BOOK V, CHAPTER VII
THE REDEMPTION AND CONVERSION OF DEBT
§ 1. A study of the conditions and limitations under which public borrowing is alone admissible naturally leads to the conclusion that the maintenance of a permanent debt ought to be avoided. If loans should be contracted only under great pressure, and to prevent the exhaustion of the agency of taxation, and if, while they exist, they act as a drag on the financial power of the State, it cannot be disputed that their speedy redemption must be eminently desirable. The same reasons that made taxation preferable to borrowing give support to the policy of raising taxes in order to pay off existing debt. So far as loans are derived from capital, their repayment by taxes obtained from revenue is a restoration of the wealth previously abstracted from the work of production to its earlier and more economic use. In any event the return of their wealth to the fundholders will not diminish the economic power of the community, as some productive employment will certainly be found for it, in order to escape the loss of income that the holders must otherwise suffer. The redemption of debt is thus a mode of increasing the amount of national capital, unless on the hardly possible assumption that the whole amount of taxation raised for the purpose is drawn from capital, or in the case of a foreign loan.*19
§ 2. The assertion of the general position that the redemption of public debt is desirable has necessarily to be qualified by reference to the particular circumstances of each case. As it is sometimes allowable to borrow, so must it be admitted that cases may occur in which neither borrowing nor repayment is judicious. In the crisis of war, or under extra pressure of any kind, the suspension of the mechanism of repayment is obviously prescribed, and it is quite conceivable that such a state of things may long continue. The utmost that English financiers could have done during the protracted war with France was to pay the current expenses of the State, and even this, as we know, they failed to accomplish. The postponement of debt redemption is in such cases a necessity, the non-recognition of which was one of the blots in the sinking-fund theory.
On precisely similar grounds should the amount of debt to be paid off in any given year be determined. Sudden demands may make it prudent to reduce the sums devoted to this purpose, as a preferable course to the hasty increase of taxation. A review of the last forty years of English financial history supplies a series of illustrations. Exactly the same redemption of debt could not be right in such years as 1868, 1885, and 1900, when large extra expenditure was incurred, as in years like 1873 and 1889, when considerable surpluses were realised. Rapid changes in the public burdens are if possible to be avoided; indeed one of the great services of developed public credit is the assistance that it gives in escaping this evil. But here, again, there is a further influencing condition. A plan of redemption or reduction is generally organised as a permanent system, and is intended to operate through a long series of years. Suspension of an arrangement of the kind for any slight cause has a disturbing effect that is as objectionable as a small increase of taxation. To stop the normal action of the English terminable annuities for a few millions' increase in expenditure would be a departure from a settled policy and a bad precedent for the future. The increase in outlay must be large in proportion to the total amount to justify such action.*20
Debt redemption must also be affected by the position of taxation. Where inconvenient and oppressive duties are levied it may be wiser, even with a view to ultimate repayment of loans, to relieve industry and trade from their burdens and trust to the increased productiveness of the reformed system for compensation. This was the policy of Peel in 1842 and 1845, and of Gladstone in 1853 and 1860. As proved by these great examples, a thorough reform in fiscal policy may prove the best sinking fund, or, at least, its best feeder. Between the remission of very bad taxes and their retention for the redemption of debt, there is often ground for deliberation. Still, on the whole, the reasons in favour of substantial redemption preponderate. There is no hard and fast line between good and bad taxes. Every tax is so far an evil, and any one may, if raised sufficiently high, become oppressive and unproductive. Now if we hesitate to redeem debt on account of the badness of the necessary taxes, we must remember that we are thereby rendering necessary the retention in the future of worse taxes than would otherwise be required. For let us suppose the several forms of contribution to be arranged in the order of their eligibility as follows—A, B, C, D, E, F. Then the surrender of F—the worst tax—in preference to paying off debt means the prolongation of the existence of E, which, ex hypothesi, is worse than D, since with the disappearance of the debt the taxes appropriated to its service would also disappear. The true adjustment is therefore more complicated, and requires for its scientific solution more refined calculations than are ordinarily recognised.*21
§ 3. In the preceding section it has been taken for granted that all payment of debt is made out of surplus revenue. That, in Hamilton's words, 'the excess of revenue above expenditure is the only real sinking fund by which public debts can be discharged,"*22 is a position too evident to require formal vindication. Any valuable property possessed by the State can be employed to pay off liabilities, but only at the sacrifice of the revenue obtained from it. Both of public and private credit it is indisputably true that repayment can be made in no way except by excess of receipts over expenditure. The only possible mode by which either the individual or the State can get rid of liabilities is by making income greater than outlay. Hence in all well-organised financial systems the surplus of each year is applied for this purpose, and in the continuous action of those excess receipts lies the hope of complete redemption.
