Not all the returns from borrowing, however, are spent
in fostering productive enterprise. In fact, a large part
has been used in the destruction of productive capacity,
for a large percentage of borrowed funds has been used in
the prosecution of war. In such cases a derangement of
the industrial system occurs. Individual enterprises
change the nature of their production in order to supply
the materials of war, which the government is demanding.
These materials are largely for immediate consumption,
and with their consumption a large amount of capital and
labor is destroyed. The result is that, for a time at least,
after the emergency is past, the amount of commodities
which can be produced is less than what is desired. This
results in higher prices. It is not meant to infer that these
effects are inherent in the institution of credit they
merely arise from the use which the state makes of its
funds. Borrowing simply increases the ease of securing
funds.

Social and Political Effects. Public indebtedness, if car-
ried to extremes, may also influence social and political
institutions. The fear has often been expressed that the
public securities will, to a great extent, fall into the hands
of a wealthy few, and thus help to create an idle leisure
class. It is also quite possible that this class of security
holders may secure enough political power to influence
legislatures in prolonging a state's indebtedness longer
than the economic situation might justify. The situation
exists, of course, that a part of the citizenship is taxed to
pay the other part. Too frequently the holders of public
securities bear little of the burden of taxes to meet interest
or principal charges.

Experience has shown that these fears have not been
entirely unfounded. Fortunes have been swelled through
the manipulations of the public security market. The



396 OUTLINES OF PUBLIC FINANCE

Civil "War furnishes a number of examples of this. That
the securities tend to fall into the hands of a few is illus-
trated by the fact that before the Great War the entire
amount of United States bonds was held by less than one
thousand individuals and six hundred corporations. At
present about one fifth of the holders of United States
bonds live in one state, and these hold nearly one third of
the total issue.

Another danger of public borrowing is that since the
burden of present expenditures is not realized, legislators
may undertake ventures, the wisdom of which would be
seriously questioned if the funds had to be secured from
taxes. In other words, where public borrowing can be
resorted to with little difficulty, the citizenship will feel
less obligation to guard closely the public purse strings
than if expenditures had to be met through the channels
of taxation. This danger was recognized in the formation
of most of the constitutions of the American common-
wealths. These generally contain strict limitations upon
the power of the legislatures to issue bonds. Similar re-
strictions are generally placed upon the governing bodies
of municipalities.

International Complications. The holding of the securi-
ties of one country by another may become the source of
political difficulties. Numerous examples have arisen
where smaller nations have become involved with larger
ones because of debt obligations. International law has
established the principle that any unsatisfied debts of one
nation held by another are sufficient grounds for diplo-
matic intervention. This intervention has often taken
the form of armed force. Egypt became a British pro-
tectorate, among other reasons, because she abused the
credit which England had extended to her. The same
influence was potent in the French domination of Tunis.
The Monroe Doctrine has been called into use to prevent
the forcible seizure- of property to settle debt claims
among some of our southern neighbors, especially Mexico.



PUBLIC INDEBTEDNESS 397

It is entirely possible for bonds issued by some common-
wealths to be held by a foreign power. The political en-
tanglements with the Federal government, which a forced
collection of such an obligation would entail, can be easily
imagined. As public credit becomes more firmly estab-
lished, and as nations less frequently repudiate either
principal or interest, these difficulties automatically dis-
appear.

204. All Countries Have Not Taken the Same Attitude
Toward Extinguishing the Public Debt. The question
naturally arises as to what disposition shall be made of a
public debt after it has been contracted. The answer
which ordinarily occurs to American students is that the
debt will be canceled at the earliest convenience. The
American people have shown little sympathy with the
policy of perpetuating a debt. Most other countries, to
a greater or less degree, do not share this attitude. Eng-
land, to some extent, assumes the American viewpoint,
while the countries of Latin origin generally show little
concern in regard to the extinction of their indebtedness.
Since these two viewpoints are prevalent, it is of impor-
tance to note the reasons advanced for the adoption of
each policy.

