War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation
In every great war monetary calculation was disrupted by inflation. … The economic behavior of the belligerents was thereby led astray; the true consequences of the war were removed from their view. One can say without exaggeration that inflation is an indispensable means of militarism. Without it, the repercussions of war on welfare become obvious much more quickly and penetratingly; war weariness would set in much earlier.1
[Governments] know that their young men will readily sacrifice their lives and limbs and that their old men will readily sacrifice the lives and limbs of their sons and grandsons, and that their women will readily sacrifice the lives and limbs of their husbands, their sons, and their brothers in what they believe to be a noble cause, but they have a deadly fear— sometimes, but not always, well founded—that women and old men will shrink from pinching the stomachs of themselves and the young children, so that warlike enthusiasm will decay if it once gets about that the association of war with abundance to eat, drink, and wear is delusive, and that there is still truth in the old motto of “Peace and plenty.”… True that to be pinched by high prices rather than by small money incomes and large taxes made the people rage in the first place against the persons who were supposed to profit and often did profit—most of them quite innocently—by the rise of prices instead of against Government.2
[T]he true costs of the war lie in the goods sphere: the usedup goods, the devastation of parts of the country, the loss of manpower, these are the real costs of war to the economies.… Like a huge conflagration the war has devoured a huge part of our national wealth, the economy has become poorer.… However, in money terms the economy has not become poorer. How is this possible? Simply … claims on the state and money tokens have taken the place of stocks of goods in the private economy.3
“War, huh, what is it good for? Absolutely nothin’.
It ain’t nothin’ but a heartbreaker
Its got one friend, that’s the undertaker.…
War can’t give life, it can only take it away.”4
The costs of war are enormous, as the above quotations trenchantly indicate, and inflation is a means by which governments attempt, more or less successfully, to hide these costs from their citizens. War not only destroys the lives and limbs of the soldiery, but, by progressively consuming the accumulated capital stock of the belligerent nations, eventually shortens and coarsens the lives and shrivels the limbs of the civilian population. The enormous destruction of productive wealth that war entails would become immediately evident if governments had no recourse but to raise taxes immediately upon the advent of hostilities; their ability to inflate the money supply at will permits them to conceal such destruction behind a veil of rising prices, profits, and wages, stable interest rates, and a booming stock market.
In the following section I explain how war, completely apart from its physical destructiveness, brings about the economic destruction of capital and a consequent decline in labor productivity, real income, and living standards. The argument in this section draws on the Austrian theory of capital as expounded in the works of Ludwig von Mises and Murray N. Rothbard. Section 3 analyzes the reasons why different methods of war financing will have different effects on the public’s perceptions of the costs attending economic mobilization for war. The analysis developed in this section owes much to the classic discussion of inflationary war financing by Mises.5 Section 4 concludes the paper with a brief explanation of how inflation constitutes the first step on the road to the fascist economic planning that is typically foisted upon capitalist economies in the course of a large-scale war.
2. The Economics of War
The conduct of war requires that scarce resources previously allocated to the production of capital or consumer goods be reallocated to the raising, equipping, and sustaining of the nation’s fighting forces. While the newly enlisted or inducted military personnel must abandon their jobs in the private economy, they still require food, clothing, and shelter, in addition to weapons and other accoutrements of war. In practice this means that “nonspecific” resources such as labor and “convertible” capital goods including steel, electrical power, trucks, etc., which are not specific to a single production process, must be diverted from civilian to military production. Given the reduction in the size of the civilian labor force and the conversion of substantial amounts of the remaining labor and capital to the manufacture of military hardware, the general result is a greater scarcity of consumer goods and a decline of real wages and civilian living standards.
