Exactly how much of a fiscal burden governments can bare is the subject of frequent debate. Some believe any debt is problematic and others believe that, at least for some countries, there is no limit to the fiscal headroom available. Historically, it is in times of war that governments push themselves to the very limit. During the First World War, Britain borrowed an unprecedented amount of money with unprecedented speed. While it did succeed in raising this money, the indebtedness strained the government for more than a decade thereafter and limited its ability to confront the renewed threat of war in the 1930s.
Britain had relatively restrained defense spending prior to the start of war in 1914 after which war-related production surged. The scale and swiftness of the change was unrivaled. In 1914, the United Kingdom produced 245 aircraft, no tanks, 91 artillery pieces, 300 machine guns, and approximately 500,000 artillery shells. By comparison, in 1917, the country produced 14,748 aircraft, 1,110 tanks, 5,137 artillery pieces, 79,700 machine guns, and 87.7 million shells. Remarkably, 1917 was not even the peak production year in three of these five items.
Such purchases, along with maintaining an enlarged army deployed abroad caused a remarkable rise in defense spending which had stood at £72.5 million in fiscal year 1912-13. This increased to £437.5 million in 1914-15 and £1.4 billion by 1916-17. This was a rise from 3.1% of GDP to 40.8%. Defense spending remained at elevated levels for four years. After 1919, demobilization sharply reduced expenses but still, spending levels did not return to pre-war levels as a percent of GDP until 1923.
To pay for the war, taxes were increased, especially starting after the autumn of 1915 when it became clearer the war would not be so short as many had hopefully predicted at its start. The income tax rate rose from one shilling and two pennies in the pound to six shillings in the pound, or equivalently, a rate of 30%. The taxpaying base also widened as a result of the impact of wartime inflation on incomes and a reduction in the exemption limit from £160 to £130 in 1915. Overall, an extra 2.4 million people, most notably those in the lower middle classes, became payers of income tax, bringing the number of income tax payers to 3.5 million from just 1.1 million at the start of the war.
A wartime excess profits tax was also introduced. This tax was set at 50% of excess corporate profits in 1914-15; the rate increased to 60% in 1916 and 80% in 1917. This was a significant innovation and would make up 31% of state revenues in 1917-18, an amount greatly exceeding all excise taxes and customs revenues together and almost as much as all other property and income taxes combined.
Part of the military spending was paid for with cuts to other spending; civil spending fell from 10% of GDP to 5%. Still, even together with tax increases, this could not match the growth in war-related spending. While tax revenues quadrupled during the war years, expenses increased by a factor of twelve. So, only 25% of spending was met by taxes in the five fiscal years starting April 1, 1914.
The government’s goal with the tax increases was merely to raise just enough revenues to cover normal peacetime spending plus mounting interest on the growing debt. The actual military spending itself would be covered elsewhere. The deficits peaked in the 1917-18 fiscal year when total spending of £2.7 billion was matched by just £0.7 billion in tax revenues. This was not really even a peculiarly bad year; in fact, the fiscal deficit was in excess of 40% of GDP in all years from 1915-1918.
Of course, a deficit can be met by printing money as well as by borrowing. As in other belligerent countries, money was also printed in Britain with the flexibility afforded by a suspension of the gold standard. The Treasury supplemented Bank of England notes with its own new monetary issuances. During the First World War, the monetary base increased from £288 million in 1914 to £531 million in 1918 helping prices to double.
Still, borrowing had to cover the unprecedented budget shortfalls which amounted to 148% of GDP cumulatively between 1914 and 1919. In all, there was £7,280 in public sector borrowing over those years. Together, this took the government debt from £706 million in 1914 to £2,190 million by 1916 and £7,481 million by 1919. Few countries would have been able to pull this off. Indeed. Britain’s strategy during the war was to use its unique financial strength to ensure the Allies were the last side standing.
First and Second War Loan
To fund the day-to-day expenses, the government would initially raise money by issuing short-term bills which would accumulate until they could be replaced by periodic long-term loans. While some of this money was borrowed from the United States, 80% of it was raised in Britain. In addition to funding its own war effort, the country also provided credit to other dominions in the British Empire and the governments of Britain’s allies. In fact, despite its American borrowing, the United Kingdom still lent more abroad than it borrowed during the war years; remarkable considering how much Britain was borrowing. During the war years, Britain lent £1.7 billion to foreign governments. This official foreign lending replaced large private lending that Britain conducted with foreign governments before the war.
Marketing for the first major long-term loan raised during the war began soon after the war itself. The prospectus was published on November 17, 1914. The first Great War Loan was offered at a price of £95, with interest at 3.5%, to be redeemed in 13.5 years. While most of the debt outstanding at the start of the war consisted of perpetual bonds called consols, the war-time borrowing consisted of ‘dated’ securities of varying maturities and not perpetual loans. The subscription could be paid for in installments and the Bank of England served as agent for the sale of the bonds.
