|William Wordsworth, whose retirement savings were in
US state bonds, denounced Pennsylvania after it defaulted.
A precipitous situation, not without precedent
Unless Congress acts, the United States will reach a statutory limit on federal debt in early August. The US Treasury might then default on its loans. This, says Treasury Secretary Timothy Geithner, would be “an unprecedented event in American history’’ that would inflict catastrophic damage on the economy.
But it isn’t entirely unprecedented. While the federal government has never defaulted, we’ve had a very similar experience.
Between July 1841 and December 1842, eight of the country’s 26 states defaulted on their loans. Other states and the federal government also struggled to avoid insolvency. The entire nation quickly became a pariah in international financial markets.
In 1842 the country was in the midst of its first great depression. A real estate bubble fueled by easy credit had burst in 1837. American banks that financed this speculation collapsed two years later. The economy ground to a halt.
Many states were caught up in the mania of 1836-37. They borrowed in Europe and competed with each other to build infrastructure that would open their markets. Legislators spent indiscriminately. Every new canal, railroad, and turnpike was supposed to pay for itself. But when the economy collapsed, so did the projects.
There was no toll revenue to repay the loans. Foreign creditors pressed the states to raise property taxes instead. But voters resisted new taxes, and many states simply lacked the capacity to collect them. So the states defaulted.
In Britain, the main source of investment, there was outrage. American visitors were barred from London clubs and snubbed at dinner parties.
William Wordsworth published a poem denouncing the “degenerate men’’ of defaulting Pennsylvania. (His retirement savings were in American state bonds.) Another writer said Americans were “guilty of a fraud as enormous as ever disgraced the worst king of the most degraded nation of Europe.’’
European anger was indiscriminate. States that never defaulted, such as Massachusetts, could not sell bonds in Europe. The federal government tried to place a “trifling loan’’ in Europe in 1842. “Tell your government,’’ Baron James de Rothschild told US representatives, “that you cannot borrow a dollar.’’
Trans-Atlantic relations approached the boiling point. The doctrine of sovereign immunity meant that European investors had no legal remedy. States were free to repudiate their loans - if they were prepared to bear the humiliation and give up access to international finance.
Most states chose a different path. The crisis was a critical point in the evolution of American government. States abandoned their infrastructure schemes and adopted constitutional restrictions on borrowing.
Voters accepted new taxes, and governments developed the capacity to collect them efficiently.
None of this came easily. Many Americans had just acquired the right to vote, and the ideal of popular sovereignty was ascendant. Now, voters were being asked to restrict their own political power. Most agreed that it was necessary.
“Self-government is no longer a theory,’’ said John Pettit, an Indiana legislator. “We must take our cool and calm moments to bind and restrict ourselves.’’
By the late 1840s, European confidence was restored, and investment once again flowed into the United States. Wordsworth conceded that Pennsylvanians, now repaying their loans, might not be degenerates after all. The trans-Atlantic default crisis was over.
But Americans had learned a hard lesson about the limits to popular sovereignty within a globalized economy.
Alasdair Roberts is the Jerome L. Rappaport Professor of Law and Public Policy at Suffolk University Law School. His book The First Great Depression will be published by Cornell University Press in 2012.