How States Pay for Wars

By Rosella Cappella Zielinski

Armies fight battles, states fight wars. To focus solely on armies is to neglect the broader story of victory and defeat. Military power stems from an economic base, and without wealth, soldiers cannot be paid, weapons cannot be procured, and food cannot be bought. War finance is among the most consequential decisions any state makes: how a state finances a war affects not only its success on the battlefield but also its economic stability and its leadership tenure. In How States Pay for Wars, Rosella Cappella Zielinski clarifies several critical dynamics lying at the nexus of financial and military policy.

Cappella Zielinski has built a custom database on war funding over the past two centuries, and she combines those data with qualitative analyses of Truman’s financing of the Korean War, Johnson’s financing of the Vietnam War, British financing of World War II and the Crimean War, and Russian and Japanese financing of the Russo-Japanese War. She argues that leaders who attempt to maximize their power at home, and state power abroad, are in a constant balancing act as they try to win wars while remaining in office. As a result of political risks, they prefer war finance policies that meet the needs of the war effort within the constraints of the capacity of the state.

• Language: English
• Publisher: Cornell University Press
• Release date: Jul 11, 2016
• ISBN: 9781501706516

Book preview

HOW STATES PAY FOR WARS

Rosella Cappella Zielinski

CORNELL UNIVERSITY PRESS ITHACA AND LONDON

For Michael and Rosa Cappella

If we can go on giving the army what they want longer than the Germans can do this to theirs, we may appear to win by military prowess. But we shall really have won by financial prowess.

—John Maynard Keynes, 1916

Contents

List of Illustrations

Preface

Acknowledgments

Introduction: Making Money, Making War

1. How States Pay for Wars

2. Truman and the Korean War

3. Johnson and the Vietnam War

4. Britain and Currency Reserves during World War II and the Crimean War

5. Taxation and Currency Reserves during the Russo-Japanese War

6. Confronting the Costs of War, 1823–2003

Conclusion: Long War Finance in Perspective

Notes

Bibliography

Index

Illustrations

Figures

 I.1 Variation in US war finance

1.1 War finance continuum

1.2 War finance strategy model

2.1 Public support for a tax increase, 1951–1953

3.1 Percentage of Americans in favor of a tax increase, 1966–1968

6.1 War cost and war taxes in US war finance

6.2 Percentage of World War I cost by belligerent met by taxation

Tables

1.1 United States Civil War finance, 1861–1865

4.1 Monthly drain on dollars and gold reserves held by the British, January to June 1940

5.1 Japanese foreign exchange balance, 1901–1906

Preface

I began work on what would become this book about war finance in 2008–2009. At that time, the United States was in the midst of two wars: the 2007 surge in Iraq was ending and the 2009 surge in Afghanistan was beginning. The American economy was plunging into a recession that has since been dubbed the worst financial crisis since the Great Depression. The strength of American military and economic power was coming into question.

It was against this backdrop that this project was conceived. This American landscape sparked three questions for me: How and why was the United States paying for two wars without a tax increase? What does the state of the American economy mean for America’s ability to project its military power? Do the horrific consequences of war also mean economic ruin for a state? In pursuing the answers to these questions, the puzzles of this book emerged: What explains the variation in how states finance war? Why does taxation finance some wars while others are paid for via domestic debt, external funding, or printing?

As I started to explore war finance, I found state and military power to be not what I thought they were. I had thought military power generally reflected the size of a state’s economy—more money, more guns. Instead, I found that mobilizing resources for war was a wholly different ball game from military power, broadly defined. First, I was mistaken to think a state’s resources were bound by its economy. States can tax, print money, borrow from their domestic population, borrow from abroad, and plunder. Second, I was mistaken to think war finance was a simple tax-versus-debt tradeoff. This dichotomy obscures the various forms of taxation—sales taxes, income taxes, excess profit taxes, and tariffs, to name a few—and various forms of debt—floated at fixed or market rates, purchased by individuals or banks, a targeted bond campaign, or issued to society at large—all of which have different political and economic costs for leaders and citizens. Third, I had a go-it-alone attitude. I thought states could finance wars domestically if the state had the capacity to raise taxes or float debt. Regardless of domestic economic might, however, when states are constrained by their currency reserves when purchasing inputs for the war effort from abroad, they are forced to rely on external third parties. Fourth, I thought war trumps all. That is, when fighting a war, leaders are concerned with the war effort above all else. Leaders, however, often use war finance policy to meet other domestic goals, that is, the redistribution of wealth, beyond the war effort. Finally, it was confirmed for me that to study guns separately from money is a mistake. If we as scholars and policymakers are ever to truly understand state power—our own, an ally’s, or an adversary’s—we need to understand how money affects guns and vice versa.

