The Redemption And Conversion Of Debt.

A STUDY of the conditions and limitations under
which public borrowing is alone admissible naturally leads
to the conclusion that the maintenance of a permanent
debt ought to be avoided. If loans should be contracted
only under great pressure, and to prevent the exhaustion
of the agency of taxation, and if, while they exist, they act
as a drag on the financial power of the State, it cannot be
disputed that their speedy redemption must be eminently
desirable. The same reasons that make taxation preferable
to borrowing give support to the policy of raising taxes in
order to pay off existing debt. So far as loans are derived
from capital their repayment by taxes levied out of revenue
is a restoration of the wealth previously abstracted from
the work of production to its earlier and more economic
use. In any event the return of their wealth to the fund-
holders will not diminish the economic power of the com-
munity, as some productive employment will certainly be
found for it, to escape the loss of income that must other-
wise come on the holders. The redemption of debt is thus
a mode of increasing the amount of national capital, unless
on the hardly possible assumption that the whole amount
of taxation raised for the purpose is drawn from capital, or
in the case of a foreign loan.

2. The assertion of the general position that the re-



614 PUBLIC FINANCE. [BOOK V.

demption of public debt is desirable has necessarily to
be qualified by reference to the particular circumstances
of each case. As it is sometimes allowable to borrow, so
must it be admitted, that cases may occur in which neither
borrowing nor repaying is judicious. In the crisis of war
or under extra pressure of any kind, the suspension of the
mechanism of repayment is obviously prescribed, and it is
quite conceivable that such a state of things may long con-
tinue. The utmost that English financiers could have
done during the protracted war with France was to pay
the current expenses of the State, and even this, as we
know, they failed to accomplish. The postponement of
debt redemption is in such cases a necessity, the non-recog-
nition of which was one of the blots on the sinking-fund
theory.

On precisely similar grounds should the amount of debt
to be paid off in any given year be determined. Sudden
demands may make it prudent to reduce the sums devoted
to this purpose as a preferable course to the hasty increase
of taxation. A review of the last thirty years of English
financial history supplies a series of illustrations. Exactly
the same redemption of debt could not be right in such
years as 1868 and 1885, when large extra expenditure was
incurred, as in years like 1873 and 1889, when considerable
surpluses were realized. Rapid changes in the public bur-
dens are if possible to be avoided ; indeed one of the great
services of developed public credit is the assistance that it
gives in escaping this evil. But here again there is a fur-
ther influencing condition. A plan of redemption or reduc-
tion will generally be organized as a permanent system,
and is intended to operate through a long series of years.
Suspension of an arrangement of the kind for any slight
cause has a disturbing effect that is as objectionable as a
small increase of taxation. To stop the normal action of
the English terminable annuities for a few millions' increase
in expenditure would be a departure from a settled policy,
and a bad precedent for the future. The increase in outlay



CHAP. VII.] THE REDEMPTION AND CONVERSION OF DEBT. 615

must be large in proportion to the total amount to justify
such action 1 .

Debt redemption must also be affected by the position of
taxation. Where inconvenient and oppressive duties are
levied it may be wiser, even with a view to ultimate repay-
ment of loans, to relieve industry and trade from their
burdens and trust to the increased productiveness of the
reformed system for compensation. A thorough reform in
fiscal policy may prove the best sinking fund, or at least its
best feeder. Between the remission of very bad taxes and
their retention for the redemption of debt, there is often
ground for deliberation. Still, on the whole, the reasons in
favour of substantial redemption preponderate. There is
no hard and fast line between good and bad taxes. Every
tax is so far an evil, and any one may, if raised sufficiently
high, become oppressive and unproductive. Now if we
hesitate to redeem debt on account of the badness of the
necessary taxes, we must remember that we are thereby
retaining worse taxes in the future than would otherwise be
required. For let us suppose the several forms of contri-
bution to be arranged in the order of their eligibility as
follows A, B, C, D, E, F. Then the surrender of F the
worst tax in preference to paying off debt means the pro-
longation of the existence of E, which ex hypothesi is worse
than D, since with the disappearance of the debt the taxes
appropriated to its service would also disappear. The
6,000,000 of taxation to take an actual case at present
applied to reduce the English debt, no doubt represents the
worst part of the English revenue, but were the operation
completed it would allow of the remission of 25,000,000
of the heaviest part of taxation. The true adjustment is
therefore more complicated, and requires for its scientific
solution more refined calculations than are ordinarily
recognized 2 .

1 Perhaps 10 per cent, of the total amount would represent the limit within
which increased expenditure should not alter the established system.

2 Cp. Mill, Principles, Bk. v. ch. 7. 2, for a statement of the cruder view.



6l6 PUBLIC FINANCE. [BOOK V.

3. In the preceding section it has been taken for
granted that all payment of debt is made out of surplus
revenue. That, in Hamilton's words, ' the excess of revenue
above expenditure is the only real sinking fund by which
public debts can be discharged V is a position too evident
to need much formal vindication. Any valuable property
possessed by the State can be realized to pay off liabili-
ties, but only at the sacrifice of the revenue obtained from
it. Both of public and private credit it is indisputably true
that repayment can be made in no way except by excess
of receipts over expenditure. The only possible mode by
which either the individual or the State can get rid of
liabilities is by making income greater than outlay. Hence
in all well-organized financial systems the surplus of each
year is applied to this object, and in the continuous
action of those excess receipts lies the hope of complete
redemption.

