University of California, Los Angeles economist Sebastián Edwards’s new book, American Default: The Untold Story of FDR, the Supreme Court, and the Battle over Gold, challenges this assertion. Edwards argues that the United States defaulted on federal debt during the 1930s when it withdrew monetary gold from circulation and abrogated the gold clause in both public and private contracts.
Overview / Before I delve into the details of Edwards’s insightful study, I want to give you an overall assessment of the book: It is fascinating, well-written, and thoroughly researched. It provides new perspective on an important era of American history. It discusses the ideas, personalities, politics, economics, and finance underlying the principal policies by which the Franklin D. Roosevelt administration resuscitated the U.S. economy after the catastrophic contraction of 1929–1933. An academic press published the book, but the clarity of its prose and vividness of its narrative make it accessible to a general audience. The book should and will be read widely. It’s worth pondering and debating, and I will debate some aspects of it later in this review.
Edwards’s book asks provocative questions about fundamental features of the U.S. and international financial systems. The author lists these questions at two points in the book: the end of the introduction and the beginning of the conclusion. The lists contain 15 total queries, which I condense into five:
- Did the United States default on federal government debt in 1934 when it abrogated the gold clause for government bonds (particularly the fourth Liberty Bond)?
- Why did the federal government abrogate the gold clause? Was this action necessary?
- Who made the key decisions during this episode and how did they justify their actions?
- What were the consequences for investors and the economy as a whole, both in the United States and abroad?
- Could this happen again?
Edwards answers these questions over the course of 17 chapters plus an introduction, an appendix, a timeline, and a list describing the people around whom the story revolves. The introduction lays out the issues of interest. Chapters 1 through 15 narrate the story. The narrative revolves around such policymakers as Roosevelt, Sen. Carter Glass, and members of the Supreme Court, as well as the people who advised them. Among those advisers were Roosevelt’s Brain Trust, whose initial members included Raymond Moley, a law professor from Columbia University, Rexford Tugwell, an economics professor at Columbia, and Adolf Berle, another law professor from Columbia. The narrative describes the decisions that these men made (or had to make), their rationales for those decisions, and the state of knowledge and state of the world at the times those decisions were made.
Fearing devaluation / The narrative starts in March 1932, during the economic downturn now known as the Great Depression. A few pages describe the poverty and desperation imposed upon people from all walks of life. Nearly a quarter of the labor force experienced unemployment. Commodity prices declined by more than half. These declines proved particularly hard on people running small businesses, such as family farmers who made up a quarter of the U.S. population. Declining farm prices accentuated farmers’ debt burden because the nominal value of debts remained fixed, forcing farmers who wanted to pay their mortgages and crop loans to double production (which was often impossible) or cut consumption (particularly of durable goods like cars, radios, and clothing). Some farmers (and eventually almost all farmers) stopped paying their debts, defaulted on their loans, and faced bankruptcy, which often resulted in the loss of lands and livelihoods.
Chapters 1 through 4 cover Roosevelt’s campaign platform and policies and the economic turmoil from November 1932 through February 1933. During those last five months of the Herbert Hoover administration, a nationwide panic drained funds from the banking system and gold from the vaults of the Federal Reserve. The public feared for the safety of deposits and rushed to convert their claims against banks into coins and cash. The public (particularly foreign investors) also feared for the value of the dollar because they anticipated that the Roosevelt administration would lower the gold content of U.S. currency or leave the gold standard altogether, as had Britain and numerous other nations.
In March, gold outflows forced the Federal Reserve Bank of New York below its gold reserve requirement. To prevent the New York Fed from shutting its doors, the newly inaugurated President Roosevelt declared a national banking holiday. This segment of the story ends by describing the policies that the Roosevelt administration implemented as it resuscitated the financial system and sparked economic recovery.
