Public Principles of Public Debt: A Defense and Restatement
The New Orthodoxy
The currently dominant theory of public debt is called here the "new orthodoxy." I have adopted this term because of the virtual unanimity which is to be found among scholars. The word "new" modifies "orthodoxy," and it should not be taken to suggest that the ideas themselves are "new" or modern. Long before the "new economics" came into existence, articulate statements of the currently ruling theory of public debt are to be found. And, even today, there is far from a one-to-one correspondence between the proponents of the "new economics" and those who accept the new orthodoxy of debt theory. This may be quite simply illustrated by stating that Professor Pigou himself belongs to the latter group.
The new orthodoxy of the public debt is based upon three basic propositions. These are:
1. The creation of public debt does not involve any transfer of the primary real burden to future generations.
These three propositions are clearly not independent of one another, but this means of classification does provide a useful model for exposition and initial discussion. Each of the three propositions will be discussed in turn; the additional supplementary and qualifying propositions which may legitimately be attributed to the new orthodoxy will be introduced at appropriate points.
This whole chapter might take the form of selected citation from any one or several of the many modern works on public finance or, more particularly, on the public debt. There is some advantage, however, in avoiding the tedium of excessive direct citation at the outset. But in order to convince the still skeptical reader that my purpose is not that of smashing straw men, I shall include one section containing specific references which should prove both necessary and sufficient.
It is especially difficult to present an argument objectively without appearing to support it. In the discussion which follows I shall assume the position of an advocate of the new orthodoxy and present the argument as I think he would. This procedure will provide for efficiency and clarity, and it will eliminate continual repetition of qualifying phrases such as "the ruling theory holds," "the new orthodoxy alleges," and so forth. This initial warning should be sufficient to prevent any direct citation out of proper context.
"We Cannot Mortgage the Future"
The process of government borrowing transfers current purchasing power from the hands of individuals or institutions to the government. The utilization of this purchasing power by the government employs resources in the same general time period as that in which the borrowing operation takes place. Insofar as these resources are drawn from private employments, the full opportunity cost, that is, the real cost, of the public expenditure is held to be borne by those individuals living in the initial or "current" time period. The real sacrifice of private goods and services, that is, real income, allegedly occurs during this initial period, and this sacrifice stems, not from the debt per se, but rather from the decision of the government to undertake the public expenditure in question. In this particular respect, the financing of a public expenditure by borrowing is little different from financing it by taxation. In either case, the "real" burden is borne currently. Any shifting of the primary real burden of public expenditure over time by changing the method of financing is impossible.
The loan method of financing, as opposed to the tax method, does, of course, involve different effects on individuals living in time periods following that of the debt creation. Debt issue leaves "future" generations with a heritage of both claims and obligations. But these claims and obligations can represent no aggregate real burden because they cancel each other, at least for the internally held public debt. Individuals living in "future" generations are obligated to pay sufficient taxes to service the debt, that is, to meet the interest and amortization charges, but these revenues collected in taxes are returned to this same generation in the form of interest payments on debt instruments held by individuals within the same economy. Therefore, the debt places on individuals of "future" generations nothing more than some obligation to make some transfers among themselves. There can be no real sacrifice of resources involved in this transfer. This transfer is not at all comparable with the sacrifice of resources which was borne during the period when the debt was originally created and the public expenditure carried out.
The public debt is, of course, not burdenless. Early advocates of the modern view admittedly overlooked the possibility that the process of making the required interest transfers involves a net burden. However, this brush of excessive enthusiasm was quickly discounted by more sober heads, and general recognition is now given to the fact that the heritage of public debt does create serious problems of transfer. These transfer burdens are essentially of a "frictional" or "stresses and strains" variety. This secondary transfer burden, as distinct from the primary real burden, depends on numerous variables. Significant among these is the distribution of the debt instruments. If the taxpayers are roughly identical to the bondholders, there is no serious transfer burden, but if these two groups are widely different in make-up, real costs are imposed on the "net" taxpayers, and real benefits on the "net" interest receivers. The full recognition of the existence of such a transfer burden does not, however, invalidate the first fundamental principle of the new orthodoxy: The primary real burden cannot be shifted to future generations. The secondary transfer burden is akin to the frictional or incentive burden of collecting taxes currently, if this method were to be chosen in lieu of the public loan. These are second-order real costs or burdens, over and above that represented by the direct or primary sacrifice of resources actually withdrawn from private usage and subsequently employed by government. This primary burden must always rest with the individuals living in the time period during which the government utilizes the resources.
