Hamish McRae: Don't expect war to spare us from the ravages of recession

'The one thing we can be sure of is that living standards will be depressed by what has happened'
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The Independent Online

War is good for the world economy, right? No, wrong – very wrong.

There is a general perception that public spending associated with conflict stimulates economies and that the world is now entering a new Keynesian period, with government spending – rather than low interest rates – being the engine that will pull the world economy out of recession.

There is already a lot of this in the press and there is going to be a lot more. Quite aside from military spending, there are practical ways in which the public sector has been pushed into its stopgap role of keeping things running when the private sector is unable to do so. Thus, here in Britain people are looking to the state to rebuild the railway network, while in the United States and Europe, government money is going into propping up bankrupt or near-bankrupt airlines. This experience is a useful reminder that national governments – not multinational corporations or supranational bodies like the European Union – remain the main seat of power in the world. They get things done.

When push comes to shove, we can see that a developed country national government's power to tax can call on resources that no commercial organisation can command. But that is different from expecting public spending to pull the world out of recession.

That there will be a general world recession this autumn and winter is not now in doubt. The world's two largest economies, the US and Japan, are almost certainly already in recession. The third largest, Germany, may well be. Other countries, like Britain and France, are still growing, but that will not be enough to pull the rest of the world along. The latest forecasts show Britain as the fastest-growing large economy through next year ... but before you cheer too loudly, note that this is mainly because the others are expected to slow even more than we are.

The fact that the big three are going down together raises the probability of a synchronised global recession: it is very hard to see where private-sector demand will come from. Hence people look to governments and past experience of wartime expenditure.

In the past, large-scale military spending has undoubtedly helped boost demand, and in the most extreme example, at the end of the 1930s, did pull the world out of the great depression. But there are at least five reasons why it won't help now.

First, this is a war where the outlays on hardware will be quite limited, notwithstanding the military attacks taking place at the moment. This will be a conflict that will be won more by intelligence – software, you could say, rather than hardware.

Second, the world economy is now dominated by services, not manufacturing. In the past, underused manufacturing capacity was switched from building, say, cars into building tanks. Now we do not need the extra tanks.Not only that, but we spend a relatively small proportion of our income on buying items and a high proportion on buying services. Thus it has been tourism and travel that have been most severely hit: you cannot switch underused tourist capacity into military use.

Third, the world economy is just that: an immensely complex series of global links. Even 20 years ago, that was not true to the extent it is today. So while individual countries can spend more money on public sector projects, the overall performance of their economy will depend on the world economic performance. True, some countries (like the UK) may come through in somewhat better shape than others, while some (like Japan) may come through in worse. But the idea that any one country can buck recession by increasing domestic public spending is at best naive and at worst destructive. Look at the way that higher public spending has failed to revive Japan.

Fourth, the money has to come from somewhere. Any additional public spending has either to come from higher taxation – money, therefore, that is not available for consumption – or it has to come from borrowing, in which case it not only has to be paid back but may also increase the cost of borrowing for business and consumers. We are in a world of low inflation. During previous conflicts it was possible to borrow and then whittle away the real cost of the loans by inflation – essentially stealing from savers. That cannot be done now, for a generation of high inflation has taught governments that it is impossible to pull that trick. Long-term borrowing costs go up. Japanese experience suggests that the more a government borrows, the more its citizens worry and cut back their own spending.

That leads to the final reason: what matters above all else is consumer confidence. In Britain, consumption is two-thirds of GDP. So the thing that will pull the world out of recession is all of us deciding to spend more money. In the UK, spending has been astoundingly strong in recent months, with retail sales in September reported to be running nearly 6 per cent up year-on-year in real terms. But if the conflict continues for many months and if there are further terrorist attacks in Western countries, then it would be surprising, to put it mildly, if people felt secure enough to keep hitting the shops.

So what is to be done? National governments are responsible for the security of their citizens. They have many other functions, but one of the things of which we have been reminded in recent weeks is that security is absolutely fundamental. So the greater the success of the extraordinary alliance that has been assembled to fight terrorism, the greater the likelihood of a reasonable economic recovery.

It will not be the military spending itself but rather the success of that spending that will determine the strength and timing of the economic recovery. A reasonable assumption for the world is a V-shaped recession, with things looking much better by the second half of next year. A reasonable assumption for Britain would be much slower growth through the winter and spring, but an acceleration by the autumn of 2002.

But that is only an assumption. There are grave risks, some of which are obvious and some of which don't really bear thinking about. The one thing we can be sure of is that living standards will be depressed by what has happened. More resources will have to go into security at home and abroad. It is not just a question of fewer new cars; there will also be fewer hospitals and schools.

Of course, by the standards of the Second World War, the damage to consumption will be minimal. Compared with the resources that had to be allocated to fighting the Cold War, the funds devoted now to providing greater security should be relatively limited. But there will be a price to pay, and we as citizens have no option but to pay it.

To say that is not to carp at the size of the bill. Most people in the developed world have experienced two decades when their living standards rose sharply. Now we will have a time when they will not rise so quickly. But our leaders should be open about this – that we will be poorer as a result of the need for greater security.