Reasons for Extinguishing Debts. A factor of primary
importance in the consideration of debts is the burden
placed upon the citizens of a country, and it is upon this
phase, largely, that the policy of debt extinguishment dif-
fers. The payment of a debt necessarily means heavier
taxation with a corresponding burden upon industry. If
the principal is allowed to stand, however, the burden can
gradually be decreased by the natural expansion of indus-
try, and gradual increase of the social income and wealth.
With this development the burden of an interest charge
gradually becomes less because the financial ability of the
citizenship has been increased. In England, for example,
in 1815, the interest charge of the public debt was slightly
less than 10 per cent of the annual social income. By 1880



398 OUTLINES OF PUBLIC FINANCE

the same interest charge represented less than a 3 per
cent burden upon the social income. The same situation
is, of course, true in many other countries.

The tendency for money to depreciate in value also
lessens the burden of indebtedness. In periods when the
value is appreciating, as following 1873, however, the op-
posite effect will ensue. When the present indebtedness
of most countries is taken into account, however, it is too
much to hope that currency depreciation will make any
appreciable diminution in the burden. Debts are fre-
quently contracted at times when currency is at the peak
of depreciation in periods of war inflation and the
chances are that the subsequent changes in the value of
the currency will enhance, rather than decrease, the bur-
den of indebtedness.

The burden which the extinction of a debt will place
upon the industry of a country has often been over-
emphasized. It is true that the state has no independent
source of capital out of which to pay the bondholders.
It must resort to taxation, and taxes are paid from the
capital or income held by the citizenship. What the state
does is to collect a fund from one class of citizens, the tax-
payers, and turn it over to another class the bondholders.
In order that nothing be lost by the transfer, the second
class must use the funds as efficiently as the first class
would have used them. It is not at all unlikely that they
may be used more efficiently. If taxes are so contrived
that they take funds for the state that otherwise would
have been squandered, then productive capacity may
actually be increased by the payment of debts.

The productive capacity of a country would be de-
creased, of course, if its debts were paid when the security
holders lived in another country. This is usually true to
such a small extent as to have little influence in shaping
the course of action. Cancellation of debts may have a
further wholesome effect upon industrial workers, in that
their minds are relieved from the thought that a part of



PUBLIC INDEBTEDNESS 399

the products of their exertions is going to the class of
bondholders, and perhaps is assisting to maintain them as
an idle class.

205. Public Debts May Take a Number of Forms. Not
all public debts are of the same nature, and may differ
materially in a number of ways. One of the first distinc-
tions to be drawn was between funded and unfunded
debts. As the terms indicate, a funded debt was one
against which some particular fund or collateral was
placed to insure payment, while an unfunded one was
simply a debt contracted on general credit. These terms
are still in common usage, yet their significance has lost
much of the defmiteness of the earlier years. Not infre-
quently the terms bonded and floating debts are used as
almost synonymous with the two older expressions. In
general, the important distinction between a funded or
bonded debt, and an unfunded or floating one, is the time
element. The old idea of security has disappeared to a
large extent, and in many cases has been reversed. Mod-
ern long-term obligations, as a rule, are issued upon the
general public credit, while short-term obligations fre-
quently have specific revenues pledged for their redemp-
tion. Public borrowings for short periods, such as to meet
a deficiency of revenue, or a small unexpected call upon
the treasury, which can soon be taken care of from general
revenues, take the form of floating debts. A good exam-
ple of borrowing of this nature was the large amount of
treasury certificates issued by the Federal government
during the Great War in anticipation of revenue from the
Liberty Loans and taxes. The Liberty Loans, of course,
would be classed as bonded or funded debt.

The use of the expressions " short time" and "long
time," hi the above distinction, is far from definite. It
is, however, the best that can be made. There is no uni-
formity among writers or fiscal authorities in the various
political units as to what constitutes a short-term or a
long-term obligation. With some, a short-term loan may



400 OUTLINES OF PUBLIC FINANCE

extend over a period of years, while with others it may
not be considered proper to extend over as many weeks.
It is to be hoped that some more definite distinction will
gradually be adopted. It might not be disadvantageous
if the commercial distinction between short and long term
obligations would convey similar ideas when applied to
fiscal transactions.

