TCS Daily

Military Action and Malaise

By Kevin Hassett - September 5, 2002 12:00 AM

The economic statistics have turned fairly sour this summer, with initial claims for unemployment insurance inching back up, and most other indicators about flat since the second quarter. The deceleration of activity has been striking in its suddenness, and marks an odd and perplexing departure from the apparently strong recovery that was underway last winter. Indeed, throughout economic history it has generally been the case that the end of a recession is the sweetest of economic times, marked by high output growth and a surging stock market. Clearly, the force driving the economy back toward recession is not a normal economic one. What gives?

A look back at history suggests a plausible and disturbing possibility: the impending war with Iraq is harming the economy already.

Here's why. First, a look at the last 50 years of data suggests that it is almost certain that significant Middle-Eastern conflict will lead to recession in the U.S. The list is a long one. In 1956, war in Egypt shut the Suez Canal. With nowhere to send their oil, producers cut back their production by 1.7 million barrels a day, roughly a 10 percent decrease in world production. Oil prices surged, and by the next summer the world economy was in recession. The sequence has sadly repeated itself often. An Arab oil embargo in 1973, Iran-Iraq war in 1980, Iraqi invasion of Kuwait in 1990, and last year's events all led to sharply higher oil prices and economic downturns. But this war has not happened yet, how can it harm the economy now?

The answer is, that firms and consumers have likely learned the lessons of last conflicts, and likely recognize that the President's rhetoric has significantly increased the chance that we will have another recession in a few months. Firms undoubtedly are making the following calculation. If there is going to be a recession next fall, how aggressive should we be expanding our production now? "Not very" is the clear answer, and the decline in hiring and soft capital stock growth suggest the concern is real. Consumers likewise have been battening down the hatches as if they see a recession coming, with consumption in the second quarter of this year only a tad above its low level during last year's recession and current data looking even worse.

This line of reasoning suggests that the President's strategy of gradually talking up the war with Iraq may have serious economic consequences. While recessions are normally fairly short, the decline in activity associated with anxiety over an Iraq war may well be long lasting if the war continues to lurk on the horizon. If, for example, we still are rattling our sabers 6 months from now, economic agents will continue to face the possibility of an impending slowdown. Only one word can describe such an economy, "malaise."

This war economy scenario has significant policy implications. For fiscal policy, such a scenario will ignite partisan name calling and finger pointing, which will reach an unusually fevered pitch as the November election nears. Democrats will claim that the disappointing recovery is the result of higher deficits. Republicans will point to the weaker than desired stimulus package passed last Spring, and argue that another round of tax cuts is in order. Monetary policy will also be affected. Indeed, one could argue that the most plausible explanation of the Fed's relatively loose monetary policy this year is that the Fed itself has expected a double dip in response to the second round of the war on terrorism. Going forward, the Fed will likely accept a higher inflation risk (and even lower interest rates) if it becomes convinced that a significant war in the Middle East is near.

But in the short term, these policy maneuvers will have little impact. When enormous and difficult to assess ambiguities are front and center, traditional economic relationships become less reliable. If the past is any guide, an economic celebration can only be kicked off by a victory parade following a successful conclusion to the war with Iraq. Whether that parade results from a military campaign or a more peaceful solution mechanism, its occurrence is likely a prerequisite to a strong economic expansion. In the meantime, expect the economic news to continue to disappoint.

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