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War and the World EconomyIoD Economic Paper
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Graeme Leach
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This economic paper was written by Graeme Leach, Chief Economist. It was produced byLisa Tilsed.
January 2003
ISBN 1 901580 94 6
Copyright © Institute of Directors 2003Published by the Institute of Directors116 Pall Mall, London SW1Y 5ED.
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Contents
Summary
1 Introduction
2 The fog of war
3 How much will PGW-2 cost?
4 Collateral economic impact
5 US defence expenditure trends
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15
20
35
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Summary
• Whilst the overriding concern about any conflict must inevitably be the human cost,there also needs to be a consideration of its impact on an already fragile world economy.
• There are tremendous geo-political and military uncertainties at present, and as a result,a wide-range of potential US economic scenarios exist – depending on the impact on oilprices and economic confidence. The IoD has identified 6 potential US GDP growthscenarios for 2003, with very different impacts.
Table 1 The US Economy in 2003 – War Scenarios
Scenario GDP %change
Probability Explanation
Stand-off –no war
2.2%LOW toMEDIUM
• Oil price higher than under capitulation scenarios.• Direct defence spending less than under war
scenario.• Fiscal stimulus delayed on Capitol Hill by
Democrats.Capitulation– no war
2.5%MEDIUM
• Oil price higher than capitulation short war scenariodue to uncertainty of no regime change
Capitulation– short war
2.9%HIGH
• Oil price falls back quickly to $20 due to removal ofwar premium and potential long-term supply boostfrom Iraqi production.
• Fiscal stimulus swiftly driven through in full onCapitol Hill.
• Stock market rises 5% in 2003.EscalationScenario 1
1.0%LOW toMEDIUM
• Oil price spike to $45.• Fiscal stimulus delayed by Democrats – sensing
‘damaged’ President.• Stock market falls 10% in 2003.
EscalationScenario 2
- 0.5%VERYLOW
• Oil price spike to $60.• Yield curve steeper.• Stock market falls 20% in 2003.
EscalationScenario 3
- 2.0%VERYLOW
• Oil price spike to $80.• Steep yield curve.• Stock market falls 30% in 2003.• Negative housing wealth effects.
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• Table 1 shows the range of potential US GDP forecasts depending on alternativemilitary and geo-political developments. The US GDP forecasts are based on differentassumptions regarding; the duration of any conflict, defence spending, oil price effectsand the potential response of monetary and fiscal policy.
• The key messages from Table 1 are:
(1) In economic terms, a short war is better than no war, or no regime change,because of the removal of uncertainty.
(2) The highest GDP growth scenario has the highest probability.
(3) The lowest GDP growth scenario has the lowest probability.
• US economic prospects will be maximised if President Bush swiftly takes both Baghdadand opposition to his fiscal stimulus on Capitol Hill. Under the short war capitulationscenario (highest probability), the President will find it easier to obtain Congressionalapproval for the recently announced fiscal stimulus package. A short and successful warcould guarantee speedy and full implementation of the fiscal package. Lower oil priceswould also provide the Federal Reserve with further opportunity to reduce interest rates.
• Escalation scenarios are very worrying because of the knock-on implications for worldequity markets. Under escalation scenarios 2 and 3 world equity markets could fallheavily.
• Escalation scenarios do not bode well for the Euro-zone and the Japanese economy. TheECB’s 2% inflation target would almost certainly be breached under escalation scenarios,thereby reducing the potential for a stimulus from lower interest rates. The Growth andStability Pact also limits the opportunity for fiscal stimulus. In the case of Japan interestrates have already been pushed to zero and the public debt to GDP ratio and budgetdeficit have exploded over the past decade.
• The total economic costs of conflict are not easy to quantify since they are so wideranging:
• Direct combat costs – The direct military costs for the duration offighting - weapons, ammunition and transportation.
• Indirect ‘knock-on’ costs – There are a wide range of additional indirectcosts which tend to be excluded from conflict cost assessments. Theseinclude long-term medical costs and additional training costs to replacelost or injured soldiers, sailors and airmen, the future cost of humanitarianassistance, peace keeping and nation building activity, where the sums ofmoney involved could be considerable and long-lasting.
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• Collateral economic effects – The collateral economic effect of war refersto the wider macroeconomic effect of changes in defence spending andkey macroeconomic variables such as the price of oil, consumer andcorporate confidence and the stock market. Collateral effects also includemonetary and fiscal policy responses.
Table 2 Oil Price Scenarios – Persian Gulf War 2003
Oil price scenario Explanation Oil price movement
Stand-off – wardelayed until late 2003
• US-UK don’t act – due tointernational pressure – untilinspectors have ‘smoking gun’.
• Possible use of volunteer humanshields by Iraq.
• Oil price holds at current levelsbecause of the risk of future conflict.
Oil price remains around$30 throughout 2003
Capitulation – no war • Saddam offers full disclosure anddisarmament.
• Fallback stops at $25 because ofcontinued uncertainty owing to noregime change.
Oil price falls back to $25by the end of 2003.
Capitulation – shortwar
• Rapid victory followed by regimechange and Iraqi commitment to meetall UN Security Council resolutions.
• Loss of Iraqi production for threemonths.
• No draw-down on US strategic reserveneeded.
Oil price falls back to lessthan $20 by the end of2003.
Escalation scenario 1 • US controls virtually all of Iraq exceptfor Baghdad which holds out.
• US plays a waiting game in order toavoid heavy urban fighting.
• Loss of Iraqi production for 3-6months.
• Limited draw- down on US strategicreserve.
Oil price rises to $45 (inreal terms similar to thespike in 1990) beforefalling back to $35 by theend of 2003.
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Escalation scenario 2 • Iraqi forces concentrate in urban areasand trigger heavy fighting.
• Much larger US ground forces arerequired with heavy airlifts.
• OPEC uses oil price as a politicalweapon.
• Fears of oil shortages trigger stock-building
• Lower GDP growth dampens demandfor oil
• Greater draw-down from US strategicreserve
Oil price rises to $60before falling back to $40by the end of 2003
Escalation scenario 3 • OPEC intensifies the use of oil priceas a political weapon and cutsproduction sharply.
• US loses use of Middle East bases tolaunch operations – therebyprolonging conflict.
• Panic buying on world oil markets.• Iraq production off the market 12
months plus.• US/OECD strategic reserves heavy
draw-down
Oil price rises to $80 (inreal terms similar to thespike in 1980) beforefalling back to $50 by theend of 2003.
Any of the above regime change scenarios risk destruction of Iraqi oil capacity by Saddam, as adefiant final gesture.
• Any assessment needs to distinguish between gross and net costs. The direct cost to theUS of a new war in Iraq will be much higher than in 1991. The gross US direct cost ofthe 1991 war was $80 billion (in 2002 prices). However, cash and other contributionsfrom Saudi Arabia, Kuwait and Japan reduced the net cost to just $4 billion (in 2002prices). Various US studies suggest that depending on how short or protracted a new waris, the direct cost will range from $50 to $150 billion in 2003. One study suggests thatover the next decade the total direct and indirect cost might range from around $150 to$750 billion.
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1 Introduction
Over the course of history the economic impact of war has been very significant. Goldstein(War & Economic History, JS Goldstein, in The Oxford Encyclopedia of Economic History,ed. J. Mokyr, OUP 2002) has stated that wars can be expensive, destructive and disruptiveand whilst there may be some positive aspects from short-term stimulation and long-term re-building, war generally impedes economic development. The ancient Chinese militarystrategist Sun Tzu (The Art of War, c 400BC) argued that the short-term economic effect ofwar was to push up inflation:
“Where the army is, prices are high, when prices rise the wealth of the people is exhausted”.
In this report we focus on the potential economic impact of a second Persian Gulf War(hereafter PGW-2) on the US and world economy. When the world’s largest economy goesto war, we all need to be aware of the potential economic fall-out.