However, the transformation of the economy to a war footing implies much more than merely a “horizontal” reallocation of factors from consumer goods to military production. It also entails a “vertical” shift of resources from the “higher” stages of production to the “lower” stages of production, that is, from the production and maintenance of capital goods temporally remote from the service of the ultimate consumers to the production of war goods for present use. For, as Mises6 points out, “War can be waged only with present goods.” but, in substituting the production of tanks, bombs, and small arms destined for immediate use for the replacement and repair of mining and oil drilling equipment intended to maintain the flow of future consumer goods, the economy is shortening its time structure of production and thus “consuming” its capital. Initially, this capital consumption is manifested in the idleness of fixed capital goods that cannot be converted to immediate war production, e.g., plant and equipment producing oil drilling machinery, and the simultaneous over-utilization of fixed capital goods that can be so converted, e.g., auto assembly plants now used to produce military vehicles. In the short-run, then, the flow of present goods or “real income,” in the form of war goods and consumer goods, may actually rise, even in the face of a loss of part of the labor force to military service. But as years pass, and industrial and agricultural equipment is worn out and not replaced, real income inevitably declines—possibly precipitously— below its previous peacetime level.
Schumpeter7 has provided a graphic summary of the horizontal and vertical shifts of resources caused by the exigencies of a war economy, and the deleterious effect of the vertical shift on the capital stock:
First, “war economy” essentially means switching the economy from production for the needs of a peaceful life to production for the needs of warfare. This means in the first place that the available means of production are used in some part to produce different final goods, chiefly of course war materials, and in the most part to produce the same products as before but for other customers than in peacetime. This means,furthermore, that the available means of production are mainly used to produce as many goods for immediate consumption as possible to the detriment of the production of means of production-particularly machinery and industrial plant—so that that part of production that in peacetime takes up so much room, namely the production for the maintenance and expansion of the productive apparatus, decreases more and more. The possibility to do just this, that is to use for immediate consumption goods, labor, and capital which previously had made producer’s goods and thus only indirectly contributed to the production of consumer’s goods (i.e., which made “future” rather than “present” goods, to use the technical terminology), this possibility was our great reserve which has saved us so far and which has prevented the stream of consumer’s goods from drying up completely.… Our poverty will be brought home to us to its full extent only after the war. Only then will the worn-out machines, the run-down buildings, the neglected land, the decimated livestock, the devastated forests, bear witness to the full depth of the effects of the war.
In commenting upon the effects of World War I on the British economy, Edwin Cannan8 also drew attention to the crucial fact of the vertical shift of resources and the capital consumption it implies, observing that
… during the war addition to material equipment at home and foreign property abroad wholly ceased. The labor thus set free was made available for war production and for the production of immediately-consumable peace-goods.
[Moreover] everyone conversant with business knows that renewals, if not repairs, have been very seriously postponed in all branches of production and that stocks of everything have run down enormously. The labor which would in ordinary times have been keeping up the material equipment was diverted to war-production and the production of immediately consumable peace-goods.… It was chiefly the tapping of these resources that enabled the country as a whole to get through the war with so little privation.
It may be objected that empirically, the vertical shift of resources is likely to be trivial, because “investment” constitutes such a small segment of real output and therefore the increase in the output of war goods must come mainly from resources diverted from the consumer goods industries combined with a reduction of the leisure of the civilian population, i.e., through increased overtime and labor participation rates. But this fallacious consumer-belt-tightening theory of war economy is based on the Keynesian national income accounting framework, according to which capital investment constitutes a small fraction of total GDP. For example, during the fourth quarter of 1994, the annual rate of real gross private investment in the U.S. totaled $939.7 billion or slightly more than 17 percent of real GDP while real personal consumption expenditures in the same quarter equaled $3629.6 billion or almost 67 percent of real GDP.9
Unfortunately, in this framework the investment in “intermediate inputs” is netted out to avoid “double counting.” These intermediate inputs to a great extent comprise precisely those types of capital goods, namely, stocks of raw materials, semi finished products, and energy inputs, that can most readily be converted for use in the production of present goods, whether for military or consumption purposes. As Mises10 observes, this is one form that capital consumption took in Germany during the First World War: “The German economy entered the war with an abundant stock of raw materials and semi-finished goods of all kinds. In peacetime, whatever of these stocks were devoted to use or consumption was regularly replaced. During the war the stocks were consumed without being able to be replaced. They disappeared out of the economy; the national wealth was reduced by their value.” These future or higher-stage goods permanently “disappeared” because the resources previously invested in their reproduction had been withdrawn in order to augment the production of war materials.
