The Economic Costs of a War in Iraq
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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
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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
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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.
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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
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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
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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”
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Some Useful Facts About the Cost of Peace
Only Nordhaus tries to estimate the costs after the war is over.
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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”
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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”
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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”
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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”
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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”
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http://www.economicscenarios.com
The Modeling Framework Used
The G-Cubed model
www.gcubed.com
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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
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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
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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
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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
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Agents and Markets
AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money
Bond Equity Foreign Exchange
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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
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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
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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
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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
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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)
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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
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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.
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Summary
Critical question is what the baseline would actually be if there wasn’t a war?
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