RISEC, Volume 54 (2007), No.

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CLASSICAL ECONOMISTS AND PUBLIC DEBT

by
LEFTERIS TSOULFIDIS Abstract: Classical economists had developed advanced theories of public debt. These theories, however, have received less attention compared with those of value and distribution. Classical theories of national debt at best receive cursory consideration and are only used to offer further justification to modern theories. Smiths discussion of the unproductive role of the state and the Ricardian equivalence theorem are examples that are found routinely in the books of public finance or macroeconomics. As for the ideas of classical economists per se these are considered inappropriate for modern economies and are ignored even in books of history of economic thought. This paper takes issue with this view and argues that the ideas of classical economists on public debt might be more relevant nowadays than is commonly thought. (JEL: B12, B22) Keywords: classical economists, public debt, Ricardian equivalence

1. Introduction The theories and economic policies of classical economists do not only represent questions of historical but also of current interest, especially nowadays where the level and the structure of taxation, as well as the deficit and the public debt are high in the list of urgent problems requiring immediate treatment from governments. In our analysis we argue that classical economists (mainly Smith, Ricardo and J. S. Mill) had developed
Department of Economics, University of Macedonia, Thessaloniki (Greece). E-mail: lnt@uom.gr A version of the paper was presented at the annual conference of the ESHET in Porto (April, 2006). I thank the participants of the session Heinz Kurz, Persefoni Tsaliki, Nicholas Theocarakis and Karsten von Blumenthal for useful comments and suggestions. The detailed comments of an anonymous referee of this journal made the paper more readable.

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advanced theories of public debt. These theories, however, are usually considered inappropriate for modern economies and, as a result, they are ignored even in books of history of economic thought. This is the reason why we present and critically evaluate the essential aspects of the views of classical economists on public debt. Moreover, we argue that the so-called Ricardian Equivalence Theorem might be an exception rather than the rule in the writings of Ricardo and the other classical economists. The main reason for this difference in the results with respect to the effects of the method of financing government expenditures is the distinction of productive and unproductive activities, so fundamental in the writings of classical economists. In our discussion of public debt we concentrate on three major classical economists (Smith, Ricardo and J.S. Mill) because they share a common set of principles among which is included the idea that government expenditures satisfy useful social functions which, in general, cannot or are inappropriate to be performed by the private sector. However, in order to perform these useful social functions the government consumes part of the social wealth that has been produced and in this sense government expenditures are unproductive. These classical economists also share the view that the equality of savings and investment is established automatically without the mediation of any equilibrating mechanism such as the variations in the interest rate according to neoclassical economics or the variations in income through the operation of the multiplier according to Keynesian economics; making a long story short, for the classical economists an act of saving is, at the same time, an act of investment. Consequently, there cannot be a generalized overproduction of goods which is equivalent to saying that supply and demand are expected to be equal, when we consider the economy as a whole. There are of course critics of the classical view. Malthus, for example, thought that the general overproduction of goods is a threatening possibility for the economies and therefore public debt, if nothing else, helps since it inflates demand and provides for the additional demand needed in the economy, which in and by itself fails to provide. So Malthus and to a certain extent Lauderdale argued that governments should maintain an adequate level of public debt because otherwise the generalized overproduction of commodities from a mere possibility will become a harsh reality.1 Consequently, these economists deviate from the main classical analysis, in the sense that they do not strictly follow the logic of Says law. The remainder of the paper is organized as follows: Section 2 focuses on
Dome (1997) discusses Malthuss views on public debt and Bleaney (1976) discusses Malthuss and Laundardales views in the context of underconsumption theories.
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the views of Smith and Ricardo as regards the incidence of public debt on economic growth and argues that the financing of government expenditures through taxation leads to results different from those of financing through the issue of public bonds. The third section submits to empirical testing J.S. Mills conjecture of the effects of public debt and the last section concludes and makes some remarks about future research efforts. 2. Smith and Ricardo on Public Debt We begin our analysis with Smith who in the fifth book (chapter III) of the Wealth of Nations [1776] discusses the economic effects of public debt. In the forty-one pages of this chapter, Smith argues that governments should not run budget deficits, because the accumulation of debt is considered pernicious for the nation even if all of it is owed to domestic investors. In fact, Smith attacks the mercantilist notion according to which the payment of interest on public debt is like the right hand which pays the left. For Smith this is an apology founded altogether on the sophistry of the mercantile system (Smith, 1937, p. 879). The reason is that soon the need to redeem the debt will lead to increased taxation, causing the flight of domestic capital and the devaluation of the currency with negative effects on the remaining domestic producers (Smith, 1937, pp. 927-9). The debt, according to Smith, severely retards the natural progress of a nation towards wealth and prosperity (Smith, 1937, p. 674) since resources that could be used productively from the private sector of the economy are diverted by the state in order to finance its unproductive activities. Consequently, Smith proposed balanced budgets, where all government expenditures are financed by taxation.2 Budget deficits can be justified only in emergencies, as those that arise during wars or natural disasters. In such circumstances, Smith argues that the method of financing public expenditures (i.e., via taxation or issue of public bonds) is crucial for capital accumulation. He describes the difference in the following way:
The public expence, however, when defrayed in this manner [through taxation], no doubt hinders more or less the further accumulation of new capital; but it does not necessarily occasion the destruction of any actually existing capital [as a result of the reduction of saving]. When the public expence is defrayed by funding, it is defrayed by the annual destruction of some capital which had before existed in the country; by
Smith was pessimistic about the future reduction of debt and he believed its burden will in the long-run probably ruin, all great nations of Europe (Smith, 1937, p. 911).
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the perversion of some portion of the annual produce which had before been destined for the maintenance of productive labour, towards that of unproductive labour. (Smith, 1937, p. 878)

