How do governments pay for wars?

Russia’s invasion of Ukraine has led to a sharp rise in defence spending writes John Paul Rathbone in the FT

Next April, for the first time in more than three centuries, Danes will have to work on the holiday of Great Prayer after the government scrapped the religious day off partly to pay for extra defence spending. 

The decision, approved in March, was deeply unpopular: in one poll, 70 per cent of Danes opposed it. But economists have praised Copenhagen for enacting a plan to meet its rising defence bills, unlike many other governments. 

“Nobody wants to pay more taxes. But at the same time, everybody wants better defence and good health services too,” John Llewellyn, a former head of economic forecasting at the OECD, said. “At some point the issue will be forced into the public arena, as nobody is clear how the funds will be raised.” 

Japan, worried by China’s rise and the risk of war in the Indo-Pacific, has not specified how it will fund a planned two-thirds increase in its defence budget by 2027. The UK, spurred by Russia’s war on Ukraine, wants to eventually boost military spending to 2.5 per cent of gross domestic product but only as “fiscal and economic circumstances allow”. 

Germans, unnerved by Russian aggression, want to increase defence spending, but not if it means losing a public holiday. France has not detailed how it will pay for a planned 40 per cent rise in its military budget over the next five years. The same is true for Poland, which aims to almost double its spending to 4 per cent of GDP. 

How to pay for wars is an issue as old as war itself. Cicero, the Roman statesman, said the “sinews of war are infinite money”. In 1694, the Bank of England was founded to help William III finance war with France. Today, even as the world appears increasingly chaotic, spending looks more finite amid an environment of rising interest rates and high government debt burdens. 

Europe is in the middle of its biggest armed conflict since 1945. Geopolitical tensions between China and Taiwan are on the rise. Iran may soon be able to make a nuclear weapon. In addition, global challenges such as climate change and migration may also force governments to spend big. 

The Stockholm International Peace Research Institute (Sipri) calculates that global defence spending rose by 4 per cent to reach a record $2.24tn last year. This year, it is set to continue rising, even as higher rates increase governments’ borrowing costs. 

Economists such as Lawrence Summers, former US Treasury secretary, and Olivier Blanchard, former chief economist at the IMF, have suggested higher defence spending could even contribute to driving interest rates higher. 

“One scenario is that countries which already increased defence spending in 2022 continue to do so, while those that have said they will begin to increase defence spending in 2023 actually start,” said Diego Lopes Da Silva, senior researcher at Sipri’s military expenditure and arms production programme. 

Among the world’s five biggest defence spenders, the numbers are mind-boggling. 

In the US, politicians carved out an exemption in the debt ceiling talks to allow for a 3 per cent rise in military spending to $886bn in 2024. China’s defence budget, which Sipri estimates to be $292bn, is on track this year for its 29th consecutive annual increase. 

Russia, which spent an estimated $86bn on defence last year, has meanwhile said there will be “no funding restrictions” for its war against Ukraine, even as its budget remains classified. India plans to increase its defence budget by 13 per cent this coming year to $73bn, while Saudi Arabia, fearful of a nuclear Iran, now spends 7.5 per cent of GDP on defence, second only to Ukraine. 

In Nato, only seven of its 31 members last year met the alliance’s self imposed defence spending target of 2 per cent of GDP. If they all did, total outlays would rise by over $150bn a year, FT research shows. 

While war was one of “the most expensive and least productive of human activities”, James Grant, a financial historian and editor of the Grant’s Interest Rate Observer, noted that there was “also a tendency for peace to explode periodically in our faces.” 

Grant added: “When that happens, there is often a confluence of promises to pay and money printing.” 

As a general rule, “short, hot wars” that require a sudden surge in spending are financed by extra borrowing, while “long, cold wars” that require sustained defence spending are financed by taxes. 

The Napoleonic and first and second world wars were largely financed by debt. By contrast, during the long decades of the cold war, the west financed its defence spending through higher taxation. In the quarter century that preceded the fall of the Berlin Wall, tax revenues among OECD countries rose on average to more than 32 per cent of GDP from 25 per cent, while debt levels generally fell. 

“For short wars, governments can finance the expenditure by borrowing,” said James Macdonald, author of A Free Nation Deep in Debt, a history of public finance and wars. “But if there is a long war, the more it goes on, the more you have to use other methods, such as taxes.” 

Wars are also often accompanied by higher inflation and the suppression of interest rates. During the second world war, US wholesale prices rose by an average of 8.2 per cent a year, even as interest rates on long-term debt were fixed at 2.5 per cent — a gap that helped Washington inflate away the value of the bonds the US issued. 

“All wars are generally associated with some inflation. Politicians don’t like to put up taxes [to pay for wars], and inflation is a hidden tax,” said Richard Sylla, co-author of A History of Interest Rates. 

Economists suspect rebuilding long-term defence spending, which has dropped by a third across OECD countries since the fall of the Berlin Wall, would require a mix of higher taxes and spending cuts elsewhere. 

“The politics can’t be avoided,” said Llewellyn. “Societies face a series of conundrums and some difficult choices have to be made.”