SINCE THE IRAQ war began, oil prices have gone from about $25 a barrel at the outset to more than $90, and as this book goes to press, they are rising still higher.1 Americans have felt it at the gas pump and so has everyone else. Cooking fuel prices are higher in Indonesia and bus fares are more expensive in Ethiopia. But it does not stop there. Because of the knock-on secondary effects, higher oil prices affect almost every aspect of an economy. In oil-importing countries like the United States, higher oil prices lead to larger trade deficits and inflationary pressures. Central banks often respond to these pressures by raising interest rates. Since governments then have to spend more on importing oil and on interest payments on outstanding debt, it becomes harder to balance their budgets. Higher interest rates also lead to lower investment and consumer spending, declines in share prices, and a slowing of the economy. In America, the war has hurt the economy in other ways. This chapter attempts to identify these macroeconomic costs and, where possible, quantify them.
First, however, we need to dispel the common myth that wars are good for the economy. This idea gained prominence in World War II. America (and much of the rest of the world) had been in a depression for years. There was a problem of insufficient demand. The economy’s potential supply—what it could produce, if everyone were fully employed—exceeded what people were willing to buy, and so the economy stagnated and unemployment was high. World War II created a demand for tanks and armaments; the economy ran at full steam; everyone who wanted a job could get one—and the war even demanded that those who could work two shifts do so.
Today, no serious economist holds the view that war is good for the economy. The economist John Maynard Keynes taught us how, through lower interest rates and increased government spending, countries can ensure that the peacetime economy operates near or at full employment. But money spent on armaments is money poured down the drain: had it been spent on investment—whether on plants and equipment, infrastructure, research, health, or education—the economy’s productivity would have been increased and future output would have been greater.
The question is not whether the economy has been weakened by the war.2 The question is only by how much. Where you can put a figure on them, the costs are immense. In our realistic-moderate scenario outlined in this chapter, they total more than a trillion dollars.
Oil
MANY PEOPLE AROUND the world, not just in the Middle East, believe the U.S. government went to war because it wanted to get its hands on Iraqi oil.3 We aren’t going to discuss their arguments here. It is enough to say that if America went to war in the hope of securing cheap oil, we failed miserably. We did however succeed in making the oil companies richer. Exxon-Mobil and other oil companies have been among the few real beneficiaries of the war, as their profits and share prices have soared.4 Meanwhile, the economy as a whole has paid a high price.
To estimate how high a price, we need to answer three questions: How much of the increase in the price of oil can be attributed to the war? What have been the direct costs to the U.S. economy from these price increases? And what have been the secondary effects—the effects on the overall macroeconomy?
Oil prices started to soar just as the war began, and the longer it has dragged on, the higher prices have gone. This certainly suggests the war has something to do with the rising prices. On this, almost all oil experts agree. But what fraction of the total price increase is due to the war? To answer this, we need to ask: What would the price have been had there been no war?5
Futures markets—which summarize what buyers and sellers of oil contracts think prices will be in a year or more—provide some insight. Before the war, they thought prices would remain in the range that they had been, $20 to $30, for the next several years.6 Futures markets work on the basis of “business as usual,” that is, they assume nothing out of the ordinary is going to happen. The war in Iraq was the most notable out of the ordinary event at the time prices began to rise, and it is hard to identify any other disruption that could be given similar credit for the changes in demand or supply, especially in 2003 and 2004. (The 2005 arrival of Hurricanes Katrina and Rita, however, did cause a large temporary drop in U.S. oil production, which in turn lifted prices.) Now, “business as usual” means that the turmoil that the Iraq war let loose will continue, and futures markets are betting that prices will remain high for the next several years.7
We conclude, accordingly, that a significant proportion of the increase in the price of oil resulted from the war. Exactly how much the war increased prices cannot be gauged with precision, so we are putting forward two estimates: a conservative one that assumes only $5 per barrel of the price increase is due to the war; and a more realistic one that assumes the figure is $10. (We have discussed these estimates with oil industry experts; and although they disagree on the relative importance of different factors in the soaring prices, they have all agreed that, if anything, we have underestimated the role of the Iraq war.) Our conservative estimate assumes the duration of these higher oil prices to be seven years; the realistic-moderate estimate eight years.
With these estimates in place, we can calculate the direct cost to the U.S. economy. The United States imports around 5 billion barrels a year,8 which means that a $5 per barrel increase translates into an extra expenditure of $25 billion (a $10 increase would be $50 billion) per year.9 Over the seven years projected in our conservative estimate, that is $175 billion.10 For our $10 realistic-moderate estimate, which assumes the effect will last for eight years, the cost is $400 billion.
As oil prices reach $100 a barrel, and as futures markets continue to predict that high prices will persist years into the future, we feel that $5 to $10 a barrel for just seven or eight years is really too conservative. If even half of the difference between the current price ($95–$100 a barrel) and the price before the war ($25 a barrel) is attributed to the war, then the oil costs of the war today are $35 a barrel—not $10. More generally, attributing just half of the price increase in the post-Iraq world to Iraq over the period for which we have futures markets (2015) brings the direct costs of the oil price increase alone to somewhat in excess of $1.6 trillion.
Higher oil prices mean people have less money to spend on everything else. Since oil prices started their ascent, American families have had to spend about 5 percent more of their income on gasoline and heating than before.11 Even governments—especially those on the state and local level, which must limit spending to revenues—have had to cut back other spending to pay the higher prices of oil imports. Paying Saudi Arabia, Russia, and Venezuela more for oil means that America is spending less on American goods. And, of course, this lower spending will cause the economy to produce less.
Put another way, if we took the estimated $25 billion we have been sending to Saudi Arabia and other oil exporters every year and instead spent it on American goods, output in the United States would be higher. The increased spending on goods made in America would, in turn, have increased wages and profits, the bulk of which would have been spent again in America, further strengthening the domestic economy.
While there is general agreement that spending $25 or $50 billion more on oil every year leads to a reduction in American gross domestic product and incomes, there is some disagreement on the size of the reduction. Economists call the extent to which a change in oil imports translates into a change in total output the oil import multiplier. A multiplier higher than 1 means that a $25 billion fall in demand for American goods generates a decrease in national output larger than that amount. Standard estimates of the multiplier are around 1.5.12 For our conservative estimate, we assume GDP has gone down $25 billion 1.5, or $37.5 billion, for seven years—a total of $187 billion.13
High oil prices dampened our trading partners’ economies just as it dampened ours. As a result, our partners bought less from the United States. Econometric models that attempt to measure these global effects have come up with multipliers that are larger (sometimes by two or three times) than the 1.5 number we used in our conservative scenario. Theoretical analyses focused on long-run global effects also generate much larger multipliers. In order to stay on the cautious side, we use a multiplier of 2 to generate our realistic-moderate estimate.14 We take our GDP reduction of $50 billion per year over eight years, apply the multiplier, and arrive at a total estimated reduction in GDP of $800 billion. We divide that $800 billion impact into three components: the $400 billion direct impact; a $200 billion conventional multiplier effect, through domestic “aggregate demand”; and a $200 billion global multiplier effect, which we refer to as the global general equilibrium effect. (Still more realistically, if we attribute $35 a barrel to the war, then the total oil impact of the war itself is in excess of $3 trillion.)
Of course, increased demand can lead to more production only if the economy has the capacity to produce more. Unfortunately, during most of the period of the war, our economy has been operating well below its potential. Throughout the period there has been sufficient excess capacity so that if consumers, for instance, had increased their demands for American goods—rather than spending money on foreign oil—output could have expanded to meet this increased demand.15
Government Spending
WRITING A WHOPPING yearly check to oil-producing countries has undoubtedly affected the economy, but so too has government spending on the war. Government money spent in Iraq does not stimulate the economy in the way that the same amounts spent at home would. We can ask, what would the country’s output have been if even part of the money that was spent on building military bases in Iraq was spent on building schools in the United States? Such expenditure switching would have led to higher output in both the short run and the long.
Earlier, we described how reduced spending by consumers on U.S.-produced goods as a result of higher oil prices reduced the economy’s output. By the same token, increased government spending, of say $1 billion, increases national output by an amount greater than $1 billion, by a factor which is called the expenditure multiplier.16 But different kinds of expenditures have different multipliers. The multiplier—the bang for the buck, the increase in GDP for each dollar of government spending—is much lower for expenditures on Iraq than for other forms of government expenditure. Consider, for instance, $1,000 spent to hire Nepalese workers to perform services in Iraq. The spending does not directly increase the income of Americans, so we say there is no “first-round” effect on domestic GDP. There is, moreover, little further impact, except to the extent that the Nepalese buy goods made in the United States. By contrast, $1,000 spent on university research in the United States registers a full $1,000 first-round impact and then further high impacts, as those in the university spend their money on goods and services, many of them made in America.
While the multipliers used to measure the effect of spending on GDP differ according to the type of spending, those associated with Iraq spending must be among the lowest. In our realistic-moderate scenario, we assume a small difference of 0.4 between a normal domestic government spending multiplier and an Iraq spending multiplier. Switching just $800 billion (over the fifteen years we project we will be engaged in Iraq)17 to domestic investment would result in increased GDP of $320 billion. This is the number we use in our realistic-moderate estimate.18
Expenditure switching is one methodology used in incidence analysis, in which public sector economists attempt to ascertain the consequence of one policy or another. All of the methodologies are based on the simple premise that spending on Iraq displaces (or as economists put it, “crowds out”), in one way or another, some other kinds of spending. Each methodology tries to trace through the full consequences of this displacement. All of the results yield significant macroeconomic impacts. The expenditure-switching methodology assumes that Iraq war expenditures crowded out government investments. Other methodologies focus on the consequences of war expenditures displacing private investment or consumption.
When the government opts to let the deficit grow instead of reducing government investment, private investment is “crowded out.” In chapter 2, we assumed that government did not reduce other expenditures, at least to a significant degree; the Iraq war simply led to larger deficits. As we explained there, there were convincing reasons to believe that to be the case. The reason we began with the expenditure-switching methodology was that the macroeconomics effects were easiest to see. But the macroeconomic effects of deficits are at least as great. As the United States runs a deficit year after year, the value of the national debt—what the U.S. government owes—increases. By the end of fiscal year 2008, the wars in Afghanistan and Iraq will have led to an increase in U.S. indebtedness in excess of $900 billion. In our realistic-moderate scenario, over the time horizon of this study (through 2017), the increased debt from just the increased military spending (ignoring veterans’ benefits and health care), including the cumulative interest on the debt-financed war borrowing, exceeds $2 trillion.19
The economic analysis of the effects of these increased deficits is broken down into two parts. First, did Americans increase their savings in response to the increased deficits? Some theories (popular among supply-side economists) argue that deficits do not matter, because households just increase savings, with private savings increasing by a dollar for each dollar of increased deficits.20 Even in normal times, the weight of evidence is against these theories—savings only increase to a limited extent.21 In this economic episode, though, savings did not increase to offset the increased deficits at all, but actually fell—to levels not seen since the Great Depression.
That part of increased deficits which is not financed by increased savings either leads to less investment or to more borrowing from abroad. The budget deficits have played a role in the soaring U.S. borrowing from abroad—in 2006, America borrowed $850 billion. The richest country in the world could not live within its means—partly because it was fighting one of history’s most expensive wars. The seriousness of this situation has attracted attention from David Walker, Comptroller General of the United States. He has warned that there are “striking similarities” between America’s current situation and the factors that brought down Rome, including “an over-confident and over-extended military in foreign lands and fiscal irresponsibility by the central government.”22 Even so, standard estimates suggest that half or less of the shortfall is financed abroad. The rest comes out of domestic investment. As the private sector competes for funds with the government, private investment gets crowded out;23 and again, this private domestic investment has a far greater multiplier than the Iraqi war expenditures. As a result, output is lower. This subtracts from the (rather limited) expansionary effects of the Iraq war itself, so much so that the net effect may be not only negative but greater than the adverse effects estimated in our expenditure-switching methodology.24
As important as these effects during the war are the effects in the aftermath of the war. The money spent on Iraq could have been spent on schools, roads, or research. These investments yield high returns. It could also have been spent more productively within the Department of Veterans Affairs, in its teaching and research programs, or in expanding medical facilities such as mental health clinics and TBI treatment facilities. Expenditures on the Iraq war have no benefits of this kind.
As a result of not making these investments, future output will be smaller. Earlier, we considered the short-run effects of growing the deficit as we have done. One of the reasons that there is such concern about growing deficits is that they crowd out private investment. With lower investment, the economy’s potential output in the long run is diminished. If the previously estimated increased indebtedness of $2 trillion crowds out just 60 percent of this amount in private investment,25 then the loss in investment is $1.2 trillion. And if this investment were to yield a return of 7 percent, and if we discount at the “social discount rate” of 1.5 percent, then the value of the forgone output is over $5 trillion; at a 4 percent discount rate, it is over $3 trillion; at a 7 percent discount rate, $1.2 trillion.26
Even if the increased borrowing is totally financed from abroad—so that there is no crowding out of domestic investment—America’s wealth will be lower, by some $2 trillion. If America has to pay just 4.5 percent interest on this indebtedness, and manages to finance the increased interest payments (from then on) by increased taxes, taxes would have to be raised permanently by some $90 billion a year to finance the interest payments. Taxes will have to be raised, other expenditures will have to be crowded out, or the deficit will have to be increased still more—all unpleasant alternatives, each with adverse consequences. If, for instance, public investment expenditures are crowded out, it will mean that future output will be lower—by hundreds of billions, or even trillions, of dollars.27
Similar results are obtained in the “expenditure-switching” methodology. In that case, it is public investment, not private investment, which is crowded out. Assume, for instance, that of the $1.6 trillion of direct military costs of the war that we estimate in our realistic-moderate scenario, one half—$800 billion—was put into investments yielding conservatively a 7 percent real return.28 That would mean that America’s output would be greater by $56 billion a year—forever; every American family would, on average, have an income that was $500 greater, forever.29 At a 7 percent discount rate, this amounts to $800 billion; at a 1.5 percent discount rate, to almost $4 trillion.
