P
Public Debt
James M. Buchanan
Public debt (government debt) is a legal obliga-
tion on the part of a government to make interest
and/or amortization payments to holders of desig-
nated claims in accordance with a defined tempo-
ral schedule. Public debt is created through
government borrowing from individuals, corpora-
tions, institutions, and other governments. Bor-
rowing is part of a bilateral exchange process in
which lenders transfer funds to government and
government, in turn, transfers to lenders desig-
nated instruments that represent claims on gov-
ernment revenues over a series of periods
subsequent to that in which the borrowing occurs.
In simple balance-sheet terms, public debt is a
liability item on the government’s account, and
as asset on the combined accounts of the holders
of the debt instruments.
In its essential respects, public debt is not dif-
ferent from the debt of individuals or
nongovernmental institutions. The positive anal-
ysis is equivalent over the several settings, and the
normative principles for the use of debt are the
same. These two propositions are not universally
This chapter was originally published in The New
Palgrave: A Dictionary of Economics, 1st edition, 1987.
Edited by John Eatwell, Murray Milgate and Peter
Newman
# The Author(s) 1987
Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics,
DOI 10.1057/978-1-349-95121-5_1883-1
accepted by economists, whose understanding
and analysis of established classical principles
were eroded in the emergence of the macroeco-
nomic mind-set of the post-Keynesian era.
Because of the continuing confusion and ambigu-
ity in the basic economic theory of public debt,
extended discussion is required on what should
otherwise seem quite elementary analytics.
Taxes, Money and Public Debt
In order to finance spending programmes
(including transfers) government must first secure
revenues. Three means are available to govern-
ments with independent monetary systems: taxa-
tion, money issue, and public debt. Only two
means are available to subordinate governments
without money creation powers or to national
governments that tie domestic currencies to exter-
nal forces in the international economy: taxation
and public debt.
It is useful to make two critical distinctions
between taxation on the one hand, and public
debt on the other. With taxation there is only one
possible ‘exchange’ embodied in the combined
fiscal process, that effectuated via government
between individuals as taxpayers and individuals
as beneficiaries of government spending
programmes. This two-sided fiscal operation is
‘exchange’ only in the aggregative sense that per-
sons in the community secure benefits from the
taxes paid by persons, whether or not the taxpayer
2 Public Debt
and beneficiary groups are overlapping. However,
even if the fiscal process satisfies the aggregative
and the individualistic efficiency standards such
that all persons pay tax-prices, at the relevant
margins, equivalent to public-goods benefits,
coercion is required to implement the solution.
The basic fiscal ‘exchange’ is not, and cannot be,
voluntary.
With public debt issue, by comparison, two
‘exchanges’ are involved in the combined fiscal
operation, one, the political ‘exchange’ analogous
to that in taxation, and the other the whole set of
privately negotiated and wholly voluntary
exchanges between government and those who
lend funds to government. Failure to recognize
the double set of exchanges that public borrowing
combined with spending of the proceeds
embodies is the source of major confusion in
determining the location of the burden of debt,
to be discussed below.
A second critical distinction between taxation
and debt issue lies in the temporal difference in the
politically determined imputation of the liabilities
what are made necessary by the fact of govern-
ment spending. With taxation, these liabilities are
imputed to those persons and institutions that
make the funds available directly to government
in the period of the spending operation. With
public debt, by contrast, there is no current or
initial-period imputation of fiscal liability. Reve-
nues are secured from those who lend voluntarily,
who do so in exchange for promises of future
period interest and amortization payments, and
not in ‘political exchange’ for the benefits of
spending programmes, even indirectly. With gov-
ernment borrowing (debt issue) the ultimate fiscal
liability made necessary by the spending
programme in the initial period is postponed.
This liability is placed, in the aggregate, on tax-
payers in periods subsequent to that in which the
debt is issued. The aggregate liability is not, how-
ever, imputed or assigned to individuals or to
groups of individuals. The postponement of lia-
bility implies, therefore, postponement of pay-
ments for public programmes.
