CHAPTER XVII

PUBLIC INDEBTEDNESS

201. Indebtedness Is Characteristic of Modern Fiscal
Systems. In the early existence of governments, borrow-
ing was looked upon as an extraordinary means of secur-
ing revenue. This method was to be employed when all
others failed, or when the need was occasioned by an
emergency, such as war or pestilence, and the ordinary
sources of revenue were inadequate to meet such sudden
demands. In some of the earlier states, moreover, there
was no need, even in cases of emergency, for the use of
public credit. As need arose, the state simply demanded
more services from its citizenship, or extended its power
to confiscate any commodities of which it might be in
need. As the state evolved from this condition of direct
appropriation of materials and services, and as constitu-
tional government gradually took on more definite form,
the institution of public credit gradually became more
prominent.

The present widespread use of public borrowing was
reached only after a long and slow development. Its
history would not be the same in all states. In most of
the older states it developed with the growth and remodel-
ing of fiscal systems, while some of the newer states, in
imitation of the already established governments, have
used their credit as a source of revenue from the start.
Whatever the development, the institution of borrowing
has assumed a place of such importance in modern fiscal
systems, that few governmental units can be found which
do not practice the policy of deficit financiering. This



388 OUTLINES OF PUBLIC FINANCE

condition not only applies to national units of both mo-
narchical and democratic types, but to the minor political
units, such as the commonwealth, county, and munici-
pality.

Money Market Necessary. Before public borrowing can
be successfully carried out, a money market must be in
existence, and public credit must be established. It is
evident that before a government can borrow money, the
people of that government, or some other, must have
money to loan that is, there must be a money market in
existence. Since a money market is characteristic of a
people of somewhat intense commercial life, it naturally
follows that public borrowing can develop only in coun-
tries whose citizenship is of the commercial type.

It already has been indicated that, among early states,
a new prince or ruler frequently repudiated the debts of
his predecessor. Under such conditions the institution of
public credit was indeed weak, while the loans of the
individuals were frequently of an involuntary nature. It
was only with the development of constitutional govern-
ment, wherein the citizenship gained control over the
affairs of the government, that guarantees began to be
made against repudiation. With these guarantees public
credit grew stronger and public debts grew apace.

The Republic of Venice is usually credited with having
inaugurated successfully the policy of public borrowing.
England did not use it until the time of William III. At
present, however, a political unit which is free from debt
is very exceptional. Many of the debts, indeed, are of
such magnitude that the meeting of the interest charge
entails such an enormous burden upon the citizenship
that any effort to pay off the principal seems out of the
question.

Failure of a Reserve Fund. The policy of public borrow-
ing has not always received the sanction of students of
fiscal problems. In the earlier stages of political develop-
ment the maintenance of a reserve fund, or "war chest/'



PUBLIC INDEBTEDNESS 389

as it was called, was looked upon as the most feasible
method for meeting an emergency. This was gradually
abandoned until, in recent years, Germany has been the
only important state which still followed this policy.

The maintenance of a reserve fund by the state received
the sanction of early fiscal authorities because it appeared
that this was the only way to relieve the state from
financial embarrassment in time of emergency. Subse-
quent developments, however, have led to the almost
total abandonment of the policy. One reason for its fail-
ure has been the inability of a state to acquire and main-
tain a reserve of sufficient size to meet the need which
modern emergencies impose. The insignificance of Ger-
many's war chest of $30,000,000 is apparent when the
total of her war expenditures are calculated. To secure
and maintain a fund sufficient to meet such an emergency
expenditure as the Great War entailed upon its partici-
pants, would require sacrifices which no citizenship would
be willing to endure.

The time and occasion for the use of the reserve fund,
moreover, are uncertain, and individuals discount the
future to such an extent that they are unwilling to make
any great sacrifice hi the present to meet a remote and
uncertain need. The subtracting of a large amount of
gold from the monetary supply of the country, if the
reserve be kept in this form, must curtail commercial
and industrial development, and thus lessen the patri-
mony of the state. If the state keep its reserve in the form
of securities, it constantly faces the danger of having to
dispose of them in a poor market, while an element of
instability is introduced in the market for securities be-
cause of the possibility of the state unloading its holdings
at any time.

