Peace on earth?

In these pages, I have tried to make sense of the world from a financial and quantitative viewpoint, so let me try to focus on a framework that is appropriate for the season. Sometimes this form of analysis can provide an economic framework for analysis showing the incentives for different actors that is different from conventional wisdom.

'Tis the season to wish "Peace on earth and goodwill towards men." Indeed, when I examine some of the literature, there are strong financial incentives for peace. In a recent article, Geoffrey Kemp and John Allen Gay wrote that there are strong disincentives for the United States to go to war with Iran. They mainly cite the economic costs of an oil spike on the global economy and the resources needed to open the Straits of Hormuz and keep them open. The article is well worth reading in its entirety, the conclusion was:

Living with a nuclear Iran would require expensive countermeasures and create significant risks. But going to war to impede Iran’s nuclear ambitions, and containing the subsequent chaos – including oil-price spikes, increased regional volatility, and reduced American strategic flexibility – would be far more costly. If Obama stands behind his first-term declarations, the world will pay a very high price.

If we were to turn the spotlight on the Holy Land, Lawrence Solomon believed that there are strong economic incentives for Israel to make peace, largely because it is able to significantly cut government spending in the form of military expenditures:

Should that ever-elusive peace deal with the Palestinians one day materialize, Israel’s economy would be ever so much stronger, probably growing at 5% to 7% per year, according to 2010 estimates from Bank of Israel Governor Stanley Fischer.

Part of that boost would come from Israel’s ability to cut its military spending, which today is about 7% of its GDP, just a fifth of its mid-1970s levels but still painfully burdensome. In contrast, the U.S., despite its military presence around the globe, spends less than 5% of its GDP on the military; countries with peaceable neighbours such as Denmark, Sweden and Canada typically spend 1.5% or less.

On the other hand, a Palestinian state would lose much of the foreign that flows into the region:

But would peace serve Palestinians as well? Probably not. As a fully fledged state, Palestinians would no longer have an entitlement to Israeli aid and with the high-profile Israeli-Palestinian issue defused, Arab oil states that have reluctantly provided aid in solidarity against Israel would be able to bow out. More importantly, with the end of unrest Palestine would soon lose the raison d’être for international aid from Western countries and agencies such as the World Bank — the belief that the West could leverage its aid to end conflict and arrive at a peace treaty. Foreign aid diplomacy, in fact, has driven the peace process since Bill Clinton in 1993 brought together PLO chairman Yasser Arafat and Israeli prime minister Yitzhak Rabin to sign what is known as the Oslo Accord.

This gives the Palestinian the paradoxical incentive of embracing peace talks, but not peace itself:

Unlike Israelis, Palestinians fear they would see no glorious peace dividend — to them peace looks more like a punitive tax. Not surprisingly, while public opinion polls show Israelis to overwhelmingly favour a two-state solution in which Israel and an independent Palestine live side by side, they also show Palestinians in the Palestinian territories to overwhelmingly oppose it.

At the same time that Palestinians reject peace, they embrace peace talks. Earlier this year, the Palestinian Center for Policy and Survey Research surveyed Palestinians on how the government should meet a budget shortfall for this year. Only 9% backed tax increases while “a majority of 52% selected the option of returning to negotiations with Israel in order to obtain greater international financial support.”

Greg Mankiw once said that people respond to incentives. If we do want peace on earth, then the correct incentives must be put in place to encourage those ends.

Whatever your beliefs, let me close this post with a tribute to one of the giants of science and early pioneers of mathematics, without whom quantitative finance would not be possible without his work. December 25 was the birthday of Sir Isaac Newton.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.