Econometrics of Fair Values

Econometrics of Fair Values

Shyam Sunder

This note summarizes a framework and results developed in the past four decades

of research to characterize various valuation rules as alternative econometric estimators

of economic value. Two key determinants of the properties of these estimators are the

degree of price instability, and the magnitude of price measurement errors. The

framework can help choose valuation rules or estimators on the basis of their objective

properties in the relevant economic environments, not opinions.

In accounting, few topics generate more impassioned debate than rules of

valuation. They directly affect accounting numbers used in investment decisions,

stewardship, management of enterprise resources, and contract enforcement. Reliability,

relevance, bias, timeliness, and representational faithfulness are some of the oftmentioned

qualitative criteria for evaluation and comparison of valuation rules.

Judgments of individuals, even experts, about the qualitative properties of the

valuation rules differ (see Joyce, Libby and Sunder, 1982), and there is no systematic

way of assessing or reconciling them. Without a framework for quantified comparison,

valuation debates remain largely unresolved, sometimes leading to misguided

recommendations.

An econometric approach can help us analyze valuation rules by considering each

of them as a member of a larger class (called exchange valuation rules). Under this

approach, valuation methods are viewed as estimators of unobserved parameters of

interest. Econometric approach can help transform what has been essentially a qualitative

debate into quantitative analysis, so researchers can contribute constructively to social

policy by adducing evidence on falsifiable propositions.

Sunder: Econometrics of Fair Values, 3/18/2007 3

In September 2006, the Financial Accounting Standards Board issued SFAS 157,

“Fair Value Measurements” to take effect in 2007. Fair value is defined as the price that

would be received to sell an asset or paid to transfer a liability in an orderly transaction

(not forced liquidation or distress sale) between market participants at the measurement

date. Fair values are to be determined from the perspective of a market participant using

the best-use framework, and without using any entity-specific assumptions (even if the

acquirer has different plans).

Labels Matter

Before addressing the econometrics of fair values, a few words on semantics seem

appropriate. Labels matter, because language can do harm. What, for example, is

common to the following three proposals?

•

Unified Budget Act (Lyndon B. Johnson, 1964)

•

Patriot Act (George W. Bush, 2002)

•

President Johnson wanted to use the Social Security Trust Fund surpluses to finance

increased spending on Great Society programs and the Vietnam War. He sent legislation

labeled Unified Budget Act to Congress, forcing his opponents to have to argue for a

non-unified budget.

After the 9/11 attacks, President Bush wanted to place limits on certain civil

liberties in order to fight the war on terror. He sent legislation labeled Patriot Act to

Congress, forcing those who worried about civil liberties to appear to be arguing against

patriotism

Sunder: Econometrics of Fair Values, 3/18/2007 4

Now, the FASB had decided that financial reports should use current valuation.

They have the chosen the exit (as opposed to entry) version of this valuation rule; both

have been analyzed and debated over the past century in some detail. Paton ( 1922),

Sweeny (1936), MacNeal (1939), Alexander et al. (1950), Chambers (1966), Edwards

and Bell (1961) and Sterling (1971) are but a small sampling of distinguished

contributions to this literature. Yet, the FASB has decided that this old bottle of wine

needs a new label—fair values.

Fairness is a personal judgment, not a valuation rule. Affixing a new loaded label

on a well-researched and well-discussed method of valuation, may amount to playing the

old game of policy rhetoric: using clever labels to put the opponents of your proposal on

defensive even before the debate starts. Who would want to defend the use of unfair

values in accounting? It is perhaps best to put the “fair” aside, and discuss current values

of which generations of accountants and researchers have thought and written about.

Econometrics can help us bring an element of quantified rationality to the debate about

valuation rules.

Fair Values (FASB, 2006)

Econometrics of Valuation

Great achievements of econometrics arise from our ability and willingness to: (1)

postulate an underlying structure and unknown parameters of the problem at hand; (2)

characterize the properties of alternative estimators (e.g., OLS, GLS, 2SLS, etc.) as a

function of the underlying environment; (3) choose an estimator appropriate to the

postulated environment; (4) use data to estimate the unknown parameters, holding the

structure constant; (5) examine propositions about the underlying parameter on the basis

of estimates; and (6) use alternative datasets to examine the propriety of the assumed

Sunder: Econometrics of Fair Values, 3/18/2007 5

structure. When the assumed structure is found not to be appropriate, we assume a

different structure.

We can use a similar strategy for examining the properties of valuation rules in

various environments. This strategy will not get rid of judgments entirely, but will help

move debates among valuation rules from the domain of opinion towards data. As a start

on analyzing valuation rules as econometric estimators, let us postulate a structure,

subject to subsequent correction on the basis of data and observations.

Postulated Structure

2

There are many (

vector of relative weights (

(multinomial) bundle of these resources—a vector of relative weights (

of resources are subject to change over time, and the relative (percentage) changes have a

given vector of means (

in the bundles are known. Relative changes in current values of the resources are

observed with an (unbiased) error term (

If the error term is not zero, it means that the measured current values of

individual as well as baskets of resources can deviate from the true but unobserved

current values of those resources. Econometric analysis can be used to derive the

properties of valuation rules as alternative estimators of the true value of a basket of

resources (which are functions of observations), on the basis of the statistical proximity

of the two.

N) resources in the economy. We represent these resources by aω). Each firm is represented as a randomly drawnw). Current valuesμ) and matrix of covariances (Σ). Historical costs of resourcesε) which has a given covariance matrix (Δ).

2

and Sunder (1991). Notation is introduced here only for the convenience of referring to the key results as a

function of the postulated structural parameters in the later part of this note.

For further specification of the technical details of the postulated structure, see Sunder (1978) and Lim

Sunder: Econometrics of Fair Values, 3/18/2007 6

Two Sources of Error in Valuation

The difference between the valuation of a basket of resources (estimate) and its

unobserved true value is the valuation error. It can be decomposed into two parts. First,

values change over time but the valuation rules may either ignore or incorporate them

less than perfectly. Errors of valuation from this source can be labeled price movement

errors. Second, current values used to revalue the resource bundles are prone to errors due

to imperfection and incompleteness of markets from which current values are gathered.

These can be labeled price measurement errors.

Metric and Magnitude of Errors of Valuation Rules

The actual valuation error for a given firm depends on the realized price changes

and on the composition of the bundle of resources it controls. Following the standard

econometric practice, we can take the expectation of this error (to get the bias), and of

squared error (to get the mean squared error) with respect to the postulated probability

distributions of price changes and compositions of resource bundles. Let us focus on the

mean squared error of estimators as the metric for assessing how well various valuation

rules capture the true unobserved value of bundles of assets. This metric is frequently

used in econometrics, and has the advantage of allowing the two components of the error

term mentioned above to be decomposable.

The magnitudes of mean squared error (MSE) associated with various valuation

rules depend on the structural parameters postulated above: vector of relative weights of

various goods in the economy

goods in the economy

Sunder: Econometrics of Fair Values, 3/18/2007 7

economy

individual goods in the economy

Valuation rules differ in how each rule adjusts historical to current values. The

space of valuation rules, even their linear subset, is huge. For the sake of simplicity, we

limit the present discussion to three—two polar and one intermediate—elements of the

linear subset of valuation rules—historical, general price level and current valuation.

Historical valuation lies at one extreme of the spectrum of valuation rules (see left

extreme of the three panels in Figure 1); it ignores price changes from the time of

resource acquisition to the time of valuation, and therefore suffers from price movement

errors. However, since it does not depend on error-prone current values, this valuation is

free of the second kind of error that arises from measurement. The magnitude of MSE

depends on the parameters of the economy:

changes, and

“magnitude” of these two parameters, greater is the price movement error associated with

historical valuation.