So simple and obvious a fact ought to have commanded universal assent, but the phenomena of credit have always had a remarkable tendency to create misapprehensions respecting their true character, and nowhere more than in respect to public finance. The whole history of the 'sinking fund' doctrine is an illustration of this tendency. In its earlier form the sinking fund was simply the surplus of certain parts of the public revenue set apart for the discharge of debt, and it derived all its efficacy from the excess of revenue over expenditure. But very soon the fund, from being a part of the financial mechanism, was transformed. into a positive entity, and treated as if it had an independent existence. On its security fresh loans were contracted, and the absurdity of borrowing with one hand while repaying with the other, was frequently perpetrated.
The theory propounded by Dr. Price led to a new development. This writer dwelt on the great effect of compound interest. He truly calculated that a very small sum would with interest upon interest accumulate in a few centuries to an enormous amount. If such a principle were applied to the treatment of debt, it would, he argued, secure its speedy repayment. All that was needed was a definite capital to start with, which would increase automatically by reinvestment of the interest, until it would equal the whole debt. If to every new loan a sinking fund of moderate amount were attached, its redemption would be secured by the growth of the fund through interest.*23
This extraordinary theory was reduced to practice in Pitt's 'Sinking Fund' of 1786, by which a special board of commissioners was created and £1,000,000 annually assigned to them for the purchase of stock, which was not to be cancelled, but allowed to accumulate, the interest being applied to fresh purchases, until each original £1,000,000 had risen to £4,000,000. Further additions were made in 1792. The surplus of that year, amounting to £400,000, and a further annual sum of £200,000 were voted to the fund; it was also provided that all future loans should have a sinking fund of one per cent. attached to them, by which they would be paid off in, at farthest, forty-five years.*24
The pressure of war proved too much for the strict observance of this condition and various modifications were introduced, but the fundamental mistake of regarding the sinking fund as a separate and distinct source of wealth was still obstinately adhered to. From this error followed the simultaneous borrowing and redemption that were supposed to keep up public credit, but which really confused the accounts, and increased the cost of management. Purchases of stock for the sinking fund and the issue of new loans at probably lower price meant so much loss to the State. A calculation of the differences shows that the annual charge imposed by the use of the sinking fund during the period 1794-1816 was over £550,000.
So mistaken a policy could not be maintained in the face of the rational criticism, which was supplied by Hamilton and Ricardo. The true principle of regarding the surplus as the sinking fund was recognised in 1819 by the resolution of the House of Commons that a real surplus of £5,000,000 annually should be provided for the repayment of debt; but this course was not adopted owing to the bad position of the finances, and finally, after a careful inquiry, in which it was established that the method used had added £1,600,000 to the charge between 1785 and 1829, the sinking fund in 1829 was abolished as a separate institution, and the stock held for it cancelled.
The sinking fund has also been employed in the United States, where it was introduced, on Alexander Hamilton's proposal in 1790, in order to deal more effectively with the war debt. Opinions have differed as to the relation between Pitt's scheme and that of Hamilton,*25 but in any case the circumstances were widely different. Under Gallatin's administration of the Treasury the system was reformed, and his admirers claim that he anticipated the doctrine of Robert Hamilton that surplus income is the only source from which debt can be paid off.*26 The later sinking fund of 1862 has hardly operated in practice, as owing to the large surpluses more debt was redeemed than the sinking fund provisions contemplated.
