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10 April 2019

Will today's Global Trade Wars Lead to World War III?

Daniel W. Drezner

You might not know about a minor trade skirmish in the Balkans that started late last year. But you should, because it signals a worrying shift in how national security considerations are altering the fabric of globalization in ways eerily similar to how they did at the dawn of the 20th century. That first shift helped start World War I, so in case you're wondering, yes, I'm going there: The current rise in protectionism could be the precursor to World War III.

The story starts in 2008, when the small southeast European nation of Kosovo unilaterally declared independence from Serbia after nearly a century of being bound to its larger neighbor, followed by a war for secession that ended only after NATO intervened. The Serbian government refused to recognize the breakaway province and, as part of this diplomatic position, late last year successfully pressured members of Interpol to not admit its former territory as a member.

In response, Kosovo decided to impose a 10 percent tariff on Serbian imports. As the dispute escalated, it raised the tariff rate to 100 percent, even though Serbia is the country's most important trading partner. Both the United States and the European Union pressed Kosovo to drop the tariffs and negotiate a reduction in tensions. Instead, its government widened the levies to include Bosnia and Herzegovina, since that country also does not recognize Kosovo's independence.

Kosovo's actions clearly violate the Central European Free Trade Agreement, which includes all three countries. Despite this, and despite the obvious costs of the tariffs, Kosovo has refused to back down, triggering a near-total collapse in trade between the countries that used to be part of Yugoslavia. Even if this particular trade dispute is resolved, a larger challenge remains: The Kosovar government's explicit aim is to reduce its economic dependence on its former occupier. So far, it's been successful; imports fell by 99 percent from a year earlier.

This is the kind of kerfuffle that causes world-weary observers of international affairs to shrug their shoulders and say, "the Balkans" with a knowing smile. That would be fair enough if not for the déjà vu it inspires among attentive students of economic history.

In the first decade of the 1900s, it was the newly independent Serbia taking actions to try to reduce its economic dependence on the Austro-Hungarian empire. The country increased its imports from France and signed a customs union with Bulgaria. In 1906, Austria-Hungary responded by slapping high tariffs on Serbia's chief export: pork. The "Pig War" lasted another five years, during which time Serbia painfully weaned itself from economic dependence on the Habsburg empire. Austria-Hungary's share of Serbian trade fell from 90 percent to 30 percent.

The Pig War prompted Austria-Hungary to annex Bosnia and Herzegovina, a move that escalated tensions with Russia—and sowed the seeds for the assassination of Archduke Franz Ferdinand in June 1914 by a Bosnian Serb.

Economic closure in the Balkans did not ignite the First World War. It did make the kindling that much easier to spark, however.

Is this more than just a casual historical parallel? I am beginning to worry it is. To be clear, I'm not saying that (another) war to end all wars is imminent. But it's important to understand the role that economic interdependence played in the run-up to that conflict.

Before the First World War started, powers great and small took a variety of steps to thwart the globalization of the 19th century. Each of these steps made it easier for the key combatants to conceive of a general war.

We are beginning to see a similar approach to the globalization of the 21st century. One by one, the economic constraints on military aggression are eroding. And too many have forgotten—or never knew—how this played out a century ago.
The Capitalist Peace

A central tenet of the liberal approach to international relations is that economic interdependence reduces the likelihood of war. While the "democratic peace" is more widely known, the last 30 years have seen an explosion of research into what's come to be known as the "capitalist peace" or "commercial peace."

Proponents of this hypothesis offer multiple reasons commercial activity fosters harmony. For some, the development of free markets reduces the profit motive for territorial expansion. For others, it's that exposure to global capital markets forces states to act in a less bellicose manner because they worry about a cross-border exodus of money and investors.

A third camp says high degrees of economic interdependence increase the incentive to reduce conflict through nonviolent means. And some researchers think, "Why choose?" and argue that all of these factors are interlocking. Some scholars of the capitalist peace go so far as to claim that the pacifying power of markets is what actually explains the democratic peace. These propositions are debatable, but there is an awful lot of evidence that something is going on.

