What War with Iraq Would Do to the Economy

A short one could provide a boost. A long one could bring a recession

The U.S. was teetering on the edge of recession when Iraqi troops stormed into Kuwait in the summer of 1990. The surprise strike by Saddam Hussein shook financial markets. Oil prices spiked, the stock market swooned and consumer confidence plunged. The combination drove the economy decisively into a downturn that lingered for months--and dashed the reelection hopes of Commander-in-Chief of Operation Desert Storm, George H.W. Bush.

Flash forward to 2002. With George W. Bush beating the war drums for a "regime change" in Baghdad, fears are rampant that the economic pricetag for U.S. military intervention could again be high. But while Mideast war carries many risks for the economy, there is good reason to believe that it won't be as devastating as it was a dozen years ago. In 1990, the sudden Iraqi "annexation" of Kuwait spooked consumers into curbing spending and drove the economy into recession. This time, a U.S. assault on Iraq has been so well-telegraphed that it shouldn't be a shock to anyone--consumers, companies, or investors--if and when it occurs.

Surprised or not, though, Americans will have to pay the price for a campaign to oust Saddam Hussein. The question is: At what cost? That depends on how long the war lasts and how well it goes. A quick victory by the U.S. would barely put a dent in the economy, the dollar, or the stock market. Indeed, it might ultimately prove beneficial by boosting confidence in the U.S. But the longer the war drags on, the greater the risks for the economy. The biggest danger: a conflict spreading beyond Iraq to elsewhere in the Mideast. In that case, consumer and business confidence could crack, overwhelming whatever small kick the economy might receive from U.S. government spending on the war, sending the economy into recession.

For the moment, the slow buildup to war is spreading the economic toll from the Mideast tensions over months rather than concentrating it in the kind of short, sharp shock that often presages a downturn. That's a mixed bag: While it may reduce the risk of an outright recession, it has also consigned the economy to months of malaise as investors, companies, and consumers nervously await the attack on Iraq. "Until the war starts, the uncertainty and anxiety will dampen the markets and the economy," says Thomas D. Gallagher, a political economist at ISI Group.

Higher oil prices are already crimping U.S. growth. Oil prices have climbed 45% over the past year, to close to $30, largely in anticipation of an assault on Iraq. Consumers have been hit hard. Peter Hooper, chief U.S. economist at Deutsche Bank, reckons that each $1 increase in the price of oil costs consumers about $12 billion a year.

Companies are hurting, too. According to consulting firm Economy.com Inc., each $5-per-barrel rise in oil prices cuts already paltry profits of nonenergy, nonfinancial companies by 2% over a year.

The transportation sector, of course, is in particular pain. To cope, trucking companies have tried to insulate themselves against oil-price fluctuations by charging customers an energy surcharge. Says Christopher B. Lofgren, CEO of Schneider National Inc., a $2.4 billion trucker in Green Bay, Wis.: "Any time you hear rumblings in the Middle East, that puts a real burden on us."

But it's more that just the hit from higher energy outlays that's dragging down growth. The uncertainty surrounding the timing and outcome of any hostilities in the Mideast is hanging like a dark cloud over the economy. It adds to the many reasons that already skittish corporate chieftains have continued to trim costs and hold back on investment in the absence of any sense of an upturn. Investors, too, are playing it safe by avoiding stocks.

The U.S. slowdown, coupled with the higher oil prices, is also casting a pall over the rest of the world economy. Europe and Japan are more energy-efficient than the U.S., but they're also more dependent on imported oil because they lack much domestic production. Some of the emerging Asian nations are particularly vulnerable to an oil-price spike, though in some cases, such as South Korea, the strength of the local currency is offsetting some of the impact from the rise in dollar-based prices.

Yet if the slow-motion march to war is depressing the economy and financial markets, it's also giving the U.S. and its allies time to prepare contingency plans to cushion the fallout and reduce the risk of recession once the shooting begins. Working through the U.N., the U.S. and Britain have gradually put the squeeze on internationally sanctioned oil exports from Iraq so that its shipments today are virtually inconsequential. Iraqi oil exports averaged only 780,000 barrels a day in August, compared with almost 2 million barrels a day in 2000. The loss of such a paltry amount on its own wouldn't have much impact on the oil market, experts say.

At the same time, the U.S. and its fellow industrial nations have sought assurances from Saudi Arabia and the rest of OPEC that they're ready to make up for any shortfall in supplies in the event of war. Saudi sources say the country is committed to filling any gaps in production but that it won't boost output to damp down speculatively driven oil-price jumps. The U.S. has also sought to coax added production from outside OPEC, though that's obviously limited. Russia, which exports 3 million barrels of oil a day, is already running its production at maximum.

To counter a spike in oil prices and restore calm to the market, individual nations may have to release oil from their strategic stockpiles. In 1990, they were slow to tap those reserves, which now amount to 1.2 billion barrels of oil. This time, experts say, they won't hesitate.

Indeed, the U.S. has been gradually rebuilding its stockpile in anticipation of a war against Iraq. The U.S. reserve now holds 584 million barrels of oil, equivalent to 120 days' worth of U.S. imports from OPEC.

Japan, too, has been building its reserves. State-owned Japan National Oil Corp. and the biggest private oil refiner, Nippon Oil Corp., have been adding to their inventories this summer. According to the government figures, Japan's oil reserves account for about 170 days of consumption--a cushion that's plenty big enough, says UBS Warburg oil analyst Toshinori Ito.

Of course, once the shooting starts, a lot could go wrong. The halting march to war has given Saddam Hussein time to prepare and plan as well. If he manages to broaden the war beyond Iraq's borders--perhaps by lobbing a chemically armed Scud at Israel--oil prices would skyrocket on fears of disruptions in supplies not only from Iraq but from Saudi Arabia and other Arab producers. And that could send the global economy into recession.

But unless that occurs--and oil consultant Philip K. Verleger Jr. of the Council on Foreign Relations puts the odds at just 5%--the U.S. should be able to avoid a gut-wrenching downturn. After all, the U.S. economy has shown amazing resilience despite terrorist attacks and stock market blues. And short of a prolonged battle with no clear prospect of victory, the betting is that it will pull through again.

By Rich Miller and Stan Crock in Washington, with Michael Arndt in Chicago, Stanley Reed in London, and Brian Bremner in Tokyo

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