From the foregoing facts it is evident that a sinking fund can be useful only in so far as it is based on a surplus of revenue over outlay, and, therefore, the belief in its efficacy rested on a fiction. Its sole advantage consisted in the pressure that it brought to bear on the finance minister to supply the requisite funds, while 'its operations are scarcely perceptible to a public, justly if sometimes ignorantly impatient of taxation.'*27 The effect was in practice to keep the surplus at a higher point than it would otherwise have reached, and to prevent the reductions of revenue, which as, subsequent experience amply proves, were certain to be demanded. But this benefit was too dearly purchased by the extra cost, and was always exposed to the risk of being swallowed up by fresh loans.
§ 4. The modern methods of redemption are all founded on the necessity of providing surplus revenue for the purpose; while at the same time they endeavour to secure the stability of the sinking fund, by ear-marking a special sum to be used in repayment. Such is the idea common to the new English Sinking Fund, by which a specified sum is annually devoted to discharge of debt, to the 'terminable annuities,' and to the 'redeemable' debt as it exists in France. Under all these systems there is a determination of part of the revenue to the purpose of repayment, which, if steadily persisted in, will extinguish the liabilities, unless the relief so obtained is used for fresh loans.
The chief difficulty in the way of debt discharge arises from the carelessness or positive dislike of the great body of the taxpayers in respect to the adoption of vigorous measures for its attainment. The simple and straightforward policy of appropriating a large surplus, maintained expressly for the purpose, to the useful function of reducing the public liabilities is not regarded by them with approval. Unless surrounded by some rather complicated financial arrangement, which disguises the true nature of the process, the surplus is apt to be frittered away in expenditure, or to disappear by reductions of taxation. The redemption of the English debt after 1829 suffered in this way, and nothing but very exceptional circumstances could have brought about the great repayments of the United States debt after 1866.
Nevertheless it is perfectly evident that the redemption of debt must sooner or later be faced. If in times of peace and low expenditure no surplus is raised, and if borrowing is freely resorted to whenever exceptional demands occur, then the proposition previously quoted from Hamilton*28 will certainly be applicable, and the debt will ultimately 'amount to a magnitude which the nation is unable to bear.' Insistence on this fundamental point is the duty of the wise financier who regards the future as well as the present, and is concerned for the continuous prosperity of his country. The extent to which taxation should be carried for this purpose, and the particular arrangements adopted, must necessarily be varied, but the general principle always holds good.
An additional advantage of debt redemption should also be noted. All repayment tends to raise the credit of the State and to improve the basis for possible future loans. A real sinking fund—i.e. one based on an actual surplus—keeps up the price of stock, though a fictitious one does not.*29 Each portion of debt withdrawn from the market reduces the amount available for investors, and though this cannot alter the permanent conditions affecting interest, it yet improves the character of the particular stock. Where the debt is below par, redemption by purchase at the market rate steadily brings it up to that point, when a new agency can be brought into operation.
§ 5. This is the process known as 'conversion,' by which a stock bearing a given rate of interest is altered or 'converted' into one at a lower rate. We have seen several examples of its use in England, France, and the United States,*30 from the first conversion of 1716 down to the recent English conversion in 1888 and the equally successful French one in 1894. The principle is very simple, and is applicable to both public and private credit. A landlord who has a mortgage on his estate on which he pays 5 per cent. will naturally, if he can borrow the amount at 4 per cent., give the mortgagee the option of taking 4 per cent. instead of 5 per cent., or of repayment of the principal. Loanable capital, like other commodities, will be sought on the cheapest terms, and conversion is only an example of the general tendency. Indeed, we may go further, and say that, where it is practicable, there is a duty imposed on the finance minister, who is the agent of the taxpayers and bound to consult their interest, to carry out a scheme of conversion on the best terms. Such a view does not, however, commend itself to the fundholders, and where they form a numerous class very strong opposition to any measure of the kind may be expected.*31
As the method of conversion can only be effectively applied when stock is over par, it requires as a condition precedent a good state of public credit. Punctual payment of interest, adequate provision for debt redemption, and prudent administration generally will all assist in this work. It need hardly be added that the higher the original rate of borrowing the greater room there is for the employment of this agency, a fact which we found to be one of the strongest arguments against the creation of a higher nominal capital than that really borrowed, but bearing low interest.*32
Certain plain general rules hold good with reference to this part of finance. First, the capital of the debt should not be increased, unless for a sufficient consideration, as it amounts to an addition to the future burden. English conversions have for the most part been free from this mistake, but the offer in 1883 of £108 of 2½ per cents. for £100 3 per cents. was a doubtful step. Some of the French conversions, notably that of 1862, were tainted by it. Next, it is desirable to make the scheme simple and free from complicated stipulations, in order that it may be readily understood. A direct reduction of interest, with, perhaps, a guarantee against further conversion for a period, is on the whole the best. The fundholders will not of their own accord accept any plan of reduction; the motive power comes from the capital available elsewhere, and therefore the plainer the offer, the better is its chance of acceptance. Thirdly, it is well to choose the time for the operation carefully. The commencement of the period of returning prosperity that usually comes some years after a commercial crisis is the most suitable. Loanable capital is then abundant, and the rate of interest is low, so that the chances of succeeding are at their highest. Fourthly, there is an advantage in using the conversion to consolidate stock of different kinds, as has been accomplished in several English cases;*33 but this consideration should not be carried too far, as it may be essential to separate stocks bearing the same interest, but issued on different terms, and in any case the operation will deal with that part of the debt that bears the highest interest.