No international relations theory is perfect, and the Achilles heel of the commercial peace hypothesis has long been the outbreak of the First World War. The stylized facts are well-known: Economic globalization seemed to be at its peak in 1914, with trade levels having surged across Europe in the previous half-century. Great Britain and Germany were each other's largest trading partners. After the war, John Maynard Keynes wrote nostalgically about how "the inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep."

Norman Angell in 1909 wrote a bestseller, The Great Illusion, in which he declared that globalization had rendered territorial conquest unprofitable: "Since trade depends upon the existence of natural wealth and a population capable of working it, an invader cannot 'utterly destroy it' except by destroying the population, which is not practicable." Angell concluded that war for profit was inconceivable to any rational human being. The absence of a prolonged war between two or more great powers in the previous 60 years seemed to confirm that supposition. Even as tensions mounted before the Great War, many observers believed that policy makers in Berlin, Paris, and London would not risk their economic well-being over some minor dispute in the Balkans.

We know how history played out. Skeptics of the capitalist peace always invoke the start of World War I as the biggest empirical challenge to the argument. Even many proponents of economic interdependence usually acknowledge that this data point is "challenging" to their thesis. Angell's contention is often mentioned in the same breath as Francis Fukuyama's claims about the "end of history" in the 1990s: as optimistic arguments dashed by reality.

As the historian Margaret MacMillan wrote just a few years ago, "What Angell and others failed to see was the downside of interdependence." She argues that economic connectedness generates frictions rather than resolving conflicts.

Is she right?
Globalization Succeeds—Too Well

The truth is a bit more complex. The potted history of 1914 as the peak of prewar globalization obscures some underlying trends. Namely, most of the "great power" governments had been rebelling against the doctrine of free trade for decades.

In many ways, 19th century globalization was a victim of its own success. Reduced tariffs and transport costs flooded Europe with inexpensive grains from Russia and the United States. The incomes of landowners in these countries suffered a serious hit, and the Long Depression that ran from 1873 until 1896 generated pressure on European governments to protect against cheap imports.

Unsurprisingly, agrarian sectors in Great Britain, France, and Germany lobbied furiously for protection. They succeeded on the continent, setting off a series of ripple effects.

In 1879, German chancellor Otto von Bismarck assembled his "iron and rye" coalition and began to increase tariffs. France responded in kind in the 1880s. By 1887, German tariffs on rye had reached 47 percent, and French tariffs on wheat were at 22 percent. Many middle powers in Europe, such as Italy, Spain, and Sweden, responded with higher tariffs of their own.

Economic closure in the Balkans did not ignite the First World War. It did make the kindling that much easier to spark, however.

If these countries were raising tariffs so much, why is the pre-1914 period thought of as a halcyon age of globalization? One reason is that the United Kingdom, the leading economy of the day, resisted protectionism.

But the bigger reason is that technological change swamped the effect of tariffs. In 1870, the U.K. alone had more rail track than Latin America, Canada, Australia, Russia, South Africa, and India combined. By 1913, those regions had 10 times as much as the United Kingdom. The diffusion of railroads and steamships meant that transport costs fell faster than tariff rates increased, thereby increasing trade flows even as most countries raised protectionist barriers. Indeed, world trade more than doubled between 1896 and 1913.

While globalization still seemed robust in 1914, the restrictions on trade and investment affected the patterns of economic interdependence, particularly in Eastern Europe. Austria-Hungary and Serbia became locked in their trade war, and similar economic conflicts proliferated across the continent. The Habsburgs had a trade skirmish with Romania between 1886 and 1893. France and Italy had one between 1886 and 1895. Germany had one with Spain around that time and followed it up with multiple commercial conflicts with Russia over the next few decades.

In some cases, these tariff disputes were resolved and trade returned to normal. In other cases, however, there were lasting and debilitating effects. Serbian-Austrian trade never recovered from the Pig War. German tariffs on rye successfully reduced its dependence on imports from Russia, and by 1912, despite booming global trade, Russian rye exports were only 30 percent of their 1902 levels.