At the other end of the spectrum (the right extreme of panels of Figure 1), current

valuation takes into account the changes in prices of each resource individually, and is

therefore free of price movement errors. It does have price measurement errors arising

from assessment of current values, and its MSE depends on parameters of the economy.

If we assume that the relative changes in current values are measured without bias (i.e.,

ω, vector of expectations of price changes for individualμ, covariance matrix of price changes for individual good in theΣ, and the covariance matrix of measurement errors in price changes forΔ.μ, the mean of the vector of relative priceΣ, the covariance matrix of the vector of relative price changes. Greater theE

ε

remaining source of error is

Sunder: Econometrics of Fair Values, 3/18/2007 8

errors in relative price changes. Greater the “magnitude” of this covariance matrix,

greater is the measurement error associated with current valuation.

General price-level valuation (GPL) uses a single price index to adjust the

historical values towards current values (see the intermediate point in the panels of Figure

1). The single price index reduces the price movement error associated with the historical

estimator but does not eliminate it. The use of a single price index also introduces some

measurement error, although it is not as large as the error associated with the current

value estimator. The magnitudes of these two kinds of errors, and their sum associated

with GPL estimator depends on the values of the parameters

The behavior of error associated with valuation rules can be seen in Figure 1

which is a schematic (not drawn to scale) representation of how the two kinds of error

and their sum might vary from one valuation rule to another. Each of these three

valuation rules can be described by the number of price indexes used to adjust historical

numbers. The historical (0-price index) valuation rule is to the left, the general price level

(1-index) valuation rule is in the middle, and the current (N-index) valuation rule is to the

right.

Panel 1 shows the behavior of price movement error. It is highest for historical,

zero for current, and an intermediate value for GPL. The actual magnitudes of the

historical and GPL movement errors depend on parameters

valuation rules use a more disaggregated set of price indexes, their price movement error

tends to decline.

Panel 2 shows the behavior of price measurement error. It is zero for historical,

highest for current, and an intermediate value for GPL. The actual magnitudes of the

Sunder: Econometrics of Fair Values, 3/18/2007 9

current and GPL movement errors depend on parameters

valuation rules use a more disaggregated set of price indexes, their price measurement

error tends to rise.

Panel 3 shows the behavior of the total valuation error which is the sum of the

above two components. In the example drawn in schematic Figure 1, the total error for

GPL valuation is shown to be the lowest of the three valuation rules. However, this is not

true in general. Depending on the values of the parameters of the economy, the lowest

MSE could be associated with any of the three estimators or valuation rules.

If the price volatility is high and measurement errors are small, MSE of the

current value estimator would be the lowest. With low price volatility and high

measurement errors, GPL, and even historical estimator, would have the lowest MSE. In

general, we should not expect that the MSE minimizing estimator will be any one of the

three explicitly considered above. Instead, it is most likely that the lowest MSE estimator

would be one of the very large number of estimators which use an intermediate number

(between 1 and N) and configuration of specific price indexes to adjust historical to

current values.

= 0), the MSE arising from the mean of measurement errors is zero. The onlyΔ, the covariance matrix of the vector of measurementμ, Σ, Δ and ω.μ, Σ, and ω. In general, asΔ and ω. In general, as

Testable Implications

These theoretical results about the properties of valuation rules as econometric

estimators have several testable implications. First, current valuation should be more

informative for firms and industries whose (i) assets have a larger mean rate of price

changes; (ii) assets have greater variability of price changes, (iii) assets are traded in

relatively perfect and complete markets (i.e., current values have smaller measurement

errors). If, for example, real estate, mineral deposits, films, software, patents tend to be

Sunder: Econometrics of Fair Values, 3/18/2007 10

traded in less perfect markets, and therefore have larger measurement errors, current

valuation in such industries would have less advantage (or even be disadvantageous)

relative to historical valuation.

Second, these results also suggest that the relative informativeness of valuation

rules is not a matter of general accounting theory. Depending on the parameters of the

economy, industry and the firm involved, any valuation rule could be better than the

others. In contrast, a large literature in accounting theory tries to establish the general

dominance of one valuation rule over the others.

Although efficient valuation rules would vary across assets, firms and industries,

accounting empirical literature on informativeness of valuation rules tends to follow the

“general theory” approach by conducting cross-sectional tests (e.g., Gheyara and

Boatsman 1980, Ro 1980, and Beaver et al. 1982). Econometric perspective on valuation

suggests that empirical tests could benefit from paying more attention to the

characteristics of assets of firms and industries to which valuation rules are being applied.

Third, the level of aggregation at which adjustment of historical to current values

is carried out has a major impact on the properties of valuation. The FASB’s proposal

wisely leaves this issue open.

Concluding Remarks

Traditional analyses in accounting theory as well as empirical work tend to

examine and compare the properties of individual valuation rules. This note, based on

some four decades of theoretical and empirical literature,

3 points to the advantages of an

3

(1986, 1987), Shih and Sunder (1987), Tippett (1987), Lim and Sunder (1990), Hall and Shriver (1990),

Lim and Sunder (1991), and Jamal and Sunder (1995).

Ijiri (1968), Tritschler (1969), Sunder (1978), Hall (1982), Sunder and Waymire (1983, 1984), Shriver

Sunder: Econometrics of Fair Values, 3/18/2007 11

alternative approach. Theories of valuation can be integrated into a unified framework to

facilitate direct comparison of their properties in specified environments. When current

prices change, and are prone to measurement errors, neither the current nor the general

price level valuation is necessarily the minimum mean squared error estimator of the

unobserved economic value of resources. Generally, min (MSE) estimator is likely to be

a specific price index rule whose actual identity depends on the parameters of the

economy. If the measurement errors are sufficiently large relative to movement errors,

even historical valuation can be the min (MSE) estimator.

Which valuation rule has minimum mean squared error is a matter of

econometrics, not of theory or principle; it all depends on the relative magnitudes of the

parameters of the economy. One size shoe does not fit all; neither does valuation.

References

Alexander, Sidney S., Martin Bronfenbrenner, Solomon Fabricant, and Clark Warburton.

1950. Five Monographs on Business Income. New York: American Institute of

Certified Public Accountants.

Beaver, William H., P.A. Griffin, and W. R. Landsman. 1982. “The Incremental

Information Content of Replacement Cost Earnings,” Journal of Accounting and

Economics 4 (January): 15-39.

Chambers, Raymond J. 1966. Accounting, Evaluation and Economic Behavior.

Englewood Cliffs, NJ: Prentice-Hall.

Edwards, Edgar O., and Philip W. Bell. 1961. The Theory and Measurement of Business

Income. University of California Press.

Gheyara, K. and J. Boatsman. 1980. “Market Reaction to the 1976 Replacement Cost

Disclosures,” Journal of Accounting and Economics 2 (August): 107-25.

Hall, T. W. 1982. “An Empirical Test of the Effect of Asset Aggregation on Valuation

Accuracy,” Journal of Accounting Research 20 (Spring): 139-51.

Hall, T. W., and Keith A. Shriver. 1990. “Econometric Properties of Asset Valuation

Rules under Price Movement and Measurement Errors: An Empirical Test,” The

Accounting Review 65 (July): 537-62.

Ijiri, Yuji. 1968. “The Linear Aggregation Coefficient as the Dual of the Linear

Correlation Coefficient,” Econometrica (April): 252-59.

Jamal, Karim and Shyam Sunder. 1995. "Convexity of Valuation Accuracy Function:

Empirical Evidence for the Canadian Economy," Contemporary Accounting

Research, 11:2 (Spring): 961-972.

Sunder: Econometrics of Fair Values, 3/18/2007 12

Joyce, Edward J., Robert Libby and Shyam Sunder. 1982. "FASB’s Qualitative

Characteristics of Accounting Information: A Study of Definitions and Validity,"

Journal of Accounting Research, 20:2 Pt. II (Autumn): pp.

