The Washington Times reported Wednesday:

U.S. debt shot up $239 billion on Tuesday — the largest one-day bump in history — as the government flexed the new borrowing room it earned in this week’s debt-limit increase deal.

The debt subject to the statutory limit shot way past the old cap of $14.294 trillion to hit $14.532 trillion on Tuesday, according to the latest the Treasury Department figures, which are released on the next business day.

That increase puts the government already remarkably close to the new debt limit of $14.694, which means one day’s new borrowing ate up 60 percent of the $400 billion in space Congress granted the president this week.

That didn’t take long. Clearly normalcy has returned. But sighs of relief seem inappropriate.

Weathering the “Cuts”

The day after The Deal was signed, lifting the debt limit and “averting default,” America awoke to CNN reporter Richard Quest’s Keynesian lament that “the economy won’t weather the cuts.” Cuts? He apparently meant the small reductions over ten years in the rate of spending growth. That’s Washingtonese for “cuts.” What Murray Rothbard called a “cut-cut,” where the amount spent actually falls from the present level, long ago passed from consideration. In our world there are only two varieties of “cuts,” both of which are in The Deal: “real cuts” (reducing the rate of growth) and “phony cuts” (canceling an authorization for spending that no one expected to occur anyway). If you don’t get that, don’t worry. It will all be in the next edition of the Newspeak dictionary.

Even if we accept the Keynesian framework for the sake of argument, we might wonder about an economy that is so fragile it won’t survive modest reductions in the rate of increase in government spending. Even the New York Times sees what’s going on:

There is something you should know about the deal to cut federal spending that President Obama signed into law on Tuesday: It does not actually reduce federal spending.

By the end of the 10-year deal, the federal debt would be much larger than it is today.

Indeed, both the government and its debts will continue to grow faster than the American economy, primarily because the new law does not address federal spending on health care.

One gets the feeling that the frantic opposition to the mere slowing of the growth rate is motivated less by concerns about the economy than by concerns that the people may be catching on that government spending is the problem not the solution. After all, besides 9.2 9.1 percent unemployment, almost no economic growth, and much more debt, what exactly do we have to show for a trillion dollars in “stimulus” spending?

Government as Consumer

Anxiety over cuts, assuming it is sincere, is unnecessary. We need not wonder what would happen if government spending were reduced because we already know. To the extent government abstains from spending, the resources it would have consumed will be available for private production. (Let’s throw in the repeal of all privilege too.) Government is a consumer of scarce resources. The promise of government investment is debunked when we understand that real market investment is a price-guided entrepreneurial commitment of resources driven by hunches about what consumers will want in the future. Assuming a freed market, whether a particular use of resources best serves consumers is eventually revealed in the profit-and-loss statement.

Although advocates of government projects try to appropriate the aura of market investment, their schemes can’t escape being acts of consumption. They are guided not by market prices and expected consumer preferences but by politicians’ wish to be reelected. The funds won’t be acquired by consent and therefore put to a market test, and the services won’t be offered on the market to free consumers with the power to say no thank you. Rather, resources will be acquired either by taxation, that is, by the threat of force, or by borrowing, which is possible only because the government has power to tax. Any resulting services will be provided not on the market but through the political process in which some are compelled to subsidize others. Costs are severed from benefits.

Value Lost

Thus we have no reason to think that government transforms resources from less-valued to more-valued forms as freed markets tend to happen to do.

Those who fear for the economy if the government fails to spend ever more money should review the near-laboratory test of their belief that took place at the end of World War II in 1945. At that time the Keynesians despaired that if government spending (and hence aggregate demand) dropped sharply after the war and government employment declined with the discharge of 10 million draftees, the economy would fall “back” into depression, complete with the high unemployment seen in the 1930s. Yet this did not happen.

Robert Higgs writes,

The unemployment rate in 1947, when the transition was nearly complete, was less than 4 percent.… The year 1946, when civilian output increased by about 30 percent, was the most glorious single year in the entire history of the U.S. economy. By 1948, real output was back on its long-run growth trend, and during the decades that followed, the economy was spared the sort of deep and long debacle that a congeries of wrongheaded government policies had caused during the 1930s.

