AMERICAN DEFAULT

Sebastian Edwards on a forgotten episode in U.S. history

20 min readMay 8, 2019

The United States Treasury Bill is an IOU issued by the federal government. It has long been considered a risk-free asset, and while it may not offer a high return these days, at least they promise your money back. After all, they say the U.S. has never defaulted on its debt in its 240-year history.

In studying the 16-year long saga of Argentina’s default (which began in 2001), UCLA economics professor Sebastian Edwards frequently heard this view expressed, only to discover that it was not true.

His new book, American Default: The Untold Story of FDR, the Supreme Court, and the Battle over Gold (Princeton University Press, 2018) documents a forgotten episode in which the U.S. technically defaulted on its debts in the form of President Roosevelt’s 1934 devaluation of the dollar.

Most economists agree that the Great Depression was worsened by the collapse in prices — especially commodity prices — which made it impossible for farmers and others to earn a reasonable living or pay back their loans. The sudden rush by the public to hoard gold depleted the financial system of the backing for money, leading to a rapid deflation that crushed borrowers beneath burdensome debts.

One solution, widely acknowledged since Milton Friedman and Anna Schwartz’s Monetary History of the United States, is to create inflation by printing money and devaluing the dollar. However, lending contracts in the 1930s period frequently contained a clause that required debts to be paid back in gold or gold equivalent. This meant that any devaluation attempt would correspond to even higher dollar payments, sinking debtors even further into debt.

FDR improvised, and on the urging of a heterodox economist named George F. Warren, doubled the price of an ounce of gold with the stroke of a pen, while simultaneously abrogating the gold-backing clauses that would have otherwise thwarted his plan.

**Buy the book:** *American Default: The Untold Story of FDR, the Supreme Court, and the Battle over Gold*. Princeton University Press, 2018, Sebastian Edwards

Oddly, Friedman and Schwartz largely neglected this vital chapter of the Great Depression. The first book-length study of the dollar devaluation, American Default splits its focus between the economics and the legal challenges of FDR’s devaluation. 68 pages are dedicated the Supreme Court decision — frequently read in law schools — that upheld FDR’s move as constitutional, since the U.S. still technically paid back its creditors (albeit in devalued dollars).

If this doesn’t debunk the notion that default could never happen here, we might take a look at the U.S. government’s debt as a percentage of GDP. Edwards notes that his colleagues Carmen Reinhardt and Kenneth Rogoff’s research shows that 90% debt-to-GDP ratios have been the historical tipping point triggering default in places like Turkey, Argentina, Mexico, Russia and Chile.

Listen to a Cato Institute podcast ft. Sebastian Edwards

We’ve been watching Venezuela’s slow-motion meltdown at the hands of populist macroeconomics. Could such a fate await the United States if we continue down the path of unsustainable entitlement spending?

Sebastian Edwards joined me for the full hour to discuss his research on the politics and economics of FDR’s devaluation, and the parallels to the populist macroeconomics of today.

Listen now:

Or read the transcript:

Dispelling the Myth of America’s Perfect Credit

Bob Zadek: Hello everyone and welcome to the Bob Zadek Show, the longest running live libertarian talk radio show in all of radio. Thanks so much for listening this Sunday morning. We are the show of ideas, never ever the show of attitude.

Part of the American ethos is that our country has never, and never will, default on any of its obligations. We have had an unblemished record throughout our almost 240 year history. We proudly honor our obligations. However, is this really true? Most people who hear that question would say, “Of course it is. There is no record of America, even during troubled times, not honoring its contractual–and more specifically–its economic obligations. We just don’t do that. After all, this is America.”

Well, my friends, I’m afraid I have to destroy your view of the tooth fairy and of Santa Claus, and of America’s never defaulting. That is simply not the case.

In a little known but significant part of American history, FDR, under the advice of one of the most significant economists you have never heard of, was able to default without defaulting on our debt. Not only did FDR actually cause a default, but the default was strategic. By many observations, this engineered default by FDR and his advisers in 1933 may very well have been a brilliant economic and political move. It may have shortened or at least postponed the Depression and given Americans a significant respite from the evils of the Depression.

What is this story of American Default you have never heard of? To help us understand, I’m happy to welcome my new best friend, Sebastian Edwards. Sebastian teaches economics in the graduate program at UCLA, has worked with Milton Friedman and other very well-known Chicago school free market economists, and discovered the story of this default by FDR almost accidentally. It is a great story.

Sebastian, welcome to the show this morning.

Sebastian Edwards: Good morning Bob. Great to be with you and your listeners.

