I’ve heard free-market economists and even downright libertarians say that government borrowing is different from taxation and inflation in the sense that it is a voluntary means of extracting funds and thus can be considered legitimate. Even though it’s true that government borrowing (typically through the issuance of bonds) is a voluntary exchange, its successful application relies on the government’s use of the two other coercive methods of raising revenue; taxation and inflation. How is this so? Let’s fundamentally review the purpose of borrowing and lending first. The only reason people choose to lend money to someone is because their subjective time preference indicates that they prefer a certain greater sum of money in the future rather than a discounted sum in the present. Obviously, every debt taken, due to the phenomenon of the interest, has to be paid in a greater sum than was initially received (principal plus the interest). When people lend money they’re careful to observe in whose hands that money is going to. Even though their time preference may indicate that they want to lend, they may refuse to do so if they thought the money would be given to people whom they believe weren’t capable of paying it back. Lending doesn’t only occur as a result of the willingness to do so from a time preference perspective, but also from the perceived risk involved with the lending itself. This is why the subjective factor of risk is always added to the time preference in the composition of interest. Riskier lending implies a higher interest rate. This, however, doesn’t necessarily mean that the lender who has accumulated his capital through savings is willing to lend at any interest rate just because it’s adjusted for risk. The intention of the borrower, on the other hand, is to use that borrowed money for an investment which he believes will be successful and bring him profits. A bad borrower may consume the money or choose not to pay the debt by defaulting on his obligations. In normal circumstances, the borrower will seek to invest that money. There is mathematically no way for the borrower to pay back his debt if he doesn’t generate a new source of income, whether through the successful investment of the borrowed money or transfer payments by his relatives or friends in the form of social help. The only reason the lender is confident that he will get the money back is his belief that the investment that the borrower is going to make will successfully generate a new source of income.
But when it comes to lending to the government, where do people get the confidence that they will be paid back? Initially we’re tempted to point to government’s “might” and its historical tradition of being able to roll over the debt. “Rolling over the debt” is a financial term which refers to government’s issuance of new bonds to cover the bonds that are maturing. This form of explanation, however, is a fallacy of circular reasoning for rolling over the debt is just another act of lending to government. No matter how many times it’s done or under what conditions, it is a mere act of lending. It is therefore irrelevant to take into consideration every point of the historical timeline and trace the impulses behind lenders’ belief that government will pay back. All we have to do is ask ourselves why a borrower would be confident that government will pay back in any case. The clear cut answer to that is, again, taxation and inflation. The only reason a lender believes government is able to pay back is because it can tax and print money. When the government rolls over the debt, it does nothing but feed on this monopoly status by attracting a new set of people who again for the same reasons choose to buy its bonds. Whether we’re talking about buying bonds now or in the future, the same principles are at work. The lender will only be confident to do so because the government can take money away from someone else to pay back the principal and the interest, or simply print it out. We can thus see that the strength of the government to borrow is its monopoly over taxation and inflation. Absent these two and nobody would lend money to the government. It will be like lending to a private company that is going broke; nobody will do it because they know the company can’t generate new sources of income to pay back the debt. Not even a pyramidal Ponzi scheme would work for the government. Ponzi schemes are fraudulent credit systems where the early lenders are paid back enormous returns with the money of later lenders. They are always bound to collapse, unless the number of new lenders always supersedes that of current lenders whose loans are maturing. The reason a Ponzi scheme would fail to work in a hypothetical situation where the government can’t tax or print money is because everybody would know it’s a Ponzi scheme. Normally, Ponzi schemes are hidden behind “lucrative investment” deals. When they are started, the persons in charge use their own money. In the case of a government unable of taxing and inflating this would be impossible, for the government doesn’t have a “starting balance.” If it did, it would have to come from a certain individual or a group. In that case, it wouldn’t be a government but a private entity willing to stage a Ponzi scheme. So there is not even a starting point for the government to even attract someone to its scheme if it lacks the power of taxing and inflating. It is thus impossible for the government to raise revenue without its coercive forces which unfortunately serve as “collateral” in the eyes of the would-be lenders. Ironically, the government rarely uses these two tools to pay maturing debts because their “notoriety” itself is sufficient to attract a new group of lenders which makes the rolling of debt possible.
Naturally, government borrowing has a crowding-out effect, similar to other government activities such as spending in general. Crowding-out refers to a market situation where private investment goes down as a result of transfer of wealth from there to the government sector. This is possible, again, through the government’s monopoly on taxation and inflation. These two means offer the government almost unlimited funds and will enable it to offer any kind of interest for its bonds way above the market rate. This distorts private borrowing because it encourages a flow of funds towards the inefficient government sector and away from the private sphere.
Is there a limit to taxation and inflation, and can governments go broke? The answer is yes to both. Iceland in 2008 was a prime example. We don’t need to look at the reality to confirm this for the theory is just equally indicative. Taxation is generally ineffective in times of recessions due to high unemployment numbers and reduced pay. Government revenues from taxes are always down in these harsh periods. Inflation, on the other hand, is very risky in a recessionary situation because it can escalate into galloping prices and flight into real values. Ineffective taxation and high inflation would directly undermine the government’s ability to offer a false assurance to the would-be lenders, thereby reducing the possibility of rolling over the debt. This in turn would lead to a sovereign default and the final collapse.