Over the past few months, I have written about the economic prospects associated with various potential disruptions in the Middle East and elsewhere. The topic of the moment is, of course, a war with Iraq. As is my custom, I will avoid the temptation to express any views one way or the other on the merits of such a conflict. I decided a long time ago to restrict my public comments on policy issues to things economic (unless it somehow relates to baseball).
There are obviously multiple outcomes that are possible, but a few conclusions are apparent. Whenever there is uncertainty or instability in the world, there is a flight to safety among investors. Treasury bonds will be popular, thus impacting interest rates to a modest extent. The Federal Reserve will work to continue its pattern of monetary ease, which coupled with a sluggish private market should keep interest rates low.
Oil prices already have a “risk premium” built into them. In all likelihood, any invasion of Iraq will not significantly impact world oil supplies. There are several mechanisms to make up for any lost quantities that might reasonably be expected, and current production capacity has a considerable surplus. (There is, of course, a doomsday scenario in which all of the Middle East removes petroleum from the market in protest of any invasion. The cost of such a move to the countries involved would be astronomical in many cases, so I doubt that is a real threat. The other one is the destruction of significant production capacity, again not impossible, but the chances are remote.) I suspect that the real impact on oil prices will be minimal, at the most a (very) temporary spike followed by a return to prices in the mid-$20s per barrel range. Such a pattern is similar to that observed following the invasion in the early 1990s and will not make a huge difference in inflation.
Another issue is the growing budget deficit of the US government. A sluggish economy, a big tax cut, and new spending on terrorism and security have rapidly transformed the fiscal situation from one of substantial surplus to one of substantial deficit. It appears that a war with Iraq would not take too long, as it is akin to a battle between the New York Yankees and a decent high school team. Nonetheless, it will be expensive, and the need for an ongoing presence will persist for quite some time. While the impact on the budget will hardly be devastating, a war with Iraq will likely cost $100-$200 billion over time, will further limit the ability to achieve balance, and will crimp private sector borrowing and investment capacity as the economic recovery begins (not a good thing). It will also reduce the potential to meet other pressing needs in such areas as healthcare, transportation, and security.
In short, on the issues that people usually discuss, the effects are notable but not dramatic. Interest rates, oil prices, and inflation will likely see only minor impacts; the federal budget will be affected a bit more, but not beyond the bounds of reason. The bigger issue is the aftermath of the war itself. If a stable government emerges and overall Middle East tensions are lessened, significant benefits can occur. The world petroleum situation will settle down to some extent, and the US could probably add new and stronger trading partners for our massive output capacity. An accelerated domestic energy policy could also generate substantial gains while preserving environmental integrity. On the other hand, if a war leaves the region more uncertain than it is now, ongoing economic dislocations will limit expansion potential throughout the world for decades to come.
The biggest wild card is, as is becoming all too common in economics these days, psychological. How will consumers and investors react? There is no doubt that we have been a bit skittish of late; terrorism and corporate scandals have taken their toll. The smart money is on a temporary (but potentially sharp) adverse reaction that is quickly reversed as the reality of American military superiority surfaces.
To sum up, on purely economic grounds, a war with Iraq will likely have measurable but modest consequences for business activity. Its implications in other areas may well be far more extensive. From my perspective, the most important factor for the economy is that we work toward a more favorable environment in the region after it is behind us, whatever “it” is.