Creditors have better memories than debtors. This elegant line was coined by Benjamin Franklin—political philosopher, prolific writer, humorist and American ambassador to France. Mr. Franklin also was one of the Founding Fathers of the United States of America. A true polymath and a man of great common sense.

An entrepreneur assumes he is entitled to an inexhaustible supply of credit and nonchalantly racks up debt. Soon, he will discover that creditors have better memories than debtors. Credit will dry up. Workers will stop working. Suppliers will stop supplying. Debt, after all, needs to be paid back. Credit and debt are two sides of the same coin.

They will insist there is something subtle about debt we don’t understand.

“The creditor is always a virtual partner of the debtor. He has linked his fate with that of the debtor. Every grant of credit is a speculative entrepreneurial venture, the success or failure of which is uncertain.” – Ludwig von Mises in Human Action (Chapter 20 – p539)

Mainstream economists will not deny this. After all, how could they? Yet, they will say we got it wrong. They will argue we don’t get the full picture. They will insist there is something subtle about debt we don’t understand.

We Owe it to Ourselves

The subtlety we fail to see—according to the mainstream—is that public debt and private debt are two different animals. When government owes money to other organizations or individuals, a different rule applies than when a private person or a private enterprise owes money. That rule is: we owe it to ourselves.

Krugman claims government can continue to pile up debt without ever worrying to pay it off because we owe it to ourselves.

Here is an example. When Japanese business leaders questioned their government’s policy of reckless racking up of debt, Nobel Prize laureate Paul Krugman immediately rose to the occasion. He wrote an article in the New York Times humbly titled “The economic wisdom—or lack thereof—of business leaders”. It is a shocking read.

Mr. Krugman essentially argues that government can spend and spend and spend. It can continue to pile up debt without ever worrying to pay it off because we owe it to ourselves. He even surreptitiously hints that anyone who fails to understand this simple notion surely is not of his intellectual level.

Murray N. Rothbard, not a Nobel Prize laureate, but in my view a far better economist and a much more humble man, pointedly observed that “we” and “ourselves” are not necessarily the same.

Animal Farm

Perhaps what Paul Krugman and other mainstream economists are alluding to is that the pigs in Animal Farm are right after all. "All animals are equal, but some are more equal than others." Transcribed to mainstream economist language, this reads as all debt is equal, but government debt is more equal than others. If you think this sounds a bit strange, it does.

Every dollar a government spends has to be paid. That is the sheer reality. Have you ever wondered where government gets its money from? The answer is simple. There are three sources it can choose from. These are taxes, borrowing, and inflating the money supply. Unlike taxes or inflating, the money collected through borrowing needs to be paid back in future, eventually.

Time Machine

In our world, there are no time machines. This may seem obvious. But it has important implications! No time machines mean that all goods are produced out of present resources. When government or the private sector spends money, present resources are used. It is not possible to go to the year 2100, take robots, airplanes, pizzas, oil, or whatever there is to take and flash them over to use in our present time.

Government pays for all this now, irrespective of whether the money is sourced from taxes or borrowing.

All bridges, airports, tanks (and pizzas) that government orders are made using present resources that are provided by the present generation. Government pays for all this now, irrespective of whether the money is sourced from taxes or borrowing. Naturally, in practice, there is a difference in how the burden of this spending is shared among the present generation.

Nobody likes to pay taxes (with the exception of Warren Buffet). Taxes are never popular. Neither is inflation. When government pays for the stuff it spends on, with borrowed money at least, that doesn’t feel as bad. Taxes are paid for by everyone. Borrowing comes from a small group of lenders. People might feel a bit worried about the principle of it, but they don’t feel the pain of it the way they don’t want to pay taxes and dislike inflation.

Just Moving Around

We owe it to ourselves is based on the idea that the small group who lends money receives government bonds in return, which are financial assets. These lenders are entitled to a stream of interest payments and eventually will receive the principal back. They even can hand down the financial assets to their children and grandchildren.

According to mainstream economists, it means that down the road, borrowing by government is nothing more than moving money around internally. It is "transfer payments." Just like that. Taxpayers reimburse their own people, albeit from a big group of taxpayers to a small group of lenders. Let Murray N. Rothbard have his fun and say “we” and “ourselves” are not necessarily the same. Who cares? It is all the same. It is not making a country richer or poorer.

We are back to the original analysis and we owe it to ourselves remains not a problem.

Obviously, if the lenders are foreigners, it could be that we owe it to foreigners, and we are living beyond our means. But if we extrapolate the present generation to mean all humans, and future generations to mean all future humans, then we are back to the original analysis and we owe it to ourselves remains not a problem.

