Will uncertainty vanish along with Saddam?

news.ft.com By Alan Beattie in Washington Published: March 19 2003 22:18 | Last Updated: March 19 2003 22:18

From the point of view of the global economy, the timing of the Iraq war could scarcely be worse.

Depending on who you believe, looming war has either put on pause a recovery that was gaining pace, or fast-forwarded the process towards the second dip of global economic downturn.

But both optimists and pessimists concur that a war which increases uncertainty about the future, makes accurate assessments of current growth all but impossible, and pushes up oil prices, is the last thing the economy needs.

War will intensify the battles between optimists and pessimists. Keith Wade, chief economist at Schroders investment bank, says: "The crucial questions are: to what extent is the current weakness genuinely due to the effect of war fear; will uncertainty disappear along with Saddam; and what will be the cost?"

The US will remain the key both during and after conflict. Even without the effect of war, the eurozone, stymied by the fiscal confines of the stability and growth pact and more vulnerable than it thought to financial market weakness, has failed to take up the slack left when the US went into recession in 2001.

Japan has been unable to contribute much. The attention of its economic policymakers at present is concentrated largely on damage limitation, trying to prevent stock market falls ripping a fresh hole in the already tattered balance sheets of its banks.

But while the other two large economic blocs had clear weaknesses well before the build-up to war, opinions have remained divided over the US economy's underlying condition.

Optimists, including policymakers at the Federal Reserve who left interest rates on hold this week, say the US - having sputtered erratically in 2002 - was at the point of picking up sustained speed when war talk intervened. Corporations had substantially rebuilt their balance sheets, cutting net debt after the binges of the late 1990s and leaving themselves in a better position to invest again.

Pessimists point to remaining underlying imbalances in the US, notably the very low savings ratio among consumers. War could provide the trigger for the eventuality many economists have feared and long predicted: consumers finally throwing in the towel and deciding to retrench and pay down debt before business investment takes up the slack.

"Household sector finances remain on a knife-edge," says Andrew Cates at UBS Warburg.

Policymakers, in particular the Federal Reserve, will be watching two factors as evidence that the war factor is weakening the economy.

The most immediate and obvious transmission mechanism from conflict in Iraq to the global economy is the oil price.

Economies have become efficient in energy use in the past three decades but the immediacy of oil costs in taking chunks out of households' and companies' spending power means it will demand attention.

If the war seems likely to be lengthy, and pushes oil prices back up after recent falls, central banks will not hesitate to cut interest rates to offset its effects.

But opinions are also divided as to how far oil prices will go up during the conflict and then fall back if and when the Saddam Hussein regime falls. Many economists have looked back at the first Gulf war in 1991 for clues as to how oil prices are likely to react this time.

However, exact parallels are hard to draw. One positive implication for the current situation compared with the early 1990s is that the Iraqi invasion of Kuwait in 1990 came as a shoc k, driving oil prices higher because of uncertainty as well as supply disruption.

Given the protracted build-up to war, that extra surprise effect is unlikely to happen this time. In fact, recent falls in oil prices suggest traders are looking forward to the resolu tion of uncertainty that the war would bring.

On the negative side, there are several other reasons that oil prices should be high, including political unrest that has disrupted supply in Venezuela and Nigeria and the after-effec ts of an unusually cold winter in North America. Those Fed officials hoping for a quick drop in oil prices, to the low $20s range, when the war is resolved may be disappointed.

The second, and related, factor is consumer spending, above and beyond what amounts to a tax on consumers arising from the higher oil price. Falls in consumer confidence have yet full y to be reflected in actual behaviour. But a war could finally make concrete ethereal fears that have floated around the household sector for months.

Wars are convenient excuses for economic weakness. But no one can argue that they did not see this one coming. The test of policymakers to cope with external shocks to the global econ omy is on very public display.