MAY 1972
CROSSROADS - Page 5
The National Debt:
It Shrinks While It Swells
Stanley J, Dudko Assistant Professor, Department of Economics and Economics and Business
There is a story economists like to tell of the former student who
came back to visit his old economics teacher a few years after
graduation and found him preparing an exam. The alumnus
looked at the text and remarked that this was practically the same
one he had taken 15 years ago. “Yes,” the professor replied, “in
economics the questions are always the same.”
“Aren’t you worried that the students will pass the questions on
to next year’s class?” asked the old student.
“No,” said the professor. “In economics the questions are
always the same; it’s the answers that change.”
CHANGE IN ECONOMIC VIEWS
It seems that no topic in economics fits the story better than
the significance of the national debt. Most of those who studied
economics before the 1930’s were taught that the budget should be
balanced every year and the national debt kept as low as possible.
In 1932, when the national debt has risen spme $5 billion over its
$16 billion level of 1929, there was widespread expression of
concern lest the government bankrupt itself and the rest of the
economy. When the national debt reached some $48 billion in 1939,
many people, including a number of Congressmen, were
prophesying economic collapse. We can imagine what the
reaction then would have been to a prediction of a national debt in
1972 in excess oT $450 billion! A prediction of this sort would have
been tantamount to one of national disaster.
Yet we see economists today teaching that there is nothing
wrong with a national debt of over $450 billion, and that there are
many times when a budgetary deficit is the most appropriate
hscal policy.
This change in economic thinking has still not been accepted by
a large number of government officials and businessmen. Yet it
can be easily explained and defended. It should be emphasized,
however, that the change in approach to the national debt was not
conceived or conspired by the economists. It was probably made
necessary by the unfortunate events of the 1930’s, which changed
the role of economics in our society.
The main reason why the balanced budget was considered so
important before the 1930’s was that the Government’s role in
economics was the passive one of maintaining business con
fidence. It was felt that as long as business had confidence in the
economy, business spending would continue at a reasonable level
and this spending in turn would sustain econoniic activity. As to
the Government’s help in maintaining this confidence, what could
be more reassuring than to see the national debt as low as possible
and the Federal Government striving to have its revenues match
its expenses year after year?
Why the government changed its economic role is simple: it did
not work. In the early 1930’s, while the Government tried to
balance the budget, our economy experienced the greatest
depression in its history. It was soon realized that the Govern
ment’s role would have to be active if total spending were to be
strong enough to keep the economy stimulated.
CHANGING ROLE OF THE FISCAL POLICY
Fiscal policy was changed from a passive to an active force
helping the economy to recover in depressions and recessions and
helping to contain inflationary pressures during prosperty. In the
same way, monetary policy ceased to be a neutral force main
taining the flexibility of the money and credit supply. Both
monetary and fiscal policy became, instead, active forces helping
to stabilize the economy.
With fiscal policy and the national debt acting as stabilizers, the
direction in which the debt is moving at any given time became
more significant than the absolute size of the debt itself.
USES OF DEFICITS
In recession years, when private spending is not adequate to
keep the economy operating at a satisfactory level, deficits are
welcome because government spending is helping to keep the
economy vibrating. The common worry that government deficits
bring inflation does not make sense in such a circumstance. For
with excess productive capacity and unemployment both high,
stimulation by deficit spending would not push prices higher.
Instead, it would put more of the available men and machines to
work Some of the healthiest periods of expansion and growth in
real output have occurred at times when the public debt was in
creasing most rapidly.
On the other hand, deficit spending in a periochof boom, when
the economy is operating close to capacity and unemployment is
relatively low, would be more likely to help bring inflation. If the
stimulation of government deficit spending takes place at a time
when private spending is already taxing capacity, this increase in
federal spending cannot bring about more production of goods and
services. Instead it will bid up the prices of available men and
material and lead to inflationary pressures. In short, sound fiscal
policy today involves deficit spending in recessions, when the
economy needs a stimulant, and budgetary surpluses during
prosperous times when some curtailment on economic activity is
needed to avoid price advance.
