NEW YORK – Not all government debt is created equal. Some governments get a much better deal than others, and no one gets a better deal than the United States.
The United States borrows in its own currency, and it borrows at extremely low interest rates. It also borrows under its own laws, an often overlooked advantage. Such a situation makes default – or at least involuntary default – impossible because the government can print dollars if need be. The value of the dollars it repays may be less than the value of the dollars it borrows, but that is a risk the lenders accept. The United States could change its laws, but it is trusted not to abuse that right.
The perils of not having that flexibility became clear 80 years ago.
In 1933, when Franklin D. Roosevelt became president, the world was in the Great Depression and many countries were devaluing their currencies in a desperate attempt to stimulate exports and growth. That left the United States at a disadvantage, and one of the first things the president did was to persuade Congress to devalue the dollar.
The United States, like other countries, was on the gold standard. A dollar was worth 25.8 grains of gold, and anyone with a dollar bill could turn it in for that much gold. Roosevelt and Congress redefined the dollar as being worth 15.238 grains and made it illegal for Americans to own gold coins. They were required to turn in their old gold coins for dollars at the new rate.
U.S. government bonds of that era specified that the payment of interest and principal was to be made in gold dollars, at the old rate. Many private bonds had similar provisions. Congress overruled all those provisions.
Was that legal?
In 1935, the Supreme Court answered. Chief Justice Charles Evans Hughes, with the support of four of his colleagues, concluded that the government could change the private contracts, just as it could pass a bankruptcy law that enabled some debtors to escape their obligations. But, he said, the government had no legal right to amend its own bonds.
Then, in a pirouette that left legal scholars gaping, he ruled that because it was no longer legal to own gold coins, a bondholder suffered no actual losses. Had the government paid gold coins, the bondholder would have been required to exchange them for dollars at the new rate.
It was not one of the great court decisions, at least in terms of legal logic. But it was necessary for the health of the U.S. economy.
Consider what would have happened if the gold clause had been upheld, for both government and private debts. Suddenly any debtor who owed $1,000 in gold dollars would owe $1,690 in new dollars. But incomes would not have risen. Companies that were barely hanging on would have gone broke. The Depression would have become much worse.
I bring this up because most sovereign nations now do not have the luxury the United States has. When they borrow internationally, they borrow in a foreign currency. And the bonds often specify that any disputes will be settled under foreign law - usually American or British law.
Many recent national defaults stemmed in part from those problems. The 1990s Asian financial crisis began in Thailand, which had tied its currency to the U.S. dollar - and had borrowed a lot of dollars. When it was forced to devalue its currency, the baht, it suddenly owed far more baht than it had borrowed, not to mention far more than it could hope to repay.
Obviously any country would prefer to borrow from foreign investors in a currency it can print, under laws it can change. But few countries have enough credibility with investors to do that. Right now, there are three: the United States, Japan and Britain.
Mario Draghi, the president of the European Central Bank, said Thursday that a debt-limit deal was needed to protect world financial stability, adding that “a short-term agreement produces less stability.” But, he told the Economics Club of New York, “The world still does not believe that the United States will not find a way out of this.”
That is why those who are warning of a disaster if there is a default on U.S. debt might turn out to be wrong, or at least premature. If it is widely assumed that any default will be temporary, certain to be fixed in the immediate future, the reaction could be muted.
But there is no guarantee of that. Why risk destroying the United States’ world standing over a dispute about health insurance?
In 1935, Justice James Clark McReynolds wrote for three of his colleagues in denouncing the decision to allow the United States to renege on its promises. His opinion concluded, “Loss of reputation for honorable dealing will bring us unending humiliation; the impending legal and moral chaos is appalling.”
He was wrong. By the time the decision came down, it was clear that the repudiation of the gold clause had not destroyed the government’s credit. Decades later, the economists Carmen M. Reinhart and Kenneth S. Rogoff would classify the repudiation as a default, but in 1935, most Americans - and most foreign lenders - did not see it that way.
But the McReynolds forecast could come true if defaults become acceptable in pursuit of partisan political advantage. Then the unique position of the United States could erode or even vanish.
“To throw that away,” said Robert J. Barbera, of the Center for Financial Economics, “would be the single greatest mistake in American economic history.”