Public Principles of Public Debt: A Defense and Restatement

David Hume was one of the first English writers to address himself specifically to the subject of public credit. His whole discussion represents an attack on what he calls the “modern” maxim that the “public is no weaker upon account of its debts; since they are mostly due among ourselves, and bring as much property as they take from another.”*63 Hume categorically rejected this line of reasoning, claiming that it was a result of “specious comparisons” and not based upon “principles.”

Adam Smith devoted forty pages of The Wealth of Nations to the public debt.*64 He dismissed the transfer-payment argument as an “apology founded altogether on the sophistry of the mercantile system.”*65 But perhaps the most important insight of Smith lies in his clear recognition that the bond purchaser undergoes no sacrifice when the debt is created:

By lending money to government, they do not even for a moment diminish their ability to carry on their trade and manufactures. On the contrary, they commonly augment it…. The merchant or monied man makes money by lending money to government, and instead of diminishing, increases his trading capital.*66

This statement is nothing more than an elemental recognition of the mutuality of advantage from voluntary exchange, but it is important because this is precisely the point which the holders of the currently orthodox views on public debts have consistently overlooked.

As we have already seen, Ricardo lent some support to the currently orthodox view that interest payments, being in the nature of internal transfers, involve no primary burden. This idea was, in fact, based upon his assumption that future tax payments would be fully capitalized in a world of rational individuals. If taxpayers living during the period of debt creation fully capitalize future tax payments, the interest payments do become mere transfers which involve no “sacrifice” on the part of future generations. Thus, public debt does not shift the real cost of government expenditure forward in time. “The argument of charging posterity with the interest of our debt, or of relieving them from a portion of such interest, is often used by otherwise well informed people, but we confess to see no weight in it.”*67

Ricardo did not, however, swing all the way to the mercantilist position and argue that public debt creation was in the social interest. Hume, Smith, and Ricardo were in agreement in predicting the consequences of public loans. Their attitudes on this point stemmed from their implicit assumptions concerning the usage to which governments would put revenues. All government expenditure was considered to be wasteful and unproductive; therefore, the real evil of public debt lay in the destruction of capital which it facilitated, not in the debt itself. Thus, we find this group of writers condemning public debt for reason of the public expenditures which it finances as opposed to the post-Keynesian writers who praise debt issue for the same reason. Both groups are equally in error; both fail to separate the two distinct aspects of the fiscal operation; the securing of the funds and the spending of them.

A “classical” theory of the public debt was not provided by the English classical economists. The views of Smith, which were perhaps closest to being the correct ones despite his predilection against debt issue, were never wholly accepted. Ricardo confused the whole argument by his highly abstract model which appeared to contain elements of the earlier mercantilist views. And the third major figure among the English classical economists was hopelessly confused. J. S. Mill, apparently much influenced by the ideas of Chalmers, tried to combine elements of contrasting views. This led him to claim that the public debt has a double burden, one which is borne by the current generation of laborers because resources which would otherwise be used to support labor are withdrawn from private employments, and one which is shifted forward to future generations because of the taxes required for the interest payments.*68

The “classical” formulation of public debt theory took shape only in the last two decades of the nineteenth century. By this time, the extreme views of the earlier writers on the wastefulness of public expenditures had been sufficiently modified to allow a judicious and careful analysis to be constructed. Also, the world economic situation was such that there arose no great popular or academic clamor for economic policies based on mercantilist ideas of an earlier epoch. It is useful to emphasize, however, that a complete intellectual victory for classical views on public debts was never really achieved. Perhaps even more than in other areas of economic policy discussion, earlier ideas continued to exist side by side with the newer ones. This dichotomy was not clarified by Ricardo’s influence since his work seemed to represent both views.

The classical formulation is best represented in the works of H. C. Adams, C. F. Bastable, and P. Leroy-Beaulieu. Their works remain today the most careful analyses of public debts in the literature. The work of H. C. Adams in the United States does not quite measure up to that of Bastable in analytical clarity while that of Bastable remains somewhat below that of Leroy-Beaulieu. By confining any detailed discussion to these three writers, a more incisive statement of the classical position may be conveyed.

