to my lot to initiate the policy of foreign loans,” he wrote, “I know, perhaps better than anybody else, the origin of these loans. . . . I have heard, at times, arguments to the effect that the money we advanced to friendly governments during the war were not loans at all, except in form; that they were in reality gifts or contributions. . . . These arguments have no basis in fact or in anything but the imagination of those who make them.”
“Every borrowing government understood that it was receiving loans, not gifts, and that it was expected to repay them,” he continued. “The obligation further provides that the principal and interest thereon shall be paid in gold coin of the United States without any deduction.”
International Negotiations and Debt Plans
By the mid-1920s, it was obvious that repayment was not happening and could not happen. The debt crisis then gave rise to a complex negotiation and agreement, with restructuring of obligations and new credit for Germany, in what was considered at the time a landmark success. The similarities to the fevered negotiations in today’s Europe are apparent.
The 1920s negotiation was carried out by the inter-national Dawes Committee and resulted in the contemporaneously celebrated Dawes Plan of 1924. This complicated and politically charged effort was chaired by Charles Dawes, who was elected later that year as vice president of the United States and awarded the Nobel Peace Prize in 1925 for the Dawes Plan.
“By 1936, more than 35 percent (by dollar volume) of 1920s sovereign bonds floated in the world’s new financial capital were in default.”Under the Dawes Plan, German reparation payments were reduced and restructured, and the French military occupation of part of Germany to enforce payments of reparations was to end. Foreign creditors were to have oversight of the Reichsbank, Germany’s central bank, and to have as collateral German customs duties; taxes on tobacco, beer, and sugar; and revenue from alcoholic spirits. But how can you enforce your rights to such collateral against a powerful government that decides not to pay? You cannot.
New loans to Germany from the United States would make Germany’s required payments possible. So in short: since the United States would lend Germany money, it could pay France and Britain so that France and Britain could pay the United States. Stated in this bald fashion, one might think this was not sustainable, which turned out to be exactly the case.
But at the time, its negotiation and approval were considered “the outstanding events of the year.” The German External Loan of 1924 that followed “was a brilliant success.” This 7 percent bond was offered in New York and London at a price of 92 and then rose above par. “In 1924,” Brendan Brown writes philosophically, “only a genius in imagination could have painted as a possible future state of the world the full catastrophe that developed.”
In fact, German economic growth was very strong and impressive to creditors from 1924 to 1928, but it was accompanied by and dependent on heavy foreign borrowing, especially from the United States. “Germany made a recovery, which seemed to many observers phenomenal. . . . Foreign investors and speculators bought German securities and deposited heavily in German banks,” Joseph Davis noted. As late as 1930, the 7 percent Dawes Loan bonds, with nineteen years left to maturity and, as it turned out, four years to default, traded at 109.
With investors’ imagination focused on “new era” prosperity, enthusiasm grew for new foreign government bonds in the 1920s, as the leading center of international finance moved to New York City from London. “The Dawes Loan in 1924 opened the eyes of American investors to the romance of buying foreign securities”—a romance investors subsequently regretted, as Winkler observed: “The American investor is now [in 1933] learning what his cousin across the ocean experienced half a century earlier: non-payment.” By 1936, more than 35 percent (by dollar volume) of 1920s sovereign bonds floated in the world’s new financial capital were in default.
As the 1920s progressed, the government debts created by the Great War did not go away. By 1929, renewed conflict over German reparations gave rise to new international negotiations and a new agreement, the Young Plan, which further reduced payments and scheduled them over the next fifty-nine years. This plan also established the Bank for International Settlements, which would later host the Basel Committee on Banking Supervision. That committee gave rise to the zero capital requirement for European government debt—an institutional link between the 1920s crisis and the twenty-first century’s painfully relearned lessons in the reality of sovereign credit risk.
Take the Real Assets?
Of course, 1929 to 1931 experienced accumulating financial disasters on a worldwide scale. In 1931, contemplating the enormous outstanding debt of European governments to the United States, McAdoo brooded: “You cannot collect a debt, no matter how sacred, from a debtor who lacks the means of payment.” Very true.
But, he wondered, “Is there any way in which those vast governmental debts can be liquidated or transformed into other obligations which will . . . accomplish their ultimate extinguishment with honor to the nations involved?” The correct answer to this question was “No.”
However, McAdoo made a modest proposal: to settle the debt of the British and French governments, the United States would “tak[e] over their West Indian possessions . . . together with British and French Guiana,” in addition to “stocks and bonds in railways, steamships, telephone and telegraph companies, in manufacturing concerns and other enterprises . . . and also real estate in some of their large cities.”
Now, there’s a memorable offer from your ally and creditor! Note that the proposal is not entirely dissimilar to what happens to the assets of a private company in bankruptcy liquidation. Considering this, we should rewrite that quote of Walter Wriston’s from the beginning of this Outlook to say: “While countries do frequently default on their debt, they cannot be put into a bankruptcy proceeding.” In contradiction to Wriston’s intent, this emphasizes, not dismisses, the risk to their creditors.
