World War I outbreak after years of stability shows butterfly effect

The events that triggered World War I are a warning of the fragility of the global political system and economy. Looking at the current levels of global markets, one should be wary of complacency, as history suggests stability can come to an end in a way that is totally surprising.

The lessons of 1914

This year is the centenary of the outbreak of World War I, an anniversary that has prompted the publication of numerous books and articles on what caused this momentous event, which so decisively changed modern history.

For the past 100 years there has been a sense of astonishment that a seemingly unimportant incident, the assassination of the heir to the thrones of Austria-Hungary by a Bosnian revolutionary, could have such profound consequences, and could trigger a chain of events that resulted in a world war.

Austria declared war on Serbia, which it blamed for the assassination. Russia mobilised its army to support Serbia. Germany regarded this as an unacceptable threat and declared war on Russia and Russia’s ally France. Germany’s inflexible military planning required it to invade France through Belgium. Britain had a treaty with Belgium and joined the war against Germany. Within two weeks all the great European powers were at war.

The role of chance and accident in these events was remarkable. For example, the assassin, Gavrilo Princip, was not standing on the chosen route for Archduke Franz Ferdinand’s car. However, Ferdinand’s driver took a wrong turn and gave Princip the opportunity to carry out his purpose.

So one can say that the consequences of a driver taking a wrong turn were the Great War, the overthrowing of the dynasties ruling Germany, Austria and Russia, the advent of Russian communism and, as a consequence of German defeat, the rise of Adolf Hitler who launched a second, even bigger war to reverse the decision of the first one. All because one driver made one mistake.

It also triggered a century of debate among historians about how this could have happened. How could a seemingly stable political order, which had lasted 99 years following the end of the Napoleonic wars in 1815, suddenly implode?

Perhaps the surreal character of these events is best evoked by the winning entry in a competition organised by a newspaper in the 1920s asking what would be the most sensational news headline. The winner was: “Archduke Franz Ferdinand alive. World War a mistake”.

Risk in a connected world

One of the achievements of 20th-century mathematics was to explain why we cannot successfully make long-range forecasts about the weather or the economy.

Seemingly trivial and totally unpredictable events can have profound consequences, which make such predictions impossible. We now understand that if a butterfly flaps its wings in the Himalayas, it can trigger a hurricane in the Caribbean.

Complex systems tend to be less stable than simple ones. In an increasingly complex and interconnected global economy there is a growing danger that some totally unexpected event will have far-reaching adverse consequences. In recent years natural disasters, such as the tsunami that flooded and disabled the Fukushima Daiichi nuclear reactor in Japan, floods in Thailand and the Eyjafjallajökull volcanic eruption in Iceland, which disrupted air traffic in Europe, had adverse repercussions throughout the global supply chain.

The great recessions of 1931 and 2008 were triggered by the failure of specific financial institutions (Creditanstalt and Lehman Brothers), with consequences that cascaded through markets leaving few countries unaffected. History suggests that an economic system of ever-increasing complexity will inevitably become unstable.

Hyman Minsky

In the agendas of governments and policymakers, economic stability always ranks as a key objective. They regard stable currencies, stable price levels and stable exchange rates with approval.

Above all, they want steady economic growth and abhor recessions. However, since market systems are inherently unstable, achieving these goals is extremely difficult.

Some of the most important insights into this problem came from Hyman Minsky, an American economist who lived between 1919 and 1996. Minsky argued that stability creates instability. In financial markets long periods of stability promote ever-increasing risk taking, with market participants assuming increasingly extreme positions and taking on more and more debt.

The longer the period of stability, the greater the financial excess and the more severe the inevitable correction. The conundrum governments face is that, in creating a stable economy, they ultimately generate a serious financial crisis.

The most recent example of this was the implosion of the US housing bubble promoted by the Federal Reserve’s success in creating a stable financial environment over a long period.

Minsky believed that the solution to this conundrum lay in substantially more regulation of financial markets, a view shared by many, and probably most, regulators.

However, this approach does not solve the key problem that Minsky identified, which is that stability ultimately causes instability.

Another approach is to welcome greater market volatility, which would rapidly shut down excessive speculation. Unsustainable positions would be eliminated before they became big enough to threaten the stability of the system as a whole.

Long-term stability requires an underlying instability to be sustainable. The lessons of 1914 and of Minsky are the same. A long period of stability can come to an end suddenly and in a way which is totally surprising.

A time for caution

Investors are most complacent when they have been most successful. A long bull market breeds such complacency. We have now passed the fifth anniversary of the present bull market, which commenced in March 2009. In this period South Africa’s FTSE/ JSE all share index and the MSCI world index denominated in dollars have both appreciated 135 percent.

The actions of central banks have promoted a stable financial environment, which has allowed investors to make a lot of money. It is difficult to predict how and when the current financial boom will come to an end.

However, the longer the upward movement in prices, the greater the risks of some unexpected event which brings what seems to be an inexorable bull market to a sudden end.

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