The cost of war

The good, the bad and the ugly

Experts agree war in Iraq will have profound economic consequences. But, as Faisal Islam explains below, it all depends on how far the conflagration spreads, and global recovery may be hampered by a US trade war

Sunday March 23, 2003 The Observer

· As good as it gets Quick decisive victory, no use of biological or chemical weapons, no reduction of Opec exports of crude oil (35-40 per cent chance)

Markets are itching for a swift victory, most likely to be brought about by the capitulation of Iraqi forces.

Confidence in equity markets has begun to return as the Stars and Stripes is hoisted over Iraqi oil towns. Even the dollar has rebounded and appears to be heading back to parity with the euro.

If the benign scenario plays out, Brent crude oil will remain at or below $25, averaging $23 by the end of this year, says the Centre for Global Energy Studies. Then, after reorganisation and possible privatisation of the Iraqi oil industry, production is set to shoot up, offering a prolonged era of $20 per barrel oil.

The Ernst & Young Item Club believes that US growth would remain sluggish this year, but nowhere near recession. Growth, it predicts, would be 2.5 per cent - slow by US standards, but probably the fastest of the G7 industrial nations.

Then next year, on the back of a bull run in stock markets, and cheap oil, growth would surge to 3.7 per cent, returning the US econ omy to the growth rates of the late 1990s.

An additional benefit for the US economy would be less pressure on its budget deficits. Lehman Brothers' John Llewellyn predicts total costs of $75 billion.

'Besides deployment and repatriation costs, this scenario would presumably require the funding of a war of four weeks or less, occupation and peacekeeping outlays consistent with the maintenance of 100,000 troops for some two years, and reconstruction costs that are still towards the lower end of existing estimates,' he says.

But there are three key risks. Many of the upsides of this scenario are already discounted by the markets. Any deviation from this path now would see serious falls for the dollar and equity markets.

Also, as HSBC economists say: 'Given the most likely outcome of a short sharp war, the economic impact should be little different from no war at all'. There are plenty of bearish economists who believe that the US will continue to struggle with its post-bubble economy for at least two years.

And although an easy victory might help heal transatlantic tensions it could also encourage hawks in the US administration to pursue more unilateral actions.

· Damage limitation A more protracted war, Iraqi troops dig in, military costs surge, geopolitical tensions increase (40 per cent chance)

If Iraqi armed forces choose to fight, drawing coalition forces into Baghdad, then the market gains from assuming a rollover would go quickly. Awar longer than a month would be troubling for the world economy. Already tenuous political support for the action would dwindle further.

Any attacks on the oil infrastructure of the Middle East or even an attempt to draw Israel into the conflict would bring considerable geopolitical uncertainties into play. Ethnic strife between Iraq's minorities destabilises the country post-Saddam.

Some of the geopolitical poison spread at the UN Security Council would begin to infect economic relations.

Mark Cliffe, the chief economist at ING, calls this 'new world disorder'. Trade talks would become frostier. The World Trade Organisation's Doha round could founder in this atmosphere.

Turkey's economy risks a financial crisis following disagreements with the US about stationing of troops and overflight rights. Loan guarantees and aid are at risk.

The alliances that underpinned 50 years of relative prosperity in the West, such as the UN, Nato and the European Union, are split down the middle. Already key countries want to exclude Britain from a common defence project.

And within European nations support for war by governments would cause mounting public unrest. Tony Blair says his premiership is at risk. In Spain, PM Aznar's party risks being voted out of office.

'We could easily lose sight of the tectonic shifts that are now occurring in the world order - and the instability and insecurity that lies ahead,' says Stephen Roach, chief economist at Morgan Stanley.

Under this scenario, oil prices will stay up at about $30 for the rest of the year, falling to $25 in the middle of next year, says the Centre for Global Energy Studies.

Lehman Brothers chief economist John Llewellyn says that this would lead to 'a longer and more manpower intensive period of occupation [200,000 troops for five years], for reconstruction and nation-building'. The total cost could be as high as $250bn, and without Saudi Arabia, Germany or Kuwait to foot the bill, the US budget deficit would have to expand further.

· Worst-case scenario The conflagration spreads to other Gulf areas (10 per cent)

Oil and Weapons of Mass Destruction are the key to this situation degenerating into an economic cataclysm. The one WMD that Saddam Hussein undoubtedly possesses is his ability to destabilise world oil supplies. By yesterday the US claimed to have control over most of Iraq's oilfields, leading to a slump in crude oil prices.

But there is still tremendous uncertainty over the price of oil. A direct hit on the Kuwaiti or Saudi oilfields, either by a missile or through terrorist-related acts, would see the oil price spike. The Centre for Global Energy Studies estimates that any attack seriously threatening Saudi and Kuwaiti production would see oil 'at $50 with even higher spikes' for as long as there were problems.

Venezuela's battered oil industry, and tanker shortages, will add to oil prices. By next year, if hostilities have ceased, crude will fall to around $30. But if Iraq attacks Israel with chemical or biological weapons that trigger a response , there will be massive political unrest throughout the region. Significant casualties among either British or US forces, or Iraqi civilians, will exacerbate international discord. Item Club forecast this scenario will see an acute global recession this year. Overall growth in 2003 will be -0.8 per cent, bouncing back to around 2 per cent next year, still well below trend.

Any open-ended conflict like this risks confidence, a plunge in stock markets, global recession, deflation and evaporation of cross-border capital flows, says ING's Cliffe. Brazil and Turkey could easily relapse into financing difficulties.

Mindful of even the slim chance of such an outcome, European finance Ministers were reassuring markets last week. On Thursday, European finance Ministers and the European Central Bank said that they would monitor financial markets and 'stand ready to cooperate as necessary'. Earlier last week the US Federal Reserve promised 'heightened surveillance' for the world economy.

For the US, the direct costs of this nightmare scenario could unhinge the economy. 'One possible benchmark would be the Vietnam War, where US involvement resulted in a bill equivalent to 12 per cent of contemporary GDP [£800bn],' says John Llewellyn. Bush banks on a short war to avoid having to pay this price.