Updated November 11, 2016
Financing an Economic Mobilization
In my recent article on the urgent necessity for an economic mobilization, I put forward the principle that “any trajectory of economic development, which is feasible in physical, technological and human resource terms, can in principle be financed.” This assumes, of course, that the nation has a minimum of sovereignty over its own economic and financial affairs, or can restore it by suitable actions; so that the necessary steps will not be blocked by interference or pressure from outside.
There are well-documented historical examples for how economic mobilizations and analogous periods of rapid, state-promoted economic development have been financed in various nations in the past (see discussion below). These mobilizations have occurred under widely differing political, financial and economic circumstances, and utilized a variety of institutional arrangements and financial tools. It it is not necessary to invent anything fundamentally new. The basic principles and techniques for financing economic mobilizations have been established and demonstrated in practice – not perfectly, of course, but sufficiently well to serve as reference-points for what must be done today.
The financial tools which governments have used at various times in defense mobilizations and to promote rapid economic development in peacetime – e.g. large-scale state capital investment, deficit spending, special bond issues and other debt instruments, issuance of fiat currency, state-directed credit generation, dirigistic “channeling” of credit to specific sectors and projects, state control of central bank policy, massive monetary expansion, development banks, subsidies and special tax measures, tariff protection, price controls etc. etc. -- have been the subject of endless disputes among economists. These disputes often have the character of “religious wars”, with violent clashes between opposing ideologies and opposing interests. Amazingly, throughout this endless conflict, very little serious attention has been given to the physical economy!
Like all tools, these financing methods are neither good nor bad in and of themselves; everything depends on how they are used. If used wrongly, they can in fact lead to severe inflation, financial bubbles, mountains of unpayable debt and even sovereign defaults etc. The crucial problem lies in insuring a proper relationship between processes in the financial sphere, and processes in the real, physical economy. In order to do so, it is necessary to distinguish between those activities which are indispensible for maintaining and developing the productive potential of the economy -- agriculture, industry, physical infrastructure, necessary services such as health, education, scientific research etc. – and all the other sorts of activities going on in an economy.
The methodological problem is particularly obvious in the endless debates about the dangers of inflation or even hyperinflation. It is not surprising that economic mobilizations have always been connected with massive monetary expansions -- the creation of huge amounts of new money “out of nothing”. Everyone familiar with how the financial system works, knows money is constantly being created by banks through their lending activity, and that bank lending is the main source of money in a modern economy. Nevertheless, people who are used only to thinking in terms of their own private or company budgets, regard money-creation as a kind of “black magic” and are scared that it will inevitably lead to inflation. The irony of the present situation is that the quantity of money in the U.S. and Euro zone economies has grown dramatically since the 2009 crisis, and yet we are experiencing overall deflation!
The spectre of hyperinflation is routinely exploited by advocates of neoliberal policies as an argument against government use of money-creation (in various forms) in order to finance large-scale infrastructure projects and other measures for economic development. But the following should be intuitively obvious: If an economic mobilization is organized in such a way, that the real output of useful goods and services increases at a sufficient rate, in parallel with the expansion of the money supply, and if effective measures are taken to prevent bottlenecks and large mismatches between supply and demand in key areas of the economy, then the risk of inflation can be contained.
Unfortunately the various established schools of monetary theory, including the so-called classical Keynesian, monetarist and Austrian schools, basically ignore the reality of the physical economy. The parameters utilized in the various monetary theories -- aggregate supply, aggregate demand, economic output, GDP, real income etc. – reflect trends in the physical economy to a limited extent; but the relationship is greatly obscured by the fact that these parameters are defined in monetary terms, and make no rigorous distinction between productive and nonproductive, between the real economy and the “virtual economy” of financial markets.
Today, much of the growth in parameters such as aggregate supply and demand, GDP etc. comes from purely commercial activities, financial trading, real estate, advertizing and marketing; the entertainment, media and sport “industries”; things like gambling casinos, video game halls etc. Nevertheless, it has become a nearly universal practice to use GDP as the main criterion of success or failure of economic policies. As I note in my book, “GDP growth can go hand-in-hand with gigantic speculative bubbles and unsustainable investment booms; with the failure of governments to maintain and renew essential infrastructure, with widespread technological obsolescence and waste, a falling educational and cultural level of the general population etc.”