The result was a European economy in which the western half was still largely interconnected, but trade in the eastern half was segmented by security blocs. Scholars of the capitalist peace argue that this explains why pre-1914 disputes in Western Europe were largely resolved nonmilitarily, whereas Eastern Europe was the scene of multiple smaller conflicts in the two decades before the assassination of Archduke Ferdinand.

It also explains why, in the summer of 1914, the commercial peace broke down. As countries in Eastern Europe began to mobilize their militaries for war after the assassination, Austria-Hungary was not particularly worried about disrupting trade with either Serbia or Russia, since it was barely trading with both. And Russia had raised tariffs on German wheat imports in the month before Ferdinand was shot.

Other mechanisms of interdependence also broke down in the years prior to World War I. Whereas most 19th century trade treaties were bilateral, the gold standard—a monetary system in which all major currencies were convertible into gold (and each other) at a fixed rate—was a more multilateral arrangement, with most of the key central banks assisting each other during times of financial distress. Between 1889 and 1907, national banks in Germany, England, France, and Russia helped each other stay solvent. Despite rising geopolitical tensions, the central bankers of the world were still cooperating. Their economies relied on each other.

That cooperation came to an end in 1911 with the Agadir crisis, which drew its name from a Moroccan port where Germany dispatched warships as a challenge to French pre-eminence in the region. Just as Germany was fomenting conflict overseas, it faced a financial panic at home. Its stock market plunged 30 percent in a single day, and German citizens began converting their paper currency into gold.

Unaided by other central banks, the Reichsbank came perilously close to having to suspend the gold standard. Germany eventually backed down in Morocco—but Kaiser Wilhelm II told his bankers to be prepared to fund a general war as quickly as possible. In the next few years, the Reichsbank more than doubled its holdings in gold, and German banks began restricting loans to foreigners. By the time the First World War started, German gold reserves were more than twice as large as the Bank of England's.

The primary lesson to draw from the years before 1914 is not that economic interdependence was a weak constraint on military conflict. It is that, even in a globalized economy, governments can take protectionist actions to reduce their interdependence in anticipation of future wars.

In retrospect, the 30 years of tariff hikes, trade wars, and currency conflicts that preceded 1914 were harbingers of the devastation to come. European governments did not necessarily want to ignite a war among the great powers. By reducing their interdependence, however, they made that option conceivable.
Is Globalization Imploding Again?

Fast forward to 2019. Are we seeing a replay of this slow-motion implosion of globalization?

Let's start with the obvious historical parallels. In both cases, there has been an absence, lasting decades, of great power war. As in John Maynard Keynes' day, one can order the various products of the whole earth using one's phone and expect their speedy delivery. And if there is a modern successor to Norman Angell, surely it is Steven Pinker. His 2011 book The Better Angels of Our Nature offered a detailed account of the verifiable long-term secular decline in international violence. Pinker credited many factors, but commerce was important among them. In the book, he acknowledged that, as he developed his argument, "more than one concerned colleague took me aside to educate me about Norman Angell," but Pinker said "Angell deserves the last laugh."

In the years since he published that book, however, violence has trended back upward. The 2018 Global Peace Index reported that "the world is less peaceful today than at any time in the last decade."

In the pre-1914 era, agricultural price shocks and the Long Depression stoked the fires of protectionism on the European continent. In the current era, the China shock hit import-competing regions of the U.S. manufacturing sector hard. It is not a coincidence that U.S. public attitudes turned against free trade in the years after China was admitted to the World Trade Organization. That country's entry into the global economy was a net gain, but it had severe distributional effects.

It did not help that Beijing adeptly gamed the liberal economic order. When Chinese President Xi Jinping praised free trade at Davos in early 2017, it was not hard to identify the massive hypocrisies contained in his speech. China's subsidies to its state-owned enterprises, refusal to respect intellectual property rights, and insistence on keeping its currency undervalued in the first decade of this century helped to increase public skepticism toward the liberal international order. If they're not going to follow the rules, many began to wonder, why should we?

