How Should Governments Deal With Debt?

Release Date
September 14, 2011

Topic

Gov't Debt & Spending
Description

Nations that spend themselves into debt face very difficult choices. As Dr. Stephen Davies sees it, a country in debt has three potential options to fix their debt problem. The first option is some combination of raising taxes and cutting spending. The second is to repudiate on the debt. The third option is inflation. Among these options, Dr. Stephen Davies finds that cuts in government spending are the most effective solution in the long run.

How Should Governments Deal With Debt?
Nations that spend too much face very difficult choices and options. One is to actually return to the path of virtue and bring the public spending under control, through a combination, typically, of raising taxes and cutting spending. This can be done, but it can often take a very long time. But it’s certainly better than the alternatives.
The other two alternatives are, first of all, for the government to repudiate its debt. In some ways, this is actually the least painful, but it does mean, in the future, nobody is going to lend money to that government except at prohibitively higher rates of interests. And this is in itself not good, not least because it raises the general level of interest rates in that economy, which has all kinds of negative effects on economic activity.
The more common solution, unfortunately, is for the government to result to inflation and to inflate away the value of the debt by depreciating the currency. There are already alarming signs that this is what the American administration is thinking of doing. In the long run, also, totally dysfunctional public finances are associated with dysfunctional politics and dysfunctional government. And, historically, they’ve often been a major cause of serious political unrest and upheaval, even revolutions, as in the French case, for example.
Increasing taxes to get out of debt is better than the alternative route of causing inflation, which is in fact in this sense just another kind of tax. However, it’s ultimately undesirable, simply and straightforwardly, for two reasons. The first is that taxes inhibit and distort economic activity, as any economist will tell you. So to the extent that you raise taxes, you’re going to slow down or reduce economic growth and the increase in human wellbeing. The other thing is, the principle one, that a rise in taxation means an increase in the proportion of income that is decided and allocated by the political process rather than by personal or individual choice. And that is a bad thing to do on civil liberties’ and independence’ grounds. So therefore, the best way of dealing with the kind of fiscal crisis that many countries face today, not least the United States, is to cut spending and to reduce the number of things that the government does.