The carrot and the stick

Finance lessons from Alberta’s political history

For nervous investors there appears to be no end in sight. The markets are tanking the rest of the financial world is in a mess and even that savvy investor Warren Buffett says he doesn’t have the faintest idea when stocks will hit bottom.

The result is what the investment people call a flight to safety. Investors are sucking up their losses pulling their money out of the equity markets and fleeing to what they view as the relative security of government bonds. They figure that because these bonds are backed by the credit of a stable government their money will be protected.

What if it turns out that the government like Iceland today is insolvent? What if it transpires that the government can’t afford to pay the interest due on these bonds much less redeem them upon maturity?

That’s exactly the situation Alberta’s hapless Social Credit government found itself in at the beginning of April 1936 just eight months after being elected as the party of economic reform. A visibly shaken Premier William Aberhart stood up in the legislature and announced that his government would be unable to redeem $3.2 million worth of provincial bonds coming due later that month. “We have no choice” said Aberhart. “The government is broke.”

Aberhart’s announcement came as a shock to voters who had placed their faith in Social Credit as the party that would lead the province out of the Depression. The party had campaigned successfully on a promise to give $25 a month to every adult Albertan. Now it was reneging on that commitment in addition to defaulting on the upcoming bond maturity.

Appealing to Ottawa for help was not an option for Aberhart. The federal government would only lend money to Alberta if the province submitted to the jurisdiction of the Canada Loans Council an agency that supervised provincial borrowing. This Aberhart flatly refused to do. “It would mean forfeiting our status as a province” he said. “We won’t be held up to ransom like that.”

With the province’s credit in the dumper Aberhart resorted to desperate measures to prevent further bond defaults. None worked. His bill to unilaterally halve the bond interest rates was struck down by the Alberta Supreme Court as unconstitutional. A scheme to have the bondholders exchange their defaulted bonds for new guaranteed government securities failed when the bondholders discovered they could earn more interest from bank savings accounts.

When Aberhart died in 1943 the province owed $34 million on defaulted bonds plus $25 million in unpaid interest. This was the mess inherited by Aberhart’s successor 34-year-old Ernest Manning who had been the premier’s right-hand man throughout Aberhart’s eight troubled years in provincial politics.

Like Barack Obama today Manning was a chief executive without executive experience. Nothing in his background prepared him for the fallout from the worst financial crisis of the 20th century. He was not an economist had never run a business and had never worked for a financial institution. But he was cool intelligent and tough and he wasn’t afraid to face down the bondholders who insisted on collecting every penny the government owed them.

The bondholders seemed to think they could hold out indefinitely after eight years of standing up to Aberhart. They quickly came to the negotiating table when Manning threatened to legislate an acceptance deadline on a renewed government offer to exchange defaulted bonds for new low-paying guaranteed securities. “It’s either lower interest rates or nothing” said Manning. “Take it or leave it.” The bondholders took the offer reluctantly and Alberta re-entered the North American investment community with its credit rating restored.

Reaching a settlement with the bondholders was the first step in Manning’s efforts to restructure Alberta’s entire provincial debt which by 1945 stood at $219 million. The next step was to conclude agreements with investment houses in Toronto and New York to underwrite a new bond issue covering the full amount of the debt. The net result was that Alberta reduced the annual cost of servicing its debt to 14.5 from 47 per cent of the provincial budget.

This aggressive act of refinancing Alberta’s provincial debt still stands as one of the great achievements of Manning’s 33-year political career. There are lessons to be learned from that achievement. Some might be applied to the current global economic meltdown. Manning as a free market fundamentalist firmly believed in letting business leaders control the economy. He also knew that when times get tough a government has to take charge and use whatever sticks or carrots it requires to find a fix.

Calgary journalist Brian Brennan is the author of The Good Steward: The Ernest C. Manning Story published this month by Fifth House.