How War Will Reshape the Economy

Entrepreneurial risk-taking and investment require peace and stability. In a hostile world, growth suffers

Predicting the economic impact of war and its aftermath used to be simple. In the old industrial economy, a big hike in defense spending would boost growth as factories geared up to build more tanks and planes. And as sure as summer follows spring, the economy would hit its limits on production capacity, and inflation would skyrocket. Worse, the corrosive effects of high prices often continued well after the actual shooting stopped -- a pattern that held true in the wake of World War II and the Korean and Vietnam Wars.

So does the war in Iraq pose the same risks for the U.S. economy? With U.S. troops launching a major assault on Baghdad amid fears that urban fighting may be necessary, it's impossible to predict how long the war will last, how difficult or costly the reconstruction phase will be, or how the broader fight against terrorism will proceed post-Iraq. Still, in the short run, the old rules apply. As military spending ramps up in earnest, the sagging economy will get a lift. Including the $63 billion in extra defense funding President George W. Bush recently requested, defense spending should hit close to $450 billion in fiscal year 2003, up from roughly $350 billion the previous year. All told, defense spending will account for 4.1% of this year's gross domestic product, a big jump from last year's 3.4%. More important, given the continued weakness in manufacturing and elsewhere, defense will account for 29% of GDP growth this fiscal year -- almost as much as during the Vietnam War.

Such a gain makes it unlikely that the U.S. will sink into a double-dip recession. The extra money for the military will put a floor under the economy, just as defense spending always has in the past. The wild card is a damaging jump in oil prices. But with Iraqi oil fields largely under U.S. control, that possibility looks increasingly remote.

But the long-term economics of this war aren't so rosy. Inflation isn't the worry this time since the 1990s investment boom and its huge productivity gains created plenty of excess capacity. Indeed, inflation, outside of food and energy, is still running at only 1.5%, with no apparent signs of danger yet.

Instead, the real threat is to the rapid productivity growth of the 1990s, which may may be tough to sustain in an unsettled and hostile world. New Economy growth depends on globalization and innovation, both of which could be dampened by war and a potentially difficult aftermath. If things go badly, the 2.7% average productivity growth of the last five years could peter out. That would seriously weaken the U.S. economy -- and global growth as well.

It's easy to see how such a scenario might unfold. The need for more security, already tightened due to the heightened risk of terrorism, impedes the free flow of goods, ideas, and people -- the very things that propelled global growth in the 1990s. The diplomatic tensions surrounding the war could spill over into trade talks, threatening the continued opening of global markets. And innovation is a high-risk activity that depends on easy access to capital and an open environment that is difficult to sustain in a country on a war footing. With some exceptions, "war is the enemy of most useful innovation," says Joel Mokyr, an economic historian at Northwestern University.

Opposition to the conflict in Iraq is also energizing anti-capitalist, anti-globalization groups. Opposing the U.S. is "attacking the country that incarnates the capitalist system," says Serge Weinberg, CEO of large French retailing group Pinault-Printemps-Redoute. Longer term, the effect could be to weaken political support for globalization.

These dangers won't abate soon, even if the Iraq war is short. The aftermath could be expensive and tumultuous. Iraq will need to be rebuilt, possibly without much help from other countries. And under the evolving Bush doctrine of preemption, Iraq may be just the first place where the U.S. undertakes military action. "It's a dangerous world," says Lawrence J. Ellison, CEO of Oracle Corp. (ORCL ) "We had this amazing 10-year period when we pretended it wasn't."

The immediate question is how much of a short-term lift the Iraq war will give to U.S. growth. The government's request for funds assumes a short war, with little added spending to rebuild Iraq. But despite Iraq's enormous oil wealth, reconstruction costs could mushroom. Even if oil revenues pay for much of the rebuilding, tens of thousands of U.S. troops could be deployed there for a considerable time. At the same time, outlays for those troops and their supplies could provide additional stimulus to the U.S. economy.

