The Day After Tomorrow

By Harold James

PRINCETON – When (and how) to end the COVID-19 lockdown has become the leading political question in every afflicted country. German Chancellor Angela Merkel has gone so far as to describe the increasingly intense debate as a collection of “discussion orgies.”

At the heart of the issue is the question of how to distribute the soaring economic and fiscal costs associated with the crisis. The closest historical analogy is to the twentieth century’s interwar period, which offered a crash course in navigating extreme fiscal circumstances.

Like the COVID-19 crisis, World War I was a prolonged affair, lasting much longer than people initially expected. In the summer of 1914, many assumed that it would all be over by Christmas. Likewise, in early 2020, many hoped that a brief shutdown would stop the spread of the virus in its tracks. In both cases, the economic shock was grossly underestimated at the outset.

WWI triggered two completely different kinds of national response, though this wasn’t apparent initially. Each brought long-term disruption, but one was far more calamitous than the other.

No belligerent could pay for the massive military mobilization through taxation alone, so the war was funded through borrowing, and much of that was eventually monetized by central banks. Such action was necessary and appropriate for dealing with the emergency, and central bankers duly congratulated themselves for their can-do attitude and patriotism in the face of extenuating circumstances.

The impact on budgets was relatively uniform across countries. By the last year of the war, military expenditures as a share of deficits were around 70% in Italy, the United States, and the United Kingdom, 80% in France, and over 90% in Germany. Price increases in each country were also broadly comparable: they more than doubled, but there was no radical inflation outside of Russia.

The bigger differences emerged after the war. The UK and the US, facing massive debt-servicing costs from their wartime liabilities, tried to return to normal as quickly as possible. That meant pursuing a balanced budget through substantial tax increases, including unprecedentedly high tax rates for the rich. This approach – the modern world’s first experience of induced austerity – choked off demand and triggered an exceptionally deep but short-lived recession.

By contrast, a defeated Germany, like almost every other central European country, feared severe deflation. With the population exhausted and demoralized by the conflict and its outcome, the government was not inclined to impose new taxes. Policymakers considered social programs necessary for maintaining domestic peace and order, so they relied on the central bank to do the financing, and continued to spend freely on welfare payments and public-sector employment.

Unlike the UK and the US, the German government assumed that the wartime emergency had not ended; the peace was merely an extension of the conflict. Policy discussions continued to feature emergency measures and the radical rhetoric that had been used to justify similar policies during the war. Of course, Germany’s policy response eventually produced hyperinflation, and much more profound social disintegration thereafter.

Policymakers today will face a similar temptation to extend the emergency and defer the eventual reckoning and distribution of costs. After all, it is not clear what would even constitute an end to the COVID-19 crisis, given that there could be recurrent waves of infection, as happened with the influenza pandemic that began at the end of WWI.

Moreover, the response to the 2008 global financial crisis set a terrible precedent. As with any wartime mobilization, emergency actions to deal with the immediate crisis were clearly needed. But a perception of fragility and vulnerability remained long after the emergency had passed, because many countries were unwilling or unable to pursue debt reduction through write downs, for fear that doing so would trigger a new wave of financial turmoil.

As in the aftermath of 2008, policymakers today are committed to doing “whatever it takes.” While major central banks have the firepower to deal with the immediate liquidity crisis, the hard part will come with the allocation of costs. These costs will include not just the increased spending to deal with the medical emergency, but also the losses incurred by businesses affected by the lockdown. If private enterprises are not bailed out, the question shifts to the fate of their workers. Will temporary measures to compensate for displaced workers’ lost income become new permanent features of the welfare state? Will countries start embracing some form of universal minimum or basic income?

The 1920s were also a time of radical social-policy experimentation. The lesson from that period is that such programs cannot be financed simply through a continuation of emergency measures. To be sustained, they eventually must be priced correctly and funded through taxation (or, in some cases, with the help of debt cancellation).

Obviously, when confronting an emergency, one shouldn’t think about the bill. But nor can one ignore what comes next. Those now calling for an immediate end to the lockdown have an obligation to speak frankly and openly about how costs will be distributed in the future. So far, this debate has been evaded. The experience of the interwar period suggests that avoiding the hard questions is a recipe for disaster.

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James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation.