Debt, Default and the Special Relationship

While revising Óscar Ugarteche's entry on "Sovereign Default" for The New Palgrave Dictionary of Economics, I was struck by a historical connection that deserves more attention. Óscar discusses the rather forgotten history of Confederate and Southern debt after the Civil War. That led me back to Jay Sexton’s excellent Debtor Diplomacy: Finance and American Foreign Relations in the Civil War Era, 1837–1873, and from there to David James Gill’s The Long Shadow of Default, on Britain’s First World War debts to the United States, which I had used for another paper on Keynes and the negotiations of the British and inter-Allied debts in the inter-war period.

Taken together, they tell an interesting story about debt and the so-called special relationship. Sexton emphasizes that the nineteenth-century United States was a debtor country whose development and even territorial expansion depended heavily on British, finance. Foreign indebtedness therefore shaped American diplomacy.

After the Civil War, this included the political settlement with Britain, the treatment of Confederate obligations, and the refinancing of the enormous Union debt. The United States declared Confederate debts void and did not assume them after victory. British creditors certainly lost money, but Britain ultimately accommodated the American settlement rather than making assumption of Confederate debt a condition for restored relations, which could have been a possible outcome. Note that this was an unilateral repudiation of the Confederate debts, that the British government might not have accepted.

Britain had never recognized the Confederacy as an independent sovereign state, only as a belligerent. That gave London a perfectly respectable legal basis for accepting the US contention that there had been no state succession. From Washington's perspective there was no vanished sovereign whose public debt passed to a successor, merely an unsuccessful rebellion. Indeed, Sexton shows how aggressively Washington asserted this theory after the war. The victorious Union claimed Confederate property on the premise that the Confederate government had never possessed lawful existence. But that was itself a contestable position. Britain could have said, in effect, you cannot simultaneously treat the Confederacy as sufficiently belligerent to generate international rights and obligations during the war, acquire its assets after victory, yet disclaim all its liabilities. The British chose not to pursue that line.

Not only that, but London continued to provide the capital that helped finance American development. The role of the Morgan House, particularly after the collapse of Jay Cooke's bank in the Crisis of 1873 is worth noticing (I'm reading on the side Liaquat Ahamed's book on that, btw).

This mattered because the United States still faced an external constraint. Under the gold standard, payments required, for practical purposes, obtaining the international means of payment centered on the pound sterling. In that respect the problem was not fundamentally different from the later dollar constraint faced by peripheral countries like Argentina right now. The post-bellum political and financial settlement eased that constraint. Essentially the British limited their claims, while maintaining access to its financial markets.

Fast-forward to the inter-war period and the positions were reversed. The First World War transformed Britain from creditor to debtor vis-à-vis the United States. Gill shows that Britain eventually stopped servicing its wartime obligations in 1934. The debt, btw, was never formally forgiven and remains technically outstanding, a fine point that was missed by Óscar. Effectively, it is the same result. The British didn't pay. But more importantly, as both Gill and Óscar note, the consequences for Britain were remarkably mild compared with what the standard sovereign default literature might lead one to expect. Britain was not permanently excluded from American finance, and the United States subsequently provided enormous assistance during and after the Second World War.

There is a symmetry worth emphasizing. Britain accommodated the rise of the United States, and the United States subsequently accommodated Britain's relative decline. Debt obligations that could have become major sources of conflict were subordinated to broader geopolitical objectives. Perhaps that is one way of thinking about what might be called development by invitation. Britain, through political accommodation, made the external constraint of the US considerably less binding. Later, the United States softened the financial consequences of Britain's loss of international primacy.

The important qualification is that this sort of flexibility has rarely been extended to peripheral countries. Latin American defaults, in particular, have normally brought creditor pressure, conditionality, prolonged negotiations and harsh adjustment. Even when the blow is lessened to allies, like Milei in Argentina, the adjustment at home is severe.

The history of Anglo-American debt relations is therefore useful precisely because it reminds us that there is nothing automatic about the supposedly inviolable rules of sovereign debt. Whether a sovereign debt remains enforceable is not determined simply by the sanctity of contract. It is determined through political settlements among states. Which debts must be paid, which can be forgotten, and which defaults can be accommodated have always depended heavily on international power relations and creditor-debtor hierarchy. It is ultimately a geopolitical matter.

Óscar Ugarteche (1949-2026)

 

At the Institute of Economics in México in 2018

I was traveling attending a conference in Rio, and didn't have time to write a post on the passing of my good friend Óscar Ugarteche. IDEAS published an obit here. I met Óscar at UNAM many years ago (way before that photo, btw). Later, when I worked at the Central Bank of Argentina, I invited him to speak there. His work was an important influence on my own understanding of sovereign debt and the international financial architecture.

