September 20, 2004

Adam Smith on Government Deficits, and the Debt to Which They Give Rise

Adam Smith does not like budget deficits at all: "destruction," "perversion," "pernicious," "sophistry":

Smith: Wealth of Nations: Library of Economics and Liberty: When the public expence is defrayed by funding [i.e., borrowing], it is defrayed by the annual destruction of some capital which had before existed in the country; by the perversion of some portion of the annual produce which had before been destined for the maintenance of productive labour.... When funding... has made a certain progress, the multiplication of taxes which it brings along with it [to service the debt] sometimes impairs as much the ability of private people to accumulate even in time of peace as the other system would in time of war....

In the payment of the interest of the public debt, it has been said, it is the right hand which pays the left. The money does not go out of the country. It is only a part of the revenue of one set of the inhabitants which is transferred to another, and the nation is not a farthing the poorer. This apology is founded altogether in the sophistry of the mercantile system, and after the long examination which I have already bestowed upon that system, it may perhaps be unnecessary to say anything further about it. It supposes, besides, that the whole public debt is owing to the inhabitants of the country, which happens not to be true; the Dutch, as well as several other foreign nations, having a very considerable share in our public funds. But though the whole debt were owing to the inhabitants of the country, it would not upon that account be less pernicious.

Land and capital stock are the two original sources of all revenue both private and public. Capital stock pays the wages of productive labour, whether employed in agriculture, manufactures, or commerce. The management of those two original sources of revenue belong to two different sets of people; the proprietors of land, and the owners or employers of capital stock. The proprietor of land is interested for the sake of his own revenue to keep his estate in as good condition as he can, by building and repairing his tenants' houses, by making and maintaining the necessary drains and enclosures, and all those other expensive improvements which it properly belongs to the landlord to make and maintain. But by different land-taxes the revenue of the landlord may be so much diminished, and by different duties upon the necessaries and conveniences of life that diminished revenue may be rendered of so little real value, that he may find himself altogether unable to make or maintain those expensive improvements. When the landlord, however, ceases to do his part, it is altogether impossible that the tenant should continue to do his. As the distress of the landlord increases, the agriculture of the country must necessarily decline.

When, by different taxes upon the necessaries and conveniences of life, the owners and employers of capital stock find that whatever revenue they derive from it will not, in a particular country, purchase the same quantity of those necessaries and conveniences which an equal revenue would in almost any other, they will be disposed to remove to some other. And when, in order to raise those taxes, all or the greater part of merchants and manufacturers, that is, all or the greater part of the employers of great capitals, come to be continually exposed to the mortifying and vexatious visits of the tax-gatherers, the disposition to remove will soon be changed into an actual removal. The industry of the country will necessarily fall with the removal of the capital which supported it, and the ruin of trade and manufactures will follow the declension of agriculture.

To transfer from the owners of those two great sources of revenue, land and capital stock, from the persons immediately interested in the good condition of every particular portion of land, and in the good management of every particular portion of capital stock, to another set of persons (the creditors of the public, who have no such particular interest), the greater part of the revenue arising from either must, in the long-run, occasion both the neglect of land, and the waste or removal of capital stock. A creditor of the public has no doubt a general interest in the prosperity of the agriculture, manufactures, and commerce of the country, and consequently in the good condition of its lands, and in the good management of its capital stock. Should there be any general failure or declension in any of these things, the produce of the different taxes might no longer be sufficient to pay him the annuity or interest which is due to him. But a creditor of the public, considered merely as such, has no interest in the good condition of any particular portion of land, or in the good management of any particular portion of capital stock. As a creditor of the public he has no knowledge of any such particular portion. He has no inspection of it. He can have no care about it. Its ruin may in some cases be unknown to him, and cannot directly affect him.

The practice of funding has gradually enfeebled every state which has adopted it. The Italian republics seem to have begun it. Genoa and Venice, the only two remaining which can pretend to an independent existence, have both been enfeebled by it. Spain seems to have learned the practice from the Italian republics, and (its taxes being probably less judicious than theirs) it has, in proportion to its natural strength, been still more enfeebled. The debts of Spain are of very old standing. It was deeply in debt before the end of the sixteenth century, about a hundred years before England owed a shilling. France, notwithstanding all its natural resources, languishes under an oppressive load of the same kind. The republic of the United Provinces is as much enfeebled by its debts as either Genoa or Venice. Is it likely that in Great Britain alone a practice which has brought either weakness or desolation into every other country should prove altogether innocent?

The system of taxation established in those different countries, it may be said, is inferior to that of England. I believe it is so. But it ought to be remembered that, when the wisest government has exhausted all the proper subjects of taxation, it must, in cases of urgent necessity, have recourse to improper ones. The wise republic of Holland has upon some occasions been obliged to have recourse to taxes as inconvenient as the greater part of those of Spain. Another war begun before any considerable liberation of the public revenue had been brought about, and growing in its progress as expensive as the last war, may, from irresistible necessity, render the British system of taxation as oppressive as that of Holland, or even as that of Spain. To the honour of our present system of taxation, indeed, it has hitherto given so little embarrassment to industry that, during the course even of the most expensive wars, the frugality and good conduct of individuals seem to have been able, by saving and accumulation, to repair all the breaches which the waste and extravagance of government had made in the general capital of the society. At the conclusion of the late war, the most expensive that Great Britain ever waged, her agriculture was as flourishing, her manufacturers as numerous and as fully employed, and her commerce as extensive as they had ever been before. The capital, therefore, which supported all those different branches of industry must have been equal to what it had ever been before. Since the peace, agriculture has been still further improved, the rents of houses have risen in every town and village of the country—a proof of the increasing wealth and revenue of the people; and the annual amount the greater part of the old taxes, of the principal branches of the excise and customs in particular, has been continually increasing—an equally clear proof of an increasing consumption, and consequently of an increasing produce which could alone support that consumption. Great Britain seems to support with ease a burden which, half a century ago, nobody believed her capable of supporting. Let us not, however, upon this account rashly conclude that she is capable of supporting any burden, nor even be too confident that she could support, without great distress, a burden a little greater than what has already been laid upon her.