Adams was quite clear in his recognition that debt creation per se involves no sacrifice on the part of lenders. “A loan calls for no immediate payment from the people…. the lenders are satisfied, since they have secured a good investment.”*69 His refutation of the argument that the burden of expenditure cannot be shifted forward in time warrants reasonably complete citation:

… there are writers of respectability … who deny the inability of a people to meet within the year all necessary expenditures, and who refuse to assent to the time-honored argument that by a loan the burden of a war may be distributed. Such writers claim that the generation engaged in the contest must bear the burden of its expenses, that this burden can in no manner be bequeathed; but that, if the war entail a debt upon the following generations, its burden is borne twice—once by the fathers who furnished the capital that was destroyed, and once by the sons who furnished the money to expunge the debt. Although this latter conception of war expenditure does not appear to me to be quite accurate, it is yet based upon the manifest truth that each generation must subsist upon the product of its own industry. No father can eat the potatoes to be hoed by an unborn son, nor can any army live on bread to be delivered, at the option of the baker, between ten and forty years from the date of the contract….

Such a statement of truisms, however, is no final argument in favor of the taxing policy, nor does it meet fairly the claim of those who say that by means of loans the burden of a conflict may in part be thrown upon posterity … they fail to understand the difference between capital expended in a war and the burden entailed upon the citizens of a country by a war. The consumption of capital may or may not give rise to the consciousness of extraordinary expenditure on the part of the state, according as it does or does not effect involuntary privation. The real burden of a war consists in the fact that men are deprived of property without the compensation of hope. In the second place—and here lies the kernel of the argument—they fail to perceive that the most important factor for the financier is not the material but the psychological factor.*70 (Italics supplied.)

The work of C. F. Bastable is somewhat more adaptable to the organization of this essay since he makes reference to each of the three basic propositions which we have classified as essential to the new orthodoxy. Bastable hardly felt it necessary to spell out the shiftability of the debt burden to future taxpayers. The distinction between the loan and the tax is clearly drawn. “A loan is voluntary, and supplied by willing givers; taxation is levied on the willing and the unwilling alike…. To make things smooth for the present at the cost of the future is not the duty of the wise and far-seeing statesman.”*71

The false analogy claims were also summarily dealt with. “In all essential points the analogy between the public and private debtor does hold good and should never be lost sight of.”*72 The transfer or right-hand-left-hand argument “rests on the same ground as certain views about expenditure and taxation already rejected. The action of indebtedness on the economic system cannot be altogether without influence or effect.”*73 “The peculiar position of the state economy and the great importance of public borrowing have both tended to obscure the fundamental truth that public credit is but one form of credit in general, and is, or ought to be, regulated by the same leading principles.”*74

The limitations on the internal-external loan distinction were clearly perceived.

The fact that a good deal of the funds obtained by public borrowing are derived from abroad is of some weight in judging loan policy. Not that a foreign loan is in its purely financial bearings so different from a home one as is sometimes supposed, but that the possibility of drawing on the capital of other countries weakens the argument in favor of taxation on the ground that in any event the expenditures must be met from the national resources.

… from a purely financial point of view the source of a loan is really immaterial. In any case it is an immediate relief to the taxpayer counter-balanced by greater charge in the future.*75

It is, however, to Paul Leroy-Beaulieu that credit must be given for the most concise and careful analysis of the nature of public debts. Many of the specific points made earlier in this essay are to be found in his treatment, which has been largely overlooked, at least by the English-language scholars. Leroy-Beaulieu begins his analysis by a careful consideration of the contrasting views of the eighteenth-century writers (Melon, Voltaire, Condorcet) and those of the English classical economists. He recognizes that both the extreme views are partially erroneous. The public loan is, in and of itself, neither a good nor an evil. The classical economists are criticized for their failure to recognize that public expenditures can be productive. But the main part of his argument is devoted to a refutation of the eighteenth-century ideas, which Leroy-Beaulieu considers to be not only false but dangerous. He classifies these ideas, which are those of the current orthodoxy, as sophisms which have the appearance of truth, and which persons not versed in economics find difficulty in refuting.*76

Leroy-Beaulieu’s work on public debt theory has not, to my knowledge, been translated into English. This provides an added reason why a somewhat lengthy citation seems appropriate at this point. The translation is my own.

