Debt crises in a monetary union: the case of Indiana

As Europeans we tend to think of America as new, young, and modern, whereas in Europe everything is old and traditional. At least that’s what I thought, until I noticed this while driving around in the American Midwest:


The license plate celebrates the 200th birthday of the State of Indiana in 2016. 200 years! This means, in a sense, Indiana is older than many of the states of the European Union. In 1816, Germany was still a patchwork of small territories, loosely connected through the German Confederation – of which Austria was a part. Italy was merely a geographical description – the process of Italian unification had not even begun. Greece was just a province of the Ottoman empire. Belgium, until 1815 known as „Austrian Netherlands“, was part of the United Kingdom of the Netherlands. France did exist as a nation then, however, while the people of Indiana lived for 200 years under the same political system and only once made marginal changes to their constitution (more about this below!), the French during the same time went from the post-Napoleonic Bourbon monarchy to the Second Republic to the Second Empire, then back to the Third Republic, then to totalitarian rule under the Nazis, and finally back to Fourth and now the Fifth Republic. As far as I am aware, there is no European country which has had the same constitution for the past 200 years without interruptions or major changes – the single exception I can think of is the United Kingdom which always had the same constitution: none.

There is another striking fact about the history of Indiana. Indiana has been in a monetary union with the rest of the United States for as long as it existed. And during its early history, it has had its own debt crisis which bears a striking resemblance to the recent history of the much younger European monetary union.

When Indiana became a State in 1816, it was mostly a wilderness at the margin of civilization. The only major road in the country was the Buffalo Trace – literally a trace created by migrating bison herds. Population was only 65,000 initially, but growing fast. The government of the young state decided to take the country’s infrastructure into the 19th century. And 19th century infrastructure, they figured, was going to be canals. So, they launched a giant public investment program, called the Mammoth Internal Improvement Act, spending 10 million dollars (equivalent to 260 million current dollars, roughly 100% of GDP at the time) on canals and toll roads. The heart of the project was the Wabash & Erie Canal connecting the Great Lakes with the Ohio River. „Crossroads of America“  was the official state motto of Indiana.

To finance these projects, the governor of Indiana, a certain Noah Noble, had a plan: some money was to be raised by selling public lands, some by raising taxes, and some by borrowing from the Bank of Indiana, which was partly state-owned. The Bank of Indiana refinanced itself by issuing bonds, backed by the state, at the London exchange.

Initially, the plan looked like a big success. The construction works employed many thousands of people and provided a stimulus for the economy. Borrowing costs were low and spirits were high. But soon, problems started to appear. It turned out that the government had greatly underestimated the costs of building the canals, mostly because they failed to take into account the damage done by muskrats who burrowed through the walls of the dams. Critical voices in the State Congress regarded the canals as a total waste of money. Railroads, they argued, were the future! Nobody seemed to listen.

And then, in 1837, a financial crisis broke out. The crisis was triggered by the Bank of England which, in an attempt to curb the outflow of gold and silver reserves, raised interest rates. This had a direct impact on Indiana whose borrowing costs skyrocketed. It also had an indirect effect: since the United States was on a gold and silver standard, American banks were forced to follow the Bank of England in raising interest rates, which led to a credit crunch and a nation-wide recession. (A classic example of a monetary policy spillover effect!)

The combination of stagnant tax revenues, exploding construction costs and rising interest rates meant that State of Indiana was effectively bankrupt at the end of 1841. So they sent the head of the Bank of Indiana to London to negotiate a restructuring of the debt. The creditors agreed to a haircut of 50% of the debt. In exchange, Indiana handed over control of most of the canals and roads, many of them still unfinished. The Wabash and Erie Canal was held in trust to pay off the remaining debt. It operated until the 1870s yielding a low profit, but was soon made obsolete by – the railroads which turned out to be the key infrastructure of the 19th century.

The conclusion Indiana drew from this was that the long-run costs of government borrowing far exceed the short-run benefits. Which is why in 1851, they adopted an amendment to their constitution, forbidding the State government to get into debt (except in cases of emergency).

I’d say there is a thing or two our modern European states can learn from this story.


Some More on the Crisis Vulnerability of Countries

A couple of weeks back we had a great post by Christoph Zwick on current account rebalancing in the Eurozone. In the comment section I mentioned I had my doubts on what the variables are that we should look at in order to determine which countries are most vulnerable to experiencing “sudden stops” of capital inflows, thus triggering a financial crisis, which is in essence what happened in the southern Eurozone periphery. In particular I found the argument unconvincing that debt ratios are of much use in this discussion, my thoughts on which I attempted to summarize in a follow-up post I did back then.

I don’t mean to pick on this, but I feel it is important since it is a fairly widespread view that excessive debt ratios (both public and private) are a large part of the reason why some countries fared so badly in the financial crisis while others did much better. The subsequent calls for austerity, often based on this flawed analysis, are also what is destroying the future of an entire generation of young people in the affected economies.

I just happened to stumble on some research by Frankel and Saravelos (.pdf) that seems to address specifically this issue, and I thought it would be a useful addition to the conversation. In essence it is a literature overview that tries to summarize the findings regarding which variables proved to be statistically significant as “early warning indicators” for financial crises. The top 5 indicators they found are as follows (Table 1): foreign exchange reserves, the real exchange rate, GDP growth, growth in credit and the current account. Clearly not all of these are applicable to countries in a monetary union, such as the Eurozone, which essentially by definition have no foreign exchange reserves of their own, for instance. But what struck me the most is the indicator at the very bottom of that list: External Debt. In fact, of the 83 studies reviewed, only 3 found external debt to be a statistically significant indicator to predict a financial crisis. “Budget Balance”, the meaning of which is unfortunately not really defined in the paper, was found to be significant in only 9 of the 83 studies surveyed. Both government as well as external debt simply do not seem to be what we should be looking at here.

P.S.: As a side-note, some economists at Well’s Fargo (.pdf) took these indicators to estimate which of the 30 biggest developing economies in the world are more likely to be subject to crises in the near future. Might be interesting to keep an eye open.

Edit: The survey I quoted in the post relates to pre-2008 crises. The authors then conduct some analysis of their own for 2008-2009 episodes, and for some reason do find external debt to be a significant indicator. I’m not sure how that works, but it does of course change the story I tried to tell.