Sovereign risk and fiscal (in)attention a look at the US State default of the 1840's

SOVEREIGN RISK AND FISCAL (IN)ATTENTION:
A LOOK AT THE U.S. STATE DEFAULT OF THE 1840S
Huixin Bi & Nora Traum
Federal Reserve Bank of Kansas City & North Carolina State University
July 2017
The views expressed in this paper are those of the authors and not of the Federal Reserve Bank of Kansas City, or the
Federal Reserve System.

MOTIVATION
• European sovereign crisis:
• How did the sovereign interest rate hikes relate to country-speciﬁc
ﬁscal fundamentals?
• Did investors change their pricing behavior during the crisis? If so,
why?
• How did the sovereign risk spread in the union?

MOTIVATION
• European sovereign crisis:
• How did the sovereign interest rate hikes relate to country-speciﬁc
ﬁscal fundamentals?
• Did investors change their pricing behavior during the crisis? If so,
why?
• How did the sovereign risk spread in the union?
• Sargent’s Nobel Prize lecture:
• “United States then, Europe now”
• This presentation gives an interim report towards:
• Use U.S. state default (8 states and 1 territory) in the 1840s ...
• ... to explore questions relevant for policymakers today.

FINDINGS
• Non-defaulting vs. defaulting states had distinct ﬁscal
policies/fundamentals before the crisis
• Ohio and New York: more careful and responsible
• Indiana and Pennsylvania: over optimistic or irresponsible

FINDINGS
• ... But no signiﬁcant difference in bond prices before the crisis

FINDINGS
• Investors’ attention to fiscal fundamentals seemed to depend on
the economic condition
• Evidence from newly constructed fiscal information index from
newspaper coverage of fiscal policy from 1834/1 to 1845/12
• Higher fiscal information index (i.e. more and better coverage)
during the crisis
• Fiscal index’s ability to predict bond prices varies before vs. during
the crisis

FINDINGS
• Investors’ attention to fiscal fundamentals seemed to depend on
the economic condition
• Evidence from newly constructed fiscal information index from
newspaper coverage of fiscal policy from 1834/1 to 1845/12
• Higher fiscal information index (i.e. more and better coverage)
during the crisis
• Fiscal index’s ability to predict bond prices varies before vs. during
the crisis
• One potential explanation
• Costly information processing [in the spirit of rational inattention,
Sims(2003)]
• Investors pay less attention to fiscal news in good times

UNITED STATES IN 1840
• 8 states and 1 territory defaulted between 1841 and 1843

U.S. STATE BOND PRICES (1820-60)
Jan20 Jan25 Jan30 Jan35 Jan40 Jan45 Jan50 Jan55 Jan60
0
20
40
60
80
100
120
140
OH
KY
NY
IN
IL
MD
PA
Source: Sylla, Wilson, and Wright (2002) background

Background:
The Role of Fiscal Fundamentals

RISING STATE DEBTS
• Outstanding state debt by 1841 was $198 million, with more than
half incurred after 1836
• Northeastern/western states: internal improvement projects
• Southwestern states: chartered state banks
State Date of % of Debt to
Default Banking (1841)
Indiana January 1841 19%
Florida January 1841 98%
Mississippi March 1841 100%
Arkansas July 1841 100%
Michigan July 1841 0%
Illinois January 1842 22%
Maryland January 1842 0%
Pennsylvania August 1842 0%
Louisiana February 1843 93%
Source: English (1996), House Report No. 296 to 27th Congress (1843) more

DEBT OUTSTANDING ON SEPTEMBER 1, 1841
BY YEARS OF AUTHORIZATION
’30−’32 ’33−’35 ’36−’38 ’39−’41
0
0.5
1
1.5
2
2.5
3
3.5
4
x 10
4
ThousandsofDollars IL
IN
KY
OH
MD
NY
PA
Source: William Cost Johnson House Report No. 296 to 27th Congress (1843) more

JUSTIFYING STATE DEBTS
• Increasing land values were a key factor underlying the massive
state borrowing
• Expectation of property tax revenue (especially important for
“new” states)
1835 1836 1837 1838 1839 1840 1841 1842 1843 1844 1845 1846 1847 1848 1849 1850
Year
4
6
8
10
$peracre
Land price in Indiana
Source: Indiana Annual Auditor Reports for various years
• Early success of New York (1817) and Ohio (1825) canals