So simple and obvious a fact ought to have commanded
universal assent, but the phenomena of credit have always
had a remarkable tendency to create misapprehensions re-
specting their true character, and nowhere more than in
respect to public Finance. The whole history of the 'sink-
ing-fund ' doctrine is an illustration of this tendency. In
its earlier form the sinking fund was simply the surplus of
certain parts of the public revenue set apart for the dis-
charge of debt, and derived all its efficacy from the excess
of revenue over expenditure. But very soon the fund,
from being a part of the financial mechanism, was trans-
formed into a positive entity, and treated as if it had an
independent existence. On its security fresh loans were
contracted, and the absurdity of borrowing with one hand
while repaying with the other was frequently perpetrated.

The theory of Price led to a new development. This
writer dwelt on the great effect of compound interest. He
truly calculated that a very small sum would with interest
upon interest accumulate in a few centuries to an enormous

1 Hamilton, 10.



CHAP. VII.] THE REDEMPTION AND CONVERSION OF DEBT. 617

amount. This principle, applied to the treatment of debt,
would, he argued, secure its speedy repayment. All that was
required was a definite capital to start with, which would
increase automatically by reinvestment of the interest, until
it would equal the whole debt. If to every new loan a sink-
ing fund of moderate amount were attached, its redemp-
tion would be secured by the growth of the fund through
interest 1 .

This extraordinary theory was reduced to practice in
Pitt's 'Sinking Fund' of 1786, by which a special board
of Commissioners was created and 1,000,000 annually
assigned to them for the purchase of stock, which was not
to be cancelled, but allowed to accumulate, the interest
being applied to fresh purchases, until the original
1,000,000 had risen to 4,000,000. Further additions
were made in 1792. The surplus of that year, amounting to
400,000, and a further annual sum of 200,000 were voted
to the fund ; it was also provided that all future loans should
have a sinking fund of one per cent, attached to them by
which they would be paid off in, at farthest, 45 years 2 .

The pressure of war proved too much for the strict ob-
servance of this condition, and various modifications were
introduced, but the fundamental mistake of regarding the
sinking fund as a separate and distinct source of wealth
was still obstinately adhered to. From this error followed
the simultaneous borrowing and redemption that were sup-
posed to keep up public credit, but which really confused
the accounts and increased the cost of management. Pur-
chases of stock for the sinking fund and the issue of new
loans at probably lower price meant so much loss to the
State. A calculation of the differences shows that the
annual charge imposed by the use of the sinking fund
during the period 1794-1816 was over 550,000.

1 Price, Observations on Reversionary Annuities; criticised by Hamilton,
129-48.

2 For Pitt's Sinking Fund, Hamilton, 97-8 ; Ricardo, Works, 517. For
criticisms of it, Hamilton, 149-60; and for a more favourable view, Rosebery,




6l8 PUBLIC FINANCE. [BOOK V.

So mistaken a policy could not be maintained in the face
of rational criticism, which was supplied by Hamilton and
Ricardo. The true principle of regarding the surplus as
the sinking fund was recognised in 1819 by the arrange-
ment that a real surplus of 5,000,000 annually should be
provided for the repayment of debt ; but this course was
not maintained owing to the bad position of the Finances,
and finally after a careful inquiry, in which it was estab-
lished that the method used had added ,1,600,000 to the
charge between 1785 and 1829, tne sinking fund in 1829
was abolished as a separate institution, and the stock held
for it cancelled.

From the foregoing facts it is evident that a sinking
fund could be useful only in so far as it was based on a
surplus of revenue over outlay, and therefore the belief in
its efficacy rested on a fiction. Its sole advantage consisted
in the pressure that it brought to bear on the finance
minister to supply the requisite funds, while * its operations
are scarcely perceptible to a public, justly if sometimes
ignorantly impatient of taxation 1 .' The effect was in
practice to keep the surplus at a higher point than it would
otherwise have reached, and to prevent the reductions of
revenue, which, as subsequent experience amply proves,
were certain to be demanded. But this benefit was too
dearly purchased by the extra cost, and was always ex-
posed to the risk of being swallowed up by fresh loans.

4. The modern methods of redemption are all founded
on the necessity of providing surplus revenue for the
purpose ; while at the same time they endeavour to secure
the stability of the sinking fund, by ear-marking a special
sum for the object of payment. Such is the idea common
to the new English Sinking Fund, by which a specified sum
is annually devoted to discharge of debt, to the * terminable
annuities,' and to the ' redeemable ' debt as it exists in
France. Under all these systems there is a determination
of part of the revenue to the purpose of repayment, which,

1 Lord Rosebery, Pitt, 83.



CHAP. VII.] THE REDEMPTION AND CONVERSION OF DEBT.

if steadily persisted in, will extinguish the liabilities, unless
the relief so obtained is used for fresh loans.

