Analysis: Economic consequences of the war

By DAVID HALE, Special to UPI  |  March 20, 2003 at 6:12 PM
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CHICAGO, March 20 (UPI) -- There is little doubt that America's war with Iraq will be the dominant event shaping the world economy and financial markets during the next few weeks and months.

A country with a gross domestic product about the size of that of Louisiana has brought the world to a standstill. The paralysis won't be resolved until there's a military conflict that produces a regime change.

Even before the conflict actually began, the prospect of war had several economic consequences. Oil prices, for example, had risen to about $40 per barrel -- the highest in several years.

This oil price shock raised business costs and depressed consumer income when the economy was already burdened by corporate caution about investment and a stock market decline equal to 90 percent of U.S. gross domestic product.

There's no precise way to quantify the impact of risk aversion linked to war on economic performance, but the contrast between employment in the United States and Canada during February is very revealing.

The U.S. economy lost more than 300,000 jobs; Canada gained 55,000 jobs. American business has been very cautious during recent months because of concern about the war and the lagged impact of the Sarbanes/Oxley legislation on management perceptions of personal liability risk in the event that they make a serious mistake.

The Sarbanes/Oxley legislation and the war risk will probably delay any upturn in capital spending until companies have far more confidence in the medium-term economic outlook. Canadian companies, by contrast, are more confident because their country didn't suffer from major corporate scandals last year -- and it won't join in the war.

All the major recessions since 1974-75 have been preceded by oil price shocks. At the time of the first oil shock in 1973-74, energy consumption was equal to about 6.2 percent of GDP. During the late 1970s, it rose to 7 percent to 8 percent of GDP and then spiked to nearly 11 percent after the oil price shocks of 1979-1980 (the Iranian revolution).

The energy consumption share of GDP plummeted during the 1980s back to 6 percent to 7 percent of GDP and troughed at 5 percent during 1998-1999, when oil prices fell to $10 per barrel.

The recent oil price shock will probably push the energy consumption share of GDP back to 7 percent of GDP this spring and summer. The result will be to reduce the economy's potential growth rate by nearly 1 percentage point of GDP if everything else is equal.

The United States imports about 3.4 billion barrels of oil per year, so the increase in the merchandise trade deficit will be about $65 billion -- or a sum equal to 0.6 percent of GDP.

The prospect of war with Iraq wasn't the only factor pushing up oil prices. The markets have been so tight during recent months that the recent strikes in Venezuela also had a major impact on prices. Three months ago, it was widely perceived that OPEC had about 7.1 billion barrels of spare productive capacity.

As a result of the Venezuelan strikes and production hikes that have already occurred to compensate for Iraqi output losses, the level of spare capacity is now only about 2.1 million barrels. As a result, markets will be very apprehensive until they see the progress of American military forces in the coming battle.

If Iraq was able to hit Kuwaiti or Saudi oil production centers with Scud missiles, the price of oil could easily shoot up to $50 to $60 per barrel.

In recent congressional testimony, Fed Chairman Alan Greenspan said geopolitical uncertainties were a major cause of the recent economic weakness. But the economy has performed better than it did during the run-up to the Gulf War in 1990-91.

At that time, retail sales fell for four consecutive months (from October 1990 through January 1991) before rebounding 0.5 percent in February and 1.1 percent in March 1991. Durable goods orders also fell during those months before rebounding sharply during February and March 1991.

If that pattern is repeated, the economy would probably rebound to a growth rate of 3 percent to 4 percent in the second quarter of 2003 after expanding at an annual rate of only 1 percent to 2 percent during the current quarter.

The recovery from the first Gulf War proved very disappointing despite the U.S. military victory because of a banking crisis. As a result of speculative real estate lending during the 1980s, there was a surge of American bank failures, which caused a wave of regulatory intervention followed by a severe credit crunch.

The Fed slashed interest rates to 3 percent to revive lending but its policy failed.

The first Bush administration also worsened the situation by agreeing to a tax hike at a time when monetary policy was impotent. During the past two years, there have been only 11 bank failures compared with nearly 500 during 1989-1991 -- but the economy is still suffering from an overhang of debt and depressed equity prices, which could constrain private spending after the war ends.

Greenspan says the economy will recover without any additional stimulus, but the fact is the economy has already lost momentum during recent months despite extraordinary monetary and fiscal stimulus since the terrorist attacks of Sept. 11.

In the first quarter of 1991, the U.S. economy benefited from the fact that everyone perceived America had won a decisive victory. The war also ended when Iraqi forces fled from Kuwait.

The United States didn't prolong the war by attacking Baghdad. The clarity of the outcome had an immediately beneficial impact on oil and equity prices and consumer confidence.

It is far from clear that this war will produce as decisive and clear an outcome.

First, the U.S. goal this time is to encourage regime change through a military occupation of Iraq. As a result, the fighting could be more prolonged than during 1991.

The United States is likely to win a decisive military victory over the Iraqi armed forces in the first week of combat but there could be insurgent actions against U.S. forces for months after the occupation.

Second, there is a risk that Islamic extremists could respond to the U.S. attack by launching a terrorist assault on the United States itself or American interests abroad (embassies, military bases, etc.).

In 1991, there had not yet been any Arab terrorist attacks on the United States itself. If there is a significant terrorist event in this country, it could delay any recovery in consumer and business confidence.

Third, the U.S. led a broad global coalition against Iraq in the 1991 war. This time, it faces tremendous opposition from traditional European allies, such as Germany and France, as well as many developing countries. There have also been large anti-war demonstrations in Europe, Australia, Mexico and elsewhere.

The United States believes it can justify acting unilaterally if it wins a quick victory and moves to establish a prosperous democratic Iraq. But it is unclear what the consequences will be of disrupting the Western alliance and undermining the authority of the United Nations.