The Ricardian Theorem
on the Equivalence Between Taxation
and Government Borrowing
David Ricardo (1817, 1820) advanced a theorem
to the effect that taxation and government borrow-
ing are logically equivalent. This Ricardian theo-
rem was rediscovered by macroeconomists in the
1970s, notably by Robert Barro, and it became an
important element in the ‘new classical macroeco-
nomics’ of that period.
On its face, the theorem seems to reject the
critical distinctions between taxation and debt
discussed above. In what respects are taxation
and government borrowing alike rather than dif-
ferent? Both extract revenues from private citi-
zens and transfer these to government for
spending on public programmes. The basic
Ricardian logic does not reject the difference in
status between the taxpayer, who faces govern-
mentally imposed coercive levies, and the bond
purchaser, who voluntarily transfers funds to gov-
ernment in private exchange for future-period
interest and amortization payments. The theorem
does, however, reject the second distinction noted
above, that which involves any postponement of
the costs of public spending. In the Ricardian
model, individuals recognize that any issue of
debt by government embodies a commitment to
meet payments in future periods. These payments
can be converted into individualized shares in the
aggregate liability, discounted, and capitalized
into a present-value measure, which can then be
reckoned as a liability item on individual initial-
period balance sheets. If persons think that they
will live forever, or if they have intergenerational
bequest motives that cause them to act as if their
lives are infinite, the liability items, summed over
all persons, will just offset the value of the debt in
the balance sheets of those who hold debt
instruments.
If the equivalence theorem is valid, there are
important macroeconomic consequences. If per-
sons treat government debt equivalently with tax-
ation in all respects other than the actual timing of
the payments, they will make portfolio adjust-
ments as required by this differential timing.
When debt is issued, persons will, knowing that
Public Debt
payments must be made in future periods rather
than currently, put aside some funds to facilitate
such payments. There will be no difference
between tax and debt financing in their effect on
consumption and investment spending. Individ-
uals, as taxpayers-citizens, will when debt is
issued, increase savings to allow a share of the
future-period debt obligations to be met. How-
ever, this increase in saving will equal the full
value of the debt only if the governmental outlays
take the form of ideally efficient transfers. This
neutrality theorem, which we may associate with
Barro, is more restrictive than the Ricardo theo-
rem. If the governmental outlays are made for the
provision of real goods and services, the neutrality
theorem may not hold although debt financing and
tax financing of these outlays may still exert
equivalent effects (the Ricardo theorem).
The Ricardo equivalence theorem (along with
the stronger neutrality theorem) is best evaluated
as an extreme model of rational individual behav-
iour under idealized sets of circumstances.
Ricardo himself recognized that persons did not,
in fact, treat taxation and debt in the same way. All
persons do not act as if they live for ever; persons
differ in age as well as interest in future-period tax
obligations. Further, taxes are not lump sum,
interpersonally or intertemporally. More impor-
tantly, there is no assignment of present-value
liability among persons such as would allow port-
folio adjustments to be made in the manner pos-
tulated in the equivalence theorem setting. Even if
individuals do recognize that public debt does
embody future-period tax liabilities, they cannot
reduce this aggregate to individualized shares in
any plausible reckoning.
The central flaw in the equivalence theorem
stems from the logic of debt itself, which may be
illustrated by analogy with private behaviour.
Why does a person borrow? He does so in order
to rearrange spending temporally. If borrowing
and current payment (the private analogue to tax-
ation) are equivalent, there is no point in the
exercise. As an institution, borrowing has as its
purpose the adjustment of spending flows through
time. Governments, as agents are citizens, borrow
for analogous reasons. There is no raison d’être
3
for public debt if this instrument is behaviourally
equivalent to taxation.