As Higgs documents, the war did not end the Depression, unless you count consumer deprivation and eliminating unemployment through military conscription as signs of prosperity. It was the government’s retrenchment after the war that did the trick.

“In brief, the war boom as typically comprehended did not occur; nor did the corresponding ‘crash of 1946′ so evident in the standard GDP data,” Higgs writes.

The lesson then is that real and dramatic spending cuts through a radical reduction in what government does is the authentic way to stimulate economic growth, not to mention expand individual freedom.

In light of that, no one will be surprised that Tracy opposed government borrowing. In this day of trillion-dollar-plus federal deficits, his critique is especially relevant.

Tracy begins by noting that government debt is “a subject on which the general good sense has greatly preceded the science of the pretended adepts. Simple men have always known, that they impoverished themselves by spending more than their income, and that in no case is it good to be in debt….”

On the other hand, “men of genius believed and even wrote, not long since that the loans of government are a cause of prosperity, and that a public debt is new wealth created in the bosom of society.” (All emphasis has been added.)

In his sarcasm about “men of genius” Tracy was clearly rejecting the idea that government borrowing creates wealth. He had already disposed of the claim that government spending could stimulate productive economic activity. Rather than adding to “the general mass of circulation,” he said, government expenditures “only change its course and in a manner most often disadvantageous.” Here is Bastiat’s “broken window” a few decades earlier.

Still, he takes up the question: “when expenses are very considerable, ought we to felicitate ourselves on being able to meet them by loans, rather than taxes? or, in other words, is it happy for the governed, that the government should make use of its credit, or even that it should have credit?”

Politicians and pundits  say yes, believing that borrowing brings good economic times, provides money in emergencies, and “thus …  is the true palladium of society.”

“Yet,” Tracy responds, “I think I have good reasons for combatting their opinion.”

Here Tracy pauses, cagily, to state he “will say nothing of the grievous effects of loans on the social organization, of the enormous power they give to the governors[,] of the facility they afford them of doing whatsoever they please, of drawing everything to themselves, of enriching their creatures, of dispensing with the assembling and consulting the citizens; which operates rapidly the overthrow of every constitution.”

Well, for someone who planned to say nothing on the subject, that was quite a lot! Borrowing increases the power of rulers and the wealth of their cronies at the expense of the people.

But he doesn’t want to write about that; he wishes to focus only on the economic effects of government borrowing.

Economic Effects

“The first thing said in favour of loans,” he wrote, “is, that the funds procured by these means are not taken involuntarily, from any one.” Taxes are compulsory. But loans are freely made.

Tracy didn’t buy the argument: “I think this an illusion. In effect it is very true, that when government borrows it forces no one to lend; ….When, therefore, the lenders carry their money to the public treasury it is freely and voluntarily; but the operation does not end there. These capitalists have lent, not given: and they certainly intend to lose neither principal nor interest. Consequently, they force the government to raise, one day or other, a sum equal to that which they furnish and to the interest which they demand for it. Thus, by their obligingness, they burthen without their consent not only the citizens actually existing, but also future generations…..”

(I’d make just one correction: Members of future generations who inherit the debt would benefit by the tax burden on the others. Borrowing consists of two separate intragenerational transfers. See this.)

Borrowing doesn’t dispense with taxes; it merely shifts them to the future, except that they must be raised high enough to pay the interest as well as the principal. “Thus, sooner or later, it [borrowing] affects industry as much and in the same manner as if it had been levied at first.”

But this raises a question “which I am astonished to have seen no where discussed”: Does government have “a right thus to burden men not yet in existence, and to compel them to pay in future times [its] present expenses?”

No, Tracy answered. “One generation does not receive from another, as an inheritance, the right of living in society; and of living therein under such laws as it pleases. The first has no right to say to the second, if you wish to succeed me, it is thus you must live and thus you must conduct yourself. For from such a right it would follow that a law once made could never be changed.”