The above passage implies that taxation decreases mainly the households expenditures and only to a limited extent savings. Taxation, therefore, does not have the same effects as those of public borrowing which encroaches mainly on savings. Consequently, the amount of money raised by government through borrowing crowds out an equal amount of private investment. Hence, the underlying idea is that for Smith and the classical economists in general, savings are identified with investment. Consequently, taxation interferes with new investment and thus with the accumulation of new capital leaving the existing productive capacity intact; the same is not true, however, with public borrowing which undermines the existing productive capacity by displacing savings from the maintenance of productive labour to unproductive and wasteful uses. In general, the two methods of financing government expenditures are not equivalent, and taxation is preferred to borrowing since the latter diminishes savings, that is, the investible product and hence the accumulation capacity of the nation. In the analysis of public debt Ricardo shares Smiths views on the unproductive character of state expenditures and on the notion that their financing via public borrowing decreases the investible product and, therefore, it becomes detrimental to societys capacity to accumulate wealth.3 Nevertheless, many modern economists attribute to him the idea of the equivalence of the two forms of financing in the so-called Ricardian Equivalence Theorem (Barro, 1974), which is particularly popular in the literature of public finance, as well as in modern macroeconomics.4 This theorem ascribes to Ricardo the view that taxation and public borrowing constitute essentially equivalent forms of financing public expenditures. The rationale behind this view is that the government is expected at some future time to redeem its debt. If we now suppose a closed economy the repayment of debt will take place via increased future taxation, which means that on the basis of the rational expectations hypothesis individuals increase their savings buying the bonds that have been issued by the government. In other words
It is interesting to note that Ricardo does not have a separate chapter in his Principles that refers to public debt, he only discusses this issue en passant in his chapter titled: Taxes on Other Commodities than Raw Produce. For Ricardos general statements on public debt see Churchman (2001) and Dome (2004). 4 The term Ricardian Equivalence was coined by Buchanan (1976) and then became a standard topic in public finance and macroeconomics. For a critique of Barro (1974) see the article by ODriscoll (1977) and for a review of the subsequent treatment of the concept see Abel (1987, pp. 174-9).
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the amount of savings matches the size of public deficit and, therefore, the interest-rate remains the same, which means that there is no crowding out effect of private investments from public expenditures and, therefore, the overall demand remains the same together with the other real variables of the economy. There is a similar operating mechanism in the case of an open economy, where the redemption of public debt takes place via the sale of assets to international institutional agents. Such a possibility raises, once again, the question of the limited future government income and, hence, the inevitable future increase of taxation. Consequently, Barro (1974) and the new classical economists argue that either method of financing public expenditures, i.e. through taxation or borrowing, leads essentially to the same final results. The truth, however, is that Ricardo categorically rejects the notion of the equivalence of the two ways of financing government expenditures:
[The system of borrowing] is a system which tends to make us less thrifty to blind us to our real situation. If the expense of a war be 40 millions per annum, and the share which a man would have to contribute towards that annual expense were 100l., he would endeavour, on being at once called upon for this portion, to save speedily the 100l. from his income. By the system of loans, he is called upon to pay only the interest of this 100l., or 5l. per annum, and considers that he does enough by saving this 5l. from his expenditure, and then deludes himself with the belief, that he is as rich as before. (Ricardo, 1951a, p. 247)

