Britain has run debt to income ratios way in excess of current levels at several points in its history. Around the times of the Napoleonic War, and both the First and Second World Wars the debt to income level exceeded 200% – levels that today would be regarded as crippling and would lead the markets to expect imminent default. Yet there has never been a formal default, and much was made about the UK paying off the last of 50 instalments of World War 2 debt to the US and Canada in 2006.
But it cannot be said to be true that the UK’s credit record is unblemished. In their brilliant book, This Time Is Different (we’ve plugged it before), Reinhart and Rogoff do not have Britain in their very short list of six nations that have never defaulted (New Zealand, Australia, Thailand, Denmark, Canada and the USA). There are (at least?) two instances of the UK defaulting. In 1932, in the grip of the Great Depression, Britain (and France) defaulted on First World War debt to the United States – the so-called inter-allied debt. Britain had linked its ending of paying of these debts to the premature end of German reparation payments earlier in the year – academics therefore have termed this an “excusable default” where Germany was the real defaulter. The Americans didn’t seem to be especially cross about it in any case, although it was done without consent.
Another event that I would classify as a default was the changing coupon on the gilt known as War Loan. Issued in 1917 (“If you cannot fight, you can help your country by investing all you can in 5 percent Exchequer bonds. Unlike the soldier, the investor runs no risk”, the adverts said), the bond’s coupon was reduced from 5% to 3.5% in 1932. You can read Chancellor Neville Chamberlain’s speech announcing his plan in Hansard, here. This was a voluntary conversion – you could have had your money back – but the moral screws were on. Chamberlain ends his speech saying “For the response we must trust, and I am certain we shall not trust in vain, to the good sense and patriotism of the 3,000,000 holders to whom we shall appeal”. 92% of holders accepted the new, lower coupon (probably not just for patriotic reason, but because 3.5% was still a better rate of interest than was available elsewhere in those deflationary times). Today, we have seen the ratings agencies classify similar events as defaults, even if such disadvantageous changes were consensual.
Perhaps just as interesting is the question – why didn’t the UK default more often? A paper called Sustainability of High Public Debt: What the Historical Record Shows by Albrecht Ritschl suggests that it isn’t obvious why it didn’t. Post WW1, growth was disappointing, in contrast with expectations of a peace dividend. Yet even during the deflationary years between the wars (1926 to 1933) the conservative establishment view was to run budget surpluses, and to go onto the Gold Standard (until 1931), which didn’t allow a devaluation and thus help boost UK exports. Why the UK decided to beggar itself rather than default was in part due to the culture in the Treasury (the “treasury view” was hardline), and also due to the emergence of the United States as a rival economic power and financial centre. Post WW2, Ritschl argues that Marshall Aid was effectively a “rescue operation” that prevented a default. So reputation is extremely important in preventing default, the competitive threat from other financial centres matters, and having allies with deep-pockets (Germany or the IMF in the case of Greece?) can also prevent defaults. Remember the golden rule – willingness to pay is as important as ability to pay. Britain was willing to accept austerity in the 1930s to maintain its reputation; Ecuador has defaulted with a debt to GDP ratio of under 20%.
So to the present day. This weekend the papers were full of headlines about Conservative leader David Cameron postponing austerity for the UK. Today, in what looks like a different view, his Shadow Chancellor George Osborne has committed his party to maintain the UK’s AAA credit rating: “Judge us in the first few months of a Conservative government on whether we’re able to protect our credit rating”. I’d have thought that as a result, the UK’s 5 year CDS spread would have narrowed a little, but it’s stuck at 85 bps (we’ve written protection on Her Majesty’s Government because although fiscally we face a crisis, we don’t believe this will result in a default). Perhaps the market fears that the Conservatives are going to have a Devon Loch moment; the latest polls point to the forecast overall majority having slipped away, and a hung parliament is in prospect. With the UK economy at least growing again, albeit it only just, the chances of Osborne getting his chance to be Mr Austerity are slightly lower.