Increased corporate and national security may be propping up the labor market, too. Already, there has been a sharp jump in the number of what the Bureau of Labor Statistics calls "protective service workers," including police, fire, and security guards. In the 1990s, they made up no more than 1.8% of the workforce. Now, they account for 2%, or 300,000 more jobs -- enough to knock two-tenths of a percentage point off the jobless rate.

Taken together, defense and security spending, combined with tax cuts and other fiscal stimulus, could sharply boost growth later this year. James W. Paulsen, chief investment officer for Wells Capital Management in Minneapolis, estimates that growth in the second half will be at least 4%. Most forecasters agree, pegging second-half growth in the 3.5% to 4% range.

Of course, extra government spending won't fully offset the struggling corporate sector. Given continuing weak demand and overcapacity, many economists and executives are becoming increasingly pessimistic. "We aren't looking for a recovery in the capital-goods market until mid- to late 2004," says Steven Loranger, executive vice-president and COO of Textron Inc. (TXT ), an industrial conglomerate that lowered its profit forecast on Mar. 27. Daniel R. DiMicco, CEO of Nucor Corp. (NUE ), a top steel producer, thinks the economy is in for a rough ride even if the war ends swiftly.

Other corporations are less gloomy. While auto sales at Ford Motor Co. (F ) fell 8% in March, sales declines in recent weeks haven't been as steep as some forecasters feared, and the auto maker is confident that a new round of incentives will kick-start business. "I think we'll have a big April," says Ford sales analyst George Pipas.

And despite the national fixation on the war, only 17% of the CIOs surveyed by Merrill Lynch & Co. say it has affected tech spending. "We've expected all along that this would be a slug-it-out year," says Michael E. Marks, CEO of Flextronics International Inc. (FLEX ), a top contract manufacturer with operations around the world. "The war is not changing our plans." Jerry L. Fiddler, chairman of Wind River Systems Inc. (WIND ) in Alameda, Calif., doesn't think the war is a "big issue one way or another." Wind River makes the embedded software inside the Hughes satellite phones and BAE Systems chemical detectors being used throughout the war zone.

Indeed, tech may benefit from a hike in government spending. The Bush Administration will lift its tech outlays by about 8% this year, vs. the more typical 1% to 2% rate, according to Paul J. Bell, who runs the government business for Veritas Software Corp. (VRTS ), which makes storage software used by many branches of the military. And Bell says they're starting to see a trickle-down effect as local and state governments put more effort into safeguarding their computer systems from cyber attack.

The same can't be said for Europe, where companies are coping with global uncertainty and weak demand without benefiting from higher defense spending and other fiscal stimulus. In the fourth quarter of 2002, the U.S. grew at roughly twice the rate of euro zone countries. But according to Eurostat, the Continent's statistical agency, U.S. government spending drove fully half of that difference.

It's important to remember, though, that the positive effects of fiscal stimulus from higher defense spending last only a short while. Over time, higher spending on defense and security hurts growth and productivity. The most obvious example of a medium-term drag is the spending jump for homeland security. Those 300,000 extra security guards, police, and firemen cost about $10 billion a year. Moreover, if the economy heats up, those workers won't be available for more productive pursuits.

Moreover, uncertainty is already eroding the efficiencies produced by globalization and technology. U.S. multinationals are beginning to build redundancies into the sprawling, low-cost global supply networks they built during the '90s. Their aim is to preempt any supply disruptions brought on by terror attacks or shipments caught up in the dragnet of global security. Auto-parts maker Delphi Corp. (DPH ), which has long ferried parts built in Asia across the ocean in cargo liners, now has at its disposal a fleet of cargo planes in case of disruption. Says Mark C. Lorenz, Delphi's vice-president for logistics: "We've learned not to wait for crises to happen."

Companies are also thinking about moving some production out of riskier countries such as Bangladesh, the Philippines, and Indonesia to higher-cost but more stable rivals. "You're going to see a fairly dramatic shift away from countries that are deemed 'at risk,"' says Eric Schwalm, a consultant at Bain & Co. The winners will be Eastern Europe, Russia, and even Mexico and Canada. Mexican wage rates may be 25% higher than in Bangladesh, but Mexico is closer and much safer.