The recognition of this homely fact should presumably remove substantially the suspicion that governments, if allowed too much access to the loan method of financing, might overspend on frivolous public projects. Only those misguided laymen and politicians can now entertain such suspicions, for the analysis clearly reveals that governments do not, in effect, postpone paying the real costs of expenditure when it is directly undertaken. The loan is fundamentally a form of a tax, in many cases the ideal form.
"The False Analogy"
The key to an understanding of the perseverance of the vulgar fallacies is provided in the proclivity of individuals to extend family and institutional standards of accounting to government. Public finance is considered analogous to private finance. This analogy is fundamentally fallacious, especially when problems of internal public debt are considered. Therefore, a central feature of the new orthodoxy is its demonstration of the conceptual distinctions which must be made between the two accounting standards.
To the individual or the private institution, the interest charges which are necessary to service a private debt clearly represent a real burden. Either consumption spending or savings must be reduced, and purchasing power transferred to the holder of the debt claim. The private debt is in this way analogous to the external public debt. But if the public debt is internal, the holders of the claims are from the same group of individuals as the taxpayers. No net real income is transferred outside the budget of the collective entity.
The individual, in creating a debt, is deliberately placing an obligation on his expected real income over future time periods. He is effectively transferring or shifting the burden of payment for whatever expenditure he undertakes to future time periods. He is changing the time shape of his income flow. This being acknowledged, he should exercise caution and restraint in making expenditures which can only be financed by borrowing. It is entirely possible that excessive borrowing can place such a weight on future income that the individual may be threatened with bankruptcy.
Almost none of these conclusions hold with equal force, however, when the internal public debt is considered. Since all resources employed in making the expenditure must come from within the economy initially and must be used up in the initial time period, there can be no shifting of the primary real burden forward in time. The time shape of the community's income stream is not modified substantially. Therefore, the ordinary prudence suggested for the private individual is not fully applicable as advice to the national government, although subordinate governmental units are acknowledged to be similar here in all relevant respects to the private individual. The frictional or transfer burden placed on future incomes of the community through the necessity of making interest transfers is a real one, but it is surely minor relative to the primary burden which is fully shifted forward in the individual debt. There is little or no danger that the government could go bankrupt regardless of the size of its internal debt.
All of this suggests that "living beyond its income" is not an overriding consideration for the national government. The excess of expenditure over revenues is nothing to cause especial concern, and this condition may be necessary and beneficial during certain phases of the business cycle. The rule of budget balance which properly dictates the behavior of the private family may represent an especially dangerous myth when it is applied to national governments. Deficit financing and, by implication, debt creation, may be a permanent and necessary feature of the modern public economy.
The size of the public debt is of relatively little concern for the public economy because the debt carries with it claims as well as obligations. To individuals who own the bonds, public debt is an asset. And since these individual bondholders live in the community along with the taxpayers, the value of the asset just matches the value of the liability represented by the debt at any chosen point in time. For the private individual, his debt is entered as a liability only. The asset side of the debt is held by a "foreigner" insofar as the individual's private budgetary calculus is concerned.
Internal and External Debt
The discussion of the two preceding sections is applicable only to the internal public debt, or so says the new orthodoxy. The impossibility of transferring or shifting the primary real burden forward in time as well as the fallacy in the analogy with private debt stems from the interdependence of the social economy. The public economy, the government, has within its accounting limits both the debtors and the creditors. The debt in such circumstances is a mere financial transaction. No outside resources are imported and employed when debt is created; no net reduction in income flow takes place (aside from the frictional effects of transfer) when interest is paid or the debt is amortized.
If the debt is externally held, however, the analysis must be sharply modified. For external or foreign debt the "classical" or vulgar ideas are almost fully applicable. The primary real burden can effectively be shifted forward in time since there need be no net domestic sacrifice of resources during the period of debt creation. The payment of interest does represent a real burden here because the domestic income stream is reduced by the necessity of transferring resources abroad. Future generations will find their incomes reduced by such transfers. And finally when debt is to be repaid, domestic resources must be transferred to foreigners; this real burden of repayment is also borne by future generations. The analogy with private debt fully holds. External public debt may be a signal of fiscal irresponsibility, something which must be avoided when possible. The rule of budget balance should be replaced by one which reads: Taxes plus internal debt should equal public expenditures.
Line and Verse
I believe that the preceding argument accurately and honestly represents the "new orthodoxy." I can only rely for this on some sort of subjective test which indicates that the argument presents the fundamentals of public debt theory in substantially the way I should have written a textbook chapter on it a few years ago. For purposes of completeness, however, some reference to the literature is indicated, although economists at all familiar with the subject matter field are encouraged to proceed immediately to the next chapter.
