Government Debt vs Private Debt

To understand the difference between government debt and private debt, we must first understand the distinct roles played by base money and bank money.  This distinction is of little significance to the average person, but it is of crucial importance to the banking system.

Why the Government Borrows 

When we adopted a monetary base of intrinsically worthless paper money in the mid-20th century, we created a new paradigm that is still widely misunderstood.  The imperatives are quite different from those of the earlier gold-based system.  The key to maintaining the purchasing power of money is to control the price of credit.  That means controlling the cost to banks of acquiring the reserves of base money they need to back their lending.  It is up to the Treasury and Fed acting together to do that, and Treasury plays an indispensable role.

The public borrows from banks in order to acquire transaction deposits (bank money) to spend on investment or consumption.  The government borrows from the public only to recapture its deficit spending.  Otherwise the money supply could grow too rapidly and create unacceptable inflationary pressures.

Rolling Over Government Debt

Nothing about government debt in a fiat money system requires that it be paid off.  Of course individual securities must be redeemed as they mature.  But the Treasury can roll over its maturing debt indefinitely.  Rolling over means selling new securities to pay for the redemption of maturing securities.  This involves no new tax revenues.

Treasury securities offer a risk-free, interest-earning alternative to base money spent into circulation by the government.  If the private sector has more non-interest-earning base money in the aggregate than it wishes to hold, its only alternative is to buy Treasury securities.  Since the Treasury can pay whatever interest rate the market demands, there will always be willing buyers of its securities.

Government Debt as Perpetuities 

The debt can be carried indefinitely at no financial risk to either the government or the private sector.  Individuals can become bankrupt with too much borrowing, but the government can never become bankrupt if it borrows in the same currency it issues. 

Government debt is commonly regarded as a future tax liability of the private sector.  However the unique position of the government as issuer of the monetary base enables it to roll over its debt continuously.  In doing so, its securities become the functional equivalent of perpetuities, i.e. bonds that never mature and thus are never redeemed.  De facto, there can be no net tax liability on perpetuities. 

Net Financial Wealth of the Private Sector 

Treasury securities are valuable assets for the holders.  They can readily be sold for money or pledged as collateral for loans.  Together with the monetary base they comprise the net financial wealth of the private sector.  By contrast, bank lending does not affect the financial wealth of the private sector because all such credit is matched by an equal amount of borrower debt. 

The value of the Treasury securities to the private sector as a whole is not in the interest payments they shed.  The interest payments are matched by tax revenues, and are therefore a wash in the aggregate.  The value of the Treasury securities is in the principal, just as in the case of Federal Reserve notes.  They represent stored financial wealth for the holder.  The public trades one for the other, depending on the degree of liquidity it desires at any given time.

The Upper Limit to Government Debt 

If the net financial wealth of the private sector is allowed to grow too large, the penalty could be price inflation due to the "wealth effect."  But as long as the private sector treats government securities as a savings vehicle, they are benign and a valuable asset for the nation. 

The debt/GDP ratio reached an all-time high in World War II, well above what it is today.  Yet the annualized inflation rate was only 2% for a period of two decades following the war.  During the Reagan and Bush administrations of 1981-1992, the inflation rate trended downward even though the debt quadrupled.  If there is an upper limit to government debt in terms of its effect on price inflation, it has yet to be experienced.