Why Economic Wars Cause Inflation

Why Economic Wars Cause Inflation

Why Economic Wars Cause Inflation

The economic consequences of Covid-19 are often compared to a war, prompting fears of rising inflation and high bond yields. However, historically, pandemics and wars have had diverging effects. This column uses data extending to the 1300s to compare inflation and government bond yield behaviour in the aftermath of the world’s 12 largest wars and pandemics. It shows that both inflation and bond yields typically rise in wartime but remain relatively stable during pandemics. Although every such event is unique, history suggests high inflation and bond yields are not a natural consequence of pandemics.

Wars result in higher inflation and bond yields, pandemics do not

Figure 1 displays the median behaviour of inflation around major wars, together with its interquartile range (and also a median based only on global wars in our sample). Inflation has typically risen sharply both during and – especially – in the aftermath of major wars, with median inflation peaking at 8% one year after the war has ended.

Putting aside the very real human cost, war has also serious economic costs – damage to infrastructure, a decline in the working population, inflation, shortages, uncertainty, a rise in debt and disruption to normal economic activity.

Why Economic Wars Cause Inflation

From some perspectives, war can appear to be beneficial in terms of creating demand, employment, innovation and profits for business (especially when the war occurs in other countries.) However, when we talk about the ‘economic benefits’ of war we must be aware of the ‘broken window fallacy‘ – when we spend money on war, this creates demand, but also it represents a huge opportunity cost – rather than building bombs and rebuilding destroyed towns, we could have used this money to improve education or health care.  For example, the opportunity cost of the Iraq war was estimated at $860 billion by end of 2009 (source: NY Times)

War and inflation

In many circumstances, war can lead to inflation – which leads to loss of people’s savings, rise in uncertainty and loss of confidence in the financial system. For example, in the US civil war, the Confederacy struggled financially to meet the cost of the war. Therefore, they started printing money to pay soldiers’ salaries. But, as they printed money, the value of money soon declined. High inflation hits middle-income savers the most as they see the value of their savings wiped out.

During the Second World War, the United States saw a rise in inflation because the economy was running close to full capacity, the high levels of government spending and shortage of workers saw inflationary pressures. During war, the economy can also experience cost-push inflation due to shortages of goods and services and rising price of raw materials like oil. (Interestingly inflation in the Second World War was limited by price controls and rationning)

If a country is devastated by war and the capacity to produce goods is sharply reduced, it can create the circumstances of hyperinflation as governments desperately print money to try and deal with the lack of goods. For example, with a devastated economy, in 1946, Hungary and Austria experienced the highest rates of hyperinflation on record.

War and National debt

During war we often see a rapid rise in public sector debt. The government is willing to borrow a lot more than usual because – there is patriotic support for the war effort.

Both the First and Second World Wars were very costly for the UK. In both cases, the national debt rose very sharply. In the post-war period, debt continued to rise due to reconstruction and the creation of the welfare state.

For the US, which was not involved for the first two years, the rise in national debt was not as pronounced. The US profited from selling arms and equipment to the UK during the early years (though on generous lend-lease terms)

Why Economic Wars Cause Inflation
Why Economic Wars Cause Inflation

Financial cost of war

Although war can provide a temporary boost to domestic demand, it is important to bear in mind the cost of war. In particular the opportunity cost of military spending, the human cost of lost lives, the cost of rebuilding after the devastation of war. Also, it depends on the kind of war, how prolonged it was, where and how it is fought. For example, the US fought wars – WWII, Korean War, Vietnam War and it appeared that these wars led to a boost in domestic demand and some manufacturing companies did very well. However, we shouldn’t forget that these wars occurred on territories outside the US. The real devastation took place in Asia and Europe.

Cost of civil war

Civil war can have a devastating impact on the economic development of countries. Countries experiencing civil war will see a collapse in tourism, foreign investment and domestic investment. It can lead to shorter life-expectancy and lost GDP. A report entitled “Africa’s missing billions”  (Oxfam, 2007) estimates the cost of war in Africa has been equal to the amount of international aid. A country like the “Democratic Republic of Congo” has experienced a particularly difficult war, which besides causing the deaths of about 4 million people, has cost it £9bn, or 29% of its gross domestic product.

The report also notes that ongoing war and increased availability of weapons can lead to increase in rates of armed violence and organised crime.

However, the aftermath of war is not always so positive. The UK struggled after the end of The Napoleonic war and after the end of the First World War. In the 1920s, the UK struggled with a long period of unemployment – returning soldiers found very poor employment prospects. Yet, after the Second World War, the US and Europe experienced full employment.

The German economy was ravaged by the aftermath of the First World War and the demand for reparation payments. Struggling to meet reparation payments, Germany resorted to printing money – leading to hyperinflation. The discord around the German hyperinflation of the 1920s sowed the seeds for political extremism and future wars.

However, after the Second World War, the Allies didn’t make the same mistake. The US gave generous aid to Western Europe – helping the rebuilding process and leading to the economic miracle of Europe, and Germany in particular.

 

 

 

Share to Social Media

Share on facebook
Share on telegram
Share on twitter
Share on linkedin
Share on pinterest
Share on reddit
Share on whatsapp

Recent News

Hot stories

Promotion

Join Our Newsletter