Public Principles of Public Debt: A Defense and Restatement
Debt Retirement and Economic Stabilization
Any fiscal operation which includes debt retirement will tend to exert some effect on prices, income, and employment. The one case in which the effect on these variables does not assume major importance has been discussed in Chapter 13. In all other situations, the important consideration in any policy of debt management must be economic stabilization. Since there are two ways of financing debt retirement, taxation and money creation, it follows that a fiscal operation embodying debt retirement on the one side may serve either to prevent inflation or to prevent deflation or depression. We may first consider anti-inflation measures.
Retirement of Bank-Held Debt
The preceding chapter indicated that a policy of taxation coupled with the retirement of debt held by individuals and nonbanking institutions is, on balance, probably deflationary. But the deflationary impact is not at all certain, and, if present, it is likely to be so slight that a fiscal operation of this sort is not likely to prove suitable for stabilization policy in a period of threatening inflation. When we consider the retirement of public debt held by the banking system, different conclusions follow. We shall first consider the retirement of debt held by the central bank.
Retirement of debt held by the central bank is neither inflationary nor deflationary. The central bank receives money claims for debt instruments. But when the taxation side is taken into account, the combined operation must be deflationary. The deflationary effects of the taxation are not offset by any reflationary effect of the repayment. In a period of threatened inflation, therefore, the levy of taxes to finance the retirement of central bank debt is indicated. The most appropriate means of disposing of a budgetary surplus in such periods is the repurchase of debt instruments held by the Federal Reserve Banks.
For all forms of public debt other than that held by the central bank, the retirement side, taken alone, will tend to be inflationary. As Chapter 11 indicated, debt issue, not debt retirement, is the appropriate anti-inflation measure. Debt held by the central bank does not conform to this rule because it is not pure debt at all. Its retirement does not place additional units of money in the hands of individuals and nonbanking institutions. The retirement process, per se, is completely neutral.
Debt held by the commercial banks occupies a position between that held by the central bank and by individuals. The retirement side, taken alone, will increase bank reserves. It will, therefore, be inflationary. Retirement must be financed, however, and when the taxation side is added, the combined process may be deflationary. When taxes are collected, banks must write down demand deposits. When bonds are retired, an asset item is reduced. Reserves are unchanged in the whole operation. Banks can, therefore, expand loans and deposits to the level prevailing prior to the fiscal operation. However, to the extent that the government securities which are retired possess liquidity properties over and above those possessed by other earning assets, banks will not expand deposits back to the previous level. On balance, the operation will tend to be deflationary, although not, of course, equally deflationary with the tax-financed retirement of debt held by the central bank.
Debt retirement which is financed by money creation is an appropriate antideflation measure. This may be called debt monetization. Debt instruments are replaced by money; liquidity is increased, and spending will be encouraged. In this way the interest cost may be reduced to zero, or at the least to a very nominal figure. In the current institutional setting, effective debt monetization can take place through a retirement of debt held by individuals and institutions and an accompanying sale of debt to the central bank.
Quite clearly this sort of measure represents appropriate policy only when the economy is threatened with, or is characterized by, recession or depression. It will be useful to examine the effects of this operation in some detail. Just as debt issue to ward off threatened inflation serves to impose some future burden on taxpayers, so debt monetization which prevents deflation removes a burden from the shoulders of future taxpayers. The alternatives to debt retirement in this situation are decreased taxation and increased public spending. Purchasing old government bonds, reducing current tax bills by financing old expenditures, and purchasing new public services are three ways of utilizing newly injected currency, any one of which will accomplish the same real stabilization purpose. The first alternative, monetization of debt, reduces the interest burden on future taxpayers; the other two alternatives largely benefit individuals living at the time of the fiscal operation either in their roles as current taxpayers or as current recipients of public goods and services. The choice among these alternatives must include some consideration of the comparison between present and future benefits.
An example will perhaps help in demonstrating that, even when unemployment exists, the differential beneficiaries of debt monetization are future taxpayers. Assume that an individual holds a government bond worth $100 which may be called by the government. This bond is monetized and the individual receives $100 in currency. With this currency he is able to go into the market and purchase either consumption or investment goods. His net worth is not modified by the debt retirement operation. The bond was valued at its full worth; the transaction shows up on his balance sheet as a simple transformation of assets. Let us assume that he invests the $100 in private securities providing a yield equivalent to that on the government bond which he has given up. In any subsequent income period, the former government bondholder will be in a position identical to that which he would have enjoyed had the debt monetization not taken place. But the individual living in future income periods as a taxpayer will be better off since he will no longer be forced to give up command over real goods and services in order to finance the debt service. The taxpayer is better off through the debt monetization having occurred.
