Sunday, May 10, 2020
Wartime lessons on deficits, debt and the role of the state
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

On Friday we marked 75 years since VE Day, and the end of the Second World War in Europe. Will we still be talking about this coronavirus crisis in 75 years’ time? Whether it becomes one of the great pandemics, in terms of the global death toll, remains to be seen, but if its economic effect is anything like the 14% fall in gross domestic product (GDP) this year sketched out by the Bank of England on Thursday, we will remember it for a very long time.

It could be, of course, that we are moving into an era in which very dramatic swings in GDP become the norm, as they were in the agricultural era, when harvests were all-important, though there is no good reason to think that. Normal service, in which annual changes in GDP are measured in low single-figure percentages, should be resumed in a year or so.

The Bank’s scenario, which according to its own database would represent the biggest fall in GDP since 1706 has had us scratching our heads. When the Office for Budget Responsibility (OBR) suggested a drop of just under 13% this year, the biggest since 1709, the year of the Great Frost, that was easy. But in 1706, the Act of Union (England and Scotland) was signed and there was the War of the Spanish Succession, but no obvious economic hit.

I shall leave that one for now but will return to the Bank later. However, as suggested by this weekend’s VE Day anniversary, it is another piece of history I wanted to draw on today. Now I know you are all pretty fed up of wartime analogies about the coronavirus crisis. And, to paraphrase a well-known political putdown, I didn’t know Winston Churchill and Boris Johnson is no Winston Churchill. There isn’t an obvious John Maynard Keynes around at the moment either.

But for somebody who grew up on Sunday afternoon black and white war films, the myth and reality of the Dambusters’ raids and had family members directly involved in some of the war’s great episodes, the Second World War has always been fascinating. And it is also fascinating that we are still finding out new things about it.

A new book from and the Centre for Economic Policy Research, The Economics of the Second World War: Seventy Five Years On, edited by Stephen Broadberry and Mark Harrison, provides fresh insights. There is a lot in it but, in the context of the current crisis, I wanted to highlight just a few points.

At a time when we are seeing the economy transformed, if only temporarily, the much bigger transformation in the 1939-45 period is worth dwelling on. As the chapter by Broadberry points out, the UK went from being a small-state economy in the pre-war period, with public spending accounting for roughly 15% of GDP, to a large-state economy, with government spending around 50% of GDP, as the war effort was cranked up.

Some of hat increase was funded by taxation, including an excess profits tax, a device that was also employed during WW1. Mostly, the government borrowed, mainly domestic long-term debt, which covered two-thirds of the debt, including patriotic savers, but also short-term borrowing and an expansion of the money supply. The country was also, of course, left with external debts at the end of the war, mainly to America and Canada. These debts were not fully paid off until 2006, more than 60 years after the war’s end.

The economy grew strongly in WW2, by 27% or nearly 5% a year, Broadberry points out, though within that, consumer spending dropped from a pre-war GDP share of 78.8%, to just 51.9% in 1943, a drop of more than a third in its share of GDP. Then as now, if now only temporarily, consumers were limited in what they could spend. The war effort was extraordinary. In another chapter, David Edgerton notes that the UK outproduced Germany in the war years in production of planes, warships and tanks.

What lessons can we draw from that period? There are three, I think. One is that, when governments do exceptional things, and the current economic intervention is exceptional, they have to know when to let go, to have an exit strategy. At the end of WW2, letting go proved to be hard for policymakers to do, even if they wanted to. Rationing remained in place until the summer of 1954.

A larger role for the state was also accepted. The private sector had not covered itself in glory in the 1930s and a state-run economy had won the war. So, as Broadberry puts it: “Britain may have learned the lessons of the war economy too well, with the state too ready to accept restrictions on the operation of market forces, with adverse effects on Britain’s post-war productivity performance.”

Second, the Treasury is worried about the debt consequences of the current crisis, but set against the situation at the end of the war, things would have to go very badly wrong to come close to that. The Office for Budget Responsibility looked at this recently. At the end of WW2 government debt was 270% of GDP but it then fell sharply, so that by the late 1970s it was below 50% of GDP.

Some of that fall reflected the demobilisation of the economy in the immediate aftermath of the war, reducing the number of people in the armed forces, and so on. There was also post-war austerity, albeit alongside a huge nationalisation programme. Mostly it reflected what is known as financial repression. The government was able to issue debt, gilt-edged securities, at interest rates below the rate of inflation. Exchange controls and limits on bank lending forced financial institutions to buy and hold government debt, even when the returns were negative in real terms. The effect was striking. In the 30 years after WW2 the economy expanded by more than 1,200% in cash terms. The cash value of government debt, in contrast, grew by only 137%, so it fell sharply relative to GDP. The interest on government debt is below inflation again now but there are plenty of other factors pushing the debt higher.

There is a third lesson to be drawn from the war. Economists were instrumental in the war effort. Some of the greatest names in economics were closely involved in developing the data, policies and planning framework that contributed significantly to victory. They included not just Keynes, but James Meade and Richard Stone, and economists like Wassily Leontief in America.

Economists have not been much involved in the decisions made during the current crisis, during which the government has insisted it is guided by the science, not the economics. Maybe, given the scale of the economic damage now unfolding, they should have been.