Scottish Enlightenment-era philosopher David Hume penned a prescient and incisive essay about public debt in 1752, long before our current age of fiat currencies and staggering federal deficits. He would have been horrified at how public finance has evolved — or devolved, from his perspective — over the preceding 250-some years.
To Hume, national debt is a slowly metastasizing cancer at the core of society. If it isn't cut out completely, it will eventually consume the host body. "It must, indeed, be one of these two events; either the nation must destroy public credit, or public credit will destroy the nation."
On the surface, this assertion seems rigid and extreme. But the line of reasoning presented in Hume's essay is at least worthy of consideration. In my judgement, it's also quite persuasive.
The Inevitable Abandonment of Fiscal Prudence
Hume starts his essay by praising the wisdom of storing up treasure in the good times so that it is available to be spent in wars or calamities. It sounds somewhat proto-Keynesian, but it can also be interpreted as a form of self-insurance.
Unfortunately, says Hume, his own generation does not follow this timeless wisdom.
On the contrary, our modern expedient, which has become very general, is to mortgage the public revenues, and to trust that posterity will pay off the incumbrances contracted by their ancestors: And they, having before their eyes, so good an example of their wise fathers, have the same prudent reliance on their posterity; who, at last, from necessity more than choice, are obliged to place the same confidence in a new posterity.
Hume asserts that the "ancient maxims are . . . more prudent than the modern." Government authorities, Hume observes, are not at all farsighted or prudent about public finance, but rather they readily and eagerly "mortgage future revenues" in order to pay for the expenses of today.
It is very tempting to a minister to employ such an expedient, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamours against himself. The practice, therefore, of contracting debt will almost infallibly be abused, in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London, than to impower a statesman to draw bills, in this manner, upon posterity.
This policy of continuously financing current expenses with future revenues (via debt issuance) is extremely tempting to the official who is in power today but won't be forever. Some of them may even look at this way of financing government as preferable. As if anticipating the eventual appearance of Modern Monetary Theory, Hume asks,
What then shall we say to the new paradox, that public incumbrances, are, of themselves, advantageous, independent of the necessity of contracting them; and that any state, even though it were not pressed by a foreign enemy, could not possibly have embraced a wiser expedient for promoting commerce and riches, than to create funds, and debts, and taxes, without limitation?
What follows in Hume's essay is his refutation of this viewpoint.
Advantages and Disadvantages of Public Debt
Without the benefit of contemporary economic studies, Hume held some faulty beliefs about public debt. For one, he thought that merchants who owned public debt securities would demand less profit from commercial activities, and thus commodity and goods prices would fall. There's little evidence that this line of reasoning holds true. But a second benefit of debt-funded public spending rings true: namely, that it is a boon to the merchants who carry out the spending priorities of the government.
The government can't do everything on its own or through its agencies. It requires the collaboration of at least some private actors. When those private actors benefit, others in the private sector who do business with them also benefit.
However, this is of little importance, says Hume, because the disadvantages of public debt far outweigh whatever advantages it offers. Hume lists five major drawbacks of carrying heavy public debt burdens:
1. It concentrates power around the political center of the nation, for two reasons: first, because the heavier tax burden required (eventually) by deficit spending draws "a mighty confluence of people and riches [i.e. special interests] to the capital," and second, because certain business groups (again, special interests) stand to benefit from political choices about allocation of spending.
These are two sides of the same coin. At least some of those with the financial resourcefulness to lobby for special tax treatment and/or greater benefit from public largesse will do so. Some may have moral reservations about jockeying for such beneficial treatment, but some others are bound to put such reservations aside. And once some demonstrate success in lobbying for benefits, it becomes more urgent for others to do the same.
2. Though public debt is basically paper-credit, it soaks up a portion of the real currency of a nation, preventing that money from being spent elsewhere. Hume believed this causes inflation, and in the short term, it does.
In the long term, however, the productivity of public debt shrinks and eventually turns negative, beginning to drag down the economy with incremental issuance. Money that could have been spent buying goods and services (immediately stimulating the economy) or invested in wealth-generating enterprises (stimulating the economy in the future) is instead locked up for long periods of time in public debt securities.
