The Wealth of Nations
Book 5, Chapter 3
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Chapter 3 Summary
In a commercial country, the sovereign spends a large portion of his revenue on luxury goods—often to the detriment of the state's military power. His expenditures will often outweigh his revenue, sometimes requiring him to borrow from his subjects. During wartime, most states are required to go into debt, with investments being made in increasing the size of the army, equipping fleets, and preparing garrisoned towns for defense, including the purchase of arms, ammunition and provisions. Vast amounts of capital are therefore required fast in order to prepare for war—which will not wait for the gradual returns on new taxes. The government therefore secures this capital through borrowing.
Commercial countries are home to many wealthy merchants and manufacturers, who are in a position to be able to advance large sums of money to the government. These people trust the government, since the government provides them with security and a legal system that enable them to operate their businesses. This fact, coupled with the extremely favorable loan terms offered by the government for such loans, disposes people to lend to them.
Aware that they will be able to borrow in times of need, governments of such countries often cease to manage the country's economy effectively. This results in major debts, which are likely in the long term to ruin Europe. Nations, like private men, have generally started to borrow through personal credit, without assigning or mortgaging specific funds for the reimbursement of this debt. When this system has failed them, they have started to borrow against the assignment of specific funds or a mortgage. Britain's so-called “unfunded debt” consists of a debt that is partly at zero interest and partly at full interest—very much like a private person’s contract against a promissory note. The Bank of Britain maintains their value and facilitates their circulation, which enables government to contract these large debts when needed. When this resource is exhausted, the government turns to specific branches of public revenue in order to raise the capital it needs to repay this debt. It raises this money either as a short-term or a perpetuity mortgage. Money raised from a short-term loan is known as anticipation; that raised through a perpetuity mortgage is known as perpetual funding.
In Britain, annual taxes on loans are anticipated according to the terms stipulated in the loan’s borrowing clause. The Bank of Britain lends at interest rates of between 8% and 3%. If there is a deficiency, which there always is, it is provided for in the funds for the ensuing year; the only major branch of public revenue that is still unmortgaged is therefore regularly spent before it comes in. Like an extravagant spendthrift whose social engagements do not allow him to wait for his regular salary, the state constantly borrows from its own agents, paying interest for the use of its own money.
Over time, various acts have been passed under which taxes that had previously been anticipated only in the short term were rendered perpetual, to be used to pay only the interest on the borrowed amount.
There are two other loan methods: annuity loans—either for a specific period of time or an entire lifetime. During the reigns of King William and Queen Anne, large sums were frequently borrowed in annuities for a specific period of time, both short and long term. In 1691, an act was passed enabling a million to be borrowed as a lifetime annuity (a form of group life annuity devised by Tonti) at 14%; however, such was the supposed instability of government that even these favorable terms resulted in few purchasers.
In modern governments, peacetime expenses are largely equal to peacetime revenues. When war occurs, the government is both unwilling and unable to increase its revenue in proportion to the increased expense. Increasing revenue would mean increasing taxes—which is not an option since an increase in taxes would cause major disillusionment amongst the people, with regard to the war. The government is, however, able to borrow from individuals—which enables it to raise sufficient money to fund the war, with just a moderate tax increase. Through perpetual funding, they are able to raise large amounts of money with very moderate tax increases.
Any new tax is always immediately felt by the people and will generally be faced with opposition and resistance. The more taxes are increased, the more the people object; the more loudly they object to each new tax brought in, the more difficult it becomes to implement new taxes or raise current rates.
In Britain, from the time of the first recourse to borrowing, to the ruinous practice of perpetual funding, the reduction of public debt during peacetime has come nowhere near to paying off the debt accumulated during wartime. Indeed, Britain’s current huge debt dates way back to the 1668 war, which concluded with the Treaty of Ryswick in 1697.
When government expense is paid for using annual revenue from the produce of free or unmortgaged taxes, a portion of the people’s revenue is just being redirected from maintaining one form of unproductive labor towards another. When public expense is paid for through funding, this draws on capital that already exists in the country—redirecting a portion of the annual produce destined for the maintenance of productive labor towards that of unproductive labor.
The latter method of funding, although depleting this existing capital, is more favorable to the accumulation or acquisition of new capital than the method of defraying public expense through revenue raised throughout the year. Under the funding system, some careful spending and diligence amongst a country’s people can more easily repair the damage caused by a government’s waste and extravagance.
It is said that payment of the interest on public debt is like the right hand paying the left; the money does not leave country—it is one group of inhabitants' income being transferred to another. This view suggests that the whole public debt is owing to the inhabitants of the country, which is in fact not the case; the Dutch, as well as several other foreign nations, have a considerable share in our public funds.
Land and capital stock are the two original sources of all revenue, both private and public. Although it is in a landowner's interest to maintain his estate in as good a condition as he can, the various land taxes often leave him with insufficient revenue to do so. With landowners unable to maintain their land, the country's agricultural industry inevitably declines.
When national debt accumulates beyond a manageable level, the country’s economy spirals out of control, often culminating in bankruptcy and the need to tap into public revenue. Countries often disguise public bankruptcy as a “pretend payment” by increasing inflation rates. When a state or individual is forced to declare themselves bankrupt, the best policy is to do so openly and transparently; this result in the least dishonor to the debtor and the least damage to the creditor.
Almost all states, however, both in the past and today, when faced by this situation, have attempted to redress the situation through inflation: gradually decreasing their currency below its original value so that the same nominal amount gradually contains less and less silver.
Britain's public revenue can never be completely liberated since the surplus remaining after payment of annual expenses is so small as to be insignificant. The liberation of public revenue can never be brought about without considerably increasing public revenue or reducing public expense.
Commerce within the United States is conducted exclusively in banknotes rather than gold and silver, with any gold and silver that does come into their system being sent to Britain in exchange for commodities. But without gold and silver, there is no means of charging taxes; Britain receives all of the US's gold and silver—how is it possible to draw from them what they do not have?
The present scarcity of gold and silver in America is not due to poverty in the country or the inability of American citizens to purchase it. In a country where wages are significantly higher and the price of provisions much lower than in Britain, the majority of the population are in a position to be able to purchase large quantities of gold and silver should they so wish. In reality, the scarcity of gold and silver is through choice, not necessity.
Any country's domestic business can be conducted using banknotes, with nearly the same degree of convenience as using gold and silver money. The use of banknotes has proven convenient for the Americans, who are able to invest the profit made on surplus produce from the land in purchasing tools of trade, clothing, furniture, and iron needed to further improve, build and extend their settlements and plantations. Colonies’ governments find it in their interest to supply their people with sufficient banknotes to maintain their domestic business. Pennsylvania derives revenue from lending money to its subjects. Others, like Massachusetts, fund extraordinary emergencies by advancing banknotes to defray public expense, which are redeemed at a later date, when convenient for the colony, at the depreciated value to which it gradually falls.
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