Bob Zadek: Just a word for our listeners. Sebastian, who gets the “Bob Zadek Award for Valor,” had a flight scheduled for later this morning, but American Airlines (as they are wont to do) canceled his flight and put him on an earlier flight. So instead of sharing his thoughts with us from the comfort of an easy chair at home, he is at the terminal right now waiting for his flight. But he assures me he will not be doing this from his seat in the airplane. He has enough time to do the entire show. So, Sebastian, thank you for the Yeoman’s duty this morning.

Sebastian Edwards: You’re welcome, Bob.

Bob Zadek: Now Sebastian, you discovered this economic event quite recently, quite by accident. Tell us briefly how you discovered this story. Who told you the story of FDR’s engineering the default?

Sebastian Edwards: About 16 years ago I was asked by a law firm to work as an expert witness in a number of cases related to the Argentine default of 2002. I was preparing in my report for those cases and I read the brief that Argentina provided to the arbitrations tribunal, and I found one paragraph that was very intriguing. It said there were some U.S. presidents who had defaulted on their debts. One of them was the President of the United States in 1933. The Supreme Court said that it was okay. Therefore, Argentina argued it must be okay for Argentina to do as well.

I started asking around and almost no one knew about it and that was when I decided to write a book on it.

Bob Zadek: Of course, it didn’t occur to you–given the quality of the law firms — that they had just made the whole thing up to justify the default by Argentina. So you took it seriously, and that was the right call, because you then discovered that Argentina was relying upon the bad example set by the United States during the early stages of the depression in 1933.

Sebastian Edwards: The first thing I did was I went to the amazing work that Milton Friedman wrote, entitled The Monetary History of the United States, and I found one very short paragraph on this case. At the time I was a member of Governor Arnold Schwarzenegger’s Council for economic advisors and Milton Friedman was also a member. So, in one of the meetings during the coffee break I asked Milton about it. He knew about it but he said, “Well we didn’t have time or space to go in detail into the episode.”

And I said, “Milton, I am thinking of writing a book on it.”

The “Gold Standard”: A Security Against Inflation

Bob Zadek: Help the audience understand a few concepts that will be quite important as you tell the story. The first is the concept of the “gold standard.” That is a phrase that is part of American vernacular, but it is a very important economic concept. When you use the phrase “gold standard,” what do you mean in general, and particularly, what does it mean in the concept of indebtedness, especially bond indebtedness?

Sebastian Edwards: The gold standard is a monetary system whereby the liabilities for the central bank, in our case, the Federal Reserve system, are backed by gold — usually in a large percentage like 50%. So, the Fed gives you paper money but it is backed by gold. The only way to issue more paper money is if you have more gold backing, and that is the gold standard. There is a fixed price between thg paper money and bold. In the US, since 1834, that price was $20.87 and it had been constant for a hundred years. FDR said, well, we have the Depression, maybe we should end this tight connection between gold and the United States dollar, and that was the beginning.

Bob Zadek: The reason why creditors insist upon having dollar debt linked to gold is that when bonds are issued by the government, a government could obviously simply issue more money, and when there is more of anything, it become worth less. So, if the government issues more money, which in everyday language is inflation, the buying power of a dollar is decreased. So, if somebody owes you $10,000, but the $10,000 buys less, the value of the obligation goes down. So, as a hedge, and as protection against the government in effect inflating their way out of obligations, creditors have forever learned to link the dollar to a commodity, so government cannot issue more money unless they acquire more gold, which they cannot do. This is how a creditor is protected against having inflation via government action diminish the value of their holdings. That is the key.

Sebastian Edwards: The only thing I would add is that during the Civil War we had two currencies that were circulating side by side. Gold backed and greenbacks, which were not backed by gold. The problem was that creditors wanted to know in which of the two currencies their funds were going to be invested. Most debt — not only government debt, but private debt as well — incorporated gold clauses. In effect, we are going to pay you back the gold equivalent of so many dollars. This is how the gold clause became incorporated into our debts.

However, it was not only the government, but also the private sector, which is what made the situation so complicated. There was roughly a hundred billion dollars debt, something like $25 trillion dollars today, mostly from utilities and railroads that had the gold clause. If we changed the value of gold in dollar terms, that meant that debtors had to pay much more in terms of paper dollars.

Bob Zadek: Just so the audience can really relate to this gold standard, many transactions today, such as in Social Security and various aspects of our tax law, are keyed to inflation — an index such as the consumer price index. That is the same thing. When you have your social security benefits keyed to the consumer price index, as inflation causes the dollar to be worth less, your payments go up accordingly, so inflation cannot diminish the absolute value of your payments.

