Financial Mobilization in the Great War, 1914-1916

Financial Mobilization in the Great War, 1914-1916

Overview

Before the outbreak of the Great War, a number of analysts predicted that European states would be unable to fund participation in a general European war for over a year. Consequently, any war would be short, and minor powers with less financial resources might be forced to leave early.

This prediction was almost completely wrong. While even the great powers had to resort to new financial expedients to fund the war, it was ultimately the mobilization of materiel, not money, that caused real bottle-necks. Nonetheless, the financial means that the great powers employed to raise funds for war drastically impacted their domestic economies and their post-war fiscal health. In certain cases, the credit-driven inflation of the war years caused social unrest; in others, war-time austerity had the effect of mobilizing political opposition. Particularly in the last three years of the war, states came under increasing fiscal strain, creating inflationary pressures in domestic economies and threatening the viability of the Gold Standard.

Great Britain

Great Britain entered the war with one of the healthiest financial balance sheets. Their debt-to-gdp ratio was a little under thirty percent, and their extensive colonial empire and London’s status as the financial capital of the world conferred a number of unique advantages. Nonetheless, Britain also had two key vulnerabilities: firstly, despite being on the gold standard, the Bank of England held relatively small gold reserves; secondly, the assets owned by the Central Powers in London would be called in in the event of a war, creating a run on this relatively small gold supply.

Through a number of moratoriums, bank holidays, and other financial expedients, Britain was able to avert financial catastrophe in the first three months of the war. Even as there was a local run on gold due to a micro-recession, British fiscal policy ensured that the extensive gold holdings in its Joint-Stock Banks did not leave the country. From a low of just under ten million sterling, the bank of England’s gold reserves reached 27 million sterling by the end of August, and a little over fifty million sterling by the end of the year. The commitment of the British treasury to maintaining convertibility - which the treasury believed was essential to financial solvency - would animate British financial policy throughout the first three years of the war.

As the de facto financier of the Entente, Britain had the job of financing the war effort of France, Russia, and Italy, and of coordinating the fiscal policy of the Entente as a whole. By serving as the frontman for other Entente powers (Russia in particular) in New York money markets, they were able to secure generous loans that would have been impossible for the more economically backwards Entente nations to negotiate on their own. However, by 1915, tensions between Britain and America had conspired to make it more difficult for Britain to raise money in New York, particularly when New York financiers believed that the credits would simply be loaned out to Russia.

The Alexandria Agreements of 1915 paved the way for a reduction in British-American enmity, and also led to a temporary alignment of American and British fiscal policy. As British imports of American goods soared to 163% of their levels in 1913, American financial firms, particularly those controlled by Morgan Stanley, began showing a pattern of subtle preference for British interests. The surge of American exports and American currency into Britain had the effect of devaluing the British pound vis-a-vis the American dollar, and also created inflationary pressures in the United States as gold bullion flowed into American coffers to make up Britain’s trade deficit.

For President Bryan, this was a salutary development: the consequences of the accumulation of gold reserves were not unlike those predicted by the “free silver” movement of the late 19th century. The money supply slowly expanded, and Debtors were able to repay their loans more easily, while the government was able to expand the money supply without fears of inflationary spirals. Unsurprisingly, Bryan encouraged the inflow of British gold and the spike in American exports. In this, he was supported by both the financial interests who lent money to Britain and the industrial firms that profited from British import orders.

This harmony between British and American fiscal strategy would not last. In 1916, American financiers began showing increased wariness toward the British government after the Polish offensive. Simultaneously, the deterioration of the pound led Britain to undertake extraordinary measures to prop up its value, employing a firm registered as a Bank of London affiliate to buy pounds with dollars in New York. President Bryan was in something of a bind, as it was the flow of Entente capital and import orders which had allowed American businesses to recover from the recession of 1913-1914. A complete collapse of the British pound due to British financial insolvency would likely lead to at least a temporary cutback in American exports, causing a recession just before a tightly contested presidential election.

