To Arms

by Hew Strachan

  Revenue therefore declined during the war, but the scale is hard to estimate. In 1913/14 Turkey’s receipts were £T29,201,865. In October 1914 monthly spending if Turkey entered the war was projected to be £T500,000, but by February 1915 it had risen to £T1 million. In 1915/16 receipts fell to £T22,325,793, and although they rose by almost £T3 million in the following year the currency was rapidly depreciating and the cost of the war up to March 1917 averaged out at £T5 million a month. At that stage Djavid reckoned actual monthly war spending to be £T7 million.258

  After the war Karl Helfferich averred that Britain had covered only about 12.5 per cent of its war expenditure from taxation. While conceding that Germany had not done so well, he nonetheless argued that at least a small part of its war spending had been met through tax. Recent calculations suggest that Helfferich claimed too little for both powers: Britain covered 18.2 per cent of its war expenditure from taxation, and Germany 13.9 per cent.259 But his central point remains valid. None of the belligerents was capable of meeting the major part of its war costs from taxation. Helfferich’s case contains less special pleading than might at first appear. More united the belligerents in their fiscal policies than divided them. All could have taxed with far greater severity than they did. All could have made those rates of tax that they did in fact adopt more realistic if they had accompanied them with truly effective prices-and-incomes policies.

  But it is this latter point that constitutes the basis for the criticism of Helfferich. The former minister of finance was still seeking an explanation of war finance that related outgoings to income. What he had still not comprehended was the relationship between taxation and the money supply. During the war inflation had positive effects: it meant that some of the war’s costs were met by those whose incomes could not stay abreast of rises in prices. It therefore functioned as a form of indirect, discreet, and immediately productive taxation. If those on falling real incomes ultimately ceased to buy goods, they released productive capacity for other forms of (ideally) war-related production. Simultaneously, those who profited from inflation simply became liable for higher rates of tax. Josiah Stamp, reflecting Britain’s relaxed view on inflation, concluded that ‘the illusion of prosperity, and the incentive to production created by inflation have their real value in war-time, provided that they are not carried out of hand’.260

  It was this final caveat which Helfferich failed to grasp. All the belligerents proceeded cautiously in relation to taxation for fear of undermining the principle of consent on which its collection (especially when tax authorities were understaffed) rested. But taxation managed inflation by drawing in the surplus cash of consumers, and so moderating prices. Helfferich’s anxiety concerning the fragility of the Burgfrieden seems to have blinded him to this relationship.

  Inflation also eroded the real value of the national debt. Given Helfferich’s preference for loans, herein is a further reason for his blindness to the wider functions of taxation. By reducing the value of investments, inflation had taxing effects. But again, the value of inflation as a mechanism for wartime finance depended on its relationship to taxation. Investors had to be persuaded to invest in government bonds. Fiscal rectitude, even if more an appearance than a substitute, helped sustain confidence at home and credit abroad. The former was an important prerequisite for domestic borrowing; the latter was part of the armoury for seeking foreign loans.

  DOMESTIC BORROWING

  The principal functions of taxation in the First World War were the suppression of inflation and the maintenance of creditworthiness. Taxation did not cover the daily expenses of fighting—or at least not to any significant degree. At best (in the United States and Britain), taxation paid for less than a quarter of the war’s ongoing costs; at worst (in France, Austria-Hungary, and Russia) for none of them. The war was therefore predominantly funded by borrowing—and this is a generalization applicable to all belligerents.

  In August 1914 borrowing reinforced two aspects of the popular response to the outbreak of the war. The first was the sense that the war had healed social divisions, and so united the nation; the second was the belief that the war would be short. Unlike taxation, which was compulsory, loans were voluntary. They therefore enabled the warring peoples to cement their enthusiasm into positive action without at the same time courting the odium and awakening the divisions generated by proposals for new taxes. Furthermore, those most likely to contribute were the wealthy; levels of popular consumption remained unaffected. Thus, liquid capital could be mobilized with far more rapidity and far less pain than through taxation.

