Adam Smith surveys several methods in Book V, Chapter 3 of The Wealth of Nations by which a government can borrow money. He begin his comprehensive survey with two types of public debt: “unfunded debts” (V.iii.11) and “mortaged debts” (V.iii.12), followed by a stinging critique of government overborrowing:

1. UNFUNDED PUBLIC DEBTS

To begin, Smith identifies two types of unfunded public debts: “What is called the unfunded debt of Great Britain, is contracted in … two ways. It consists partly in a debt which bears, or is supposed to bear, no interest, and which resembles the debts that a private man contracts upon account, and partly in a debt which bears interest, and which resembles what a private man contracts upon his bill or promissory note.” (V.iii.11)

The first type of unfunded debt thus consists of one-off, non-interest bearing IOUs — when the government needs money pronto to pay its own armed forces or to bribe foreign leaders: “The debts which are due either for extraordinary services, or for services either not provided for, or not paid at the time when they are performed, part of the extrordinaries of the army, navy, and ordnance, the arrears of subsidies to foreign princes, those of seamen’s wages, &c. usually constitute a debt of the first kind ….” (V.iii.11)

The second type of unfunded debt consists of interest-bearing “Navy and exchequer bills.” (ibid.) The government must pay back what it borrows plus interest: “… Navy and exchequer bills, which are issued sometimes in payment of a part of such [extraordinary military] debts and sometimes for other purposes, constitute a debt of the second kind—exchequer bills bearing interest from the day on which they are issued, and navy bills six months after they are issued.” (ibid.) This second type of unfunded debt consists of interest-bearing promissory notes or IOUs issued by the Bank of England: “The Bank of England, either by voluntarily discounting those bills at their current value, or by agreeing with government for certain considerations to circulate exchequer bills, that is, to receive them at par, paying the interest which happens to be due upon them, keeps up their value and facilitates their circulation, and thereby frequently enables government to contract a very large debt of this kind.” (ibid.)

2. MORTGAGED PUBLIC DEBTS

Next, Smith identifies two types of “mortgaged debts” (so to speak) — public debt raised by anticipation and public debt raised by perpetual funding — in which the government earmarks the revenue from specific taxes (taxes on beer, salt, etc.), either for a number of years or in perpetuity(!), to pay back those public debts:

“When this resource is exhausted, and it becomes necessary, in order to raise money, to assign or mortgage some particular branch of the public revenue for the payment of the debt, government has upon different occasions done this in two different ways. Sometimes it has made this assignment or mortgage for a short period of time only, a year, or a few years, for example; and sometimes for perpetuity. In the one case the fund was supposed sufficient to pay, within the limited time, both principal and interest of the money borrowed. In the other it was supposed sufficient to pay the interest only, or a perpetual annuity equivalent to the interest, government being at liberty to redeem at any time this annuity upon paying back the principal sum borrowed. When money was raised in the one way, it was said to be raised by anticipation; when in the other, by perpetual funding, or, more shortly, by funding.” (V.iii.12)

3. SMITH’S STINGING CRITIQUE OF GOVERNMENT OVERBORROWING

After reviewing the history of the British government’s fiscal policies going back to 1697, Smith identifies a troubling pattern: “In consequence of those different acts [by the British government going back to 1697], the greater part of the taxes which before had been anticipated only for a short term of years were rendered perpetual as a fund for paying, not the capital, but the interest only, of the money which had been borrowed upon them by different successive anticipations.” (V.iii.25; my emphasis)

But it’s not just the British government that has been fiscally irresponsible. Smith rebukes “the greater part of European governments” for “overloading” their public debts (i.e. overborrowing) in the following passage:

“Had money never been raised but by anticipation, the course of a few years would have liberated the public revenue without any other attention of government besides that of not overloading the fund by charging it with more debt than it could pay within the limited term, and of not anticipating a second time before the expiration of the first anticipation. But the greater part of European governments have been incapable of those attentions. They have frequently overloaded the fund even upon the first anticipation, and when this happened not to be the case, they have generally taken care to overload it by anticipating a second and a third time before the expiration of the first anticipation. The fund becoming in this manner altogether insufficient for paying both principal and interest of the money borrowed upon it, it became necessary to charge it with the interest only, or a perpetual annuity equal to the interest, and such unprovident anticipations necessarily gave birth to the more ruinous practice of perpetual funding. But though this practice necessarily puts off the liberation of the public revenue from a fixed period to one so indefinite that it is not very likely ever to arrive, yet as a greater sum can in all cases be raised by this new practice than by the old one of anticipations, the former, when men have once become familiar with it, has in the great exigencies of the state been universally preferred to the latter. To relieve the present exigency is always the object which principally interests those immediately concerned in the administration of public affairs. The future liberation of the public revenue they leave to the care of posterity.” (V.iii.26; my emphasis)

In other words, governments like to overborrow not because politicians like to spend other people’s money, but because they like to spend future people’s money! Politicians are focused on problems that require immediate (and expensive!) solutions. They thus borrow (steal?) all the money they can now, leaving it to future taxpayers to pay the bill later! Adam Smith thus deserves the title of father of public choice theory, alongside James Buchanan and Gordon Tullock.

Nota bene: In addition to these two types of public debts, Smith identifies yet another method of government borrowing — one that occupies a “middle place” between temporary “anticipations” and “perpetual funding”. (V.iii.29) We will proceed to this intermediate method in my next post.