Professor Abba P. Lerner occupies a unique, and noteworthy, position in the tradition of the new orthodoxy. In his work, the tradition reaches its extreme logical conclusion, and his contribution in pushing the argument to this point merits high praise. It is sometimes more valuable to complete with full rigor an argument which is at base fallacious than it is to accept the argument generally but to qualify analysis with "yes, but." And there are many "yes, but" statements in the public debt literature of the last quarter century.
Lerner's work on the public debt is best represented in his paper "The Burden of the National Debt," an essay contributed in honor of Alvin H. Hansen.*7 This essay may be characterized as the "standard" model for the new orthodoxy. The following excerpts will suffice:
By far the most common concern about the national debt comes from considering it as exactly the same kind of thing as a private debt which one individual owes to others.... (p. 255)
The simple transferability of this rule to national debt is denied by nearly all economists.... (p. 255)
One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt.... But this does not hold for national debt which is owed by the nation to citizens of the same nation. There is no external creditor. "We owe it to ourselves." (p. 256)
A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else. (p. 256)
Similar statements are to be found in almost any standard modern work on public finance or fiscal policy. "The parallelism of private and public finance is false"; "the analogy just does not hold," says Professor Harris, whom we have previously cited.*8 Professor Hansen says: "A public debt, internally held, is not like a private debt. It has none of the essential earmarks of a private debt."*9 In Professor Harold Groves' widely used textbook we find:
It is easy to demonstrate that, as far as the physical or "objective" burden is concerned, all (or nearly all) must come from the generation that fights the war.... To put the argument another way, when a nation borrows from itself or within the family, it may have to tax future generations to pay principal and interest on the debt, but the future generations in turn receive this interest and principal and may, if they like, enlarge their consumption with it.*10
We find Pigou stating:
It is sometimes thought that whether and how far an enterprise ought to be financed out of loans depends on whether and how far future generations will benefit from it. This conception rests on the idea that the cost of anything paid for out of loans falls on future generations.... Though twenty-five years ago this idea could claim some respectable support, it is now everywhere acknowledged to be fallacious.*11
The list of such statements could be extended almost indefinitely, but perhaps one additional citation from what is one of the best current textbooks will be sufficient. Brownlee and Allen, while recognizing the similarities between government and private borrowing, conclude:
Internally held debts, however, need not impose such burdens on the nation as a whole. There may be losses in that more productive uses for the resources could have been found, ... but interest payments are made to economic units within the country. The problems associated with internally held debts are frequently problems associated with taxation for any purpose.*12
The Burden of Transfer
The rediscovery of the transfer payment approach to the public debt and its affinity to the fiscal policy held to be desirable caused its early modern advocates to be somewhat extravagant in their claims. In the years between the appearance of the General Theory and World War II, many writers held the public debt to be completely burdenless.*13 This natural overenthusiasm generated a reaction which might have been expected. In the works of Wright, Ratchford, and Meade a more balanced version of the new orthodoxy was achieved.*14 The contribution which these works made lay in their emphasis upon the existence of a real burden of making the internal transfer of resources required in the servicing or the amortization of the domestic public debt. These writers did not dispute the orthodox view that the primary real burden rests on the generation living at the time of debt creation; their emphasis was almost wholly placed on the secondary burden of making the necessary transfers of real income among individuals within "future" generations. These writers were essentially modifiers of the new orthodoxy, not critics. The approach is best summarized in the statement by Wright:
The layman is likely to consider merely what he would do, if he were confronted by an ever-increasing debt—and is inclined to transfer this picture without modification to the case of national debt. Such a mode of thought is clearly inadequate, but it is equally unwarranted to go to the opposite extreme and deny that an internally held debt can ever be a burden....
We may therefore conclude that the statement that an internally held public debt imposes no economic burden on society is not entirely true. The burden has been enormously exaggerated, but it would be foolish to deny that it does exist.*15 (Italics supplied.)
In still another place, Wright says: "I have tried, in several places, to show the existence of some burden."*16 The emphasis is clear; the more extreme versions of the new orthodoxy are not entirely correct, and the old view enormously exaggerated the burden. All that was presumed to be required was a slight repair job which will allow adequate recognition to be given to the frictional and incentive-induced burdens involved in making the required internal transfers. Quite clearly the taxation which must be levied to service a large internal debt will exert some effect on incentives to work and to invest in new capital formation. Insofar as these effects are negative, that is, act to reduce real incomes, the transfer payment imposes some burden. But this suggests that proper and careful taxing policy might do much to remove this secondary burden. As Wright suggests: "Careful tax policy could reduce it almost to the vanishing point."*17
Ratchford explicitly denies that modification in the tax structure could eliminate the secondary burden, and he is somewhat more insistent than Wright on the necessary existence of some real burden of transfer. While Ratchford centers his attention on the retardation of investment, Meade emphasizes the effects of the transfer upon the incentives to work, and he concludes that individuals must work less with a large internal debt than they would without such a debt.
