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2.15 How to Pay for the War

According to Skidelsky (2000), from 1937 onwards Keynes began to devote

his attention to the problems posed by rearmament in an economy as it

‘neared full employment’. In a fully employed economy, room has to be

created for the necessary increase in war production involved with rearmament.

This could only be engineered by reducing the consumption component

of aggregate demand given the need to maintain exports and investment

expenditures. To achieve this objective, Keynes, in his How to Pay for the

War (1940), advocated wartime fiscal restraint. This pamphlet is described by

Vines (2003, p. 343) as a ‘marvellous piece of applied economics’ even if his

plan was only partially adopted (Keynes believed that an alternative system

of universal rationing amounted to ‘Bolshevism’; see Skidelsky, 2000, p. 68).

Keynes’s analysis involved comparing aggregate demand, including war expenditures,

with potential aggregate supply. Keynes (see Skidelsky, 2000,

p. 84) defined the ‘inflationary gap’ as ‘the amount of purchasing power

which has to be withdrawn either by taxation or primary saving … in order

that the remaining purchasing power should be equal to the available supplies

on the market at the existing level of prices’. The aim of fiscal restraint

(forced saving) was to eliminate the ‘inflationary gap’ by reducing consumption.

It should be noted that Keynes’s proposal reveals his great faith in the

price mechanism rather than bureaucratic control as the most efficient allocation

mechanism even if at the macro level there was likely to be market

failure requiring aggregate demand management.

An important side effect of Keynes’s discussions in the Treasury after the

outbreak of the Second World War was that it became increasingly obvious

that there was an urgent need to develop and improve national income accounting

calculations and procedures, and also there developed an increasing

acceptance of the need for demand management both in depressions and

booms. For Skidlesky (2000) the idea of demand management is Keynes’s

most important intellectual legacy. It also shows that Keynes was not an outand-

out expansionist. For Keynes, the need for demand management was

symmetrical if both inflation and depressions were to be avoided. As Skidelsky

(2000) makes clear, Keynes was always prepared to warn of the dangers

posed by inflation. We should also remember that in the General Theory

(1936, pp. 295–6) Keynes makes it clear that once full employment is achieved,

‘the wage unit and prices will increase in exact proportion to the increase in

effective demand’, and we are back to the world where the classical model is

relevant. But for Keynes (1936, p. 3) the classical world is a ‘special case’

and not the ‘general case’ of the ‘society in which we actually live’.