This book has a vast mandate. Given that scholars have largely ignored the nature of war finance, it was necessary to go beyond one country’s experience or war finance in the post–World War II era. Hence the book explores two hundred years of war finance from 1800 to 2003. Beyond empirical breath, the project provides theoretical depth. It invests in concept building: What is war finance? What do we mean by cost of war? What are the various attributes of war finance? It is only after investing in concept building that I could begin to answer the question of what explains the variation in war finance. In brief, I argue that war finance is a function of political decision making as leaders attempt to control the costs of war as well as the capacity of the state to extract resources from its citizens and abroad.

While the mandate for the book is large, it is designed in such a way that the reader can pick and choose the aspects in which he or she is interested. The Introduction and chapter 1 of the book examine the study of war finance thus far, present various war finance concepts, and theorize the manner in which states pay for wars. Chapters 2 through 5 provide the empirical analysis of my theory using six case studies in a theoretical (versus chronological) order. Chapters 2 and 3, Truman’s financing of the Korean War and Johnson’s financing of the Vietnam War, explore how war finance policy is affected by a leader’s attempt to control the political costs of war via fear of inflation and public support. Chapters 4 and 5 investigate how leaders’ attempts to control the political costs of war are constrained by state capacity. Chapter 4 explores British war finance in the face of balance of payments constraints during World War II and in the absence of those constrains during the Crimean War. Chapter 5 explores a state’s extractive tax capacity as well as the need for currency reserves by comparing Russian and Japanese financing of the Russo-Japanese War. The empirical section of the book closes with a bird’s eye view of war finance. Using a novel data set of interstate war finance from 1823–2003, chapter 6 provides descriptive statistics of how wars have been financed during this period. I conclude the book with a discussion of future research on war finance.

In an era when states are facing ballooning deficits, economic austerity, and increased financial globalization, understanding war finance is more important than ever. How a state finances war has implications for the outcome of the war, the economic health of the state (particularly regarding debt accumulation, inflation, and the redistribution of wealth), state autonomy, and leadership survival. Thus, as economies contract and states cut spending to balance their budgets, the source of war finance is at the forefront of contemporary debates regarding future economic growth, political stability, and national security.

Acknowledgments

It takes a village. This project, supported by various people and institutions, took a village, and I am forever grateful for their support.

This book began at the University of Pennsylvania under the advisement of Edward Mansfield, Avery Goldstein, Michael Horowitz, and Alex Weisiger. Together, these four scholars provided the intellectual and emotional support that allowed me to embark on a relatively understudied subject area with boldness and confidence. It certainly helped that they are wonderful people who made me laugh along the way. The support received at the University of Pennsylvania extended beyond my committee members. This project could not have been written without the insights and merriment of Justin Bolker; Ryan Grauer; Ellen Kennedy; Matthew Levendusky; Ian Lustick; Rogers Smith; Rudy Sil and Eileen Doherty-Sil and their children Anna, Analyn, and Aiden; Matthew Tubin; and Pablo Yanguas. I also thank Jennifer Bottomly, Pat Kozak, and Naya Sanders for always making the administrative process pleasant and easy. I also consider myself lucky to have shared my graduate student journey with three amazing and talented women: Barbara Elias, Allison Evans, and Meredith Wooten.

Beyond the University of Pennsylvania, I was fortunate to have enjoyed the financial and scholarly support of the John Sloan Dickey Center for International Understanding at Dartmouth College. I owe thanks to Stephen Brooks, William Wohlforth, and Christianne Hardy Wohlforth, who helped get this project ready for publication and shared with me their love of the great outdoors. I thank Michael Beckley for great conversations and letting me have the desk with the view. My time at Dartmouth could not have been completed without the generous hospitality of the Seale family.

My current intellectual home, Boston University, has provided me the support and encouragement to bring this process to completion. Cathie Jo Martin, David Mayers, and Graham Wilson have been wonderful mentors. I have appreciated the thoughtful words of encouragement from Ivan Arreguín-Toft and William Grimes. I could also not be more grateful for the friendship and intellectual camaraderie of Kaija Schilde and her family.

