Government borrowing is likely to have effects upon the economy substantially different from those of other methods of financing, and the existence of a sizable debt may likewise have important consequences. The effects of retiring (or repaying) the debt may also be significant. National government borrowing has the greatest impact, but that of subordinate units may have some influence as well.

Government borrowing in the strict sense includes only borrowing from the private sector of the economy—from individuals, corporations, and various financial institutions, including banks. When the government obtains its funds from the central bank (the Bank of England, the Bank of Italy, the Bank of Japan, or the Federal Reserve System in the United States), it is really creating money rather than borrowing it, since the purchasing power is made by the central bank and no obligations to the public are created.

When a government borrows, funds are transferred from the lender to the government, the lender exchanging his money for government securities. The effect is to reduce the liquidity of the lender—his command over cash—to an extent dependent upon the nature of the securities. The reduction in liquidity is small with short-term securities and greatest with nonsalable, nonredeemable securities—a type seldom issued except in time of war or other crises that create financial emergencies.

Funds loaned to the government almost certainly come from savings, unlike, for example, funds paid in higher taxes, which are more likely to come out of consumption. In many countries the major holders of public debt are, in fact, pension funds, which invest in government debt on behalf of the individual members of their pension schemes. To pay higher taxes, many individuals are forced to reduce their consumption since they have no margin of savings and are unable or unwilling to go into debt; others do so as a matter of choice, in an effort to keep their savings intact. Lending, on the other hand, is entirely voluntary. The person who buys government securities is not likely to increase his rate of saving or to decrease his consumption. If government borrowing raises the market rate of interest, this may in turn encourage the diversion of additional money to saving, as may government securities that offer additional attractions—such as small denominations or redeemability—not possessed by other securities. But both effects in total are not likely to be of any particular significance.

The net effect of government borrowing on total spending and thus on employment and national income depends upon its influence on real investment—the purchase of new capital goods. In a period of unemployment, when savings are available in greater quantity than is required for investment, government borrowing does not compete with private investment nor make it more costly. In effect, the government absorbs funds that would otherwise be idle.

In periods of full employment the situation is substantially different. With banks loaned up to the limit of their reserves and real investment absorbing all of savings, government borrowing will restrict private spending as much as an increase in taxation will under the same conditions.

Government borrowing is of economic significance in several other respects. First, the buying and selling of government securities provides the central bank with a means of influencing the money supply, essential for effective monetary policy. Second, borrowing avoids the adverse effects that taxes may have on incentives, particularly if the taxes are raised sharply above levels to which persons have become accustomed. Third, borrowing permits government expenditures to be higher than would otherwise be feasible. Finally, the foreign borrowing of some governments gives them access to a greater quantity of foreign exchange, which enables them to finance the import of capital goods essential for economic growth. This consideration is not of concern to highly developed countries.

The existence of a government debt is of economic significance in itself, as distinct from the effects of the borrowing. In the first place, individuals who hold government securities regard them as a portion of their personal wealth. This is true even though the only way the government will ever pay the interest on the debt or repay the principal is by levying taxes on the community, which holds the debt. In this sense “we owe it to ourselves.” But since these links are not immediately apparent, the existence of a debt may make individuals spend more on consumption and save less than they otherwise would. The additional consumption may reduce the rate of capital formation and economic growth; it may also increase the level of employment over what it would otherwise be.

Second, because government securities are more liquid than most other investments, their holders are able to increase consumption out of accumulated savings more easily than they could otherwise. This may contribute to inflationary pressures.

Third, if investors, and particularly the business community, regard the national debt as a source of potential economic instability, their willingness to undertake real investment will be lessened. At times, particularly in the 1930s, there has been widespread fear of government debt even though there was, in reality, little basis for the fear. A similar phenomenon sometimes arises in the case of subordinate units of government. A large debt may discourage expansion of economic activity because of the fear of high taxes in the future and the realization that the large debt may prevent borrowing for urgently needed local improvements.

When governments borrow they must meet interest obligations, and these are usually paid out of taxes. The payment of interest on government debt thus involves a transfer of wealth from taxpayers to bondholders. The taxes may have adverse effects upon incentives, while receipt of the interest will provide no offset to these adverse effects. The tax-and-interest-payment program is also likely to redistribute wealth in favour of higher income groups, since government bonds are likely to be held to a greater extent by those groups. The effect may be to increase saving and reduce consumption.

Finally, large interest obligations lessen the ability of the government to finance other governmental activities. This effect is particularly obvious at the local level, where there are limited tax potentials.