  However, as it became clear that the war was not going to be short, the initial attractions of borrowing turned to disadvantages. On the one hand, loans put the burden of war finance on a minority of the population, who might feel aggrieved that others were not making a comparable contribution. On the other, the more loan stock an individual acquired, the more he was enabled to increase his wealth at the expense of the masses. The interest and principal would be paid off through taxation levied on the entire population. Moreover, the attractions of the investment were diverting capital from productive uses to unproductive. The long-term cost would be a reduction in national wealth which would afflict the population as a whole rather than the owner of the original capital. Thus, a continuation of borrowing on the principles applied at the beginning of the war made less and less sense as the war continued. Social division would replace social unity.

  But it was no solution to this conundrum to switch from borrowing to taxation. Fiscally, it would be insufficiently productive; socially, the same problems would resurface, albeit in different form. Once they had begun borrowing, the nations had little choice but to continue. The buoyancy of war loan stock became an indication of confidence in ultimate victory; to change horses might set prices tumbling and so erode a state’s creditworthiness. To maintain the latter governments had to show that they could raise fresh loans, with the result that borrowing promoted more borrowing. The task of the government was to find a sensible balance in the management of debt. War loans had to be issued in denominations sufficiently low to draw in the small investor as well as the big; they had to offer a rate of interest sufficiently high to ensure success, but not so high as to suggest financial desperation or to saddle the taxation system with an insupportable burden of interest payment; finally, they had to be the means by which short-term borrowing and floating debt were converted into long-term obligations.

  Most governmental debt was taken up not by private investors but by financial institutions. Short-term treasury bills were the dominant and immediate means by which governments procured the cash to pay for the war. The treasury bills were discounted by the banks. Having acquired the status of securities, the bills could then become the basis for new note issue. Thus, at the cost of expanding the money supply governments could extend their credit indefinitely. By spending the money so generated on war production, the state put the cash back into circulation. War loans were therefore a means of soaking up surplus money, and of shifting the government’s short-term borrowing at the bank into long-term debt with the people. But the circle was not thereby broken, because war loan stock could itself be bought by the banks or be treated as security by them. So it too became the basis for an increase in the money supply. Therefore, domestic currency was freed from the restraint of a set percentage of gold cover. But the goods and services procurable with the purchasing power that the money represented were diverted from private individuals to the state. A. C. Pigou argued that bank credits therefore constituted a concealed form of taxation, albeit an inefficient one.261 The most immediate and evident form of state credit was the quantity of unearned currency in circulation—’a form of interest-free forced loan’.262

  The banks, therefore, became the essential intermediaries in the onward transmission and multiplication of government debt. Throughout the belligerent countries the banks saw an increase in deposits and in credits. In France the deposits of the
Banque de France and the six leading commercial banks rose from 7,058 million francs on 30 June 1914 to 10,882 million by the end of 1918; their credit expanded 242.58 per cent, from 17,289 million francs to 41,937 million.263 In Austria the deposits of the major Viennese banks rose from 163,628,000 crowns at the end of 1913, to 324,700,000 at the end of 1918, and of credits from 3,252,061,000 to 11,498,642,000.264 In Italy, the deposits of the four Italian banks increased 344 per cent between 1914 and 1918.265 In Germany the holdings of the seven major Berlin banks rose from 7,661 million marks to 21,979 million over the same period, and their credit from 4,508 million marks to 17,126 million.266 The deposits of the Russian state bank grew from 184.7 million roubles in July 1914 to 2,454.7 million in September 1917, of savings banks from 2,073 million roubles to 6,739.8 million between the same dates, and of private banks from 3,393.3 million roubles in August 1914 to 9,153.3 million in July 1917.267 In Britain the deposits and current accounts of the joint stock banks of England and Wales (excluding the Bank of England) grew from £809.4 million on 31 December 1914 to £1,583.4 million on 31 December 1918, and of all banks from £1,032.9 million to £1,988.3 million.268 Although this expansion was expressed in depreciating currencies, the point was often lost on bankers gratified by the ease with which they had shuffled off the blows to private business and international commerce. The president of the Deutsche Bank, Arthur von Gwinner, was entirely positive in his annual report for 1917: ‘the placement of deposits in the Treasury bills of the Reich, the federal states, and the large cities now offers the easiest opportunity to invest every available sum in a short-term and secure manner at acceptable interest rates which run at an average of per cent to per cent.’ Not until the end of the following year would he recognize ‘monetary depreciation’ rather than real wealth as the source of the bank’s increase in business.269 Moreover, the key point remained: the banking systems of the belligerents proved capable of sufficient growth to keep pace with the demands of war finance.

