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Debt and Entanglements Between the War by Era Dabla-Norris

The seven chapters in this book—about the United States (US), the United Kingdom (UK), the four Dominions of the British Commonwealth (Australia, New Zealand, Canada, and Newfoundland), France, Italy, Germany, and Japan—describe how, by affecting fiscal policy, political and economic interests influenced alliances, defaults, or quasi defaults and the unwinding of debts. The distinct domestic and external debt securities issued by these countries and the intricate network of sovereign debts and credits that emerged at the end of World War I (WWI) underpin our analysis.

     The interwar years offer an exceptionally rich laboratory for studying international monetary and debt policies. With the onset of WWI, the unprecedented trade and capital flows seen in the prewar period of globalization ceased, and the gold standard was suspended. But the war also proved to be a watershed for sovereign debt. The US emerged as a major creditor nation; the governments in Europe were swamped with debt. The victors had borrowed to win, and the losers were saddled with reparations. Buoyed by the fragile monetary and trading system assembled in the 1920s, American banks entered a period of massive international lending to allies and belligerent governments alike, partly intermediated by British banks. The boom in private and sovereign credit ultimately ended spectacularly in a crash, turning a financial panic into a worldwide depression.

The years that followed the First World War are a rich source for the study of monetary and sovereign debt. They are also an object lesson. The absence of effective mechanisms in this period for collaboration and resolution in this period had disastrous consequences for the entire global economy. Analysis of the economic aftermath of war in Western and westernised countries provides unique insights into how politics and policy influenced alliances, defaults and the unwinding of debts

The decades after WWI are replete with instances of commodity price busts, financial catastrophes, hyperinflations and deflations, devaluations, protectionist pressures, and stabilizations—both failed and successful. The ensuing implications for debt management, restructurings and repudiations of domestic and external loans were similarly momentous. And although today’s circumstances are undoubtedly different from those experienced in the past, parallels exist with the historical episodes covered in this volume. Taking stock of past events can thus provide insights into the theories, opinions and interests that motivated how governments managed situations that resemble ones that we confront today, as well as those that lie ahead.

     The country narratives exploit granular information on the nature, size and characteristics of public debt instruments and the purposes for which they were issued. This offers unique insights into how countries managed their debt, its composition and the role that debt conversions and restructurings played. In theory, a sovereign debt contract is an ownership title expressing a claim on part of a state’s future revenue.

     These claims transcend international borders. In this respect, the comprehensive inventory of domestic and external debt instruments assembled can shed light on the linkages among debt, macro-economic policies and the political interests they create.


What does this book cover?

In each of the countries covered in this volume, fiscal policy and its distributional impacts grew in importance as questions regarding who would pay for postwar reconstruction and how to cope with fallout from the depression came to the fore. This boiled down to the questions of whom to tax and how much. However, the international dimension was equally relevant. Large government debts politicized issues about units of account, monetary policies and exchange rate policies. Indeed, inflation and deflation fueled the debate surrounding currency stabilization—namely the level at which to peg the currency to gold—and the resulting implications for creditors and debtors. Ultimately, domestic politics and international entanglements shaped the constellation of fiscal-monetary and sovereign debt outcomes observed during this period, a connection highlighted in this book.

Era Dabla-Norris


The chapter on the US constructs a quantitative account of Henry Carter Adams’s (1887) ‘political complications sure to come with an extension of international credits’ by the US during WWI and the absence in 1914 of ‘a clearly [US] formulated policy, upon which the public may rely.’ WWI and the emergence of New York as a major financial center led to investment decisions by private US citizens that influenced US foreign policy and federal expenditure, monetary, debt management and taxation policies in unintended and long-lasting ways. The impact of these decisions for belligerent and Allied countries was no less consequential. Ultimately, what began as foreign loans by the US during the war became subsidies by the early 1930s.