There are, of course, other beneficiaries of the complete operation of which the debt monetization is only a part. The individual's purchase of the private security allows some firm to expand its purchases of investment goods, which in turn increases employment. Individuals owning resources previously unemployed are made better off by the injection of the new purchasing power. But this effect results from the injection of the new money, not from the debt retirement. Again it is necessary to separate the two sides of the process and to analyze the problem in differential terms. The benefits from the injection of new money will be present under any of the three alternatives mentioned. If the new currency (directly issued or secured by "borrowing" from the central bank) is used to finance established public services, allowing current taxes to be reduced, the owners of unemployed resources benefit equally with the situation under debt monetization. The differential beneficiaries in this case are current not future taxpayers. Similarly with the third alternative; if the new currency is used to finance new public services, the differential beneficiaries are the recipients of these services, whether living presently or in the future.
The extent to which opportunities for substantial debt monetization will present themselves depends upon both the institutional and the behavioral factors in the economy. If the economy should be characterized by the threat of stagnation, as some writers of an earlier period predicted, then opportunities for large-scale debt monetization may exist. However, on the basis of the analysis of the democratic choice process contained in Chapter 12, the hypothesis may be advanced that debt monetization will not normally be chosen over its alternatives. Thus, even in periods of continually threatened recession it seems highly unlikely that significant debt monetization will take place. This conclusion depends, of course, on the implicit assumption that choices among the various stabilization alternatives are made, in the final analysis, in such a way that they are subject to the ordinary pressures inherent in democratic government. If, on the contrary, the choice among these alternatives is not really subjected to the pull and haul of the highly individualized process which we associate with representative government, substantial debt monetization may be accomplished. For example, if a recession threatens to occur, and the Congress should refrain from its natural proclivity to reduce taxes and to expand public spending, the partially independent decision-making authority vested in the Treasury Department and the Federal Reserve Board might monetize a good share of the outstanding national debt. In this case, the analysis of Chapter 12 clearly does not hold since the three alternatives are not really presented to the voter-representative. If, however, Congress should exert its power in the fiscal policy area and act so as to reduce taxes and to increase federal spending, the debt management authorities may not be able to effect any debt monetization even during periods of economic decline. Of course if a deep and long-continued depression should develop, both fiscal policy and debt management policy would be fully appropriate. Significant debt monetization might take place if the 1930's were to be repeated. Indeed the absolute height of folly would be represented by the end of a new depression characterized by more rather than less outstanding debt, measured in some real sense.
If the institutional forces of the economy and the behavior characteristics of individuals are such that neither recession nor inflation should prove to be serious threats, gradual monetization of the national debt can take place as economic growth places new demands on the circulating medium. If the average product price level is to be prevented from falling secularly, some injection of new currency will be needed to finance the expanded flow of real goods and services. One means of injecting this new currency is through debt monetization. Both the tax reduction and the expenditure increase alternatives exist also in this case, but these do not seem so likely to be chosen in this particular setting.
Many competent students think that, at the present time, the forces of the economy are such that inflation represents the underlying tendency, and that stabilization policy over the next few decades will be directed primarily toward countering inflation rather than checking incipient deflation or merely standing neutral with nothing much to do. If this prediction holds true, the chances for substantial debt retirement financed through new currency creation are, for all practical purposes, nonexistent. Debt monetization in this setting would require heroic fiscal policy measures. If inflation is to be prevented, while at the same time debt is to be monetized, increased taxation and reduced spending must do double duty. Not only must fiscal policy, through the generation of budgetary surpluses, be sufficient to offset the natural tendencies of the economy toward inflation, but it must also offset the inflationary effects deliberately fostered by the monetization of debt.
A far more likely prospect is that some unintended debt retirement will be accomplished through inflation itself. One of the distributional gainers from inflation is the future taxpayer obligated to finance the fixed service charge on the national debt. Inflation can all but wipe out the real weight of the debt. This is accomplished, in large part, by the simple dispossession of the bondholder.
If inflation is to be avoided, recent experience indicates that reliance must be placed on monetary policy. While the effects of central bank policy to increase interest rates may be to reduce the real value of outstanding debt instruments, when refunding takes place, additional debt, in real terms, must be created unless the Treasury policy is to run counter to that of the central bank. In many respects, as suggested in Chapter 11, fiscal policy measures would be more appropriate, more efficient, and perhaps to some, more equitable. But democratic governments do not seem to impose direct taxes upon the people solely to prevent the hidden taxes of inflation. So long as the quasi-independent monetary authorities can accomplish the same purpose through monetary policy, perhaps the additional burden thereby placed on future taxpayers is not too high a price to pay for stability. An entirely acceptable solution to the problem of economic stabilization is not likely to be achieved until and unless there are incorporated into the institutional structure some clearly defined and predictable rules for policy. Inflation does not represent a proper alternative to be placed before individuals who must make decisions on economic policy, whether they be voters, representatives, or administrators. Society should not be forced to decide on the question as to how much economic stability it desires. Economic stability should be a predictable outcome of the rules of the system, rules which are constructed once and for all, and which are, in a real sense, relatively absolute absolutes.
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