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Tetiana Bogdan – Scientific Director, the “Growford Institute”

Superimposing national trends in public finances on the global patterns of the functioning of warfinances allows us to identify the main vectors of the modification of the fiscal policy of Ukraine and the adjustment of the activities of the central bank during the war for the independence of our state.

Since the beginning of the full-scale war, the Government of Ukraine has been spending huge resources on fighting the aggressor and financing the country’s social and economic needs. Since lateFebruary, the volume of budget expenditures and the budget deficit, as well as the structure of its financing, reflect the increase in the share of the state and its reorientation to the primary financing of military needs.

According to the Ministry of Finance of Ukraine, for January-June 2022, cash expenditures of the state budget amounted to UAH 1,032.9 billion, or UAH  +400 billion compared to the first half of 2021 and +41.5% in real terms. However, in the first half of 2022, the state budget was executed with a deficit of UAH 405.2 billion. This amount was several times higher than in the first half of last year (UAH 43.2 billion).            

State borrowings to the general fund of the budget for January-June 2022 amounted to UAH 561.3 billion. The main part of this deficit was financed by the internal creditors of the Government. The share of emission resources of the National Bank as part of the budget deficit financing sources was40% (or UAH 225 billion).

To what extent can the outlined processes and proportions of the public finances of Ukraine be considered “natural” for the conditions of martial law and what happened in other world countries during military operations?              

Objectively, the principles of war economy are radically different from the principles of the peacetime market economy, which requires a radical transformation of public finances from the beginning of war. Throughout human history, the destructive impact of wars, epidemics, and natural disasters forced states to adopt extraordinary fiscal measures, which rapidly increased budget deficits and public debts in the affected countries.               

During the World War II, the public expenditures of European countries increased to 40-70% of their national income. In the USA, military spending increased from 1.4% of GDP in 1940 to 37% of GDP in 1945. And the US federal budget deficit increased from 3% of GDP in 1939 to 27.5% of GDP in 1943.   

In general, during World War II, the public finances of the USA were transformed in the following way:

  • state expenditures peaked (they increased from USD 13.6 billion in 1941 to USD 35.1 billion in 1942 and to USD 91.2 billion in 1944);   
  • tax receipts gradually increased, but they covered only small shares of wartime spending (if in 1940 and 1941 the revenues of the federal budget were 64-68% of its expenditures, then in 1944-1945 this ratio decreased to 48%);  
  • after World War II, government spending fell, and tax revenues remained elevated, letting the government run a primary surplus for many years;       
  • the Central bank (Federal Reserve System) purchased part of the issues of government bonds and controlled the cost of government borrowing.   

Theoretically, fighting the enemy requires increased government spending, which can be financed in the following main ways:

  • by increasing taxes;   
  • by reducing expenditures not related to military purposes;   
  • by Government borrowing from investors/creditors through loans or sales of government bonds;   
  • by printing money and involving  the central bank in the internal debt operations of the Government.  

The actual data for the US economy during World War II show that debt financing of the budget became the predominant way of financing the expansion of public expenditures. Although an increase in the tax burden on personal income and emission financing of the budget also played a certain role.  

G. Hall and T. Sargent measured the shares of tax, debt and monetary financing of the surges in government spending in the US wartime economy:  

                                              Taxes                     Bonds                            Money 

World War I                     20.8                        74.6                          7.0 

World War II                     30.2                       46.0                          10.1

Source: “Three World Wars: Fiscal-Monetary Consequences”, April 4, 2022.

Expanding the historical period of the study, G. Hall and T. Sargent established that in the USA the predominant form of financing additional financial needs of the state during the wars had been:   

  • Debt financing (World Wars I and II, “cold” war, wars in Iraq and Afghanistan);
  • Increased taxes (Korean War);    
  • Fueled inflation and increased seigniorage (Vietnam war).

Regarding the functions of the central bank in the war economy, during World War II, the Fed purchased 7% of new debt. Since 1942, the Fed fixed interest rates on short-term Treasury securities at 3/8 of percent per annum. As the demand of private investors for these securities was low, the Fed repurchased them in large quantities and served as “a buyer of last resort”. Between 1944 and 1948, the Fed held between 40 and 89% of outstanding Treasury bills. And private investor holdings were more heavily weighted toward long-term Treasury notes and bonds.       

To reduce the Government’s costs for financing the record high budget deficit during the war, the Fed undertook to control the prices and yields of government bonds and ensure the stable financial market. In 1939, before the start of the war, the Fed conducted open market operations to influence the yield on short-term government securities. The purpose of this policy was to promote the stability of the Government’s short-term funding market. When the USA officially entered the War, the Fed agreed to protect bond prices from declining. In April 1942, the Fed announced that it would cap the interest rates on short-term Treasury bills at 3/8 percent per annum  by purchasing and selling them in any amount necessary for target interest rate.    

