Chapter 14: The Default Waltz
1929 - 1931
Most debt is nominal. It is denominated in dollars or gold; when the value of those measures change, so too does the value of debt. If the demand for gold were to increase, it would become more expensive and so too would gold denominated debt or debt denominated in a gold backed currency.
In 1929, the US had 173 billion dollars worth of net debt (government ownership of other government debt is not counted, nor is corporate debt owned by corporations). If that figure remained the same, it would be worth 1.18 times more at the end of 1932 compared to the price of goods and services, or 204 billion 1929 dollars. If instead you were to deflate it by the sum of all income in the US (GDP), it would be 1.36 times larger or 225% of GDP (compared to 165% of GDP in 1929).
As the world economies contracted, the debt burden increased. This debt needed to either be paid with increasingly large shares of income or defaulted on. Farmers would find they couldn’t keep up with their mortgages and lose the farm. Corporations would declare bankruptcy with creditors only getting some fraction of face value of their debt. Governments too would feel the pinch, especially when it came to debt owed to foreign countries.
In 1923, Germany had defaulted on its debt and the French had occupied the Rhineland in turn. Rather than just Germany, the situation in 1931 brought all of Europe to its knees. The failure of the Danatbank in Germany on July 6th would send the world into a panic as stocks slumped once more in response to the untenability of the current situation.
Against his earlier reticence, Hoover would respond by announcing his intentions for a one year debt moratorium on the 13th to bring the situation back in line. Stocks would rally upon the announcement due to hopes for international cooperation to combat the depression. Perhaps the moratorium could give countries enough time to get their finances in line and pave the way for reductions in trade barriers (American tariffs in particular made it extraordinarily difficult to create the net exports needed for interest payments) or a coordinated expansionary policy in order to prevent gold flight.
Weeks of arguments with the French finalized in August. They were upset that Hoover had made the announcement without consulting them as the moratorium would also impose a pause on Germany war debt payments. France might have been a net debtor due to their loans from the UK and US needed for materiel, but they were a superpower when it came to international finance in the depression and they wanted to be treated like one. As the major power least hard hit, outside of the Soviet Union, with the most gold in the world, they were in a bargaining position second only to the US.
Even still the US was looking worse for wear with extreme stock declines and rampant unemployment. Certainly its prestige as a land of opportunity where streets are paved with gold and the parties never end had been damaged.
Throughout Europe, where the nations were loaded down with war debts and struggling with adverse budgets and snarling at one another over their respective shares of a trade that would not expand, men looked at the news from the United States and thought, “And now, perhaps, the jig is up even there.”
- Since Yesterday, Frederick Lewis Allen, Chapter 2 Section 4
Much like France, American politicians had been soured with regard to international cooperation. The main thing preventing more outrage from congress to Hoover’s proposal was the positive reaction of the market.
Even with the moratorium, the Bank of England would move the Sterling to a floating exchange rate with regard to gold on September 21st. Despite intense discount rate hikes, the Pound would rapidly devalue. The Nordic countries would follow in September and October along with Japan in December.
Consequently there was a sudden collapse in prices of foreign bonds from both the devaluations and expectations of future risks of devaluation. This trend also applies to domestic bonds as fears of devaluation in America were fanned. Organizations increasingly hoarded gold due to the now apparent risk associated with currency denominated securities.
Banks went bankrupt at increasing rates and the federal reserve raised their discount rate. Gold would flow to France due to its safety from default backed by their large gold stocks.
The Domestic US
Net Debt in the United States
Year | Public Debt | Long Term Debt | Short Term Debt |
|---|
1929 | $29,412 | $87,041 | $56,545 |
1930 | 30,037 | 91,585 | 52,049 |
1931 | 32,589 | 89,684 | 43,801 |
1932 | 35,007 | 85,494 | 32,391 |
1933 | 50,835 | 69,105 | 30,119 |
Note the precipitous decline in short term debt owing to a collapse in securities held on margin and consumer debt for purchases of durables such as cars.
Similarly, note the enormous gain and fall in Public and Long Term Debt in 1932-33 respectively. This is an artifact of the transfer of the assets and liabilities of America’s rail transportation sector to the federal government. Similarly, the acquisition of land shifted the debt burden in part from American Mortgages to American Treasury Notes and what few NRA bonds make it into the public’s hands.
This reallocation of debt from the railroads and equity from their shareholders to the United States government would prove to either show a dramatic mispricing on March 3rd or incredibly unlikely event coming to fruition. On March 3rd, the terminal value of railroad debt was $12,973 million but would be replaced with $9,285 million following a reorganization of the many obligations into a standard ARC bond partially backed by the treasury reflecting the substantial discount they were traded on in the secondary markets relative to government yields of 3-4% per annum on 10 year notes.
Equity too was purchased at a total cost of $1,229 million, usually at a 10% premium to the March 3rd prices on exchanges though far from it’s level 4 years earlier. Despite the fact that the federal government had almost doubled its net debt from 18 billion to 34 billion, the increase in leverage would prove extremely prudent following other government policies.
On March 9th, FDR would sign Executive Order 6073 which would immediately ban the foreign sale of gold and would require that all non trivial quantities of gold be turned into the Federal Reserve System in exchange for $20.67 per troy ounce under penalty of a 10k fine or up to 10 years imprisonment.
On May 4th, a joint resolution of Congress annulled all existing contracts denominated in gold dollars and stated that no such contracts could be written in the future.
