Costs of Financing U.S. Federal Debt Under a Gold Standard: 1791-1933
What this paper finds — and why it matters
Overview
This paper constructs a new dataset of US federal bond prices and uses it to estimate the full term structure of yields on gold-denominated US federal debt from 1791 to 1933 — the entire gold standard era. The core research question is how the costs of financing US federal debt evolved over this period and what monetary, fiscal, and financial policy changes drove that evolution, with the ultimate aim of understanding how the US built fiscal capacity and transformed its debt from a “junk bond” into a global “safe asset.”
Data and Methodology. The authors compile monthly prices, quantities, and descriptions of all US Treasury securities from 1776 to 1960 (the Hall et al. 2018 dataset). Bonds with less than one year to maturity are excluded from the main estimation due to liquidity premia. The primary estimation uses a Dynamic Nelson-Siegel (DNS) model with stochastic volatility (Diebold and Li 2006; Hautsch and Yang 2012), estimated by Bayesian MCMC. A key methodological innovation is the addition of bond-specific idiosyncratic pricing errors (Assumption 3), which allows the authors to include bonds with heterogeneous contract features — call options, indefinite maturities, conversion features — that characterize 19th-century US debt without either dropping them from the sample or having their idiosyncrasies distort the common yield curve. The data are “big” in the time-series dimension but sparse in the maturity (cross-sectional) dimension, frequently offering fewer than five price observations per month; the DNS framework pools information across time to address this sparsity.
For the greenback period (1862–1878), the authors extend the approach by modeling the greenback yield curve as a function of the gold yield curve and a time-varying VAR model of exchange rate expectations (Assumptions 4–5). Only nine greenback-denominated bonds exist in the sample, most of them short-term; the VAR is estimated jointly using exchange rate data and the relative prices of greenback and gold bonds.
Main Findings.
Long-run decline in yields. The 10-year gold-denominated zero-coupon yield fell from approximately 8% in 1800 to approximately 2% in 1900, consistent with global secular decline trends, but the trajectory stabilized near 2% after 1900 — suggesting US debt began to play a distinctive “safe-asset” role from the turn of the 20th century.
War spikes were much larger than previously understood. The paper’s estimate of the 10-year gold yield reaches a peak of approximately 16% near the end of the Civil War. This is substantially higher than the Homer and Sylla (2004) peak of 6% at the start of the war. The discrepancy arises because Homer and Sylla used bonds trading at par — which did not exist during the Civil War — while this paper uses the full universe of bonds at monthly frequency.
Yield curve slope switched sign. The term spread (10-year minus 2-year gold yield) was typically negative before the Civil War (inverted yield curve) and turned persistently positive afterward. The authors link this switch to a change in long-run inflation predictability: inflation was relatively hard to forecast before the Civil War and easier to forecast after, consistent with a negative inflation-risk premium in the pre-war period.
Default risk premium disappeared around 1905. Comparing hypothetical gold-denominated US consols to UK consols (the 19th-century benchmark safe asset), US yields were persistently above UK yields until approximately 1905, when US yields fell below UK yields. This indicates that US federal debt acquired safe-asset characteristics well before World War I, foreshadowing the shift in global reserve asset status during and after Bretton Woods.
Nominal anchor during the Civil War. Despite a 60% depreciation of the greenback against gold during the Civil War (100 greenback dollars could be purchased for as few as 40 gold dollars in summer 1864), investors expected greenbacks to eventually return to gold parity. Estimated long-run exchange rate expectations remained anchored at one-for-one parity throughout the period. This kept greenback-denominated bond yields flat at approximately 6% — bonds traded around par — explaining the “Civil War yield puzzle” noted by Friedman and Schwartz (1963).
Short-rate disconnect. Short-maturity government bonds (less than one year) traded with a premium of approximately 0.25 to 0.5 percentage points relative to model-implied yields throughout most of the 19th century, reflecting scarcity of money-like assets. This premium effectively disappeared from the 1880s until World War I — coinciding with the National Banking Era — and then reappeared in the 1920s after the Federal Reserve created a secondary market for Certificates of Indebtedness.
Q&A
Q1: Why does the paper restrict estimation to bonds with maturity greater than one year? Short-maturity Treasury notes exhibited particularly large estimated bond-specific pricing errors in preliminary analysis, which the authors attribute to a liquidity premium: short-term government debt was used for transactions and thus commanded a money-like premium that a common discount function cannot accommodate. To keep this liquidity premium from distorting estimates of the longer end of the curve, these bonds are excluded from the main estimation. Short-maturity bonds are then studied separately as an “out-of-sample” exercise (the short-rate disconnect).