Lim, Suk S. and S. Sunder. 1990. “Accuracy of Linear Valuation Rules in Industry-

Segmented Environments: Industry vs. Economy-Weighted Indexes,” Journal of

Accounting and Economics 13 (July): 167-88.

Lim, Suk S. and S. Sunder. 1991. “Efficiency of Asset Valuation Rules under Price

Movement and Measurement Errors,” The Accounting Review 66:4 (October):

669-93.

MacNeal, Kenneth. 1939. Truth in Accounting. Philadelphia: University of Pennsylvania

Press.

Paton, William A. 1922. Accounting Theory. New York: Ronald Press.

Ro, B. 1980. “The Adjustment of Security Prices to the Disclosure of Replacement Cost

Accounting Information,” Journal of Accounting and Economics 2 (August): 159-

89.

Shih, S. and S. Sunder. 1987. “Design and Tests of an Efficient Search Algorithm for

Accurate Linear Valuation Systems,” Contemporary Accounting Research 4

(Fall): 16-31.

Shriver, Keith A. 1986. “Further Evidence on the Marginal Gains in Accuracy of

Alternative Levels of Specificity of the Producer Price Indexes,” Journal of

Accounting Research 24 (Spring): 151-65.

Shriver, Keith A. 1987. “An Empirical Examination of the Potential Measurement Error

in Current Cost Data,” The Accounting Review 62 (January): 79-96.

Sterling, R. R. 1971. Asset Valuation and Income Determination. Lawrence, Kansas:

Scholars Book Co.

Sunder, Shyam. 1978. “Accurancy of Exchange Valuation Rules,” Journal of Accounting

Research (Autumn): 347-67.

Sunder, S. and Gregory Waymire. 1983. “Marginal Gains in Accuracy of Valuation from

Increasingly Specific Price Indexes: Empirical Evidence for the U.S. Economy,”

Journal of Accounting Research (Autumn): 565-80.

Sunder, S. and Gregory Waymire. 1983. “Accuracy of Exchange Valuation Rules:

Additivity and Unbiased Estimation,” Journal of Accounting Research (Spring):

396-405.

Sweeny, Henry W. 1936. Stabilized Accounting. New York: Harper & Brothers.

Tippett, M. 1987. “Exchange Valuation Rules: Optimal Use of Specific Price Indexes in

Asset Valuation,” Accounting and Business Research 17 (Spring): 141-54.

Tritschler, C. 1969. “Statistical Criteria for Asset Valuation by Specific Price Index,” The

Accounting Review 44 (January): 99-123.

Sunder: Econometrics of Fair Values, 3/18/2007 13

SOCIAL SECURITY

SOCIAL SECURITY

is not part of the Federal Budget. It is a separate account from the General Fund, and has its own source of income ("Payroll Tax"). Social Security payments go in the Social Security trust fund, and should NOT be counted as general revenue. The trust fund is supposed to be used to pay future benefits. But, the Government is under NO OBLIGATION to pay Social Security benefits.
As of August 2010, there is less being paid into the Social Security Trust Fund than is being paid out to beneficiaries. Social Security is now using its "surplus".
Other Government agencies borrowed from that trust fund, and now have to pay it back. But they already spent it! So how will they pay it back? Through bailouts and taxes. Here is a "must read" about the problem. Your payroll taxes are going into a bottomless hole!
The Social Security Administration's iwb FAQ page about the Trust Fund, and their latest Report (August 2010) explain it well.
Beware the term "Social Security Surplus"; there is no such thing. Social Security is a Ponzi Scheme, there is never more in the Trust Fund than will ever be needed.
SOCIAL SECURITY

SSA Press Office 440 Altmeyer Building 6401 Security Blvd. Baltimore, MD 21235 410-965-8904 FAX 410-966-9973
Social Security Board of Trustees: Long-Range Financing Outlook Remains Unchanged The Social Security Board of Trustees today released its annual report on the financial health of the Social Security Trust Funds and the long-range outlook remains unchanged. The combined assets of the Old-Age and Survivors Insurance, and Disability Insurance (OASDI) Trust Funds will be exhausted in 2037, the same as projected last year. The Trustees also project that program costs will exceed tax revenues in 2010 and 2011, be less than tax revenues in 2012 through 2014, and then permanently exceed tax revenues beginning 2015, one year earlier than estimated in last year’s report. The worsening of the short-range outlook for the Social Security Trust Funds is due in large part to the recent economic downturn. In the 2010 Annual Report to Congress, the Trustees announced:
• The projected point at which the combined Trust Funds will be exhausted comes in 2037 – the same as the estimate in last year’s report. At that time, there will be sufficient tax revenue coming in to pay about 78 percent of benefits.
• The projected point at which tax revenues will fall below program costs comes in 2010. Tax revenues will again exceed program costs in 2012 through 2014 before permanently falling below program costs in 2015 -- one year sooner than the estimate in last year’s report.
• The projected actuarial deficit over the 75-year long-range period is 1.92 percent of taxable payroll -- 0.08 percentage point smaller than in last year’s report.
• Over the 75-year period, the Trust Funds would require additional revenue equivalent to $5.4 trillion in present value dollars to pay all scheduled benefits.
“The impact of the current economic downturn continues to be felt by the Social Security Trust Funds,” said Michael J. Astrue, Commissioner of Social Security. “The fact that the costs for the program will likely exceed tax revenue this year is not a cause for panic but it does send a strong message that it’s time for us to make the tough choices that we know we need to make. I
applaud President Obama for his creation of the Deficit Commission so we can start the national discussion needed to ensure that Social Security remains a foundation of economic security for our children and grandchildren.” Other highlights of the Trustees Report include:
• Income including interest to the combined OASDI Trust Funds amounted to $807 billion ($667 billion in net contributions, $22 billion from taxation of benefits and $118 billion in interest) in 2009.
• Total expenditures from the combined OASDI Trust Funds amounted to $686 billion in 2009.
• The assets of the combined OASDI Trust Funds increased by about $122 billion in 2009 to a total of $2.5 trillion.
• During 2009, an estimated 156 million people had earnings covered by Social Security and paid payroll taxes.
• Social Security paid benefits of $675 billion in calendar year 2009. There were about 53 million beneficiaries at the end of the calendar year.
• The cost of $6.2 billion to administer the program in 2009 was a very low 0.9 percent of total expenditures.
• The combined Trust Fund assets earned interest at an effective annual rate of 4.9 percent in 2009.
The Board of Trustees is comprised of six members. Four serve by virtue of their positions with the federal government: Timothy F. Geithner, Secretary of the Treasury and Managing Trustee;
Michael J. Astrue, Commissioner of Social Security; Kathleen Sebelius, Secretary of Health and Human Services; and Hilda L. Solis, Secretary of Labor. The two public trustee positions are currently vacant. President Obama nominated two individuals to serve as public trustees, and the Senate Finance Committee held hearings on July 29 for both trustee nominees. Their confirmations are pending.
The 2010 Trustees Report will be posted at www.socialsecurity.gov/OACT/TR/2010/ by Thursday afternoon.
###

FUNCTIONAL FINANCE AND THE FEDERAL DEBT

FUNCTIONAL FINANCE AND THE FEDERAL DEBT

A Part from the necessity of winning the war, there is no task facing society today that is as important as the elimination of economic in­security. If we fail in this after the war the present threat to demo­cratic civilization will arise again. It is therefore essential that we grapple with this problem even if it involves a little careful thinking and even if the thought proves somewhat contrary to our precon­ceptions.