The modern state, hi order to meet not only extraor-
dinary expenditures, but frequently ordinary ones, enters
the money market alongside individuals, and bids for the
use of capital. National, state, and municipal bonds are



390 OUTLINES OF PUBLIC FINANCE

so extensively used in modern fiscal systems that they
are accepted, without question, as an ordinary occurrence.
One needs but to glance over the list of securities which
leading banking and brokerage houses offer, to see the
importance of the role which the various forms of public
evidences of indebtedness play in our modern security
markets.

202. All Aspects of Public and Private Debts Are Not
the Same. While public borrowing in general partakes
of the nature of private indebtedness, yet in some respects
differences may occur. In both cases some form of credit
must be established, and a source of loanable funds must
be in existence. One important difference, however, is
the sovereignty of the state. Because of this sovereignty
the state cannot be compelled to fulfill any contract it
has made. In the United States, for example, no common-
wealth can be sued by an individual without its consent.
Hence, if a state should wish to repudiate a debt, as has
been frequently done, the creditor has no redress.

In the case of states, then, there is no political or legal
method of enforcing the fulfillment of contract. As a
matter of fact, however, there does exist a strong eco-
nomic force which acts as a compelling motive to the
keeping of obligations. The fear of the inability to place
future contracts in a satisfactory manner compels the
state to be cautious about violating present contracts.
The old adage that "the truth itself is not believed from
one who often has deceived," has a public as well as an
individual significance. The fact that states were slow to
recognize this accounts, in large part, for the slow develop-
ment of public credit.

Payment of Public Debts. Public borrowing differs
from private, also, in the purposes for which it may be
undertaken, and in the basis for the payment of the in-
terest and principal. In modern private borrowing the
great majority is for commercial enterprises of a produc-
tive nature. As long as borrowing was for consumptive



PUBLIC INDEBTEDNESS 391

purposes, ecclesiastical as well as political authorities for-
bade the exaction of interest on the ground that the bor-
rowed capital did not create any ability to meet an inter-
est charge. The devices which were used to evade these
restrictive measures when capital came to be demanded
for productive purposes soon led to the legalizing of in-
terest payments. A large part of borrowed capital, then,
because of the productive uses to which it is put, has in
itself the ability to meet the interest charge, and perhaps
in time even to provide for the repayment of the principal.
There is a mutual gain the creditor gets interest while
the debtor gets productive capacity.

These conditions of private borrowing may be true in
the case when the state is the debtor, but frequently are
not. The important difference in the two kinds of debts
is that the state does not have to depend upon the pro-
ductivity of its borrowed funds to meet the payment of
the interest or principal. The payment of interest some-
times represents the charge for a public sacrifice, rather
than for a public benefit. The funds may have been
squandered in some worthless industrial venture or ex-
pended on a war in which defeat was the outcome. And
defeat usually comes to one of the contending belligerents.

In private enterprise the squandering of funds, or fail-
ure of the undertaking, frequently means the inability to
meet liabilities. In the case of the state, however, lia-
bilities can be met from the general taxing power. As
long as taxes can be secured, the interest and the principal
of debts can be paid. The ability of an individual to meet
a liability depends upon the success of his particular in-
dustry, while the ability of the state to meet liabilities
depends upon the success of industry in general. It is
because of this broad patrimony that the state is often
able to secure funds on better terms than individuals.

Purpose of Debts. -The power of a state to meet its
indebtedness charges from general revenues has led to
much discussion of what constitutes the legitimate pur-



392 OUTLINES OF PUBLIC FINANCE

poses for public borrowing. Some have held that a state
should borrow only in those cases where the use of the
funds will provide the means of paying the interest and
principal. No modern state restricts its borrowing to
such narrow limits. No definite rule can be given as to
when a state should borrow, and the best measure of
justification can be found in comparing the benefits de-
rived from the debt, with the sacrifices involved because
of it. Difficulty creeps hi here because many important
public services, such as protection, education, and parks,
are of such an immaterial nature that no money standard
can be placed upon them.