The 2008 financial crisis also triggered predictable calls for more trade protectionism in the West. Most great power governments resisted those calls in the immediate aftermath of the crisis, but populist nationalism ushered in a new wave of leaders who were eager to scapegoat foreigners. Between 2012 and 2018, the stock of G20 nontariff barriers, such as the anti-dumping measures the Obama administration imposed on Chinese steel imports, more than tripled. And those numbers do not include other steps toward deglobalization, such as Brexit and the American withdrawal from the Trans-Pacific Partnership (TPP).

All this transpired before Donald Trump tweeted in March 2018 that "trade wars are good, and easy to win"—and then acted on those beliefs. Invoking a little-used national security provision in the 1962 Trade Act, the administration slapped across-the-board tariffs on steel and aluminum.

Despite assurances from Trump administration officials that countries would not retaliate against the United States for these moves, the backlash was swift: The E.U. imposed retaliatory measures on U.S. exports, from bourbon to textiles to Harley-Davidson motorcycles. Other trading partners ranging from Japan to India to Mexico have applied their own countermeasures. The administration then pivoted to China, imposing tariffs on $250 billion worth of Chinese imports, with threats to impose them on another $267 billion unless a deal was quickly reached. China reciprocated, imposing tariffs on more than $60 billion worth of U.S. exports, including a 25 percent tariff on American soybeans and automobiles.

Trump's trade wars can appear to be scattershot, but China is the primary focus of the administration's enmity. Trump officials have stated repeatedly that economic openness with China was a policy failure because the country did not fully liberalize.

This is certainly the belief of U.S. Trade Representative Robert Lighthizer and Peter Navarro, director of the White House National Trade Council. Nearly every profile of either man points to a preoccupation with China and belief that the Sino-American economic relationship is a zero-sum game. For example, one of the elements Lighthizer included in the renegotiated North American Free Trade Agreement—now the United States-Mexico-Canada Agreement (USMCA)—was a provision making it more difficult for any member to sign a trade deal with a "non-market country" such as China. This matches how Trump reportedly thinks about trade.

In another echo of the pre-1914 era, the combined effect of protectionism has not actually dented the overall level of economic interconnectedness much. The Swiss Economic Institute's Globalization Index shows that a growth of financial globalization and cross-border data flows have compensated for the stalling out of trade liberalization. Similarly, the McKinsey Global Institute finds that the massive growth of trade in services and digital products counteracts the effect of manufacturing becoming less trade-intensive in recent years. And the DHL Global Connectedness Index released in February 2019 reached a record high.

The Trump administration ostensibly launched its trade wars to improve the balance of trade—that is, to increase U.S. exports vis-à-vis imports—but by December 2018, America's trade deficit had surged to its highest level since the 2008 financial crisis. Even as Trump-based trade deals like the USMCA face an uncertain future in Congress, the TPP went into effect and the European Union inked bilateral deals with Japan and Canada.

This does not mean that the recent uptick in protectionism had no effect on the global economy. Economists at Princeton, Columbia, and the New York Fed estimate that the trade wars exacted a deadweight loss of approximately $7 billion in the United States during the first 11 months of 2018—and the monthly costs are rising over time. An industry-funded study suggests that in 2019, the tariffs will cost American households an average of $2,400 from higher consumer prices.

China's entry into the World Trade Organization was a net gain, but it had severe distributional effects.

More significantly, the trade war might disrupt the global supply chains that have increasingly integrated the two economies over the past two decades. The economists who calculated the $7 billion in deadweight loss further estimated that the 2018 trade wars had redirected roughly $165 billion in global trade flows. According to a UBS survey of 200 exporters based in China, 37 percent of businesses have already shifted production outside the country, and another 33 percent are planning to do so in 2019. Chinese investment into Europe and the United States plummeted by 73 percent last year. The Baltic Dry Index, which is a good proxy for expectations of cross-border trade by sea, has fallen by 47 percent since the middle of 2018.

