A tempest in a local fiscal teapot demonstrates how history repeats itself in government finance. A local suburban municipality, population 13,000, decided it wanted a new rec center that would cost $25 million. Its financial advisers came up with a complicated set of bonds that were to be paid off with revenues from the center. It would not cost taxpayers a dime. At least that was the theory.
Now actual revenues are only a fraction of those projected. The city council decided to wash its hands of the project. Covering the shortfall would necessitate a sharp increase in property taxes. These are revenue bonds, not general obligation ones backed by the full faith and credit of the city, so the bondholders will get stiffed.
From a state or national perspective, a partial default on a $25 million project is of piddling importance. But for an economist, particularly one with a historical point of view, it is an opportunity to explore economic and political cycles. For this local default has many elements in common with earlier defaults, including those by numerous U.S. states in the 1830s and that of Argentina a decade ago.
Start with the 1830s episode. Most of us know nothing about the hardships in our country after the Panic of 1837. Yet some economic historians deem it America's first great depression, because the scope, depth and length of the economic contraction were so severe.
No one was compiling unemployment figures or tracking GDP growth back then, but the available financial indicators and contemporary accounts make it clear the recession was severe, and human suffering was great.
Then as now and in many other recessions following financial crises a bust is preceded by a boom. For a variety of reasons, credit had been freely available. Settlement was expanding rapidly in states including Michigan, Wisconsin, Iowa, Missouri and Mississippi. Land speculation was a national pastime, and the price of land on the frontier had soared.
The real economy also had boomed. Agricultural output including cotton, corn, hogs and wheat had risen rapidly, and so had manufacturing in New England. Construction of buildings and infrastructure such as new canals and, increasingly, railroads had surged.
The Erie Canal, which linked Lake Erie and Midwestern shipping channels with the Hudson River and New York City, was barely a decade old. Its success touched off a frenzy of canal building, nearly all of it financed by states.
This was made possible by a large influx of British capital. Nearly all the newer states, but also established ones like Maryland and Pennsylvania, issued bonds either to build internal improvements like canals or railroads or to set up state-owned banks to finance agricultural and commercial expansion. These banks were especially popular in Southern states like Louisiana, Mississippi and Florida, where the need for capital to set up new plantations, including the purchase of slaves, was enormous.
In no case was any thought given to the states' ability to raise taxes. Some of the Western states did not even have any direct taxes. Their revenue came largely from sales of state-owned land. The bonds issued in London or at home were to be paid off from the profits of the canals or banks they financed. The taxpayers did not have to worry about anything.
Then, of course, everything blew up in the Panic of 1837 and became spectacularly worse in the period from 1839 through 1842. Nine states defaulted on their bonds to one degree or another.
Because most bondholders were British citizens of only moderate means, the U.S. state defaults caused political and economic commotion in Britain and strained relations between the two nations. Poet William Wordsworth, several of whose relatives were rendered indigent through U.S. state defaults, wrote poems chastising Americans for lack of honesty.
Meanwhile, the U.S. government maintained it had no business in the financial affairs of individual states. In addition, state governments successfully cowered behind the shield of sovereign immunity against being sued.
Some bondholders hired lobbyists to petition legislatures to make some payment on the bonds. Over time, partial payments were made, except by Mississippi, which adamantly repudiates all its bonds from that era to the present day. But most investors lost most of their money.
What are the common lessons in this ?
First, during a boom, elected officials don't take very hard looks at projects they think will be popular with voters. Due diligence falls by the wayside. Projections of revenue are rosy.
Second, during a boom, bond buyers are equally guilty of failing to use due diligence. Ferreting out information to distinguish a truly viable project from a stinker takes time and effort. Even bond rating houses don't do a very good job, instead relying greatly on the past credit history of the issuing state or city.
Third, investors always overlook risk when chasing yield which rises with greater risk. British investors in the 1830s had safer investments available but, like the Italian households that bought Argentine government bonds in the 1990s or German banks that bought Greek government bonds over the last decade, were seduced by higher interest rates.
Finally, while politicians love to be identified with a new canal or civic sports center, they are quick to disclaim any responsibility for failures. Statements by local council members in 2012 hit all the same themes that Floridas governor did when his state repudiated its debts in 1842. Truly, nothing is new under the sun.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at email@example.com.