The research in this book could not have been done without the support of various institutions. I owe a debt of gratitude to the Harry S. Truman Presidential Library for the generous financial support that allowed me to spend a week in the archives. I thank the Christopher H. Browne Center at the University of Pennsylvania for support that allowed me to attend various conferences at early stages of this project as well as a visit to the LBJ Presidential Library. The Earnhardt Foundation and the Boston University Political Science Department supported a visit to the British National Archives as well as the Rothschild Archive. I also want to thank the generous support of the Boston University Center for Finance, Law, and Policy and its director Cornelius Hurley for a grant to support the expansion of the data set. Finally, I want to thank the various archivists who took the time to help me navigate their collections.

I also want to acknowledge insights from colleagues I have gathered along the way, two anonymous reviewers, and Roger Haydon of Cornell University Press. As the book has come to fruition, it was influenced by insightful conversations with Adriana Lins de Albuquerque, Jonathan Caverley, Benjamin Cohen, Benjamin Fordham, Erik Gartzke, Jarrod Hayes, Sarah Kreps, Paul Poast, and Hugh Rockoff. The comments that the two reviewers provided were illuminating and the process of responding to them improved the project beyond my expectations. I have read many book acknowledgments thanking Roger Haydon, and now I understand why. His sense of humor coupled with his professionalism makes him a delight to work with.

The motivation for this project began when I was an undergraduate at the University of Southern California. I thank John Odell and Peter Rosendorff, who encouraged me to pursue my research. Every Christmas when I came home to Los Angeles to visit my family, I always looked forward to stopping by John’s lovely home in Pasadena to share my tales of academia. In addition, the School of International Relations and the Center for International Studies fostered my early research projects with grants to conduct field research in Geneva, Switzerland.

Writing a book is an isolating experience. I owe particular thanks to my friends and family. My sister, Roxy Cappella, endured many phone calls as I pined for California sunshine. My best friend of countless years, Janna Velasquez, kept me grounded. Richard Agron is a force of laughter like no other. My stepchildren, Owen and Grace, whom I met while editing this book, have taught me a whole new level of love. Thank you for your patience while I wrote. My husband, John Cappella Zielinski, is my ultimate confidant. Not only did he graciously read multiple drafts, his ability to know just what to say (or not to say) always provided the best emotional support. He is truly my favorite person to spend time in nature with.

Finally, I thank my parents, Michael and Rosa Cappella. Growing up as the daughter of two public high school teachers in Los Angeles, I learned to value education at an early age. My mother, an immigrant from El Salvador, and my father, a child of a Sicilian immigrant and an Irish mother, instilled in me that life is hard and while we should always be trying to better ourselves, it is important to help others along the way. I hope that the lessons from this work make life a little easier for others and I will continue to do my best. This work is dedicated to them.

Introduction

MAKING MONEY, MAKING WAR

John Maynard Keynes predicted World War I would not last more than a year. An extensive international conflict was economically unsustainable. The world, he believed, was wealthy, yet because its wealth consisted primarily of capital equipment, it could not be converted into cash and goods for war purposes. As soon as cash funds were used up, warring states would have to negotiate. Keynes was wrong. World War I lasted four years and imposed enormous human and financial costs, with daily war expenditures for the primary belligerents averaging more than $30 million.¹

World War I was not the only war in which national financial conditions were expected to influence duration or outcome. During the Russo-Turkish War (1877–1878), Ottoman Turkey was dismissed as unable to fight a long war because of its economic disarray. A British military observer wrote, A total financial collapse had been predicted for months, and yet large bodies of troops were moved about, and the provisioning of the huge armies in the fields went on without interruption.² Similarly, during the First Balkan War, the Wall Street Journal wrote, Lack of funds will probably put an end to the new Balkan war. All of the states in the Balkan League—Bulgaria, Serbia, Greece, and Montenegro—are close to bankruptcy. The powers are expected to refuse any more loans, in order to compel the cessation of hostilities.³ Yet in both conflicts, insufficient funds did not force a cessation of hostilities.

Each of these states found ways to avoid capitulating or negotiating with their enemies due to financial constraints, but their strategies for mobilizing resources varied in interesting ways. For example, despite the near equal cost for all primary belligerents, each state paid for World War I differently. The United States and Britain were the only countries that paid for a significant percentage of the war by taxation, 30 percent and 25 percent, respectively.⁴ France raised taxes but was unable to meet any of the cost with the increased revenue. Britain, France, and Russia borrowed both domestically and from allies abroad. The United States, on the other hand, did not engage in any foreign debt. Finally, while the war was inflationary for all states, Russia and Germany printed money most frequently. When faced with military emergencies, states find creative solutions to pay for war.