     The chapter on the UK presents a narrative account starting with the forces that contributed to the beginning of the end of British hegemony. As the country with the deepest financial markets, the UK borrowed to finance its own war efforts; it also extended loans to its colonies and other allies in Europe. On the domestic front, conversion provisions by financial players in London left the government more heavily indebted than it needed to be at the end of the war. On the external front, the decision to borrow from the US to finance the war and the emergence of the US at the epicenter of the international debt network heralded the end of British financial might.

     The four Dominions of the British Commonwealth—Australia, Canada, New Zealand, and Newfoundland—offer case studies of external dependence, boom-bust cycles, macroeconomic adjustments, bailouts, and restructuring not unlike those seen today. Once overseas lending dried up, what bound them to London (New York in Canada’s case) was ‘the crushing weight of accumulated debt’ (Cain and Hopkins 2016). All four Dominions faced difficult choices between honoring debts and selectively defaulting on their domestic and external debt obligations and on contracts denominated in different currencies. This chapter documents the trade-offs they faced.

Advancing the Frontiers of Monetary Policy, cover
From Great Dpresseion to Great Recession, cover

The chapter on France examines how the country answered the ‘who should pay’ question to reduce its sizeable debt overhang during the interwar period. In the 1920s, France partially taxed away its large pile of domestic debt through inflation. Budget deficits were predicated on the premise that reparation payments from Germany would eventually permit the retirement of any new debt. When these payments failed to materialize, higher deficits were covered by printing money. But the government also resorted to short-lived austerity measures and a wide range of debt management tactics to keep the sovereign afloat.

     On August 18, 1926, amid speculative attacks on the currency, Benito Mussolini declared that he would defend the exchange rate ‘whatever the cost’. This chapter documents how altering the cost and composition of the country’s debt was an integral part of the strategy to achieve the exchange rate objective. In an environment of weak tax capacity, the government required banks and other captive financial institutions to hold debt at artificially low interest rates. This was tantamount to a tax on savings.

     The chapter on Germany documents how a sovereign can try to ‘camouflage’ its fiscal position in an attempt to obfuscate the extent of its financing needs and level of indebtedness. With memories of the Weimar hyperinflation still fresh, the Nazi government resorted to creative accounting and domestic financing mechanisms that deliberately misrepresented its fiscal position. It manipulated fiscal data and price indices to misinform the public about the underlying inflationary pressures from rearmament. It misled foreign creditors on its intentions to service reparations and external loans. Exchange controls formalized a default on foreign obligations, even as bilateral trade negotiations were used to play creditors against one another.

Era Dabla-Norris is a Division Chief in the IMF’s Fiscal Affairs Department. She is currently working on issues pertaining to structural reforms and productivity, income inequality, fiscal risks and spillovers, and demographics and fiscal dynamics. Since joining the IMF she has worked on a range of advanced, emerging market, and low-income countries and published widely on a variety of topics

The chapter on Japan relates the nation’s experience in the interwar period in the form of a narrative in three acts. In the first act, monetary dominance and fiscal discipline were anchored by a desired return to the gold standard and the ambition to internationalize the currency. The second act, characterized by monetary subordination and cooperation to aid economic recovery, followed in the wake of the worldwide depression. The final act was one of fiscal dominance amid capital controls and limited access to international markets. The result was a significant debt overhang and one of the longest quasi-sovereign default episodes in history.

     The sequence of macroeconomic events and debt and economic crises described in the chapters are country specific but common economic forces and disturbances were clearly in play. The narratives also illustrate how the absence of effective international collaboration and resolution mechanisms can amplify shocks and inflict enormous damage on the global economy. The interwar period saw recurrent failures of international cooperation. Often, policymakers seemed to be mostly looking backward, hoping to reconstruct pre-WWI monetary and trading arrangements. But that world was lost. In 1944, at Bretton Woods, the delegates with the voices that counted were looking forward and wanted to create something new. Nevertheless, the fundamentals of international sovereign debt politics endure.


