Credible Commitment, War and Public Debt

Recently I was intrigued to read about Henry St John Viscount Bolingbroke’s effect on David Hume’s thinking, and their shared concern about the insidious links between Britain’s burgeoning public debt and the overly easy financing of modern war in the early to mid 18th century. Bolingbroke, Montesquieu, and Hume all believed that state indebtedness was not the sustainable engine of growth which many Whigs believed it to be, but rather it was beyond the capacity of human reason to efficiently manage, it harmed commerce and industry, and it could be a greater threat to national security than war itself. 

A big national debt left countries vulnerable and exposed to any unanticipated deterioration in the economic or geopolitical environment. Bolingbroke proposed that if financial interests would not accept losses and retrenchment then there must be “patriotic bankruptcy” to eliminate the burdensome and dangerous public debt. Hume almost identically suggested the necessity of a “natural death” or “voluntary bankruptcy” to reduce public debt. But whereas Bolingbroke appealed to a strong leader -- a patriot king -- to exploit the crisis and lead the country through austerity and structural reform (“out of universal confusion order may arise”, he said), Hume, writing some years later with the benefit of lengthier hindsight, displayed a resignation to the realities of human nature, and stoically foresaw that governments would return to the pattern of borrowing followed cyclically by shock and frugality after every successive crisis. All this sounds depressingly familiar today.

Neither David Hume nor Henry St John could have imagined that 250 years later their anxiety, which was shared by Adam Smith, would be demonstrated by historians and institutional economists to have been utterly groundless. Although Hume and St John were naturally unaware of it at the time, it was a smart institutional design called ‘credible commitment’ that rescued Britain from what Hume had supposed would be “the violent death of our public credit”. Discovery of this uniquely British institutional innovation was announced in a 1989 article by North and Weingast published at the Journal of Economic History. Heated debate persists, evidenced by the publication of a recent tome ‘Questioning Credible Commitment’. It is in the opening paragraph of that book that we find the most pithy summation of the thesis: “institutional change arising from England’s 1688-89 Glorious Revolution created, for the first time, a ‘credible commitment’ that the government would not default on its debt in the future”. 


Francisco Goya 'La Tauromaquia' 1815-16 [credible commitment]

North-Weingast had said “our thesis is that credible commitment by government to honour its financial agreements was part of a larger commitment to secure private [property] rights”, which they unpacked as elements of the separation of powers identified in previous posts on this blog, in particular the creation of various constraints on arbitrary governance - a new supremacy of parliament and common law courts vis-a-vis the royal court relating mainly to control over government revenue, expenditure, and the associated property rights in society (one criticism of North-Weingast has been their neglect of advances made prior to 1689). The constitutional effect, argued the authors, was to raise “the predictability of the government”. The fiscal effect was to secure property rights in capital markets. Institutional innovations diminished discretion by earmarking tax revenues to service payments of national debt, and incorporated the Bank of England to manage debt issuance for and on behalf of the state. All this brought reassurance that the owners of capital who invested in national debt by lending to government would obtain low-risk profit from a steady repayment stream.


The devil is in the detail. Staying for a moment at the general level, let’s examine the core dynamic relating to public debt which has been broadly agreed on by historians before and after the controversial 1989 intervention from North-Weingast. Following the new constraints on arbitrary taxation resulting from the revolutionary separation of powers, public debt grew exponentially (in absolute and debt to GDP terms) principally because borrowing was the only viable way to finance a succession of wars. Wars may or may not have been necessary for Britain’s survival as a nation, but in the context were probably unavoidable. In the British post-1689 institutional environment, borrowing could only be achieved rapidly and in such quantity by generating credible commitments to repay creditors. 


The precondition of credibility was the regularisation of tax instruments that were both efficient and legitimate. So here is the broad generalisation: 18th century British fiscal-institutional designs modernised the revenue system to pay for public debts purportedly to fund costly wars. As Joel Mokyr has explained, wealthy well-connected financiers owned state debt that was willingly serviced by the middle class mainly through indirect taxation smoothed over long periods by means of increasingly sophisticated methods that lenders considered credible and predictable. Mokyr: “Britain’s government was in debt, but it was solid and reliable”. A central positive outcome of “orderly borrowing” was the creation of a revenue-raising administrative apparatus which substantially modernised the British state.