The impact of any conflict on the US economy is of paramount importance. One recentstudy (The impact of US economic growth on the rest of the world, V. Arora and A. Vamakidis, IMFWorking Paper 119, 2001) shows a US GDP correlation coefficient with the advancedeconomies of close to 1. The world economy is hugely dependent on the fortunes of the USeconomy, which buys 20% of the world’s imports. Over the 1992-2001 period US importvolumes recorded average growth of 10% per annum.
It is fairly obvious that the short-term impact of PGW-2 on the Iraqi economy will becatastrophic. The first Persian Gulf War (hereafter PGW-1) destroyed about $230 billion ofIraqi infrastructure (The economy of Iraq, CT Westport, 1994). Nordhaus (The economicconsequences of a war with Iraq, WD. Nordhaus, NEBR Working Paper 9361, December 2002)has stated that:
“Overall, the wars and sanctions during the Saddam regime [Including the Iran-Iraq war] probablycost Iraq in the order of two decades of GDP in lost output, capital and financial resources. There areno parallels in modern history to economic devastation on that scale”.
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Table 1.1 The Human Cost of War
Conflict US fatalities – number Fatalities - % of US populationRevolutionary War 4,435 0.13%War of 1812 2,260 0.03%Mexican War 1,733 0.01%Civil War 184,594 0.54%Spanish American War 385 0.00%World War 1 53,513 0.05%World War 2 292,131 0.22%Korean War 33,651 0.02%Vietnam War 47,369 0.02%First Persian Gulf War 148 0.00%
Numbers refer to US military personnel. Source www.cwc.1su.edu/cwc/other/stats/warcost)
Conflicts in the Middle East are naturally associated with the oil price. This means that anyrise in oil prices reduces the amount of money companies and consumers in the rest of theworld can spend on other goods and services.
This report will show that war can have a positive economic impact, but when oil prices arepushed up the impact tends to be negative. Given the weakness of the world economy atpresent, this may be a particularly bad time to go to war (see Chapter 4 - Boxes 4.1 and 4.2).
Nevertheless, this does not mean that a war should automatically be avoided because of theeconomic impact. Wars tend to be fought over issues such as freedom and democracy whichdefy economic quantification. Moreover, one also has to consider the counterfactual i.e. ifconflict is avoided now, will it simply have been deferred to a future date when the humanand economic costs could be even higher.
As an illustration, consider what might have happened if Britain and France had opposedGermany marching into the Rhineland in 1936 - there would have been a cost in lives andmoney, but we will never know if this would have avoided the greater cost of World War 2.
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2 The fog of war
The fog of war and economics is uncertainty. No two wars are the same. Tables 1.1 and 2.1show the huge variation in the costs of conflict - as measured by lives and money – frommajor American wars.
It’s also important to recognise that subsequent wars can be different, even when they takeplace within the same ‘theatre’ of operation:
• PGW-1 mainly involved air warfare, desert conflict and heavy armour punching into Iraqand Kuwait. Any future PGW-2 may/may not involve more urban fighting and an evengreater emphasis on air warfare.
• The nature of conflict has changed in the decade since PGW-1. During PGW-1 only 7%of air launched munitions were so-called smart bombs. In the recent fighting inAfghanistan 70% of air launched munitions were precision guided smart bombs.
• In 1991 Saudi Arabia was ‘picking up the tab’ for the cost of PGW-1. It was also preparedto pump more crude in order to stabilise oil prices1. PGW-2 will have a much greaterdirect impact than PGW-1 on the US budget deficit. The gross cost of PGW-1 (inconstant 2002 US$) to the US was almost $80 billion, but after allied cash contributionsthe net cost fell to just $4 billion (in constant 2002 US$).
1 Saudi Arabia has good reason to ‘fear’ PGW-2. Any conflict could stir Islamic fundamentalists athome. Regime change in Iraq could also threaten to stir up calls for democracy in the kingdom. Froman economic perspective, regime change is likely to result in a surge in Iraqi oil production over thenext 5 years. Iraq contains 112 billion barrels of proven oil reserves – the third largest reserves in theworld (source: www.eia.doe.gov/emeu/cabs/iraq).
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Table 2.1 The Economic Cost of US Wars
Conflict Total $ directcost of war –billions currentprices
Total $ directcost – billions2002 constantprices
Per capita $ cost– billions 2002constant prices
Cost - % of annualGDP
Revolution War 0.1 2.2 447 63%War of 1812 0.09 1.1 120 13%Mexican War 0.07 1.6 68 3%Civil War 5.2 62 1,686 104%Spain-US War 0.4 9.6 110 3%World War 1 16.8 190.6 2,489 24%World War 2 285.4 2,896 20,388 130%Korea 54 335.9 2,266 15%Vietnam 111 494.3 2,204 12%First Gulf War 61 76.1 306 1%(Costs are direct and generally exclude postwar costs of veteran’s pensions and health care. Source:Table 2, Nordhaus, NEBR, December 2002)
There are tremendous military uncertainties at present, and as a result a wide range ofpotential economic scenarios exist (see Chapter 4). The IoD has reviewed a number ofsources (for example see: military and geo-political briefing papers on the effect of an attackon Iraq produced by the Center for Strategic and International Studies, CISS, Washington DC,November 2002) on the military and geo-political consequences of PGW-2 - and used theseto generate (see Chapter 4) 6 potential economic scenarios with very different impacts.
The military uncertainties include:
• Will there be a conflict?• When will the fighting start?• What will be the scale of any military action?• How long will the fighting last?• Will the conflict be confined to Iraq?• Will Iraq use weapons of mass destruction (hereafter WMD)?• Will the conflict trigger acts of mega-terrorism on a par with 9-11?• What will be the scale of subsequent peace-keeping activities?
Military uncertainty compounds economic uncertainty. Abraham Lincoln’s Secretary of theTreasury estimated that the direct costs of the Civil War to the North would be $240 million– 7% of GDP. The actual cost was 13 times higher at $3,200 million (page 2, The EconomicConsequences of a War with Iraq, WD Nordhaus, NBER Working Paper 9361, December2002).
Boxes 2.1 and 2.2 highlight the potential ‘wild-cards’ which could lead to an escalation orreduction in economic and geo-political tension.
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Box 2.1
12 Wild Cards that might lead to an escalation in economic and geo-political tension
1. US & UK go to war without full UN Security Council support.2. TV coverage of colateral damage inflames Middle East.3. WMD targeted at US-UK forces.4. WMD targeted at Israeli forces.5. Conflict descends into ‘Chechnya style’ urban warfare.6. Saudi Arabia takes an increasingly hostile stance towards the US.7. Iraq attacks Gulf oil facilities with WMD.8. Mega-terrorism attacks – on the scale of 9-11.9. Iraq murders prisoners of war or uses them as human shields.10. Israel drawn into the conflict – without WMD.11. Arab sentiment forces closure of all US bases in Middle East.12. North Korea threatens missile attacks on US bases in South Korea and Japan.
Box 2.2
6 Wild Cards that might lead to a reduction in economic and geo-political tension
1. Lack of a ‘smoking gun’ provokes a stand-off and no military action throughout 2003 – adiplomatic war of attrition over whether Iraq is in ‘material breach’ of the UN resolution.
2. Military coup in Iraq and a declaration of intent to comply with all UN Security Councilresolutions.
3. Opposition groups within northern and southern no-fly zones rise-up immediately fighting starts.4. Iraqi army surrenders in massive numbers immediately ground fighting begins – or possibly
during preceding air campaign.5. Moderate Arab states, seeing the ‘writing on the wall’, voice support for regime change in Iraq.6. Developments in US military technology since PGW-1 result in a rapid and comprehensive rout
of Iraqi forces.
The costs of conflict – a conceptual model
The total economic costs of conflict are not easy to quantify since they are so wide ranging:
• Direct combat costs – The direct military costs of fighting in 2003, entailing weapons,ammunition and transportation. It is important this calculation only measures‘additionality’ – in other words it excludes wages and other costs which would have beenincurred regardless of any conflict.