The empirical evidence gained from straight-
forward observation of modern politics points
clearly toward rejection of the equivalence theo-
rem. Taxation and debt are not treated as identical
by voting constituents, as is suggested by the fact
that politicians responsive to constituents are not
indifferent as to the mix between these instru-
ments. Within broad threshold limits, debt
financed outlay arouses less political opposition
than tax-financed outlay of comparable magni-
tude. The observed US Federal deficits of the
1980s could not have been eliminated by tax
increases without generating significant political
struggle.
Classical Principles of Public Debt
Both the positive analysis of and the normative
precepts for public debt were broadly understood
by the classical economists, and these principles
were carefully articulated in the dominant theory
of public debt developed in the 19th century.
There is no essential difference between the gov-
ernment account and the account of an individual
or private firm in the classical model. Borrowing
is a means of raising revenues that allows the
borrower to put off or to postpone payments. It
is a means of adjusting spending needs to revenue
flows over time; in effect, borrowing allows
intertemporal trades to be made.
For the government, as for the individual or
firm, there would be no basis for borrowing unless
the burden of payment could be delayed in time.
By the very meaning of debt, therefore, there must
be a shifting forward of burden intertemporally.
The ultimate payments for the enhanced spending
programme during the initial period when debt is
issued must be borne exclusively in later periods.
From this straightforward and indeed simple
analysis, normative principles for public debt cre-
ation emerge. Resort to debt financing is indicated
only with nonrecurrent or extraordinary demands,
or requirements for public spending that are
expected to be temporary. Traditionally, such
demands were associated with war emergencies,
4 Public Debt
and the principles of fiscal prudence dictated that
debts accumulated during was periods would be
retired when the emergency spending demands
were past. In addition to these extraordinary
spending justifications for resort to borrowing,
government is also within bounds under classical
norms when debt is issued to finance genuinely
productive capital projects, analogously with pri-
vate firms making capital investments.
When capital spending is debt financed by
government, the principles suggested that a
scheme for debt retirement be put in place to
insure that the pay-off period corresponds to the
income-yielding period from the investment asset.
Public Debt in Keynesian
Macroeconomics
The classical principles of public debt were not
understood by the pre-classical mercantilists and
these principles were also questioned by a few
fiscal and monetary expansionists in the
pre-Keynesian period. Only with the ‘Keynesian
revolution’ in economic thinking in the middle of
the 20th century, however, did a rejection of these
classical principles become a ‘new orthodoxy’.
An analysis of public debt, along with relevant
normative implications, came to be dominant dur-
ing the 1940s and 1950s that sought to contradict
basic elements of the classical model.
As noted earlier, the classical principles are
starkly simple, and are based on the essential
similarity between the government and the indi-
vidual account. The Keynesian logic rejected this
analogy. Specifically, the argument denied that
public debt embodies any shift of burden onto
taxpayers in periods of time subsequent to debt
issue, a temporal shift that was acknowledged to
occur in both private debt and external
public debt.
The conclusion that public debt could involve
no intertemporal shift of burden emerged from an
undue concentration on the macroeconomic
aggregates and an overlooking of individual
adjustments to macroeconomic instruments.
Again, the logic is seemingly quite straightfor-
ward. Resources are used up only in periods
when spending programmes take place; if govern-
ment borrows to finance spending on guns, the
resources that go into producing these guns must
be given up by some persons during the period
and not later. With internal public debt, therefore,
the burden of war spending could not, by defini-
tion, be transferred forward.
The basic flaw in the argument is clear from the
discussion in section “Taxes, Money and Public
Debt”. The two-part exchange that debt-financed
public spending embodies is overlooked. The
argument fails to recognize that those who actu-
ally give up claims over resources during the
period of the spending do so because they volun-
tarily exchange funds for promises of interest in
future periods. These purchasers of bonds do not,
in any sense, ‘pay for’ the benefits of the public
spending programme. The fact that these persons
may also be members of the community of
citizens-taxpayers is irrelevant for the temporal
location of burden. Taxpayers in later periods are
faced with claims against their incomes that must
be met, and which exist only because of the initial-
period debt issue. If, indeed, the Keynesian ortho-
doxy of public debt were valid, economists and
finance ministers would have discovered the fiscal
equivalent of the perpetual motion machine. No
non-voluntary transfers of revenues are required
to finance spending in the initial period, and, if
there is no burden on future-period taxpayers, the
spending that is carried out would have required
no burden on anyone.