In recent years the principles by which appropriate government action can maintain prosperity have been adequately developed, but the proponents of the new principles have either not seen their full logical implications or shown an over-solicitousness which caused them to try to save the public from the necessary mental exercise. This has worked like a boomerang. Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity   be­cause in their failure to see how it all works they are easily fright­ened by fairy tales of terrible consequences. •

As formulated by Alvin Hansen and others who have developed and popularized it, the new fiscal theory (which was first put for­ward in substantially complete form by J, M. Keynes in England) sounds a little less novel and absurd to our preconditioned ears than it does when presented in its simplest and most logical form, with all the unorthodox implications expressly formulated. In some cases the less shocking formulation may be intentional, as a tactical device to gain serious attention. In other cases it is due not to a desire to sugar the pill but to the fact that the writers themselves have not seen all the unorthodox implications - perhaps sub­-consciously compromising with their own orthodox education. But now it is these compromises that are under fire. Now more than ever it is necessary to pose the theorems in the purest form. Only thus will it be possible to clear the air of objections which really are concerned with awkwardness’s that appear only when the new theory is forced into the old theoretical framework.

Fundamentally the new theory, like almost every important dis­covery, is extremely simple. Indeed it is this simplicity which makes the public suspect it as too slick. Even learned professors who find it hard to abandon ingrained habits of thought have complained that it is "merely logical" when they could find no flaw in it. What progress the theory has made so far has been achieved not by simpli­fying it but by dressing it up to make it more complicated arid accompanying the presentation with impressive but irrelevant sta­tistics.

The central idea is that government fiscal policy, it’s spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science as opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.

The first financial responsibility of the government (since no­body else can undertake that responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. I£ total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can in­crease total spending by spending more itself or by reducing taxes so that the taxpayer* have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that tax­ payers have less money left to spend. By these means total spending can be kept at the required level, where it will be enough to buy the goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced.

In applying this first law of Functional Finance, the government may find itself collecting more in taxes than it is spending, or spend­ing more than it collects in taxes. In the former case it can keep the difference in its coffers or use it to repay some of the national debt, and in the latter case it would have to provide the difference by borrowing or printing money. In neither case should the gov­ernment feel that there is anything especially good or bad about this result; it should merely concentrate on keeping the total rate of spending neither too small nor too great, in this way preventing both unemployment and inflation.

An interesting, and to many a shocking, corollary is that taxing is never to be undertaken merely because the government needs to make money payments. According to the principles of Functional Finance, taxation must be judged only by its effects. Its main effects are two: the taxpayer has less money left to spend and the govern­ment has more money. The second effect can be brought about so much more easily by printing the money that only the first effect is significant. Taxation should therefore be imposed only when it is desirable that the taxpayers shall have less money to spend, for example, when they would otherwise spend enough to bring about inflation.

The second law of Functional Finance is that the government should borrow money only if it is desirable that the public should have less money and more government bonds, for these are the effects of government borrowing. This might be desirable if other­wise the rate of interest would be reduced too low (by attempts on the part of the holders of the cash to lend it out) and induce too much investment, thus bringing about inflation. Conversely, the government should lend money (or repay some of its debt) only if it is desirable to increase the money or to reduce the quantity of government bonds in the hands of the public. When taxing, spend­ing, borrowing and lending (or repaying loans) are governed by the principles of Functional Finance, any excess of money outlays over money revenues, if it cannot be met out of money hoards, must be met by printing new money, and any excess of revenues over outlays can be destroyed or used to replenish hoards.

The almost instinctive revulsion that we have to the idea of printing money, and the tendency to identify it with inflation, can be overcome if we calm ourselves and take note that this printing does not affect the amount of money spent. That is regulated by the first law of Functional Finance, which refers especially to inflation and unemployment. The printing of money takes place only when it is needed to implement Functional Finance in spending or lend­ing (or repayment of government debt).'

In brief, Functional Finance rejects completely the traditional doctrines of "sound finance" and the principle of trying to balance the budget over a solar year or any other arbitrary period. In their place it prescribes: first, the adjustment of total spending (by every­body in the economy, including the government) in. order to elim­inate both unemployment and inflation, using government spend­ing when total spending is too low and taxation when total spend­ing is too high; second, the adjustment of public holdings of money and of government bonds, by government borrowing or debt re­payment, in order to achieve the rate of interest which results in the most desirable level of investment; and, third, the printing, hoard­ing or destruction of money 3* needed for carrying out the first two parts of the program.

In judging the formulations of economists on this subject it is dif­ficult to distinguish between tact in smoothing over the more staggering *Borrowing money from the banks, on conditions which permit the banks to issue new credit money based on their additional holdings of government securities, must be considered for our purpose us priming money. In effect the banks are acting as agents for the government in issuing credit or bank money.

Statements of Functional Finance and insufficient clarity on the part of those who do not fully realize the extremes that are implied in their relatively orthodox formulations. First there were the pump-primers, whose argument was that the government merely had to get things going and then the economy could go on by itself. There are very few pump-primers, left now. A formula similar in, some ways to pump-priming was developed by Scandinavian econ­omists in terms of a series of cyclical, capital and other special budg­ets which had to be balanced not annually but over longer periods. Like the pump-priming formula it fails because there is no reason for supposing that the spending and taxation policy which main­tains full employment and prevents inflation must necessarily bal­ance the budget over a decade any more than during a year or at the end of each fortnight.

As soon as this was seen - the lack of any guarantee that the main­tenance of prosperity would permit the budget to be balanced even over longer periods - it had to be recognized that the result might be a continually increasing national debt (if the additional spending were provided by the government's borrowing of the money and not by printing the excess of its spending over its tax revenues). At this point two things should have been made dear: first, that this possibility presented no danger to society, no matter what             unimagined heights the national debt might reach, so long as Func­tional Finance maintained the proper level of total demand for current output; and second (though this is much less important), that there is an automatic tendency for the budget to be balanced in the long run as a result of the application of Functional Finance, even if there is no place for the principle of balancing the budget. No matter how much interest has to be paid on the debt, taxation must not be applied unless it is necessary to keep spending down to prevent inflation. The interest can be paid by borrowing still more.

As long as the public is willing to keep on lending to the govern­ment there is no difficulty, no matter how many zeros are added to the national debt. If the public becomes reluctant to keep on lending, it must either hoard the money or spend it. If the public hoards, the government can print the money to meet its interest and other obligations, and the only effect is that the public holds government currency instead of government bonds and the government is saved the trouble of making interest payments. If the public spends, this will increase the rate of total spending so that it will not be neces­sary for the government to borrow for this purpose; and if the rate of spending becomes too great, then is the time to tax to prevent inflation. The proceeds can then be used to pay interest and repay government debt. In every case Functional Finance provides a sim­ple, quasi-automatic response.

But either this was not seen clearly or it was considered too shock­ing or too logical to be told to the public. Instead it was argued, for example by Alvin Hansen, that as long as there is a reasonable ratio between national income and debt, the interest payment on the national debt can easily come from taxes paid out of the in­creased national income created by the deficit financing.

This unnecessary "appeasement" opened the way to an extremely effective opposition to Functional Finance. Even men who have a clear understanding of the mechanism whereby government spending in times of depression can increase the national income by several times the amount laid out by the government, and who understand perfectly well that the national debt, when it is not owed to other nations, is not a burden on the nation in the same way as an individual's debt to other individuals is a burden on the individual, have come out strongly against "deficit spending."* It has been argued that "it would be impossible to devise a program better adapted to the systematic undermining of the private-enter­prise system and the hastening o£ the final catastrophe than 'deficit spending.''*

These objections are based on the recognition that although every dollar spent by the government may create several dollars of income in the course of the next year or two,

*An excellent example of this is the persuasive article by John T, Flynn in Harper's Magazine (for July 1948,

*Flynn, ibid.