This review will not go into detail about the policy decisions and the logic underlying them. For that information, you should read the book, which presents the materials cogently and clearly. Other recent readable treatments on the topic include Jonathan Alter’s The Defining Moment, Anthony Badger’s FDR: The First Hundred Days, Adam Cohen’s Nothing to Fear, and David Kennedy’s Freedom from Fear. All of these cover similar material and reach similar conclusions. I also recommend the memoirs of Herbert Hoover and Roosevelt’s principal advisers; see Edwards’s bibliography for a list. To it, I recommend adding Fifty Billion Dollars: My Thirteen Years with the RFC, the memoir of Jesse Jones, who headed the Reconstruction Finance Corporation.
Monetary expansion / Chapters 5 through 10 describe the Roosevelt administration’s efforts from the spring of 1933 through the winter of 1934 to help the economy recover. The administration believed a key cause of the contraction was the devaluation of the dollar and decline in prices—particularly of farm commodities—that occurred during the 1920s and early 1930s. Prices of wholesale goods fell an average of 25% between 1926 and 1933. Consumer prices fell by the same amount. The average price of farm crops fell more than 66%.
Declining prices made it difficult for farmers and other producers to earn sufficient profits to pay their debts, which were fixed in nominal terms. As a result, families and firms cut consumption and investment in order to avoid bankruptcy, or else defaulted on their debts, which was often worse for them and put banks out of business. That, in turn, restricted the availability of credit, triggered banking panics, and resulted in further economic contraction. The Roosevelt administration sought to alleviate this cycle of debt-deflation by convincing (or forcing) individuals and firms to redeposit funds in banks, encouraging banks to lend, and refilling the Federal Reserve’s vaults with gold. All of these actions would expand the money supply and eventually raise prices.
The administration also sought to speed the process along by directly influencing commodity prices, particularly those traded on international markets. Those commodities had fallen substantially because of foreign governments’ decisions to devalue their own currencies, usually by abandoning the gold standard and allowing the price of their currencies to be determined by market forces. The quickest way to raise commodity prices and alter the exchange rate was to change the dollar price of gold. The federal government had lowered and raised gold’s dollar price in the past; the Constitution provided Congress with the power to do so. Congress authorized the president to raise the dollar price of gold by up to 100% (or synonymously cut the gold content of dollar coins by as much as 50%) in the Thomas Amendment to the Agricultural Adjustment Act in May 1933. The Roosevelt administration used these powers to the utmost, periodically and persistently raising gold’s dollar price from the spring of 1933 through the winter of 1934. Roosevelt’s gold program concluded in January 1934 with the passage of the Gold Reserve Act, which set gold’s official price at $35 per troy ounce.
Gold clauses in contracts impeded this policy. An example was printed on Liberty Bonds: “The principal and interest hereof are payable in United States gold coin of the present standard of value.” Clauses like this were common in public and private contracts. Their intent was to protect creditors from declines in the value of currency or inflation, which is the same phenomenon but stated as an increase in the average price of goods. Gold clauses ensured lenders that they would be repaid with currency or gold coins with the same real value (in terms of the goods and services that they could purchase) as the funds that they had lent.
Gold clauses had a pernicious effect, however, when deflations and devaluation decisions of foreign governments reduced prices and economic activity. Then, gold clauses prevented governments from quickly and effectively remedying the situation by altering the money supply, interest rates, exchange rates, and prices to push the economy back toward equilibrium. In Chapter 16, Edwards admits monetary expansion was the optimal policy to pursue. He “strongly” believes it was the “main force behind the recovery.” He indicates, correctly, that this is the consensus of scholars who have studied the issue (and he offers no alternative explanation). The Roosevelt administration understood this problem and on May 29, 1933 convinced Congress to void gold clauses in all contracts retroactively and in the future.
Chapters 5 through 10 do a good job of conveying this material and describing the thought process of the Roosevelt administration as it struggled to make difficult decisions in real time with limited information. The chapters reflect the conventional wisdom found in canonical accounts of this period, including Milton Friedman and Anna Schwartz’s Monetary History of the United States, Peter Temin’s Lessons from the Great Depression, and Barry Eichengreen’s Golden Fetters. The chapters also do a good job of describing concerns and criticisms of Roosevelt’s recovery plans. Perhaps as a narrative device, the chapters do not tell you who was right. That material appears 100 pages later, in Chapter 16.