The Keynesian argument was driven by a
stance on policy that viewed public debt as the
only means of financing demand-increasing defi-
cits during periods of depression. The primary
policy instrument of Keynesian economic policy
was the budget deficit, and there was an elemen-
tary failure on the part of pro-Keynesian econo-
mists to recognize that demand-enhancing deficits
could be financed with non-interest bearing
money creation. If this macroeconomic objective
is the only justification for the creation of budget-
ary deficits, it becomes totally unnecessary to
impose the future-period taxes that debt interest
reflects. Money creation in such settings carries
with it no future-period burden.
Public Debt
Public Debt and Deficits in Post-
Keynesian Politics
The Keynesian replacement of classical principles
of public debt was never total, and in the late
1950s and early 1960s there was a reemergence
of economists’ support for the earlier analysis,
along with its normative implications. There was
not, however, a ‘paradigm shift’ at all comparable
to the earlier overthrow of the classical analysis.
Somewhat begrudgingly perhaps, economists of
the 1960s came to recognize the deficiency in the
simplistic Keynesian logic, but there was no gen-
eral reaffirmation of classical principle. The dis-
cussion of public debt that characterized the
1960s, 1970s and 1980s remained confused by
an admixture of the two contradictory models of
analysis. Economists seemed to concentrate atten-
tion on the secondary and tertiary macroeconomic
consequences of debt-financed deficits; their con-
siderable formal skills were directed toward
attempts to extend the ancient Ricardian theorem.
While confusion and ambiguity described
economists’ discussion of public debt, the politi-
cians had learned the Keynesian policy lessons
with roughly a two-decade lag. By the early
1960s, the ‘old-time fiscal religion’, based on
adherence to the normative precepts of the classi-
cal analysis, had lost its constraining influence.
The political leaders of the 1960s and beyond had
learned that demand-enhancing deficits may be
justified in some economic settings. Their natural
proclivities to spend without the levy of taxes on
constituents caused them to look on economic
settings in a biased or one-sided fashion. The
idealized Keynesian policy set – deficits in
depression, surpluses in booms – proved to be
unworkable in democratic politics.
The regime of apparently permanent debt-
financed deficit spending was born. During the
1970s and 1980s, for the first time in modern
fiscal history, governments explicitly used debt
to finance ordinary public consumption outlay,
including transfers. This fiscal operation, consid-
ered in isolation, is equivalent to a destruction in
national capital value. When persons, privately or
publicly, abstain from consuming current income,
capital value is created. When persons, privately
5
or publicly, consume more than current-period
income, capital value (defined as the discounted
present value of anticipated future incomes) is
destroyed. For both individuals and governments,
resort to borrowing allows a ‘using up’ of future-
period income as a means of increasing current
consumption, just as resort to saving allows a
‘using up’ of current income (in an opportunity
cost sense) to increase future-period consumption.
Only if borrowing is used to finance genuine
capital investment, private or public, will the net
effects be intertemporally neutral; only in this case
will the capital value of anticipated income be
unchanged. With debtfinanced public consump-
tion, the present value of anticipated future
incomes of persons in the polity is reduced rela-
tive to that which might have been maintained in
the absence of the combined fiscal operation. The
fact that some or all of the debt is held by for-
eigners rather than citizens does not modify this
conclusion.
