Debt and Taxes, War and Peace
Should a government pay its debts? Should a central government pay debts incurred by subordinate governments? Are there situations where states should pay debts incurred by a central government?
These may seem like long-settled questions, but the answers have not always been so obvious. Arrangements governing debt and taxes are the product of economic circumstances and political forces, which have led to different decisions over time. A close look at the history of these fiscal decisions can yield important lessons for the economic issues we face today, writes 2011 Nobel laureate Thomas J. Sargent.
In looking to history, Sargent, a Distinguished Visiting Fellow at the Becker Friedman Institute, follows the example of the late University of Chicago economists George Stigler and Milton Friedman. Both studied economic history because they were vitally interested in recognizing patterns and extracting generalizations about successful and failed economic policies. Likewise, Sargent and his colleague George Hall have been meticulously documenting the fiscal history of the United States to learn from the past. In a January 2017 paper, Sargent writes:
“In the spirit of Stigler and Friedman, I offer some examples of past situations and choices about government debts and taxes that resemble the ones we face today. An account of forces at play in the United States during the transition from the Articles of Confederation to the US Constitution in the 1780s naturally brings to mind difficulties Europe confronts as it experiments with the Euro as a step toward creating a United States of Europe. Another lesson relevant for today comes from the 1840s, when the US Congress weighed the consequences of bailing out creditors of state governments. Large deficiencies in provisions for funding state and municipal pension obligations today might soon confront Congress with similar choices. And a reader of my account of the situation shaping attitudes of American holders of UK and French bonds in late 1916 could be forgiven for thinking about Mr. Trump’s summer 2016 musings about renegotiating payments promised to holders of US government bonds.
In “Honoring Public Debts,” Sargent examines the interlocking connections between debt, taxes, the political arrangements that control them, and cross-border lending, all through the lens of bond prices. He shows how fiscal policy influenced events, alliances, and even revolutions.
The framers of Articles of Confederation and the Constitution “wanted markets to value US public debts highly, Sargent writes. Still, there’s a case to be made against paying public debts; not everyone owns government bonds, and those who don’t still must pay costly and distortionary taxes to cover these debts. Yet honoring public debt preserves a good national credit rating, in case there’s a need to borrow in the future.
Creditors matter politically, Sargent observes. “Owners of government bonds want to be paid, and that makes them want tax collectors to succeed.” What’s more, bondholders worry about policies that influence the price level, which determines their real return. Domestic creditors also care about units of accounts, monetary policies, and international exchange rate policies. After the US Civil War, an important issue in the 1868 campaign was about the units of account in which to pay interest and principal on vast quantities of US government bonds issued to finance the war. Ulysses Grant won and carried out the Republican promise to pay in gold, rather than paper scrip proposed by Democrats.
Sargent points out that bond holders’ desire for policies yielding high real returns “has practical ramifications about how the US should account for federal debt today.
Large portions of federal debt today are implicit, taking the form of retirement, disability, and medical “entitlements” that have been promised to citizens but that are not recorded as debt on the government’s books and are not recorded as assets in private citizens’ accounts. This obscures what should be the interest of entitlement holders to support the taxes that will be required to deliver them. A “tell-it-like-it is” proposal for “privatizing” these entitlements would award federal debt certificates to US citizens as a way to make those promises explicit and tangible.
Sargent also shows how bondholder’s interests cross international borders and drive foreign policy. In the words of 19th-century economist Henry Carter Adams, “the granting of foreign credit is a first step toward the establishment of an aggressive foreign policy, and, under certain conditions, leads inevitably to con- quest and occupation. (Adams 1887, p. 25)
In one example, Sargent outlines how Germany, concluding that the US would enter the war to protect the interests of creditors holding vast amounts of British and French debt, began unrestricted submarine warfare. After the war, Britain and France imposed punishing reparations on Germany in part to pay off public and private American credit.
Cross-border debt remains a critical issue today, Sargent concludes: “Today, residents of China and Japan hold substantial fractions of outstanding US marketable government debt. About 35% of marketable US government debt is held by foreigners. They have large claims on taxes to be collected by the US government. They are interested in US fiscal policy. Though they don’t vote in US elections, they have other ways of expressing their preferences.”
Download full version of “Honoring Public Debts” (.pdf)
Thomas J. Sargent, winner of the 2011 Nobel Prize in Economic Sciences, is a recognized leader in the field of macroeconomics working on monetary and fiscal economics and applied time series analysis. He is the William R. Berkley Professor of Economics and Business at New York University. He also is Distinguished Research Fellow and codirector of the Fiscal Studies Initiative at the Becker Friedman Institute for Research in Economics.