Breach and default? / Chapters 11 to 15 contain the novel part of the narrative. They describe investors’ reactions to Roosevelt’s gold policies and the abrogation of the gold clause. Investors quickly sued in state and federal courts, demanding that borrowers repay debts with gold coin as required by gold clauses, rather than currency as determined by Congress. Courts consistently ruled against the plaintiffs, usually indicating that the Constitution gave Congress the power “to coin money and regulate the value thereof” and to determine what was legal tender for the discharge of public and private debts. Plaintiffs appealed these decisions and the cases quickly reached the Supreme Court.
American Default’s coverage of these court cases is seminal and stimulating. I know the literature on this topic well. As the official historian of the Federal Reserve System, I co-wrote essays on “Roosevelt’s Gold Program” and the “Gold Reserve Act of 1934” for the Federal Reserve’s Federal Reserve History website (www.federalreservehistory.org). I have read much of what scholars have published on this topic. I know of no comparable source for information on these court cases, the arguments presented by the plaintiffs and defendants, and the rationale underlying the Supreme Court’s confusing decision that Congress’s abrogation of the gold clause in private contracts was constitutional while Congress’s abrogation of the gold clause for government bonds—particularly the Liberty Bonds—was constitutional in some ways but unconstitutional in others, did not harm the plaintiffs, and therefore would not be overturned by the courts.
Now we get to one point on which I disagree with the author. Edwards clearly believes the U.S. federal government defaulted on its debts. The Supreme Court equivocated but generally seemed to think that the United States did not default. I agree with the Supreme Court. Here’s why:
The Merriam-Webster Dictionary defines a default as either (1) a failure to do something required by duty or law, or (2) a failure to pay financial debts. The U.S. Supreme Court decision in the gold cases indicated that the federal government defaulted in the first sense by not fulfilling a promise printed on the bonds, which was to literally repay bond holders with U.S. gold coins at the standard of value that prevailed when the bonds were issued in 1918. At that time, the basic gold coin was the Eagle. It was worth $10 and contained 0.48375 troy ounces of gold and 0.05375 troy ounces of copper. So, a Liberty Bond with a face value of $100 promised upon maturity payment of 10 gold Eagles containing a total of 4.8375 troy ounces of gold and 0.5375 troy ounces of copper. When the Liberty Bonds matured in 1938, however, the government gave bondholders neither the Eagles nor the metals that they contained.
However, the Supreme Court ruled that the federal government did not default in the second sense: it fully paid its financial debts. The latter conclusion requires explanation, particularly because the book emphasizes the “American Default” aspect of the Court’s decision. The Court justified this conclusion using two arguments originally advanced by the federal government. The first began with the fact that in 1933, the federal government had withdrawn all monetary gold from circulation and paid in return paper currency at the standard of value that had prevailed since 1900. This meant that an individual holding 10 Eagle coins had to give them to the government and accept $100 in paper currency in return. The government argued that Liberty bond holders could and should be treated the same way as everyone else in the United States. In a hypothetical scenario, when the bonds matured, the government would pay bondholders the gold coins as promised, but then would immediately confiscate the coins and compensate the former bondholders with currency at the same rate that everyone else had been compensated a few years before. This hypothetical sequence of transactions was legal. The U.S. Constitution enumerated Congress’s power to determine the standards of coinage and legal tender. These enumerated powers enabled Congress to convert gold coins to paper currency and/or redefine the standards of value and objects accepted as payment for public and private debts. If the government executed this hypothetical sequence of transactions when the bonds matured in 1938, an individual who had purchased a $100 Liberty Bond in 1918 would in the end receive $100 in currency. The Supreme Court ruled that it was acceptable for the government to give that currency directly to the bondholders upon maturity, rather than go to the hassle of giving them gold coins, taking them back, and then paying the currency for them.