In June 1931, then-president Herbert Hoover drew a different conclusion from McAdoo’s. He proposed, and got other countries to agree to, a one-year moratorium on all payments of Great War debts and reparations. Another international crisis negotiation, the Lausanne Conference of 1932, followed.
“Because governments always promote government debt, future sovereign debt crises are inevitable.”
But this chapter in the eventful history of sovereign debt was over. A new plan for government debt, which certainly would have required debt forgiveness, did not emerge, and great majority of the sovereign debt created by the war defaulted.
Who Promotes Government Debt?
Eight decades ago, in the last chapter of Foreign Bonds: An Autopsy, Winkler offered a prediction about future lending to sovereigns: “Debts will be scaled down and nations will start anew,” he wrote. “All will at last be forgotten. New foreign loans will again be offered, and bought as eagerly as ever.” All accurate—and then: “Investors will once again be found gazing sadly and drearily upon foreign promises to pay.”
In the 1980s, they gazed sadly again at such promises and now are doing so once more with the Greek government. Ultimately, losses are taken, and life goes on.
We should consider, in conclusion, the important role of banks in lending to sovereigns, especially as today’s European banks face dramatic losses on their loans to governments. Who promotes loans to governments? 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. They may even create a reassuring name for these loans: “risk-free assets.” Banks are extremely vulnerable to pressure and direction from governments—the more regulated they are, the more vulnerable. Bureaucratic government employees will never discourage loans to their political masters.
In addition to promoting their own debt to all possible buyers at all times, governments promoted Great War loans to Allies, loans to Germany in the 1920s, loans to developing countries to “recycle petrodollars” in the 1970s, loans to Fannie Mae and Freddie Mac until they failed, and loans to fellow governments in the European Union up to today.
Herein lies a knotty conflict of interest—one that is, I suspect, impossible to untangle and relevant both to the instructive past and the future. Because governments always promote government debt, future sovereign debt crises are inevitable.
Alex J. Pollock ([email protected]) is a resident fellow at AEI.
1. Max Winkler, Foreign Bonds: An Autopsy (Washington, DC: Beard Books, 1999), 19.
2. John H. Makin, The Global Debt Crisis: America’s Growing Involvement (New York: Basic Books, 1984), 147.
3. Richard Sylla, “Where’s Walter?,” Chief Executive Magazine, October 1, 1996, http://chiefexecutive.net/wheres-walter (accessed March 6, 2012).
4. Carmen Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton UP, 2009), 111.
5. Winkler, Foreign Bonds: An Autopsy, 10, 39, 206–86.
6. David Lloyd George, The Truth about Reparations and War Debts (London: William Heinemann, 1932), 7 (italics added).
7. Emanuel Derman, Models.Behaving.Badly. (New York: Free Press, 2011), 215.
8. Lloyd George, The Truth about Reparations, 78.
9. John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace and Howe, 1919).
10. Lloyd George, The Truth about Reparations, 138–9.
11. John Maynard Keynes, “War Debts and the United States,” in Essays in Persuasion (New York: WW Norton, 1931), 57.
12. Nouriel Roubini and Arnab Das, “Back to the Future? The Shape of Reforms to Come,” Roubini Global Economics Analysts Blog, May 31, 2010, www.economonitor.com/analysts/2010/ 05/31/back-to-the-future-the-shape-of-reforms-to-come (accessed March 6, 2012).
13. Lloyd George, The Truth about Reparations, 141.
14. William G. McAdoo, Crowded Years: The Reminiscences of William G. McAdoo (Boston: Houghton Mifflin, 1931), 414.
15. Ibid., 414–5 (italics added).
16. Joseph S. Davis, The World between the Wars, 1919–39: An Economist’s View (Baltimore: Johns Hopkins UP, 1975), 55, 68.
17. Brendan Brown, Monetary Chaos in Europe (Kent, UK: Croom Helm Ltd., 1988), 204.
18. Davis, The World between the Wars, 77.
19. Brown, Monetary Chaos in Europe, 235.
20. Charles Kindleberger and Robert Z. Aliber, Manias, Panics and Crashes, 6th ed. (New York: Palgrave Macmillan, 2011), 55.
21. Winkler, Foreign Bonds: An Autopsy, 7.
22. Marc Flandreau, Norbert Gaillard, and Frank Packer, “Ratings Performance, Regulation and the Great Depression: Lessons from Foreign Government Securities” (Centre for Economic Policy Research Discussion Paper #7328, June 2009), 24, http://graduateinstitute.ch/webdav/site/iheid/users/Stefano_Ugolini/public/CEPR-DP7328.pdf (accessed March 6, 2012).
23. McAdoo, Crowded Years, 416.
24. Ibid., 419–20.
25. Winkler, Foreign Bonds: An Autopsy, 179.
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