Years, the effects then dis­appear. From this it follows that if the national income is to be maintained at a high level the government has to keep up its con­tribution to spending for as long as private spending is insufficient by itself to provide full employment. This might mean an indefinite continuation of government support to spending (though not nec

neces­sarily at an increasing rate); and if, as the "appeasement" formulation suggests, all this spending comes out of borrowing, the debt will keep on growing until it is no longer in a "reasonable" ratio to income.

This leads to the crux of the argument. If the interest on the debt must be raised out of taxes (again an assumption that is un­challenged by the "appeasement" formulation) it will in time con­stitute an important fraction of the national income. The very high income tax necessary to collect this amount of money and pay it to the holders of government bonds will discourage risky private in­vestment, by so reducing the net return on it that the investor is not compensated for the risk of losing his capital. This will make it necessary for the government to undertake still more deficit financing to keep up the level of income and employment. Still heavier taxation will then be necessary to pay the interest on the growing debt - until the burden of taxation is so crushing that private investment becomes unprofitable, and the private enter­prise economy collapses. Private firms and corporations will all be bankrupted by the taxes, and the government will have to take over all industry.

This argument is not new. The identical calamities, although they are now receiving much more attention than usual were prom­ised when the first income tax law of one penny in the pound was proposed. All this only makes it more important to evaluate the significance of the argument.

III

There are four major errors in the argument against deficit spend­ing, four reasons why its apparent collusiveness is only illusory.

In the first place, the same high income tax that reduces the re­turn on the investment is deductible for the loss that is incurred if the investment turns out a failure. As a result of this the net return on the risk of loss is unaffected by the income tax rate, no matter how high that may be. Consider an investor in the $50,000 - a-year income class who has accumulated $10,000 to invest. At 6 per­ cent this would yield $600, but after paying income tax on this addition to his income at 60 cents in the dollar he would have only
$240 left. It is argued, therefore, that he would not invest because this is insufficient compensation for the risk of losing $10,000. This argument forgets that if the $ 10,000 is all lost, the net loss to the investor, after he has deducted his income tax allowance, will be only $4,000, and the rate of return on the amount he actually risks is still exactly 6 percent; $840 is 6 percent of $4,000. The effect of the income tax is to make the rich man act as a kind of agent work­ing for society on commission. He receives only a part of the return on the investment, but he loses only a part of the money that is invested. Any investment that was worth undertaking in the absence of the income tax is still worth undertaking.

Of course, this correction of the argument is strictly true only where 100 percent of the loss is deductible from taxable income, where relief from taxation occurs at the same rate as the tax on returns. There is a good case against certain limitations on permis­sible deduction from the income tax base for losses incurred, but that is another story. Something of the argument remains, too, if the loss would put the taxpayer into a lower income tax bracket, where the rebate (and the tax) is at a lower rate. There would then be some reduction in the net return as compared with the potential net loss. But this would apply only to such investments as are large enough to threaten to impoverish the investor if they fail. It was for the express purpose of dealing with this problem that the cor­poration was devised, making it possible for many individuals to combine and undertake risky enterprises without any one person having to risk all his fortune on one venture. But quite apart from corporate investment, this problem would be met almost entirely if the maximum rate of income tax were reached; it a relatively low level, say at $25,000 a year (low, that is, from the point of view of the rich men who are the supposed source of risk capital). Even if all income in excess of $25,000 were taxed at go percent there would
be no discouragement in the investment of any part of income over this level. True, the net return, after payment of tax, would be only one-tenth of the nominal interest payments, but the amount risked by the investors would also be only ten percent of the actual capital invested, and therefore the net return on the capital actually risked
by the investor would be unaffected.

In the second place, this argument against deficit spending in time of depression would be indefensible even if the harm done by debt were as great as has been suggested. It must be remembered that spending by the government increases the real national income of goods and services by several times the amount spent by the gov­ernment, and that the burden is measured not by the amount of the interest payments but only by the inconveniences involved in the process of transferring the money from the taxpayers to the bondholders. Therefore objecting to deficit spending is like argu­ing that if you are offered a job when out of work on the condition that you promise to pay your wife interest on a. part of the money earned (or that your wife pay it to you) it would be wiser to con­tinue to be unemployed, because in time you will be owing your wife a great deal of money (or she will be owing it to you), and this might cause matrimonial difficulties in the future. Even if the in­terest payments were really lost to society, instead of being merely transferred within the society, they would come to much less than the loss through permitting unemployment to continue. That loss would be several times as great as the capital on which these interest payments have to be made.

In the third place, there is no good reason for supposing that the government would have to raise all the interest on the national debt by current taxes. We have seen that Functional Finance permits taxation only when the direct effect of the tax is in the social interest, as when it prevents excessive spending or excessive investment which would bring about inflation. If taxes imposed to pre­vent inflation do not result in sufficient proceeds, the interest on the debt can be met by borrowing or printing the money. There is no risk of inflation from this, because if there were such a risk a greater amount would have to be collected in taxes.

This means that the absolute size of the national debt does not matter at all, and that however large the interest payments that have to be made, these do not constitute any burden upon society as a whole, A completely fantastic exaggeration may illustrate the point. Suppose the national debt reaches the stupendous total of ten thousand billion dollars (that is, ten trillion, $10,000,000,000,000), so that the interest on it is 300 billion a year. Suppose the real national income of goods and services which can be produced by the economy when fully employed is 150 billion. The interest alone, therefore, comes to twice the real national income. There is no doubt that a debt of this size would be called "unreasonable," But even in this fantastic case the payment of the interest constitutes no burden on society. Although the real income is only 150 billion dollars the money income is 450 billion - 150 billion in income from the production of goods and services and 300 billion in income from ownership of the government bonds which constitute the na­tional debt. Of this money income of 450 billion, 300 billion has to be collected in-taxes by the government for interest payments (if 10 trillion is the legal debt limit), but after payment of these taxes there remains 150 billion dollars in the hands of the tax­payers, and this is enough to pay for all the goods and services that the economy can produce. Indeed it would do the public no good to have any more money left after tax payments, because if it spent more than 150 billion dollars it would merely be raising the prices of the goods bought. It would not be able to obtain more goods to consume than the country is able to produce.

Of course this illustration must not be taken to imply that a debt of this size is at all likely to come about as a result of the application of Functional Finance. As will be shown below, there is a natural tendency for the national debt to stop growing long before it comes anywhere near the astronomical figures that we have been playing with.

The unfounded assumption that current interest on the debt must be collected in taxes springs from the idea that the debt must be kept in a "reasonable" or "manageable" ratio to income (what­ever that may be). If this restriction is accepted, borrowing to pay the interest is eliminated as soon as the limit of "reasonableness" is reached, and if we further rule out, as an indecent thought, the possibility o£ printing the money, there remains only the possibility of raising the interest payments by taxes. Fortunately there is no need to assume these limitations so long as Functional Finance is on guard against inflation, for it is the fear of inflation which is the only rational basis for suspicion of the printing of money.

Finally, there is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full em­ployment, the government must always be borrowing more money and increasing the national debt. There are a number of reasons for this.

First, full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase.

Second, since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself; the guarantee of permanent full employment will make private investment much more attractive, once investors have got over their suspicions of the new procedure. The greater private investment will diminish the need for deficit spending.

Third, as the national debt increases, and with it the sum of pri­vate wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending1 by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and it can devote them to paying the interest on the national debt.

