Wars and impact on financial markets

I didn’t know how to summarise this paper in the title of the post.

I just finished reading this paper from Niall Fergusson. It is such an amazing paper and a must read. He begins the paper saying:

We are living through a paradox—or so it seems. Since September 11, 2001, according to a number of neo-conservative commentators, America has been fighting World War III (or IV, if you like to give the Cold War a number). For more than six years, these commentators have repeatedly drawn parallels between the “War on Terror” that is said to have begun in September 2001 and World War II. Immediately after 9/11, Al Qaeda and other radical Islamist groups were branded “Islamofascists”. Their attack on the World Trade Center was said to be our generation’s Pearl Harbor. In addition to coveting weapons of mass destruction and covertly sponsoring terrorism, Saddam Hussein was denounced as an Arab Hitler. The fall of Baghdad was supposed to be like the liberation of Paris. Anyone who opposed the policy of pre-emption was an appeaser. And so on.

Yet throughout this period of heightened terrorist threats and overseas military interventions, financial markets have displayed a remarkable insouciance. The U.S. stock market was affected only momentarily by the attacks of 9/11. True, between September 10 and September 21, 2001, the Dow Jones Industrial Average declined by as much as 14 per cent. Within just over two months, however, the Dow had regained its pre-9/11 level.

He says it is amazing how financial markets discount geopolitical events and don’t anticipate it. It is only when war events turn true and sour, do markets start chickening out.

History suggests that financial markets do not always anticipate major geopolitical crises. Part II of this paper shows how the majority of investors in London, then the world’s biggest capital market, were caught unawares by the escalation of the conflict in the Balkans in July 1914—so much so that there was a disastrous liquidity crisis in most financial centers even before war had broken out.

However, the markets learn the lessons with certain conditions:

Part III shows how the origins of the First World War have been revealed only with the benefit of hindsight; at the time, they were largely invisible. The same, however, cannot be said of the Second World War. Investors learned from the searing experiences of 1914-23, which saw a wide range of European currencies and securities drastically reduced in value as a result of inflation and outright default. They therefore sought to adjust their portfolios defensively as soon as they saw a renewed risk of world war. Indeed, to judge by securities price data, the City of London (like other markets, notably those in Scandinavia) began positioning itself for another major conflict some years before it actually began. If 1914 was a bolt from the blue, 1939 seemed long overdue.

What are the lessons?

The first point is that it is as hard for investors as for generals to learn lessons from a previous war. Knowing what had happened to various asset classes after 1914 did not make it easier to know when to sell those that had lost out or buy those that had fared well. Nor was there any guarantee that the next war would have the same financial impact as the previous war, because of changes in military technology and government regulation.

As part V argues, these same problems arose again for investors after 1945. Simply because the Cold War never became truly “hot” does not mean that the probability of a nuclear war between the superpowers was always zero. Investors once again tried to learn from history when the Korean War broke out, acting on the assumption that it might have similar effects to World War II (for example on commodity prices).

Twelve years later, by contrast, financial markets evinced only short-lived and mild anxiety at the time of the Cuban missile crisis, reflecting a realization on the part of investors that a world war in the age of the hydrogen bomb would have incalculable consequences against which it would be futile to hedge. In the remaining three decades of the Cold War, the superpowers’ consistent success in settling their disputes by diplomatic means (or proxy conventional wars) reassured investors that their rivalry would not erupt into a hot war, so that markets became progressively less sensitive to international crises.

If financial market data and commentary are reliable guides, then, this is roughly how expectations of war are formed: retrospectively more than prospectively, though with some allowance for changes in the nature of warfare. Excellent stuff. The linkages of war with financial markets is something I hve never read before. What amazing lessons

Super stuff from Ferguson. What insights on thinking about geopolitical risks and impact on financial markets.

What are the risks in current times?

A period such as our own, of sporadic terrorism and small conventional wars, might therefore be expected to encourage the belief that future wars will also be small, with inconsequential financial effects.

The seeming indifference of today’s financial markets to political risk should therefore be regarded not as evidence that the world will likely avoid a major conflict in the foreseeable future, but merely as evidence that the world has avoided a major conflict in the recent past. Given the relative youth of most employees in the financial sector, and the relative shortness of most senior executives’ careers, “recent” may be taken to mean approximately the past twenty-five years.

A major conflict would strike this generation of bankers and fund managers much as the war of 1914 struck their predecessors: like “a bolt from the blue”.

Well, well, well…..

Read the whole thing. Very rich…Is a nice revision of World War History as well.

On reading the paper, I just recalled this previous post where I wondered whether financial markets see the emerging risks in the Indian political system as well? We can see the similarity in Indian situation as well. If you read any India based newspaper politics section would suggest huge risks but financial section would suggest “All is well”. Things in political only look worse going from hereon and still nothing seems to matter financial markets. Can this continue? Will something hit Indian financial markets – a bolt from the blue? I hope not but the possibility cannot be ignored. Atleast Fergusson’s paper tells you why it cannot be ignored.

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2 Responses to “Wars and impact on financial markets”

  1. Wars and impact on financial markets « Mostly Economics Economic Finance news Says:

    […] View original here:  Wars and impact on financial markets « Mostly Economics […]

  2. Sanfter Tourismus Says:

    Nachhaltig Leben…

    Wars and impact on financial markets « Mostly Economics…

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