Adam Smith and the Public Debt

In March 2020, the U.S. government faced a serious public health issue, Covid 19. It responded by running large government deficits, adding to the public debt. Two and a half years later, the United States is experiencing long Covid 19 economic effects. Adam Smith addresses unanticipated government expenses like these in “Of Public Debts,” the final chapter in An Inquiry into the Nature and Causes of The Wealth of Nations, published in 1776.

In ordinary years, Smith writes, a sovereign country can balance tax revenue with government expenditures and, at times, even accumulate a surplus. He quickly adds, however, that extravagant increases in public debt occur when officials high and low are given to lavish or imprudent expenditures. Therefore, “The amassing of treasure can no longer be expected, and when extraordinary exigencies require extraordinary expenses, he [the Sovereign] must necessarily call upon his subjects for an extraordinary aid.”

The lack of prudence in good times requires contracting debt in moments of immediate distress. In such an exigency, the government cannot wait for the gradual and slow return of new taxes and has “no other resource but in borrowing.” Smith argues that certain residents, if they choose, are in a position to advance large sums of money to the government. They will do so provided they have the support of the government for private contract enforcement and faith in receiving the principal and interest due. In a state where property rights are protected, the government can count on its subjects “to lend it their money on extraordinary occasions.”

The ability to borrow for unexpected expenses such as war, for example, delivers the sovereign “from the embarrassment which this fear and inability [to finance] would otherwise occasion.” Government officials are “unwilling, for fear of offending the people, who by so great and sudden an increase in taxes, would soon be disgusted [with the expenses].” Besides, it is not known “what taxes would be sufficient to produce the revenue wanted.”

Advancing money to the government crowds out the private accumulation of capital stock. Smith says that though creditors will regain what they advanced to the government, the nation will experience loss from forfeited capital stock and from the burden of repayment. Nevertheless, Smith argues that public debt in times of crisis, unlike a sharp increase in taxes, could enable the public to somewhat sustain the stock of private capital needed for production in the short and long run. He cautions, however, that wars are prolonged when financed through debt. Those far from the front experience little inconvenience from increased taxes as they enjoy “a thousand visionary hopes of conquest and national glory, from a longer continuance of war.”

Smith suggests that increasing the public debt becomes addictive, “The progress of the enormous debts which at present oppress, and will in the long-run probably ruin all the great nations of Europe, has been pretty uniform.” He observed that following a crisis any residual, or what economists call the “peace dividend,” is likely never used to pay down the public debt. “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid.”

What follows in Smith’s chapter “Of Public Debts” is a discussion of the types of financing instruments employed and the methods governments resort to when the size of the debt becomes unsustainable.

Most public debt bears interest from the day on which it is issued. Smith categorizes public debt as either backed by anticipated tax revenue or mortgaged to a particular stream of government revenue.

Treasury notes held by the public, or what Smith refers to as Exchequer bills, pay interest and can be traded in secondary markets. At maturity, they are redeemed at face value. Consols, which Smith refers to as perpetuities, pay a steady stream of interest indefinitely. If it is reasonable to anticipate the certainty of future tax revenue, these instruments retain their value and thus allow the government to contract large amounts of debt.

When the public is unwilling to hold notes backed by anticipated general tax revenue, the government can mortgage for several years or in perpetuity some particular stream of public revenue. For example, usage fees could be transferred to bond-holders for having financed public infrastructure.

Smith considers the government’s practice of “borrowing of its own factors and agents” as “paying interest for the use of its own money.” For example, the Bank of England would advance funds to the government at interest. At present, the Federal Reserve Bank in the U.S. remits interest earned on its holding of government bonds back to the Treasury. Therefore, a better example of government borrowing from itself is represented by the “trust fund” of the Social Security Administration. Annual Social Security payroll contributions over and above payments made to recipients are held in Treasuries, used to finance current federal government deficits. The assumption is that this “trust fund” backed by general tax revenue will be available to pay Social Security recipients when payroll contributions fall short.

When market rates of interest drop, the refinancing of government debt should yield a surplus in the federal budget. Smith refers to this bonus as a “sinking fund.” He notes, however, “A sinking fund, though instituted for the payment of old [debts], facilitates very much the contracting of new debts.”

Smith considers yet another government option in raising funds for deficit spending, i.e. selling annuities for life or a set number of years. “In 1693, an act was passed [in Great Britain] for borrowing one million upon an annuity of fourteen percent or 140,000 pounds a year, for sixteen years. In 1691, an act was passed for borrowing a million upon annuities for lives, upon terms which in the present times would appear very advantageous.” Even at these good terms, Smith notes, the Exchequer procured few purchasers.