Fourth, as the national debt increases it acts as a self-equilibrat­ing force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow conies completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (pos­sibly through a corporation in which he has shares), and who re­gards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income. As current saving is thus discouraged by the great accumulation of past savings, spending out of current income increases (since spending is the only alternative to saving ' income). This increase in private spending makes it less necessary for the government to undertake deficit financing to keep total spending at the level which provides full employment. When the
government debt has become so great that private spending is enough to provide the total spending needed for full employment, there is no need for any deficit financing by the government, the budget is balanced and the national debt automatically stops grow­ing. The size of this equilibrium level of debt depends on many things. It can only be guessed at, and in the very roughest manner. My guess is that it is between 100 and 300 billion dollars. Since the level is a result and not a principle of Functional Finance the latitude of such a guess does not matter; it is not needed for the application of the laws of Functional Finance.

Fifth, if for any reason the government does not wish to see private property grow too much (whether in the form of govern­ment bonds or otherwise) it can check this by taxing the rich in­stead of borrowing from them, in its program of financing govern­ment spending to maintain full employment. The rich will not reduce their spending significantly, and thus the effects on the economy, apart from the smaller debt, will be the same as if the money had been borrowed from them. By this means the debt can be reduced to any desired level and kept there.

The answers to the argument against deficit spending may thus be summarized as follows:

The national debt does not have to keep on increasing;

Even if the national debt does grow, the interest on it does not have to be raised out of current taxes;

Even if the interest on the debt is raised out of current taxes, these taxes constitute only the interest on only a fraction of the benefit enjoyed from the government spending, and are not lost to the nation but are merely transferred from taxpayers to bond­holders;

High income taxes need not discourage investment, because appropriate deductions for losses can diminish the capital actually risked by the investor in the same proportion as his net income from the investment is reduced.

iv

If the propositions of Functional Finance were put forward with­out fear of appearing too logical, criticisms like those discussed above would not be as popular as they now are, and it would not be necessary to defend Functional Finance from its friends. An especially embarrassing task arises from the claim that Functional Finance (or deficit financing, as it is frequently but unsatisfactorily called) is primarily a defense of private enterprise. In the attempt to gain popularity for Functional Finance, it has been given other names and declared to be essentially directed toward saving private enterprise. I myself have sinned similarly in previous writings in identifying it with democracy,* thus joining the army of salesmen who wrap up their wares in the flag and tie anything they have to sell to victory or morale.

*In "Total Democracy and Full Employment," Social Change (May 1941).

Functional Finance is not especially related to democracy or to private enterprise. It is applicable to a communist society just as well as to a fascist society or a democratic society. It is applicable to any society in which money is used as an important element in the economic mechanism. It consists of the simple principle of giving up our preconceptions of what is

proper or sound or tradi­tional, of what "is done," and instead considering the functions performed in the economy by government taxing and spending and borrowing and lending. It means using these instruments simply as instruments, and not as magic charms that will cause mysterious hurt if they are manipulated by the wrong people or without due reverence for tradition. Like any other mechanism, Functional Finance will work no matter who pulls the levers. Its relationship to democracy and free enterprise consists simply in the fact that if the people who believe in these things will not use Functional Finance, they will stand no chance in the long run against others who will.

Repudiate the National Debt

Repudiate the National Debt
by Murray N. Rothbard
by Murray N. Rothbard
 
  
   
In the spring of 1981, conservative Republicans in the House of Representatives cried. They cried because, in the first flush of the Reagan Revolution that was supposed to bring drastic cuts in taxes and government spending, as well as a balanced budget, they were being asked by the White House and their own leadership to vote for an increase in the statutory limit on the federal public debt, which was then scraping the legal ceiling of one trillion dollars. They cried because all of their lives they had voted against an increase in public debt, and now they were being asked, by their own party and their own movement, to violate their lifelong principles. The White House and its leadership assured them that this breach in principle would be their last: that it was necessary for one last increase in the debt limit to give President Reagan a chance to bring about a balanced budget and to begin to reduce the debt. Many of these Republicans tearfully announced that they were taking this fateful step because they deeply trusted their President, who would not let them down.
Famous last words. In a sense, the Reagan handlers were right: there were no more tears, no more complaints, because the principles themselves were quickly forgotten, swept into the dustbin of history. Deficits and the public debt have piled up mountainously since then, and few people care, least of all conservative Republicans. Every few years, the legal limit is raised automatically. By the end of the Reagan reign the federal debt was $2.6 trillion; now it is $3.5 trillion and rising rapidly [ed. note: $10.5 trillion, Oct. 23, 2008]. And this is the rosy side of the picture, because if you add in "off-budget" loan guarantees and contingencies, the grand total federal debt is $20 trillion.
Before the Reagan era, conservatives were clear about how they felt about deficits and the public debt: a balanced budget was good, and deficits and the public debt were bad, piled up by free-spending Keynesians and socialists, who absurdly proclaimed that there was nothing wrong or onerous about the public debt. In the famous words of the left-Keynesian apostle of "functional finance," Professor Abba Lerner, there is nothing wrong with the public debt because "we owe it to ourselves." In those days, at least, conservatives were astute enough to realize that it made an enormous amount of difference whether – slicing through the obfuscatory collective nouns – one is a member of the "we" (the burdened taxpayer) or of the "ourselves" (those living off the proceeds of taxation).

Since Reagan, however, intellectual-political life has gone topsy-turvy. Conservatives and allegedly "free-market" economists have turned handsprings trying to find new reasons why "deficits don't matter," why we should all relax and enjoy the process. Perhaps the most absurd argument of Reaganomists was that we should not worry about growing public debt because it is being matched on the federal balance sheet by an expansion of public "assets." Here was a new twist on free-market macroeconomics: things are going well because the value of government assets is rising! In that case, why not have the government nationalize all assets outright? Reaganomists, indeed, came up with every conceivable argument for the public debt except the phrase of Abba Lerner, and I am convinced that they did not recycle that phrase because it would be difficult to sustain with a straight face at a time when foreign ownership of the national debt is skyrocketing. Even apart from foreign ownership, it is far more difficult to sustain the Lerner thesis than before; in the late 1930's, when Lerner enunciated his thesis, total federal interest payments on the public debt were one billion dollars; now they have zoomed to $200 billion, the third largest item in the federal budget, after the military and Social Security: the "we" are looking ever shabbier compared to the "ourselves."
To think sensibly about the public debt, we first have to go back to first principles and consider debt in general. Put simply, a credit transaction occurs when C, the creditor, transfers a sum of money (say $1,000) to D, the debtor, in exchange for a promise that D will repay C in a year's time the principal plus interest. If the agreed interest rate on the transaction is 10 percent, then the debtor obligates himself to pay in a year's time $1,100 to the creditor. This repayment completes the transaction, which in contrast to a regular sale, takes place over time.
So far, it is clear that there is nothing "wrong" with private debt. As with any private trade or exchange on the market, both parties to the exchange benefit, and no one loses. But suppose that the debtor is foolish, gets himself in over his head, and then finds that he can't repay the sum he had agreed on? This, of course is a risk incurred by debt, and the debtor had better keep his debts down to what he can surely repay. But this is not a problem of debt alone. Any consumer may spend foolishly; a man may blow his entire paycheck on an expensive trinket and then find that he can't feed his family. So consumer foolishness is hardly a problem confined to debt alone. But there is one crucial difference: if a man gets in over his head and he can't pay, the creditor suffers too, because the debtor has failed to return the creditor's property. In a profound sense, the debtor who fails to repay the $1,100 owed to the creditor has stolen property that belongs to the creditor; we have here not simply a civil debt, but a tort, an aggression against another's property.

