Despite the breadth and depth of the London stock market, the British government came to rely on an élite of bankers to manage its borrowing through the mechanism of competitive auctions by the Bank of England. Until at least the time of the Crimea, the Rothschilds played a leading role, though competition subsequently drove down the profits to be made from underwriting issues of consols – the practice whereby banks guaranteed the government a certain price for a new issue and then sold them on to the public. The continuity from the early modern period is striking: Nathan Rothschild had made his reputation in London conducting, albeit on an unprecedented scale, precisely the kind of wartime transfers of money across the Channel that had been carried out by men like Horatio Pallavicino in the 1570s and Edward Backwell in the 1650s.54 Where banking was less developed, the Rothschilds’ multinational partnership came closer to monopolizing new bond issues. This was true to varying degrees in France, Belgium, Austria and Italy, while the Barings came to dominate Russian public borrowing and the Morgan group that of the United States. Rulers who chafed at the power of the Rothschilds sought to encourage rivals like the Crédit Mobilier in France and its many imitators throughout Europe. But it was only gradually that the new joint-stock banks really took over from the private partnerships like Rothschilds.55
The alternative to reliance on banking intermediaries was direct sale via subscription to the public. Such an operation was tried as early as 1506 in Basle, but its success depended on the existence of a relatively developed and broad capital market. For bigger political entities, the risks of public subscription for a long time seemed too high, and it was not until the later nineteenth century that states like Italy sought to liberate themselves from the dominance of the Rothschilds by selling bonds this way.
In practice, however, all debt-issuing agencies tended to deal more with financial intermediaries than with individual private investors.56 There was considerable variation in the precise channels through which government bonds were sold. In London a dedicated profession of ‘jobbers’ evolved whose sole function was the purchase of new securities (while stockbrokers sold them on to investors). The system in the United States, by contrast, remained closer to the nineteenth-century model of competitive auctions between big institutions. In France there was something more like a cartel of big banks. Nevertheless, the crucial relationship everywhere was between debt-management departments and the major financial institutions like pension and insurance funds which were now holding a growing proportion of bonds in their portfolios.
WAR DEBTS AND THEIR LEGACY
In Ford Madox Ford’s First World War tetralogy Parade’s End, the hero Christopher Tietjens is introduced in the ‘perfectly appointed railway carriage’ of a train which ‘ran as smoothly … as gilt-edged securities’.57 This, however, was on the eve of a conflict that would pose a formidable challenge to the smooth running of government debts.
The immense expenditures occasioned by the war, which not even the most pessimistic pre-war commentators had forecast accurately, required a transformation in the techniques of government borrowing. It was not long before the language of mobilization which had been adopted to justify the creation of mass armies was applied to war finance too. The system of selling bonds directly to the public by subscription was widely adopted during the First World War, when buying war bonds was portrayed in official propaganda as a matter of patriotic duty. The British films You! and For the Empire (commissioned by the Committee on War Loans for the Small Investor) exhorted audiences to invest in war bonds; the latter went into great detail to show ‘the quantity of munitions’ an investment of 15s. 6d. would provide.58 A German poster of 1917 depicted a naval officer explaining to a soldier as they watch an enemy ship sinking: ‘That’s how your money helps you to fight. Turned into a U-boat, it keeps enemy shells from you. So subscribe to war loans!’59 ‘A man who can’t lend his government $1.25 at the rate of 4 per cent interest’, declared the American Treasury Secretary William Gibbs McAdoo in 1917, ‘is not entitled to be an American citizen.’60
However, as the war wore on it became steadily harder (especially for the Central Powers) to persuade their subjects to put their cash into war bonds.61 For that reason, the First World War also saw a revival and development of short-term debt instruments, principally Treasury bills. By the end of the war, 32 per cent of the German national debt was in this form – of which more than two-fifths were held by the Reichsbank – and 37 per cent of the French. The continental states at first relied on sales of long-term bonds to the public; when demand for bonds waned, sold short-term Treasury bills to fill the gap; and when the public declined to buy these, sold them to the central bank (with consequences for monetary policy to be discussed in the next chapter). The British also reduced their long-term debt. The funded national debt (mainly consols) had accounted for 90 per cent of the total debt in March 1914; five years later consols accounted for less than 5 per cent of the total debt.62 However, the Treasury sought to mop up the excess liquidity generated by its own short-term borrowing by issuing a variety of medium-term instruments with maturities longer than Treasury bills. Around 31 per cent of the British national debt in December 1919 was therefore made up of bonds due for redemption after periods of between one and nine years.63 ‘Gilts’ (short for gilt-edged government securities) were now available with a range of maturities. This was the real difference between British and continental war finance. On average, only 18 per cent of the British wartime debt was short-term. The United States, which spent in relative terms less on the war, was unique in being able to rely almost entirely on long-term bonds.64