The sophisms, in regard to public loans, have been presented in many forms, but there are two main ones which we have already indicated: A State which is indebted only to itself is not impoverished, says Voltaire; public debts, writes Melon, are the debts which the right hand owes to the left hand: the right hand here being the contributor, the left hand, the rentier: but it is of little importance for the prosperity of the State whether this sum of money belongs to the rentier or to the contributor: the nation is equally rich in the two cases.

The fallacy of these sophisms may be demonstrated as follows: It is very true that one of the consequences of public loans is the levying upon contributors by means of a tax a certain sum which is subsequently distributed to the rentiers as interest. If this superficial view is maintained, it could be said that the state is indifferent, that there is no reduction in the public fortune, because certain citizens, under the name of rentiers, receive that paid by other citizens, under the name of contributors or taxpayers. These latter may be pitied, but the nation will not be impoverished. But it is necessary to extend this analysis further. Let us suppose that there had been no loan. The contributors would have retained for themselves the increased tax which is now destined to pay interest to the rentiers. On the other side, the rentiers would have in their possession the capital which they loan to the state in the case of the public loan, and whether they invest this themselves or lend it to entrepreneurs or to industrialists, they would have received an interest approximately equal to that which the state agrees to pay when it creates the debt. Thus, in the case where a public loan is contracted, the rentiers only gain the interest on the capital loaned to the state at the expense of the contributors who pay the taxes. In the case where the loan is not made, the contributors retain the money which they would have had to pay in increased taxes, in order to service the loan. The rentiers, having conserved in their own hands and having invested the capital which they would have loaned to the state otherwise, are not deprived of their interest. One sees the difference in the two cases: When there is a loan, one of the parties is injured; when there is no loan, each of the two parties, the contributor and the rentier, has for his disposition the sum which, in the loan case, would only belong to one of them. To utilize again the image of Melon, when there is a loan, the right hand, that is to say, the contributor, passes his money to the left hand, that is, the rentier. When there is no loan, each of the two hands remains full; no one is dispossessed of anything, and this position is clearly to be preferred.

We have said that a loan has for its object the securing of disposition over outside capital by means of accepting an obligation to pay the interest and sometimes also to pay off the loan at a fixed date. This operation is, in itself, perfectly innocent. It will be useful or it will be harmful according to the employment of the capital which will be made by the borrower who will be assured of the possession of the capital and subsequently the sacrifices which it will be obliged to impose upon itself in order to pay the interest and to amortize the loan. If the borrowing unit employs this sum in a productive manner, in public works, for example (since this is almost the only form in which capital borrowed by the state can be preserved), if it invests in railroads, in canals, in ports, in schools, and if, in addition, investments in these enterprises are made carefully, it is probable that the society will not suffer any detriment by the fact of the public loan. It is even possible that it will prove to be a great benefit if the public works have been judiciously conceived and executed with economy. Because then the society will be deprived of a capital which the rentier will have given up, but this will be transformed into another sort, that of a railroad, a canal, or a port from which the taxpayers will profit. If, on the contrary, the capital which a state has borrowed and from which the rentier is separated, is wasted in the pleasures of the court, in ostentatious buildings, or in foolish enterprises, then it is clear that the society will be impoverished, because the capital which the rentier will have given up will have absolutely ceased to exist, or it will only be represented in unproductive works, such as palaces and jewels.

A loan will be useful or harmful to the society in general depending on whether the state preserves and usefully employs the proceeds, or wastes and destroys the capital which the rentiers have given up. In the past, the passions of sovereigns and the mistakes of governments have had for an effect the disbursing of the greater part of the proceeds of public loans for useless expenditures. This has led many to condemn public credit absolutely, as an instrument of evil. This conclusion is exaggerated. It is as much as to say that it would be desirable for a man to be without sense because he often does not use it properly.*77

All of the essential elements of the classical theory of public debt are contained in the above citation. Leroy-Beaulieu was careful to avoid the two major errors to be found in other treatments. First of all, he separated the effects of the debt creation from those of the public expenditure financed. The failure to accomplish this conceptual separation led the English classical economists to condemn debts erroneously just as it led both the late mercantilists and the neo-Keynesians to applaud debts unduly. Secondly, and this error is also fundamental to the first one, Leroy-Beaulieu’s analysis was properly conceived in terms of relevant alternatives. He did not compare the public debt with no debt, ceteris paribus. He went back to the initial period when choice among alternatives is possible, and then he compared what would happen with and without the loan.

