The Bear’s Lair: Back to the Kaiser’s world

As anyone who has played “Diplomacy” knows, the economic and political world from 1871 to 1914 was one of Mancihean struggle, with countries attempting to establish spheres of influence behind high tariff barriers, and multiple power centers between which war was by no means impossible. As the mildly social democrat Nirvana of the 1990s recedes into history, it is becoming increasingly clear that weak US leadership and poorly designed policies have led us back into a similarly unpleasant economic environment.

The great advantage of Pax Americana, as of Pax Britannica between 1815 and about 1870, was that a single hegemonic power was able to enforce trading rules and prevent a descent into economically damaging protectionism. In the early 19th century, once Britain’s economic position had been righted by the Liverpool ministry from the excessive debts incurred in the Napoleonic wars, the move towards free trade was steady. The Corn Laws were reduced in 1828 and abolished in 1846, while further tariff reductions culminating in the Cobden-Chevalier Treaty of 1860 reduced British tariff barriers to a minimal level.

Most of those tariff reductions were unilateral, but the 1860 Treaty pushed France also in the direction of free trade. Meanwhile U.S. tariffs remained moderate until the Civil War, as the South had the ability to veto tariff increases by the protectionist North, with a final tariff reduction under the much maligned President James Buchanan in 1857 reducing U.S. tariff rates to an average 18%. Germany was divided between protectionist Prussia and the free trading Rhineland, while Austria-Hungary and Russia retained high tariffs both internal and external. Nevertheless, until the 1860s it appeared that the world was moving gradually towards free trade, as economists were already recommending.

After 1870 Britain was no longer economically hegemonic – partly because of the damage done to her economy by her unilateral tariff disarmament in 1846-1860 while other countries retained protection – and tariffs began to rise. The U.S. Lincoln administration raised tariffs twice, in 1861 and 1862 and further tariff increases were enacted regularly, culminating in the ultra-protectionist McKinley tariff of 1890, with a 50% average rate, enthusiastically supported by Andrew Carnegie seeking to protect his steel business from British and now German competition. Germany, united in 1871, increased its tariffs sharply in 1879. Thereafter it pursued a policy of protectionism, seeking to draw smaller countries into its sphere of influence, which was to continue through the Nazi economic order of the late 1930s. France also increased her tariffs after her defeat of 1871, passing a particularly protectionist tariff law in 1892.

Thus while 1870-1914 saw the apogee of free international finance, it saw marked backsliding in the area of free trade. By 1900, all the major powers except the luckless Britain were thoroughly protectionist and industries such as steel and automobiles grew up along nationalist lines. World War I intensified this trend, the Smoot-Hawley Tariff of 1930 carried it to its absurd destructive extreme, and it was only after World War II, when a new hegemon emerged, that tariffs once more began to decline.

The rise of tariff protection after 1870 also changed the relations between states. Before 1870 small states, for example those of Western Germany, had been able to prosper by forming global trade relationships, perhaps with limited free trade areas between themselves such as the German Zollverein. After 1870 this was no longer possible. Germany and Italy were formed as economically and politically powerful states and smaller states such as those in the Balkans prospered only by attaching themselves to a major power. Outside Europe, the period after 1870s was the apogee of Imperialism with countries in Africa and Asia that had remained independent in spite of their technological backwardness becoming increasingly dominated by one or more European powers or in some cases, such as China, the subject of diplomatic and occasionally military conflict between them. It was not an accident that Japan felt the necessity in 1868 of modernizing itself in order not to fall victim to one of the Europeans; no such modernization had appeared necessary in 1820.

Kaiser Wilhelm II, to his contemporaries a bogeyman, to modern eyes a figure of fun overshadowed by his dreadful successor, both epitomized the 1870-1914 period of protectionism and, together with his mentor Otto von Bismarck, was its most successful protagonist. He believed in a German sphere of influence including Austria, much of the Balkans, the crumbling Ottoman Empire and, he hoped, eventually the oil-rich Middle East, held together by the Imperial Berlin-Baghdad Railway project. Germany’s tariffs sufficed to fund a gigantic army, social security provisions that were generous by the standards of the time, rapidly improving living conditions and, after 1900 an embryonic navy that was regarded as serious threat by British governments.

