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All is fair in love and economic warfare

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The economics team at investment managers Payden & Rygel has written an extensive note on ‘economic warfare’ and the history of globalisation, sanctions and the US dollar. Settle in for a long, informative and entertaining summer read…

Russia’s invasion of Ukraine sparked a seemingly unprecedented, united response from the West, consisting of a barrage of economic sanctions on Russia. Never shy to offer predictions, commentators quickly sounded the death knell for globalisation and the reserve currency reign of the U.S. dollar.

While many financial commentators are prone to hyperbole, history provides a more sober perspective.

An examination of the history of sanctions reveals that nothing unleashed in response to the Ukraine assault is new and that the long-term efficacy of sanctions remains mixed at best.

And while it’s difficult to gauge the implications of the latest round of sanctions in real-time, interesting historical parallels could help provide much-needed context.

From Herodotus to Hussein: Economic sanctions have a long history. Economic coercion has long been a key tool for warring states. For example, in the Peloponnesian War, Thucydides’ account of rival city-states in Greece includes a story of Athens’s commercial ban against the Greek port city of Megara’s merchants in 432 BC – perhaps the first recorded case of economic warfare.

In more modern but no less barbarian times, the nightmare of the First World War inspired hope for “economic sanctions” as an alternative to military aggression. U.S. President Woodrow Wilson described economic sanctions as “something more tremendous than war.” Sanctions could create “an absolute isolation… that brings a nation to its senses just as suffocation removes from the individual all inclinations to fight.”

However, this “alternative to military aggression” would not be possible without the interconnectedness of the global economy.

The First World Economic War

The reason economic sanctions were possible in 1914 was globalization itself. In fact, the decades leading up to the First World War marked the first golden age of globalisation. Trade’s share of global economic output increased from about 5 per cent in 1850 to 14 per cent in 1913.

However, trade statistics don’t do the story justice. Instead, let’s examine one example of a critical material: steel.

On the eve of the First World War, Germany was a world leader in steel-making. But there was a catch: Germany remained utterly dependent on manganese imports (a key input in steel production), consuming 25 per cent of the annual world production of manganese.

Getting manganese was no simple task. Consider the example of Krupp, a German steel company.  Acquiring more manganese involved a complex chain of transactions.

First Krupp used a London agent to place orders from one of the many global mining companies clustered there.

Itabira, a mine in the state of Minas Gerais in Brazil, was owned by the British Itabira Iron Ore Company. Once Itabira Iron Ore’s sales desk in Rio received a “bill of exchange” on behalf of Krupp from the Banco Alemán Transatlántico, Deutsche Bank’s subsidiary in Brazil, the miners got to work.

Manganese was extracted, loaded on a railroad car, and sent along a railway to converge with bigger cargo trains that carried the manganese 300 hundred miles (500 kilometres) southeast to Rio de Janeiro on the coast.

From Rio, it took three weeks to reach Rotterdam by steamboat, where the cargo transitioned to another railcar, onto a boat, and then another 130 miles to Krupp’s plant in Essen.

Steelworkers in Germany could then finally fire up the blast furnaces to smelt manganese and iron ore into the final stainless-steel product.

Phew! Simple enough? There’s more.

The British Financial Insurance Nexus

Any cargo loaded onto steamships out of Rio and hauled across the ocean had to be insured. Lloyd’s, the world’s foremost marine insurer, covered most of the steamboats that transported products. Those steamers also needed fuel.

So British coal traders bought and sold coal to steamers worldwide. Like gas (petrol) stations that dot (some say, scar) our landscape, on the eve of the First World War, about 25 million tons of coal was stored in British- controlled depots from the Falkland Islands to Gibraltar and beyond to make sure fuel was ready and available for vast sea voyages.

Finally, there was payment.

The delivery process took an average of six weeks. The “bill of exchange” issued by Deutsche Bank’s subsidiary was effectively a “promise to pay” once the shipment was received. With a large bank like Deutsche Bank as the underwriter, though, the bill of exchange was as good as cash and could be sold or borrowed against in the London money markets. Moreover, Britain was in a unique position as the centre of the global economy leading up to World War I with 60 per cent of the world’s trade flowing through its discount market.

Put another way, a large share of global savings was entrusted to Britain, its money markets, and the pound sterling to invest capital and earn a return, effectively financing the entire global economy. The US and its currency play a similar role today.

Swift 1.0?

So why are we retelling a story about a dizzying array of steps required to make the world work?

Armed with our German steel story, aspiring financial blockaders of 1916 used mining company officials and bankers in London to thwart enemy activity. Britain effectively leveraged its limited personnel by transferring enforcement responsibility to financial institutions themselves!