In earlier centuries, the insolvent debtor's offense was considered grave, and unless the creditor was willing to "forgive" the debt out of charity, the debtor continued to owe the money plus accumulating interest, plus penalty for continuing nonpayment. Often, debtors were clapped into jail until they could pay – a bit Draconian perhaps, but at least in the proper spirit of enforcing property rights and defending the sanctity of contracts. The major practical problem was the difficulty for debtors in prison to earn the money to repay the loan; perhaps it would have been better to allow the debtor to be free, provided that his continuing income went to paying the creditor his just due.
As early as the 17th century, however, governments began sobbing about the plight of the unfortunate debtors, ignoring the fact that the insolvent debtors had gotten themselves into their own fix, and they began to subvert their own proclaimed function of enforcing contracts. Bankruptcy laws were passed which, increasingly, let the debtors off the hook and prevented the creditors from obtaining their own property. Theft was increasingly condoned, improvidence was subsidized, and thrift was hobbled. In fact, with the modern device of Chapter 11, instituted by the Bankruptcy Reform Act of 1978, inefficient and improvident managers and stockholders are not only let off the hook, but they often remain in positions of power, debt-free and still running their firms, and plaguing consumers and creditors with their inefficiencies. Modern utilitarian neoclassical economists see nothing wrong with any of this; the market, after all, "adjusts" to these changes in the law. It is true that the market can adjust to almost anything, but so what? Hobbling creditors means that interest rates rise permanently, to the sober and honest as well as the improvident; but why should the former be taxed to subsidize the latter? But there are deeper problems with this utilitarian attitude. It is the same amoral claim, from the same economists, that there is nothing wrong with rising crime against residents or storekeepers of the inner cities. The market, they assert, will adjust and discount for such high crime rates, and therefore rents and housing values will be lower in the inner-city areas. So everything will be taken care of. But what sort of consolation is that? And what sort of justification for aggression and crime?
In a just society, then, only voluntary forgiveness by creditors would let debtors off the hook; otherwise, bankruptcy laws are an unjust invasion of the property rights of creditors.
One myth about "debtors'" relief is that debtors are habitually poor and creditors rich, so that intervening to save debtors is merely a requirement of egalitarian "fairness." But this assumption was never true: in business, the wealthier the businessman the more likely he is to be a large debtor. It is the Donald Trumps and Robert Maxwells of this world whose debts spectacularly exceed their assets. Intervention on behalf of debtors has generally been lobbied for by large businesses with large debts. In modern corporations, the effect of ever-tightening bankruptcy laws has been to hobble the creditor-bondholders for the benefit of the stockholders and the existing managers, who are usually installed by, and allied with, a few dominant large stockholders. The very fact that a corporation is insolvent demonstrates that its managers have been inefficient, and they should be removed promptly from the scene. Bankruptcy laws that keep prolonging the rule of existing managers, then, not only invade the property rights of the creditors; they also injure the consumers and the entire economic system by preventing the market from purging the inefficient and improvident managers and stockholders and from shifting the ownership of industrial assets to the more efficient creditors. Not only that; in a recent law review article, Bradley and Rosenzweig have shown that the stockholders, too, as well as the creditors, have lost a significant amount of assets due to the installation of Chapter 11 in 1978. As they write, "if bondholders and stockholders are both losers under Chapter 11, then who are the winners?" The winners, remarkably but unsurprisingly, turn out to be the existing, inefficient corporate managers, as well as the assorted lawyers, accountants, and financial advisers who earn huge fees from bankruptcy reorganizations.

In a free-market economy that respects property rights, the volume of private debt is self-policed by the necessity to repay the creditor, since no Papa Government is letting you off the hook. In addition, the interest rate a debtor must pay depends not only on the general rate of time preference but on the degree of risk he as a debtor poses to the creditor. A good credit risk will be a "prime borrower," who will pay relatively low interest; on the other hand, an improvident person or a transient who has been bankrupt before, will have to pay a much higher interest rate, commensurate with the degree of risk on the loan.
Most people, unfortunately, apply the same analysis to public debt as they do to private. If sanctity of contracts should rule in the world of private debt, shouldn't they be equally as sacrosanct in public debt? Shouldn't public debt be governed by the same principles as private? The answer is no, even though such an answer may shock the sensibilities of most people. The reason is that the two forms of debt-transaction are totally different. If I borrow money from a mortgage bank, I have made a contract to transfer my money to a creditor at a future date; in a deep sense, he is the true owner of the money at that point, and if I don't pay I am robbing him of his just property. But when government borrows money, it does not pledge its own money; its own resources are not liable. Government commits not its own life, fortune, and sacred honor to repay the debt, but ours. This is a horse, and a transaction, of a very different color.
For unlike the rest of us, government sells no productive good or service and therefore earns nothing. It can only get money by looting our resources through taxes, or through the hidden tax of legalized counterfeiting known as "inflation." There are some exceptions, of course, such as when the government sells stamps to collectors or carries our mail with gross inefficiency, but the overwhelming bulk of government revenues is acquired through taxation or its monetary equivalent. Actually, in the days of monarchy, and especially in the medieval period before the rise of the modern state, kings got the bulk of their income from their private estates – such as forests and agricultural lands. Their debt, in other words, was more private than public, and as a result, their debt amounted to next to nothing compared to the public debt that began with a flourish in the late 17th century.
The public debt transaction, then, is very different from private debt. Instead of a low-time preference creditor exchanging money for an IOU from a high-time preference debtor, the government now receives money from creditors, both parties realizing that the money will be paid back not out of the pockets or the hides of the politicians and bureaucrats, but out of the looted wallets and purses of the hapless taxpayers, the subjects of the state. The government gets the money by tax-coercion; and the public creditors, far from being innocents, know full well that their proceeds will come out of that selfsame coercion. In short, public creditors are willing to hand over money to the government now in order to receive a share of tax loot in the future. This is the opposite of a free market, or a genuinely voluntary transaction. Both parties are immorally contracting to participate in the violation of the property rights of citizens in the future. Both parties, therefore, are making agreements about other people's property, and both deserve the back of our hand. The public credit transaction is not a genuine contract that need be considered sacrosanct, any more than robbers parceling out their shares of loot in advance should be treated as some sort of sanctified contract.
Any melding of public debt into a private transaction must rest on the common but absurd notion that taxation is really "voluntary," and that whenever the government does anything, "we" are willingly doing it. This convenient myth was wittily and trenchantly disposed of by the great economist Joseph Schumpeter: "The theory which construes taxes on the analogy of club dues or of the purchases of, say, a doctor only proves how far removed this part of the social sciences is from scientific habits of mind." Morality and economic utility generally go hand in hand. Contrary to Alexander Hamilton, who spoke for a small but powerful clique of New York and Philadelphia public creditors, the national debt is not a "national blessing." The annual government deficit, plus the annual interest payment that keeps rising as the total debt accumulates, increasingly channels scarce and precious private savings into wasteful government boondoggles, which "crowd out" productive investments. Establishment economists, including Reaganomists, cleverly fudge the issue by arbitrarily labeling virtually all government spending as "investments," making it sound as if everything is fine and dandy because savings are being productively "invested." In reality, however, government spending only qualifies as "investment" in an Orwellian sense; government actually spends on behalf of the "consumer goods" and desires of bureaucrats, politicians, and their dependent client groups. Government spending, therefore, rather than being "investment," is consumer spending of a peculiarly wasteful and unproductive sort, since it is indulged not by producers but by a parasitic class that is living off, and increasingly weakening, the productive private sector. Thus, we see that statistics are not in the least "scientific" or "value-free"; how data are classified – whether, for example, government spending is "consumption" or "investment" – depends upon the political philosophy and insights of the classifier.
Deficits and a mounting debt, therefore, are a growing and intolerable burden on the society and economy, both because they raise the tax burden and increasingly drain resources from the productive to the parasitic, counterproductive, "public" sector. Moreover, whenever deficits are financed by expanding bank credit – in other words, by creating new money – matters become still worse, since credit inflation creates permanent and rising price inflation as well as waves of boom-bust "business cycles."