Kaiser Wilhelm II’s worldview was to modern eyes thoroughly unpleasant – witness his speech to troops departing to fight the 1900 Boxer Rebellion “When you come upon the enemy, smite him. Pardon will not be given. Prisoners will not be taken. Whoever falls into your hands is forfeit. Once, a thousand years ago, the Huns under their King Attila made a name for themselves, one still potent in legend and tradition. May you in this way make the name German remembered in China for a thousand years so that no Chinaman will ever again dare to even squint at a German.” It was a long way from the civilized waltzing of the 1815 Congress of Vienna, and protectionism and the lack of a hegemon had caused the change.

From the 1970s, it became obvious that the world was moving back to a system of free international finance, similar to that of 1870-1914, but its move to free trade resembled more the middle rather than the tail-end of the nineteenth century. After the fall of Communism in 1989-91 the US became a truly unchallenged hegemon, far more powerful in relative terms than Britain in 1815-1870. International institutions such as the World Bank, the IMF and even the United Nations spread a center-left, mildly statist big-government version of the U.S. worldview, the “Washington Consensus” among the nations of the new emerging markets. Small countries, in particular those emerging from Soviet domination, could hope to prosper on the basis of universal free trade, and the success of the east Asian tigers showed that small size was no barrier to economic success.

Beginning in 2000, and more particularly since the financial crash of 2008 and the Obama presidency, the world has changed again. The U.S. is no longer an unchallenged hegemon, far from it. After one barely successful war in Iraq and another in Afghanistan that seems increasingly likely to end in failure, the United States’ ability to project power is greatly diminished, its moral authority even more so. The Washington Consensus has broken down, being replaced on the left by a reversion to out-and-out statism, on the right by a fierce determination to reassert control over runaway government finances and rent-seeking banking systems.

Small countries are finding the world an increasingly unforgiving place. Of the former Russian satellites Georgia was invaded by Russia without significant opposition from the U.S., Ukraine has reverted to Russian domination, Kazakhstan has reversed its previous tentative opening to the West and Kyrgyzstan appears to be descending into chaos. In the Middle East Iran is increasingly self-confident, Turkey has turned away from the West, the Iraqi democracy appears likely to be short-lived and Israel is increasingly beleaguered. In Latin America, increasing numbers of countries are falling prey to the followers of the sinister Hugo Chavez. Even in Asia, which had appeared capitalism’s most shining monument, Thailand and Sri Lanka are no longer progressing smoothly to a future of democracy and ever-increasing prosperity, while Japan appears less and less an example to follow.

As for free trade, the Doha round of trade talks is dead and buried, and even bilateral agreements with the United States have no chance of being ratified by the current Congress. The economic downturn has produced numerous new trade barriers of one kind or another, even if full 1930s-style protectionism has so far been avoided. The financial services sector is wholly unreformed from its rent-seeking metastisization since the 1980s, and increasing numbers of governments are erecting barriers to its depredations in the form of capital controls of one sort or another.

The U.S. is unlikely ever to enjoy again its hegemony of 1990-2008. Its economy retains the flexibility that had made it so admired, but the burden of state spending has increased by over a third since 2005 and taxation will inevitably rise in response. Most important, a decade and a half of ultra-low interest rates have de-capitalized the economy, not only leaving American savers without enough savings to finance their old age, but also leaving American business starved of capital for expansion, as ever-increasing percentages of the available finance pool head into the government deficit maw. Going forward, U.S. living standards will inevitably decline, while politically the likely result will be a retreat into isolationism and a refusal to get involved in the intractable problems of the international order. Even if the United States attempts to project its power under some new president, it will find financial constraints prevent it from doing so.

The international order has thus returned to the Kaiser’s world of multiple states, high tariff barriers and unfair trade competition. Small countries will have no alternative but to seek protection in the spheres of influence of their larger neighbors. Participants in the protectionist new world order will be a diminished United States, a sclerotic and inward-looking EU, projecting its power no further than the Balkans, one or possibly two left-leaning Latin American blocs led by Brazil and Venezuela (which may or may not combine), a resource-rich and oppressive bloc led by Russia, a highly unstable Middle East dominated by Turkey and Iran, and an impoverished and unstable south Asian bloc led by India. By far the most powerful and successful bloc will be led by China, which will include much of south-east Asia and large parts of Africa. There will remain a few substantial independent states: an isolationist Japan, an unstable Indonesia, perhaps a modestly prosperous Australia. However overall the world will geopolitically look like that of the aggressively competitive 1890s or, if we are unlucky, the haunted 1930s.

And ironically enough, the new Kaiser Wilhelm II will be Chinese.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)