Public Principles of Public Debt: A Defense and Restatement

James M. Buchanan.
Buchanan, James M.
(1919- )
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First Pub. Date
Indianapolis, IN: Liberty Fund, Inc.
Pub. Date
Foreword by Geoffrey Brennan.

Chapter 3The Methodology of Debt Theory


Before any meaningful analysis of the public debt can take place, it is necessary to examine the methodology within which analysis may properly be conducted. Put more directly, and more correctly, this means that we must know precisely what the problem is before we start trying to reach conclusions concerning its solution. We must be clear as to what we are talking about.


First of all, some classification is required. "Public debt" is far too generic a term to be subjected to incisive analysis without prior classification and specification. A government may borrow for many reasons; the operation may involve large or small sums; the effect can be real or monetary. Before any analysis is complete, all possible cases must be catalogued and each case considered separately if essential differences appear.


There are listed below the specific types of public debt, by characteristic, which shall be discussed. It is noted that the separate types are not mutually exclusive.

1. Public debt issued during periods of substantially full employment of economic resources for the purpose of providing government with funds with which to secure command over real resources.
2. Public debt issued during periods of less than full employment.
3. Public debt issued during periods of threatening inflation and designed only to neutralize monetary resources.
4. "Marginal" issues of public debt which are small enough relative to the whole economy and to the financial market to allow the influences of debt issue upon the interest rate, the absolute price level, and the structure of relative prices to be neglected.
5. "Supra-marginal" issues of public debt for which effects upon the structure of interest rates and prices cannot be neglected, and which must, therefore, be included as a part of the analysis.
6. Public debt issued during war periods and purchased largely by the banking system.
7. Public debt, the proceeds of which are devoted to collective investment in long-term capital projects, which are calculated to yield social income.
8. Public debt, the proceeds of which are invested in self-liquidating public projects which produce monetary revenues.
9. Public debt, the proceeds of which are used wastefully.


The above listing could be extended, but it suffices to indicate the difficulties likely to arise when all of the separate characteristics are neglected and the "public debt" discussed. The listing includes the major characteristics which must be thoroughly examined.


Once we have specified the characteristics of the debt form which we desire to examine, great care must be taken to make an analytical comparison which is methodologically appropriate and which will produce relevant results. This point is an extremely important one, and it provides a key to an understanding of much of the error which has been pervasive, not only in debt theory, but in fiscal theory generally. A brief digression on this general methodological issue seems warranted at this point.


Analysis must consist largely of comparison. The effects of a given change in a variable are discussed normally in terms such as "before and after," or "with and without." In a system embodying many relationships and many variables, it is often highly useful to allow one variable to change and to trace the effects of this change while neglecting the changes on the remaining variables of the system. This is the normal procedure in Marshallian partial-equilibrium economics. One variable is allowed to change, for example, one price, with the closely related variables frozen into the other things equal or ceteris paribus pound. In this way, the impact of the changed variable on behavior can be isolated and examined, for example, the effect of the change in the single price on the quantity demanded of the single commodity. All users of this method must recognize that many related variables are modified, indeed must be modified, by the initial change imposed on the variable of impact. But if the system is sufficiently large, the offsetting or compensating variation may be so small that these may be neglected for any one variable. This is partial-equilibrium analysis in its standard form, but care must always be taken to insure that nothing more than partial equilibrium conclusions may be obtained from it. Any attempt to extend the conclusions reached from the usage of such a model to the total system or economy is doomed to failure and can only produce fallacious results. This is true because, for the total economy, the offsetting changes which may be neglected or put in ceteris paribus are, in the aggregate, as important as is the initially imposed change on the variable of impact or action. The analysis is only one-half complete if these offsetting changes are neglected.*32


What has all of this to do with the theory of the public debt? The variable which we wish to examine is the size of the debt itself. Debt theory should enable us to obtain some rough predictions concerning the effects of issuing debt, or of changing the magnitude of the outstanding debt. But meaningful analysis, and by this we mean analysis which will produce useful predictive results, cannot proceed on the assumption that we can change the debt without anything else in the system changing at the same time. All other variables in the economic system cannot be held in ceteris paribus when debt issue is examined. The partial equilibrium approach falls down here, as it does in all of fiscal theory. It is inapplicable for two reasons.


First of all, the system of relationships with which we must work is small. If the number of relationships and the number of variables is not large, ceteris paribus as a methodological tool has no place in analysis and is likely to produce more harm than good.*33 A change cannot be imposed on a dependent variable without offsetting changes being introduced elsewhere in the system. And, what is perhaps more important, dependent and independent variables cannot be arbitrarily classified. Economic relationships of dependence and independence alone can determine the appropriate classification.


