How to pay for the war
If the battle against terrorism is protracted, the problem will soon be not how to stimulate domestic spending, but how to restrain it
I find slightly shocking how little the world of economics has adjusted to the destruction of the World Trade Center. Too much discussion has been in terms of marginal adjustments and too little about how to adapt to a world at war.
I hear debating points about why the right wing President George W Bush should be giving the US economy a bigger stimulus than centre left governments in Europe. Perhaps nobody has told the president that he is betraying the monetarism in which he is supposed to believe. I sometimes have the impression that few mainstream economists have ever met a real live Republican or Conservative.
On the economic right there is still a tendency to assume that this will be a minimal war over by Christmas and that we can soon get back to the game of sticking pinpricks into the government of Tony Blair - one of the few world leaders who has risen to the occasion.
We are told by the American president, defence secretary and generals that the struggle to make the earth inhabitable again for civilised people will be long drawn out and costly with no easy victory in sight. As two Brookings analysts remarked in Personal Viewpoint yesterday, an Afghanistan-first strategy should not be confused with an Afghanistan-only strategy. In any case, there will have to be large and expensive redeployment of military and domestic security expenditure on the part of the US and its allies. It will not be many moons before President Bush and Fed chairman Greenspan have to wrestle with the problem of withdrawing the financial injections they have already made.
The Afghan war is likely only to be the first phase of a much longer conflict where much of the action is likely to be a good deal nearer home than the North West Frontier. The war cannot be won if misplaced consideration for human rights prevents western governments from putting behind bars or deporting those who incite to murder for religious or ideological reasons at home or abroad. In the 19th century, Britain had a great tradition for welcoming refugees from oppression. These refugees were allowed to sit in the British Museum and formulate theories as revolutionary as they liked. But they were not allowed to incite assassination attempts on the Tsar, the Austrian or German emperors or the Turkish sultan - still less the British Prime Minister.
The attack of September 11 came at a time when obviously over-optimistic forecasts of world growth had been revised down several times in succession. The destruction of the World Trade Center was treated as just another shock to confidence; and there is now much learned discussion on whether we are likely to see (as if there were any doubt) a recession - and for how long recovery may be postponed.
History never repeats itself exactly. The last few weeks were not exactly like the Phoney War period of World War II between its declaration in September 1939 and the Battle of Britain in June 1940. The Phoney War came after several years of deficit-financed rearmament which Baldwin and Chamberlain had forced on a reluctant Treasury. By 1939-40, unemployment was falling, state borrowing was rising and prices were starting to creep upwards. In economic terms, the present is more comparable to 1938, which saw a short-lived recession mainly imported from the US.
It remains true that a prolonged and expensive war leads not to depressed demand but to inflationary overstretch. The problem of war economics is, not, how to stimulate domestic spending but how to keep it down to release resources for the war effort. Almost no prolonged conflict in history has been financed by taxes alone, with the possible exception of Hugh Gaitskells unfortunate attempt to finance in that way the Korean rearmament drive of 1950-51 which led to the resignation of Aneurin Bevan, the most flamboyant member of the Attlee government,
The art of war finance is how to borrow on the best possible terms without imposing an excessive burden on the post-war generation. This was the theme of Lord Keyness own How To Pay For the War (1940) and which his biographer Robert Skidelsky regards as arguably the quintessence of his achievement.
Keyness idea was that compulsory savings bonds should be issued which would be repaid later to offset the widely expected post-war slump. A vestige of this idea emerged from the Treasury in the form of post-war credits which were repaid over many years to taxpayers who reached pensionable age.
It has taken a long time for the message of the real Keynes - as distinct from the Keynesians - to percolate. Lyndon Johnson first tried to finance the Vietnam War on a guns plus butter basis, then very reluctantly persuaded Congress to raise taxes. But the Fed undid most of the good with an excessively lax monetary policy. The Gulf War of 1990 might have offset the pre-Clinton world recession. But because it was associated with a severe spike in the oil price it only gave the world one further period of stagflation (that is inflation plus recession) and contributed to knocking the UK out of the European Exchange Rate Mechanism.
In the UK today the question of war finance has been muddled up with the viability of Gordon Browns social spending plans. The UK Treasury rightly points out that the targets for budgetary balance are meant to cover a whole economic cycle and permit some deficits during a recession. The exceptionally rapid in spending in the 2000-3 spending cycle was originally meant to be a temporary bulge to offset several earlier years of low spending. But those who speak for public opinion will not tolerate a slowdown after 2003. So - war finance apart - some further increase in the tax burden is necessary to finance the schools, hospitals and transport improvements for which so many voices clamour.
Yet if the struggle to preserve freedom is as drawn out and expensive, this or any other government might both have to rein in some of its social ambitions and also find the most cost effective means of borrowing, not to fight a recession but to pay for military hardware and software.
The basic idea in World War II was to finance it at low interest rates - in wartime the normal function of interest rates in adjusting savings and investment, is in abeyance. This indeed would have worked out quite well but for the mishandling of post-war finance following the premature death of Keynes and the repeated downward plunge of government securities to the point where one of my predecessors, Harold Wincott, called them guilt-edged.
It remains an open question whether the trick can be pulled off a second time. The last decade of low inflation and sound finance might make low interest rate borrowing possible again. To this extent the insistence of Gordon Brown and his counterparts elsewhere that his budgetary rules - and central bank independence - are here to stay, should help. But the time for what Wordsworth called the nicely calculate lore of less or more is over. The game is for higher stakes.