Q2: How does the Dynamic Nelson-Siegel model with stochastic volatility solve the cross-sectional sparsity problem? The DNS model parameterizes the entire yield curve at each date using only three latent factors — level (L), slope (S), and curvature (C) — which follow a driftless random walk. The stochastic volatility component, captured in the covariance matrix Σt, governs how much information is pooled across adjacent time periods. When Σt → 0, the yield curve is assumed constant (full pooling); when Σt → ∞, estimates are date-by-date (no pooling). By allowing Σt to vary, the model pools more heavily in sparse periods and less during wars when yields change rapidly. The companion paper (Payne et al. 2023a) confirms via information criteria that stochastic volatility and correlated shocks improve fit without overfitting.
Q3: What is the bond-specific pricing error and why is it essential for historical data? Assumption 3 adds to each bond i a Gaussian pricing error with mean zero and bond-specific standard deviation σ(i)_m (scaled by Macaulay duration to approximate yield-space errors). This allows bonds with idiosyncratic contract features — call options, conversion clauses, ambiguous payment currency — to inform the common yield curve without unduly distorting it. Bonds with larger σ(i)_m receive less weight in estimation. In modern datasets, researchers pre-select homogeneous bonds and use time-specific pricing errors; the historical sparsity prevents that approach here.
Q4: How large were Civil War yields compared to prior estimates, and why does the discrepancy arise? The paper’s posterior median for the 10-year gold zero-coupon yield peaks at approximately 16% near the end of the Civil War. Homer and Sylla (2004) report a peak of 6% at the start of the war. The discrepancy arises because Homer and Sylla used bonds trading close to par, but during the Civil War no federal bonds traded at gold-price par (Lincoln’s re-election was uncertain in summer 1864; 100 greenback dollars could be purchased for 40 gold dollars, implying 6% coupon bonds were priced at 40% of par, implying yields in excess of 15%). This paper uses the full universe of Treasury bonds at monthly frequency and allows all bonds — regardless of trading price — to inform the yield curve.
Q5: When did US debt cease to carry a default risk premium relative to UK debt, and how is this measured? The authors compare yields-to-maturity on gold-denominated UK consols to those on hypothetical gold-denominated US consols promising the same coupon flows. Because both countries were on a gold standard for most of the period and UK consols were the 19th-century safe asset, the spread is interpreted as a risk premium on US debt. US yields fell below UK yields persistently after approximately 1905, indicating that US debt was priced as a safe asset well before World War I. US yields were temporarily close to UK yields in the 1820s but the spread re-widened after the Jacksonian era, state defaults in the 1840s, and the Civil War. The spread closed only after Civil War disruptions resolved, the National Banking System matured, and gold-greenback parity was restored in 1879.
Q6: What is the “nominal anchor” finding during the greenback era, and what econometric method uncovers it? During 1862–1878, the federal government issued non-convertible greenback dollars alongside gold bonds. The greenback depreciated substantially (to 40 cents per gold dollar in 1864), yet greenback-paying bonds traded near par, implying greenback yields near 6%. The authors model the greenback yield curve as a product of the gold discount function and a “multiplier” z(j)_t capturing the expected future gold-to-greenback exchange rate at each horizon j (Assumption 4). The exchange rate expectations are estimated via a time-varying VAR(2) model of the gold-to-greenback and gold-to-goods exchange rates (Assumption 5), jointly constrained by the prices of greenback bonds via an interest-rate parity condition. The resulting estimates show that throughout the greenback era — even during large wartime depreciations — investors’ long-run expectations of the exchange rate remained anchored near gold parity, consistent with anticipated eventual resumption.
Q7: How did political events affect exchange rate expectations during and after the Civil War? The time-varying VAR captures shifts in exchange rate expectations associated with identifiable political events. Grant’s victory in 1869 (which resolved uncertainty about whether debts would be honored in gold) coincided with an increase in the price of greenbacks, a decrease in expected greenback appreciation, and a closing of the gap between greenback and gold 10-year yields. In the early 1870s, following the Panic of 1873 and uncertainty about resumption, investors came to expect that gold-greenback discrepancies would persist almost indefinitely, causing gold and greenback yields to converge. The Resumption Act of January 1875 then shifted 2-year and 10-year expectations back toward parity.
Q8: What is the short-rate disconnect and what does it reveal about the National Banking Era? The short-rate disconnect is the difference between observed yields-to-maturity for bonds with less than one year to maturity and the yields-to-maturity implied by the model estimated on bonds with more than one year maturity. A positive disconnect means short-maturity bonds yielded less than long-maturity bonds conditional on the model — indicating a liquidity premium on short-term debt. The authors find a persistent premium of 0.25 to 0.5 percentage points through most of the 19th century, reflecting scarcity of money-like assets when state bank notes circulated at variable discounts. The premium disappeared from approximately the 1880s to World War I, coinciding with the mature National Banking Era after greenback-gold parity was restored in January 1879. The authors interpret this as evidence that the National Banking Acts (1862–1866), which allowed National Banks to issue standardized bank notes backed by long-term US government bonds, ultimately succeeded in supplying liquid assets and equalizing the pricing of short- and long-term federal debt — but only after the currency risk from the greenback period had been resolved.
Q9: How does the composite long-term yield series (Officer-Williamson / Homer-Sylla) distort historical narratives? The composite series combines Homer and Sylla US federal yields (1798–1861), New England Municipal bond yields (1862–1899), and corporate bond yields (1900–1940). The paper shows that this composite series substantially underestimates the increase in US federal borrowing costs during Civil War deficits (peak of 6% vs. this paper’s 16%) and overstates post-Civil War borrowing costs by mixing in riskier private obligations. The authors argue that earlier findings of no strong association between 19th-century interest costs and deficits (Evans 1985, 1987) may reflect the composite series’ failure to accurately capture federal borrowing costs during large deficit episodes.
Q10: How did the yield curve slope change after the Civil War and what explains it? The term spread (10-year minus 2-year gold yield) was typically negative before the Civil War and positive after the late 1870s. Major wars caused sharp temporary decreases (inversions). The authors connect the sign switch to a change in long-run inflation dynamics documented in a companion paper (Payne et al. 2023b): long-run inflation was hard to predict before the Civil War and easier to predict after, suggesting gold bonds provided a better inflation hedge in the pre-war period (negative inflation-risk premium), which is consistent with asset pricing theory producing a downward-sloping yield curve. After the Civil War, as inflation became more predictable, the inflation-risk premium became positive and the yield curve turned upward-sloping.
Q11: What did the National Banking Acts seek to do and was the puzzle of bank note under-issuance resolved? The National Banking Acts (1862, 1863, 1865, 1866) authorized federally chartered banks to issue bank notes up to 90% of the par or market value of eligible US Treasury bonds deposited as collateral, subject to a 1% annual tax on notes outstanding (0.5% after 1900), compared to a 10% tax on state bank notes. The intended goals were to increase the supply of short-term liquid assets and to increase bank demand for long-term federal debt, thereby lowering long-term yields and eliminating the short-rate disconnect. A long-standing puzzle (Friedman-Schwartz, Cagan, Champ, Calomiris-Mason) held that yields on eligible Treasuries did not fall enough to equal the note tax rate, implying under-issuance. The paper’s analysis of the short-rate disconnect offers a resolution: if one focuses on the disconnect rather than the yield-tax spread, the National Banking Acts appear to have largely achieved their goals by the 1880s — but only after greenback-gold parity was restored, suggesting that currency devaluation risk had initially restrained bank note issuance, as hypothesized by Cagan (1965).
Key Concepts
Dynamic Nelson-Siegel (DNS) model with stochastic volatility: A parametric yield curve model (Diebold-Li 2006) parameterizing zero-coupon yields at each date as a function of three latent factors — level (L), slope (S), curvature (C) — following a driftless random walk. The paper extends this with time-varying shock volatilities (stochastic volatility) to allow the degree of information pooling across time periods to vary with institutional and wartime disruptions. Used here to handle cross-sectional sparsity in historical bond data.
Bond-specific pricing error: A Gaussian pricing error with bond-specific standard deviation σ(i)_m (scaled by Macaulay duration) added to each bond’s observed price. Allows bonds with heterogeneous and idiosyncratic contract features (call options, conversion clauses) to inform a common discount function without distorting it, by automatically down-weighting “peculiar” bonds through higher estimated σ(i)_m.
Short-rate disconnect (liquidity premium): The systematic difference between observed yields-to-maturity on bonds with less than one year to maturity and yields implied by a pricing kernel fitted on bonds with more than one year to maturity. Interpreted as a money-like convenience yield (liquidity premium) on short-term debt: when money-like assets are scarce, short-term bonds are overpriced (lower yields) relative to the term structure implied by longer maturities. Measured here as an out-of-sample fit residual from the DNS model.
Denomination risk: The risk that the unit of account in which bond payments are promised may change in value relative to gold. During the greenback era (1862–1878), bonds denominated in greenbacks carried denomination risk because greenbacks could depreciate against gold. The paper distinguishes denomination risk from default risk by estimating separate gold and greenback yield curves and modeling exchange rate expectations.
Nominal anchor: The phenomenon in which long-run market expectations of the gold-to-greenback exchange rate remained anchored near gold parity (one-for-one) even during large short-run depreciations during the Civil War. Inferred from the observation that greenback-denominated bonds traded near par (yield ~6%) while the spot greenback depreciated by up to 60% against gold, implying investors anticipated eventual full appreciation.
Default risk premium (US-UK yield spread): The difference between yields on hypothetical gold-denominated US consols and yields on UK consols. Since both were on a gold standard (so inflation expectations are similar), and UK consols were the 19th-century benchmark safe asset, the spread is interpreted as the compensation investors demanded for the risk that the US might default or alter payment terms. Persistently positive until approximately 1905, then became negative.
Convenience yield: An implicit yield that accrues to holders of money-like or safe assets because of their use in transactions or as collateral. In this paper, it emerges as the spread between yields on US federal bonds and other low-risk bonds in the late 19th century, reflecting increased demand for Treasuries as reserves under the National Banking System. Historically identified via the short-rate disconnect disappearing in the National Banking Era.