Government debt

Public debt or government debt are obligations of governments to pay certain sums to the holders at some future time. Public debt is distinguished from private debt, which consists of the obligations of individuals, business firms, and nongovernmental organizations.

History
Modern debt institutions evolved gradually. Loans were typically highly nontransparent, with ill-specified interest rates and repayment schedules and often no specific dates on which principal repayments would be made. A king's promise to "repay" could often be removed as easily as the lender's head. Borrowing was frequently strongly coercive in nature. Early history is replete with examples of whole families who were slaughtered simply to seize their lands and other land. In thirteenth-century France, the Templars (of Crusades fame) were systematically exiled by the French kings, who seized their wealth.

Medieval Italy
For much of the fourteenth and fifteenth centuries, the medieval city-states of Tuscany - Florence, Pisa and Siena - were at war with each other or with other Italian towns. This was war waged as much by money as by men. Rather than require their own citizens to do the dirty work of fighting, each city hired military contractors (condottieri) who raised armies to annex land and loot treasure from its rivals. The cost of incessant war had plunged Italy’s city-states into crisis. Expenditures even in years of peace were running at double tax revenues. To pay the mercenaries, Florence was drowning in deficits - the city’s debt burden increased a hundred-fold from 50,000 florins at the beginning of the fourteenth century to 5 million by 1427. It was literally a mountain of debt - hence its name: the monte commune or communal debt mountain. By the early fifteenth century, borrowed money accounted for nearly 70 per cent of the city’s revenue. The ‘mountain’ was equivalent to more than half the Florentine economy’s annual output.

The Florentines borrowed this huge sum from themselves. Instead of paying a property tax, wealthier citizens were effectively obliged to lend money to their own city government. In return for these forced loans, they received interest. Technically, this was not usury (which was banned by the Church) since the loans were obligatory; interest payments could therefore be reconciled with canon law as compensation for the real or putative costs arising from a compulsory investment. A crucial feature of the Florentine system was that such loans could be sold to other citizens if an investor needed ready money; in other words, they were relatively liquid assets, even though the bonds at this time were no more than a few lines in a leather-bound ledger. In effect, then, Florence turned its citizens into its biggest investors. By the early fourteenth century, two thirds of households had contributed in this way to financing the public debt, though the bulk of subscriptions were accounted for by a few thousand wealthy individuals.

One reason that this system worked so well was that a few wealthy families also controlled the city’s government and hence its finances. This oligarchical power structure gave the bond market a firm political foundation. Unlike an unaccountable hereditary monarch, who might arbitrarily renege on his promises to pay his creditors, the people who issued the bonds in Florence were in large measure the same people who bought them. Not surprisingly, they therefore had a strong interest in seeing that their interest was paid.

Nevertheless, there was a limit to how many more or less unproductive wars could be waged in this way. The larger the debts of the Italian cities became, the more bonds they had to issue; and the more bonds they issued, the greater the risk that they might default on their commitments. Venice had in fact developed a system of public debt even earlier than Florence, in the late twelfth century. The monte vecchio (Old Mountain) as the consolidated debt was known, played a key role in funding Venice’s fourteenth-century wars with Genoa and other rivals. A new mountain of debt arose after the protracted war with the Turks that raged between 1463 and 1479: the monte nuovo. Investors received annual interest of 5 per cent, paid twice yearly from the city’s various excise taxes (which were levied on articles of consumption like salt). Like the Florentine prestanze, the Venetian prestiti were forced loans, but with a secondary market which allowed investors to sell their bonds to other investors for cash.

In the late fifteenth century, however, a series of Venetian military reverses greatly weakened the market for prestiti. Having stood at 80 (20 per cent below their face value) in 1497, the bonds of the Venetian monte nuovo were worth just 52 by 1500, recovering to 75 by the end of 1502 and then collapsing from 102 to 40 in 1509. At their low points in the years 1509 to 1529, monte vecchio sold at just 3 and monte nuovo at 10.

Now, if you buy a government bond while war is raging you are obviously taking a risk, the risk that the state in question may not pay your interest. On the other hand, the interest is paid on the face value of the bond, so if you can buy a 5 per cent bond at just 10 per cent of its face value you can earn a handsome yield of 50 per cent. In essence, you expect a return proportional to the risk you are prepared to take. At the same time, the bond market influences interest rates for the economy as a whole. If the state has to pay 50 per cent, then even reliable commercial borrowers are likely to pay some kind of war premium. It is no coincidence that the year 1499, when Venice was fighting both on land in Lombardy and at sea against the Ottoman Empire, saw a severe financial crisis as bonds crashed in value and interest rates soared. Likewise, the bond market rout of 1509 was a direct result of the defeat of the Venetian armies at Agnadello. The result in each case was the same: business ground to a halt.

Europe
In Northern Europe, too, urban polities grappled with the problem of financing their deficits without falling foul of the Church. Though they prohibited the charging of interest on a loan, the usury laws did not apply to the medieval contract known as the census, which allowed one party to buy a stream of annual payments from another. In the thirteenth century, such annuities started to be issued by northern French towns like Douai and Calais and Flemish towns like Ghent. They took one of two forms: rentes heritables or erfelijkrenten, perpetual revenue streams which the purchaser could bequeath to his heirs, or rentes viagères or lijfrenten, which ended with the purchaser’s death. The seller, but not the buyer, had the right to redeem the rente by repaying the principal. By the mid sixteenth century, the sale of annuities was raising roughly 7 per cent of the revenues of the province of Holland.