Here he offered a proposal:

[W]hatsoever is decreed by any legislature whatsoever, their successors can always modify, change, annul; and that it should be solemnly declared, that in future this salutary principle shall be applied, as it ought to be, to the engagements which a government may make with money lenders. By this the evil would be destroyed in its root: for capitalists, having no longer any guarantee, would no longer lend; many misfortunes would be prevented, and this would be a new proof that the evils of humanity proceed always from some error, and that truth cures them.

He was calling for future generations to repudiate the government debt of past generations and predicting, sensibly, that no one will lend money to the government if that principle is in effect! Laissez-fare advocates were true radicals in those days.

Tracy also debunks the claim that money lent to the government has no opportunity cost.

The second advantage which is found in loans, is that the sums which they furnish are not taken from productive consumption: since it is not undertakers of industry who place their funds in the hands of the state; but idle capitalists only living on their revenue, who choose this kind of annuity rather than another…. [E]ven admitting that all were equally idle if the state had not borrowed, it is certain that if they had not lent it their money they would have lent it to industrious men. From that time these industrious men would have had greater capitals to work on, and, by the effect of the concurrence of lenders, they would have procured them at a lower interest.

Well, then, how about this justification for borrowing: Loans “furnish in a moment enormous sums, which could only have been very slowly procured by means of taxes, even the most overwhelming.”

Tracy rejects this too. “Now I do not hesitate to declare that I regard this pretended advantage as the greatest of all evils.” (This was an era when economists could call things evil in their treatises.)

Some might contend this is an abuse rather than a use of credit, but not Tracy. “I answer, first, that the abuse is inseparable from the use, and experience proves it.”

But I go farther. I maintain that the evil is not in the abuse; but in the use itself of loans, that is to say that the abuse and the use are one and the same thing; and that every time a government borrows it takes a step towards its ruin. The reason of this is simple: A loan may be a good operation for an industrious man, whose consumption reproduces with profit. By means of the sums which he borrows, he augments this productive consumption; and with it his profits. But a government which is a consumer of the class of those whose consumption is sterile and destructive, dissipates what it borrows, it is so much lost for ever; and it remains burdened with a debt, which is so much taken from its future means. This cannot be otherwise.

I think you’ll agree that they’re not making many economists like that anymore.

More recently, though, the Federal Reserve has used the same term to describe the problem it currently faces because it massively expanded the monetary base over the last year.  In response to the financial crisis in the fall of 2008, the Fed tried to avoid a scramble for cash that could have rippled through the banking system in ways similar to the early years of the Great Depression.  There is much debate over exactly what it should or should not have done, but even if one thinks some expansionary response was in order, the degree of the expansion and the assertion of new powers the Fed was never meant to have were way beyond what was necessary.  Now the Fed finds itself in a predicament: Having overreacted to the crisis last fall, it now must defuse a monetary time bomb.

The problem is that the Fed enormously expanded the quantity of reserves that commercial banks hold.  Since the banks are hesitant to lend in a recession and the Fed is paying interest on them, right now the reserves are sitting there ticking away.  But that can change. Those reserves are the basis for loans that banks can potentially make. The larger the pool of reserves, the more loans — which means the larger the money supply can grow. And that means high rates of inflation are a serious threat.

The Fed’s problem is how to get rid of those reserves and avoid inflation.  Normally when the Fed wants to reduce bank reserves it sells U.S. Treasury bonds to banks or intermediaries.  As buyers pay for those bonds, the Fed reduces their reserve accounts.  This is easy enough to accomplish when it involves small changes in the level of reserves.

But to reduce the tens of billions of additional reserves sitting out there right now would require a massive sale of bonds.  The problem with doing so is twofold.  First, it requires buyers.  Given the indebtedness of the federal government at the moment and the rather precarious state of the U.S. economy, are there people willing to buy that quantity of government bonds?  The economist’s response, of course, is to say “perhaps, at the right price.”

