Governments certainly shouldn’t borrow to fund current spending (as opposed to capital spending). That makes no more sense than a household borrowing to pay for food or fuel.
As to projects which are supposed to pay for themselves (e.g. a toll bridge) I don’t see what’s wrong with borrowing to fund that as long as the terms of the loan are exactly the same as if a private sector firm had built the bridge: in particular, if the bridge makes a loss, then lenders take a hair-cut.
As to government borrowing to fund a capital project which is not commercial (e.g. school buildings) the community as a whole benefits from that, so a simple and perfectly logical way to fund that is out of tax.
Borrowing is a possibility, but in effect that amounts to lenders lending to citizens who don’t buy government bonds. (I.e. the latter pay less tax as a result of others lending to government). But the problem there is how to gauge the right rate of interest. A fair market price is only reached where there is a genuine meeting of buyers and sellers and that “fair market” does not exist at the moment.
That is, at the moment, the effect of government borrowing to fund school building type investments is that each person who does NOT BUY government debt is FORCED to pay less tax and effectively borrow from those who do buy such debt.
To get a “fair market” we’d need to have government offer loans to “non government bond buyers” to match the bond buyers. That would constitute a genuine meeting of buyers and sellers. But citizens can borrow and lend to each other ANYWAY (perhaps via banks and perhaps not). So it’s hard to see any logical place for borrowing to fund school buildings. I.e. they might as well be funded out of tax.
And there is a definite problem with getting the interest rate in respect of loans to fund school buildings wrong: if the interest rate is too high, it will crowd out private lending and investment. Why lend to a private sector entity at X% of you can make an entirely safe loan to government and get X%?
Government borrowing to fund stimulus.
As Keynes said, stimulus can be funded out of borrowed or printed money. Quite what the point of borrowing money is when you can print the stuff is a mystery. I suspect the only reason Keynes put any emphasis on the borrow option is that whenever the words “money” and “print” appear in the same sentence, hoards of economic illiterates start hyperventilating, and chanting “Mugabwe” and “Weimar”.
The case for government borrowing is weak. There is some sort of argument for government borrowing to fund commercial projects like toll bridges, but in that case, the terms of the loan should be identical to those that would obtain with a bridge that is funded, built and operated by the private sector. So that’s not really “government”: it’s “government acting as entrepreneur”.
P.S. (16th Dec 2013). In contrast to my above claim that money creation by commcial banks artificially depresses interest rates, Messers Huber and Robertsonclaim that that money creation enables commercial banks to “cream off a special profit” (p.31). However, it’s generally accepted in economics that if competitive forces are working, firms cannot make “special” or “above normal” profits for any length of time. That is, competition reduces those profits to a standard return on capital sooner or later. So I’d argue that the benefit is passed on to the customer (i.e. the borrower) in the form of lower interest rates.