Government Debt: Norm or Necessity

According to renowned economist Milton Friedman, governments often carry debt as a matter of economic prudence. This article delves into the reasons behind this norm and explains how government debt management affects fiscal policies and economic health.

Introduction: The Norm of Government Debt

Milton Friedman, one of the most influential economists of the 20th century, argued that it is normal for governments to carry debt. This perspective emphasizes the strategic use of debt as a tool for economic stabilization, long-term investment, and fulfilling social obligations. In this article, we explore the reasons behind Friedman's assertion and the interconnections between government debt, fiscal policy, and economic sustainability.

Milton Friedman’s Perspective on Government Debt

Economic Stability

One of the primary reasons governments carry debt is to maintain economic stability during downturns. By borrowing funds, governments can implement fiscal stimulus measures, support public services, and create jobs. These actions help mitigate the negative effects of recessions and promote overall economic resilience.

Intertemporal Budget Constraint

Another rationale for government debt is the ability to spread the cost of public investments over time. Long-term projects, such as infrastructure development, can provide benefits to future generations. Although current taxpayers bear the cost, borrowing ensures that the burden is distributed rather than shouldering a heavy financial burden all at once.

Low Borrowing Costs

In many cases, governments can borrow at low interest rates, especially if they have a strong credit rating. This makes it feasible for governments to finance deficits without significantly increasing their overall debt burden. The low cost of borrowing can be a crucial factor in sustaining public services and investments.

Inflation and Monetary Policy

Under some circumstances, governments can manage their debt levels through inflation. If a government issues debt and the economy grows, the real value of that debt can decrease over time, making it easier to manage the debt load. This is a complex and sometimes risky strategy but can be an effective tool in certain economic conditions.

Social and Political Considerations

Governments are often under pressure to meet social needs and invest in public goods. Borrowing can be a means of fulfilling these obligations without immediately raising taxes. This approach provides flexibility in addressing immediate social concerns while spreading the financial burden over time.

Cyclical Nature of Revenues

Government revenues are inherently cyclical, fluctuating with economic conditions. Borrowing allows governments to maintain spending levels even when revenues fall short. This helps to smooth out the effects of economic cycles, ensuring continuous public services and investments.

The Nature of Government Debt: A Closer Look

It is crucial to understand that government debt and the currency itself are deeply interconnected. The concept of currency does not exist independently of the government that creates it. Sovereign currencies, such as the U.S. dollar, Canadian dollar, and Australian dollar, are created by governments through the process of double-entry accounting. The government records a debt when it spends, resulting in an equivalent increase in private sector financial assets.

It is often misunderstood that government debt and currency creation are distinct processes. For instance, in the United States, the banking system leverages currency created by the government to create credit, which is indistinguishable from the sovereign currency in your hand. However, the process of how that currency came into existence and its removal from the economy differentiates it from the currency directly issued by the government.

The Fundamental Connection Between Debt and Currency: A Graphical Explanation

To better understand this concept, consider the following graph:

A graph showing the relationship between government debt and currency creation over time with zero starting point.

At some point, the government, acting through its representatives, began creating national currencies. In the process of spending, the government records a debt, increasing the financial assets of the private sector by an equivalent amount. Therefore, the debt exists the moment the currency is created, and bond sales come later.

When the government decreases its debt, it also decreases the number of financial assets in the private sector, reducing the currency in circulation. It is important to note that the government cannot increase the amount of currency it created, as the starting point was zero. All actions merely redistribute the currency, never creating more than was initially created.

A Simpler Example: Credit Card Analogy

To further simplify this concept, imagine you have a credit card that allows you to withdraw money from an ATM. If you withdraw the following amounts each day:

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Every time you withdraw dollars, you gain financial assets (cash in hand) and simultaneously accumulate debts of the same amount. On a graph, this would look like:

A graph showing the proportional increase in cash and debt as money is withdrawn.

On a graph, we start at zero, and as money is withdrawn, cash in hand increases at the same rate as debt.

The crucial point is that we started at zero, and as cash increases, debt increases proportionally. Money created always equals debt, and the two always net to zero. Repayment reduces debt at the same rate as cash in hand is reduced, eventually returning to zero.

Conclusion: The Role of Government Debt in Economic Health

In essence, government debt and currency creation are fundamental aspects of modern economies. While it is a norm, it must be managed prudently to avoid fiscal imbalances. Governments play a crucial role in stabilizing the economy, supporting public services, and fulfilling social obligations through strategic use of debt. By understanding the relationship between government debt and currency, policymakers can make informed decisions that promote economic stability and growth.