In fact, in a modern capital-using economy, at any given moment during peacetime, the aggregate value of resources devoted to production and maintenance of capital goods in the higher stages of production far exceeds the value of resources working to directly serve consumers in the final stage of the production process. As an example, for the U.S. economy in 1982 total business expenditures on intermediate inputs plus gross private investment totaled $3,196.7 billion while personal consumer expenditures totaled $2,046.4 billion. Over 6o percent of the available productive resources, outside the government sector, was therefore devoted to the production of capital, or future, goods as opposed to consumer, or present, goods.11,12
3. The Financing of War
Governments have at their disposal three methods for financing a war: taxation, borrowing from the public, and monetary inflation or the creation of new money. Governments may also resort to coercive requisitioning, that is, confiscating the material resources and conscripting the labor services they deem necessary for the war effort without compensation or in exchange for below-market prices and wage rates. Historically, a combination of these methods has generally been used to effect the transfer of resources from civilian to military uses during a large-scale war. From the viewpoint of technical economic theory, however, the government could always realize the funds necessary to carry out its war aims exclusively from increased taxation and noninflationary borrowing on capital markets. As Schumpeter13 pointed out with regard to Austria, immediately after the First World War, “It is clear … that strictly speaking we could have squeezed the necessary money out of the private economy just as the goods were squeezed out of it. This could have been done by taxes which would have looked stifling, but which would in fact have been no more oppressive than the devaluation of money which was their alternative.14
Why, then, if strictly fiscal measures are capable of yielding sufficient revenues to pay market prices for all the resources required to conduct war, have belligerent governments almost always had recourse to the methods of monetary inflation and the direct commandeering of commodities and services? The answer lies in the fact that war is an extremely costly enterprise and the latter two methods, although in very different ways, operate to partially conceal these costs from the public’s view.15 When the public is accurately apprised of its full costs, war becomes increasingly unpopular, civilian enthusiasm and labor efforts flag, and unrest and even active resistance may ensue on the home front and spread to the front lines. The movement for “revolutionary defeatism” successfully fomented by Russia’s Bolsheviks during World War I is just one example of such mass resistance.
As Robert Higgs16 points out with regard to the tendency of governments to partially substitute a command-and-control economy for the regular fiscal mechanism during wartime and other so-called national emergencies:
Obviously, citizens will not react to the costs they bear if they are unaware of them. The possibility of driving a wedge between the actual and the publicly perceived costs creates a strong temptation for governments pursuing high-cost policies during national emergencies. Except where lives are being sacrificed, no costs are so easily counted as pecuniary costs. Not only can each individual count them (his own tax bill); they can be easily aggregated for the whole society (the government’s total tax revenue). It behooves a government wishing to sustain a policy that entails suddenly heightened costs to find ways of substituting non-pecuniary for pecuniary costs. The substitution may blunt the citizen’s realization of how great their sacrifices really are and hence diminish their protests and resistance.
The direct expropriation of resources works best when the resources in question are non-reproducible, as in the case of labor. By legally compelling its citizen-subjects to serve a specified term in military service at wage rates far below market levels, the government significantly reduces the budgetary costs of war and thus the amount by which it must ratchet up taxes. The cost concealment this facilitates explains the widespread use of mass conscription especially by almost all modern mass democracies, beginning with revolutionary France. But uncompensated confiscation of reproducible resources confronts an insuperable difficulty: while it does yield access to existing stocks of resources, it destroys the incentive on the part of private individuals and firms to reproduce these resources.
Continuation of industrial production processes requires pecuniary compensation to the producers as determined by the market, unless the government is willing to completely abolish exchange and implement a totally moneyless (and particularly chaotic) form of socialism, in which resources are allocated and the products distributed by bureaucratic ukase. This was attempted by the Bolsheviks during the period known as War Communism in the U.S.S.R. from 1918 to 1921 and proved a miserable failure.17 While governments of mass democracies in fact went a long way toward replacing market incentives and processes with substantial elements of the centrally-planned or command-and-control economy during the two great wars of the twentieth century, at least at the inception of hostilities they still required a cost-concealing device that would yield them the money revenues with which to purchase real resources from their still-operative money-exchange economies. For this purpose, they consolidated the power to issue money in the hands of their central banks. Thus it was, for example, that within days of the outbreak of World War I each and every one of the belligerent governments suspended the operation of the gold standard, effectively arrogating to itself the monopoly of the supply of money in its own national territory.