This book clarifies several critical yet chronically underexamined dynamics lying at the nexus of financial and military policy. For millennia, ruling groups have had to acquire resources to support their war efforts. Leaders must decide where to get money. Do they raise money domestically or borrow from abroad? If the sources are domestic, who should pay? Should the state levy taxes, incur debt, or print money? If leaders look outside their borders for finance, where should they look?

Each war-financing alternative—taxation, domestic debt, printing money, and external funding—has distinct political and economic costs and benefits. Borrowing compounds the cost of war through high interest rates, printing can result in disastrous inflation, taxation combats inflation yet can be politically damaging, and garnering money from abroad invites outside influence and fosters dependency. What explains the variation in war finance policy chosen?

These are important questions, as military power stems from an economic base. Without wealth, soldiers cannot be paid, weapons cannot be procured, and food cannot be bought. States, however, do not act in a vacuum. They are constrained by domestic and international politics. Understanding how states finance war is essential to understanding the extent to which state capacity and leaders’ preferences affect a state’s ability to meet its foreign policy goals via military and economic power as well as its pursuit of domestic macroeconomic stability.

The Study of War Finance

It is only recently that social scientists began to explore how states finance war. The contemporary origins of this literature can be traced back to Charles Tilly’s 1975 edited volume, The Formation of National States in Western Europe. Tilly and participating scholars looked to war finance as a key variable to explain the rise of the modern state, as exemplified by Gabriel Ardant and his contribution, Financial Policy and Economic Infrastructure of Modern States in Europe.⁵ While these works emphasize the effects of war finance, they ignore how leaders choose a particular war finance policy.

Around the same time, international relations scholars were beginning to link financial and military power.⁶ Knorr, Organski and Kugler, and Kugler and Domke argued that the ability to extract resources from society, particularly tax revenue, was essential for projecting military power.⁷ Paul Kennedy and Karen Rasler and William Thompson emphasized the role of credit to sustain and fight great power rivalries as well as the effect of amassing large amounts of war debt to explain power decline.⁸ Continuing this theme of scholarship, Kenneth Schultz and Barry Weingast argued states that have better access to credit, specifically democracies, are more likely to win long-standing rivalries.⁹ While these works emphasize the importance of war finance and their effects, they also do not address how war finance policy is chosen.

Economists have a more varied history with the study of war finance. Early political economists, such as David Hume, Adam Smith, David Ricardo, Alexander Hamilton, and Francis Hirst, framed early Western debates on war finance.¹⁰ These works, written around the time of war, were policy oriented and normative in nature.¹¹ During the 1980s, economists attempting to understand the optimal policy to finance government expenditures began to tackle war finance in a more systematic manner. The concept of tax smoothing emerged from this line of thought.¹² Tax smoothing proponents argued when a government faces an exogenous expenditure, tax rates should not necessarily adjust to achieve a balanced budget because extreme tax increases distort microeconomic incentives.¹³ Thus states should borrow to pay for costly wars.

A general consensus emerged from these works—how a war is financed has lasting effects on state capacity, can fundamentally alter the relationship between state and society, and sustained periods of particular forms of war finance can account for balance of power shifts in the international system. Perhaps more significantly, what also emerged was the consensus that regime type and debt dominate war finance. Wars are financed by debt, and democracies are better able to float said debt.

These studies, indispensable for drawing attention to the importance of war finance, almost always put the proverbial cart before the horse, as they focused on the effects of the finance policy chosen and ignored how the policy came to be. Moreover, these theories too willingly assumed static preferences of state leaders as well as insufficiently addressed variation in state capacity. Through assuming static preferences, these works disregard the role of the war in shaping decision making and state capacity. That is, the tides of war affect leaders’ preferences for war finance and the ability of the state to raise taxes and float debt. By failing to take war into account, these theories ignore the costs and trade-offs of decision making by leaders.

Furthermore, these works overemphasize the role of regime type. Schultz and Weingast’s work is excellent at drawing our attention to the importance of credit.¹⁴ However, the study makes an assumption that regime type matters to creditors. It also assumes that elected officials, fearful of political fallout, worry about the political cost of default. Michael Tomz, for example, found that creditors value reputation formed by the repeated successful repayment of debt, not necessarily regime type.¹⁵