It is for all these reasons that the Jeffersonians and Jacksonians (who, contrary to the myths of historians, were extraordinarily knowledgeable in economic and monetary theory) hated and reviled the public debt. Indeed, the national debt was paid off twice in American history, the first time by Thomas Jefferson and the second, and undoubtedly the last time, by Andrew Jackson.
Unfortunately, paying off a national debt that will soon reach $4 trillion would quickly bankrupt the entire country. Think about the consequences of imposing new taxes of $4 trillion in the United States next year! Another way, and almost as devastating, a way to pay off the public debt would be to print $4 trillion of new money – either in paper dollars or by creating new bank credit. This method would be extraordinarily inflationary, and prices would quickly skyrocket, ruining all groups whose earnings did not increase to the same extent, and destroying the value of the dollar. But in essence this is what happens in countries that hyper-inflate, as Germany did in 1923, and in countless countries since, particularly the Third World. If a country inflates the currency to pay off its debt, prices will rise so that the dollars or marks or pesos the creditor receives are worth a lot less than the dollars or pesos they originally lent out. When an American purchased a 10,000 mark German bond in 1914, it was worth several thousand dollars; those 10,000 marks by late 1923 would not have been worth more than a stick of bubble gum. Inflation, then, is an underhanded and terribly destructive way of indirectly repudiating the "public debt"; destructive because it ruins the currency unit, which individuals and businesses depend upon for calculating all their economic decisions.
I propose, then, a seemingly drastic but actually far less destructive way of paying off the public debt at a single blow: out-right debt repudiation. Consider this question: why should the poor, battered citizens of Russia or Poland or the other ex-Communist countries be bound by the debts contracted by their former Communist masters? In the Communist situation, the injustice is clear: that citizens struggling for freedom and for a free-market economy should be taxed to pay for debts contracted by the monstrous former ruling class. But this injustice only differs by degree from "normal" public debt. For, conversely, why should the Communist government of the Soviet Union have been bound by debts contracted by the Czarist government they hated and overthrew? And why should we, struggling American citizens of today, be bound by debts created by a past ruling elite who contracted these debts at our expense? One of the cogent arguments against paying blacks "reparations" for past slavery is that we, the living, were not slaveholders. Similarly, we the living did not contract for either the past or the present debts incurred by the politicians and bureaucrats in Washington.

Although largely forgotten by historians and by the public, repudiation of public debt is a solid part of the American tradition. The first wave of repudiation of state debt came during the 1840's, after the panics of 1837 and 1839. Those panics were the consequence of a massive inflationary boom fueled by the Whig-run Second Bank of the United States. Riding the wave of inflationary credit, numerous state governments, largely those run by the Whigs, floated an enormous amount of debt, most of which went into wasteful public works (euphemistically called "internal improvements"), and into the creation of inflationary banks. Outstanding public debt by state governments rose from $26 million to $170 million during the decade of the 1830's. Most of these securities were financed by British and Dutch investors.
During the deflationary 1840's succeeding the panics, state governments faced repayment of their debt in dollars that were now more valuable than the ones they had borrowed. Many states, now largely in Democratic hands, met the crisis by repudiating these debts, either totally or partially by scaling down the amount in "readjustments." Specifically, of the 28 American states in the 1840's, nine were in the glorious position of having no public debt, and one (Missouri's) was negligible; of the 18 remaining, nine paid the interest on their public debt without interruption, while another nine (Maryland, Pennsylvania, Indiana, Illinois, Michigan, Arkansas, Louisiana, Mississippi, and Florida) repudiated part or all of their liabilities. Of these states, four defaulted for several years in their interest payments, whereas the other five (Michigan, Mississippi, Arkansas, Louisiana, and Florida) totally and permanently repudiated their entire outstanding public debt. As in every debt repudiation, the result was to lift a great burden from the backs of the taxpayers in the defaulting and repudiating states.
Apart from the moral, or sanctity-of-contract argument against repudiation that we have already discussed, the standard economic argument is that such repudiation is disastrous, because who, in his right mind, would lend again to a repudiating government? But the effective counterargument has rarely been considered: why should more private capital be poured down government rat holes? It is precisely the drying up of future public credit that constitutes one of the main arguments for repudiation, for it means beneficially drying up a major channel for the wasteful destruction of the savings of the public. What we want is abundant savings and investment in private enterprises, and a lean, austere, low-budget, minimal government. The people and the economy can only wax fat and prosperous when their government is starved and puny.
The next great wave of state debt repudiation came in the South after the blight of Northern occupation and Reconstruction had been lifted from them. Eight Southern states (Alabama, Arkansas, Florida, Louisiana, North Carolina, South Carolina, Tennessee, and Virginia) proceeded, during the late 1870's and early 1880's under Democratic regimes, to repudiate the debt foisted upon their taxpayers by the corrupt and wasteful carpetbag Radical Republican governments under Reconstruction.

So what can be done now? The current federal debt is $3.5 trillion. Approximately $1.4 trillion, or 40 percent, is owned by one or another agency of the federal government. It is ridiculous for a citizen to be taxed by one arm of the federal government (the IRS), to pay interest and principal on debt owned by another agency of the federal government. It would save the taxpayer a great deal of money, and spare savings from further waste, to simply cancel that debt outright. The alleged debt is simply an accounting fiction that provides a mask over reality and furnishes a convenient means for mulcting the taxpayer. Thus, most people think that the Social Security Administration takes their premiums and accumulates it, perhaps by sound investment, and then "pays back" the "insured" citizen when he turns 65. Nothing could be further from the truth. There is no insurance and there is no "fund," as there indeed must be in any system of private insurance. The federal government simply takes the Social Security "premiums" (taxes) of the young person, spends them in the general expenditures of the Treasury, and then, when the person turns 65, taxes someone else to pay the "insurance benefit." Social Security, perhaps the most revered institution in the American polity, is also the greatest single racket. It's simply a giant Ponzi scheme controlled by the federal government. But this reality is masked by the Social Security Administration's purchase of government bonds, the Treasury then spending these funds on whatever it wishes. But the fact that the SSA has government bonds in its portfolio, and collects interest and payment from the American taxpayer, allows it to masquerade as a legitimate insurance business.
Canceling federal agency-held bonds, then, reduces the federal debt by 40 percent. I would advocate going on to repudiate the entire debt outright, and let the chips fall where they may. The glorious result would be an immediate drop of $200 billion in federal expenditures, with at least the fighting chance of an equivalent cut in taxes.
But if this scheme is considered too Draconian, why not treat the federal government as any private bankrupt is treated (forgetting about Chapter 11)? The government is an organization, so why not liquidate the assets of that organization and pay the creditors (the government bondholders) a pro-rata share of those assets? This solution would cost the taxpayer nothing, and, once again, relieve him of $200 billion in annual interest payments. The United States government should be forced to disgorge its assets, sell them at auction, and then pay off the creditors accordingly. What government assets? There are a great deal of assets, from TVA to the national lands to various structures such as the Post Office. The massive CIA headquarters at Langley, Virginia, should raise a pretty penny for enough condominium housing for the entire work force inside the Beltway. Perhaps we could eject the United Nations from the United States, reclaim the land and buildings, and sell them for luxury housing for the East Side gliterati. Another serendipity out of this process would be a massive privatization of the socialized land of the Western United States and of the rest of America as well. This combination of repudiation and privatization would go a long way to reducing the tax burden, establishing fiscal soundness, and desocializing the United States.
In order to go this route, however, we first have to rid ourselves of the fallacious mindset that conflates public and private, and that treats government debt as if it were a productive contract between two legitimate property owners.
This article was published in the June 1992 issue of Chronicles.
Murray N. Rothbard (1926–1995) was dean of the Austrian School, founder of modern libertarianism, and academic vice president of the Mises Institute. He was also editor – with Lew Rockwell – of The Rothbard-Rockwell Report, and appointed Lew as his literary executor.