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Nber Working Paper Series the U.S. Debt Restructuring NBER WORKING PAPER SERIES THE U.S. DEBT RESTRUCTURING OF 1933: CONSEQUENCES AND LESSONS Sebastian Edwards Francis A. Longstaff Alvaro Garcia Marin Working Paper 21694 http://www.nber.org/papers/w21694 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 November 2015 Sebastian Edwards is with the UCLA Anderson School and the NBER. Francis A. Longstaff is with the UCLA Anderson School and the NBER. Alvaro Garcia Marin is with the Universidad de Chile. We are grateful for the capable research assistance of Colton Herbruck, Scott Longstaff, and Yuji Sakurai. All errors are our responsibility. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2015 by Sebastian Edwards, Francis A. Longstaff, and Alvaro Garcia Marin. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. The U.S. Debt Restructuring of 1933: Consequences and Lessons Sebastian Edwards, Francis A. Longstaff, and Alvaro Garcia Marin NBER Working Paper No. 21694 November 2015 JEL No. E43,E44,E65 ABSTRACT In 1933, the U.S. unilaterally restructured its debt by declaring that it would no longer honor the gold clause in Treasury securities. We study the effects of the abrogation of the gold clause on sovereign debt markets, the Treasury's ability to issue new debt, investors' willingness to hold Treasury bonds, and on the Treasury's borrowing costs. We find that the restructuring was followed by a flight to quality in the sovereign market. Despite this, there was little effect on the Treasury's ability to sell new debt or the willingness of investors to roll over restructured debt. The Treasury incurred a marginally higher cost of capital by issuing new bonds without the gold clause. Sebastian Edwards Alvaro Garcia Marin UCLA Universidad de Chile Anderson Graduate School of Management Department of Economics 110 Westwood Plaza, Suite C508 Diagonal Paraguay 257 Box 951481 Santiago, Chile Los Angeles, CA 90095-1481 [email protected] and NBER [email protected] Francis A. Longstaff UCLA Anderson Graduate School of Management 110 Westwood Plaza, Box 951481 Los Angeles, CA 90095-1481 and NBER [email protected] 1. Introduction A recurrent myth regarding the U.S. economy is that the federal government has never defaulted on its debt. This notion comes up every time the debt ceiling is reached and Congress wrangles about increasing the public debt limit. Consider the following quote from White House Press Secretary James “Jay” Carney in 2011:1 “The United States government has never defaulted on its obligations to pay its debt. It has never, ever missed a payment. This is one of the reasons that “flights to quality” typically involve buying U.S. Treasury debt. Uniquely in the history of sovereign borrowers, the United States haspaidwhenitsaiditwouldpay.” However, the U.S. did restructure its debt unilaterally during the first ad- ministration of Franklin D. Roosevelt, and imposed a 41 percent loss on investors. On June 5, 1933, Congress passed a joint resolution altering the nature of debt contracts retroactively. Gold clauses, which established that debts were to be paid in “gold coin,” were eliminated for all debts (public and private). This was the first step in what would become one of the largest transfers of wealth (from creditors to debtors) in the history of the world. The next step took place on January 31, 1934, when the U.S. dollar was officially devalued by 41 percent—the price of gold went from $20.67 to $35.00 per ounce.2 In February 1935, the cycle was closed when the Supreme Court, in a 5 to 4 decision, ruled that the abro- gation of the gold clauses was constitutional. Investors collected their monies in depreciated dollars. The debts involved (both public and private) amounted to almost 1.7 times the nation’s GDP. Although in recent years most of the popular press and news analysts have ignored this episode, a number of scholars have acknowledged it. For example, Reinhart and Rogoff (2009, p. 113) include it in their list of sovereign defaults.3 An important question, and one that has not been addressed in detail in 1Carney (2011) in http://www/cnbc.com/id/43140915. The distinction between federal and state debt is important. A number of states defaulted during the 19th and 20th centuries. For example, see MacDonald (2013) and Ang and Longstaff (2013). 2This number is close to the historical average market haircut of 37–40 percent computed independently by Benjamin and Wright (2008), Cruces and Trebesch (2013), and Edwards (2015a). 3See also Friedman and Schwartz (1963), Kroszner (1999), and Edwards (2015b). 