The amount of debt affected by the abrogation of the gold clause was enormous, almost twice as large as the nation’s gross domestic product. Since World War I most public debt—bonds, notes and certificates—were payable in “gold coin” and many private bonds issued by railway companies and public utilities, as well as commercial and residential mortgages, included gold clauses. According to the administration’s estimates in 1933, $120 billion dollars of debt—national income was only slightly higher than $66 billion—were linked to the value of gold; of this, $100 billion corresponded to private debt and $20 billion to government debt.
- The US Debt Restructuring of 1933: Consequences and Lessons, altered
Over the interim, US foreign exchange ratios had sunk like a rock as the stock and bond markets kept soaring. This decision would do little to hamper that growth as treasury yields remained quite stable and Baa yields would catch up to Aaa yields as risks of further bankruptcy decreased. Although people would not receive gold anymore and thus took a 20% loss in foreign gold terms, private gold ownership was already illegal and forced to be redeemed at $20.66 so the decision did not change compensation, only backed up past policy.
Government meddling in rail had been an unmitigated success, debt was restructured at rock bottom prices while equity too was purchased at the bottom. If the value of rail stocks had increased in line with the stock market as a whole, which was an understatement due to the debt restructuring and highly leveraged nature of the railroads at the time, the value had increased over 150% relative to their purchase making a net gain of $1.8 billion.
A similar scenario played out among almost all other debt burdened entities. Homeowners once struggling to pay their mortgages saw their hours and eventually wages rise while interest payments remained the same. Governments expected future increases in nominal tax value while interest rates lowered due to fed policy. Deflation had gotten them into this mess and inflation would get them out.
Where under a gold standard future inflation is inherently unpredictable as otherwise the price of gold would adjust, the floating dollar and explicit goal of price restoration meant that inflation was forecasted to be high. Expected real interest rates thus went negative The low nominal interest rates maintained by the federal reserve thus required enormous asset purchases.
The American devaluation too represented a default. American debt, especially war debt like the Victory Bonds, was explicitly valued in Gold to avoid the effects of a devaluation. By rendering all such contracts void, the US partially defaulted on its debt while it was chastising other countries for doing the same. American debt, federal or otherwise shrunk in value as the economy grew and prices rose.
1932 - 1934
In January, Germany, the United Kingdom, France, Belgium, Italy and Japan would meet to discuss the future status of Germany’s war debts. This Lausanne Conference would begin with a German plea for complete cancellation of its debt as their situation was untenable, obviously a nonstarter without the explicit backing of the United States.
France and the UK would counter with a question of what other portions of the Treaty of Versailles would have to be amended in order to get Germany to make a one time payment on their debt. Germany would ask for an elimination of the war guilt clause and an end to disarmament.
Ultimately the conference would conclude that Germany’s debt would be reduced to 9 billion Reichsmarks worth of bonds which would begin payment in 1934. However, the inability for the US to accept the settlement would lead to none of the parties officially signing on to the conclusions of the Lausanne conference. Despite the failure, hope remained that the situation could be sorted out before the end of the Moratorium in August.
Boosted by the failures of negotiation and inability for the government to repudiate war guilt and disarmament, the Nazi party became ascendant in Germany. Though hope remained that they could be controlled by the conservatives, fears of German intransigence causing a French and British default would keep Hoover at the negotiating table. Another stock market bump could prove just the thing he needed to eek out a victory against Roosevelt in November.
The even larger Nazi victory in July would lead Hoover to extend the moratorium by an additional 6 months. This would not seem to impact the markets much as international cooperation appeared to be dead with the rise of extremists and the immiseration at home. The second moratorium would not do much to alleviate fears of an American devaluation which the markets had been negatively reacting to.
Although the moratorium had expired by February and Hoover was unwilling to extend it one more time, no major debt payments were due for a couple more months and the minor payments to the US had resumed as normal. The new German government was unwilling to make anything but interest payments on existing debt and debtors were barreling towards collapse at the same time as American banks were dying in droves, but the payments were holding for now.
The swearing in of Roosevelt and sudden devaluation of the Dollar would come just in the nick of time to avoid a French of British default as suddenly their debts were worth 20% less with more to come in time.
Roosevelt’s unwillingness to stabilize the dollar was bad for their ability to maintain an ideal balance of trade but provided assurance that the debt load would remain manageable. American movement on trade barrier reduction would be conditioned on continued payment furthering the incentives to keep the payments coming.
Bilateral tariff reductions would begin taking effect in mid 1934 but even before that time period, America’s sudden economic strength had greatly increased its imports. In February 1933, only $68.3 million worth of general merchandise was imported to the US, compared to $127.2 million in 1932, $174.9 million in 1931, $281.7 million in 1930 and $369.4 million in 1929. However, by July imports had reached $141.0 million and $203.8 million by December.
American exports however would also be boosted by the devaluation. Increased American demand had certainly improved the balance of trade for France but fears that tariff reductions would lead to a flood of undervalued American goods remained high. As they had been given the go-ahead by the US in the London Economic Conference, France would allow the Franc to float with regard to gold similar to what had happened to the Sterling in 1931. It wouldn’t quite return to the exchange rate of 1932 but the devaluation combined with the lowering of American tariffs for French goods would explode French exports.
France’s monetary allies in the Gold bloc such as Belgium, Switzerland and Poland would follow suit and all would experience an end to their economic contractions. Poland would remain depressed relative to 1929 but at least the situation was improving as markets for their agricultural commodities improved.
Where international trade had all but died by the end of 1932, in 1934 it had made quite a strong recovery. Although it would not return to the levels of 1929 and certain actors such as Germany would remain more isolated, the Atlantic was once more abuzz with merchant vessels.
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