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Sovereign Defaults during the Great Depression: New
Data, New Evidence
Andrea Papadia, London School of Economics
([email protected])
Supervisors: Professor Albrecht Ritschl & Dr Olivier Accominotti
The debt crisis of the early 1930s was a key event of the Great Depression and contributed to
shaping post-WWII finance. I focus on two aspects of this episode: the maturity structure of
countries’ debts and local borrowing by presenting a new dataset for over 20 countries
constructed from original sources. While many authors have highlighted the large share of
short-term debt in the interwar era, this has not been quantitatively linked to the sovereign
defaults. To the best of my knowledge, I am the first to investigate the magnitude and impact
of local debt for a wide range of countries. This is surprising given that some local authorities
borrowed massively and that, in many cases, defaults began at the local level, then expanding
to the national level.
Through the use of the new data and panel data methods, I provide quantitative
evidence for the suggestion in the historiography that the unusually high level of short-term
debt of the interwar era was decisive in the 1930s crisis. Contrary to common knowledge, and
the assumptions of almost all theoretical models, I furthermore show that, once country
characteristics are controlled for, higher debt-to-GDP ratios and higher economy-wide
reliance on foreign credit led to a lower, rather than higher, incidence of default.
The interwar debt crisis: opportunism or ‘bad luck’?
Recent research has highlighted the macroeconomic relevance of the interwar debt crisis.
Ritschl and Sarferaz (2014) provide evidence that the German default aggravated the Great
Depression in the US, while Accominotti (2012) shows that it sped up UK's exit from gold.
Given that most defaults were concentrated in the early 1930s, their compound impact is
likely to have had large effects on creditor nations.
The importance of the defaults is not restricted to their impact on the Great
Depression. The wariness of free capital mobility created by the financial crisis induced
policy-makers – in a classic trilemma framework – to forgo the free movement of capital
rather than either fixed exchange rates or an independent monetary policy after WWII
(Obstfeld and Taylor, 1998). In the USA, the defaults were seen as a failure of banks to
manage their conflicts of interest and this was used as a key justification for the 1933 GlassSteagall Act (Carosso, 1970; Benston, 1990).
The narrative around the time of the debt crisis was that the economic slump revealed
the international lending of the 1920s as misguided and excessive, leading to defaults in Latin
America and Europe (Harris, 1935; Madden et al, 1937; Lewis, 1938). Indeed, US Congress
investigations confirmed the distorted incentives, partial or false information and unorthodox
practices of some key actors (Flandreau et al, 2010).
Other research has stressed the ‘bad luck’ element of the defaults. Diaz-Alejandro
(1983) and Fishlow (1986) identified the magnitude of the Great Depression shock as the
main driver of default. Flandreau et al (2010) take their finding that distortions in
international financial markets were not as pervasive as previously thought as evidence that
‘bad luck’ played the leading role in the defaults. A partial challenge to this view is
represented by Eichengreen and Portes (1986) who found that both economic shocks and
policy choices mattered: terms of trade deterioration and the foreign debt to export ratio were
related to default, but so was the degree of fiscal adjustment following the onset of the Great
Depression.
New data on public debt
Reinhart and Rogoff (2009) and Abbas et al (2010) provide historical series on public debt,
but these have major shortcomings for the pre-WWII era due to issues of cross-country
comparability originating from the different accounting standards used by countries. For the
interwar period, they rely on data collected in a United Nations (1948) volume, which is also
my starting point. The working version of this paper provides details of the limits of the UN
data on a country by country basis. Whenever possible, the comparability of the data was
improved by including or excluding certain items, but the overall picture remains imperfect.
On the positive side, the different reporting techniques used reflect the perception of the
public debt held by statistical offices and, presumably, countries’ authorities. In a study of
default decisions, this should be the key variable of interest.
Figure 1 – Short term debt as a share of total debt, 1927-19361
Data transcribed from the volume illustrate that default was more common in
countries with larger shares of short-term debt (Figure 1). Below, I show that this correlation
holds even after controlling for a wide range of economic and political variables.