Geen Gezeik, Iedereen Rijk

So then, why not abolish all taxes and source all government revenue through borrowing? Government debt doesn’t matter after all. We owe it to ourselves. It is nothing more than a mere act of bookkeeping and accountancy. Zero taxes surely will make everybody happy. It even could be a catchy election slogan: Geen Gezeik, Iedereen Rijk.(*)

The truth is that government debt matters. Government debt negatively impacts an economy, deeply. We owe it to ourselves is a fallacy! There are many reasons why this is. Here are some of them: crowding out, misallocation, and capital.

Crowding Out

Here is what that means. All government spending drains scarce funds and scarce resources away from entrepreneurs and channels them into projects selected by government officials.

Entrepreneurs will have to pay higher interest rates and higher input prices to fend off competition from government.

Remember, all goods are produced out of present resources. When government borrows to finance its spending, it competes with other borrowers for scarce funds and scarce resources that are now available in an economy. Other borrowers end up with less.

As a result of crowding out, entrepreneurs will have to pay higher interest rates and higher input prices to fend off competition from government. There will be less incentive for them to invest in the fewer available funds and resources to make innovative new products, buy more equipment, hire more people, build new factories, create new companies, and so forth.

Some may argue that government will use the borrowed money to pay suppliers. So, after all, the money goes back in the economy. But this argument doesn’t hold. This brings us to another reason why government debt undermines an economy.

Misallocation

Government is accountable to spend money within its budget. It is not accountable to profit and loss and, therefore, does not know how to use the borrowed funds and resources as productively as entrepreneurs.

“In public administration, there is no connection between revenue and expenditure.” – Ludwig von Mises in Bureaucracy (Chapter 2 – p47)

For entrepreneurs, success is measured by the size of profits. If there is no profit in making something, it is a signal that capital and labor directed to producing whatever this something may be is misdirected. It signals that capital and labor are not used in an effective way.

In public administration, success is measured by the size of the budget.

Yes Minister is a British political satire that ran on TV in the 1980s. One of the protagonists—a fictitious top civil servant named Sir Humphrey—explains in a most un-cynical manner the difference between the workings of public administration and the private sector.

In Sir Humphrey’s words, in public administration, success is measured by the size of the budget. The more money that is available to be spent, the more success public administration can claim. A big department is more successful than a small one.

Sadly, the possibility of borrowing and issuing bonds leads to more and more government spending. And a higher probability of resource misallocation than compared to a pure market outcome.

Capital

We owe it to ourselves completely fails to understand capital. It completely ignores what takes place across time. It is the pinnacle of the short-term principle.

There is no such thing as an abundant or a presently inexhaustible supply of capital.

When government squanders money today on unproductive projects and misallocates scarce resources, this seriously impacts the process of capital accumulation and capital maintenance down the road. As a result, there will not be an increase in productivity in future.

Capital is not a direct gift from nature. It does not reproduce itself automatically. It is not a homogeneous thing. It has different uses. There is no such thing as an abundant or a presently inexhaustible supply of capital.

Capital accumulation is a process of trial, error, and entrepreneurial discovery, which takes time. Capital goes through a series of stages of production, from unfinished and unusable, to finished and usable, to usable capital, and eventually usable consumer goods.

When this process is tampered with, future generations will inherit fewer innovative products, less equipment and fewer machines, fewer well-trained people, fewer factories, and so forth. This is a major factor in explaining why government deficits translate into a poorer future.

All Government Debt Leads to Taxes

In the end, government can raise only so much through borrowing.

As debt grows, interest payments to service that debt typically grows as well. Nobody believes that government can drag eternally the burden of these interest rates. Increasingly larger parts of tax revenue must go to paying interest on the debt.

Eventually, the only source of revenue that will remain open is taxes.

It is obvious that sooner or later lenders will become nervous at the size of the debt and demand much higher interest rates. If government still wants to spend more, it then will activate the printing press (AKA inflating the money supply).

When this happens, lenders will react and insist on even higher interest rates, knowing that the purchasing power of the dollar will fall over time.

Credit will dry up. Government will learn the lesson. “The creditor is always a virtual partner of the debtor.” Eventually, the only source of revenue that will remain open is taxes.

When the friendly civil servant from the tax department knocks at your door and demands your money to pay for the government debt, you might just as well tell him taxes are unimportant for the same reason as government debt is unimportant. And that is: we owe it to ourselves.

(*)Geen Gezeik, Iedereen Rijk is Dutch and translates as No Hitch, Everybody Rich. This catchy a slogan was created many years ago in The Netherlands by comedians Kees van Kooten and Wim de Bie. The duo founded a fictional political party De Tegenpartij (The Antiparty) and used humor and parody to fight the populist tendencies of other political parties. Things turned out a bit differently. De Tegenpartij became so popular that it actually might have won several seats in parliament had they participated in elections.

Reprinted from the author's Linkedin page.