http://www.economicscenarios.com

The Economic Costs of a War in Iraq

Presentation to:

ANU — April 2003

Warwick J McKibbin

ANU and The Brookings Institution

And

Andrew Stoeckel

Centre for International Economics

Overview

The purpose and methodology of the study Other studies The modeling framework used Budgetary Costs of the war Oil market Equity risk premia Two Scenarios

A “short war” A “long war”

Summary and Conclusion

Some Background

Cost of the war is not just the budgetary costs just as the benefits of the war will not not be found in the budget

One measure of costs are the costs to the defence budget, but this paper attempts to go further by analyzing the global economic impacts of the Iraq war.

The Approach

The approach is to use a variety of estimates to generate 2 scenarios which are plausible

The scenarios are A short war A longer war

The key inputs are the budgetary changes The impact on oil markets The impact on investor confidence globally

Other Studies (all US based)

Direct budgetary costs CBO (2002) House Budget Committee (2002) Nordhaus (2002)

Broad Macroeconomic Costs to the US Nordhaus (2002)

– Based on estimates from the 1991 Gulf War

Some Useful Facts about cost of War

Direct Budgetary costs to US budgets of wars have fallen WWII cost 130% of GDP Korea cost 15% of GDP Vietnam cost 12% of GDP First Gulf War cost 1% of GDP

BUT the official estimated costs of wars are always significantly underestimated

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

Some Useful Facts About the Cost of Peace

Only Nordhaus tries to estimate the costs after the war is over.

Some Useful Facts About the Cost of Peace

Occupation – need to avoid conflict between the Kurdish Shi’a and Sunni groups Based on Bosnia, Pollack (2002) estimates 250,000 to 300,000

peacekeepers Various estimates but based on experience in Balkans, South

Korea etc plausible that between $75 billion and $500 billion for a decade

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

Some Useful Facts About the Cost of Peace

Reconstruction and Nation Building Minimum requirements:

– Report on the UN estimated $22 billion in 1991 prices ($30 billion current) to restore Iraq to pre first Gulf war infrastructure

– Nordhaus back of the envelope to get GDP per capita in Iraq up to Egypt ($1200 per capita) then about $30 billion

Marshall Plan equivalent– Cost the US $450 billion in today’s dollars or $2000 per person over

4 years– This would cost $75 billion

Overall estimate for successful nation building could be $30 to $105 billion

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

Some Useful Facts About the Cost of Peace

Humanitarian Assistance $1 billion to $10 billion

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

Some Useful Facts About the Cost of Peace

Who Will Pay? Oil

– Currently Iraq produces 2.7 million barrels per day– Has roughly 10% of world reserves– But require between $10 billion to $80 billion is investment to get oil

infrastructure in place Current debts

– $100 billion in Kuwaiti claims from Gulf War 1– Another $200 billion in other claims including from France and

Russia for oil investments, arms sales from the 1980s

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

Some Useful Facts About the Cost of Peace

Will the US pay? We assume that they will but note

– Total US foreign aid budget is $15 billion annually– By Sept 2002, Afghanistan war has cost the US $13 billion in direct

war costs and $10 million in reconstruction and humanitarian aid

Source: Nordhaus (2002) “The Economic Consequences of a War in Iraq”

http://www.economicscenarios.com

The Modeling Framework Used

The G-Cubed model

www.gcubed.com

The G-Cubed Model

Countries (in this version)– United States– Japan– Australia– Europe– Rest of OECD– China– Eastern Europe and Former Soviet Union– Oil Exporting Developing Countries– Other non Oil Exporting Developing Countries