The second reason why such models fail to be applicable in fiscal theory is that we are almost always interested in general equilibrium or general welfare conclusions. We do not seek sectoral or partial results, but rather results applicable for the whole governmental unit or for the whole economy.*34


Fiscal theory must always recognize the fundamental two-sidedness of the government's fiscal account. It is not methodologically permissible to examine, for example, a change in the level of taxes without examining, at the same time, the offsetting or compensating changes on the expenditure side, provided that the quantity of money is held unchanged. Similarly, it is not permissible to examine the change in a single tax without, at the same time, analyzing the compensating change in another tax, in government expenditure, or in the money supply. The major contribution which the Italian scholars have made to fiscal theory lies in their continued emphasis on this point, as opposed to the Anglo-Saxon tradition in which the error has persisted and is, even now, vigorously defended.*35


The general issue may be restated in the following way. Analysis is meaningful only if relevant and realizable comparisons are made. It would do the engineer little good to attempt to analyze the movements of one side of the teeter-totter on the assumption that the other side remains unchanged, for the other side must change to allow for any initial movement. The two sides are dependent variables, and they cannot be treated as independent for useful analysis.*36


But let us return to debt theory in a more specific way. The relevance of the methodological issue can be made clear by the use of practical examples. Borrowing is only one means through which the government secures command over monetary resources, which, except in the case of anti-inflationary debt issue, the government uses to purchase real resources. Borrowing is, therefore, an alternative to taxation. If a given public expenditure is to be financed, this can only be accomplished in three ways: taxes, loans, and currency inflation. The analysis of the effects of debt issue must, therefore, compare what will happen under the debt with what will happen under the tax or inflation.


It is perhaps better to look at the problem in terms of the whole set of fiscal alternatives. Debt creation is an alternative to increased taxation, currency inflation, or expenditure reduction. When we analyze the effects of debt we must always conduct the analysis in differential terms; that is, we must allow one of the three possible compensating variables to be changed in an offsetting way. This is the only permissible means of actually comparing what will happen with and without the debt. If the debt is not to be issued, either taxes must be increased, currency inflation must take place, or the public expenditure cannot be financed. It is wholly improper to hold the level of taxes, the money supply, and government expenditure in ceteris paribus, either explicitly or implicitly, when debt issue is examined.*37


It will be useful to illustrate the methodological issue discussed here by means of a specific example. We may cite the work of Professor J. E. Meade, one of the "modifiers" of the currently ruling theory.

Consider two communities which are otherwise identical, but in the first of which there is no internal national debt, while in the second there is a national debt the interest on which is as great as the rest of the national income put together.
Net national income at factor cost 100 100
National debt interest Nil 100
Taxable income 100 200
Rate of taxation   0  50%
Income after tax 100 100
In Community I, individuals earn 100; the state has nothing to pay out, and there is not taxation. Individuals are left with a tax-free income of 100 on the assurance that they will lose the enjoyment of the whole of any income which they desist from earning. In Community II, individuals earn 100; they receive 100 in interest.... Their taxable incomes are, therefore, 200, of which the State takes 100 in taxation to finance the ... debt interest. Individuals are left (as in I) with a tax-free income of 100, but this time on the assurance that they will lose only 50% of any increase which they desist from earning. Naturally, in the second case they will work less hard, and will strike a balance between work and leisure which is more inclined to leisure than the facts of the economic situation really warrant."*38 (First italics only supplied, others in original.)


Professor Meade appears to have committed the methodological error against which we have warned. By his assumption that the communities are otherwise identical, he seems to have overlooked the necessary compensating change in some other variable. If the internal debt had not been undertaken, taxes must have been increased, public expenditure reduced, or currency inflation allowed to take place. In the general case some effects upon the incentives to work and to invest would be present under each of these alternatives. And, in this way, the level of real incomes over future time periods would have been modified. In any specific time period, aggregate real income could be less than, greater than, or equal to, that which is present when the debt alternative is examined. There is no a priori way to state which of these possibilities is the more likely to occur. Meade's assumption of equivalent real income is, therefore, only one possible case out of many.


Let us place ourselves, for the moment, in the position of an advocate of the extreme "new orthodoxy" in replying to the Meade argument. It could be postulated that, as an alternative to debt creation, public expenditure is reduced, and with it, the level of real income and employment. The amount of resources devoted to capital formation is reduced, and future income streams are correspondingly lowered. With the internal debt, the admitted effects on incentives to work and to invest generated by the necessity of making interest transfers may lower real incomes also. But there is no assurance that the level of real income would be higher without the internal debt than it would be with the debt.


