Saturday, October 10, 2020

When the U.S. Defaulted On The Debt It Used To Finance World War I

Some Know Your Customer stuff they don't teach in Econ 10 (sorry Professor Mankiw)

A repost from the 100th anniversary of the war's end (November 11, 2018) has the short version of the story along with some of the other U.S. government defaults:

...The Liberty Bond Default of 1934

The financing of the United States government stepped up to a whole new level upon its entry into the Great War, now known as "World War I." The new enterprises of the government included merchant-fleet maintenance and operation, production of ammunition, feeding and equipping soldiers entirely at its own expense, and many other expensive things it had never done before or done only on a much smaller scale.

To finance these activities, Congress issued a series of debentures known as "Liberty Bonds" starting in 1917. The preliminary series were convertible into issues of later series at progressively more favorable terms until the debt was rolled into the fourth Liberty Bond, dated October 24, 1918, which was a $7 billion dollar, 20-year, 4.25 percent issue, payable in gold at a rate of $20.67 per troy ounce.
By the time Franklin Roosevelt entered office in 1933, the interest payments alone were draining the treasury of gold; and because the treasury had only $4.2 billion in gold it was obvious there would be no way to pay the principal when it became due in 1938, not to mention meet expenses and other debt obligations. These other debt obligations were substantial. Ever since the 1890s the Treasury had been gold short and had financed this deficit by making new bond issues to attract gold for paying the interest of previous issues. The result was that by 1933 the total debt was $22 billion and the amount of gold needed to pay even the interest on it was soon going to be insufficient.

In this exigency Roosevelt decided to default on the whole of the domestically-held debt by refusing to redeem in gold to Americans and devaluing the dollar by 40 percent against foreign exchange. By taking these steps the Treasury was able to make a partial payment and maintain foreign exchange with the critical trade partners of the United States.

If we price gold at the present-day value of $1,550 per troy ounce, the total loss to investors by the devaluation was approximately $640 billion in 2011 dollars. The overall result of the default was to intensify the depression and trade reductions of the 1930s and to contribute to fomenting World War II.
This was not a "technicality". The decision to renege on the terms of the debt resulted in an immediate 41% loss of the principal's purchasing power.

For the longer version of the story see the Summer 2015 edition of Financial History Magazine:

A Brief History of the Default on the Fourth Liberty Loan 
By Joshua Herbstman
If one were to ask a financial professional about the safety of US Treasury bonds, the answer likely proffered would be something along the lines of the following: “US Treasury securities are the safest assets in the world. They are the bench- mark of all debt instruments, sovereign or otherwise. Treasuries always pay. Always.”

For almost every investor alive today, this answer is perfectly sound. You buy a Treasury bill, note or bond, and America will pay you, in full, every dime of principal and interest you are owed. Be it a time of war, recession or political disagreement, the United States always pays its debt obligations.

That is not to say people have not lost money on government bonds. Due to the ever-changing financial markets, the price of Treasuries continually fluctuates to reflect prevailing interest rates. Failing to hold a bond until maturity may very well result in a loss. Leveraged positions betting on the direction of interest rates may also produce a red balance sheet. But if you purchase a Treasury security and hold it until maturity, you are going to receive 100 cents to the dollar on your investment. That is a promise that millions of individuals and institutions around the world have (literally) “taken to the bank.” And it has always been the case.

Except for this one time...

A century ago, during the summer of 1914, armies across Europe embarked on what would be the bloodiest war humanity had yet experienced. The root causes of the Great War were varied: the political assassination of Archduke Franz Ferdinand of Austria, colonial and territorial disputes involving the European powers and the difficult political landscapes of those very same nations. To be sure, the July Crisis of 1914, which resulted from the assassination of the Archduke (heir to the throne of the Austro-Hungarian Empire) by a Serbian was the match which began the conflagration.

When the Kingdom of Serbia refused the politically untenable Austro-Hungar- ian ultimatums, war was declared. Two great alliances would face each other: the Allies, composed of the British Empire, France and Russia, and the Central Powers, composed of Germany and the Austro-Hungarian Empire. Other nations would soon entire the conflict, notably the Ottoman Empire joining with the Central Powers in late 1914, and Italy joining with the Allies in 1915.

At the war’s onset, the United States maintained a strict foreign policy of neutrality. Americans had no appetite for intervention in a foreign war, and President Woodrow Wilson vowed to keep it that way. As the war progressed, however, events began to change public and political opinions. On May 5, 1915, a German U-Boat sank the British ocean liner RMS Lusitania. Of the nearly 1,200 passengers on board, 128 of them were American citizens.

