Tuesday, 4 March 2014

The economics of war (introduction)

Contrary to the beliefs of some economists (who really should not be titled economists), wars do not create wealth.

There is a popular notion that when the US economy headed into the Great Depression, it was the Second World War that enabled the US to come out of its recession - that coupled with a massive growth in the Federal government and many agencies.

The myth follows a Keynesian view of the economy that it is demand that drives wealth creation, rather than production. Accordingly, when an economy gears up for war, governments go on a spending spree and order more of war's apparatus. The industrial concerns producing arms, etc., thereby receive increased orders which then lead to an increase in employment and higher orders from their suppliers and the primary industries that ultimately produce the raw materials for the war machine. In terms of what students learn in basic economics, a change in the economic wealth of the country can be stirred by an increase in government spending - for the simple minded economists, what that expenditure goes on does not matter (i.e., expenditure is neutral - money spent on the armed forces or on hospitals or education has the same return): a war will be as just as good for the economy as spending on the infrastructure.

Of course, this is usually not the case - some projects will produce more wealth than others. Yet many historians and economists believe that war is good for the economy. I'm not sure if they have ever really thought about what they are saying, or whether they are financially or otherwise attached to groups that do have an interest in war: the military industrial establishment as it has been called. Ethically, declaring one's interests would be useful! For instance, does the economist work for a department that depends on military grants? Is the economist a member of the political elite which has much to gain from war (fame, honours)?

When an economist sincerely has no interest in defending war from a personal point of view, we may then proceed to clearly analyse the logic. When a government increases its expenditures, the payments must ... be paid for. (Sometimes we get the impression that our politicians miss this simple step in their thinking.)

If it possesses a surplus, then we can claim that the surplus is being put back into the economy through whatever channels the money is spent on. Some channels may be more conducive to producing economic wealth than others, but again we'll let that go. By relieving itself of a surplus nonetheless, the money is returned to the market place once the money has been spent by the civil servants in charge of disbursements. All things being equal, returning funds to the market will ensure that they are better used than kept in the government's coffers.

But what happens if the government does not have a surplus to spend? There are only three vehicles for the government to use:

 1) it can raise taxes to pay for the war - which means money is taken out of the productive economy of the market and put through less efficient government channels. This redistributes resources from one group in the economy to another.

 2) it can borrow money to pay for the war, which means it has to pay interest on the funds; while providing a cheaper source of financing that raising taxes (which always has the possibility of a popular backlash), the incursion of the government into the market for investment funds creates the problem of diverting funds that would otherwise have gone into profitable endeavours into government channels.

 3) it can print money or pursue an easy money policy by permitting the banks to create more funds that they would otherwise do. Inflation is taxation through the back door, for although it creates immediate funds for the government to spend, its effect is to raise prices and thereby squeeze the standard of living of people on a fixed salary relative to those receiving the new monies. They thus lose out in a wealth transfer which inflation creates.

Once the monies and credits to spend have been raised, the immediate effects on the economy will not be immediate but will be drawn out as the new expenditures gradually filter through markets along essentially unpredictable paths. Then we can focus on the military path that is unleashed.

Government cannot, by definition, spend money as efficiently as the private sector: this is because it has no incentive to do so. But when it spends money on an activity that destroys capital and people's lives, the theory that somehow wars create wealth collapses. When people are killed and machines are destroyed, the potential for the economy to sustain itself, never mind grow, is thwarted.

And guess what that does to the production possibility frontier?

It shrinks - and we can add that, since war creates numerous inefficiencies and distortions, the theoretical combination point will be below the second line anyway.


When a war is declared, there is typically a flight to quality. We are currently seeing this in the increasing tensions in the Ukraine. Consider that billions of dollars (and other currencies) can be highly liquid, that is they can be moved from market to another with a few clicks on the keyboard, then the fund managers in control of looking after the returns on their clients’ monies (pension funds, insurance funds, mutual funds, etc.) will be highly sensitive to alterations in the political tensions around the world. 

Where money can flow can be summarised in the investors’ quadrant: 

Each quadrant will have its own matrix of potential areas to hold liquid funds. The diagram below is a mere cartoon - there are hundreds of equities markets and also sectors of equities (industrial indices, pharmaceutical indices, entertainment, banking, etc).

Money will always seek safe havens when war is afoot. It will move from weaker stock markets that have a higher sense of risk to markets that are deemed more stable. It will move from equities into harder, less risky commodities such as gold, it will also move into areas that will be expected to see price hikes - such as oil, gas, and food. To what extent and as to the quantities involved no one can predict: no one knows where the market is going, as the markets are a process involving millions of people’s decisions as well as some big players such as investment fund operators, banks, and central banks. 

For instance, just for fun, consider a change in the distribution of funds overnight in these two examples, where the ‘balloon’ in each quadrant represents the quantity of funds currently invested in liquid assets:

In this case, the equities markets around the globe experience a decline, while commodities, harder or safer currencies and the relatively more secure bond markets experience an influx. 

The actual story will of course be much more subtle. For instance, when Russia moved troops into the Crimea in March 2014, the rouble fell in the forex markets - when wars occur, there is a high expectation that the funds required will be printed. Russia has a history of printing money, so not surprisingly investors dropped the rouble in favour of other currencies. Which? The Euro, GBP, and USD all saw rises as did the AUD (Australian dollar). Gold also rose a little as did oil. 

The Russian stock market dropped while the US markets reached for record highs. Accordingly, we can imagine a flow of money from the countries now deemed to be relatively less stable than the month before (Russia, Ukraine, surrounding countries, countries likely to be hard hit by rising oil or gas prices) into more stable economies (or those perceived to be). 

War generates a flight to quality. 

Interestingly, contrary to what socialists and statists think, capitalism avers warfare. When Russia was looking to invade the Ukraine, the run on the rouble cost Russia $11.3 billion dollars trying to protect its currency on the forex markets - the cost may have prompted Putin to think twice about engaging the Ukraine in conflict. 

At the global level this is witnessed in the ‘hot money’ flows that anger politicians (who expect the monies to stay put and be subject to devaluation and expropriation!). Money will flow, ceteris paribus, to safer areas and away from the danger zones.

This impedes a warring country’s ability to maintain and grow its economy of course. Investment flows dry up and the cost of borrowing rises. As state expenditures rise, the government requires  higher levies on its people, which divert funds and economic activity from productive pursuits to destructive ends. (Why? Each missile and bullet fired is a destruction of capital). Even without monetary inflation, the cost of living for people will rise - and usually governments then impose price controls, which worsen the situation.

The market converges on a price of P1 but politicians believe that the price is ‘too high’ for the people, so they introduce a legally mandated maximum price (for say food items) which then causes an excess demand over supply. The lower price encourages people to enter the market to stock up or consume more, while supplies are cut back as producers cannot sell the same quantities as they did before because the return is so much lower. This has nothing to do with ‘not being patriotic’ - it’s a simple economic law. Reduce the price and supply falls. Mandate a price reduction and excess demand results. 

Even with the great distortions occurring in the economy as a result of the war footing, governments tend to introduce further interventions and distortions in the economy causing further distortions and loss of efficiency. 

The war machine shifts resources from productive to destructive ends and reduces the economy’s ability to maintain itself, never mind grow. 

Of course, when fighting a defensive war the costs associated with losing may be too high to consider and the state is right in gearing its people for a just war (I've written on just war theory here and written on the philosophy of war below).

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