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Manufacturing a U.S. debt crisis without end

The United States defaulted on its debt for the first time only months after it issued its first debt. Meeting in Philadelphia in the summer of 1775, the Continental Congress issued credit notes (payable within four years) for two million Spanish dollars. In July, it issued notes for another million – and then another three million. In 1776, it issued notes for a further 13 million. By the time the Revolutionary War ended, it had issued notes for 241 million of these so-called "Continental dollars."

Because the Continental Congress had no authority either to create a currency or to levy taxes, it persuaded people to accept its notes at face value by simple coercion. Any person who refused to accept them, or who accepted them below par, committed an offence punishable by the cutting off of ears and other comparably sobering penalties.

Even so, it was a hard sell. In November, 1779, the Congress devalued the notes, firstly by 38.5 dollars to one, subsequently by 1,000 dollars to one – producing an eventual loss (in 2011 terms) of $7-billion, a devastating hit to the colonial economies. Benjamin Franklin accurately described the loss as a tax, which is precisely what sovereign defaults always are. Lest it happen again, Congress prohibited paper notes. "No state ... shall make any thing but gold and silver coin a tender in payment of debts," the new Constitution stipulated.

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We hear repeatedly these days that the United States has never yet defaulted on its debt. In his July 11 news conference, President Barack Obama himself said so. Congressional failure to raise the country's debt ceiling, he said, would threaten U.S. full faith and credit "for the first time in our history." But the assertion is not true. In commentary posted last week on the website of the Alabama-based Ludwig von Mises Institute, John S. Chamberlain reminds us that the United States has defaulted on its debt a number of times.

In the decades after the Revolutionary War, Congress left public finance to private banks and issued only limited debt. In 1861, however, Congress created a paper currency – "the greenback" – to finance the Civil War. The first greenbacks, $60-million in demand notes, were declared redeemable at the rate of 0.048375 troy ounces of gold per dollar. The Treasury defaulted on these notes within five months yet kept issuing more of them. The greenback routinely traded throughout the war at a discount of 40 per cent.

During the Great Depression, the U.S. defaulted again, this time on debt incurred during the First World War. In 1917-1918, the U.S. issued its famous Liberty Bonds, 20-year debentures that paid 4.25 per cent and were proclaimed redeemable in gold at the rate of $20.67 per troy ounce. By 1933, however, the government had $22-billion in bonds set to mature in 1938 – and only $4.2-billion in gold to redeem them.

President Franklin Roosevelt defaulted on much of this debt, devaluing the dollar by 40 per cent – and, as Nobel economist Robert Mundell has argued, thus making the Great Depression worse and thus contributing to the causes the Second World War.

Beginning in 1980, presidents began periodically to shut down the federal government in budget showdowns with Congress. President Ronald Reagan was the first, Bill Clinton was the most recent (with the longest closing of government: 26 days). In 30 years, presidents have shut the government 11 times, without harmful consequence.

Further: In 1979, the United States defaulted on its debt payments accidentally for three weeks. (The government made good on its missed interest payments.) In its defaults so far, the U.S. has protected foreign bond holders – which explains the reputation of the greenback as a safe haven in times of trouble. It will do so, Mr. Chamberlain says, again now. In any extreme circumstance, the debt crisis "will be foisted onto the Federal Reserve." The Federal Reserve already holds $1.2-trillion in debt issued by the Treasury.

By having the Fed buy more Treasury debt, and then defaulting on it, the United States could postpone cataclysmic consequences indefinitely. By creative accounting, in other words, it could engineer an inter-agency default that would cause harm "to no real investor, foreign or domestic." Mr. Chamberlain argues this stratagem, alas, could be repeated "essentially forever" – implying a U.S. debt crisis without end.

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About the Author
Neil Reynolds

Neil Reynolds is an Ottawa writer whose columns on national economic issues appear in Wednesday's and Friday's Globe and Mail. He is the former editor-in-chief of The Vancouver Sun and the Ottawa Citizen. More

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