Perspectives on economics and finances with GFD

How the United States Avoided Default with Only Hours to Spare – in 1895

Once again, the government has cut a deal to avoid defaulting on its debt by raising the debt ceiling. The chance of the United States defaulting on its debt has been avoided, at least until January 15, 2014. The reason for these dramatic battles over the debt ceiling is that originally, each bond issue by the government had to be approved by Congress. When the United States entered World War I, instead of requiring that the government approve each and every bond issue, the government changed tack and set a general debt limit, enabling the government to issue new bonds at will up to the limit that was established. It may surprise you, or probably not, but even when the government had to approve each bond issue, prior to World War I, the United States almost defaulted on its debt because of political wrangling. OMG! How shocking. This happened in 1895 when the United States was on the Gold Standard as Jean Strouse related in her book, Morgan: American Financier. In 1895, the United States was suffering through the recession that followed the Panic of 1893. Foreigners were selling their stocks and bonds and were converting their dollars into gold which was sent out of the United States. Between 1890 and 1894, foreigners had redeemed $300 million in gold. By the end of 1893, US gold reserves were down to $60 million and about $2 million in gold was being redeemed each day. By February 1894, the US government had about three weeks of gold left in its vaults. After that, the US would have to technically default on its debts because it would be unable to redeem the demand for gold that foreigners would make. Sound familiar? Congress was aware of this problem and knew of the possibility of default, but many Representatives thought this “emergency” was being created by the money interests in New York, and in particular, J. P. Morgan, to force the government to issue bonds and put the government further in debt. President Grover Cleveland, a Democrat, knew this, but wanted to avoid default. He contacted Nathaniel Mayer Rothschild to help, who in turn contacted J.P. Morgan. One problem was the Secretary of the Treasury, John G. Carlisle. Carlisle thought the bond terms were too tough, and he wanted Congress to issue bonds directly to the public. The problem was there wasn’t enough time to do this without the government going into default, and whether the bill could get through Congress was questionable. Do you have a feeling of déjà vu all over again? Although Secretary Carlisle was a staunch Agrarian Democrat, similar to William Jennings Bryan, he eventually responded to the economic downturn caused by the Panic of 1893 by ending silver coinage and opposing the 1894 Wilson-Gorman Tarrif Act bill. By 1896, Carlisle was so unpopular that he was forced to leave the stage in the middle of a speech in his home town of Covington due to a barrage of rotten eggs. Those were the days. Realizing that time was of the essence, J. P. Morgan took a train to Washington D.C. At first, Cleveland didn’t want to meet with him. Even though most members of the cabinet favored the bond issue, Carlisle was against it. In reality, the government was technically in default. There were $12 million in warrants for gold outstanding with only $9 million in the vaults. Unless something was done immediately, the United States would be in default for the first time in its history. J.P. Morgan, however, had a trick up his sleeve. During the civil war, Congress had authorized then Treasury Secretary Salmon P. Chase to issue bonds that could be offered for coin. By calling this a bailout for coin, the government could do an end run around Congress and issue the bonds without Congressional approval. Attorney General Olney investigated, found the clause was still valid, and gave his approval. President Cleveland asked that the international bailout team of Morgan and Rothschild keep the gold in the United States. The government agreed to buy 3.5 million ounces of gold from the bailout team at $17.80 per ounce, in exchange for $62.3 million worth of 30-year bonds paying 4%. Since the price of gold was $18.60 per ounce, the government ended up paying $65.1 million in gold for $62.3 million in bonds, earning the bailout team $3 million. Twelve days later, the bond offer was made, and it sold out in 20 minutes. The data for this bond shows that purchasers of the bond did well. Not only did the US pay $3 million extra for the bonds, but the price shot up to 125 after issue, yielding 3.2%, so the US could have gotten a better coupon yield as well as a better price. The 30-year bond was redeemed in 1925 at 100, trading above its par value, particularly during World War I, during the entire time of its issue. Whether the issue is establishing a first or second Bank of the United States, issuing bonds to make sure the United States doesn’t run out of gold, raising the debt ceiling to make sure the government can pay its bills, or any other government financial crisis, the players are the same and the result is the same as well. As the saying goes, I’ve seen this movie before. It’s the Washington version of Groundhog Day. One hundred years from now when the US government has its twenty-second century version of potential default with only days and hours before the United States defaults on its debt for the first time, the movie will be the same, as will the ending. Be sure and re-read this blog in January 2014, and in 2015, and in 2016, and…

The Mississippi Bubble, or How the French Eliminated All Their Government Debt (So Why Can’t Bernanke?)