In the case of a nation mobilizing to defend itself under wartime conditions it would obviously be insane to use GDP growth as the main criterion for economic decision-making. The United States’ mobilization for World War II was not focussed on promoting GDP growth, but rather on expanding the entire productive apparatus needed to supply military hardware and other supplies needed for the war, including mining, transport and energy production, manufacturing, on manpower, on military R&D, plus supplying food and other essential goods to the population. Today we are in the middle of a gigantic economic and social crisis, in which many nations are fighting for their survival. Although the goals are very different, the situation is in many ways analogous to fighting a war; it requires mobilizing the productive resources of the country in a systematic way. Accordingly, it is time to forget the GDP and focus instead on the physical economy!
In the era of hegemony of neoliberal policies – which I believe is coming to an end – we have been accustomed to hearing ideological arguments against any state intervention into the economy. Keynesian and post-Keynesian macroeconomists generally support the use of monetary expansion, government spending etc. to stimulate an economy, but in that context they rarely think in terms of the physical economy. Recently, for example, it has become fashionable for Keynesian-leaning economists to propose gigantic state investments in the “Green Economy” as a way to promote growth. In doing so they ignore the fact that policies favored by environmentalists, such as eliminating modern agricultural methods or building tens of thousands of wind turbines, can destroy the productivity of the physical economy, increasing the real, physical cost of producing energy, food and other commodities . Financing “anti-productive” projects may generate impressive GDP growth for a while, but if continued it will sooner or later lead to disaster.
Leaving ideologies aside, it is useless to debate about the beneficial or harmful effects of various financing measures without a thorough analysis of the physical economy, and without specifying how exactly the financing tools are going to be used in a given scenario. The latter impact cannot be determined within the financial realm per se; rather, it depends on the interaction between financial-monetary processes, and those of the real economy. It also depends also on subjective factors, which operate completely differently in a situation of national mobilization, than according to behavioral models used in monetary theories. Contrary to the theories of von Neumann and Nash, real economics is not a game!
There are a number of well-documented cases of how economic mobilizations have been financed in the past. They should be studied carefully, not as models to be followed in a mechanistic way, but rather because they provide many valuable lessons for the design of policies today. Among the most useful, from my standpoint, are the WWII mobilization in the U.S., the postwar economic mobilizations (“economic miracles”) in Japan, West Germany and France, and more recently the investment-led economic boom in China in the 1980s and 1990s.
Here are a few examples of points which deserve attention:
1. At the very outset of the U.S. mobilization, the Federal Reserve Bank and the Treasury Department pledged to closely cooperate in financing the war effort, and declared that the mobilization would not be hindered by lack of money. This is significant since the Federal Reserve is intended normally to operate independently from government influence, like the central banks in most countries today. The U.S. did not nationalize the Federal Reserve, but during the war it acted in many ways like a state-owned national bank.
2. U.S. money supply (as measured in bank deposits and currency held by individuals and businesses) grew exponentially during the period of the war, more than doubling in the five years from 1941 to 1945.
3. The expenditures of the U.S. government grew by ten times between 1941 and 1945. Total expenditures in the period 1941-1945 amounted to the equivalent of roughly $4.2 trillion as measured in 2016 dollars, of which $3.7 trillion were directly connected with the war. Of this, about 45% was covered by taxes and other non-debt income of the state, and the remaining 55% was financed by the sale of government bonds.
4. The spectacular increase in the real physical output of the American economy during the war was accomplished to a large extent by a combination of government purchases, government investments and – extremely important! – the issuance of large amounts of low-interest, government-guaranteed loans via the private banking system to key sectors of the economy. By a variety of means, the government exercised a large degree of control over the flow of credit, channeling it according to the needs of the physical economy. Particularly important was the granting of government loan guarantees to selected sectors of industry. At the same time, the Federal Reserve Bank implimented various measures to discourage consumer loans and other non-productive uses of credit.
