Will an End to the War with Iraq Unleash Economic Prosperity?


Kevin L. Kliesen

Prior to the start of military hostilities with Iraq on March 19, numerous Fed officials, including Chairman Alan Greenspan and St. Louis Fed President Bill Poole, said that the economic expansion was being tempered by rising oil prices and "geopolitical uncertainties." In other words, businesses were unwilling to expand their payrolls and were postponing new capital investment projects until the dust settled in the Middle East and elsewhere. This uncertainty was also being reflected in financial markets (falling stock prices and increasing interest rate risk premiums). How did the conflict affect the U.S. economy? Moreover, will the war's end be the spark that starts another economic boom?

Doctors worry when a virus attacks a patient who has been weakened by another unrelated illness. In similar fashion, the conflict with Iraq was occurring against the backdrop of one of the weakest economic recoveries in the post-World War II period. Once again, the nation found itself experiencing a "jobless recovery"—much like that seen in 1991-92 after the first Gulf War.

In economics, it is sometimes difficult to link cause and effect—particularly for large, complex economies like the United States. Nevertheless, one can reasonably identify four major economic effects arising from the conflict with Iraq. First, given that Iraq is a major oil-producing country and that it is situated in an oil-rich region, the most immediate effect was a sharp rise in crude oil prices. Because modern industrial economies use large amounts of energy, users were particularly keen to guarantee an uninterrupted source should Iraq's oil fields have become damaged and taken off-line for longer than expected; to do so, users were willing to bid up the prices.

Second, with higher oil prices cutting their purchasing power, households became more reluctant to spend. Likewise, higher oil prices, increased uncertainty and a more cautious consumer led firms to trim expenses and reduce production. Both of these effects caused economic growth to slow. In turn, investors became concerned about the future growth of corporate profits and earnings. This caused stock prices to fall, which reduced household wealth—perhaps exacerbating the cutback in spending—and increased the cost of capital for businesses.

The third drag on the economy was the hit to consumer and business confidence. Economists have found that changes in consumer confidence tend to produce fairly small changes in consumer expenditures on big-ticket items like automobiles and household appliances. Surveys of firms, though, found that many were postponing, or in some cases canceling, plans for new capital investments and new hires until a clearer picture of the economic outlook emerged.

Finally, with a greater perceived threat of future terrorist attacks, leisure and business travel fell noticeably, which adversely affected the nation's travel and tourism industry. Firms also found themselves devoting more of their scarce resources to enhancing workplace security.

After their March 18 FOMC meeting, Fed policy-makers said that they expected "an improving economic climate over time" once the conflict ended. This was also the view of the majority of private forecasters in early April, as reported in the Blue Chip Economic Indicators. With the conflict over, will the economy bloom like spring flowers? This is the most likely outcome given that inflation and interest rates remain low, fiscal policy is stimulative (tax cuts and increased government spending) and oil prices have fallen significantly.

At another level, the economy is still struggling with the remnants of the investment boom of the late 1990s. With manufacturing capacity at historically high levels relative to GDP, growth of business investment spending has been weak. Further, persistent declines in stock prices (down three consecutive years) have cut household wealth significantly. Initial indications suggest that the end of the Iraqi conflict, though helpful, has not produced enough euphoria to offset the drag from these impediments.