There is, in fact, little that may be added to the discussion of Leroy-Beaulieu. In a sense, this essay represents an elaboration and an extension of his theory of public debt, although, as is perhaps usual in such cases, I did not fully appreciate or fully discover Leroy-Beaulieu’s work until after my own critique of the new orthodoxy had been substantially completed.

The central ideas contained in Leroy-Beaulieu’s approach appear to have been widely accepted up until World War I and even into the decade of the 1920’s. In his 1917 paper on war finance, O. M. W. Sprague adopts the classical position, but, somewhat similar to the Ricardo case, this is not evident except on a careful reading. And, taken out of context, some of Sprague’s statements seem to lend support to the new orthodoxy.*78

In the period between World War I and the Great Depression the most important work in public debt theory is represented in the report of the Colwyn Committee in 1927.*79 It is difficult to criticize the statements which are made in the Majority Report, because, by and large, these are carefully qualified. There is, however, a certain ambiguity present. In reading the report, one gets the impression that the committee was impressed by both of the contrasting arguments and attempted to incorporate both into its own statement.

The loss to the nation was, of course, due to the expenditure, and not to the particular method of financing it. The burden of expenditure was incurred once and for all by the nation as a whole: so far as it was met by taxation, it was immediately shared out between individual citizens; so far as it was met by internal War Loans, the tax burden on the individual was postponed, the subscriber receiving a claim to future goods and services—in exchange for his money—a claim which could only be met by future taxation on himself and his fellow citizens. The loan entailed a subsequent transfer of wealth within the community for payment of interest and repayment of capital. This transfer, which is the burden to be attributed to the internal debt itself—as distinct from the war expenditure behind it—does not destroy wealth: it merely redistributes wealth within the community.*80

Public debt theory had already begun its retrogression from the high point attained in the work of Leroy-Beaulieu. And the Minority Report accepted almost all the basic points later made by the new orthodoxy.*81

The classical formulation had never achieved a mastery of the field. Both scholars and lay publicists continued to put forward the propositions which Adams, Bastable, and Leroy-Beaulieu had effectively demolished. The onset of the Great Depression and the shift in thought which it engendered, including the doctrines of Lord Keynes, provided a golden opportunity for these discredited, but never wholly dead, propositions to be revived. New life was pumped into them, and for the first time in two centuries they became respectable.

Appendix: Public Loans Versus Extraordinary Taxes: The Italian Debate

The theory of public debt has occupied an important position in Italian fiscal theory. The contribution of the Italians is sufficiently unique, both in approach and analysis, to warrant special discussion. The theory has been developed almost wholly in terms of the basic Ricardian proposition concerning the fundamental equivalence between extraordinary taxes and public loans. This proposition has been discussed at such greater length in Italian works that it may be properly said to belong to the Italian rather than to the English tradition. Since details of doctrinal history are not important for this book, the specific argument which follows may be limited to the main contributors.*82

The Ricardian thesis, which was elaborated and extended by de Viti de Marco, has been briefly discussed in Chapter 4, but it may be reviewed again.*83

It is argued that the fully rational individual should be indifferent between paying a tax of $2,000 once-and-for-all and paying an annual tax of $100 in perpetuity, assuming an interest rate of 5 per cent. The analysis is then extended to apply to all individuals, and it is concluded that if the government borrows $2,000 and thereby commits taxpayers to finance interest payments of $100 annually, the effects are no different from the levy of an extraordinary tax of $2,000. In each case individuals living in future time periods will be in identical positions. The individual living during the time that the expenditure decision is made will fully capitalize all future tax payments, and he will write down the value of the income-earning assets which he owns by the amount of the present value of these future payments.

The limited life span of the individual does not affect the analysis. If an individual pays the once-and-for-all tax, his heirs will receive capital assets reduced in value by this amount. If, on the other hand, the debt is created, his heirs will receive capital assets yielding a higher gross income. But when the interest charge is deducted, the net income stream is equivalent to that received in the tax situation.

The analysis would, at first glance, appear to apply only to those individuals possessing patrimony or capital. Its extension to other individuals, members of professional or laboring groups, who own no income-earning assets is not initially apparent. But both Ricardo and de Viti de Marco anticipated this objection and attempted to overcome it. The individual who possesses no capital assets which he can sell to raise funds to meet his tax obligation must, through necessity, borrow privately, thereby obligating himself to meet future interest charges on a private debt. In this case, provided only that the interest rate on the public and private debts is the same, the individual owes the same interest charges in each future income period. The effect of the government’s replacing the tax with the public loan is nothing more than the replacement of a whole set of private loans with a single public loan.

