A THEORY OF WAR FINANCE

This paper analyses the financial and war-spending policies of a state that faces a conflict in which defeat would result in the loss of sov ereign power and in which the material consequences, conditional on av oiding defeat, are stochastic. The analysis takes explicit account of the historical experiences of lenders, who face debt repudiation if th e state to whom they have lent is defeated and who also face partial d efault if the material consequences of the war are unfavorable for the debtor state, even if it avoids defeat. In this analysis, the state u ses war debt to smooth expected consumption intertemporally in respons e to temporary war spending, and the state also uses contingent debt s ervicing to insure realized consumption against the risk associated wi th the material consequences of the war. An important innovation in th e analysis is to treat the equilibrium amount of war spending, the sta te's resulting probability of avoiding defeat, as well as the equilibr ium amount of borrowing as a set of endogenous variables to be determi ned simultaneously.