War Financing for Ukraine

The public support of the war is high. 63% of Ukrainians believe that Ukraine should fight for the Donbas

Authors:

Ukraine is living through very trying times. Among Ukraine’s many problems, the Russian aggression in Donetsk and Luhansk regions is likely to be a top priority issue: it costs thousands of human lives. In addition, it weighs heavily on the Ukrainian economy. On December 20, 2014, President Poroshenko reported that each day of Anti-Terrorist Operation (ATO) in Eastern Ukraine costs UAH 100 million. According to the recently approved budget for 2015, the government plans to spend UAH 90 billion on national security (approximately 5% of Ukraine’s GDP).

While there is some progress in containing the conflict, in all likelihood it will smoulder for a long time before it’s resolved and, thus, the total bill could be in hundreds of billions of hryvnia. How should Ukraine finance these expenditures?

There are three main sources of war financing: printing money (seigniorage), increasing taxes, and borrowing.

Printing money is an easy option for the government because it does not require an explicit approval from the voters. It could be efficient in the early stages of a conflict and in moderate amounts. Also, it can take indirect forms such as financial repression when the government sets a ceiling on interest rates and limits the ability of the public to invest in securities other than the government debt. Obviously, excessive use of this source leads to increased inflation and currency depreciation. A prominent example of such excessive use is Germany after the WWI.  To pay reparations, the German government stopped convertibility of currency into gold and started printing money at an increasing pace. As a result, in 1922, the price level living increased fifteen times and the economy collapsed. After this dismal experience, financing wars through seigniorage is rarely used. After World War II, only the Republic of Korea in the Korean War (1950-1953) and the Republic of Vietnam in the Vietnam War (1965-1975) used seigniorage to a significant extent.

Economists disagree on the optimal mix of taxes vs. borrowing to finance a war as each of these sources has pros and cons. For example, borrowed funds could be available immediately and additional debt often does not have to burden taxpayers immediately, while collecting tax money takes some time and, in most cases, new taxes have to be approved by voters. At the same time, heavy borrowing can result in high costs of servicing debt in the future. Many famous economics scholars weighed into this debate. Adam Smith in his famous “Wealth of Nations” advised to increase borrowing during war periods. In contrast, Arthur Pigou suggested that governments have to use not only borrowing but tax money in emergency cases. John Maynard Keynes suggested that military expenditure have to be financed by higher taxation and compulsory savings.

Cappella (2010) provides a nice overview of how governments actually financed wars between 1823 and 2003. She makes several observations. First, richer countries (e.g. with higher GDP per capita) with more efficient government sectors are likely to finance more through taxation. This is also true for countries which experienced high inflation in the past. However, regime type or duration of conflict does not affect decision about financing war efforts with taxes. Second, democratic countries are less likely to print money to finance wars, but if a war continues for a while, then seigniorage could be a mode of choice. Finally, borrowing could also be a preferred choice of financing if a war lasts for a long time.

In a related study, Cappella (2012) examines U.S. war financing of the Korean and Vietnam wars, Russian and Japanese financing of the Russo-Japanese War, and British financing of the Crimean War and World War II. Cappella argues that war efforts are financed by taxation in case of i) high support for war, ii) high inflationary fears, and iii) efficient bureaucratic machine able to extract tax revenues. Furthermore, government prefer to borrow externally when own currency reserves are low.

While the optimal mix of funding sources typically emphasizes long-term aspects, the short-run macroeconomic implications of war financing are important in the current Ukrainian context. Ohanian (1997) is an excellent case study illustrating the difference between debt and tax-based financing. Ohanian compares U.S. macroeconomic outcomes of two wars: World War II (primary financed by issuing debt) and the Korean War (almost exclusively financed by balanced-budget approach through higher capital and labor taxes).  Macroeconomic statistics for these two wars are summarized in Table 1.  Annual growth in real output is about 3.3% higher during World War II compared to the Korean War. This finding is also confirmed by simulations suggesting that World War II policy applied to the Korean War would have resulted in modest welfare gains. In short, debt financing could stimulate the economy more than tax-based financing.

Korean War vs. World War II

Korean War (1950-53) World War II (1941-45)
Real output growth 5.1% 8.4%
Inflation rate 0.4% 9.6%
Standard deviation of money growth 0.03% 2.5%
Government spending, deviation from least square trend 29.0% 124.0%
Average capital tax rate: during war 62.6% 60.2%
Average capital tax rate: prior to war 51.5% 43.8%
Average labour tax rate: during war 19.8% 17.5%
Average labour tax rate: prior to war 16.2% 8.7%

What lessons could Ukraine learn from these studies? Ukraine experienced hyperinflation in 1990s which works against printing money to finance the current war. Indeed, to generate seigniorage revenue, the government must print money at a rate that exceeds expectations of households and businesses. Since inflation expectations are unanchored in Ukraine, even moderate seigniorage revenue could require high levels of inflation to generate surprise inflation (that is, inflation exceeding expectations of the private sector). The effectiveness of financial repression could be limited too because a large chunk of the economy is dollarized, the shadow economy is huge (close to 50%), and main economic players have access to financial markets abroad.

The public support of the war is high. 63% of Ukrainians believe that Ukraine should fight for the Donbas. Given this support, tax financing is politically feasible. However, to collect enough taxes quickly, Ukraine has to have an efficient bureaucratic machine. Unfortunately, the capacity of the state to collect taxes is very limited because of corruption, poor administration of tax collection, and inefficient/incompetent bureaucracy. In addition, increased taxes can further weaken Ukraine’s economy which has been in a deep recession.

This leaves borrowing (especially, external borrowing) as the most attractive option. It hurts the economy in the short run less than other forms of war financing. It gets the money to the government quickly. It is less likely to crowd out other government spending (healthcare, education, etc.). And the money is available: potential creditors in the West signaled their willingness to lend to Ukraine if the government does serious reforms.

In summary, if the government needs to fund military spending and help the economy, weaponized Keynesianism with debt financing could be the way to go for Ukraine.


Disclaimer

The authors do not work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations