We have already noticed that public credit may take the form of perpetual bonds, a principal and interest charge, or some form of annuity payment. In administering these various forms, especially the principal and interest charge, perplexing problems often arise. Problems occasionally arise when a state with perpetual bonds or life annuities decides to reduce its indebtedness, but these do not occur as frequently as the problems of conversion or payment of a terminable debt.

Conversion of Debt. - A state may frequently desire to change the nature of a bond issue. It is not able to cancel the indebtedness, but has an opportunity to put it into a more favorable form. It often happens that the extensive government borrowings are made in times of stringency, and the rate of interest is necessarily high. Had it been possible to wait a few years much better terms might have been secured. It is the problem of the fiscal authorities, while they cannot cancel the debt, to refund or convert it into an issue of more favorable terms. Most modern government bonds are so drawn as to aid this procedure. A 5-30 bond, for example, is one which may be paid any time after five, and before thirty years from the time of issue. If, after five years, a loan can be contracted for on much better terms than the original one, the fiscal authorities need but float a new issue of securities and use the proceeds to take up the old obligations. It often happens that a number of conversions of the same original debt may take place until satisfactory terms are the result. The holders of the old obligations are frequently given the privilege of exchanging them for issues of the new, at a fixed rate of exchange. These processes are not designed to reduce the indebtedness, but simply to change its form.

Use of Sinking Fund. - The general tendency has been for countries to adopt the policy of debt extinction. The use of this policy creates the problem of securing funds to meet the debt obligation when it falls due. Conversion may be used to postpone payment, but it does not cancel it. A scheme for debt payment which was developed in England, and which is widely used, is known as the sinking fund. Under this scheme, in order to meet a debt obligation when it matures, there is set aside a certain sum from the general revenue each year, so that the sum of the accumulations will equal the debt.

The early use of the sinking fund was very popular in England because of the fallacious idea that it provided a burdenless method of paying indebtedness. A small amount of bonds were to be purchased and retained by the government, and the interest on these bonds the next year was to be used in buying more bonds. This was to continue until these interest payments canceled the debt. The scheme, no doubt, would eventually cancel the debt, but the burden of doing so would still fall on the taxpayer. The annual interest charge which made the purchasing power had to come from somewhere, and taxation was the only source,

Any justification for the use of a sinking fund does not come from the reduction of burdens, but from providing the assurance that a source of funds will be on hand, out of which the payment of debts can be made when they fall due. The maintenance of such a fund may even enhance burdens. The administration of the fund must be provided for. It must be kept separate from other government funds, so that the treasury will not be subjected to the evils of a surplus, and so that the fund will not be used for other purposes than the cancellation of the debt. The fund should, of course, be used in some productive capacity, or it will entail the burden of putting capital out of use. Yet it must be kept absolutely safe or the scheme fails. The administration of such a fund grows into a task of no little magnitude.

Sinking Fund in the United States. - The various political units in the United States have made extensive use of some sinking fund arrangement. At the end of the Revolution the early English scheme of an accumulating interest fund was adopted. A little later specified revenue receipts were added to this. Much the same provision was made during the Civil War to insure debt payment. Customs receipts were to go to the payment of interest and to redeem a part of the debt. The redeemed debt, as well as its interest charge, was to be used as a sinking fund.

The sinking fund arrangement has again been invoked to take care of the liquidation of the Liberty Loans. The period required by the arrangement is twenty-five years. Experience has shown, however, that such arrangements have not been needed by the Federal government, for its debts in the past have been canceled more rapidly than the sinking fund provision anticipated. American states and cities have made, of necessity, a wide use of this principle of debt payment. State constitutions generally make it obligatory that, upon the contraction of a debt by the state or its cities, provision for the payment of the debt must immediately be made through the establishment of some sinking fund arrangement.