The concept of having an inflation-proof transaction is quite familiar to Americans in many aspects of life. It happens in tax law, social security, and many other relationships. Isn’t that a fair parallel, Sebastian?

Sebastian Edwards: That’s a very good parallel — COLA (cost-of-living) adjustments to clauses like the one social security has. The main difference is that in COLA or Social Security, what we have is a basket of goods, and in this case it was linked just to one commodity — gold.

Bob Zadek: So, now we have creditors who have learned this very effective device to assure themselves that inflation cannot diminish the absolute value of their obligations. Keep in mind as well that inflation is a conscious governmental activity.

In 1933, there was the Depression. Farmers were suffering. There was huge deflation. Nothing is worth very much at all. Prices in the entire globe have declined in value, and here we have the farmers that have one financial relationship which is locked to gold, and that is their debts. Everything else in their life, however, is deflating. When your income goes down in absolute terms, but your debts do not go down in absolute terms, you are in a vice. That was the circumstance that FDR found himself in in 1933.

Sebastian Edwards: That is true. FDR had massive support from the rural states during the election when he defeated Herbert Hoover in 1932. In addition to that he thought of himself as a gentleman farmer. He owned a farm in upstate New York and he also owned a farm in Georgia where he had his summer house where he would exercise for his leg. So FDR wanted commodity prices to go up. Someone told him that one way to do this was to devalue the dollar relative to gold. So, instead of the price of gold being 21 dollars, why don’t you make the price of gold more expensive. This same person told him that the United Kingdom just devalued the pound and they were experiencing some recovery.

FDR loved to experiment and he loved new ideas. He was also getting pressured by agricultural members of Congress. So he was about to do this, when someone says that all the debt is linked to gold. If gold is more expensive every railway and every utility and the government, all those debts just go through the roof.

Bob Zadek: The value of gold, as you explained, was last set in the 1830s at $20.87 cents an ounce. That is a question of governmental action. It is not a value determined by a marketplace. Government, in effect, determines, because the Constitution allows them to, how much a dollar is worth in terms of gold. So, government can simply devalue the dollar by raising the price of gold in terms of dollars. By doing so, they were in effect undoing the benefits of the gold standard were they not? In other words, it was an end-run around the gold standard on debt.

Sebastian Edwards: The government commits itself to buying and selling infinite amounts at this ongoing price. The government, as you said, has the ability to fix the price.

FDR’s Two-Step Plan to Undo the Gold Standard

Bob Zadek: Roosevelt could not undo the gold standard as such (it was in the contract and the government couldn’t impair contracts under the Constitution), so this was an end-run in order to give relief to the farmers and other debtors. He came upon a plan, and the plan had two steps. Tell us the two steps and the result of those two steps.

Step 1: Buy All the Gold and Abrogate Gold Clauses

Sebastian Edwards: The first step was to unlink the clause from gold, forbidding private and public debt to be linked to gold. This was not a legal problem going forward. What they decided to do, because a lot of government debt had already been issued, the controversial act was to de-link debt from gold retroactively. This created a constitutional crisis. So the first step was abrogating the gold clauses and the second step was to devalue the dollar, which eventually we did to $35 an ounce, a price that lasted until 1971 when President Richard Nixon brought that system to an end.

Bob Zadek: Roosevelt first said it is illegal for individuals outside of government to own gold. By executive order, he required everybody sell their gold back to the government.

Sebastian Edwards: That’s a very important step Bob, which I detail in this book, American Default. Exactly one month from FDR’s inauguration, he issued this executive order, which obligated every individual to sell his or her gold to the Federal Reserve at the ongoing official price of 20.87. He then abrogates the gold clause and devalues the dollar and that would bring all the lawsuits. Finally, the Supreme Court ruled in February of 1935.

Bob Zadek: The reason it was important for the government to buy all the gold back under compulsion is that if you have gold, it is probably because you don’t trust the government not to resort to inflation to devalue the dollar. And just imagine if you had a carton full of dollars and the government whom you do not trust can by government action say that box of paper underneath your bed is now worth less. If you believe that government might do that, you are not going to put dollars in that carton underneath your bed. You are going to have gold because gold has a value in the world market. Whatever the US does with a dollar, you would still have gold, which the government cannot alter the value of. So, Roosevelt can’t succeed unless he first sucks up all the gold. Is that a fair analysis?

Sebastian Edwards: That is a fair analysis, Bob.

