October 10, 2005

Financial markets blind to worldwide risk

Posted in International Economy ·
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An old transvestite’s story of Berlin in the 20th century does not generally spark thoughts of economics, finance and risk.

Yet the other night, watching the dazzling one-man performance of I Am My Own Wife at the Gaiety, I was struck by how much today’s financial markets could learn from a bit of early 20th century history.

Our heroine – the transvestite – was born just before the outbreak of World War I in the Kaiser’s Germany and the play centred on history – her own imagined history and the history she would like the world to believe about her. At that time, Germany was the most sophisticated country in Europe and Europe was still the most sophisticated place in the world. It also had the most sophisticated financial markets.

Like today, the pre-World War I financial markets claimed to be assessors of risk. They claimed to digest all the relevant information about the investment environment and price the risk accordingly. The best instrument to assess future risk was the interest rate.

The pre-World War I period was remarkably similar to the present. Capital and goods were highly mobile. Europeans in particular were migrating in huge numbers, not only to the US, Canada and Australia, but also to Argentina, Brazil and South Africa.

Railroads in Russia were financed by Anglo-Irish gentry, many of whom invested the proceeds of land reform in rural Ireland in the Tsarist empire. This was the first age of globalisation.

Throughout the 20 years that preceded the war, interest rates fell progressively all around the world. From Turkey, Russia, Germany, France, Japan, India and Mexico, the story was the same: interest rates were falling because the world had entered a happy-clappy period of globalisation where countries did not go to war, geo-political risk was ignored and all investments were safe.

Amazingly, in June 1914,onthe eve of the First World War, yields on British government bonds were 3.6 per cent.

Equally striking is the fact that Europe’s stock markets continued to rally throughout July 1914 – weeks after Gavrilo Princip had assassinated Archduke Franz Ferdinand. According to fascinating research carried out recently at Harvard by Professor Niall Ferguson, only on July 22, 1914, did the European markets begin to get jittery.

Until August 1, when German and Russian armies were mobilising on the continent, The New York Times was still suggesting that war could be avoided.

On August 3, the world’s stock markets simply shut down and did not open again for months and months. How’s that for the financial market’s legendary foresight? If there was a war coming, the financial markets certainly did not see it!

Let’s contrast these facts with the story our history books recount about the run-up to World War I. I can still remember the way it was taught in school.

A typical Leaving Cert question would be phrased: �Trace the causes of the outbreak of World War I.� The right answer would begin by stating that it was all, in some way, inevitable. The student will talk about the decades of instability in the Balkans, the fragility of the Russian monarchy, the ambitions of the Kaiser’s Germany, the Triple Alliance and so on.

The basic narrative which we all learned was that, if you were knocking around Vienna, Paris or London at the time and didn’t see this one coming, you were some sort of eejit. But the reality is quite different. The people paid to forecast the future at the time � who were as sophisticated, learned and greedy as anyone hanging out on a trading floor today – hadn’t a clue.

�Ah, yes,� some will argue, �but today we have trading screens, instantaneous live feeds, 24/7 news and the like, so the financial markets have perfect information all the time.�’ Really?

The only difference between 1914 and 2005 is a matter of hours, not weeks. Remember the old global telegram system? While not the internet, it wasn’t bad. And it was certainly well beyond the days when a system of spies in both camps allowed the great Nathan Rothschild to make a fortune by knowing the outcome of the Battle of Waterloo before anyone else in London.

One of the most interesting financial lessons of the run-up to World War I is that, contrary to today’s popular history, no-one saw it coming. Second, when the apocalypse became apparent, the financial markets – rather than reacting quickest – actually went into a collective state of denial for weeks.

Further, when the severity of the situation finally dawned on these latter-day �masters of the universe’�, far from rationally absorbing the news and re-pricing risk accordingly, they simply ran for cover and shut down the exchanges!

What is so fascinating is the false belief that financial markets can assess the future. They can’t. They can have a decent stab and most of the time they are right, but missing World War I completely ranks as a bit of a boo-boo, particularly as Leaving Cert students will tell you that global geo-political risk was evidently rising dramatically in the period 1904-1914.

During these years, a paradox emerged where financial risk (as measured by global interest rates) diminished at precisely the same time as geopolitical risk (as measured by arms build-up, nationalist problems at the fringes of the big empires and vulnerability at the core of those empires themselves) rose.

Fast-forward to today and arguably the same paradox is emerging across the globe. Financial risk is diminishing constantly, while geo-political risk – whether in Iraq, China or the price of oil – appears to be rising. The potential for conflict, while not apparently on the scale of 1914, is there. Indeed, the surprising weakness of the world’s hyperpower, the US – in Baghdad, in New Orleans or in its basic inability to pay its bills without having to borrow from the rest of us – is increasing geo-political risk.

No one is saying that we are on the cusp of a major world disaster. However, it does appear logical that banks and investment houses should spend more time looking at geo-political risk when making their decisions regarding your money. The financial-versus-political risk paradox is now evident, with the financial markets telling us everything is hunky dory when patently it is not.

I’m not sure where the real risk is. It’s probably somewhere below where it was in July 1914 and somewhere above the chance of me becoming my own wife! Place your bets.


  1. j

    Well the test worked. My comment is to say that consumer
    inflation is now at 6% in the states (at least) and
    heading towards 10% if the producer price inflation of 14%
    is correct. We see signs of it here too. Lidl, Aldi,
    Tescos and Dunnes are setting up shops all across the
    country. Why aren’t marks and spencers following them.
    Prices will go up everywhere and thus their market share
    will increase as it’s likely that these low cost high-
    throughput superstores will be the cheapest places to
    purchase necessities after the post-greenspan-inflation
    virus. Even if goods are produced cheaply in chinA, who
    cares, the transport costs of importing them may bridge
    the gap as oil soars again. Thus, the post-greenspan-
    inflation virus is the next big thing and interest rates
    will follow very very quickly indeed. Expect the fed funds
    rate to be at 10% within two years and the ECB rate and
    every other rate to follow suit. I expect that greenspan
    will spook the markets the day after holloween, November
    1. I agree we should forget about taxation, who cares, Joe
    Bloggs is more exposed to his massive interest rate move
    and the preceding inflation right now and should get out
    of any debt related investments yesterday. The housing
    market will burst as soon as investors realise there’s a
    huge queue at the check outs.

  2. adrian

    Global activity is the sum of individual activity.
    Individual operators in the financial markets aren’t paid
    to assess long term risk. The end of year bonus is the
    only goal.
    Pump it up this year – thatta boy – pump it up next
    year – nice quarterleys guys – lets do it again….

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