State dissolution, sovereign debt and default: Lessons from the UK and Ireland, 1920-1938

New EHES working paper

How do financial markets react to the dissolution of a sovereign state?  Do dissolutions lead to sovereign defaults? Events in Scotland, Spain and the Ukraine underscore the importance of these questions. In the absence of recent case studies, historical studies can provide insight. A new EHES working paper studies the breakup of the United Kingdom (UK) of Great Britain and Ireland in 1922.

Photo of an Irish land bond

Compiling daily historical data from the Dublin Stock Exchange, Nathan Foley-Fisher (Federal Reserve Board) and Eoin McLaughlin (Edinburgh) utilise a type of sovereign debt termed ‘Irish land bonds’. Before independence in 1922, all land bonds issued carried a UK government guarantee.  After independence, the Irish government guaranteed new land bond issuance. The authors exploit this institutional structure to analyse market participants’ perception of the strength of the UK’s guarantees.

Foley-Fisher and McLaughlin find persistent uncertainty about the value of the British government’s guarantee. This uncertainty lasted until 1932, when the Irish government refused to transfer payments on the land bonds to the British Treasury.  The default forced the British government to make good on its guarantees.  Demonstrating that the guarantees were sound removed the surrounding uncertainty. As a consequence, the yield spread on the pre-independence land bonds fell significantly.

‘Weighted average (nominal amount outstanding) current yields on UK and Irish bonds

The main lesson is that uncertainty about fiscal responsibility can persist for a long time after independence has been declared.  Even with sovereign guarantees, market participants may expect compensation for the uncertainty in the form of higher yields. This compensation may, in turn, raise the cost of borrowing, as can be seen from the above graph.

The working paper can be downloaded here:

Nathan Foley-Fisher is an Economist at the Federal Reserve Board 

Eoin McLaughlin is an Early Career Fellow at University of Edinburgh