Bob Zadek: Since the dollar was linked to gold, the only way the government could issue more dollars is by having more gold, and the way that it got more gold is to require it to be sold at the old price of $20.87. Most Presidents take a while to learn how to operate the levers of government, but Roosevelt didn’t miss a step. He gets elected and his first day in the Oval Office he is already issuing an executive order which had never been issued before, requiring Americans to return all their gold to the Treasury and accept dollars, which is fiat currency. The holders of it cannot control the value. That’s where we are when the curtain goes down on Act One.

Step 2: Retroactive Breach of Contract

Bob Zadek: If there was ever a guy who was born to be president, it was not Beto, but it was certainly FDR. So, Sebastian, the government has sucked up all the gold and in return has given Americans instead pieces of paper, albeit paper backed by gold, but paper nonetheless. Now, what is the next step? We still haven’t gotten in our story to any relief to farmers or to the government or to other debtors. How does the relief come about and who takes it in the shorts as a result of that relief?

Sebastian Edwards: The first act, as you say, was the abrogation of gold clauses — when FDR demands the gold, and the second act consists of the abrogation process, which happened in June.

Bob Zadek: Congress passes something called the “Joint Resolution.” Both houses of Congress join FDR –FDR, of course, controlled both houses of Congress — and what did the joint resolution declare?

Sebastian Edwards: That was to vote for the issue in the future, but the controversial part was this applied to debts that had been issued already, including Liberty bonds, which had been issued in 1917 in order to finance World War I. Remember that liberty bonds were bought by households, so every American family owned some liberty bonds, which were linked to gold.

The gold clause at this point was illegal, so even though the gold still cost 20.87.

Final Act: Devaluation

Bob Zadek: The third act is when the government declares that the gold, which was worth $20.87, is now by governmental action worth $35 dollars. So, the effect of it is that the dollar has become less valuable because you need more dollars to buy the same ounce of gold. Once you reduce the value of a dollar, now the bargain that creditors negotiated for — whether it is the family owning a liberty bond at $5 that they bought to support World War I, or whether it’s a creditor who holds private bonds issued by a railroad or an oil company — those bonds for which the creditors bargained for the right to be protected against inflation, that bargain was removed, and the effect on the creditor is that the value of their debt went down.

It allowed the government to pay their debts back with cheaper dollars than they bargained for, and the creditor lost protection. Is that too dramatic a way to express it or is that exactly what happened?

Sebastian Edwards: In April, 1933, people are forced to sell their gold, so now the government owns all this gold which is valued at the official price of $20.87. Then the dollar’s value with respect to gold changes because now gold is worth $35. When the dollar is devalued with respect to gold in 1934 — this is act 3, act 2 was the abrogation of the gold clause — and now gold is worth $35. So now the government is worth more. Where does this money go? Some of it goes into what is known as the currency stabilization fund. That fund was used in the 1990s to bail out Mexico in a very controversial measure, (Mexico ended up repaying plus interest) but because of this devaluation, the government who owned all the gold got a capital gain, and this was used to finance this fund which is used later to bail out Mexico in 1985.

Bob Zadek: What is really interesting is when the government raised the value of gold from $20.87 cents to $35. Just imagine if you owned a home and you were able to make a rule, such that your house increases in value by 67%. Imagine the windfall to you and how unfair it is to somebody else who might want the house. You realized a gain which you gave to yourself and the government, having acquired all the gold, then passed a law that said this gold that we now have is worth a lot more in dollars. It seems outrageous, but Roosevelt did this in 1933. What was the immediate effect upon all of the creditors who both held private debt and public debt? Wasn’t it just a profound wealth transfer (by statute) from creditors to debtors?

Sebastian Edwards: That is exactly what happened.

The Supreme Court’s Ruling and the Concept of Necessity

Bob Zadek: The Supreme Court was at that time quite unsympathetic to Roosevelt’s new approach to the power of the Federal Government. Under the commerce clause and other broad clauses, the government can essentially do what is necessary and proper. “Necessary” becomes an important concept, both in how you discovered this in Argentina’s approach to its default and Roosevelt’s approach with the Supreme Court. So let’s divert a little bit. Roosevelt, in defending this action, used this concept of necessity. That is a word that Argentina used as well. So tell us how the concept of the necessity comes into play.

Sebastian Edwards : You are the lawyer and the Constitutional expert. I am the economist. But in our constitutional as well as in international law, there is this concept called a justified contract breach which happens under a concept of “force majeure,” which means that there is some calamity imposed on the creditor so that they are unable to pay, or that, in order to survive, the creditor needs to breach the contract.

