Posted on 03/07/2003 6:07:28 PM PST by Axion
The Economy of War Summary
Mar 07, 2003
Conventional wisdom argues that war in Iraq will be bad for the U.S. and global economies. Leaving aside the more serious aspect of lives risked and lost -- and focusing strictly on the economics -- we find this argument dubious. Wars historically have been stimulatory because of deficit spending. Since the fear in the United States, a few months ago, was of deflation, wartime stimulation should be welcome. Wars historically lead to economic expansions, with the crisis being at the end of the war rather than during. There might be many problems with an Iraq war, but we do not see economics among them. The financial markets are misreading the situation.
Analysis
Financial markets have become obsessed with the possibility of war in Iraq. There is a core assumption that war would be economically bad for the United States if it happened, good if it did not. Thus, when it appears that war is less likely, the stock markets rise and commodity markets -- particularly oil -- fall. When war appears to be more likely, the reverse happens. Now, there might be other causes for the markets' behavior, but in the short run, market perception becomes market reality. On the other hand, markets sometimes misinterpret reality, particularly in the short run. Therefore, the crucial question is whether the markets have understood the effect of war correctly.
To frame the question appropriately, we need to begin by defining the current war. The United States, having been attacked by al Qaeda, is engaged in a global war against that organization and against militant Islamic fundamentalism in general. This war has three aspects: First, there is the defense of the United States against future attacks; second, there is the covert, global war against enemy operatives; and third, there is the war against nation-states that enable or potentially would enable al Qaeda.
The attack on Iraq is not a war, properly understood. It is a campaign within a much broader war. Just as the U.S. invasions of North Africa or the Philippines during World War II were simply campaigns in a much broader global struggle, so too is the Iraq operation. Afghanistan was a precursor campaign. There will be follow-up actions against other countries, ongoing covert operations and homeland defense. The question of the impact of war cannot be limited to Iraq. It has to be posed this way: What will the effect of the global war, defensive and offensive, be on the U.S. and global economies?
The economic effects of wars are not mysterious; there are plenty of historical benchmarks. In World War II, the last global war, the effect was very much differentiated based on whether a country won, lost or just came out even. The effects on Japan and Germany were devastating: It took a generation to recover. The effect on the Soviet Union and the United Kingdom also was negative. Both lost a great deal in the course of the war. The effect on the United States was positive. World War II helped end the depression and allowed the United States to emerge from the war as a global economic engine. After problems with transition, the result was the massive expansion of the 1950s.
Therefore, the real focus of economic analysis must, in the first instance, be on the damage that is sustained by the United States in the course of a war. The effect of the Sept. 11 attacks was substantial. Imagine, then, an attack that is orders of magnitude greater and multiply its effect on the economy. Therefore, the real, long-term economic question is: what is the best strategy for keeping the United States from being devastated by multiple al Qaeda attacks?
The conventional argument is that a war in Iraq will increase the risk of militant attacks against the United States. This is not Stratfor's view. The Sept. 11 attacks occurred in the absence of an Iraqi war, and al Qaeda will -- if it can -- carry out further actions. Within the Islamic world, al Qaeda argues that the United States is weak, indecisive and corrupt -- that al Qaeda's cause is not hopeless because the United States will not fight effectively. At this point, a decision by Washington not to go to war in Iraq would (a) confirm this argument (b) turn Saddam Hussein into an Islamic hero and (c) leave U.S. allies like Kuwait, Bahrain and Qatar completely exposed. At this point, in our view, whatever might have been the case in the past, leaving Hussein in place would dramatically increase the legitimacy, credibility and capabilities of al Qaeda and its allies. It would raise the likelihood of attack against the United States -- and that would be the worst thing for the U.S. economy. A dirty bomb exploding in three or four American cities would really shave points off the GDP. The markets seem to assume that an Iraq war increases the chances of attacks; we take the opposite view.