Consider the case where debt instruments are
purchased exclusively by domestic citizens, who
may also be future period taxpayers. Securities are
purchased voluntarily; hence, there is no change
on the asset side of purchasers’ balance sheets at
the time of debt issue. Purchasers could, alterna-
tively, hold or buy privately issued securities with
equivalent yields. On the other hand, the fiscal
operation does place debt-interest claims against
the anticipated private income flows of citizens as
taxpayers. There is a net increase in the present
value of liabilities on properly calculated individ-
ual balance sheets. This increase in the value of
liabilities is, of course, equivalent to the value of
the debt instruments. But these two items are not
offsetting since there are two fully offsetting items
on the asset side of the accounts, leaving no net
change from this side. The combined fiscal oper-
ation necessarily reduces net worth, or capital
value, in the economy, so long as the government
outlay does not generate anticipated income flows
from public assets, a result that is ruled out with
pure public consumption.
6 Public Debt
Return to Classical Principles?
Public Debt is a topic in political economy in
which the level of understanding experienced
serious retrogression over the course of the middle
decades of the 20th century. Policy-motivated
macroeconomic confusion generated political
spillovers that remained in the 1980s. Economists
seemed unable to contribute to clarification in
analysis, in part because they were reluctant to
drop either suprarational models of individual
behaviour or erratic manipulation of data. The
classical analysis, out of which emerged precepts
that offered simple guidelines for governmental
fiscal authorities, no longer commanded wide-
spread support, either among political economists
or among politicians and, indirectly, their constit-
uencies. Governments in the 1980s were observed
to be financing sizeable shares of their public
consumption outlays by interest-bearing debt.
Interest outlays made up ever-increasing propor-
tions of total government budgets.
The simple logic of compound interest
guaranteed that the budgetary regimes observed
in the 1980s were not sustainable. Default on
government’s debt obligations becomes increas-
ingly attractive to politicians as interest charges
mount and as borrowing rates for new issues of
debt simultaneously increase. Default on public
debt has occurred often in history, both through
explicit destruction of real value obligations by
means of inflation.
The ultimate prospects for default may be gen-
erally recognized, but the political difficulties in
restoring some adherence to classical norms can-
not be overlooked. Once debtfinanced deficit
spending for public consumption came to be an
element in the quasi-permanent status quo,
attempts to restore budgetary balance faced enor-
mous political opposition, as indeed the events of
the 1980s demonstrated. To reduce the deficits,
and hence merely to reduce the rate of increase in
public debt issue, governments must resort to tax
increases or to spending cuts, both of which
arouse political opposition. Those taxpayers who
must bear the burden of continuing debt are, at
best, only partially and indirectly represented in
the decision structure of democratic politics.
Restoration of the classical principles of public
debt seemed unlikely from the temporal perspec-
tive of the 1980s. The old-time or pre-Keynesian
‘fiscal religion’ did exert an influence on the
behaviour of politicians, and through them, on
governments. Public debt, as a revenueraising
instrument, has an appropriate and well-defined
use as a means of allowing governments to alter
the time stream of payments for extraordinary
outlays. There was nothing comparable to a ‘fiscal
religion’ in post-Keynesian politics. Public debt,
as it was actually used in the years after the 1960s,
became a mere balancing element between pro-
clivities of politicians to tax on the one hand and
spend on the other. The absence of immediate
fiscal breakdown was explained by some residual
carry over of classical norms, some introduction
of a Ricardian-like consciousness of future tax
liabilities, and some fear of default risk on the
part of prospective lenders. But the situation
observed over the decades of the 1970s and
1980s could not have represented temporal
stability.
The classical principles of public debt, whether
they be labelled as such, must eventually return to
general acceptance if the fiscal responsibility of
governments is to be maintained. Whether or not
this acceptance comes before or after a sequence
of default-engendered fiscal crises could not be
predicted from the temporal perspective of the
middle 1980s.
See Also
▶ Burden of the Debt
▶ National Debt
▶ Public Finance
▶ Ricardian Equivalence Theorem
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