Will Germany and France be less co-operative on economic and other security issues? Will Germany and France slow down the process of European integration to punish the eastern European countries that supported America? Will Germany and France exclude Britain from all important European policy decisions because Prime Minister Tony Blair supported the Americans?

Will Blair lose political support because of the war? Will the United Nations be less able to play an effective role in defusing other crises, such as the new one in North Korea?

The markets are concerned about American unilateralism because they perceive it as opening the door to a new age of imperialism that could have significant economic consequences. After a great peace dividend following the end of the Cold War, U.S. defense spending is now increasing dramatically.

The surge in the defense budget will magnify the federal budget deficit and raise the risk of the current-account deficit widening further.

During the Cold War, American allies often helped to shoulder the burden of U.S. military spending. During the 1960s, Germany had a formal offset program in which it engaged in financial transactions, such as stockpiling dollars at the Bundesbank, to offset the cost of U.S. defense spending.

During the late 1980s, the Japanese engaged in massive currency intervention to stabilize the dollar because of concern about the falling dollar jeopardizing American financial stability. During the Gulf War of 1991, the United States received huge subsidies from Japan, the Gulf States and Saudi Arabia to pay for the cost of evicting Saddam from Kuwait.

America actually appointed an ambassador for burden-sharing to obtain financial support for the war.

The United States will get no subsidies to pay for this war. If the occupation meets great resistance and proves to be expensive, the United States will also have to assume all of the costs. The markets would regard such a development as negative because of the potential consequences for the budget deficit and the current account deficit.

Congress would probably respond to a high-cost war by vetoing the Bush tax cut proposals, which were designed to bolster the equity market.

Asian central banks have spent large sums defending the dollar during the past year purely for economic reasons; they don't want dollar depreciation to undermine their trade competitiveness.

Such support operations could continue to with or without a benign outcome to the Iraq war. But there is little doubt that private selling of dollars could intensify if investors thought that the United States was accepting a major new financial burden when its current account deficit is already 5 percent of GDP.

Many Europeans believe that America wants to conquer Iraq to control the country's oil wealth. It is far from clear that Iraqi oil will compensate for the cost of the war. While the country has large untapped reserves, its production is only about 2.5 million barrels per year. That's worth only about $25 billion or about one-quarter of the projected cost of the war.

If Iraq were to boost output significantly, there would probably also have to be at least $20 billion to $25 billion of new investment in infrastructure and petroleum development.

The United States has played an imperial role in the past. Aside from Germany and Japan after 1945, it has engaged in military occupations of Nicaragua, Haiti, Panama, the Dominican Republic, the Philippines, Cuba, Mexico, South Korea and South Vietnam.

At the end of the 19th century, many Americans believed the country had a manifest destiny to play an imperial role promoting Christian values and democracy. But as a result of its own anti-colonial history, the United States was never fully comfortable with the idea of imperialism. Its institutions are also poorly equipped to preside over a colonial empire.

Until 2003, the international affairs budget of the government had been in decline for many years. The CIA has not been able to recruit the best and the brightest from the country's elite Ivy League universities for nearly two generations. It depends heavily upon former Mormon missionaries because they are the only Americans prepared to learn exotic foreign languages. The Congress has become highly isolationist and protectionist since the end of the Cold War.

Many of the world's current problems resulted from Franklin Roosevelt's decision to promote the liquidation of the British Empire after World War II. If the Americans had supported the British rather than promoting the end of the empire, there would be no conflict now between Palestinians and Israelis, no threat of war between India and Pakistan and no need to attack Iraq.

The African continent would also not be suffering from brutal and incompetent dictatorships presiding over starvation and uncontrolled epidemics of AIDS. The consequences of Roosevelt's foreign policy have been catastrophic for hundreds of millions of people in the Third World as well as for America's own security position.

The United States is about to go to war because of a balance of power vacuum in the Middle East created by the withdrawal of the British nearly half a century ago. The British understand the consequences of this vacuum more clearly than the Germans and the French, so they are prepared to help the Americans. But it was the United States that deliberately created the vacuum in the first place as a result of a naive anti-colonialism that spawned some of the most brutal dictatorships in human history.

Despite enthusiasm for war among Washington neo-conservatives, it is unclear if America is truly prepared to accept an imperial role on a sustained basis. The United States accepted the cost of the Cold War because the Soviet Union was clearly a threat to the security and freedom of the American people. The same cannot be said of Iraq, North Korea, and other rogue states in the Third World.

Such regimes are a clear threat to their own people and other states in their region. But they don't directly threaten America's own territory and security. The events of Sept. 11 are being used to justify to pre-emptive foreign policy and the American people appear willing to accept the administration's decision to use military force without the other side attacking first.

But as a result of the 1991 war, Americans also expect a quick and decisive military victory. It is unclear if they comprehend all the costs and consequences of a prolonged military occupation.

The deployment of military power is, by definition, a high-risk event. As the Challenger demonstrated, there can be mistakes with technology that disrupt the best-laid plans of generals and presidents.

There is little doubt that the United States will conquer Iraq and drive Saddam from power. But the decision to act unilaterally has set in motion political shock waves that won't fully comprehensible for some time. The markets will rally on positive news about the military conflict. But the sustainability of the rally will hinge upon how America reconciles its new imperial ambitions with the realities of large fiscal deficits and unprecedented current account deficits.

The cost of the war has clearly put Bush's fiscal strategy at risk. What remains to be seen is what additional sacrifices America will have to make to support its new imperial responsibilities.

David Hale, former global chief economist for Zurich Financial Services, is President of the Chicago-based economic consultancy Hale Advisers LLC.

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