The classical school of thought considered that government debt was an impediment to economic progress. They were a proponent of laissez-faire and advocated a market economy. The individuals were characterized as rational decision-makers who were far-sighted, unlike myopic individuals as assumed by the Keynesian school. These individuals respond to real changes in their wealth and plan their consumption behaviour over their entire life cycle.
David Hume, a classical economist, was perhaps the first one to convey his thoughts on public debt. In 1752, he said, “either the nation must destroy public credit or public credit will destroy the nation.” Accordingly, he was sceptical about the power vested in the hands of creditors who could abuse the debtors. Public debt, according to him, can pose adverse social-political consequences and is a threat to the security of the state as it encourages an idle and useless rentier class and oppresses the poorer class.
J. B. Say made a distinction between private borrowing and government borrowing. The purpose of private debt is to create beneficial employment, whereas public debt creates barren production and consumption, and the burden is transferred to future generations.
Adam Smith (1776) held the view that ”The progress of the enormous debts which at present oppress, and will in the long-run probably ruin, all the great nations of Europe, has been pretty uniform.” He considered the state as wasteful. Public debt takes away resources from the private capitalist; the annual produce is directed towards servicing of debt rather than capital formation and towards the maintenance of unproductive labour.
He argued that land and capital would be burdened by the higher taxes imposed on service debt. Public debt will lead to a transfer of resources to unproductive creditors, and as a result, “the ruin of trade and manufacture will follow the declension of agriculture.”
He and Ricardo were concerned with the consequences of public debt- the usage to which it was put. The consequence of debt is the destruction of capital caused by it.
Ricardo advocated a one-time capital levy as a means of redemption of debt and use of tax revenues for the financing of the war. The aim should be to be debt free within the period of three years. According to him, a nation free from public debt will witness high private capital formation and thus enjoy higher economic growth. A one-time tax in the form of a capital levy will free the nation from the debt; otherwise, a continuous tax burden will drive resources out of the economy and thus discourages economic growth.
Malthus also recognized the evils of public debt. He argued that high debt and accompanying higher taxes are injurious to food production, could lead to burdensome tax increases and tempt voters to default. He recognized that disequilibrium exists in the market in the form of high unemployment, poverty, disinflation, lower profits and economic recession. However, he was not in complete agreement with Ricardo regarding the levy of one-time tax. Rather he believed that it would aggravate the economic problems. \
According to him, both overconsumption and under-consumption hinder economic growth. The public creditors, namely the Capitalists and the landlords, would find it difficult to increase their consumption and demand to the extent necessary to close the gap between production and consumption. Instead, the gap between the two would widen, resulting in further distress to the economy.
John Stuart Mill (1848) was against public borrowing as it destroys capital which otherwise could be used more productively. A country should raise debt within acceptable limits. Accordingly, a country would be spared from the evil effects of public debt if it pays it off expediently through general contribution or out of the surplus revenue.
The classical theory on public debt took the best shape with the works of H. C. Adams, C. F. Bastable, and P. Leroy-Beaulieu. They carefully analyzed the effects of public debt. They made a clear distinction between the creation of public debt and the effects of public expenditure.
Adams argued that debt creation per se does not adversely affects the lenders. According to him, “A loan calls for no immediate payment from the people…. the lenders are satisfied since they have secured a good investment.” He refuted the argument that the burden of expenditure cannot be forwarded.
Bastable stated that public credit is only one form of credit in general and is governed by the same principles which control private credit. Further, he made a distinction between loan finance and tax finance. “A loan is voluntary and supplied by willing givers, taxation is levied on the willing and unwilling alike to make things smooth for the present at the cost of the future is not the duty of the wise and far-seeing Statesman.” He believed that loans are made out of capital, and taxes are paid out of new income. Both public debt and taxes affect income as well as capital.
Paul Leroy-Beaulieu made a clearer piece of the classical position on public debt. He maintained an open position on public debt, i.e. neither evil nor good. He condemned the classicists for ignoring the beneficial aspect of public expenditure.
As he puts it, “a loan will be useful or harmful to the society, in general, depending on whether the State preserves and usefully employs the proceeds or wastes or destroys the capital which the rentiers have given up.”
He criticized the view held by the earlier Classists. A nation could remain ultimately indifferent as the rentier receives returns from the taxpayers. There is a transfer of resources from one hand to another. In the absence of a loan, say, for example, the creditors, instead of lending to the government, would have lent to business, entrepreneurs or invested themselves and would receive an interest exactly like in the case of the amount lent to the government. The taxpayer would retain the increased tax.
Therefore, in the case of public debt, the rentiers receive interest on the capital advanced to the state at the expense of the taxpayers. In the situation where the credit is not made, the patrons hold the money that they would have to pay in taxes to service the debt. The rentiers, having invested the capital that otherwise they would have lent to the state, are not denied interest.
We can make out the distinction between the two cases: When there is an advance, one of the parties is harmed, and when there is no advance, each of the two, the giver and the rentier, has for his demeanour the aggregate which in the case of debt would have belonged to only one.
Summarizing the view of Paul Leroy–Beaulieu, the impact of public debt on society will depend on how the government employs the proceeds of the loan/ capital which the rentier has given up. During the past, the greater part of the proceeds of the loan was used for unproductive purposes leading to a belief among economists that public debt is undesirable. However, he condemns this belief saying it is exaggerated as public expenditure can be productively utilized too.
His ideas were widely acceptable until World War I. Subsequently, The report of the Colwyn Committee in 1927 represents the most important work on debt theory made during World War I and the Great Depression. According to the report, the burden of the public debt is faced by the nation as a whole in the form of future taxes for servicing of the debt as it involves redistribution of wealth within the nation.
The following points summarize the dominant views held by the Classical on Public Debt:
- Public debt leads to a reduction of resources for productive private employment.
- Deficits were considered less harmful compared to current taxes, and unbalanced budgets led to irresponsible government action and unnecessary expansion of its activity.
- Future financing gets more troublesome due to public debt as more funds out of the budget have to be spared for fixed charges and by increasing the amount of taxes which must be paid to service the debt.
- Currency depreciation and a rise in inflationary expectations are caused by a rise in public debt.
- Public debt financing requires funds for interest payment and amortization, hence a double burden for the exchequer.
Overall the Classists believed that an increase in fiscal deficit leads to government dissaving and will have a detrimental impact on economic growth if a rise in government dissaving is not fully matched rise in private savings. In this scenario, overall savings in the economy gets reduced, exerting pressure on interest rates.
The Classists were the proponents of no government intervention, and markets clear automatically, so there is the full employment of resources. This, in return, leads to a tax burden on future generations and a rise in future consumption. Increased consumption means lesser savings in a closed economy; external borrowings to finance national debt in case of an open economy. External borrowing involves currency appreciation and a fall in export earnings. Thus according to Classical debt theory, public debt leads to declining national savings, investment, and exports but a rise in consumption.
A recent estimate by Gale and Orszag on the US economy suggests that a rise in fiscal deficit by one percent of GDP will lead to a 50-100 basis point increase in long-term interest rates. Thus, countries must ensure fiscal discipline to achieve long-run growth objectives.
Read More in: Theory of Public Finance
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- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
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- Politico Eco Bureaucracy: Concept & Explanation
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- Samuelson’s Model of Public Expenditure
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- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
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- Effect of Regional Imbalances on Stabilization Policy
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- Tax System and Its Principles
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- Ability to Pay and Benefits Received Principle of Taxation
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- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment