Cyclopedia Of Economics 1st edition

War I. War and the Business Cycle

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I. War and the Business Cycle

Peace activists throughout the world accuse the American administration of profit-motivated warmongering. More sophisticated types remind us that it was the second world war - rather than President Franklin Delano Roosevelt's New Deal - that ended the Great Depression. "Wag the Dog" is a battle cry in Europe implying that the United States is provoking yet another conflict in Iraq to restart its stalled economy and take the collective mind off an endless stream of corporate sleaze.

In the wake of the previous Gulf war, in the Spring 1991 issue of the Brookings Review, a venerable American economist, George Perry, wrote:

"Wars have usually been good for the U.S. economy. Traditionally they bring with them rising output, low unemployment and full use of industrial capacity as military demands add to normal economic activity." According to Perry, writing long before the dotcom euphoria and slump, war is counter-cyclical.

The National Bureau of Economic Research (NBER) Business Cycle Dating Committee tends to support this view. The strongest expansions were registered during and after major crises - the Civil War, the first and second world wars, the Korea War, throughout most of the conflict in Vietnam and immediately following Operation Desert Storm, the previous skirmish in Iraq.

In the wake of September 11, US military spending is already up one tenth and poised to continue its uptrend. Defense contractors and service industries, concentrated across the southern USA stand to undoubtedly benefit after a lean decade following the unwinding of the Cold War. GDP may grow by 0.6 percent this year based on $50 billion in war-related expenditures, project DRI-WEFA for MSN's Money Central.

This is an unrealistic price tag. According to the Cato Institute, Operation Desert Storm cost $80 billion (in 2002 dollars), the bulk of which was covered by grateful allies. This war may be more protracted, less decisive and its costs are likely to be borne exclusively by the United States. Postwar reconstruction in Iraq will dwarf these outlays, even allowing for extra revenues from enhanced oil production.

DRI-WEFA present a worst case scenario in which GDP falls by 2.2% over two quarters, the Fed Funds rate ratchets up to 6% to staunch inflation, and unemployment peaks at 7.8%. Recovery is unlikely in the first 18 months of this nightmarish script.

On the minus side, the budget deficit has already ballooned, crowding out lending to the private sector, stoking inflation and threatening to reverse the downtrend in interest rates. Edward Yardeni of Prudential has demonstrated how inflation has followed every single military conflict since 1800. Ultimately, taxes are likely to rise as well.

Yet, that war impacts the timing and intensity of the business cycle is by no means universally accepted.

In an International Finance Discussion Paper titled "Money, Politics and the Post-war Business Cycle" and published by the Board of Governors of the Federal Reserve system in November 1996, the authors, Jon Faust and John Irons, sweepingly dismiss "political effects on the economy". "If they exist" - they add - "they are small and difficult to measure with confidence."

David Andolfatto, from the Department of Economics of Simon Fraser University in British Columbia, Canada, in his "U.S. Military Spending and the Business Cycle" dated October 2001, quotes an email sent to him by one of his students:

"I heard someone say that the US government tends to 'find themselves in war' every time they are in a recession. This person also claimed that the increased government expenditures on war pulled the US out of each of the last few recession they've been in. Furthermore, this person said that the 'military industry' is one of the biggest industries in the US, which is why greater government expenditures on war always pull the US out of recessions ... the boom the US had in the last decade was in large part attributed to all their considerable military effort..."

Andolfatto then proceeds to demolish this conspiratorial edifice. Military spending per adult in the USA has remained constant at $2000 between 1947-2000. It actually declined precipitously from 15 percent of gross domestic product during the Korea War to 4-5 percent today. Military buildups - with the exception of the Gulf War - mostly happen during peacetime.

During the Unites States' recent spate of unprecedented prosperity in the 1990s, military layouts actually shrank. When they did expand in 1978-1987, the economy endured at least one serious recession (1979-1983). In reality, changes in military expenditures lag changes in GDP. Surprisingly, mathematical analysis reveals that GDP growth does not respond measurably to unexpected surges in military spending. Rather, military budgets swell when GDP suddenly increases.

But this is a minority view. Even economists who dispute the economic schools of shock-driven cycles admit that war does affect the economy. Theoretically, at least, government spending, investment decisions and consumer confidence should be affected.

Jonas Fischer at the Chicago Federal Reserve Bank claims that real business cycle models cannot account for the response to fiscal shocks of real wages and hours worked, unless they unrealistically assume that marginal income tax rates are constant and that increased government purchases are financed in a specific manner.

In any case, war, or a commensurate military buildup, do cause expansionary deficit-financed government purchases, employment, output and nonresidential investment to rise while real wages, residential investment and consumption fall. This is compatible with the predictions of neo-classical business cycle models.

There are longer-term effects. According to Martin Eichenbaum from Northwestern University, productivity in the manufacturing sector declines - though it rises in the private sector as a whole. Ultimately, the production of durable goods contracts and interest rates, having initially dropped, end up rising. Marginal income tax rates tend to mount post conflict.

Consumers and investors are inclined to postpone big-ticket decisions in times of uncertainty. Hence the adverse reaction of the capital markets to the recent crisis over Iraqi disarmament. With the exception of the Gulf War and the Cuban Missile Crisis, the Dow Jones Industrial Average has always crumbled in the face of hostilities, only to skyrocket when the situation stabilized and certainty was restored.

The DJIA went down 12 percent when the Korean War broke in 1953 - only to reverse the entire loss and climb yet another 18 percent in the following 3 months. After September 11, 2001 it plunged 14 percent and then clawed back the shortfall and soared an extra 21 percent by the yearend.

After the first victorious day in Operation Desert Storm, stocks surged by 4.6 percent on Jan. 17, 1991, by another 7 percent in the following 30 days and by a total of 25 percent in the next 2 years. According to Ned Davis Research, quoted by USA Today, the Dow has risen on average by c. 15 percent in the year after every triumphant excursion by America's military. Messier conflict, though - like the Vietnam War - induce no exuberance, it seems.

The Gulf War was preceded by a brief recession in the United States. The Dow lost one fifth of its value. Unemployment soared. House prices fell and so did retail sales. When the war erupted, business in shopping malls, car dealerships and airlines ground to a halt. The spike in oil prices added to their woes.

But the recession lasted merely nine months and ended officially a month before the actual invasion of Kuwait by Iraq. It was followed by the longest expansion on record. It affected both sides of the Atlantic. This, despite the fact that the economy was in bad shape long before Saddam's antics. Interest rates stood at about 8 percent, inflation was running at double the current rate and President George Bush Sr. raised taxes rather than lower them, as his son has done.

Was the quiver in 1991-2 induced by the war in Iraq - or by the contraction of defense and aviation industries following the end of the Cold War? Probably the latter.

But talking about a uniform trend in a country as vast as the United States is misleading. As Knight Kiplinger, editor-in-chief of the Kiplinger Letter notes, regions and industries in the USA have endured recessions even as the entire economy boomed.

So, is war good for business?

Depends on which economist you happen to ask. Some would say that war reflates the economy, re-ignites the economic engine, generates employment, increases consumption, innovation and modernization. Others, that it is merely a blip. The truth is out there but don't count on the dismal science to reveal it.

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