Where has all the risk gone?

Professor Ferguson thinks that we can learn a lot from looking at developments in the Twentieth Century, a period of extraordinary violence and ‘megaconflict’. The century, he argued, should not in fact have been quite so violent – GDP growth was strong and the 100 year period was more economically successful than any before it. However, it also saw brutality with more than 180 million violent deaths. Some theories have argued that more lethal weaponry and extreme ideologies caused this violence. However, these fail to explain disparities of timing and location – not all places or time periods saw turmoil. Why did Canada remain peaceful, but not Croatia? Why should a man born in Glasgow in 1965 have enjoyed a peaceful life, but not one born in the same city in 1900?

A century of 'megaconflict': what can we learn from the 20th century?

Ferguson argues that four ‘Es’ were responsible for the century of megaconflict: economic volatility; ethnic disintegration; empires in decline; and eastern resurgence.

Economic volatility was much higher in the inter-war 1919-1939 period than during the rest of the Twentieth Century. Ferguson is not sure whether economic volatility was the cause of the conflict or vice versa; but, the timing of the two is perhaps no coincidence. Looking at ethnic disintegration, while western Europe was fairly homogeneous for most of the Twentieth Century, central and eastern Europe was highly heterogeneous with many different ethno-linguistic groups. There was a large amount of violent death over the century, stretching from the Baltics through the Balkans to the Black Sea. The conventional World Wars of the Twentieth Century served to exacerbate the local conflicts existent in these areas, leading to a succession of civil wars.

These first two “Es” by themselves are not reasons enough to explain the century of ‘megaconflict’ – there were plenty of places that saw economic volatility and ethnic heterogeneity that were not seats of mass conflict. New York City is one example. An added reason is the collapse of empire. The Twentieth Century witnessed a series of imperial crises, with one or more empires constantly declining or falling. From the collapse of the centuries’-old Portuguese and Qing empires in the early years of the century to the fall of communist Russia in the early 1990s – it was a period of regime change. Ends of empires tend to be dangerous times; consider the violence in India surrounding independence in 1947, while the most extreme acts of violence committed by Nazi Germany came towards the end of its short period of Imperial power in 1943/4.

Finally, eastern resurgence: from 1900, western populations have been in gradual decline. At the same time, there has been a resurgence in Asia, in terms of population and economic growth. In 1904, Japan inflicted its first military victory on a Modern Western power (Russia) for some time. Second World War saw an ‘explosion’ of Japanese power – while this was reversed by the US and its allies during the Second War, Japan soon recovered and exerted itself strongly in economic terms post-1950. Today, we are seeing a continuation of this development across the region: Asian economies recovering from Western subjugation by selectively taking Western technologies to fuel growth.

Nobody seems to think it all might happen again...

So why does Ferguson think these four "Es" are relevant? Well, he feels they can be applied to our time. Economic volatility? Look at the Middle East. While the volatility of per capita growth was low in the 1986-2005 period in the US and EU, it was higher in countries such as Saudi Arabia, Kuwait and Jordan. Ethnic disintegration? Turn to Iraq, which is headed from insurgency to civil war. Most deaths in Iraq now are related to ethic conflict between Sunnis and Shias. At the beginning of the war in 2003, the monthly casualty number in Iraq was around 300. It is now closer to 3,000 – the majority of which are Iraqis. This is only likely to get worse if the US pulls out. The potential for ethnic cleansing in the area is high. Empire in decline? The US suffers from a financial, manpower and attention deficit which make it poorly suited to being a successful imperial power. In 1920, the UK quelled an insurgency in Iraq with one soldier for every 23 Iraqis. Today, there are 169 Iraqis to every US soldier. The US is unlikely to succeed because it is faced with such a relatively large number of insurgents. Eastern resurgence? Look at the advancing Iran and China. Populations are declining in the West while they increase in the East. In 1950, the UK population was around 50 million compared to 20 million for Iran. By 2050, the projection is for 60 million Britons, compared to more 100 million Iranians.

The problems that we saw in the Twentieth Century are still here – they've just moved to a new location. But, says Ferguson, with such potential for future 'megaconflict', where is the financial fear? Markets are acting like there are no risks on the horizon: EMD spreads are very tight and the Dow is hitting all time highs. Ferguson wonders whether we are being fooled by liquidity – confusing the presence of liquidity for the absence of risk.

A familiar past: have we been here before?

Compare the period 1880-1914 to now – Ferguson believes we've been here before both economically and politically. In the earlier period, long-term rates were low – in 1914, the bond yield was around 3.4%. EMD spreads had narrowed dramatically so that in 1914 there was no major market where yields were not within 200 bps of British government bonds. At the same time volatility was declining and energy prices were on the rise. Sound familiar?

The 1880-1914 period was characterised by growing complacency, as investors appetite for risk grew and grew. Then the mood in financial markets went suddenly from 'there's nothing to worry about' to a period of panic in a matter of weeks. July 22 1914: first mention of the stockmarket being affected by the assassination of Archduke Ferdinand. August 1: stock exchanges in London and New York close. August 4: Britain declares war on Germany. The period shows us how quickly liquidity can dry up in an interconnected globe as a result of geopolitical risk. During the First World War both equities and gilts fell, EMD spreads widened dramatically as emerging markets become emergency markets.

Conclusions

Ferguson feels a low probability, high impact event is more likely than we generally assume. However, there are limits to what history can tell or predict for us, he admits. World War I was unexpected; World War II was expected, but came later than investors feared; World War III was expected, but didn’t happen (or only in the Third World). A great Middle Eastern war is now more likely today than a World War. If this happens, the US is likely to intervene, particularly if the fate of Israel is at stake. But, Ferguson concluded, no country will subsequently intervene against the US. Russia or China will stay away – in fact, Russia may embrace this, because what is bad for Iran (its major competitor in the natural gas market) is good for Russian revenues

Important information:

These notes are based on a presentation by Professor Niall Ferguson of Harvard University, dated 29 May 2007, and do not necessarily represent Schroder Investment Management's house view. Please note that these notes have been complied by Schroders staff and are not directly attributable to the speaker.

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