• Indirect ‘knock-on’ costs – There are a wide range of additional indirect costs whichtend to be excluded from conflict cost assessments, because they might extend over
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many years. These include long-term medical costs and additional training costs toreplace lost or injured soldiers, sailors and airmen. Of greater relevance to PGW-2 is thefuture cost of humanitarian assistance, peace keeping and nation building activity, wherethe sums of money involved could be considerable. In Bosnia, which is one eighth thesize of Iraq, with one sixth of the population, NATO deployed 50,000 peace keepingtroops at a cost of $10 billion per annum. Six years later nearly 20,000 troops remain(Should the war on terrorism target Iraq? Implementing a Bush Doctrine on Deterrence,Brookings Policy Brief 93, January 2002)
• Collateral economic effects – The collateral economic effect of war refers to the widermacroeconomic effect of changes – in 2003 and subsequently - in defence spending andkey macroeconomic variables such as the price of oil, consumer and corporate confidenceand the stock market. These induced effects would also include any monetary and fiscalpolicy response to changes in the macroeconomic environment.
The overall impact of any conflict could take years to completely work through theeconomy. For example, ammunition stocks may become depleted, but if the post-conflictenvironment was deemed to be stable, a decision might be made to rebuild stocks verygradually. Alternatively, the cost might be incurred immediately, in order to be prepared forany resumption of hostilities. The overall costs of any conflict need also to consider anyfinancial contributions from other countries, as experienced during PGW-1 – the need todistinguish between gross and net costs.
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3 How much will PGW-2 cost?
Former economic adviser to President Bush, Larry Lindsey, was quoted by the Wall StreetJournal (16 th September 2002) as stating the ‘upper bound’ cost of PGW-2 would be $100-200 billion. Lindsey also argued that a short war followed by regime change in Iraq wouldhave an upbeat impact on the world economy because it would remove uncertainty andboost oil supplies:
“When there is regime change in Iraq, you could add 3-5 million barrels of world production to worldsupply each day … the successful prosecution of the war would be good for the economy”.
Lindsey’s estimate of the cost of PGW-2 at around 1-2% of GDP is the only estimate whichhas been provided by any figure in the Bush administration2. Lindsey’s estimate3, draws onthe direct costs of PGW-1, and two recent studies on the potential costs of PGW-2:
• Estimated Costs of a Potential Conflict with Iraq – Congressional Budget Office(September 2002).
• Assessing the Cost of Military Action Against Iraq: Using Desert Shield/DesertStorm as a Basis for Estimates – An analysis by the House Budget CommitteeDemocratic Staff (September 2002)
Direct combat costs
The direct costs of Operations Desert Shield and Desert Storm (PGW-1) are known. Thedirect cost of PGW-1 was $61 billion – equivalent to $80 billion in today’s prices. The cost tothe US taxpayer of PGW-1 was a mere $4 billion in today’s prices because of cash and in-kind contributions by other countries – most notably Saudi Arabia, Kuwait and Japan. Thelack of financial contributors for PGW-2 is clearly very significant from both a political andeconomic perspective.
2 Press reports suggest that an unpublished analysis may have been provided to President Bush fromthe Council of Economic Advisers. Larry Lindsey may have been using figures drawn from such areport.3 Two days later, Office of Management and Budget (OMB) Director, Mitchell Daniels, stated thatLindsey’s estimate was “very, very high”.
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Battle plans for PGW-2 are obviously secret, but press leaks suggest that total US manpowerwill be between 125,000 and 250,000, compared with a US total of around 540,000 forPGW-1.
September 2002 - House report
The House report uses a top-down approach, assuming the costs of PGW-2 can be projectedon the basis of the costs of PGW-1. The House report employs two scenarios, New War A(involving 250,000 US military personnel) and New War B (involving 125,000 US militarypersonnel). Both scenarios assume the conflict would be over between 30-60 days from thestart of combat. In 2002 prices New War A is projected to cost between $75-93 billion dollars(0.8% to 0.9% of GDP) whilst New War B is projected to cost between $48-61 billion dollars(0.5% to 0.6% of GDP). Excluding debt interest payments, the cost of New War A isprojected at $48-60 billion and New War B at $31-39 billion (see Table 3.1).
Table 3.1 Comparing the Cost of the Persian Gulf War to Estimates of theCost of a New US-Iraq War (scenarios in constant 2002 dollars - billions)
Cost category PGW-1 New War A New War BAirlift & sealift(build-up)
10.6 6.6 5.0
Personnel & personnelsupport
21.5 11.3 – 13.4 6.7 – 7.7
Operating support & fuel 32.2 14.6 - 24.1 7.9 – 12.7Investment 10.1 10.1 7.0 – 10.1
All other 5.6 5.6 3.9
Total (exc. Interest costs) $79.9 bn $48.3 – 59.8 bn $30.6 – 39.4 bnTotal (inc. interest costs– 10 year)
$ 124.2 bn $75.1 – 93.0 bn $47.6 – 61.3 bn
(Source: Assessing the Cost of Military Action Against Iraq: Using Desert Shield/Desert Storm as a Basis forEstimates , House Budget Committee, Democratic Staff, 23rd September 2002). Range dependent on30/60 days combat. Figures exclude occupation and post-conflict assistance.
The House report projections include only the initial direct cost of military victory. Theprojections do not include the subsequent cost of peacekeeping operations or the impact of aspike in the price of oil. The House report speculates that when these other costs areconsidered a new war against Iraq could easily total $200 billion.
Clearly simple comparisons with PGW-1 are not possible, because the number of personnelwill be different, so might the duration of conflict, the capability of the Iraqi forces, the scaleof air warfare, the potential use of WMD and any future exit strategy. However, given thatthe conflict will be in the same theatre of operations and assuming the conflict is relativelyshort, estimates based on PGW-1 costings can reasonably be assumed to be in the correct‘ball-park’.
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The gross costs of New War A and B are lower than PGW-1 because force levels areprojected to be much lower.
The net costs will be higher because of the lack of cash contributions from countries such asSaudi Arabia, Kuwait and Japan.
September 2002 – Congressional Budget Office (CBO) report
The CBO report uses a different approach to the House study. It examines two options – aHeavy Ground scenario (involving 370,000 US military personnel) and a Heavy Air scenario(with 250,000 US military personnel). The CBO report uses a bottom-up approach whichprices out individual components then adds them up to generate a monthly cost. CBOestimate that initial deployment would cost $9-13 billion, with costs of $6-9 billion permonth during conflict and $1-4 billion per month of occupation. Post conflict re-deploymentis projected to cost $5-7 billion. The higher estimates are attached to the Heavy Groundoption.
It is possible to compare the two reports by plugging in the assumptions for duration in theHouse report into the CBO costs for deployment, initial and subsequent combat andoccupation. Under the assumption of 30 days combat plus 75 days of post combat presence,the CBO report suggests a short and successful war would cost around $50 billion.
It is important to note that neither report estimates the cost of a longer and more protractedwar. Nordhaus (2002) speculates that a year-long conflict could raise the direct cost to around$140 billion – around 1.5% of GDP, on the scale of the Mexican or Spanish-American warsbut not the costly Vietnam or Korean campaigns. In reality, the uncertainties involved meanthat we will just have to wait and see what a protracted campaign will cost. It is not possibleto state with precision how long or intense a protracted campaign might be. Chechnyascenarios seem out of place, but in war, the only certainty is uncertainty.
Indirect knock-on costs
Nordhaus (2002) has attempted to quantify the indirect knock-on costs associated withPGW-2. His estimates of the indirect costs associated with PGW-2 are based on comparisonswith other geo-political hot spots and conflict zones where some measure of the costs ofhumanitarian assistance, peace keeping and nation building are known. Based on variousassumptions, Nordhaus estimates the indirect costs of PGW-2 as:
• Humanitarian assistance– Humanitarian assistance in Bosnia cost around $500 perperson per year – a total of $12-14 billion over the course of the conflict and the post warperiod (International Humanitarian Assistance in the Conflict Context, October 2000,www.stakes.fi/gaspp/seminar/papapic.pdf). This is equivalent to around $10 billion perannum for Iraq. One possible source of aid could be the estimated 3 million Iraqis inexile.
