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260 THEAMERICANECONOMIC REVIEW MARCH 1996

were, for the most part,unable to do so. Statesthatdefaultedtemporarilywere able to regainaccess to the creditmarketby settlingtheir olddebts. More

surprisingly, two states that re-pudiated a partof theirdebtwere able to regainaccess to capital markets after servicing theremainderof their debt for a time. Thus thesecases provide evidence for a signaling modelof sovereign debt similar to that presented byHarold L. Cole et al. (1995).

Of course, the fact that U.S. states do notaefault on theirdebtstoday could also be takenas evidence against the sanctions view, sinceit is still not clear that bondholders couldimpose sanctions on defaulting states. The

1840's defaults provide more compelling ev-idence, however, because we can observe thatno direct sanctions were imposed followingactual defaults and repudiations,whereas onecan only conjecturewhat the costs would turnout to be today. Indeed, there is reason to be-lieve that sanctionswould be easier to imposetoday than they were in the 1840's. The frac-tion of state debts held outside the issuingstate, either in other states or abroad-whichwas very largein the 1840's-is likely smallernow, owing, in part, to the favorable federal

and state tax treatmentof state securities. De-faults on state residents, however, might leadto adverse political consequences for the pol-iticians supportingdefault, while defaultingonresidents of other states might lead to inter-vention by the federalgovernment. Moreover,the far greaterrelative size of the federal gov-ernmenttoday provides much largerscope forsuch interventionthan was the case in the pre-Civil War era. Even in the case of foreignbondholders,the federal courts' interpretationof sovereign immunity has been narrowed in

some respectssince World WarII, and so legalaction might be more effective than it wouldhave been a century and a half ago (see thediscussion in Lewis S. Alexander [1987]).

I. State Debtsas SovereignDebts

A. Legal and ConstitutionalIssues

One might expect that U.S. states could becompelled to repaydebtsby the federal courts.The power of the federal courts to do

so wastested in Chisholm v. Georgia (1793), in

which a citizen of South Carolina sued thestate of Georgia for nonpaymentof a debt. Thefirst Supreme Court decided that it had juris-

diction in such cases, and it found against thestate (John V. Orth, 1987 Chapter2). In re-sponse to this decision, Congress passed theEleventh Amendment to the Constitution, andwithin two years it had been passed by therequired two thirds of the states. The amend-ment declares that "The judicial power of theUnited States shall not be construed to extendto any suit in law or equity, commenced orprosecuted against one of the United Statesby citizens of another state, or by citizens orsubjects of any foreign state." This amend-

mentreversedChisholm, andmade it very dif-ficult for creditors to force states to repaydebts.

An obvious route around the Eleventh-Amendmentobstacle is to arrange o have thesuit brought by an agent not covered by theamendment.There are four possibilities: a cit-izen of the state, the government of anothercountry, the federal government, or the gov-ernment of another state. The first two possi-bilities have been ruled outby Supreme-Courtdecisions. In Hans v. Louisiana (1890) the

SupremeCourt ruled thatthe federal courts donot havejurisdiction over suitsbroughtagainsta state by a resident of that state (Orth, 1987pp. 140-41). In Monaco v. Mississippi (1934)the court found that, since foreign states areimmune from suits by U.S. states, U.S. statesshould be immune from suits by foreign coun-tries (Orth, p. 141).

In contrast, the Supreme Court has beenwilling to accept jurisdiction in suits betweenthe federal government and a state and be-tween two states. In United States v. NorthCarolina ( 1890) the SupremeCourt ruled thatit had jurisdiction over a suit by the federalgovernmentfor paymentsthatthe governmentclaimed were owed by North Carolina. (Thecourt,however, found for the state.) In 1904 anarrowly-dividedcourt sided with South Da-kota in a suit it broughtto obtain payment onReconstruction-eraNorth Carolinabonds thathad been donated to the state. While thismethod of forcing states to pay their debtsworked, other states were unwilling to bring

such suits, and South Dakota refused a secondgift of bonds (Orth, 1987 pp. 83-85).



VOL.86 NO. I ENGLISH:THE COSTSOF DEFAULT 261

Anotherpossible route aroundthe EleventhAmendmentis to turnto the state courts. Thisroute seems unpromising,given the likely un-

popularityof the bondholders,but it was triedin two states following the defaults in the1840's. In Mississippi the bondholderswon a

rulingby the stateSupremeCourt,butthe stateconstitution did not provide for any wayfor the judgment to be collected (Orth, 1987p. 45). Thus the bondholders were able toshow the justice of their claims, but were un-able to force the stateto pay. Similarly,holdersof defaultedArkansasbonds were able to ob-tain judgments in that state's Supreme Courtdeclaring that their claims were proper, but

they too were unable to collect on the bonds(Reginald C. McGrane, 1935 pp. 258-59,263-64).

B. Who Werethe Bondholders?

The defaultedstatedebts in the 1840's werenot generally owed to state residents. Most of

the statebonds were sold in Europe (primarilyLondon), New York, or Philadelphia.For ex-ample, the par value of the bonds of Pennsyl-vania-the most heavily indebtedstate-was

$34.5 million in 1842. Of this, over $20 mil-lion was held in England, and an additional$1.8 million in Holland. Even France, whichheld $570,000 of Pennsylvania bonds, heldmore than any U.S. state other than Pennsyl-vania itself (McGrane, 1935 p. 71n).

Although detailed informationis not avail-able for other states, a substantialfraction of

many states' bonds were held abroad.For ex-ample, about two fifths of the New York debtwas held in Europe in 1843, and some of thebonds held in this countrymay have been heldby agents of foreign investors (Thomas P.Kettell, 1848 p. 252). About half of the Flor-ida and Arkansasbonds were held in Amster-dam or London (McGrane, 1935 pp. 228-29,251-52). By 1846 a substantial majority ofthe Illinois canal debtwas held in London (F.Cyril James, 1938 v. 1, p. 169). The governorof Mississippi claimed that all of that state'sdebtwas held by foreignersin Januaryof 1840(Robert Lowry and William H. McCardle,1891 p. 289). Some states even made their

bonds payable in foreign currencies in Euro-pean cities in orderto sell them more easily in

those markets.For example, nearly half of theMaryland debt was denominated in poundssterling and was payable in London (U.S.