In other words, the public would not perceive the debt as a tax of an equal amount and, therefore, people would tend to save less than in the case of taxation and so capital accumulation would slow down. As a consequence, income and tax revenues would fall and the government would raise the tax rates in the effort to raise the same tax revenues slowing further down capital accumulation and eventually leading to national bankruptcy. This is the reason why he proposed the simultaneous reduction of public debt otherwise two options will be available:
[] either the whole expenses of that war must be defrayed by taxes raised from year to year, or we must, at the end of that war, if not before, submit to a national bankruptcy; [] (Ricardo, 1951a, p. 249)

Similar arguments were developed three years later in his article on the Funding System [1820] (Ricardo, 1951b), where Ricardo evaluates three ways of financing a war of an annual cost of 20.000.000l. First, through direct taxation of 20.000.000l; second, through a loan, where the government will pay annually a specified sum in perpetuity and with an agreed interest

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rate; if for example the interest rate is 5% and remains constant, then the annual sum (or the sinking fund) will be 1.000.000l; third with a loan which will be paid in a specific time interval. If, for example, the interest rate is 5% and remains constant, then the annual payments of taxes will be counterbalanced with 1.000.000l plus a sum; for example with 200.000l for the settlement of the loan, whose maturity date is calculated at 45 years. From these three ways of financing, Ricardo argues that the first is preferred over the others and the reason is
[t]he burthens of the war are undoubtedly great during its continuance, but at its termination they cease altogether. When the pressure of the war is felt at once, without mitigation, we shall be less disposed wantonly to engage in an expensive contest, and if engaged in it, we shall be sooner disposed to get out of it []. (Ricardo, 1951b, p. 186)

He further draws attention to the idea that from a purely economical point of view there is no real difference among the various ways of financing, because in the end the same sum is being paid with the same collection cost. More specifically he notes:
n point of economy, there is no real difference in either of the modes; for twenty millions in one payment, one million per annum for ever, or 1,200.000l for 45 years, are precisely of the same value; [] (Ricardo, 1951b, p. 186)