  Broadly speaking, the structural changes which underpinned this enlargement were in place before the war; the war accelerated their development rather than originated them. Most significant and most fortuitous was the establishment in the United States of the Federal Reserve System. Until 1914 the banks of America lacked any central organization, with the result that their reserves were scattered and immobile and their capacity for development severely restricted. Three months before the outbreak of war the Federal Reserve act divided the country into twelve districts, with a Federal Reserve bank for each district. All national banks were obliged to join the system, and others were encouraged to do so. The member banks subscribed capital to the regional Federal Reserve bank, and in return the reserves required to be held against deposits were reduced in varying percentages according to the size and status of the member bank. The interest rates of the Federal Reserve banks fell by up to 2 per cent between 1914 and 1916. In practice, the decline in the reserve ratios was offset by the gold imports generated through the war: on 5 April 1917 the reserve ratio was still 89 per cent, and on 17 November 1916 the reserves of the member banks were $2,536 million, of which only $1,510 million was actually required. The United States therefore possessed a flexible system for credit expansion of considerable capacity.270

  Although no other belligerent underwent reforms so crucial to its capability to finance war industry, all saw an alteration in banking profiles. In Italy the issue banks’ proportion of the total assets of all banks rose from 23.9 per cent in 1913 to 46.1 per cent in 1918, largely at the expense of the savings banks and popular banks. The four or five largest credit banks expanded their assets from 16.7 per cent of the whole in 1914 to 33.9 per cent in 1919. And the government and the Bank of Italy combined forces in 1914–15 to create a new commercial bank, the Banca Italiano di Sconto, to contest the field with two Milanese banks, the Banca Commerciale Italiana and the Credito Italiano.271 In Germany the existing banking structure was reinforced by the Darlehenskassen, which moved from being upmarket pawnshops to full-blown credit institutions. In Britain the process of bank amalgamations, already evident before the war (the number of British banks halved between 1895 and 1914), continued during it. Twelve of the largest London banks formed the ‘big five’. The gap between them and their medium-sized competitors widened: the former commanded 70 per cent of deposits by 1918, and were able to write down their capital to only 5 per cent of deposits (when 13 per cent had been normal in 1910).272

  Two general and interlocking trends predominated. First, the central banks were increasingly required to fall into step with government policy. In Britain this was symbolized by the Treasury’s defeat of the nominally independent Bank of England over the policy to be followed on gold reserves and interest rates in July 1917. Secondly, the central banks became bankers to the commercial banks. In Russia the balances of fifty banks (representing a total of 782 branches) with the Russian State Bank increased from 64 million roubles at the beginning of 1914 to 160 million two years later.273 Thus, the commercial banks as well as the central banks were enlisted for government service.

  The banks therefore grew, but by means of state credit and at the expense of private business. In Germany trade bills constituted 17 per cent of the Reichsbank’s assets in 1914 but only 0.7 per cent in 1918: the bank’s role in refinancing commerce had been all but extinguished. Meanwhile, the credit banks themselves acquired ‘the character of deposit banks lending chiefly to public authorities’; by 1918 government treasury bills constituted the bulk of the Deutsche Bank’s liquid engagements.274 At the other end of the banking spectrum the deposits of the savings banks grew 50 per cent during the war, but almost entirely through their handling of war loan stock: in Bavaria the savings banks dealt with 66 per cent of all war loan transactions.275 In Italy the commercial portfolio of the banks declined 25 per cent between 1914 and 1916, its gross increase in these years being attributable to the discount of treasury bonds.276 In the joint stock banks of Britain the ratio of other securities to British government securities declined from 86.8 per cent in 1913 to 24.6 per cent in 1918. The entire increase in bank deposits between June 1917 and December 1918, a total of £467 million, representing 40 per cent of total deposits, was generated by the needs of war finance.277 In France in December 1914 31.07 per cent of all advances from the banks were made to the government; four years later this figure stood at 63.7 per cent. The gross profits of the Banque de France itself, which had averaged 52 million francs a year up to 1913, had reached 344 million in 1919—almost entirely through state business.278