DEFAULTERS VS. NON-DEFAULTERS
Literature and historical documents reveal distinct policies crucial for
ﬁscal outcomes.
• Non-Defaulters
• Ohio and New York: taxes and funded canal funds dedicated to
improvement projects; good credit history
• New York: dramatic austerity measures (Stop and Tax Law in
March 1842)

DEFAULTERS VS. NON-DEFAULTERS
Literature and historical documents reveal distinct policies crucial for
ﬁscal outcomes.
• Non-Defaulters
• Ohio and New York: taxes and funded canal funds dedicated to
improvement projects; good credit history
• New York: dramatic austerity measures (Stop and Tax Law in
March 1842)
• Defaulters
• Pennsylvania and Maryland: borrow-as-you-go policy (pay interest
with more borrowing, and delay taxing until default)
“An act to repeal the State tax on real and personal property, and to
continue and extend the improvements of the State... ”
– Pennsylvania Bank Improvement Act of 1836
(printed in several newspapers)
• Indiana: over-optimistic ﬁscal forecasts

INDIANA: OVER-OPTIMISTIC FISCAL FORECASTS
• Land taxes were crucial for Indiana: 40% of total tax revenue in
1835 vs. 84% in 1838
• Fiscal forecast assumptions in 1836 (to authorize $10 million
bond, compared to its annual revenue of about $50,000):
• Value of taxable property would grow at 15% annually
(only 4.4% ex-post)
• Set up a dedicated sinking fund with return of 9%
(didn’t happen before default)
1836 1838 1840 1842 1844 1846 1848
Year
0
100
200
300
400
LandTaxRevenue(thousands)
Actual
Forecast
Source: Indiana Report of the State Board of Internal Improvement (1836)

Newspapers & Information
• Historical documents show defaulters vs. non-defaulters had
distinct ﬁscal policies before the crisis
• Debt more than doubled in 1836-1838 relative to preceding three
years.
• How were investors thinking about ﬁscal fundamentals during
this period?

FISCAL INFORMATION INDEX
• Construct index of newspaper articles related to ﬁscal
information
• Monthly counts of articles with {tax} and {debt} and name of
state from Gale digitized databases:
• the 19th century U.S. newspapers database
• the 19th century British newspapers database
• the Times London archive 1785-2010
• Focus on seven states: Indiana, Illinois, Maryland, Pennsylvania,
New York, Ohio, and Kentucky
• Index for each state and composite index from sum of all states
• Divide the count for each month by the count of all articles
written
• Penny newspaper in the 1830s

138 Newspapers included
• 91 within U.S.
• 84 from contemporary states (as of 1840), 7 from territories
• 47 within U.K.
• England: 39; Scotland: 5; Ireland: 2; Wales: 1
• Example: New York
• New York Herald, New York Spectator, Emancipator and Free
American, Log Cabin, Voice of Freedom, Weekly Herald
• Herald included a “money article” by 1835 which Mott (1950)
credits as precursor to modern ﬁnancial page

FISCAL INFORMATION INDICES
Jan34 Jan36 Jan38 Jan40 Jan42 Jan44
0
20
40
60
80
Article Counts
OH
KY
NY
IN
IL
MD
PA
0
100
200
300
400
500
600
Article Indices with Normalization
• Article indices at monthly frequency

DATA ANALYSIS
Test for breaks in the coverage of newspaper articles by estimating
Markov-switching model:
It = µ(st) + σ(st) t
• Allow for two regimes in estimation
• It: ﬁscal information indices
• µ(st): average level of index in regime st
• σ(st): volatility of index in regime st

RAW MONTHLY COMPOSITE INDEX
MARKOV-SWITCHING ESTIMATION
• µ and σ signiﬁcantly different across regimes
µ(low) µ(high) σ(low) σ(high) pll phh SBIC
(1) 59.21*** 179.93*** 34.52 0.94 0.78 10.56
(3.41) (7.96) (2.19) (0.02) (0.08)
(2) 54.30*** 152.49*** 28.37 56.65 0.96 0.90 10.44
(3.17) (10.27) (2.28) (6.42) (0.02) (0.05)
• Probability of low article count regime
Jan34 Jan35 Jan36 Jan37 Jan38 Jan39 Jan40 Jan41 Jan42 Jan43 Jan44 Jan45
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

