Part II—Public Debt
In our island example of private debt, let us now introduce government. Government might be assumed be elected or imposed. Suppose the individuals who comprise it look just like anyone else, except let us say that they have armbands with a pronounced “G” printed upon them.
What sets government apart is that these people, through legislation or regulation, have some very special privileges that allow them to violate the normal rules of the marketplace. The market place, for example, operates under the rule of voluntary exchange and no stealing or taking of property. The government can take property, income or wealth from others through a number of means that would be illegal for the rest of the population. Their justification for doing so, of course, is that they employ this power only for “the greater good” of the island society—for example national defense, the general welfare, and various “public” goods which are thought to be inadequately provided by private markets. The more cynical among us might be excused for believing that governments often exercise these powers instead to feather their own nests or to reward those who allow them to retain power.
How does government succeed in financing itself, in the taking of output or wealth from private individuals? First, there is direct taxation. The government can determine tax rates applied to income, returns to capital, trades, property etc. It can make these tax rates specific to certain types of trades or activities that are either politically favored or disfavored. Secondly, most governments have the power to exclusively control and issue the fiat currency that is used to accomplish trades in the private sector. Since this currency is backed by nothing other than the faith of those who use it, this very valuable power can be thought of simply as the exclusive right to be the only legal “counterfeiter.” A more ponderous power also exercised by government to interfere in the marketplace is the power of mandate. That is, certain types of disfavored trades can be prohibited whereas other types of favored trades can be required. Direct mandates tend to be controversial and not very covert. Therefore, they are the last resort of shrewd politicians. Finally, of course, governments can borrow.
In borrowing, a government which also has the power to issue fiat money as well as to control and regulate a private banking system holds almost all the cards. In pernicious and extreme cases it can come to naturally view itself as the sole arbiter of the allocation of private savings. Thus, it is not only greedy but, if we allow it, it is also in effective control.
How is that? Let us first consider the advantages of the government as a borrower. Whatever the required rate of return for private lenders is, the government can meet it. Why? Simply because the government has the theoretical power to raise whatever funds are needed for its debt and interest payments through taxes. This simple fact assures lenders that the government need not default on its loans. Thus, if lenders believe this, the government benefits from a lower risk-adjusted return required upon its debt and the broad perception of “no credit risk.” Less attractive to borrowers, of course, the government also has the power to buy its previously issued debt or bonds with newly issued fiat currency. It can thus “monetize” its previous debt. By doing this it inflates the currency to the point where the real value of debt (that is, the value of the nominal government bonds in terms of output) is reduced to whatever level the government prefers. The government can and does alter the supply of fiat currency to artificially manipulate the cost of borrowing in the loan market (that is, to achieve central bank interest rate targets).
Additionally by setting or changing the minimum proportion of vault reserves required within a fractional-reserve banking system, the government has control over the volume of private loans. Worse, it controls the disposition of these loans through its regulation and licensing of private banks and through the legislative mandates it applies to them. Put bluntly, an aggressive government can control how much is lent, by whom it is lent, to whom it goes, and at what price. Clearly, that outcome is not a free market in lending.
It is any surprise that such a control and power over the allocation of aggregate private savings generates credit bubbles or gross distortions? Our opinion is that such a top-heavy debt and lending system can explain virtually all of them. Pushed to an extreme, the government’s own debt can become the biggest credit bubble of all. If government spending growth dramatically exceeds the growth rate of the economy that bears it, an eventual collapse of the entire economy can be the logical result. This happens. For example, consider Greece. Can such government aggressiveness explain the under-investment in capital that occurs in many economies? Of course! Not only does capital have to compete for savings on an un-level fiat money playing field, but private capital investment itself can be an officially “disfavored” use of savings. How? It is easy—simply raise capital gains rates, or raise corporate income taxes, or increase regulation. Additionally, government can subsidize preferred types of capital investments and punish those that are out of favor. Finally, when government abuses its power over private savings to an extreme, the general atmosphere prevailing in the market place discourages all types of private investment or allocation of saving. Immediate consumption rules!
The bottom line is obvious. It should come as no surprise that, as a government gets more aggressive in controlling private savings and its allocation, the efficient investment in productive capital may well be the first casualty. It is no surprise (as we argue in our book Capital as Money) that the likely outcome of such an inefficient lending market is aggregate under-investment in new productive capital. That is, the result is an economy that simply doesn’t have as much productive capital as it should have to maximize the wealth, economic growth, prosperity, and consumption of its citizens.
Of course, as in the case of private debt, the issue of a unit of public debt does not increase aggregate wealth. Simplistically the asset value of a piece of government debt to its specific holder is exactly offset by the present value of the taxes required to pay its future stream of interest and principal payments—that is a liability all of us. In fact, a critical observer may make the following inference: Given the close historic relationship between public debt and fiat money issuance, issuance of public debt implies a corollary: the inevitable future issuance of fiat money to monetize it. This, in turn, implies an increase in the level and volatility of future inflation—tending to impair the wealth, prosperity and growth of the overall economy. In fact, a good way to view the government’s monopoly of the money supply function is that it is precisely this power that affords governments the only “legal” loophole to effectively default on their debt. It is exactly analogous to a counterfeiter paying off a loan obligation he has incurred by turning on his printing presses and printing up more bogus currency. Wealth is destroyed, or at least stolen, by such behavior.
Considering public debt, total debt and its unfortunate de-stabilizing linkage to fiat money and monetary policy, it appears that our money is far too important to leave in the hands of government or central banks. The supply of money and interest rates should not be gamed but instead should be market determined. Money is not a public good! We now have the tools and technology to allow us to choose a private money with a supply determined by private free market demand. What is it? Broad productive capital should be used as a unit of value and as a medium of exchange. The solution is capital as money.