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Thursday, January 2, 2014

Echoes of 1914?

With the 100 year anniversary of the beginning of WWI approaching, I've suddenly seen a lot of articles exploring whether we are repeating the follies leading to "the Great War." One of these is a commentary by Graham Allison at the National Interest entitled, "2014: Good Year for a Good War?" Allison writes:

As we enter 2014, war between great powers seems almost inconceivable. But if we start at the other end of the telescope by imagining that a Great War with some similarities to World War I actually happened, what could future historians find in current conditions that permitted events to ride mankind to another catastrophe?

If we start with the fact that it happened, we know who the primary combatants had to be. Russia is no longer a great power player; Europe has disarmed itself; the Middle East, Africa, and Latin America are arenas for local wars. In the growing competition between the U.S. and China, however, one can hear echoes of 1914.

First, a tangled cluster of factors can be summarized as "Thucydides Trap." When a rapidly rising power rivals an established ruling power, trouble ensues. In 11 of 15 cases in which this has occurred in the past 500 years, the result was war. The great Greek historian Thucydides identified these structural stresses as the primary cause of the war between Athens and Sparta in ancient Greece. In his oft-quoted insight, “it was the rise of Athens and the fear that this inspired in Sparta that made war inevitable.”

Note that Thucydides identified two factors: rise and fear. Today, a rising China naturally expects more respect and predictably demands greater say and sway in the resolution of differences among nations. It becomes more conscious of past grievances, especially in relations with Japan, and more determined to revise previous arrangements and practices to reflect new realities.

For the US, accustomed to our position in the pecking order, calls for revision in the status quo raise concerns. The Pax Pacifica established and enforced by the US for seven decades since World War II has provided an economic and security order in which the nations of Asia, including China, have enjoyed unprecedented peace and prosperity. Demands for change, especially through unilateral actions, not only seem ungrateful, but raise alarms.

Historically, when rising assertiveness becomes hubristic, and fears paranoid, mutual exaggeration can feed misperceptions and miscalculations, spurring posturing and provocations that lead to unintended consequences.
 However, Allison doesn't see a war starting, at least initially, between China and the U.S. Rather, he theorizes that a conflict could break out between Japan and China, thereby drawing the U.S. into war.

Thus my most likely scenario for war in 2014 would begin with initiatives like China's recent unilateral declaration of an exclusive air zone over the islands in the East China Sea that trigger escalatory responses by Japan leading to the downing of a plane or sinking of a ship with scores of casualties. There could follow a process of retaliatory risk-taking in which each responds to the other, producing a small naval and air conflict between Japan and China at sea in which dozens of ships and planes are destroyed. Expecting the US Navy and Air Force to have its back, and certain that together, Japanese and US military forces currently have decisive superiority, Japanese politicians could adopt a strategy of "tit +" for "tat" and expect China to back down.
Allison is not saying war is inevitable, or even likely. Rather, he wants to remind us that war is possible. As I've noted before, close ties between nations increases, rather than decreases, the risk of armed conflict.

Interestingly,  Ambrose Evans-Pritchard makes similar remarks in his prediction for the coming year.

In case you had forgotten, China has imposed an Air Defence Indentification Zone (ADIC) covering the Japanese-controlled Senkaku islands. The purpose of this escalation in the East China Sea is to test US willingness to back its military alliance with Japan, just as Kaiser Wilhelm provoked seemingly petty disputes with France to test Britain's response before the First World War.
 
The ploy has been successful. The US has wobbled, wisely or not depending on your point of view. While American airlines comply, Japanese airlines fly through defiantly under orders from Japan's leader Shinzo Abe. Mr Abe has upped the ante by visiting Tokyo's Yasukuni Shrine - the burial place of war-time leader Tojo - in a gesture aimed at Beijing. 
Asia's two great powers are on a quasi-war footing already, one misjudgement away from a chain of events that would shatter all economic assumptions. It would leave America facing an invidious choice: either back Japan, or stand aloof and let the security structure of East Asia disintegrate. 
Trade this if you wish. The Dow Aerospace and Defense index (ITA), featuring the likes of Raytheon and Lockheed Martin, has risen 60pc over the past year, compared with 29pc for Wall Street's S&P 500. 
Fuji Heavy Industries (robotics) is up almost 200pc this year in Tokyo, and Yamaha (also robotics) has doubled. Equities are pricing in rearmament. Japan raised spending on military equipment by 23pc last year. It has launched an 800-foot long DDH-class helicopter carrier, an Osprey aircraft carrier in all but name. 
The US is stepping back from the Middle East, leaving the region to be engulfed by a Sunni-Shia conflict that resembles Europe's Thirty Years War, when Lutherans and Catholics battled for supremacy. Sunni allies are being dropped, Shia Iran courted. Even Turkey risks succumbing, replicating Syria's sectarian fault lines. 
Some blame Barack Obama for abdication, but the roots lie in two botched wars before him. Besides, Gulf oil is passe. Shale promises to turn the US into the world's top oil producer by 2017.
However, his primary predictions are economic. In this regard, he expects the value of the dollar to rise as the Fed cuts back on "quantitative easing."
Euroland will be hit on two fronts by Fed action. Bond yields will ratchet up, shackled to US Treasuries. Emerging market woes will ricochet into the eurozone. The benefits of US recovery will not leak out as generously as in past cycles. Dario Perkins from Lombard Street Research says the US is now more competitive than at any time since the Second World War. America is poised to meet its own consumption, its industries rebounding on cheap energy. Europe will have to generate its own stimulus this time. Don't laugh.
Turning to China and Japan:

Over all else hangs the fate of China. The sino-bubble is galactic. Credit has grown from $9 tillion to $24 trillion since late 2008, as if adding the US and Japanese banking systems combined. The pace of loan growth - 100pc of GDP over five years - is unprecedented in any major economy, eclipsing the great boom-bust dramas of the past century.
 
The central bank is struggling to deflate this gently, with two spasms of credit stress in the past six months. I doubt it will prove any more adept than the Bank of Japan in 1990, or the Fed in 1928, and again in 2007. This will be a bumpy descent. 
China may try to cushion any hard-landing by driving down the yuan. The more that Mr Abe forces down the Japenese yen, the more likely that China will counter with its own devaluation to protect the margins of it manufacturing industry. We may be on the brink of another East Asian currency war, a replay of 1998 but this time on a much bigger scale and with China playing a full part. 
If so, this will transmit an a further deflationary shock through the global system, catching the West sleeping with its defences against deflation already run down. The US may be strong enough to cope. For Europe it would be fatal. The denominator effect would push Club Med into a debt compound spiral. Let us give it a 30pc probability. 
Happy new year.

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