The government is running a large deficit and it can’t cover its expenses. The government debt exceeds the GDP of the country. The central bank’s balance sheet is exploding as the government buys its own debt. Sound familiar? This was France in 1719. Everyone has heard of the South Sea Bubble, but few have heard of the French version, the Mississippi Bubble, which happened one year before. Not only was the Mississippi Bubble bigger than the South Sea Bubble, but it was more successful. It completely wiped out the French government’s debt obligations at the expense of those who fell under the sway of John Law’s economic innovations. The Compagnie du Mississippi was chartered in 1684 at the behest of Renee-Robert Cavelier who had been appointed Governor of Fort Frontenac, at the mouth of the Mississippi. After getting his charter, he went to Mississippi with four vessels full of inhabitants, but the venture floundered, and Renee-Robert Cavelier died there, killed by a party that mutinied against him. In August 1717, Scottish businessman John Law acquired a controlling interest in the then-derelict Compagnie du Mississippi and renamed it the Compagnie d’Occident. The company’s initial goal was to trade and do business with the French colonies in North America, which included much of the Mississippi River drainage basin, and the French colony of Louisiana. As John Law bought control of the company, he was granted a 25-year monopoly by the French government on trade with the West Indies and North America. In 1719, the company acquired the Compagnie des Indes Orientales, the Compagnie de Chine, and other French trading companies and combined these into the Compagnie Perpetuelle des Indes. In 1720, it acquired the Banque Royale, which had been founded by John Law as the Banque Generale in 1716, and which was the source for the quantitative easing which enabled the government to eliminate its debts. John Law then schemed to create speculative interest in the Compagnie des Indes. Reports were skillfully spread as to gold and silver mines discovered in these parts. Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. This was the way Gregor McGregor was to generate interest in Poyais one hundred years later. Law had promised the French regent that he would extinguish the public debt. To keep his word he required that shares in the Compagnie des Indes should be paid for one-fourth in coin and three-fourths in billets d’Etat or public securities, which rapidly rose in value on account of the foolish demand which was created for them. The speculation was further fed by the huge increase in the money supply introduced by John Law in order to stimulate the economy. The South Sea Company and the British government learned from John Law and imitated these techniques in 1720. The shares traded around 300 at the end of 1718, but rose rapidly in 1719, increasing to 1000 by July 1719, 5000 by August 1719 and broke 10,000 in November 1719, an increase of over 3000 percent in less than one year. By contrast, South Sea Company shares rose by 900 percent in 1720. The Comagnie des Indes shares stayed at the 9000 level until May 1720 when they fell to around 5000. The fall in the price of the stock increased, and at the end of 1720, John Law was dismissed by Regent Philippe II of Orleans.

The number of outstanding shares of the company was probably around 500,000 in 1720. A stock price of 10,000 livres would have given the company a market capitalization of 5 billion livres. By comparison, the French government expenses in 1719 were 150 million livres in 1700, and the French government debt in 1719 was 1.6 billion livres. At its height, the capitalization of the Compagnie des Indest was greater than either the GDP of France or all French government debt. With the demand for company shares being high, the government and John Law set out to buy back the whole 1.6 billion livres government debt for shares in the company. The plan was successful, and in 1720 the whole government debt was acquired by the company.
As the creditors bought shares in the company with their bonds and debt papers, the whole government debt became property of the company. The company then became property of the former creditors, now the shareholders, and the effective control fell into the hands of the government that paid an annual 3% interest to the company, which amounted to 48 million livres. Through these transactions the French government successfully unloaded their whole gigantic debt (perhaps 200% – 400% of GDP) and became basically debt free. The company sought bankruptcy protection in 1721. It was reorganized and open for business in 1722. In 1723 it was granted fresh privileges by Louis XV. Among these were the monopoly of sale of tobacco and coffee, and the right to organize national lotteries. Compare this outcome with that of the South Sea Company, which was unable to find any business that enabled it to make a profit for its shareholders after its collapse in 1720, but relied on the government bonds the South Sea Company held to provide income to its shareholders. From 1726 to 1746 the Compagnie d’Inde flourished from its overseas trade and domestic business. It brought wealth to the port cities it was operating from: in Bordeaux, Nantes, Marseille, and, in particular, its home port of Lorient (initially called L’Orient). During this period the company lost its trading rights for the western hemisphere, but it kept trading with the east and prospered from that business. Its main goods of trade during the period were porcelain, wallpapers, lacquer and tea from China, cotton and silk cloth from China and India, coffee from Mocha (Yemen), pepper from Mahe (South India), gold, ivory and slaves from West Africa. After 1746 the spendthrift policies of the French Government began to hurt the Company, and the Seven Years’ War brought severe losses. In February 1770 an edict required the Company to transfer to the state all its properties, assets and rights, then valued to just 30 million livres, quite a decline from the 5 billion livres the company had been valued at in 1719. The king agreed to pay all the Company’s debts and annuity (rente) obligations. The company was officially dissolved in 1770, although its liquidation dragged on into the 1790s.
The debt-laden governments of today probably wish they could create a scheme similar to the Mississippi Bubble to unburden themselves of the debts they have accumulated over time. With many western government debts equal to or greater than GDP, it would provide a great relief. No one knows how the huge expansion in the Fed’s balance sheet caused by quantitative easing will end, or if there were another recession, if it might even expand. Might the Fed end up buying the debt of Detroit or Puerto Rico or California or Illinois? Might the Fed even buy corporate debt during the next financial crisis, or even shares in companies? Perhaps Ben Bernanke and Janet Yellen should summon John Law’s ghost for some advice on how to get out of their current predicament.