The Central Powers did not want the United States to enter the conflict, and Germany pledged that neutral ships and passenger vessels would be off-limits. How- ever, in 1917, Germany resumed a policy of unrestricted submarine warfare. This, coupled with the famous Zimmermann Telegram (an intercepted German diplomatic cable proposing a military alliance with Mexico against the United States), pushed America into the war. In April of 1917, the US declared war on the German Empire, and by the end of the year, the Austro-Hungarian Empire as well.

To finance America’s participation in the conflict, President Wilson turned to his Treasury Secretary, William Gibbs McAdoo. McAdoo had limited options in raising the needed revenues to finance the war, namely domestic bond sales and / or changes in tax policy. Both options had strong support and opposition in various political circles. Ultimately compromise prevailed, and a combination of both policies was undertaken.

Through a series of three Revenue Acts beginning in 1916, Congress raised individual and corporate tax rates. The lowest individual tax bracket went from a net income level of $20,000 and above in 1916 to a level of $5,000 and above by 1918. The highest tax rate paid on individual income jumped from 13% to 65% in the same period. Furthermore, corporate taxes increased and Congress implemented a war profit tax as well. Approximately one- quarter of the cost of the war was paid for by the changes made to the tax code.

The remaining revenue would come from the sale of government debt. All told, more than $20 billion would need to be generated by the sale of war bonds over a two-year period. Such debt issuance had never been attempted before in American history. Indeed, the national debt stood at only some $3.6 billion in the summer of 1916. Previous Treasury bond sales were usually targeted at banks and large inves- tors, but the Liberty Loan program was to be different. McAdoo knew that financial institutions alone could not buy up all of the needed debt, so the Liberty Loans had to be sold to individual American families as well.

The Liberty Loans (also known as Liberty Bonds) were sold throughout five different issues: a First Liberty Loan (30-year bond), a Second (25 -year bond), a Third (10 -year bond), a Fourth (20-year bond) and a Vic- tory Loan (four-year note). Issued from June 1917 through May 1919, the program raised some $21 billion through the sale of about 66 million securities.

McAdoo went to great lengths to promote Liberty Bond sales. Hollywood stars such as Charlie Chaplin and Douglas Fairbanks promoted the sale of war loans. The Boy Scouts went door-to-door campaign- ing for subscriptions to the Liberty Loans. Various women’s auxiliary groups held bond drives. Through massive campaigns of advertisement and propaganda, immigrant communities were encouraged to prove their patriotism by the purchase of Liberty Loans.

And the efforts did not stop there. The First and Second Liberty Bonds featured convertibility provisions that allowed for bondholders to freely exchange their securities should interest rates rise in the future. The First Liberty Loan, originally issued at 3.5% in June of 1917, was converted twice: once to a 4% loan and then to 4 l/4%. The Second Liberty Loan, originally issued at 4% in November of 1917, was subsequently converted to 4 1/4 % as well. In addition to the conversion provisions, Congress exempted the interest on the Liberty Loans from all federal taxes, save the estate tax. And banks were encouraged to lend money at below market rates for the sole purpose of allowing individuals to buy Liberty Bonds and arbitrage the difference.

Ultimately the bond drives were successful, as was the Allied cause. Hostilities came to an end, and exactly five years to the day of Archduke Ferdinand’s assassination, the Treaty of Versailles ended the war between Germany and the Allied powers. Further treaties soon followed, as peace finally came to a war-torn world.

As the 1920s progressed, the US Treasury began to partially retire the Liberty Loans. The Victory issue, which was a short-term Treasury note, was retired by 1923. The next issue on the Treasury’s radar was the 10 -year Third Liberty Loan, which would mature in 1928. This refinancing would be complicated by a competing interest, which was the fact that an early redemption of the 25 -year Second Liberty Loans would save the Treasury money in the long term. The Treasury would ultimately balance the challenges of refinancing the older war debt by issuing new securities and giving bondholders the option to exchange their Liberty Loans for new debt issues.

The roaring prosperity of the 1920s gave way to an economic collapse in the 1930s. The Great Depression saw US unemployment quadruple in a matter of years, with breadlines and “Hoovervilles” emerging throughout the nation. As one response to the economic catastrophe, President Franklin D. Roosevelt reigned [sic] in the private ownership of gold and gold instruments. The rationale was that by preventing the hoarding of gold, economic activity would increase, and the Federal Reserve could increase the money supply available....MORE