The significance of the more complicated ‘term structure’ of national debts after 1914 was twofold. First, the diversification of bond maturities added to the flexibility of the system by giving investors wider choice. Secondly, and less positively, the growth of short-term debt created complex and not always well-understood links between fiscal and monetary policy. In particular, central banks which were statutorily obliged to discount short-term Treasury bills simply monetized short-term debt, leading to considerable inflationary pressure during and after the First World War (see Chapter 5). Moreover, the need regularly to renew or ‘roll over’ short-term debts could expose modern states to funding crises not dissimilar from the one that had undermined the French ancien régime.
Few countries after 1919 shared the British readiness to run budget surpluses in order to repay short-term debt or to ‘fund’ it by converting it into long-term debt.65 Indeed, in France, Belgium and Italy, ‘funding crises’ – a refusal by lenders to roll over short-term debts – led to serious monetary instability in the mid-1920s. In 1925 long-term bonds accounted for just over half of the total French debt; the same was true in Belgium. In Italy the proportion was roughly two-thirds, but here too a funding crisis struck.66 One of the keys to the stabilization of war debts in the 1920s was a reduction of the proportion of short-term debt.67
In the Second World War British policy aimed at maximizing sales of medium- and long-term debt instruments by restricting other investment opportunities through the Capital Issues Committee. A wide range of bonds and bills was used to soak up liquidity: Defence Bonds, National Savings Certificates, War Bonds and Exchequer Bonds for institutions.68 The maturity structure by the end of the war was rather shorter than it had been in 1918/19, but the difference was small.69 The balance was similar in the United States, where borrowing from the public and money creation financed roughly equal proportions (a quarter apiece) of total wartime spending.70 But the Axis powers relied heavily on short-term borrowing which in effect meant printing money. In Germany and Japan wartime monetary growth was roughly sevenfold; in Italy eighteenfold.71 As in the First World War, the lion’s share of the expansion was due to the monetizing of short-term government debt by the central bank.
The real difference between 1918 and 1945 in Britain was that after the Second World War there was much less of a drive to fund the short-term debt run up du
ring the war. As a result, it was Britain that now experienced the problems associated with substantial levels of short-term debt and artificially low short-term interest rates. For most of the post-war period, it was assumed that there was a relationship between the structure of public debt and the supply and demand for money. The authorities therefore strove to limit the stock of liquid assets available to the banking system, at the same time relying on direct controls to limit bank lending. Instead of trying to convert short-term gilts into long-term gilts, the Bank of England adopted a passive ‘tap’ system of funding, whereby the quantity of long-term securities sold was determined by the jobbers in the market.
This somewhat unsatisfactory (and theoretically flawed) system was swept away in the 1980s as a result of the abandonment of the credit ‘Corset’, the revival of the Bank of England’s base rate as the primary tool of monetary policy and the institutional ‘Big Bang’ which did away with the jobbers as intermediaries between government and investors. Henceforth, new gilts were sold directly to the big institutions in auctions, much as had been done in the 1850s and early 1900s. However, the shifting attitudes of Conservative Chancellors towards government borrowing as an influence on the money supply led to inconsistencies in debt management. In the early 1980s the authorities actually sold more gilts than the deficit required (‘over-funding’), hoping to increase the proportion held by private investors other than banks, which it was assumed would merely use additional gilts as the basis for new lending. This practice was abandoned when monetary targets were dropped by the Treasury. Instead, a ‘full funding’ rule was adopted, whereby all public sector borrowing was absorbed outside the banking system. But in the recession of the early 1990s the government once again allowed itself to count sales of gilts to banks as funding. Finally, the Debt Management Review of July 1995 declared the complete separation of debt management and monetary policy, a theoretical break institutionalized by the decision to entrust monetary policy to the ‘operationally independent’ Bank of England (1997) and debt management to the new Debt Management Office of the Treasury (1998).72 This separation of public debt management from central bank control of monetary policy is in some ways historically novel, given the origins of most central banks as managers of public debt. Perhaps significantly, it coincided with a rapid fall in the government’s borrowing requirement.