The Great Stock Exchange Forgery – Who Committed the Perfect Crime?

Most stamp collectors are aware of the Great Stock Exchange Forgery that occurred in London in 1872 and 1873, even though most Americans who do not collect stamps are not. In 1870, the telegraph system of the United Kingdom was nationalized and run by the Post Office. This was useful to people on the stock exchange because without a ticker tape, traders used the telegraph to send stock quotes to customers throughout the United Kingdom. If someone wanted to send a stock quote, they would go to the telegraph office at the Stock Exchange, write down the information, purchase a stamp generally costing one shilling, depending upon the number of words, then send it off to the customer. The customer would purchase the stamp, put it on the telegraph message, and then have the message sent off, only seeing the actual stamp for a few seconds. The clerk would then cancel the stamp and send off the message. A fraudulent clerk supplied forged stamps and pocketed the one shilling fee. He used both fraudulent and real stamps so when the actual stamps were audited, none showed up as missing. The stamps were only used on certain days, were convincing forgeries, and the stamps were not retained by the customers who might have noticed the fraud.
Although the telegraph messages were filed in a bag for disposal, the stock exchange kept the forms and they were later disposed of as waste paper. Some of the stamps were obtained by stamp collectors and 25 years later, in 1898, a philatelist, Charles Nissen, noticed differences between the forged stamps and the real stamps. First, the stamps used letters that indicated the position of the stamps on the sheets of stamps, but some of the letters were incorrect. These letters were also slightly larger than on the genuine stamps and the corners of the stamps were blunter. Second, the stamps were not watermarked, while genuine stamps did have a watermark. Third, the forged stamps were lithographed while the real stamps were typographed, producing a lower quality of stamp. By the time the forgeries were discovered in 1898, the clerk who had committed the forgery had disappeared, and to this day, no one knows who committed this perfect crime, perfect because no one even knows who committed the crime and the criminal kept all the proceeds. One shilling was equivalent to twenty-five cents or about $6 in today’s money, and over a year, the forgeries could have added up significantly for the perpetrato rs. Perhaps after 1873, the fraudster simply retired. Stock exchange forgery stamps are available to collectors, but sell for more than the originals since they are scarcer than the originals. You can buy one on Ebay for about $800 if you want a piece of stock market history.

Have the Financial Markets Given a Once-in-a-Generation Signal?