The United Kingdom

by Martin Ellison, Thomas J. Sargent and Andrew Scott

The United Kingdom (UK) was the world’s economic superpower at the beginning of the 20th century, able to call on the significant resources and wealth of an industrialised economy and the expansive British Empire. However, it was singularly unprepared for the events that unfolded in the summer of 1914. Militarily, the UK had been falling behind in the arms race with Germany from 1900 to 1913, primarily as defence spending failed to keep pace with global trends. Financially, London had great difficulty coping with the international scrimmage for liquidity when the Austria-Hungary ultimatum to Serbia caused market perceptions of the risk of war to shoot up on Thursday, July 23, 1914. Foreign exchange and money markets broke down early the following week and, even though the Bank of England raised the bank rate from 3 percent to 8 percent, on Friday, July 31, the London Stock Exchange closed for the first time in its 117-year history. It was not to open again for five months. Thus, the UK government found itself in dramatic need of increasing its military expenditure at the same time that its financial infrastructure became impaired.

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The extent of the problem facing the UK government is illustrated by the fact that in the fiscal year 1912–13, defence spending was £72.5 million (3.1 percent of GDP), a proportion of GDP that had remained largely unchanged since the end of the Second Boer War in 1902. By fiscal year 1914–15, defence spending had increased  to £437.5 million (14.9 percent of GDP) and by 1915–16 to £1.4 billion (40.8 percent of GDP), a level where it remained until 1918–19.4 Only after the end of demobilisation in 1923 did defence spending return to pre-war levels as a proportion of GDP. 

     The exigencies of war meant that almost all defence spending from 1914–19 was through Votes of Credit that granted lump sum funds to the Treasury to be spent on the Navy, Army and Ministry of Munitions as the government best decided, without the prior approval of Parliament. The increase in defence spending during 1914–18 was partially offset by other line items in the government budget not keeping pace with the GDP of the wartime economy. Most notably, spending on education fell from 2.4 percent to 1.3 percent of GDP and spending on transport fell from 2.0 percent to 0.9 percent of GDP. Overall, civil spending decreased from 10 percent to 5 percent of GDP during the war, although it rebounded quickly afterward.

     Taxes were raised to provide ongoing financing for the war. First to rise were income and property taxes, which went from producing £44.8 million in fiscal year 1912–13 to bringing in £239.5 million in 1917–18 (£134.8 million at 1913 prices) and £398.8 million by 1921–22 (£213.3 million at 1913 prices). This was partly due to an increase in the standard rate of income tax from one shilling, two pennies in the pound (5.8 percent) to six shillings in the pound (30 percent) but also because expansion in coverage meant an extra 2.4 million people became eligible to pay income tax. 

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In fiscal year 1914–15, the government introduced a new Excess Profits Duty to tax what it deemed ‘excessive’ business profits at 50 percent; by 1917–18 the duty had risen to 80 percent, and receipts amounted to almost one-third of government revenue. 

     Over the period 1914–18, the total take from income and property taxes more than trebled, from 3.0 percent to 9.6 percent of GDP. Later to rise were indirect taxes, mostly through increases in customs and excise duties on basic commodities and luxury goods. However, the increase in defence spending during the Great War massively dominated the impact of this reduction in civil expenditures and higher taxes. The result was the government’s gross primary deficit being propelled to unprecedented levels as a proportion of GDP. The gross primary deficit was at its maximum in 1917 and 1918, cumulating to 148 percent of GDP over the period 1914–19. Although deficits of this size were short lived, the strain they put on the UK economy and London financial markets was extraordinary. 

     The modern concept of ‘fiscal space’ favoured by the IMF (2018) and the Organisation for Economic Co-operation and Development (OECD) stresses the capacity for governments to raise spending or cut taxes while assuring financial market access and debt sustainability. With its fiscal space limited in 1914, the UK government had little alternative but to increase either borrowing or the money supply. Britain came off the gold standard with the Currency and Bank Notes Act of 1914, and the monetary base did indeed almost double from £288 million in 1914 to £531 million in 1918. However, the subsequent upsurge in inflation and depreciation of the pound tempered any desires the government may have had to print more money to further increase the money supply. Instead, the primary deficits of 1914–18 were largely funded by borrowing in domestic financial markets and through inter-governmental loans. The difficulties in doing so contributed to the beginning of the end for British hegemony and are the subject of this chapter.