Argentina, in 2002 said we had linked our contracts to the US dollar irrevocably, but we have to fix the crisis because otherwise the state will disappear, and there will be riots and there will be a revolution. FDR made a similar argument in the brief to the Supreme Court — that, in order for the United States to get out of the Depression, it needs to devalue the dollar and increase the price of gold, because, if we don’t, then every utility, every railroad, and every property owner will go bankrupt. That’s where the term comes in.

Bob Zadek: The Supreme Court starts off being unsympathetic to Roosevelt. There was a five-four split, just like today. The conservatives had five votes, including Charles Evan Hughes, the Chief Justice of the Supreme Court. He was kind of a swing vote, like Justice Roberts is today.

The Supreme Court had to decide if Roosevelt had all of these implied powers to declare that the only way out of the Depression was to make, in effect, the creditors pay debtors money in order to get out of the Depression. So, the Supreme Court has this decision to make and what do they decide?

Sebastian Edwards: Charles Evans Hughes had been a Presidential candidate for the Republican Party. He was barely defeated in a highly contested election by Woodrow Wilson, and he had been Governor of New York. The Supreme Court, in a 5–4 decision, looks at these cases. There is a lot of anxiety in the financial markets at that time. The Supreme Court ruled very soon after hearing the case — a few weeks after that. It was very exciting moments and a lot of dignitaries were present.

The Supreme Court have not moved yet to its building, so it is connected [to Congress]. Joe Kennedy, the Patriarch of the Kennedys, is on the phone conveying to FDR what is going on in the Supreme Court.

First comes the ruling of the private debt. The Supreme Court holds that the Constitution gives Congress the right to coin money and determine the value thereof. In order to have the Constitutional mandate put in place and carried forward, it needs to change contracts, so that is okay. So, for private contracts, it is okay to abrogate the gold clause. Then came government contracts. The Supreme Court said it was unconstitutional for the government to breach contracts retroactively.

The argument was that the Constitution gives government the power to coin money and determine the value thereof, but it also says that Congress has the power to issue US Debt on the credit of the United States. The Supreme Court says issuing debt implicitly brings with it the obligation of paying it back. The government cannot use one power to annul another power.

FDR was dismayed when listening to it, but then there is the second part of this ruling where the court declares that “there are no damages.” So although it is unconstitutional, there are no damages, and there are no damages because due to the inflation, the same amount of paper dollars allows people to buy more goods than before, or the same amount of goods as before. They say that it is true you cannot buy as much gold, but we are going to use the assets that people buy as a benchmark instead.

Bob Zadek: The Supreme Court said that even though there was an increase in the devaluation of the dollar relative to gold, since the government is still paying back $1,000 debt with $1,000, even the repayment dollars are much less valuable, so there was nobody hurt. Of course, the government always had the power to inflate the currency anyway. So, in other words the court forgot about the fact that, in absolute terms, creditors were denied about one third of their obligations. Under the dictionary definition of default, paying back something with less value than you are obligated to do, is not default, but the Supreme Court skipped over that in its 82-page decision. So the action of Roosevelt stood even though it was, in everyday terms, a default.

As you mentioned in your book, by the time the Supreme Court heard the case, there was one year of commercial activity after Roosevelt increased the price of gold and went off the gold standard. As you explained in the book, that was a pretty healthy year. So, the country reacted positively to Roosevelt’s actions. Therefore, if the Supreme Court had decided otherwise, they would have taken away what seemed like a road away from the Depression. Don’t you think that was a significant consideration by the Supreme Court?

Sebastian Edwards: We will never know. I went through the archives of the Supreme Court Justices, and it seems that is the case, even though they argued they were just using legal arguments.

Bob Zadek: What we have learned from Sebastian’s book is that, most assuredly, the United States in 1933 defaulted in its obligations. Government decreed that the way out of the depression was to compel creditors to pay debtors or relieve debtors of a third of their debt. Nothing is default more clearly than that. Forgetting about phrases like “abuses of power,” many observers believe that Roosevelt’s action did take a giant step towards getting us out of the Depression, even though we dropped back in, in 1937 for other reasons.

Sebastian, your book is a fascinating read and it helps all of the readers understand the relationship between obligations and inflation, how the government can repay through inflation, and it indicates the power of Roosevelt exercising the incredible power of the presidency, including a phrase that we hear every day today, which is “by executive order.” We also understand how, in effect, the three branches of government cooperated in what might be a questionable governmental activity, but which may have had a positive result. So the question is, do the ends justify the means?

Sebastian Edwards: I couldn’t summarize better than that. Thank you for having me on the show.

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