March 26 , 2003

When economists are faced with uncertainty, such as in the current conflict with Iraq, they sometimes use a device called a decision tree. 

The branches of this tree are the possible outcomes that might happen.  However, they do not start from the end, whether we win or lose, but from the beginning. 

To begin to build the tree you must ask what are the important economic issues.  There certainly are many, and any overlooked factor will alter the results.  However, I have concentrated on four:

How long and how costly will the military action take?  How much rebuilding, how long, and how costly will the occupation be? How long and after how much aid will the Iraqi economy be able to provide enough value to sustain its people? And what will happen to Iraqi oil production?

On the military issues, I must defer to the generals and what they have revealed to the administration.  Of course, the issue would be more complex if we were facing another coalition.  However, the assumption that most of the Iraqi troops will not fight probably is valid.  They did not provide much resistance last time. 

Even on this issue, casualties clearly depend upon whether weapons of mass destruction will be used against our troops.  Even in this dire condition, however, we have capabilities to repel and overcome such activity. 

Thus, I will assume that the one month horizon and the $95 billion price tag for financing that activity which has been mentioned in Congress is close to the mark.  Of course, much of that financing will be to replace equipment exhausted in the war effort and will impact the economy a year hence. 

The rebuilding and occupation costs are more interesting.  In order to get estimates, we must resolve one set of uncertainties.  Will the people be hostile or friendly?  If hostile, how many troops are needed for how long to subjugate them and find an amenable government?  If friendly, how long will it take to help develop a government that recognizes the diversity of Shi'ite, Sunni, and Kurd and is acceptable to all?

Some people have estimated that as much as $25 billion of resources will be needed the first year even if the Iraqi response is friendly.  (Suicide attacks almost certainly would be expected even if the Iraqi citizens opposed them.)  An unfriendly occupation has been estimated as more than $75 billion per year and almost certainly would need to occur for a much longer time. 

The issue of return to market based normalcy clearly depends upon the magnitude of destruction of goods and people.  The question of hostility returns, for the Iraqi casualties will depend upon how strongly they resist.  A defeated country might have its economy run by the occupation for a long period of time.  A liberated country will only need to have the destruction repaired and the lost production replaced before returning to some degree of sustainable activity. 

I am hopeful that we can make the more favorable assumption.  But even a month's replaced production would cost about $5 billion.  The destruction and casualties probably would require at least another month's worth of production to be available.  Thus, I would assume about $10 billion of aid will be needed before any return to normalcy in a liberated country can be accomplished. 

Finally, oil must be considered.  About two thirds of exports and production come from the Southern oil fields.  They can be occupied in a few short days.  This also would liberate the oil shipping port.  In the week before hostilities, tanker shipping stopped because of insurance worries.  However, the pipelines through Turkey continued to operate. 

If the oil fields are not destroyed, the port could begin receiving tankers again in a few short weeks.  The world would lose about 20 days of Iraqi production (about 30 million total barrels of oil) but that would not do much to tighten supplies as spring arrives. 

If the fields are destroyed, no production will be available for at least 4 months.  Then the return to capacity production could be delayed by more than another year.  (The last Kuwaiti oil fire was contained almost 18 months after the Iraqis set fire to the fields).  In that scenario, production loss could total as much as a half billion barrels before normal activity returns.

Because of the low inventory I discussed in a previous column, that loss of oil could temporarily push oil prices to $45 per barrel.  A global recession would be possible.  Even then, a return to more normal conditions would be apparent by the second half of 2004. 

At this time, I am looking at all the possible outcomes and concluding that our deficit will rise to $450 billion in the next twelve months because of the war (about $150 billion more than otherwise would be the case).  However, those estimates go up if we are not liberating and if the oil fields are burning.


mbar.jpg (9380 bytes)