The Hindu Business Line : World waits for word on war

The question is whether the persistent global economic slowdown is because of the prolonged stalemate in Iraq or due to other factors. Mr Alan Greenspan and the Federal Reserve have taken the view that the economy's progress was halted by the renewed focus on war. They believe that once this uncertainty is removed, the economy will continue its recovery path, says V. Anantha-Nageswaran

IN A way, it was somewhat heartening to see global equities (particularly Europe) rally strongly on rumours that the CIA was negotiating with Iraqi military officials on the terms of surrender of the latter to the US. After all, the market was celebrating the prospect of a `peaceful' end to the stand-off over Iraq. The rest of the world does not have to give up on the financial market place as the civilisation's dark corner, yet. The broader question is whether the persistent global economic slowdown is necessarily because of the prolonged stalemate on dealing with Iraq or is it due to other economic factors.

Mr Alan Greenspan and the Federal Reserve have taken the view that the economy was negotiating its soft spot well as it entered into 2003 and that the progress has been halted by the renewed focus on war and its uncertain aftermath. Consequently, they believe that once this uncertainty is removed, the economy would continue its recovery path. This author has been sceptical of this belief and is now joined by many others. For example, at the turn of the year, the commonly held belief on Wall Street was that the Federal funds rate would go up this year. Discussion centred on the magnitude and the timing of such a rate rise. Now, many are talking about the Federal funds rate, currently at 1.25 per cent, going down and are discussing if it would happen in March or May.

If the first quarter economic slowdown is attributable solely to war-related anxieties, then once the war is over, its related anxieties should disappear. There should be no need to lower rates. Hence, this author believes that the rising chorus of forecasts for lower rates suggests that the economic recovery would be slow to arrive and that the process of wringing out the excesses of the bubble-soaked US economy has more distance to cover. Further, the approach to the war has weakened the hopeful presumption that war related uncertainties should disappear at the onset of war.

Hence, we deal with war-related uncertainties in two parts. In the first part, we will deal with the issue of whether risk appetite would return after the war. In the second part, we will examine the economic forces that hold back a normal recovery, war or not.

Consequences of a military victory

It is true that the mere dropping of the first bomb on Iraq would end the uncertainty of whether there would be a war or not, but it could give rise to fresh uncertainties about its consequences. `War optimists' counter that a massive military victory or a surrender would be such a massive triumph for the US President that the resultant confidence boost would be of significant proportion for capital markets, for businesses and consumers that it would boost the economy considerably. A virtuous circle would be set in motion and it would be unstoppable.

While one should never discount the power of optimism, we need to examine the foundations of such a premise. First, if the war results in a `massive military victory', is it not possible that it will stoke anger in the Arab world, focus their anger on the US, Britain and Spain and raise the risk of terrorist attacks? A crushing defeat simply raises the sense of impotence of vast swathes of Muslim population, that the terrorists have sought to tap in the past, in the face of such brute force and not only could popular feeling towards the US turn more bitter (if there is any scope), but other Arab governments also become more ambivalent towards the US, wondering if they would be next in line.

In fact, Dr Paul Krugman, writing in The New York Times, poses an interesting question: If the war ended with a massive military victory for the US, would it not raise questions over the very rationale for the war? That is, if the Iraqi regime really possessed weapons of mass destruction and had the delivery capability, it cannot result in a quick and easy victory. If the latter was achieved, then would it not be reasonable to conclude that they really had neither weapons of mass destruction nor the capability to deliver them? Then, what was the battle for? He sums it up well: "... more and more people now realise that even if all goes well at first, it will have been the wrong war, fought for the wrong reasons — and there will be a heavy price to pay" (The New York Times, March 14).

Let us turn to the economic effects of a massive military victory. This administration will have no qualms over splitting the decades old alliance with Germany and France in retribution for their stance on the war. Furthermore, it would be emboldened to pursue its policy of polarising the world into `ours and theirs'. Second, the President, basking in temporary glory, would be emboldened to push through his tax cuts (perhaps, add some more billions to it) and damage the US fiscal situation almost irreparably. These moves, together and in isolation, would raise economic tensions and cause interest rates to rise in the US with disastrous consequences for mortgage holders and for the corporate sector. To add, it would make US equities look more expensive than they already are.

Consequences of a prolonged conflict

On the other hand, one does not have to be super-intelligent to divine the consequences were the war to be prolonged and victory turns out to be neither quick nor massive. The price of oil will rise further and the global economy will not just trip into recession but plunge into it. The recent run-up price of oil has perhaps already caused enough damage to both consumers and producers in the US. Petrol prices have risen 60 per cent since mid-2001 and raw material price inflation is at 30 per cent while the inflation rate for finished goods is around 3 per cent. Producers' margins are being squeezed hard. As the US private sector hurts, it translates into adversity for the global economy that is bereft of an alternative growth engine.

Equity markets will tryst with oblivion and most of the financial sector jobs will be in jeopardy. East Asia — with a large external oil dependence — would see itself revisiting the horrors of the crisis of 1997-98 even though the threat looks somewhat remote now. Those of us who have only read about the global depression of 1929-35 would have the `rare privilege' of experiencing one.

Thus, neither scenario makes for a rose-tinted view of the world. The former (a seemingly easy US victory) would cause long-term economic damage while the latter scenario (a messy war) would wreak more immediate and lethal havoc.

Consequences of the `third way'

The only way both sets of negative possibilities could be avoided is for the present Iraqi regime to walk into exile with or without disarming and for the US allied forces to discover huge stacks of weapons of mass destruction. Then, they can show the world that they were correct and that they achieved their goals the way the world wanted only because they dared to threaten deployment of massive force.

This would not only be personally very popular for Mr Bush but also positive for the global economy as it would significantly reduce the risk of terror and one of its sources of weapons supply. Credibility of both Mr Tony Blair and Mr Bush would rise. Confidence would return and risk-appetite would increase. Risky assets such as equities would appreciate and risk-free assets such as government bonds would see their prices drop. Western stock markets will have their best chance to break the three-year downturn. The allies would then turn their attention to other benefactors of global terror.

Too early to celebrate

Thus, it is not clear that the optimism that global equities chose to latch on to on Thursday and Friday is well founded and sustainable. Hence, one would be better off still keeping one's safe assets and buying into them in periods of weakness such as the one witnessed in the last two days. Spot gold shed nearly USD20 in these two days. Yield on the US 10-year Treasury note jumped from around 3.55 per cent to 3.70 per cent. The euro weakened from $1.108 to $1.074.

If our sombre assessment above is correct, one should treat the sell-off in safe-haven assets such as the euro, gold and government bonds (non-dollar, preferably) as opportunities to add them further to one's investment portfolio.

What about economic issues?

This article began with the promise of examining the question of a return to a normal world in two parts. One was whether the beginning or the end of an armed conflict would signal a return to a more normal world and the second was whether there were economic forces that would hold back a robust recovery in capital spending and economic growth.

In this piece, we have argued that the mere resolution of the question of whether there would be a military conflict or not would not result in dissipation of uncertainties.

Indeed, the more one thinks about it, the more one feels that it would be hard to disentangle the effect of the polarised and divisive global politics on the global economy from the effect of the stock market and credit bubble of the nineties.

Therefore, the second part of the question — even assuming an implausibly benign impact of the war on the world — as to whether the post-bubble adjustment would be invariably more drawn out than is currently assumed will be taken up in the next column. Just to preview the conclusion, before the evidence is presented, the author believes that the answer is in the affirmative.

(The author is Director of Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. The views are personal. Feedback may be sent to anantha@nageswaran.com)

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