Hamish McRae: How will war affect global economy?

War, so the conventional wisdom goes, is good for the economy. It certainly boosts demand and pushes any spare capacity back to work. In narrow GDP terms it might be true. But it carries huge losses in welfare – in real living standards – that can last for many years. The crude figures may look better but people are worse off, maybe very much worse off – and that is only in economic terms, for in human terms the losses are, of course, impossible to calculate.

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Shares fall and oil prices rise on fears of war

War, so the conventional wisdom goes, is good for the economy. It certainly boosts demand and pushes any spare capacity back to work. In narrow GDP terms it might be true. But it carries huge losses in welfare – in real living standards – that can last for many years. The crude figures may look better but people are worse off, maybe very much worse off – and that is only in economic terms, for in human terms the losses are, of course, impossible to calculate.

This distinction is worth remembering now that a new burst of conflict in the Middle East seems inevitable. There is a presumption that an attack on Iraq will help sustain what is at the moment a pretty weak recovery. But there are grave doubts – or there certainly should be – that this indeed will be the case.

The best starting point for thinking about the economic impact of an attack on Iraq, naturally, is the Gulf War in 1990. The world was at that time starting to head into the last recession, the early 1990s one, so the timing of the war in relation to the economic cycle was rather different. War then came towards the end of a boom, rather than during the early stages of the recovery.

So what happened? Some work by HSBC compares the last experience with what might happen now. Then Iraq's invasion of Kuwait led to a sharp increase in the oil price, which briefly topped $40 a barrel (see chart). But once the war was over, the price swiftly returned to its pre-invasion trading range of $16 to $24 a barrel. So there was a spike, but no long-term effect.

That spike, however, was damaging. It came at a bad time, when the 1980s boom ran out of steam and the US and UK were heading into recession. (Europe's recession came about 18 months after the Anglo-American one, as the Continental economy was for a while buoyed up by German reunification.)

For the US, however, the recession was mild and brief – the UK's recession was deepened by the need to match German interest rates as we sought to remain within the exchange rate mechanism. And the dollar, which had been on a downward drift ahead of the invasion, recovered swiftly once victory had occurred (next graph). The main reason for that recovery was huge transfers of funds from the Gulf states as their contribution to the US towards the cost of reclaiming Kuwait. These transfers amounted to about 1 per cent of GDP and pushed the US current account briefly into surplus. It will not be like that now, so the dollar would seem to be more vulnerable this time round. There are other reasons for expecting some further dollar weakness, the most obvious being that the current account deficit is now more than 4 per cent of GDP, so there is a real risk here.

A second risk concerns physical supplies of oil, rather than the price. US oil dependency has risen sharply since 1990. Domestic production has been stable, while demand has risen by 15 per cent. In the short term this is not a problem as the US has been furiously stockpiling. By the end of this year its Strategic Petroleum Reserve is estimated to reach 600 million barrels. Current stockpiling has almost certainly been one of the main forces behind the recent climb in the oil price (see graph).

Still, were a Middle East war to drag out, there would be a very obvious threat to supplies, and demand for oil is not very elastic. Were there to be serious disruption to supplies – and hence a much higher oil price – a Middle East war could be very damaging to the still-fragile recovery.

On the other hand, were Iraq to re-enter the world oil market as a mainstream producer, instead of being allowed to sell limited amounts of oil for humanitarian purposes, then pressure would come off the price. It is in the self-interest of both the producers and the buyers that oil should not become too cheap, for an oil price of much less than $20 leads to almost as serious distortions as one of $40. But with Iraq back, oil stops being a potential constraint on economic recovery.

In short, the oil price should not behave very differently this time round from the way it behaved in the Gulf War. The dollar, however, is not likely to stage a post-war revival because there will not be the large transfer of funds that took place then. This time the US is going to have to foot most of the bill itself.

But all this is a rather mechanical interpretation of the oil and currency markets. It is what ought to happen, given what we know and can reasonably assume. But it does make the assumption that events will turn out towards the favourable end of the possible scale. It takes no account of the "what ifs?". These obviously include a protracted conflict, an American failure, and/or renewed terrorist attacks in the US and maybe Europe. Such outcomes range from the worrying to those that don't bear thinking about.

Whatever happens, though, there is a bill that has to be paid. In the Gulf War it was largely paid by the region itself – though I suppose you could say that it was ultimately funded by the consumers of developed countries. They paid higher prices for energy and the extra oil revenues then received by Middle East governments were then recycled to the US. This time the bill will be footed, one way or another, by consumers in Europe, Japan and America. We will either pay by higher oil prices, or by higher taxation, or by higher long-term interest rates (because of a rise in government borrowing). Or all three.

That leads to the great imponderable: how will consumers react to war?

US consumers, with a little help from their British cousins, have pulled the world out of recession. But they have had to keep borrowing to do so. While interest rates remain low, servicing that debt is not a serious problem, and there is every prospect of short-term rates remaining low for a very long time. The markets do not now expect any rise in rates world-wide for a year, a sharp change from expectations even six weeks ago.

Suppose however there is indeed a war in the Middle East. Do you rush out and buy a new car? Surely you are more likely to pause a few weeks just to see what happens. So the cars pile up in the showrooms, workers have to be laid off, and the bit of the US economy that has put in the strongest performance over the past year takes a beating. Indeed, the one really big difference between the American and the Continental European markets over the past year has been in cars. In the US sales have been strong; in Europe weak.

It does not require a fundamental long-term change in our spending habits to cause serious disruption to the supply chain of goods and services. All it requires is for buyers to hold off a while, as they seem to be doing in Europe after the introduction of the euro. US buyers, watching the television screen as a Middle East war unfolds, may start to hold off too. In economic terms that surely is the biggest danger.