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Dose of reality hits financial markets

The opening salvo of the war in Iraq was not enough to test the theory that a quick, decisive U.S. victory will provide a substantial boost to the economy.  By Martin Wolk.
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President Bush’s warning that the Iraqi war could be “longer and more difficult than some predict” injected a note of sobriety Thursday to financial markets, where many investors are hoping for a short conflict that might boost the U.S. economy.

Stock prices have surged and bond prices have slumped over the past week on the theory that U.S. forces will vanquish their Iraqi foes quickly, leading to sustained lower oil prices, improved consumer and business confidence and ultimately higher corporate profits.

“If things go well with this war I think certainly one of the major hurdles — maybe the major hurdle — for the economy will be removed,” said Bob DiClemente, chief U.S. economist for Salomon Smith Barney.

But Bush’s comment about the length of a war, even though it might have been intended largely to dampen overoptimistic expectations, was enough to cast at least some doubt on the idea that war would provide a quick shot in the arm to the ailing economy, said Hugh Johnson, chief investment strategist for First Albany Cos. He said the initial early salvos of the war were hardly enough to confirm or dispel any economic theory.

“Now we need to see something that puts that on firmer ground,” Johnson said. “Let’s see some evidence that it’s going to be a short war and the price of oil is going to come down permanently.”

Tough economic road ahead
Of course, even in that best-case scenario, many analysts doubt the economy will rebound quickly from its long slump.

“My belief is the fundamentals for households are not conducive to recovery yet,” said Bob Gay, global strategist for Commerzbank Securities. “Savings are too low and balance sheets are in too poor of shape. The same is true for the corporate side. Debt service is draining free cash flow and constraining investment.”

William McDonough, president of the Federal Reserve Bank of New York, cautioned Thursday that uncertainty over war is not the only factor holding back a U.S. recovery.

“One concern I have is that the recovery in the business sector continues to be restrained not just by geopolitical uncertainty and the need for further restructuring in some key sectors, but by caution on the part of investors and lenders,” he said in a speech to a bankers group.

Earlier this week, the Fed’s rate-setting Federal Open Market Committee said uncertainty in the run-up to war was a major reason for the latest economic sluggishness. But the Fed concluded that the imminent war made it impossible to comment on the likeliest near-term risks for the economy.

Oil prices hold the key
Stock prices ended Thursday with modest gains after a seesaw session that saw traders keep a close eye on war developments and particularly oil prices, which ended sharply lower in New York despite reports that several wells were on fire in southern Iraq.

Traders’ intense sensitivity to crude markets reflects the widespread belief that the price of oil is perhaps the most important economic variable likely to be affected by the outcome of the war.

“Probably the most important cost to the economy in the macroeconomic view is the higher cost of oil and the loss of confidence,” said Sung Won Sohn, chief economist for Wells Fargo. “In the case of a quick, decisive war the costs will not be so great. In fact we could see some boost to the economy in form of lower prices and higher consumer confidence.”

A recent analysis of likely economic consequences of a war with Iraq concluded that the price of oil was by far the biggest swing factor. Under a best-case scenario, the price of oil could fall below its recent long-term average of about $25 a barrel, boosting U.S. economic output by $40 billion over the next decade, according to the analysis by Yale economics professor William Nordhaus. A negative outcome, such as an oil boycott or regional destabilization that seriously disrupted world oil supply, could send prices soaring to $75 a barrel and cost the United States $778 billion over the next decade, Nordhaus said in the paper, published by the American Academy of Arts and Sciences.

The direct costs of a war on Iraq were estimated at $50 billion, compared with the inflation-adjusted $80 billion spent on the first Gulf war in 1991. In the seemingly unlikely event of a protracted ground conflict lasting about a year, Nordhaus offered an outside estimate of $140 billion, still less than 1.5 percent of the annual U.S. output, which is about $10 trillion.

“We fight these wars out of inventory, basically,” said Steven Green, chairman of the economics department at Baylor University.

The cost of occupying Iraq for the next five years or more is likely to outstrip the direct cost of fighting the war, said Nordhaus, who offered a range of $75 billion to $500 billion spread over the next decade. Still, earlier U.S. wars imposed far greater costs on the federal budget relative to the size of the economy, which is why those wars tended to stimulate economic activity.

The war in Iraq could have other costs which are harder to quantify. The U.S. decision to attack over the objections of once-close allies including Germany and France could make it harder for U.S. companies to do business in Europe.

Green, the Baylor professor, said he was most concerned that the war could spark a major terrorist attack against U.S. interests.

“A dirty bomb or something like that could have a potentially serious effect on durable goods consumption,” he said. “Even a truck bomb going off in a crowded shopping center would have a pretty serious effect on consumer confidence and investment.”