Public Principles of Public Debt: A Defense and Restatement
Public Debt and Inflation
In the two preceding chapters public debt issue which serves as a means of securing the effects of money creation has been discussed. Public borrowing in depression when there exist unemployed resources and public borrowing from the banking system in war provide the two separate cases. As suggested, neither of these forms of public debt is essential to accomplish the real purpose desired; the same results could be achieved by direct issue of currency without interest cost. Hence the real burden differentially associated with debt could be avoided. Debt issue in such situations becomes a rather clumsy way of inflating the currency.
Instead of serving as a substitute for money creation, debt issue should, fundamentally, be viewed as its opposite. The sale of government securities bearing positive interest returns is necessary only if some reduction in the purchasing power of private individuals and institutions is needed and if the process of sale accomplishes this reduction. The sale should involve some sacrifice of command over resources in the private sector. This suggests that public debt issue, in its real meaning, is appropriate only in two situations. The first is the genuinely classical case in which the government desires to replace the private demands upon resources with public or collective demands. The second situation is presented when stabilization criteria indicate that some reduction in private demand is needed quite apart from the public need for additional real resources. This occurs when inflation is threatened, and it is considered to be desirable social policy to prevent its taking place. It is with this second sort of debt issue that this chapter will be concerned.
Debt issue provides one means of combatting inflation since it involves an exchange of debt instruments for money. The sale of securities effectively withdraws money from the private sector, "destroys" currency in circulation. As Henry Simons suggested:
Borrowing is an anti-inflation measure, not a proper means for financing reflationary spending. Borrowing is properly a means for curtailing purchasing power, private and governmental. To use it for injecting purchasing power is like burning the fire engines for heating purposes when there is an abundance of good fuel to be had free.*91
Debt issue in inflationary periods has as its only purpose the reduction of the liquidity in the private economy. It is not, therefore, akin to the classical model in that government does not utilize the proceeds to purchase real goods and services. Presumably, the government should neutralize the proceeds collected from the sale of securities. (In the modern context this should mean retiring that part of the national debt held by the central banks.) Only one half of the classical debt-expenditure operation takes place, the opposite half to that which takes place with war borrowing from the banking system. With anti-inflation debt issue, government does withdraw current command over resources from the private sector, but it does not use this source to finance collective purchases. The result is deflation, at least in some relative sense; deflation occurs when compared to what would happen were not the debt issued. In the war borrowing case, which is the precise opposite, the result is inflation.
Anti-inflation debt issue combined with effective neutralization of the funds does not, of course, increase the government's employment of economic resources. Therefore, in the aggregate, private people living during the period of debt creation retain disposition over the same quantity of real goods and services with or without the fiscal operation. Debt creation acts so as to modify the distribution of these currently produced real goods and services among the separate classes of the population. For those who purchase securities, the exchange represents a voluntary sacrifice of current command over real income in return for some greater command over real income in the future. This group possesses current purchasing power (money) which it could employ if inflation (in a relative sense) were allowed to occur. This purchasing power is exchanged for debt and, in this way, disappears. The interest receipts accruing to this group in periods subsequent to the initial one represent a part of an original quid pro quo transaction.
For the remaining groups in the economy, debt creation serves to improve their position. The purchasing power which they hold is not reduced in real value by so much as would be the case were debt not issued. The deflation (relative) imposed by debt creation must represent a net benefit to individuals who do not purchase the government securities. In the absence of debt creation, prospective security purchasers will utilize their power to purchase real goods and services causing prices to be higher than they would be in the alternative situation. And with prices higher, the purchasing power of the remaining groups in the economy is reduced.
The real cost of the operation rests on future taxpayers, as in all cases of pure-debt issue. If the purpose of debt creation is the prevention of inflation, that is, the maintenance of stability in the absolute price level, the cost of attaining this goal is shifted to future taxpayers. In a sense, this sort of fiscal operation can be conceived as a means through which portions of the population are "bribed" to refrain from exercising purchasing power through the promise of a larger share of future incomes. No coercion takes place in the process. As in the classical debt model previously discussed, only future taxpayers are coerced into giving up command over economic resources. Considered in the aggregate, and without regard to distributional considerations, future taxpayers will be worse off with the debt than they would be without it.
In the absence of the anti-inflationary debt creation, two alternatives are present. First, inflation could be allowed to occur, or, secondly, taxation could be levied to offset it. An example may be introduced for the first of these. Suppose that the current monetary-financial situation is such that a 10 per cent rise in prices will take place if no offsetting measures, either debt creation or taxation, are taken. Assume further that this increase will absorb the excess purchasing power which is present in the economy, and that once this price rise has occurred the economy will settle down again into some predictable stability pattern. It is possible to prevent this rise in prices by the issue of $5 billion of additional debt at a 4 per cent interest rate. The issue will create an annual interest charge of $200 million which must be borne by future taxpayers. If debt is not issued, on the other hand, the generation living during the present period of the price rise will largely bear the inconveniences and the distributional burdens associated with the inflation itself. Individuals living in later periods will be burdened only insofar as the effects are of permanent duration.
The remaining relevant alternative to debt issue for anti-inflationary purposes is current taxation sufficient to accomplish the same thing. Here the differences are clear and simple. The cost of stability is exclusively placed on current taxpayers in the one case; it is placed, at least in considerable part, on future taxpayers in the other. The choice between the tax and the public loan as a means of preventing inflation is only one aspect of the larger normative problem of "taxes versus loans." This problem will be discussed in its general setting in the following chapter.
Notes for this chapter
Henry Simons, "On Debt Policy," Journal of Political Economy, LII (December, 1944). Reprinted in Economic Policy for a Free Society (Chicago, 1948), p. 226.
End of Notes
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