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War and Peace

The paper War and the World Economy: Stock Market Reactions to International Conflicts, by Gerald Schneider and Vera Troeger, is an honest and yeomanlike study of the influence of hot and cold wars on stock markets, and is well worth study.

The paper uses a daily index of the increase in tension caused by events in the Iraq wars, the Israel/Palestine conflict and the Yugoslavia wars as a foundation for differentiating between two hypotheses:

  1. War hurts stock markets because it disrupts trade.
  2. War helps stock markets because it's good for defense-related industries.

The authors conclude that markets react negatively to increases in the likelihood and intensity of war. They contend that "international traders only welcome conflictive events whose anticipated costs lift the uncertainty over the future course of action and promise a less costly resolution of the conflict than originally anticipated." They also conclude that conflicts increase the volatility of stock markets in an asymmetric way, with increases in tension increasing the volatility more than positive developments decrease it.

There are many defects in the paper. Foremost is the use of parametric rather than non-parametric statistical tests to carry their points. Also, the authors don't discuss the magnitude of the reduction in uncertainty or prediction error of the stock market that their model provides. Nor do they take account of the multiplicity of their retrospectively-concocted hypotheses that seem to fit the data. A more direct and convincing test could have been performed with a Siegel-Tukey test. Furthermore, the lumpiness of their data relative to the exact timing of the events undercuts the utility of their analysis.

This is one of those papers where the road is much better than the inn, i.e. the path taken is better than the conclusions. Many readers will be introduced to a class of models developed by Jean-Michel Zakoian in Threshold Heteroskedastic Models, Journal of Economic Dynamics and Control, 1994, which model volatility as a function of the the surprise and the over/underestimates in the previous period, with a dummy variable to differentiate between the overestimates, which cause increased volatility, and the underestimates, i.e. the positive surprises, that have no impact. Such a model could be much more meaningfully tested by enumerating the 10 biggest surprise events that seem to account for the only meaningful reactions that the market had during the period, and seeing whether the negative events affected variance more than the positive ones. The use of headlines from Dow Jones News or the New York Times would have been a useful adjunct here. Nevertheless, the methods used would find a much more tractable and useful set of data involving the reaction of individual company news to cardinal events like earnings announcements or the reaction of markets to economic reports such as the month employment reports.

I learned many things from this paper:

  1. Wars fought on foreign soil have a much more positive impact on a country than those fought on its own soil.
  2. Cooperation versus conflict is a key variable in determining market responses.
  3. There is a group of theorists out there who are brave enough to state openly that "economic agents abhor war because it endangers mutually profitable exchanges." The extension of this idea to a quantified series of trade moves, including those relating to the Smoot-Hartley tariff bill that was a key link in the Great Depression, and the key events in the removals and increases in trade barriers since that time would be most fruitful.
  4. Markets might respond positively to violence during a war because it might signal that the worst is over.
  5. A scale of increasing tension has been developed by Goltstein and similar attempts to analyze the impact of war on bond markets has been made by Frey and Kucher.
  6. Collectivist scholars have shown that they can develop models where, depending upon the level of trust between the parties, trade in military goods can arise between warring parties themselves such as those that accompanied the Civil War and led to Rhett Butler's fortunes in Gone with the Wind.
  7. Scholars have studied the influence of wars on tourism in Israel and the degree of pessimism in England during WWII.
  8. The day-to-day reactions in the Russo-Japanese War during were limited because they were predictable. However, it seems to me that this was one of the most important wars because its aftermath destroyed the credibility of Czar Nicholas in Russia and allowed the Communist takeover for the next 70 years.
  9. Decisive actions are key, military or non-military, as they alter the beliefs about different crisis scenarios. This is something that would have been very good to test.
  10. Two modifications of the GARCH model to take account of asymmetric volatility are the EGARCH and TGARCH models.
  11. If conflict occurs unexpectedly, the reactions of the markets are most often unambiguously negative, but if conflict had been anticipated for a long time, the reaction is muted.

In short, although none of the conclusions of the Schneider and Troeger paper are carried by their data and techniques, there are many interesting facts and approaches outlined that have applicability and utility in many fields of specinvestment warfare and research.


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