Hence, Ricardo gives the impression that he is in favor of the equivalence between taxation and various forms of borrowing. However, a more careful reading of his text reveals that Ricardo claims that only in point of economy the alternative ways of financing of a war are equivalent.5 Ricardo explains:
[] but the people who pay the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think, that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of 20,000l., or any other sum, that a perpetual payment of 50l. per annum was equally burdensome with a single tax of 1000l. He would have some vague notion that 50l. per annum would be paid by posterity, and would not be paid by him; [] (Ricardo, 1951b, p. 186-187)
This quotation at first sight lends support to Barros (1974) view who by returning to the issue at hand (Barro, 1989 and also 1998) claims that on the one hand there is textual support of the Ricardian Equivalence, while on the other hand he invokes the Steven Stiglers Law of Eponymy according to which none of the major theoretical breakthroughs is attributed to its inventor.
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A critique to the above argument is that individuals have limited lifetime and, therefore, they do not care very much about the tax, since what they will pay at the end of their lives will be less than what they are called to pay once and for all. The individuals as a result of tax reductions engage themselves more in consumption spending rather than in saving. The counterargument here is that the bequests also must be accounted for. Ricardo further argued that the economic unit of his analysis should not be limited to the individual but it must expand to include the household. In Ricardos analysis, the household becomes an institution with infinite lifetime (since the income and the assets in general are transferred as bequests) and thus his initial assumption about the difference in the method of financing continues to hold unaltered. More specifically he remarks:
[] but if he leaves his fortune to his son, and leaves it charged with this perpetual tax, where is the difference whether he leaves him 20,000l., with the tax, or 19,000l. without it? This argument of charging posterity with the interest of our debt, or of relieving them from a portion of such interest, is often used by otherwise well informed people, but we confess we see no weight in it. It may, indeed, be said, that the wealth of the country may increase; and as a portion of the increased wealth will have to contribute to the taxes, the proportion falling on the present amount of wealth will be less, and thus posterity will contribute to our present expenditure. That this may be so is true; but it may also be otherwise the wealth of the country may diminish individuals may withdraw from a country heavily taxed; and therefore the property retained in the country may pay more than the just equivalent, which would at the present time be received from it. (Ricardo, 1951b, pp. 187)

Hence, Ricardo claims that the methods of financing government expenditures are not equivalent and this because the loans create the deception to the individuals that their income remains intact. Ricardo further argues that, in the exceptional case, when the public deficit is financed through taxation it may produce in the short-run the same results as those that would be caused from public borrowing. But in the long run, the ruinous results of public borrowing on societys capacity to accumulate are even worse than those that are caused by taxation, since borrowing drains savings ready to be invested productively, while taxation falls on current incomes for which we do not really know whether they were to be invested or consumed. For example, in a letter to McCullough (March 29, 1820) Ricardo points out:
[] but when we are carrying on an expensive war and it is necessary to raise large funds within the year, either by loan, or by taxes equal in amount to such loan, the former will I think be most injurious to the labourer, because it will more materially affect the accumulation of capital. (Ricardo, 1951c, p. 170)

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The reason is that so long as capitalists or the rich consumers are forced to pay an unusually high tax, they will try to increase their income to the pretax level by limiting their consumption and other unnecessary expenses. Thus it is possible for capitalists in one year to decrease the amount of their savings; however, in the next years they will make every possible effort to replenish their savings, in order to maintain their capital on the pretax scale. Ricardos analysis refers to the usual case where government expenditures are not productive (as for example in the case of a war). If individuals anticipate the future taxes, it follows that the present value of their future incomes decreases, which entails a pari passu reduction in their consumption expenditures. However, since the income level remains the same, it follows that the increase in the absolute and not the relative amount of savings will function as anticipation for future tax payments. The interest rates are expected to increase, thereby crowding out private investment expenditures. Consequently, if the government spends its money on wars or on consumption, then according to Ricardo taxation is preferred to borrowing. There are cases, however, where there is equivalency in the modes of financing government expenditures. For example, if the deficit is caused by public investments in the provision of infrastructures in general, it follows that the results may not be different if these expenditures are financed through taxation or borrowing.6 3. Testing J. S. Mills Conjecture J.S. Mill argued along similar lines with Smith and Ricardo with regard to the equivalence of the methods of financing public expenditures. For example, in the case of unproductive government expenditures he notes:
[] if the capital taken in loans is abstracted from funds either engaged in production, or destined to be employed in it, their diversion from that purpose is equivalent to taking the amount from the wages of the labouring classes. (J.S. Mill, 1976, p. 230)