Congress, House of Representatives,1843b

ReportNo. 296, pp. 56-57; Kettell, 1849b p.491). Similarly, over two thirds of the Geor-gia debt was denominatedin pounds and pay-able in London, as was over 70 percentof thedebt of Mississippi (U.S. Congress, House ofRepresentatives, pp. 68-69; McGrane, 1935p. 197) and more than 90 percent of thedebt of Louisiana (Benjamin R. Curtis, 1844p. 137; McGrane,pp. 171-75).

Even if bonds were held in the UnitedStates, the holders could still be residents of

other states. For the large northeasternstates,bonds not held abroadwere mostly held in thestate.Less than5 percentof the New York andPennsylvania bonds were held in other states(McGrane, 1935 p. 71n; Kettell, 1848 p. 252).In contrast, the Ohio debt was explicitlydivided into a "domestic" debt-payablelocally-and a "foreign" debt which was

payable in New York. The foreign debt was

aboutthreequartersof thetotal(U.S. Congress,House of Representatives,pp. 82-85). Simi-larly, all of the Indianabondeddebtwas "for-

eign debt" (Logan Esarey, 1918 v. 1, p. 435).

II. StateDebts n the 1830'sand1840's

Between 1820 and 1839 the debts of U.S.

states increased by a factor of thirteen. As

can be seen in Table 1, these debts were pri-marily for two purposes: transportationim-

provements and banking. The success of theErie Canalhad shown that state investment in

internal improvements could be productiveand profitable.Other states, primarilythose in

the North, attemptedto emulate New York'ssuccess by building their own canals and rail-roads. In contrast, southern states borrowedprimarilyto obtain the capital for banks. Thesouthernstates felt that their banking systemswere insufficient, especially after the UnitedStatesBankwas not rechartered.See McGrane,1935 Chapter1.)

A. WhyDid States Default?

By thefall of 1841, nineteen U.S. states

and two territories had issued bonds, while



262 THE AMERICANECONOMICREVIEW MARCH 1996

TABLE 1-STATE DEBTS IN SEPTEMBER 1841(THOUSANDS OF DOLLARS, BY PURPOSE OF ISSUE)

Purpose

Other orState or territory Transportation Banking not available Total debt

Alabama 0 15,400 0 15,400Arkansas 0 3,176 0 3,176Connecticut 0 0 0 0Delaware 0 0 0 0FloridaTerritory 0 3,900 100 4,000Georgia 1,321 0 0 1,321Illinois 9,517 3,035 975 13,527Indiana 8,998 2,390 2,863 14,251Iowa Territory 0 0 0 0Kentucky 3,046 0 40 3,086Louisiana 1,200 17,389 585 19,174Maine 0 0 1,735 1,735Maryland 11,789 0 226 12,015Massachusetts 5,675 0 294 5,969Michigan 5,320 0 291 5,611Mississippi 0 7,000 0 7,000Missouri 20 389 433 842New Hampshire 0 0 0 0New Jersey 0 0 0 0New York 20,822 0 975 21,797North Carolina 0 0 0 0Ohio 13,594 0 1,489 15,083Pennsylvania 30,024 0 6,342 36,366Rhode Island 0 0 0 0South Carolina 3,350 138 2,203 5,691Tennessee 1,716 1,500 0 3,216

Vermont 0 0 0 0Virginia 6,193 801 0 6,995Wisconsin Territory 0 0 418 418

Source: See the Data Appendix.

seven other states and one territory (Iowa)did not have any debt. Of the borrowingstates, eight would default within two years:Arkansas, Illinois, Indiana, Louisiana, Mary-land, Michigan, Mississippi, and Pennsylvania.In addition, a territory Florida) repudiated tsdebt.'

Although the borrowin-gwas for differentcauses, the basic problem was the same for

states in the North and the South. The longinflationary boom of 1834-39, which hadbeen checked by the panic of 1837, came toan abruptend in 1839. The causes of the col-lapse are not entirely clear, but probably in-volved a tightening of credit by the Bank ofEngland and a resulting outflow of gold fromthe United States to Britain (Peter Temin,1969). In any case, the transportation nvest-ments of many northern states were not yetcomplete, and additional credit was not avail-able. Since the incomplete projects generatedlittle revenue, the bonds issued for their con-structionbecame a burdenfor the states. In theSouth, many of the banks that had been startedwith theborrowed funds failed in the few years

after 1839, and the bonds issued on their be-half fell on state budgets.

' In addition,the Territoryof Wisconsin seems to haverepudiateda portion of its debts (U.S. Congress, House ofRepresentatives, 1843b, Report No. 296, pp. 48-49).Given that the repudiationseems likely to have resultedfrom malfeasance on thepartof the stateagent,rather hanthe territory'sunwillingness orinability to pay, Wisconsin

is not counted in this paper as a defaulting or repudiatingstate.



VOL. 86 NO. I ENGLISH: THE COSTS OF DEFAULT 263

The troubled states (i.e. those that defaultedor repudiated) were considerably more in-debted than the other states.2 As can be seen

in Table 2, the defaulting states had debts ofmore than 20 percent of annual state income,while those that had debts but did not defaulthad borrowed only about 9 percent of stateincome on average. Surprisingly, the statesthat repudiated ompletelyhad somewhat owerdebt burdens than the states that repudiatedpartially. In addition, some heavily indebtedstates did not default (e.g., Alabama) whilesome states with relatively light burdens re-pudiated (e.g., Mississippi).

The debt burdens shown in Table 2 are

based on debt data from September of 1841and income data for 1839. Since most stateswere not able to borrow after 1839, the debtburdens in Table 2 are roughly correct for1839. As measured by the Warrenand Pearsonwholesale price index, prices fell by one thirdbetween 1839 and 1843, thereby boosting thereal burdensof the debts substantially.3 n ad-dition, there may have been a decline in realoutput between 1839 and 1843, although the

size of this decline is subject to debate (seeTemin [1969] and Charles W. Calomiris andChristopherHanes [1994] for discussions).

