But let’s assume, contrary to fact but for argument’s sake, that an actual government – an agency with a monopoly on the lawful authority to initiate coercion – can forever fund all of its operations with borrowed funds. This fairytale government repays and services all of its debts simply by borrowing, infinitely into the future. Contrary to the belief of many, this situation would be especially bad for freedom and free markets. Government would grow even larger and more intrusive.
As argued above, deficit financing allows real-world governments to grow too large and intrusive by enabling today’s citizens-taxpayers to free-ride on the resources of tomorrow’s citizens-taxpayers. Yet in the real-world there remains at least some constraint on government growth – namely, the need eventually to raise taxes or to cut programs.
But in the fairyland world in which government never collects taxes, even this relatively small constraint on government growth disappears. Dominant coalitions of citizens-taxpayers can get whatever they want from government in whatever quantities they desire, with the monetary expenses all being paid by an infinite series of creditors.
Why is this situation bad if the full monetary costs of government programs are financed only with funds from creditors who voluntarily lend their purchasing power to government? A chief reason is that government – retaining all governmental powers except that of taxation – can use these borrowed funds to impose programs that benefit special-interest groups at the greater expense of the general public.
Consider agricultural subsidies. A government funded exclusively with borrowed funds will still be pressured by the same interest groups who operate in the real world to grant such inefficient subsidies. But in the fairyland world in which all government revenues come from borrowed funds, the size of such subsidies would be even greater. In this fairyland world there would be even less incentive than there is in the real world for government to constrain the size of these subsidies.
When creditors in the real world lend money to private producers to expand their operations, these creditors have strong incentives to lend only to projects that are efficient. Lending money to projects that turn out to be excessively costly – that is, inefficient – results in creditors not being repaid in full, and sometimes not being repaid at all.
In contrast, a government that subsidizes production has no incentive to consider the efficiencies or inefficiencies of the production that it subsidizes. Ability to extract funds from taxpayers allows government to subsidize inefficient operations. The only constraint on such government subsidies in the real world is that which comes from the need to make budgetary trade-offs: Should the government expand the subsidies by another $100 billion if doing so requires a tax hike or a cut in some other program?
As weak as this constraint is, at least it exists. But even this weak constraint would be absent in a world in which government could perpetually borrow all that it spends. In such a fairyland world, market-distorting subsidies – subsidies that over time make the citizenry poorer by channeling resources into inefficient uses – would be even more commonplace and gargantuan than they are in the real world in which governments must eventually raise taxes or cut spending to meet their debt obligations.