SCALING THE MOUNTAINS
So much for the techniques of government borrowing. Now let us turn to the question of scale. How big were past deficits and debts?
In the century after the Glorious Revolution all the great powers tended to spend more than they raised in taxation. Between 1692 and 1815, for example, the average British budget deficit amounted to approximately 3.3 per cent of national income.73 A strikingly high proportion of Britain’s expenditure during the wars of the eighteenth century was financed by loans: nearly 40 per cent between 1776 and 1783 and as much as 27 per cent between 1793 and 1815.74 Russia’s deficit was around 18 per cent of expenditure in 1764 and 29 per cent in 1796.75 When Louis XVI’s Comptroller-General Calonne laboriously calculated the extent of royal insolvency in 1786, he estimated the deficit at 19 per cent of expenditure.76 However, revolutionary France ran far larger deficits: 70 per cent of total expenditure in 1791, 40 per cent in ‘the Year III’ (1794–5) and nearly 50 per cent in the Year V (1796–7).77 The wars against France of the eighteenth and early nineteenth centuries were indeed, as George III said, in some measure ‘wars of credit’.78 So obvious did it seem to Kant that public debts had become the basis for war finance that Article 4 of his Thoughts on Perpetual Peace (1795) envisaged a ban on ‘debts … contracted in connection with the foreign affairs of the state … either from without or from within the state’.79
Calculated as percentages of total expenditure, total deficits in the nineteenth century – commonly thought of as an era of ‘sound finance’ – were also far from negligible. Only in Britain, and only after the Napoleonic Wars, was the balanced central government budget the norm. Between 1816 and 1899 the UK government ran a deficit in excess of 1 per cent of GNP in only four years. Indeed, if payments for debt service are excluded, the British primary budget surpluses of the nineteenth century were remarkably large – averaging 4.6 per cent of GDP every year between 1816 and 1899, and reaching a peak of 11.1 per cent in 1822. The figures would be even larger if payments to the new sinking fund after 1875 – counted as current expenditure under the Treasury’s idiosyncratic conventions – were also omitted.80 When not at war the American federal government also tended to run surpluses.81 But most continental countries ran budget deficits most years. France had a budget surplus in only seven years between 1816 and 1899. Italy ran a deficit every year of its existence from 1862 until 1899; the same was true of the German Reich until 1924. Between 1870 and 1913 the Austrian budget was only balanced in two years, 1892 and 1893; Russia had only three surplus years between 1890 and 1913.82 To be sure, deficits tended to be quite small in relation to national income before 1914 (see Table 2). Only the German Reich’s averaged more than 3 per cent of net national product between 1890 and 1913, and most of the federal government’s deficit was financed by ‘matricular contributions’ from the member states, rather than by borrowing.83 However, when we take into account the relatively small size of pre-1914 government budgets the deficits look more significant.
By any measure, the world wars resulted in vastly larger deficits in all combatant countries. In Britain the deficit exceeded 30 per cent of GNP between 1915 and 1918; in Germany it rose above 40 per cent, and may even have exceeded 60 per cent in 1917; in Italy it averaged 22 per cent. In the Second World War the orders of magnitude were similar: deficits in 1943 ranged from between 19 per cent of net material product in the Soviet Union to 36 per cent of GNP in Germany.84 Between the wars most states sought to return to balanced budgets. Of the former combatants, few apart from Britain succeeded (though the United States did in the 1920s); and even Britain slipped briefly into the red in 1933.85 This was also the pattern after the Second World War, though in the period to 1969 not only Britain but also the defeated powers Germany and Japan were able to run surpluses.