The essential contributions of these economists to debt theory was considered to be corrective, not adverse, to the main stream of the new orthodoxy. The three bulwarks summarized in the form of the three propositions at the beginning of this chapter were not breached. The influence of these writers in toning down the new orthodoxy has been important, and some recognition of "frictions," "stresses and strains," is to be found in most of the more recent discussions of the subject. But nothing has yet been done toward attacking the central core of the new orthodoxy itself.
New Orthodoxy—Old Ideas
As stated at the beginning of this chapter, it is necessary to emphasize that it is the orthodoxy which is new rather than the ideas which are contained. In this, as in many other respects, the "new" economics has suffered from a failure of its advocates to conduct a careful examination of the existing literature. This seems to have been especially true of the American contributors to the discussion.*18 It may be suggested that if some of the more enthusiastic modern propounders of the newly rediscovered doctrine should have realized that the same arguments have been floating around since the early years of the eighteenth century, they might have been encouraged to examine the doctrine somewhat more carefully. The "classical" scholars in public finance were not ignorant of the "transfer" or "false analogy" approach. They knew it, studied it, and, after careful consideration, rejected it.
A conception of public debts strikingly similar to those which are currently orthodox was widely prevalent in the eighteenth century and before, and this was considered an essential part of the whole mercantilist doctrine. Public debts augment the riches of the country, according to the Dutch writer Pinto. And Berkeley called public debts a mine of gold.*19
One of the first explicit statements of the false analogy argument appears to have been that of J. F. Melon, whose work appeared in 1734. He said: "Les dettes d'un Etat sont des dettes de la main droite à la main gauche, dont le corps ne se trouvera point affaibli."*20 Voltaire stated that the government could not impoverish itself by debt issue. Condorcet argued that public debts were bad only insofar as interest was paid to foreigners.*21 An anonymous writer of An Essay on Public Credit (1748) said: "... if 60 millions of our debt be the property of the people of Great Britain we are not the richer nor the poorer for that part of the debt."*22 Sir James Stuart clearly accepted the falsity of the analogy between public and private debt.*23 These views were so widely held that Leroy-Beaulieu could say with authority: "Such were the current ideas in the 18th century."*24
The central features of the doctrine seem to appear in that least likely of all places, Ricardo. He states clearly and precisely that the full primary burden is placed on the current generation and is caused by the government's usage of resources. The interest payments are mere transfers.
When, for the expenses of a year's war, twenty millions are raised by means of a loan, it is the twenty millions which are withdrawn from the productive capital of the nation. The million per annum which is raised by taxes to pay the interest of this loan is merely transferred from those who pay it to those who receive it.... The real expense is the twenty millions, and not the interest which must be paid for it.*25
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 we can see no weight in it.*26
As we shall show later, the ideas of Ricardo were based upon a highly simplified model which is not fully reflected in these citations taken out of context.
German writers more or less accepted the "productivity" conception of public debt from the outset. Dietzel emphasized the wisdom of public loans,*27 and Wagner stated that the future burden argument was based on a misunderstanding of the simple process of debt creation.*28
The currently orthodox argument was fully and explicitly recognized by most writers of the late nineteenth and early twentieth century, some of whom accepted it, while others rejected it. In 1896, Knut Wicksell could say, with full approval, that the impossibility of transferring the primary real burden has been often noted.*29 In the great Italian debate over the Ricardian proposition that loans and taxes exert identical effects on the economy, the essential elements of the currently orthodox argument were incorporated.*30 The Colwyn Committee, in its careful and thoughtful analysis, recognized each of the points made in the modern treatment, but tried to frame these with the necessary qualifications.*31
The above references are perhaps sufficient to indicate that the ideas central to the new orthodoxy are indeed old ones. They have been fully recognized in nearly all pre-Keynesian fiscal theory discussion, as will be further indicated when we review the pre-Keynesian public debt theories in Chapter 8. How then can the burst of enthusiasm for these old ideas be explained? In retrospect, such an explanation seems difficult to construct. But the 1930's were perilous times, and the Great Depression left deep scars. The revolution in economic thought stirred men's souls; the banner of full employment was to be advanced at all costs and against whatever odds. This became the vital center of attention. Little time was available for careful examination of the intellectual stumbling blocks which the old-fashioned ideas on public debt seemed to represent. Out these ideas went, and the "new" ideas were left only to be picked up and carried forward, not by scholars of public debt theory, but by fiscal policy advocates.