5. A series of huge media propaganda campaigns was launched by the government and the Federal Reserve, to induce private citizens to invest income and savings in war bonds. The bond marketing effort mobilized the patriotic sentiment of the population, and was aided by the rationing and restrictions on purchasing of consumer goods, which made it hard for people to spend their whole income. The amount of excess income was increased by the fact that larger part of the population (including previously unemployed or marginally-employed persons) was recruited into higher-paying industrial jobs, compared to employment in the pre-war period.
6. As the war effort continued, the financing requirements grew in an explosive manner. The Federal Reserve Bank was authorized by Congress, to purchase government bonds directly from the Treasury Department, which is the issuer of U.S. government bonds. This practice was essentially equivalent to printing money and giving it to the government to spend! The only difference was a nominal indebtedness of the government to its own central bank, which existed only on paper and could be maintained indefinitely or even cancelled in the future. As it turned out, only a small part of the war effort was financed by this mechanism. It provided an option that could have been expanded if circumstances demanded; but up to the end of the war most of the funds were raised from taxes and the sale of bonds.
7. Inflation was contained by a variety of direct and indirect means. The direct measures included wage and price controls, rationing of certain commodities, and restrictions placed on the issuance of consumer credit. The main anti-inflationary factor, however, was certainly the enormous growth of output and productivity, achieved by the economic mobilization. Extremely important is the fact that this growth was not limited to the realm of military production, but embraced most of the other industrial and agricultural sectors. Despite limitations on consumer consumption, the real incomes and overall living standards of the population improved substantially during the war.
8. The rapid growth in agricultural and industrial productivity – especially the productivity of labor – was catalyzed by deliberate policies to encourage and help finance the introduction of new technologies and other innovative techniques in production.
9. All of this was made possible by the burst of patriotic feeling, enthusiasm and optimism which accompanied the war mobilization. The U.S. entry into the war totally transformed the atmosphere of demoralization and pessimism, unleashed by the Great Depression of the 1930s, and which had persisted despite the recovery measures of the New Deal. The active engagement of the population in the well-organized economic mobilization, together with the passionate leadership provided by President Roosevelt and other public figures, provided sense of moral purpose and encouraged trust in their government.
10. The effectiveness of the U.S. economic mobilization in World War II is proven by the economic boom which followed the end of the war. Instead of being exhausted by the huge war effort, the United States entered a period of unprecedented prosperity and physical-economic development which continued into the 1970s. The additional burden of government debt which had accumulated during the war, was essentially “marginalized” by the economic boom and resulting growth of government income in the postwar period.
11. The postwar boom did not occur automatically, but was facilitated by a series of government policies and measures which were prepared already before the end of the war. Already in 1944, plans began to be worked out for converting the U.S. industry from war production into civilian production. This applied especially to the automotive sector, which had been key to the war effort, and subsequently became a motor for the postwar boom. Another very important measure was the G.I. Bill, signed into law already before the end of the war, which provided government financial support for returning U.S. soldiers to attend colleges, universities and job training centers. More than half of the returning veterans from World War II took advantage of this support, generating a new “army” of scientists, engineers, teachers, doctors and other skilled professionals. Another key factor was the massive government support for fundamental and applied scientific research, which had played a crucial role in the war – in the development of radar, nuclear energy, electronics, computing machines, aerospace technology etc. -- , and was expanded into a vast apparatus of “Big Science” after the war. I discuss these and other measures in detail in my book.
12. In many ways one can say the government-promoted economic mobilization of the United States did not stop at the end of the war, but continued in another form in the 1950s and 1960s. This fact is relevant to the question: To what extent do the methods which were used in the U.S. mobilization in World War II, apply to an economic mobilization in peacetime -- when the purpose is economic development rather than war-fighting and the political environment is very different? I am convinced that the relevance much greater than it might seem to be at first glance, for various reasons: The basic economic and political system of the U.S. was not changed during the war. Although the military strategy and foreign policy decisions of President Roosevelt received overwhelming support from the population and both political parties, economic and financial measures were hotly debated, and frequently had to be changed as a result of opposition in Congress.There was no “command economy”, no massive nationalization of industry and banking. Financial and commodity markets continued to function, although with substantial government intervention and regulation. Through a variety of instruments the government steered the economy along a desired trajectory. But the spectacular expansion of production was carried out nearly entirely by private enterprises, and benefitted from a large amount of decentralized decision-making, problem-solving and innovation. The private banking system provided a large part of the loans to industry.