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• Peacekeeping - Nordhaus estimates assume each peacekeeper costs between $200,000and $250,000 per annum. The US has stationed 30,000 troops in South Korea for half acentury. If it was to station the same number in Iraq over the next decade the cost wouldbe around $6.0 to $7.5 billion per annum in today’s prices. Depending on the number oftroops involved, the time commitment and the extent to which peacekeepers willoperate in a hostile environment, Nordhaus estimates peacekeeping operations will costa minimum $75 billion and a maximum of $500 billion over the next decade. In a post-Saddam world keeping Iraq together as one country will present a considerablechallenge given the splits within and between Sunnis (17%), Shiites (65%) and Kurds(17%) and between the Iraqi National Congress (INC) and the Iraqi National Accord(INA).
• Reconstruction and nation building – It is stated US policy to ‘promote theemergence of a democratic government’ in Iraq. But this will not be easy. Iraq has nodemocratic tradition; not under Britain, not under the king and certainly not under themilitary-Baath Party authoritarian (possibly totalitarian) regimes. Nordhaus estimatesthat this will cost from a minimum $30 billion up to a maximum $105 billion - for a‘Marshall Plan for Iraq’ - over the next decade. However, not all the cost will fall on theUS. Other countries, keen to exploit the economic opportunities arising from the endingof sanctions, are likely to contribute as well. Iraq will be able to help itself as well.Investment in the oil industry could help push Iraqi oil production back up towards 3million barrels per day (bpd), yielding $25 billion per annum at current prices. It is as yetunclear how much of this revenue would need to be diverted to meet Kuwaiti reparationclaims and the $100 billion of foreign debts.
Table 3.2 Cost Estimates (over the next decade) to the US of a Potential War inIraq (US $ billions – 2002)
Cost source Low (short and favourable) High (protracted and unfavourable)Direct cost – militaryspending
$50 $140
Indirect cost – follow-onpeacekeeping
$75 $500
Indirect cost – follow-onreconstruction
$30 $105
Indirect cost – follow-onhumanitarian aid
$1 $10
Total direct and indirect cost $156 $755
(Source: Nordhaus, p. 39, NEBR, December 2002)
Table 3.2 suggests that the minimum direct and indirect cost of a short PGW-2 is likely tobe around $150 billion – note that the indirect cost will be spread over subsequent years andnot just in 2003. However, if there was a protracted conflict with massive subsequent peace-keeping operations, the direct and indirect cost of PGW-2 might extend to more than $750billion over the next decade. This latter figure from Nordhaus seems particularly excessive,given that the US is highly unlikely to commit a long-term peacekeeping force on this scale.
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A more realistic range is probably to add the low indirect cost total to both the short andfavourable and protracted and unfavourable direct cost of PGW-2. This results in a totaldirect and indirect cost ranging from $156 billion to $246 billion over the next decade.
The most favourable economic scenario is a short conflict with minimal subsequentpeacekeeping and other indirect costs. Whilst the minimum direct cost may be feasible, theavoidance of significant follow-on indirect costs will be difficult.
Collateral economic effects
Collateral effects refer to the impact on the world economy of PGW-2. The macroeconomicimpact is highly uncertain – it could be hugely negative but it might be positive. The impactdepends on:
• The extent and duration of any oil price spike.• The impact on consumer and business confidence.• The impact on aggregate demand from higher defence spending.
The largest impact of PGW-2 may not be the direct or indirect cost (with the exception ofmassive peace keeping operations) but instead the wider impact on oil prices and the macroeconomy.
Given the significance of potential collateral effects on the US and world economy, a moredetailed analysis is undertaken in Chapter 4.
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4 Collateral economic impact
This chapter develops illustrative scenarios of the potential macroeconomic impact of PGW-2 on the US and world economy in 2003, based on:
• Current macroeconomic conditions.• Potential oil price scenarios.• Potential changes in fiscal and monetary policy.
The worries of the world
The latest forecasts from Consensus Economics (Consensus Forecasts, A digest of internationaleconomic forecasts, survey date 13th January 2003) projects US GDP growth of 2.7% in 2003,compared with just 1.4% GDP growth in the Euro zone and 0.4% GDP growth in Japan. Onthe basis of these forecasts it would not take much to record negative GDP growth inEurope and Japan this year (see Box 4.2). Moreover, the uncertainty surrounding the impactof war on the US economy, means that a larger than normal risk factor needs to be attachedto any US GDP growth forecast. Economic uncertainty is compounded by geo-political andmilitary uncertainty.
Box 4.1 The worries of the world
Stock market boom-bust in the US Savings deficiencies in the US Systemic failure in Japan Structural weakness in the EU Sector crises (air travel, dot.coms)
During previous downturns in the world economy, such as at the beginning of the 1990s,American weakness was offset by continued firm growth rates in Europe and Asia. IoDestimates (using OECD figures) show that the weighted average of GDP growth across theUS, EU and Japan in 1991 was 1.1%. In other words, despite falling GDP growth in the USin 1991, firm growth in Japan and the EU helped buoy up the world economy. Similarly,over the 1992-1993 period, just as GDP growth in the EU and Japan slowed sharply, the USeconomy took up the reins of growth.
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In contrast, in 2003, if the US economy were to falter, it is difficult to see where the impetusfor growth could come from (see Box 4.2).
Box 4.2 Global Economic Fragility
A previous IoD report highlighted the risks to the global economy at the beginning of the 21st century(The worries of the world, IoD internal briefing paper, December 2001).
Key highlights with updates:
US economy
• The US economy would escape with a short and shallow recession over the 2001-02 period, butthe risk of a long and deep recession was probably greater than at any time since the 1930s. Giventhe length of the economic upswing in the 1990s, together with the scale of the stock marketboom, a short and shallow recession would be a very considerable achievement. Over the past 50years the length of US recessions has averaged 10 months, with a peak-to-trough GDP fall ofaround 2%.
• The US personal sector financial deficit reached almost 8% of GDP in 2001. Although it hasfallen back to 4% subsequently, it remains in heavy deficit. Any rise in unemployment thereforethreatens a re-appraisal of debt levels by households and a rise in the savings ratio from its currentlow level, below 4%. The US net national saving rate (personal, business & government postdepreciation) fell to a record low in 2002Q3.
• US household equity holdings fell by $4.4 trillion over the end-1999 mid-2002 period (latestavailable figures cited in: IMF Global Financial Stability Report, December 2002). This was offsetby a $2.8 trillion increase in home equity over the same period. Overall net wealth fell by $2.3trillion – a decline of 5%. Estimates of the wealth effect coefficient on consumption range from0.02 to 0.05 i.e. from 2-5 cents of every dollar change in wealth. The net worth to income ratiostands at 5.2, compared with a 1990-95 average of 4.8.
• The scale of the current account deficit and consequent increase in overseas liabilities, risks aflight from the dollar. The current account deficit reached 5% of GDP in 2002. There may be alimit to the willingness of investors to hold ever more dollar assets. One Federal Reserve studyconcluded that large current account deficits in developed economies usually begin to reversewhen they exceed 5% of GDP. This adjustment was also accompanied by an average 40% fall inthe nominal exchange rate.
Japan
• Monetary policy is ‘pushing on a string’ with a classic liquidity trap whereby zero nominal interestrates fail to stimulate consumption and investment.
• Japan is experiencing debt deflation with rising real interest rates. Deflation is fuellingprecautionary behaviour by companies and consumers.
• A huge cumulative fiscal stimulus – of the order of $1 trillion – only stimulated average GDPgrowth of 1% per annum. Japan has been in and out of recession over the past decade.
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• The fiscal stimulus has led to an explosion in public sector debt to 150% of GDP. Deflation –with falling nominal GDP – means that Japan risks further explosion in the public debt to GDPratio. The gross public debt to GDP ratio could reach 175% of GDP over the next 3 years.
