War and Inflation: The Monetary Process and Implications

0:00As Bert said, I'm going to be talking about war and its connection with inflation. Wars have invariably been financed by printing money since the invention of paper money. Indeed, it might be said that paper fiat money and central banks were invented mainly to finance wars. The first irredeemable paper currency in the Western world was issued in 1690 by the British colony of Massachusetts in order to pay its soldiers in its sporadic wars of plunder against the French colony of Quebec. The first central bank in history, the Bank of England, was established in 1694 to finance the mercantilist and imperialist foreign policy of the Whig Party that had gained control of the British government. In order to explain the seemingly inherent propensity of governments to finance war by monetary inflation, it is necessary to clearly comprehend the true nature of war.

0:50This is not an easy task because commentaries on war, stretching back more than two millennia to the Peloponnesian Wars have enshrouded the fundamental causes and implications of wars in an almost impenetrable fog of myths, fallacies and lies. Most significantly, war is portrayed as the inevitable outcome of complex historical forces and circumstances beyond the control of its human participants. Fortunately, there exists a well-developed of Science of Human Action which encompasses economics. This science is sometimes referred to as praxeology and allows us to analyze and dispel this mythology of war.

1:36The basic conclusion of this science is that war is the objective outcome of the human endeavor to make war. As a human activity like any other, war making is a product of reason, purpose, and choice. The praxeological analysis of war takes into account the goals of the war makers and the means at their disposal, the benefits they anticipate from the war, and the costs they expect to incur in executing it. It also distinguishes between the beneficiaries and the victims of the war, who may coexist in the same territory controlled by an organization of war makers, which is historically almost always a national government. Given that war makers are national governments, which are are non-productive organizations by nature. The resources needed to wage war must be extracted from producers.

2:26Economics demonstrates who bears the losses of real wealth and income seized by the war-makers and the means the war-makers use to conceal these losses from their victims. And this will be my theme. Waging war requires that scarce resources previously devoted to producing consumer and and Capital Goods be diverted to producing tanks, missiles, fighter jets, and other war goods. And to give you an example of a modern war and what needs to be produced during a modern war, in World War II, from 1940 to 1945, there were produced 86,000 tanks, this is the United States, States, 297,000 airplanes, 17,400,000 rifles, carbines and sidearms, 315,000 pieces of field artillery and mortars, 4,200,000 tons of artillery shells, 41,400,000,000 rounds of small arms ammunition, 64,000 landing vessels, 6,500 other naval ships, 5,400 cargo ships and transports and vast amounts of other munitions, which means that all of these things displace resources or require resources that would have produced consumer goods and capital goods.

3:47So in addition to all of this, part of the labor force formerly employed in consumer and capital goods industries must be shifted into the armed forces, where they must continue to be fed, clothed and sheltered, as well as equipped with the armaments I mentioned. This means that non-specific resources, resources like labor and capital goods, such as steel, electric power and means of transportation that have many different uses, must be reallocated to production for military purposes. The inevitable result of this reduction of the civilian labor force and the conversion of a substantial amount of labor and capital to the manufacture of military hardware is is a greater scarcity of consumer goods, and therefore lowered real wages and living standards.

4:33Okay, so as we'll see, war definitely does not breed prosperity. Okay. However, the transition to a war economy requires more than the horizontal shift of resources involved in substituting military production for the production of peacetime consumer goods. A war economy also entails a vertical shift of resources In other words, the production and maintenance of capital goods that are destined to satisfy consumer demands in the future are drastically curtailed in order to expand the supply of military goods for immediate use in warfare. Warfare. In effect, tanks, missiles, field rations and uniforms are substituted for the repair and renewal of industrial plant and equipment necessary to maintain the future flow of consumer goods.

5:24In stark terms, the war economy literally consumes society's capital stock, apart from any physical destruction the war itself may cause. Stocks of raw materials and semi-finished products, which constitute a large portion of the economy's capital stock, are used First up and never replaced, the steel mills and power plants are run at maximum capacity and undergo progressive deterioration because the manpower machinery previously devoted to making repairs and manufacturing spare parts are now at work churning out the present goods consumed by those waging war. Since real wages are determined by the amount of capital per worker in the economy, the civilian labor force and their dependents become progressively Let me turn to financing a war. Modern governments that rule over market societies have at their disposal three methods for financing war. Taxation, borrowing from the public, and creating new money. They may also resort to the pre-modern practice of coercively requisitioning In the modern world, this really just works with labor services.

6:40If you try to just seize the resources that you need without paying for them, that destroys the incentive for private firms and so on, to continue to produce such things. In the wars of the last two centuries, a combination of these three methods has generally been important in the history of the United States, and in the history of the United States of America, The creation of these three methods has generally been employed to bring about the large-scale transfer of resources from civilian to military uses. From the point of view of technical economic theory, however, it is no more difficult for government to squeeze a given quantity of goods out of the private economy entirely by taxing than it is to acquire these same goods by combining taxation with creating money and borrowing.

