Tuesday, November 20, 2012

"Could 18th Century’s ‘Sinking Fund’ Solve Fiscal Cliff?"

From Bloomberg's Echoes blog:

Echoes: Robert Walpole
Can Robert Walpole's debt-reduction scheme avert the "fiscal cliff"? 
Source: Library of Congress Prints and Photographs Division
As President Barack Obama and congressional Republicans seek to resolve the so-called fiscal cliff, the combination of automatic tax increases and spending cuts scheduled for next year, a mutually agreeable solution is lurking in an unexpected place: the 18th century.

In the 1700s, Great Britain had a debt burden that was even more ominous than the $16 trillion the U.S. government now owes. In 1716, Parliament proposed an ingenious, and fairly uncontroversial, way to reduce this debt, called a sinking fund. The scheme was copied 74 years later by the U.S. Congress. And it could work just as well now as it did three centuries ago. The sinking fund was the brainchild of Robert Walpole, who was then the first lord of the Treasury and chancellor of the Exchequer. Its purpose was to chip away at a national debt that had swollen to 55 million pounds, which Parliament considered “insupportable.”

The concept is simple: A government imposes a special tax for the sole purpose of sinking -- reducing -- its debt. As the sinking fund cuts into the debt, it reduces the amount of interest that has to be paid every year. The crucial step is for these interest savings to be plowed back into the fund. If the annual interest rate was 2 percent, then every $100 reduction in the government’s debt would diminish its annual interest obligation by $2, which would allow another $2 to be diverted to the sinking fund -- not just in that year but every subsequent year. As the amount owed gradually decreased, the sinking fund would grow at an accelerating rate, not unlike the way compound interest swells an untouched savings account.

Interest Savings
Richard Price, a British preacher and political economist, published a pamphlet in 1772 demonstrating that a country paying 5 percent interest on a 258 million pound debt could pay the whole thing off in 86 years if it established a 200,000 pound sinking fund and put all interest savings back into it. Parliament created another sinking fund in 1786, and it helped slow the growth of Great Britain’s national debt. Unfortunately, the temptation to raid the funds for other purposes was always strong. In “The Wealth of Nations,” which appeared in 1776, a sadder-but-wiser Adam Smith complained that often “a sinking fund, though instituted for the payment of old, very much facilitates the contracting of new debts.”...MORE