• Japan cannot resume sustained economic growth until it effectively overcomes the bad debts inthe banking system and the problem of non-performing loans. The scale of bad debts is awesome– the Japanese Government acknowledges these debts have reached 9% of GDP, but privatesector estimates suggest the real figure may be 35% of GDP. As a comparison, the US savings andloans crisis at the beginning of the 1990s amounted to less than 3% of GDP.
• Any further fiscal stimulus is hugely constrained by the level of public debt and the expectationthat Japan’s debt burden will rise even more in the future as a result of the economic costs of anageing population. Over the 1999-2002 period the general government financial deficit averaged7.5% of GDP.
Euro zone
• Structural rigidities, particularly in the labour market, have resulted in a higher rate of structuralunemployment and inflationary pressures emerging earlier in the economic cycle. Thisconclusion has been supported by recent OECD research showing rigidities cause ‘sticky’inflation in the Euro area (OECD Economic Outlook, Number 72, December 2002).
• The European Central Bank’s inflation target of 2% interacts with structural problems to lowerthe rate of potential GDP growth.
• The deficit limits imposed by the Growth & Stability Pact provide an added fiscal constraint onGDP growth – as a result of increased taxation. Early 2003 statistical releases suggest Germanymay have slipped into recession.
Global financial system
• Swift and sharp interest rate reductions by central banks have helped offset negative wealtheffects over recent years, but the spectre of deflation remains.
• Globalisation and excess supply in many traded goods markets is creating a deflationaryenvironment. Increasing globalisation of services may be spreading deflation into other sectors.The US GDP deflator is at its lowest level in half a century.
What will happen to oil prices?
Oil prices are sensitive to a number of key variables such as US oil consumption, OECDcrude oil stocks, OPEC production quotas, OPEC capacity utilisation, together with seasonalinfluences. Oil prices are also sensitive to expectations, particularly at times of Middle Eastconflict, when uncertainty encourages stock building.
In October 1990, following the invasion of Kuwait, oil prices spiked to $40 per barrel beforefalling back thereafter – despite the destruction of Kuwaiti facilities by retreating Iraqi
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forces. Forward day demand stocks are now less – but not significantly - than in 1990 (seeFigure 4.1), but the expected disruption to global oil supply is also less. Between August1990 and January 1991 oil supplies were disrupted by around 4.2 mbpd as a result of theinvasion of Kuwait.
At the present time – mid-January - oil prices stand at $31 per barrel, despite fears of PGW-2coinciding with a supply disruption from Venezuela. At present the oil supply and demandbalance does not justify a spike in oil prices. Total OECD oil stocks were 3.8 billion barrelsat the end of September 2002 – around 78 days of forward demand. This compares with 86days of forward demand prior to the invasion of Kuwait in 1990. OPEC spare capacity issimilar to the levels seen in 1973 and 1979, but higher than in 1991.
In real terms (2002 US$) the current oil price is slightly above the 1950-2002 average of$27.50 per barrel. In order to have the same real impact as the oil price spike in 1980, thecost per barrel would need to rise to more than $80 now. To have the same real impact as the1990 oil price spike it would need to rise to around $50 per barrel.
It is quite possible that a short war with successful regime change could see oil prices fall inboth the short-term (with the removal of any war premium) and the long-term (from anincrease in Iraqi oil supply). A recent Royal Institute for International Affairs (RIIA) paper(The future of oil in Iraq: scenarios and implications, V. Marcel, RIIA briefing paper, December2002) suggests that regime change in Iraq, with a resumption of foreign investment and thelifting of sanctions, could see Iraq doubling its share – from 2% to 4% - of world oil supplieswithin three years. The RIIA report suggests that with major investment Iraq could increaseits share to 6-7% of world supply over a 5-10 year period.
Figure 4.1 OECD Oil Stocks (IEA figures)
0
20
40
60
80
100
1990 end 2002
Forward demand -number of days
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Table 4.1 below shows various IoD oil price scenarios under a range of geo-political andeconomic assumptions. More worrying projections of potential oil price movements havealso been made by other commentators.4
Table 4.1 shows that under the first three scenarios (stand-off and capitulation scenarios) anynegative oil price effect is not expected to be significant. Indeed, under the short warcapitulation scenario oil prices are expected to fall back in 2003.
This is very important because we have given capitulation scenarios the highest andescalation scenarios the lowest probability.
Table 4.1 Oil Price Scenarios – PGW-2
Oil price scenario Explanation Oil price movement
Stand-off – wardelayed until October2003
• US-UK don’t act – due tointernational pressure – untilinspectors have ‘smoking gun’.
• Possible use of volunteer humanshields by Iraq.
• Oil price holds at current levelsbecause of the risk of future conflict.
Oil price remains around$30 throughout 2003
Capitulation – no war • Saddam offers full disclosure anddisarmament.
• Fallback stops at $25 because ofcontinued uncertainty owing to noregime change.
Oil price falls back to $25by the end of 2003.
Capitulation – shortwar
• Rapid victory followed by regimechange and Iraqi commitment to meetall UN Security Council resolutions.
• Loss of Iraqi production for threemonths.
• No draw-down on US strategic reserveneeded.
Oil price falls back to lessthan $20 by the end of2003.
Continued Overleaf:
4 One recent study (The war on terrorism, the world oil market and the US economy, GL Perry, BrookingsInstitution Analysis Paper, www.brook.edu/views/papers/perry/200111024.htm) investigated theimpact of a growth in Islamic fundamentalism amongst OPEC members, and any resulting supplycutbacks. Perry’s scenarios include: a bad case (oil rises $7 per barrel, as a result of a net supplyreduction of 2.5 mbpd), a worse case (oil rises to $75 per barrel as a result of a net supply reduction of4.5 mbpd) and a worst case (oil rises to $161 per barrel as a result of a net supply reduction of 7.5mbpd) disruption of world oil supplies. Perry makes an assumption that a 1% cut in oil supply couldlead to a 20% rise in price. This is a doubtful assumption. We would question not only the priceelasticity of supply, but also the degree of supply cut backs implied by Perry. If prices were toaccelerate, non-OPEC supply could be brought on stream. It must be remembered that Arab OPECcountries account for only 40% of world oil supply. Spare capacity, albeit limited, from othercountries, stock draw-downs, together with fuel switching and demand restraint measures, suggestany price spike would be less than suggested by the worse and worst case Perry scenarios.
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Escalation scenario 1 • US controls virtually all of Iraq exceptfor Baghdad which holds out.
• US plays a waiting game in order toavoid heavy urban fighting.
• Loss of Iraqi production for 3-6months.
• Limited draw- down on US strategicreserve.
Oil price rises to $45 (inreal terms similar to thespike in 1990) beforefalling back to $35 by theend of 2003.
Escalation scenario 2 • Iraqi forces concentarte in urban areasand trigger heavy fighting.
• Much larger US ground forces arerequired with heavy airlifts.
• OPEC uses oil price as a politicalweapon.
• Fears of oil shortages triggerstockbuilding.
• Lower GDP growth dampens demandfor oil.
• Greater draw-down from US strategicreserve.
Oil price rises to $60before falling back to $40by the end of 2003
Escalation scenario 3 • OPEC intensifies the use of oil priceas a political weapon and cutsproduction sharply.
• US loses use of Middle East bases tolaunch operations – therebyprolonging conflict.
• Panic buying on world oil markets.• Iraq production off the market 12
months plus.• US/OECD strategic reserves heavy
draw-down.
Oil price rises to $80 (inreal terms similar to thespike in 1980) beforefalling back to $50 by theend of 2003.
Any of the above regime change scenarios risk destruction of Iraqi oil capacity by Saddam, as adefiant final gesture.
What will be the economic impact of oil prices?
In recent years some economists have argued that whenever there is a spike in the price ofoil, there follows a recession in the world economy – based on the evidence of oil pricespikes in 1973, 1979 and 1990. There are four mechanisms which could account for this:
• Higher oil prices increase inflation and result in a tightening in monetary policy – higherinterest rates – which pushes the economy into recession.
• Higher oil prices result in a transfer of income to oil exporting countries, reducingdomestic demand in oil importing countries.