One of the principal decisions investors have to make is how to allocate their assets between stocks and bonds. Although stocks generally provide a higher rate of return than bonds, stocks are also more volatile, and investors run the risk that when they need to take money out of their portfolio, stocks might be in a bear market, reducing the amount of money available to them. One of the indicators we look at to determine the optimal allocation between financial assets, is the relative returns between stocks and bonds, and in particular, the 10-year and 20-year rates of return for stocks and bonds. We have found these to be one of the most effective indicators for allocating assets. Five-year rates of return have too much noise in them to provide useful signals, and thirty-year rates are too stable to provide important signals on the relative returns on stocks and bonds. We use the return on the S&P 500 for stocks and the GFD’s index of returns on 10-year government bonds for bonds. As most investors know, stocks generally outperform bonds over time because equities are riskier than bonds and investors must be compensated for this risk with a higher rate of return. However, this is not always true. Occasionally, though rarely, bonds outperform stocks over a period of 10 or 20 years. This only happens once in a generation, and the Financial Crisis of 2008 created one of those rare events. As a result of the financial crisis, for the first time since the 1970s, stocks underperformed bonds over the previous 10 years, and for the first time since the 1940s, stocks underperformed bonds over the previous 20 years. Typically, investors look at the annual returns to stocks, bonds and bills and the volatility of returns to determine the level of risk they face in choosing between assets. In reality, investors don’t look at one-year time periods in making their long-term investment choices, but want to look at periods of ten, twenty or more years in order to prepare for their retirement. Without a long set of data, there is insufficient evidence to make informed decisions about how to allocate investment resources between different asset classes. Global Financial Data has over 150 years of history on the interaction between the 10-year and 20-year returns on stocks and bonds in the United States. This amount of data provides a more realistic view of the information investors need to make long-term investment decisions. The 10-year total returns to stocks and bonds are illustrated in the graph below with stocks represented by the blue line and bonds represented by the red line.

The graph illustrates that stocks generally outperform bonds over time, and that stock returns are more volatile than bond returns. What is more interesting than these well-known facts are the periodic, but rare, occasions when bonds outperform stocks over a ten-year period. The primary periods when stock returns fell below bond returns were in the 1880s and 1890s, the 1930s, the 1970s and the 2000s. Over the past 150 years, these have been once-in-a-generation events that are followed by periods of several decades in which stocks consistently outperform bonds, in some cases by wide margins.

Several important facts should be noted about this graph. In most cases, increases in the rate of return to stocks at the beginning of each cycle were accompanied by decreases in the rate of return to bonds, as was true from around 1900 to 1930 and from 1940 to 1970. This occurred when nominal interest rates were low at the beginning of a cycle. The period between 1980 and 2005 was different from the other periods because the cycle began when inflation rates, and thus nominal interest rates, were relatively high. Consequently, as inflation and nominal interest rates fell, these changes generated capital gains which increased the long-term return to fixed income investors. Once inflation fell to normal levels, the 10-year return on bonds began to fall. Yields on 10-year bonds have been declining consistently since 1981 which means that over the next few decades, the graph is more likely to look like the 1940s and 1950s than the 1980s. It should also be noted that the 10-year relative returns to stocks and bonds cross over several times before stocks begin to consistently outperform bonds for a period of 25 years or more. Although it is impossible to know the returns this graph will show over the next 30 years, stock returns will probably fluctuate dramatically over the rest of the decade, and during the next bear market, 10-year returns to stocks will temporarily fall below the returns to bonds before rebounding. Nevertheless, the 10-year returns to stocks and bonds have begun to show a divergence which is likely to continue in the future. Below is the graph for the relative 20-year returns on stocks and bonds over the past 150 years. As can be seen, there have only been three times in the past 150 years when bond returns exceeded stock returns over a 20-year period: at the bottom of the bear market in 1932, during 1949, and during the financial crisis in 2009 and 2010. Since long-term bond total returns probably will continue to decline, 20-year stock returns are unlikely to drop below 20-year bond returns again for decades. As is true of the 10-year graph, stock and bond returns are beginning to diverge. Although there is no guarantee financial markets will repeat their past performance, there are several possible implications of this once-in-a-lifetime signal from financial markets.

  1. Stocks should generally outperform bonds over the next 30 years because a new cycle in the relative rates of return began a year ago.
  2. When the current bull market runs into trouble sometime in the next few years, the relative 10-year return on stocks will temporarily fall below the return on bonds, but will soon recover.
  3. The 10-year rate of return on bonds is in long-term decline, and is likely to continue. Because, unlike in the 1980s, inflation rates are not excessively high, during the initial phase of this cycle, long-term return to bonds should decline not only in relative terms, but in absolute terms as well, before reversing about half-way through the cycle.
  4. At the height of the cycle, stocks will have returned 15%-20% over the previous ten years. This peak should be reached sometime in the 2020s.
  5. This cycle reinforces the conclusions I made in my paper, Are You Ready for the Bubble of the 2020s which discusses the convergence of long-term factors which favor a strong bull market in the 2020s. The stock market could fluctuate for the rest of the decade before breaking into a secular bull market in the 2020s.

One possible conclusion to draw from these graphs is that long-term investors should consider allocating more of their assets toward stocks, and take advantage of market downturns during the next few years to reallocate money from bonds into stocks. Of course, past performance is no guarantee of future returns, but as anyone who looks at these graphs should realize, events such as these only happen once in a generation.

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