Will an Iraq war cause a recession?

Will an Iraq war cause a recession?

Will an Iraq war cause a recession?

The search for better economic policy.
Oct. 2 2002 10:40 AM

The Cost of Toppling Saddam

Will an Iraq war hurt the economy?

Security at any price is a fine sentiment when you're under attack (or believe you are). But what exactly will it cost us to get rid of Saddam Hussein, and what will it mean for the economy?

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Wars loom large in the imagination, and a big military conflict can permanently change how an economy develops and performs. That's especially true for the losers: The Iraqi economy will probably never be the same once we're done. From our side, the same war should have pretty modest direct economic effects, but its second- and third-order reverberations could mean slower growth for several years.

Wars that produce big economic change usually do so because the conflict costs so much. For example, fighting World War II consumed a mind-boggling 37 percent of our GDP in 1943. These colossal costs transformed the country's manufacturing plant, reshaped the labor force by drawing in women and shifting low-skilled laborers from the South to the Northeast and Midwest, and ultimately raised the average skill level of working men through military training and the GI Bill.

Since democratic governments are reluctant to ask their citizens to pay much higher taxes while they're also placing their children in mortal peril, most large wars also involve changes in monetary arrangements to finance the conflict. America's first national currency and modern bond operation grew out of the Union's financing schemes for the Civil War. World War I funding demands transformed the infant Federal Reserve from a lender of last resort in bank panics into a modern central bank. And the deficit financing of the Vietnam War (and monetary policies to accommodate it) helped launch the inflation of the 1970s.

But a large economy like ours may hardly notice a small war. During Desert Storm, for example, female employment fell slightly for a time when the wives of the nearly half-million married men deployed there had to assume more child-care responsibilities. A brief spike in oil prices also occurred. Neither change was responsible for the 1990-91 recession. That downturn had already begun when Saddam invaded Kuwait, driven by the Fed's decision to hike interest rates in 1989 and by a pullback in bank lending after the credit binge of the '80s.

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The Sept. 11 attacks have had minor economic consequences, akin to a natural disaster like Hurricane Andrew. Its aftereffects have been mainly distributional—less demand in the tourism and airline industries, large losses in the insurance sector, and a burst of new orders for security and defense companies. But the al-Qaida attacks had no discernable effect on overall consumer demand, retail sales, industrial production, or home sales. In fact, the mild recession that began in early 2001 ended soon after 9/11, and the economy grew faster in the next quarter (at a 5 percent annual rate) than it had in two years.

War with Iraq will have more economic repercussions than 9/11, but its direct effects should be small. Unofficial estimates of the cost of "regime change" by force range from $60 billion to three times that amount over two years. That's a lot of money compared to almost anything, except a $10 trillion-a-year economy. At the top end, it would cost less than 1 percent of GDP—a far cry from the Korean War, which saw military outlays jump from 5 percent of GDP to more than 13 percent, and less even than the additional military spending of the Reagan buildup. Still, with economic growth today in the doldrums, the additional war spending should boost the economy a little bit—though less than if Congress were to provide, say, the drug coverage for seniors that the president and most members have long promised.

While a war with Iraq won't much affect overall growth and investment, at least directly, it will breed more uncertainty about the future, which usually drives businesses and consumers to delay some large investments and purchases. This would mean slightly slower growth in the short run that could offset the modest stimulus from the higher military spending. Once we win—and assuming the victory comes fairly easily—a brief surge of investment and purchasing could follow. But much of this effect could be offset, too, by tighter credit conditions from higher budget deficits. Like most wars, this one could also affect exchange rates, and here we're likely to benefit. The United States is the No. 1 safe haven for foreign capital. Trouble anywhere draws funds to our markets, strengthening the dollar and pushing down our interest rates.

Wars are bearish for international trade, and it is in the international oil trade that the coming war with Iraq might cause some economic havoc. Our two worst recessions of the last half-century—the 1974-75 downturn and the deep trough of 1981-82—were closely associated with sustained spikes in oil prices. Today, as both the world's largest consumer and largest importer of oil, and the most energy-intensive advanced economy, we remain acutely vulnerable to higher oil prices.

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The ultimate cost of the coming conflict to the American economy will depend on how high the price of oil goes and how long it stays up. The last Gulf War produced a brief period of $40-a-barrel oil, and experts predict that the outbreak of hostilities this time will push the price to $50. Such a run-up in oil prices won't matter much if it doesn't last long. And whatever happens, the United States will not run out of oil. Producers outside the Gulf account today for nearly three-quarters of world oil production. Moreover, we have large private oil inventories, as well as a Strategic Petroleum Reserve that holds about 600 million barrels of crude—enough to cover more than seven months of U.S. oil imports from the Gulf.

But an actual interruption in crude from the Gulf would still send world oil prices sky-high. If the conflict wears on or, worse, spreads, the economic consequences become very serious. Late last year, George Perry at the Brookings Institution ran some simulations and found that after taking into account a reasonable use of oil reserves, a cut in world oil production of just 6.5 percent a year would send the United States and the world into recession. The price of a barrel of oil would rise to $75, a gallon of gas would cost $2.78, inflation would jump 5 points, and U.S. growth would fall nearly 3 percent. A 10 percent net cut in the world's supply of oil for a year would be very nasty: Crude would sell for as much as $160 a barrel, gasoline would cost nearly $5 a gallon, 15 points would be added to the inflation rate, and growth would drop 4.6 percent.

Let's assume a more plausible scenario: The conflict is limited to Iraq, the military action reduces world oil exports—net of the use of reserves—by 1 million barrels a day or 1.3 percent, and it takes a half-year. That would add $7 to the price of a barrel of oil, 16 cents to a gallon of gas, and cut growth by a little more than a half-percent. Like the last Gulf War, it won't make the difference between boom and bust.

But it also wouldn't help, especially in an economy that may already be set on a course of, at best, moderate growth. A small oil shock could undermine consumer confidence and stock prices, both of which have been weakening; slow business investment, which has been depressed recently; weaken income growth, which has been stalled; and increase corporate and household debt, which are already at record levels.

But the main reason for most of this disappointing performance is not a coming war with Iraq but the president's careless fiscal policies. Even if the war on Saddam and terrorism costs $300 billion—double the higher estimates—that will still be less than one-fifth of the 10-year cost of the president's tax cut and barely one-third the cost of the president's other defense spending increases. In all likelihood, the greatest burden on future growth and prosperity will come not from the war but from the president's own budget and economic policy decisions.