  Long-dated government stock and its absorption in a pattern of long-term bank deposits—for all its discounting and the consequent expansion of the money supply—had one major anti-inflationary effect: it reduced liquidity. The latent inflation generated by wartime borrowing could therefore be kept in check; the fact that governments adopted deficit financing during the war did not in itself guarantee hyperinflation after the war.

  Germany’s declared policy at the war’s outset—that of borrowing—was certainly in marked contrast to Britain’s formal position. But, to reiterate a point, its gross effect in cash terms was less different. By the end of the war 90 per cent of the ordinary budget was devoted to interest payments on war debt; in other words, Germany—unlike some other belligerents—serviced its war debt out of ordinary revenue and still had a surplus. Taxation made at least some contribution to Germany’s war costs: the customary calculation is 6 per cent.279 But total tax revenue, if the states are included, was at least 16.7 per cent, and possibly 17.7 per cent, of all wartime spending.280 The significant difference is the fate of the 94 per cent of Reich war costs not funded through taxation. In 1918 only 60 per cent of the debt was fixed in long-term loan stock, and fully 34 per cent consisted of floating debt. This was high, although certainly in France and possibly in Italy it was higher. But by 1920 the floating debt of the last two had fallen, while Germany’s had grown to over 50 per cent.281 Germany’s primary problem at th
e war’s end was excessive liquidity.

  What was a vice in 1918 had been a virtue in 1914. At the war’s beginning Germany’s financial policy was directed to the achievement of liquidity.

  Borrowing was one manifestation of this overarching principle; the rejection of a formal moratorium was another. The limited and short-lived hike in interest rates served the same end: the Reichsbank’s rate rose from 5 per cent to 6 per cent, but fell back to 5 per cent on 23 December 1914, and stayed there for the rest of the war. Anticipating that mobilization would not only generate a shortage of cash but would also leave industry short of hands, so causing unemployment and rendering plant idle, Germany flushed its economy with cash in order to stimulate activity. It recognized the danger of inflation, but believed that the evidence would be found not in the growth of the money supply but in the movement of prices. Price controls appeared reasonably effective in 1914 because prices were restrained by short-term unemployment But, as employment levels rose and war orders generated competition for increasingly scarce goods, Germany needed to throttle back on liquidity. It could have applied harsher taxation or increased interest rates in order to draw in deposits. It did neither.

  Symptomatic of the failure to rethink financial policy in terms of a long war and full employment rather than a short war and unemployment was the development of the Darlehenskassen. The Darlehenskassen offered an interest rate of up to 6.5 per cent (as against the Reichsbank rate of 5 per cent), and only required deposits to be fixed for between three and six months. Thus, cash remained effectively on call. Although designed to help commerce and private business surmount the liquidity crisis of mobilization, their attractions soon drew in a different range of creditors. By 1916 25 per cent of their loans were to states and communes; a further 28.2 per cent were to banks; only 12 per cent were to trading and transport interests, 3 per cent to industry, and 0.7 per cent to agriculture. In 1917 74.9 per cent of loans were to states and communes. By then, of 7,700 million marks held in securities, only 89 million represented goods in kind; the vast majority were paper. At the end of the war the total issue of Darlehenskassenscheine, 15,626 million marks, was ten times the original authorization of 1,500 million. But, because the Darlehenskassen relieved it of a major burden, particularly in the funding of local government, the Reichsbank had little interest in calling a halt to what was going on. Moreover, the Darlehenskassenscheine, although currency in practice, were still not legal issue, and thus helped disguise the real—as opposed to the theoretical— increase in total circulation.282