In the late-18th century, Britain was awash in debt. So large was this debt that even relatively cheap financing couldn’t save the British government from interest costs that ate up half of state revenues. To pay down this debt, the country implemented a sinking fund, a fund established to repurchase bonds that had previously been floated, or issued, to investors.
The aim of repurchasing the bonds was to reduce the net debt of the state, essentially repaying it. The sinking fund was a British revival of an older Italian lending tradition. Regardless of its origins though, the concept would be copied by other borrowers in the decades following its British adoption. Today though, the sinking fund has largely given way to amortizing loan and bond structures pushed by wary creditors on borrowers.
In Britain, a sinking fund for the national debt was imposed voluntarily; its creation was a preemptive act of Parliament rather than a demand of creditors. However, make no mistake about it, Britain was heavily indebted by the late-18th century. The public debt, comprised mostly of perpetual bonds paying 3% interest, summed to £250 million after the American War of Independence ended in 1783. This was, according to more recent estimates, an amount well in excess of 100% of British GDP at the time.
Fighting the American War doubled Britain’s debt which was almost entirely the product of the numerous wars it fought in the 18th century. A hundred years earlier, prior to the Glorious Revolution of 1688 and the War of the Grand Alliance, Britain’s debt was a mere £2 million. After the War of Spanish Succession in the 1710s, but still before the Seven Years’ War, it had risen to £50 million. Now, on the eve of the establishing of a sinking fund intended to pay down that debt, it was five times that sum.
Dr. Richard Price
The biggest proponent of creating a sinking fund was not a financier but a theologian, Dr. Richard Price, a prominent pamphleteer and Unitarian minister in 18th century Britain. A radical Whig, Dr. Price was involved in numerous of the most sensitive moral and political discourses of his era. His friends in these discourses included the likes of Mary Wollstonecraft and Benjamin Franklin.
However, he also had interests outside philosophy and theology. Dr. Price was a statistician and published works on demography and annuities that influenced the insurance industry for decades. Elsewhere in finance, compound interest particularly fascinated Dr. Price who argued that the power of compound interest could be harnessed to pay down Britain’s national debt just as it could be used to amass great wealth.
“Money bearing compound interest increases at first slowly. But, the rate of increase being continually accelerated, it becomes in some time so rapid, as to mock all the powers of the imagination. One penny, put out at our Saviour’s birth to 5 per cent. compound interest, would, before this time, have increased to a greater sum, than would be contained in a hundred and fifty millions of earths, all solid gold” – Dr. Richard Price, “Appeal to the Public on the Subject of the National Debt”, 1772
To explain what he meant about compound interest, and to make the case for a sinking fund, Dr. Price published an “Appeal to the Public on the Subject of the National Debt” in 1772. In the pamphlet, Price explained that allocating a sum for the repurchase of issued bonds, say £1 million a year, would reduce the net debt by that sum but would also free up money going to interest on that amount for further debt repayments in the future. Over time, the annual value of this ‘interest on interest’ would exceed the repayments of £1 million. At 3% interest, the rate on British government bonds at the time, this would happen 25 years into such a scheme. However, where rates were higher, this would happen even sooner.
In terms of Britain’s national debt of £250 million, so long as the interest was paid out of the revenues of the state as opposed to further borrowing, that is to say so long as no further deficits were run, £1 million per year would pay off the massive debt within 73 years and not 250 years. This is because in year two, the amount available to pay down the debt would be not just the £1 million allocation but also the interest saved on the previous £1 million bond repurchase, or £30,000 which is 3% of £1 million. This compounding effect would grow with time.
For example, in year three, the amount available to repurchase old bonds would be a fresh £1 million allocation into the sinking fund plus the interest on the bonds repurchased the prior two years, £30,000 from year one and £30,900 from year two, which is 3% of £1,030,000. To a public weary of having to repay the public debt if it meant higher taxes, this approach to thinking about the debt presented an easy way out, especially alluring at a time when debt service costs consumed 50% of Britain’s state revenues from taxation.
However, there was a flaw in this thinking. The reason for a sinking fund structure was to capture the ‘interest on interest’ earned on repurchased bonds in the fund but this interest was just being paid out of the state budget. Once one consolidated the balance sheet of the sinking fund with the broader state debt it became clear that the effect of compound interest was illusory.
The flaw in Dr. Price’s thinking was that the interest paid on the bonds in the sinking fund was essentially paid out of the government budget, so it was essentially one part of the state paying another and not genuine interest earnings on the government’s investment into the fund. Dr. Price and others actually believed that if interest rates were higher, it would actually help and not hinder the repayment of the debt because it would enhance returns on the sinking fund but it is obvious to us that once we take account of the entire financial position of the state that this would clearly not be so.