7:29Why is it, then, if strictly fiscal measures, that is, taxing, would always yield sufficient revenues to pay market prices for the resources needed to wage war, that belligerent governments have almost always resorted to deficit spending, printing money and directly commandeering commodities and services? The answer to this question lies in the fact that modern war is an extremely costly enterprise that imposes severe losses of real income and wealth on the civilian population, the victims of the war makers. Taxation makes these losses immediately evident to those who must endure them. In contrast, deficit spending financed by money and the drafting of men into the military at below market wages Each in their own way contributes to concealing these losses from the civilian population by distorting monetary calculation and postponing the day of true reckoning of the losses of war.

8:26When the public is accurately informed about the full costs they bear, war becomes increasingly unpopular. This even happened in World War II in the United States after 1943 or so. Civilian enthusiasm and labor efforts weighing in unrest and even resistance may result on the home front and spread to the front lines. As Mises wrote in 1919, in every great, and I'm quoting him, 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.

9:17War weariness would set in much earlier." More recently, the libertarian historian, economic historian Robert Higgs, pointed out a similar rationale for governments to partially substitute an inflationary command and control economy for the regular fiscal mechanism of taxation during wartime and other national emergencies. Quoting Professor Higgs, Obviously all 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, money costs.

10:05Not only can each individual count them in his own tax bill, they can easily be aggregated for the whole society through government's total tax revenue. It behooves the 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." Let me talk now about financing war by taxation. Thus, the creation of new money has become the preferred method for government to hide the losses of income and wealth from its citizens. These losses are particularly visible at the outbreak of a war when higher taxes are employed to finance it.

10:53Ratcheting up taxes to confiscatory levels not only depresses current income and living standards but also brings about a crisis in which financial markets plummet and the real economy is plunged into a recession. What we might call a war mobilization crisis occurs for three reasons when war is financed by taxation. First, in order to pay for their increased tax liabilities, citizens cut back on their saving as well as their present consumption. However, because the increase in taxes depresses their current incomes and Living Standards, the taxpayers sharply increase their time preferences, meaning that they become much less willing to postpone their consumption from the immediate to the more or less remote future, okay?

11:38So people tend to give less care to the future during more time. And this is a direct result of the heavy cost that they bear. As a result, aggregate saving falls proportionally more than spending on present consumption. This disproportionate effect of increased taxation on saving is aggravated by a second factor. The rise in tax rates on interest income lowers the net interest return on saving, meaning that the consumer can now expect to receive fewer dollars of future consumption for every dollar of present consumption sacrificed. The worsened terms of trade between present and future goods encourages the taxpayer to escape the tax by further increasing consumption and decreasing saving for future consumption. Finally, on the spending side, the additional tax The tax revenues extracted by the war makers from the private economy, some of which would have been saved, are almost all spent on present goods for military operations and to sustain the domestic war bureaucracy.

12:36So basically there's a tremendous decline in saving and a big increase in consumption both for war and civilian purposes during wartime. And this has a very deleterious effect on our capital stock. Overall then, war taxation induces a general rise in time preferences, which is reflected in the aggregate, an increase in the aggregate amount of consumption compared to saving. The resulting decline in the supply of savings drives up interest rates and chokes off business investment in capital goods. There is an abrupt and radical shift of expenditure flows from industries providing for the maintenance, repair and replacement of capital goods to industries producing present military and consumer goods. The precipitous decline in the demand for capital goods drives some firms out of business and forces others to abandon new investment projects and to severely contract their operations and labor forces.

13:30This is especially true of firms producing durable capital goods or inputs into these goods. The other side of the coin is a vast expansion of the demand for present goods and high prices and profits for firms manufacturing armaments and other goods for military consumption. Capital consumption and a retrogressing economy are the outcome of this rapid and unanticipated readjustment of the economy's production structure towards present consumption on a scale required by modern war. The consumption of capital is manifested in abandoned factories, machineries, mines and commercial building sites that were originally constructed to provide consumer goods in the future and that cannot be easily converted into immediate military uses. The reason is that the complementary labor, energy and raw materials are no longer available at prices that make the continued use of these capital goods profitable.

14:24They're now being used and being paid much higher prices to produce armaments and so on. This destruction of capital, and again it's not a physical destruction, is caused by the transition to a war economy. And results in a retrogressing economy, meaning an economy that becomes poorer and poorer, that features falling labor productivity and real wages. and also business losses, aggregate business losses for the entire economy. It's really only the munitions makers that are making money and other consumer goods industries. So in any case, this war mobilization crisis is quickly and clearly revealed to a panicked public by monetary calculation as interest rates skyrocket and the price of the financial assets collapse. The quick reaction of financial markets stems from the fact that stocks and bonds are prorated shares of ownership to existing complementary capital goods, which we call business firms.