Such a critique of the Meade argument would be quite appropriate since Meade failed to specify carefully the nature of the compensating variation assumed in his analysis. The critic would likely go on to state that, under the conditions outlined in the above paragraph, there is no real burden of public debt when properly considered in a meaningful, differential sense. In this extension of his argument the critic would, however, be committing a second, and related, methodological error which has led to much confusion in debt theory. He would be attributing to debt issue the effects of the combined debt-expenditure operation. Although it is essential for sound analysis to consider both sides of a prospective fiscal operation, the effects of changes in the primary variable (debt) must be kept quite distinct from the effects of changes in the compensating variable (in this case, public expenditure).


The two sides of the combined fiscal operation must be kept conceptually distinct. If they become too closely connected, the availability of other, and possibly preferred, alternatives to either half will tend to be overlooked. For example, if the effects of public expenditure which is debt financed are attributed to debt creation, it is likely to be forgotten that the same results could possibly have been achieved by either tax financing or currency creation.


Meade was quite justified in his attempt to eliminate this sort of confusion through his otherwise equal assumption. His fault lay in the failure to state explicitly the conditions under which his assumption would prove valid. If he had postulated, as a condition for analysis, that the alternative to debt issue is currency creation and that the period in which the choice among these two relevant alternatives is made is characterized by Keynesian-type unemployment, there would be no differential income effects other than those directly attributable to debt issue per se. The differential effects between the two relevant alternatives would, in this case, reduce to those of debt issue only. This sort of model is, however, extremely limited in its applicability. In the more general case, each side of the fiscal operation will have separable effects which must be analyzed separately. If debt issue is employed as a means of financing expenditure, fiscal analysis must attempt to isolate the effects of debt issue from those of the expenditure. Or, if debt issue is employed to substitute for taxation, the effects of tax reduction must be separated from those of debt increase. Only in a special sort of model does currency inflation possess no characteristics of taxation. Public debt issue is a means of financing public expenditure, tax reduction, or deflation. Analysis is partial and incomplete which neglects the second half of the transaction; and analysis is apt to misplace emphasis if it fails to keep the two sides conceptually distinct.


As stated earlier, many of the errors in the new orthodoxy may be traced to an oversight of these methodological principles. As a result, conclusions which are true in a broad or general sense become false when applied specifically. This will become evident in the more-extended discussion of both war debt and depression debt in later chapters, but an illustration will be useful at this point. The burden of a war must fall largely upon the generation living during the war period. This conclusion is supported by the argument of this book and by the new orthodoxy. But the conclusion is true only to the extent that taxation or inflation occurs. It is improper to attribute this burden to debt issue rather than to the inflationary spending which debt issue makes possible, for in so doing, the relevant alternative, which is direct currency creation, tends to be overlooked. Debt issue is a means of raising funds, not of spending them, and a meaningful general theory of public debt must recognize this point.

Notes for this chapter

Milton Friedman in his outstanding paper, "The Marshallian Demand Curve," Journal of Political Economy, LVII (December, 1949), 463-95, has shown how the partial equilibrium approach can be modified to escape this inherent difficulty. In his other works, notably, "The 'Welfare' Effects of an Income Tax and an Excise Tax," Journal of Political Economy, LX (February, 1952), 25-33, he has shown how a neglect of the necessary compensating changes has produced serious analytical errors.
For a further and extended discussion of this and related points, see my "Ceteris Paribus: Some Notes on Methodology," Southern Economic Journal (January, 1958).
Cf. Gustavo Del Vecchio, Introduzione alla finanza (Padua, Italy, 1954), p. 10.
For a recent controversy in which the issues are clearly drawn along these lines, see my "Capitalization of Excise Taxes: Comment," American Economic Review, XLVI (December, 1956), 974-77, and the reply by J. A. Stockfisch (977-80). For a more general discussion of the issue, see my "La metodologia della teoria dell' incidenza," Studi economici (December, 1955).
Professor Frisch has recently made essentially this same point in reference to Hotelling's tax analysis. See Econometrica, 24 (July, 1956), 311.
This point is recognized by Cesare Brasca, "Intorno agli effetti economici del debito pubblico," Rivista internazionale di scienze sociale, XXV (1954), 423.
J. E. Meade, "Mr. Lerner on 'The Economics of Control,' " Economic Journal, LV (April, 1945), 62.

End of Notes

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