In the middle part of Book V, Chapter 3 of The Wealth of Nations, Adam Smith restates and rebuts two contemporary arguments in defense of government borrowing. The first argument is a proto-Keynesian one:

“The public funds of the different indebted nations of Europe, particularly those of England, have by one author been represented as the accumulation of a great capital superadded to the other capital of the country, by means of which its trade is extended, its manufactures multiplied, and its lands cultivated and improved much beyond what they could have been by means of that other capital only.” (WN, V.iii.47; my emphasis)

In other words, the gist of this argument is that public debts translate into public spending, and public spending contributes to a nation’s GDP. Smith, however, explains why this argument is a based on a logical fallacy:

“He [i.e. the “one author” mentioned in the passage above] does not consider that the capital which the first creditors of the public advanced to government was, from the moment in which they advanced it, a certain portion of the annual produce turned away from serving in the function of a capital to serve in that of a revenue; from maintaining productive labourers to maintain unproductive ones, and to be spent and wasted, generally in the course of the year, without even the hope of any future reproduction…. Had they [the creditors] not advanced this capital to government, there would have been in the country two capitals, two portions of the annual produce, instead of one, employed in maintaining productive labour.” (WN, V.iii.47; my emphasis)

In other words, public debts “crowd out” private investment in more productive pursuits. Now, what about the other argument in defense of government borrowing? Smith restates this second argument as follows: “In the payment of the interest of the public debt, it has been said, it is the right hand which pays the left. The money does not go out of the country. It is only a part of the revenue of one set of the inhabitants which is transferred to another, and the nation is not a farthing the poorer.” (WN, V.iii.52) Smith, however, immediately exposes this argument as a cheap accounting trick:

“This apology is founded altogether in the sophistry of the mercantile system, and after the long examination which I have already bestowed upon that system, it may perhaps be unnecessary to say anything further about it. It supposes, besides, that the whole public debt is owing to the inhabitants of the country, which happens not to be true; the Dutch, as well as several other foreign nations, having a very considerable share in our public funds. (WN, V.iii.52; my emphasis)

Smith then adds for good measure: “But though the whole debt were owing to the inhabitants of the country, it would not upon that account be less pernicious.” (WN, V.iii.52; my emphasis) That is, even if all of a nation’s public debts were from domestic lenders, government overborrowing and the accumulation of public debts would still be bad — not in a moral but in an economic sense. Why? Because, in the immortal words of Adam Smith:

“Land and capital stock are the two original sources of all revenue both private and public. Capital stock pays the wages of productive labour, whether employed in agriculture, manufactures, or commerce. The management of those two original sources of revenue belong to two different sets of people; the proprietors of land, and the owners or employers of capital stock.” (WN, V.iii.53; my emphasis)

Simply put, a nation’s wealth [“revenue, both private and public”] is a function of the amount of land and capital that is put to productive use, but when the government borrows money, that money is no longer available for investment in the private sector. But that is not all, for Smith makes the following ominous observation:

“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has ever been brought about by bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.” (WN, V.iii.57; my emphasis)

In other words, when the public debt becomes too large, the government will either have to default on its debts (“bankruptcy”) or perform the “juggling trick” of a currency devaluation (“pretended payment”):

“The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment…. The honour of a state is surely very poorly provided for when, in order to cover the disgrace of a real bankruptcy, it has recourse to a juggling trick of this kind, so easily seen through, and at the same time so extremely pernicious” (WN, V.iii.58; my emphasis)

Both options (default and devaluation) are bad because, in both cases, a nation’s wealth is transferred from private creditors, who would have invested that wealth in productive (i.e. revenue-generating) pursuits, to the government, which will then have no incentive to cut back its spending on wars and other wasteful projects. So, what is to be done? Should the government spend less, or tax more? We will explore Smith’s solution to the problem of government overborrowing in my next post.

So, what is to be done? How can we avoid either of these dreadful outcomes, i.e. default or devaluation? We will explore Smith’s solution to the problem of government overborrowing in my next post.