Economic Aspects of the War in Iraq

Economic Aspects of the War in Iraq

Theme: As the drift towards military action against Iraq continues, the short-term future of the world economy remains in the balance, suspended amid the debilitating hangover effects of the 1990s boom, the deepening rifts between allies in multilateral fora and the unsettling uncertainties of war.

Summary: The economic risks implied by a war against Iraq are quite high, particularly for the US. Higher budget deficits, a weaker dollar, higher oil prices and a possible recession are all possible consequences. While the rest of the world, including Europe, also stands to lose if an oil price spike tips the world back into a double-dip recession, the US has the most to lose over the middle-run given its increasingly ambitious international strategic agenda.

Analysis: Economic analysis, particularly forecasting, is inherently fraught with uncertainty. When it must also deal with the potential costs of war, it becomes even more difficult and tentative as so much remains dependent on factors that, by their very nature, are unknown. What follows is an attempt to delineate what might be considered the most important economic factors related to a military conflict in Iraq. When possible, each will be treated from the perspective of a number of plausible scenarios for the war and the so-called “day after.”

Costs of the War
A number of estimates as to the potential costs of the war have been made. While there exists a general consensus on the estimated direct costs, large discrepancies remain with respect to the varying possible war and “day after” scenarios, and the potential secondary impacts of the war.

During the last Gulf War, of the total direct costs of US$80bn (measured in 2002 dollars), the United States paid only some 10%. The rest of the costs were ultimately defrayed by contributions from Germany, Japan and Saudi Arabia. The latter alone paid for about 25% of total costs. This time around, given the difficulties the US has experienced in convincing most of its traditional allies of the necessity of an early war, it is unlikely that the US will be able to avoid paying at least half –if not two-thirds– of the total costs (nearly certain to go far beyond direct military costs).

The UK and Japan are likely to contribute, but it is still far from clear that Saudi Arabia is prepared to do more for the war effort than providing some use of its territory as a staging point for operations and augmenting its oil output to offset some of the potential war-induced losses to world supply. Under the current climate, it is also unlikely that cash contributions from Germany or France will be more than minimal. It is also hard to imagine the Spanish government stumping up much cash when it has had such a difficult time articulating to its people why Spain stands to gain in either diplomatic or economic terms from its backing of the US position. The absolute and relative portions of the total costs that the US will have to bear, therefore, will probably be much higher than during the last Gulf War. Then, the total costs actually borne by the US came to less than 0.2% of GDP, far below the 130% of annual GDP paid to execute the American effort during WWII or the 12% for Vietnam. This time round, they are likely to come closer to 1% of GDP for a number of years, depending on what exactly happens during the post-war scenario.

A few high profile estimates produced in the US last autumn on the costs of the war have been mentioned quite frequently in the press. The first came from the Democratic staff of the House Budget Committee. They estimated that the direct military costs of a war with Iraq would run between US$48bn and US$60bn. The Congressional Budget Office (CBO), a branch of the US administration, estimated that a new Gulf War would cost US$44bn. An official bipartisan consensus would therefore put the direct military costs at approximately US$50bn (or 0.5% of GDP). Yale economist, William Nordhaus (internationally renown for his co-authorship of Paul Samuelson’s best-selling introductory economics textbook), has provided some more detailed estimates. He points out that both the House and CBO estimates are “best-case scenarios” and, in any event, ignore other significant costs –like humanitarian assistance, peacekeeping and occupation, and political and economic reconstruction– that are more than likely to be entailed for as many as ten years into the future.

Nordhaus estimates that a more complicated and protracted war (lasting from three to six months) could cost US$140bn. The other costs mentioned above could come to an additional US$100bn in the best-case scenario, but would be closer to US$600bn under a less favourable scenario. These costs include US$1bn to US$10bn for humanitarian assistance, US$75bn to US$500bn for peacekeeping and occupation, and US$25bn to US$100bn for political and economic reconstruction.

Taking an intermediate range (assuming both a relatively easy war for the US, but also the cost overruns that the US has historically experienced during wartime) yields an expected cost this year of approximately US$90bn for direct military costs, or close to 1% of GDP in 2003 (assuming the war actually does take place this year). Most economists are now estimating that the US government budget deficit will be around 3% of GDP this year without calculating possible effects of war-related spending or the president’s new budget proposal. The spending-related effects of a war could therefore bring the US budget deficit to around 4% of GDP in 2003.