Figure 2 – Average share of central and local debt over total debt, 1927-19362
1
Unweighted average. Defaulters: Bulgaria, Czechoslovakia, Germany, Greece, Poland, Argentina, Bolivia,
Brazil, Colombia, Peru. Non-defaulters: Belgium, Denmark, Finland, United Kingdom, Ireland, Netherlands,
Norway, Switzerland, Venezuela, Japan, Canada, New Zealand.
Cross-country comparability issues are, however, dwarfed by the failure to consider
local public debt. By using a variety of original sources detailed in the working version of this
paper, I show that sub-sovereign debt constituted around 25 per cent of total public debt on
average (Figure 2). Its exclusion thus leads to a severe underreporting of public debt levels.3
My local debt estimates also reveal that the comparative debt burden picture is
distorted by the omission of local debt due to vast cross-country heterogeneity (Figure 3).
Countries with federal structures – such as Brazil and Germany – borrowed massively at the
local level. In more centralised and less sizable countries – like Belgium and Bulgaria – local
borrowing was almost insignificant. Given that all public debt, whether national or local, is
serviced through resources generated by the country's economy, both the underreporting and
the bias in relative debt burdens are problems for any study investigating sovereign defaults.
In the econometric analysis, I also rely on data collected by other researchers, as well
as additional newly transcribed data. The working paper version documents the sources and
discusses data reliability in detail.
Figure 3 – Average share of local debt over total debt, 1927-1936
Empirical strategy
I study the determinants of default size – defined as the share of the principal of public-sector
foreign Dollar bonds in default – by regressing it on a series of control variables. I treat Dollar
bonds separately from others given that distinct bondholders categories were often treated
differently (Eichengreen and Portes, 1988).4
I employ panel data techniques to account for unobserved time-invarying crosscountry heterogeneity (e.g. creditworthiness, institutional quality, default history), which is
likely to have been a key driver of defaults (Reinhart et al, 2003). By relying on the timeseries variation of variables rather than their cross-sectional levels, panel data methods also
minimise the impact of the cross-country comparability issues of the data discussed above.
To account for endogeneity, I control for state-dependence (i.e. default status) and
employ internal instruments for the lagged explanatory variables, represented by further lags
2
Unweighted average. Countries included: Belgium, Bulgaria, Denmark, Finland, Germany, United Kingdom,
Ireland, Italy, Netherlands, Norway, Poland, Sweden, Switzerland, Argentina, Brazil, Colombia, Uruguay,
Australia, Japan, Canada, New Zealand.
3 The principal sources for the local debt data are the Yearbooks of the German Statistical Office (Statistiches
Reichsamt, 1936-39/40). For certain countries, these are integrated by publications of the Institute for
International Finance, the Corporation of Foreign Bondholders and, most importantly, Moody's (1933-37),
which are also used to estimate default size.
4 Data collection on Sterling bond defaults is currently under way and these will be included in the analysis as
soon as possible.
of the explanatory variables themselves. I run the dynamic Arellano-Bond (1991) generalised
method of moments (GMM) estimator and carry out standard tests (Sargan and ArellanoBond), which confirm its validity. The model, includes country fixed-effects, time fixedeffects and a vector of controls 𝒙:
𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑖𝑧𝑒𝑖,𝑡 = 𝛾 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑖𝑧𝑒𝑖,𝑡−1 + 𝒙𝑖,𝑡 𝜷 + 𝑙𝑖 + 𝑞𝑡 + 𝜀𝑖,𝑡
[1]
I test three sets of channels. The first relates the severity of the economic slump to the
incidence of default. The second investigates the influence of economic and political
characteristics of countries (e.g. trade openness, financial fragility, reliance on borrowing).
The third, examines whether the fiscal and monetary policies enacted had any effect on the
default outcome.
