Working Paper Series no. 627: Monetary and Fiscal Policy in England during the French Wars (1793-1821)

NON-TECHNICAL SUMMARY

How do you finance a world war or any costly crisis? What role should the central bank play in financing public expenditures? And once public debt has accumulated and inflation occurred, how do you exit from such a situation? We answer these questions by studying the French Wars (1793-1815). As the wars exerted unprecedented pressures on Britain's budget—only World War 1 would prove more expensive—they offer a unique case to study the interactions between fiscal and monetary policies. Their outcome also shaped what economist put forward as the proper way of implementing monetary and fiscal policies for the century to come.
Our analysis is particularly relevant for the euro area where the euro plays a role that is analogous to gold in former times and where the European Central Bank is the principal actor of crisis management (Reis 2014). We also inform the policy choice between maintaining a fixed exchange rate and restructuring a debt overhang, as under discussion in certain euro area countries. Finally, we contribute to the analytical debate concerned with the conditions under which the variations of a central bank's balance sheet affect prices (Chamley and Polemarchakis 1984).  
Over the 22 years of almost uninterrupted warfare, policy makers adjusted monetary and fiscal policies to meet increasing needs of war finance. This meant implementing monetary and fiscal policy innovations, such as the suspension of the gold standard and the instauration of Britain's first income tax—60 percent of the extra cost incurred by the war was covered by tax revenues (O'Brien 1988). These adjustments signalled the government's commitment to undertake the necessary to win the war, without jeopardizing fiscal sustainability.
Drawing on new hand-collected data, we also show that the Bank of England played an essential role in two successive phases of the war. It granted ample liquidity to the domestic payment system, by purchasing large amounts of private bills. It also financed the last and decisive phase of the wars by purchasing large amounts of public debt. While the Bank's balance sheet increased substantially during the wars, its composition may have mattered more than its growth.
The Figure above shows the Bank's holdings of public debt and the exchange rate of its notes into gold. During the suspension of the gold standard, contemporaries used this exchange rate to assess inflationary tensions. Bank notes devalued when the demand for funds intensified with the war in 1809/10 and fiscal prospects deteriorated. Prices declined when fiscal pressure subsided with the end of the war. Overall, inflationary tensions evolved with the fiscal backing of the Bank's notes. The variations in the Bank's balance sheet affected asset prices and the aggregate price level because they interacted with fiscal policy.
The exit strategy, i.e. reversing the war stimulus came with high economic and social costs. The rate of unemployment increased from 5 to 17 percent in the post-war depression of 1816 (Feinstein 1998). These costs were, however, largely unaccounted for since public manifestations of social discontent were rendered illegal and the electoral system entailed an under-representation of the citizens most affected.The mistakenly perceived ease with which the resumption of the gold standard was undertaken in 1821 shaped monetary orthodoxy (Fetter 1965). It also ushered in the gold standard's second resumption after World War One, an event that prolonged and aggravated the Great Depression (Bernanke 1995, Eichengreen and Temin 2000). This is also a relevant lesson for the current policy choice between maintaining a fixed exchange rate and restructuring an outstanding debt overhang, as under discussion in certain euro area countries.