An intermediate estimate for the other associated costs (humanitarian assistance, peacekeeping and occupation, and political and economic reconstruction) would come to approximately US$350bn over as many as ten years. This would increase the budget deficit by an additional 0.35% of GDP during the coming years. Of course, incorporating the fiscal effects of the administration’s new budget proposals, the US government budget deficit as of 2004 could easily surpass 5% of GDP unless emergency measures are taken to reduce spending or reverse the tax cuts introduced in 2001 and the new ones planned for this and the coming years.

There is always the chance, as the Bush administration assumes (or at least hopes), that a healthy economic recovery will be spurred by a rapid and successful military campaign. This scenario does hold out the possibility that a dissipation of current economic uncertainty and a rebound in confidence will produce enough growth to eat away at some of this deficit accumulation. Nevertheless, this is a “best-case scenario”, which –given the underlying weakness of the economy (including significant spare capacity, high levels of corporate and consumer debt, an historically large current account deficit, and a weakening dollar)– is unlikely to pan out, even if the war is quick and clean. As a matter of fact, as we argue below, the odds are that a military action against Iraq will depress the world economy still further, increasing the US budget deficit as a percentage of GDP over the next few years.

There is also the possibility, mentioned above, that allied contributions might defray some of the costs and therefore take some pressure off of the build-up in the US deficit. Only the Japanese, however, seemed prepared to stump up any significant cash. On the other hand, the US will potentially have to pay some countries –like Turkey– for access to their territory for staging operations against Iraq. The US has offered Turkey $US26bn for use of bases there as a staging point for a second front invasion across Iraq’s northern border with Turkey. So far, this offer includes US$4bn in grants and US$20bn in loan guarantees (or, alternatively, a lump sum grant of US$6bn).

However, the Turks have demanded more. Foreign Minister Yasar Yakis, and Economy Minister Ali Babacan, visited President Bush a few weeks ago to ask for upwards of US$90bn. Bush refused, however, and stuck to US$26bn as a final offer. In response, the Turkish parliament delayed its treatment of US military use of Turkish territory in the attack on Iraq. The Turks subsequently came back with a more moderate request of US$30bn (US$10bn in grants, a US$10.6bn bridge loan, and another US$10bn in other facilities), which is likely to ultimately be accepted (assuming, of course, that the Turkish parliament finally approves US military use of Turkish territory for staging an attack on Iraq.) Nevertheless, Parliament has already rejected this proposition once. Although a second vote might still authorize US troop presence and use of the country as an invasion base, the Turkish government is waiting for a second resolution from the Security Council authorizing force against Iraq before bringing the vote back before Parliament.

In any event, such a payment to Turkey could end up offsetting much of the rather limited contributions the US can expect to receive from other allies. On the other hand, if Turkey does ultimately refuse to provide the US with its coveted northern route into Iraq, then what the latter would save in paying off Turkey would no doubt be more than compensated for by the much higher costs of war that this strategic limitation would imply.

Economic Impacts
Nordhaus estimates that the macroeconomic effects of the war in the US, via depressed investment, consumption and financial markets, could range between 0 and US$345bn over the next several years. Adding the potential effects of oil price volatility, he estimates additional costs of between -US$30bn and US$500bn. In the best-case scenario, the marginal effect on the economy would be nil to slightly positive. This estimate forms the foundation of the optimistic scenario in the markets that sees oil prices falling sharply, stock markets rebounding vigorously, and the dollar recovering, once the hostilities have begun and uncertainty dissipates. This assumes, however, that without the depressing effects of pre-war uncertainty, the economy would now be in sharp recovery.

But this assumption is weak. As we have argued before, even without the war factor, the US economy would likely remain sluggish for years (see Henrik Lumholdt, La economía estadounidense: ¿recuperación, doble-fondo o bajo crecimiento? Implicaciones para Europa, Análisis del Real Instituto Elcano,18-9-2002). This would be the uncomfortable result of the lingering overhangs (overcapacity and high levels of private indebtedness) and disequilibria (current account deficit and an over-valued dollar) produced during the boom of the 1990s. GDP growth in the US would be a mere 1%-2% for the next several years and only after assuming a public deficit and current account deficit both approaching 6% of GDP. Without the stimulative effects of such ballooning deficits, the US economy would likely stagnate, much as Japan did for most of the decade following the bursting of its bubble economy. The idea that war spending by itself would prove a sufficient stimulus to put the economy on a sustainable upward path is also a delusion. While it is true that WWII proved to be a significant stimulus, this was only because the economy had already suffered nearly ten years of depression and stagnation first, and then, only with a massive infusion equivalent to 130% of GDP. The tentative conclusion, then, is that without a truly cleansing recession, the US economy lacks a healthy basis for a strong and sustainable recovery.

