War finance and inflation

A key aspect of fighting a war is a government's ability (or otherwise) to lay claim to a larger share of total output than in peacetime. This involves an increase in government expenditure and requires raising additional funds. The data on war expenditure as a proportion of real GDP (see table 3.9) reflect the extent to which the Habsburg state was able to mobilise material resources and to sustain the war effort over time. An initial sharp increase from 4 per cent to 30 per cent was followed by decline to 17 per cent over the last year of the conflict. This decline is indicative of both the state's weakening capacity to generate revenue with which to command real resources, and the severe problem of sustaining state claims on falling output. The latter point was of particular significance in the Habsburg case where real GDP contracted continuously throughout the war. Under such conditions, maintaining a constant proportion of national income devoted to the war would suffice to further compress real private consumption.

Table 3.17 reports on the rise in Austrian government expenditure (measured in current prices) between 1913 and its 1917/18 maximum. Virtually all of this fivefold nominal increase was due to war expenditure: in 1913, Austria spent 740 million crowns on the military,13 equal to about 21 per cent of overall government expenditure; for the fiscal year 1917/18,

Table 3.17. Austrian government expenditure and revenue (million crowns and current prices)

1913

1917/18

Expenditure

3,469

22,169

Revenue

3,123

4,194

Deficit

338

17,975

Deficit, percentage of GDP

1.9%

16.3%

Percentage of revenues (%):

Taxes, of which

42.1

45.0

Property and income taxes

13.8

16.1

War profits tax

-

7.2

Customs

6.4

2.4

Excise

13.4

8.4

Fees

8.5

10.9

Non-tax revenues, of which:

57.9

55.0

Monopolies

13.9

15.5

Commercial income

38.7

37.2

Other revenues

5.3

2.3

Note: 1917/18 GDP recalculated to correspond with financial year and reflated using Winkler's price index for Austria.

Note: 1917/18 GDP recalculated to correspond with financial year and reflated using Winkler's price index for Austria.

Source: Winkler (1930: 69-73).

Austrian war expenditure had risen to more than 18,500 million crowns, or 84 per cent of the total. Similar changes characterised Hungary's public finances.14 Bogart (1920: 237) emphasises that 'the finances of the Dual Empire were probably in worse condition at the outbreak of the war than any of the other belligerents, with the possible exception of Turkey'. In fact, the deficit in Austria's last prewar budget amounted to almost one-tenth of government expenditure (or 2 per cent of GDP), while the national debt/ GDP ratio had reached 73 per cent by 1913 (table 3.20) - these levels are indeed high by the standards of the time. However, by 1917/18, the last complete fiscal year during the war, the deficit had grown to more than 80 per cent of expenditure and 16 per cent of GDP. Here, the comparison with Britain in particular is instructive, throwing the Habsburg experience into sharper relief (see table 7.7). First, as a richer and more developed economy with a more advanced fiscal system at its disposal, the British government managed to cover a larger proportion of its wartime expenditure through tax and non-tax revenue. Second, and perhaps more importantly, it could draw on a sophisticated, flexible capital market of international scope that was able to absorb far larger amounts of government debt - both in absolute terms and relative to GDP. Third, the state of

Britain's prewar public finances, with a stock of debt amounting to less than a third of GDP (table 7.9), left far more room for increased borrowing to finance the war than in the Habsburg case (table 3.20).

Revenue, then, played only a modest role in financing Austria-Hungary's war effort, rising by about one-third between 1913 and 1917/18. By the latter date, tax and non-tax receipts covered less than a fifth of expenditure. Yet there were some changes in the composition of revenue. The overall tax contribution increased slightly relative to nontax revenue, as income flows from property and income taxes, and, in particular, the war profits tax, became more important over the course of the war. However, in international comparison the Habsburg Empire was among the group of belligerents, like France, Germany, and Russia, where increases in tax revenue as a means of covering wartime expenditure were of limited significance and below the cross-country average for 1914-19 (Mendershausen, 1941: appendix, table III). In addition, the evidence shows that the wartime budget deficits exceeded the war expenditure of the two Habsburg states from as early as 1914/15 (see tables 3.9 and 3.18 for sources). By 1917/18, for instance, Austria's revenue was insufficient to cover both the level of prewar spending and the service of her war debt, which then stood at about 1,700 million crowns (table3.17; Winkler, 1930: 69-75). Thus borrowing was used by the authorities not only to fund war expenditure, but it was also resorted to as a means of meeting the interest charges on the growing war debt and even significant parts of the civil expenditure burden (cf. Bogart, 1920: 255).