Nonetheless, Bryan still wished for Britain to halt its attempts at currency manipulation. In February 1916, he instructed the treasury department to begin “giving the British their own medicine” by employing measures to artificially push down the price of the pound, causing its value to begin slowly depreciating against the dollar. In March, at the talks to renew the Alexandria Agreements, Anglo-American fiscal diplomacy became imbricated in blockade negotiations. Treasury Secretary Carter Glass leveraged the increasing British dependency on American loans and imports to impose a series of harsh terms on the British:

1. In exchange for America ceasing to manipulate British currency, Britain is to cease all efforts at currency manipulation if the exchange rate reaches above 1 pound for every 4.7 dollars (the exchange rate was currently at 1 pound per 4.67 dollars).
2. The cap on American exports to the Central Powers is to be raised by 85%.
3. At least 25% of all credit extended by America to Britain must be backed by gold.

In the short term, these agreements forced Britain to place more pressure on its allies to surrender their gold reserves so that the sterling-dollar exchange rate could be maintained. They also led Britain to fix the rate at which they bought gold from Australian and South African mining companies at a very low rate, alienating some of the business interests in the Dominions. In the medium term, they strengthened the hand of the Tories in the coalition government, who argued that the Liberals had been too conciliatory toward Bryan. Most importantly, they prompted the British government to turn away from American financing and toward domestic and imperial credit markets (and somewhat more tepidly, from American imports and toward Imperial autarky). The slow decoupling of the British market from the American one would have profound consequences for the relationship between the two countries.

Following the renewal of the Alexandria Agreements, British fiscal policy was faced with a series of dilemmas. The ambitious army expansion program had depressed domestic manufacturing capacity, forcing Britain to import weapons from America and increasing the need for foreign credit. It also reduced the tax base within Britain, depleting the availability of funds for the government. The series of defeats in early 1916 in Lille, Galicia, and Isonzo and the severity of the conditions imposed by Bryan both conspired to make low-interest loans more difficult to secure, and convinced the core of the Tory Party of the need to attain some measure of fiscal independence from America.

Britain was likely the only state which actually had the means of accomplishing this. It had the highest per capita income in the world, and unlike the other belligerent powers, it already had a well-established tax system which could tap into the country’s enormous wealth. The need for increased taxation was buttressed by the inflationary pressures that were being placed on Britain itself by the inevitable monetary overhang that comes with a shift to war production (too much money chasing too few goods).

In 1916, the British cabinet got to work on crafting a bill that would begin reducing Britain’s need for foreign credit. Income taxes would be raised and the tax base for income taxes, currently sitting at a little over 1 million of the 8 million eligible voters, broadened. A series of new import duties would cut back American imports, depress domestic consumption (and thus inflation), and raise money for the war effort. New bodies would be created and staffed to regulate and enforce the taxation of excess war profits.

Both Conservatives and Liberals were wary of specific provisions in the planned bill. Bonar Law did not wish to substantially raise the income tax, and was also apprehensive about any increase in the taxation on excess war profits. Lloyd George worried that a drastic hike in import duties would strengthen the anti-war left flank of his party and tarnish the image of the Liberals’ as advocates of free trade. He was also concerned that a turn toward protectionism might harm London’s global position in financial markets.

Yet even the most ambitious versions of the tax reform portion of the bill would not raise government revenues sufficiently to obviate the need for borrowing: most projections indicated that even a broadening of the income tax base and a sharp hike on top earners would still raise less than half the money required to pay for the war. Consequently, schemes to tap the domestic market for money gained new importance. The conservatives in particular wished to push for a series of regressive taxes that would empty the pockets of lower earners while pressuring the wealthy to invest in government bonds.