In the best-case scenario, a war that proved stimulative in economic terms would have only a marginally positive effect, while any of the other possible scenarios could only damage the economy further. Given the reality of a consolidated euro, a growing US government budget deficit above 3% –in the context of weak growth, a current account deficit of 5% of GDP, and a weakening dollar– will certainly begin to translate into higher long-term interest rates, weighing still further on the economy. Such a development could potentially burst the housing market bubble and, via higher mortgage payments and an increase in the number of foreclosures, provoke a significant slump in consumption. Recalling our analysis of the effects of war and “day-after” spending on the US budget deficit (to say nothing of Bush’s new budget proposals, including new and accelerated tax cuts totalling some US$674bn and structured in such a way so as to limit their short-term stimulative impact), it is clear that the future outlook for the US economy does remain clouded indeed.

The argument has been made that the Gulf War (1990-91) took place at the end of a cycle (albeit short) of expansion and played a role –via the oil price shock it produced– in provoking the recession that followed. Since this new Gulf War will occur after the slowdown and recession of 2001, so the argument goes, war is now merely playing the role of impeding the recovery. But 2001 did little to cleanse the US economy of its significant disequilibria. Consumer spending, propped up by an excessively strong housing market (itself the product of three years of declining equity markets and 13 Federal Reserve interest rate cuts), continues to serve as the last leg of support to the US economy. If the pre-war period of uncertainty and now the war itself do anything at all, they are likely to have the effect of undermining consumer spending once and for all, particularly if long-term interest rates begin to rise.

The US Conference Board’s consumer confidence index already fell from 78.8 in January to 64.0 in February, its lowest level since 1993 and the third consecutive monthly decline. It now stands at levels associated with sharp recessions. In order to spur a real recovery, consumer confidence needs to increase dramatically enough so that consumers feel assured that their future incomes will be sufficient to allow for both continued spending and feasible servicing of their debts. A strong fiscal stimulus theoretically could contribute to this, but only if most consumers believe that the proposed tax cuts will quickly and significantly increase their disposable income. But with the Bush tax cuts appearing like a boon-doggle for the well-off and employment conditions remaining negative, this is unlikely to happen. Unemployment has begun to rise again and now stands at 5.8%, one of the highest levels in ten years. Regardless of the prospects for increased savings provided by the tax cut, business confidence and investment are not likely to rebound until it is clear that consumer spending is back on a sustainable upward path. On the other hand, if consumer confidence continues to fall, the war could easily prove to be the trigger that ultimately provokes a truly cleansing recession in the US. Nevertheless, recognizing this reality –while important for the mid-term health of the US economy– would imply running significant electoral risks that the Bush administration will no doubt do everything in its power to avoid.

Oil Prices
The odds of this scenario panning out increase still further when we consider the role of oil prices on consumer confidence, aggregate demand and inflation. Oil prices have not yet risen by as much as they did during the lead up to the last Gulf War, when they peaked in the fall of 1990 at more than 80% above their pre-Kuwait invasion levels, and remained some 60% above those levels at the beginning of war in early 1991. Nevertheless, since September 1st, 2002, oil prices have jumped by approximately US$10/bbls –barrels– (from US$25/bbl to US$35/bbl), or some 40%. The thesis arguing that oil prices will fall significantly –as they did in 1991– after the initiation of hostilities, lending consumer and business confidence a boost, and thereby stimulating the world economy, assumes that the recent price rise is due solely to a war premium. However, much of the recent price rise has been stimulated by the reduction of Venezuelan production (from 2.8mbd to 350,000mbd –million barrels per day–) in December and January.

Even now, however, after the conclusion of the strike in Venezuela, oil production has returned to less than half of its pre-strike level. It now appears that Venezuela will not be capable of returning to its pre-strike production levels for some time. Given that the international oil market remains very tight at the moment, with a very cold winter elevating world demand and US commercial reserves at their lowest level in a generation, the world economy is highly vulnerable to an oil price shock should an attack on Iraq take its 2mbd off the market. Furthermore, the world oil market has far less spare capacity now (only 2mbd) than in 1991 (over 6mbd).

All this points to a likely price spike above US$40/bbl at the beginning of a war. How far and fast prices come down afterwards will depend on three factors: (1) how fast the US and other OECD countries release their strategic petroleum reserves (more than 1.5bn barrels or the equivalent of approximately 20 days of world consumption); (2) how much damage to Iraqi oilfields (and perhaps to those of its neighbours) results from the war (US sources have recently claimed that Iraq is preparing its oil fields for possible destruction as part of a scorched earth defence strategy); and (3) how fast Saudi Arabia increases its remaining spare capacity to replace Iraqi and Venezuelan oil on the market. One might feel confident in being optimistic about the first and third variables presented here, but the second factor (potential damage to oilfields) is not something that anyone can feel confident about predicting.