B. Histories of the Defaultsand Resumptions

The defaulting states can usefully be dividedinto three groups both by region and by thesource of their difficulties. Pennsylvania andMaryland, both of which had borrowed tobuild canals, defaultedtemporarily n the early1840's. Both states eventually paid in full.Three states in the Midwest-Indiana, Illi-nois, and Michigan-borrowed to build trans-

portation networks. Their difficulties weremore serious than those of Pennsylvania andMaryland, and the outcomes for their bond-holders were less satisfactory. Finally, threesouthern states and the FloridaTerritory ssuedbonds on the behalf of banks or guaranteed hebonds of banks. When the banks failed in theearly 1840's, all four refused to pay all or partof their bonds. (See Table 3.)

Pennsylvania and Maryland.4Both ofthese states borrowedheavily to construct ca-

nal systems linking their ports to the Midwest.Although they borrowed large sums, bothstates were populous and relatively rich, andtheir debt burdens were lower than those ofseveral other states (see Table 2). In the re-cession of the early 1840'.showever, both weretemporarilyunable to make their interestpay-ments. Although the defaults generated out-rage among European investors, neither statewas likely to repudiate.After several attemptsboth states were able to raise their taxes suf-ficiently to resume the paymentsowed on theirdebts, andboth states funded their arrears ntonew bonds.

MidwesternStates.5The midwesternstatesof Ohio, Indiana, Illinois, and Michiganall borrowed heavily to build transportation

2 The grouping of states by their default status is some-what problematical. Those that paid without interruptionare straightforward,as are those that repudiatedmore orless completely. The distinction between defaulting with-out repudiating and partially repudiating is less clear.Pennsylvania and Marylanddefaulted, but eventually paidin full (including interest on their arrears). Indiana andIllinois reached settlements that were not quite completerepayments because their arrearswere not repaid for sev-eral years, and they did not pay interest on their arrears.In addition, the Indiana settlement was ultimately a dis-aster for the bondholders.Nonetheless, I count these fourstates as defaulting but not repudiating. Michigan clearly

repudiated a part of its debt. Arkansas defaulted on itsdebts until after the Civil War, but then paid some of itspre-war debts. It is counted here as a partially repudiatingstate. Louisiana repudiatedits bank debt, but paid its re-maining debt. In addition, the banks ultimately repaidmuch of the bank debt. The fraction of debts paid (by thebanks as well as the state) may have been quite high, butI still count Louisiana as a partially repudiating state be-cause the eventual outcome was not known in the early1840's.

'According to Robert E. Gallman (1964) the GNP de-flator fell by only 4.4 percent between 1839 and 1844.Thus the Warren-Pearson ndex may overstate the declinein prices. Since most out-of-state sales were probably

wholesale commodities, the focus here on the Warren-Pearson index seems warranted.

' See Kettell (1847a, 1849a, 1849b) and McGrane(1935 Chapters 4 and 5).

5 See Kettell (1849c, 1849d, 1850, 1852) and McGrane(1935 Chapters 6-8).



264 THE AMERICANECONOMICREVIEW MARCH1996

TABLE 2-DEBT BURDENS

Per capita (in dollars) Ratios (in percent)

Gross state Interest on Debt to Interest toState or territory product State debt state debt income income

Those without debt:Connecticut 126.67Delaware 94.66Iowa Territory 52.90New Hampshire 89.09New Jersey 115.54North Carolina 70.99Rhode Island 164.26Vermont 90.48

Average: 95.94

Those that did not default:Alabama 73.78 26.06 1.39 35.32 1.88

Georgia 79.35 1.91 0.10 2.41 0.13Kentucky 72.39 3.96 0.23 5.46 0.32Maine 79.35 3.46 0.20 4.36 0.26Massachusetts 148.95 8.09 0.40 5.43 0.27Missouri 73.78 2.19 0.16 2.97 0.21New York 111.36 8.97 0.46 8.06 0.41Ohio 66.82 9.92 0.59 14.85 0.89South Carolina 77.95 9.58 0.53 12.29 0.68Tennessee 65.43 3.88 0.21 5.93 0.32Virginia 75.17 5.64 0.33 7.50 0.44Wisconsin 111.36 13.49 0.81 12.11 0.73

Average: 87.28 7.88 0.43 9.03 0.49

Those that defaultedtemporarily:

Illinois 65.43 28.42 1.71 43.44 2.61Indiana 57.07 20.77 1.07 36.40 1.87Maryland 87.70 25.56 1.39 29.15 1.58Pennsylvania 104.40 21.09 1.05 20.20 1.01

Average: 86.86 22.69 1.19 26.13 1.37

Those thatpartially repudiated:Arkansas 94.66 32.41 1.93 34.24 2.04Louisiana 157.30 54.47 2.74 34.63 1.74Michigan 61.25 26.47 1.59 43.21 2.60

Average: 117.27 42.24 2.25 36.02 1.92

Those that repudiatedcompletely:Florida Territory 96.05 74.07 4.41 77.12 4.59Mississippi 116.93 18.62 0.98 15.92 0.84

Average: 114.31 25.58 1.41 22.38 1.24All states and territories:

Average: 90.48 11.79 0.63 13.03 0.70

Notes: Debt and interest dataare as of September 1841. State income data are for 1839. For definitionsof categories, seetext note 2. Averages are weighted by income.

Sources: See the Data Appendix.

networks. Of the four, only Ohio was able toavoid default.

The Illinois and Indiana debts were accu-mulated while the statesconstructedmajorca-

nal networks linking their states with the GreatLakes and, via the Erie Canal, the easternsea-board. In the early 1840's both states were un-able to borrow to complete their canals and



VOL. 86 NO. I ENGLISH: THE COSTS OF DEFAULT 265

TABLE 3-DATES OF DEFAULTS, REPUDIATIONS, AND RESUMPTIONS

State or territory Default Resumption/repudiation Outcome

Those that defaulted temporarily:Illinois January 1842 Resumptionin July 1846. Virtuallycomplete repayment.Indiana July 1841 Resumption in July 1847. Debt split (see text).

State debt: virtuallycompleterepayment.Canal debt: not clear, but the canalultimately failed.

Maryland January 1842 Resumptionin January1848. Virtuallycomplete repayment.Pennsylvania August 1842 Resumptionin February Virtuallycomplete repayment.

1845.Those that partiallyrepudiated:

Arkansas July 1841 Resumptionin July 1869. Low, since no interest was paid on thearrears.The Holford bonds wererepudiated n 1884 (see text).