That raises the second problem: If the only way to sell those bonds is to cut their price, that will mean a dramatic increase in interest payments — the interest payment being the difference between the face value and the price paid.  This will only add to it to an already enormous deficit, not to mention raising the cost of borrowing across the private sector as well.

It is not clear at all how the Fed will extract itself from this situation, just like it is not clear how, or even if, President Obama will extract us from Afghanistan and Iraq.  The absence of credible exit strategies in all these cases is a consequence of the rush to action in the wake of a crisis, real or perceived.  Politicians and central bankers love to “do something” when faced with a crisis, and since doing something is politically better than doing nothing, quick action is often taken without thinking through all the possible consequences.  Like the person who paints a floor and ends up painting himself into a corner, both the Pentagon and the Fed have, in their haste to do something, created a situation where there is no exit strategy that doesn’t involve making a real mess.  In this case, though, the Pentagon’s mess will fall on the backs of the innocent citizens of two decimated countries and the Fed’s mess might do serious damage to the U.S. economy.

As noted in the movie War Games, sometimes the only way to win a game is not to play.  And sometimes the best exit strategy is not to enter in the first place.

Neither the government nor anyone else can spend future dollars. In reality all current spending must come from current revenues and can use only existing resources. Every dollar the government spends, even if borrowed, has to come out of some existing person’s pocket and therefore preempts the use of that dollar somewhere else in the economy—not in the future, but here and now.

The government can obtain its borrowed money by selling Treasury bonds to either American citizens or foreigners. If it borrows from domestic sources, it is getting money that Americans would have either invested somewhere in the economy or spent on goods and services. Government borrowing simply diverts the cash from other uses, just as if its spending were financed by taxation. Economists call this the “crowding out effect.” 

A typical response is that most of the government borrowing will be from foreigners and that the Obama deficit won’t crowd out economic activity in the United States. Thus we are said to be mortgaging our children’s future to people in other countries. The first thing to notice is that we can’t know who the bondholders will be in the future when the loans come due. Treasuries are sold and resold many times over. This is also true of debt originally issued to Americans. 

The real problem has nothing to do with who holds the note at the time of repayment. A good economist asks what else these foreigners would be doing with their dollars. Because they are lending dollars, as opposed to euros or yen, this money would ultimately be either spent on American goods, thereby increasing exports, or invested in the U.S. economy. We reach the same conclusion regardless of who lends the government the money. The real costs of government spending, no matter how it is financed, are experienced here and now.

Government Spending Always Competes with Private Spending

Also, regardless of where the money comes from—taxation, borrowing, or printing press—government spending always preempts other spending in the economy. Those who get the borrowed money have purchasing power transferred to them that will increase the demand for the resources they use. That will increase the cost of those resources to other buyers. Government spending thus always competes with private-sector spending for scarce resources and preempts growth.

This is not to argue that deficit spending is the same as tax-financed spending. It is not. Deficit spending creates the occasion for coercive wealth transfers from future taxpayers to future government bondholders. When the bills come due, most of our children and grandchildren will have part of their incomes coercively transferred through higher taxes to those who hold the Treasury notes. Government debt makes our children less free.

Furthermore, deficit spending obfuscates the true cost of government, not only in lost liberty but also in lost productivity and wealth. Deficit spending is dishonest because it leads people to believe they are getting something for nothing while in reality their wealth is diminished just as if the spending were covered by taxation. But that cost is not seen in the tax bill. This is why politicians find deficit spending so appealing. It is a tool for pulling the wool over citizens’ eyes while rewarding special-interest groups and expanding the state’s control over the private sector.

Ultimately, the real choice is not between deficit-financed and tax-financed spending. The moral question is whether we should have more spending and bigger government with less liberty or less spending with a smaller government and more liberty. The hand-wringing on the left and right about passing the cost of “stimulating” our economy onto future generations is misplaced. No matter how it’s financed, Obama’s new spending has the potential to stimulate only one thing: the size, scope, and power of government.