• As the cost of energy rises, firms are forced to reduce costs in order to maintain profitmargins, resulting in employment losses.
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• For oil exporting countries such as the UK, higher oil prices produce a petrocurrencyeffect, driving up the exchange rate and reducing output and employment in the exportsector.
However, the fact that recessions followed the oil price spikes of 1973, 1979 and 1990 doesnot necessarily imply causality. The recession of the early 1990s was more a product of theprevious boom turning to bust. However, oil may have acted as ‘the straw that broke thecamel’s back’. Similarly, today, the negative wealth effects from a falling stock market riskbeing compounded by rising oil prices. Oil could yet push the US economy past the ‘tippingpoint’.
The IMF estimates that a $5 per barrel rise in the price of oil reduces US and world GDP by0.3% over the next year5. A January 2003 summary of economic models in Business Weekmagazine (Business Outlook, Business Week, 20th January 2003) concluded that a useful ‘rule-of-thumb’ was that every $10 per barrel increase in the price of oil, if sustained for a year,would knock 0.5% off the subsequent US GDP growth rate and increase inflation by 1%.
Table 4.2 Cost Estimates (over the next decade) to the US of a Potential War inIraq (US $ billions – 2002)
Cost source Low (short andfavourable)
High (protracted and unfavourable)
Direct cost – militaryspending
$50 $140
Indirect cost –follow-onpeacekeeping
$75 $500
Indirect cost –follow-onreconstruction
$30 $105
Indirect cost –follow-onhumanitarian aid
$1 $10
Collateral effect –impact on oil market
-$40 $778 *
Collateral effect –macroeconomicimpact
-$17 $391 #
Total $99 $1,924(Source: Nordhaus, p. 39, NEBR, December 2002) * $175 billion in year 1. # Covers years 1 and 2of cyclical impact.
5 OECD estimates of the impact of higher oil prices in the December 2000 Economic Outlook, showsimilar results.
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Nordhaus (2002) assumes that a protracted war would result in a recession equivalent to thatfollowing PGW-1. Table 4.2 shows Nordhaus (2002) estimates of the total costs (direct,indirect and collateral) of PGW-2 over the 2002-2012 period. According to Nordhaus (2002),the minimum cost under a short and favourable conflict is estimated to be $99 billion, with amaximum $1.9 trillion if the conflict becomes protracted and unfavourable.
Nordhaus (2002) uses a simple regression relating real GDP to real oil prices, lagged GDPand a trend variable. This suggests that a sustained rise in the oil price to $75 per barrelwould induce a 3.5% decline in GDP relative to trend growth6 – similar to the loss ofpotential output in PGW-1.
The total in the minimum cost scenario in Table 4.2, is less than the direct and indirect costshown in Table 3.2, because of the positive collateral effects of a short and successful war –lower oil prices and improved economic confidence.
The high and low scenarios in Table 4.2 are very useful, but do not fully reflect the potentialinteraction of oil prices with changes in monetary and fiscal policy.
Fiscal and monetary policy
Wars do not occur in economic isolation. The negative growth effects of a rise in the oil priceneed to be set against the fiscal expansion used to finance the war. Under the first threescenarios any negative oil price effects are likely to be offset by the rise in defenceexpenditure7. However, there could still be a negative impact on GDP growth from thedamage to economic psychology. Monetary and fiscal policy can play an important role inoffsetting any such effect.
When considering the collateral economic impact of PGW-2, one needs to incorporate theeffects of additional changes in monetary (interest rates) and fiscal policy (governmentexpenditure and taxation).
Seizing Baghdad and Capitol Hill
Under the stand-off and capitulation scenarios the Federal Reserve will have room tomanoeuvre and be able to cut interest rates if economic confidence weakens. Moreover,under the short war capitulation scenario, President Bush is likely to find it much easier toobtain approval and implementation for his tax cutting fiscal stimulus package (see below).A short and successful war could guarantee speedy and full implementation of the fiscalpackage.
Under the first escalation scenario the oil price spike becomes more significant and theimpact on general inflation stronger. However, the Federal Reserve is likely to view the
6 Relative to trend does not mean the actual GDP decline would be of this magnitude.7 Although there will be some expenditure ‘leakage’ out of the US economy where defence spendinginvolves payments overseas for transport, weapons and fuel. There might also be additionalinternational aid to countries helping the US.
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inflationary threat as secondary. The primary concern would be the impact on economicconfidence. Consequently, under the first escalation scenario (see Table 4.3), we would stillexpect the Federal Reserve to respond by reducing interest rates.
The fiscal policy environment would become less clear under the first escalation scenariobecause the proposed fiscal stimulus package might then be ambushed on Capitol Hill - byDemocrats sensing an opportunity to weaken the President.
Escalation scenarios 2 and 3 provide the most concern, but hopefully the least probability. Ifoil prices were to rise to $60-80 per barrel the economic fall-out would be very damaging.
Stagflation or deflation?
Previous wars in the Middle East, associated with spikes in oil prices, have also beenassociated with a tightening in monetary policy – higher interest rates – in response. Couldthe US and world economy face a return to stagflation – with higher inflation, interest ratesand unemployment? There might also be alarming stock market consequences with theS&P500 falling by up to 30% (see Box 4.3).
Thankfully, there is good reason to believe the Federal Reserve wouldn’t respond withtighter monetary policy, under escalation scenarios 2 and 3. We believe the Federal Reservewould look beyond temporary problems of stagflation, towards the threat of deflation, if theUS economy was pushed into recession. The Federal Reserve would surely recognise thatconsumer spending power was being undermined by the proportion of income absorbed byhigher oil prices – a sustained $10 per barrel rise would reduce consumer spending power byroughly $50 billion.
We do not believe that the Federal Reserve would seek to raise interest rates to dampendemand when consumption is already weakening due to higher energy costs for companiesand households. In such circumstances the Federal Reserve would be more likely to focuson domestic non-oil price pressures and only move towards a tightening in monetary policyif the inflationary ‘pass-through’ on wages and other prices became a concern:
• From pass through to profits squeeze – Pass through pressures from higher oil pricescould be reduced by companies absorbing costs i.e. rising input prices would not lead toan equivalent increase in output prices, resulting in a profits squeeze.
• Spiked or sustained price rises – Econometric models focus on the sustained one-yearimpact of oil price rises. Spikes in prices of a shorter duration are less inflationary.
Given the weakness of the US economy at present, with continued low savings rates, highdebt levels and uncertainty as to the stock market consequences of a ‘deep double-dip’, wefind it difficult to believe that the Federal Reserve would tighten monetary policy in theknowledge that a deep recession would almost certainly ensue. The fear of debt-deflationwould overpower concerns of inflation – although in such an environment the effectivenessof monetary policy would be limited – because:
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• US interest rates have been cut to 1.25% already with the risk of further reductions innominal rates being less effective – monetary policy would be ‘pushing on a string’.
• The US GDP deflator is very low. Any weakening in demand might trigger deflation innon-oil prices. Deflationary pressures would result in rising real interest rates.
Although the Federal Reserve would aim to pump liquidity into financial markets and keepthe Fed Funds rate around current levels (or lower), this is unlikely to prevent some upwardmovement in long bond yields. This steepening in the yield curve would not represent aworsening in long-term inflationary expectations, but more likely, fears as to the possibilityof a ballooning budget deficit. The higher oil prices rise, the steeper the yield curve maybecome – further undermining economic confidence and investment.
Table 4.3 The US Economy in 2003 – Illustrative Scenarios
Scenario GDP %change
Probability Explanation
Stand-off –no war
2.2% LOW toMEDIUM
• Oil price higher than under capitulation scenarios.• Direct defence spending less than under war
scenario.• Fiscal stimulus delayed on Capitol Hill by
Democrats.Capitulation– no war
2.5%MEDIUM
• Oil price higher than capitulation short war scenariodue to uncertainty of no regime change
Capitulation– short war
2.9%HIGH
• Oil price falls back quickly to $20 due to removal ofwar premium and potential long-term supply boostfrom Iraqi production
• Fiscal stimulus swiftly driven through in full onCapitol Hill.
