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Calculating the Uncertain
Subject Recession
Topic Productivity and Growth
Key Words Recession, Economic Growth, Budget Deficit
News Story

The possibility of war with Iraq is generating much discussion and speculation about its likely impact on the U.S. The first Gulf War was very costly, and resulting higher oil prices helped to push the U.S. into recession. The impact of a war on the U.S. economy would largely result from higher oil prices, lowered stock prices, changes in consumer spending and federal government spending. While economists are being asked to provide answers, there is sufficient uncertainty concerning how the war will play out that any answers provided are naïve guesses.

One assumption that is important to an analysis is how the war would progress. The 1990-1991 Gulf War was very short but there was some damage to Kuwaiti oil fields, causing oil prices to rise. Oil price increases are costly to the economy. Martin Baily, former chairman of the Counsel of Economic Advisors, estimates that each $10 increase per barrel of crude oil costs U.S. consumers about $120 billion a year. Higher oil prices would hurt the Japanese and European economies as well. If these economies slowed, there would be an additional effect on the U.S. resulting from reduced demand for U.S. goods.

A second area of concern is how government spending would be affected. Increased use of military manpower and material would boost government spending, providing some stimulus to the economy. Depending on the duration and strategy of the war, there could be a considerable outlay of dollars that would add to projected budget deficits. U.S. allies covered the major share of the cost of the Gulf War, but this is not likely to happen this time.

Macroeconomic Advisors LLC, a St. Louis forecasting firm, released a forecast of the macroeconomic consequences of a war with Iraq. Assuming oil prices rise initially by $15 the first quarter and decline thereafter, stock prices fall 6 percent and consumer confidence falls as well, economic activity would fall at a 0.7 percent annual rate for the first quarter and would lag predicted growth for the first 3 quarters of the year. Unemployment, resulting from a war, would be one-half percent higher than the no war scenario.

(Updated October 10, 2002)

Questions
1.

The above scenario assumes that the Federal Reserve leaves interest rates unchanged. What effect would decreased interest rates have on the economy? Rising interest rates?

2. The above scenario assumes that consumer spending would decrease as a consequence of reduced consumer confidence. Could the U.S. government stimulate consumer spending? Should it?
3. Should the cost of a war with Iraq and its consequence on the U.S. and world economies be an element in the debate over U.S. action? Why or why not?
Source John M. Berry, "Economists Weigh the Uncertainties Arising From War With Iraq," The Washington Post, September 21, 2002.

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