The basic proposition does show that the extraordinary tax and the loan are fundamentally equivalent. It is in their attempts to extend the conclusions beyond this that both Ricardo and de Viti de Marco became confused. Both of them suggested that the analysis reveals that the public loan does not differentially place a burden on future generations, that this burden in either case rests solely with the individuals living at the time of the initial decision.

Before the question concerning the location of the burden of the debt can be examined, the meaning of “burden” must be examined. If the location of this burden on current generations is to be explained by the full capitalization of all future tax payments, the analysis is consistent with that developed in this book, and the whole issue becomes that of determining whether individuals do, in fact, capitalize future taxes. In this case even if the present generation bears the burden through a reduction in the capital value of their assets owned, it is the future interest charges which represent the weight of the debt. The discounting process merely serves to shift the burden of these interest payments backward in time. The process does not eliminate the burden of the interest item in any way. Ricardo argued, however, that the payment of interest did not involve a burden; instead he suggested that the real burden of the public debt is best represented in the initial destruction of capital occasioned by the “profuse expenditure of government.” In this way, Ricardo commits the second of the methodological errors discussed in Chapter 3; he confuses the effects of debt issue with the effects of the expenditure which it finances. The productivity or unproductivity of the public expenditure is irrelevant for determining the location of debt burden; this is represented by the interest charges. And the argument reduces to that of determining whether or not these are capitalized.

De Viti de Marco was more careful, and his analysis does not follow Ricardo (and the new orthodoxy) in suggesting that since capital is destroyed in the initial period the debt burden must rest with individuals living in that period. His argument consists in showing that the discounting does, in fact, take place. Even if it is accepted, however, that all individuals owning capital assets or receiving sufficient current income to allow them to contract private loans do fully discount future taxes, there still may be other large groups of individuals. These latter comprise the bulk of the lower income or laboring classes. It is impossible to levy extraordinary taxes upon them which will be drawn from capital formation or property. Such a tax can only be levied on the first two groups. If the public debt is created, on the other hand, some portion of the annual interest charges may be financed from taxes levied upon this third group. The lower income classes in future time periods may bear a portion of the burden of the public loan whereas they must, by definition, escape fully the burden of the extraordinary tax. This is the objection which Griziotti raised to the de Viti elaboration of the Ricardian thesis.*84

De Viti de Marco attempted to refute this objection, but he was not really successful. He tried to show that even the complete exemption of all nonpropertied individuals from the extraordinary tax would not affect his conclusions. Here he introduced a long-run competitive model. He reasoned that such an exemption would tend to increase the relative attractiveness of the professional nonpropertied occupations. This would, in turn, cause more people to enter these occupations, and to turn away from those activities such as the management and the administration of property. In the long run, the lot of the nonpropertied classes would tend to be identical with that which they would have enjoyed had they been taxed. As Griziotti suggested, this stretching of the competitive model to the equalization of returns among the separate productive factors is going a bit too far. Griziotti’s objection cannot be dismissed as introducing a mere distributional consideration which is not a part of the more abstract model. To be sure, the objection holds only insofar as the actual distribution of the burden of the extraordinary tax differs from that of the debt. But Griziotti’s whole point is that the two financing forms themselves must involve different distributions of the burden among income classes, and because of this, among separate time periods.

Griziotti also questioned the basic assumption that individuals, even those owning capital assets, discount future tax payments. Individuals do not act as if they live forever, and family lines are not treated as being continuous. There is nothing sacred about maintaining capital intact, and individuals will not necessarily do so. The equivalence hypothesis requires continued abstinence from consuming capital on the part of those holding assets after public debt is created. Whereas the extraordinary tax effectively removes from an individual’s possibilities the capital sum (once he has paid the tax, he can no longer convert this portion of his capital into income), the disposition over this capital remains in his power in the public loan case. He may convert this capital into income at any time, without in any way removing the tax obligation on his heirs which is necessitated by the debt service.