• Stock market rises 5% in 2003.EscalationScenario 1
1.0% LOW toMEDIUM
• Oil price spike to $45.• Fiscal stimulus delayed by Democrats – sensing
‘damaged’ President.• Stock market falls 10% in 2003.
Escalationscenario 2
- 0.5%VERYLOW
• Oil price spike to $60.• Yield curve steeper.• Stock market falls 20% in 2003.
EscalationScenario 3
- 2.0%VERYLOW
• Oil price spike to $80.• Steep yield curve.• Stock market falls 30% in 2003.• Negative housing wealth effects.
Table 4.3 shows the range of US GDP growth forecasts depending on alternative militaryand geo-political developments. The key messages from Table 4.3 are:
• The highest GDP growth scenario has the highest probability.
• The lowest GDP growth scenario has the lowest probability.
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Fiscal stimulus 2003
The recent US fiscal stimulus package – announced in January 2003 - is significant becauseit aims to help underpin the economy by:
• Maintaining consumption levels and dampening any tendency for the savings ratio toincrease.
• Maintaining stock market values in order to prevent further erosion in household wealth.
There is a political paradox at the heart of the proposed fiscal stimulus. The longer any warcontinues - and the greater the need for a fiscal stimulus to offset weaker economicconfidence – the more likely the possibility of political in-fighting leading to a delay. Incontrast, a sweeping military success – with less damage to economic confidence – wouldenable Republicans to use their majority and the President’s popularity, to easily push thestimulus package through Congress.
The US economy recorded its longest economic upswing and the largest equity marketboom in history during the 1990s. To only record a very short and shallow subsequentrecession is almost a miracle in such circumstances. However, with the savings ratio still athistoric lows, and potential negative wealth effects from trillions of dollars in fallen equityprices, measures to underpin consumption and the stock market are sensible policy – seeBox 4.2.
The new fiscal package combines a long-term structural reform with a short-term fiscalstimulus – it is a bolder vision than just fine tuning. However, it also needs to beacknowledged that any rise in the budget deficit may drive-up interest rates and therebyoffset (some of) the effect of the fiscal stimulus – although this is a controversial issue. TheBush administration argues – with good reason – that the tax stimulus will not cost as muchas the headline figure, because of the impact on economic incentives. For example, theending of dividend taxation will lower the cost of capital and this could encourageinvestment, which in turn will boost economic growth and tax revenues. A recent Treasurystudy suggests that the ‘static’ revenue loss is halved when a ‘dynamic’ assessment is made.
The $670 billion tax cutting package over 10 years involves a $98 billion fiscal stimulus (1%of GDP) in 2003. The scrapping of taxation on dividends is estimated to cost $300 billionover the next 10 years. However, the actual cost may be less if it encourages greater stockmarket activity and capital appreciation – thereby boosting future revenues from capitalgains taxes. The changes should encourage a switching of funds towards equities and out ofthe municipal bond market (value $1.8 trillion) whose main attraction was its tax-exemptstatus. Estimates suggest (Fiscal heavy lifting, M. Zandi, The dismal scientist,www.economy.com, 8th January 2003,) the elimination of dividend taxation may add up to5% to stock market values – some of which may have already been discounted in stockmarket prices. This suggests that the elimination of dividend taxes may be more significantvia indirect wealth effects than the direct income effect. However, it may also play animportant role in containing any upward movement in the savings ratio.
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Research by the Federal Reserve suggests that the fall in the savings ratio in recent yearswas concentrated in high-income households. This suggests that the elimination of dividendtaxation, could be particularly important in boosting economic confidence in this group.
The Bank of England has stated (p. 21, Financial Stability Review, Bank of England, June2001) that,
“Much of the fall in the aggregate saving ratio [in the US] over the past few years can be accounted for by reducedsaving by higher-income households, who have benefited most from past increases in equity prices. Hence there is arisk that the aggregate saving rate might be pushed up by a reaction of these households to equity marketdevelopments [falls]”.
Table 4.4 The Decline in the US Saving Rate by Income Quintile
Income category $000 Saving rate % (1992) Saving rate % (2000) Difference
81-100 8.5 -2.1 -10.6
61-80 4.7 2.6 -2.1
41-60 2.7 2.9 0.2
21-40 4.2 7.4 3.2
10-20 3.8 7.1 3.3
Total 5.9 1.3 -4.6
(Source: Disentangling the wealth effect: a cohort analysis of household saving in the 1990s, DM Maki &MG Palumbo, Federal Reserve Board, April 2001)
Much of the wealth losses of recent years have been borne by wealthier households whoaccount for a relatively small share of total consumption. This also helps explain why thesavings ratio hasn’t risen sharply in response to negative wealth effects.
Table 4.5 The Potential Impact of Monetary & Fiscal Policy Changes in 2003
Positive NegativeTax cuts announced in fiscal stimulus Budget deficit fears push up long term interest
rates – steeper yield curveIncrease in defence spending for PGW-2 Higher taxes at state levelFurther easing in Fed Funds rate Fed Fund rate rise – due to oil impact on CPI?
The direct fiscal stimulus in 2003 will be muted by the fact that any money will only get intopeople’s pockets in the second half of the year. White House figures suggest 92 millioncitizens will get a tax cut of $1,083 in 2003. This is important because there are likely toremain significant downward pressures on consumer confidence. Moreover, economic theorysuggests consumers will change their spending behaviour in response to changes in theirperception of permanent income. It also has to be acknowledged that consumers may use
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any tax gains to pay down debt rather than increase expenditure. Of course, with the savingsratio so low, it could be argued that American consumers just spend the money they have,regardless of perceptions of permanent income. With regard to the elimination of taxes ondividends, the fact that half of Americans own stock, must also be balanced by theconsideration that most small investors have their money in individual retirement accounts,which are already tax exempt.
Our assessment is that the fiscal stimulus package, if enacted, could boost GDP growth byaround 0.5% points in 2003 and 2004. This stimulus is less than the 1% of GDP total in thepackage because:
• Timing – some of the planned stimulus may not be implemented in 2003, even ifauthorised.
• The stimulus from reductions in Federal taxes may be offset by the contractionaryinfluence of higher taxes at the state level - where balanced budgets tend to bemandatory.
Box 4.3 The Risk to Wall Street
At first glance, if recent conflicts are a reliable guide, PGW-2 should not hold too many fears for WallStreet. Between the start and finish of the Korean War the Dow Jones index rose 28%. Between thestart and finish of the Vietnam War the Dow Jones index fell 2.3%. Between the start and finish ofPGW-1 the Dow Jones index rose by 1%. However, the crucial factor is the value of the stock marketat the outset of conflict – very high, high, fair, low or very low.
Over the past century the price-earnings ratio on the S&P 500 has averaged 15, whilst the dividendyield has averaged 4.5%. At the present time (January 2003) the price earnings ratio stands at 40 andthe dividend yield is at 1.5% (2% with share buy-backs). These ratios are not very good at predictingshort-term market movements, over the next year, but they are much more reliable over a long-termhorizon, over the next decade.
The p-e ratio exaggerates the overvaluation because profits will recover from their current weakness.Adjustments for this distortion, together with other valuation models, suggest Wall Street may now be‘fair’ value. However, it must also be recognised that stock markets tend to overshoot both up anddown. In previous bear markets in 1974 and 1982 the p-e ratio dipped into single figures.
Despite the equity market falls of recent years, it is not only the price-earnings ratio which providesconcern. Other valuation measures such as the ratio of stock market capitalisation to GDP, Tobin’s Qand the equity risk premium all flash red, albeit less intensely than 2 years ago. The US stock marketcapitalisation to GDP ratio is above 100% having reached 155% at peak. Before the 1990s the ratiohad remained well below 50%. Tobin’s Q stands around 1.5 compared to a 1926-97 average of 0.7 –implying the US market could yet fall by a third.