The G-Cubed Model Sectors

… Electric Utilities

… Gas Utilities

… Petroleum Refining

… Coal Mining

… Crude Oil and Gas Extraction

… Other Mining

… Agriculture, Fishing and Hunting

… Forestry and Wood Products

… Durable Manufacturing

… Non Durable Manufacturing

… Transportation

… Services

The G-Cubed Model

Key features Based on explicit intertemporal optimization by households and

firms in each economy in a dynamic setting Substantial sectoral dis-aggregation with macroeconomic structure Explicit treatment of financial assets with stickiness in physical

capital differentiated from flexibility of financial capital Short run deviation from optimizing behavior due to stickiness in

labor markets, myopia Model (version 48e) has 7170 equations with 153 jumping (co-

state) variables and 227 state variables

Based on Simple Neoclassical model in the long run

Plus stickiness in the short run Adjustment costs in capital accumulation Some agents re-optimize while others use long run optimal

rules of thumb Money required for transactions Nominal wages adjust gradually

Agents and Markets

AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money

Bond Equity Foreign Exchange

The Scenarios

1) Baseline 2002 to 2100 Assumptions about

– population growth by country– Productivity growth by sector catching up by 2% per year to US

leading sector– Given tax rates, monetary growth rates etc in all countries

Solve for rational expectations equilibrium for the global economy

The Scenarios

2) Short War Fiscal costs for 3 year Oil price spike 90% (to $47 per barrel) in 2003, 45% in 2004

and then below base thereafter Uncertainty resolved after one year

3) Long War Fiscal costs for 10 year Oil price spike for 2 years and then below base thereafter Uncertainty resolved in 5 years

Budgetary costs of a war

Conflict phase Rebuilding phase 2003–07 2008–12

United States 1.3 0.8Japan 0.2 0.8Australia 1.0 0.5Europe 0.5 0.5Other OECD 0.2 0.2East Europe & Russia 0.2 0.2OPEC 2.0 0.0

Conflict phase Rebuilding phase 2003 2004–05

United States 1.3 0.8Japan 0.2 0.8Australia 1.0 0.5Europe 0.5 0.5Other OECD 0.2 0.2East Europe & Russia 0.2 0.2OPEC 2.0 2.0

Extra government spending from a war with Iraq under two scenarios (annual percent of GDP)

Short war Long war

Rising oil prices

‘Average’ price US$25 (2000 prices) per barrel

Some price increase already

10

14

18

22

26

30

34

38

$US

per b

arre

l

Jan 1985 Jan 2003Jan 1991

Gulf war

West Texas Intermediate Crude Oil Prices

Oil price - long and short war

Short war scenario– Price spike 90 per cent above

baseline in 2003 then falls to 20 per cent below baseline

Long war scenario– The 90 per cent price spike

above baseline takes longer to dissipate and prices stay above baseline for more than a decade.

-20.00.0

20.040.060.080.0

100.0

2002 2006 2010 2014 2018 2022

Long war scenario (percentage deviation from base of $25 per barrel)

-20.00.0

20.040.060.080.0

100.0

2002 2006 2010 2014 2018 2022

Short war scenario (percentage deviation from base of $25 per barrel)

Risk Shocks long and short war

Short war – equity risk premium rises by 5% in 2003 and then returns to base in 2004

Long War – equity risk premium rises by 5% above base in 2003

4% above base in 2004, 3% above base in 2005, 2% above base in 2006, 1% above base in 2007 back to base in 2008

Short war: more government spending

Initial boost to GDP

But extra spending crowds out private activity

Slowdown in investment as extra borrowing and expectations of slowing economy

-6.0

-4.0

-2.0

0.0

2.0

2002 2006 2010 2014 2018 2022

Real investment, USA (per cent change from base)

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

GDP

Consumption

Real GDP and consumption, USA (per cent change from base)

Short war more government spending

Few implications for long term real interest rates

Other economies similarly affected

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

AustraliaJapan

Europe

Real GDP: Japan, Australia and EU (per cent change from base)

-0.5

0.0

0.5

2002 2006 2010 2014 2018 2022

Long real (percentage point change)

Interest rates, USA (per cent change from base)

