Michael Brandl is a senior lecturer in the Department of Finance in the McCombs School of Business. His article was featured in the McCombs Today blog.
I was having a lunchtime chat the other day when the conversation turned to one of my favorite topics: economic history. Eugene Sepulveda and I were discussing the size and impact of the current government budget deficit. Eugene asked me: How did we deal with all of the government borrowing during World War II?
Well, that generation — which Tom Brokaw correctly described as the “Greatest Generation” — actually thought about how to finance what it was going to spend before they did it. Think before you spend — what a concept!
Watch a video of Brandl explaining economics as the study of people and society.
Basically, the leaders of the time realized that in order to finance a large increase in government spending, you can basically do three things:
- Raise taxes
- Have government borrow money from the public by issuing bonds
- Print money for the government to spend
During the Civil War we did No. 3, and it was a disaster. The issuing of Green Backs to fund the Civil War led to a financial collapse as the money supply skyrocketed.
Financing World War I
Learning from the mistake in financing World War I, we did a combination of No. 1 and No. 2. Taxes were raised, and the government issued Liberty Bonds. The Liberty Bonds were basically 30-year, tax-free bonds that appealed to people’s patriotism.
But, since a large amount of the bonds were financed by an expansionary monetary policy, the result was rapid inflation. The annual inflation rates were about 17 percent during World War I and about 15 percent until a severe recession hit in 1921.
Financing World War II
When the “Greatest Generation” set out to finance World War II, it took a cue from history. It knew it had to do No. 1 (raise taxes) and No. 2 (sell bonds), but without trigger inflation. How on earth would they do that?
The answer came from John Maynard Keynes. Writing in 1940 in a pamphlet aptly titled “How to Finance the War,” Keynes argued that in order to keep inflation under control, rationing should be used for essential products. He also argued for wage and price controls to be applied to key industries to keep prices (and especially wages) from going up. The idea was to keep aggregate demand from increasing — or in English, to keep spending down so prices didn’t go shooting upward.
Keynes also argued for high progressive income tax rates. His argument was that the rich could benefit from war production so thus they should help pay for the cost of the war. He also argued that the high tax rates would keep the rich from spending and thus also help control inflation.
Continuing reading Brandl’s thoughts on the financing of World War II and what the past tells us about our future.