Louisiana February1843 Debt split (see text).State debt proper: Virtuallycomplete repayment.resumptionc.1844.Propertybank bonds: The bonds repaidby the propertybanks.not paid by the state. The amountrepaid is not clear, but

was probablyfairly high in somecases.

Michigan July 1841 Debt split (see text).Fully paid bonds: Virtuallycomplete repayment.resumptionin January1846. About 30 cents on the dollar.Partpaid bonds:resumptionin July 1849.

Those thatrepudiatedcompletely:FloridaTerritory January1841 Repudiatedin February Floridamade no furtherpayments on

1842. the bonds. Some portion of the bondswere paid by the companies forwhich they had been issued. Totalpayments were likely small.

Mississippi:Planters Bank Bonds March 1841 Repudiated in November Mississippi made no furtherpayments

1852. on the bonds. Between 1848 and1852 the accumulatedfund wasdistributed o the bondholders. Anadditional$54,000 of these bondswere received by the state in paymentfor public lands in the 1850's.

Union Bank Bonds May 1841 Repudiatedin February Mississippi made no furtherpayments1842. on the bonds.

Sources: Illinois: J. W. Putnam (1909), Laws of the State of Illinois (1845); Indiana: Kettell (1849c); Maryland:Kettell (1849b): Pennsylvania: Kettell (1849a): Arkansas:McGrane (1935), Scott (1893); Louisiana: McGrane (1935);Michigan: Kettell (1850); Florida:McGrane (1935); Mississippi: Corporationof Foreign Bondholders (1932).

unable to pay the interest due on their bondswithout the canals, hence both defaulted ontheirinterestpayments.Ultimately, both statesreached agreementswith their creditorsunderwhich the creditorsprovided additionalfundswith which to complete the main canals (the

Illinois andMichigan Canal in Illinois and theWabash and Erie Canal in Indiana). In return,

the states resumed interest payments on theirbonds. In addition Illinois deeded the IllinoisandMichigancanal in trustto its creditors,andIndianaagreed to pay half the bonds and theWabash and Erie canal was held in a trust topay the other half.

Michigan followed a pattern similar toIllinois and Indiana, borrowing heavily to



266 THEAMERICANECONOMICREVIEW MARCH 1996

build a transportation etwork, althoughMich-igan was building railroads, not canals. As inthe other two states, the investments were not

completed, andthe state was unable to pay theinterest on the debts accumulatedfor them. Inaddition, the state lost a great deal of moneyin its dealings with the Morris Canal andBanking Company. It sold almost all of itsbonds to the company in returnfor a series offuturepayments. When the company failed in1841 the state hadreceived only $2.15 millionin return for the $5 million in bonds turnedover to the company. The state went into de-fault in 1841, and was unable to obtain a finalsettlement with its bondholders until 1848.

Under the terms of the settlement, the staterepaid only the fraction of the debt for whichit had received payment from the MorrisCanal and Banking Company plus accumu-lated arrears.

SouthernStates.6-Most of the debts of thesouthern states resulted from issuing statebonds to banksfor them to sell to raise capital,or from guaranteeingthe bonds of banks inorder to aid them in obtaining capital. Manystates assisted banks in this way in the 1820's

and 1830's (see Table 1).The state of Louisiana was the third most

heavily indebted state in 1841, after Pennsyl-vania and New York. Its debts had been ac-cumulatedprimarilyto provide the capital forthree banks. In 1842 two of the three bankswere put into liquidation, and the legislaturemade no effort to pay the coupons on the statebonds issued for them. The governor claimedthat the shareholdersof the banks should beforced to pay before the state was requiredtostep in (McGrane, 1935 p. 181).

In 1844 the state legislature divided thestate debt into two pieces. The bonds issueddirectly by the state were called the "state debtproper." These debts amountedto somewhatless than $4 million, andthe state acceptedre-sponsibility for them. Most of the remainderof the debt, about $17.5 million, had been is-sued for the banks,and the state refusedto takeresponsibility for it. By the late 1840's, how-

ever, two of the three banks had settled theirdebts by paying off the old bonds or by issuingnew bonds backed only by the bank (George

Green, 1972 p. 27). The thirdbank was takenout of liquidationin 1852, and it was expectedto raise sufficient money from its shareholdersto retire the state bonds (Green, p. 132; seealso Ralph Hidy, 1949 pp. 333-35).

During the 1830's Arkansas issued bondsto raise money for the establishment of twobanks. The total amount raised for these insti-tutions was over $3 million-a large amountfor so small a state (see Table 2). The banksopened for business in 1838, andsuspendedinthe panic of 1839. In 1840 one of the banks

hypothecated an additional$500,000 of bondswith a bank, which then transferred hem to aLondon investor, James Holford. This trans-action was in violation of at least the spirit ofthe state law authorizingthe bonds, which re-quiredthe sale of the bonds at par.

In 1841 both banks defaulted on the bonds.As in the case of Louisiana, the state refusedto make thepaymentson the state bonds issuedfor the banks, and the bondholders found itdifficult to collect from the banks. Althoughthe Arkansas Supreme Court found that the

state was liable for the bonds (including theHolfordBonds) if the banks could not pay, thebonds were not settled in the time before theCivil War.7

Holders of the Mississippi bonds faredevenworse than the holders of the Arkansas bonds.Mississippi issued $2 million of state bonds toprovide funds for the Planters' Bank of Mis-sissippi in 1831-33. In 1837 the state issuedanother $5 million of bonds for the UnionBank. The Union Bank bonds were not issuedand sold strictly in accordance with statelaw-violations which later provided a pre-text for theirrepudiationby the state(McGrane,1935 pp. 197-200).

The banks failed to make interestpaymentson their bonds in 1841, and the state refused

6 See McGrane (1935 Chapters 9-12, 14).

7Several years after the Civil War,in 1869, the Recon-struction government issued bonds paying 6 percent tocover the principal and unpaid coupons on the pre-warbonds. Interest was not paid on the arrears English, 1991p. 17n). In 1884, however, an amendment to the state

constitution specifically repudiated the Holford bonds(McGrane, 1935 pp. 296-98).