Both the French and Spanish crowns sought to raise money in the same way, but they had to use towns as intermediaries. In the French case, funds were raised on behalf of the monarch by the Paris hôtel de ville; in the Spanish case, royal juros had to be marketed through Genoa’s Casa di San Giorgio (a private syndicate that purchased the right to collect the city’s taxes) and Antwerp’s beurs, a forerunner of the modern stock market. Yet investors in royal debt had to be wary. Whereas towns, with their oligarchical forms of rule and locally held debts, had incentives not to default, the same was not true of absolute rulers. The Spanish crown became a serial defaulter in the late sixteenth and seventeenth centuries, wholly or partially suspending payments to creditors in 1557, 1560, 1575, 1596, 1607, 1627, 1647, 1652 and 1662. Part of the reason for Spain’s financial difficulties was the extreme costliness of trying and failing to bring to heel the rebellious provinces of the northern Netherlands.

The United Provinces were able to finance their wars by developing Amsterdam as the market for a whole range of new securities: not only life and perpetual annuities, but also lottery loans (whereby investors bought a small probability of a large return). By 1650 there were more than 65,000 Dutch rentiers, men who had invested their capital in one or other of these debt instruments and thereby helped finance the long Dutch struggle to preserve their independence. As the Dutch progressed from self-defence to imperial expansion, their debt mountain grew high indeed, from 50 million guilders in 1632 to 250 million in 1752. Yet the yield on Dutch bonds declined steadily, to a low of just 2.5 per cent in 1747 - a sign not only that capital was abundant in the United Provinces, but also that investors had little fear of an outright Dutch default.

England
With the Glorious Revolution of 1688, which ousted the Catholic James II from the English throne in favour of the Dutch Protestant Prince of Orange, financial innovations crossed the English Channel from Amsterdam to London. The English fiscal system was already significantly different from that of the continental monarchies. The lands owned by the crown had been sold off earlier than elsewhere, increasing the power of parliaments to control royal expenditure at a time when their powers were waning in Spain, France and the German lands. There was already an observable move in the direction of a professional civil service, reliant on salaries rather than peculation. The Glorious Revolution accentuated this divergence. From now on there would be no more regular defaulting (the ‘Stop of Exchequer’ of 1672, when, with the crown deep in debt, Charles II had suspended payment of his bills, was still fresh in the memories of London investors). There would be no more debasement of the coinage, particularly after the adoption of the gold standard in 1717. There would be parliamentary scrutiny of royal finances. And there would be a sustained effort to consolidate the various debts that the Stuart dynasty had incurred over the years, a process that culminated in 1749 with the creation by Sir Henry Pelham of the Consolidated Fund. (This was the very opposite of the financial direction taken in France, where defaults continued to happen regularly; offices were sold to raise money rather than to staff the civil service; tax collection was privatized or farmed out; budgets were rare and scarcely intelligible; the Estates General (the nearest thing to a French parliament) had ceased to meet; and successive controllers-general struggled to raise money by issuing rentes and tontines (annuities sold on the lives of groups of people) on terms that were excessively generous to investors.)

In London by the mid eighteenth century there was a thriving bond market, in which government consols were the dominant securities traded, bonds that were highly liquid - in other words easy to sell - and attractive to foreign (especially Dutch) investors.

In 1720s in England, the Prime Minister Sir Robert Walpole has introduced the sinking fund, a funding system designed to pay down England's public debt. Taxes, which had before been laid on for limited periods, were rendered perpetual, and the fund should not be used for any other purpose. The government obtained a reduction on the interest of the public debt. The savings were added to the fund and it was for some time regularly applied to the discharge of debt. But soon, the principle of an inviolable sinking fund was abandoned. During the wars which were waged while it subsisted, the whole of its produce was applied to the expense of the war; and even in time of peace, large sums were abstracted from it for current services. The sinking fund has greatly increased debt instead of diminishing it.

From then on, government debt never needed be repaid. It was enough to create a regular and dependable source of revenue and use it to pay the annual interest and the principal of maturing bonds. Then for every retired bond would be sold a new one. In this way, a national debt could be made perpetual. Walpole's system proved its worth in financing British overseas expansion and imperial wars in the eighteenth and nineteenth centuries. The government could now maintain a huge peacetime naval and military establishment, readily fund new wars, and need not retrench afterward. The British Empire was built on more than the blood of its soldiers and sailors; it was built on debt. The ever-growing debt had the ancillary benefit of attaching the interests of wealthy creditors to the government. This example was not lost on some leaders of the infant American Republic, Alexander Hamilton for one.

Importance
A government's ability to establish political institutions that sustain large amounts of debt repayment constitutes an enormous strategic advantage by allowing a country to marshal vast resources, especially in wartime. Arguably, one of the most important outcomes of England's "glorious revolution" of the late 1600s was a framework to promote the honoring of debt contracts, thereby conferring on England a distinct advantage over rival France. (France was at the height of its serial default era during this period.) Warfare was already becoming extremely capital intensive.

French monarchs had a habit of executing major domestic creditors (an early and decisive form of "debt restructuring"), the population came to refer to these episodes as "bloodletting". The French finance minister Abbe Terray, who served from 1768 to 1774, even opined that governments should default at least once every hundred years in order to restore equilibrium.

Debt and crises
Banking crises almost invariably lead to sharp declines in tax revenues. On average, during the modern era, real government debt rises by 86 percent during the three years following a banking crisis. These fiscal consequences, which include both direct and indirect costs, are an order of magnitude larger than the usual bank bailout costs.