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The Economic Costs of a War in Iraq

The Economic Costs of a War in Iraq. Warwick J McKibbin ANU and The Brookings Institution And Andrew Stoeckel Centre for International Economics. Presentation to: ANU — April 2003. Overview. The purpose and methodology of the study Other studies The modeling framework used

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The Economic Costs of a War in Iraq

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  1. The Economic Costs of a War in Iraq Warwick J McKibbin ANU and The Brookings Institution And Andrew Stoeckel Centre for International Economics Presentation to: ANU — April 2003

  2. 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

  3. 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.

  4. 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

  5. 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

  6. 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”

  7. Some Useful Facts About the Cost of Peace • Only Nordhaus tries to estimate the costs after the war is over.

  8. 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”

  9. 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”

  10. 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”

  11. 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”

  12. 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”

  13. The Modeling Framework Used The G-Cubed model www.gcubed.com

  14. 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

  15. 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

  16. 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

  17. 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

  18. Agents and Markets • AGENTS MARKETS • Households Goods & Services • Firms Factors of Production • Governments Money Bond Equity Foreign Exchange

  19. 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

  20. 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

  21. Budgetary costs of a war Extra government spending from a war with Iraq under two scenarios (annual percent of GDP) Long war Short war Conflict phase Rebuilding phase 2003 2004–05 United States 1.3 0.8 Japan 0.2 0.8 Australia 1.0 0.5 Europe 0.5 0.5 Other OECD 0.2 0.2 East Europe & Russia 0.2 0.2 OPEC 2.0 2.0 Conflict phase Rebuilding phase 2003–07 2008–12 United States 1.3 0.8 Japan 0.2 0.8 Australia 1.0 0.5 Europe 0.5 0.5 Other OECD 0.2 0.2 East Europe & Russia 0.2 0.2 OPEC 2.0 0.0

  22. West Texas Intermediate Crude Oil Prices 38 Gulf war 34 30 26 $US per barrel 22 18 14 10 Jan 1991 Jan 2003 Jan 1985 Rising oil prices • ‘Average’ price US$25 (2000 prices) per barrel • Some price increase already

  23. Short war scenario (percentage deviation from base of $25 per barrel) 100.0 80.0 60.0 40.0 20.0 0.0 -20.0 2002 2006 2010 2014 2018 2022 Long war scenario (percentage deviation from base of $25 per barrel) 100.0 80.0 60.0 40.0 20.0 0.0 -20.0 2002 2006 2010 2014 2018 2022 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.

  24. 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

  25. Real GDP and consumption, USA (per cent change from base) 1.0 Consumption 0.0 GDP -1.0 2002 2006 2010 2014 2018 2022 Real investment, USA (per cent change from base) 2.0 0.0 -2.0 -4.0 -6.0 2002 2006 2010 2014 2018 2022 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

  26. Interest rates, USA (per cent change from base) 0.5 Long real (percentage point change) 0.0 -0.5 2002 2006 2010 2014 2018 2022 Real GDP: Japan, Australia and EU (per cent change from base) 1.0 Europe 0.0 Australia Japan -1.0 2002 2006 2010 2014 2018 2022 Short war more government spending • Few implications for long term real interest rates • Other economies similarly affected

  27. Real GDP and investment (per cent change from base) 2.0 Investment 1.0 0.0 GDP -1.0 -2.0 -3.0 2002 2006 2010 2014 2018 2022 Short war - temporary oil shock • Negative income effect leads to a drop in investment causing a drop in GDP

  28. Real GDP: Japan, USA and EU (per cent change from base) 0.5 USA 0.0 -0.5 Japan Europe -1.0 2002 2006 2010 2014 2018 2022 Equity prices, USA (percentage point deviation from baseline) 2.0 0.0 -2.0 -4.0 2002 2006 2010 2014 2018 2022 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

  29. Real GDP and consumption, USA (per cent change from base) 1.0 Consumption 0.0 -1.0 GDP -2.0 2002 2006 2010 2014 2018 2022 Real investment, USA (per cent change from base) 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 2002 2006 2010 2014 2018 2022 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

  30. Real GDP (per cent change from base) 1.0 Japan Europe 0.0 Australia -1.0 2002 2006 2010 2014 2018 2022 Equity prices, USA (percentage point change from baseline) 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 2002 2006 2010 2014 2018 2022 Short war - combined effects • Japan, Australia and Europe less effected • Share markets could be 8 per cent lower in 2003 than otherwise before recovering

  31. Real GDP and consumption, USA (per cent change from base) 1.0 Consumption 0.0 -1.0 GDP -2.0 2002 2006 2010 2014 2018 2022 Real investment, USA (per cent change from base) 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 2002 2006 2010 2014 2018 2022 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

  32. Real interest rates (percentage point change) 0.5 10 year bond rate 0.0 -0.5 2002 2006 2010 2014 2018 2022 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

  33. Real GDP and consumption, USA (per cent change from base) 1.0 GDP 0.0 Consumption -1.0 -2.0 2002 2006 2010 2014 2018 2022 Real investment, USA (per cent change from base) 4.0 0.0 -4.0 -8.0 -12.0 -16.0 2002 2006 2010 2014 2018 2022 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

  34. Real GDP (per cent change from base) 1.0 Europe 0.0 -1.0 -2.0 Australia Japan -3.0 2002 2006 2010 2014 2018 2022 Equity prices, USA (percentage point change from baseline) 4.0 0.0 Japan -4.0 -8.0 -12.0 USA -16.0 2002 2006 2010 2014 2018 2022 Long war - combined effect • Australia adversely affected due to higher government spending than Europe (France and Germany out) and Japan

  35. Loss in real GDP: Japan,$US billion (year 200 values) Short war Long war 2003 2003–10 2003 2003–10 USA 34 65 1470 491 Japan 33 122 39 429 Australia 2 18 4 69 Europe 47 157 67 748 Rest of OECD 7 51 10 149 China 3 2 4 56 Non-oil developing countries 36 129 35 469 Eastern Europe and Russia 11 73 15 183 Total 173 1043 237 3573 Loss in GDP

  36. 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.

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

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