Not surprisingly, the different methodologies all yield large results for the total macroeconomic effect, or short run plus long run.30 Simply to be conservative, we use the number $1.1 trillion, which is the same number used by the Joint Economic Committee.31 There is no free lunch—and there are no free wars. In one way or another, today and in the future, we will pay for the war. In this particular war, the administration and Congress have chosen to push the bills onto future administrations, perhaps onto future generations. We believe that the numbers that we have used in our realistic-moderate scenario are almost surely a gross underestimate of the actual costs our economy will be paying.32
Other Macroeconomic Costs
OVER THE PERIOD from March 2003 to October 2007, stock prices have been doing well, and at first blush this seems inconsistent with the worries we have expressed in this chapter. But when you consider that, over the same period of time, wage increases have been moderate and corporate profits have surged, it is clear that we have not seen the kind of increase in stock prices we would expect given those facts. The U.S. economist Robert Wescott estimated in the years immediately following the beginning of the Iraq war that the value of the stock market was some $4 trillion less than would have been predicted on the basis of past performance.33 Uncertainties caused by the war, the resulting turmoil in the Middle East, and soaring oil prices dampened prices from what they “normally” would have been. This decrease in corporate wealth implies that consumption was lower than it otherwise would have been, again weakening the economy.
The Federal Reserve sought, of course, to offset the adverse effects of the war, including those discussed earlier in this chapter. It kept interest rates lower than they otherwise might have been and looked the other way as lending standards were lowered—thereby encouraging households to borrow more—and spend more. Even as interest rates were reaching record lows, Alan Greenspan, then chairman of the Federal Reserve, in effect invited households to pile on the risk as he encouraged them to take on variable rate mortgages.34 The low initial interest rates allowed households to borrow more against their houses, enabling America to consume well beyond its means.
Household savings rates soon went negative for the first time since the Great Depression.35 But it was only a matter of time before interest rates rose. When they did so, hundreds of thousands of Americans who had taken on variable interest mortgages saw their mortgage payments rise—beyond their ability to pay—and they lost their homes.36 This was all predictable—and predicted: after all, interest rates could not stay at these historically unprecedented low rates forever.37 As this book goes to press, the full ramifications of the “subprime” mortgage crisis are still unfolding. Growth is slowing, and the economy is again performing markedly below its potential.
The Iraq war and especially the high oil prices have contributed to a weaker American economy; but these weaknesses have not been as apparent as they otherwise might because of low interest rates and lax lending standards.38 If not for these policies, we would have seen more fully the adverse macroeconomic effects of the high oil prices, high deficits, and expenditure switching toward Iraq.39 Output would have been lower and the depressing effects more obvious. We as a country have been living off of borrowed money and borrowed time. In earlier chapters, we showed how, by deficit financing, we have not paid the full financial costs of the war during the past five years. In this chapter, we have shown that neither did we pay the full macroeconomic costs of the Iraq war. We will be paying those costs in the coming years. Just as the country paid a heavy price for President Lyndon B. Johnson’s guns-and-butter policies during the Vietnam War long after the war was over—in the form of inflation in the 1970s—so it is paying a heavy price for America’s guns-and-butter policies today, and will be doing so for years to come.40
In our estimates, we have not included the long-run costs of the war’s impact on the stock market or the “legacy of household debt” resulting from U.S. policies in this decade.41 There is, however, little doubt that had the economy been stronger as a result of lower oil prices and patterns of expenditures that stimulated the economy more, the Fed would not have lowered interest rates as much and gone to such extremes to encourage debt-financed consumption. And with a smaller mountain of debt, the American economy would have been in a better position to face the challenges of the future.
IN TABLE 5.1 (at chapter 5), we summarize the quantifiable macroeconomic costs. In the “best case” estimate, simply to be extremely conservative, we have excluded the macroeconomic consequences of expenditure switching, or the increased deficits, the global feedbacks, the supply-side effects (not just from reduced investment, but also from a labor force diminished by those killed and disabled, and those caring for the disabled), and the long-term growth impacts. These are, however, real costs to the economy. We have included these costs in our realistic-moderate estimates. But even here, we have excluded large costs that are hard to quantify: how greater global uncertainty dampened investment, in turn further reducing demand and output; the supply-side effects of resources (including labor) being diverted to fight the war; the knock-on effects on stock market prices; and the resulting lower aggregate demand.
