World War I once more?
By Martin Hutchinson
In early August next year, it will have been 100 years since investors suffered a very nasty shock indeed, when the London and New York stock markets closed for some five months and many international bonds previously thought to be high-grade proved worthless. It should be remembered: for the average investor, World War I, the cause of this disruption, blew up very quickly out of a clear blue sky.
The sky is again blue; certainly many markets, notably that for US stocks, are priced as if it were positively ultra-violet. So could such an event occur again?
The closure of the New York market at the outbreak of World War I had surprisingly little effect; the Dow Jones Industrial Average opened on December 12, 1914, at 54.3, somewhat above the 52.6 at which it had closed on July 30. The market then went into a steady upward march, so that by the peak in November 1916, after Woodrow Wilson had won re-election on the slogan "He kept us out of war", it had more than doubled to 110.
Needless to say, the US actually entering the war was a dreadful shock to the investor class, and fighting the battles proved much less profitable than supplying munitions for them, so that by the nadir of Allied fortunes in May 1918, the index had dropped by about a third to the mid-70s.
Nevertheless, at the end of 1919, it was once again at the 1916 peak, although wartime inflation meant that investors who had held since 1914 had achieved little profit in real terms, had received some nice juicy dividends, but had paid some unpleasant taxes, at ordinary income tax rates, on capital gains that were purely the result of inflation.
The London Stock Exchange had no index before the Financial Times established one in 1935, reflecting the greater amateurishness of London equity markets compared with New York. Even though London was the center of world finance in 1914, and the London merchant banks were the world's most sophisticated, they played little role in equity financing, which was handled by stock brokers and dubious company promoters unconnected with the better end of the business.
Stock prices, which had been sluggish during the Edwardian period, declined sharply during World War I, while inflation soared so by 1919 real prices were less than half what they had been in 1914.
In France, stock prices declined even more than they did in Britain, while in Germany, stocks were little protection against the virulent inflation that took hold during the war, before giving way to the hyperinflation of 1923. Thus for investors as a whole, World War I was an unmitigated disaster, with only American investors and those in some of the neutral countries such as Sweden managing to preserve their wealth more or less intact in real terms.
The economic causes of World War I have been largely neglected. Much modern scholarship, notably Christopher Clark's The Sleepwalkers published earlier this year, has shown that the major protagonists in World War I were not very aggressive in their outlook, that the system of alliances which Britain fatally joined with the 1904 Entente Cordiale was inherently destabilizing, and that the assassination of the Archduke Frank Ferdinand was merely one of a number of possible triggers, albeit a trigger that with better diplomacy by Britain in particular need never have resulted in conflagration.
The neglected causes of conflict however were the barriers to trade in the pre-1914 world, which was not fully globalized and had economic rivalries at least as destabilizing as political ones. Whereas travel between the major countries was freer than today, with passports unnecessary to visit most countries, the trade system was highly protectionist.
The British-led free-trade movement, which in the middle of the 19th century, after the 1846 repeal of the corn laws, had spread to other countries through the Cobden Treaty of 1860 with France, the German Zollverein and the low-tariff US legislation of the pre-Civil War period, had after 1860 run into an international roadblock.
The United States passed the highly protectionist Morrill Tariff in 1862 and the even more protectionist McKinley Tariff in 1890; France abandoned free trade with the protectionist Meline tariff of 1892; and the newly united Germany under the tutelage of Otto von Bismarck passed a highly protectionist tariff in 1879.
Thus by 1900 the world was no longer governed by free trade but had erected massive trade barriers. Had Britain been sensibly run, it would itself have abandoned free trade, passing something like the modest Imperial Preference tariff of 1932, which would have bound together the colonies and dominions in a large free-trade area. As it was, Britain suffered a steady deterioration of its competitive position, which it exacerbated by a massive export of capital, both to colonies and foreign countries, notably in Latin America.
By 1914, the European countries were no longer united by deep trade links exploiting different countries' comparative advantages, but were instead locked into a battle by which each new development, such as the German Berlin-Baghdad railway, was a protectionist dagger aimed at its competitors' economies. In such an atmosphere, war was all too probable.
Given this background to World War I, the probability of another such event no longer seems so low. It is becoming increasingly clear that the modern era of free trade, similar to the 1840s-1860s efflorescence, ended with the financial crash of 2008. Since then we have seen a kind of creeping protectionism.
It took 30 years for the 19th century free-trade era to lapse into protectionism; if the global economy suffers the breakdown which I fully expect from recent monetary and fiscal policies, it's likely that the next such relapse will be on us more quickly.
We didn't get a re-run of World War II a generation later the way we had after World War I for one reason: the world of 1964 was no longer multipolar, but bipolar. No country other than the United States or the Soviet Union could prevail in any conflict with the Big Two. Consequently geopolitics was simple; the two superpowers could watch each other's movements and counter them, with very little chance that a crisis would escalate into Armageddon.
When crises occurred, as in Berlin in 1961 or Cuba the following year, the two superpowers could signal carefully to each other to defuse the trigger, thus preventing conflict. No action by a third party, such as Germany or Cuba in those cases, was important enough to fog communication between the two major adversaries.
Before 1914, geopolitics was much more difficult, as it is today. The pre-1914 alliance system, together with the reality of several roughly equal powers, combined the worst of bipolar and multipolar systems. Communication between the players was poor and confused by messages from other players, while the actions of members of one alliance were existentially threatening to members of the other alliance.
While from 1990 to about 2005 the world was effectively unipolar, that is no longer the case. The United States has been drastically weakened by the ineptitude of the George W Bush and Obama administrations, and other powers have become stronger, notably China, Russia, India and Brazil, while a partly united EU and an economically powerful and no longer US-dominated Japan can no longer be ignored.
We are not in the 1914 position of a half-dozen roughly equal powers with different strengths and weaknesses; we are instead in a world of multiple powers of different sizes and capabilities, without a single dominant player.
Without an alliance system, today's world is less dangerous than that of 1914. However, further growth in Chinese strength and Russian assertion would push the world's geopolitical system towards the dangerous 1914 configuration, as would closer alignment between Chinese and Russian diplomacy. We can no longer comfort ourselves that today's countries, being democracies, are better run than the traditional societies of 1914.
Neither Russia nor China are true democracies, while all 1914's major players except czarist Russia incorporated substantial democratic elements in their governance. In 1939, at least two and arguably three of the world's major powers were run by madmen, but that was no more the case in 1914 than it is today.
One additional protection today that did not exist in 1914 is that of the international organizations. Certainly a United Nations, had one existed in 1914, might have encouraged sufficient dialogue between the conflicting powers to prevent all-out war, and a Group of Eight type alliance system covering the major powers, similar to the Quadruple/Holy Alliance of 1815-22, would almost certainly have prevented war. But the League of Nations' unhappy experience in 1938-39 shows that ineffective international organizations may be powerless to prevent conflict.
In today's world, the best protection against war may come at an earlier stage, through the World Trade Organization keeping open the channels of more-or-less-free trade. Unfortunately that body, already fairly feeble against protectionist impulses, has been further weakened by the appointment of a Brazilian protectionist as its director-general. The WTO is a help, but if a major recession fans the fires of protectionism, it's almost certainly not a sufficient one.
In summary, we are probably better protected against the outbreak of global war than they were in 1914, but not by much. The combination of another recession, weak leadership and bad luck could easily lead over that precipice once again - with even more devastating effect on our civilization than World War I had on theirs. It's another downside risk that should be considered when investing in long-term assets, and by no means the smallest one.