War bonds are back on the agenda, but history urges caution

In 1914, the UK government needed to raise money to fight the first world war – and fast. It set out to raise a £350m war loan from the public. At the time, this scheme was dubbed a great success, with fawning articles in the press describing how the loan had been oversubscribed by patriotic investors doing their duty.

But in reality, it was a dramatic failure. Only £91m was raised this way, less than a third of the target. The Bank of England was forced to make up the shortfall and stage a cover-up to avoid a propaganda disaster.

Academics at Queen Mary University of London, studying newly released archive materials in 2017, found that the Bank’s chief cashier, Gordon Nairn, and his deputy Ernest Harvey had purchased huge chunks of the loan in their own names and buried them in an obscure corner of the Bank’s balance sheet. Nairn subsequently swore in a statement that all £350m had been sold to the public. Yet appeals to patriotic duty and “sacrifice” had in fact failed to drum up sufficient investor demand.

Our defence spending needs aren’t quite so acute today, but they are nonetheless increasing and war bonds are back on the agenda. Proponents think they could, once again, help to deliver the government’s costly ambitions on defence spending.

They could come in different forms. Nicholas Lyons, chair of Standard Life, has argued in this paper for inheritance tax-exempt defence bonds as a means of financing additional spending.

Government bonds – “gilts” – are already exempt from capital gains tax, which makes them a tax-efficient investment vehicle for a particular corner of the retail market. The argument is that if a new, special tranche of “defence bonds” were also made exempt from inheritance tax, they would be of considerable appeal to wealthy investors looking to leave financial assets to their families without incurring a hefty charge from the taxman. They would be willing to accept a lower coupon (interest rate) on the bond in return for the favourable tax treatment, potentially lowering government financing costs.

There are a few issues here. First, having a subset of gilts subject to their own particular tax treatment would fragment the market, making it shallower and less liquid. Second, and more importantly, lower interest costs in the short term would be offset by lower inheritance tax receipts later. It’s not a free lunch, even if it might appear that way to a short-termist government more focused on the near-term interest savings than the long-term loss in tax revenues. And third, as I’ll come back to, however it’s badged, additional borrowing is still additional borrowing.

Alternatively, the Liberal Democrats have suggested that rather than fiddle around with tax reliefs, the government should simply issue £20bn of special defence bonds, to give the public the “opportunity to invest directly in defence as part of a collective national effort”.

There’s something to be said for this. The Treasury absolutely should be thinking about ways to find new domestic buyers for its debt, to lessen our reliance on flighty hedge funds and what Mark Carney called the “kindness of strangers”. If there are indeed large numbers of retail investors out there with spare cash, looking to scratch a patriotic itch while earning a decent rate of return, marketing some form of war bond might help to broaden the retail buyer base – especially if coupled with reforms and products which make it simpler, cheaper and easier to buy gilts. It could be a job for Savvy the Squirrel, the mascot of the government’s new retail investing campaign.

But, again, there are issues. The 1914 war loan experience suggests that appeals to duty and sacrifice alone might not be enough to secure favourable borrowing rates; savers might even require higher rates to persuade them to lock up their money for an extended period. When viewed as a more expensive, less flexible form of borrowing, war bonds start to look rather less attractive.

Yet the fundamental problem is this: additional borrowing via special defence bonds would still be additional borrowing. There is a perfectly reasonable argument for borrowing to accelerate the rearmament process, especially if combined with policies that yield substantive savings only in the long-term (such as scrapping the state pension triple lock, or disability benefit reform). But ultimately, as the US retreats from its role as security guarantor in Europe, the UK needs to spend more on defence not just as a one-off, but indefinitely. Borrowing is not a sustainable solution. The country also needs to divert resources away from other sectors and towards the military – more guns, less butter – which borrowing would do nothing to achieve.

Instead, if we’re to meet our Nato commitments, the government will need to spend less on something else, raise taxes, or both. Harking on about war bonds distracts from that choice, which cannot be ducked forever.

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