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«Carl-Ludwig Holtfrerich School of Business & Economics Discussion Paper Economics 2013/4 Government Debt in Economic Thought of the Long 19th Century ...»

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Government Debt in Economic Thought of the Long

19th Century

Carl-Ludwig Holtfrerich

School of Business & Economics

Discussion Paper



Government Debt in Economic Thought of the Long 19th Century

Carl-Ludwig Holtfrerich

J.F. Kennedy Institute for North American Studies, Free University of Berlin

Contributed to the symposium on “Government Debt in Democracies” in Berlin

30 November and 1 December 2012

I. Introduction

The first half of the long 19th century covers the publication of Adam Smith’s Wealth of Nations in 1776 through the work of subsequent representatives of classical political economy in Great Britain. The second half of that long century is marked by the contributions of German economists to public finance theory spanning the sixty years preceding the First World War. In this paper I will contrast the views of four classical British economists regarding the issue of public debt, namely those of Adam Smith, David Ricardo, Thomas Robert Malthus and John Stuart Mill, with those of three German economists, Carl Dietzel, Lorenz von Stein, and, with the internationally prominent (at least up to the First World War), Adolph Wagner.

The position of British economists of the classical school that government debt was an impediment to economic progress is relatively familiar. Maybe due to their harsh judgment they treated the issue only in passing. In contrast, considerably less well-known today are the contributions of these three German economists who published entire books devoted to the issue of public debt with a subtly differentiated analysis and who were led to significantly more favorable assessments of the use of debt finance by governments.

Before outlining the views of the classical economists in Great Britain, I begin with a brief discussion of the origins and magnitude of the British debt problem, the times when the main representatives of the British classical school shaped their views. Having the times and doctrines of English political economy before us, we move to consider each of the three German economists to see what led them to discover a more positive role for the use of debt in a system of public finance. The paper concludes by highlighting the main differences between the two traditions.

II. The origins and magnitude of the British public debt problem For the historical setting in which the theoretical debate in Great Britain took place, a brief sketch on the unfolding of Britain’s public debt problem in practice is a useful point of departure.

The Glorious Revolution of 1688 marks the beginning of modern public finance in Britain, as Parliament took effective control of taxes and outlays. While government debt before then was essentially a private credit to the monarch, thereafter it was transformed to a public credit based on a pledge by Parliament, representing all citizens of the nation, to set aside the revenue of particular taxes for debt service and, thus, fund these “securities.” This Funding System not only facilitated public borrowing on a larger scale, but also made it cheaper. For example, a state with its taxing powers and its practically infinite horizon would generate more confidence as a secure debtor than a king as a private debtor and private businesses were able to. The Bank of England was founded in 1694 to act as the government's banker and debt-manager. These developments have been dubbed the Financial Revolution that preceded the Industrial Revolution by almost a century (Dickson 1993: 12).

At first, public debt creditors were almost exclusively large chartered companies. But when broker services had developed in connection with the South Sea Bubble in 1720, a large part of the population was also involved (Churchman 2001: 133). This had the advantage that the moneyed classes as well as small savers had a vested interest in the integrity and wellbeing of the state. 1 In those days, the origin of large increases of public debt was always found in the exigencies of war-finance. Between 1688, the Glorious Revolution, and 1815, the end of the Napoleonic Wars, Britain was at war more than half the time. The terms familiar to modern readers: the British [central government only] debt-to-GNP ratio amounted to a little less than 300 percent in 1821. In that year the share of [central government] expenditure in GNP amounted to 20 percent. 2 Also in 1821, two years after Britain’s return to gold convertibility of Pound Sterling notes, which the Bank of England had suspended in 1797 after several severe banking crises, [central] government outlays for debt service amounted to 55 percent of total [central] government expenditure, and military expenditure for another 29 percent. Until the 1840s war debt service plus military outlays never fell below 80 percent of British public expenditure.

Yet debt service alone ranged between 20 and 60 percent until the end of the 19th century.

Public debt in Britain had risen from 3.1 million Pounds in 1691 to a peak of 844 million in 1819.

Nominal public debt was barely reduced over the next century. In 1913 it still amounted to 711 million Pounds (All previous data calculated or taken from Mitchell/Deane 1962: 366, 396-9, 401-3). But by that time, the debt-to-GNP ratio had fallen to 26 percent (for this calculation the GNP figure is from Mitchell 1978: 416). The important point here is that hardly any of Britain’s public debt was actually paid off, rather it was strong real economic growth alone (no inflationary trend for over a century) that reduced the U.K.’s public-debt-toGNP ratio.

The data in the second-last paragraph might serve as a statistical background for the huge relative size of public debt in the UK when Great Britain’s classical economists addressed the issue in their active times before the second half of the 19th century.

III. British classical political economy The first U.S. Secretary of the Treasury, Alexander Hamilton, was well aware of this point, when shortly after the founding of the U.S. he proposed to Congress that the federal government assume all the debt of the states. Congress decided accordingly.

This equals the 2011-public-expenditure-to-GDP ratio of the U.S. central government.

Under mercantilism governments dominated economic life by regulation, public enterprises and taxation well into the 18th century. Public debt in that view had no harmful economic consequences because it would be “due from the right Hand to the left, whereby the Body will not find itself weakened, if it hath the necessary Quantity of Aliments, and they are properly distributed” (Melon 1738: 329. Quoted in German translation in Fossati 1932: 599). De Pinto (1771: 60) also held this view.

David Hume, generally considered a pre-classical, but by O’Brien (2004: 1-7) a classical

economist, set the new tone when he argued in 1752:

“either the nation must destroy public credit or public credit will destroy the nation” (quoted in Churchman 2001: 137).

Public debt would have grave social and political consequences, argued Hume. He was also concerned about the power that the existence of public debt vested in public creditors, who were not immune to abuse it (Churchman 2001: 137. More on Hume’s view of public credit in Dome 2006: 1-5).

In France, Voltaire had praised and supported Melon’s positive view of public debt. However, Montesquieu in his Esprit des Lois of 1748 rejected it and thus paved the way for Hume’s view of the destructiveness of government debt. Montesquieu, in turn, was attacked by Isaac de Pinto (1771). Siding with Melon, de Pinto argued in favor of expansionary economic effects of a moderate use of public debt. He contended that Montesquieu could not see this point due to lack of practical experience in financial matters (For this paragraph and more on the 18th century debate on the public–debt issue see Isenmann 2013: esp. 106-111).

Adam Smith:

“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.” These words could have been written by today’s proponents of austerity not only in Europe but in the U.S. and Japan as well. Of course this is an easily recognizable quotation from Adam Smith (1776, Book Five, Chapter III entitled “Of Public Debts.” All of Smith’s following quotations are taken from that source). All the more striking is the fact that Smith wrote this before Britain’s huge debt financing of its military efforts in the War of Independence by its North American colonies and those involved in the Napoleonic Wars.

Smith demanded the “liberation of the public revenue” from debt service by reducing government debt to zero. He went into details of the then current British tax system and offered concrete proposals regarding which increased taxes would be simultaneously just and least harmful to manufacturing and commercial activity. He spoke of “the waste and extravagance of government,” “the pernicious system of funding,” i.e., redeemable bonds, and of the even “more ruinous practice of perpetual funding,” i.e., “consols” on which the government pays only interest without ever redeeming principal..

However, Smith acknowledged that modern governments are not only “unwilling,” “for fear of offending the people who by so great and so sudden an increase of taxes would soon be disgusted with the war,” but also “unable” to do so.

“… by means of borrowing they are enabled, with a very moderate increase of taxes, to raise, from year to year, money sufficient for carrying on the war, and by the practice of perpetual funding they are enabled, with the smallest possible increase of taxes, to raise annually the largest possible sum of money.” 3 Smith mainly deplored the omission of government to provide for an adequate sinking fund in order to “liberate” the budget from the interest burden of the war debt over a limited time period once peace has returned. On the one hand, he sees some advantages of debt financing war expenditure for the functioning of the private economy as long as the war lasts. He also recognizes that the oppressive taxation with its disadvantages for the private economy is only postponed until after the war when the debt should be duly reduced.

“Were the expence of war to be defrayed always by a revenue raised within the year, the taxes from which that extraordinary revenue was drawn would last no longer than the war.” The ability of the private economy to accumulate capital and to increase the wealth of the nation would have been less during the war but much greater once peace returned. And there

would be an additional advantage of financing war by taxation instead of debt:

“Wars would in general be more speedily concluded, and less wantonly undertaken. The people feeling, during the continuance of the war, the complete burden of it, would soon grow weary of it, and government, in order to humour them, would not be under the necessity of carrying it on longer than it was necessary to do so. … The seasons during which the ability of private people to accumulate was somewhat impaired, would occur more rarely, and be of shorter continuance.” Smith, however, admitted the following: “Great Britain seems to support with ease, a burden which, half a century ago, nobody believed her capable of supporting.” Smith refuted the proposition that it makes a difference for the wealth of the nation whether the government is indebted to its own or to foreign citizens. He also pointed out that “the two great sources of revenue,” namely land and capital stock, will be burdened by higher taxes to defray the service on the public debt. Productive capital would be removed from the good management of every particular portion of capital stock and would be transferred to the creditors of the public debt “who have no such particular interest.” As a result, “the ruin of trade and manufacture will follow the declension of agriculture.” Smith asserted that debt financing has always enfeebled states and mentions the cases of the Italian republics in general and of Genoa and Venice in particular, of Spain, of France and the United Provinces of the Netherlands. He then raised the rhetorical question: “Is it likely that in Great Britain alone a practice, which has brought either weakness or desolation into every As an aside, Smith immediately goes on with the following observation: “In great empires the people who live in the capital, and in the provinces remote from the scene of action, feel, many of them, scarce any inconveniency from the war; but enjoy, at their ease, the amusement of reading in the newspapers the exploits of their own fleets and armies. To them this amusement compensates the small difference between the taxes which they pay on account of war, and those which they had been accustomed to pay in time of peace. They are commonly dissatisfied with the return of peace, which puts an end to their amusement, and to a thousand visionary hopes of conquest and national glory, from a longer continuance of the war.” other country, should prove altogether innocent?” He continued to discuss the different forms of bankruptcy, also the hidden ones by debasement of the coinage. (For more on Smith’s view of public debt see Dome 2006: 56-60.) Finally Smith proposed how Great Britain could by taxation raise funds very rapidly “sufficient in a few years to discharge the whole debt and thus to restore completely the at present debilitated and languishing vigour of the empire.” The principal source for the creation of the “great sinking fund” was to be the extension of the four most important British taxes - namely the land-tax, the stamp-duties, and the different duties of customs and excise – to Ireland and “our American and West Indian plantations.”

His justification:

“That public debt has been contracted in the defence, not of Great Britain alone, but of all the different provinces of the empire; the immense debt contracted in the late war in particular [French and Indian Wars 1754 – 1763], and a great part of that contracted in the war before [Spanish War 1739-1742 4], were both properly contracted in defence of America.” Smith, of course, was well aware of the difficulty of imposing new and higher taxes on its North American colonies. Perhaps this is why he ended his treatment “Of Public Debts” on a

rather pessimistic note:

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