Griziotti’s claim that the creation of public debts does involve a shifting of the financial burden forward in time was not successful in overcoming the dominance of the de Viti de Marco elaboration of the Ricardian thesis in Italy. The prestige and apparent logical clarity of the de Vitian argument were successful in reducing the Griziotti influence. There have been isolated supporters of Griziotti,*85 but the de Viti formulation continues to dominate the Italian scene. The argument of Griziotti is, of course, closer to that developed in this essay than is the opposing one.

Additional elements of the de Viti de Marco conception of public debt may be mentioned since he anticipated much of the new orthodoxy. To anticipate erroneous ideas is, of course, no great contribution, but de Viti’s arguments concerning the problem of debt repayment are surprisingly modern in this respect. Included in his discussion of the public debt is what he called the theory of automatic amortization. De Viti used this to demonstrate that debt should never be repaid. His construction is worth discussing here because it illustrates yet another failure to consider relevant alternatives. De Viti started from his interpretation of the Ricardian argument that public debt merely serves as a substitute for private debts. He assumes a community of three individuals, only one of whom is a capitalist.*86 Now assume that the state requires a sum of 1,200,000 and levies an extraordinary tax, 400,000 on each individual. Individual 1 being the capitalist, individuals 2 and 3 will find it necessary to borrow from him in order to meet their tax obligations, paying an assumed interest rate of 5 per cent. As these individuals save in future periods, they may amortize their debt to the capitalist.

Now assume that the government, instead of levying the tax, borrows the 1,200,000 directly from Individual 1. The annual interest charge will be 60,000, and it is assumed to collect 20,000 from each of the three citizens. As in the first case, as individuals 2 and 3 save, they may utilize this savings to purchase the government securities, which are assumed to be marketable, from Individual 1. Their purchase of government securities in this case is identical in effect to their paying off private debts in the other case. Therefore, as the government securities are widely circulated among the population the real debt is more or less automatically amortized. Individuals, in purchasing debt instruments, acquire an asset to offset their tax liabilities. The weight of the debt is effectively destroyed; hence debt need never be repaid and there need be no fear that a country cannot bear the burden of public debts, however heavy these might appear to be.

This construction is both ingenious and misleading. Let us consider the private borrowing case carefully. Individuals 2 and 3, as they accumulate savings, increase their net worth, and they must also increase some item on the asset side, let us say, cash. When they accumulate sufficient cash to warrant paying off a portion of the private debt, the transaction is represented on their balance sheets as a drawing down of the cash item and a corresponding drawing down of their liability item. Net worth does not change with debt repayment.*87

The construction is identical with the public loan. As individuals accumulate savings these must take some form, such as cash or savings accounts. Net worth is increased along with whatever asset item the individual chooses to put his savings into. At one point we assume that the individual accumulates sufficient funds to purchase a debt instrument. In so doing, he reduces his cash item and increases another asset item, government securities. He has, in this particular transaction, merely transformed one asset into another. His net worth is not modified. Therefore, the weight of having to pay the annual tax upon the debt instrument is precisely as heavy after as before his acquisition of the security.

De Viti de Marco is correct, in the extremes of his model, in saying that this transaction is equivalent to the repayment of private loans. In this sense the public debt may be said to be amortized. But his error lies in inferring from this that public debt should not be repaid in fact. This error is the same that we have discussed in Chapter 5. It is based upon a misunderstanding of private loans. Implicit in the de Viti formulation is the idea that the repayment of private loans is necessarily beneficial to the individual. De Viti assumed that such repayment increases private net worth, and thereby reduces the weight or “pressure” of the loan. He failed to see that the new savings which go into private debt repayment have alternative employments. Whether or not private debt repayment reduces “pressure” on the individual economy depends solely upon the relative rates of return.

The same is true for public debt. Having demonstrated that the transfer of public debt instruments might be similar in some models to private debt repayment, de Viti inferred that this “amortization” reduces the pressure or weight of the public debt. This is not necessarily true at all. The weight of debt remains as it was before, and the purchase of government securities can modify this only insofar as the relative rates of yield on government securities and other assets place the individual in a more preferred position.

This demonstration that the de Viti argument does not show that public debt should not be repaid cannot be applied in reverse. By saying that de Viti de Marco was wrong in making this extension is not to say that public debt should be repaid. The argument of this essay will be turned to this problem in Chapter 13.