15:19The decrease in the prices of existing capital goods therefore coincides with a fall in the value of firms, especially those producing durable capital goods. These capital losses are in turn imputed to the titles of ownership to these firms. Basically, they're stocks and bonds. The collapse of the financial markets is also accompanied by a depreciation of real estate because commercial and industrial construction and land sites represent particularly durable resources whose capital values are extremely sensitive to the higher discount on future goods. Now, the government can also try to replace taxation by borrowing from the public without inflation. When the government tries to borrow, when it substitutes borrowing from the public for higher tax levies, it only makes the crisis worse.

16:07The reason is straightforward. Raising war revenues through taxation falls on both consumption and saving, although it does disproportionately burden saving. In contrast, government borrowing directly and specifically taps saving. When selling its securities, the government competes with business for the public saved funds, and because it is capable of bidding up the interest rate, it is willing to pay to practically any level, the government can obtain all the funds it desires. By thus crowding out private business investment, government borrowing ensures that the entire burden of adjustment to a war economy is borne solely by the capital goods industries. This method of war finance therefore results in an even greater consumption of capital and a more severe crisis than tax financing.

16:54Now let me give you some examples of these crises I've been talking about. Historically, even the prospect of enormous government borrowing for war has caused financial crises. For example, on the eve of World War I between July 23rd and July 31st, 1914 and before any of the soon to be belligerent states had gone off the gold standard, panic selling forced the closing of all major stock exchanges from St. Petersburg in Vienna to Toronto in New York. This event was primarily response to expectations of heavy government borrowing to finance war mobilization under the non-inflationary conditions of the gold standard. In other words, people didn't realize at the time that all governments would go off the gold standard and begin to use paper money to finance the war. European governments swiftly responded to the crisis by imposing debt moratoria, allowing people not to have to pay off their debts, especially banks, and advancing inflationary bank credit.

17:48The war mobilization crisis also roiled U.S. financial markets leading up to and during World War II. Using Robert Higgs' calculations, the transition to the war economy involved a heavy dose of capital consumption, as real private gross investment in the U.S. economy fell by 64% between 1941 and 1943. During the four years of the war, it never exceeded 55% of the 1941 level. As we would expect, consumption also declined to make room for military production, but by considerably less than investment. and Investment. From 1941 to 1943, per capita consumption declined by 6%. By 1945, it was still 1.7% below the 1941 level. Now, this massive readjustment in the U.S. economy towards the production of present military goods was manifested in the stock market. You can remember we were coming out of a depression, or we were still in a depression at the start of the war. So, stock prices were still very low. From 1939 to 1942, the Standard and Poor's The market value of all stocks on registered stock exchanges during the same period fell by a whopping 62 percent, and in 1944 still remained 14 percent below the 1939 level.

19:09Okay, now let me get to financing the war, the reasons for financing war by money creation. As I noted above, regardless of the fiscal technique or combination of techniques, borrowing, taxation, and so on, economic calculation immediately reveals the enormous consumption of real wealth and income that is entailed in mobilizing for a large-scale war. People recognize right away falling stock market, huge business losses, and so on. However, economic calculation can be distorted and the crisis postponed by creating money to pay for the war. This is why governments regularly resort to this device to finance a large proportion of war expenditures. One of the main reasons why inflation distorts monetary calculation is because business accounting assumes a stability of the value of money, which never exists in reality.

19:57However, under the classical gold standard before 1914, fluctuations in the purchasing power of money were minor and could be ignored without falsifying business calculations of revenue, cost, profit and loss. These calculations guided entrepreneurs under the gold standard in allocating resources to their most valuable uses and permitted them to build up a mighty and complex structure of capital goods that was bequeathed to the 20th century. However, when government operating through a modern central bank significantly expands the money supply to pay for a war or for any other purpose, it causes a large decrease in the value of money that is reflected in an overall rise in prices. However, this rise in prices does not occur instantaneously or evenly.

20:44In fact, it involves a time-consuming process in which prices rise at different times and varying degrees. During this inflation adjustment process, there also occurs a distortion of relative prices, especially the interest rate, which is the ratio of prices between present and future goods. Both effects, the delayed change in the value of money and the distorting of the interest rate, serve to falsify calculations of profits and losses and conceal the process of capital consumption during its early stages. And let me just explain briefly why. The artificial decrease in the interest rate that occurs when the Fed purchases through open market operations, government securities, it pushes down interest rates.

21:29And what that does is it keeps or maintains the price of capital goods at the same old high level. Also it prevents stocks and bonds from falling. And even increases the stock market as prices go up. Secondly, as the money supply increases, as I said, the price of consumer goods and military goods in particular shoot up, because most of the new money is spent on them.