13. The methods and instruments utilized by the governments Japan, West Germany and France to launch the “economic miracles” of the postwar period, are in many ways analogous to those used by the U.S., but under very different economic and political conditions, and within very different institutional frameworks. The same applies to China in the post-reform period. A most striking common feature is the systematic “channeling” of low-interest credit into productive sectors of the economy, and massive support for the dissemination of new technologies throughout the economy. Another common feature is large government spending -- not in the indiscriminant “Keynesian” mode, but to promote specific areas such as strategic industries, infrastructure, high-technology research and development, higher education etc. In all four cases equity funding (e.g. sales of ownership shares) played only a minor role.
14. In Japan the economical mobilization was financed on the basis of a close cooperation between the Ministry of International Trade and Industry (MITI), the Ministry of Finance and the Bank of Japan. As I wrote in my book, “The huge flow of credit provided to industry by Japanese banks was made possible by banks borrowing directly from the Bank of Japan, and relending the money preferentially to sectors that had been identified as priority sectors by the Japanese planners, according to the principle of ‘window guidance’. Interest rates were rigidly controlled. Meanwhile, the rapidly growing tax base allowed the government to finance most of its investments internally, without incurring external debt.” China followed Japan’s example in many respects, except with a much larger share of state ownership in the productive sectors. Most notable is the role of state-owned “policy banks”, especially the China Development Bank. (The example of China is discussed in a separate chapter of my book.)
15. In France the postwar economic mobilization was directed by the famous “Commissariat général du Plan”, in a succession of five-year plans spanning the period 1946-1975. The mobilization had the long-term goal of transforming France into a highly developed and technologically advanced economy. In my book I write: “This was achieved not only by large-scale state investments (amounting to about 30% of all investments in the country), but also by a policy called “the nationalization of credit”. From the outset the French state organized a network of public and private institutions and supervisory agencies that would guarantee the flow of sufficient credit to finance the national economic and social priorities set by the plan. The priority was long-term credits, otherwise known as ‘investment credit’, as opposed to short-term credit. As part of this policy, the central bank (Banque de France) and the four major commercial banks were nationalized in December 1945. The majority of banks remained private, but operated in an environment that was strongly shaped by the policies of the Banque de France and other government agencies.”
16. The case of West Germany the story is more complicated, shaped much more by external factors -- especially the United States. It began under emergency conditions of a nation devastated by war, occupied by foreign armies and subjected to an initial period to a policy of deindustrialization (the Morgenthau Plan). This changed only at the end of the 1940s when the U.S. launched a systematic policy for developing a strong Western Europe in the face of the growing Cold War. West Germany was crucial, among other things, as the main source of capital goods for European development. A leading role in the West Germany’s ensuing “economic miracle” was played by a state-owned bank: the Kreditanstalt für Wiederaufbau (KfW) (Reconstruction Credit Institute), founded in 1948. The KfW channeled funds provided by the U.S. Marshall Plan into the West German economy in the form of low-interest loans, mainly for housing construction, industry, infrastructure and mining, and later for the promotion of exports. As the West German economy picked up steam, the KfW shifted its priority to supporting the so-called “Mittelstand” – the small and medium-sized enterprises which are the secret of Germany’s economic strength – with special attention to suppliers of precision machine tools and other modern production equipment. Many new Mittelstand companies were created with support by the KfW. The bulk of the Mittelstand financing, however, was accomplished in a decentralized way, via the close partnership between Mittelstand enterprises and private banks (Hausbanken). Another important factor was large-scale state funding of specific high-technology areas, exemplified by the famous “Atomministerium” – the government agency which systematically funded and managed the buildup of West Germany’s capabilities in the area of nuclear energy.
17. Finally, it is well-known that earnings from exports played a crucial role in the “economic miracles” of West Germany, Japan and more recently China. In contrast to the case of many so-called developing countries, these exports consisted nearly 100% of manufactured goods.