Lotterman: World War I's economic lessons still matter today

July 4, 2014 

Austria WWI

Members of regiments in historical uniforms march June 28 in front of the castle in Artstetten, Austria, where Austrian Archduke Franz Ferdinand and his wife, Sophie, found their last home. The couple were assassinated in Sarajevo on June 28, 1914, triggering the start of World War I.

RONALD ZAK — AP

In history, it is important to distinguish between the cause of an important happening and the precipitating event. A century ago this June, Serbian nationalist Gavrilo Princip assassinated Archduke Franz Ferdinand, next in line to the throne of the Austro-Hungarian Empire, together with his wife, Sophie, in the Bosnian city of Sarajevo, then part of that empire.

Five weeks later, German troops poured across the French and Belgian borders while Russian ones did the same at German and Austrian frontiers. World War I had begun. But the assassination in Sarajevo was not the cause of the war - just the precipitating incident that touched off explosive forces that had been gathering for years.

The results were the deaths of tens of millions of people, military and civilian, the destruction of the Austro-Hungarian and Ottoman empires, impoverishment in the major combatant countries, and the redrawing of the map of the Middle East, among many outcomes.

The after-effects of World War I and the peace treaty that ended it remain apparent in contemporary affairs. Witness Iraq, now descending into civil war, and Ukraine, struggling with Russia.

What does this have to do with economics? A lot. The war offers many lessons. I'll touch upon a few.

One is the idea of an "exogenous shock." Economists long have debated why there are such marked fluctuations in economic activity. Are there factors "endogenous," or within economic systems themselves, that drive the business cycle? Or are these forces primarily exogenous, or outside the system? The question is important, because it bears on whether Keynesian policies to speed or slow the economy by changing taxing, spending and the money supply have much chance of succeeding.

A group of economists that largely overlaps with the anti-Keynesian Rational Expectations school of thought argued that exogenous shocks are the primary factor.

World War I certainly was a shock. In the short run, it boosted output in combatant nations of France, Germany and the United Kingdom. The boost spilled over to nations on the sidelines that could supply commodities or manufactured goods to Europe. So economies hummed during the war, unemployment was low and commodity prices high.

But the warring nations largely bankrupted themselves, using up their gold and currency reserves and selling off foreign assets to pay for the imports - primarily from the Western Hemisphere - needed for the war effort. U.K. investors owned large chunks of the U.S. economy in 1914, but four years later, that was mostly gone. Ditto for much British investment in South America.

The United States was an exception, largely because its involvement in the war was so brief. It declared war in April 1917, some 32 months after hostilities began. But its buildup was so slow that no U.S. units participated in major combat until June 1918, only five months before the armistice. Yes, U.S. deaths exceeded 117,000. But this amounted to only 0.13 percent of the population compared with 4 percent or more for France, Germany and Austria; 3 percent for Italy and Greece; 1.9 percent for the U.K. and Russia; and 0.9 percent for Canada.

Millions of young men died, often on the cusp of what should have been their most productive years economically. A whole generation of European women was condemned to be widows or spinsters. And the financial problems engendered by the war and its peace settlement caused economic and political turmoil that dominated the next two decades and contributed to an even more destructive war 21 years after the armistice ended the first one. So it would be hard to find another exogenous shock in recorded history that had deeper and more long-lasting effects on world history than this war.

Another aspect of contemporary economics evident in the events of 1914 is how "cognitive biases," or irrational patterns of thinking, were common among general populations and national leaders.

One such bias is an "availability cascade," or situation where a collective belief gains more and more credibility as it is repeated, even without any objective evidence. Military leaders on all sides were wildly overly optimistic about their own capabilities. This was especially true of the French, whose "Plan 17" of headlong attack depended on force of will overcoming superior arms.

This is part of a more general "optimism bias," a fancy term for wishful thinking. Political and military decision makers in every combatant country were unrealistic in assessing how well their forces would do.

Only weeks after fighting broke out, the fallacies in both sides' thinking became evident. The impotence of French offensive gallantry against German machine guns was clear within days. But the reaction, at least for a tragic while, was "irrational escalation" or doubling down and using a failing approach even more intensely.

This is one aspect of the "sunk cost" fallacy well known even to economists who reject the behavioral school. This is the human tendency to believe ever more strongly that one should continue with a failing effort just because one already has spent so much money, and in the case of war, so many lives, on it. This is true in most conflicts. It is also common today in private companies or government agencies seeing big software projects spin out of control.

As the war went on, the sorrow and pain on all sides became enormous. To cut one's losses and seek a negotiated peace came to be seen as a betrayal of those who had died. More prosaically, it would have required leaders to admit their mistakes. The real contribution of the United States was not in actual fighting against the Germans but rather in the fact that the slow, but inexorably growing, buildup of U.S. forces finally overcame the self-denial of German leaders.

Of course, we have to be cautious of "hindsight bias," or the belief that things were clear simply because of the way they turned out.

Write Ed Lotterman at boise@edlotterman.com.

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