How the United States Avoided Default with Only Hours to Spare – in 1895

Posted by Bryan Taylor in Fixed Interest, Government with no response yet

Once again, the government has cut a deal to avoid defaulting on its debt by raising the debt ceiling.  The chance of the United States defaulting on its debt has been avoided, at least until January 15, 2014.

The reason for these dramatic battles over the debt ceiling is that originally, each bond issue by the government had to be approved by Congress.  When the United States entered World War I, instead of requiring that the government approve each and every bond issue, the government changed tack and set a general debt limit, enabling the government to issue new bonds at will up to the limit that was established.

It may surprise you, or probably not, but even when the government had to approve each bond issue, prior to World War I, the United States almost defaulted on its debt because of political wrangling. OMG! How shocking.  This happened in 1895 when the United States was on the Gold Standard as Jean Strouse related in her book, Morgan: American Financier.

In 1895, the United States was suffering through the recession that followed the Panic of 1893. Foreigners were selling their stocks and bonds and were converting their dollars into gold which was sent out of the United States.  Between 1890 and 1894, foreigners had redeemed $300 million in gold.  By the end of 1893, US gold reserves were down to $60 million and about $2 million in gold was being redeemed each day.  By February 1894, the US government had about three weeks of gold left in its vaults.  After that, the US would have to technically default on its debts because it would be unable to redeem the demand for gold that foreigners would make.  Sound familiar?

Congress was aware of this problem and knew of the possibility of default, but many Representatives thought this “emergency” was being created by the money interests in New York, and in particular, J. P. Morgan, to force the government to issue bonds and put the government further in debt.  President Grover Cleveland, a Democrat, knew this, but wanted to avoid default.  He contacted Nathaniel Mayer Rothschild to help, who in turn contacted J.P. Morgan.

One problem was the Secretary of the Treasury, John G. Carlisle.  Carlisle thought the bond terms were too tough, and he wanted Congress to issue bonds directly to the public.  The problem was there wasn’t enough time to do this without the government going into default, and whether the bill could get through Congress was questionable.  Do you have a feeling of déjà vu all over again?

Although Secretary Carlisle was a staunch Agrarian Democrat, similar to William Jennings Bryan, he eventually responded to the economic downturn caused by the Panic of 1893 by ending silver coinage and opposing the 1894 Wilson-Gorman Tarrif Act bill.  By 1896, Carlisle was so unpopular that he was forced to leave the stage in the middle of a speech in his home town of Covington due to a barrage of rotten eggs.  Those were the days.

Realizing that time was of the essence, J. P. Morgan took a train to Washington D.C.  At first, Cleveland didn’t want to meet with him.  Even though most members of the cabinet favored the bond issue, Carlisle was against it. In reality, the government was technically in default.  There were $12 million in warrants for gold outstanding with only $9 million in the vaults.  Unless something was done immediately, the United States would be in default for the first time in its history.

J.P. Morgan, however, had a trick up his sleeve. During the civil war, Congress had authorized then Treasury Secretary Salmon P. Chase to issue bonds that could be offered for coin.  By calling this a bailout for coin, the government could do an end run around Congress and issue the bonds without Congressional approval.  Attorney General Olney investigated, found the clause was still valid, and gave his approval.

President Cleveland asked that the international bailout team of Morgan and Rothschild keep the gold in the United States.  The government agreed to buy 3.5 million ounces of gold from the bailout team at $17.80 per ounce, in exchange for $62.3 million worth of 30-year bonds paying 4%. Since the price of gold was $18.60 per ounce, the government ended up paying $65.1 million in gold for $62.3 million in bonds, earning the bailout team $3 million. Twelve days later, the bond offer was made, and it sold out in 20 minutes.

The data for this bond shows that purchasers of the bond did well.  Not only did the US pay $3 million extra for the bonds, but the price shot up to 125 after issue, yielding 3.2%, so the US could have gotten a better coupon yield as well as a better price.  The 30-year bond was redeemed in 1925 at 100, trading above its par value, particularly during World War I, during the entire time of its issue.

Whether the issue is establishing a first or second Bank of the United States, issuing bonds to make sure the United States doesn’t run out of gold, raising the debt ceiling to make sure the government can pay its bills, or any other government financial crisis, the players are the same and the result is the same as well.  As the saying goes, I’ve seen this movie before.  It’s the Washington version of Groundhog Day.

One hundred years from now when the US government has its twenty-second century version of potential default with only days and hours before the United States defaults on its debt for the first time, the movie will be the same, as will the ending.  Be sure and re-read this blog in January 2014, and in 2015, and in 2016, and…

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