Attacking Iran/Syria Would Crash the US Economy
by Bonddad, Sat Jul 22, 2006 at 09:51:59 AM EDT
I had the extreme displeasure of listening to a few minutes of the Sean Hannity radio show yesterday. All of his guests were pushing for an attack on Iran, Syria or both. These opinions join the chorus of other rightwing pundits who are pushing for an escalation of military activities. No one is looking at the possible economic implications of increased military conflict. What I will clearly demonstrate is the US economy cannot withstand an escalation of military activities and such a course will in fact crash the US into a recession at best or depression at worst.
As a consequence, a sustainable, non-inflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past three years to a pace more consistent with the rate of increase in the nation's underlying productive capacity.
In particular, the central tendency of those forecasts is for real GDP to increase about 3-1/4 percent to 3-1/2 percent in 2006 and 3 percent to 3-1/4 percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4-3/4 percent and 5 percent, close to its recent level.
There are several reasons for the expected slowdown, but the most important reason is the Fed's policy of rate hikes over the last year and a half. Conventional economic thought states it takes 12-18 months for these rate increases to move completely through the economy. That means last months rate hike won't completely impact the economy until early next summer. This does not include the cumulative impact of all the preceding rate hikes. In short, there is a fairly large amount of impact still left in the rate increases that has yet to fully effect the economy. In addition, the 50+ straight months of consumer spending combined with the increase in total consumer debt from 70% of GDP in 2001 to 90% in the first quarter of 2006 adds weight to the slowdown scenario, especially when consumer spending accounts for 70% of US GDP growth. Finally, there is the housing market slowdown. This has been a primary driver of the current expansion as both a jobs engine and source for new consumer funds. In short, there are a lot of reasons why the general economic consensus is for a gradual slowdown in late 2006-07.
The Federal Reserve is attempting to engineer a "soft landing", meaning they are trying to slow the economy down without starting a recession. By gradually raising interest rates, the Federal Reserve is "tapping on the economic breaks", hoping to slow the economy down to a slower speed. However, increasing the scale of the war would be akin to jamming of the breaks, halting any economic growth. Attacking Iran or Syria would first spike oil prices which are already having a negative impact on the economy. Next, increasing the scope of military activity would worsen and already dangerous fiscal situation.
In his recent testimony before Congress, Fed Chair Bernanke highlighted the effect of higher oil prices on inflation:
As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol.
The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation.
However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook.
A weekly chart of oil indicates very clearly that crude oil prices are in a one and a half year bull market. The reasons are simple. As the Chinese and Indian economies have expanded, they have increased their oil demand. At the same time, the supply of oil has remained constant. Increased demand plus constant supply equals higher prices. A US attack in the Middle East would increase political tensions in an already tense region. This would send oil prices higher, adding to US inflationary pressure.
In addition, higher oil prices would further crimp US consumer spending. Again, Fed Chair Bernanke highlighted this in his recent Congressional testimony:
In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes.
As documented by the Census Bureau's median income numbers, the Federal Reserve's Survey of Consumer Finances 2001-2004 and the Bureau of Labor Statistics, inflation adjusted wages for US workers have not increased for the duration of this expansion, even after the US economy achieved the economically significant 5% level of "full employment." Higher energy prices are taking a larger portion of a stagnant pie, forcing consumers to spend less on other items. As Bernanke observed, higher energy prices negatively impact US consumer spending. They do this is two ways. The first is the actual crimping of a consumer's budget as he spends more money on energy. Secondly, there is the psychological impact of higher oil prices which depress consumer sentiment and by extension consumer spending. Because the US is heavily dependant on consumer spending for GDP growth, an oil price shock caused an expansion of US military activities would seriously hamper US economic growth by slowing consumer spending and depressing consumer sentiment.
Secondly, increasing the scope of US military activities would worsen an already terrible fiscal situation. On July 13, the Congressional Budget Office issued a report detailing total US military costs for the War in Iraq:
The Congress has appropriated $432 billion for military operations and other activities related to the war on terrorism since September 2001. According to CBO's estimates, from the time US forces invaded Iraq in March 2003, $290 billion has been allocated for activities in Iraq.
The CBO also provided the cost estimates of two scenarios. The first scenario was for a rapid redeployment of US troops from the region. The CBO estimated this would cost an additional $166 billion over 2007-2016. This is an unrealistic cost appraisal of expanding the US' war efforts. The CBO also estimated costs of a less rapid redeployment of troops at $368 billion for 2007-2016. Considering the war effort has already cost $290 billion for three years, this number may be low. However, it makes the point.
Expanding the effort would greatly strain US finances. According to the Congressional Budget Office defense spending increased from $306 billion in 2001 to $493 billion in 2005. An escalation in military activity would obviously increase these numbers.
An increase in defense spending would exacerbate the increasing federal debt situation. According to the Bureau for the Public Debt the yearly total debt issued for 2002-2004 was (in billions and respectively) $555, $596, and $553. With three months left in fiscal year 2005, the current total is $468 billion. The facts are clear; increasing the scale of US military operations would increase the US Federal debt.
In conclusion, expanding the US military actions in the Middle East would increase strain on the US fiscal situation. It would also increase oil prices, which would in turn increase inflationary pressures and decrease US consumer spending. All of this would occur at a time when the Federal Reserve is attempting the incredibly difficult task of engineering an economic soft landing. All of these combined shocks could negatively impact an economy that is already on shaky financial footing. In short, this is not a good idea.