The Bush Administration may have already decided to broaden the war against terrorism to Iraq, with the explicit goal of toppling Saddam Hussein from power. Such a decision could have important implications for the US economy through several channels including: defense outlays and the federal government budget, and the global oil supply and oil prices. Moreover, a broader war would have implications for monetary policy, the trajectory of bond and stock prices, and the dollar.
We conclude:
(1) A military campaign would lead to a sizable buildup of military forces in the Persian Gulf and a further increase in defense expenditures.
(2) The risk of an oil price shock would increase. Not only would a war likely halt Iraqi oil exports, but also there would be a risk of a broader interruption of supplies from the region.
(3) Fed officials would tend to be more patient in tightening monetary policy.
(4) Risk premia in US financial markets would increase. Bond yields would rise and the warat least initiallywould hurt the US equity market.
(5) The dollar would weaken as the US encountered difficulties funding its large current account deficit.
The Debate of War vs. Containment
Iraq already possesses weapons of mass destruction, including large stores of biological and chemical agents. Moreover, Iraq has been trying to develop a nuclear weapons capability for decades. Some experts believe that this program has advanced to the point that all that Iraq now needs is the weapons-grade nuclear material for the bomb core.
The Bush Administration wants to prevent Saddam Hussein from being able to develop and use these weapons. The debate among policymakers is whether it is better to reinvigorate the policy of containment (essentially the policy in place since the Gulf War) or to develop a more lasting solutionthe forcible removal of Saddam Hussein from power. Advocates of containment argue that this policy has worked. Saddam has been bottled up and has been unable to destabilize the Middle East since the conclusion of the Gulf War in 1991. Advocates of containment argue that maintaining this policy would be less risky and costly than a war effort. They argue that a military campaign against Iraq would require a major US ground force. Unlike Afghanistan, there is not a viable opposition military force, such as the Northern Alliance, that the Bush Administration could use to help fight the land war.
Advocates of a military campaign argue that a containment strategy will be difficult to sustain over time. Moreover, with the departure of the UN weapons inspectors in late 1998, the ability to monitor Saddam's efforts to enhance his weapons of mass destruction capabilities has been critically impaired.
At this juncture, the hawks appear to be winning the debate. Reportedly, the Bush Administration has been rebuilding the US military's armaments to replace those used in Afghanistan. The US is also engaged in the logistical work needed to wage war against Iraq.
The biggest fly in the ointment for a war is the rapid deterioration in relations between Israel and the Palestinians. This threatens to discourage Arab countries from allowing the US the forward bases and overflight privileges that would facilitate prosecution of a war against Iraq.
Assuming that the Bush Administration decides to proceed with a war, the implications include: (1) a further increase in defense spending, (2) an accompanying deterioration in the budget balance, and (3) the risk of a significant oil price shock.
Defense Spending and the Budget
Although it is difficult to be precise about the likely costs of a war effort, the 1990-1991 Gulf War provides a reasonable benchmark. The total cost of that warthe movement of two Army corps to Saudi Arabia, the forward basing of large components of the US Navy and Air Force, and less than a week of ground fightingwas about $20 billion in incremental outlays. Fully-loaded costs were considerably higher. For example, Congress enacted $51.4 billion of supplemental spending bills over the 1990-1992 period to fund the Desert Shield and Desert Storm operations. In the end, US allies absorbed virtually all of these costs, paying $48.7 billion to the US in burden-sharing contributions. The costs of a war could be somewhat higher now due to inflation (the GDP defense expenditures price deflator has climbed about 25% since 1991) and because the US might have to occupy Iraq for an extended period of time.
As shown in Exhibit 1, the costs of a war would just add to the rapid buildup of defense expenditures that is already underway. Defense outlays were already on track to rise to $351 billion in fiscal 2002, a 6.6% increase from the prior year. Actual outlays are likely to be higher. Recently, the Bush Administration submitted a $27.1 billion supplemental budget request that included an additional $14 billion for defense spending in fiscal 2002.
The Bush Administration has proposed $397 billion in defense outlays for fiscal 2003. This figure would undoubtedly get bumped higher should the Administration pursue a military effort to topple Saddam Hussein.
The costs of the war would result in a higher budget deficit. But the incremental expense would probably not be that large (probably no more than $20-$30 billion), as the Bush Administration has already planned on a large increase in defense outlays. However, the fact that there would be any increased budgetary cost at all would stand in marked contrast to the 1990-1991 Gulf War, when virtually all of the costs were borne by US allies.
