How To Avoid Sovereign Default

Governments sometimes get themselves into trouble with too much debt. Early economist Adam Smith devoted the last chapter of his famous Wealth of Nations (1776) to the topic of sovereign default. “The progress of the enormous debts which at present oppress, and will in the long-run probably ruin, all the great nations of Europe, has been pretty uniform,” Smith wrote. “The practice of funding [financing deficits with debt] has gradually enfeebled every state which has adopted it.”

More recently, the economists Carmen Reinhard and Ken Rogoff compiled information about many episodes of sovereign default since the time of Adam Smith, and some from before him as well, in This Time Is Different: Eight Centuries of Financial Folly (2009). Their basic conclusion was that, taking statistical averages, governments tended to get themselves into trouble when debt/GDP exceeded 90%. This was followed by varieties of sovereign default, typically involving either a failure to make debt payments and a restructuring of debt terms, or a bout of currency depreciation to inflate away debts denominated in domestic currencies.

Using a similar, statistical approach, Ray Dalio, founder of the macro hedge fund Bridgewater Associates, recently released How Countries Go Broke: The Big Cycle (2025). This also compiles many historical examples into a sort of average tendency, culminating again in default and devaluation.

What we can conclude, from these two statistical historical studies, is that most governments do not escape their debt situations, and drift rather hopelessly into predictable outcomes. Their progress has been “pretty uniform,” as Smith termed it.

But what these kinds of statistical studies don’t indicate are the exceptions – those countries with big debt loads, of more than 90% of GDP, that don’t default, don’t devalue their currencies, bring the debts down to manageable levels, and enjoy decades of prosperity in the process. It would not surprise us if these countries, avoiding all the problems of the average governments that achieve the average terrible outcome, become world-beating champions. And indeed, these two countries had the most prosperous economies and the most influential world empires of the nineteenth and twentieth centuries.

What these two countries had in common was an identifiable strategy. They did not default on their debt or devalue their currencies. They reduced spending to a level that balanced their budgets (including debt service costs), so that the debt load would not grow further. Then, they adopted a business-friendly strategy that included lower taxes, not higher. With the debt held in check, and a business-friendly tax and regulatory environment, economies prospered. GDP grew; and as GDP grew, debt/GDP fell while tax revenues increased. As tax revenues increased, debt service costs (which remained stable) became less and less burdensome.

When the Battle of Waterloo ended the Napoleonic Wars in 1815, Britain was, arguably, among the worst-off of the European governments. The French Revolution, and later the toppling of European governments by Napoleon, at least relieved those countries from the debt burdens that Adam Smith complained about 40 years earlier. Britain’s debt/GDP, in 1815, has been estimated at 178% of GDP. 63% of total government tax revenue went to debt service.

Britain introduced its first modern Income Tax during the war, which helped raise the money to achieve military success. After the war, many argued that the Income Tax should be kept, to pay down the huge debts. But the freedom-loving British wouldn’t have it. The Income Tax was eliminated in 1816, and all the tax records were publicly burned. Britain returned to a system of indirect taxes only, mostly excise taxes and tariffs – one of the lowest tax burdens in Europe.

Britain also balanced its budget. Spending collapsed from 113 million pounds in 1814 to 59 million in 1817, right in line with tax revenue of 59 million.

The British pound floated during the war, from its prewar gold parity. Under the demands of wartime, the Bank of England was pressured to keep interest rates low, and the value of the pound sagged vs. gold. After the war’s end, many argued that this floating currency should be maintained. Some even argued that the Bank of England could just print up some money out of nowhere, and this could be used in government public works projects to “stimulate” the economy. This actually happened: In 1817, a ten million pound issue of government bonds was sold to the Bank of England. The value of the floating pound sank disgustingly, and this strategy was soon abandoned. In 1821, Britain returned to the gold standard, at its prewar parity, after 24 years of floating currency. No devaluations. No defaults.

The economy boomed, as Britain led the Industrial Revolution of the nineteenth century, becoming the wealthiest country of the time until it was surpassed by the United States around 1900. As GDP grew, debt/GDP came down. On the eve of World War I, Britain’s total debt, in nominal pounds, was about the same as 1819. They didn’t pay any of it back. However, debt/GDP had fallen to an estimated 29%.

The United States pursued a similar strategy after the Civil War. President Lincoln imposed a 10% Income Tax during the war; this was eliminated in 1872. The dollar also floated, the infamous “greenback” period. This was remedied in 1879, as the dollar’s value was again fixed to gold, at the prewar parity. No devaluations.

Again after World War II, the United States repeated this strategy. Federal debt/GDP was 119% in 1946, and the dollar, though officially worth the same $35/oz. of gold that it had been worth since 1933, in fact floated from this value in the open market. The Federal Reserve had been pressured to keep interest rates low to facilitate wartime financing, resulting in a dollar that sagged badly from its official gold parity.

Federal spending of $93 billion in 1945 collapsed to $30 million in 1948, producing an ample budget surplus that year. Budgets were nearly balanced during the 1950s and 1960s. From 1947 to 1970, the average Federal deficit was 0.22% of GDP. The biggest deficit was during the infamous “guns and butter” budget of Lyndon Johnson in 1968. It was 2.7% of GDP.

The wartime floating dollar was repaired in the 1951 Accord between the Federal Reserve and the Treasury, which ended pressure from the Treasury to manipulate interest rates lower. The dollar’s value returned to its prewar $35/oz. gold parity in 1953. No devaluations. No defaults.

With the war’s end, taxes immediately fell. The marginal rate on income up to $8000 fell from 33% in 1945 to 19.36% in 1948. The Korean War of 1950-51 returned policy to a stance of high wartime taxes, but in 1952 Republicans organized a bill to reduce all income taxes by 30% across the board. President Eisenhower blocked this effort, citing continued deficits (under 1% of GDP). Frustrated tax-cutters instead turned to punching the tax code full of exemptions, reducing the tax base where they could not reduce the rates. Hardly anyone paid the high income tax rates of the time.

Further reduction in tax rates had to wait until Democrat John F. Kennedy organized a similar 30% across-the-board reduction in income tax rates, passed in 1964. The economy boomed. In 1970, Federal debt/GDP was 35%. No hardship was involved; the 1950s and 1960s are today regarded as the most prosperous decades for the United States since 1914.

Balanced Budgets. Lower Taxes. Stable Money, in both cases fixed to gold. I called ths strategy The Magic Formula (2019). No defaults and no devaluations. This is how the most successful countries do things.