The British government had already issued two war loans, the first a series of five-year exchequer bonds all paying less than 4% interest, and the second a series of 5-30 pound bonds for small investors paying at a more attractive 4.75% rate. It was decided that the third loan included in the up-coming bill would be targeted to the wealthy population: an exchequer bond of 100 pounds at 5.75% interest, free of income tax and half of the “supertax” on high income earners, and repayable in 1944.

The 1916 War Revenue Act, passed in August, was less ambitious than it might have been without a coalition government, but it still represented the most significant expansion of British taxation in history. Largely at the insistence of the conservatives, the income tax base was expanded from those earning 130 or more per annum (already a reduction from the pre-war 160 per annum), to those making more than 100 per annum, more than doubling eligible tax-payers. The “supertax” on top earners was increased by 21%, a measure Conservatives begrudgingly agreed to because the hike was necessary to ensure the success of the new 5.75% bond. A series of new import taxes on tobacco, coffee, cocoa, chicory, dry fruits, sugar, and imported luxuries were introduced, and the excess profits tax was increased from 55% to 62%, with funds granted to the Inland Revenue department to create a new department dedicated to enforcing the tax on war-time profits.

Discussion of the consequences of the War Revenue Act must begin with the extraordinary success of the new 5.75% bond. Faced with the prospect of paying the new supertaxes, and re-assured by the broad increase in the income tax that war-time inflation would be suppressed, the wealthy purchased 4,942 million of the new bond, flushing the British Government with cash. There were costs to the bill: the influx of money to the Government quickly led to liquidity issues for private businesses, some of which began to gravitate into the camp of the anti-war liberals. The new bond also caused a general raising of interest rates. This was not necessarily an unintended consequence, but it did real harm to middle-class borrowers and small businesses. Conversely, it made domestic British money markets more competitive than American ones, attracting foreign buyers to British bonds but also making it more difficult for Britain to export its debt to American markets. Additionally, the bond had the effect of slightly raising the interest rate in America, further disincentivizing borrowing in New York.

Meanwhile, the new series of import taxes began to push down the amount of American imports to British Markets, easing pressure on British gold reserves and gradually strengthening the pound’s position against the dollar. They also represented a sharp tax hike on the lower and middle classes, and though the new customs taxes were deflationary on the whole, they did at least temporarily increase the price of many every-day goods. In conjunction with the broadening of the tax base, this represented a significant new burden on middle-class British consumers.

Politically, the act would have long consequences, strengthening the position of Haldane’s anti-war liberals and generating middle and lower class discontent with the coalition government. The strong deflationary effects of the bill made life more difficult for many borrowers, including, in the medium-term, the British government itself. Despite this, the bill did achieve many of its prime objectives: by the end of 1916, Britain was taking out around a third less new loans in America than it was at the beginning of the year.

Germany

In 1914, Germany’s financial apparatus was considerably less well-equipped than Britain’s to finance a long war. Unlike Britain, there were no income taxes, with Germany raising many of its funds through customs and other forms of indirect taxation that would be hard-hit in the event of a war. The power vested in individual states to set their own fiscal policy made a unified financial strategy onerous to coordinate. Additionally, Germany’s isolation from international markets would inevitably weaken German exports, causing problems in procuring foreign exchange, and ultimately in securing foreign credit.

Germany did have a system of war finance that was derived from its history as a bellicose continental European power. It possessed a reserve of 240 million gold marks, meant to pay for the cost of mobilization and the first months of warfare. The Reichsbank, technically a private entity but obligated to serve the needs of the state, was designated as the prime financier of any war effort. Studies by the army in the decade leading up to the war indicated that the cost of a European conflict would run far beyond past projections, leading the Reichsbank to expand its reserves and issue new twenty-mark and fifty-mark notes in 1907.

At the outbreak of the war, German banks were able to check a run on gold, and total gold reserves only fell from 1358 million marks to a little under 1,250 million marks. Commercial interest rates were raised to check further withdrawals, and gold reserves completely recovered by the end of August after German military successes. Recognizing its more precarious financial situation, the Reichstag suspended the convertibility of notes and treasury bills into gold for the duration of the war, trusting in the Reichsbank to sustain confidence in the Mark.