Table 3.18 documents the rise in the total Austro-Hungarian budget deficit in current prices and shows the extent to which this was covered through the proceeds of war loans and advances from the central bank. Since the agreements between Austria and Hungary did not allow for contracting joint loans, the most important sources of finance were the eight war loans that the Austrian and Hungarian governments each placed on the domestic market, with some limited take-up in Germany and neutral countries. These were issued at the rate of four loans in each fiscal year (offering 5.5 or 6 per cent return), though no new issues (either in the form of treasury notes or bonds) came onto the market after June 1918. In this way, the empire raised about 51 billion crowns. The remainder of the cumulative total budget deficit was largely covered by advances from the Austro-Hungarian Bank totalling nearly 36 billion crowns. These amounts translated into a dramatic, inflationary increase in the money supply: M1 rose from 2.19 billion crowns in July 1914 to 34.85 billion in late October 1918 (Popovics, 1925: table II). Table 3.19 indicates the effects this had on price movements and the exchange rate. Note, though, that the reported fall in the crown/Swiss franc exchange rates, as an

Table 3.18. Austria-Hungary: finance of combined budget deficits (billion crowns and current prices)

New

Increase in

Total

loan issues,

central bank

Other finance

deficit

nominal proceeds

advances

(residual)

1914/15

11.05

7.25

5.52

-1.72

1915/16

18.07

12.93

3.58

1.56

1916/17

23.64

14.57

3.67

5.40

1917/18

27.41

18.97

12.65

-4.21

1918, July to October

10.70

-

10.31

0.39

Total

90.87

53.72 (51.48) a

35.73

1.42 (3.66)

a Estimated actual proceeds: assuming same ratio of subscribed over paid-up loans in Austria as in Hungary (0.958) on average over 1914-18. b Includes syndicate loans, loans against collateral, promissory notes, deposit certificates and, as by far the largest component, certificates of indebtedness. Note: Gratz and Schüller (1930: 176-7) report slightly higher nominal and lower actual proceeds (53.98 and 50.92 billion crowns).

Sources: Grebler and Winkler (1940: tables 11, 12; 140-1); Popovics (1925: table II); Winkler (1930: 271).

Table 3.19. Austria-Hungary: money, inflation, reserves, and exchange rates (percentage of July 1914)

Metallic reserves at central bank

Currency in circulation

M1

Cost of living a

Gold

Total

Exchange rate, K/SFr

1914, Dec.

168

191

129

96

84

86

1915, Dec.

234

217

261

63

57

67

1916, Dec.

356

330

615

26

25

49

1917, Dec.

602

596

829

24

27

44

1918, Oct.

1,167

1,016

1,589

24

24

42

a Cost of living index excluding rent (Austria).

Note: All measures refer to end of month except exchange rate Austro-Hungarian crown/ Swiss franc (K/SFr) which is based on monthly averages.

Sources: Popovics (1925: tables I, II, IV); Winkler (1930: 40-1).

example, far underestimates the actual decline in external purchasing power of the crown. The authorities used extensive exchange controls and exchange rate manipulation in an effort to maintain credit domestically and abroad (Grebler and Winkler, 1940: 119). The fast rise in the money supply met with widespread supply shortages and high levels of government demand: the result was a steep increase in the price level, and by the end of hostilities Austrian consumer prices were about sixteen times higher than they were in July 1914. Note, though, that inflation in Hungary took a somewhat different course. Up to late 1915, prices in the Hungarian part of the empire rose at similar or slightly higher rates than in the western half. Thereafter, however, Austrian inflation outstripped the rate of price rises in Hungary,15 reflecting the far better food supply situation in the Hungarian lands, the progressive disintegration of goods markets within the empire, and more expansive financial policies pursued by the Austrian government. While the two Habsburg states' total proceeds from war loans corresponded fairly closely to their agreed quota contributions to the joint affairs (0.636 vs. 0.364), Austria drew far more heavily on cash advances from the Austro-Hungarian Bank. By the end of the war about 72 per cent of the fast-growing governments' liabilities at the bank were due to Austrian borrowing. Popovics (1925: 154-5) argues that from 1917 this was largely an outcome of increased subsistence payments to soldiers' families and indemnities for war damages, the latter being more severe in the Austrian lands. These issues fell into the competence of the individual states, rather than the imperial administration. To sum up, the Habsburg state proved incapable of controlling inflation, which from 1916 ran ahead of the rate of money growth. This, it would appear, was less an outcome of hesitant use of long-term bond finance per se than a reflection of a desperate attempt by the authorities to extract through money creation a larger claim on a progressively less elastic supply of goods. In fact, Austria-Hungary's wartime inflation record compares extremely unfavourably with almost every other major belligerent in World War I (Hardach, 1987: 171-2; Ferguson, 2000: 424-5) - taxation failed to mop up excess private expenditure, and price controls on foodstuffs and other commodities failed to prevent open inflation.

