The Upside of Government Default

February 23, 2012

Given the number of economic indicators that suggest impending trouble, few doubt that the government will be forced to default on some of its fiscal obligations within the next few decades.  However, as the experience of state defaults in the 1840s has taught, this may not be an entirely negative event -- benefits can be drawn out of a default, says Jeffrey Rogers Hummel, an associate professor at San Jose State University.

In the mid-1840s, a number of states defaulted on their obligations for a multitude of reasons.

  • State lawmakers, inspired by the incredible success and profitability of New York state's Eerie Canal, began a canal-building craze that brought 3,326 miles of largely unjustified canals at an expense to the states of $125 million.
  • Many of the debts from the War of 1812 had not yet been repaid and payments constituted a large portion of contemporary budgets.
  • The final straw was a pair of banking crises in 1837 and 1839, which caused a large fraction of banks to fail entirely, a 42-percent decline in prices, and nine states to hit major financial trouble.

In subsequent debate, the Whig Party under Henry Clay supported federal assumption of state debts and the Democrats under President Martin Van Buren opposed it.  Eventually, the latter party won out and states were allowed to default and suspend payments, thereby damaging their own credit-worthiness.  Nevertheless, this financial problem yielded several benefits.

  • The crisis prompted state governments to make major fiscal reforms, with almost two-thirds of the states writing new constitutions over the next 10 years that focused on, among other policies, capping states' capacity for accumulating debts.
  • The costs associated with heavy involvement in canal-building encouraged states not to intervene when the railroading craze hit.
  • Aggregate economic indicators, while registering substantial financial shock and monetary devaluation, showed little disruption to consumers -- unemployment remained manageable and the country enjoyed exceptional growth soon after the crisis.

Perhaps most crucial in the experience with state defaults was that it encouraged states to restructure and reform to a degree that would likely not have been possible without the traumatic event of default.  This set the stage for years of prosperity soon after the crisis had abated.

Source: Jeffrey Rogers Hummel, "The Upside of Government Default," The American, February 16, 2012.

For text:

http://www.american.com/archive/2012/february/the-upside-of-government-default

 

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