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Is the U.S. Economy Ready for War?

What will be the economic consequences of a war with Iraq for the U.S. economy?

March 17, 2003

What will be the economic consequences of a war with Iraq for the U.S. economy?

A country with a GDP comparable to Louisiana's has brought the world to a standstill. The prospect of war between America and Iraq has already had several economic consequences. The price of oil has risen to about $40 per barrel — or the highest level in several years.

This oil price shock is increasing business costs and depressing consumer income at a time when the U.S. economy is already suffering from corporate caution about investment — and a stock market decline equal to 90% of GDP.

There is no precise way to quantify the impact of risk aversion linked to war on the U.S. economy's performance.

But the difference between employment in the United States and Canada during the month of February is very revealing. The U.S. economy lost over 300,000 jobs — while Canada gained 55,000 jobs.

How come? U.S. businesses have been very cautious during recent months because of concern about the war.

Canadian companies, in contrast, are more confident because any Canadian role in the war with Iraq will be very modest.

Fed Chairman Alan Greenspan claims that the U.S. economy will recover without any additional stimulus.

But his nation's economy has lost considerable momentum during recent months despite extraordinary monetary and fiscal stimulus since the terrorist attack of September 11, 2001.

Little wonder, then, that financial markets are concerned about any notions of American imperialism. Any leanings in that direction would have grave budgetary consequences. After a great peace dividend following the end of the cold war, U.S. defense spending is now increasing dramatically.

The upsurge of the defense budget will magnify the U.S. federal deficit — and it will also increase the risk of the current account deficit expanding further.

If the occupation of Iraq meets great resistance and proves to be expensive, the United States may likely have to assume all of the costs. The markets would regard such a development as negative — because of the impact of the extra spending on the budget deficit and the potential consequences for the current account deficit.

The results of the ballooning budget deficit? First, Congress would probably respond to a high cost war by voting against the Bush tax cut proposals which were designed to bolster the equity market.

Second, pressure on the U.S. dollar could intensify. Investors get nervous quickly — if they perceive that the United States is accepting a major new financial burden at a time when its current account deficit is already 5% of GDP.

What about all that Iraqi oil money? Contrary to the wishful thinking emanating from Washington, it is far from clear that Iraq's oil wealth will compensate for the cost of the war.

True, Iraq is estimated to have huge oil reserves. They are said to be 112.5 billion barrels, compared to 262 billion barrels in Saudi Arabia.

But Iraq's production yield is very low. The peak in oil production during the past 25 years was 3.5 million barrels in 1979, while production in 2002 was only 2.6 million barrels. That is worth only about $25 billion per annum — or just one quarter of the possible cost of the projected war itself.

After a U.S. occupation, there could be more investment to improve the infrastructure and boost output. But on a best-case scenario, Iraqi oil production would only increase to about 3.5 million barrels over the next few years. If the oil price stabilizes at $25 per barrel, the country's oil earnings would bring in just $35 billion per year.

Iraq will probably need $10-20 billion of foreign capital merely to achieve that oil output of 3.5 million barrels. That leaves little for the country's immense needs for investment in social services and repair of infrastructure.

The coming war is therefore not going to produce major dividends for the occupying power. The ultimate economic verdict on the war will therefore depend upon how effective the Americans prove to be in rebuilding Iraq after the military conquest.

Some U.S. intellectuals look back with nostalgia at what America achieved in Japan and Germany after 1945.

The problem with these scenarios is that Iraq has a very different history. Japan and Germany had been strong nation states with some experience of democracy before dictators gained power during the 1930's.

Iraq is a synthetic nation created by the British after WWI. It has no tradition of democracy — or even benign dictatorship. It has been ruled by ruthless military despots since the late 1950's.

Iraq has a large population of exiles who could play a helpful role in creating a new society incorporating human freedom, the rule of law — and democracy. But we do not yet know who will play a leadership role among the exiles.

With so many issues still up in the air, the only thing that is certain is this: The potential costs of invading Iraq are very large. And the uncertainty is great.

That means that invading Iraq is likely to leave the U.S. economy with some pretty big problems — and not a lot of money to solve them.