A war effort would sustain the strong fiscal impulse that is already in place. It is doubtful that the Bush Administration would seek tax increases to fund the costs of a war.
The Risk of an Oil Price Shock
A war against Iraq would likely increase both the volatility and the average level of oil prices. The economy would be damaged as the oil price spikes pulled down growth to match the available supply of oil. Our Commodity Strategy group emphasizes that the damage to the economy could be considerably greater than suggested just by the average increase in oil prices.
Two weeks ago we considered two oil price scenariosa 1990-1991 style shock, which would be modest and transitory, and a 1979-style shock, which would be severe and sustained.1 In terms of a war with Iraq, whether the shock would look more like the mild/transitory shock or the sustained/severe shock case probably depends mainly upon two factors:
* When the war occurs.
* The degree and duration of the disruption to oil supplies.
The timing matters because it will influence the degree of pressure on oil supplies. If the war were to occur this year, there would be excess capacity available elsewhere within OPEC that could help offset any shortfall from Iraq. However, if the war did not occur for 18-24 months, the margin of excess supply would likely diminish as the global recovery caused the demand for oil to increase faster than the potential supply. Thus, the further off in time the war is, the greater the risk of a big oil price shock when it occurs.
The degree and duration of the disruption to oil supplies depends most critically upon whether the disruption extends beyond the Iraqi oil supply. Iraq has been exporting only about 1.8 million barrels per day. If only this oil is lost, then the upward pressure on prices would be relatively modest. During the Gulf War, the supply disruption was greater because both Iraqi and Kuwaiti oil supplies were lost (see Exhibit 2). In contrast, if Iraq were able to disrupt the oil supplies from the region more generally, then oil prices would rise significantly.
Even a small disruption to oil supplies could have a relatively large impact on oil prices. First, the amount of excess capacity in OPEC is probably smaller than generally realized. Our Commodity Strategy Group estimates that the immediately available excess capacity is in the range of two- to three-million barrels per day.
Second, oil supply is also constrained by infrastructure limitations. For example, the focus on Russia as a source of incremental supply ignores the fact that Russia's oil export infrastructure is already at capacity. In the same vein, Saudi heavy crude oil is not a perfect substitute for Iraqi crude. Given refinery constraints, our Commodity Strategy Group estimates that increased Saudi supply could probably only offset a little more than two-thirds of a complete Iraqi outage.
The US Strategic Petroleum Reserve (SPR) could also be used to augment the supply of oil. However, since the SPR would ultimately be replenished, the use of the SPR would work more to dampen the magnitude of the initial price spike than to shorten the duration of the oil price rise.
Longer term, the most important issue would be the ability to foster a stable successor regime in Iraq and greater political stability in the region.
Implications for Financial Markets
All else equal, a war against Iraq probably would cause Fed officials to be more patient in tightening monetary policy. That is because the war would raise uncertainty and potentially push down financial asset prices. Fed officials would be reluctant to tighten without knowing the duration of the war or the impact on oil prices. However, once the war was concluded, Fed officials would probably move aggressively to hike short-term interest rates. After all, risk premia would likely fall at that point, leading to more buoyant financial asset markets and easier financial market conditions.
Bond yields would likely climb due to greater risk premia. Also, some market participants might be nervous that the FOMC's patient approach could lead to an increase in inflation, especially if the war turned out to be protracted and/or there was a large, sustained rise in oil prices.
The onset of the war would likely lead to a temporary appreciation of the dollar against the yen and the euro as safe haven concerns predominated. Longer term, however, the dollar would likely weaken, perhaps substantially. That is because risk aversion would increase, punishing the currencies of countries like the United States with large current account deficits. The Gulf War provides a template of the likely impact on equity prices. The initial invasion of Kuwait by Iraq provoked a selloff. But the equity market rallied sharply once investors realized that the war would be short-lived and successful (Exhibit 3).
What to Watch
1. Israel/Palestinian relations. If they deteriorate further, it could delay and complicate efforts by the Bush Administration to broaden the war to Iraq.
2. Discord within the Bush Administration. The less talk, the more likely the decision has been made to forcibly remove Saddam Hussein from power.
3. UN inspectors. One important issue is whether there will be a last-ditch renewal of the UN inspection program. The US could pursue this as a means of broadening support for the war that would follow should the UN inspection effort be stymied by a lack of Iraqi cooperation.
Conversely, Iraq might find a concession here attractive in order to delay any war effort.
Bill Dudley