Methods of Originating Debts. A second distinction in
public securities may be based upon the difference in the
way in which the obligation originates. The sovereign
power of the state gives it the advantage over the individ-
ual borrower, in that it can force loans from its citizen-
ship. These forced loans frequently take the form of
short-term obligations, such as the treasury certificates
which have frequently been issued in payment for goods
or services at times when funds were scarce. These cer-
tificates are usually interest-bearing, and made payable
as soon as sufficient revenue is expected to accrue. Cities
frequently make use of similar forms of obligations to tide
over a shortage of funds. The action of the state in issu-
ing fiat money is somewhat similar to a forced loan, yet
in the strict sense it cannot be called a credit transaction.
The importance of forced loans, in the modern state, is
comparatively insignificant.

The class of public loans which is by far the most im-
portant comprises those obligations in which a voluntary
agreement has been entered into between the state as
debtor, and the individual as creditor. There may be
many terms about which the agreement must be made,
and it is on the basis of these terms that voluntary
loans, or, as some call them, contract loans, may be
classified. 1

The debtor-creditor relation with the state often arises
through comparatively simple transactions, in which the
fact that the state becomes a debtor is often not consid-

1 For an excellent classification of contractural debts, see Introduction to
Public Finance, by Plehn, third ed., p. 389.



PUBLIC INDEBTEDNESS 401

ered. In these cases the redemption of the debt does not
depend wholly, or even in part, upon the credit of the
state, but upon additional assurances. When an individ-
ual purchases a postal money order, he becomes the
creditor of the state, yet he feels, in no sense, that the
credit of the state is involved. The numerous cases in
which some form of collateral is required before business
transactions are permitted, are other examples. Insur-
ance companies are often required to deposit bonds before
engaging in business, while national banks must deposit
bonds with the Federal treasury before circulating notes
may be issued. In all these cases the amount received by
the government is kept for redeeming the obligation, so
that its credit is an insignificant factor. Much the same
situation exists between the government and the holders
of its representative paper money. The holder of gold
and silver certificates is protected by a 100 per cent de-
posit of specie.

In the more purely credit transactions, differences in
the contract frequently exist. The state may agree to
pay no more than interest. This is true when a govern-
ment issues a perpetual bond, which is frequently done
by some European countries, and was formerly attempted
in the United States. It may be true that the government
agrees to pay no more than the principal. This situation
is approximated when a state uses redeemable paper
money. The most ordinary contract is one in which the
state agrees to make payment of both principal and inter-
est, the details of which will depend upon the time for
which the capital will be needed, the general condition of
the money market, and the pressure of the state's need.
Loans have been negotiated frequently on some annuity
plan of payment, in which the creditor is to receive a fixed
payment for a definite number of years or for life. In all
these cases the creditor has been a voluntary partner to
the contract, and expects the state to comply to the terms
agreed upon.



102 OUTLINES OF PUBLIC FINANCE

206. Many Problems Arise in Floating a Bond Issue.
Many problems confront the fiscal authorities when they
decide to float an issue of public securities. The rate of
interest is an important consideration, as well as the
method of securing subscriptions to the loans. Other con-
siderations are from what source the funds will come, the
special privileges which shall attach to the holders of the
securities, and the length of tune they are to run. Many mi-
nor considerations exist, also, which must not be neglected.

Interest Rate. The rate of interest which the securities
are to draw, while it is not a distinct factor unrelated to
other conditions, is of primary importance in determining
the conditions of a bond issue. Ordinarily the attempt
will be made, if the bonds are to be put on the market
and sold, to have the rate of interest as near as possible
to the current rate. If it should be below this, the bonds
will sell below par, and the principal of the indebtedness
will be larger than the amount which becomes available
for the use of the state. If the provision is imposed that
the bonds must be accepted at par, the state will be dis-
appointed in finding a market for its securities unless a
strong element of patriotism be hi existence. Franklin
experienced this situation in attempting to borrow from
European countries during the Revolution. Because of
the low rate of interest he was authorized to pay, no aid
could be secured except from France, and this was given
from other than economic motives. It may happen at a
time when funds are scarce, and the needs of the govern-
ment are pressing, that the rate of interest will have to be
higher than the current rate in order to draw funds to the
use of the government.