J.S. Mill (1976, pp. 231) further qualified his view by arguing that public debt might not be accompanied with pernicious consequences for a country; for example, when it is financed from foreign savings, when government borrowing generates savings that would otherwise have not taken
It could be argued along Keynesian lines that output increases by the amount of taxes, but such an analysis requires a long run theory of output, which, however, is missing in the works of classical economists.
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place and also when government borrowing absorbs domestic savings that would be either invested unproductively or invested in foreign countries. If government borrows from surplus savings, it follows that the downward pressure on interest rates is contained. If, by contrast, the government competes with the private sector over funds that would have otherwise been invested productively, it follows that this competition will be manifested in rising interest rates. J.S. Mill (1976, p. 232) takes issue also with the argument that the increase in the interest rate can be attributed, at least in part, to the increase of the rate of profit, and he argues that the public debt decreases the private capital and, therefore, competition between workers intensifies and decreases their real wage which is equivalent to saying that the economys rate of profit increases. By so doing, J.S. Mill essentially places the classical economists theory of public debt to empirical testing. We consider that England is the most suitable country for testing the hypothesis of the classical economists during the period that begins around mid-eighteenth century and includes the Seven-Years War (1756-1763), the War of the American Independence (1775-1783) and of course the Wars with France that were carried out in two phases: first from 1793 up to 1801 and second from 1803 until 1815. Consequently, starting from 1752 and extending the time period for a few years after the Wars with France (i.e., 1818) the time span is sufficiently long to study the economic consequences of wars and of course the economic effects of rising debt on the variables that have been singled out by J. S. Mill. In fact the mounting debt during the period under investigation has been documented in the empirical literature. For example, Mitchell (1988) finds that the ratio of public debt to GDP in the UK rose from 137% in 1759 to 197% in 1801 and it was maintained at this level up to 1811, when it increased to 202%, while in 1821 it soared to 277%. Barro (1989, p. 238) gives more conservative estimates of the public debt-GDP ratio, according to which it was at 90% in 1750 and increased to 140% in 1764, it fell to 100% in 1775 and increased to 130% in 1785 and to 160% in 1816, while in 1822 reached the level of 185%. Despite differences, the two data sets convey approximately the same picture with regard to the rising tendency of the ratio of debt to GDP. These figures further suggest that the relative size of the government debt was much greater compared to todays standards and that the concerns of the classical economists about the size of debt and its consequences were absolutely justified. Figure 1 below displays in a scatter graph the relationship of the real interest-rate (RIR) with the rate of profit (ROP), as well as with the real wage

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(RW).7 Although the data during the investigated period is less than accurate, the behavior of the three variables is consistent with the classical (J.S. Mills) hypothesis concerning the economic effects of public debt. In fact, we observe a positive correlation between the real interest rate and the rate of profit (the correlation coefficient is 33.3% and the t-statistic is 2.83), while the real interest rate and the wage rate are inversely related (the correlation coefficient is 26.0% and the t-statistic is 2.17). We also find that the real wage and the rate of profit are inversely related (the correlation coefficient is 41.1% and the t-statistic is 3.63). Of course, such data were not available to J.S. Mill, however it is certain that he, as well as the other classical economists had a good perception of the evolution of these variables. Finally, the relative strength of these correlations might be questioned; however, given the complexity of the issue at hand the results can only encourage further research.
30

25

ROP WR

20

15

10

RIR
Figure 1. Real interest-rate against real wage and rate of profit in the UK, 1752-1818.