VOL.86 NO. I ENGLISH: THE COSTS OF DEFAULT 267

to provide the money. The staterepudiated heUnion Bank bonds in 1842, but did not repu-diate the Planters' Bank bonds. In 1844, the

Governorstated that the Planters' Bank bondswere obligations of the state, and should bepaid (Governor's message of January 1, 1844,reported in U.S. Congress, House of Repre-sentatives [1846 Document No. 226, p. 886] ).Nonetheless, the state made no effort to paythe debts. In 1848 the state used the sinkingfund of the Planters' Bank to pay some cou-pons of the Planters'Bank bonds, and allowedholders of these bonds to use them to purchasestate lands. Finally, in 1852 the state passed alaw by plebiscite repudiating the Planters'

Bank bonds.During the 1830's the Territory of Florida

issued $3 million of bonds for the Union Bankof Florida, and guaranteed $500,000 of thebonds of the Bank of Pensacola and $400,000of the bonds of the Southern Life Insuranceand Trust Co. The total amount of debt wasnot particularly arge, butFlorida was poor andlightly populated at the time, and the burdenof the debt was higher than that of any state(see Table 2).

The Florida banks performed poorly after

the panic of 1839. As in Mississippi, the wayin which some of the bank bonds were soldprovided a pretext for their repudiation. In1841 the Governorof the territoryrefused anappeal by the bondholdersto pay the intereston the bonds, and stated that the creditorsshould collect from the banks' stockholders.By January1844 the Southern Life Insuranceand Trust Co. had retired all of its state-guaranteedbonds. The Union Bank also re-tired a small portion of the state bonds issuedfor it. (See the annual message of GovernorCall in Januaryof 1844, reported n U.S. Con-gress, House of Representatives [1846 Docu-ment No. 226, pp. 776-77].)

III. Implicationsor Modelsof SovereignDebt

There is substantial debate in the academicliterature over why a sovereign debtor mightchoose to repay its debts. Because it is sov-ereign, it cannot be forced by a court to doso. The economics literature provides two

possible explanations for repayment. First,in reputationalmodels repayment safeguards

the borrower's reputation as a "good" bor-rower, and allows the country continued ac-cess to international credit markets (Eaton

and Gersovitz, 1981). If the value of beingable to borrow in the future is large enough,then the borrower may choose to repayeven though doing so is not in its short-runinterest.

Bulow and Rogoff (1989a) provide a dis-arminglysimple counter-argumento the Eatonand Gersovitz model. Their argument can beseen most clearly in a nonstochastic example.Consider a country with high income in evenperiods and low income in odd periods. Forsimplicity assume thatthere is no growth, and

that the world real interest rate is fixed andequal to the country's rate of time preference.Eaton andGersovitz show that there can be anequilibrium n which the country borrows eachodd period and repays the loan each evenperiod. In such an equilibrium, the countrychooses to repay because the future cost of notdoing so-i.e. unsmoothed consumption-ishigher than the short-term benefit of higherconsumption.

Bulow andRogoff point out that the countrycould default in an even period and take the

funds that would have been used to repay thecreditor and use them instead to smooth con-sumption from thatperiod on by saving at theworld interest rate in even periods and dissav-ing in odd periods. Doing so makes the coun-try strictly better off because it earns interestrather than pays interest, raising consumptionin every future period. Bulow and Rogoffshow that this intuitive result holds in astochastic model as long as actuarially fairpayment-in-advance insurance contracts areavailable. Their result shows that the implicitassumption in Eaton and Gersovitz is thatcreditors can not only cut off new loans to adefaulting country,but can also interfere withnational saving.

Given this theoretical result, and the factthat sovereign debts are often repaid, Bulowand Rogoff conclude that creditors must beable to impose some direct sanction on de-faulting sovereign borrowers. Borrowers re-pay only if the cost of the sanctions is largerthan the amount owed. The sanctions could

include war,restrictionson international rade,or reductions in internationalaid.



268 THE AMERICANECONOMICREVIEW MARCH 1996

A. Evidence Against Sanctions

TheU.S. state defaults of the 1840's provide

strong evidence against the direct sanctionstheoryof sovereign debts. Some in the UnitedStates, including ex-President John QuincyAdams, feared that defaulting on debts owedto Britishcitizens could lead to warwith GreatBritain (McGrane, 1935 pp. 35, 57). After thedefaults had taken place, however, it was clearthat this was not the case. The British govern-ment refused to get involved in the nego-tiations over the debts. The British ForeignSecretary, Lord Aberdeen, noted that thebonds were not obligations of the federalgov-

ernment, and so the British government had''no concern with the securities ... and nopower to compel payment of the sums re-quired" (quoted in McGrane, p. 53). Simi-larly, Lord Palmerston,a later British ForeignSecretary, noted,that, "British subjects whobuy foreign securities do so at their own riskandmust abide the consequences" (quoted inMcGrane,p. 202).

While British banking houses might havebeen able impose costs on defaulting states bycutting off trade credit, doing so would have

been difficult because of the freedom of tradebetween states. In addition, it is not clear thatBritish banks had the incentive to imposecostly penalties on the states. The banksthem-selves did not generally hold the state bonds.Instead,the bonds were sold to private inves-tors in Britain (Leland H. Jenks, 1927 p. 79).In any case, the availabledata on trade, importprices, and export prices show no indicationof such sanctions. (See English [1991 pp. 22-23], for a discussion.)

Similarly, there is no evidence that bond-holders in the United States were able to im-pose sanctions on the defaulting states. Oneobvious possibility is that bondholders whowere citizens of the defaultingstate could haveattemptedto defeat the politicians who votedfor default when they were up for reelection.In practice, however, this does not seem tohave been done, although foreign bondholdersdid attemptto lobby elected officials in somestates in order to gain supportfor resumption(McGrane, 1935 Chapter 3). In many cases,

however, default, and even repudiation, werequite popularwith the electorate-perhaps be-

cause of the low level of debts held in stateand, more speculatively, the concentration ofthe domestic holdings. (See English [1991] for

a discussion of the politics of default.)Given the evident lack of direct sanctions,models of sovereign debts based on such costssuggest that all of the states should have re-pudiated.As noted above, however, all of thestates except Mississippi and Florida eventu-ally paid at least partof theirdebts. One couldclaim that the states thatpaid were threatenedwith sanctions and so chose to pay, and thestates thatdid not pay were the ones on whichno direct sanctions could be imposed. Thus nosanctions were imposed, but they still played

an importantrole in inducing the repaymentsactually made. But this argument s very weak:why could costs be imposed on Alabama butnot Mississippi, on Illinois and IndianabutnotMichigan?