War could raise the equity risk premium because it makes the world a riskier place or because itreduces investor appetite for risk. In the 1990s part of the reduction in the risk premium – andresulting justification for higher stock market values -over that period was the impact of the end of the‘Cold War’ and the resulting peace dividend.
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At the beginning of the 21st century the geo-political environment suggests we should be talkingabout a war premium in investment markets, instead of a peace dividend:
• The post 9-11 awareness of the risk of mega-terrorism attacks.• The risk of the proliferation of weapons of mass destruction to rogue states and terrorist groups
(see National Strategy to Combat Weapons of Mass Destruction, December 2002, available viawww.whitehouse.gov).
• A new US National Security Strategy (NSS) of pre-emptory response where force may be usedwithout evidence of an imminent attack to ensure that a threat does not gather or grow over time(The National Security Strategy of the United States of America, September 2002, available viawww.whitehouse.gov).
The new NSS states:
“The gravest danger our Nation faces lies at the crossroads of radicalism and technology. Our enemies haveopenly declared that they are seeking weapons of mass destruction, and evidence indicates that they are doing sowith determination. The United States will not allow these efforts to succeed … History will judge harshly thosewho saw this coming danger but failed to act. In this new world we have entered, the only path to peace andsecurity is the path of action”.
Over the long-term profits should grow in line with GDP growth. Assuming trend 3% GDP growthand a dividend yield of 2%, the total real return on equities will be around 5%. If one reduces thisreturn by 1% for investment management fees, the real return falls to 4%. This compares with a realinterest rate on risk free bonds of around 3%. The implied equity risk premium is just 1%.
A recent study (Triumph of the Optimists: 101 Years of Global Investment Returns, E. Dimson, P. Marshand M. Staunton, Princeton University Press, 2002) shows the US equity risk premium over bonds at5% over the 1900-2000 period - implying the market is still seriously overvalued and potentiallyvulnerable to war and acts of mega-terrorism.
Doom and gloom
As shown above (see Box 4.2), GDP growth projections for Japan and the Euro-zone in 2003are already very weak. Consensus Forecasts (Consensus Economics Inc., January 2003) showexpected GDP growth of 0.4% in Japan and 1.4% in the Eurozone. These poor growth ratescome in the wake of a 0.3% GDP fall in Japan in 2002 and growth of just 0.8% in the Eurozone in 2002. This is not a strong platform from which to withstand any negative fall-outfrom PGW-2.
In the case of Japan there is no room for fiscal policy manoeuvre because of the scale ofrecent deficits and outstanding public debt. There is also little chance of any monetarystimulus given that interest rates are already set at zero.
In the Euro-zone fiscal and monetary policy are also constrained. Fiscal policy by theconstraints imposed by the Growth & Stability Pact; monetary policy by the ECB’s 2%inflation target which could force a tightening in monetary policy in order to offset theinflationary effects of any spike in the oil price.
This possibility would be accentuated by any ‘flight to quality’ towards the dollar in theevent of conflict – because oil is denominated in dollars. As a result the extra burden of
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higher oil prices would be compounded by the exchange rate effect. Admittedly, a weakeryen or euro could provide some stimulus to exports, but in the short-term this effect mightbe countered by the weakness of export markets. Any trade gains might take some time tocome through, whilst inelastic demand for oil would drain spending power away fromdomestic consumption.
Consequently, in both Japan and the Euro-zone, any of the escalation scenarios could pushthe economies into recession. As a result, PGW-2 could have a more damaging impact ongrowth prospects, than in the US.
It must also be considered that an alternative scenario is for the US dollar to weaken, withthe possibility of capital flight towards the euro. Capital flight towards the yen seemsunlikely. For the Euro-zone this could help offset some of the rising cost of oil, but it wouldnot be particularly good news, because a weak dollar may constrain the Federal Reserve’sfreedom of action to reduce interest rates. It is all very uncertain.
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5 US defence expenditure trends
After a defence build-up in the 1980s there was a defence draw-down in the 1990s8. Duringthe late 1990s US defence spending had returned to the levels seen during the isolationistand depression era of the 1930s. During World War 2 US defence expenditure peaked above40% of GDP.
Table 5.1 US Economic Stimulus from Defence Spending
War Period Rise in US defencespending % of GDP
Real % GDP growthover build-up period
World War 2 1939-1945 41.4% 69%Korean War 1950:3-1951:3 8% 10.5%Vietnam War 1965:3-1967:1 2% 9.7%Persian Gulf War 1990:3-1991:1 0.3% -1.3%
(Source: National Income and Product Accounts, www.bea.gov)
The Congressional Budget Office (CBO, January 2003 – all figures are in 2002 US$) hasrecently published forward year defence estimates showing that US defence expenditurewill rise from $345 billion in 2002 to $359 billion in 2003 (around 3.5% of GDP), reaching$408 billion by 2007. These estimates do not incorporate the direct cost of PGW-2 – seeChapter 3. CBO estimate that under the 2003 forward year projections defence spendingwill remain around 3% of GDP up until 2007. The 18% real increase in defence expenditurebetween 2002 and 2007 is significant, but well below the speed of the Reagan defencebuild-up in the 1980s.
8 Empirical studies on the impact of defence expenditure on GDP growth have produced ambiguousresults. Part of the explanation is that defence expenditure may provide a short-term positive effectbut the long-term impact may be negative. However, one recent OECD review of the literaturestated that any detrimental effect is likely to be small (p30, The Economic Consequences of Terrorism,OECD Working Paper 334, July 2002).
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Figure 1 US Defence Expenditure - % of GDP
(Source; AH Cordesman, CSIS, Center for Strategic and International Studies, 2020 estimate byCongressional Budget Office)
US Defence Secretary, Donald Rumsfeld, has recently stated (in evidence to aCongressional hearing, May 2002) that the Pentagon faced a ‘bow-wave’ of spending incoming years as new weapons systems are introduced.
CBO estimate that defence spending will average $464 billion over the 2008-14 period and$480 billion over the 2015-20 period9. Whilst these are significant real terms increases inspending, the CBO estimates that defence spending will still fall as a proportion of GDP toaround 2% by 202010. This compares with an average of 6% of GDP in the 1980s and 4% ofGDP in the 1990s. However, it is also true that the nature of war and military doctrine ischanging in the wake of 9-11 and technological advances. The October 2002 QuadrennialDefence Review overturned the previous Pentagon strategy of having the capability offighting two overlapping wars on the scale of PGW-1. This was replaced with six newobjectives: protecting the homeland and forces overseas, projecting and sustaining power indistant theatres, denying enemies sanctuary, protecting the American information networkfrom attack, using information technology to link US forces and protecting American spacecapabilities. There is also a new National Security doctrine based on the principle of pre-emptory response.
9 The CBO estimates for the 2008-2020 period assume ‘overspend’ in Pentagon weaponsprocurement. Over this period 1000s of new aircraft such as the F/A-22 Raptor tactical fighter and theJoint Strike Fighter will be brought into service, together with the proposed Comanche helicopter andtilt motor V22 Osprey.10 CBO projections assume a long-term GDP growth rate of 3% per annum.
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Carter 1980 Reagan1986
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Defence spending % of GDP
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It is as yet uncertain where all this will lead. For example, in the form of unmanned dronesequipped with weapons, which were used in the recent fighting in Afghanistan. It is unclearas yet as to what this will mean for defence spending in the long-term. For example, in thearmy, it is possible that greater use of light mobile forces could cost less money than thehistoric cold-war legacy of emphasis towards heavy armoured divisions. Alternatively, thenew battlefield might require a host of new weapons and transport systems not yetenvisaged. In the air force, stealth technology and precision guided munitions might resultin a requirement for fewer planes. Alternatively, technological advances might rendercurrent stealth technology redundant and force the development of a new generation toreplace the already hugely expensive stealth fleet – where an individual plane costs morethan $1 billion.
The combination of the war on terrorism and the replacement costs of new kit will add toUS defence spending over the coming years, but not massively. The CBO projects that inmeeting these requirements defence spending will still fall to 2% of GDP by 2020.