The result, The Wall Street Journal's Greg Ip recently wrote, has been a bifurcated world trading system. Between the United States and its allies, the overall effect of trade hostility has been modest. Between the United States and China, however, the disruption has been far more severe, because "the Trump administration regards economic policy and national security as inseparable when it comes to Beijing."

A final weakening link has come from the Trump administration's assault on global economic governance. The United States has announced its planned withdrawal from high-profile agreements (the Paris climate change accords) and low-profile agreements (the Universal Postal Union) alike. And two additional steps have angered both allies and rivals.

First, the White House has, ostensibly to increase U.S bargaining power in trade disputes, refused to approve appellate judges to the World Trade Organization's dispute settlement mechanism. As of this past October, the body lacks the judges necessary to adjudicate all the trade disputes in its docket. Because the rule of law is a linchpin of the WTO system, a weakened dispute resolution capability seriously undermines it.

Second, Trump has tried to exploit the U.S. dollar's privileged role in global capital markets by ratcheting up the country's use of financial sanctions against other governments. Prior administrations were aggressive in their use of financial statecraft, but this administration has taken their unilateral use to a new level. For example, it successfully pressured SWIFT, the private-sector messaging system that facilitates cross-border financial transactions, to comply with unilateral U.S. sanctions against Iran after Trump withdrew from the Iranian nuclear deal. In response, the European Union, China, and Russia created INSTEX, an alternative payment system to bypass SWIFT.

In the short term, this means little. In the longer term, it is significant that E.U. leaders can conceive of financial channels outside U.S. capital markets. The dollar isn't going anywhere for now, but this kind of hedging begins to echo German behavior after the Agadir crisis.
The Rhyme of History

Five years ago, the centennial of the Great War's start spawned a cottage industry of warnings about the rhyme of history. The possibility of a replay of the First World War was a popular one to make. These predictions of doom did not come to pass. The success of Peter Jackson's astonishing World War I documentary They Shall Not Grow Oldnotwithstanding, it would be easy to reject the analogy in 2019.

But most of these efforts missed or mischaracterized the economic dimension of what happened in the run-up to the guns of August. Even though the global economy seemed highly interconnected, in actuality, statesmen had been trying to segment the system for several decades. By 1914, protectionist measures and geopolitical tensions ensured that key actors did not think of themselves as too interdependent to launch an aggressive war.

Analogies are imperfect means of understanding the world. There are several ways in which the early 21st century does not resemble the early 20th century. Other checks on a great power war exist, such as nuclear deterrence. Despite the wave of populism, "there is broad support for key economic features of globalization," according to the Pew Research Center. Trump might get so spooked by stock market gyrations that he will back down on the trade wars. Pinker was correct when he observed that the martial valor of war is less prized now. And if nothing else, current leaders have the lessons of 1914 to digest. Another major war is not inevitable.

Nonetheless, the backlash to globalization that preceded the Great War seems to be reprised in the current moment. Indeed, there are ways in which the current moment is scarier than the pre-1914 era. Back then, the world's hegemon, the United Kingdom, acted as a brake on economic closure. In 2019, the United States is the protectionist with its foot on the accelerator. The constraints of Sino-American interdependence—what economist Larry Summers once called "the financial balance of terror"—no longer look so binding. And there are far too many hot spots—the Korean peninsula, the South China Sea, Taiwan—where the kindling seems awfully dry.

After World War I, Keynes wrote that the conventional wisdom in the summer of 1914 had taken peace for granted: "The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of [the average person's] daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice." Five years later, at least 15 million people had died, another 23 million were wounded, and a quarter-century of hyperinflation, depression, fascism, and war was about to descend upon the world.

Leaders benefit from the lessons of history only if they are aware of what actually transpired. It would be nice if today's world leaders knew more about the eerie parallels between now and the pre-1914 era. Otherwise, the curdling of interdependence will continue—and the capitalist peace that we have all become so accustomed to may not survive.

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