What Happens When Governments Cannot Sell Their Debt?

QUESTION: Marty, you have mentioned that at some point in history, when Italy could not pay off its 30-day short-term paper because it could not sell the new debt to pay off the old, as they do today, they converted 30-day paper to long-term. I cannot find the details on that. Could you please explain this, as it is a risk here in Europe today?

Bret

ANSWER: Yes, that was during the Panic of 1893 that became a Global Contagion. Italy, when faced with similar circumstances to what we see today, did not officially default in the classic sense of failing to pay. Still, it executed a coercive debt restructuring that is widely considered a selective default or soft default in 1893-1894. This is what we refer to as a forced loan.

Italy was facing a run on its short-term debt and unable to roll over the maturing paper because there were no buyers, the Italian government, led by Prime Minister Francesco Crispi, did not formally declare a default. Instead, it passed a law (Legge 11 luglio 1894, n. 386) that forcibly converted the short-term Buoni del Tesoro into a new long-term bond.

The law mandated that holders of the short-term Treasury notes could not be repaid in cash upon maturity. Instead, they were forced to exchange their maturing short-term paper for a new long-term government bond, called the “Rendita Italiana 5%” (5% Italian Annuity).

This new bond had a 5% coupon but was issued at a price below par (effectively giving a higher yield to compensate, somewhat, for the forced nature of the deal). Crucially, it was a perpetual bond, meaning it had no final maturity date.

The Italian government unilaterally changed the terms of its debt. Investors lent money for 30 days, expecting to be repaid in cash at the end of that term. The government broke that promise.

Investors had no choice. They could not get their cash back; their only option was to accept the new long-term instrument. While they received a new security, it was illiquid (perpetual) and its value was uncertain. This action caused significant financial losses for many Italian banks and citizens who held the paper.

I would expect that Europe will pull this one off when it can no longer issue new debt to pay off its old debt. We are living in a perpetual Ponzi scheme. There is ONLY one way this ends, and that is a default or a forced loan.