Posted by DeLong at September 20, 2004 07:46 PM | TrackBack
Comments

It's a sad, sad day when a "liberal" has to lecture the "conservatives" on the foundations of modern economics.

That it's been true for the last 20 years or so just shows how screwed up our political system really is.

Posted by: mac at September 20, 2004 08:44 PM

As the XXIst century is rolling on, who will raise the point about Smith's final burial ?

This is a 6 billions people world : do we have some place left for a savings oriented, scarce capital belief theory ? Please let M. Mankiw manage this memorial while we give up the "England moneybox model" or the Jean Baptise Say "Where is the crisisi ?" misconception.
We need ,instead, a a Global Collective Knowledge-based analysis with a voluntarily organised system to raise people's capabilities.

Seems to me that, from an analytical point of view, Adam Smith is Lucy in front of the need we have to understand socio-economic problems.

Jean-Louis Perrault

Posted by: Jean-Louis Perrault at September 20, 2004 11:57 PM

As the XXIst century is rolling on, who will raise the point about Smith's final burial ?

This is a 6 billions people world : do we have some place left for a savings oriented, scarce capital belief theory ? Please let M. Mankiw manage this memorial while we give up the "England moneybox model" or the Jean Baptise Say "Where is the crisisi ?" misconception.
We need ,instead, a a Global Collective Knowledge-based analysis with a voluntarily organised system to raise people's capabilities.

Seems to me that, from an analytical point of view, Adam Smith is Lucy in front of the need we have to understand socio-economic problems.

Jean-Louis Perrault

Posted by: Jean-Louis Perrault at September 20, 2004 11:58 PM

We now have a republican party that believes in big, insolvent govt. and a democratic party that believes in big, solvent govt.

Posted by: spencer at September 21, 2004 05:12 AM

Forgive the naive historian...but from the perspective I have usually heard (not being an expert on the issue or period), it was precisely government borrowing (relatively [only relatively!] well secured) that enabled Britain's military and commercial rise in Europe and overseas (insofar as the latter depended at least in part on the former). In consequence, Britain could always pay its bonds, thus leveraging future prosperity on earlier government borrowing.

True, the French and Spanish crowns also borrowed profilically, but with ever weaker security and consequently higher interest rates and spectacular defaults (in the Spanish case going back to the 1550s and repeated every generation or two since). Perhaps this was the model in Smith's eye as he decried government borrowing (as opposed to funding government out of running income)?

Of course, the opportunity to bash Republicans and so-called "fiscal conservatives" with Adam Smith should not be missed, and the memes launched now in this way may have a long and valuable life, so go ahead, Brad!

Posted by: PQuincy at September 21, 2004 06:26 AM

PQuincy,

It was Britian's managment of its borrowings though the Bank of England and Parliament that allowed it to secure loans at lower rates of interest then its continental rivals - allowing it to porject power more effectively and dominate the Globe.
Niall Ferguson's Cash Nexus has a good description of how democratic accountability to creditors and a determination to tax heavily when necessary - rather then inflate or default (ie France) made England superior.

The path to political dominance for liberals lies though anti-deficit/ debt reduction policies. If we take this issue as our own we can not only have a policy that helps us fund our programs but we can add to our majority by bringing fiscal conservatives into our fold. It is a winning strategy. One need only look at the electoral success of the Liberal Party of Canada or the Socialist NDP party in the Province of Manitoba to see how electorally powerful a sound money platform by a left of centre coalition can be.

The key is getting social welfare advocates to understand that sound finance is the path to steady funding and that patience not petulance is the road to progressive victory. Once the left flank is on board you are ready to roll. It is even good to have a few left of center critics outside of the tent because it demonstates toughness and leadership in standing up to your base - the current failure of the right in America: no limits.

Adam Smith: the new patron saint of the Left. :)

Posted by: Nemesis at September 21, 2004 08:44 AM

Deficits, big solvent or insolvent government...the issues surrounding both will forever be discussed and debated. But, is it not the ends to which deficits are put that really have consequences that matter?

Posted by: bncthor at September 21, 2004 08:49 AM

'The Economist's Voice', suggests that in recent years Democrats have become fiscal conservatives and Republicans have become fiscally irresponsible.

But does it really matter if a national government overspends? The European Union says yes: member nations are pulled up if their deficits are thought unreasonable. Moreover, the report by the International Fund on US fiscal prudence at the end of last year said the US was endangering the world economy with its huge borrowing. And there's a breach of the fiduciary contract between a government and its taxpayers: when a government tells its voters at the start of the fiscal year it will spend $X, it reneges on the contract if it then spends $X + 5%.

Does the size of the public deficit matter? A former US Secretary of Commerce said this month that the off-balance sheet liabilities in the public sector are upwards of $45 trillion. He thinks the deficit is understated by about $1.5 trillion annually.

Posted by: IJ at September 21, 2004 09:37 AM

"When a conservative says it is bad for the government to spend more than it takes in, he is simply showing the same common sense that tells him to come in out of the rain." Ronald Reagan

Whatever happened?

Posted by: joe at September 21, 2004 10:56 AM

I wrote a paper about Smith's view of deficits and debts as an undergrad, and got a B on it b/c my professor was irritated b/c I kept bringing up the funding point (note bold in text). He pointed out that we don't fund our debts.

I wonder if that B kept me out of Berkeley?

Posted by: Catuli at September 23, 2004 08:06 AM