To understand the second argument that abrogating the gold clause did not involve a financial default, it may help to step back from the legal technicalities and think of the repayment in an economic sense. The purpose of the gold clause was to protect bond holders from a fall in the value of American currency, a phenomenon known as inflation. The clause promised that individuals who invested in the United States would be repaid with dollars whose real value in terms of goods and services was equivalent to the real value of the dollars with which the individuals purchased the bonds. Did the U.S. government do this? The answer is yes. The purchasing power of the dollar rose 4% between 1918, when the fourth Liberty Bond was issued, and 1938, when the fourth Liberty Bond matured. So, an American citizen who in 1918 purchased a $100 Liberty Bond received in 1938 funds sufficient to purchase goods and services that would have cost $104 in 1918. The government also paid 4.5% interest each year along the way. So the government did honor its pledge to maintain the purchasing power of the funds entrusted to it by purchasers of Liberty Bonds and return that to the purchasers plus interest.
What about foreigners? They owned many U.S. bonds. The largest group of foreign investors were English. Their position is worth considering. In October 1918, when the Liberty Bonds were issued, the dollar–pound exchange rate was 4.77. An English investor could exchange £1 for $4.77 and purchase a $100 Liberty Bond for £20.96. In October 1938, when the Liberty Bonds matured, the dollar–pound exchange rate was 4.77. An English investor who redeemed his bond for $100 in U.S. currency could convert that into £20.96, exactly what he had paid for it. And with those funds he could buy goods that would have been valued at £46.69 in 1918 because the purchasing power of the pound had risen substantially since that time. So English investors, like many others overseas, made large profits from investing in Liberty Bonds.
Plaintiffs in the gold clause cases before the Supreme Court hoped that their suit would allow them to reap even higher returns. They argued that the government should be required to pay them with old gold coins, like the Eagle, at the 1918 standard of value, and then they should be able to convert the Eagles to dollars at the price established by the Gold Reserve Act of 1934 ($35 per troy ounce of gold). The government countered that this was infeasible: there was not enough gold in the United States to pay all the Liberty Bond holders. The plan was also illegal; the law no longer allowed the public to own, save, or spend monetary gold. In that case, the plaintiffs argued, they should receive the amount that would result from a hypothetical sequence of transactions where the government gave them gold coins at the 1918 standard of value (as stated on the bonds) and then immediately converted that gold to currency at the 1934 standard of value. This sequence would pay $166.67 on a $100 Liberty Bond upon maturity in 1938, a sum sufficient to purchase goods and services that would have cost $174.19 in 1918. The majority of the Supreme Court rejected this claim and referred to it as unjust enrichment.
No evidence of distress / Chapter 16 discusses the consequences of the abrogation of the gold clause. At the time, opponents of the policy contended that its effects could be catastrophic. Contracts would not be trusted. Creditors would no longer want to extend loans. Interest rates would rise. Investment would fall. The economy would stagnate.
Edwards looks for evidence of these ailments in data on investment, borrowing, bonds, stocks, prices, interest rates, and output. He finds none. After abrogation, the government actually found it easier to borrow, rather than harder. Edwards concludes that there is
no evidence of distress or dislocation in the period immediately following the abrogation, or the Court ruling. … It is possible that if the gold clause had not been abrogated, output and investment would have recovered faster than they did, and that the costs of borrowing would have declined even more. Those outcomes are possible, but in my view, highly unlikely.
The reason abrogation had no detectable effect, Edwards concludes, was that it was an excusable default. Excusable defaults occur under circumstances “when the market understands that a debt restructuring is, indeed, warranted, and beneficial for (almost) everyone involved in the marketplace” when the restructuring is done according to existing legal rules, and when the default is largely a domestic matter with few foreigners involved. Excusable defaults do not stigmatize sovereigns because they do not change borrowers’ expectations of sovereigns’ probability of repaying future debts.
