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Obama Says We Must Never Default, But Would It Really Hurt Us If We Did?

Paul Solman: President Obama says America must never default. Maybe that's because he remembers what happened when Pennsylvania did. And Illinois. And Maryland. And Mississippi still hasn't paid its debts from 1842. Law professor Alasdair Roberts recounts how states decided they could no longer operate with budget deficits.

Alasdair Roberts: In last night's State of the Union Address, President Barack Obama asked Congress to promise that the United States would never default on its debt. "Let's agree," Obama said, "to keep the people's government open, pay our bills on time, and always uphold the full faith and credit of the United States of America."

It's incredible that the leader of an economic superpower should feel obliged to say anything about the need to honor the country's debts. But there's no doubt that default would cause enormous damage to America's reputation abroad. We already have the evidence, provided by one of the most humiliating moments in America's economic history.

The humiliation came in 1842. But the real cause of American embarrassment arose several years earlier.

In the mid-1830s, the American economy was booming. Cotton exports to the United Kingdom were growing rapidly, British investors were pouring capital into the United States, and lightly-regulated American banks were lending generously. Land speculation was rampant.

State governments wanted in on the action. Voters were pleading for new infrastructure -- canals, railroads and turnpikes -- as well as more access to loans to speculate in real estate. Legislators believed they could meet those demands easily. States could establish government-owned banks that borrowed at 3 percent in London and lent at 6 percent at home. Or they could repay infrastructure loans from the tolls and fees that were sure to come from new roads, railways and canals.

It seemed like a riskless proposition, and states borrowed massively. Within three years, from 1836 to 1838, U.S. states incurred obligations equal to the combined national debt of Russia, Prussia, and the Netherlands.

Then the bubble burst.

A series of crises hit the U.S. financial sector, which finally collapsed in the autumn of 1839. The country slid into a deep depression. Revenues from infrastructure projects evaporated, and loans issued by state-owned banks went bad. Few states had other sources of revenue. They had no money to pay their overseas creditors.

Michigan and Indiana were the first states to default, in July 1841. They were followed in October 1841 by Arkansas, Illinois and Maryland. Then Florida and Mississippi defaulted in March 1842, and Pennsylvania in August 1842, and Louisiana in January 1843. Nine governments, responsible for two-thirds of all American government debt in private hands, were delinquent on their loans.

The outrage in London was immediate and intense. British investors had been assured by statesmen such as Daniel Webster that state bonds were a safe bet. No state, Webster said in London in 1839, would risk "dishonor and disgrace" by defaulting.

Americans visiting London were barred from clubs, snubbed at dinner parties, and mocked in the newspapers. "Great bitterness of feeling is very naturally felt," the American ambassador wrote home. "Many have by their investments lost all the earning of active life and the fund on which they relied for their support in old age."

The low point might have been the summer of 1842. The federal government itself went to London to sell its bonds. This should have been easy: the United States had completely paid off its debt six years earlier. But investors refused to touch anything from the far side of the Atlantic.

"You may tell your government," James de Rothschild told the U.S. agents, "that you have seen the man who is at the head of the finances of Europe, and that he has told you that you cannot borrow a dollar, not a dollar."

Anger over the defaults permeated every aspect of Anglo-American relations. The British poet William Wordsworth confided to an American friend that his elderly relatives had lost much of their savings because of the default. He was indignant that Pennsylvania -- "one of the richest countries in the world" -- had chosen to evade its creditors