The funds set free by conversion are of course available either for the remission of taxation or for further redemption. It seems, however, that the latter use is the preferable one. Gains from skilful management of the debt are in justice to be credited to it, and their application in this way is, unless in exceptional cases, to be recommended. The retention of the fixed debt charge at £28,000,000 would have brought the present English provisions for repayment nearer to the position they should occupy.
§ 6. Among the plans proposed for getting rid of a national debt, that of a general contribution by the holders of property has commanded most support. Ricardo declares that 'a country would act wisely by ransoming itself, at the sacrifice of any portion of its property which might be necessary to redeem its debt,' and Mill allows that this course 'would be incomparably the best, if it were practicable.'*34 The objections are, however, overwhelmingly strong. The method would place the whole burden on property-holders, as earnings could not contribute to the extent that would in fairness be required. But all property is not equally disposable, and some of it will at any given time be almost incapable of realisation. As a consequence this class of wealth would be sacrified, or its owners compelled to borrow on far more onerous terms than the State has to pay. In fact, the same arguments that prove the necessity of borrowing at times of pressure also prove the impossibility, or at all events the great inexpediency, of wiping out debt by a general contribution.
The use of capital in investments at a higher rate of interest has also been suggested as a mode of creating a surplus. Such a method really involves the action of the State as a capitalist, the danger of which appeared in connexion with the economic receipts,*35 and, in any event, it is rather a mode of increasing state income than a simple means of debt redemption. If the policy be justifiable, it is so quite apart from the existence of public liabilities, and it should be judged on its own merits.
§ 7. It has often been pointed out that, altogether independent of the agencies already noticed, there are certain normal forces in operation which tend to diminish the pressure of debt, and which will, in the future, make its redemption easier. The progress of society, so much relied on by Macaulay, adds to the national wealth, and makes a public debt, that once seemed formidable, of comparatively little importance. The progress of Great Britain in the last century would have reduced the debt charge as it stood in 1791 to a very small part of the present public revenue. Other countries show the same phenomenon, and therefore there is some apparent force in the argument that the redemption of debt should be postponed to a more seasonable opportunity. In a country like the United States the steady increase of national wealth is sure to make the debt burden much lighter as time passes on.
But though this fact undoubtedly deserves recognition, it hardly supports the inference drawn from it. The repayment of debt is not a weakening of national power, nor ought it to be a severe pressure on the existing members of the society. Its amount should be kept within the bounds set by the extent of suitable taxation which would not press heavily on any class of taxpayers. The reduction of debt is, moreover, an effective aid to public credit, and by its progress affords the means for reducing taxation. Again, as each period has its own charges to meet, the neglect of repayment will make the future burden at least equal to the increased resources. Such a policy is a dangerous discounting of the future, and the tendency to adopt it is one of the worst symptoms in modern finance. There is, it must be added, no sure ground for concluding that economic progress will continue indefinitely. Many possible causes, some of them in action at present, might bring it to a standstill. Jevons has familiarised us with the idea that England's prosperity depends on her coal supply, which must at some time be exhausted.*36 This relation of industrial expansion to the possession of certain material agents points to the necessity of taking careful account of the potential extent of these conditions of progress before allowing the accumulation of debt. We cannot foresee the precise line of economic change, but it is well to err on the side of safety, and provide for the liquidation of existing liabilities within a reasonable period.