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Without the hindsight and data available to modern historians and economists, Hume and St John could not have foreseen the complex cumulative unintended consequences that made the extraordinary growth of public debt ‘sustainable’ despite the devilish motives and short run myopia of the institutional designers who colluded with moneyed interests. But they appear to have been right in other respects. Henry St John was correct to identify the parasitic partisan-political nature of the rent-seeking alliance between the Whig party and financiers. Historian David Stasavage has found that ‘credible commitment’ depended not so much on constitutional changes highlighted in the North-Weingast story, but rather on the partisan preferences of the government’s creditors who were intimate with Whig politicians during their party’s “unchecked control over British political institutions” after 1715 elections. 


Party autocracy based on rent-seeking coalitions where the underlying motive for public debt was the purchase of political support could have turned nasty for Britain; this was the worry of Henry St John. David Hume was also right. Although he foresaw a disastrous outcome if public debt grew unchecked, he recognised the benefits of the financial revolution. In an essay 'Of Public Credit' he theorised that, as a side effect of institutionalised public debt, individual savings could be brought into the financial system and put to good use in commerce and industry: 

“Public securities are with us become a kind of money … the merchant can dispose of them, or pledge them to a banker, in a quarter of an hour; and at the same time they are not idle, but bring him in a constant revenue. Our national debts furnish merchants with a specie of money that is continually multiplying in their hands, and produces sure gain … [A] great consumption ... helps to spread arts and industry throughout the whole society.”
North-Weingast made the same point as Hume more than once; thanks to government borrowing “the amount of wealth available for use by others increased tremendously”. Similarly, Bruce Carruthers: “The financial machinery necessary to borrow on a large scale was erected in this period and, once created, it could be used for other purposes.” Hume, however, was preoccupied with modern tabula rasa features of public debt. The benefit of public debt that institutional economists fastened onto (a benefit which Hume is credited with being the first to identify) was, in Hume's own words, “of no very great importance”, and greatly outweighed by the “many disadvantages”. War is counterproductive, not least in causing “increase of taxes, decay of commerce, dissipation of money”. But what Hume railed against most strongly was “the new paradox”, the excuse for abuses on the grounds that public debt was “advantageous, independent of [military] necessity”. A prudent ruler has the foresight to save funds in case of unforeseen threats, however “the modern expedient is to mortgage the public revenues”. 

From a modern viewpoint the main disadvantageous consequences Hume highlighted were: 

  1. “taxes which are levied to pay the interests of these debts … are ruinous and destructive”, they “overburden a nation” even to “losing its commerce and industry”. Then, “fluctuations in commerce require continual alterations in the nature of the taxes” and “throw the whole system of government into confusion”, threatening a return to absolutism; 
  2. the sustentation of an unproductive elite that lives easily on trading in sovereign bonds; 
  3. weakening of the over-indebted nation in its transactions, conflicts, and negotiations within the “society of nations”. The latter problem is worse when “foreigners possess a great share of our national funds, they render the public, in a manner, tributary to them”. The public debt “can never become the foundation of a constant national defence”
“[A] government [that] has mortgaged all its revenues necessarily sinks into languor, inactivity and impotence … What then is to become of us? … either the nation must destroy public credit, or public credit will destroy the nation. It is impossible that they can both subsist … And this, I think, may be called the natural death of public credit … [But] such great dupes are the generality of mankind, that, notwithstanding such a violent shock to public credit as a voluntary bankruptcy would occasion, it would not probably be long, before public credit would again revive in as flourishing a condition as before.”
On an assumption that these annoyances of Hume’s had been vanquished by one or another clever institutional innovation (credible commitment), Hume’s concerns quietly dropped out of history books like unwanted or unbound pages. Yet, the essential question that inevitably begins to hover around the mind of us ‘dupes’ at this stage in the piece is whether the growth of public debt was important enough to Britain’s future to justify the central thesis of North-Weingast, namely that the Glorious Revolution ushered in a fiscal revolution that enabled sustainable government borrowing, which as a byproduct created modern capital markets, and permitted Britain’s exceptional long-run economic success. 