Darlehenskassen , or loan banks, were set up to ensure that private businesses and local governments had sufficient liquidity to make purchases without straining the Reichsbank. The Darlehenskassen were authorized to issue a distinct currency, Darlehenskassenschein , which were exchangeable for notes (though not for gold) at the Reichsbank. Although these notes were technically not legal tender, they came to effectively substitute for it in private markets, and provided a crucial prop for private businesses. They also undoubtedly contributed to currency inflation as German circulation of all money types (including the Darlehenskassenschein) rose by over 50% in the first three months of war.

Some progress was made before the war in instituting a more progressive system of taxation. With the Reich constantly wrangling with states in an attempt to impose more direct taxation, adjustments were made to indirect taxation in 1912-1913 and a progressive tax placed on capital gains to raise money to fund the armed services. Despite this, the power of the individual states had not been meaningfully challenged, and the system of indirect taxation was still highly regressive.

In early 1914, before the outbreak of the Great War, a three-year direct tax on property was passed to help fund an army expansion program, providing the government with a significant source of revenue. However, despite hopes that this tax could fund most war-time expenses, it quickly became clear that the army’s demands for money would not be met with the taxation instruments of the Reich government. On August 5th, the Reichstag approved a short-term credit of 5,500 million marks, to be secured on bills held in the Reichsbank. The German government itself already held a substantial amount of debt, and used budgetary maneuvers, such as the creation of an extra-ordinary budget and the rolling over of deficits, to obscure this.

Unlike in Britain, the German Parliament (the Reichstag) largely pawned off its responsibility to review German financial policy to the more conservative and oligarchic Bundesrat. One effect this had was a strengthening of their hand when there was a felt need to actually formulate new tax policy in 1915-1916. In 1916, the three-year property tax took in significantly less revenue as a consequence of the war-time shrinkage of the German economy, and the centrist and right-wing parties refused to renew it. The German secretary of the treasury, Karl Helfferich, proposed to tax any increases in war-time profits by 20% of their income. However, both inherited property and corporate profits were initially excluded.

The discord within the Social-Democratic Party at the time prevented them from exerting pressure to shape Helfferich’s bill, leading to a more regressive and less effective measure. The final version of the bill set a tax rate of 7% on 2% excess in profits, gradually rising to 25% on sums in excess of 15% of pre-war profits. Both individuals and private companies were originally exempt from the bill; in June 1916, private companies were included through an amendment, but individuals remained untouched by the law, meaning that it was strictly a tax on banks and businesses. The Reichsbank itself, however, was exempted from the law, allowing its private shareholders to continue extracting handsome profits from the war.

Extensive domestic borrowing and surprising successes in procuring foreign credit weakened the position of those who wanted a more extensive tax on war-time profits. Nonetheless, the measure itself was temporary, constituting a one-time levy on profits between 1914-1916. It improved the financial solvency of the government, especially in conjunction with the increased revenues from customs duties in 1916 as a consequence of the Alexandria agreements. It did not, however, offer a long-term solution to the inflationary pressures caused by borrowing and the Reich’s ballooning debt.

Internationally, the Mark’s position remained fairly steady throughout the first three years of the war. It was principally the trade deficit with neutrals which caused its value to depreciate by around half against the dollar and the florin. America’s neutrality in the war gave neutral markets increased leverage in resisting British pressure, particularly the Netherlands. By 1916, the increased flow of American imports to Germany and the depreciation of the German Mark had created the conditions necessary to incentivize the extension of American foreign credit. Kuhn Loeb, an affiliate of the Hanseatic Warburg family, began extending Germany hundred million dollar loans, and several smaller firms soon followed. Although the value of these loans was a fraction of those that went to the British, they did provide the German government with much needed foreign credit, and modestly reduced the inflationary effects of domestic borrowing.