The effects of wartime borrowing on the stock of national debt are illustrated in table 3.20. During the war, the Habsburg Empire's debt increased to more than six times its prewar level, measured in current prices. However, apart from a brief rise in Austria in 1914-15, the debt/ GDP ratio remained barely above peacetime levels and, in the Austrian case, even fell below this in the last year of the war. This demonstrates clearly the constraints that a relatively small, underdeveloped domestic capital market placed upon the ability to sustain wartime borrowing. Although the Habsburg authorities were able to tap foreign funds, principally from their German allies but also from several neutral countries, these were overall of only minor quantitative significance. Apart

Table 3.20. Austria-Hungary: national debt (billion crowns and percentage of GDP)

Austria

Hungary

Billion

Percentage

Billion

Percentage

Year

crowns

of GDP a

Year

crowns

of GDPa

1913

12.61

72.6 b

1913

6.20

62.3 b

1914

17.96

110.2

1914/15

11.06

71.0

1915

27.05

100.6

1915/16

17.20

69.7

1916

43.27

77.6

1916/17

22.93

72.7

1917

64.05

71.8

1917/18

33.08

70.4

1918

82.32

63.9

1918, remainder

36.00

62.7

a GDP reflated using Winkler's cost of living index for Austria and Teleszky's wholesale price index for Hungary (cited in Winkler), as GDP deflators are not available. b If housing were included in GDP: 65.9 per cent for Austria, 56.5 per cent for Hungary. Note: Austrian level of debt 1917-18 and Hungarian debt 1916/17-18 estimated, using increase in war loans finance and central bank advances.

Sources: Austria - (Österreichisches Statistisches Handbuch 1916/17; Hungary - Magyar Statisztikai Evkönyv 1916/18, Popovics (1925: table II), Winkler (1930: 40-1, 225, 271-2), tables 3.10 and 3.11.

a GDP reflated using Winkler's cost of living index for Austria and Teleszky's wholesale price index for Hungary (cited in Winkler), as GDP deflators are not available. b If housing were included in GDP: 65.9 per cent for Austria, 56.5 per cent for Hungary. Note: Austrian level of debt 1917-18 and Hungarian debt 1916/17-18 estimated, using increase in war loans finance and central bank advances.

Sources: Austria - (Österreichisches Statistisches Handbuch 1916/17; Hungary - Magyar Statisztikai Evkönyv 1916/18, Popovics (1925: table II), Winkler (1930: 40-1, 225, 271-2), tables 3.10 and 3.11.

from their limited subscription to Austrian and Hungarian war loans, German banks provided continuously prolonged credit against mark-denominated bills issued by the treasuries in Vienna and Budapest. Over the course of the war, these bank loans added up to about 3.5 billion marks (or 4.1 billion crowns at the prewar exchange rate) - less than 4 per cent of the Habsburg debt in 1918 (table 3.20; Popovics, 1925: 120-2). Numerically these were by far the most important foreign funds made available to the empire's war effort. Their main purpose was to acquire marks for the purchase of goods from Germany - the country's main ally and trading partner. By 1917, for example, merchandise imports from Germany (2.14 billion crowns) accounted for 42 per cent of all Austro-Hungarian imports, while exports to Germany (1.35 billion crowns) made up 75 per cent of the export total. Cumulated over the whole duration of the war, the empire's negative trade balance with Germany amounted to a quarter of her total trade deficit (table 3.21; Austria-Hungary - Statistik des auswärtigen Handels 1917 (I)). However, with few overseas assets to dispose of, overseas remittances rapidly drying up (and stopping completely with the US entry into the war), no significant access to international capital markets, and the few credit arrangements with neutral countries severely limited in volume, the remainder of the

Table 3.21. Austria-Hungary: balance of visible trade (billion crowns and current prices)

1913

1914

1915

1916

1917

1918a

Merchandise imports Merchandise exports Merchandise balance

3.51 2.99 -0.52

2.98 2.24 -0.74

3.85 1.43 -2.42

6.09 1.63 -4.46

5.08 1.81 -3.27

3.79 1.64 -2.15

a First ten months only. Source: Winkler (1930: 62).

a First ten months only. Source: Winkler (1930: 62).

balance of trade deficits had to be financed largely by the depletion of gold and foreign exchange reserves (table 3.19).

The key issue here is how large a trade deficit a country can run as a means to augment its resources for fighting the war. In the Habsburg case, the increment to domestic product was small indeed. Whether measured in nominal or real terms, the wartime deficit accounted only for between 2 per cent and a maximum of 5 per cent of GDP (table 3.8; table 3.21; Winkler, 1930: 61-3) - in terms of percentage points, and ignoring the vast absolute differences in foreign trade and national product, this was about one-seventh to one-half of the additional resources made available to the British war economy through merchandise trade (Broadberry and Howlett, this volume). In short, the Habsburg Empire's war effort was subject to a strong balance of payments constraint that was effective at a low level of net imports.

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