Evans On The Economy -- A Victory Without Spoils

Dec. 21, 2004
A Middle East win won't necessarily benefit the U.S. economy.

Although no one really knows what will happen in the Middle East later this year, it is becoming increasingly precarious to generate any macroeconomic forecast without considering some of the possible consequences. The main concern is not so much what happens in Israel, but George W. Bush's announced plan to invade Iraq later this year unless Saddam Hussein completely mends his ways. That stern warning might be enough to eliminate another war against Iraq, but based on past performance, it would not be good planning to ignore the situation. Anyone who has bought gas recently knows that gasoline prices have risen about 25 cents a gallon over the last two months. Some of this increase is seasonal. Nonetheless, most of the increase has stemmed from a $10 per barrel rise in benchmark crude oil prices. Analysts have not been hesitant about suggesting that the rise in oil prices stems directly from the increase in Middle East tensions. That certainly played a role, but in addition, some recent gains are due to the simultaneous recoveries in the U.S., Japanese, and European economies. Oil prices are likely to remain above $25 per barrel this year even if Middle East tensions abate. I expect to see isolated examples of gasoline prices above $2 per gallon again this summer. The Iraqi situation cannot be predicted with any substantial degree of accuracy, but it cannot be ignored either. The Bush Administration has publicized its plans to topple Hussein with a full-scale attack that will involve many ground troops. An optimistic assessment of the military strategy is the war will be won quickly, strong internal opposition to Saddam will materialize once it is clear we are serious about removing him from office, and the U.S. and free nations everywhere will welcome this important victory. Of course the outcome won't necessarily turn out this well, but even if it does, that might not be beneficial to the U.S. economy. After all, the economy failed to move forward after Desert Storm in spite of what was considered at that time an impressive victory. This time, demand is likely to be hampered by rising interest rates. It may sound curmudgeonly to interpose higher interest rates on this victory scenario, but consider what is likely to happen if the U.S. does decide to expand its military operations in the Middle East. The economic situation is much different than it was in early 1991. Then, the world economy was heading into recession; now, it is recovering. Oil prices had been unusually high by recent standards, then returned to normal levels; earlier this year, they were unusually low. Increased military expenditures will keep the Federal budget in deficit for an extended period. It is also likely that the dollar would drop, as was indeed the case after Desert Storm, hence reducing foreign saving. The combination of higher oil prices, a somewhat weaker dollar, and higher military expenditures would probably boost the inflation rate to the 3.5%-to-4% range. In turn, the combination of a recovering economy, higher inflation, and a drop in national saving will lead to a substantial increase in interest rates, which would retard the recovery in capital spending. The big increase in defense expenditures would thus provide a short-term boost to economic growth, but at the expense of slower growth afterward. While the defeat of Iraq and the abatement of Middle East terrorism would pay tremendous dividends in terms of the long-term security of the U.S. and the world, it probably would not help the U.S. economy -- particularly in view of the inflationary potential that currently exists because the Federal funds rate was cut to 1% below the recent rate of inflation. Thus whether the Fed tightens vigorously later this year or not, the current situation in the Middle East, both in Israel and Iraq, points toward higher inflation, higher interest rates and sluggish stock prices later this year. Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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