A possible critique to J.S. Mills view, especially for the post-1770s years,
The real interest rate on consols (interest rate minus the inflation rate) is estimated from data provided in Mitchell (1988) and the real wage is available in Makridakis et al. (1998), while the data on the rate of profit come from Mirowski (1982).
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would be that the interest rate was rising and it was positively related to the rate of profit not because of the mounting public debt, but because of the rapid progress in industrialization. J.S. Mills (1976, p. 233) response was that the progress in industrialization would have been even faster if the government had not appropriated capital during the wars that could have been invested productively. 4. Concluding Remarks In our discussion of the theory of classical economists (mainly Smith, Ricardo and J.S. Mill) on public debt, we showed that they shared some common principles that led them to similar conclusions. In fact, the analyses of the three classical economists are complementary to each other and in our view they work cumulatively to the formulation of a single theoretical approach. According to this approach the financing of public expenditures via borrowing is injurious to the economy and to its wealth-generating capacity. The idea is that borrowing diminishes savings directly, that is to say, the income ready to be invested productively. Since government expenditures, by and large, are not productive (e.g., payments of public employees, maintenance of the army, engagement of wars, etc.), it follows that public borrowing undermines the economys capacity to accumulate. In the case where these expenditures are necessary, the preferred way of financing them is through taxation. Smith was the first that articulated with great clarity the idea that taxation is mainly paid by currently earned incomes and it simply decreases private consumption without affecting the economys capacity to accumulate. Ricardo further elaborated the details of this view while J.S. Mill explained the precise relationship among the variables involved, i.e. the real interest rate, the real wage and the rate of profit. The empirical results suggest that the theoretical analysis and intuition of J.S. Mill and by extension of Ricardo and Smith are consistent with the available evidence and encourage further research within their theoretical framework and in its possible extension to current situations. REFERENCES
ABEL A., Ricardian Equivalence Theorem, in J. Eatwell, M. Milgate and P. Newman, eds., The New Palgrave: A Dictionary of Economics, New York: MacMillan, 1987, pp. 174-78. BARRO R., Are Government Bonds Net Wealth?, Journal of Political Economy, 1974, 82(6), pp. 1095-1117.

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, The Ricardian Approach to Budget Deficits, Journal of Economic Perespectives, 1989, 3, pp. 37-54. , Reflections on Ricardian Equivalence, in J. Maloney, ed., Debt and Deficits: An Historical Perspective, Cheltenham, UK: Edward Elgar, 1998. BLEANEY M., Underconsumption Theories, New York: International Publishers, 1976. BUCHANAN J., Barro on the Ricardian Equivalence Theorem, Journal of Political Economy, 1976, 84(2), pp. 337-42. CHURCHMAN N., David Ricardo on Public Debt, Basingstoke: Palgrave, 2001. DOME T., Malthus on Taxation and National Debt, History of Political Economy, 1997, 29(2), pp. 275-94. , The Political Economy of Public Finance in Britain, 1767-1873, London: Routledge, 2004. MAKRIDAKIS S., WHEELWRIGHT S., and HYNDMAN R., Real Daily Wages in Pounds, England, 1260 1994, www-personal.buseco.monash.edu.au, 1998. MILL J.S., Principles of Political Economy, Fairfield, NJ: Augustus M. Kelley, 1976 [1848]. MIROWSKI P., Adam Smith Empiricism and the Rate of Profit in Eighteenth Century England, History of Political Economy, 1982, 14(2), pp. 179-98. MITCHELL B., British Historical Statistics, Cambridge: Cambridge University Press, 1988. O DRISCOLL G.P., The Ricardian Nonequivalence Theorem, Journal of Political Economy, 1977, 85(1), pp. 207-10. RICARDO D. (1951a), On the Principles of Political Economy and Taxation, in P. Sraffa, ed., with the collaboration of M. Dobb, The Works and Correspondence of David Ricardo, vol. I, Cambridge: Cambridge University Press, 1951 [1817]]. (1951b), The Works and Correspondence of David Ricardo, vol. IV, in P. Sraffa, ed., with the collaboration of M. Dobb, Cambridge: Cambridge University Press, 1951 [18101815]. (1951c), The Works and Correspondence of David Ricardo, vol. VIII, in P. Sraffa, ed., with the collaboration of M. Dobb, Cambridge: Cambridge University Press, 1951 [18191821]. SMITH A., The Wealth of Nations, in E. Cannan, ed., New York: Random House, 1937 [1776].