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The Reality Of War

A version of this essay was first published in The Daily Reckoning.

There is an important point investors should be aware of, which may have been overlooked during the peaceful and financial bubble years of the 1990s: wartimes are common in the history of the world; it is times of peace that are the exception. According to the historian Will Durant, war is one of the constants of history, and has not diminished with civilization or democracy. In the last 3,421 years of recorded history, only 268 have seen no war.

Just look at the period between 1895 and 1918. During this brief span of years, there were continuous conflicts around the world, including the Russo-Japanese War (1895), the war between Turkey and Greece over Crete (1897), the Spanish- American War of 1898, the Anglo-Boer War of 1899-1902, the military expeditions of the great powers in China in 1900, the Russo-Japanese War (1904-1905), the Russian Revolution of 1905, the Turkish Revolution of 1908, the French military expedition in Morocco (1907), the military conflict between Italy and Turkey over Tripoli (1911), the First Balkan War (1912), the Second Balkan War (1913), the Chinese Revolution of 1911, the First World War (1914- 1918), the February Revolution in Russia (1917), the October Revolution and the Russian Civil War (1917-1921).

According to Durant, the causes of war are the same as the causes of competition among individuals: acquisitiveness, pugnacity, and pride; the desire for food, land, materials, fuels, and mastery. The state has our instincts without our restraints. The individual submits to restraints laid upon him by morals and laws, and agrees to replace combat with conference, because the state guarantees him basic protection in his life, property, and legal rights. The state itself acknowledges no substantial restraints, either because it is strong enough to defy any interference with its will, or because there is no super-state to offer basic protection, and no international law or moral code wielding effective force.

As to the causes of the Iraq war, I leave them to the reader to ponder.

I am not necessarily suggesting that the next 20 years will be as turbulent as the first 20 years of the 20th century. But we must realize that the late 1980s and 1990s were extremely unusual from a historical point of view, since, aside from some minor conflicts, there were no major wars or revolutions. So, purely from a probability point of view, investors should not expect the relatively peaceful time that has followed the Korean War, and especially the peace dividend we have enjoyed over the last 15 years or so, to continue forever.

The peace dividend that followed the end of the cold war was certainly a contributing factor to higher stock valuations around the world (declining interest rates and rising profits aside). If the world is now moving into an era of increased tensions, then this will be an additional negative factor for equity valuations. Moreover, during the relatively peaceful 50 years that followed the Second World War, trade as a percentage of GDP increased rapidly and peace allowed a truly global capital market to be created, both of which factors were favorable for economic development around the world. As a percentage of the world's GDP, trade increased from around 5% in the 1950s to over 20% at present.

Moreover, since the creation of a truly global capital market in the late 1980s, international capital flows financed the investment boom in the emerging economies in the early 1990s, and have in the last few years financed the excessive consumption in the U.S., which is reflected by the growing American current account deficit.

If we assume, therefore, that rising global trade and an increase in global financial flows had something to do with peace around the world in the 1990s, we should also assume that in the case of increased geopolitical tensions and, especially, a major conflict, there could be some interruption in these favorable trade and financial trends. In the worst case, severe geopolitical tensions could lead to an interruption of free trade or of international financial flows and bring about supply shortages, trade embargos or outright trade wars, the imposition of foreign exchange controls, and even the freezing of assets held by foreigners or, in an extreme case, their outright expropriation.

In short, the financial markets and financial intermediaries seem to me to be particularly vulnerable, since they have become so disproportionately large in comparison to the real economy. One point is clear to me. In the next major conflict in the world, the derivatives market is most likely to cease to exist, since financial institutions throughout the world hold derivative positions. Therefore, if one major player somewhere in the world doesn't settle or fails altogether, a vicious chain reaction could follow, with the result that the markets will be closed.

It is not my intention to sound alarmist, but I think that investors who grew up during the last 50 years have no idea of what unpleasant financial and economic consequences might result from a major conflict. Throughout history, asset freezes, the imposition of foreign exchange controls, and expropriations have been very common, and I have no doubt that sometime in the future we shall experience such emergency measures once again. Therefore, investors should seriously consider diversifying not only their assets, but also how they hold those assets.

To hold all of one's assets in one country with just one financial institution may be imprudent in an age of rising risks of international conflicts. Consequently, an investor may want to hold some of his assets in the U.S., but also consider the ownership of assets through a foreign bank or the holding of real estate in a foreign country.

Such diversified allocation is an important - if not essential - safeguard against the negative consequences of major conflict.

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