Notes for this chapter
Abba P. Lerner, "The Burden of the National Debt," in Lloyd A. Metzler et al., Income, Employment and Public Policy (New York, 1948), pp. 255-75. Cited by permission, W. W. Norton and Company.
Seymour E. Harris, The National Debt and the New Economics (New York, 1947), pp. 25, 55.
Alvin H. Hansen, Fiscal Policy and Business Cycles (New York, 1941), p. 185.
Harold M. Groves, Financing Government (New York, 1954), p. 560. Cited by permission, Henry Holt and Company.
A. C. Pigou, A Study in Public Finance (3d ed.; London, 1949), p. 38. Citations by permission, Macmillan and Co., Ltd.
O. H. Brownlee and E. D. Allen, Economics of Public Finance (2d ed.; New York, 1953), p. 127. Cited by permission, Prentice-Hall, Inc.
Perhaps the best example is Jorgen Pedersen, whose paper in Weltwirtschaftliches Archiv (May, 1937) is cited by Hansen, who is in almost complete agreement with Pedersen. See Hansen, op. cit., p. 142.
David McCord Wright, "The Economic Limit and Economic Burden of an Internally Held National Debt," Quarterly Journal of Economics, LV (November, 1940), 116-29; "Moulton's 'The New Philosophy of the Public Debt,' " American Economic Review, XXXIII (September, 1943), 573-90; B. U. Ratchford, "The Burden of a Domestic Debt," American Economic Review, XXXII (September, 1942), 451-67; J. E. Meade, "Mr. Lerner on 'The Economics of Control,' " Economic Journal, LV (April, 1945), 47-70.
Wright, "The Economic Limit and Economic Burden of an Internally Held National Debt," op. cit., 117 and 129.
David McCord Wright, "Mr. Ratchford on the Burden of a Domestic Debt: Comment," American Economic Review, XXXIII (March, 1943), 115.
David McCord Wright, The Creation of Purchasing Power (Cambridge, Mass., 1942), p. 148.
Cf. Giannino Parravicini, "Debito pubblico, reddito, occupazione," Rivista di diritto finanziario e scienza delle finanze (1951).
Paul Leroy-Beaulieu, Traité de la Science des Finances (7th ed.; Paris, 1906), Vol. II, p. 223.
J. F. Melon, "Essai Politique," Chapter 23 in Economistes Financiers du 18me siecle, p. 479. Cited in C. F. Bastable, Public Finance (2d ed.; London, 1895), p. 613.
Leroy-Beaulieu, op. cit., p. 224.
Cited in E. L. Hargreaves, The National Debt (London, 1930), p. 74, where, in turn, the citation is taken from a reference in Malachy Postlethwayt, Dictionary of Trade.
Sir James Stuart, An Inquiry into the Principles of Political Economy (1767), p. 625 as cited in Hargreaves, loc. cit., p. 81.
Leroy-Beaulieu, op. cit., p. 224.
David Ricardo, "Principles of Political Economy and Taxation," Works and Correspondence, P. Sraffa, ed. (Cambridge: Royal Economic Society, 1951), Vol. I, pp. 244-45. This and subsequent citations by permission Cambridge University Press.
David Ricardo, "Funding System," Works and Correspondence, ibid., Vol. IV, p. 187.
Gustav Cohn, System der Finanzwissenschaft (Stuttgart, 1889), pp. 740-43.
Adolf Wagner, Finanzwissenschaft (Leipzig, 1877), Vol. I, p. 122.
Knut Wicksell, Finanztheoretische Untersuchungen (Jena, 1896), p. 131.
See Maffeo Pantaleoni, "Imposta e debito in riguardo alla loro pressione," Giornale degli economisti (1891), reprinted in Scritti varii di Economia, Serie Terza (Rome, 1910); Antonio de Viti de Marco, "La pressione tributaria dell' imposta e del prestito," Giornale degli economisti (1893); Benvenuto Griziotti, "La diversa pressione tributaria del prestito e dell' imposta," Giornale degli economisti (1917), reprinted in Studi de scienza delle finanze e diritto finanziario (Milan, 1956), pp. 193-261.
See Report of the Committee on National Debt and Taxation (London, 1927), especially p. 27.
End of Notes
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