Iraq war may not boost economy

Lim Say Boon, Director, OCBC Investment Research, The Straits Times, Asia News Network, Singapore

Wars are a beastly business, but they are not necessarily bad for economies and stock markets.

In the tensions between the United States and Iraq, what may turn out to be more damaging to the global economy and equities is not a U.S.-Iraq war per se, but the prelude to such a war.

Yes, global markets could head lower in the near term. But when or if war eventually breaks out, it could actually propel the market into a huge counter-trend rally.

Indeed, given the markets' anticipatory nature, the bottom could be reached fairly soon before a Desert Storm Mark II. During the Gulf War of 1990-1991, oil prices peaked in September at nearly US$40 (S$71) per barrel, months before the U.S. hit Iraq.

And it is no coincidence that the Dow Jones Index bottomed early that October, and then rallied strongly in the lead-up to Desert Storm. It dipped sharply when the air attacks commenced, and then continued its rally within days when it became clear the U.S. would achieve its objectives easily.

Could war with Iraq go on to spark a sustainable bull market and end the threat of a double-dip recession in the U.S.?

Each conflict has its own set of very specific circumstances and accompanying market and economic backdrops. The massive spending during World War II probably did help end the Great Depression. And it also coincided with a rally in the Dow that took the index up ten-fold from 100 points in the early 1940s to 1,000 points in the early 1960s.

The Vietnam War involved massive spending by the U.S. government spanning over a decade. And yet, it coincided with a lost decade for the Dow. Is war may be good for the market?

Firstly, remember that wars are inflationary. The Vietnam War contributed to a period of high inflation in the U.S. -- with no "payback" in the form of offsetting lower costs through, say, cheaper oil, as is possible at the end of "regime change" in Iraq.

The deficit spending on the Vietnam War pushed U.S. inflation from just over 1 percent around the Gulf of Tonkin attacks in 1964 to nearly 13 percent just before the fall of Saigon.

The U.S. prime lending rate went from around 4.5 percent at the start of the Vietnam War to 12 percent in late 1974. And this was accompanied by a period of low growth and recession even at the start of 1970.

And of course, the same dynamics could strangle the U.S. economy and equity markets today with regard to Iraq, if the conflict spills over into a widespread Middle East quagmire.

But if you are looking at a short, sharp conflict with decisive victory for the U.S., you may refer to presidential economic adviser Lawrence Lindsey, who put the cost at between U.S.$100 billion and U.S.$200 billion. That's approximately 1 percent to 2 percent of U.S. gross domestic product. In a deflationary environment,that could prove more helpful than harmful to the economy.

Indeed, those who warn that war with Iraq could prove economically disastrous for the U.S. are largely speaking about the effects of a prolonged prelude to war, rather than war itself.

And this prelude to war is already doing tremendous damage by raising oil prices, taking spending power out of the pockets of consumers and undermining confidence.

But if the price of oil is one of the transmission mechanisms by which damage is inflicted on the economy, then the flip side of the coin is arguably that successful "regime change" in Iraq might offer "payback" for the money spent on war through lower oil prices.

This is not to suggest that the U.S. is going after Iraqi President Saddam Hussein for oil. But Iraqi oil reserves are the second-largest in the world after Saudi Arabia, and the country is only producing a fraction of what it could.

And if there is successful "regime change" in Iraq, presumably the regime after Saddam will be favourably disposed towards opening up the economy and paying for rebuilding through pumping out a lot more oil.

Lower oil prices mean lower costs for U.S. companies, indeed for everybody. It will help boost profitability, offset the inflationary effects of war and reconstruction spending, and boost economic activity.

But be wary of the glib conclusion that this could then trigger a new bull market. The long rally in the Dow that started in 1943 came after some 25 years of wide fluctuations for the index around the 100-point resistance.

Conversely, the stagnation in the Dow that coincided with the Vietnam War also came after a blistering 20-year bull run that took the Dow from 100 points to 1,000. Where are we today?

By the start of 2000, the Dow had just completed another massive 17-year rally that took it from 1,000 to 10,000 points. And along with overvalued stocks, there is massive over- investment for the economy to digest.

I wouldn't count on a counter-trend rally on the back of war with Iraq being sustained against more powerful super-cycle trends.