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Quotation of the Day…

… is from pages 210-212 of my colleague Richard Wagner’s insightful paper “Liability Rules, Fiscal Institutions and the Debt,” which is chapter 11 in the 1987 collection Deficits (James M. Buchanan, Charles K. Rowley, & Robert D. Tollison, eds.):

The ability of government to borrow at a lower rate of interest than other borrowers is not at all a sign that it is a less risky enterprise than other enterprises. Rather it is a sign of government’s ability to cover up through taxation what is really its greater costs and riskiness. The force of government’s coercive potential is represented by the spread between its borrowing rate and that of diversified corporations. If a government can borrow at, say, 10 per cent while a diversified corporation must pay, say, 12 per cent, the 2 per cent differential is at least equal to the anticipated taxpayer loss that would otherwise be borne by bondholders. I say ‘at least’, because that loss would be even larger if government were a less efficient enterprise than private firms – a proposition that finds considerable support in the literature on bureaucracy….

The argument that public debt allows people to borrow at government’s borrowing rate, while correct, entails a grossly misplaced emphasis as it is commonly developed. The ability of government to borrow at a lower rate than diversified private institutions would not seem to reflect any social gain due to a lowering or risk, but rather would seem to represent the strength of government’s promise to use the police powers of government to cover what would otherwise be losses to borrowers by imposing higher taxes on taxpayers.

DBx: Yes. By paying attention to what happens on the real side of a fiscal ledger (as opposed to confining one’s attention exclusively to the monetary side) one sees the true consequences – the real benefits and real costs – of each method of financing government expenditures. And a comparison of these real benefits to these real costs is what must be done to determine the merits of any method of financing.

Because government’s use of debt financing does not miraculously create real resources out of thin air – or, rather, out of the presses that print government bonds – government’s use of debt financing would be superior to its use of taxation only if (1) the real resource costs of using debt financing to fund $X amount of spending were lower than are the real resource costs of funding $X amount of spending through taxation, and (2) the use of debt financing does not cause the amount spent to be higher than necessary. In some cases debt financing might, on these criteria, be advisable.

But in general debt financing of government spending is highly unlikely to be anything other than more costly than financing through taxation. The reason is that debt financing allows today’s citizens-taxpayers to free-ride on the wealth of tomorrow’s citizens-taxpayers. The people who must pay interest and principal on government debt incurred today are citizens-taxpayers tomorrow. And when Jones gets to spend Smith’s money, Jones spends both unwisely and excessively. Deficit financing causes the amount spent to be, not $X, but more than $X.

Note that every government can tax directly – say, by raising income-tax rates in ways that result in people paying more money over to the government. But most national governments can also tax surreptitiously, chiefly through inflation.

(Note to experts in public finance: I don’t buy the claim that Ricardian equivalence describes reality – and nor did Ricardo! But even if it were true that today’s citizens-taxpayers increase their savings by an amount equivalent to the full discounted value of tomorrow’s higher tax burden, debt financing would be no miraculous means of lowering, and much less of eliminating, the real costs of the programs paid for today with borrowed funds.)