Learning from America’s Forgotten Default
The comments below are an edited and abridged synopsis of an article by Sebastian Edwards
Every time the debt ceiling is debated in Congress, politicians and journalists dust off a common trope: The US doesn’t stiff its creditors. There’s just one problem: It’s not true.
In April 1933, President Franklin Roosevelt announced plans to take the US off the gold standard and devalue the dollar.
In June 1933, Congress passed a resolution annulling all gold clauses in past and future contracts. The door was opened for devaluation, and for a political fight.
In January 1934, the dollar was officially devalued, and gold went from $20.67 to $35 an ounce. Those holding securities protected by the gold clause claimed that the abrogation was unconstitutional.
Four law suits reached the Supreme Court; the question in each case was essentially the same: Did Congress have the authority to alter contracts retroactively?
In February 1935, the Supreme Court ruled in favour of the government and against investors seeking compensation. The Roosevelt administration could invoke ‘necessity’ as a justification for annulling contracts if it would help free the economy from the Great Depression.
Today, the 1935 ruling is invoked when attorneys are defending countries in default (Venezuela). As more governments face down new debt-related dangers (such as unfunded liabilities associated with pension and health-care obligations) the argument may surface even more frequently.
Today, the US government’s unfunded liabilities are estimated to be a staggering 260% of GDP, not including conventional federal debt and unfunded state and local government liabilities. And it’s not just a US problem.
A key question is whether governments seeking to adjust contracts retroactively may once again invoke the legal argument of ‘necessity.’ The 1933 abrogation of the gold clause provides abundant legal and economic reasons to consider this possibility. The US Supreme Court agreed with the ‘necessity’ argument once before. It is not far-fetched to think that it may happen again.