B. The Costs of Default

Rather than direct sanctions, the cost of de-fault appears to have been loss of access tonew loans. The loss of access, in turn, appearsto have been the resultof damageto defaulting

states' reputations n credit markets.The statesthat serviced their debts were able to borrowagain in the 1840's and 50's while those thatrepudiated found it difficult to do so. Of theeleven states that repaid without interruptionin the early 1840's, all were able to borrow(U.S. Departmentof Interior, 1884 v. 7, pp.523-639). Indeed, all but threeof these states(Maine, South Carolina, and Alabama) hadlarger debts in 1860 than in 1841. Maine andSouth Carolinapaid off a substantial fractionof their debts in the 1840's, but borrowedagain in the 1850's. Alabama, which had thehighest debt burden of the states that did notdefault, did not increase its debt but did issuenew bonds in order to retire old bonds.

In contrast, the states that repudiatedall oftheir debts did not borrow significant sums inthe period before the Civil War. Neither Mis-sissippi or Floridaissued new bonds, althoughboth states borrowed small amounts, presum-ably by issuing warrantsor by borrowingfromstate trust funds (U.S. Departmentof Interior,

1884 v. 7, p. 588). The Barings tried to induceMississippi to resume payments on its debts



VOL. 86 NO. 1 ENGLISH: THE COSTS OF DEFAULT 269

32 -

Indiana

24- Pennsylvania ----

e /

1a

1840 1844 1848 1852

FIGURE 1. UNITED STATES, PENNSYLVANIA, AND

INDIANA BOND YIELDS, 1840-1852

when the state was trying to raise money forthe Mobile and Ohio railroad, but this effortfailed (Hidy, 1949 p. 336). Florida decided toissue bonds for railroadsin the 1850's, but itappearsthat the state did not actually issue anybonds until the 1860's (U.S. Department ofInterior, v. 7, pp. 587-89; Carter Goodrich,1960 p. 160).

The experiences of the states that partially

defaulted were more varied. As noted above,in the period before the Civil War Arkansasdid not take responsibility for the bank bondsit had guaranteed.As a result, it looked muchlike Mississippi and Florida, and, like thosestates, it did not borrow again until after thewar. In the 1850's some in the state arguedthat the defaulted debts should be settled inorder to allow the state to borrow to build rail-roads, but this was not done (McGrane, 1935p. 262).

Surprisingly, the other two states that par-tially repudiated heir debts were able to regainaccess to credit markets by repaying only afraction of their debts. As noted above, Loui-siana paid its state debt proper while notdelivering on its guarantee of bank bonds.Nonetheless, by the mid-1850's yields on Lou-isiana bonds were similar to those on the bondsof other states-such as Georgia, North Car-olina, Tennessee, and Virginia which hadnot defaulted (Benjamin U. Ratchford, 1941p. 133). In 1854 the state borrowed more than

$2.5 million (U.S. Department of Interior,1884 v. 7, p. 597).

One could argue that the Louisiana defaultwould have been more costly except for theability of the Louisiana banks ultimately to

pay back much of the debt that had been guar-anteed by the state. This argumentcannot bemade, however, in the case of Michigan. Asnoted above, Michigan repaid only the amountit had received from the Morris Canal andBanking Company, and it too seems to haveregained access to credit markets fairly rap-idly. At the time of the settlement, one com-mentator wrote "Michigan has passed a law... cunningly devised to slip their neck out ofthe noose and obtain from theircreditor an ac-quiescence in their repudiation" (quoted in

McGrane, 1935 p. 167). By the mid-1850's,yields on Michigan bonds were under 6 per-cent (U.S. Departmentof Interior, 1884 v. 7,p. 628).

Yields on the bonds of states that defaultedtemporarily n the early 1840's, buteventuallypaid their debts in full, remained elevatedfor several years after their resumptions. Thespreadsof these yields over those on Treasurybonds declined over time, however, presum-ably as a result of lower perceived risk.8 Forexample, Pennsylvania resumed payments in

1845, but yields on state bonds remainedabout4percentagepoints higher than those onTreasuries for several years. By the early1850's, however, yields on Pennsylvaniabondswere only 1-2 percentage points higher thanthose on Treasuries(see Figure 1). Similarly,yields on Marylandbonds were close to thoseon Treasurybondsby the early 1850's (Hunt'sMerchantMagazine and CommercialReview,1853 v. 28(4), p. 488).

As noted above, Indiana and Illinois bothreceived new loans to allow the completion of

their canals. These loans presumably did notreflect an improvement in the states' reputa-tions for repayment since they preceded thestates' resumptions.Ratherthe creditorslikelybelieved thatwithout the completion of the ca-nals, the old loans would not be repaid, butwith their completion, the loans might be

8 Similarly, Sule Ozler (1993 pp. 610-12) notes thatmore recentdefaultshad a larger effect on the interestrates

charged on developing country debts in 1968-1981 thandid earlierdefaults.




serviced. In addition, the states transferredownership of the canals to the borrowers,mak-ing subsequentrepudiationof their claims less

likely.9 Nonetheless, steady payment on thestates' debts appears to have improved theirreputations by the 1850's. Yields on Indianabonds, which peaked at nearly 32 percent in1842, fell to within 2 percentage points ofTreasuryyields by the early 1850's (Figure 1).Similarly, yields on Illinois bonds, which wereeven higher than those on Indianabonds in theearly 1840's, declined to less than 6 percentby 1855 (James, 1938 v. 1, pp. 143, 172).

Most of the states that settled their defaultsin the 1840's increased their borrowing little

in the periodbefore the Civil War. As a result,they generally paid out in debt service morethanthey received in "new money." This factshould not be taken as evidence against theview that the statesrepaidin order to maintainaccess to capitalmarkets.Rather t may be thatthe situations under which the states wouldhave borrowedmoredid not arise.Indeed, rep-utation models generally imply the existenceof lending ceilings (as noted in Eaton andGersovitz [1981]), and some states may havebeen near their ceilings, making additional

borrowing unlikely. Nonetheless, states neartheir borrowing ceilings may choose to ser-vice their debts because they value the abilityto borrow again following a period of netrepayment.