I agree with Edwards that the abrogation of the gold clause fits these circumstances and I argued, in the preceding paragraphs, that the abrogation fit another classic characteristic of an excusable default: bondholders received payment equal to (or better than) what they expected when the debt was issued. Since past holders of Liberty Bonds received the repayments that they expected when they purchased the bonds on origination in 1918, despite the tremendous shocks to the United States and world economies between then and maturity in 1938, future bondholders had no reason to doubt that their expectations would not be met.
A future default? / Could it happen again? The author asks that question at the beginning and end of the book (and in the title to Chapter 17) because, he says, “among all questions, [it was] the one that kept coming back again and again.” In emerging economies, Edwards indicates, “situations that mirror what happened in the United States during 1933–1935 have occurred recently in a number of … countries, and it is almost certain that they will continue to arise in the future.” Examples from the recent past include Argentina, Mexico, Turkey, Russia, Indonesia, and Chile.
Advanced economies are not immune from these economic forces. In 2008, Iceland faced “a gigantic external crisis with a massive devaluation and a complete collapse of the banking sector. It took almost ten years for Iceland to recover.” Greece continues to struggle with a similar situation, as do other European nations such as Portugal, Italy, and Spain. These nations may be tempted to leave the eurozone, reintroduce independent currencies, and devalue their exchange rate in order to speed economic recovery. But any nation that tries (or is forced) to do this will struggle with contracts, all of which are written requiring payment in euros. If these are rewritten to permit repayment in new currencies of lesser value, the issue is sure to end up in domestic and foreign courts as well as the World Bank’s tribunal for international investment disputes.
While the rest of the world may be in danger of experiencing events similar to the U.S. abrogation crisis of the 1930s, Edwards argues that “it is almost impossible that something similar will happen again in the United States.” The main reasons are the change in the monetary system and the exchange rate regime. The United States’ exchange rates are now determined by market forces. Gold no longer underlies the monetary system. Most contracts are denominated in lawful currency, not gold, commodities, or foreign currency.
Even if a repeat is extremely unlikely, the chance of the United States restructuring its debt, Edwards argues, is not zero. The federal debt outstanding is now nearly equal to gross domestic product. A tenth of the debt is fixed in real terms because, upon maturity, bondholders receive a premium payment linked to increases in the Consumer Price Index. The implicit debt for future entitlements—particularly Medicare, Medicaid, and Society Security—exceeds 400% of GDP. There is little agreement on how to pay for these promises, Edwards notes, and at some point in the not too distant future the U.S. government may be forced to restructure its payments. This potential crisis, he argues, differs from the crisis of the 1930s because that crisis stemmed from deflation, exchange rates, and the structure of the monetary system. The modern problem arises from promises made in the present for the future delivery of services.
On all of these points, I agree with Edwards. I am, however, less hopeful for the future. The unsustainable federal debt is not an accident. I believe it was consciously created by Republican politicians to justify reducing (or eliminating) future federal entitlements. With Republicans in control of all three branches of the federal government, taxes cut, deficits up, and a recession on the horizon, the day of reckoning may soon be upon us. I anticipate a massive abrogation of federal medical and retirement entitlements within the next decade—sooner if Republicans retain control of Congress and the White House in the next two election cycles.
The roots of the past and current crises may have more in common than Edwards indicates. Most payments for federal entitlement programs are indexed for inflation. Federal entitlement obligations are, in other words, guaranteed in real terms, just like payments for Liberty Bonds 100 years ago. They cannot be adjusted on aggregate by monetary policies that generate inflation; they can only be adjusted through the legislature and the courts. On this point, Edwards’s American Default ends on a high note.
The ability of the United States to deal with the crisis of the 1930s and the abrogation of the gold clause demonstrate the strength of our legislative and judicial institutions. Given these, it is likely that our nation will be able to overcome future federal financial restructurings. Memories of those events will fade and be forgotten just like the events that Edwards masterfully recounts in his book, and America’s federal debt will remain the risk-free standard for the rest of the world.