Frontier and Developing Asia, cover
Boosting Fiscal Space, front cover
Funding the Great War

In 1914 the face value of the UK national debt stood at £706 million, having fallen steadily relative to GDP since the 1820s. The early years of the conflict led to the face value of debt rising to £2,190 million by 1916, mostly due to the government issuing war loans on the London Stock Exchange (+£963 million) and extensive use of floating debt (+£573 million, the majority in Treasury Bills) to pay for military expenditure. Subsequent years saw additional war loans issued, further expansions in the use of floating debt and the arrival of external financing from foreign governments. 

     By 1919 the total debt was £7,481 million, the increase since 1916 driven by issuance of securities specific to the war (+£2,818 million), floating debt (+£826 million), and external funding (+£1,292 million). The nominal face value of the national debt remained relatively stable after 1919, albeit with increased emphasis on issuing short-dated Treasury bonds with a maturity of one to two years, rather than longer-dated securities explicitly tied to the war. 

     Although there was stability in the nominal value of debt in the 1920s, the value of debt as a percentage of GDP continued to rise due to falling prices and recurrent recessions that combined to depress nominal GDP. Other internal debt not quoted on the London Stock Exchange gained greater prominence with the successful retail launch of National Savings Certificates in 1921.


The domestic effort

The prospectus for the first Great War Loan was published on November 17, 1914, accompanied by a widespread advertising campaign encouraging the general public to buy war bonds to help the war effort. The price of issue was £95, with interest at 3½ percent payable half-yearly on March 1 and September 1. Redemption was scheduled at par on March 1, 1928, although the government reserved the right to redeem the loan at par any time on, or after, March 1, 1925, subject to giving at least three months’ notice. The amount issued was £350 million, of which £100 million was placed prior to publication of the prospectus. The first Great War Loan was not a success as it attracted only £91 million of funding from a very narrow group of investors.

The second Great War Loan was issued on June 21, 1915, at a price of £100, paying a coupon of 41⁄2 percent and redeemable at the earliest on December 1, 1925, and at the latest on December 1, 1945. The higher coupon payment reflected the increasing quantity of funding required and the need to compensate financiers for wartime inflation. Unlike when the first war loan was issued, subscribers also benefitted from being offered an additional option to convert some of their existing holdings of government securities into the second war loan. For example, it was possible to exchange £100 of the first loan into £100 of the second loan for a one-off payment of £5. Given the superior interest rate paid on the second loan, it was not surprising that the option to convert proved wildly popular. Of the £901 million total face value of the loan, only £611 million was new money since £137 million came from conversion of the first war loan and £176 million came from the conversion of existing 2.5 percent and 2.75 percent Consolidated Stocks. The option to convert was extremely valuable to financiers, especially since the prospectus also contained a pledge of future convertibility should the government need to issue debt at a still higher interest rate:


In the event of future issues (other than issues made abroad or issues of Exchequer Bonds, Treasury Bills, or similar short-dated securities) being made by His Majesty’s Government, for the purpose of carrying on the War, Stock and Bonds of this issue will be accepted at par, plus accrued interest, as the equivalent of cash for the purpose of subscriptions to such issues.


On June 11, 1917, the government published the prospectus of the third Great War Loan, issued at £95, paying a coupon of 5 percent, and redeemable at par anytime between June 1, 1929, and June 1, 1947. The initial yield of nearly 5.4 percent attracted a flood of conversions.13 Almost all of the second Great War Loan was converted, alongside £281 million from Exchequer Bonds and £130 million from Treasury bills, meaning that only £845 million of the £2.08 billion raised was new funding ...

Debt and Entanglements Between the War by Era Dabla-Norris

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