The Iraq war has exacerbated international tensions. The war, whatever its initial aims, has not increased stability and security in the Middle East. It has not reduced the threat of terrorism. On the contrary, the threat seems to have increased, as evidenced by the number of recent terrorism incidents.42 Disruptions at airports have become worse, not better. The bombings and attempted bombings in Bali, Spain, and the United Kingdom in recent years show again that the impact reaches around the world. Insecurity is, of course, bad for the economy—businesses dislike risk and work hard to keep it under control. Risk is bad for investment and growth.
All recent presidents have emphasized the virtues of international trade and its stimulating effect on the economy. But new barriers brought about by the increasing global tensions resulting from the Iraq war impede the flow of goods and services and people across borders. Some of the new trade impediments arise from the war on terror, but the Iraq war has worsened matters.
These impediments are not just an “inconvenience.” Globalization has brought enormous benefits to the world. It has meant the closer integration of the countries of the world as goods, services, and labor move more freely across borders, largely as a result of lower transportation costs and communication costs, but also because of the reduction of man-made barriers.43 We now have a new set of impediments to cross-border movements, offsetting many of the earlier gains, and the costs to America, and to our economy, may be particularly significant. America has reaped the lion’s share of the gains from globalization, well out of proportion to the size of its economy. And just as America has gained so much from globalization, it stands to lose much.
The war has contributed to changing perspectives, which we describe at greater length in the next chapter. Much of the world has always had mixed views about the United States, from admiration for its successes and its democracy, to envy and resentment for the perceived abuses of its powers. Today, the mix of attitudes has changed, with a far greater weight toward resentment and anger for the United States’ unilateralism. Guantánamo Bay and Abu Ghraib have altered admiration for its democracy and its strong advocacy of human rights: the focus is now on its hypocrisy and its double standards.
These changes in perspective have their economic consequences. Large numbers of wealthy people in the Middle East—where the oil money and inequality put individual wealth in the billions—have shifted banking from America to elsewhere. Singapore saw the opportunity, and grasped it. Others, like Dubai, are trying to follow suit. American firms, especially those that have become icons, like McDonald’s and Coca-Cola, may also suffer, not so much from explicit boycotts as from a broader sense of dislike of all things American. Some American firms have been especially hurt badly, but they have also had a hard-to-quantify effect on the macroeconomy.
Lastly, we have not included in our estimates, especially in our conservative estimate, the full effects of the soaring national deficit and some of what now appear so clearly misconceived monetary policy responses to the weak economy—weaknesses for which the war was at least partly responsible.
Table 5.1 The Running Total: Adding the Macroeconomic Costs—Iraq and Afghanistan
| Cost in billions | Best Case | Realistic-Moderate |
| Macroeconomic Costs | ||
| Oil Price Impact | $187 | $800 |
| Budgetary Impact | $0 | $1,100 |
| Subtotal Macroeconomic Costs | $187 | $1,900 |
| Plus Budgetary and Social Economic Costs | ||
| Total Operations to Date (spent to date) | $646 | $646 |
| Future Operations (future operations only) | $521 | $913 |
| Future Veterans’ Costs (Veterans Medical + Veterans Disability + Veterans Social Security) | $422 | $717 |
| Other Military Costs/Adjustments (Hidden defense + future defense reset + demobilization, less no-fly zone savings) | $132 | $404 |
| Total Budgetary Costs | $1,721 | $2,680 |
| Social Costs Total | $295 | $415 |
| Total Budgetary and Social Costs | $2,016 | $3,095 |
| Total Budgetary, Social, and Macroeconomic Costs (without interest) | $2,203 | $4,995 |
The Full Tally
BY ADDING THESE macroeconomic costs to the costs calculated in previous chapters, we can get a full tally of the costs of the war. The numbers are staggering. In the realistic-moderate scenario—the numbers that we believe (conservatively) best capture the costs of the Iraq venture, even without counting interest—the total for Iraq alone is more than $4 trillion; including Afghanistan, it increases to $5 trillion. Even in the best case scenario, where we have excluded most of the macroeconomic costs and have assumed a rosy scenario for the wind-down of the war, the cost of the Iraq war reaches $1.8 trillion, and the cost of the two conflicts together reaches close to $2.2 trillion without including interest.
But these are only the costs to the American economy. Our war on Iraq has imposed costs on others—numbers that themselves are in the trillions. We turn to these in the next chapter.