3. The taxes used, in part, to pay the interest on this debt either raise the price of labor (in the same way that they cause consumer price inflation) or fall disproportionately on the poor who cannot afford to organize lobbying efforts. Or both.
4. Since much public debt is held by foreigners, "they render the public, in a manner, tributary to them, and may in time occasion the transport of our people and our industry." In other words, interest payments to foreign holders of debt transfers a piece of the nation's wealth across borders, which can then be used to purchase more of that nation's assets.
5. Hume asserted that a large portion of public debt was held by "idle people, who live on their revenue." Perhaps he had the English aristocracy in mind, who could afford to purchase such securities and enjoy the resulting stream of income. Public debt gave such rentiers "great encouragement to an useless and unactive life."
Would Hume have condemned those rentiers if their capital had gone to farmland, private businesses, merchant ships, or any other productive activity? Perhaps he still would have condemned the lifestyle, but surely he would not view their investments as "useless."
Hume anticipates the response that is still common among defenders of large national debts today:
We have, indeed, been told, that the public is no weaker upon account of its debts; since they are mostly due among ourselves, and bring as much property to one as they take from another. It is like transferring money from the right hand to the left; which leaves the person neither richer nor poorer than before.
In Hume's view, national debt is a mortgage on future tax revenue, even if it's mostly held domestically. And if all revenue is accounted for via debt, the nation will have to raise taxes. "[I]f all our present taxes be mortgaged, must we not invent new ones? And may not this matter be carried to a length that is ruinous and destructive?"
As taxes are increased, they at some point become a burden on society by stunting economic growth. When increasing amounts of private revenues are channeled to the government to be redistributed to other private actors, it becomes more difficult to make longterm investments. It also becomes more lucrative for the moneyed interests to lobby government in order to protect their revenues. Indeed, Hume pessimistically laments: "Elections are swayed by bribery and corruption alone: And the middle power between king and people being totally removed, a grievous despotism must infallibly prevail."
Have we not seen an empowering of the executive branch of government due to the "middle power" — the legislature and bureaucracy — becoming captured by moneyed interests? Is this not the cause of the populist backlash we now see in democracies across the world?
Populists on both sides of the political aisle share Hume's lament. Populists of the Right cheer Donald Trump's promise to "drain the swamp" of Washington DC, while populists of the Left applaud promises to dethrone the de facto ruling class of "millionaires and billionaires."
There is more to taxes, then, than "the mere transferring of property from the one hand to another." In both spending and tax policy inlay the opportunities for self-interested actors to reduce their tax burden, increase their share of government largesse, or act as the grantor of such benefits.
Higher Debt —> Higher Taxes —> Higher Debt
A progressively heavier debt load necessitates higher taxes, if not now then eventually. Great care must be taken that tax policies do not discourage productivity or encourage rent-seeking, but that is a lot to ask from self-interested human beings. Writes Hume,
Though a resolution should be formed by the legislature never to impose any tax which hurts commerce and discourages industry, it will be impossible for men, in subjects of such extreme delicacy, to reason so justly as never to be mistaken, or amidst difficulties so urgent, never to be seduced from their resolution. The continual fluctuations in commerce require continual alterations in the nature of the taxes; which exposes the legislature every moment to the danger both of wilful and involuntary error.
This sentiment is reminiscent of Milton Friedman's classic quote about greed, in which he asks,
Is it really true that political self-interest is nobler somehow than economic self-interest? You know, I think you’re taking a lot of things for granted. Just tell me where in the world you find these angels who are going to organize society for us?
To justify the self-interest of both voters and government officials, the argument is typically made that debt-financed spending will produce a future return by which the debt will be paid down. "We all own, that the most sanguine imagination cannot hope, either that this or any future ministry will be possessed of such rigid and steady frugality, as to make a considerable progress in the payment of our debts," says Hume. But this never happens.