Moreover, studies that assume that creditors look to regime type when extending loans ignore the political aspects of war debt. The Cold War is a prime example. The United States and Soviet Union extended vast amounts of war debt to myriad nonliberal regimes with bad credit for geopolitical reasons. The Japanese and Russian experience during the Russo-Japanese war serves as another counterexample. Both nations were able to secure credit despite being nondemocratic. Russia’s credit, provided by France and Germany, wavered with battlefield success and not with political cost to elected representatives. Furthermore, worried investors found confidence not in Russia’s institutions but in Russia’s gold reserves and the state’s perceived ability to pay.¹⁶ Japan’s credit, provided by England and the United States, continued to be extended as Japan advanced successfully in battle.¹⁷

FIGURE I.1 Variation in US war finance

Sources: What constitutes a tax, domestic debt, external funding, and printing are discussed in chapter 3. For US financing of the War of 1812 to the Korean War, see Paul Studenski and Herman Kroos’s Financial History of the United States (New York: McGraw-Hill Book Company, 1952). For US financing of the Vietnam War, see Tom Riddell, A Political Economy of the American War in Indo-China: Its Costs and Consequences (Washington, DC: American University, 1975). For Gulf War finance, see US Department of Defense, Conduct of the Persian Gulf War: Final Report, US Congressional Report (1992), appendix P. In the Revolutionary War column, other is referring to plunder and the selling of land for money.

In addition to the inability to capture preferences, these theories connecting regime type to resource extraction do not capture important variation within democracies.¹⁸ Consider the variation in US war finance presented in figure I.1. None of the aforementioned theories can explain why the United States chose to finance World War II by 50 percent taxation and the Korean War entirely by taxation, whereas the wars in Iraq and Afghanistan have been financed by domestic and foreign debt.

Finally, as made apparent in figure I.1, war finance-related theories do not advance beyond the tax-versus-debt dichotomy and thus cannot account for the complexity of leaders’ decisions. As mentioned previously, leaders can also engage in external extraction as well as printing. Moreover, treating taxation and debt as unitary concepts ignores variation in types of taxation and debt, each with different political and economic costs.

Argument in Brief

I build on previous theories and discussions of war finance and account for the variation in war finance policy options, the dynamics of the war, and leaders’ preferences. First, I invest in concept building. War finance has been studied in a piecemeal fashion, and therefore, scholars who study it are at risk of talking past each other.¹⁹ Thus I address what is meant by the cost of war, the various war finance policy options, the difference between what I term short- and long-term war finance, and introduce the concept of war finance strategy.

I argue that the various means of war finance lie on a continuum characterized by direct resource extraction at one end, indirect resource extraction in the middle, and external extraction at the other end. Where a war finance policy lies on the continuum is contingent on the ability of citizens or groups within society to opt out of the government’s claim on resources and the extent to which citizens are aware of war finance policy. Direct resource extraction, such as forced labor or an income tax, is compulsory and, therefore, results in a high level of citizen awareness. In contrast, indirect resource extraction, such a borrowing, only requests citizens to interact with the war finance policy. Thus, citizens may (or may not) interact with the policy, resulting in some awareness. Finally, when the government engages in external resource extraction, it asks nothing from society. Thus citizens do not interact with the policy, resulting in low awareness.

Second, I argue that leaders, attempting to maximize their power at home and state power abroad, are in a constant balancing act, attempting to win the war and remain in office. Thus they prefer war finance policies that meet the needs of the war effort and are the least politically costly. Political costs, shaped by public support for the war, dictate leaders’ preference for direct or indirect resource extraction or an external war finance policy to avoid the citizenry entirely via procuring resources from abroad.

Leaders’ attempts to maximize power, however, are constrained by the capacity of the state to extract revenue as well as secure currency reserves when purchasing war inputs from abroad. If state capacity limits the ability to extract revenue via direct means and leaders desire to continue the war effort, they will have to engage in indirect revenue extraction or external war finance. In addition, if the state needs currency to pay for goods purchased from abroad, it will need to engage in external war finance.

It is through this lens of constrained decision making that I derive three hypotheses of war finance. Leaders are more likely to engage in direct resource extraction to finance a war when they fear inflation, when public support for the war is high, and when the state has the capacity to extract revenue. Indirect resource extraction and external war finance are more likely when the fear of inflation or public support for the war is low or when the state does not have extraction capacity. External funding becomes a necessary component of war finance when the state has to purchase inputs for the war from abroad and does not have the currency to pay for it. I also derive a corollary hypothesis. When fear of inflation and public support for the war are both high but the state does not have the initial capacity to raise revenue, the state invests in state building. That is to say, it is only under these conditions—high inflation fear and public support—when the Tilly war makes states notion is realized.²⁰

The Importance of War Finance

The study of war finance is critical to understanding the relationship between international relations and domestic politics.²¹ How and under what circumstances will