Unfortunately, relatively few investors participated. The offering failed to place the £350 million planned; only £91 million was raised. The rest of the issue was registered under the names of the chief cashier of the Bank of England, Gordon Nairn, and his deputy Ernest Harvey, with money advanced by the Bank at no risk of loss to the men themselves, to hide the fact it had failed.
A second attempt was launched on June 21, 1915. In the meantime, the government had required new private loan issuances to be cleared with the government first. So, as compared to £200 million in 1914, new capital issues in London would fall to £82.9 million in 1915 and £34.7 million the following year. The new war loan was floated at an issue price of £100 but at 4.5% interest this time with a term of up to thirty years.
Investors in the first bond, or in pre-war securities, were given the option to convert their bonds for the new 4.5% war loan. This attempt was met with far greater success than the first loan. The amount raised came to £901 million, or £611 million after considering amounts that were simply conversions from earlier loans. There were almost 600,000 subscribers in all.
The conversion option gained significance as the government borrowed more money. In the absence of this conversion option, investors in older debts would have been disadvantaged by new bonds issued at higher interest rates, potentially discouraging participation and making higher interest rates a necessity. Starting from the second war loan, the government promised to allow conversion at face value of bonds into new issuances should the government need to borrow at higher rates in the future. This protected investors from rising interest rates.
Third Great War Loan
The largest wartime issuance, the third Great War Loan launched on June 11, 1917. It was offered at £95 and paid 5% interest over a term of thirty years though they could be redeemed by the government as soon as June 1, 1929. Given the bond was issued at a price below face value, investors secured a yield of 5.4%.
Investors in the second war loan, along with many holders of pre-war debts, opted to convert into this third loan. Indeed, most of the £2.08 billion secured was simply comprised of conversions from older debts. Still, £845 million in new money was raised. To support demand, banks offered financing to allow investors to “borrow-to-buy” the war loan. This was supported by advantageous financing the Bank of England provided to banks themselves financing holdings of the war loan. With this assistance, two million people were invested in the third war loan.
Prime Minister David Lloyd George, a Liberal presiding over a multi-party coalition, argued in retrospect that raising the interest rate was unnecessary given the threat of a forced loan could have gotten people to invest willingly at a lower rate. While perhaps it rendered the increase unnecessary, the specter of a forced loan was in fact raised by the Conservative Chancellor Andrew Bonar Law who threatened bankers and insurance companies with confiscation of capital unless they raised £620 million and £100 million respectively.
In any case, by the end of the war, the third war loan was the dominant security in the debt markets. Indeed, conversions meant that almost all longer-term broadly-syndicated war-related securities outstanding at the end of the war were those of the third war loan. Industrialists enriched by the war recycled that capital into these bonds before their industries went into decline in the 1920s. At 5% interest, servicing this debt was expensive. As a result, 40% of tax receipts in the 1920s went to debt service.
This fiscal strain was reduced in the 1930s though. Crucially, Britain abandoned the gold standard in 1931. Initially, the result was volatility in interest rates in 1931 and bond prices fell. However, interest rates in Britain fell sharply in the subsequent year, from 5% in February to 2.5% in May and 2% in June. This caused prices of the old 5% war bonds to rise back to par and then above their face value.
Recall that after 1929, the bonds were redeemable by the government. So, in response to the changed circumstances, Neville Chamberlain, then the Chancellor of the Exchequer, refinanced the entire long-term war debt into a new 3.5% perpetual bond. With this, Britain’s fiscal position took a large step towards improvement, though just in time for rearmament in anticipation of yet another world war.
During the First World War, Britain hoped to use its deeper financial resources to ensure the Allies were the last side standing. Because of the government’s ability to marshal credit for the war effort, it was able to finance not only its own war effort but contribute to that of its allies. However, the cost was tremendous. After the war, several belligerent countries were in financial disarray and even Britain was strained. So, however remarkable the financial feat of 1914-19 was, no less dramatic was the extent to which this success weakened the country’s ability to address the challenges that led to a new war in the 1930s.
More from the Tontine Coffee-House
Read about the immediate financial repercussions of the start of the First and Second World Wars and how sales of stamps were used to raise money during the First World War in the United States. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
1. Anson, Michael, et al. “Your Country Needs Funds: The Extraordinary Story of Britain’s Early Efforts to Finance the First World War.” Bank Underground, 8 Aug. 2017.
2. Broadberry, Stephen, and Peter Howlett. “The United Kingdom during World War I: Business as usual?” The Economics of World War I, 2005, pp. 206–234.
3. Cohen, Norma. “How Britain Paid for War: Bond Holders in the Great War 1914-32.” Bank Underground, 14 Jan. 2021.
4. Ellison, Martin, et al. “Funding the Great War and the Beginning of the End for British Hegemony.” Debt and Entanglements between the Wars, edited by Era Dabla-Norris, International Monetary Fund, Washington, D.C., 2019, pp. 59–79.
5. Higgins, Benjamin. “Lombard Street in War and Reconstruction.” Lombard Street in War and Reconstruction, New York, Financial Research Program, National Bureau of Economic Research, 1949, pp. 10–25.
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