To grasp how the issuing of new money obscures and distorts the true costs of war, we first must analyze the case of financing a war exclusively through the imposition of increased taxes supplemented with borrowing from the public. Prior to the increase of taxes and issue of government securities to raise war revenues, the national economy is operating with an aggregate capital structure whose size is determined by the “time preferences” or inter-temporal consumption choices of the consumer-savers. The lower the public’s time preferences, and therefore the more willing its members are to postpone consumption from the immediate to the more remote future, the greater is the proportion of current income that is saved and invested in building up an integrated stucture of capital goods. The greater the stock of capital goods, in turn, the greater the productivity of labor and the higher the real wage rate earned by all classes of workers.18
From the point of view of individual investors in the capital structure—business proprietors, stockholders, bondholders, insurance policyholders—the values of their titles and claims to capital goods are revealed by monetary calculation, specifically, capital accounting, and are therefore conceived as sums of monetary wealth.19 The accumulation or consumption of capital will always be readily evident in the changing monetary wealth positions of at least some individuals, assuming the purchasing power of money is roughly stable. It will especially be manifested in movements in the stock and real estate markets, which are devoted largely to the exchange of titles to aggregates of capital goods.20 In addition, enlargements or diminutions of the capital stock will be manifested in fluctuations in current incomes—in aggregate pecuniary profits in the economy and in the general levels of salaries and wages.
As pointed out above, large-scale war involves a marked increase in preferences for present goods and necessitates a thoroughgoing reorientation of society’s productive apparatus away from future and toward present goods. To effectuate this temporal restructuring of production in a money-exchange economy, there must occur a radical alteration in the proportions of money expenditure, with consumption and military spending rising relative to saving-investment. Regardless of what technique is utilized to accomplish this shift in relative expenditure, it must give rise to a “retrogressing economy” during the transition to the war economy. The retrogressing economy is one characterized by a declining capital stock. Its onset is marked by a “crisis” involving aggregate business losses, rising interest rates, plunging stock, bond, and real estate markets, and a deflation of financial asset values.21
When taxes are raised to finance the war, the crisis is immediately evident. In order to pay their increased tax liabilities, citizens retrench on their saving as well as their consumption. In fact, they reduce their saving proportionally more than their consumption, for two reasons. First, assuming an increase in the income tax, the net interest return on investment is lowered, meaning that the investor can now expect less future consumption in exchange for a given amount of saving or abstinence from present consumption. If his time preference remains unchanged, the worsened terms of trade between present and future goods encourages the taxpayer to escape the tax by increasing spending on present consumption and reducing saving and, thereby, his prospects for future consumption. With all saver-investors responding in this manner, the aggregate supply of savings will decrease and the interest rate will be driven up to reflect the increased tax on investment income.
Second, moreover, because the incidence of the increased tax always falls on his present income and monetary assets, it leaves the taxpayer less well-provided with present goods. As his supply of present goods diminishes toward the bare subsistence level—at which point the premium he attaches to present over future consumption becomes approximately infinite—the individual experiences a progressive rise in his time preference, and the prevailing (after-tax) interest rate no longer suffices as adequate compensation for sustaining his current level of saving-investment. He accordingly further reduces the proportion of his income allocated to saving investment.22
Finally, as a means of quickly generating the enormous revenues typically required at the outset of a large-scale war, the government might seek to tap, in addition to current income, accumulated capital. This most likely would involve a wealth tax that is levied on each household in some proportion to the market value of the property it owns, including and especially its cash balances. The tax, if it were uniformly enforced on all categories of wealth, would force capitalist-entrepreneurs to liquidate or issue debt against their real assets in order to discharge their tax liability. By its very nature, then, a wealth tax results directly in the consumption of capital. Moreover, even though such a tax is levied on net wealth accumulated in the past, it operates to powerfully increase time preferences and reduce savings even further, because it must be paid out of present income and monetary assets and the prospect of its recurrence can easily be precluded by completely consuming income as it is received and by consuming whatever privately owned capital remains.23
While the incidence of war taxes falls disproportionately on private sa
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