August 11, 2014

By Bill O’Grady

Reflections on WWI: Geopolitics and Markets


WWI began on July 28, 1914. It was the second industrial war1 and considered a “world war,” although nearly total global military engagement didn’t occur until WWII. It was a devastating conflict, with an estimated 37 million military and civilian casualties and roughly 17 million fatalities.


The postwar effects were also substantial. Europe’s global domination was severely weakened and, as a consequence, the U.S. became a rising global power. Classical economic liberalism, which supported free markets, free trade and small government, was replaced by deeper government involvement in the economy. This occurred because governments, in an effort to mobilize the economy for the war effort, began to extend their regulatory control of the economy. The war tightened labor markets, allowing for increased union membership. As laborers increased their political power, the gold standard was undermined. The gold standard required governments to manage their monetary policies toward external balance, meaning that if a nation was running a persistent trade deficit then contractionary policies were automatically implemented. These austerity policies tended to most disadvantage the working class. For the gold standard to work, therefore, a compliant and politically

weak working class was necessary.2 After the war, the rise of organized labor made it very difficult to maintain the gold standard.


From a market perspective, measuring the impact of geopolitics is difficult. Some events are very short-term in nature and have only a modest impact. Others are more substantial but are still mostly cyclical. And then there are those events that permanently change the investing landscape. At the time the event is unfolding, it is never easy to know exactly what sort of situation one is dealing with. In retrospect, cause and effect can appear almost perfectly linear; however, in the fog of the moment, it is never completely clear whether a geopolitical event is a “game changer” or simply a blip.


In this report, we will begin with a short recap of the onset of WWI. We will also examine the problem that comes from induction, the logical process of observing the world and predicting the future. From there, we will discuss the “lessons learned” from the post-WWII and post-Cold War era with an analysis of what may be changing. As always, we will conclude with market ramifications.


The Onset of WWI

Going into the second decade of the 20th century, global economic growth was steadily expanding. European nations dominated international relations due to the colonial expansion of the previous two centuries. Although the U.S. had the world’s largest economy, it had only a passing interest in global affairs.

It should be noted that the present boundaries of the lower 48 states were not completed until the Gadsden Purchase of 1912. America’s focus had been on building out its “manifest destiny” and populating the West. Britain was considered the global superpower with the British pound as the global reserve currency. Furthermore, the world economy was heavily globalized;3 some economists have argued that the global economy did not exceed the pre-war level of integration until the 1980s. In 1910, Norman Angell published The Great Illusion, which argued that society and theglobal economy had reached a point where war was simply futile because it didn’t pay. Because of economic integration, even


The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He…could dispatch (sic) his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent…Theprojects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.

victors in war would not make significant gains compared to the benefits that come from peace. In other words, Angell argued that using war as an instrument of foreign policy was outdated. Although Angell has been criticized for saying war was “impossible,” that really wasn’t his position. He said it would be futile; the events of 1914-18 generally proved his point.


Historians have debated the causes of the war. Barbara Tuchman’s 4 theory was that the structure of treaties and the beginning of mobilizations made the war inevitable, much like dominos set in motion. In a book published recently, Christopher Clark5 argues that a series of miscalculations by European leaders, rising Balkan nationalism and a crumbling Ottoman Empire were the proximate causes. However, at any point, a different decision may have led to a different outcome. Tuchman would argue that the war was unpreventable; Clark would counter that the war could have been avoided if the parties involved had not played a “game” of brinkmanship that ended up triggering the conflict.


The fact that eminent historians can come away with different theories as to why WWI occurred shows how complicated Europe was before the war. Despite these differences, nearly all historians that have examined this period (including the aforementioned) have noted the tensions that a rising Germany caused in Europe. Germany formed in the aftermath of the 1870 Franco-Prussian War and developed into an economic powerhouse. Germany’s army became the strongest in Europe and its navy grew rapidly. The response to a rising

Germany was the creation of treaties between France, Britain and Russia. Germany countered with its own treaties with the Austro-Hungarian Empire and Italy (which the latter failed to honor).


This chart shows the global shares of GDP of Germany6 and Britain from 1850 to 1925. Just before 1910, the German economy had eclipsed the British economy. When a rising power begins to rival the ruling power, the tensions that arise are called the “Thucydides’s Trap.” Thucydides noted


that a rising Athens threatened the hegemony of Sparta, leading to the devastating Peloponnesian War.


WWI turned out to be the war that signaled the beginning of the end of Western European hegemony in world affairs. At the outset, it wasn’t obvious that this war would be as devastating as it was. Although most nations go into war on the assumption it will be short, the European powers were really not prepared for how this war evolved. Trench warfare and the introduction of industrial weapons (aircraft,

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