Economic Battles: A Look at War and the U.S. Economy

A cloud of uncertainty has hung low over the economy for several months. The start of the military campaign in Iraq has removed the question of "if" or "when" there would be a conflict; now the question is how quickly the conflict will be resolved. Some consumer and business spending had been delayed because of this uncertainty, reflecting lingering doubts about overall economic vitality and the need for consumption goods and services. The most likely economic outcome of the war in Iraq is a strengthening in economic growth in the second half of 2003.

People Dislike Uncertainty

Consumers, business managers and investors make spending decisions every day without perfect foresight into the future. However, when the near-term outlook is clouded by a large number of risks that are difficult to evaluate, consumers and businesses tend to become concerned with their current economic well-being and make more conservative spending and investment decisions.

"When consumers feel lousy, they postpone purchases of discretionary items until the future appears brighter"

Consumer-confidence measures reflect how well off families expect to be in the coming months, whether they expect to have a job and whether they are likely to purchase big-ticket items, like a car or a house. The exhibit shows the consumer confidence index compiled by The Conference Board and how it has behaved during recent outbreaks of war or conflict: Iraq's invasion of Kuwait and the subsequent Gulf War (August 1990-February 1991), the September 11 attack and America's ousting of the Taliban (September 2001-January 2002), and the passage of U.N. resolution 1441 (November 2002) and the ensuing war with Iraq.

Tragic, unexpected shocks precipitate a fall in family views regarding the future, as with the invasion of Kuwait or the tragedy of September 11. The ensuing uncertainty regarding the military conflict and its effect on the U.S. economy dampen consumer confidence. When consumers feel lousy, they postpone purchases of discretionary items until the future appears brighter. During the three events depicted on the exhibit, the average drop in the confidence index was 33 percent. The start and quick, successful conclusion of the military campaigns brought relief to the American psyche and a concomitant rebound in optimistic feelings

Business managers are little different from consumers. Economy.com conducts a weekly survey of business confidence and found that its measure for the six-month economic outlook fell 40 percent between mid-January and March 14. It's not surprising that firms are delaying investment spending and hiring of workers when they have a pessimistic view.

Higher Oil Prices Slow Economic Growth

The disruption of crude oil supplies is another dimension of any Mideast conflict. Crude oil futures have been elevated for months because of concerns that a military campaign could bring the destruction of pipelines or even entire oil fields. Energy is a necessary ingredient to business production and to consumer activities, and higher prices slow economic growth by raising production costs and eating into the family budget. Macroeconomic Advisers has estimated that for each $5 hike in oil prices that is sustained for six months, economic growth will be 0.07 percent (annual rate) slower. (For example, if prices jump $20, the effect will be 0.28 percent, or four times greater.) The longer that oil prices remain elevated, the more serious the negative ramifications for economic growth. For each $5 increase in price that is sustained for a full year, economic growth will be about 0.25 percent lower — a $20 increase shaves 1 percentage point off economic growth for the year.

Interest Rate Gyrations Reflect Investment Uncertainty

Investors shift funds into high-quality financial assets during uncertain times. As war rhetoric heated up, a "flight to quality" led to monies flowing into U.S. Treasury securities and other high quality assets, such as Freddie Mac debt and mortgage-backed securities, and a lowering of market yields. Ten-year Treasury yields ended at 3.59 percent on March 10, and 30-year fixed-rate mortgages averaged 5.61 percent that week, both the lowest in more than 40 years. This also meant that investment dollars were not flowing into common stock, and stock values moved lower. The start of the war in Iraq changed investor sentiment as the early view was that the war would be short and victorious, and that the economy would be expanding smartly in the aftermath. It is likely that the low point for interest rates is behind us, but we will continue to see the stock market and bond prices gyrate in coming days based on the war news, with higher stock values emerging in the aftermath of a successful war.

Economic Growth to Rebound in Second Half of 2003

If the war in Iraq is short and successful with little or no disruption in oil supplies, consumer and business confidence should bounce back, and consequently, so will consumer and investment spending. Also, oil prices will decline and the deleterious effect of higher energy prices will be short-lived. Thus, our view is that U.S. economic growth will accelerate in the second half of 2003 to 3.5 -4.0 percent, at an annual rate. However, the military risk still remains high, and a protracted conflict with significant oil supply disruption could well lead to the opposite outcome: a stagnant economy with rising energy prices, reminiscent of the mid- to late 1970's experience.