The Perception of Default vs. Actual Default | Denewiler Capital

Observations on the Market //

The Perception of Default Versus Actual Default — A Historical Context Helps.

Written by Greg Denewiler, CFA® // May 25, 2023

Here we are again, watching the full drama and political polarization of the debt ceiling debate. The blame game has only become more pronounced since the last time we went through this. Nobody knows exactly how this gets resolved (though there are plenty of gurus out there that think they do). Nevertheless, the financial markets may be the arbitrators that eventually bring the parties together by introducing some good old fashion fear into the debate. A deal will inevitably get done (yes, this is a prediction because it must get done). To hopefully put this affair in perspective let’s defer from the drama to some history regarding the debt ceiling. We should probably start with the claim that: “America has never defaulted on its debt.” Centuries ago, our new country began with much optimism, however, there was one big problem.



America had no revenue before 1789. During that year, Alexander Hamilton (our first Treasury Secretary) sent a letter to the French government asking for a delay in payment: “I venture to say to you, as my friend, that if the installments of the Principal of the debt could be suspended for a few years, it would be a valuable accommodation to the United States… Could an arrangement of this sort meet the approbation of your Government, it would be best on every account that the offer should come unsolicited as a fresh mark of goodwill” (Letter from Alexander Hamilton to Lafayette). The situation became more dire in March 1790 when Hamilton wrote to Washington that congressional paychecks were about to bounce. He laid out the situation in a letter that stated the government owed $185,000 in salaries, bills, and a Dutch loan that had already been behind on interest payments. He then explains that the Treasury only has “A sum not exceeding fifty thousand dollars” and was in serious financial trouble. As the country grew, prior to 1917, we solved our debt problems with Congress approving specific loans for specific projects. There were 200 such loans between 1789 and 1920. World War One changed that.



The 1st World War had costs that could not be predicted, so Congress established what would be the beginning of a general debt ceiling. In 1917 they issued the First Liberty Loan Act totaling $2 billion. This was shortly followed by the Second Liberty Bond Act of 1917 which approved the spending of another $13.5 billion. We were off to the races, spending money without any specified requirements attached. By this point, there were few options. In 1935 Congress set a comprehensive debt ceiling, and by 1939 Congress completely abandoned issuing specific debt limits and went entirely to an overall aggregate limit. However, we still haven’t answered the question: has the US ever defaulted?



Jamie Catherwood has written a paper about the history of U.S. debt entitled: “A History of Debt Limits & Defaults.” Within it, he suggests there have been three technical defaults since our country was founded. The first was during the War of 1812 when the government could not meet all its debt obligations. Wars are expensive. The second came in March 1933 when President Roosevelt suspended the gold standard, and some bonds that should have been paid in gold were restructured to be paid in cash. The gold bond holders were not happy with the cash substitute and claimed they had been shorted the value of gold. Finally, in 1979 there was a “mini” default: “The U.S. Treasury was forced to delay payments to individual investors redeeming about $122 million of Treasury bills maturing on April 26, May 3, and May 10, 1979. The Treasury blamed the delay on an unprecedented volume of participation by small investors and the unanticipated failure of word-processing equipment used to prepare schedules needed to cut individual paper checks” (Reuters). The answer is yes, we have.



The Economist has a simple explanation of the debt ceiling: “…The legal cap that Congress sets on the amount that the Treasury can borrow. It does not authorize any new spending; it simply lets the government pay for what Congress has approved.” This is just an observation, but it seems that both parties want to blame the other for causing a default. The markets have been sanguine so far because investors seem to realize that it will eventually get resolved. If we do have a ‘technical’ default, the markets will vote fast and decisively, and it won’t be pretty. In this scenario, the debate will be quickly resolved because neither party wants to be anywhere close to a severe recession. There are checks and balances in the system beyond politics. The markets (we the investors) also have a voice in our government through the impact of prices, which is a good thing. Politicians do understand panics. Maybe if Congressional salaries are the first to get cut, miracles will happen sooner and there would be no drama in the first place.


Observations On The Market No.383

About The Author:

Greg Denewiler, CFA®
Owner & Chief Investment Advisor at Denewiler Capital Management