The retirement of government debt arising from a budget surplus has effects opposite from those of borrowing. Bondholders receive money in exchange for their bonds; though they could increase their consumption, they are more likely to put the funds into other securities and, as a consequence, security prices rise and money capital becomes more readily available for business investment. Whether it is used for that purpose depends, of course, on factors within the existing general economic situation.

Money for retirement must be obtained from some source. If it is simply created, there is no repressive effect on consumption or investment, and total spending in the economy rises—although by an amount relatively small compared to the total retirement. If, as is more common, the debt is retired from tax revenues, consumption is reduced in substantial measure; the remainder of the tax is absorbed from savings, and real investment may be reduced. The net curtailment in spending from the program of debt retirement is likely to reduce total spending in the economy. Elimination of the debt has one other effect: while current taxes will be increased, future taxes required to meet interest and principal obligations will be reduced.

It is commonly thought that borrowing shifts the burden of governmental activities to future generations, since those generations will be assessed higher taxes to pay the interest and principal. Some economists have disputed the idea, noting that future generations will inherit both the bonds and the obligations to pay them and collectively will be neither richer nor poorer than if the debt had not been incurred, except as a result of the difficulties incident to the debt and its retirement noted in preceding sections. Regardless of the methods of financing, the real cost of any governmental activity, war or otherwise, is borne in the form of reduced private consumption and investment and harder work or the like during the period in which it is carried on. The only burden on the future is that arising from the depletion of natural resources, and this is not affected by methods of financing. Nevertheless, the method of financing may affect the way in which the burden of public expenditure is shared among different groups, including age groups.

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International Monetary Fund headquarters, Washington, D.C.

Courtesy, International Monetary Fund

Although borrowing can often seem an attractive alternative to raising money from taxation or indeed to spending less, there are limits to how far a government can allow itself to become in debt either to its own citizens or to overseas investors (including intergovernmental agencies, such as the International Monetary Fund). In many countries, particularly in Latin America and in Africa, these limits have been exceeded in the late 20th century, with serious results for the stability of the country concerned. When debt rises to unacceptable levels, so that investors cease to believe in the ability of the country’s tax base to support it, then drastic measures are forced upon the country, including severe contraction of the economy.

The desirability of government borrowing has been debated for centuries. The traditional argument against borrowing is, of course, the interest burden to which it gives rise, an argument applicable equally to private and governmental borrowing. These interest obligations require either higher levels of taxes, with possibly adverse effects on the economy, or reduced expenditures for other purposes. The payment of interest may easily result in a transfer of purchasing power to higher income groups, contrary to accepted standards of equity.

As well as causing more and more of the government’s resources to be used to pay interest on its debt, a large public debt can push interest rates up for other borrowers. If the government is persuading a high proportion of available funds to be spent on public debt, the amount remaining for investment in other places, for example, investment in industry, is correspondingly small, with the result that a higher price (or higher interest rate) needs to be paid to attract such investment. This has been seen as a serious constraint in recent years, and most Western governments have tried to reduce their borrowing in order to keep interest rates down. There is some debate over just how important public borrowing is for interest rates, with monetarists believing it to be extremely important. Other types of economists are more skeptical, contending that factors such as inflation and the availability of private sector investment opportunities are more significant.

The financing of expenditures by borrowing instead of taxation and the debt itself, once incurred, increase total spending and so tend to produce higher prices and other inflationary effects in periods of full employment. During periods of full employment, any increase in government expenditures not offset by an equivalent decline in private spending for consumption or business expansion will be inflationary. This is the usual argument made against the use of borrowing instead of taxation from the standpoint of the goal of economic stability. It is primarily relevant to national government borrowing because the national government must assume the primary responsibility for lessening economic instability. But state and local borrowing is, of course, equally inflationary.

Borrowing, if freely employed, can easily lead to increases in government expenditures beyond levels regarded by society as the optimum and may reduce the pressures for efficiency and elimination of waste. As governments consider expenditure levels, the adverse reaction to taxation serves as an offset against the favourable response to increased services that will have to be paid for by taxation and thus facilitates the attainment of a balance between government-produced services and privately produced services. But if borrowing replaces taxation and is generally accepted as a suitable routine method of financing, the pendulum will swing in the direction of increased governmental activity, and appropriate balancing will be lost. The best evidence of this danger is to be found in the history of state and local government finance in the early 19th century in the United States, when large sums of money were borrowed for purposes of limited usefulness to society. Borrowing appears to be a less painful method of financing government, but, as has been noted, the costs of public expenditure still have to be met from current consumption or investment.