FISCAL INFORMATION ROLLING-WINDOW INDICES
100
200
300
400
500
600
Article Counts
OH
KY
NY
IN
IL
MD
PA
100
200
300
400
Article Indices with Normalization
• RW indices of accumulated counts for past 12 months (low frequency ﬁscal news)

• Regime change in the amount of fiscal news reports:
• More fiscal news reports available in general during the crisis
• Regime change in the cyclical pattern of fiscal news reports:
• More relevant fiscal news during the crisis
• More reports published following the publication dates of State
Auditor and Treasury reports

BOND PRICES & FISCAL INFORMATION INDEX
• Did the ﬁscal information index affect bond prices?
• Estimate following equation over period Jan. 1834 to Dec. 1845:
ln pb
it = β0 + β1Irw
t + βr
1Irw
t dRt + β2 ln pb
it−1 + βr
2 ln pb
it−1dRt
+β3zit + βr
3zitdRt + it
• pb
it: bond prices
• Irw
t : rolling-window ﬁscal index
• dRt: crisis dummy (January 1839)
• zit: control variables

DATA: BOND PRICES
• Data from Price Quotation database of Sylla, Wilson, and Wright
(2002)
• market prices from contemporary newspapers over 1790-1860 in
seven markets: London, New York, Philadelphia, Boston,
Baltimore, Richmond, and Charleston
• average price quotes within month to get monthly series
Number of bonds for each state
MD: 13 PA: 34 IN: 24
IL: 27 KY: 16 OH: 25
NY: 95

DATA: BOND PRICES
Jan30 Jul32 Jan35 Jul37 Jan40 Jul42 Jan45 Jul47 Jan50 Jul52
40
50
60
70
80
90
100
110
120
130
New York
• New York bond prices in New York market

DATA: BOND PRICES
Jan30 Jul32 Jan35 Jul37 Jan40 Jul42 Jan45 Jul47 Jan50 Jul52
30
40
50
60
70
80
90
100
110
120
130
Maryland
• Maryland bond prices in Baltimore market More States

DATA: BOND PRICES
• Calculate average price of state bond across securities
• linearly interpolate missing points between individual securities
• take average across all securities

REGRESSION RESULTS: JAN. 1834 TO DEC. 1845
ln pb
it = β0 + β1Irw
t + βr
1Irw
t dRt + β2 ln pb
it−1 + βr
2 ln pb
it−1dRt
+β3zit + βr
3zitdRt + it
Coefficient Specification
(1) (2) (3) (4) (5)
RW fiscal index, β1 0.14*** 0.00014 0.00023 -0.0015 -0.0016
(0.027) (0.0010) (0.0012) (0.0020) (0.0019)
RW fiscal index X crisis dummy, βr
1 -0.30*** -0.012*** -0.012*** -0.010*** -0.0098***
(0.069) (0.0032) (0.0028) (0.0032) (0.0032)
Lagged bond price 0.99*** 0.99*** 0.95*** 0.95***
(0.005) (0.008) (0.011) (0.015)
Lagged bond price X crisis dummy 0.051*** 0.051***
(0.014) (0.011)
Lagged Commodity price -0.048*** -0.049*** -0.023*** -0.023***
(0.0079) (0.0092) (0.0045) (0.0058)
Lagged Commodity price X crisis dummy -0.052*** -0.052***
(0.014) (0.012)
Lagged S&P 500 Index -0.0016 0.0027
(0.011) (0.0074)
Lagged S&P 500 Index X crisis dummy 0.0030
(0.0057)
RW fiscal index in crisis: β1 + βr
1 -0.16*** -0.012*** -0.012*** -0.012*** -0.011***
N 576 572 572 572 572
Adjusted R2
0.54 0.99 0.99 0.99 0.99
State-fixed effect Yes Yes Yes Yes Yes