Óscar's central insight was that sovereign-debt crises should not be understood simply as the result of irresponsible borrowing or excessive government spending. They form part of recurrent international credit cycles. Periods of abundant liquidity and low interest rates encourage lenders to expand credit aggressively. When interest rates rise, commodity prices fall, or capital flows reverse, countries that appeared solvent suddenly face an external constraint and may be forced into default. The debt cycle is therefore produced by creditors and the international monetary system as well as by debtors.

Debt restructuring is necessary when the original payment schedule has become economically impossible, but the existing system is fragmented and biased. Bondholders, commercial banks, official creditors, multilateral institutions, and suppliers are treated through different forums, while multilateral institutions generally refuse to restructure their own claims. Collective-action clauses can limit holdouts within a particular bond issue, but they cannot coordinate all classes of creditors. Óscar therefore favored a comprehensive, multilateral sovereign-debt restructuring and arbitration mechanism capable of imposing comparable treatment and preventing vulture funds or individual creditors from benefiting from concessions made by everyone else.

 

His view of the IMF was correspondingly critical. He wrote a brief history of the IMF that is worth reading, but I think is only in Spanish. After the end of Bretton Woods, the Fund ceased to be principally an institution of international monetary stabilization and became, in his phrase, a kind of "policeman for the banks." It supplied finance and imposed adjustment so that private creditors could be repaid. Responsibility was placed almost entirely on debtor governments, while neither creditors nor the international financial conditions that produced the lending boom were held accountable. Conditionality imposed the costs on wages, public services, growth, and state capacity, while the United States remained largely exempt from the disciplines imposed on the Global South. His preferred alternative was to reduce the IMF's power, transfer stabilization functions to regional monetary funds, and create an independent international debt-arbitration framework.

 

He wrote the entry on "Sovereign Default" for the New Palgrave Dictionary of Economics. An interesting point that he discusses is the forgotten history of the Confederate external debt. While cases of defaulters that do not pay their debts are almost nonexistent, contrary to common belief about deadbeat countries, Óscar discussed in his entry the only  historical exception, which involved the unresolved debts of several former Confederate and Southern states, with Mississippi providing Óscar's principal example of outright and permanent debt repudiation.

 

In Óscar's account, the decisive role of the US government during the 1930s was to construct the legal and diplomatic conditions under which confederate debt could remain unpaid and eventually disappear. The federal government denied any responsibility for contracts entered into by individual states and claimed that it lacked the constitutional power to compel Mississippi and the other states to pay. The Eleventh Amendment also protected states from suits brought by foreign citizens. At the international level, the southern bloc in the Senate had repeatedly inserted reservations into arbitration treaties precisely because arbitration might reopen the repudiated Southern debts. Ugarteche says that in 1930 the United States prevented the creation of an international arbitration tribunal in Geneva for fear that the bonds would be brought before it. This left British bondholders without either access to the debtor states through diplomacy or a neutral international court.

 

Óscar's hypothesis is that after World War II, the United States effectively forgave Britain’s inter-Allied war debt, and British bondholders may in return have abandoned their claims against the American states. In other words, the power of the US made the enforcement of debt contracts impossible and then helped shape the postwar settlement in which the claims disappeared.

Oscar Ugarteche on German Debt Reduction

"The largest debt problems in terms of GDP faced in financial history have belonged either to the United States or to European Governments. Large debt problems in developing and emerging nations have usually stemmed out of a drop in GDP size due to a fall in export earnings and a rise in interest rates. The reason is that creditors stop lending at a certain point and start restructuring existing debt which leads to debt growth but it is not really new lending. In major nations, lending goes on as the strategic reason for borrowing has normally been justified: a war. As a result, the leading debt reduction and innovative management schemes are related to these. Contrary to the impression generated by extensive works on the Latin American and African debt, it is the under researched European and US historical debt that must be looked into in order to understand some historical solution patterns to debt problems. Current European very high debt levels (over 90% of GDP) are due partially to accumulated current account deficits of over 3% of GDP for over a decade plus the cost of bank rescues in 2009-2010 plus some countercyclical policy costs. Greece has additional debt due to major infrastructure works. It entered the Euro with a high debt level (around 100% of GDP) but the total GDP amount shrunk 33.3% from 55,318 million euros to 36,866 million euros in constant terms between 2007 and 2013 as a result of austerity policies. If GDP had remained stagnant, the index would be 131% and not 174.9% and rising."

Read rest here.

BRICS Bank mini-symposium at the IDEAS Network

The International Development Economics Associates (IDEAS) Network has published a series of short papers on the BRICS Bank, from the more negative views of Prabhat Patnaik, that suggests that the South continues to pursue neoliberal policies and the bank will not be of much help in this context, to the more optimistic of my good friend Oscar Ugarteche (second part here), who thinks that the declaration of the last BRICS Summit had a distinctive anti-neoliberal flavor, and that the bank might be one of the pillars of an alternative to the neoliberal order, in which the dollar has a less prominent role. Jayati Ghosh's views are also less pessimistic than Patnaik (for my preliminary thoughts go here).