How to pay for war
War bonds such as these are a way for governments to borrow money for war. Source
War has been an ancestral and irrefutable pillar of human existence for thousands of years. Humanity has been at war with itself for nearly all of recorded history. This raises a rather important question: how on earth are we paying for all this? Paradoxically, we have been financing wars before the advent of finance and economics as a professional field of study.
Ostensibly, the answer seems very straightforward: allocate increasing proportions of the budget to your newfound war while slowly letting the other vital sectors take a backseat. And this is exactly what governments did and have been doing but the problem is that wars cost truly astronomical sums of money. Thus, we find that the costs of a war often cannot be contained in the routine course of things and thus need to be addressed through supplementary means.
This gave rise to a whole sub-branch of economics: War finance, which figures out what those supplementary means are and which one best fits the situation.
It is worth noting that war finance deals only with fiscal and monetary measures, factors such as opportunity costs and the non-monetary costs of destruction of property and loss of life are not a consideration here. They are, however, a part of the scope of the wider field of defence economics.
War expenditure of the United States after 9/11. This is not counting opportunity costs, which would cause these figures to skyrocket. Credit
There are three primary measures to raise funds for war:
Basically earning more to spend more. Trade also falls under this section as the state levies excise and customs as well as sales taxes on international trade. Depending on the circumstances, entirely new taxes such as the victory tax in the United States during WWII may be levied.
Sovereign debts are formed to shoulder the expense of fighting a war. This can be in the form of loans from external entities such as the IMF and foreign governments or from the public at large, usually as bonds. Special bonds called war bonds are often issued for this purpose.
Print money to make money. Always a popular choice. The scale on which it needs to be done to make a difference almost always leads to a decrease in the purchasing power of money, leading invariably to inflation.
While this seems simple enough, the intricacies of diplomacy, politics, geopolitics and the overall threat of impending violence make it anything but simple. There are caveats to the measures stated above, of course. One only has to open a history book to know that one of the primary objectives of warfare throughout history was the much anticipated looting and economic exploitation of the defeated state.
The Historical Context
Moving on from the basics, it’s time to look at a real world example, namely, the rearmament and financing of World War II as orchestrated by the Nazi government.
The victorious Allies after the First World War imposed sanctions and various economic restrictions on the Post-First World War German governments which also greatly inhibited large scale rearmament of the German military. In these circumstances, it was unfeasible for their government to directly employ any of the three strategies above without alerting foreign governments about their renewed war efforts.
In this position, the President of the Reichsbank (the German Central Bank at the time) and the Minister of Economics for the Nazi government, Hjalmar Schacht, came up with an economic solution that would allow the Germans to procure financing for the upcoming war and above all, be able to do so going under the metaphorical radar.
Hjalmar Schacht, the architect of Germany’s rearmament.
Credit – United States Library of Congress
This solution was the infamous Mefo bill, a type of promissory note that enabled the government to pay off their defence contractors without ever actually having to pay off their defence contractors. The underlying motivation for the creation of the bills was that the Reichsbank was restricted from lending more than a predetermined amount to the German government, which made borrowings and creation of money for the purpose of rearmament impossible. The Mefo bills are what made it possible.
The government first created a fake company (namely, Metallurgische Forschungsgesellschaft or rather its abbreviation Mefo which, I am sure, all of us find more agreeable). They then paid their military contractors in bills issued by Mefo. The contractors turned them over to private German banks who happily accepted them as it was known the central bank would always honour Mefo bills. The central bank paid the banks by either printing more money or later on in the war, with money looted from their conquests.
It has been speculated that one of the reasons that Germany rushed off to war in the time frame that it did was that the Mefo bills would need to be paid off soon from the funds acquired by appropriating the resources of the annexed states. Which is exactly what they did after getting an infusion of wealth from occupying countries like France in the first few years of World War Two.
Here is a transcript from the Nuremberg trials of Hjalmar Schacht, explaining how the Mefo bills worked:-
Transactions in “mefo” bills worked as follows: “mefo” bills were drawn by armament contractors and accepted by a limited liability company called the Metallurgische Forschungsgesellschaft, m.b.H. (MEFO). This company was merely a dummy organization; it had a nominal capital of only one million Reichsmarks. “Mefo” bills ran for six months, but provision was made for extensions running consecutively for three months each. The drawer could present his “mefo” bills to any German bank for discount at any time, and these banks, in turn, could rediscount the bills at the Reichsbank at any time within the last three months of their earliest maturity. Source
Furthermore, the importance of Mefo bills can be seen here:
Schacht has conceded that his “mefo” bill device “enabled the Reichsbank to lend by a subterfuge to the Government what it normally or legally could not do” (3728-PS). Source
There were other measures adopted by the Nazi government for their war financing but it is important for students of economics to be aware of the crucial role played by Mefo bills in circumventing pre-war sanctions and restrictions, a scenario which is not utterly without context on the global stage today.
The Modern Context
The Russia-Ukraine war.
Credit: New York Times
The perception that peer-to-peer conventional war is obsolete has been dashed by the ongoing Russia-Ukraine conflict. The long term economic effect of this war on not just Russia and Ukraine but the world at large remains to be seen. The fields of defence economics and war financing have seen a resurgence in relevance, as countries evaluate their preparedness for similar crises.
The financing for the war on both sides has not been without struggle. Russia has spent a staggering $82 billion dollars in the first nine months of the war, about a quarter of its annual budget. Ukraine on the other hand has received about 115 billion euros (approximately $120 billion) in aid for the first nine months of the war in addition to the public borrowings and tax earnings.
It is worth noting that the aid provided to Ukraine is not by any sense of the word, free. The aid provided by the United States government is covered under a lend-lease agreement signed explicitly for the purpose of combating the illegal Russian invasion of Ukraine. The agreement relaxes American legislation concerning arms export and foreign aid, which enables the U.S government to expedite assistance to Ukraine. They are not exempt from repayment although payment is deferred until the immediate crisis is resolved.
Considering that the last lend-lease agreement signed between the U.S. and the U.K. was finally paid off in 2006, 61 years after it was signed, Ukraine is not off the hook for repayments by any means. This further validates the basic principle of economics that there is no such thing as a free lunch.
And just as there is no free lunch, there is no such thing as an inexpensive war!