Findings
Column one in Table 1 contains the baseline specification, column two adds economy-wide
(public and private) US-originating debt over GDP, column three controls for default
expectations by including bond yields and column four breaks down public debt into central
and local.
default size
L.defaultsize
L.total public debt/GDP
L.short term debt/total debt
L.trade/trade 1929
1
2
3
4
0.692***
(0.0756)
-0.177***
(0.0676)
0.318***
(0.106)
0.0182***
(0.00601)
0.668***
(0.0800)
-0.235***
(0.0680)
0.435***
(0.101)
0.0176***
(0.00674)
-0.863***
(0.259)
0.663***
(0.0826)
-0.135**
(0.0684)
0.404**
(0.158)
-0.000738
(0.00599)
0.628***
(0.0837)
L.total US debt/GDP
L.bond yield
-0.0216
(0.0153)
L.central gov debt/GDP
L.local gov debt/GDP
Constant
Observations
Number of countries
0.364**
(0.158)
0.0159*
(0.00861)
-0.235
(3.495)
169
23
2.015
(3.518)
145
20
4.660
(3.859)
129
20
-0.255
(0.173)
0.200
(0.378)
0.0471
(4.103)
148
21
Robust standard errors in parentheses. Time fixed-effects included in all specifications. L.=lagged.
Insignificant controls not shown in the table: L.on gold, L.polity score, L.trade/GDP, L.GDP
percapita, L.foreign debt/total debt, L.%change in deficit w/r 1929, L.%change in reserve ratio,
L.banking crisis, L.GDP change over 1929.
*** p<0.01, ** p<0.05, * p<0.1
Table 1 – Arellano-Bond GMM estimation of the determinants of default size, 1927-36
Columns one to three indicate that the total public debt-to-GDP ratio is negatively
associated with default size, while the result disappears in column four where central and
local public debt are entered separately in the equation. This surprising result might be
attributed to reverse causality: more creditworthy countries were able to borrow more, leading
to a negative correlation between the debt-to-GDP ratio and default size. By controlling for
country fixed-effects, however, I rule out this possibility, at least if creditworthiness is timeinvarying (or slow moving). An alternative and more plausible explanation is that countries
with higher debt-to-GDP ratios were those whose public sector relied more on borrowing.
Countries with higher debt burdens would benefit more from default, but would also be more
adversely affected by being excluded from financial markets. Column two adds a further layer
to this interpretation: the economy-wide dependence on US-originating credit also led to a
lower incidence of default, giving further support to the idea that credit dependence
discouraged countries from damaging their access to financial markets through default.
I also find that the share of short-term debt is positively related to default. This result
fits well with economic intuition and the Great Depression context. Difficulties in rolling over
short-term debts are considered a key driver of default (Erce, 2012). Liquidity dried up on
international financial markets in 1930 after the 1924-28 surge, piling up pressure on debtor
countries, which had borrowed short-term on a large scale (Feinstein and Watson 1995).
Indeed, the first item to be tackled in the German debt crisis was the short-term debt, which
was suspended through the 1931 Standstill Agreement (James, 1986; Ritschl, 2013). South
American countries – the other big defaulters of the interwar era – also relied heavily on
short-term debt (Jorgensen and Sachs 1988).
A result that might be difficult to reconcile with economic intuition is the fact that, in
columns one and two, countries that saw a smaller deterioration in their trade compared to
1929 were more likely to default. The result, however, is not robust and disappears with the
inclusion of further controls in columns three and four. Finally, I show that, contrary to
previous findings (Eichengreen and Portes, 1986) and consistently with Eichengreen's (1992)
later argument that policy responses to the Great Depression were either misguided – in core
countries – or extremely limited – in the periphery, neither monetary nor fiscal policy played
a role in the defaults.
Robustness
The results presented above are robust to different measures of economic contraction,
trade deterioration and the inclusion of higher order polynomials of the debt-to-GDP ratio to
account for nonlinearities. In the working version of the paper, I also present the results of
cross-sectional estimations similar to those used by Eichengreen and Portes (1986), as well as
the Blundell-Bond (1995) GMM estimator and the dynamic Tobit random-effects model
suggested by Wooldridge (2005). These models rely on additional assumptions, which are not
likely to be satisfied in this application and should be taken with caution. In any case, each of
the main results of the Arellano-Bond estimation is confirmed by at least one of the two
models.
Conclusion
The new data presented not only provides a more historically accurate picture of public debt
burdens in the interwar era, but also turn out be a decisive element in explaining the defaults.
The differences between the results of this paper and those of previous work are stark.
However, as Eichengreen and Portes (1986), I show that mono-causal interpretations of the
1930s debt crisis, which assign the key role to either `bad luck` or opportunism should be
ruled-out. The interwar debt crisis was a complex event in which exogenous shocks and
discretionary choices both mattered.
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