It has generally been conceded to be bad fiscal policy
for a state to expect to meet continually its regularly re-
curring expenditures from borrowing. No one would jus-
tify such a method of procedure on the part of individuals.
It often happens, however, with both states and individ-
uals, that revenues are less than were anticipated, or that
expenditures are greater. It may be necessary to borrow
to tide over until new revenues are available from the
ordinary sources, or from new ones. When states borrow
under these conditions it is only for a short period, and
the intention is not to create permanent indebtedness.

Modern public borrowing, with no difficulty in justify-
ing it, goes much farther than this. It is the pride of the
American people to improve and extend public property.
Large municipal bond issues are continually being floated
for the purpose of improving streets and parks, for better-
ing educational facilities, or for undertaking some public
enterprise, such as the waterworks or the electric plant.
The national government, as a rule, has made its ordinary
improvements, such as the improvement of rivers and
harbors, with funds which regularly flow into the treasury
each year. When some gigantic project is undertaken,
such as building the Panama Canal, borrowing has been
used to supplement the other sources of revenue.

In such capitalistic enterprises as some that have been



PUBLIC INDEBTEDNESS 393

suggested, where the returns are expected to be more than
enough to make them self-supporting, there is little ques-
tion about the feasibility of borrowing the funds to estab-
lish them. The justification of borrowing for giving in-
tangible benefits will depend upon the ideas which are
held as to the function of the state, and since these are so
diverse, no generally accepted opinion can be given. The
tendency, however, is for borrowing to occupy a more
important place among the sources of public revenues.

203. The Economic and Political Effects of Public In-
debtedness Are Important. Much has been said and
written concerning the economic and political feasibility
of public borrowing. Opinions have varied from the ut-
most condemnation to the heartiest approval. The earlier
writers were usually extremists in whichever view they
took, while modern opinions have been tempered by ex-
perience. No longer are a nation's debts looked upon as
gold mines, or the creators of an equal amount of capital,
or as an institution necessarily destructive of national life.
Certain results do appear, however which are worthy of
notice,

Competitor for Capital. The first obvious effect of pub-
lic borrowing is that the government enters the money
market as a competitor against individuals for capital.
This increase in the demand for capital naturally tends to
increase interest rates. The state has the advantage over
individual competitors that, since it is not dependent
upon the productivity of the borrowed capital to meet
the interest or principal charge, it may bid for the capital
by offering high or excessive rates of interest. It has the
further advantage that, in offering the normal or a lower
rate of interest, it can often appeal to patriotism, or make
special concessions to its creditors. The real industrial
effects of public borrowing will depend upon the method
used in securing the loans, and the purpose to which the
capital is applied.

If the government enters the money market, and offers



394 OUTLINES OF PUBLIC FINANCE

the normal rate of interest with no special concessions,
the effects upon industry will be scarcely noticeable. If
funds are secured, they will come from a supply of free
capital, for industry will not readjust itself to supply this
demand. Industrial effects would result, however, when
public loans are sought through offering a high rate of
interest. In the first place, this will bring forth more
savers, and a greater amount of saving from the previous
class of savers. Money that has been spent for the prod-
ucts of industry will now be turned over to the govern-
ment. The lessened demand decreases the profitableness
of industry, until it is probable that investments of capi-
tal which are bringing a smaller return than that offered
by the government, when readjustments become possible,
will seek government securities rather than a continuation
in industry. Under such conditions production under in-
dividual management will decrease, accompanied by a
decrease in the demand for labor.

Use of Borrowed Funds. The use to which a state puts
borrowed funds is an important factor hi determining the
ultimate effects of public borrowing. If debts are con-
tracted for the purpose of carrying on some industrial
enterprise, such as constructing and operating canals,
railroads, or other similar enterprises, the effects of bor-
rowing may be negligible. It may simply mean that the
state is supplying a commodity by using capital and em-
ploying labor that would be demanded otherwise by indi-
viduals. Assuming the degree of efficiency to be the same
in either case, borrowing by the government would have
no effect on the social income or upon the prices paid in
the money or labor market.

The ability of the state to undertake industrial enter-
prises of such long duration and of such gigantic propor-
tions that they would not appeal to individuals, may often
enable the state to increase the social income by increas-
ing the opportunities for the use of capital by individuals,
as well as by increasing the effectiveness of capital already

in use. Borrowing by the United States government for
constructing the Panama Canal, or for its numerous rec-
lamation projects, are examples of this sort.