Short war - temporary oil shock

Negative income effect leads to a drop in investment causing a drop in GDP

-3.0-2.0-1.00.01.02.0

2002 2006 2010 2014 2018 2022

Investment

GDP

Real GDP and investment (per cent change from base)

Short war - temporary uncertainty

Uncertainty increases the required rate of return on capital

Implies the capital stock is too large so investment falls

– and with it so does GDP

Equity prices fall in response

-4.0

-2.0

0.0

2.0

2002 2006 2010 2014 2018 2022

Equity prices, USA (percentage point deviation from baseline)

-1.0

-0.5

0.0

0.5

2002 2006 2010 2014 2018 2022

Europe

USA

Japan

Real GDP: Japan, USA and EU (per cent change from base)

Short war - combined effects

Overall, real GDP 1 per cent lower below baseline in 2006

… and real investment over 8 per cent below before recovering

-10.0-8.0-6.0-4.0-2.00.02.0

2002 2006 2010 2014 2018 2022

Real investment, USA (per cent change from base)

-2.0

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

GDP

Consumption

Real GDP and consumption, USA (per cent change from base)

Short war - combined effects

Japan, Australia and Europe less effected

Share markets could be 8 per cent lower in 2003 than otherwise before recovering

-10.0-8.0-6.0-4.0-2.00.02.0

2002 2006 2010 2014 2018 2022

Equity prices, USA (percentage point change from baseline)

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

JapanEurope

Australia

Real GDP (per cent change from base)

Long war - extra government spending

Under a long war, effects are deeper and more protracted

– nearly 2 per cent below barrier

… and real investment decline is deeper and last much longer

-10.0-8.0-6.0-4.0-2.00.02.0

2002 2006 2010 2014 2018 2022

Real investment, USA (per cent change from base)

-2.0

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

GDP

Consumption

Real GDP and consumption, USA (per cent change from base)

Long war - extra government spending

Extra spending crowds out private investment as extra sales of bonds sends long rates up by nearly 50 basis points in 2003

-0.5

0.0

0.5

2002 2006 2010 2014 2018 2022

10 year bond rate

Real interest rates (percentage point change)

Long war - combined effect

Long term effect is double the shot term war effect and lasts longer– … most of effect is from extra

government spending– real GDP 2 per cent below base

… and real investment is double the decline of a short war and takes longer to recover

-16.0-12.0-8.0-4.00.04.0

2002 2006 2010 2014 2018 2022

Real investment, USA (per cent change from base)

-2.0

-1.0

0.0

1.0

2002 2006 2010 2014 2018 2022

GDP

Consumption

Real GDP and consumption, USA (per cent change from base)

Long war - combined effect

Australia adversely affected due to higher government spending than Europe (France and Germany out) and Japan

-16.0-12.0-8.0-4.00.04.0

2002 2006 2010 2014 2018 2022

USA

Japan

Equity prices, USA (percentage point change from baseline)

-3.0-2.0-1.00.01.0

2002 2006 2010 2014 2018 2022

Australia Japan

Europe

Real GDP (per cent change from base)

Loss in GDP

Short war Long war2003 2003–10 2003 2003–10

USA 34 491 65 1470Japan 33 122 39 429Australia 2 18 4 69Europe 47 157 67 748Rest of OECD 7 51 10 149

China 3 2 4 56Non-oil developing countries 36 129 35 469Eastern Europe and Russia 11 73 15 183Total 173 1043 237 3573

Loss in real GDP: Japan,$US billion (year 200 values)

Summary

A long war could wipe up to 2 per cent off world GDP by 2005 with costs persisting for a decade.

Even a short war could cost the world 1 per cent of GDP per year over the next few years.

– The cumulative cost to 2010 could be over US$1000 billion, half of which is borne by the USA.

Investment is one of the main casualties of war.

Equity markets will be under pressure.

Exchange rates of major economies may not be greatly affected if there is global participation in the war and the rebuilding of Iraq.

Summary

Critical question is what the baseline would actually be if there wasn’t a war?