From May 1916, banks in Allied countries were made to sign guarantees that their accounts would not be used “for any business which will in any way, either directly or indirectly, assist or be for the benefit of an enemy of Great Britain or her Allies.”

Furthermore, blacklisting, prosecution, and forced closure were held over the heads of London’s private bankers. The Finance Section of the UK government created its intelligence-gathering network by tapping select banks to report their weekly flows to and from neutral countries.

From May 1916, banks in Allied countries were made to sign guarantees that their accounts would not be used “for any business which will in any way, either directly or indirectly, assist or be for the benefit of an enemy of Great Britain or her Allies.”

Furthermore, blacklisting, prosecution, and forced closure were held over the heads of London’s private bankers. The Finance Section of the UK government created its intelligence-gathering network by tapping select banks to report their weekly flows to and from neutral countries.

Moreover, because orders to transfer money and securities were sent by post or by telegram, a financial blockade was in effect a communications blockade: whoever controlled postal routes and undersea telegraph cables controlled payment flows.  Communications interruptions effectively severed enemy banks from the global financial system— and, conveniently, Britain operated 70 percent of the global telegraph cable network!

Far from ending globalisation, the World War I era economic warfare “worked” only because the world was globalised.

The Thought that Counts?

Sadly, the economic sanctions track record is not a good one. The “economic war” went on long after the physical fighting of the First World War ended. The League of Nations mobilised 52 out of 58 member states to punish Italy’s 1935 invasion of Ethiopia. Undeterred, Mussolini won that war and realised acquiring more territory was needed to offset future sanctions!

Germany and Japan were also inspired to conquer in order to counteract sanctions or pre-empt them altogether. Later, when the US abruptly cut off oil supplies to Japan and redirected them to Russia in July 1941, the stage was set for Pearl Harbor, and America joined the war shortly after.

Moreover, sanctions have since been used frequently—in some cases, levelled on countries for decades—but with limited effectiveness.

Despite their limited historical success, we cannot escape the fact that sanctions have a certain appeal. Wouldn’t it be nice if instead of bullets and bombs, blockades and blacklists sufficed?

The Death of Globalisation?

So, what does history mean for the present conflict? Does de-globalisation loom? Will the US dollar be supplanted? Instead of predictions, we offer historical parallels.

First, while 1840 to 1914 marked the first heyday of globalization, the two world wars did not mark an end to globalisation. Instead, a new global regime fostered trade and cross-border investment like never before. The new regime, though, was based on the dollar system and the U.S. military serving as “global police.”

The period from 1950 to 1973 featured rapid economic growth in almost every country on Earth, with the average annual global growth rate and per capita gains nearly 2.5 times the much-vaunted 1850 to 1913 era. The value of export goods as a share of the global economy rebounded from a post-World War II low of 4 per cent to 14 per cent by 1974, similar to the 1913 number as a share of GDP but on much higher trade volumes.

Globalisation took another leap after 1973. International trade as a share of GDP rose from 30 per cent in 1973 to 61 per cent in 2008 on a six-fold increase in international trade. Most of that increase happened since 1999 and with the rise of China as a major global economy.

For a less abstract perspective, consider that the post-1973 globalisation wave meant tripling the weight of goods shipped. In 1975, China had no container traffic, and U.S. and Japanese ports accounted for half of the global activity. By 2018, China accounted for one-third of international shipping, with the combined U.S. and Japanese shares falling to 10 per cent.

If indeed there is another globalisation wave, it could be an unbundling of China as the global shipping source and the use of a wider array of countries for production and input, which could lead to more cross-border flows, not less.

While we’ll stop short of calling globalisation a relentless force, it is similar to the force that stops you, dear reader, from reshoring all production within the bounds of your household.

Why don’t you? Well, put simply, you’d be vastly poorer if you did, not just due to the limited resources in your garden or know-how of production, but the scarcity of time—there are only 24 hours in a day. Instead, you specialise, and when everyone does so on a global scale with a truly global market, we call it globalization because it spans political borders.

So, what has history taught us about this latest act of physical and economic aggression?

First, all warfare is economical. Without interconnected supply chains, countries cannot access the materials they need to wage war nor can they inflict as much economic pain.

Second, the latest round of sanctions is not unprecedented. The names and details are different, and trade is more complex today, but the dawn of economic sanctions in the First World War mirrors much of what has been implemented in 2022, right down to the SWIFT messaging network cutoff used against Russia.

Third, the reimplementation of sanctions will not end globalisation. Geopolitical tensions may slow the growth of international trade, but they rarely stop it for long.

And lastly, unless the USD money markets find a new rival (as the mighty dollar rivalled sterling in the 1920s and onward), the end is not nigh for the dollar’s reign.

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