There is, however, a broader view to be taken of war. In countries that are not harmed by enemy attacks, wars historically are stimulative, simply because they tend to be financed through deficit spending. Wars, like capital expenditures, carry long-term returns and should be costed out over the long term. Accounting issues aside, this is the way it historically is done, and that is certainly the way the war against al Qaeda is being financed as well. By combining homeland defense, funding of expanding intelligence capabilities and increased military operations, deficits are inevitable. We know of no multi-year war that avoided them.
However, just a few months ago, the more depressed market analysts were talking about the danger of deflation. Keynesian theory might be old, but it does teach us a basic truth, which is that the cure for deflation is economic stimulation through government spending. During the Vietnam War, anti-war economists argued that capitalism was able to sustain itself only through wars and arms races, because that was the only way to stimulate the economy. This is nonsense, as the 1990s showed, but the usefulness of stimulation is not nonsense. Wars generate demand both directly and indirectly, through increased spending, unless someone tries to do what the United States has never in its history done: pay for a major war through current tax receipts. So, anyone who was concerned about deflation should be relieved that the Bush administration has readopted Keynes.
Wars serve another stimulative purpose: They increase research and development in technologies that, over the long run, generate new civilian technologies. World War I force-fed aviation technology. World War II generated a vast variety of advances in electronics. The Cold War stimulated everything from communications satellites to the Internet. Particularly at a time when corporate R&D is under pressure, the current surge in research for homeland defense, intelligence and military uses will represent a new wave of products -- stimulating exactly the sector that was devastated in the recent crash. The brutality of war also has stimulated creativity.
There is then the question of oil prices and the fear that higher prices will abort recoveries. Higher energy prices certainly would do that, but it is not clear that higher oil prices will last or that they can be traced to realities in Iraq. We should remember that one of the world's major oil producers, Venezuela, was forced entirely out of the market by internal crises late last year and early this year. Its production still has not fully recovered, and it may never do so. Iraq's current oil exports, at about 1.8 million barrels per day, are not insignificant, but fears that they may be lost hardly explain current prices. Venezuela coupled with irrationality does explain them. Given U.S. planning to minimize damage to Iraq's oil fields and to rapidly repair damage that is caused, we would not expect an extended loss of Iraqi oil. The war premium built into the current price is irrational.
If all of Iraq's current exports were forced off the markets, other countries could, with some effort, replace them. They also are highly motivated to do so. Saudi Arabia and other producers have serious economic problems -- they need the cash flow from oil, and they are constantly fighting for market share. The Iraqi shortfall would be quickly absorbed. On the other hand, the United States clearly intends to ramp Iraqi oil production quickly to pay for reconstruction. If Iraqi exports grew in the wake of the war to say, 2.5 million or 3 million bpd in one year and 5 million bpd in three years, prices would decline.
The threat of higher prices is linked to a shutdown in Saudi production caused by internal unrest or war. These are real threats, but it is not clear that if it were to become reality it would be a result of the conflict in Iraq. The broader war against al Qaeda has many dimensions that are both unavoidable and potentially destabilizing. That danger remains, regardless of Iraq.
The threat of war to an economy is first, the damage of attack or defeat, and second, the management of the slowdown following a war. The danger to the economy tends to come when defense spending slows suddenly, unemployment rises and recessions kick in. It is also possible, as in the case of Vietnam, that an interminable, mismanaged war -- overfunded by deficits -- will undermine confidence and capitalization.
But the Iraqi campaign is not really the issue here. The issue is a much broader one -- how to prosecute the current war without falling into the Vietnam trap. The Vietnam trap was that a war begun in 1964 could not be won by 1970. To put it differently, it is not war that threatens an economy, but defeat. Regardless of whether the United States carries out a campaign in Iraq, the specter of defeat -- in the wider war -- is the real threat to the U.S. and global economies.
The reasoning here is fallacious, as proven beyond any reasonable doubt by Bastiat.
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