The net result: higher production and shipping costs. At the Port of Los Angeles, more inspections and other security measures are delaying cargo, says W. Guy Fox, executive vice-president for freight forwarder Stonepath Logistics International Services Inc. (STG )

Further trade liberalization may also be imperiled. Blame that largely on the diplomatic tussle over war in Iraq, as well as earlier Bush decisions to put steep tariffs on some steel imports and to boost farm subsidies. The war "is pouring salt into the already gaping wound of our relationship with our major trading partners," says Richard Fisher, who was deputy U.S. Trade Representative in the Clinton Administration. One likely result: a delay in the World Trade Organization talks in Geneva.

There are some signs of a backlash at the consumer level, too. In Europe and elsewhere, there have been calls for boycotts of American brands as well as demonstrations at symbols of U.S. business, such as McDonald's Corp. (MCD ) Still, such incidents have been few, and the boycotts have gained little traction so far. Indeed, "scattered protests and boycotts have not had any significant impact on Starbucks Corp. (SBUX ) sales," says Howard D. Schultz, chairman of the Seattle-based coffee purveyor, which operates some 1,500 stores outside the U.S.

Of course, it's not a given that conflict will derail globalization. The first great era of global trade, which ran from 1870 to 1914, saw plenty of nasty colonial and intra-Europe wars. However, "the wars that occurred back then were not that disruptive to economic life," says Michael Bordo, a Rutgers University economist. But today's globalization may be more vulnerable to war. "Because we are much more closely integrated," says Bordo, "if anything does slow down, the reverberation around the world could be quite serious."

In particular, any slowdown in the free flow of trade, people, and technologies could significantly dampen innovation and growth in the U.S. and abroad. According to estimates by economists Samuel Kortum of University of Minnesota and Jonathan Eaton of Boston University, the U.S. gets 30% to 40% of its productivity-enhancing technology from other countries. The liquid-crystal displays that power laptop screens were invented in the U.S., for example, but the development and commercialization were done in Japan. Barriers to trade could slow the benefits of international technology-sharing.

And nothing would hurt the global mind-meld more than throwing up barriers to foreign visitors and skilled immigrants. That's already happening in academia, where "extensive visa delays for students and scholars have become common," says David Ward, president of the American Council on Education, which represents 2,000 colleges and universities. That could mean fewer foreign students and foreign faculty, as well as lower foreign attendance at scientific conferences held in the U.S.

One of the great assets of the U.S. economy in the 1990s was its ability to attract brainpower from around the world. A cutback in the flow of educated people from overseas will hurt information technology and biotech companies that rely on skilled non-U.S. workers. "We're making foreign technical talent feel unwelcome in this country," says Paul Saffo, director of the Institute for the Future in Menlo Park, Calif. "If we pull in the welcome mat, we'll kill the technology industry."

Innovation could suffer, too. Over the long term, growth depends on the willingness of companies and individuals to take risks on developing and implementing new technologies. If they are worried about factors beyond their control, they may opt for safety, and the rate of innovation could slow. One sign of that: the continued fall in venture-capital funding, which reflects not just weakness in the tech sector but uncertainty about the future.

Of course, it's possible that innovation will continue at a healthy rate, especially as the tech sector pulls out of its deepest slump ever. Some people argue that these tough times will actually provoke more innovation rather than less. "When you're under financial stress, you're more likely to change, you're more likely to innovate, than when you're fat and happy," says Ellison.

Economists have never really been able to satisfactorily explain why productivity growth accelerates in some periods and slows in others. What we do know is that the market-driven growth the U.S. enjoyed in the 1990s thrived on an atmosphere of global peace and a steadily decreasing role of government in the economy. The war in Iraq, the tough rebuilding task ahead, and the rise in global tension all signal an end to that fertile era.

By Michael J. Mandel in New York, with William C. Symonds in Boston, Dean Foust in Atlanta, Steve Hamm in New York, and Peter Burrows in San Mateo, Ca.

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