Outlook: As war against Iraq looms, oil still has the power to shock

Bank Larges it up; Zurich Financial

This column claims no particular intelligence on whether the US is going to invade Iraq, but you don't need to be much of a political or military analyst to realise that barring some inexplicable change of mind by President George Bush, it's highly likely to happen. It's Dubya's destiny, and he's determined to fulfil it. Neither Congress, a divided Administration, or the condemnation of the Arab world is going to stop him. Production in the US defence industry of smart bombs, aircraft, spares, guns and all the other paraphernalia of war is already in overdrive. Only media and public opinion, and perhaps the stock market too, hasn't yet fully caught up with the near certainty of conflict. That's presumably how Mr Bush wants it, so as better to keep his enemy guessing.

So on the assumption that war on Iraq is inevitable, what's the likely impact on the capital markets and the wider international economy? Assuming it's the short, sharp and successful campaign that military strategists hope for, resulting ultimately in the installation of a broadly pro-Western government in Baghdad, the longer-term consequences can only be neutral to beneficial. There could, however, be quite a bit of pain in the meantime, and if Saddam proves a tougher nut to crack than anticipated, then the wider economic consequences begin to look pretty grim. This is not so much because of the costs and geo-political fallout of a long drawn out war as its potential for causing a further oil shock.

All of the last three global recessions – 1973-75, 1979-81 and 1990-91 – have to varying degrees been induced by rising oil prices. The parallel with the last of these recessions is hard to ignore. The Kuwaiti war, although swift and successful from a Western point of view, produced an oil price spike that tipped an already fragile world economy into recession. The oil price didn't stay high for very long, but by the time everyone realised there would be no long-term disruption to supply, the damage had already been done.

This time around, the consequences could be very similar, only worse. War on Iraq finds the world economy in the same fragile condition. Even without an oil shock, the risk of a double dip recession in the US remain high. That risk would be turned to near certainty if the price of oil were to surge towards the $40 a barrel mark.

Now, of course, it is the case that Western economies are much more resilient to rising oil prices than they used to be. Previous oil shocks have had the effect both of galvanising industry into using oil more efficiently and of closing down old energy intensive, smoke stack industries by making them uneconomic. But Western reliance on oil none the less remains strong, and there are few things as toxic for Western economic health than a rapidly rising oil price. The effect is both inflationary and deflationary at the same time. The inflationary effect is felt most immediately in rising fuel costs. If more money is being spent on oil, then there is less money to be spent on other things, so the other consequence is a reduction in demand across the economy as a whole. Past oil shocks have thus been characterised by rising inflation and falling GDP at the same time.

A worrying scenario, then, made all the more so by the fact that Saudi Arabia cannot on the face of it mitigate the effects of a disruption in oil supplies from Iraq by increasing its own production. To do so would make it look as if Saudi was supporting the Americans, which its leaders cannot afford because of the risks of a popular backlash. It didn't take long for the summer rally in the stock market to come to an end, and it is easy to see why.

Bank Larges it up

The Old Lady of Threadneadle Street is not known for obvious displays of anger but by the end her irritation at the absence of a replacement for David Clementi, until last week one of two deputy governors of the Bank of England, was almost visible. Yesterday's appointment of Sir Andrew Large must have more than made up for the Chancellor's tardiness in coming to a decision. An almost audible sigh of relief greeted the appointment of a man who will fit in as neatly at the Bank as hand in glove.

It is still a bit hard to understand why the Bank of England needs to have two deputy governors, or indeed what the second governor really does. These days the Bank of England's only obvious functions are to set interest rates and administer the money supply, responsibility for prudential supervision of the banks having been taken away and vested with the Financial Services Authority.

Of the two deputy governors, Mervyn King is very definitely the first among equals. He's responsible for the Inflation Report and his influence on policy is formidable. The Bank's other publication, the Stability Review, still manages to grab headlines, but only because it indulges in the sort of "what if" speculation that financial journalists love on the housing market, the consumer boom and anything else with the potential to blow up everyone's face.

In theory, Sir Andrew will have responsibility for systemic stability, but given that Sir Howard Davies, chairman of the Financial Services Authority, reckons that's his job too along with everything else, it is not clear that there is any point in Sir Andrew at all. Still, the appointment of a second deputy is written into the legislation, so it had to be made, and it is certainly hard to think of someone better qualified for the post than Sir Andrew, a former investment banker and City regulator. As such he's been both poacher and gamekeeper and must understand the financial system as well as almost anyone.

Within a year, Sir Andrew will find himself working with a new Governor. Sir Edward George, the present incumbent, is due to retire in June. The scramble for his job has developed into a three horse race, with Mervyn King, Sir Howard Davies and Andrew Crockett, outgoing general manager of the Bank for International Settlements, running neck and neck. There's plenty of time for all three to stumble yet, though presumably the Chancellor won't leave his appointment quite as late as he did Sir Andrew's.

Zurich Financial

Zurich Financial has got lots of problems specific to itself. It's also just fired the man responsible, Rolf Hüppi, and brought in Jim Schiro, a former chief executive of PwC and as tough a cookie as they come, to fill his shoes. The upshot is that Zurich's plans to raise £1.6bn of new capital via a rights issue, expected to be announced tomorrow with figures confirming that the company has plunged deep into the red, will be grudgingly received by markets as unavoidable.

Whether other insurers desperately trying to recapitalise themselves find the markets quite so receptive remains to be seen. Royal & SunAlliance would like to launch a rights issue too, but there is no chance until a credible replacement is found for the incumbent chief executive, Robert Mendelsohn. Axa yesterday said it had no plans to raise more capital, but its statement is seen more as a half-hearted display of machismo than a reflection of underlying capital strengths. Aviva, the former CGNU, has already announced a dividend cut to conserve capital while HBOS managed to whip in with a £1bn share placing before the sector's financial position was fully understood. There's still every possibility someone big will go bust before the bear market finally comes to an end.

jeremy.warner@independent.co.uk