22:26Business people through accounting techniques have only set aside a mere fraction of what it's going to cost to replace capital. In this way, there's been capital consumption, which has made the economy much poorer. Now, it takes five or six years, or three or four years, whatever it is, to recognize that when you have monetary inflation. At the outset of a war that's financed simply by taxation, everyone would see the collapse in the stock market, losses, bankruptcies of businesses right away. away, and the war would be much shorter. So because of monetary inflation, war appears to cause universal prosperity. The crisis in capital consumption only appears much later when capital goods have to be replaced at much higher costs.

23:12What I want to convey to you now is how three major wars were financed. Okay, let's start with World War II. The current expenditure on this war varies. It was between $250 billion to $380 billion in 1940, which is a couple of trillion dollars today. It was an extremely expensive war. 40% was financed by taxation. The other 60% was split between non-inflationary borrowing, about 35%, and 25% was through money creation. What about the war in Vietnam? The total budgetary cost of the war in Vietnam, again it varies, is somewhere between 112 billion to 155 billion.

24:01So I took 140 billion as a nice round figure. There was a total budget deficit, so it's 140 billion in 1965. The total budget deficits from 1965 to 1973 were about 70 billion, about exactly half the cost of the war. Taxation, therefore, paid for about 50% of the Vietnam War. Non-inflationary borrowing paid for 21% and money creation paid for over a quarter again, 27%. What about the Iraqi War? This is an interesting war because almost none of it has been paid for through taxation. Zero. And let me explain why. Total budgetary cost of the war, which you can find on something called the National Priorities NPP internet site, and it shows you the dollars clicking off.

24:58So when I looked yesterday, it was up to $314.8 billion that the incremental cost of the Iraqi war has cost us. The total budget deficit from 2003 when the war started until the second, through the second quarter of 2006, okay now so remember the Iraqi war is about $314 billion, was over $1 trillion, okay, was $1,195 billion. But the change in debt held by foreign and international agencies and individuals was $802 billion. So most of the debt, probably about 75% of the debt to finance these deficits has been purchased by foreigners, which is more than twice the cost of the war.

25:50This is why taxes haven't gone up. Foreigners have paid for this war. But money creation has also been paid for proportion of the war. And I estimated money creation has paid for about 43% of the war, non-inflationary borrowing has paid for 56% of the war, taxes have paid for nothing, and of the non-inflationary borrowing, 100% has been paid, more than 100% has been paid by foreign lenders. So we're not seeing the cost of the war yet here in the U.S. in the U.S. And thus we don't have much of a widespread resistance or reaction to the war. Do I have a minute or two more before questions? I was thinking about, over the summer I've been thinking about writing a short book on war in which we apply praxeology, which is we apply to economics and Austrian economics, But applying it to war, and one thing I was thinking about was how do you choke or how do you bring a stop to war in a peaceful manner?

26:55Can we say anything that's economically valid, that's absolutely true? I think you really can. The communist revolutionary dictator Vladimir Lenin once said that all wars between nations must be turned into a class war. There's a lesson to be learned there by libertarians. As libertarians we have to say all wars must be turned into, all imperialist wars, because that's what we're fighting these days, must be turned into a war between the ruling elites, that is the tax consumers and the war makers, and the productive class who pay taxes and suffer the depreciation of their real wages and cash holdings by inflation. What are some of the ways then, so we have to strike at the means by which the war makers can wage their wars.

27:41And how do we do that? One way is a good old general strike, okay? Since we have withholding, there's no way to have a tax revolt. However, we can indirectly choke off taxes by going on strike, not going to work, okay? Now, this would give large businesses and corporations an incentive to be against the war, as they saw their profits plummeting and so on, as middle-class productive people stayed out of work, okay? So, it wouldn't be the state versus small individuals. You would now have a class of corporations in the middle, many of them with an incentive to put pressure on government to bring an end to the war. Secondly, middle class people could turn to a cash-only economy, that's easy.

28:26Everyone should take all their money out of their checking accounts, savings deposits, certificates of deposit. In that way, the banking system would grind to a halt. It is true that all the deposits are insured, even though only 10% of your checking deposits are held and 0% or half a percent of your savings deposits are held. It would take a while for the banks to pay all the depositors off, but the government could no longer use a banking system where it would be disrupted to finance the war. Also, of course, to the extent that you can, selling off of government bonds. Boycott the government post office and then that welfare program. They use only email and so on. And finally, setting up alternative people's tribunals of the natural elites, the productive people in society, people who have good reputations, people like Bill Gates and people like that, and to try, in absentia, the ruling cast members, that is, the people who are making the wars and who are committing treason to the U.S. Constitution.

29:34I'll end here. Thank you.