Rather, as an economy grows and new revenue streams are added, the government finds a way to tax and mortgage those revenue streams. The relatively little garnered in new tax receipts acts as justification for adding a relatively large amount of national debt to fund the expenses of today. Thus, even if certain government spending produces a future return, that future return will likewise be mortgaged through a new round of debt issuance.
This process will spiral on and on — in fits and starts, perhaps, but nevertheless indefinitely — because, as Friedman contends, there are no angels among us to determine and execute fiscal policy.
The nation slowly erodes the growth of revenue needed to carry its debt load, and this inevitably continues to the point of either crisis (as in the case of contemporary Greece) or permanent economic lethargy (as in the case of contemporary Japan).
In Hume's words, "We have always found, where a government has mortgaged all its revenues, that it necessarily sinks into a state of languor, inactivity, and impotence."
The United States was spared from this fate in the aftermath of World War II when, perhaps, it should have lapsed into the above state due to its enormous national debt load of 119% of GDP. Instead, for a handful of decades, we became the world's manufacturing powerhouse and were forced by ever-rising interest rates to keep the debt in check as the economy grew into it. The national debt hit a low of 32% of GDP in 1981, not coincidentally the same year that interest rates peaked.
Thereafter, America's manufacturing dominance slowly diminished, and perpetually falling interest rates have enabled the normal pattern of debt buildup to resume. Today, the national debt has reached 105% of GDP and continues to grow faster than tax receipts. For now, GDP growth is faster than federal debt growth, allowing debt-to-GDP to remain steady. But we can't rely on that to continue indefinitely. The longterm trend has been one of rising debt-to-GDP, spiking especially fast during recessions.
Federal Debt-to-GDP Since 1978. Source: Trading Economics
Will we be insightful and farsighted enough to change course before it's too late? Given the present state of complacency about the national debt, the answer is almost certainly not. As Hume observes, the behavior of men is more commonly governed by what has been seen than by what is foreseen.
Will this lack of foresight result in an explosive crisis? Not necessarily. More likely, it will result in an indefinite state of economic anemia. America is more likely to tread the path of Japan than Greece.
Simple Application For Investors
How does this apply to investors? Staring down the barrel of a low-growth, low-inflation, low-interest rates future leaves investors in perhaps the worst kind of predicament. An explosive crisis would at least produce the kind of volatility that offers a steady supply of investment opportunities in which potential reward outweighs risk.
Currently, however, investors find ourselves in a position in which risk seems to outweigh potential rewards almost everywhere. The American stock market is trading at all time highs. As are the housing and commercial real estate markets. And yet, the global economy is slowing and the last bastion of meager growth (the US) is stockpiling federal debt like it's going out of style.
The conclusion should be clear, then: A situation that is not fundamentally sustainable will not be sustained. Trends that can't continue, won't. At least, not forever. Remember the wisdom of the grandfather of value investing, Benjamin Graham: In the short run, the market is a voting machine. But in the long run, it's a weighing machine. Popularity and investor sentiment rule for a time, but eventually they are overtaken by substance and fundamentals.
The application for investors, specifically, is patience, one of the most difficult of all virtues. Store up dry powder in the good times to be put to more productive use in the bad times. Perhaps those "bad times" will look like another 50% drawdown in the stock market and double-digit drawdowns in the value of real estate. Or, perhaps, they will be confined to certain industries, sectors, companies, or geographic areas.
In any case, value investing is not dead. Indeed, as the developed world sinks into a state of economic anemia, it is more important than ever. Not just because we investors stand to profit from it, but also because we play a valuable role when the unsustainable can no longer be sustained. That is, value investors are a source of capital in the most economically dire times. This is why Warren Buffett was called upon during the financial crisis to save ailing companies, giving him the opportunity to take ownership of valuable assets at a deep discount.
I submit that it is better to be ready to act as that direly needed source of capital in the bad times than to participate in the market's last leg of euphoria in the good times.
I'm not selling everything. But I'm not a net-buyer either. I'm mainly just waiting for economic reality to catch up with asset prices and, in a broader sense, with the nation as a whole.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.