Another supposed alleviation of the pressure of state debts has been discovered in the progressive depreciation of money or, in other words, a change in the standard of value. That the Australian and Californian gold discoveries had, among other consequences, the effect of making the real weight of public debts lighter is evident enough. All depreciation favours the debtor at the creditor's expense, but so does appreciation give the latter a like advantage. The mention of this possibility shows the weakness of the position of those who look to monetary depreciation as a source of relief. For the last twenty years the weight of debt has been increasing, and we cannot say whether in the distant future the standard of value will rise or fall, so that no satisfactory conclusion can be based on its probable movement. But even on the assumption that depreciation will ultimately take place, it does not follow that the State will gain. Is it not likely that lenders will hesitate to make advances on a depreciating security, unless they receive compensation in higher interest for the risk they run?*37 There is in addition the objection that to count on this change is really to speculate on a defect in the standard of value. Neither on grounds of fact nor of equity can we regard the relief of the state debt through depreciation as well established or desirable.
§ 8. The distinction drawn between home and foreign loans and the error of exaggerating its importance have been previously noticed. In connexion with repayment it has been said that a public loan held by foreigners is, when productively applied, an augmentation of the country's capital, and that its redemption is not desirable. Not to dwell again on the fact that the boundary between inland and foreign loans is not very easily determined, it may be remarked that the service of a loan consists in its application, not in the existence of the obligation. The advances made to the Australian colonies for railways were of service by allowing those agencies of transport to be speedily built, for which purpose the continuance of the debt is not needed. The real question at issue is rather between the use of state funds for redemption, or for fresh production, or again between raising loans to pay off debt, and leaving that wealth in the possession of the citizens. To settle this question the rate of interest and the probable effect of the other courses open must be duly considered. When gains are high the continuance of a loan at a low rate of interest may be expedient, but effective provision for repayment is the best mode of securing loans at a low rate.
Notes for this chapter
Sir R. Giffen has declared 'that it would now be the wisest thing for us to give up any attempt at the reduction of debt, so long, at least, as the mean for paying are really derived from taxes on capital.' Economic Journal, ix. 363-4.
Perhaps ten per cent. of the total amount would represent the limit within which increased expenditure should not alter the established system.
Cp. Mill, Principles, Bk. v. ch. 7, § 2, for a statement of the cruder view.
Price, Observations on Reversionary Annuities: criticised by Hamilton, 129-48.
For Pitt's Sinking Fund, Hamilton, 97-8; Ricardo, Works, 517. For criticisms of it, Hamilton, 149-60; and for a more favourable view, Rosebery, Pitt, 81-3.
See Adams, Public Debts, 265; Ross, Sinking Funds, 51-3 Dunbar, Quarterly Journal of Economics, iii. 46-54.
'There is disclosed in the administration of Mr Gallatin the true policy of debt payment ... Under the guidance of his clear insight this country departed from the pernicious methods of English financiering.' Adams, 268. Cp. Ross, 60.
Lord Rosebery, Pitt, 83.
Bk. v. ch. 5, § 4.
The very high price of English Consols in the period 1894-9 was mainly due to their purchase by the National Debt Commissioners, operating in a limited market. See Giffen, 'Consols in a Great War,' Economic Journal, ix. 353 sq.
Bk. v. chs. 3 and 4 passim.
In France, for example, conversion has not for this reason been attempted at certain favourable periods, viz. (1) under the Orleanist governments, and (2) between 1878 and 1883.
Bk. v. ch. 6, § 5.
Those of 1716, 1751, and 1888 are examples. The conversion of the French 3½ per cents. is another good instance.
Ricardo. Works, 149; Mill, Principles, Bk. v. ch. 7, § 2.
Bk. ii. ch 4, § 1.
This important question is again exciting public interest.
This statement is in accordance with Prof. Irving Fisher's theory that appreciation of money tends to lower interest. See his Appreciation and Interest; also Prof. Clarke's articles, Political Science Quarterly, x. 389 sq., xi. 249 sq., 493 sq.; and Marshall, Principles (3rd ed.), 673-4.
Book V, Chapter VIII
End of Notes
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