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The financial revolution, of course, fits nicely with the Schumpeterian thesis that capitalism would from the outset depend fundamentally on availability of private credit to finance innovation. Capital markets made the entrepreneurial industrial revolution possible. However, it was Schumpeter, more or less like Hume, who also warned about the fatal dangers of fiscal-state reliance on public debt and taxes. The two arguments can be reconciled by saying that in the ideal linear knowledge-driven world, financial revolution would not necessarily need to be the unintentional side-effect of a somewhat destructive sequence of war, public debt, and taxes.



Francisco Goya 'This is Worse' 1812-13 [war and public debt]

An even broader related question, therefore, is whether wars and the protection of empire and mercantilist trade routes, which eventually justified or required the dramatic growth in national debt and taxation, explain Britain’s economic growth over a 200-year period. Patrick O’Brien uses this long run incremental argument against North-Weingast’s 1689-focused institutional discontinuity. Joel Mokyr, in a Schumpeterian vein, concludes instead that, notwithstanding its positive side-effects such as state fiscal-bureaucratic modernisation, on balance higher taxes needed to service the debt that sustained the empire were probably distortional and a drag on economic development, and were in any case feasible only because of prior market deepening. Public investment did not go to service improvements such as education or infrastructure in quantities or by means that would best enhance the market and technology potentials of the age. Instead, other unique factors -- for Mokyr especially ideas or ideologies and political meta-institutions -- ultimately matter more in the explanation of Britain’s market-centric economic exceptionalism. Mercantilist wars were of “dubious economic value” and perhaps threatened Smithian growth even more than did insecure property rights. I wonder if Joel Mokyr would agree that Hume’s intuition about the counterfactuals would appear, then, to be proved good?


There is little space left to mention other criticisms of North-Weingast in ‘Questioning Credible Commitment’. The most relevant is Sussman-Yafeh (chapter 11, and articles since 2002). Institutional quality, they argue, did not have immediate impact on Britain’s ability to borrow sustainably because credible commitment takes time to establish. Their evidence is that the cost of borrowing remained high, just as high as other nations that had not undergone institutional reforms. Nor did Britain borrow more than its competitors. The cost of borrowing fluctuated not due to institutional credibility but in response to military conflict and political stability. The authors confirm Robert Barro’s finding that British public borrowing to finance military spending crowded out private consumption and private investment, but they add a distinctive focus on fluctuations in borrowing costs caused by wars and political violence, which are unrelated to “institutional and political reforms such as the introduction of a constitution, or efficiency-enhancing structural reforms". Their interesting concluding statement:

“In the short run, peace and stability seem to matter more for countries’ borrowing costs than does the establishment of investor-friendly institutions.” 
My reaction to Sussman and Yafeh is that the definition of ‘institutions’ is affecting their interpretation. Peace and stability might be considered direct institutional effects too. Other chapters in ‘Questioning Credible Commitment’ argue that the institutional cause and effect (whatever it is!) dates back significantly earlier. Ron Harris (chapter 2) finds an “impressive” evolution of “credible commitment devices” involving constitution, parliament and judiciary in England between 1558-1640. Later developments were founded on that pre-existing state credibility, which was already greater than in other European nations. D’Maris Coffman (chapter 4) builds on O’Brien (above, et al.) and a tradition of theorising about the English state, arguing that preconditions for good governance of public finance were laid in the 1640s and 50s when new debt instruments and public expectations were created, and when the state acquired or was endowed with special characteristics. A subject to return to on another occasion.

In defence of North-Weingast. Although they exaggerated the 1689 discontinuity and probably misstated the linkage between institutional innovation and public debt -- and also irrespective of whether their several subsequent theoretical enhancements have rectified the faults of 1989 -- they were and remain correct about the centrality of institutions. In fact it may be their detractors and indeed even some of their admirers who most urgently need to reassess their understandings of ‘institutions’. Perhaps at least they could all stop observing 1689 only via 1989. 


A final thought. In the midst of a pre-existing sovereign debt crisis can any state afford to go to war if one should present itself out of the blue or out of the red? Quoting Hume, has any “wise emperor discovered the prudent foresight of saving great sums against such a public exigency?” And what if our country is “pressed by a foreign enemy that possesses a great share of our national funds?”. Recall the cartoon of a broke Uncle Sam turning out both his left and right trouser pockets disconsolately on the eve of war? No, insisted Hume, public credit “is not like transferring money from the right hand to the left”.





Michael G. Heller ©2014

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