Table 2. Average annual central government budget deficits as a percentage of national product, selected periods
Sources: US, France and Italy: Masson and Mussa, ‘Long-term Tendencies’ (original data kindly provided by Professor Masson). UK: Goodhart, ‘Monetary Policy’. Germany: 1890–1913: Mitchell, European Historical Statistics; Hoffmann, Grumbach and Hesse, Wachstum; 1914–18: Roesler, Finanzpolitik, pp. 197 ff.; Witt, ‘Finanzpolitik’, p. 425; 1919–38: Balderston, German Economic Crisis, p. 226; Bresciani-Turroni, Economics of Inflation, pp. 437 f.; James, German Slump, p. 375; 1939–43: Hansemeyer, ‘Kriegswirtschaft’, p. 400. Austria: 1890–1913: Mitchell, European Historical Statistics; Hobson, ‘Military-extraction Gap and the Wary Titan’. Russia: 1890–1913: Mitchell, European Historical Statistics, and Gregory, Russian National Income, pp. 58 f.; 1939–45 (in fact only available for 1942–5): Harrison, ‘Soviet Union’, p. 275. All figures for 1990–1999 from OECD, except for Russia which are from the IMF and cover the period 1993–9.
The absence of deficits in Britain in every year between 1948 and 1972 (with the partial exception of 1965, when expenditure was recategorized) gives the lie to the idea that there was a ‘Keynesian revolution’ in public finance prior to the 1970s, in the sense of deliberate strategy of using public borrowing to raise the level of domestic demand. To be sure, Keynes began arguing for ‘loan expenditure’ as a way of increasing effective demand as early as 1933. But he always saw deficit finance as ‘a desperate expedient’. Keynes’s argument against Treasury proponents of the perennial balanced budget was that ‘there is no possibility of balancing the budget except by increasing national income, which is the same thing as increasing employment’. During a depression, in other words, deficits in the short term would yield balanced budgets in the medium term. Moreover, Keynes wished the deficit to be see
n in the context of a ‘capital budget’, in other words to finance public investment, not current government spending.86 In practice, even those politicians who thought of themselves as Keynesian found themselves unable to pursue a counter-cyclical policy, not least because of the recurrent conflicts between the pursuit of full employment and the maintenance of a stable exchange rate. Possibly the only authentic attempt at a Keynesian fiscal expansion was Anthony Barber’s 1972 budget, which ushered in sixteen years of deficits. After a febrile boom in 1973, when GDP rose by 7 per cent, the economy collapsed as the balance of payments deficit ballooned, sterling slumped and inflation soared.87
The lack of deficits before 1973 also casts doubt on the theory of the inherent ‘democratic deficit’, which predicts that democratic governments will tend to run deficits because the electorate favours public spending but is averse to taxation.88 The preponderance of voters over direct tax payers in the twentieth century described in the previous chapter might have been expected to give rise to such a politically induced deficit. But in the British case, deficit finance only became a feature of policy after the oil shock of the early 1970s. The same has been true of Japan.
Nevertheless, it is possible that Britain and Japan are merely the exceptions that prove the rule. Table 2 shows that central government deficits were the norm in both France and the United States in every period except 1890–1913. The Italian state has always run a deficit (even in the period when the franchise was based on a narrow tax qualification). Moreover, the period between 1970 and 1999 was marked almost everywhere by deficits higher than any previously recorded in peacetime. Especially noteworthy was the way Japan, having traditionally run budget surpluses (even in war periods), plunged into deficit. Britain too continued to run deficits – with the exception of the years 1988–90 – despite the efforts of a consciously anti-Keynesian government to bring fiscal policy under control. Reductions in the redefined ‘Public Sector Borrowing Requirement’ were a key objective of successive budgets under Margaret Thatcher, culminating in Nigel Lawson’s hubristic declaration in 1988 that ‘hence-forth a zero PSBR will be the norm’. By 1994 it had risen to 8.3 per cent of GDP. Indeed, by the old measure the deficit was even wider. The bottom line was in many ways disguised in the Thatcher years by a combination of reduced capital expenditure and counting receipts from sales of public assets (privatization) as current revenue.89
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