One of the most prominent studies on possible oil price paths has come from the Centre for Strategic and International Studies in Washington, D.C. The CSIS sees prices peaking between US$40/bbl and US$80/bbl (best-case versus worst-case scenarios) during the first quarter following the initiation of a war with Iraq. Two years later they would return to US$20/bbl in the best-case scenario, to US$30/bbl in the intermediate case, and to US$40/bbl in the worst-case. The best-case scenario foresees a very quick and clean war, with Iraqi production off the market for about three months and no further damage to oil infrastructure in the region. The average price of oil during the first year from the beginning of the war would be only US$26/bbl, more or less in line with the average for 2002.

However, the intermediate scenario envisages stiff resistance by the Republican Guard resulting in considerable military and civilian casualties. The fighting would be over within a few months at most, but sporadic attacks on US forces, along with sabotage against Iraqi oil facilities, would complicate market psychology in this scenario. The average price during the first year would be US$37/bbl, more than US$10/bbl higher than the average in 2002. This would imply, according to the IMF’s rule-of-thumb calculations, a reduction of 0.5 percentage points –pp– from world growth. The worst-case scenario would imply stiff resistance and the desperate use of weapons of mass destructions against US forces and possible attacks on Israel. This scenario foresees a widening of the war across the region and significant damage to oil infrastructure, taking as much as 6mbd off the market. The average oil price during the first year would reach at least US$60/bbl, implying more than a 1.5pp reduction from world growth. Only a no-war scenario would see the average price during the first year lower than that in 2002.

Of course, higher oil prices would hit Europe just as hard as they would the US. Last November, the European Commission estimated the economic effects of higher oil prices resulting from an attack against Iraq. The first scenario sees oil prices at US$50/bbl for two months, followed by a decline to US$28/bbl. This would strip one decimal point from EU GDP growth and add a further two decimals points to EU inflation. The second scenario foresees an oil price of US$57/bbl for one quarter, following by a drop to US$39/bbl. This would eliminate four decimal points from EU growth and inject another half a percentage point of inflation. A third scenario sees oil prices remaining between US$35/bbl and US$40/bbl for two or three years. This would reduce growth by two to four decimal points and increase inflation initially by some seven decimal points, and by four and two decimal points, respectively, in each succeeding year. Finally, the last scenario is one of total shock. A recession is provoked with a clearly negative impact on EU growth of up to 1.4pp.

Conclusions: The economic risks of an attack against Iraq are currently quite high. Rising deficits in the US, heightened risk aversion and uncertainty at a time of economic fragility, an oil price spike and a possible renewed recession all loom on the economic horizon. Furthermore, the US is likely to begin to experience potential overreach problems should it be forced to pay the lion’s share of the post-war costs. The dollar’s hegemony in the international economy will be eroded more quickly as a result of rising deficits. Higher interest rates will also constrain the US economy in a way that will be highly uncomfortable for a hegemón, making guns and butter budget debates unavoidable in the US for the first time since WWII. The US economy –and dollar hegemony– will become increasingly dependent on European and Asian investment, which continues to finance the US’s “twin deficits.” Will Europeans and Asians continue to collaborate in the financing of the US’s new strategic agenda?

They were willing to do so back in the 1960s and 1980s, when there was more or less a consensus over the objectives of the Cold War and on the optimal manner in which to pursue them. Nevertheless, today the most striking characteristic of the US strategic agenda is the deep discord it has produced around the world. With the dollar weak and depreciating further, the deficits this war is likely to contribute to will only speed up the process of euro internationalisation. Given the dollar’s structural disadvantages, therefore, this will occur even despite lingering economic weakness in Europe. Any future European reforms, therefore, are likely to only strengthen the potential international position of the euro and, with it, Europe’s fiscal and monetary flexibility. By insisting on a war now, together with major tax cuts, the US runs the risk of undermining its future capacity to continue financing its increasingly ambitious strategic agenda. Whether the US likes it or not, allies will become even more important in the future.

Paul Isbell
Senior Analyst for International Economy and Trade
Real Instituto Elcano

Written by Paul Isbell

Paul Isbell was Senior Research Fellow at the Elcano Royal Institute, and former Senior Analyst for International Econimics. He is also the CAF Energy Fellow at the Center for Transatlantic Relations (CTR) at Johns Hopkins University’s School for Advanced International Studies (SAIS), in Washington, D.C., and the lead energy specialist of CTR’s flagship projects, the […]