Nonetheless, Dr. Price’s ideas influenced many in government, though the succeeding decades were not the first experiment with a sinking fund in Britain’s system of public finances. A sinking fund was established by the government of Prime Minister Robert Walpole in the 1720s. However, it became something of an afterthought and was raided as a source of funds rather than faithfully used as a destination of surpluses. A series of tax cuts reduced revenue available for the retirement of the debt and it was altogether abandoned. By now, Britain’s debt had since quintupled.
William Pitt the Younger, who had been Prime Minister since December 1783, was among those influenced by Dr. Price’s insistence on a sinking fund for the resolution of the country indebtedness. His government promised to create a sinking fund and endow it with £1 million annually.
Unlike Walpole, Pitt would prioritize the fund, putting control over it in the hands of a special commission farther removed from the purview of extravagant ministers. He made it so only an act of Parliament, in full view of the public, could abolish the fund. So it was, that in 1786, the legislation creating the sinking fund was passed and royal assent given by King George III. Estimates at the time suggested it could pay off the entire national debt within 35 years.
That said, Pitt and others, however keen they were on eliminating the debt, were also weary of keeping taxes higher than a reluctant public would accept. As such, once the annual income of the sinking fund, between annual contributions from the Treasury and interest on its bonds, reached £4 million, any further interest income on the fund would be diverted to the Treasury and so could be used to reduce future taxes.
These politicians also made the same mistake as Dr. Price, coming to think of the fund as being outside the state finances, rather than a part of it. This resulted in silly actions like borrowing money to make payments into the fund, defeating the purpose of the sinking fund altogether. Of course, the fund made sense if the British government was truly running budget surpluses, but such a favorable fiscal situation lasted just five years after its creation. A new war with France started in 1793 and large-scale borrowing began anew.
The return of extensive borrowing posed an obvious challenge to the sinking fund. What was the point of providing for an annual allocation if the government was running deficits? The efficacy of a sinking fund depended on the government running surpluses consistently, even if only small ones. The compound interest on the bonds held in the fund would be of no help paying down the debt that was itself accumulating interest at the same rate. For politicians so enamored by the idea of harnessing the power of interest for easy debt repayment, it was a surprise that what mattered in the end was simply the “all-in” deficit or surplus.
The French Revolutionary Wars of the 1790s and the Napoleonic Wars of the following 15 years meant surpluses were out of the question for a quarter century. Even after the war, in 1819, money was borrowed from the sinking fund. Pitt’s creation, years after the young Prime Minister’s death, was beginning to suffer the same fate as that of Walpole. Britain’s debt was breaking new records, reaching nearly £500 million by 1800 and £850 million by the time the sinking fund was abandoned under the government of Lord Liverpool in 1828. By then, debt stood at over 250% of British GDP
Whatever the flaws in Dr. Price’s theories, the sinking fund was perhaps still a noble cause nonetheless. After all, there can never be any shame in aiming to be free of debt. To this end, the sinking fund may have been useful if for none other than psychological reasons. Dedicating certain sums for debt repayment without needing a regular vote by politicians may make paying down massive debt less politically difficult, especially in a society hostile to anything more than the bare minimum level of taxation needed. In this way, thinking of the fund as beyond the reach of the public finances may have actually been useful thinking.
That said, Britain’s sinking fund failed to meaningfully reduce the debt burden for decades whilst it existed. Thereafter, debt did come down in Britain but the reason was not a sinking fund, but peace. It was war more than anything else that has historically wrecked the fiscal health of countries, including that of Britain.
The decision to implement a sinking fund to pay down debt had more profound implications for the bond market in its nascency than might be assumed. It is important to recall that in the early-19th century, London became the center of the world’s sovereign debt markets. Governments across Europe and the Americas floated bonds there. Because Britain had its own sinking fund to complement its floated debt, investors expected many of these other bond issuers to implement their own such funds. As a result of London’s financial dominance, the sinking fund became a typical feature of speculative sovereign bond issues in an era when the bond market was growing rapidly.
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1. Antipa, Pamfili M., and Christophe Chamley. “Monetary and Fiscal Policy in England During the French Wars (1793-1821).” SSRN Electronic Journal, 2017.
2. Cone, Carl B. “Richard Price and Pitts Sinking Fund of 1786.” The Economic History Review, vol. 4, no. 2, 1951, pp. 243–251.
3. Price, L. L., and Edward A. Ross. “Sinking Funds.” The Economic Journal, vol. 3, no. 9, 1893.
4. Price, Richard. An Appeal to the Public, on the Subject of the National Debt. The Second Edition. With an Appendix. T. Cadell, 1772.