Don’t Blame the War for the Economy

[Woodmonkey]

Don’t Blame the War for the Economy

THE war in Iraq and the poor state of the economy will probably be the deciding factors in November’s presidential election. Many voters view them as cause and effect. In fact, they are two very different messes.

The economic case for linking the two is that war has reduced the global supply of oil and pushed its price over $100 a barrel, draining consumers’ pocketbooks and adding to inflation. Flush with cash, this argument goes, the oil-producing countries have driven down global interest rates and encouraged over-borrowing in the United States. Meanwhile, Washington has borrowed money to pay for the war, adding to the budget deficit and leaving it with few options to stimulate the economy. The Federal Reserve kept interest rates too low, and for too long, as a way of trying to encourage growth.

I am no fan of the war in Iraq, but it simply has not been a major contributor to the financial crisis and the impending recession. The high price of oil is largely the result of strong demand, notably from China and India, pressing against a limited supply. The global oil supply is growing more slowly than it could because of politics and policies in many places — Russia, Mexico, Nigeria and Venezuela as well as the Middle East. Fears that the turmoil in Iraq might spread have probably given a boost to oil prices, but nowhere near enough to account for the huge price surge.

Absent the war, Iraqi oil production under Saddam Hussein might have been somewhat higher, but not by enough to affect the American economy. Iraqi oil production has been very volatile and has experienced a downward trend since the late 1970s, despite its vast potential.

One sign that the war in Iraq is not the primary cause of the rise in oil prices is that metals and commodity prices across the board have risen sharply. Surging demand in Asia, coupled with supply that grows only slowly when prices increase, is the main story not only for oil, but for commodities broadly. The sinking value of the dollar has also played a role.

Back home, our economic fumbles can be primarily tied to the mortgage mess and the big slump in residential construction. Some borrowers lied on their mortgage applications; some originators misrepresented the terms of the loans; financial institutions were making so much money they underestimated the risks they were taking. Investment banks and hedge funds were borrowing at 30-day or even 1-day maturity to finance holdings of risky longer-term assets. The credit-rating agencies failed to assess real risks.

And, yes, the Fed and other regulators could and should have done more starting in 2005 to counteract the lowering of mortgage-lending standards and to rein in the banks. But I do not blame the Fed for interest-rate policies that sought to navigate the difficult path of encouraging economic growth while containing inflation. Rather, kudos to the Fed for its recent appropriate and aggressive response to the financial crisis.

Is government borrowing to blame? Chronic budget deficits are harmful because they increase interest rates, crowd out domestic investment and increase the trade deficit. So, in principle, budget deficits should actually have curbed the housing boom, not fueled it.

In practice, budget deficits did not result in high interest rates because of the huge flows of foreign capital into the American economy. The lack of discipline in the federal budget in recent years is deplorable and we will pay for that, especially as we face the costs of an aging population. The failure to pay for the war is part of this policy mistake, but only a part and not a big cause of today’s problems.

Did borrowing to pay for the war prevent the use of fiscal policy to offset economic weakness? Hardly. A sizable and timely economic stimulus package recently soared through Congress and was heartily endorsed by the White House.

Are the oil-rich countries to blame for sending us so much money, tempting Americans to over-borrow? Well, that seems akin to blaming your favorite restaurant for making you gain weight. The availability of money from around the world did help finance our housing boom. But the bad mortgage-lending and borrowing practices were our own. After all, that flow of capital into the United States has also helped finance American business investment and job creation.

The war in Iraq has been much more costly than anyone expected, both in lives and money, and it is tempting to wrap it into a single package with our current economic crisis and the policy mistakes that contributed to it. But muddling the messes does not help. Let’s judge the war on its own merits, and concentrate on the real causes of the financial crisis. It’s the only way to avoid making the same mistakes again.

The Source