Don't Expect a Peace Dividend After Iraq

The fog of almost-war seems to be obscuring the vision of many economy-watchers. The dollar’s decline is laid at the door of the costs of the coming war and the rebuilding of Iraq. Weak retail sales in February are said to be due to consumers’ concerns about terror attacks. Faltering business investment and depressed share prices, we are told, result from uncertainty as to the economic impact of war.

Would it were so, for then a swift conclusion of the war would put things right. But there are more enduring forces at work. For one thing, the unseating of Saddam will not bring an end to the geopolitical problems the world faces. Thousands of terrorists, intent on destroying America, will remain at large. It is difficult to persuade Americans to stock up both on duct tape and the latest consumer goodies. North Korea will remain to be dealt with, and by the United States acting alone, since other nations say this is a U.S., not a UN problem. In short, eliminating uncertainty associated with Iraq will not remove other geopolitical uncertainties that are said to be such a drag on the economy.

Then there is the dollar. Despite a surge in the sale of made-in-the-USA goods in January, America rang up its second largest trade deficit. In the past, the world’s investors were willing to make up for the fact that America buys more from foreigners than it sells to them by cycling the dollars they earned into American assets. In technical terms, the deficit in America’s trade account was offset by a surplus in the capital account.

But the now-shaky stock market is less attractive to overseas investors than when it was booming in the 1990s, and the sorry financial condition of many European firms has dried up their ability and desire to acquire U.S. companies: Vivendi and its ilk are no longer trawling the American economy for companies to buy. All of this means that the demand for dollars is down just when American consumers are flooding the world with dollars to pay for everything from cars to tee-shirts. It doesn’t take an economist to figure out that when the supply of something is increasing as the demand for it drops, the price of that something will go down.

Which is what is happening to the dollar. And will continue to happen, war or no war, according to most experts. Some see the euro, now worth close to $1.10, rising to $1.20, making Europe’s wares more expensive in America, and American products cheaper in Europe. That will help U.S. exporters and cut into the trade deficit, but be devastating for German and other euro-area manufacturers who in the last two months for which we have data ran an average monthly $8.3 billion trade surplus with America. With demand in their home markets stagnant-to-shrinking, a loss of business in America might well force the EU into a serious business downturn, which won’t upset Americans outraged at Franco-German antics at the UN.

But the reduction in the U.S. trade deficit with Europe is not likely to be repeated with China, which now accounts for the largest portion of the deficit. Because China has tied its currency to the dollar, the cheaper dollar can’t affect the U.S.-China trade balance by making Chinese goods more expensive for Americans, and U.S. goods cheaper in China.

The situation is almost the same with Japan. Japanese authorities are determined not to allow their goods to become more expensive in America, and so have been intervening in foreign exchange markets to prevent the yen from rising in value against the dollar.

All of this means that the dollar will likely continue to decline, with Euroland bearing the greatest share of the consequent adjustment in trade patterns. Note: none of this has very much to do with the coming war.

Nor does still another on-going adjustment, the post-bubble fall in share prices. The successful conclusion of a war won’t change two hard economic facts-of-life. The first is that in many industries the overhang of excess capacity that is deterring investment in new facilities has yet to be completely sopped up. The second is that profits will be hard to come by. Competition for consumers’ dollars is fierce, making it somewhere between difficult and impossible for businesses to raise prices. With health care costs rising, the need to shore up pension funds, payrolls already pared, and price increases out of the question, shareholders are right to take a grim view of the prospects for equity markets. The easing of oil prices will help, and there will be occasional upward spurts, but even an overwhelming victory, topped off by the capture of bin Laden, can’t change the fundamental forces Buffeting earnings (pun intended).

Which probably means that consumers won’t find any cheer from looking at their pension accounts and balance sheets in a post-Saddam world. And with every worker able to produce more as productivity rises, they are unlikely to see the jobs market improve very much. But they will continue to use the increased value of their homes as a source of funds by refinancing their mortgages, either to reduce monthly interest payments or to extract some of the equity that has built up in those homes. “Refi” financing in the first quarter of the year is running at an annual rate of $240 billion, compared with $157 in 2002, according to consultants at International Strategy & Investment (ISI).

All of these factors will continue in play after Saddam. But so will others that will help the economy to move gradually to a 3+ percent annual growth rate, most notably rising real incomes in response to modest wage increases and stable prices, further cuts in interest rates, and a loosening of fiscal policy as tax cuts combine with soaring spending to pump money into the economy. Like the minuses, these pluses have nothing to do with war. Their effect will be felt long after Saddam is no longer front-page news.

This article appeared in London’s Sunday Times on March 16, 2003, and is reprinted with permission.