C. WhoseReputation?

If reputationaleffects sustainsovereign debtmarkets,then it is importantto know exactlywhose reputationmatters.In the case of a de-mocracy, it seems likely that the reputation sthat of the electorate. If this is so, then thedefaults andrepudiationsof some states couldaffect the reputationof the entire country be-cause the repudiatingstates' citizens are alsocitizens of the country.

Indeed, McGrane suggests that the reputa-tion of the federal government in Europeancapital markets was temporarily affected by

the states' defaults. In 1842 the federal gov-ernment investigated the possibility of sellingbonds in Europe. The U.S. agents were told,however, that the U.S. bonds could not be soldthere because European investors feared thatthe federal government would also default(McGrane, 1935 p. 33-34). It is possible,however, that the inability to sell federal bondswas the result of efforts by European banks toinduce the federal government to assume thestate debts. William Robinson, the commis-sioner sent to Europe to negotiate the loan,

argued that the lenders had formed a cartel.As evidence he noted that the Europeanbankers seemed willing to market a largeloan if partof the funds were used to pay thedebts of Mississippi, Michigan, Arkansas,Illinois, and Indiana. (See U.S. Congress,House of Representatives [1843a DocumentNo. 197, p. 4]. English [1991] provides fur-ther discussion.)

Institutionalchanges also may affect a sov-ereign borrower's reputation. For example,Florida and Mississippi were able to issue

bonds after the Civil Warwithoutreaching anysettlement on their pre-wardebts. On the onehand, these resumptions show that the oldcreditors could not block the states from bor-rowing-indicating that their lack of borrow-ing before the war was the result of theirpoorreputations rather than legal restrictions. Onthe other hand, they also suggest that observ-able changes in government-i.e., the im-position of northern-backed governmentsduring Reconstruction-could affect reputa-tion. In addition, foreign investors may havethoughtthat the Union victory in the Civil Warstrengthenedfederal control of the states andwould allow them to use the federaljudiciaryto force states to pay their debts.'0

9But perhaps not impossible. The Fifth Amendmentrequires the federal government to provide compensationfor property taken under eminent domain, but it does notrequirestates to do so. The FourteenthAmendment,whichdoes restrict states' abilityto seize propertywas not passed

until after the Civil War. See the discussion in AmericanJurisprudence, 1974 v. 26, pp. 645-46.

0 Orth(1987 Chapter4) suggests that they were right.It was the political maneuveringfollowing the election of1876, he argues, that restored sovereign immunity to the

states. Ironically, many southern states defaulted againwhen Reconstruction ended (see William A. Scott, 1974).



VOL.86 NO. I ENGLISH:THE COSTS OF DEFAULT 271

IV. Rebuilding Reputational Models

of Sovereign Debt

The historicalevidence presentedhere in fa-vor of reputationalmodels of sovereign debtcontradictsthe theoreticalwork in Bulow andRogoff (1989a). This contradictionraises anobvious question: how could reputationhavebeen sufficient incentive to repay debts?

One way to rehabilitatereputationalmodelsis to build models in which states have morethan one marketthat depends on their reputa-tion, as in Cole and Patrick Kehoe (1994).Their paper provides a model in which sov-ereign borrowersrepay because not doing so

has large costs in anothermarket in which thegovernment's reputationfor honesty matters.These sorts of "reputationalspillovers" seemtoo small in this case, however. As notedabove, Louisiana defaultedon its bankbonds,yet by paying its state debt properit managedto recover its reputationin the bond market.Similarly, Michigan regained access to creditmarketsfairly quickly after its partialrepudi-ation. Thus the reputationalspillover from aportionof a state's debts to the rest was fairlysmall, suggesting thatthe spillover to other ac-

tivities of the state would also be small.The most obvious criticism of Bulow and

Rogoff 's argument is that actuarially fairpayment-in-advance nsurancecontracts werenot availablein the 1840's. Without such con-tracts, reputationaleffects may be sufficientto enforce repayments. Even without them,however, asset markets may still be suffi-ciently rich to make defaulting desirable.This possibility seems unlikely in this case.The main shocks to states' demand for for-eign financing were likely to come from im-

provements in transportation echnology andwars-and there were no contracts availablethatwere contingent on these events.

Furthermore, f a government tried to self-insure after a default by accumulating assets,it would have had to hold a substantialsurplus

in some periods. This strategy, however,would have been difficultpolitically. As notedby Curtis( 1844 p. 151), "The ... political par-ties, which have ruled this country since theadoption of the Constitution, agree, that anyaccumulation of money raised by taxation isnot to be thoughtof, andthatno more is to bedrawnfrom the people than is absolutely nec-essary." Curtisgoes on to argue that a state'sreputation in credit marketsis importantspe-cifically because U.S. states could not accu-mulate surpluses, and in an emergency theymight need more resourcesthanthey could taxin a single year."2

The reason for the inability of states to ac-

cumulate surpluses is not given by Curtis,butit presumablywas the result of U.S. citizens'distrustof goverument.A lack of trustin theirgoverumentcould cause citizens to choose torepay debts ratherthan repudiatethem. If, forexample, citizens believe that state officialswill either steal or waste a large enough shareof any accumulatedsurplus,then they will bewilling to give up the gain to be had by re-pudiation in order to avoid having the statehold surpluses.

Certainlythe political battleover the federal

surplus in the mid-1830's was marked byclaims that the Federal goverumentwould in-vest the money inefficiently if it were notdistributed. In addition, some argued thatthe surplus was being used by the executivebranch to enhance its powers at the expense ofCongress (Edward G. Bourne, 1885 pp. 24-25). The decision to distributethe surplustothe states in 1837 suggests that these argu-ments were persuasive. In addition, manystates distributedtheir shares of the surplustolocal goveruments, generally to be used for

education, suggesting distrustof state goverm-ment. Indeed, in Maine the surplus was dis-tributeddirectlyto thepopulation(Bourne,pp.122-23).

" Indeed, this possibility is noted explicitly by Bulowand Rogoff (1989a p. 47). They point out that the cost ofdefault in such a case is simply the cost of losing a good

reputation n the other market;there is no additionalcostto losing a good reputation n the market for loans.