Potential Explanation:
Information Processing

SIMPLE TWO-PERIOD MODEL
• Costly information processing [in the spirit of rational inattention,
Sims (2003))]
• ﬁscal fundamentals are latent variables
• more resources to process information → know more about ﬁscal
fundamentals
• Land value follows a Markov-switching model with known
transition probabilities
• Fiscal fundamentals and land value jointly determine sovereign
default

L0 = Lx
L1 = Lh
(ss, Lh) → ∆1 = 0
w/ strong
fiscal state
(sw, Lh) → ∆1 = 0
w/ weak
fiscal state
w/ prob
of p xh
L1 = Ll
(ss, Ll) → ∆1 = 0
w/ strong
fiscal state
(sw, Ll) → ∆1 = δ
w/ weak
fiscal state
w/ prob
of 1 − p
xh

Household optimization:
max E0 {u(c0) + βu(c1)}
s.t. y0 = c0 + i0 + q0(j)b0(j)dj
c1 = (1 − ∆1(j)) b0(j)dj
• simple assumption: prob. of identifying weak ﬁscal fundamental is i0
y0
Expected consumption next period:
E0c1 = b0 pxh
+ (1 − pxh
)
i0
y0
+ (1 − δ) 1 −
i0
y0
• pxh
: probability of high land value
• δ: haircut if default

Optimal resources devoted to processing information are state
dependent:
i0
y0
= max 0, 1 −
1
δ
β + 1
2β + 1
1
1 − pxh
• If L0 = Lh
, higher prob. of high land value next period → smaller i0
y0
• If L0 = Ll
, lower prob. of high land value next period → higher i0
y0

Wrap Up
• Policy implications:
• Fiscal (in)attention can play a key role in determining debt
dynamics.
• To do list:
• Reﬁne the construction of ﬁscal indexes.
• Better control variables for the macroeconomy conditions for the
regressions.
• Examine dissemination of information.

SOME ECONOMIC BACKGROUND
• Crisis of 1837:
• Banks suspend convertibility of bank notes to specie for a year
(after May 1837)
• Economy recovered in 1838
• Ongoing debate on the causes:
• international factors [Temin (1969)]
• politics: bank war between Jackson and Biddle
• policies & interbank transfers depleted reserves [Rousseau (2002)]
• Crisis of 1839:
• Banks suspended converting bank notes from Oct 1839 to 1842
• State debts were at the heart of the crisis
return

POSSIBILITY OF BAILOUT
• Some discussion about federal government bailout in the early
1840s
• In late 1839, European investors started discussing the possibility
• In December 1841, President Tyler in his message of 1841
declared no national pledge
• In 1842, European investors refused to lend to the federal
government unless it assumed the state debts
• In December 1842, a select committee of the House investigated
the advisability of federal assumption, which failed in the Congress
• However, no evidence that investors expected a bailout ex-ante
when purchasing bonds
• European investors viewed U.S. State bonds as a safe investment
• No bailout expectation ex-ante based on correspondence
between European investors

• McGrane (1935): Correspondence between Barings (British
bank) and Hope (Dutch bank)
“(the twenty-six states were) all sovereign and independent, and although
circumstances might in time enable the general government to aid the states, that
government has no power or right to interfere.”
– Barings to Hope, May 27, 1842
“... the buyers of American state stocks never contemplated until lately that the
general government was in any way accountable or that it would or could interfere
with them. ”
– Barings to Hope, June 10, 1842
American securities in 1830s “... were subject to less frequent ﬂuctuations in price.
This appealed to the British, for they purchased these stocks as a safe and more
or less permanent investment and not for speculative purposes.”
– McGrane, 1935
return

• Chisholm v. Georgia (1793):
• A citizen of South Carolina sued the state of Georgia for
nonpayment of a debt
• The ﬁrst Supreme Court found against the state of Georgia
• As a response, Congress passed the 11th Amendment to the
Constitution and made it very difﬁcult for creditors to force states
to repay debts:
“The judicial power of the United States shall not be construed to extend to any
suit in law or quity, commenced or prosecuted against one of the United States by
citizens of another state, or by citizens or subjects of any foreign state.”
return

