Public Debt v. Private Debt: Is There Really An Economic Difference?

By J. Peter Van Schaik

A fundamental fallacy accepted as fact throughout most of the economic and political
communities is private debt is better for the economy than public debt. It is considered a fact
beyond dispute that private debt stimulates an economy which leads to expansion while public
debt is always a net drain on an economic system since it diverts money from the private sector.

This is simply not true.

In reality it doesn’t matter who borrows the money: The economy cannot tell and doesn’t
care. What matters to an economy is where the borrowed funds come from and where they are
going. Who does the borrowing is completely beside the point.

To understand why where the borrowed funds originate does matter to the economic system,
you have to understand fractional reserve banking. In a fractional reserve banking system the
banking system can create and lend dollars, that is, purchasing power, out of thin air. Let’s
assume the current reserve requirements are 10%. This sounds like if a bank has one dollar in
new deposits it can only lend ninety cents since it needs to hold ten percent of its deposits in
reserve. And this would be true if there were only one bank. But when Bank A lends the ninety
cents most, if not all the money, winds up in another account at another bank increasing its
reserves by ninety cents. That bank holds onto $0.09 as reserves and lends the $0.81 which ends
up in another account at Bank C. Bank C adds $0.08 to its reserves and lends the $0.73. As you
can see, that original $1.00 increase in reserves has led to a substantially higher increase in
purchasing power. This increase in purchasing power can be inflationary. After all, that is part of
the traditional definition of inflation: An increase in purchasing power relative to the goods and
services available for purchase. In reality, it’s what this created money purchases that determines
the benefit or damage to the economy.

If the created purchasing power finances a productive investment, a new factory producing
solar panels for example, the new money is backed by real goods available for purchase and the
inflationary pressure is minimal or non-existent. But if the new money finances a service such as
haircuts or non-productive investments, then we have a problem. There’s new money floating
about the economy, feeling the full effect of the monetary multiplier, but no new goods or
services are available for purchase.

That’s why, of the two factors which do matter to the economy, the second, where the money
is going, matters most. We can borrow money to initiate new production or we can borrow
money to simply maintain the status quo. The difference between the two matters a great deal to
the economy. But, again, it doesn’t really matter whether it’s the government doing the
borrowing or if it’s the private sector. Either can finance production, which is beneficial, or
economic consumption, which is detrimental to the economy.

To say that private sector borrowing is usually productive may be true but it is an extremely
debatable point. If we are going to solve our economic problems we need to come to grips with
the reality that all private debt isn’t necessarily productive and beneficial to our economy and all
public debt isn’t necessarily without economic benefit. Sure, private debt may be productive but
there is a pretty good chance it isn’t. If the private debt goes to finance ornate corporate
headquarters it isn’t really any more productive than the government borrowing funds to build a
museum. Yes, a factory is a productive use of debt but very few of our debt dollars are going to
finance factories, at least they are not financing factories built in the United States.

What does it really mean when it is said that a debt is productive? Does it mean the debt
finances the construction of new factories and businesses? Does it mean that new mines or
farmland are brought into production? Or does it simply mean it finances spending in the
economy which in turn leads to other economic activity?

If it means the debt finances the construction of new factories and businesses, then few
private sector dollars borrowed are productive, especially when capacity utilization is under
70%.
 If money is borrowed to buy an existing business, you can’t really claim that is a productive
use of debt. The business is already there. The buildings are already there. The jobs are already
there. Any productive capacity of the enterprise is already in existence. In reality it is frequently
true when an existing business is purchased by another entity the net effect is job loss as the
buyer cuts costs in order to improve the bottom line.

Borrowed dollars spent by our various levels of government don’t disappear into an economic
black hole, never to be seen again. They are spent and dollars spent, whether you want to admit it
or not, stimulate the economy in exactly the same way regardless of who spends them.

There is also no discernable difference to your budget whether more of your paycheck goes to
higher taxes to pay government debt (local, state, or federal), more of your paycheck goes to
higher prices for goods and services to pay corporate and business debt, or more of your
paycheck goes to directly pay off your personal debt. In any case the money is out of your pocket
and no longer available to you to pay for current consumption.

Copyright 2010 – J. Peter Van Schaik