2 A similarpoint was made by AlexanderHamiltoninthe debate over the settlement of the RevolutionaryWardebt. See Peter M. Garber(1991) for a discussion of thatcase.

Note thatthere is no problemif Ricardianequivalenceholds. However, states were borrowingin Europe specif-

ically because Ricardianequivalence did not hold: privateinvestors did not have access to Europeancredit markets.



272 THEAMERICANECONOMIC REVIEW MARCH1996

It is important to note that the federal sur-plus that was distributed n 1837 was relativelysmall compared to the surplusesthat the states

would have accumulated under the defaultstrategy. The aggregate debt of the statesin 1841 was over $200 million-more thanseven times the federalsurplusthatproved po-litically insupportable. Moreover, heavily in-debted states had debts between 10 and 40times as large as their share of the federalsurplus.

V. Concluding Remarks

The defaults and repudiationsof U.S. states

in the 1840's are a powerful experiment forthose studying sovereign debt. Under theUnited States Constitution states aresovereignandcannot be compelled to repay debts. Sanc-tions that could be imposed on othersovereigndebtors,such as trade sanctions or militaryac-tion, were very difficult to impose on U.S.states because of the ease of trade betweenstates and the military power of the UnitedStates. In spite of the theoretical result inBulow and Rogoff ( 1989a), reputationeffectsappearto have been sufficient to induce most

states to repay. Evidently, some mixture ofincomplete markets and political constraintsmade it impossible for state governments toimplement the strategy suggested by Bulowand Rogoff.

Of course, the conclusion that states repaidtheir debts in order to maintain their reputa-tions in debt markets leaves open the questionof exactly how reputationwas gained and lostat that time. There are a vast numberof pos-sible reputational models and equilibria tochoose from, some of which putvery few con-straints on the patternof repayment(see, e.g.,Herschel I. GrossmanandJohnB. Van Huyck,1988). Indeed, repeatedgames generally suf-fer from a multiplicity of equilibria.Even debtmodels based on sanctions can have manyequilibria if they are repeated games (Eatonand Maxim Engers, 1992 p. 905). Evidently,one must select the model andequilibriumthatseems most reasonable given a particularhis-toricalsituation. The experiences of defaultingU.S. states in the 1840's and 1850's are con-

sistent with a signaling model like thatin Coleet al. (1995). In thatmodel, sovereignborrow-

ers are one of two types: myopic and non-myopic. Myopic borrowers default on loans,while nonmyopicborrowersdo not. A borrow-

er's type changes over time. Cole et al. showthat a reasonable restriction on the modelyields equilibria in which a borrower that de-faulted in the past but is now nonmyopic sig-nals its change of type by making paymentson its outstanding debts. In these equilibria,asettlement restores the borrower's reputationand gives it access to capital markets. Theseequilibria are appealingbecause "reputation"is not just a way to coordinate punishment,but actually summarizes lenders' informationabout the type of the borrower.

In any case, that the cost of default was areputation-based oss of access to future loansappears to have been clear to observers at thetime. In 1846 the Baringswere quotedin NilesRegister as believing that Europeans wouldnot "purchase either old or fresh [state] se-curities until ... those states which were stilldefaulters had shown their willingness andability to recommence and continue the regu-lar payment of future dividends" (quoted inMcGrane, 1935 p. 268). Similarly, the Lon-don Times wrote in thatyearthat the defaulting

states would eventually choose to pay theirdebts because they "will deem it a not disad-vantageous transaction o lay out ten or twentymillions ... in purchasinga restoration of theirforfeited respectability" (December 3, 1846,

quoted in McGrane, p. 166).

DATA APPENDIX

A. Debt Data

The primarysource for the debt data in Tables 1 and 2is U.S. Congress, House of Representatives ( 1843b) Re-

port No. 296, 27th Congress, 3rd Session. These data aresupposed to be a complete statement of the States' debtsas of September 2, 1841. State bonds are generally listedby the object of the borrowing,and the interest rate on thebonds is shown. These data allowed me to constructTable1. I have included in all cases contingentdebts. These weregenerally guaranteesby the state to pay bonds issued bybanks, railroads,etc. In some cases these bonds were in-cluded in the tables in the report, n othersthey were listedin footnotes. In some cases the interestrates on bondswerenot reported.I have assumed that such bonds paid 6 per-cent-roughly the average rate. In some cases the bondswere listed in poundssterling.I valuedsuch bonds at$4.86to the pound. In some cases there were additional com-

plications, which are discussed in the data appendix toEnglish (1991).



VOL. 86 NO. 1 ENGLISH: THE COSTS OF DEFAULT 273

B. State-IncomeData

Richard A. Easterlin(1960) provides estimates of stateincome based on the 1840 census andthe pioneeringwork

of Seaman. These data are on a income-paid basisand so

are something like net domestic (state) product.I took theper-capitalevels of state income from Easterlin and mul-tiplied by the ratio of national per-capita GNP in 1839reportedby Gallman (1964 p. 26) to Easterlin's nationalper-capita income figure. Gallman's national per-capitaGNP number is also based on the 1840 census data. Theresult is an estimate of per-capita gross state products.These are shown in Table 2.

The state population data is taken from Easterlin(1960). In contrast to ArthurGrinathet al. (1995) I usethe total population of the state rather than the whitepopulation.

C. Price Data

The Warren-PearsonWholesale Price Index is takenfrom U.S. Departmentof Commerce (1975), Series El,p. 115.

D. Bond Prices

The prices of the United States andIndiana state bondsbefore 1846 were taken from various issues of Hunt'sMerchants Magazine. From 1846 through 1851 the dataare from Bankers' Magazine and Statistical Register. Ithank Warren Weber and Andrew Economopoulos forproviding me with copies of this data. The Pennsylvaniabond prices were taken from Van Court's CounterfeitDe-

tector and Bank Note List. See Gary Gorton (1989) for adescription of this periodical. I thank Gortonfor makingmicrofilmed copies of this journal available to me. I cal-culated the yields to maturityshown in Figure 1 based onreportedbond prices and maturities.In some cases no ma-

turity was shown; in such cases the yield is based on anestimate of the maturity.

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Transcript of English, Understanding the Costs of Sovereign Default, 86 Am Econ Rev 260 (1996)