We frequently hear that a default by the US government would be unprecedented. However, one Treasury Secretary in our nation's history orchestrated a federal debt default. It was who? The name of a well-known Broadway musical bears some significance. That's accurate, Alexander Hamilton was responsible.
In the year 1789, Hamilton's got the job of Treasury Secretary of the Treasury. Because nearly one-third of the cost of the Revolutionary War had been covered by loans, both domestic and international, including state responsibilities, he was in a difficult situation. Even while the interest owing on Dutch loans was still being paid in specie (gold or platinum), the Continental Congress had switched to paying interest on its domestic debts mostly with "indents," which were essentially paper IOUs, since May of the year 1782. After 1789, it was difficult to completely pay off the debt, even with the new government's ability to levy taxes. The creditors were instead presented with brand-new securities that would pay interest in monetary terms.
Hamilton's report to Congress suggested that the $11.7 million in foreign debt be paid in full; Congress complied by approving further Dutch loans. Hamilton came to the conclusion that the initially stated interest rate of 6% was higher than the government could comfortably afford due to the domestic debt of $65.4 million (including arrears on interest and the assumed state war obligations). He thus presented Congress with a number of various plans to lower that rate.
In the end, Congress approved a plan to give holders of domestic debt instruments a 6-percent annual interest rate two-thirds of the principal that was owed. The securities were practically perpetual British consols because they lacked a set maturity. The Treasury could redeem these 6 percent consoles at no quicker than 8 percent of their initial face value per year, including interest and principal, thanks to an embedded call option. The consolation bonds would resemble today's fixed-rate mortgages (without the mortgage holders' ability to pay off their full obligation early) if the Treasury consistently exercised the call option over time.
Deferred consolation payments—paying the same 6 percent interest rate but starting only in 1801, ten years later—were made to creditors for the remaining third of the debt. Hamilton wanted to lower the effective interest rate from below six percent to an average of little more than four percent worldwide. Interest arrears were addressed separately and repaid with consolation payments of just 3% a year in interest.
The funding of the domestic debt ultimately required a haircut, which in all but name constituted a partial default. We determine that someone who traded $100 of the Continental Congress's wartime debt for assets with a present value of only $82 would have earned. This is based on a discount rate of 6%. The present value of $100 in 3-percent convertible securities at the same discount rate was $50. Furthermore, Hamilton and Congress never even thought about adding interest to the existing arrears. Additionally, the principal and interest on the projected state debts were slashed even further; the $100 present value of those loans was now only worth $59. The loss of the full 6 percent interest on all the new instruments infuriated several Revolutionary War debt holders, especially those in New England. Of course, the wartime debt securities had been trading far below their face value previous to the refunding.
Given that the 14th Amendment to the US Constitution was not ratified until July 9, 1868, you would believe that this event has no relevance to the current situation. It states, in part, in Section 4: "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned." However, the general issue of government debt had already been addressed by Section VI of the Constitution. A portion of it states: "All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation." Hamilton's haircuts so seem to be wholly pertinent to the current discussion.
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