UNITED STATES: DEFAULT, RESUMPTION, AND
REPUDIATION
State Data Resumed or Date
Repudiated
Indiana January 1841 Resumed July 1847
Florida January 1841 Repudiated February 1842
Mississippi March 1841 Repudiated February 1842
Arkansas July 1841 Resumed July 1869
Repudiated July 1884 (Holford Bonds)
Michigan July 1841 Resumed January 1846
Partially Repudiated July 1849
Illinois January 1842 Resumed July 1846
Maryland January 1842 Resumed July 1848
Pennsylvania August 1842 Resumed February 1845
Louisiana February 1843 Resumed 1844
Repudiated unknown
Source: English (1996) return

BONDHOLDERS
Bondholder Share Currency Share
State Year Total Debt In Out Foreign In Out
(mil dollar) State State Country State State
New York 1843 26.0 0.54 0.04 0.42
Ohio 1841 12.46 0.33 0.63 0.04 0.11 0.89
Kentucky 1842 5.56 0.51 0.49 0.00 0.22 0.78
Pennsylvania 1842 34.45 0.28 0.03 0.69
Maryland 1841 16.0 0.48 0.52
Ohio 1853 0.33 0.67
Kentucky 1853 0.5 0.5
Pennsylvania 1853 0.34 0.66
Maryland 1853 0.45 0.55
Indiana and Illinois 1853 0.25 0.75
Source: Hunt’s Merchants Magazine, State Annual Auditor Reports, William Cost Johnson House Report, Wilkins (1989)
return

OHIO LIABILITIES AS OF 1842 BY YEAR ISSUED
’25 ’26 ’27 ’28 ’29 ’30 ’31 ’32 ’33 ’34 ’35 ’36 ’37 ’38 ’39 ’40 ’41
0
0.5
1
1.5
2
2.5
x 10
6
In State
Out of State
Source: Ohio Annual Report of the Auditor of State, 1842 return

ATTITUDES TOWARDS U.S. STATE DEBT
BEFORE VS. AFTER 1839
“Pennsylvania ... is the gainer, and her inhabitants will bless the (internal
improvement) policy which she is pursuing. Maryland is following fast in the steps
of her sister and has in progress works of the grandest order, and beneﬁts of which
will be felt by those yet unborn. Virginia, Ohio, New York, New Jersey, and even
Michigan have works commenced, in progress or completed ...”
– Vermont Chronicle, Apr. 21, 1836
– McGrane, 1935

ATTITUDES TOWARDS U.S. STATE DEBT
BEFORE VS. AFTER 1839
“Pennsylvania ... is the gainer, and her inhabitants will bless the (internal
improvement) policy which she is pursuing. Maryland is following fast in the steps
of her sister and has in progress works of the grandest order, and beneﬁts of which
will be felt by those yet unborn. Virginia, Ohio, New York, New Jersey, and even
Michigan have works commenced, in progress or completed ...”
– Vermont Chronicle, Apr. 21, 1836
– McGrane, 1935
“The state loans depend upon banking projects and internal improvements, of
which probably, not one in ten, for years to come, will pay its own expenses ... the
debtors is at a great distance, compellable to good faith by no law whatever. ”
– London Times, Mar.5, 1839
“The plan of constructing works of internal improvement in Indiana is bad ... and
the consequence is, that a vast amount of money has to be expended before a
single dollar is received. ”
– London Times, Oct. 17, 1839

DATA: BOND PRICES
50
60
70
80
90
100
110
120
130
OH
• Monthly Ohio bond prices in New York market return

DATA: BOND PRICES
30
40
50
60
70
80
90
100
110
120
PA
• Monthly Pennsylvania bond prices in Philadelphia market
return

DATA: BOND PRICES
0
20
40
60
80
100
120
IN
• Monthly Indiana bond prices in New York market return

DATA: BOND PRICES
0
20
40
60
80
100
120
IL
• Monthly Illinois bond prices in New York market return

DATA: BOND PRICES
65
70
75
80
85
90
95
100
105
110
115
KY
• Monthly Kentucky bond prices in New York market return

DATA: COMMODITY PRICES
Jan32 Jan34 Jan36 Jan38 Jan40 Jan42 Jan44
80
90
100
110
120
130
• Monthly all-commodity index of wholesale prices for the New
York market, Cole (1938)

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