1 the literature, is the following: What were the consequences of the Treasury reneging on its promises and implementing a generalized breach on contracts? Understanding this issue is not only important from a historical perspective, it is also relevant to understanding current events and to shed light on the likely consequences of modern defaults, including the debt restructurings in Greece and Argentina. According to traditional economic theory, the violation of contracts should have a number of negative consequences for debtors. Among other things, after defaulting and imposing losses on investors, debtors should have trouble accessing capital markets and issuing new debt, the cost of capital should increase significantly, liquidity should be hampered, and there should be a “‘stigma effect” on new debt. At the aggregate level, a major credit event and a generalized breach of contracts should result in increased uncertainty and a reduction in investment and, thus, in a lower growth rate. This was indeed the view taken by Friedman and Schwartz (1963, p. 699), who in the concluding chapter of their monumental A Monetary History of the United States: 1857–1960,argue that although the devaluation of the U.S. dollar had a positive effect on liquidity, “the abrogation of the gold clauses ... had the opposite [negative] effect by discouraging business investment.” However, they offer no empirical evidence on the actual consequences of this chapter of U.S. history on investment or other variables related to the functioning of the capital markets. Interestingly, since the publication of Friedman and Schwartz (1963), there have been few analyses of the consequences of the abrogation of the gold clause and the unilateral restructuring of the U.S. debt. Meltzer (2003) provides a discussion of the abrogation proper, and of how yields on gold-linked prices im- pacted the discussions at the Federal Reserve, but provides no analysis of how this event affected real or financial variables. The same may be said about other major works that cover this period, including research by Temin (1991), Eichen- green (1992), Romer (1992), and Bernanke (2000). Important exceptions include McCulloch (1980) who analyzed the consequences of banning indexed bonds be- tween 1933 and 1977, and Kroszner (1999) who studied the evolution of different securities’ prices over a two-day window surrounding the Supreme Court’s ruling on the gold clause cases in February 1935. The purpose of this paper is to fill this void in the literature and to analyze in depth the consequences of the abrogation of the gold clause. By studying in detail this important and massive episode we hope to add to the understanding of what happens in the aftermath of a major unilateral restructuring. Four key results emerge from this analysis. First, we find that after the abrogation of the gold clause, yields on the dollar denominated debt of the remaining high credit quality sovereigns such as the United Kingdom, France, and Switzerland quickly declined to near-zero 2 or even slightly negative values. This phenomenon closely resembles the classic flight to quality pattern in the wake of major credit events such as the Long Term Capital Management (LTCM) crisis following the Russian default in 1998, or the recent global financial crisis following the default of Lehman Brothers. Second, we find that despite the apparent global flight to quality, the Trea- sury experienced little or no difficulty in issuing new debt. In particular, after controlling for key debt features, we find that Treasury auctions were just as oversubscribed after the abrogation as before. Third, we find that Treasury debtholders whose bonds were involuntarily restructured were only slightly less willing to roll over these bonds into new Treasury securities at maturity as before the abrogation. Thus, there is little evidence that holders of restructured Treasury debt “voted with their feet” by stigmatizing new debt issues. Fourth, we examine whether the abrogation of the gold clause affected the Treasury’s cost of debt by contrasting the yields on bonds with a gold clause to the yields on newly issued bonds without the gold clause. We find that prior to the devaluation, there was no significant difference in the yields of the two types of bonds. After the devaluation, however, gold clause bonds traded at a four to eight basis point premium to non-gold clause bonds. Curiously, the premium for gold clause bonds persisted even after the Supreme Court decision. One possible interpretation of this result is that investors continued to believe that a return to the gold standard might occur once macroeconomic fundamentals improved. Another possible interpretation is that the market believed there was some probability that the Supreme Court would reverse itself and grant some compensation to holders of gold clause securities.
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