For long-term government bonds, the US Fed also capped yield and undertook to purchase them in any amount determined in relation to this level. The policy of low interest rates for Treasury bills and government bonds resulted in significant amounts of the purchase of these securities by the US Federal Reserve and a large increase of the monetary base.       

For example, during August 1939 – August 1948, the monetary base in the USA rose by 149%, or 2.5 times. In addition, the active issuance of government bonds during the war caused the growth of US public debt to more than 120% of GDP at the end of 1945.        

To finance military expenditures, the Government had to sharply increase tax rates. In 1941, US political leaders spoke about the need for the widest possible use of tax instruments to mobilize the necessary amount of resources and joint efforts by all members of society. But at the initiative of the President of the USA, Congress adopted a version of tax reform with an emphasis on raising taxes on personal income. The Revenue Act of 1942 announced a new phase of tax reform that dramatically increased tax rates and reduced deductions from the tax base. The upper personal income tax rate was raised to 90%, and the tax-free minimum income of citizens was significantly reduced, as a result of which the number of tax-paying households increased 6 times. As a percentage of GDP, tax revenues of the Federal Government went up significantly and reached 20% of GDP.          

Great Britain saw similar processes during World War II. Since the beginning of the War, publicexpenditures reached 70% of GDP, and only half of them were financed from tax revenues. The cost of loans for the Treasury was low: from 1941 to 1945 it did not change and was 2.7% per annum (nominal rate). In addition, the real yield on government bonds was slightly negative. Monetary financing of the budget deficit was about 5% of its total volume.

J. M. Keynes in his works in 1939 and 1940 wrote that the absolute priority of public spending at that time was to ensure fighting on the scale provided out of existing capital capacity. Tax revenues for these purposes (even after raising tax rates and expanding the tax base) would obviously not have beensufficient to cover wartime needs. Therefore, the budget deficit was  inevitable in the war economy.

In practice, the British Government, implementing Keynes’s recommendations, issued significant volumes of public debt, and the Bank of England provided their acceptable value. Public borrowingsof private borrowers were limited to avoid competition with the Government. Currency control prevented the transfer of national currency to foreign currency and unjustified import purchases.         

After the beginning of russia’s aggression against our country, Ukraine saw the following trends in public finances:     

  • a significant increase in total state budget expenditures (by 41.5% in real terms) and the share of budget financing of the safety and defense sector;    
  • a nominal decrease in budget revenues as a result of the narrowing of economic activity and tax benefits to Ukrainian businesses;     
  • active attraction of public loans and accumulation of public debt to mitigate the decline in tax revenues under the growth of state expenditures;   
  • intensification of grant and credit support from external official creditors as a form of solidarity with Ukraine by the world’s leading states;    
  • actual closure of external private sources of financing for the Government for an indefinite period of time;     
  • the issuance of domestic war bonds by the Government and the attraction of emission resources of the central bank in order to maintain the desired volumes of bond placement with weak participation of private investors.   

Superimposing national trends on the patterns of military finances in the leading countries of the world during the wars of the 20th century allows us to identify the following common and distinctive features:    

  • Reducing tax rates or long-term providing tax benefits to people and businesses that are not in a war zone, is an anomaly for a country at war and deprives the state of necessary resources to win the war. The acceptable method of mobilization of additional revenues by the state is the increase of personal  income tax rates and the implementation of progressivity in personal income taxation;   
  • A significant increase in budget expenditures is justified in wartime economy and is of crucialimportance for viability of the state. However, this does not preclude compliance with the regime of strict economy of budget funds. But state grants for starting a small business and development of civilian transport infrastructure during the war (which is happening now in Ukraine) have no precedents in world practice;
  • Emission financing of the budget deficit is a generally accepted method of financing during the war, however, in the countries that managed to maintain macro-financial stability, the share of monetary emission among the sources of deficit financing did not exceed 20%. In Ukraine, as of the beginning of July, this share has already reached 40%. This anomalous situation requires intensifying efforts on the diplomatic front to attract external financial assistance and prudent work with domestic investors in government securities;
  • An important function of the central bank in wartime economy is to reduce the cost of government borrowing through open market operations and to implement currency control aimed at the state’s financial needs. Unfortunately, this is not happening in Ukraine, and the key policy rate of the National Bank of Ukraine (which is a benchmark for the yield of short-term government issued bonds) has been increased by 2.5 times since June.

In general, in the period of fighting the aggressor, the key tasks for all branches of government and progressive members of society are to ensure the smooth functioning of public finances and the state’s performance of its key functions, to prioritize financial and economic resources to gain victory over the enemy, to support economic activity and maintain macro-financial stability in the country