The chief difficulty in the way of debt discharge arises
from the carelessness or positive dislike of the great body
of the taxpayers in respect to the adoption of vigorous
measures for its attainment. The simple and straight-
forward policy of appropriating a large surplus, maintained
expressly for the object, to the useful function of reducing
the public liabilities is not regarded by them with approval.
Unless surrounded by some rather complicated financial
arrangement, which disguises the true nature of the process,
the surplus is apt to be frittered away in expenditure, or to
disappear by reductions of taxation. The English debt
after 1819 suffered in this way, and nothing but very ex-
ceptional circumstances could have brought about the great
repayments of the United States debt after 1866.

Nevertheless it is perfectly evident that the redemption
of debt must sooner or later be faced. If in times of
peace and low expenditure no surplus is raised, and if
borrowing is freely resorted to whenever exceptional de-
mands occur, then the proposition previously quoted from
Hamilton x will certainly be applicable, and the debt will
ultimately ' amount to a magnitude which the nation is un-
able to bear.' Insistence on this fundamental point is the
duty of the wise financier who regards the future as well as
the present, and is concerned for the continuous prosperity
of the nation. The extent to which taxation should be
carried for this purpose, and the particular arrangements
adopted must necessarily be varied ; but the general prin-
ciple holds good everywhere.

An additional advantage of debt redemption should also
be noted. All repayment tends to raise the credit of the
State 'and to improve the basis for future possible loans.
A real sinking fund i.e. one based on an actual surplus
keeps up the price of stock, though a fictitious one does
not. Each portion of debt withdrawn from the market
1 Bk. v. ch. 5. 4.



62O PUBLIC FINANCE. [BOOK V.

reduces the amount available for investors, and this effect,
while it cannot alter the permanent conditions affecting
interest, yet improves the character of the particular stock.
The amount of English debt redeemed in the last thirty
years is one of the elements in its high price. Where the
debt is below par, redemption by purchase at the market
rate steadily brings it up to that point, when a new agency
can be brought into operation.

5. This is the process known as 'conversion/ by which
a stock bearing a given rate of interest is altered or ' con-
verted ' into one at a lower rate. We have seen several
examples of its use in England, France, and the United
States l from the first conversion of 1716 down to the recent
one in 1888. The principle is very simple, and is applicable
both to private and to public credit. A landlord who has a
mortgage on his estate on which he pays 5 per cent, will
naturally, if he can borrow the amount at 4 per cent., give
the mortgagee the option of taking 4 per cent, instead of 5
per cent., or of repayment of the principal. Loanable capital,
like other commodities, will be sought on the cheapest
terms, and conversion is only a single instance of the general
tendency. Indeed, we may go further and say that where
it is practicable there is a duty imposed on the finance
minister, who is the agent of the taxpayers and bound to
consult their interest, to carry out a scheme of conversion
on the best terms. Such a view does not, however, com-
mend itself to the fund-holders, and where they form a
numerous class very strong opposition to anything of the
kind may be expected 2 .

As the method of conversion can only be effectively
applied when stock is over par^ it requires as a condition
precedent a good state of public credit. Punctual payment
of interest, adequate provision for debt redemption, and

1 Bk. v. chs. 3 and ^passim.

2 In France, for example, conversion has not for this reason been attempted,
at certain favourable periods, viz. (i) under the Orleanist governments, and (2)
between 1878 and 1883.



CHAP. VII.] THE REDEMPTION AND CONVERSION OF DEBT. 62!

prudent administration generally will all assist in this work.
It need hardly be added that the higher the original rate
of borrowing the greater room there is for the employment
of this agency, a fact which we found to be one of the
strongest arguments against the creation of a higher
nominal capital than that really borrowed, but bearing
low interest 1 .

Certain plain general rules hold good with reference to
this part of Finance. First, the capital of the debt should
not, if possible, be increased, as it amounts to an addition
to the future burden. English conversions have for the
most part kept free of this mistake, but in 1883 the offer of
108 of 2^ cents, for .100 3 per cents, was a doubtful step.
Some of the French conversions, notably that of 1862, were
tainted by it. Next, it is desirable to make the scheme
simple and unencumbered with complicated stipulations in
order that it may be readily understood. A simple reduc-
tion of interest, with perhaps a guarantee against further
conversion for a period, is on the whole the best. The
fund-holders will not of their own accord accept any plan
of reduction : the motive power comes from the capital
available elsewhere, and therefore the plainer the offer
the better the chance of acceptance it has. Thirdly, it is
well to choose the time for the operation careTutly. The
commencement of the period of returning prosperity that
usually comes some years after a commercial crisis is the
most suitable. Loanable capital is then abundant, and
the rate of interest is low, so that the chances of succeeding
are at their highest. Fourthly, there is an advantage in
using the conversion to consolidate stock of different kinds,
as has been accomplished in several English cases 2 ; but this
consideration should not be carried too far, as it may be
essential to separate stocks bearing the same interest, but
issued on different terms, and in any case the operation
will deal with that part of the debt that bears the highest
interest.