The Implications of Government Debt Default

I'm Andy Temte and welcome to Money Lessons! Join me every Saturday morning for bite-sized lessons that are designed to improve financial literacy around the world. Today is December 20, 2025.

Last week, we discovered how England built credible institutions after the Glorious Revolution of 1688, transforming government borrowing from personal promises into institutional commitments backed by Parliament. While the Bank of England initially borrowed at 8% in 1694, Britain's institutional credibility eventually allowed it to borrow at lower rates than its rivals—rates that dropped to 4-5% by the early 1700s while France struggled with higher borrowing costs driven by chronic default risk.

But here's the uncomfortable truth about sovereign debt: governments can always choose not to pay. Today, we're exploring what happens when those promises break—and why broken promises can haunt nations for generations.

France's Two-Thirds Bankruptcy

Picture Paris in August 1797. France has endured eight years of upheaval—revolution overthrew the monarchy, Louis XVI and Marie Antoinette were executed, the Reign of Terror claimed thousands of lives, and now the Directory struggles to maintain order. But revolutionary fervor cannot solve mathematics, and France's finances are catastrophic.

The revolutionary government inherited massive debts from the old regime—wars, royal extravagance, and the very financial crisis that sparked the revolution. Then the revolution added its own expenses: fighting European coalitions, suppressing internal rebellions, and managing economic chaos.

The Directory faced an impossible choice: honor debts and bankrupt the treasury, or break promises and destroy credibility. On September 30, 1797, they chose the latter. The government declared what became known as the Two-Thirds Bankruptcy.

Here's what this meant: if you held 300 francs worth of French government bonds, the government announced that 200 francs—two-thirds—were now worthless. Only 100 francs would be honored, and even that would be paid in new bonds of questionable value.

The market's reaction was immediate and devastating. The new bonds quickly traded at just 6% of their face value. If you held one of those remaining 100-franc bonds, you could only sell it for six francs. Bondholders lost over 90% of their investment overnight.

Thousands of French families—small merchants, professionals, widows living on bond income—were financially destroyed. France had chosen immediate fiscal relief over long-term credibility.

Spain's Serial Defaults

France wasn't the first to learn this painful lesson. Spain provides an even more dramatic example of how defaults create vicious cycles.

Remember the Fugger family from last week? Jakob Fugger led a consortium that raised 850,000 florins—with the Fuggers providing about 543,000 florins themselves—to secure Charles V's election as Holy Roman Emperor in 1519. That massive loan was part of a pattern that would haunt Spain for over a century.

Spain defaulted on its debts in 1557, 1560, 1575, 1596, 1607, 1627, and 1647—seven major defaults in ninety years. Each time, Spain renegotiated terms, promising this time would be different. Each time, Spain defaulted again.

Why did creditors keep lending? Because Spain controlled vast American silver mines, and creditors hoped each new government would finally establish fiscal discipline. But hope isn't a business plan, and Spain's serial defaults made borrowing progressively more expensive and difficult.

By the mid-1600s, Spain—despite controlling much of Europe and the Americas—could barely borrow at any price. The golden age of Spanish power ended not through military defeat, but through financial exhaustion caused by destroyed credibility.

Why Governments Default

Understanding why sovereigns break promises reveals something fundamental about government debt.

Private borrowers who default face clear consequences: creditors seize collateral, force bankruptcy, and prevent future borrowing. But you cannot foreclose on France. Sovereign default is fundamentally different from private default.

Governments typically default for several reasons:

Wars exhaust treasuries faster than tax revenue can replenish them. France's revolution and subsequent wars created expenses no realistic tax system could finance.

Political revolution breaks continuity. New governments often refuse to honor previous regimes' "illegitimate" debts, as revolutionary France did.

Fiscal mismanagement creates unsustainable debt burdens. Spain's repeated defaults showed that even vast silver wealth couldn't overcome chronic overspending.

The Consequences

Default provides immediate relief but imposes severe long-term costs.

Short-term, it solves the cash flow crisis. France reduced its debt burden by two-thirds overnight. Spain repeatedly escaped crushing interest payments.

Long-term, the costs compound. Loss of credibility makes future borrowing expensive or impossible—France struggled to borrow for decades after 1797. Economic isolation follows as creditors refuse new lending, hampering growth precisely when nations need it most. Domestic investment flees—why would French citizens reinvest after losing 90%? Capital fled to more stable nations like England. Political instability worsens as citizens who lost savings blame the government, creating pressure that can topple regimes.

Modern Echoes

These patterns haven't disappeared. Greece's 2010-2015 crisis was essentially a slow-motion default, with creditors eventually accepting that Greece couldn't repay its full debts. The consequences matched historical patterns: economic contraction, political turmoil, and years of expensive borrowing.

The lesson remains consistent: default is always an option for sovereigns, but choosing it starts a cycle that's difficult to escape.

The Credibility Trap

Here's what makes sovereign default so insidious: it destroys the credibility that's essential for successful government borrowing.

England's constitutional monarchy after 1688 created credible commitment—the government couldn't default without Parliament's consent, and Parliament represented creditors. France lacked these institutions. The revolutionary government could default by decree, so it did. Spain's absolute monarchy could default whenever immediate needs overwhelmed long-term thinking.

Once destroyed, rebuilding credibility requires decades. Spain needed a century to recover. France's creditworthiness remained damaged throughout the Napoleonic era.

The Path Forward

Next week, we'll see how private corporations learned from these sovereign debt lessons. Unlike governments, corporations face bankruptcy courts and legal consequences for breaking promises. This difference shaped how corporate bond markets developed and why they required different protections for investors.

The fundamental insight remains: all debt is a promise, and breaking promises—even when legally possible—carries costs that compound across generations.

Until next week...

Grace. Dignity. Compassion.