War Debt, Moral Hazard, and the Financing of the Confederacy

By Grossman, Herschel I.; Han, Taejoon | Journal of Money, Credit & Banking, May 1996 | Go to article overview

War Debt, Moral Hazard, and the Financing of the Confederacy


Grossman, Herschel I., Han, Taejoon, Journal of Money, Credit & Banking


The unsuccessful war for independence of the Confederate States of America from the United States of America, usually called the American Civil War, lasted for four years from April 1861 to April 1865. According to the calculations of Goldin and Lewis (1975), total Confederate war spending, measured in United States gold dollars, amounted to about $108 per capita. For comparison, Goldin and Lewis estimate annual per capita consumption in the Confederacy to have been about $86 in 1860 and to have declined to less than $43 by Until almost two years into the war, however, the Confederate government undertook no external borrowing. Moreover, the Confederacy's first external loan, the so-called Erlanger loan negotiated in Paris in March 1863, was also its last external loan, and the proceeds of this loan were only, as a generous estimate, about $1.12 per capita. (Gentry (1970) provides an extensive account of the Erlanger loan.)

Why did the Confederate government not undertake more external borrowing? We investigate two potential answers to this question. The traditional theory of public finance focuses on the role of war debt in financing the temporarily high levels of public expenditure associated with war and, thereby, in smoothing taxation and consumption. Accordingly, one potential explanation for the small amount of external borrowing by the Confederacy is that, given the resources available for self-financing of war spending and the terms at which external loans were offered, an intertemporally optimal plan for war spending and consumption called for only a small amount of external borrowing.

The other, more subtle, potential explanation for a small amount of external borrowing is that the issuing of war debt presents a moral hazard, which arises most starkly if, as in the case of the American Confederacy, lenders can expect that defeat would result in debt repudiation. The moral hazard is that the state as a borrower does not take into account the effect that its decisions about war spending have on the risk of debt repudiation that its lenders face. Given that the probability of repudiation of a state's war debt decreases as the probability that the state will avoid defeat increases, the interest rate that lenders require to compensate for the risk of repudiation also decreases as the probability of avoiding defeat increases. Accordingly, if an increase in a state's war spending would increase its probability of avoiding defeat, then an increase in its war spending also would imply a lower interest rate on its war debt.

But, if lenders simply quote an issue price at which they will purchase war debt, even if the implied interest rate correctly reflects the state's equilibrium probability of avoiding defeat, the state will not take into account the effect of the amount of war spending on the interest rate that it pays. A Pareto-superior equilibrium with more war spending, a lower interest rate, and more borrowing would be possible if, rather than the lenders simply quoting an issue price, the lenders could make the issue price conditional on the amount of war spending. The problem is that, especially if the equilibrium amount of war debt with conditionality would be large, enforcing the requisite conditionality is unlikely to be feasible.

As indicated above, the Confederacy's total external borrowing amounted to only about 1 percent of its total war spending. Gentry's account of the Erlanger loan makes it clear that at the time the Confederate government would have borrowed more in Europe if loans had been available on more favorable terms, and that the terms on which external loans were available reflected the high probability of repudiation resulting from the possible defeat of the Confederacy.(1) Gentry attributes the success of the Erlanger loan to the fact that "Confederate chances of military success appeared good in the winter of 1862-1863" (p. 157). Gentry also points out that "the news of Gettysburg and Vicksburg early in July [1863] sent [the price of the Erlanger bonds! …

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