The problem with annuities, according to Smith, is that the real value of an annuity begins to diminish from the moment it is granted. Generally, those that advance money to the government do not wish that their fortunes should end with themselves plus another, such as a widow or widower, “whose age and state of health are nearly the same with his own.” Smith, therefore, would view the involuntary aspect of Social Security as a benefit only for those, “who have little or no care for posterity” and to whom “nothing can be more convenient than to exchange their capital for a revenue, which is to last just as long and no longer than they wish it to do.”

Adam Smith’s readers should keep in mind his primary concern in writing The Wealth of Nations: an accumulation of capital stock that combined with labor will increase the productivity and economic wellbeing of a country as a whole. As such, he warns “the practice of funding has gradually enfeebled every state which has adopted it.” He is particularly sensitive to the distribution of the burden of national debt. Lenders to government may have a general interest in the growth of private capital but not necessarily a particular interest. On the other hand, the public, postponing an increase in taxes to meet a current crisis, may be unaware of the long-term cost and loss caused by unnecessary and excessive government spending.

Smith briefly addresses the case in which public debt is primarily held internally rather than subject to international payments. He says, “But [even] though the whole debt were owing to the inhabitants of the country it would not upon that account be less pernicious.” The crisis is realized when tax revenue is insufficient to service internal or external public debt without crowding out the private investment needed to sustain production.

Smith expressed confidence in England’s system of taxation. “But it ought to be remembered, that when the wisest government has exhausted all the proper subjects of taxation, it must, in cases of urgent necessity, have recourse to improper ones.”

Improper Responses to Burdensome Public Debt – Devaluation and Inflation

The obvious economic solution to managing public debt is to raise tax revenue and/or reduce government expenditures, but this is easier said than done. Smith writes, “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid.” To avoid bankruptcy, he indicates that the burden of the debt is relieved “frequently by a pretended payment.”

A “juggling trick” of this kind, Smith explains, involves debasing a country’s currency by devaluation and inflation. By this means:

If a domestic currency is convertible into precious metals, debasement results from adulteration of coin content or devaluation, both of which allow the government to retain enough bullion to meet its debts. For example, on one day in 1971, to meet its commitments to certain countries for gold, the U.S. devalued the dollar from $35 to $70 per ounce.

At present, the U.S. dollar is convertible neither internally nor externally to gold. The U.S. dollar also is not fixed in terms of other currencies; hence, it fluctuates in value. Up to this point, the dollar has not experienced much depreciation; it has maintained its value in international markets with respect to most currencies. This, no doubt, is due to its role as a major reserve currency.

Many countries, however, are committed to a fixed rate between their own currency and that of another country or a basket of currencies. To service international debts with scarce foreign reserves, a government may devalue its currency. This immediately reduces the ability of residents to import and potentially increases export revenue by making domestic goods more attractive internationally.

The value of the dollar is supported neither with metal nor another currency. As a fiat currency, the dollar is backed exclusively by the productive capacity of the country and trust in the U.S. government to maintain its value. To do this, the government must refrain from monetizing its debt. Monetizing debt occurs when a central bank, such as the Federal Reserve, passively increases its holding of government debt, essentially increasing liquidity in the system to finance public spending. In this case, the government borrows money from the central bank to finance its spending instead of selling bonds to individuals and other private entities. An ongoing increase in total spending results in inflation, a continual increase in the general price level. Such inflation reduces the value of outstanding public and private debt. This is the “juggling trick” condemned by Smith.

Remember that Smith was open to government financing deficit spending in emergencies. His concern was rather with continually increasing the public debt and its long-term burden. At the conclusion of “On Public Debts”, he notes the lack of revenue remitted to Great Britain for services rendered to its colonies. He says, “The rulers of Great Britain have, for more than a century past, amused the people with the imagination that they possessed a great empire on the west side of the Atlantic. This empire, however, has hitherto existed in imagination only.” He goes on to say that rulers should awaken the people if their dreams cannot be realized.

It is foolish to believe that the expenses incurred by the U.S. government during the pandemic will somehow fade away. Even if the absolute size of the national debt persists, increasing it will further destroy the loss of capital needed to maintain and increase real output. Debasement of the currency through inflation is not a solution. As Smith says, this will only subvert funds from industrious creditors. The U.S. should acknowledge realistic and ethical means for dealing with existing government debt to maintain the flow of anticipated tax revenue in order to meet its commitments.