To be sure, since few people are willing to accept higher taxes
and the reduction of government expenditures, even though they
may favor a budgetary surplus, our country is much better at
generating deficits than it is at building surpluses. But this does
not mean that the principle of a counter-cyclical fiscal policy
should be abandoned. It does mean, however, that more efforts
are necessary to gain understanding that if the federal deficit is to
serve as a stabilizing tool, there must be times when this
stabilization curtails the economy as well as times when it helps
sustain economic activity.
Economists have generally agreed that a counter-cyclical fiscal
policy is necessary and that the direction in which the debt is
moving is more important than the absolute size of the debt. But
are there not valid reasons to worry about the size of the national
debt? Isn’t the existence of a $450 billion dollar debt dangerous,
and wouldn’t we be better off if we liquidated it?
The answer is an absolute “No! ” In fact, to pay off the national
debt would be very disruptive to our economy.
PAYING OFF THE NATIONAL DEBT
The first question that comes to mind is how we would pay off
the debt. Since it is over $450 billion and since, in essence, it is
simply deferred federal taxation, to pay it off would involve
collecting over $450 billion in new taxes and using this revenue to
pay the holders of the debt. Granted, many of those who would
pay the additional taxes would also receive money as the debt was
paid off. But since many would pay much more than they receive,
or vice versa, paying off the debt would involve a giant distortion
in the flow of funds through the economy. There would be a
tremendous impact even on those few whose additional taxes
would just match the amount they would receive as their bonds
were paid off. While they would face no loss in cash, instead of
holding government securities — a safe and valuable asset - they
would be holding cancelled checks refelcting increased tax
payments.
ECONOMIC IMPACT OF DEBT REDUCTION
Moreover, approximately 20 percent of the national debt is held
by commercial banks. If these securities were to be paid off, it
would be accomplished by collecting taxes from the public. This
would reduce the public’s demand deposits, and the proceeds
would be used to retire bank-held securities. The end result would
be a decline of $60 billion in demand deposits and $60 billion in
bank-owned goverhment securities; for retirement of commercial
bank-held securities contracts demand deposits in the same way
that bank purchases of new Treasury securities increase such
deposits. Unless the banks are willing to reinvest their reserves,
the nation will face a sharp drop in its money supply and a
reduction of economic activity.
The elimination of the national debt would create a serious
problem for banks. There would be a drastic shortage of liquid
investments available for bank secondary reserves for liquidity.
For the Federal Reserve, the absence of a government debt
would mean that open market operations would be virtually
impossible, and day-to-day monetary policy would have to be
handled in a new manner. Undoubtedly, whatever substitute
could be developed for open market operations would be far less
satisfactory.
DEBTS AND ASSETS
It is important to realize that every debt must have its credit
counterpart somewhere. For every debt which someone owes,
that is, for every liability, there must exist someone else to whom
these funds are owed, someone who has a credit counterpart, an
asset of equal value. Since funds are transferred from savers to
investors primarily through the medium of debt, our willingness
to hold debts of others as our assets enables our complex
economic system to function. Not only has the national debt
grown as a part of our economic process, so have the real
productive assets behind the debt. As long as the Federal
Government borrows productively, an increasing debt is one of
the best measures of the nation’s growing wealth. What the
balance sheet equation tells us is that the debts are merely claims
against the assets. And which of us is for smaller assets?
A nation can have a steadily rising debt without ever being
brought any closer to financial ruin as long as the debt does not
grow at a faster rate than the national income. The truth of this
statement is illustrated by the history of Britain’s national debt,
as Lord Macaulay pointed out many years ago in his HISTORY
OF ENGLAND. With each major war, the British debt mounted.
He noted that “At every state in the growth of that debt, the nation
See NATIONAL DEBT Page 6